Capital gain tax on disputed sale in shareholder’s forced buyout

Tax problem with capital gain taxes, S Corp capital gain tax problem

Ninth Circuit holds that gain was recognized on disputed sale in shareholder’s forced buyout

Glenn Hightower v. Comm., (CA9 2/12/2008)

The Court of Appeals for the Ninth Circuit, affirming the Tax Court’s decision, has held that an individual who had been a 50% co-owner of an S corporation and who effectively was ousted by the other owner had to recognize gain on the forced sale of his stock in the year he received payment for it. This was so even though he continued to dispute the forced buyout in state courts after the payment was made.

Facts. Glen Hightower and Daniel O’Dowd each owned 50% of the stock of an S corporation known as Green Hills Software, Inc. Their shareholders’ agreement provided that any dispute between them would be resolved through binding arbitration and either of them could compel a buyout of the other’s stock at a formula price.

Relations between the two co-owners eventually deteriorated to the point that in ’98 O’Dowd triggered the buy/sell provision of the shareholders’ agreement by offering either to sell his shares to Hightower for $47 million or to buy Hightower’s shares for that amount. Although Hightower didn’t want to sell his stock, he couldn’t obtain financing to buy O’Dowd’s stock for $47 million. Accordingly, O’Dowd compelled a buyout of Hightower’s stock.

Hightower demanded arbitration regarding O’Dowd’s buyout, but the arbitrator ruled in O’Dowd’s favor. Hightower received a check from O’Dowd in 2000 for $41,585,388, which Hightower deposited into an interest bearing account. Hightower, who used the cash method, didn’t report this payment or any interest on it on his return. When Hightower later sought to have the arbitration award set aside in state court, he lost. He appealed all the way to the state’s top court, which in 2003 declined to hear his case.

Tax Court’s decision. The Tax Court, rejecting a wide variety of taxpayer’s arguments, held that Hightower recognized gain on the forced sale of his stock in 2000, the year he received payment for it. The Tax Court found that Hightower wasn’t holding O’Dowd’s payment in trust in a segregated account nor had he involuntarily received the funds and unconditionally renounced his right to them by creating a separate account. Hightower, who voluntarily cashed the check for the payment, intended to return the funds only if he succeeded in rescinding O’Dowd’s buyout. The Tax Court rejected his argument that the sale was incomplete because he tendered his shares without endorsing the certificates, noting that the arbitrator and state courts found that Hightower’s stock was purchased in 2000. The Tax Court concluded that even if payment to Hightower violated state law, a later determination to that effect wouldn’t absolve him from his tax liability in the year of the receipt. Further, the gain did not escape tax, as Hightower argued, under the claim of right doctrine–under which a payment is includable in income in the year in which a taxpayer receives it under a claim of right (even if that claim is disputed by another party) and without restriction as to its disposition.

Ninth Circuit finds forced sale resulted in gain. The Ninth Circuit held that the stock payment Hightower received for his share of Green Hills was taxable income in 2000 because it was received without restriction as to its disposition and because he had no fixed legal obligation to restore the funds to any other party. This conclusion wasn’t altered by the possibility that the stock transaction could have later been unwound by a state court. Hightower’s unilateral intent not to claim and exercise dominion over the funds didn’t affect his tax liability. Similarly, for federal tax purposes, it was irrelevant that the transaction may have left Green Hills with a negative net worth in violation of state law. Further, because the stock payment was taxable income to Hightower in 2000, the interest which accrued on the principal was also taxable income in the year the interest was received.

The Court also held that Hightower had to report the pass-through distributive share of Green Hills’s income allocated to him in 2000. Even though Hightower’s role in Green Hills management may have been restricted, he still retained beneficial ownership of his shares through the sale date. The arbitration award didn’t have the effect of divesting him of beneficial ownership of his Green Hills shares in ’98, as Hightower claimed. Rather, it merely gave O’Dowd the financial benefit of the bargain retroactively once the sale took place in 2000.

Mike Habib, EA