Synopsis
Section 83 of the Internal Revenue Code, Property Transferred in Connection with
the Performance of Services, contains the income recognition rules applicable to
receipt of restricted stock for less than fair market value. In general, income
is not recognized until stock is both transferred and vested, i.e., not subject
to a substantial risk of forfeiture. If stock meets these criteria, it is taxed
even if the recipient cannot transfer the property to a third party.
Alternatively stated, in order to avoid taxation, stock must be both
nontransferable and subject to a substantial risk of forfeiture.
Morton, a 1997
Tax Court Memorandum decision, highlights the need to have a formal valuation
done when employees are given the right to purchase shares of stock outright for
a price other than fair market value. The case also identifies the weaknesses in
valuation work not done contemporaneously with the issuance of the stock.
Finally, the case makes clear that the complexities of the Internal Revenue Code
need to be understood by valuation experts who issue reports for tax purposes.
Background
Morton was a business executive who specialized in retail marketing, having been
a senior vice president of operations for Home Depot, Inc. The founders of Soft
Warehouse Inc., which later became Comp USA after its sale to Dubin Clark,
recruited Morton for his proven expertise in expanding locations in May of 1989.
Relevant quotations from the case that provide the fact pattern follow:
"Dubin Clark’s purchase of SWI was structured as a stock purchase followed by a
merger. … In exchange for their stock in old SWI, the selling shareholders were
to receive a total of $5 million in cash, the right to purchase approximately 27
percent of the stock of new SWI for $60.98 per share, and contingent annual cash
payments for 5 years following the sale equal to 30 percent of the company’s
operating profit in excess of $4 million per year. One-half of the contingent
payments was designated as ‘incentive compensation’ to insure the continuing
involvement of the selling shareholders in the management of SWI. The other half
was designated as ‘earn-out’ payments." (Emphasis added)
"SWI calculated the $60.98 price per share that the former owners paid for the
stock of new SWI by dividing paid-in capital by the number of shares outstanding
after the acquisition (i.e., paid-in capital as of January 31, 1989, $439,056,
divided by total shares outstanding on the same date, 7,200). The cash portion
of the purchase price was paid with retained earnings from old SWI and the
proceeds of debt incurred by new SWI. Prior to the Dubin Clark purchase, SWI had
virtually no long-term debt. After the buyout, SWI had approximately $5 million
in outstanding debt." (Emphasis added)
The transactions described above were completed in January of 1989.
"… on June 1, 1989, SWI’s board of directors adopted a ‘Share Compensation Plan’
(hereinafter referred to as the stock plan). … The stock plan did not require
that the stock be sold at fair market value. In fact, Dubin Clark contemplated
that most of the shares would be sold for less than fair market value. Under the
terms of the stock plan, the price was originally set at $60.98 per share … No
valuation of SWI’s stock was made at the time the stock plan was adopted."
(Emphasis added)
On July 13, 1989 Morton purchased 500 shares of SWI stock for $60.98 per share.
"The stock petitioner [Morton] purchased pursuant to the agreement was subject
to certain restrictions. Petitioner could not sell, assign, transfer, pledge, or
dispose of the stock to any person or entity other than SWI. In addition, all of
the shares were initially ‘unvested’. However, 20 percent of the shares received
were to become vested on the anniversary of the purchase each year, so that all
of the shares would be vested 5 years from the date of sale. The agreement also
required SWI to repurchase all of petitioner’s shares within 90 days of any
termination of employment other than a voluntary termination by petitioner. The
repurchase price for vested shares was equal to the adjusted book value per
share. The price for the unvested shares was set at the lesser of the adjusted
book value per share or the original purchase price." (Emphasis added)
§83 and the regulations
Morton filed a §83(b) election with his tax return for 1989.[2] This election
permits the acceleration of the income recognition associated with the receipt
of restricted stock to the date of receipt, rather then the date when the
forfeiture and transferability restrictions lapse. The reason for making such an
election is to restrict the amount of ordinary income to the difference between
the value of the stock on the date of receipt and the amount paid for such stock
(if any), so that any subsequent appreciation will be taxed at capital gain
rates. It also starts the holding period for long-term capital gain purposes
(currently more than one year).
1.83-2(a) In General.
If property is transferred (within the meaning of §1.83-3(a)) in connection with
the performance of services, the person performing such services may elect to
include in gross income under section 83(b) the excess (if any) of the fair
market value of the property at the time of transfer (determined without regard
to any lapse restriction [see below], as defined in § 1.83-3(i)) over the amount
(if any) paid for such property, as compensation for services. The fact that the
transferee has paid full value for the property transferred, realizing no
bargain element in the transaction, does not preclude the use of the election as
provided for in this section. (Emphasis added)
It is important to note that the regulations under §83 describe two types of
restrictions: lapse restrictions and nonlapse restrictions. Nonlapse
restrictions are restrictions that by their terms will never lapse. Importantly,
a nonlapse restriction, taken alone, will not result in a substantial risk of
forfeiture. An example of such a nonlapse restriction from the regulations
follows: “A limitation subjecting the property to a permanent right of first
refusal in a particular person at a price determined under a formula is a
permanent nonlapse restriction.”[3] (Emphasis added)
Stock subject to nonlapse restrictions has special valuation rules:
1.83-5(a) Valuation.
“For purposes of section 83 and the regulations thereunder, in the case of
property subject to a nonlapse restriction … the price determined under the
formula price will be considered to be the fair market value of the property
unless established to the contrary by the Commissioner, and the burden of proof
shall be on the commissioner with respect to such value. … However, in certain
circumstances the formula price will not be considered to be the fair market
value of property subject to such a formula price restriction, even though the
formula price restriction is a substantial factor in determining such value. For
example, where the formula price is the current book value of stock, the book
value of the stock at some time in the future may be a more accurate measure of
the value of the stock than the current book value of the stock for purposes of
determining the fair market value of the stock at the time the stock becomes
substantially vested.” (Emphasis added)
A lapse restriction is defined as any restriction that is not a nonlapse
restriction. The fair market value of property for §83 is determined without
regard to any lapse restrictions, as stated above in §1.83-5(a). The receipt of
stock is taxable at the vesting date. If the lapse restriction subsequently
causes the stock to be forfeited, any loss on forfeiture is treated as ordinary.
“If a person is taxable under section 83(a) when the property transferred
becomes substantially vested and thereafter the person’s beneficial interest in
such property is nevertheless forfeited pursuant to a lapse restriction, any
loss incurred by such person (but not by a beneficiary of such person) upon such
forfeiture shall be an ordinary loss to the extent the basis in such property
has been increased as a result of the recognition of income by such person under
section 83(a) with respect to such property.”[4]
The Court’s analysis
“The sole dispute between the parties to this case is over the fair market value
of the stock at the time of the purchase, June 30, 1989. In their section 83(b)
election, petitioners claimed that the fair market value of the stock was $60.98
per share, the price petitioner paid for his 500 shares. In the notice of
deficiency, respondent determined that the fair market value of the stock was
$1,739.82 per share, and that petitioners’ 1989 taxable income should therefore
be increased in the amount of $839,420 (i.e., $1,739.82 minus $60.98 times 500).
In a report prepared for trial, petitioners’ [Morton] expert valued the stock at
$55 per share. At trial, respondent’s expert testified that the stock was worth
$1,798 per share.” (Emphasis added)
The presence of lapse restrictions in the Morton case was one key to the
approach taken by the Court in its analysis.
“Because petitioners made a section 83(b) election with respect to the subject
stock, and because the restrictions on the stock were not perpetual [i.e., they
lapsed], the value of the SWI stock for section 83 purposes must be determined
as though the restrictions did not exist.”
In addition, since the stock in this matter was not subject to nonlapse
restrictions, the burden of proof with respect to valuation remained with the
taxpayer.[5]
The following quote is a critical element of the case and, in fact, the
principal reason for this article. No valuation was performed at the time that
Morton purchased the stock. As noted earlier, the purchase price Morton paid was
60.98 per share, which was based upon the book value of the SWI at the time of
the Dubin Clark transaction.
“SWI did not obtain an independent valuation of its stock until June 14, 1990.
Petitioner did not personally obtain an appraisal of the subject stock until
preparation for trial. SWI stock was not publicly traded at any time during
1989.”
Judge Whalen extensively criticized Morton’s expert in the opinion. The areas of
criticism included the fact that the expert relied solely on the income
approach, using the discounted free cash flow method. Judge Whalen provided
extensive detail of the valuation assumptions, critiqued them, and then
recomputed the valuation result by varying the assumptions!
“[Petitioners’ expert] relied solely on the income approach in valuing the SWI
stock. [Petitioners expert] did not use the market comparison approach because
he believed that there were no sufficiently comparable companies in existence as
of the valuation date.”
The assumptions, as detailed by Judge Whalen
[Petitioners’ expert] utilized a “discounted cash flow analysis” to calculate
the fair market value of SWI stock. … He calculated this net income figure by
estimating the total sales SWI could expect to generate from each store and
multiplying by the number of stores SWI could be expected to operate each year.
… assumed that SWI would expand its operations rapidly from 1989 to 1994, and
that it would open a constant number of new stores each year thereafter until
1999, reaching a total of 271 stores in that year. He also assumed that newly
opened stores would generate revenues of $25 million per year, while mature
stores would generate $35 million.
… assumed that this figure [incremental working capital] for each year would
equal 7 percent of the increase in sales over the previous year. (Emphasis
added)
… reduced “debt-free residual cash flow” each year to present value, applying a
discount rate of 35 percent. … He believed that SWI presented a particularly
risky investment due to difficulties in obtaining financing for expansion and a
high degree of risk in the computer and related markets. Additionally,
[Petitioners’ expert] believed that “The [discount] rates for venture capital
funds averaged between 30 to 60 percent or more due to the business risk
associated with SWI’s position.” He did not cite any authority for this
conclusion either in his expert report or in his testimony at trial, nor did he
state whether this rate of return is generally required for venture capitalists
or is specific to an investment in SWI. [Petitioners’ expert] believed that a
35-percent rate of return was necessary not only to justify the high degree of
risk involved in Dubin Clark’s investment in SWI, but also to allow Dubin Clark
to make an overall profit despite the failure of other ventures.
[Petitioners’ expert] computed this [equity] value assuming 6 percent, 7
percent, and 8 percent “terminal growth rates”. This produced per share values
of ($72.38), $100.14, and $285.43, respectively. [He] then reduced these figures
to reflect a “minority and marketability discount” of 50 percent, which he based
on the Mergerstat Review 1989. This produced a range of values of ($36.19),
$50.07, and $142.72 per share. Based on this range, [he] concluded that the fair
market value of SWI stock as of June 30, 1989, was $55 per share.
Judge Whalen was completely unimpressed with Morton’s expert.
We find petitioners’ expert’s valuation unpersuasive. First, the results of
[Petitioners expert’s] analysis fluctuate wildly with minor changes in basic
assumptions. For example, minor changes in what [Petitioners’ expert] terms
“Incremental Working Capital” cause drastic changes in the overall value of the
stock under his analysis. “Incremental Working Capital” is measured as a
percentage of the increase in sales over the prior year. Throughout his
analysis, [Petitioners’ expert] assumed that SWI would require working capital
each year equal to 7 percent of the increase in sales over the previous year.
However, a change in this figure of just 1 percentage point to 6 percent,
leaving all of [Petitioners expert’s] other assumptions unchanged and applying a
7-percent growth rate, causes the price per share to increase, by our
calculation, to $1,748.17. This is troubling in light of the fact that
[Petitioners expert] agreed on cross-examination that 6 percent was a reasonable
figure for incremental working capital. Given the importance of incremental
working capital to [Petitioners expert’s] valuation model, and the volatile
effect this figure has on his overall valuation, we find troubling [Petitioners
expert’s] concession as to the reasonableness of using 6 percent. Moreover, we
note that information contained in [Petitioners expert’s] report suggests that
SWI’s incremental working capital had fluctuated between 1.7 percent and 7.58
percent during the 4-year period from 1986 to 1989.
… the discount rate is another extremely problematic variable in [his] model.
Changing the discount rate just 2 percentage points, from 35 to 33 percent,
leaving all other variables the same and applying a 7- percent growth rate,
causes an increase in the overall valuation from, by our calculation, $47.33 per
share to $1,161 per share. A discount rate of 30 percent produces a final value
of $3,551 per share. … the volatile nature of [his] valuation model, along with
the lack of objective support for his assumptions, causes us concern about the
accuracy of his final calculation.
Notwithstanding the strenuous attacks on Morton’s valuation expert, all of the
blame for the taxpayer’s loss of this case does not belong to the valuator. The
valuation result of $55 closely approximated the value used by Morton is his tax
return of $60.98. However, the parties to the January 1989 SWI transaction
clearly did not intend the $60.98 to represent fair market value:
“The language of the stock plan itself confirms that the board of directors
contemplated selling stock at less than fair market value. Paragraph 4(a) of the
stock plan provides as follows:
The purchase price for the shares of Common Stock to be offered and sold from
time to time by the Company pursuant to this Plan hall be initially $60.98 per
share and thereafter as determined from time to time by the Board. The Board is
authorized to offer and sell shares of Common Stock pursuant to this plan at
less than fair market value in order to compensate qualified employees,
directors, officers, consultants and advisers of the Company”
There was additional ample evidence that $60.98 was not the fair market value of
the share. A valuation performed in June of 1990, one year later, reached a
result of $2,500 per share. An October 1990 private placement memo used a value
of $15,000 per share. Morton reported the value of an additional 25 shares he
received in April 1990 at $2,600 per share.
The result
The burden of proof being on the taxpayer and that burden not having been met,
the Tax Court decided in favor of the IRS’s value of $1,739.82. This increased
Morton’s income by $839,420 and income taxes by $296,702. The Court also
sustained a negligence penalty (§6662) of $59,340.
Analysis
Mr. Morton’s expert relied solely on the income approach in his valuation.
Careful consideration of the two other approaches to valuation – the market and
cost approached – is necessary. This is not to say that the expert failed to
perform the task correctly, only that the Court disagreed. Courts have
historically preferred the market approach because of the emphasis placed on it
in Revenue Ruling 59-60. Today, the income approach enjoys a preference in the
valuation community. Valuation is always subjective, but market data is often
difficult to analyze due to incomplete information and/or inability to isolate
strategic value elements when using the Merged and Acquired Company method.
Subjective lack of control discounts for minority interests such as Mr. Morton’s
and marketability discounts are then needed. Use of the Guideline Public Company
method usually gets around the insufficient data requirement, but then requires
highly subjective application of marketability discounts to obtain the value of
a private company interest like Morton’s.
Discounted cashflow models are indeed invariably highly sensitive to one or more
variables. Depending upon the Judge, it may be advisable to identify those
variables and explain in detail the ultimate choices. On the other hand, this
can be disadvantageous if it gives the IRS a roadmap to attacking the model. It
is not clear from the record, which approach, if either was used in the Morton
case.
Conclusion
Clearly, taxpayers who fail to obtain an opinion as to fair market value where
one is necessary to determine the tax consequences of a transaction do so at
their own risk. Obtaining an expert report after the fact for litigation
purposes is a risky proposition. In choosing an expert, the taxpayer-client
should be certain to evaluate the expert’s familiarity with the Internal Revenue
Code and prior Court rulings, as well as the individual’s particular expertise
as a valuator.
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