Tax News
In Brinkley v. Comm’r, T.C. Memo. 2014-227, all Goes Wrong for the Taxpayer
November 03, 2014
Here is a case that showcases how a routine business transaction could lead to tax grief for the parties involved. In this case we have a founder, CIO exec, who worked for a company called Zavers. The CIO was paid a salary, a bonus, and also received restricted shares, much like many founders and principals in venture capital start ups. Originally, he owned approximately 10% of the company. As it happens, the exec was diluted by later investment rounds and tried to negotiate with Zavers a minimum of 3% interest, or else, he would leave. There was no official documentation to that effect.

Early in 2011 Zavers was acquired by Google in a cash merger. By that time, the taxpayer-exec owned less than 1% of the company and his shares were valued at approximately $800k. The CIO was not happy with this result and negotiated with the company that he should receive 3% of the entre merger consideration which amounted to over $3M. The rub, however, was that Zavers and Google were intent on treating the excess amount as deferred compensation. This is understandable due to the compensation deduction benefit that accrues to the employer. The taxpayer did not like this result either. He naturally expected a pure capital gain transaction as per his original agreement with the company to maintain at least a 3% ownership. He hired tax lawyers, tax accountants and so on and they drafted side letters which purportedly memorialized a capital gain transaction. However, the letters ended up including 409A language. Also, apparently the taxpayer was not entirely forthcoming with his advisers and did not elaborate that his shares were actually worth only $800k.

Long story short, come tax time, the taxpayer receives a W-2 reporting the excess of the consideration as employee compensation. So what does the taxpayer do? Instead of suing the company for a violation of the side letters, he decides to just send a demand letter. He did not receive any reply from the company. Then the taxpayer proceeded to file his tax return as if the entire consideration was from a capital transaction. He also filed Form 4852, substitute W-2, but omitted important information regarding certain employment and assignment agreements. Finally, the taxpayer also claimed estimated tax payments that he never made to achieve his sought-after tax treatment.

What did the Tax Court do? It held against the taxpayer and affirmed the accuracy-related penalty. There are several lessons here that would apply to investment fund and venture capital deals. For one, make sure that you understand the documents and that the parties are on the same page on key substantive issues. Here Google and Zavers were under the impression that they were giving the taxpayer deferred compensation (hence the 409A language) and the taxpayer was under the impression he was getting consideration for his shares. Two, sort the issue before you file your tax return. Resolving substantive issues on the tax return is not the best way to go about things. Three, if you think that there is a misunderstanding and that one party is acting contrary to an explicit agreement, do not let it slide. File a lawsuit if the facts merit it. That’s why we have our judicial system. Fourth, do not omit information from your tax advisers. That’s a sure proof way to blow the “reasonable cause and good faith” defense to any accuracy related penalties.
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Tags: 83(b) election, founder dilution, merger consideration, section 6662