United States: Tax Court Characterizes Technology Executive’s Merger Proceeds As Ordinary Income

Last Updated: November 21 2014
Article by Jonathan R. Talanksy

On October 30th, the U.S. Tax Court ruled that a key executive of a technology company acquired by Google for $93 million was required to report a large portion of his merger consideration as ordinary compensation income. Perhaps even more than the substantive tax principle it stands for, the case is a reminder that self-help is not the preferred way of addressing disagreements between taxpayers and employers regarding tax reporting positions. The salient facts of the case, Brinkley v. Commissioner,1 as well as its key takeaways, are summarized below.

Brian Brinkley ("Brinkley") was a co-founder of Zave Networks, Inc. ("Zave"). After serving in an independent contractor capacity for Zave for a number of years, Brinkley became a salaried employee in 2010. A portion of his compensation was in the form of restricted stock grants. His initial stake in Zave amounted to 9.8% of the company. Brinkley made elections under Section 83(b) of the Code with respect to all stock grants that were not vested.

As is common with early-stage companies, subsequent infusions of capital by outside investors served to dilute Brinkley's ownership stake in Zave. Brinkley threatened to leave the company if his interest fell below 3%, and Zave issued to him additional stock grants to facilitate his 3% interest. However, by the fall of 2011, Brinkley's Zave stake had fallen below 1%.

Also in 2011, Google, Inc. ("Google") began negotiations to acquire 100% of Zave. Brinkley was not involved in the negotiations, but Google did require as part of the negotiation that Brinkley turn over all his intellectual property and become a Google employee in the event of an acquisition. In connection with the Google negotiations, Zave management explained to Brinkley that his equity interest was worth approximately $800,000. Brinkley "disagreed" with this assertion, in light of his expectation to share in at least 3% of the deal proceeds (i.e., a minimum of $2.79 million). Acceding to Brinkley's request, Zave then drafted a letter agreement that required Zave to pay Brinkley, upon consummation of the transaction, an amount equal to 3.3% of the $93 million deal consideration less any amounts paid directly to Brinkley for his stock. The letter agreement used the term "compensation" to describe this obligation.

Brinkley did not accept the initial offer. Moreover, he was told by his tax advisors that the proposed arrangement would likely result in ordinary income. Following further negotiations, Zave and Brinkley came to an agreement whereby Zave would pay Brinkley "as consideration $3,100,000 of the $93,000,000 purchase price offered by Google in exchange for "(i) all of * * * [petitioner's] shares, warrants and options of * * * [Zave stock] and (ii) * * * [petitioner's] execution of a Key Employee Offer Letter and Proprietary Information and Inventions Assignment Agreement with Google as required in the Merger Agreement." The agreement further provided that any payments were subject to all applicable tax withholdings. Brinkley eventually reviewed drafts of the merger agreement but did not consult the schedules and did not consult with his tax advisors. He signed a shareholders' consent agreeing to Zave's entering into the merger agreement. The schedules to that agreement in fact identified Brinkley as a deferred compensation recipient.

Following the transaction, Zave prepared spreadsheets indicating that Brinkley's stock was worth $787,671 and that he was to receive $1,879,779 in deferred compensation. As a result of the tax withholdings, Brinkley became aware of the way in which his former employer was treating the proceeds. He then had his [under-informed] tax advisors send a letter to Zave demanding a correction of the tax reporting position. Zave did not respond to the demand, so Brinkley engaged in self-help by reporting a long-term capital gain of $2,476,455 and reporting the withheld taxes as "estimated tax payments" on his 2011 federal tax return. He also included with the return a copy of his letter agreement with Zale as well as an explanation of the "mischaracterization" effected by Zave.

The court clarified that in attempting to characterize the entirety of his consideration as long-term capital gains, Brinkley "chose to ignore a lot of relevant information," most notably, the actual value of his stock and the intended treatment of the balance of his consideration by the two parties to the merger. Brinkley argued that his letter agreement with Zave amounted to a higher share price (relative to other Zave shares) being paid for his stock in the Google transaction. In the words of the court, "His expressed desire for a 3% share of the company does not establish that his stock was equal in value to, or sold for, $3,027,515." According to the court, the terms of the letter agreement made clear that the bulk of the consideration paid to Brinkley was in respect of his signing a new employment agreement and the assignment of intellectual property to Google. Specifically, the letter agreement between Brinkley and Zave "strongly suggests that petitioner's signing of the employment and assignment agreement was an imperative condition to receive the merger-based income."

Brinkley was assessed a 20% accuracy-related penalty under Section 6662 as a result of his "substantial understatement of income tax." Furthermore, he was unsuccessful in arguing that the understatement was a result of "reasonable cause and good faith."3 The court's ruling on this point was based on the fact that Brinkley "chose to keep from his advisers essential facts, such as the amount of stock he owned and the stock's determined value in comparison to the amount he was receiving." Finally, and perhaps most importantly, the court asserted that misrepresenting information on federal tax forms does not show a good faith effort to properly compute a tax liability.

The Brinkley case underscores the hazards of trying to use a tax return to "undo" (in the words of the court) what a taxpayer feels is a mistaken tax reporting position taken by another party. This obfuscation, when detected, is not well received and may undermine a taxpayer's litigating position. In Brinkley's case, these measures included fabricating the estimated taxes paid for 2011. Another key takeaway from the case is that where a founder receives consideration that is in respect of past or future services, the amounts will be taxed as ordinary compensation income. Moreover, in the absence of compelling facts, a court will not simply disregard stock valuations and ownership percentages and treat certain executives as having received a higher per-share value for their equity. In these circumstances, additional consideration is likely to be treated as disguised compensation.

Footnotes

1 T.C., No. 7367-13, T.C. Memo. 2014-227, 10/30/14.

3 This is a defense to the accuracy-related penalty of Section 6662. See Section 6664(c).

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
Jonathan R. Talanksy
 
In association with
Related Topics
 
Related Articles
 
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
 
Email Address
Company Name
Password
Confirm Password
Position
Mondaq Topics -- Select your Interests
 Accounting
 Anti-trust
 Commercial
 Compliance
 Consumer
 Criminal
 Employment
 Energy
 Environment
 Family
 Finance
 Government
 Healthcare
 Immigration
 Insolvency
 Insurance
 International
 IP
 Law Performance
 Law Practice
 Litigation
 Media & IT
 Privacy
 Real Estate
 Strategy
 Tax
 Technology
 Transport
 Wealth Mgt
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates
Registration (you must scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these Terms or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.

Disclaimer

The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.

General

Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions