Brinkley v. Comm., (CA 5 12/16/2015) 116 AFTR 2d ¶ 2015-5520
The Court of Appeals for the Fifth Circuit, affirming the Tax Court, has concluded that payments received by a shareholder-employee and founder of the company in a merger with Google, although nominally for the exchange of his stock, was partly compensation for services rendered. Specifically, the taxpayer was compensated for his future service in his execution of the employment and assignment agreements, and he was not entitled to long-term capital gains treatment. Click here for the Opinion of the Court.
Facts. Mr. Brinkley, the taxpayer, was a founder of and employee of Zave Networks, Inc. (Zave). He initially owned 9.8% of Zave’s stock. However, each time investors infused capital into Zave, Brinkley’s interest was diluted, and he threatened to leave the company should his interest ever fall below 3%. When additional capital was infused into Zave in 2008, Zave, in deference to Brinkley’s concern, agreed to increase his stock ownership by issuing to him stock grants to facilitate his minimum 3% interest request. Nevertheless, by fall 2011, Brinkley’s equity interest in Zave had fallen to about 0.8%.
Earlier in 2011, Google began merger negotiations with Zave. In explaining the merger to Brinkley, Zave informed him that it was being sold for $93 million and that his stock holdings were about 0.8% of Zave. Brinkley disagreed with the latter amount and stated that he expected to receive 3% of the cash consideration paid by Google.
Brinkley and Zave then negotiated an agreement (the Letter Agreement) under which Zave would pay Brinkley as consideration $3.1 million of the $93 million purchase price offered by Google in exchange for (i) all of Brinkley’s Zave stock and (ii) Brinkley’s execution of an employment and assignment agreement with Google as required in Zave’s merger agreement with Google (merger agreement). The Letter Agreement also provided that Brinkley would “not be entitled to the Consideration, except for any amount you would be entitled to receive in exchange for your shares…in the absence of this Agreement, if you do not comply with the terms of the merger agreement.”
In August 2011, Brinkley received a copy of the merger agreement. Schedules of the merger agreement, which Brinkley did not see, identified him as a deferred compensation recipient. Brinkley signed a consent of the shareholders assenting to Zave’s entering into the merger agreement. By signing the consent, Brinkley agreed to be bound by the terms of the merger agreement.
Brinkley executed the employment and assignment agreement, wherein he would become a Google employee after the merger. This agreement provided that he would receive from Google an annual salary of $250,000, a $2.5 million bonus for staying with Google for three years, another bonus program that would pay an additional 25% of his salary, Google stock, and other benefits. Brinkley was required to assign his interests in certain Zave-related intellectual property to Google.
After the merger closing, Brinkley received a paycheck that represented his compensation under the Letter Agreement in excess of his 0.8% stock ownership. Zave characterized this amount as deferred compensation from the merger closing. Because of the tax withholding on this amount, Brinkley became aware that Zave was treating this amount as ordinary income.
Brinkley’s attorney then sent to Zave a letter outlining his opinion that the transaction at all times was capital in nature, but that Zave miscast it as ordinary. The letter stated that Zave’s failure to comply with Brinkley’s demand to recast the transaction would result in Brinkley’s filing suit against Zave for breach of contract. Brinkley never received any response from Zave regarding the demand letter, and he did not file any suit against Zave.
Zave then sent to Brinkley and IRS a Form W-2 consistent with its ordinary income treatment, and Brinkley filed his Federal income tax return showing the full amount that he received from the merger as having been received in exchange for his Zave stock and qualifying for long-term capital gain treatment.
On audit, IRS agreed with Zave’s position, and Brinkley brought suit in Tax Court.
Background. Under various circumstances, the acquisition by a corporation of its own stock from a shareholder in exchange for cash or property qualifies for sale or exchange treatment. (Code Sec. 302(b)) Gain from the sale or exchange of a capital asset held for more than one year is long-term capital gain. (Code Sec. 1222(3))
Tax Court decision. The Tax Court held that the preponderance of the evidence supported IRS’s finding that Brinkley’s $3.1 million merger payout could not be ascribed exclusively to the sale of Brinkley’s interest in Zave and that the $1.8 million difference between what Brinkley’s claimed was capital gain and the actual value of his stock was taxable as ordinary income. (Brinkley, TC Memo 2014-227)
Brinkley failed to explain why the express terms of the merger should be ignored and instead relied heavily on his side contract with Zave under the Letter Agreement, even though it incorporated the merger agreement. Brinkley argued that, through Letter Agreement, he negotiated a higher share price than other shareholders and that the $3.1 million he received was all consideration for the sale of his Zave stock. However, Brinkley gave no persuasive reason why Zave would be willing to pay more for his stock than its determined value. His expressed desire for a 3% share of the company did not establish that his stock was equal in value to, or sold for, $3.1 million.
The Court noted that Brinkley did not make himself aware of the merger terms between Zave and Google, which reflected the intent of the two parties that generated Brinkley’s income in issue—an intent that Brinkley would receive both deferred compensation and capital gain income from his execution of the employment and assignment agreement and the sale of his Zave stock. Brinkley testified that these terms were unknown to him, even though as a shareholder he had consented to be bound by them.
Moreover, the Letter Agreement was silent as to a specific amount being paid for the stock. Instead, it provided that to receive the merger-based income from Zave, Brinkley had to fulfill two requirements—sell his stock and sign the employment and assignment agreement. While Brinkley contended that he gave up only one asset of any worth—the Zave stock—Zave obviously considered his employment and assigns to have considerable value with respect to its merger negotiations. And, Brinkley undermined his own position when he testified that, if he had dissented, the merger would most likely not have gone through, not because of his stock ownership, but because he had to “sign over all the intellectual property and sign on with Google.”
Brinkley contended that none of the income in issue was given to him for signing the employment agreement because he was so well compensated—through wages and bonuses and other benefits—by becoming a Google employee. However, the Court said that his prior or future compensation did not preclude him from having been paid, in part, for his signing of the employment and assignment agreement. On its face, the Letter Agreement strongly suggested that Brinkley’s signing of the employment and assignment agreement was an imperative condition to receive the merger-based income.
Finally, the Court faulted Brinkley for the fact that when he became aware that Zave treated most of his consideration as deferred compensation, he did not attempt to cure Zave’s alleged breach either by requiring Zave to reissue a corrected Form W-2 or by pursuing legal recourse against Zave. It noted that he made a decision to receive his merger-based income and his position at Google without causing a stir about receiving deferred compensation. He then used his income tax return in an attempt to regain his desired preferential tax treatment that he had earlier abandoned by not challenging Zave.
Appellate decision. The Fifth Circuit concluded that there was substantial evidence that the consideration paid to Brinkley, although nominally for the exchange of his stock, was partly compensation for services rendered. Brnkley was compensated for future service to be rendered—i.e., his execution of the employment and assignment agreements. This future service was an ordinary-income producing activity that was not entitled to long-term capital gains treatment.
The Court found Brinkley’s counter arguments unpersuasive. As to its intent, the Letter Agreement was ambiguous: it provided compensation for Brinkley’s stock, but also stated in its introduction that the agreement was in consideration of Brinkley’s employment with Zave. However, the plain text of the Letter Agreement supported IRS’s position. It set out two conditions on Brinkley’s receipt of the merger consideration: (1) the exchange of Brinkley’s Zave shares; and (2) the execution of an employment and assignment agreement with Google. While Brinkley argued that the entire $3.1 million was in consideration was for the first condition alone, the Letter Agreement unambiguously listed both conditions and included a merger clause that supersedes all prior agreements. The Court determined that earlier drafts of the Letter Agreement (as it was being negotiated), which contained no reference to the second condition, were not executed by the parties and so were of limited relevance.
And while he was already set to receive generous compensation from Google for his future employment, the Court found that it was not inconsistent with the Letter Agreement for Zave to assign value to Brinkley’s willingness to execute the employment and assignment agreements, separate and apart from Google’s valuation of Brinkley’s future services. Brinkley seemed to implicitly concede as much when he said that, despite his minority share, he wielded considerable bargaining power as Chief Technology Officer.
Further, Brinkley signed the shareholder-consent form, which affirmed that he had read the merger agreement and bound him to accept its terms. The schedules to the merger agreement identified Brinkley as a recipient of deferred compensation and characterized the Letter Agreement as a deferred-compensation plan. The Court determined that even if Brinkley’s payout was not part of a formal deferred-compensation plan, this did not mean that the payout could not properly be characterized as deferred compensation.
The Court also rejected Brinkley’s argument that his stock was more valuable than other shares because he was a critical employee and because Zave viewed his consent as necessary to the merger. Brinkley failed to offer “convincing testimony” that his shares were in fact more valuable than other shares, and that Zave was not simply compensating him for future services as the plain language of the Letter Agreement indicates.
Brinkley’s signing of the employment and assignment agreements, per the requirement of the Letter Agreement, was the service he performed that entitled him to the additional payment that Zave would later distribute to him. In addition, the Letter Agreement included a paragraph titled “Internal Revenue Code Compliance including I.R.C. § 409A”—referring to a statute that addresses deferred-compensation plans—and within this paragraph stated that payment would be subject to all adjustments, tax withholdings, if any, and escrow as required in the merger agreement, and would be paid out only at the times and to the extent of the definitive merger agreements with Google. Zave’s treatment of the payment as deferred compensation subject to ordinary income tax withholding was consistent with both the definition of deferred compensation and the terms of the Letter Agreement.