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Complex Media, Inc. v. Commissioner (T.C. Memo. 2021-14)

On February 10, 2021, the Tax Court issued a Memorandum Opinion in the case of Complex Media, Inc. v. Commissioner (T.C. Memo. 2021-14). The primary issue presented in Complex Media was whether a taxpayer was eligible to disavow the form of its transactions (an asset transfer) when the alternative form achieves a tax benefit “not inconsistent” with the taxpayer’s initial tax planning and structuring of the transactions.

Background

The petitioner acquired the assets of a business previously conducted by a partnership. The petitioner issued common stock, and in accordance with a prior obligation, redeemed shares held by the partnership in exchange for $2.7 million and an obligation to pay $300,000 a year later. The partnership assigned its right to the additional payment to one of its partners.  The petitioner claimed an increased basis of $3 million in intangible assets it received from the partnership and amortized that basis under IRC § 197(a).  The IRS disallowed the petitioner’s claimed amortization deductions.

Broad Holdings

A taxpayer’s ability to identify an alternative path to a given end result that provides more favorable tax consequences than the path actually taken is not enough to entitle the taxpayer to the desired tax treatment. Commissioner v. Nat’l Alfalfa Dehydrating & Milling Co., 417 U.S. 134 (1974). Nevertheless, because any tax planning involved in structuring the transactions in issue was focused on insulating the partnership’s continuing partners from the consequences of the redemption of the partner’s interest and not on the achievement of a tax benefit inconsistent with allowing the petitioner’s increased bases in the assets it acquired from the partnership, the petitioner is not precluded from seeking to disavow the form of its transactions.

The Real Issue

The merger and reorganization issues arising under IRC § 351 and the amortization rules of IRC § 197 intangibles are secondary to the Tax Court’s analysis of the petitioner’s eligibility to disavow the transactional form it shows. If the petitioner were bound to the transactional form it chose, the petitioner would not be entitled to amortize its basis in the IRC §197 intangibles included among the transferred assets. If, however, the Tax Court permitted the petitioner to disavow the form prescribed by the governing agreements, such amortization would be permitted.

The IRS’s Argument

The IRS argues that the petitioner is bound by either the terms of the relevant agreements or the form of the transactions carried out under the agreements. In support of his position, respondent relies on Commissioner v. Nat’l Alfalfa Dehydrating & Milling Co., 417 U.S. 134 (1974), Commissioner v. Danielson, 378 F.2d 771 (3d Cir. 1967), vacating and remanding 44 T.C. 549 (1965), Makric Enters., Inc. v. Commissioner, T.C. Memo. 2016-44, aff’d, 683 F. App’x 282 (5th Cir. 2017), and Tseytin v. Commissioner, T.C. Memo. 2015-247, aff’d in part, remanded in part, 698 F. App’x 720 (3d Cir. 2017).

Nat’l Alfalfa includes an oft-quoted articulation of what is sometimes referred to as the “nondisavowal principle.” See, e.g., Dixon v. Commissioner, T.C. Memo. 2006-90, *35, supplemented by T.C. Memo. 2006-190, aff’d, 621 F.3d 890 (9th Cir. 2010). In Nat’l Alfalfa, 417 U.S. at 149, the Supreme Court held that although a taxpayer is free to organize his affairs as he chooses, nevertheless, once having done so, he must accept the tax consequences of his choice, whether contemplated or not and may not enjoy the benefit of some other route he might have chosen to follow but did not. In Danielson, the Third Circuit held that a party can challenge the tax consequences of his agreement as construed by the IRS only by adducing proof which in an action between the parties to the agreement would be admissible to alter that construction or to show its unenforceability because of mistake, undue influence, fraud, duress, etc. Danielson, 378 F.2d at 775. Similarly, in Tseytin, the Tax Court held that the taxpayer had not challenged the agreements governing the transaction on the grounds of fraud, mistake, undue influence, duress, or the like; therefore, the Tax Court concluded that the Danielson rule prohibited the taxpayer from challenging the form of the transactions in issue.

The Petitioner’s Argument

The petitioner claims that the Danielson rule does not apply to the cases before us because they would be appealable to the Court of Appeals for the Second Circuit rather than to that of the Third Circuit. Petitioner does, however, accept the potential application of the “strong proof” rule associated with the Court of Appeals’ opinion in Ullman v. Commissioner, 264 F.2d 305 (2d Cir. 1959), aff’g 29 T.C. 129 (1957). In Ullman, 264 F.2d at 308, the Second Circuit opined that when the parties to a transaction have specifically set out the covenants in the contract and have there given them an assigned value, strong proof must be adduced by them in order to overcome that declaration.

The petitioners argue that under the “strong proof” standard the taxpayer’s ability to make a “substance over form” argument is less circumscribed than under the Danielson rule. The taxpayer need not show the written agreement is unambiguous or unenforceable as between the parties but nonetheless (because the tax treatment set forth in the writing was presumably negotiated for among tax adverse parties) must produce “strong proof” showing that the agreement does not comport with the actual economic reality.  Nonetheless, the petitioner also argues that the strong proof test is inapplicable to the present case.

The Tax Court’s Analysis

The cases that the IRS cites do not erect an absolute bar to the petitioner’s disavowal of the form of its transactions. Although Nat’l Alfalfa’s oft-quoted articulation of the nondisavowal principle would, if read in isolation, suggest an absolute prohibition, read in the context of the Supreme Court’s entire opinion, the quotation should be interpreted to mean only that a taxpayer’s ability to identify an alternative path to a given end result that provides more favorable tax consequences than the path actually taken is not enough to entitle the taxpayer to the desired tax treatment.

Although Danielson itself did not involve a choice between the form of a transaction and its alleged substance, this Court and others have extended the Danielson rule to limit a taxpayer’s eligibility to challenge not only the terms of the contracts governing a transaction but also the form of the transactions as established by those contractual terms. The Court of Appeals recognized in Danielson that the case did not implicate the doctrine that the tax consequences of transactions should generally be determined on the basis of their economic substance rather than their form. In the court’s words, the case did not involve a situation where the IRS is attacking the transaction in the form selected by the parties”. Danielson, 378 F.2d at 774. Instead, the IRS was attempting to hold a party to his agreement unless that party can show in effect that it is not truly the agreement of the parties. Id. at 775.

The Tax Court has long accepted, however, that both the Danielson rule and Ullman’s “strong proof” test apply beyond the confines of allocating payments to a covenant not to compete. See Coleman v. Commissioner, 87 T.C. 178, 202 (1986), aff’d, 833 F.2d 303 (3d Cir. 1987). Nevertheless, the Tax Court has never accepted the Danielson rule.  Therefore, to the extent that the Danielson rule limits a taxpayer’s eligibility to disavow the form of its transactions as well as the terms of the contracts that govern those transactions, the rule has no application to the cases before the Tax Court. See Schmitz v. Commissioner, 51 T.C. 306, 316 (1968), aff’d sub nom. Throndson v. Commissioner, 457 F.2d 1022 (9th Cir. 1972).

After concluding that the Danielson rule prohibited the taxpayer in Tseytin from challenging the form of the transactions” in issue, we went on to note that, even if the taxpayer “were not bound by the form of the transactions he entered into, the stipulated evidence convincingly supports the conclusion that the taxpayer purchased shares from an individual on his own behalf and then transferred them to a corporation. Tseytin, T.C. Memo. 2015-247 at *15.  In sum, petitioner’s ineligibility to invoke grounds that would render its contracts unenforceable or call into question respondent’s interpretation of those contracts does not prevent it from disavowing the form of the transactions implemented under them.

Evolution of Tax Court’s Caselaw on Disavowal of Form

As the Tax Court’s caselaw has evolved, it has become more hospitable to taxpayers seeking to disavow the form of their transactions. While the Tax Court no longer reject those arguments out of hand, it has repeatedly indicated that taxpayers may face a higher burden than the Commissioner does in challenging transactional form. On occasion, as in Glacier State Elec. Supply Co. v. Commissioner, 80 T.C. 1047 (1983), we have suggested that the taxpayer’s higher burden might be an evidentiary one. But we have not identified specific factual questions that should be subject to a higher burden than that imposed by Rule 142(a) or articulated the quantum of evidence necessary to meet that burden. Nor has the Tax Court offered a clear justification for imposing on the taxpayer a higher burden to prove facts relevant to the disavowal of form than the generally applicable preponderance of the evidence standard.

Bright Line Rule (Well, Murky and Kind of Wavy, but a Rule Nonetheless)

As such, the Tax Court concluded in Complex Media that the additional burden the taxpayer has to meet in disavowing transactional form relates not to the quantum of evidence but instead to its content–not how much evidence but what that evidence must show by the usual preponderance. The IRS can succeed in disregarding the form of a transaction by showing that the form in which the taxpayer cast the transaction does not reflect its economic substance. For the taxpayer to disavow the form it chose (or at least acquiesced to), it must make that showing and more. In particular, the taxpayer must establish that the form of the transaction was not chosen for the purpose of obtaining tax benefits (to either the taxpayer itself, as in Estate of Durkin, or to a counterparty, as in Coleman) that are inconsistent with those the taxpayer seeks through disregarding that form. When the form that the taxpayer seeks to disavow was chosen for reasons other than providing tax benefits inconsistent with those the taxpayer seeks, the policy concerns articulated in Danielson will not be present.

(T.C. Memo. 2021-14) Complex Media, Inc. v. Commissioner

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