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New Capital Fire Inc. v. Commissioner (T.C. Memo. 2021-67)

On June 2, 2021, the Tax Court issued a Memorandum Opinion in the case of New Capital Fire, Inc. v. Commissioner (T.C. Memo. 2021-67). The primary issue presented in New Capital Fire, Inc. was whether the petitioner is barred under the doctrine of equitable estoppel from changing its reporting of its bases in certain assets that the petitioner acquired in the merger because the statute of limitations bars assessment.

Dancing the Merger Two Step

The petitioner, New Capital Fire was formed in November 2002 as a wholly owned subsidiary of (Old) Capital Fire.  A month after New Capital was formed, it merged with Old Capital, with New Capital surviving. This was the first step of a two-part merger.

To accomplish the two-step merger, two other corporations were organized, CF Merger, in early October 2002, and CF Acquisition, in late October 2002, which became the sole owner of CF Merger. The second step of the merger was a merger of New Capital into CF Merger with New Capital surviving. Both steps of the mergers occurred on the same date, one hour apart. After the two-step merger, petitioner was wholly owned by CF Acquisition.

The Transfers of Securities

At the time of the merger, Old Capital held a portfolio of marketable securities worth approximately $16.3 million that had appreciated by approximately $7.9 million over their cost basis, i.e., built-in capital gains (Old Capital’s securities). As explained further below, Old Capital’s shareholders wanted to divest themselves of ownership in a manner that would minimize the overall tax on the built-in gains at the corporate and shareholder levels.

Under the first step of the merger, Old Capital’s securities were transferred to New Capital. One day before the merger, the president of CF Acquisition executed a binding agreement for CF Acquisition to sell substantially all of Old Capital’s securities to PaineWebber, and Old Capital transferred the securities to a newly opened account in its own name at PaineWebber to facilitate the subsequent sale by CF Acquisition. CF Acquisition sold the securities over three days in December 2002, pursuant to the binding agreement. At that time, PaineWebber transferred $13.5 million in connection with its agreement to purchase Old Capital’s securities. The $13.5 million payment was transferred to repay a loan that was used to buy Old Capital’s stock. Thus, in substance, the built-in gains funded the payout to Old Capital’s shareholders for their stock.

Also in December 2002, New Capital purchased stock in Northmoy Ltd., a foreign private limited company. Later the same month, Northmoy purchased certain digital S&P 500 Index options (SPX options). It sold the SPX options at the end of December, for a capital loss of $9.7 million.

The Audit

In January 2006 the IRS began an audit for the petitioner’s 2002 tax year. The petitioner did not respond to this letter, refused delivery of other correspondence, and did not otherwise cooperate with the audit. The initial focus of the audit was whether the petitioner had engaged in a tax shelter transaction through the SPX options. In September 2006, the IRS issued a notice of deficiency to the petitioner for the 2002 tax year disallowing the deductions for the SPX option loss, consulting fees, and interest expense.  The IRS received a copy of the merger agreement in November 2006.  The IRS once again politely requested that the petitioner provide information (via a summons), but the petitioner was disinclined to acquiesce to the request.

In July 2012, the IRS issued a notice of deficiency to Old Capital determining that Old Capital was required to file a return for its 2002 tax year ending on the merger date, that its merger with the petitioner did not qualify as an F reorganization, and that Old Capital realized capital gains on the deemed sale of the securities to petitioner on the merger date. The petitioner, which was the successor in interest to Old Capital, finally broke ranks and filed a petition with the Tax Court in 2012.  In 2017, the Tax Court held that the notice of deficiency issued to Old Capital was untimely and the statute of limitations barred assessment against Old Capital for 2002.

After the Tax Court’s decision in the 2012 case had become final, the petitioner filed an amended petition in the present case alleging that it did not realize the capital gains from Old Capital’s securities that it had reported on its 2002 return.  Here’s where it turned hinky.

In the amended petition, the petitioner adopted the very same position that the IRS asserted had against Old Capital in New Capital in the 2012 case—that is to say, the case which the petitioner won…

The petitioner argued that the first step of the merger, indeed, did not qualify as an F reorganization, Old Capital realized capital gains from a deemed sale of the securities on the merger date, the petitioner received a basis in the securities equal to their fair market value on the merger date, and, therefore, the petitioner did not have the gain it reported on the sale of the securities.  Finally, the petitioner alleged that the IRS erred in determining that petitioner had realized the capital gains of approximately $7.8 million that petitioner had reported on its 2002 return, though the petitioner ultimately gave up this last argument on the basis that the IRS hadn’t actually adjusted the petitioner’s capital gains.  But you know, you can’t hit the ball without swinging at it…

The IRS’s Argument

Under IRC § 1001, a taxpayer must recognize any gain or loss realized on the sale or exchange of property unless an exception exists. One such exception is an “F reorganization” under IRC § 368(a)(1)(F). An F reorganization is defined as a “mere change in identity, form, or place of organization of one corporation, however effected.” IRC § 368(a)(1)(F).

An F reorganization presumes that the surviving corporation is the same corporation as the predecessor in every respect, except for minor or technical differences.  It typically has been understood to comprehend only such insignificant modifications as the reincorporation of the same corporate business with the same assets and the same stockholders.  Berghash v. Commissioner, 43 T.C. 743, 752 (1965), aff’d, 361 F.2d 257 (2d Cir. 1966). To qualify, the reorganization must occur pursuant to a plan of reorganization, have a valid business purpose, and have continuity of business enterprise and continuity of interest. Treas. Reg. § 1.368-1(c), (d), and (e).

Significantly, in an F reorganization, the transfer of the target’s assets to the successor corporation is not a taxable disposition. However, when a transaction does not qualify as an F reorganization, the target must recognize gain on its assets as if it had sold the assets to the surviving corporation for their fair market values. Honbarrier v. Commissioner, 115 T.C. 300, 315 (2000); Rev. Rul. 69-6, 1969-1 C.B. 104.

The Petitioner’s Argument

The petitioner maintains that the Tax Court should treat the two steps of the merger as two separate transactions. The trouble that the Tax Court has with this argument, however, is that none of the returns filed by the petitioner or its predecessor in interest (Old Capital) actually “disclosed” the second merger. In fact, the petitioner “chose to disclose only the first merger” and, even then, it “did not make adequate disclosures of that merger.”

Tsk, tsk…

Equitable Estoppel

The IRS argued that the Tax Court should apply the doctrine of equitable estoppel or the duty of consistency to preclude the petitioner from asserting that it did not realize gain on the sale of Old Capital’s marketable securities. The petitioner argued that the Court of Appeals for the Second Circuit, to which this case is appealable, does not recognize a duty of consistency.

The Tax Court argued that the Court of Appeals would recognize a duty of consistency under the particular circumstances of this case, namely, that petitioner (was a corporate asshat) and did not make an innocent mistake and is, instead, seeking to change its own reporting through an amended petition. Ultimately, the Tax Court did not reach the duty of consistency argument, because if found that equitable estoppel applied to bar the petitioner from having its merger cake and eating it too.

The Court of Appeals for the Second Circuit has identified four requirements for applying equitable estoppel against a taxpayer: (1) the taxpayer made a false representation or engaged in a wrongful misleading silence, (2) the error originated in a statement of fact and was not a mistake of law, (3) the IRS did not know the correct facts, and (4) the IRS is adversely affected by the taxpayer’s acts or statements. Lignos v. United States, 439 F.2d 1365, 1368 (2d Cir. 1971); see Stair v. United States, 516 F.2d 560, 564 (2d Cir. 1975). Equitable estoppel can apply to bind a taxpayer to a representation made by another taxpayer where the two taxpayers are in privity, i.e., where there is sufficient identity of interests between them. Milton H. Greene Archives, Inc. v. Marilyn Monroe LLC, 692 F.3d 983, 996 (9th Cir. 2012); see Estate of Letts v. Commissioner, 109 T.C. at 298 (stating the duty of consistency applies to taxpayers that are in privity); see also Ag Processing, Inc. v. Commissioner, 153 T.C. 34, 55-56 (2019) (dismissing the IRS’s argument to apply the duty of consistency “to one taxpayer where the period of limitations has expired with respect to a different taxpayer”). The petitioner concedes that it was in privity with Old Capital for the 2002 tax year.

The IRS argues that the requirements of both equitable estoppel and the duty of consistency are met here. Under the duty of consistency, the IRS may treat the taxpayer’s representations with respect to a prior, closed tax year as true and estop the taxpayer from asserting a contrary position in a subsequent year regardless of whether the earlier position was correct. Herrington v. Commissioner, 854 F.2d 755, 758 (5th Cir. 1988), aff’g Glass v. Commissioner, 87 T.C. 1087 (1986); Estate of Letts, 109 T.C. at 297. Applying duty of consistency requires that the IRS acquiesced in or relied on the representation made for the closed year but does not examine whether the misrepresentation was innocently or intentionally made. Beltzer v. United States, 495 F.2d 211, 212 (8th Cir. 1974) (applying a duty of consistency where the taxpayer’s mistake is “innocent or otherwise”); Estate of Letts, 109 T.C. at 297. Courts have recognized their respective applicability to an innocent mistake as the primary difference between the two doctrines. Equitable estoppel would not apply to an innocent mistake. Equitable estoppel requires “a showing that the taxpayer made an intentional misrepresentation.” LeFever v. Commissioner, 100 F.3d 778, 786 (10th Cir. 1996), aff’g 103 T.C. 525 (1994).

The Tax Court accepted, for purposes of this case, the petitioner’s position that that Court of Appeals would not apply equitable principles to estop a taxpayer who has made an innocent mistake. However, the Court of Appeals has applied equitable principles to estop taxpayers who have knowingly misrepresented facts. See United States v. Matheson, 532 F.2d 809, 819 (2d Cir. 1976) (estopping an estate from denying the decedent was a U.S. citizen where the decedent knowingly represented her U.S. citizenship to obtain benefits of citizen and did not innocently misunderstand the law); Askin & Marine Co. v. Commissioner, 66 F.2d 776, 778 (2d Cir. 1933), aff’g 26 B.T.A. 409 (1932) (applying principles of equitable estoppel so that “a taxpayer may not benefit at the expense of the government by misrepresenting facts under oath”).

Holding as to Misrepresentation of Facts

Ultimately, the Tax Court found that that equitable estoppel applied in this case because the petitioner knowingly misrepresented facts relating to the first merger and concealed that the merger occurred in two steps, petitioner’s misrepresentations were not innocent, and the IRS did not know or have reason to know the correct facts before the limitations period expired for Old Capital’s 2002 tax year. The petitioner also misled the IRS through wrongful misleading silence including Old Capital’s not filing a separate return for its 2002 tax year. The petitioner’s misrepresentations related to questions of fact; it did not make a mistake of law. The IRS reasonably relied on the petitioner’s misrepresentations and silence and has been adversely affected.

Mistake of Law

Equitable estoppel does not apply to a mistake of law. Bennet v. Helvering, 137 F.2d 537, 539 (2d Cir. 1943). The Court of Appeals for the Second Circuit has explained its refusal to apply equitable estoppel to a mistake of law, referring to it as “a kind of estoppel as to the law.” Id. Courts have applied equitable principles to estop taxpayers who have made false representations with respect to questions of fact and mixed questions of fact and law. Eagen v. United States, 80 F.3d 13, 17 (1st Cir. 1996). A mistake of law occurs when both parties have knowledge of all relevant facts before the period of limitations expired.

The petitioner argues that if it did make any misstatements, they were mistakes of law and not mistakes of fact. It argues that whether the first merger qualifies as an F reorganization is a question of law. The Tax Court disagreed. Whether a merger qualifies as an F reorganization depends on whether the circumstances and terms of the merger satisfy the legal requirements of the Code and the regulations. Each requirement set forth in the Code and the regulations for an F reorganization is predicated on questions of fact. The issue is a question of fact or a mixed question of fact and law. Further, all parties to the merger agreement understood the law and were concerned with representing to respondent that the first merger was nontaxable.

IRS’s Knowledge

The Court of Appeals for the Second Circuit has declined to apply equitable estoppel where the Commissioner had actual or constructive knowledge of the correct facts while the prior year was open. Lignos, 439 F.2d at 1368; Ross v. Commissioner, 169 F.2d 483 (1st Cir. 1948) (refusing to apply equitable principles where the IRS was fully aware of the facts shortly after they occurred and substantially before the statute of limitations barred assessment).

An audit alone does not preclude equitable estoppel. Rather, the information in the Commissioner’s possession is determinative. See Gmelin v. Commissioner, T.C. Memo. 1988-338. The IRS does not have sufficient knowledge of a reporting error where it learned of facts that suggested that there might have been an issue with the taxpayer’s reporting two months before the limitations period expired. Spencer Med. Assocs. v. Commissioner, T.C. Memo. 1997-130; see Bentley Court II Ltd. P’ship v. Commissioner, T.C. Memo. 2006-113 (holding that a criminal proceeding begun after the limitations period expired does not negate the Commissioner’s initial acceptance of the return as filed). The petitioner reported on its return that there was a merger of Old Capital into petitioner. It did not explicitly state that the merger was nontaxable or identify it as an F reorganization. The only relevant fact that petitioner disclosed on the return was that there was a merger of Old Capital into petitioner with petitioner surviving.

The IRS did not understand the structure of the merger. It was not aware that there was a two-step merger or that the second step occurred one hour after the first or that it occurred at all. The IRS’s misunderstanding of the structure of Old Capital’s and petitioner’s merger was reasonable on the basis of the information that petitioner provided or that was otherwise in respondent’s possession.  This misunderstanding was reasonable.

IRS Adversely Affected

Equitable estoppel applies only where the IRS will be adversely affected by the taxpayer’s change in reporting. Lignos, 439 F.2d at 1368-1369. The IRS is adversely affected when a taxpayer changes its reporting after the period of limitations has expired and the change harms the Commissioner. Id. The Tax Court has applied the duty of consistency where taxpayers would obtain an “unfair advantage” by taking inconsistent positions. Cluck v. Commissioner, 105 T.C. 324, 332 (1995).

Conclusion

The IRS has established that the requirements for applying equitable estoppel against the petitioner are met. The equities clearly weigh in favor of estopping petitioner from changing its return reporting. Accordingly, the Tax Court declined to let petitioner change its reporting and hold that it had capital gains in the amount it reported on its 2002 return from the sale of Old Capital’s securities.

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