On October 15, 2020, the Tax Court issued a Memorandum Opinion in the case of Watts v. Commissioner (T.C. Memo. 2020-143). The issues before the court in Watts v. Commissioner were (1) whether the “Danielson rule” applies to limit the invocation of the substance-over-form doctrine by taxpayers in certain cases; and (2) if so, whether petitioners proved that the Watts family had a separate, enforceable oral agreement with Wellspring that predated the purchase by Sun Capital, and, if so, whether the Watts family’s incentive payments to Wellspring constituted amortizable capital expenditures.
The Danielson Case
In Commissioner v. Danielson, 378 F.2d 771, 775 (3d Cir. 1967), vacating and remanding 44 T.C. 549 (1965), the Third Circuit held that the invocation of the substance-over-form doctrine by taxpayers is restricted in certain circumstances. Danielson determined the tax treatment of proceeds received by a company’s shareholders in exchange for two things: (1) their stock in the company and (2) their promise that after the sale they would not compete with the company (such a promise is known as a noncompete covenant). Id. at 773. Their agreement with the buyer stated that 41% of the price was for the noncompete covenant and 59% was for the stock. Id.
The shareholders contended that the entire price was in “fact” and in “business reality” a payment for the stock. Id. at 774. They argued that the 41%/59% allocation in the agreement should be disregarded for purposes of determining the tax consequences of their receipt of the proceeds. Id. The court rejected the shareholders’ argument and 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. Id. at 775.
The court further held that if the shareholders had attempted, in an action against the buyer, to avoid or alter the sale agreement, they would have a heavy burden of showing fraud, duress, undue influence and the like under what may loosely be called common-law principles and that examination of all the evidence adduced in this case reveals nothing to demonstrate that the contract as written was not the taxpayers’ i.e., the shareholders’ conscious agreement. Id. at 778-79.
The Danielson rule applies to a taxpayer’s argument only if the agreement in question is unambiguous. CMI Int’l, Inc. v. Commissioner, 113 T.C. 1, 4 (1999). If the contract is ambiguous, however, the Danielson rule does not apply. N. Am. Rayon Corp. v. Commissioner, 12 F.3d 583, 589 (6th Cir. 1993), aff’g T.C. Memo. 1992-610). The Court of Appeals for the Eleventh Circuit has expressly adopted the Danielson rule. See Peterson v. Commissioner, 827 F.3d 968, 987, n.30 (11th Cir. 2016), aff’g in part, dismissing in part T.C. Memo. 2013-271; Plante v. Commissioner, 168 F.3d 1279, 1280-81 (11th Cir. 1999), aff’g T.C. Memo. 1997-386; Bradley v. United States, 730 F.2d 718, 720 (11th Cir. 1984).
The Competing Arguments in Watts v. Commissioner
The IRS asserts that the Danielson rule is applicable in the case at hand because the petitioners are attempting to unilaterally recast the transaction, and that attempt, if successful, could result in different tax consequences for Wellspring. The petitioners respond that the Danielson rule does not apply because, in their view, they do not seek to change the tax consequences of the transaction by challenging the underlying agreements and reforming the contractual terms but, rather, are explaining the tax consequences of the transaction. The Tax Court is not persuaded by the petitioners.
The Danielson rule applies to preclude petitioners from reaping favorable tax benefits by recharacterizing their transaction from one in which, as the agreement provided, 100% of the net proceeds were paid to Wellspring as consideration for the sale. The Danielson rule is applicable in situations, as here, where parties to a transaction expressly agree to a characterization of a transaction in a particular form or intentionally structure a transaction in a particular form for tax purposes, and it is intended to prevent any party from unduly enriching itself by claiming a unilateral alteration of the agreed-upon consequences after the consummation of the transaction.
If a party could alter the express terms of his contract by arguing that the terms did not represent economic reality, the IRS would be required to litigate the underlying factual circumstances of countless agreements. N. Am. Rayon Corp., 12 F.3d at 587. Also, business agreements are often structured with an eye toward their tax consequences. Allowing one party to realize a better tax consequence than the consequence for which it bargained is to grant “a unilateral reformation” of the agreement, which considerably undermines the certainty of business deals. Danielson, 378 F.2d at 775.
(T.C. Memo. 2020-144) Watts v. Commissioner
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