Davis v. Commissioner, 2013 U.S. App. LEXIS 9850 (May 16, 2013)
When a bitter divorce threatened the ownership interest of the paterfamilias of a highly profitable subchaper S corporation, the husband devised a plan to recoup any lost stock. He obtained an option from the wife to repurchase any shares he had to relinquish. Per an agreement among the husband, wife, and children minority owners in the company, she then sold the option to the company, which redeemed her shares for cash and assumed the obligation under the option. The company and husband then negotiated an option amendment that included a provision for a cashless exercise allowing him to give up a number of his shares equaling $16 million, under a specified formula for the exercise price, in exchange for paying nothing. After the husband exercised the option (valued at $36.9 million), he did not report the proceeds of the transaction as income nor claim a tax deduction, believing there were no tax consequences.
When the IRS issued a deficiency notice, he claimed he received the option from the wife incident to their divorce; therefore, his exercise fell under the IRC's § 1041 nonrecognition provision. As to the value of the stock, he presented an expert who applied a 30% discount for lack of marketability (DLOM) to reflect his minority interest in the corporation. The U.S. Tax Court found for the government, and the husband appealed.
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