Stock is a capital asset - hold it for more than a year before a sale and you get long term capital gain with a tax rate much more favorable than ordinary income.  So why did a court hold that a majority of proceeds arising from a stock sale were ordinary income? Because of a combination of poor drafting, poor reporting and some unhelpful facts.

In Brinkley v. Commissioner, 116 AFTR 2d 2015 (5th Cir. 2015), an individual owned stock in a corporation being acquired by Google. As part of the deal, Google also wanted this shareholder to become its employee. In the merger, Google paid him a lump sum that was more than the deal's per share value. The selling shareholder wanted to treat the entire lump sum as capital gain. What went wrong? The court observed a few things that may have been handled differently.

First, the court considered three drafts of a letter agreement with the shareholder for the transaction, two of which weren't helpful for an all capital gain characterization. The first draft referenced a lump sum payment that it said consisted of both cash for shares and compensation. This description caused the shareholder to bring in tax attorneys who negotiated a redraft which said the consideration was all for the shares. Unfortunately, this second version - which was helpful - was never signed. Then a third re-draft surfaced stating that the payment was for (i) the exchange of shares, and (ii) the execution of an employee offer letter. This less helpful version, unfortunately, got signed.

  • It's worth noting that the court (and the IRS, for that matter) didn't limit its review solely to the signed agreement. It took into account earlier drafts, although it placed more weight on the signed version.

Second, the company reported over half the lump sum payment as compensation on a Form W-2. The tax lawyers threatened to sue unless the amount reported on the W-2 was corrected to show all of the payment as a capital transaction. The company never responded to the threat, and no suit was filed. The selling shareholder filed his 1040 inconsistently with the W-2, reporting all of the proceeds as in exchange for stock on Schedule D.

  • It's worth noting that these inconsistent filing positions virtually guaranteed an IRS review.

Finally, the merger agreement included schedules identifying the selling shareholder as a recipient of deferred compensation and referencing the letter agreement as a "deferred compensation plan." The selling shareholder read the merger agreement in draft without schedules, but signed a document saying he had read the agreement and agreeing to be bound by its terms.

The court was persuaded that the IRS correctly characterized the portion of payment reported on the Form W-2 as ordinary income.

How could the seller's desired tax characterization have been improved?

  • All of the documentation (including early drafts) should have reflected that the consideration was all for stock. This includes not only the letter agreement, but the merger agreement and its schedules.
  • Better yet, the documentation should have included a good reason why the selling shareholder got more money per share value than the deal's per share value (other than because of his employee status, assuming there was one). 
  • The agreements definitely should have required all the parties to report payments made to the selling shareholder as 100% in exchange for the stock. Everyone knows up front the payment will get reported one way or the other - why not provide for how that happens in the agreements?  Once the W-2 is issued, the cat's out of the bag and it's a difficult and uphill battle to recharacterize.

None of this is to say that compensation should ever be misreported. If in fact some of the lump sum payment was compensation, then it's best to provide for that straight up in the agreements. Specify the amount of the compensation, and how it will be reported. It's better to have those discussions in the context of negotiations, before information reports are issued, so there are no surprises down the road.