Taxpayer Has Ordinary Income From Merger-Related Payment

By James A. Beavers, J.D., LL.M., CPA, CGMA

Gross Income

The Tax Court held that part of a payment made to a company's co-founder and employee in a merger transaction was deferred compensation that was taxable as ordinary income.


Brian Brinkley was one of the founders of a computer company, Zave Networks. He initially worked as an independent contractor for the company and later as an employee in the position of chief technology officer. As one of Zave's founders, Brinkley initially owned 9.8% of Zave's stock, and as an employee he received additional stock through restricted stock grants. He made elections under Sec. 83(b) with respect to all stock grants issued to him by Zave that were not immediately vested.

Each time investors infused capital into Zave, Brinkley's interest was diluted, leading him to threaten to leave the company should his interest ever fall below 3%. When Zave raised additional capital in or around late 2008, the company, in deference to Brinkley'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, Brinkley'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.

In 2011, Google Inc. agreed to purchase Zave for $93 million through a merger. Although Brinkley did not participate in the merger negotiations, as part of the deal, Google required that Brinkley turn over his Zave-related intellectual property and become a Google employee. Based strictly on the shares of stock he owned, Brinkley was to receive $800,000 of the $93 million purchase price. This displeased Brinkley, who thought he was entitled to receive at least 3% of the purchase price. To mollify him, Zave offered to pay him more money from the sale of the company and began negotiating with him over the exact terms. He initially included his accountant and two lawyers in these negotiations, but later proceeded on his own.

In the final agreement between Zave and Brinkley related to the merger, Zave agreed that following the merger, it would pay Brinkley consideration of approximately 3% of the purchase price offered by Google for Zave in exchange for all of Brinkley's shares, warrants, and options of Zave stock and ­Brinkley's execution of a key employee offer letter and a proprietary information and inventions assignment agreement with Google as required in the merger agreement between Google and Zave. The agreement also provided that, if he did not comply with the terms of the merger agreement, Brinkley would receive only the amount he was entitled to for the value of his Zave shares in the absence of the agreement. Additionally, the agreement included a section that described how the payment would be treated for federal tax purposes, including Sec. 409A.

Brinkley later signed the required key employee offer letter and proprietary information and inventions assignment agreement. In his capacity as a Zave shareholder, he also consented to the merger agreement and agreed to be bound by its terms. In addition, he acknowledged that he had a chance to review the tax consequences of the agreement with his tax advisers.

Brinkley believed that the agreement would result in the amount he received from the merger being treated entirely as a payment for his stock and that the amount, less the basis in his Zave stock, would be capital gain. However, Zave believed differently, and it had its payroll processor send Brinkley a check that indicated that approximately $1.88 million of the amount was deferred compensation that was ordinary income to Brinkley. The W-2, Wage and Tax Statement, for 2011 that Zave sent Brinkley also reflected this treatment. However, Brinkley, in completing his 2011 returns, took matters into his own hands. On his return, he indicated that both the amounts reported as ordinary income and the amounts withheld related to that income were part of the payment for his Zave stock.

Upon receiving his return, the IRS determined that the income reported by Zave as deferred compensation was taxable as ordinary income to Brinkley and sent him a notice of deficiency. Brinkley challenged the IRS's determination in Tax Court.

The Tax Court's Decision

The Tax Court held that the amount Zave reported as deferred compensation was not part of the payment for Brinkley's stock and that it should be taxed as ordinary income. The court found that under his agreement with Zave, Brinkley was required to do two things: sell his stock and sign the employment and assignment agreement. The amount paid to Brinkley for the second requirement, which was the amount Zave reported as deferred compensation, was for service previously rendered or to be rendered in the future and thus was taxable as ordinary income.

Brinkley claimed alternatively that he had simply negotiated a higher price for his shares in the company than the other shareholders or that his shares were more valuable because Zave needed them to complete the deal with Google. The court noted, however, that Brinkley provided no evidence as to why Zave would have been willing to pay him more for his stock, and he admitted in his testimony that Zave did not need his minority stock interest to complete the merger. The court further noted that while Brinkley claimed he gave up only one asset of value under the agreement—his stock—he undermined this claim when he testified that, if he had not agreed to sign over his intellectual property and work for Google, Google would not have gone through with the merger.

Brinkley also contended that none of the merger payment was for signing the employment and assignment agreements because he was being compensated by being given a generous compensation package as a Google employee, but the court observed that prior or future compensation did not preclude him from having been paid for signing the agreements. The court in addition pointed out that the section of the agreement that dealt with compliance under Sec. 409A indicated that the agreement was not intended to memorialize a pure stock sale because Sec. 409A deals with the inclusion in income of deferred compensation from nonqualified plans.


As the Tax Court noted, Brinkley's situation seems to have been the result of his unwillingness to press Zave for an agreement related to the merger that worked better for him from a tax standpoint. Although he made an elaborate effort to obfuscate the true nature of the income he received on his return, he ended up with the tax results he deserved based on the actual agreement he made.

Brinkley, T.C. Memo. 2014-227

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