128 T.C. No. 13
UNITED STATES TAX COURT
KEVIN B. KIMBERLIN AND JONI R. STEELE, ET AL.1, Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket Nos. 24499-04, 24500-04, Filed May 8, 2007. 8752-05.
X and Y entered into a private placement agreement, pursuant to which X would serve as the placement agent for the sale of Y’s preferred stock. Y did not adhere to the agreement. A dispute ensued and was later settled. Pursuant to the settlement agreement, in 1995 Y issued to X warrants to purchase shares of Y preferred stock. In 1997, the warrants were exercised. R, in his notices of deficiency, determined that the warrants were transferred in connection with the performance of services, and the income from the warrants is taxable in 1997 pursuant to sec. 83, I.R.C.
1 Cases of the following petitioners are consolidated herewith: Kevin Kimberlin Partners Ltd. Partnership, Kevin B. Kimberlin, Tax Matters Partner, docket No. 24500-04; and Spencer Trask & Co. and Subsidiary f.k.a. Spencer Trask Holdings, Inc. and Subsidiary, docket No. 8752-05. - 2 -
Held: R’s determination is in error because the warrants were not transferred in connection with the performance of services.
Held, further, the warrants had an ascertainable fair market value on the date of grant in 1995 and are therefore taxable in that year.
Solomon Leo Warhaftig, David Lederkramer (specially
recognized), Peter Adebanjo (specially recognized), and Andre
Castaybert (specially recognized), for petitioners.
Lydia Branch, Shawna Early, and Fredrick Mutter, for
respondent.
OPINION
FOLEY, Judge: The issues for decision in these cases are
whether: (1) Warrants issued to petitioners in accordance with a
settlement and release agreement were transferred in connection
with the performance of services and therefore constitute taxable
income pursuant to section 83;2 (2) the warrants had a readily
ascertainable fair market value in 1995, on the date of grant, or
in 1997, the year of exercise; and (3) the payment to Kevin
2 Unless otherwise indicated, all section references are to the Internal Revenue Code for the years in issue, and all Rule references are to the Tax Court Rules of Practice and Procedure. - 3 -
Kimberlin (i.e., the warrants transferred to him by Spencer
Trask) is a constructive dividend, return of capital, or capital
gain.
Background
Kevin Kimberlin (Mr. Kimberlin) is an investment banker and
an 87-percent shareholder of Spencer Trask & Co. (Spencer Trask).
Kevin Kimberlin Ltd. Partners (Kimberlin Partners) is a TEFRA
partnership that was established on December 28, 1995. Mr.
Kimberlin is the sole general partner with a 1-percent interest.
The remaining interests in Kimberlin Partners are held by
entities partly or wholly owned by Mr. Kimberlin.
Ciena Corp. (Ciena), a Delaware corporation, was formed in
1992 to develop and market dense wavelength division multiplexing
systems for long-distance fiberoptic telecommunications networks.
Ciena, in need of financing, planned several private stock
offerings and a subsequent initial public stock offering. The
relationship between Mr. Kimberlin and Ciena began in 1993 when
Mr. Kimberlin, through INNO Co., a New York-based investment
company that is wholly owned by Mr. Kimberlin, provided Ciena
with $190,000 in seed capital and a $300,000 letter of credit
pursuant to a stock subscription agreement.
On November 9, 1993, Ciena entered into an exclusive private
placement agreement (1993 PPA) with Spencer Trask Ventures - 4 -
(Ventures). Ventures, a New York-based investment banking firm
that specializes in obtaining early-stage financing for
technology companies, is a wholly owned subsidiary of Spencer
Trask. The terms of the 1993 PPA provided that Ventures would
attempt to raise $3 million to $5 million through a private
placement offering of Ciena stock. In exchange for such
services, Ciena agreed to pay Ventures a cash commission equal to
10 percent of the amount raised and issue Ventures warrants3 to
purchase a number of shares (i.e., based on the number of shares
sold in the offering). The warrants were exercisable for a
period of 5 years at $5 per share.
On April 8, 1994, Ciena and Ventures amended the 1993 PPA to
allow another investment banking firm to serve as the placement
agent for the offering of Ciena series A convertible preferred
stock. These changes were memorialized by an amended private
placement agreement (1994 PPA). The 1994 PPA provided that
following Ciena’s series A convertible preferred stock offering,
Ventures would serve as the placement agent in the offering of
3 Warrants, also referred to as “stock warrants”, are similar to stock options. They are certificates that allow the owner to purchase a specified number of shares, at a specified time, for a specified price. Whereas stock options are normally granted to employees, warrants are granted to the general public. They are typically options to purchase stock over a long period and are freely transferable instruments. Black’s Law Dictionary 1617 (8th ed. 2004). - 5 -
Ciena series B convertible preferred stock (series B offering).
Pursuant to the 1994 PPA, Ciena was obligated to pay Ventures a
cash commission and warrants to purchase a number of shares
(i.e., based on the number of shares sold in the offering) of
series B convertible preferred stock. In addition, the agreement
provided:
In the event * * * [Ciena] does not, at its option, proceed with the Offering on the terms set forth herein * * * [Ciena] will issue to * * * [Ventures] a warrant, exercisable for a period equal to the earlier of (x) three years or (y) the occurrence of an initial public offering, to purchase up to 150,000 shares of Series A Preferred at a price of $1.00 per share.
Ciena subsequently decided not to use Ventures as the
placement agent for its series B offering. Instead, it sold its
series B stock through direct sales methods to institutional and
noninstitutional investors. In December 1994, Ciena sold
3,549,106 shares of series B stock for $1.50 per share and
received a subscription for another 1 million shares, and in
January and February 1995, sold an additional 2,804,986 shares of
series B stock for $1.50 per share. Ciena did not adhere to the
1994 PPA, and as a result, Ventures did not have the opportunity
to, and did not, perform any services for Ciena. Ciena asserted
that the only redress available to Ventures, for Ciena’s failure
to use Ventures as the placement agent for the series B offering,
was the damages determined pursuant to the liquidated damages - 6 -
clause in the 1994 PPA. On December 21, 1994, Ciena sent a
letter to Ventures terminating the 1994 PPA and enclosed a
warrant for 150,000 shares of Ciena series A convertible
preferred stock.
Following Ciena’s termination of the 1994 PPA, a dispute
arose between Ciena and Ventures. Ventures asserted that, as a
result of Ciena’s breach of the 1994 PPA, Ciena was liable for
full compensatory damages, rather than the liquidated damages
delineated in the agreement. On February 10, 1995, Ciena and
Ventures settled their dispute pursuant to a settlement and
release agreement (SRA). The SRA provided: “[Ciena and] each of
* * * [Spencer Trask] and Affiliates agree that, as of the date
of this Agreement, the Placement Agreement as amended to date is
hereby terminated and of no further force and effect”, thus
terminating the 1994 PPA.
The SRA also provided for the issuance of warrants to
Ventures “exercisable for an aggregate of 300,000 shares of
Convertible Preferred Stock, Series B, of Ciena Corporation” at
$2 per share. The exercise period for the SRA warrants was the
earliest to occur of: 4 years from the date of the SRA, the
consummation of any public offering of the company’s stock, or
the sale of all or substantially all of the company’s assets.
The SRA further provided for Ciena to pay $35,000 of legal fees - 7 -
Ventures incurred in preparation of documents relating to the
1993 PPA and the 1994 PPA. In addition, Spencer Trask, Ventures,
and each of its affiliates agreed to “forever release, acquit and
discharge [Ciena] * * * of and from the * * * [Spencer Trask]
claims and from any and all causes of action”.
Following the execution of the SRA, Ventures designated Mr.
Kimberlin to receive warrants to purchase 250,000 shares of Ciena
stock, Spencer Trask to receive warrants to purchase 45,000
shares, and Laura McNamara to receive warrants to purchase 5,000
shares. On June 25, 1996, upon Mr. Kimberlin’s request, Ciena
reissued, to Kimberlin Partners, the warrants to purchase 250,000
shares. Following a 5-for-1 stock split in February 1997, the
warrants to purchase 300,000 shares at $2 per share were
converted into warrants to purchase 1,500,000 shares at an
exercise price of 40 cents per share.
On February 5, 1997, Spencer Trask and Kimberlin Partners
exercised all of the warrants and purchased 1,500,000 shares of
Ciena series B convertible preferred stock. Checks totaling
$600,000 were paid to Ciena. On the date of exercise, the mean
selling price per share of Ciena preferred stock was $29.30. On
February 7, 1997, Ciena held its initial public offering. The
mean selling price per share of Ciena common stock on that date
was $35.68. - 8 -
Spencer Trask did not report, on its originally filed 1995
return, income from the receipt of warrants, nor did it report
income from the exercise of the warrants on its 1997 return. In
March 1998, Spencer Trask filed an amended return relating to
1995 and reported $13,500 of income relating to the receipt of
the warrants. On February 16, 2005, respondent mailed a notice
of deficiency to Spencer Trask. The notice of deficiency
determined that, pursuant to sections 83 and 61, the warrants
received by Spencer Trask resulted in $43,950,000 of taxable
income in 1997 (i.e., the year the warrants were exercised).
Mr. and Mrs. Kimberlin did not report income from the
receipt of warrants on their originally filed 1995 return, nor
did they report, on their 1997 return, income from the exercise
of the warrants. In March 1998, Mr. and Mrs. Kimberlin filed an
amended tax return relating to 1995 in which they reported
$76,500 of income relating to the receipt of the warrants. On
September 24, 2004, respondent mailed separate notices of
deficiency to Mr. and Mrs. Kimberlin. The notices of deficiency
determined that in 1997 Mr. Kimberlin received a dividend from
Spencer Trask of $36,625,000 relating to the exercise of
warrants.
After Mr. Kimberlin received warrants pursuant to the terms
of the SRA, the warrants were reissued, in accordance with Mr. - 9 -
Kimberlin’s request, to Kimberlin Partners. Kimberlin Partners
exercised those warrants on February 5, 1997, for 1,250,000 Ciena
shares and in 1998 sold the shares. Kimberlin Partners reported
the sale of the Ciena stock on Schedule D of its 1998 Form 1065,
U.S. Return of Partnership Income. On September 24, 2004,
respondent mailed to the tax matters partner of Kimberlin
Partners and to each partner a notice of final partnership
administrative adjustment (FPAA). The FPAA determined that, in
1998, the partnership was entitled to an increased basis for the
1,250,000 shares of Ciena stock purchased with the warrants
issued to Kimberlin Partners in 1996.
On December 27, 2004, Mr. and Mrs. Kimberlin, while residing
in Greenwich, Connecticut, filed their petition with the Court
seeking review of the 2004 notice of deficiency. That same day,
Kevin Kimberlin, tax matters partner for Kimberlin Partners Ltd.
Partnership, filed a petition seeking review of respondent’s
FPAA. At the time of the petition, the partnership maintained
its principal place of business in Greenwich, Connecticut. On
May 13, 2005, Spencer Trask, whose principal place of business
was New York, New York, filed its petition with the Court seeking
review of the 2005 notice of deficiency. On September 23, 2005,
the Court granted the parties’ joint motion to consolidate these
cases. - 10 -
Discussion
I. Applicable Law
Pursuant to section 83, the warrants are taxable as income
if they were issued to Ventures “in connection with the
performance of services”. Sec. 83(a). Whether property is
transferred in connection with the performance of services is
essentially a question of fact. Bagley v. Commissioner, 85 T.C.
663, 669 (1985), affd. 806 F.2d 169 (8th Cir. 1986). Section
1.83-3(f), Income Tax Regs., provides:
Property transferred to an employee or an independent contractor * * * in recognition of the performance of, or the refraining from performance of, services is considered transferred in connection with the performance of services within the meaning of section 83. * * * The transfer of property is subject to section 83 whether such transfer is in respect of past, present, or future services.
Ventures was prevented, by virtue of Ciena’s breach, from
performing services it very much wished to perform. The warrants
were issued to Ventures pursuant to the SRA, and not in
recognition of the performance of, or the refraining from the
performance of, Ventures’ past, present, or future services.
Indeed, respondent stipulated that Ventures “never performed any
services for Ciena”. In short, the requisite connection between
the issuance of the warrants and the performance of services does
not exist. Thus, section 83 is inapplicable. - 11 -
Respondent’s contentions throughout the course of the
litigation were inconsistent, confusing, and unconvincing.
Initially, at trial, respondent contended that the payments made
pursuant to the SRA were payments for Ventures to refrain from
the performance of services, but he later contended that the
payments were made pursuant to an employment contract. In his
opening brief, respondent changed his position and contended that
“Although Spencer Trask received a warrant to purchase 300,000
shares of Ciena Series B Stock, rather than the 150,000 shares of
Series A stock specified in the liquidated damages clause, the
warrants were granted as a result of the triggering of the
liquidated damages clause.” (Emphasis added.) None of these
positions, however, are supported by the facts. In his reply
brief, respondent continued his quest for a plausible contention.
He first suggested that “the parties renegotiated a larger
liquidated damages amount rather than settle a breach of contract
claim”, a contention squarely at odds with the plain language of
the SRA. Ultimately, respondent formed a coherent, yet flimsy
contention, asserting that the warrants were transferred in
connection with Ventures’ performance, rather than its refraining
from performance, of services. In his reply brief, respondent
states:
The essential facts in this case, which support a finding that the warrants were transferred in connection with the performance of services are: (1) - 12 -
there was an employment contract, the PPA, that required Ventures to perform underwriting services and required Ciena to transfer cash and warrants to Ventures for the performance of such services; (2) the sole consideration to be furnished by Ventures was investment banking services; (3) Ciena’s intent was to secure the services of Ventures; (4) Ventures was available to perform the services as a placement agent at the time Ciena opted not to use its services; (5) Ventures at least engaged in preparatory work and was reimbursed $35,000 for preparation of documents related to the PPA; and (6) the warrants at issue were granted to Ventures as a result of the triggering of the liquidated damages clause contained in the employment contract.
These “essential facts” simply fail to support respondent’s
position. Numbers 1 through 3 merely state that a contract
existed and describe the intent of the parties in performing the
contract. In support of number 4 (i.e., respondent’s recitation
of the fact that “Ventures was available to perform the
services”), respondent cites section 1.280G-1, Income Tax Regs.,
inapplicable regulations relating to parachute payments. Number
5, emphasizing legal fees Ventures incurred relating to the PPAs,
is not a pertinent fact. Finally, number 6 returns to the
specious contention respondent presented in his opening brief:
that the warrants were issued as a result of the liquidated
damages clause. Even if a connection was established by virtue
of the warrants in the liquidated damages clauses of the PPAs,
all such connections were severed by the SRA, which superseded
the PPAs. - 13 -
II. Determination of the Warrants’ Ascertainable Fair Market Value
Because section 83 is not applicable, the transferred
warrants are taxable in the year of grant if they had an
ascertainable fair market value at that time. See sec. 61; sec.
1.1001-1(a), Income Tax Regs. The fair market value of property
is a question of fact and only in rare and extraordinary cases
will property be considered to have no fair market value.
Schulman v. Commissioner, 93 T.C. 623, 638 (1989); sec. 1.1001-
1(a), Income Tax Regs.
Respondent’s expert testified that the warrants for Ciena
stock had no ascertainable fair market value on the date of
grant. He was not credible. Once the Court qualified him as an
expert, the performance of respondent’s expert, a former ski
instructor, went downhill fast. He inaccurately stated his
credentials, repeatedly contradicted himself, inappropriately
relied on a colleague not disclosed in his report, and insisted
that multiple errors in his report were the fault of his
“editor”. His lack of analytical rigor is exemplified by the
fact that he did not realize, until cross-examination, that the
entirety of the supporting text he relied on in the fourth
edition of a particular textbook had been deleted from the sixth
and current edition. Indeed, he conceded that two of the - 14 -
textbooks upon which he relied were 6 years old and two editions
out of date.
In his analysis of whether Ciena stock had an ascertainable
fair market value, respondent’s expert inexplicably insisted that
contemporaneous arm’s-length sales of Ciena series B stock (i.e.,
the 7,354,092 shares Ciena sold in 1994 and 1995 for $1.50 per
share) were not pertinent in determining the stock’s fair market
value. He stated:
I don’t know if the relevant facts can show a value of $1.50 to be prudent and reasonable. It’s just unclear. There’s no fact pattern to suggest the $1.50 is reasonable other than there’s unrelated parties transacting a negotiated price. [Emphasis added.]
When the Court later questioned whether he was “trying to
determine fair market value”, respondent’s expert stated that
fair market value could not be determined, as a certified
financial analyst he was obligated to follow a “higher standard”,
and he attempted to determine the “intrinsic value” of the
warrants. In sum, we find respondent’s expert’s report and
testimony of no value.4 See Parker v. Commissioner, 86 T.C. 547,
561 (1986) (opinion testimony must be weighed in the light of the
4 Pursuant to sec. 7491(a), petitioners have the burden of proof unless they introduce credible evidence relating to the issue that would shift the burden to respondent. See Rule 142(a). Our conclusions, however, are based on a preponderance of the evidence, and thus the allocation of the burden of proof is immaterial. See Martin Ice Cream Co. v. Commissioner, 110 T.C. 189, 210 n.16 (1998). - 15 -
demonstrated qualifications of the expert and all other evidence
of value).
Petitioners’ expert, founder of an economic consulting
company, was credible, consistent, and highly qualified. In
determining a fair market value for the warrants, he began his
analysis with a consideration of the 7,354,092 shares of series B
stock Ciena sold in 1994 and 1995 for $1.50 per share. He then
applied prudent valuation techniques (i.e., focusing on venture
capitalist benchmark rates of return) to arrive at a fair market
value, on the date of grant, of 90 cents per share.
Accordingly, we find that there was an ascertainable fair
market value for the warrants on the date of grant, the value of
the warrants was includable in 1995, and respondent erred in
determining a deficiency when the warrants were exercised in
1997.
III. Warrants as Dividend Income to Mr. Kimberlin
Pursuant to section 61(a)(7), gross income includes
dividends. The term “dividend” is defined in section 316(a) as a
distribution of property by a corporation to its shareholders out
of its earnings and profits. There is no requirement that the
dividend be formally declared or even intended by the
corporation. Gulf Oil Corp. v. Commissioner, 89 T.C. 1010, 1028
(1987), affd. 914 F.2d 396 (3d Cir. 1990). Any portion of a
distribution which is not a dividend is applied to the adjusted - 16 -
basis of the shareholder’s stock, and to the extent it exceeds
the adjusted basis of the stock, is treated as gain from the sale
or exchange of property. Secs. 301(c)(1)-(3), 316(a).
Mr. Kimberlin received the warrants as a distribution from
Spencer Trask in 1995. When a distribution is a distribution
other than cash, the fair market value of the property is
determined as of the date of distribution. Sec. 1.301-1(b),
Income Tax Regs.; see Weigl v. Commissioner, 84 T.C. 1192, 1220-
1223 (1985). Thus, the warrants Mr. Kimberlin received should be
valued at the time of receipt (i.e., 1995). See sec. 1.301-1(b),
Income Tax Regs. We previously determined that the warrants had
an ascertainable fair market value at the time of distribution,
and thus they were taxable income to Mr. Kimberlin upon their
receipt in 1995.
Contentions we have not addressed are irrelevant, moot, or
meritless.
To reflect the foregoing,
Decisions will be entered
for petitioners.