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Double Dipping: A Faux Pas in Tax Court Too

By : Ori Bash, ASA

In Davis, taxpayers are “whipsawed” for a $23.3 million tax deficiency

In Allen L. Davis, et al v. Comm’r1, TC Memo 2011-286, the IRS applied a section 83 attack on illiquid stock option grants that resulted in a $23.3 million tax deficiency for the individual taxpayers. In addition, the Tax Court held that no discounts were warranted for the privately held shares valued, since the shares had already been valued at a fully-discounted level of value.

Background
Check-N-Go, Inc. (“CNG”), founded in 1994 by Jared Davis (“Jared”), is a privately held S-corporation that operates a payday loan business.  From the company’s infancy, Allen Davis (“Allen”, Jared’s father) and David Davis (“David”, Jared’s brother) became shareholders and participated in the business as employees or advisors.  Enjoying great success, CNG funded its aggressive expansion through bank financing, loans from Allen, and loans from other external sources2.  By the end of 2002, CNG had 834 stores, and an annual revenue of $199.3 million.

Judith Davis (Allen’s wife) filed for divorce in 2001 and claimed that she was entitled to half of Allen’s CNG shares. The divorce was acrimonious and created strife within the family. To resolve the matter, Jared devised the following plan: (i) Allen transferred half of his CNG shares to Judith (188.86 shares), subject to an option allowing Allen to repurchase the shares for $16 million; and (ii) CNG redeemed those shares, and amended the option by adding a cashless exercise provision3.  In 2004, Allen exercised his option and received 131.8055 shares of CNG stock4.  Also, in 2004, Rosenberg exercised his warrant and received 140 shares of CNG stock.  

At issue in this “whipsaw”5 matter is the following: (i) pursuant to section 836, what amount, if any, must Allen include in his gross income as a result of his exercise of the option in 2004?; and (ii) can CNG deduct the same amount as reasonable compensation?

Court Discussion
In assessing section 83, the Court noted that the option in question was granted to Allen with the intention of securing his participation in the day-to-day management of CNG. CNG was heavily reliant on debt financing in the course of its rapid expansion, and its management feared that Allen’s departure would result in default of the credit agreement. Furthermore, the option agreement also provided objective evidence of CNG’s intent, as the agreement contained a provision that required Allen to notify CNG in writing if he made a section 83 (b) election7. As such, the Court determined that the stock Allen received by exercising the option was transferred in connection with the performance of services.

Given the section 83 treatment, the Court needed to determine CNG’s stock value in order to calculate the amount of his gross income and tax deficiency. The respondent and CNG parties contended that the stock value of $280,434 per share was established when Allen exercised the option in 2004 via the cashless exercise provision (see footnote 4). Allen hired a valuation expert, who determined the value of the shares at an approximate 32 percent discount to the cashless exercise option transaction. The Court rejected this independent appraisal, citing that the arm’s length transaction between CNG and Allen (cashless exercise) provided the strongest indication of value.  Additionally, Allen unsuccessfully argued that a 30 percent lack-of-marketability discount should be applied to the cashless exercise provision’s valuation. The Court noted that this was inappropriate since the arm’s length transaction already factored the lack-of-marketability associated with the redeemed block of stock (57.0545 shares). Essentially, CNG would have overpaid in the transaction had it not recognized the detriment to value associated with Allen’s minority interest.  Accordingly, the Court selected the per share value of $280,434, or $36,962,694 for the shares in question.

Under the reasonable compensation issue, the respondent argued that not all of Allen’s section 83 income should be allowed as a tax deduction for CNG. However, the Court decided that the respondent’s comparison of Allen’s 2002 compensation to the industry standard is not helpful because the event being taxed (and for which CNG is claiming a deduction) is Allen’s receipt of CNG stock in 2004. In addressing the 2002 grant, the Court noted that section 162 and the underlying regulations provide no guidance, and that no case precedent addresses how to ascertain the deductible value of stock received from the exercise of a section 83 option where there is no readily ascertainable value.  In making its determination, the Court made a comparison to contingent compensation agreements, assessing that contingent compensation that turns out to be greater than the amount ordinarily paid is deductible if it was the result of arm’s length bargaining. The Court affirmed that the option was granted in an arm’s length transaction because “Jared and David had interests adverse to Allen’s and did not merely acquiesce to Allen’s wishes.” Accordingly, the Court allowed the full deduction of $36,962,694 as a deduction on CNG’s 2004 tax returns.

FINAL COMMENTARY
Inconsistent tax treatment between the shareholders and CNG was probably the red flag that initiated the dispute, and the IRS ultimately won on the issue of section 83 to generate $23.3 million in additional tax revenue.  From a valuation prospective, the cashless exercise provision of the option agreement and not making the 83(b) election led to higher tax consequences. If one assumes that the 2002 divorce settlement transaction was at arm’s length, then the stock more than tripled in value between 2002 and 20048.  In a period of such rapid appreciation, a section 83 (b) election would have led to significant tax savings. Furthermore, the cashless exercise provision may have hurt Allen since it established a strong indication of fair market value. Not only did it do so, but since the stock involved in the cashless exercise was itself non-marketable, the price arrived at was not discountable. Without this provision in place, Allen’s independent valuation may have been more meaningful to the Court. Nonetheless, the result could have been worse for the taxpayers, if the full deduction on CNG’s tax return had not been accepted by the Court.

1 The case is consolidated for purposes of trial, briefing, and opinion with the cases of J. David and Dianne M. Rosenberg (“Rosenberg”, family friends), Jared A. and Bridget Davis (founder and his wife), and A. David and Tracy Davis (Jared’s brother and his wife).
2 In 2000, CNG entered into a $70 million credit facility that required the day-to-day involvement of Allen Davis, and $10 million in external financing ($5 million of the external financing was obtained from Rosenberg, who received CNG warrants in the transaction).
3 The cashless exercise provision allowed Allen to avoid paying any portion of the exercise price and to instead receive a number of shares that were worth $16 million less than the value of subject shares.
4 To effect this transaction, CNG shareholders and Allen had to agree upon the value of company at the time of exercise ($280,434/share, or $16 million / 57.0545 shares). Essentially, CNG agreed that it would retain 57.0545 shares to satisfy the $16 million exercise price.  
5 A “whipsaw” is often a situation where deficiency notices are issued to parties on both sides of the transaction, who treated the same item of the transaction inconsistently (deduction and income). In this case, CNG took a compensation deduction for Allen’s option, but Allen did not include gross income on his 2004 return.
6 Section 83 states that when property is transferred in connection with the performance of services, a taxpayer must include in gross income the excess of the property’s fair market value over the amount paid for the property. In the case of options, section 83 applies to stock received upon exercise of the options rather than at the time of receipt.
7 Section 83 (b) allows a person who performs services in connection with the transfer of property to elect to treat the property as compensation in the year it is received.
8 In 2002, 188.86 shares were worth $16 million. In 2004, $16 million was ascribed to only 57.0545 shares.

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