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participants were employed by Presidio, The returns for 1999 and 2000 re-
not Morley. Regs. Sec. 1.83-3(c)(3) ported that the Morley ESOP owned
When Morley was formed, Larson, 100% of Morley and that all Morley
Pfaff, and Makov each signed an em- provides several income for the 1999 and 2000 tax years
ployment agreement with Morley that factors that should was allocated to the Morley ESOP.
included a section titled “restricted stock Morley took the position that although
agreement.” This section stated that each be considered in Larson, Pfaff, and Makov held 95% of
determining whether
man’s respective grantor trust would re- the shares of Morley, the Morley ESOP
ceive shares of common stock of Morley stock restrictions will was properly treated as the sole owner of
and ownership of that stock would be Morley under Regs. Sec. 1.1361-1(b)(3),
be enforced.
governed by restricted stock agreements. which provides that “stock that is issued
Each restricted stock agreement in connection with the performance
provided that the shareholder of Morley of services … and that is substantially
stock could not assign, transfer, mort- BLIPS transactions, wrapped up existing nonvested … is not treated as outstand-
gage, pledge, encumber, hypothecate, or deals, and began laying off employees. ing stock of the corporation, and the
otherwise dispose of any of the Morley As a result of the notice, Makov’s holder of that stock is not treated as a
shares without consent of 100% of the work for Presidio slowed to such an shareholder solely by reason of hold-
Morley shareholders. If the employee extent that Larson believed there was ing the stock.” Because the stock of
shareholder was terminated with or no reason to provide an incentive for Larson, Pfaff, and Makov was subject
without cause before Aug. 10, 2002, Makov to stay. On Jan. 2, 2001, Larson, to a substantial risk of forfeiture, it was
he was deemed to have offered to sell Pfaff, and Makov released the forfeiture nonvested and therefore should not be
all of his shares of Morley stock. The restrictions on their shares of Morley treated as outstanding stock of Morley.
shareholders could end the agreement stock. They did not release the restric- This left the Morley ESOP as Morley’s
by written consent to termination by tions as trustees of the Morley ESOP, sole shareholder.
100% of the shareholders of outstand- nor did they resign their positions as Larson also took this position on his
ing voting common stock. If Morley trustees of the Morley ESOP before individual tax returns for 1999 and 2000.
received a written notice of consent to terminating their stock restrictions. He did not report any pro rata share
termination, it was required to promptly The provisions regarding the written of Morley’s 1999 or 2000 passthrough
deliver copies of the written notice to all consent to the termination of the Mor- income on his income tax returns.
its shareholders. ley stock forfeiture restrictions in the The IRS, however, did not agree that
The alleged purpose of the agree- restricted stock agreements were not fol- Larson was not taxable on any of Mor-
ments was to retain Makov, who had a lowed. Presidio employees were unaware ley’s earnings.
history of job-hopping. Makov did not that Larson had released the stock for- After examining Larson’s returns for
want to be singled out in this respect, so feiture restrictions, and they did not vote 1999 through 2001, the IRS issued a
Larson and Pfaff also signed agreements. to release those restrictions. Larson did notice of deficiency to Larson for those
However, Larson was aware that if the not retain outside counsel for the ESOP years. In it, the IRS determined that
stock forfeiture provisions in the re- to protect its interest. At trial, Larson Larson was required to include his dis-
stricted stock agreements were respected, testified that he did not know he had tributive share of Morley’s income in his
he, Pfaff, and Makov would be able to fiduciary obligations as an ESOP trustee gross income and that he had deficien-
defer receiving the income that would to the Morley ESOP and its participants cies of $6.9 million for 1999, $2.4 mil-
otherwise be passed through to them and he was unaware that fiduciaries lion for 2000, and $1.3 million for 2001.
by Morley. should not engage in self-dealing. Larson challenged the IRS determi-
The good times for Presidio, unfor- On its Forms 1120-S, U.S. Income nations in Tax Court, where he argued
tunately, did not last long. In Notice Tax Return for an S Corporation, for the that the Morley stock he was issued
2000-44, the IRS advised that purported 1999, 2000, and 2001 tax years, Morley was subject to a substantial risk of
losses from tax shelters such as BLIPS reported income and expenses of Presi- forfeiture under Sec. 83 because of the
were not bona fide and did not reflect dio because it was a disregarded entity. employment-related forfeiture restric-
actual economic consequences and that Morley’s income consisted of BLIPS tions in the restricted stock agreement.
penalties might be imposed on the pro- fees paid to Presidio, and its expenses Therefore, the stock did not vest until
moters of these transactions. After that, included the salary expenses of the six those restrictions were cleared on Jan. 2,
Larson, Pfaff, and Makov ceased selling Presidio employees. 2001. The IRS countered that Larson’s

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