The Tax Court has ruled in Brinkley v. Commissioner (T.C. Memo 2014-227) that a payment an employee received in excess of the fair market value of the stock he held was compensation instead of capital gain.

The case centered on the compensation of Brian Brinkley, a founder and chief technology officer of Zave Networks, Inc., which began business in 2006. In exchange for his services, he received restricted stock grants from the company, and he made elections under Section 83(b) on all of the restricted shares. As a founder, Brinkley initially owned 9.8% of Zave’s stock, but each time Zave received an infusion of capital from investors, Brinkley’s ownership percentage decreased. Brinkley threatened to leave the company if his ownership percentage fell below 3%. When Zave received a capital infusion in 2008, in deference to Brinkley’s concern, Zave agreed to increase his stock ownership to 3% by granting him restricted stock.

In 2011, Google, Inc., began merger negotiations with Zave, at which time Brinkley’s ownership percentage had fallen below 1%. Based on the aggregate purchase price negotiated by Zave and Google, Brinkley would receive approximately $800,000 for his shares of stock. Brinkley and Zave negotiated an agreement under which Brinkley would be paid $3.1 million, which was approximately 3% of the aggregate purchase price of Zave, in exchange for all of Brinkley’s shares and Brinkley’s execution of a key employee offer letter and a proprietary information and inventions assignment agreement with Google. When Zave paid the $3.1 million to Brinkley, Zave reported approximately $2.2 million as compensation income to Brinkley and withheld the appropriate payroll taxes. When Brinkley filed his Form 1040 for 2011, he reported the entire $3.1 million payment as sales proceeds (and capital gain) for his Zave stock.

Ultimately, the court ruled that $2.3 million of the payment to Brinkley was compensation income, rather than sales proceeds. The court seemed to focus on the intent of the parties. For example, the letter agreement between Zave and Brinkley included language concerning the nonqualified deferred compensation rules of Section 409A and a provision for payroll tax withholding (if any). Brinkley argued that he negotiated a higher sales price for his shares, but the court stated that his expressed desire for a 3% share of the company did not establish that his stock was equal in value to 3% of the company. The court also noted that Brinkley not only was paid for his shares but also was paid to sign the agreement with Google. Thus, the court could not presume that a payment for completing two requirements was intended to be consideration for only one of those requirements (i.e., the shares).

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