Davis: $36M Cashless Stock Option Is Contingent Compensation

Davis v. Commissioner, T.C. Memo 2011-286; 2011 Tax Ct. Memo LEXIS 278 (Dec. 12, 2011)

There’s been a lot of buzz about the Davis decision, so BVR is offering our digest of the key issues here free as customer benefit.  The court documents are also available at BVLaw.

 The Davis saga began with a $100,000 loan from the father in 1994. By 2000, the father owned 23% of the business, which operated a local chain of “payday” loan stores, and he held voting rights to the shares belonging to his two sons (33.5% apiece), who also served as officers and directors of the company. A daughter held 10% of the shares.

Aggressive expansion. To fund its nationwide expansion plans, the company secured $70 million in financing, but only by guaranteeing that the father—who had enjoyed a long and successful career in banking—would stay actively involved in day-to-day operations as an independent consultant. The eldest son became the firm’s president and CEO, and the second son stayed on as a director.

A year later, the parents filed for divorce. The mother’s demand for half of the father’s shares triggered a right of first refusal among the remaining shareholders, pursuant to their stock transfer agreements. The eldest son filed a motion in state court to declare his purchase rights, using the lawsuit as leverage to force his father to surrender his stock. By the terms of their agreement, the father would transfer half of his holdings (188.6 shares) to the mother, subject to a future option to redeem the same amount of shares for $16 million, at an exercise price (determined by formula) that was essentially worth $16 million less than the value of 188.86 shares. As part of the plan, the sister transferred her holdings to the father, but the father relinquished his voting rights back to his sons.

The deal went through in 2002, effectively distributing ownership among the two sons at 37.85% each and the father at 24.3% (a non-family member held 10%). By this time, the company had 834 stores, revenues of $199.3 million and EBITDA of $44.6 million. Two years later, the company had added nearly 200 stores and was worth $460.5 million, and sought to amend its credit facility to permit a $50 million distribution to shareholders. To participate, the father exercised his cashless option, receiving 131.8 shares of stock. The loan agreement was amended in 2004, releasing the father from any further involvement in the company.

The company treated the stock as compensation to the father, declaring a deduction of $36.9 million on its 2004 tax returns. The father, on the other hand, did not treat his exercise of the option as taxable and did not include the stock’s value in his 2004 returns. The IRS subsequently issued dual deficiency notices, declaring the $36.9 million as gross income to the father and denying the company’s deduction for the same amount as reasonable compensation.

As a first question, the Tax Court addressed whether the father’s exercise of the “cashless” option resulted in gross income. The stock that the father received by exercising his option in 2004 “was transferred in connection with the performance of services,” the court held, and thus constituted taxable income to the father (the court cites the father’s role in securing financing, among other issues).

Turning to the value of the stock, the IRS (and the company) argued that the cashless exercise formula in the parties’ agreement established a value of $280,434 per share (the $16 million exercise price divided by the roughly 50 shares retained by the company). Thus, the value of the father’s 131.8 shares equaled just over $36.9 million.

Taxpayer asserts 30% DLOM. For purposes of trial, the father retained an appraisal of the shares at $25.3 million, which included a 30% discount for lack of marketability (DLOM). But the value established by the cashless exercise provision was a better “starting point,” the court decided. As for the discount, “when determining the value of unlisted stock by reference to the value of listed stock, a discount is typically warranted to reflect the unlisted stock’s lack of marketability,” it said, citing Mandelbaum v. Comm’r, T.C. Memo 1995-355 (also available at BVLaw). “A lack of marketability discount is inappropriate, however, where unlisted stock is not valued by reference to the price of stock listed on a public exchange,” the court added, citing Estate of Cloutier v. Comm’r, T.C. Memo 1196-49.  In that case, the parties stipulated to a value which neither claimed to be the stock’s freely traded value. Similarly, in the present case, the company “would not have agreed that the price established by the [father’s] option was the stock’s freely traded value,” the court said. “Such a valuation would have created a windfall for [the father].”

Specifically, the option required the father to pay $16 million in cash to reacquire the 188.6 shares he had transferred to his ex-wife. The option’s cashless exercise permitted him to pay the $16 million with an equivalent amount of stock; according to the formula in the option, this equaled just over 57 shares at the time or exercise (2004). If, as the father argued, the cashless exercise established only a nominal freely traded value by failing to account for the stock’s lack of marketability, then that would mean the company accepted stock with a “real fair market value of $11.2 million . . . for payment of the $16 million exercise price,” the court said, or the equivalent of 70 cents on the dollar. Since the company could not have reasonably intended this effect, the court concluded that the father’s stock was worth $36.9 million on the exercise date.

Wrong industry data. To support its assertion that the father’s compensation in 2002 was unreasonable, the IRS pointed to data showing that it far exceeded amounts similar companies paid their executives that year. But this comparison “was not helpful,” the court said, because the taxable event for which the company was claiming its deduction occurred in 2004, when the father received his stock.

The events of 2002 are not “irrelevant,” the court added. It was necessary to address the 2002 grant, but the applicable statute (Sec. 162 IRC and accompany regulations) did not provide any guidance. Neither had any prior case addressed the deductible value of stock received from the exercise of an employment option when, as in this case, the stock had no readily ascertainable value. There was case law concerning contingent compensation agreements, which held that any compensation in excess of “ordinary” amounts may still be deductible if the agreement was arm’s length.

Drawing on this analogy, the court held that the father’s option operated in the same manner as a contingent compensation agreement, because its exercise provision permitted him to receive the appreciation on the 188.86 transfer of shares to his ex-wife without paying any cash. The father’s compensation was thus “contingent on [the company’s] performance,” the court held; “the better the returns on [the] business, the more [the father] was ‘paid.’”

In once again reciting the “exceptional success” of the company, the court attributed most of it to the father’s involvement. The business could not have expanded as quickly as it did without the loan covenant requiring his participation. Although an agreement among family members merits “higher scrutiny,” the court said, in this case, by the time they negotiated the stock option grant, the father and his two sons held adverse interests. The sons “had an incentive not to overcompensate [the father], because the more he was paid, the less they received,” the court said. Notably, the eldest son used litigation as leverage to force the father to relinquish voting control and management.

The granting of the option was also not a one-sided bargain; the company benefited from its success as well. Under these facts, the stock option grant was “fair” to the company, and the court permitted its $36.9 million deduction as reasonable compensation to the father in 2004.