Double Taxation: A Take On All Things Taxes

Kenneth Lay Posthumously Victorious in Tax Court; Sets Off Riotous Celebration in Hell

OK, I’ll admit it, that title may be a bit harsh, but let’s not kid ourselves…Ken Lay’s resume isn’t exactly worthy of admittance into the pearly gates.  

Need I remind you, while CEO of Enron — the once-thriving Houston-based energy company that has since become synonymous with corporate fraud and corruption –Lay oversaw deceptive accounting practices that cost 20,000 employees their livelihoods and life savings while bilking investors out of billions of dollars, leading to the largest bankruptcy in U.S history and the sudden demise of my first employer, Arthur Andersen LLP.

Lay was eventually convicted on ten counts of securities fraud and related charges, but while awaiting a probable 30-year prison sentence, he died of a heart attack. (Ed note: the rather fortuitous timing of Lay’s demise, coupled with his relationship with former president George W. Bush, has led many conspiracy theorists to speculate that Lay is still alive.)  

The decade-long string of bad news for the Lay family finally took a turn for the better today, however, as the Tax Court ruled in the favor of Lay’s estate, holding that Lay and his wife were not responsible for a $3.9 million tax deficiency related to 2001.

The case revolved around Lay’s sale of two annuity contracts to Enron in 2001. At the time, Lay had planned to retire as CEO, but when his hand-picked successor suddenly left the company, Enron’s Board of Directors urged Lay to consider staying on.

To motivate Lay to continue as CEO, the Board sought a way to provide Lay with liquidity while simultaneously offering him an incentive to fulfill a 4-year contract. Their solution was to purchase from Lay two annuity contracts he had previously acquired on behalf of he and his wife, with an agreement to transfer the contracts back to Lay in the event he fulfilled his contract. Enron set a purchase price for the contracts of $10,000,000; an amount equal to Lay’s previous investment in the two contracts, but also a fair representation of the FMV of the contracts at the time.

To facilitate this form of compensation, Lay and Enron took the steps necessary to transfer ownership of the contracts from Lay to Enron. The investment firm holding the contracts — Manulife, and as successor after a subsequent merger, John Hancock — acknowledged and recorded the change in ownership of the annuities. On his 2001 tax return,  Lay reported the sale of the contracts, reflecting a sales price and basis of $10,000,000, and no gain or loss.

The IRS argued that Lay did not actually “sell” the two annuity contracts in 2001. Rather, the IRS contended, the $10,000,000 paid to Lay was a cash bonus, and Lay remained the true owner of the contracts.

After analyzing both Texas state law and federal tax precedents to determine whether the benefits and burdens of ownership of the annuity contracts had moved from Lay to Enron in 2001, the Tax Court sided with Lay, holding that a sale had occurred. In reaching its decision, the court noted:

The Lays sold the Annuity contracts to Enron on September 21, 2001. In doing so, they complied with the requirements of the agreement and took the steps required to transfer the annuity contracts to Enron. The benefits and risks of ownership of the annuity contracts were transferred to Enron in the annuities transaction. The Lays, therefore, properly reported the transaction on their Federal income tax return as a sale of the two annuity contracts.

In perhaps the most interesting aspect of the case, the IRS argued in the alternative that the clause in the compensation agreement providing that Enron would transfer the annuity contracts back to Lay upon completion of his term as CEO should be subject to taxation under Section 83, causing Lay to recognize ordinary income to the extent of the FMV of the contracts in 2001.

What makes this argument fascinating is that three elements are required for property transferred in connection with the performance of services to be subject to immediate taxation under Section 83: You must have 1) “property,” that is 2) transferred to a service provider, and 3) the property must be transferable and not subject to a substantial risk of forfeiture in the hands of the service provider. In this case, none of the three elements were present, but that didn’t stop the IRS from posing the argument.

First, the contracts were not “property” for purposes of Section 83, as they merely represented unfunded and unsecured promises to transfer property in the future. They were not set aside from the claims of creditors by Enron on Lay’s behalf. Nor were the contracts “transferred” to Lay, as Enron retained the benefits and burdens of ownership in 2001. Lastly, the contracts were not transferable by Lay in 2001 (as Lay had no interest in the contracts at that time) and they were subject to a substantial risk of forfeiture (Lay was required to fulfill his four-year contract in order to receive the annuities).

Citation: Estate of Kenneth Lay v. Commissioner, T.C. Memo 2011-208 (August 29, 2011).