Wanting something to be true won’t necessarily make it true.  And, it turns out, hiring advisers to help you achieve the tax result you want, but then “editing” the information you provide them doesn’t allow you to rely on their work or get out of penalties when you are found to owe tax due to reality not comporting with your view of what should have been the reality.

This was the problem in the case of Brinkley v. Commissioner, TC Memo 2014-227, affirmed CA5, No. 15-60144.  The taxpayer in this case was an individual who was working for a technology company start-up and was given stock in the enterprise.  As is often true in such entities, the organization went out regularly to obtain new equity funding which served to dilute the interest of existing shareholders.

Mr. Brinkley was not happy with the dilution of his shares, telling the entity that he would not remain in the organization if his interest fell below 3% of the equity.  Initially the company issued Mr. Brinkley additional shares that brought him back to 3%, but later rounds of funding ended up diluting his interests yet again.

At this point Google made on offer to purchase the company, an offer which the company wanted to accept.  However Mr. Brinkley was upset that because his interest was less than 3% of the equity, he would receive less than 3% of the price Google was paying.

This was a problem, since as part of the acquisition Google wanted Mr. Brinkley to sign an employment agreement and agree to transfer any intellectual property rights that he might have.  So initially the company sent Mr. Brinkley an offer to pay him in cash the difference between just over 3% of the price Google was paying for the entire enterprise and the value of the stock he had. 

Mr. Brinkley was concerned that this would cause him to be taxed on that amount as ordinary income.  His accountant advised him that, yes, that payment would be taxed as ordinary income. 

At this point he hired attorneys who attempted to negotiate on his behalf a revised agreement.  However while he informed the attorneys he had an equity interest in the enterprise, he failed to inform them that the interest he currently held was far less than 3% of the outstanding interests in the entity (and thus begins his “editing” of information provided to professionals).

Eventually this negotiation resulted in the following letter from the enterprise to Mr. Brinkley:

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  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.”

Mr. Brinkley signed this agreement.  In that same month he received a copy of the merger agreement, a document he did not share with his advisers.  The merger agreement referred to schedules which were not contained in the document he received.  Despite being referenced in the agreement he read, Mr. Brinkley did not request copies of those schedules.  The schedules referred to the payments to Mr. Brinkley as deferred compensation.

Despite not having all of the agreement, Mr. Brinkley signed a letter consenting to be bound by the merger agreement.  The letter contained a clause providing that Mr. Brinkley agreed he had an opportunity to review with his tax advisers the implications of the merger agreement—though Mr. Brinkley did not take advantage of that opportunity.  He also entered into an employment agreement with Google at that time.

The Court summarized the final results of this agreement when the merger closed as follows:

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.

The amount Mr. Brinkley received that was listed as deferred compensation had taxes withheld—and Mr. Brinkley was not happy with that result.  He consulted with his tax advisers and legal counsel who suggested filing a lawsuit with regard to the issue.  However, Mr. Brinkley decided to pursue the matter through correspondence only.

His attorney wrote a demand letter to the company referencing a letter issued earlier in the negotiations than the one Mr. Brinkley agreed to—because the attorney had never been informed of this second letter. 

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.

On his return Mr. Brinkley reported the entire proceeds as being from the sale of his stock, thus obtaining long term capital gain treatment.  He removed the deferred compensation amount, and the withholdings on that amount, from his W-2.  He reported the additional taxes withheld as estimated taxes on his Form 1040, even though he had paid no such estimates.

He included a 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.) to his return to reflect his revised W-2 amount reported.  He also included an attachment to the Form 4852 indicating that $1,879,779.03 of stock compensation wages were actually proceeds from the sale.

In addition to editing material provided to his advisers, Mr. Brinkley also included selective portions of his agreement with his employer.  The Court noted:

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.

He did not include his agreement to accept the merger agreement as part of this information provided to the IRS.

The IRS, after looking at this return, concluded that, in fact, the W-2 was correct and assessed tax against Mr. Brinkley, an assessment the taxpayer challenged in the Tax Court.

The Tax Court was not impressed with Mr. Brinkley arguments, nor with his protest that he had sought out advisers that helped him conclude that the amounts were solely for the purchase of his shares.

As the Court noted:

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 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.

And continues:

...[The l]etter 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.”

Finally:

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 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.

...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.

...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.

The Court decided that he had failed to pursue obtaining a structure in his favor in order to get his (not so small) payday, and that having given up his claim to “really” own 3% of the enterprise to get the cash, he had to live with that treatment.

As well, he was subject to penalties even though he sought out professional advice.  When a taxpayer “edits” the information given to advisers, reliance on their advice is no longer a reasonable attempt to comply with the tax laws.  In this case, having kept key information out of the hands of his advisers (that he had signed a form consenting to the merger agreement and its terms, which specifically treated his payment as largely deferred compensation), he gave up the right to claim reliance on their advice.

The taxpayer did not find a sympathetic ear when he appealed the Tax Court’s decision to the Fifth Circuit Court of Appeals.  The Court found flaws in Mr. Brinkley’s positions for a number of reasons including:

• “First and foremost, the plain text of letter agreement II supports the Commissioner's position. It sets forth two conditions on Brinkley's receipt of the merger consideration: (1) the exchange of Brinkley's Zave shares and (2) the execution of a Key Employee Offer Letter and Proprietary Information and Inventions Assignment Agreement with Google. Brinkley argues that the entire $3.1 million in consideration must have been for the first condition alone, as this amount had been set in letter agreements I and I(a) — which contained no reference to the second condition — and he was set to receive generous compensation from Google for his future employment. But letter agreement I is ambiguous in its intent — it provided compensation for Brinkley's stock, but also stated in its introduction that the agreement was "in consideration of [Brinkley's] employment with [Zave]." Further, while letter agreement I(a) does seem to provide consideration exclusively for Brinkley's stock and does not mention past or future services to be performed, this letter was never actually presented to Brinkley. Most significantly, neither letter agreement I nor I(a) were ultimately executed by the parties and are thus of limited relevance. Both parties ultimately executed letter agreement II, which unambiguously lists both conditions and includes a merger clause that supersedes all prior agreements.”
• “Further, Brinkley signed the shareholder-consent form, which affirmed that he had read the merger agreement and bound him to accept its terms. The schedules to the merger agreement identified Brinkley as a recipient of deferred compensation and characterized letter agreement II as a deferred-compensation plan. Brinkley responds that letter agreement II does not appear to be a deferred-compensation plan, and he points out that he was not asked to sign the consent form required of other deferred-compensation recipients. This may be true, but it misses the mark. Even if Brinkley's payout was not part of a formal deferred-compensation plan, this does not mean that the payout could not be properly characterized as deferred compensation. The primary definition of the term "deferred compensation" actually just describes a method of payment: "Payment for work performed, to be paid in the future or when some future event occurs." Black's Law Dictionary 343 (10th ed. 2014).[8] Brinkley's signing of the employment and assignment agreements, per the requirement of letter agreement II, was the service he performed that entitled him to the additional $1.8 million payment that Zave would later distribute to him. In addition, letter agreement II includes a paragraph titled "Internal Revenue Code Compliance including I.R.C. § 409A" — referring to a statute that addresses deferred-compensation plans — and within this paragraph states that payment will be "subject to all adjustments, tax withholdings, if any, and escrow as required in the Merger Agreement" and would be paid out "only at the time(s) and to the extent of the definitive [merger] agreements" with Google. Zave's treatment of this payment as deferred compensation subject to ordinary-income tax withholding is consistent with the definition of deferred compensation and with the terms of letter agreement II.”

The panel also concurred with the Tax Court’s view that he failed to provide all information to advisers, negating any theory that he had reasonably attempted to determine his tax liability and could escape penalties based on reasonable cause.  As the Court noted:

There is no genuine dispute that Brinkley failed to consult with his advisers before signing the Action by Written Consent form, neglected to share letter agreement II with De Luna (the author of the demand letter to Zave and the sole member of Brinkley's team of advisers who testified at trial), and omitted reference to the quantity and determined value of his shareholdings in discussions with De Luna. In addition, although some testimony at trial indicated that Richter had a master's degree in accounting, Richter did not testify and so could not speak to his qualifications and the information in his possession when he advised Brinkley. Moreover, Richter was no longer in contact with Leighton and De Luna at the time he filed Brinkley's return, so while he may have conferred with the attorneys previously, there is no evidence concerning his work after his departure. These facts lend credence to the tax court's conclusion that Brinkley did not make a good faith effort to assess his tax liability and could not reasonably rely on his advisers. See Green, 507 F.3d at 872 (affirming the denial of the defense where, inter alia, "there was no evidence as to what Green told the preparer, what the preparer told Green, and whether or not Green's reliance on any advice from the preparer was reasonable").