Or, The Big Payday

 Papa Allen and his sons are fighting over the boodle, when the kids bought out Papa via a cashless stock option in Allen L. Davis, et al., 2011 T.C. Mem. 286, filed 12/12/11. Judge Kroupa faces an all-star cast of lawyers in this consolidated proceeding (fourteen for the battling Famous Famiglia Davis, and four for IRS). This is a “whipsaw”–someone owes big-time tax, and IRS doesn’t care who.

Briefly, Papa Allen fronted the kids $100K to open a business called Check-N-Go, a payday lender. In the old days, it was six for five in seven days, or three broken fingers in eight; the sharks would lend a worker five dollars and get back six dollars in seven days. Should the worker not pay, the appropriate digits would. Now, in these enlightened days with direct wage deposit, the shark just gets a check in advance for the amount lent, and cashes it electronically on the magic day–perfectly legal–and nobody gets hurt.

Now the business took off. Papa Allen just happened to have been a banker, and he had to stay in the business so the kids could get bank loans and expand the business. Did they ever; the business grew at a 37% annual rate. Now the business was a Sub S, with the kids, and some of their cronies who also bankrolled them in the earlies, as shareholders, along with Papa Allen.

There were various buyout and rights of first refusal, so when Mama Allen tried to dump Papa Allen and grab half his stock, the kids threatened to use the buy-sell to pick Mama Allen’s pocket on the way to the courthouse.

Finally, Papa Allen wants to take the money and run, he and the kids having taken turns kicking one another off the Board of Directors and out of management. The kids were now making it on their own (we don’t need no stinkin’ gratitude). So Papa Allen cashes out for $36 million, according to IRS, and $25,31,378.30, (so in original, at p. 14) according to Papa Allen’s pet appraiser, via a redemption of his stock, called the cashless option, by the corporation per an amended buy-sell. Judge Kroupa dumps the appraisal, stating that the stock could not be readily valued, the strike price for the redemption was negotiated after the kids had fought with Papa Allen, and so the price was freely negotiated. And to use Papa Allen’s appraiser’s valuation means the corporation would be taking a big loss on the redemption.

Now Papa Allen claims he had no income from the redemption. And, he claims, the corporation, which treated the payout to Papa Allen as compensation, has no deduction. The corporation (the kids and cronies) claim yes, it was compensation and we have the deduction. IRS says “we don’t care, talk among yourselves, but someone is paying tax.”

Judge Kroupa says the kids credibly testified that Papa Allen got the redemption deal because they needed to keep him in management to secure bank financing, and needed his banking creds to keep their lenders happy. Besides, the redemption agreement required Papa Allen to notify the corporation if he was electing Section 83(b) treatment and recognizing gain in the year he got the redemption option. If it isn’t compensation, Section 83 doesn’t apply, so why mention it?

Now that it’s compensation, is it reasonable? Section 162 doesn’t help. But Judge Kroupa takes a practical approach. “At the time the agreement was entered into, it was fair to CNG [the corporation]. Allen threatened to leave CNG unless he was given the opportunity to maintain his ownership interest in CNG. CNG, however, needed Allen to secure financing. The bank group extended CNG credit only because of Allen’s experience at Provident, and the covenant in the credit agreement required Allen’s participation in the day-to-day management of CNG. CNG needed that financing to fuel its exponential expansion.

“CNG was exceptionally successful from the time the Allen Option was granted to the time it was exercised. During that period, CNG opened 272 new stores. CNG’s revenues increased approximately 37 percent from $199.3 million to $272.7 million, and its EBITDA increased approximately 40 percent from $44.6 to $62.3 million.

“This success was mostly attributable to Allen. CNG could not have expanded as quickly as it did without Allen because the covenant requiring Allen’s participation in CNG’s management was not removed until the credit agreement was renegotiated in September 2004. ‘An employee responsible for the financial success and growth of a large and complex enterprise is entitled to substantial compensation.’ Lundy Packing Co. v. Commissioner, T.C. Memo. 1979-472; see also Albert Van Luit Co. v. Commissioner, T.C. Memo. 1975-56.” 2011 T. C. Mem. 258, at pp. 19-20.

So with this tribute to his business acumen and managerial skill, Judge Kroupa sticks Papa Allen with $36 million in income, and a Rule 155 bean-count to enjoy. Meantime the kids and cronies split a $36 million flow-through deduction against ordinary income.

Takeaway–Nothing like building a successful business to get you slammed by your family and the IRS.