Brinkley v. Comm'r

T.C. Memo. 2014-227

UNITED STATES TAX COURT

BRIAN K. BRINKLEY, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 7367-13. Filed October 30, 2014.

William R. Leighton, for petitioner.

Roberta L. Shumway, for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

COHEN, Judge: Respondent determined a $369,071 deficiency in

petitioner’s Federal income tax for 2011 and a $48,036.15 penalty under section

6662(a). The issues for decision are whether petitioner properly reported all of the

income he received in relation to a merger transaction as long-term capital gain

income and whether he is liable for the penalty. Unless otherwise indicated, all
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[*2] section references are to the Internal Revenue Code in effect for the year in

issue, and all Rule references are to the Tax Court Rules of Practice and

Procedure.

FINDINGS OF FACT

Some of the facts have been stipulated, and the stipulated facts are

incorporated in our findings by this reference. One document of the record has

been sealed at the request of a nonparty, Google Inc. (Google). This sealed

document was not required to resolve this case and thus will remain sealed in

accordance with section 7461(b)(1) and Rule 103(a)(7). Petitioner resided in

Texas at the time his petition was filed.

Petitioner was one of the founders of Zave Networks, Inc. (Zave), which

conducted business under the name “Zavers”. When Zave started up in 2006,

petitioner, who holds undergraduate degrees in mathematics, computer science,

and statistics as well as an M.B.A., was hired as an independent contractor to

oversee the technology side of the business. He remained a contractor until

August 16, 2010, when he became a salaried employee as Zave’s chief technology

officer. In addition to monetary compensation, petitioner received restricted stock

grants from Zave for helping to achieve its technological and economic goals.
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[*3] As a founder, petitioner initially owned 9.8% of Zave’s stock. Petitioner

made elections under section 83(b) with respect to all stock grants issued to him

by Zave that were not immediately vested. However, each time investors infused

capital into Zave, petitioner’s interest was diluted, and he threatened to leave the

company should his interest ever fall below 3%. When additional capital was

infused into Zave in or around late 2008, Zave, in deference to petitioner’s

concern, agreed to increase his stock ownership by issuing to him restricted stock

grants to facilitate his minimum 3% interest request. Nevertheless, by fall 2011

petitioner’s equity interest in Zave had fallen to less than 1% even though he held

1,340,000 shares of common stock--200,000 of which were not yet vested.

Earlier in 2011, Google began merger negotiations with Zave to acquire the

latter as a wholly owned subsidiary (merger). Petitioner did not participate in

negotiation of the merger. As part of the merger, Google required that petitioner

turn over all his intellectual property related to Zave and become a Google

employee.

In explaining the merger to petitioner, Zave’s chairman of the board of

directors and another director informed him that Zave was being sold for $93

million and that his stock holdings were worth approximately $800,000.

Petitioner disagreed with the latter amount because, in keeping with his desire to
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[*4] have at least a 3% ownership interest in Zave, he expected to receive 3% of

the cash consideration paid by Google.

To address his concern, Zave sent to petitioner a letter agreement dated July

25, 2011 (letter agreement I). Under the heading “Compensation”, letter

agreement I provided that upon completion of the transaction, Zave would pay

petitioner a lump-sum amount “equal to (i) 3.1/93rds of the aggregate cash

consideration paid by Google * * *, less (ii) the aggregate amount received by”

petitioner as consideration for all his shares of Zave stock. Petitioner was not

comfortable with this language, did not sign letter agreement I, and asked his

accountant Mark Richter to review it.

Richter had tax attorneys Luis De Luna and Leonard Leighton, whom

Richter worked for at that time, review letter agreement I. De Luna and Leighton

advised petitioner that the use of the term “compensation” within letter

agreement I indicated that the funds he would receive from the merger would be

ordinary income contrary to his objective of having only capital gain income from

the sale of stock. Petitioner engaged De Luna and Leighton to negotiate the terms

of an agreement with Zave on his behalf. However, while petitioner did inform

Richter and his tax attorneys that he held some equity interest in Zave, he
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[*5] did not disclose to them the number of shares he owned or their approximate

value of $800,000.

During negotiations with petitioner’s tax advisers, Zave sent a modified

letter agreement dated August 1, 2011, the terms of which petitioner did not

accept. Zave then sent to petitioner a final letter agreement dated August 27, 2011

(letter agreement II). Under the heading “Consideration”, letter agreement II

provided that, following the merger, Zave would pay petitioner as consideration

$3,100,000 of the $93,000,000 purchase price offered by Google in exchange for

“(i) all of * * * [petitioner’s] shares, warrants and options of * * * [Zave stock]

and (ii) * * * [petitioner’s] execution of a Key Employee Offer Letter and

Proprietary Information and Inventions Assignment Agreement with Google as

required in the Merger Agreement”. Letter agreement II also provided that

petitioner would “not be entitled to the Consideration, except for any amount you

would be entitled to receive in exchange for your shares * * * in the absence of

this Agreement, if you do not comply with the terms of the Merger Agreement”.

Under the heading “Internal Revenue Code Compliance including I.R.C. §

409A”, letter agreement II provided that payment from the merger “will be subject

to all adjustments, tax withholdings, if any, and escrow as required in the Merger

Agreement. You agree that the Consideration is to be received by you only at the
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[*6] time(s) and to the extent of the definitive agreements to be entered into with

Google Inc. in the event of a Google Liquidation Event.”

Under the heading “Governing of Law and Forum”, letter agreement II

provided that “[t]his Agreement and all disputes arising hereunder shall be subject

to, governed by and construed in accordance with the laws of the State of Kansas”.

Petitioner agreed with and accepted letter agreement II by signing it on August 27,

2011.

In August 2011, petitioner received and read a version of the then-current

merger agreement that did not include schedules. Petitioner, however, did not

consult with Richter, De Luna, Leighton, or any other tax adviser to review the

merger agreement. Schedules of the merger agreement, which petitioner did not

see, identified him as a deferred compensation recipient.

Again without consulting any tax adviser, petitioner signed a consent of the

shareholders assenting to Zave’s entering into the merger agreement. By signing

the consent, petitioner agreed to be bound by the terms of the merger agreement

and acknowledged that he had had an opportunity to review with his tax advisers

the tax consequences of the merger and transactions contemplated by the merger

agreement. However, petitioner did not sign a consent of the deferred
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[*7] compensation recipients that was given to service providers of Zave who held

stock options or warrants for Zave stock.

Petitioner did execute a Key Employee Offer Letter and Proprietary

Information and Inventions Assignment Agreement (employment and assignment

agreement), wherein he would become a Google employee after the merger.

Petitioner would receive from Google an annual salary of $231,000 to be

increased to $250,000 after his relocation, a $2.5 million bonus for staying with

Google for three years, another bonus program that would pay an additional 25%

of his salary, Google stock, and other benefits. As a condition of his employment

with Google, petitioner would assign his rights, titles, and interests in certain

Zave-related intellectual property to Google.

On September 1, 2011, Zave sent a spreadsheet to its payroll company

indicating that petitioner was to receive $1,879,779.03 of deferred compensation

from the merger closing. The merger closing took place on or around September

2, 2011. The total value of petitioner’s stock was determined to be $787,671. As

a result of the merger closing, petitioner received $3,027,515 and became an

employee of Google. Of the total proceeds of $3,027,515, $360,065 was held in

escrow and distributed to petitioner in a later year.
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[*8] After the merger closing, petitioner received a paycheck showing “stock

compensation pay” of $1,879,779.03 and, because of the tax withholdings, became

aware that Zave was treating this amount as ordinary income. Petitioner contacted

Richter and Leighton, who addressed this matter with De Luna. While his tax

advisers suggested, among other things, filing a suit against Zave to recategorize

the ordinary income characterization, petitioner elected not to pursue any formal

legal action disputing the characterization of the $1,879,779.03. Instead,

petitioner chose to pursue the matter through correspondence.

De Luna drafted and apparently sent to Zave a demand letter dated

November 14, 2011, outlining his opinion that the transaction at all times was

capital in nature, but that Zave miscast it as ordinary. In this letter, De Luna

referenced the letter agreement dated August 1, 2011, because he was unaware of

letter agreement II and of petitioner’s execution of it. The demand letter stated

that Zave’s failure to comply with petitioner’s demand would result in petitioner’s

filing suit against Zave for breach of contract. Additionally, the demand letter

stated that petitioner would challenge the tax treatment of Zave’s reporting on his

Federal income tax return by providing a detailed explanation as to the egregious

and erroneous position taken by Zave. Petitioner never received any response

from Zave regarding the demand letter, and he did not file any suit against Zave.
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[*9] Petitioner had Richter prepare his 2011 Federal tax return. On his return,

petitioner reported $226,073 for wages and, with respect to the merger, long-term

capital gain of $2,476,455 resulting from a sale price of $2,540,828 and a cost

basis of $64,373. Petitioner reported estimated tax payments of $465,782 and

withholding credits of $58,560--even though he had made no estimated tax

payments for 2011 and the total amount of Federal income tax withheld from

petitioner for 2011 was $524,341.25. Petitioner chose to report estimated tax

payments of $465,782 as a way to reclassify the amount that he had determined as

having been wrongfully withheld from the $1,879,779.03 shown on his 2011 Form

W-2,Wage and Tax Statement, as stock compensation pay by Zave’s payroll

company.

As part of his 2011 Federal tax return, petitioner included Form 4852,

Substitute for Form W-2, Wage and Tax Statement, or Form 1099-R, Distributions

From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance

Contracts, etc. On Form 4852, petitioner reported amounts different from the

Form W-2, including wages of $176,728 (as opposed to $2,056,501.85 on Form

W-2) and Federal income tax withheld of $42,524 (as opposed to $512,305.68).

He also included an attachment to Form 4852 with his explanation that the
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[*10] $1,879,779.03 of “Stock Compensation” wages was actually part of the

stock purchase and not compensation.

Petitioner also included letter agreement II, emphasizing from it in his

explanation that: “‘the company . . . will pay you (the taxpayer) an aggregate

amount (the “consideration”) equal to Three Million One Hundred Thousand

Dollars ($3,100,000) of the Ninety-Three Million Dollar (93,000,000 [sic])

purchase price offered by Google, as adjusted in the Merger Agreement IN

EXCHANGE FOR (I) ALL OF YOUR SHARES, WARRANTS, AND OPTIONS

OF THE COMPANY.’” He further explained that Zave’s payroll company had

misclassified his stock sale by treating the proceeds as ordinary income and that he

wanted the excess Federal income tax withheld to be treated as a 2011 estimated

tax payment. He concluded by stating that he was including Form 843, Claim for

Refund and Request for Abatement, to request a refund of overpaid Medicare

taxes.

OPINION

Petitioner maintains the position he took on his 2011 Federal tax return:

that the income he received as a result of the merger represented funds derived

wholly from the sale of his stock and qualifies for long-term capital gain tax

treatment. Respondent acknowledges that petitioner’s section 83(b) elections
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[*11] permitted any subsequent appreciation in his Zave stock to be taxable as

capital gain and that any gain recognized from the exchange of stock for

consideration in an acquisition is capital in nature pursuant to section 302(b)(1)-

(4). Respondent argues that all of petitioner’s merger-based income received in

2011 and in excess of the determined value of his Zave stock is taxable as ordinary

income.

Generally, the taxpayer has the burden of proving that the Commissioner’s

determinations in a notice of deficiency are incorrect. Rule 142(a); Welch v.

Helvering, 290 U.S. 111, 115 (1933). Petitioner contends, however, that pursuant

to sections 6201(d) and 7491(a) respondent should bear the burden of proof.

If a taxpayer asserts a reasonable dispute with respect to an item of income

reported on an information return filed by a third party and meets certain other

requirements, the Commissioner bears the burden of producing reasonable and

probative evidence, in addition to the information return, concerning the

deficiency attributable to that item. Sec. 6201(d). Respondent has presented

evidence, other than the information return filed by Zave, as to the character of the

income in issue. We therefore are not relying on the characterization reported in

that information return.
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[*12] If a taxpayer produces credible evidence to support her or his position as to

a factual issue, complies with substantiation requirements, and cooperates with the

Secretary with regard to all reasonable requests for information, then the burden of

proof as to that issue shifts to the Commissioner. Sec. 7491(a); see Higbee v.

Commissioner, 116 T.C. 438, 440-441 (2001). As shown below, petitioner did not

introduce credible evidence regarding the tax character of the income in issue that

merited a shifting of that burden to respondent. After consideration of sections

6201(d) and 7491(a), the burden of proof remains with petitioner.

Gain from the sale of a capital asset, such as stock, may be given the

preferential tax treatment of long-term capital gain if certain conditions are met.

See secs. 1(h), 1221(a)(1), 1222(3). Petitioner’s aim throughout the merger was to

reduce his tax liability by structuring the $3,027,515 he would receive as deriving

purely from a stock sale and deserving of preferential tax treatment. In general,

tax reduction is an acceptable goal as long as the reduction involves transactions

with substance and is by legal means. Frank Lyon Co. v. United States, 435 U.S.

561, 583-584 (1978). It does not, however, enable a taxpayer to ignore relevant

information.

Petitioner chose to ignore a lot of relevant information. He did not disclose

crucial information to his tax advisers, including the merger agreement and the
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[*13] shareholder’s consent. He disregarded the $787,671 determined value of his

stock, and he disregarded Zave’s consistent position that treated the balance of the

payments as compensation for services. He apparently did not make himself

aware of the merger terms between Zave and Google, which reflected the intent of

the two parties that generated petitioner’s income in issue--an intent that petitioner

would receive both deferred compensation and capital gain income from his

execution of the employment and assignment agreement and the sale of his Zave

stock. Petitioner testified that these terms were unknown to him, even though as a

shareholder he had consented to be bound by them. Failing to explain

persuasively why the express terms of the merger should be ignored, petitioner

instead relies heavily on his side contract with Zave, letter agreement II, even

though it incorporates the merger agreement.

Petitioner argues that, through letter agreement II, he negotiated a higher

share price than other shareholders and that the $3,027,515 he received was all

consideration for the sale of his Zave stock. However, petitioner has given no

persuasive reason why Zave, with its postmerger funds, would be willing to pay

more for his stock than its determined value. His expressed desire for a 3% share

of the company does not establish that his stock was equal in value to, or sold for,

$3,027,515. And while petitioner testified that his shares were worth a higher
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[*14] price because Zave needed his stock to complete the merger deal, he also

testified that he was a minority stockholder and his dissent essentially would not

have any effect because Zave needed only a majority interest.

Moreover, letter agreement II was silent as to a specific amount being paid

for the stock. Instead, it provided that to receive the merger-based income from

Zave, petitioner had to fulfill two requirements: (i) he had to sell his stock; and

(ii) he had to sign the employment and assignment agreement. While petitioner

contends that he gave up only one asset of any worth--the Zave stock--Zave

obviously considered his employment and assigns to have considerable value with

respect to its merger negotiations. And petitioner undermined his own position

when he testified that, if he had dissented, then the merger would most likely not

have gone through, not because of his stock ownership, but because he had to

“sign over all the intellectual property and sign on with Google.”

Still, petitioner contends that none of the income in issue was given to him

for fulfilling the second requirement because he was so well compensated--

through wages and bonuses and other benefit--by becoming a Google employee.

However, his prior or future compensation does not preclude him from having

been paid, in part, for his signing of the employment and assignment agreement.

On its face, letter agreement II strongly suggests that petitioner’s signing of the
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[*15] employment and assignment agreement was an imperative condition to

receive the merger-based income.

Another indication that letter agreement II was not intended to memorialize

a pure stock sale is its “Internal Revenue Code Compliance including I.R.C. §

409A” section. Section 409A is titled “Inclusion in Gross Income of Deferred

Compensation under Nonqualified Deferred Compensation Plans.” While arguing

that letter agreement II is not a deferred compensation plan, petitioner fails to

explain why Zave and he, with his tax advisers, negotiated letter agreement II to

include a section referencing section 409A and to include language like “payment

will be subject to all adjustments, tax withholdings, if any, and escrow as required

in the Merger Agreement”.

Petitioner also argues that Zave misclassified a portion of his merger-based

income because it did not know how to handle his particular situation. The record

strongly suggests that Zave did exactly what it intended. Zave and Google, not

petitioner, were the negotiating parties of the merger and agreed to the schedules

that listed petitioner as a deferred compensation recipient. When petitioner

became aware that Zave, through the merger terms and through its payroll

company, treated most of his “consideration” as deferred compensation, he did not

attempt to cure Zave’s alleged breach either by requiring Zave to reissue a
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[*16] corrected Form W-2 or by pursuing legal recourse against Zave in

accordance with the “Governing of Law and Forum” section of letter agreement II.

Instead, petitioner elected only to take “amenable” action to attempt to

correct the situation. This action amounted to a single demand letter, allegedly

being sent to Zave, which threatened the filing of a legal suit and the challenging

of Zave’s reporting through an adverse position to be taken on petitioner’s tax

return. In the letter, De Luna referenced the outdated letter agreement dated

August 1, 2011, because petitioner had not disclosed that he had already executed

letter agreement II. The demand letter received no response from Zave.

Consequently, petitioner chose to use his Federal income tax return to

“undo” Zave’s Federal information return, Form W-2, in an attempt to obtain

preferential tax treatment. Yet in his written explanation attached to Form 4852,

petitioner included only that part of letter agreement II that referred to the stock

sale while omitting the section that referred to the employment and assignment

agreement. Thus, petitioner obscured his true tax situation from both his tax

advisers and the Internal Revenue Service.

Petitioner also claimed estimated tax payments that he never made to

achieve his sought-after tax treatment. That he had to fabricate information on his

return in order to get this result should have been a clear indicator that what he
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[*17] was doing was improper. Cf. Jenkins v. Commissioner, T.C. Memo. 2012-

181 (ruling against a taxpayer whose goal was to have no taxable income and who

attempted to achieve this result by self-preparing revised Forms 1099-MISC,

Miscellaneous Income, and Form 1099-C, Cancellation of Debt, to reflect zero

nonemployee compensation and zero cancellation of indebtedness income).

In the end, it appears that petitioner made a decision to receive his merger-

based income and his position at Google without causing a stir about receiving

deferred compensation. He then used his 2011 income tax return in an attempt to

“regain” his desired preferential tax treatment that he had earlier abandoned by not

challenging Zave. We cannot presume that in an agreement to pay petitioner for

completing two requirements Zave actually intended for the entire amount to be

paid with respect to only one of those requirements. The preponderance of the

evidence, without regard to burden of proof, is that petitioner received the value of

his stock and compensation for service previously rendered or to be rendered in

the future. Accordingly, respondent’s determination on this issue is sustained.

Section 6662 Accuracy-Related Penalty

Section 6662(a) and (b)(1) and (2) imposes a 20% accuracy-related penalty

on any underpayment of Federal income tax attributable to a taxpayer’s negligence

or disregard of rules or regulations, or a substantial understatement of income tax.
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[*18] An understatement of income tax is substantial if it exceeds the greater of

10% of the tax required to be shown on the return or $5,000. Sec. 6662(d)(1)(A).

Because we determine that there is a substantial understatement of income tax, we

need not address negligence.

Under section 7491(c), the Commissioner bears the burden of production

with regard to penalties and must come forward with sufficient evidence

indicating that it is appropriate to impose penalties. Higbee v. Commissioner, 116

T.C. at 446-447. Respondent has satisfied the burden of production by showing

that there is a substantial understatement because the amount of the

understatement, $369,071, exceeds 10% of the tax required to be shown on the

return, $767,287, and, alternatively, is greater than $5,000.

Once the Commissioner has met the burden of production, the taxpayer

must come forward with persuasive evidence that the penalty is inappropriate--for

example, by showing that he or she acted with reasonable cause and in good faith.

Sec. 6664(c)(1); Higbee v. Commissioner, 116 T.C. at 448-449. The decision as

to whether a taxpayer acted with reasonable cause and in good faith is made on a

case-by-case basis, taking into account all pertinent facts and circumstances. See

sec. 1.6664-4(b)(1), Income Tax Regs. Generally, the most important factor is the

extent of the taxpayer’s effort to assess her or his proper tax liability. Id. While
 - 19 -

[*19] reliance on the advice of a professional tax adviser does not necessarily

demonstrate reasonable cause and good faith, such reliance can establish

reasonable cause and good faith “if, under all the circumstances, such reliance was

reasonable and the taxpayer acted in good faith.” Sec. 1.6664-4(b)(1), Income Tax

Regs.

Petitioner argues that he relied on professional tax advisers, namely his

return preparer and tax attorneys, to ensure that the capital gain tax treatment he

desired would be achieved. While his effort to achieve his desired tax treatment is

evident, that is not the same thing as making an effort to assess the proper tax

liability. Petitioner chose to keep from his advisers essential facts, such as the

amount of stock he owned and the stock’s determined value in comparison to the

amount he was receiving, and essential documents, such as the executed consent

of the shareholders and the initial merger agreement. It is not reasonable for

petitioner to rely on his tax advisers where he had knowingly obscured the

complete picture of his tax situation from them.

Additionally, the return preparer Richter--who prepared the Form 4852--did

not testify. We have no evidence as to the competence and expertise of the

preparer, and it appears that the preparer relied solely on petitioner’s

representations. Under the circumstances, petitioner is not entitled to rely on the
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[*20] preparer. See Neonatology Assocs., P.A. v. Commissioner, 115 T.C. 43, 99

(2000), aff’d, 299 F.3d 221 (3d Cir. 2002).

Moreover, misrepresenting information on Federal tax forms, as petitioner

did when he reported withheld taxes as estimated tax payments, does not show

good-faith effort to reach the proper tax liability. Petitioner has failed

to prove that he acted with reasonable cause and in good faith under section 6664.

We have considered the other arguments of the parties, but they are

irrelevant, unsupported by the record or by authority, or without merit.

To reflect the foregoing,

Decision will be entered

for respondent.