In Brinkley (TC Memo 2014-227), an October 2014 U.S. Tax Court case, the taxpayer was the founder of a company called Zave Networks (Zave). He originally held 9.8 percent of the company’s stock but this was diluted over time by various rounds of venture capital funding. On multiple occasions, the taxpayer expressed a desire that he never be diluted below 3 percent of the total outstanding stock, but subsequent financings in fact reduced his ownership to 0.8 percent.
Google became interested in buying Zave. The taxpayer thereupon demanded that he receive 3 percent of the total amount paid by Google, notwithstanding his 0.8 percent interest in Zave’s outstanding shares. The company gave in to his demand, largely because Google insisted that Mr. Brinkley sign a Google employment agreement and assign certain intellectual property to Zave.
On his income tax return, the taxpayer took the position that the full 3 percent of the proceeds he received all gave rise to capital gain income from the sale of his stock. The taxpayer argued that he had effectively negotiated a higher price per share for his stock than the price obtained by the other Zave shareholders. The IRS refuted this position, and the Tax Court found that Mr. Brinkley’s proceeds over the 0.8 percent attributable to his stock holdings constituted compensation for services and gave rise to ordinary income.
The court had little trouble concluding that only 0.8 percent of the total proceeds was paid for the taxpayer’s stock, the same price as received by the other Zave shareholders. The court further ruled that the additional 2.2 percent of proceeds were paid to the taxpayer in return for his signing the Google employment agreement and assigning intellectual property to Zave, both of which were requirements imposed by Google to complete the transaction.