Contested Buyout Doesn’t Bar Gain

The Ninth Circuit Court of Appeals affirmed the Tax Court’s decision that a cash-method shareholder’s forced buyout triggers gain recognition in the year that the buyout payment is received, even if the shareholder continues to dispute the buyout in court. Additionally, the shareholder must recognize any interest income from investment of the buyout funds as taxable in the year it is received.

Glenn Hightower and Daniel O’Dowd were each 50% co-owners of Green Hills Software Inc., an S corporation. Their relations with each other deteriorated until 1998, when O’Dowd triggered a dispute-resolution provision in the shareholder agreement. It provided for binding arbitration and that either party could force a buyout of the other’s stock based on a formula price. Hightower was unable to raise the funds to buy out O’Dowd’s shares, so he was forced to sell his shares to O’Dowd. Hightower received the buyout check in 2000, deposited it in an interest-bearing account and sought to have the sale set aside in court. By 2003, Hightower had lost in state court and had exhausted all appeal opportunities. Meanwhile, he had not reported his pass-through distributive share of Green Hills’ 2000 income, any of the gain from the forced buyout payment or the interest received from its invested proceeds.

The courts dismissed Hightower’s contention that the gain escaped tax under the claim-of-right doctrine until 2003. The doctrine requires that a payment be included in income only in the year it is received by the taxpayer without restriction as to its disposition. The courts said the doctrine did not apply because there was no restriction on Hightower’s disposition of the buyout funds and that he was under no fixed legal obligation to repay the buyout funds to another party at some future date. His decision to save the funds did not change his tax obligation. Interest income from the invested buyout funds was taxable upon receipt. Additionally, the rulings dismissed Hightower’s claim that the pass-through income was not taxable in 2000 because of his restricted management role from 1998 to 2000.

Recently, the Supreme Court denied certiorari in a similar case, Burke v. Commissioner, 99 AFTR2d 2007-2637 (see also “Tax Matters: Is Disputed Partnership Income Taxable?” JofA, May 06, page 82). In Burke, the First Circuit determined that a partner must pay income tax on his share of a partnership’s income that had been placed in escrow due to a lawsuit.

n Glenn Hightower v. Commissioner, 101 AFTR2d 2008-470

Prepared by Bob Thomas, Ph.D., assistant professor of accounting, and Darlene Pulliam , CPA, Ph.D., McCray Professor of Business and professor of accounting, both of the College of Business, West Texas A&M University, Canyon, Texas.