Archive for December 13th, 2011

Raising a son ain’t easy. If you want your boy to grow into a man you can be proud of, you can’t always be his best friend. Sometimes you have to be stern. Sometimes you have to say no. And yes, sometimes, you have to break your promises, take over the boy’s company, and replace him as CEO. It’s for his own good.

But be warned, it can be costly.

In 1996, Jared and David Davis formed Check-N-Go (CNG) — one of those “payday loan” shops oft-frequented by drunks and degenerate gamblers — with $100,000 borrowed from their father (Allen).

CNG enjoyed immediate success, and to aid expansion the corporation sought additional financing. As any good dad would, Allen loaned a significant amount to his sons’ company, and received an option to purchase 376 shares of CNG in exchange for his troubles.  But again, as any good dad would, Allen promised he would refrain from meddling in his sons’ business, and only exercise his option in the event he experienced financial distress.

There was only one problem: Allen was not a particularly good dad. In 2002, he decided it was time to take over CNG, so in a bloodless coup, he broke his promise, exercised his options, and used his newfound majority control to overthrow David and install himself as president and CEO. I’m guessing Thanksgiving dinner was rather awkward.

Allen’s presence as CEO enabled CNG to continue to grow, with the corporation borrowing $70 million predicated on Allen’s continued involvement with the company. Unfortunately, at the same time, Allen’s wife decided she no longer wanted any continued involvement with her husband, and filed for divorce; asking for half of Allen’s CNG shares as part of the settlement.

Allen threatened to leave CNG if he had to give up his ownership, which would have jeopardized the company’s financing. To remedy the problem, a creative solution was devised: Allen gave half of his shares (188 shares) to his wife, which were then redeemed by CNG. Allen was then granted an option to reacquire the 188 shares from CNG without paying any cash; instead, he would use a “cashless exercise” and only take back the number of shares that was $16,000,000 less than the fair market value of the 188 shares on the date of exercise.

In 2004, Allen exercised the option. The 188 shares had a total value of $52,000,000 on the exercise date, so Allen “paid” for the options by leaving $16,000,000 worth of stock in the corporation, and taking back 132 shares with a value of $36,000,000 .

On its 2004 tax return, CNG deducted the full $36,000,000 of stock issued to Allen as compensation expense. Allen, however, neglected to report any of the stock value on his Form 1040 as compensation income. The IRS responded by assessing Allen a $14,000,000 deficiency.

At issue was whether the granting of the option to Allen was made “in connection with the performance of services” under the meaning of Section 83. Section 83(a) provides that, in general, when property is transferred in connection with the performance of past, present or future services, a taxpayer must include in gross income the excess of the property’s fair market value ($52,000,000 in Allen’s case) over the amount paid for the property  ($16,000,000).[1]  

In the case of options without a readily ascertainable fair market value, Section 83 applies to the stock received upon exercise of the options rather than at the time of receipt.[2] If an option is not traded on an established market, the option’s value is not readily ascertainable when the option is non-transferable.[3]

Here, the Tax Court held that the CNG stock was transferred to Allen in connection with his performance of services because CNG granted the option with the intention of securing Allen’s participation in the day-to-day management of CNG. Allen threatened to leave CNG, which would have caused CNG to be in default of the credit agreement with the bank group, and CNG needed the financing provided by the bank group to continue its rapid expansion. And perhaps most damning to Allen, his own son testified that the option was granted to induce Allen to stay. Payback is a bitch.

Allen next argued that a 30-percent lack-of-marketability discount should be applied to the stock’s valuation. By way of background, when determining the value of private stock by reference to the value of public stock, a discount is typically warranted to reflect the private stock’s lack of marketability. In the immediate case, however, the Tax Court held that a lack-of-marketability discount was inappropriate, because the CNG stock was not valued by reference to the price of stock listed on a public exchange, but rather negotiated in an arms-length transaction between Allen and CNG.

After confirming that the $36,000,000 in CNG stock was properly includible in Allen’s income for 2004, the IRS then challenged whether the corresponding compensation deduction to CNG was “reasonable,” arguing that it far exceeded what other companies in the industry paid their executives that year. Interestingly, the Tax Court noted that there was no judicial precedent that addresses how to ascertain the deductible value of stock received from the exercise of a Section 83 option that is not publicly traded. In reaching its decision to permit the full $36,000,000 deduction to CNG, the court likened Section 83 compensation to contingent compensation, which is deductible in full even when the amount turns out to be greater than ordinarily paid.

When the dust settled, Allen was left with a $14,000,000 bill, while his kids were entitled to a nice fat tax deduction. This act of poetic justice should remind all parents, if you’re going to be overbearing and meddle in your kids’ lives, try and confine your fatherly misgivings to hurling empty whiskey bottles at Little League umpires, like my old man. Interfering with their careers can prove expensive.   

Davis v. Commissioner

[1] I.R.C. § 83(a).

[2] I.R.C. § 83(a)(3).

[3] Treas. Reg. §1.83-7(b)(2)(i).

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