Free Statement - District Court of Arizona - Arizona

. »\ X E _ { 5
,. ` _. l · l * xmaur
, · DATE
i Michele E. Balmer, CCR No. 50489
. OFFICE MEMORANDUM
The following document is attorney/client privileged
A and has been prepared in anticipation of litigation.
The tax treatment of the Founders’ warrants, including the assigment of any of such .
warrants to Mark or to the Class A shareholders as part of a settlement agreement, varies
depending upon the characterization of the warrants received by Michael and Peter. If the
issuance of the warrants is treated as compensatory, the tax treatment of Michael, Peter, and,
arguably, Mark will be different than if the issuance of the warrants is treated as a distribution in .
- respect of Visitalk stock. The purpose of this memorandum is to summarize the differing tax _
consequences under these two scenarios and to assess the available evidence regarding the proper
* characterization of the issuance of the warrants. The information referenced in this Z
» memorandum and the analysis are current as of 12:00 p.m. on October 22, 1999.
A. Compensation Analysis.
l. Because the warrants lacked a readily ascertainable fair market value when issued,
Michael and Peter realized no income upon receipt. Regs. §l.83~(a). When Mike and Peter
dispose of the assigned warrants in discharge of potential claims against them by Mark and/or the
Class A shareholders, they realize compensation income measured by the fair market value ofthe
warrants as ofthe disposition date. Reg. §l.83-7(a). One might argue that, for this purpose, the
— fair market value of the warrants upon disposition should be measured by the excess of the “ r
option privilege" over the strike price. See Regs § l.83~7(b)(3). More likely, however, the
correct measure is the value ofthe claims being discharged by assignment ofthe warrants. See
_ Regs. §l.83-7(a). In either case, Michael and Peter would probably not be able to deduct the fair
market value of the assigned warrants. That amount should be capitalized and included in their
_ _ _ respective tax bases for the remaining warrants because the assignments are a cost of acquiring
the retained warrants. Altematively, Michael and Peter might be treated as if they contributed
warrants to the capital of the company, which the company then transferred to Mark or the Class
A shareholders. C£ Regs. § 1.83-6(d)(l). In this case as well, capitalization, not a current
deduction, would be the appropriate tax treatment. -
2. The Class A shareholders must treat the fair market value ofthe assigned warrants
as a recovery of the capital they invested in their Class A stock to the extent of tax basis and any
excess as capital gain. WHY IS THIS'? IS THERE A SALE OR EXCHANGE OCCURRING?
WITHOUT A SALE OR EXCHANGE, EVEN A RECOVERY WITH RESPECT TO A
CAPITAL ASSET TRIGGERS ORDINARY INCOME. The holding period would be a firnction
I of the period they have held their class A stock. The suggestion that the Company might issue V
additional shares to the Class A shareholders without tax consequences to correct an "accounting `
_ error" is questionable. In the first place, the Class A shareholders each received the number of l
Pulaskc\Pl—[X\734340.02
. VT007165
Case 2 :02—cv—02405—H RH Document 384-19 Filed 07/24/2007 Page 1 of 4

g ~ _ 3
- ` shares that they purchased. Their grievance, if any, arises because, if the Founders’ warrants are
exercised according to their original terms, the Class A shareholders will be diluted.
Consequently, if they have a claim for relief; it is by virtue of a misrepresentation, not because V
they received fewer shares than they originally paid for. ‘ When an investor receives money or
property as damages because he or she was misled conceming the actual value of the investment,
the amount of the recovery in excess of the shareholder’s investment is taxable gain.
CITATIONS. -
3. The tax consequences to Mark depend upon the "origin" of the claim in settlement
of which he receives assigned warrants. If his claim arises because his stock position was
diluted without authorization, then his tax treatment would be similar to that of the Class A
shareholders. Altematively, especially based on the assumption that the warrants issued to Peter
and Michael were compensatory in the first place, Mark's entitlement also to "share" in the
A Founders' warrants would also likely be treated as compensatory, i.e., his entitlement also arose .
. by reason of services. However, in Mark's hands, the warrants lack a readily ascertainable fair
Q . market value. Under Regs. §l .83-7(a), the receipt of such a warrant in connection with services
A should not be taxable whether transferred by the corporation or by a shareholder of the
corporation. See Regs. §l.83-8(d)(l). Thus, Mark would receive the assigned options without
i current tax consequences even though, by assigning them, Michael and Peter did realize tax
· consequences, as described above.
4. When Michael and Peter (and Mark underthe “compensation" treatment described
above) exercise their warrant rights to acquire stock, the difference between the fair market value
of the stock acquired and the strike price is treated as compensation income. Visitalk is entitled
to a deduction for the taxable year for which the recipients of the stock include the fair market
value of the stock in income. Michael and Peter (and Mark) may have a cash flow issue because
. estimated tax payments will become due prior to the time that they are likely to be able to sell
stock if they are insiders. ·
B. Distribution Analysis ·
_ 1. If Michael and Peter are treated as receiving their respective warrants as of
9/12/98 in respect of their stock (in order to prevent subsequent dilution by Visitalk's initial
* The “accounting error" rationale becomes even more tenuous if one assumes that the
warrants were issued alter issuance ofthe Class A shares. _
2 Section 305(a) provides that distributions by the issuing company of its stock (or rights
to acquire stock) in respect of common stock are not taxable. Section 305(b) sets forth various
exceptions. One such exception applies if the effect ofthe distribution is to increase the
distributee’s proportionate interest in the corporation’s earnings and profits relative to other
Pulaskc\PlD<\734340.02 r ‘ n
VTOO71 66
Case 2 :02—cv—02405—H RH Document 384-19 Filed 07/24/2007 Page 2 of 4

· capital·raising activities), the fair market value of the warrants will be treated as property
" distributed in respect of their stock and taxable under 305(b) and 301(a)’. Because Visitalk has .
no E&P as of the valuation date, the value of the warrants will be treated as a retum of capital
invested in their shares of comon stock (tax basis) and then as short term capital gains. See IRC
§30l(c). Presumably, the fair market value of a right to buy stock by paying $0.1375 per share
when the value of the stock equals the strike price should not be huge-~it would be measured by
the value of the "option privilege" described in the Section 83 regulations as the right to acquire
; the optioned stock at a iixed price (and thereby to benefit trom any appreciation above the strike
j r price) without investing any capital. Quantifying the value of this "option privilege", however,
might be tricky, especially in the absence of any trading market for the underlying stock.
Z C. Characterizing the Issuance ofthe Warrants
2 1.‘ There is no known documentary evidence to corroborate Michael’s and Peter’s
i assertions that, on September 12, 1998, acting in their respective capacities as the sole directors .
S . of Visitalk, they resolved to issue the Founders’ warrants to themselves. Joe Richardson did not
prepare the documentation relative to the warrants until November, 1998. Furthermore, the term ` .
i sheet for the Series A convertible preferred indicates that there were zero warrants outstanding
prior to the Class A Preferred offering. That Joe Richardson documented the Board decision in ·
· . the form of an Action by Unanimous Consent creates additional complications because such an
Action only becomes effective when signed by all Directors. Because this has not yet happened,
the Action by Unanimous Consent is ineffective even today. In a fact-finding context, the
assertions of Michael and Peter as to a September 12, 1998 meeting would likely be discounted _
_ as self—serving. Even if Mark corroborated this version of the facts, saying that he knew about
the Founder’s warrants in September or, at least, well before Joe Richardson prepared his
documentation, a fact—tinder might be skeptical, especially if Mark was going to receive some ‘
settlement in connection with the warrants. Joe Richardson’s recollections might be more
probative, if he can corroborate this version ofthe facts. ,
2 If] because of the Action by Unanimous Consent or any other reason, the warrants
are treated as being issued subsequent to the issuance ofthe Class A Preferred, the l
characterization of the warrants as a distribution in respect of stock becomes extremely difficult
to sustain. Clearly, such an issuance would not be proportional to stock in this case. There is a
theoretical argument that holders of convertible preferred stock should not participate in a
distribution in respect of common stock. But the record indicates there are now a substantial
number of common shares outstanding besides those of Michael and Peter. Furthermore, the
impact upon Visitalk's earnings by reason of a distribution of warrants today makes this V
shareholders who hold stock convertible into the class of stock held by the distributees. See
Regs. § l.305—3(d)(1).
Pu|askc\Pl-D<\734340.02
VTOO7167
Case 2 :02—cv—02405—H RH Document 384-19 Filed 07/24/2007 Page 3 of 4

- altemative unacceptable.
3. Even if a finder of fact concluded that the issuance ofthe warrants to Michael and
f Peter occurred on September 12, 1998, compensatory characterization is still possible. Even on
that date those warrants were not issued to all holders of common stock--this is the very basis of
‘ Mark’s claims as a shareholder (as opposed to a service-provider). What emerges from this
situation is a highly abstract issue-—Acting as the sole directors of the corporation, did Michael
i and Peter resolve to issue warrants to themselves, but not Mark, in respect of their stock or as
- compensation for services? The anti-dilution rationale articulated two months later in Joe
Richardson’s draft Action by Unanimous Consent tends to support the first alternative; but
, excluding Mark from the benefit of a distribution intended, under this theory, to benefit common
’ shareholders as shareholders creates serious questions. The alternative explanation is that the
_ Directors decided to protect Michael and Peter from subsequent dilution in recognition of their
j special position as the original visionaries and Founders of`Visita1k. Translated into tax terms,
i that rationale spells "'compensation". Significantly, the Action by Unanimous Consent dratted by
5 _ Joe Richardson in November, 1998, indicates that the 7,650,000 warrants would be divided
between Peter and Michael in proportion to their respective stock ownership as of September 12,
i 1998. However, the executed document reflects a hand-written correction to the number of
, warrants distributable to each. As revised, the document allotted an equal number of shares to ·
o _ each Founder--not in proportion to their respective stock ownership. 'I`hus, even under the only
. existing documentation of the issuance of the warrants, the claim that the warrants were issued to
Michael and Peter in respect of their stock is problematic.
D. Conclusion `
Depending upon the characterization of the issuance ofthe warrants to Michael and Peter,
the tax consequences to them (and, very likely, to Mark) can vary substantially. If one concludes
that the warrants were issued for compensatory reasons, Michael and Peter would incur no tax
consequences upon the receipt of the warrants. However, assigning warrants as part of a
settlement with Mark and/or the Class A shareholders to avoid securities law or other claims or ` ` `
exercising the warrants to acquire stock would be taxable events. The fair market value of the
assigned warrants, in the first instance; and the excess ofthe fair market value ofthe acquired
r stock over the strike price, in the second instance, would constitute ordinary income. This ·
alternative requires serious consideration because, based upon the information available to me at
· this time, a fact-finder is more likely to characterize the warrants as compensatory than as issued
in respect of stock. V
Another concern relates to the tax treatment ofthe Class A shareholders if they receive
warrants as part of the resolution of these issues. Unless we can conclude that the receipt of such
warrants can be structured in a manner that constitutes a sale or exchange, any gain realized by
the Class A shareholders will be subject to taxation as ordinary income, not capital gain. Tl·HS
RESEARCH ISSUE REMAINS TO BE RESOLVED. .
_ Pulaskc\P|·lX\734340.02
VT007168
Case 2 :02—cv—02405—H RH Document 384-19 Filed 07/24/2007 Page 4 of 4

Case 2:02-cv-02405-HRH

Document 384-19

Filed 07/24/2007

Page 1 of 4

Case 2:02-cv-02405-HRH

Document 384-19

Filed 07/24/2007

Page 2 of 4

Case 2:02-cv-02405-HRH

Document 384-19

Filed 07/24/2007

Page 3 of 4

Case 2:02-cv-02405-HRH

Document 384-19

Filed 07/24/2007

Page 4 of 4