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net profit, 15 percent of the next $500,000 of its net profit, 20
percent of the next $1 million of its net profit, and 25 percent
of its net profit in excess of $2 million.
Simultaneously with the execution of the management agree-
ment, petitioner's shareholders and Mr. Ruf agreed that if Mr.
Ruf were to achieve certain objectives with respect to petition-
er, they would sell 100 percent of petitioner's stock to him. On
December 29, 1986, petitioner's shareholders and Mr. Ruf entered
into a stock option agreement that is embodied in a document
entitled "First Restatement of Stock Option Agreement" (stock
option agreement) and that provided that Mr. Ruf or his assignee
was entitled to purchase all of petitioner's stock. On the same
date, Mr. Ruf exercised that option through his wholly owned
corporation, Stanislaus Funding Corp. (Stanislaus). Stanislaus
purchased 100 percent of petitioner's outstanding stock at that
time.
The stock option agreement provided that the final purchase
price for petitioner's stock was to be the sum of (1) 4.5 times
petitioner's after-tax earnings for its fiscal year ended
February 28, 1989, and (2) its book value (with certain adjust-
ments) determined as of that date. During November 1988, peti-
tioner's former shareholders5 and Mr. Ruf decided not to follow
5 For periods after petitioner's shareholders (viz., Mr. Neiman,
Mr. Reed's estate, and Snider Lumber) sold their stock to
Stanislaus in December 1986, we shall refer to them collectively
(continued...)
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