Details matter in tax law, especially when the taxpayer was involved in setting up the details. In the case of Makric Enterprises, Inc. v. Commissioner, TC Memo 2016-44 a failure to make sure that the right corporation was sold as part of the agreement proved very expensive to the taxpayers—in the amount of $2,839,780.
There were two corporations involved in this matter—one of which was a holding company (Makric Enterprises, Inc.) whose only asset was the stock of a wholly owned subsidiary (Alpha Circuits, Inc.). A third party became interested in buying the business conducted by Alpha.
Originally the taxpayers planned to dissolve the parent (Makric), distributing Alpha’s stock to Makric’s three shareholders. Then the three shareholders would sell their stock in Alpha to the acquiring corporation.
The individual shareholders were interested in having their gain on the disposition of Alpha taxed as a capital gain with tax paid only at the individual level. The shareholders believed that this structure would attain their goal. The buyer was willing to go along with their plan and thus agreed to buy the stock, rather than the assets, of Alpha.
Negotiations ensued and preliminary documents were drafted that stated the buyer would buy Alpha stock. In addition these documents reflected the three shareholders of the parent as the sellers of the stock.
However the corporation’s outside accountant, looking at the transaction, concluded that they might not get the desired result, concluding it was unclear if the shareholders would inherit the holding period of the dissolved parent when they received the stock, or whether a new holding period would start. If they didn’t inherit the holding period, the gain would a large short term capital gain.
So at this point the shareholders decided that the deal should be restructured so that the buyer would purchase the parent company (Makric) stock rather than that of the subsidiary. The seller’s negotiator informed the buyer that they no longer intended to dissolve Makric and to restructure the sale as a purchase of Makric by the buyer.
At this point there was an exchange of emails where the buyer indicated its confusion about was happening, with their attorney who was drafting the sales agreement asking if the shareholders would be the seller of Alpha or if, rather, Makric would continue as the owner of Alpha—and, in his email, he went to ask if Makric would be the seller of Alpha.
The seller’s representative responded to that email by stating:
MakRic [sic] didn’t get dissolved. The purchase will be MakRic [sic] which owns 100% of Alpha’s shares.
He went on to explain that the buyer would buy Makric shares. However he never received confirmation that the seller’s representative received this email.
The seller’s representative redrafted the agreement shortly after the exchange, now showing Makric as the seller of the stock of Alpha—a “third structure” as the Court referred to it, that was neither the original structure nor the one that the shareholders had requested be used after they became concerned about the holding period.
That structure would clearly not accomplish the goal of a single gain that would be taxed at individual capital gain rates, rather creating a gain in the C corporation parent. As C corporations do not have special, lower capital gain rates, that would subject the gain to tax at a much higher rate and leave the sellers with a corporation holding cash which would create another tax at the shareholder level when they took the cash from Makric.
The agreement went through eleven more drafts, but each one retained Makric as the seller. The seller’s representative reviewed the agreement before it was finally signed, but apparently failed to realize it showed Makric as the seller of the stock, either during the exchange of revised drafts, or in the final review of the agreement.
The accountant who had raised the initial concerns about the structure prepare the short period return for Makric. He did not consult the actual agreement, but rather worked from his understanding of the how the agreement was to be structured from conversations with Makric’s CFO. The sale of Alpha was not shown on the corporation’s return.
Rather this accountant showed a sale of Makric stock on the individual returns of the shareholders, with resulting long term capital gains. Only when the IRS examined Makric’s short period return and the returns of the shareholders did the accountant become aware that he may not have reported the transaction in accordance with the agreement—and that doing so would be a tax disaster.
In attempt to preserve the result the sellers thought they would receive (though they had failed to sign an agreement that actually would accomplish that fact), the sellers sought refuge in three separate legal concepts:
- Texas state-law principles for interpreting contracts;
- Texas state-law remedy of reformation of contracts on the grounds of mutual mistake; and
- Federal tax law principles of substance over form and the Danielson rule
The first concept (interpreting the contracts) looked to see whether the contract could be read as a sale of the parent rather than the subsidiary. Generally this would require a determination that the contract had ambiguity under Texas law, and that due to the ambiguity extrinsic evidence of the party’s intent could be considered. Note that if the contract language itself was unambiguous, then Texas law would not allow considering of that evidence that was not part of that language.
The second concept allows for a contract to reformed under Texas state law if there was a mutual mistake—that is, the written contract does not reflect the common intention of both parties to the contract.
Both of these are tied to the third concept—the idea of substance over form, as applied by a party to the contract under the Danielson rule.
Advisers are aware of the IRS asserting substance over form when challenging a taxpayer’s treatment of a transaction, as well as the fact that the courts are willing to change the treatment in such circumstances. But it is important to remember the IRS was not a party to the original agreements. As the IRS had no input on the agreement, the Courts are willing to hear its argument that the substance of the transction does not agree with its form.
However the same ability to apply substance over form is not granted easily to a party that was part of determining that form. Generally the taxpayer, who was involved in the drafting of the agreement, cannot raise a substance over form argument with regard to the transaction unless the taxpayer can show that the contract would either be interpreted under state law in the manner the taxpayer is now arguing or that there would be a valid action to reform the contract in line with the taxpayer’s position (thus bringing in the first two concepts).
This is referred to as the Danielson rule based on the Third Circuit’s holding in the case of Commissioner v. Danielson, 378 F.2d 771, 775 (3d Cir. 1967), vacating and remanding 44 T.C. 549 (1965).
So now the Court considered if the taxpayers can clear the bar imposed by the Danielson standard—and finds they cannot.
The taxpayer argues that the agreement was ambiguous because both the shareholders and the parent corporation are shown as parties to the agreement. However the Tax Court notes that while the shareholders were parties to the agreement, they were not required to deliver stock under the explicit terms of the agreement. Rather the Court notes they were made parties to the agreement to provide potential liability to them should the representations made as part of the sale turn out to be false.
As well, the buyer clearly at all points believed it was buying Alpha, not the holding company.
The court also rejected the mutual mistake issue. While there was an email that indicated the change, the court notes that this was months before the actual sale and notes:
We consider first the email sent from Kisner (Makric’s representative) to Ronn (the buyer’s representative) on February 28, 2008. Kisner’s email shows that he intended, at one time, to structure the transaction as the sale of Makric. And, as we have found, a representative from TS3 (the buyer), at some time before the February 28, 2008 email, had assented to that structure. See supra note 8. However, Kisner sent the email to Ronn seven months before the parties executed the stock purchase agreement. Over the course of those seven months, Kisner (with Miller, Makric’s lawyer) reviewed several drafts of the stock purchase agreement, all of which contradict the premise that the parties intended to exchange Makric stock, rather than Alpha stock. Critically, the stock purchase agreement itself and several of its drafts describe a sale structure by which TS3 would acquire Alpha, not Makric.
The Court noted other items that indicate the “real” sale was from the parent, and that the single email (which may or may not have been received by the other party) can’t overcome all of these other incidents that held out Makric as the seller and Alpha being what was sold:
Additional documents, including those signed prior to the closing and at the closing itself, are consistent with the premise that TS3 intended to acquire, and Makric intended to sell, Alpha. For example, in 2007, Makric's shareholders (in their capacities as Alpha's directors) signed a consent authorizing that Alpha be listed for sale. See supra p. 7. The record contains no comparable document listing Makric for sale. Makric's shareholders (in their capacities both as directors and shareholders of Makric) also signed a "Joint Written Consent of the Shareholders and Directors in Lieu of a Special Meeting", which unambiguously authorized the sale of Alpha by Makric. See supra pp. 20-21. At the closing, Kisner, in his capacity as CEO of Makric, signed a "Written Consent of Sole Shareholder of Alpha Circuits Incorporated", which also unambiguously authorized the sale of Alpha by Makric. See supra p. 21. We consider these documents more probative of the parties' intent at the time they executed the stock purchase agreement than Kisner's single email, which he sent several months before the transaction occurred.
… Brunson, TS3’s chairman, stated in his affidavit (see supra pp. 30-31) that TS3 might have been willing to purchase Makric had TS3 undertaken the requisite steps, including an appropriate due-diligence inquiry, for such a purchase; however, the affidavit also implies that the parties did not take such steps.
What about the fact that the agreement as signed was a tax disaster? The Court found that while its tax-inefficiency may give evidence that the seller didn’t really mean to go this route, it does not show that the buyer had made a mistake—rather, the buyer believed their agreement, as looked at by the sellers, met their tax objectives. And, the Court notes, if the the buyer was mistaken about the tax consequences to the buyer that is not a mistake that reformation can remedy.
Put simply, the agreement clearly holds that the parent was selling stock of its subsidiary—and the shareholders, who voluntarily signed the agreement and failed to raise objections even though 11 drafts with that structure were reviewed after they argued they had “intended” to change the structure.
Presumably the seller, who asked for a change to a sale of parent, would not have signed the agreement if they had realized the agreement didn’t provide for that. But that leaves open the apparently conclusion that various parties involved on the seller’s side (including the shareholders themselves) did not appear to ever actually check to see if this change had actually been made.
And, unfortunately, this sort of side effect can easily happen when a team of individuals assembles to deal with a situation. Essentially it’s easy for all parties to assume that “someone else” took care of this—such as the accountant accepting the statement of CFO that the deal was structured as a sale of the parent. And, presumably, the CFO believed that because he was told that by someone else involved in the sale. In the end it appears no one actually checked to see that the crucial change requested by the accountant had actually been made.