In the

United States Court of Appeals

For the Seventh Circuit

No. 08-2173

UNITED STATES OF AMERICA,

Plaintiff-Appellee,

v.

MICHAEL J. and CYNTHIA T. FLETCHER,

Defendants-Appellants.

Appeal from the United States District Court

for the Northern District of Illinois, Eastern Division.

No. 06 C 6056—Ronald A. Guzmán, Judge.

ARGUED OCTOBER 30, 2008—DECIDED APRIL 10, 2009

Before EASTERBROOK, Chief Judge, and RIPPLE and

TINDER, Circuit Judges.

EASTERBROOK, Chief Judge. Ernst & Young spun off its

information-technology consulting group in 2000. Cap

Gemini, S.A., a French corporation, bought this business

and became Cap Gemini Ernst & Young, a multinational

firm. Today it is known as Capgemini, and we use that

name for the firm after the 2000 acquisition.
2 No. 08-2173

Consulting partners of Ernst & Young received shares

in Capgemini in exchange for their partnership interests

in Ernst & Young. This was not a like-kind exchange, so

it was a taxable event for the partners. Because Ernst &

Young and its partners expected shares in the new business to appreciate, they wanted all of the income to be

recognized in 2000. That way any appreciation would be

taxed as a capital gain. But Cap Gemini wanted to

ensure the partners’ loyalty to the new business; a consulting group depends on its staff, and if they left after

taking the stock the business might be crippled. Transferring the shares in installments might address these subjects but also would make the transfers look like ordinary

income—and, if the shares appreciated in the meantime, the partners would receive fewer. Ernst & Young

and Cap Gemini decided that a transfer of all of the

shares in 2000, subject to what amounted to an escrow,

would preserve the tax benefits while serving business

objectives. So the shares received in the transaction were

restricted for almost five years: if a partner quit, was

fired for cause, or went into competition with the new

business, some or all of the shares could be forfeited.

Ernst & Young, Cap Gemini, and the partners agreed by

contract that they would report the transaction as a

partnership-for-shares swap in 2000, fully taxable in that

year. The agreed-on characterization allowed Capgemini

to take depreciation deductions, see 26 U.S.C. §197,

starting in 2000, and ensured consistent tax treatment of

all parties. The Commissioner of Internal Revenue

might have challenged the parties’ characterization, see

26 U.S.C. §269, but decided to accept it. Approximately
No. 08-2173 3

25% of the shares were sold in 2000 to generate cash that

the partners used to pay their taxes; the remainder of the

shares were held by Merrill Lynch subject to instructions

from Capgemini until restrictions lapsed. Each ex-partner

had a separate account for this purpose.

Cynthia Fletcher, one of Ernst & Young’s consulting

partners, voted for the transaction, signed the contract,

moved to Capgemini, and received 16,500 shares in that

business as payment for her partnership interest. The

market value of these shares on the day the sale closed

was about $2.5 million. Only 12,375 shares were

deposited in the restricted account; the rest were sold

for $653,756, which was distributed to Fletcher to cover

taxes. In February 2001 Capgemini sent Fletcher a Form

1099-B reflecting that she had received $2,478,655 in

stock, taxable at ordinary-income rates (save for some

$91,000 attributable to §751 property), from the sale of

her partnership interest. She and her husband Michael

(they filed a joint return) reported this income as received in 2000, just as her contract with Capgemini required. The couple’s gross income for 2000 was reported as

$3,733,180, on which they paid $972,121 in income tax.

Had the market price of stock in Capgemini risen, as

the parties anticipated, that would have been a good

outcome for Fletcher and the other ex-partners. But

although Capgemini traded above €300 a share early in

2001, by 2003 it was below €50, where it has remained.

(So far in 2009 it has traded for about €25.) This made the

deal look bad in retrospect; the partners would have

been better off had distribution of the stock been deferred.
4 No. 08-2173

Fletcher quit in 2003. Although she left before the five

years required by the contract, Capgemini waived its

rights and directed Merrill Lynch to lift all restrictions

on the stock in her account. Fletcher then filed an

amended tax return for 2000. She now took the position

that only the $653,756 distributed from the account was

income in 2000. On her new view of matters, the rest of the

income was not received until 2003, and the amount was

much reduced in light of the lower market price of

Capgemini shares in 2003. Apparently without checking

how other taxpayers affected by the 2000 transaction

had been treated, the Internal Revenue Service paid

Fletcher a refund of about $387,000 plus interest. Contending that this refund had been mistaken, the United

States filed this suit to get the money back. Similar litigation is pending in many other district courts—some suits

by the United States, some by ex-partners who want

refunds.

The IRS’s principal argument is that Fletcher and the

other ex-partners are bound by their own characterization of the transaction as one in which all shares

were received in 2000. Having adopted this characterization with the goal of minimizing taxes, they must

adhere to it even though market movements have made

it disadvantageous, the United States insists. It relies

principally on CIR v. Danielson, 378 F.2d 771 (3d Cir. 1967),

which held just this, and on a Danielson-like remark in

Comdisco, Inc. v. United States, 756 F.2d 569, 577 (7th Cir.

1985): “[A] taxpayer generally may not disavow the

form of a deal.” Some courts have allowed taxpayers to

disregard their own forms when “strong proof” shows that
No. 08-2173 5

the economic reality was something else. See, e.g., Leslie S.

Ray Insurance Agency, Inc. v. United States, 463 F.2d 210, 212

(1st Cir. 1972); Ullman v. CIR, 264 F.2d 305, 308 (2d Cir.

1959). We used the “strong proof” formulation in Kreider

v. CIR, 762 F.2d 580, 586–87 (7th Cir. 1985), though without mentioning either Comdisco or Danielson. The district

court concluded that it was unnecessary to choose

between these approaches (or their variants), because

on any standard the parties set out to ensure that all

income was recognized in 2000—and although the Commissioner has some power to recharacterize transactions

so that they match economic substance, taxpayers can’t

look through the forms they chose themselves in order

to improve their tax treatment with the benefit of hindsight. See Gregory v. Helvering, 293 U.S. 465 (1935). See

also Joseph Bankman, The Economic Substance Doctrine, 74

S. Cal. L. Rev. 5 (2000); Saul Levmore, Recharacterizations

and the Nature of Theory in Corporate Tax Law, 136 U. Pa. L.

Rev. 1019 (1988); David A. Weisbach, Formalism in the Tax

Law, 66 U. Chi. L. Rev. 860 (1999). So the district court

entered summary judgment for the United States and

ordered Fletcher to repay the refund. 2008 U.S. Dist. LEXIS

3555 (N.D. Ill. Jan. 15, 2008).

Fletcher argues that she didn’t “really” agree to the

structure that Ernst & Young and Cap Gemini (and most of

her partners) wanted in 2000. If she had voted no and

refused to sign, she maintains, she would have been

excluded from the economic benefits and might have

been fired. If this is so, then she had a difficult choice to

make; it does not relieve her of the choice’s consequences.

Hard choices may be gut-wrenching, but they are choices
6 No. 08-2173

nonetheless. Even naïve people baffled by the fine print

in contracts are held to their terms; a sophisticated business consultant who agrees to a multi-million-dollar

transaction is not entitled to demand the deal’s benefits

while avoiding its detriments. The argument that

Fletcher can avoid the terms as a matter of contract law

is frivolous. All that matters now are the tax consequences

of the contracts she signed.

That a transaction’s form determines taxation is (or at

least should be) common ground among the parties. If

private parties structure their transaction as a sale of

assets, they can’t later treat it for tax purposes as if it

had been a merger. CIR v. National Alfalfa Dehydrating &

Milling Co., 417 U.S. 134 (1974). Cf. Landreth Timber Co. v.

Landreth, 471 U.S. 681 (1985) (same principle in

securities law). Parties who structure their transaction as

a sale and leaseback can’t treat it as a mortgage loan for

tax purposes—though the Commissioner may be able

to recharacterize it so that the tax treatment matches its

economic substance. See Frank Lyon Co. v. United States,

435 U.S. 561 (1978). If Cap Gemini transfers stock in 2000,

cash-basis taxpayers such as Fletcher can’t treat the

income as received in 2001 or 2003, even though it would

have been child’s play to do the deal so that the

income was received in those years.

The United States treats Fletcher as if she were trying

to report an asset sale as a merger, or income received

in 2000 as if it had been received in 2003. This is not,

however, the sort of argument that Fletcher advances.

She does not want to proceed as if the deal had different
No. 08-2173 7

terms. She argues instead that the deal’s actual terms

have tax consequences different from those that her

contracts with Ernst & Young and Cap Gemini required

her to report in 2000. An example makes this clear. Suppose that Cap Gemini had deposited stock in the Merrill

Lynch accounts in annual installments from 2000

through 2004, and that the parties had agreed to report

that all income from the partnership-for-stock sale had

been received in 2000 because the closing occurred that

year. That agreement would not affect taxation. Private

parties can contract about when income is received, to

be sure, but the tax rules about realization and recognition are extrinsic. People determine what transactions to

engage in; federal law then specifies how much tax is

due. Because Fletcher does not try to recharacterize the

transaction, doctrines that limit or foreclose taxpayers’

ability to take such a step are beside the point.

What, then, are the tax consequences of the parties’

chosen form? Cap Gemini deposited all of the shares into

individual accounts in 2000; from its perspective, the

consideration had been paid in full. But the accounts were

restricted. Ex-partners received 25% in cash that year,

while the rest of the stock could be reached only as time

passed. From the moment of the deposit in 2000, however,

the ex-partners bore the economic risk: If the stock rose

in the market, the ex-partners stood to reap the whole

gain, and if the stock fell the ex-partners would bear the

whole loss. This makes them the beneficial owners as

of 2000, the IRS contends. For her part, Fletcher stresses

the restrictions and maintains that until she could do with

the stock as she pleased—in other words sell it, not just
8 No. 08-2173

watch nervously as it rose or fell—it did not count as

income.

The Commissioner has the better of this argument, as

can be seen by considering the tax consequences of depositing cash into a blocked account. Suppose that an

inventor sells his patent in 2000 for $2.5 million, all paid

immediately—but by contract the inventor agrees that

$2 million will be put into a trust that will not be distributed until 2005. From the buyer’s perspective, the full

consideration is paid in 2000. And from the inventor’s, the

full consideration is received in 2000. The inventor

agrees to defer consumption for five years, perhaps as a

spendthrift precaution, but a taxpayer’s willingness to

defer consumption does not defer taxation—for the tax

falls on income rather than consumption. See 26 U.S.C.

§451(a) (any item of gross income is taxed in the year

received). Income is “received” not only when paid in

hand but also when the economic value is within the

taxpayer’s control; this is known as constructive receipt.

26 C.F.R. §1.451–2. It is why a person who earns income

can’t avoid tax by telling his employer to send a paycheck to his college, or his son, rather than to his bank.

Authority to direct the disposition of income is constructive receipt. In our example, the inventor could have

chosen to receive the $2.5 million in cash. Agreement

with the buyer that $2 million would be sent to a trustee

and held for five years does not avoid the fact that the

inventor had the power to direct what became of the

money; that’s what the contract was about. And much

the same can be said for Fletcher: She agreed by

contract that 75% of the consideration would be held in
No. 08-2173 9

a restricted account for up to five years, but her willingness to accept restrictions and defer consumption does

not eliminate constructive receipt in 2000.

Imagine that, instead of providing for payment in stock,

the contract among Ernst & Young, Cap Gemini, and the

partners had called for some cash in 2000 plus a zerocoupon bond, handed over to the ex-partner in 2000

and maturing in 2005. That bond is income in 2000, even

to a cash-basis taxpayer, because it is property that can be

sold in the market. Suppose that the partners also made

side agreements with Capgemini not to sell their bonds

for five years. (Equivalently, the ex-partners might have

accepted unregistered securities, with a side agreement

that Capgemini would register them and thus facilitate

sale in 2005 if the ex-partner were still employed.) An

agreement not to sell would not change the nature of the

bonds as property, and thus income, received in 2000. See

Racine v. CIR, 493 F.3d 777 (7th Cir. 2007) (a transaction

involving stock options, but that’s not a material difference). But deferral of the right to sell would reduce the

value of the bonds, and hence the amount of income,

because an illiquid asset is worth less than a liquid one.

Whether the security is handed over to the ex-partner

with a legend reflecting the limits on sale, or instead is

handed to an intermediary such as Merrill Lynch with

instructions to enforce contractual restrictions on the

sale of an un-legended security, should not matter for

tax purposes. The actual structure of the 2000 transaction

is much like our hypothetical zero-coupon bond, though

because the restrictions on sale were lifted year by year
10 No. 08-2173

it is more like one bond maturing in one year, another

bond maturing in two years, and so on through five years.

Three aspects of the contracts that Fletcher signed are

important to this understanding. First, it matters that

Fletcher and the other ex-partners stood to receive the

entire market gain, and to bear all loss, from the moment

the transaction closed in 2000. That feature of the deal

shows that the stock was in her constructive possession

in 2000. Second, it matters that Fletcher agreed to

postpone her unrestricted access to the stock. This is

why the deal looks like our inventor hypothetical. Third,

it matters that Fletcher agreed to the amount of the discount. The contracts among Ernst & Young, Cap Gemini,

and the partners specified that the restrictions would be

treated as reducing the value of the stock to 95% of its

market price on the closing date. (This reflects not only

illiquidity but also the risk that Capgemini would use

its power over the account in an unauthorized way, or

that Merrill Lynch might fail in its duty as a custodian.)

An ex-partner would be hard pressed in light of this

agreement to argue that the discount should be 10% or

20%; Fletcher does not try. She insists instead that nothing

counts as income in 2000 other than what was actually

put in her hands in cash. And that position is incompatible with the examples we have given.

One more complication. The consulting partners agreed

to give back some of the stock if they quit early and went

into competition with Capgemini. If the parties’ goal of

encouraging the ex-partners to remain with Capgemini

had been accomplished by giving the partners immedi-
No. 08-2173 11

ate access to the stock but requiring them to grant

Capgemini a security interest in their homes, so that

repayment would be assured, then all of the income

would be treated as received in 2000. If instead Capgemini

had doled out the stock in installments (say, 50% in

2000 and 50% if the ex-partner remained on its payroll in

2005), then only 50% would be taxable in 2000. The

actual transaction was somewhere in between: 100% of the

stock was transferred to Merrill Lynch in 2000 and the

custodian was to hold it until conditions (such as not

competing) had been satisfied. For reasons we have

covered—principally the fact that the ex-partners

received the entire economic gain and loss from changes

in the price of the securities from 2000 forward—the

transaction looks more like income in 2000 than like a

stream of payments over time. Several courts have held

that, where stock is transferred under a sales agreement

and held in escrow to guarantee a party’s performance

under the agreement, the party “receives” the stock when

it is placed in escrow rather than when it is released.

See Chaplin v. CIR, 136 F.2d 298, 299–302 (9th Cir.

1943); Bonham v. CIR, 89 F.2d 725, 726–28 (8th Cir. 1937);

see also Whitney Corp. v. CIR, 105 F.2d 438, 441 (8th Cir.

1939). That principle applies here.

The more likely it is that the conditions will be

satisfied, and all restrictions lifted, the more sensible it is

to treat all of the stock as constructively received when

deposited in the account. To see this, suppose that the

parties had wanted to defer the recognition of income

and had put $2.5 million in each partner’s account, with

the condition that the whole amount would be forfeited
12 No. 08-2173

if the temperature in Barrow, Alaska, exceeded 80/ F on

January 1, 2005. Would the remote possibility of an Arctic

heat wave enable the partners to defer paying taxes?

Surely not. See Cemco Investors, LLC v. United States, 515

F.3d 749 (7th Cir. 2008). If, on the other hand, the

parties agreed that the ex-partners would receive

$2.5 million only if the temperature in Barrow on January 1, 2005, exceeded 80/ F, then none of the partners

would constructively receive income in 2000; everything

would depend on events in 2005.

The sort of contingencies that could lead to forfeitures

were within the ex-partners’ control. That implies taxability in 2000, for control is a form of constructive possession. And the agreement to discount the stock by only 5%

tells us that the parties deemed forfeitures unlikely.

Fletcher’s acknowledgment that the risk of forfeiture was

small shows that the conditions of constructive receipt in

2000 have been satisfied.

Thus although we agree with Fletcher that the ex-partners are entitled to contest the tax treatment called for

by the 2000 contracts, we hold that the shares are taxable

in 2000 at their value on the date of deposit to the

accounts at Merrill Lynch. Income was constructively

received in that year not because the contract said that

everyone would report it so to the IRS, but because the

parties were right to think that this transaction’s actual

provisions made the income attributable to 2000. That

the price of Capgemini stock dropped in 2001 and later

does not entitle the parties to defer the recognition of

income. Fletcher must repay the refund (and amend her
No. 08-2173 13

returns for later years to reflect receipt of the income in

2000).

AFFIRMED

4-10-09