United States

Shareholder’s income ruled both capital gain and compensation in M&A deal

Tax Court recharacterizes amount received in excess of stock value

TAX ALERT  | 

In Brinkley v. Commissioner, the Tax Court held that the consideration paid in excess of the value of an executive's stock represented compensation and not capital gain.1 The shareholder executive in this case not only transferred his stock, but was required to execute an employment and intellectual property assignment agreement with the acquirer. Further, a portion of the consideration paid to the shareholder was reported by the target as "stock compensation" and ran through the target company's payroll. While shareholders generally are free to negotiate a separate price for their shares in a merger or acquisition transaction, based upon these facts, the Tax Court held that the consideration received in excess of the fair market value of the stock represented compensation.

At the time of the merger, the shareholder's ratable share of the overall value of the target corporation was approximately $800,000. However, the shareholder felt his stock was worth more than this amount. Following negotiations, the target corporation offered to pay the shareholder total consideration of approximately $3 million if the shareholder agreed to sell the stock, assign over his or her intellectual property, and sign an employment agreement with the acquirer. The agreement between the parties failed to assign a specific value to the stock, and the shareholder did not provide full details of the agreement to the tax advisors he had engaged. This fact appeared significant to the Tax Court in making the determination that the shareholder should have been aware of the tax consequences. For tax reporting purposes, the shareholder reported the entire $3 million as proceeds from the sale of stock, while the target reported the majority of the payment as compensation.

While this was not expressed in the case, had the shareholder negotiated and documented that the amounts paid solely represented consideration for the stock, it is possible that a larger portion of the proceeds would have represented capital gain as opposed to compensation.

Employee-shareholders should closely scrutinize transaction agreements and consult with their tax advisors in any merger or acquisition transaction, but particularly where consideration received by the employee-shareholder is not ratable to the shareholder’s percentage ownership.

1 Brinkley v. Commissioner, TC Memo 2014-227 (2014).

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