Tax Court denies DLOM for ‘cashless’ exercise of stock option

The president of a very successful, privately held business went through a bitter divorce, in which his wife demanded half of his shares, which accounted for a 23% interest but also held voting rights to the remaining shares, held by his two sons. One of the sons—who also managed the business—used the situation to compel the father to transfer half of his holdings to his wife, subject to a cashless option to repurchase the shares for $16 million. Essentially, on exercising the option, the father would receive a formula-determined number of shares that were worth $16 million less than the value of the total number of shares transferred to the wife.

Two years later, the father exercised the option and ended his involvement with the business. The company deducted the value of the shares as compensation, but the father declared no taxable income related to the exercise. The IRS issued a “whipsaw” notice, denying the company’s deduction and declaring the $37 million as income to the dad. At trial, the Tax Court upheld the company’s deduction as reasonable compensation for the father’s efforts in guiding the firm to its success. However, it denied the father’s argument—supported by a business appraisal from a reputable firm—that the value of the shares should include a 30% marketability discount. The company never would have accepted stock with a “real fair market value of $11.2 million for payment of the $16 million exercise price,” or the equivalent of 70 cents on the dollar, the court said, in concluding that the entire $37 million was taxable income to the dad. Read the complete digest of Davis v. Commissioner, T.C. Memo 201—286 (Dec. 12, 2011) in the March 2012 Business Valuation Update; the court’s decision will be posted soon at BVLaw.