Estate of Enron CEO Kenneth Lay Wins in Tax Court

Originally Published on forbes.com on September 8th,2011

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There is kicking somebody when they are down and then there is kicking somebody when they are dead.  Kenneth Lay of Enron fame might not be the most fondly remembered deceased CEO, but that does not mean that the IRS should be picking on his widow.  Fortunately she had my friend Charley Egerton looking out for her.  I introduced Charley in my still ongoing discussion of Obama’s phony war on hedge funds.  Besides being an authority on partnership taxation, Charley is a tax litigator.  Recently he showed his mettle in Tax Court on behalf of the Estate of Kenneth Lay.  The IRS was looking for $3,910,000 in tax plus interest.

The transaction that gave rise to the deficiency notice is a little complicated.  This is Enron we are talking about here.  So something that is a little complicated is about as simple as anything gets.  In February 2001 Kenneth Lay stepped down as CEO of Enron handing the reins to Jeff Skilling. Mr Skilling stepped down in August 2001 and the Enron Compensation Committee decided they needed to come up with something to persuade Mr. Lay to step back up:

Enron and its advisers developed proposals with incentives to entice Mr. Lay to reassume his position as CEO and to retain him for a period of years. The Compensation Committee was interested in an agreement to retain Mr. Lay for a period of years. The subsequent sudden collapse of Enron was unanticipated by the Compensation Committee during the negotiations with Mr. Lay in August 2001. The instruments that Enron would normally use for retention, stock options and restricted stock, both were problematic.

First, because Mr. Lay was over age 55 and had served for more than 5 years, if he voluntarily retired all of his restricted stock would immediately vest. Second, Enron’s stock plan documents limited the number of shares, options, or restricted shares that could be granted in 1 year in accordance with a shareholder-approved plan, and there was not time to hold a shareholder meeting to approve a modification to the plan. Accordingly, alternatives for retention were considered. At the request of the Compensation Committee, Towers Perrin prepared alternatives for the Compensation Committee to offer to Mr. Lay for consideration. The alternatives prepared by Towers Perrinwere based on two annuity contracts owned by Mr. Lay and Mrs. Lay—the contracts which underlie the dispute in the present case

Kenneth and Judith Lay each had annuity contracts.  They had moderately complicated provisions.  Basically they allow for the possibility of investmentgrowth over the guarantee amount but also provide a guaranteed incomebase.  I’ve looked at contracts like them myself, although for much lesser amounts. (Each of these two had cost $5,000,000).  They were issued by Manulife (subsequently taken over by John Hancock) and were called Flexible Purchase Payment Deferred Combination Fixed and Variable Annuity Contracts Non- Participating.  Probably somebody who understood the notes to Enron’s financial statements would see them as paragons of simplicity.  Regardless there actually is not anything really special about the contracts.  The contracts were transferable.

Enron wanted to incentivize Mr. Lay to stay long term and was precluded from using stock options.  Mr. Lay had an immediate liquidity need.  He apparently liked these annuity contracts and usually you get really hammered when you try to cash things like this in early.  So Towers Perrin came up with the clever idea of having Enron buy the contracts, providing the Lays with immediate liquidity, and hold them as deferred compensation for Mr. Lay with the idea that they would be transferred back in the future under a cliff vesting schedule.

I suppose I can’t blame the IRS for their thinking that there might be something phony about the contract.  This is Enron we are talking about.  The Lays reported the sale of the annuity contracts on Schedule D showing no gain or loss.  The IRS position was that what Enron paid for the annuities was in effect a signing bonus.

Since this is tax blogging rather than a court decision it is worth examining the emotional arguments which the courts tend to gloss over.  On the one hand many people probably think that Kenneth Lay was a scoundrel whose gains were ill gotten.  If you can come up with a way to loot his estate – go for it.  On the other hand I have a soft spot for widows.  My mother divided history between before and after my father’s death in 1965.  She always complained to me that she hated me checking single when I did her return, because she was a widow.  Nothing to do with the money – just the principle.  Further in the movie The Crooked E, Mr Lay was played by human rights activist Mike Farrell, a friend of my human rights activist friend Tom Cahill.

What do emotional arguments like that prove?  They prove that not having a law degree is not the only reason that I am ill-qualified to be a Tax Court judge.  Charley Egerton did not need to get into emotional arguments.  It was actually pretty simple to the extent anything involving Enron could be simple.  The Lays had paid 10 million dollars for annuity contracts.  They sold them to Enron for 10 million dollars in cash.  If Enron had prospered and Mr. Lay had kept working there, he would have gotten the contracts back and if my aunt’s anatomy had been differently designed she would have been my uncle.  In order to test the IRS hypothesis that  the Lays really continued to own the annuities, Linda Lay tried the following experiment

Mrs. Lay requested a partial withdrawal of $50,000 from the Linda P. Lay Annuity that she had transferred previously to Enron, in a withdrawal request form submitted to John Hancock on February 8, 2006. The annuity contracts allow withdrawals from the contract value. In response to Mrs. Lay’s request, John Hancock did not pay the requested withdrawal and instead responded with a letter to Mrs. Lay describing issues regarding the ownership of the Linda P. Lay Annuity. In its letter dated February 15, 2006, John Hancock described the agreement, quoting portions regarding the transfer to Enron and the reconveyance obligation, the change form submitted to ManuLife, and the fact that Mr. Lay had ceased serving as CEO and chairman, then concluding it was unable to determine whether Mr. Lay or Mrs. Lay had an ownership interest.

If that had worked out differently she could have then grabbed the rest of the money, paid the IRS and come out way ahead.  Why that didn’t get the IRS to give up is beyond me.  She was a smart enought lady to go to Orlando and hire Charley, though, so at least she won’t have to pay the four million plus in taxes and interest IRS was looking for since the Tax Court concluded:

The Lays sold the Annuity contracts to Enron on September 21, 2001. In doing so, they complied with the requirements of the agreement and took the steps required to transfer the annuity contracts to Enron. The benefits and risks of ownership of the annuity contracts were transferred to Enron in the annuities transaction. The Lays, therefore, properly reported the transaction on their Federal income tax return as a sale of the two annuity contracts.

Note
The full text of the case includes an interesting view of the workings of the Enron Compensation Committee.