The approval of an acquisition transaction of a privately held company typically requires a majority vote by the company’s shareholders. However, in certain circumstances, the majority shareholders may need the minority shareholders to approve the transaction as well. The minority shareholders’ approval may be required under state law or by the company’s incorporation documents, it may be desired to protect the company’s reputation, or to ensure its continuing operations without interference. To secure the minority shareholders’ approval of the transaction, the majority shareholders often pay the minority shareholders for their consent. Such payment is often referred to as a “side payment.”1
Often, a side payment is made out of the acquisition consideration. The majority shareholders may agree to be paid less for their shares, while the minority shareholders receive more for theirs. For example, assume a company with one class of common stock whereby the majority shareholders hold 80 shares and the minority shareholders hold 20 shares. Further assume that buyer is willing to pay USD100 for the company, or USD1 per share. To secure the minority shareholders vote in favor of the contemplated transaction, the majority shareholders agree to receive USD70 for their shares, and have the minority shareholders receive USD30 for their shares.2 The effect of the arrangement is that a USD10 side payment is made to the minority shareholders. The minority shareholders effectively receive USD1.50 per share for their stock, whereas the majority shareholders receive USD0.875: same stock, different price.3 And the question arises – what is the proper tax treatment of a side payment to secure the minority shareholders’ consent to a transaction?
Surprisingly, there is very little authority or guidance that deals with side payments. What little authority that exists is almost four decades old and the IRS position on this issue seems questionable, to say the least.
II. The IRS Position
The Internal Revenue Service’s (“IRS ”) position seems to be that each shareholder is deemed to receive the amount it is entitled under state law in the transaction, and that the side payment is regarded a separate consideration unrelated to the transaction, the treatment of which is based on all facts and circumstances.
In Rev. Rul. 73-233,4 a 60 percent majority shareholder made a side payment in the form of capital contribution of the target’s stock to the target in anticipation of a tax-free merger. In order to meet the applicable merger laws of the state in which the target was incorporated, a two-thirds vote of the target corporation’s shareholders in favor of the merger was required. The 40 percent minority shareholders demanded and received 50 percent of the merger consideration to agree to the merger. This allocation was implemented by having the majority shareholder make a capital contribution, immediately prior to the merger, of the required number of shares that would reduce his interest in the target to 50 percent (the “side payment ”).
The IRS, however, treated the majority shareholder as first receiving its state law-entitled 60 percent of the merger consideration, and subsequently transferring to the minority shareholders 10 percent of the merger consideration in exchange for voting in favor of the merger.
The IRS viewed the second step as a taxable sale.5 The IRS allowed the majority shareholder a positive basis adjustment in his remaining shares equal to the fair market value of the shares exchanged with the minority shareholders. The minority shareholders were treated as receiving ordinary income equal to the fair market value of the additional shares they received, which then became their basis in those additional shares.6 Rev. Rul. 73-233 seem to be implying that ordinary income treatment is appropriate, much as if the minority shareholders performed a service for the majority shareholder by agreeing to vote for the merger, and just so happened to receive additional shares, instead of cash, as consideration for the service.7
The IRS’s position was also expressed in Rev. Rul. 79-10.8 There, the IRS ruled that a non-pro rata liquidation should be treated as two separate transactions:
- A pro rata liquidation based on each shareholder’s entitled interest in the corporation’s assets giving rise to full payment in exchange for each shareholder’s stock; and
- A separate payment (the side payment) by the majority shareholder to the minority shareholders equal to the excess of the amount the minority shareholders received over their pro rata share.9
However, the IRS’s position in Rev. Rul. 73-233 and in Rev. Rul. 79-10 is questionable, at the very least. Provided that a side payment was indeed made in exchange of a property right relating to the minority shareholders’ ownership in their stock (e.g., to secure their vote for a transaction), the minority shareholders should be entitled to capital gain treatment on the entire amount paid for their stock, including the portion otherwise treated as the “side payment.”10
Shareholders generally have two sets of rights inherent in the ownership of their stock. The first relates to economic rights – for example, the right to receive dividends, the right to liquidation proceeds, and the right to the potential increase in the value of the stock. The second relates to voting – for example, the right to vote for major decisions of the corporation, to vote for or elect the board of directors, etc. Both sets of rights are property rights that determine the total value of the stock.11 The value of the stock is comprised of the value of the different rights inherent in the ownership of the stock. If a side payment were made to minority shareholders in respect of a right inherent in the ownership of the stock – for example, the right to vote for major decisions of the corporation – then that side payment would be made in respect of a property right, and not compensation for services, and would relate to the total value of the stock. As a result, it should result in capital gain treatment to the minority shareholder, and not ordinary income.12
Nonetheless, the IRS position seems to be that a side payment is treated as a separate transaction and that the federal tax consequences of that transaction will depend upon the underlying nature of the payments, which in turn depend upon all of the relevant facts and circumstances.13 These facts and circumstances must be determined from all of the extrinsic and intrinsic evidence surrounding the transaction.14III. The Tax Court View
The Tax Court view seems to be that a side payment may be related to consideration paid in exchange for stock, thereby resulting in capital gain.
In Gidwitz Family Trust v. Commissioner, 15 a minority shareholder received USD225,000 (the side payment) in settlement of a lawsuit against the controlling shareholder, who had agreed to grant the minority shareholder options. The options were orally promised by the controlling shareholder to induce the minority shareholder to approve a merger transaction. (This oral promise was the subject of the legal proceeding between the minority and the majority shareholders that resulted in the settlement amount.) The IRS argued that the side payment should be treated as consideration for the minority shareholder agreeing not to vote against the merger, thereby resulting in ordinary income.
The Tax Court, however, held that the sum received in settlement represented consideration for the minority shareholder’s stock surrendered in the merger, and as a result should be taxable as gain realized from the sale or exchange of capital assets. The Tax Court stated that “[t]he taxability of the settlement is controlled by the nature of the litigation … The nature of the litigation is, in turn, controlled by the origin and character of the claim which gave rise to the litigation.”16 The court concluded that because the underlying claim arose out of the purported inadequacy of consideration received in the merger, the settlement proceeds represented additional consideration that the taxpayers would have received in the underlying merger.17
If a side payment relates to a minority shareholder’s right inherent in the ownership of the stock – for example, the right to vote for a major transaction of the corporation (or refrain from blocking it) – then that side payment bears direct relation to the total value of the stock and should therefore result in capital gain treatment to the selling shareholder. And in any event, proper documentation should be crafted to memorialize the surrounding facts and circumstances as well as the terms of the side payment arrangement to strengthen a more taxpayer friendly tax position.
1 An important distinction should be made between side payments and amounts paid to retain talented shareholders that are also employees. Retention payments are normally treated as compensation for services and are taxed at ordinary income rates. Retention payments are not dealt with in this article.
2 Assume that the buyer in this example is indifferent to the arrangement between the majority and the minority shareholders since the overall purchase price consideration remains the same.
3 But why not? If the fair market value of property is deﬁned as the price at which the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell and both parties have reasonable knowledge of relevant facts, then the same type of stock in the hands of different stockholders could be traded in the same transaction, at a different price, for example, as a result of a different negotiation positions, sensitivity, or willingness to move forward with the transaction. For the deﬁnition of fair market value, see e.g., Rev. Rul. 59-60, 1959-1 C.B. 237.
4 1973-1 C.B. 179.
5 More speciﬁcally, as a taxable sale under §1001. All section (§) references are to the Internal Revenue Code of 1986, as amended (the “Code ”), and the Treasury Regulations (“Treas. Reg. ”) promulgated thereunder.
6 Seealso IRS Letter Ruling 200043004 (8/1/00) (similar transaction to qualify subsidiary for a §355 spinoff).
7 What is also interesting is that the IRS treated the side payment as a capital transaction for the majority shareholder, but as a service giving rise to ordinary income to the minority shareholders. As a result, the majority shareholders would not be able deduct the side payment as an expense, whereas the minority shareholders would have to treat it as ordinary income. Such treatment seems to be self-serving and inconsistent.
8 1979-1 C.B. 140.
9 See also Rev. Rul. 76-454, 1976-2 C.B. 102 (a non-pro rata distribution under a plan of complete liquidation made by a corporation having only one class of stock outstanding is treated as a pro rata distribution, the shareholders are considered to have received their pro rata share of the distribution, and the excess received over a shareholder’s pro rata share is considered as payment, in a separate transaction, from shareholders receiving less than their pro rata share). Cf. Treas. Reg. § 1.351-1(b)(1) (section 351 transaction in which stock received by transferors disproportionately to values of property transferred will be given tax effect in accordance with the transaction’s true nature; the transaction may be treated as if stock received proportionately, followed by a deemed transfer of some stock to make gifts, pay compensation, or satisfy transferor obligations).
10 Arguably, there may not be separate transaction, or a “side payment,” to analyze, since the minority shareholders’ consideration is related to the ownership of their stock and the inherent property rights that determine its total value.
11 See e.g., Rev. Rul. 83-120, 1983-2 C.B. 170 (one factor to be considered in determining the value of a stock is whether the stock also has voting rights. Voting rights, especially voting control, could increase the value of the stock. This factor may be reduced in signiﬁcance where the rights of one class of stockholders are protected under state law from actions by another class of stockholders, particularly where one class is given the power to disapprove a transaction).
12 See Ginsburg, Levin, and Rocap, Mergers, Acquisitions, and Buyouts (September 2015), 701.5 Recapitalization by T to Facilitate a “B” Reorganization.
13 Furthermore, unless the facts and circumstances suggest otherwise, the IRS’s claim that a particular piece of consideration is somehow not in exchange for the target stock appears to be inconsistent with the current position of the IRS in other instances. See LTR 201105016 (February 4, 2011) (consent fee paid in connection with redemption of debt instrument treated as payment for debt); AOD 2012-008; 2013-32 IRB (August 8, 2013) (non-acquiescing to Media Space, Inc., 135 T.C. 424, December 58,359 (2010), vacated and remanded); CA-2, 2012-2 USTC 50,564 (ﬁnding that a forbearance payment made to a corporation’s preferred shareholders not to be a distribution with respect to stock.).
14 Rev. Rul. 79-10, supra note 8. See also GCM 37649 (August 25, 1978).
15 61 T.C. 664 (1974).
16 61 T.C., at 673 (citations omitted).
17 See also David A. Delong, 43 B.T.A. 1185 (1941) acq. 1941-1 C.B. 3. In DeLong, the taxpayer was a minority shareholder in a corporation. In order to induce him to sell his stock as a part of a corporate reorganization, the principal shareholder paid him cash in addition to the stock which he received under the plan of reorganization. The Court held the cash payment to be part of the consideration received in exchange for the stock; PLR 8427024, March 30, 1984.
Originally published in Global Tax Weekly on December 15, 2017.