Venture Funding v. Commissioner

Beghe, J., concurring in result and dissenting in part: Judge Ruwe’s concern (see his dissenting op. p. 267) over the unsatisfactory result his correct analysis seems to require and my own sense that there must be more to this fully stipulated case than either side chose to present has led me to review the record made by the parties. My review of the record raises such troubling questions that I am impelled to set them forth, with supporting references to their sources in the record and petitioner’s brief, in the face of the views of my colleagues and the courts that judges must refrain from trying to tell respondent how to do his job. See, e.g., United States v. Payner, 447 U.S. 727, 737-738 (1980).

(1) Why didn’t respondent issue statutory notices of deficiency to petitioner’s employees who received Endotronics shares as compensation? 1

(2) Why didn’t respondent summarily assess employment taxes that petitioner should have withheld and paid over in respect of the Endotronics shares petitioner caused to be paid to its employees as compensation? 2

(3) Why didn’t respondent’s statutory notice, rather than determining, as an alternative to disallowing the compensation deduction claimed by petitioner, that petitioner had “taxable capital gain” in the same amount as the claimed deduction on petitioner’s transfer of the Endotronics stock to petitioner’s employees (see majority op. p. 238 note 2), instead determine that petitioner had ordinary income in the same amount as the claimed deduction upon its own receipt of those same shares as compensation? As indicated by facts in the stipulated record disclosed by the explanation of the next question, that determination would be without regard to whether the deduction claimed by petitioner were allowed or disallowed.

(4) More to the point, why didn’t respondent’s statutory notice to petitioner include in petitioner’s gross income the full stipulated value — $5,976,563—of the total number of 7,650,000 Endotronics shares that petitioner received as compensation? 3 Included in the stipulated record is the plan of reorganization 4 under which the bankruptcy court approved the issuance to petitioner of 7,650,000 shares — 51 percent of the new common stock of Endotronics 5 — as consideration for petitioner’s undertakings to provide Endotronics with management services and necessary financing. 6

(5) If the 3- and 6-year periods of limitation on assessment have expired on respondent’s right to take the actions described in any or all of the foregoing questions, would respondent still have any arguably valid grounds for taking any such actions against petitioner and/or petitioner’s controlling person or persons, as might be shown to be appropriate? Compare Burke v. Commissioner, 105 T.C. 41 (1995) with Zackim v. Commissioner, 91 T.C. 1001 (1988), revd. 887 F.2d 455 (3d Cir. 1989).

This is a fully stipulated case that was submitted without a trial pursuant to Rule 122, and with only one round of concurrently filed briefs. Included in the stipulated record, apparently at petitioner’s request, is the Debtor’s (Endotronics’) Amended Disclosure Statement, which contains the plan of reorganization above referred to. Petitioner’s proposed findings of fact, as set forth in petitioner’s brief, are replete with references to the disclosure statement and the plan, including the admission (petitioner’s proposed finding 75) that petitioner was entitled under the plan to receive 7,650,000 newly issued Endotronics shares.

The majority does not adopt any of petitioner’s proposed findings regarding the background and terms of the plan, inasmuch as those findings are irrelevant to the majority’s theory of how the case should be decided. In my view, however, petitioner, by including the disclosure statement and plan in the stipulated record, has caused the issues raised in questions 3 and 4 above in effect to be tried by consent. I believe that the case should not be regarded as fully submitted for decision until the parties have been asked to respond to questions 3 and 4, which appear to me to be ineluctably inherent in the facts of the case as presented by petitioner with respondent’s consent.

If respondent on a motion for reconsideration and leave to amend answer should attempt to raise questions 3 and/or 4, and such a motion should be denied by the Court on the grounds of lateness or surprise, or for whatever reason, then respondent could try to put question 5 in play, insofar as petitioner is concerned, if respondent should conclude that there are grounds for sending petitioner a second notice of deficiency pursuant to section 6212(c). See Burke v. Commissioner, supra.

There may be facts not in the record that would belie the inferences that have led me to concur in the majority’s result and to raise the foregoing questions. There may be explanations that would point out errors in my reading of the record and provide answers that would confirm that there’s nothing more that respondent can or should do. It’s up to respondent’s management, in the exercise of its discretion, to decide whether the questions warrant any inquiry and action at this time.

Petitioner’s brief suggests that the employees may not have reported the receipt of the shares as income because the shares were “letter stock” under the Federal securities laws and could not be sold on the public market without a registration statement for a 2-year period following receipt. The suggestion appears misplaced in two respects: (1) It was clear at the time the shares were received that letter stock is not subject to a substantial risk of forfeiture under sec. 83(a) and that letter stock restrictions do not postpone the receipt of income, as demonstrated by the cases cited in petitioner’s brief, decided prior to the receipt of the shares, see Pledger v. Commissioner, 641 F.2d 287 (5th Cir. 1981); Robinson v. Commissioner, T.C. Memo. 1985-275 ; Phillippe v. Commissioner, T.C. Memo. 1982-30 ; Cassetta v. Commissioner, T.C. Memo. 1979-384 ; see also Robinson v. Commissioner, 82 T.C. 444, 467 (1984) (sec. 83(c)(3) is not in issue here); Horwith v. Commissioner, 71 T.C. 932 (1979); Grant v. United States, 15 Cl. Ct. 38 (1988)), and (2) petitioner’s chief executive officer, owning 49.95 percent of its stock (the parties have stipulated that he directed and controlled all aspects of petitioner’s activities), signed petitioner’s return, which claimed the corporate deduction as a miscellaneous deduction for “consulting” and did not report on the officers’ salary schedule on p. 2 of the return the compensatory shares received by him and petitioner’s other officers, even as petitioner was not reporting on the same return its compensation income on receipt of a much larger number of Endotronics shares and he was not reporting on his own return his personal income on the shares received by him as compensation.

The parties have stipulated that petitioner did not issue Forms W-2 or 1099 disclosing the payments of the compensatory shares to its employees. It seems likely that petitioner omitted the value of the Endotronics shares from the amounts of compensation paid to its employees from the Forms 941 that it was required to file with respect to employment taxes under subtit. C, ch. 24 of the Code.

In addition, petitioner may well have caused Endotronics, which became controlled by petitioner under the terms of the plan of reorganization approved by the bankruptcy court, not to file a Form 1099 for the 7,650,000 shares that Endotronics issued to petitioner, including the portion of those shares issued, at petitioner’s direction, to petitioner’s employees, as compensation to petitioner for its commitments to provide management services and necessary financing. The plan of reorganization discloses that more than 3 months before issuance of the shares petitioner’s treasurer had been named chief financial officer of Endotronics.

The only clue on petitioner’s return to its receipt of the 7,650,000 Endotronics shares is that line 22 of the yearend consolidated balance sheet Schedule L shows paid-in or capital surplus of $5,976,563, which did not appear on the corresponding balance sheet for the beginning of the year. This is the exact fair market value of the 7,650,000 shares that petitioner received on Apr. 4, 1988 (at the stipulated value of $.78125 per share).

The plan of bankruptcy reorganization to which petitioner and Endotronics were parties in the transactional sense did not immunize petitioner’s receipt of the Endotronics shares from the recognition of taxable income. The transaction in which petitioner received the Endotronics shares did not satisfy the definition of a recapitalization reorganization under sec. 368(a)(1)(E) or of an insolvency reorganization defined by sec. 368(a)(1)(G) as:

a transfer by a corporation of all or part of its assets to another corporation in a title 11 or similar case; but only if, in pursuance of the plan, stock or securities of the corporation to which the assets are transferred are distributed in a transaction which qualifies under section 354, 355, or 356.

An operative requirement of both (E) and (G) reorganizations is an exchange of stock or securities. In this case there was no such exchange. Petitioner received the stock of Endotronics as compensation for providing services; petitioner did not transfer any stock or securities in itself or of any other corporation in exchange for the Endotronics shares.

The premier treatise on venture capital does not discuss the factual situation presented by the Venture Funding, Ltd. acquisition of control of Endotronics. See Levin, Structuring Venture Capital, Private Equity, and Entrepreneurial Transactions (1997), especially ch. 8, “Structuring a Turn-Around Investment in an Overleveraged or Troubled Company”. The role of the venture capitalist (VC) in the example described in ch. 8, see Levin, supra at 264-265, is to contribute $8 million in new money to “Badco” and to receive in exchange (while preexisting creditors and shareholders are suffering various “haircuts”):

$7.9 million face of new senior preferred stock, mandatorily redeemable 10 years after issuance, plus

1,000 new common shares (at a stated price of $100 per common share, i.e., an aggregate of $0.1 million). [Levin, supra sec. 802.1.1, at 264.]

Under the facts of the example, the new common shares received by VC (1,000 out of 3,950) amount to 25 percent of Badco’s postrestructuring common stock. It goes without saying that the exchange of cash by VC for newly issued preferred and common stock of Badco is a nontaxable transaction to both of them. No gain or loss is realized by (much less recognized to) either party to the transaction, and the only obvious tax question presented by the example is how the $8 million of consideration is to be allocated between the preferred and common stock.

Petitioner’s undertaking to provide necessary financing, as well as management services, would appear to cause the shares allocable to that undertaking to be treated as a commitment fee, included in the gross income of the recipient as compensation for services at the time of accrual or receipt. See Rev. Rui. 70-540, 1970- 2 C.B. 101 (issue 3), declared obsolete on another issue by Rev. Proc. 94-29, 1994- 1 C.B. 616 , 621; see also Chesapeake Fin. Corp. v. Commissioner, 78 T.C. 869, 879 (1982); Metropolitan Mortgage Fund, Inc. v. Commissioner, 62 T.C. 110, 120 (1974).