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Taxpayers Can't Change to Closed Transaction Method of Accounting for Buy-Out Payments.

(Parker Tax Publishing August 6, 2015)

Once a couple elected to report buy-out payments under the open transaction method, generating ordinary income, they were bound to continue using that method absent IRS consent to a change. The taxpayer's were thus unable amend their returns to treat the payments as long-term capital gains. Greiner v. U.S., 2015 PTC 249 (Fed. Cl. 2015).

Background

Until June 1, 2004, Jeffrey Greiner was president of Advanced Bionics Corporation. As part of his compensation package, he received stock options. On June 1, 2004, Advanced Bionics merged with Boston Scientific Corporation. In connection with the merger, all stock options held by Greiner and others were vested and then cancelled. In exchange, Greiner and other option holders had the choice of converting their cancelled holdings to either a one-time cash payment at a rate of $21 per share minus the applicable strike price for each option (the cash election), or a one-time cash payment at $11 per share, minus the strike price, plus a contractual "earn-out" right (the earn-out election). Earn-out recipients were eligible to receive pro rata shares of post-merger payments from Boston Scientific to a grantor trust (the Bionics Trust). Earn-out payments were not guaranteed or fixed, but would be measured by the future performance of certain product lines. The payment right would last nine years, from January 1, 2005, through December 31, 2013

Greiner chose the earn-out election. Boston Scientific reported the cash component as gross pay on Greiner's 2004 IRS Form W-2, and Greiner and his wife reported the cash as ordinary compensation income on their 2004 joint federal income tax return. The fair market value of the earn-out right, however, was not reported by Boston Scientific on Greiner's W-2, nor by the couple on their 2004 income tax return. This was consistent with a determination by Advanced Bionics and Boston Scientific to treat the grant of the earn-out right as not immediately subject to tax in 2004. Instead, the parties would report ordinary income on the earn-out right only when later receiving earn-out payments, reflecting an "open" transaction approach. No earn-out payments were made by Boston Scientific in 2005. In 2006 and 2007, Boston Scientific did make earn-out payments and Boston Scientific reported these payments as gross pay on Greiner's Forms W-2. Likewise, Greiner and his wife reported the payments as ordinary compensation income on their 2006 and 2007 tax returns.

Subsequently, Greiner and other earn-out recipients settled litigation with Boston Scientific which resulted in the de-merger of the two companies. Boston Scientific paid the Bionics Trust $1.15 billion in two installments in full satisfaction of all earn-out obligations under the prior agreement. Most of the other outstanding obligations under the merger agreement were terminated. Unlike the earlier earn-out payments, these payments were in fixed installment amounts and not contingent upon the future sales of any Advanced Bionics products. As a result of this agreement, Greiner received approximately $15.1 million and $11.6 million in 2008 and 2009, respectively. Boston Scientific categorized Greiner's 2008 and 2009 payments as gross pay on Greiner's Form W-2 and Greiner and his wife reported these final payments as ordinary compensation income on their 2008 and 2009 tax returns.

Greiner and his wife then amended their 2008 and 2009 tax returns, contending that the original tax returns erroneously classified the earn-out cash payments as compensation income, rather than capital gains from the sale or exchange of a capital asset. According to the couple, they should have determined the fair market value of the earn-out right in 2004 and reported it that year as ordinary compensation income and been immediately taxed on it. After doing so, they contended, they would have held a capital asset. While subsequent earn-out payments in 2006 and 2007 would still have been taxable as ordinary income (after a return of basis), the 2008 and 2009 final payments should have been reported as long-term capital gain, they said. The couple requested a refund based on the difference between the higher ordinary income tax they paid under their original returns, and the lower tax for capital gain allegedly owed under their amended returns.

Analysis

The IRS denied the refund request on three grounds: (1) the couple's reclassification of payments from ordinary income to long-term capital gain reflected a change in method of accounting for which permission was required but never obtained, in violation of Code Sec. 446(e); (2) the change in accounting violated the common-law duty of consistency that the couple, as taxpayers, owed the IRS; and (3) the 2008 and 2009 payments could not qualify as long-term capital gain because the payments did not result from the sale or exchange of a capital asset. According to the IRS, the open transaction approach taken by Greiner and his wife on their original returns was not improper and, having made an open transaction election in 2004, the couple was bound to report the subsequent earn-out payments as ordinary income.

In response, Greiner and his wife presented five arguments. According to the couple: (1) they were seeking only to correct their original reporting of the 2008 and 2009 final payments, which was not an accounting method change; (2) the IRS's change-in-method argument was invalid because there was no "specific material item" that was reported inconsistently in different tax years; (3) their amended returns did not alter the tax years of the 2008 and 2009 final payments and, thus, their attempt to re-categorize those payments as capital gain did not affect the timing of that income and, by extension, could not reflect a change in method of accounting; (4) the change-in-underlying-facts exception to the consent rule in Reg. Sec. 446-1(e)(2)(ii)(b) applied such that, even if the open transaction method were adopted for income connected to the earn-out right (including receipt of the earn-out right itself), they would not be required to seek permission to change that method with respect to the 2008 and 2009 final payments because capital gains treatment of the refund claims were driven by an unexpected change in underlying facts (i.e., termination of the earn-out right); and (5) their proposed amendments did not contravene any public policy underlying the consent requirement.

The Federal Claims Court denied the couple's refund claims, holding that the claims were based on an impermissible change in method of accounting. According to the court, once Greiner and his wife elected to report their earn-out income under the open transaction method, they were bound to continue using it absent the IRS's consent to a change. Because the couple never sought or obtained such consent, the court said, their attempt to retroactively amend their approach to reflect closed transaction reporting and subsequent capital gain was an impermissible change in method of accounting in violation of Code Sec. 446(e).

The court found most of the couple's arguments missed the mark. The court did note that, had the couple originally reported the 2004 earn-out right as a closed transaction, it might have considered whether the 2007 settlement was a change in underlying facts affording the couple the ability to recharacterize the 2008 and 2009 final payments as capital gain without seeking consent. However, the court said, the couple never laid the requisite foundation by reporting the 2004 earn-out right as a closed transaction and could not do so now because the 2004 tax year was closed and was not before the court.

For a discussion of the requirement to get IRS consent for an accounting method change, see Parker Tax ¶241,590. For a discussion of the open transaction doctrine, see Parker Tax ¶110,580. (Staff Editor Parker Tax Publishing)

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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