The distinction between ordinary income and capital gains remains paramount in federal taxation. Taxpayers often seek to characterize income as capital gains, which are frequently taxed at lower rates than ordinary income, such as interest. Congress enacted 26 U.S.C. § 483 in 1964 specifically to combat the practice of taxpayers converting what should be ordinary interest income into capital gain by structuring installment contracts without explicitly providing for interest payments. Section 483 ensures that if a deferred payment on a sale or exchange of property fails to provide adequate stated interest, a portion of that payment is imputed as "unstated interest" and taxed as ordinary income.

A recent decision from the United States Court of Appeals for the Third Circuit addresses the application of this statute in the context of a short-form merger settlement. In Trust Under the Trust of Charles G. Berwind Trust, F/B/O David M. Berwind, Jr., et al. v. Commissioner of Internal Revenue, the Third Circuit affirmed the Tax Court’s decision, concluding that the $191 million settlement payment received by the minority shareholder trusts (collectively, the "DB Trust") must include an imputed interest component under Section 483.

Factual Background of the DB Trust Litigation

The dispute originated from a family conflict concerning the control and ownership of Berwind Pharmaceutical Services, Inc. ("BPSI"), a company specializing in pharmaceutical coatings. The DB Trust held a 16.4% ownership interest in BPSI common stock. Efforts by Berwind Group Partners to acquire or redeem the DB Trust’s interest escalated, culminating in a letter in August 1999 stating BPSI was prepared to undertake a process to gain 100% ownership by year-end.

In December 1999, utilizing the Pennsylvania Business Corporation Law ("BCL") § 1924(b)(1)(ii), BPSI Acquisition Corporation (controlled by Berwind Group Partners, which held over 80% of BPSI stock) merged into BPSI via a short-form merger. The Articles of Merger were filed on December 16, 1999. The Merger Agreement stipulated that the DB Trust’s BPSI common shares would be converted into the right to receive a subordinated promissory note valued at $82,820,000, or alternatively, the fair market value determined under Pennsylvania’s dissenters’ rights provisions.

Following the merger, the DB Trust initiated the Warden litigation, challenging the merger’s validity and seeking a statutory appraisal for the fair value of its shares. BPSI subsequently filed its own state court appraisal action, which was removed to federal court and consolidated with the Warden litigation.

In November 2002, the parties reached a Settlement Agreement resolving the consolidated litigation. The agreement required BPSI to pay the DB Trust $191,000,000 (the "Settlement Amount") on December 31, 2002. The parties foresaw a tax dispute, as the Settlement Agreement did not resolve when the sale of shares occurred. The DB Trust subsequently characterized the entire payment as capital gains income in 2002.

The Taxpayer’s Request for Relief

The IRS issued deficiency notices to the DB Trust and its beneficiaries, asserting that a portion of the $191 million Settlement Amount represented unstated interest income under Section 483, taxable as ordinary income. The DB Trust petitioned the Tax Court for a redetermination of the deficiencies.

The DB Trust advanced two primary arguments in challenging the deficiency assessment:

First, the DB Trust contended the sale occurred in 2002, not 1999. They asserted the payment was made "under" the 2002 Settlement Agreement—the instrument that explicitly mandated the payment—rather than the 1999 Merger Agreement. If the sale occurred and the payment was made within one year (both in 2002), Section 483 would not apply because there was no deferred payment.

Second, the DB Trust argued that even if the sale occurred in 1999, the 1999 Merger Agreement was invalid or defective and therefore did not constitute a "contract for the sale or exchange of any property" required to trigger Section 483. Specifically, they argued the merger was void ab initio because it allegedly violated the BCL’s requirement that the plan of merger set forth the manner and basis of converting shares (BCL § 1922(a)(3)), and violated BPSI’s articles of incorporation regarding preferred stock shareholder voting. They also contended that the merger could not be a contract for sale of the DB Trust’s property because the Trust did not assent to it.

The Court’s Analysis of Law

The Third Circuit applied a de novo review to the Tax Court’s legal conclusions regarding the Internal Revenue Code and regulations, while reviewing factual findings for clear error.

Defining Sale Date

The court first addressed whether the sale of the DB Trust’s shares occurred in 1999 or 2002. It cited Pennsylvania BCL Section 1928, which dictates that a merger is effective upon the filing of the articles of merger with the Department of State, which occurred on December 16, 1999. The court held that this effectively completed the merger and the sale of the DB Trust’s shares on that date.

The court dismissed the DB Trust’s assertion that the merger was void ab initio. Regarding the alleged BCL violation (BCL § 1922(a)(3)), the court found that the Merger Agreement’s reference to the redemption notice, which specified the preferential shares would be redeemed at $1 per share, accurately set forth the "manner and basis of converting" the shares, thus complying with the BCL requirement. Regarding the alleged violation of BPSI’s articles of incorporation (lack of required preferred stock vote), the court ruled the DB Trust failed to meet its burden of proof to establish that BPSI Acquisition, as the sole holder of that preferred stock, did not provide the necessary vote.

Defining "Contract for Sale or Exchange"

Section 483 applies to a payment "under any contract for the sale or exchange of any property". The DB Trust argued the Merger Agreement was not a contract because it did not assent to it. The court rejected this, noting the Merger Agreement was executed by BPSI Acquisition and BPSI, approved by both boards, and became legally effective upon filing. This enforceable agreement constitutes a contract. Furthermore, the DB Trust’s assent was unnecessary, as a minority, dissenting shareholder is legally bound by the agreement made by the corporate entities, pursuant to the BCL’s short-form merger provision. The court referenced established precedent recognizing that forced sales are generally not distinguishable from voluntary sales under federal tax law (citing Helvering v. Hammel, 311 U.S. 504, 510 (1941), and Jeffers v. United States, 556 F.2d 986 (Ct. Cl. 1977)).

Defining "Under Any Contract"

The court analyzed the statutory requirement that the payment be made "under" the contract. Drawing on non-tax jurisprudence (citing Harrow v. Dep’t of Def., 601 U.S. 480, 486 (2025), and In re Hechinger Inv. Co. of Del., Inc., 335 F.3d 243, 252 (3d Cir. 2003)), the court determined that "under" means the provision that "served as the basis for the [conduct]," or "authorized" the action.

The court concluded that the 1999 Merger Agreement served as the basis for the payment obligation because it was the instrument that legally effected the sale and extinguished the DB Trust’s shares. The 2002 Settlement Agreement did not authorize the sale, but merely specified the subsequently disputed price term. The court warned that adopting the DB Trust’s interpretation would allow taxpayers to easily evade Section 483 by creating separate contracts for the sale and the payment terms.

The court also rejected the DB Trust’s application of the origin-of-the-claim doctrine (Lyeth v. Hoey, 305 U.S. 188 (1938)). Since the DB Trust conceded the $191 million payment was made "for the Trust’s BPSI stock," the nature of the payment was undisputed. The central issue was timing—whether the payment was made more than a year after the sale—which the origin-of-the-claim doctrine does not address.

Application of the Law to the Facts and Conclusion

The court ultimately found that all conditions for the application of Section 483 were satisfied:

The 1999 Merger Agreement was a "contract for the sale or exchange of property".
The sale of the DB Trust’s shares occurred in 1999.
The $191 million payment was paid "on account of" that 1999 sale.
The payment was due (and paid) more than one year after the date of the sale or exchange (December 16, 1999, to December 31, 2002).
The Merger Agreement did not provide for adequate stated interest.

Because Section 483 applied, the court affirmed the Tax Court’s decision holding the DB Trust liable for taxes on the imputed interest portion of the Settlement Amount, approximately $31 million, characterized as ordinary income.

Parallel Litigation: The Buyer’s Interest Deduction

The Third Circuit case represents the culmination of the DB Trust’s attempt to characterize the full settlement amount as capital gains. However, this same transaction was the subject of prior litigation involving the corporate buyer (BPSI, renamed Colorcon, Inc.).

In Colorcon, Inc. v. The United States, heard by the U.S. Court of Federal Claims in 2013, Colorcon sought a tax refund claiming an interest deduction of $31,096,783 related to the $191 million payment it made to the DB Trust in 2002. Colorcon’s position was that it was required to impute interest under Section 483 because the 1999 short-form merger was a sale or exchange, and the deferred payment was deductible under 26 U.S.C. § 163.

Crucially, the IRS opposed Colorcon’s claim, arguing that no part of the payment should be characterized as interest. The IRS asserted that Colorcon did not have an unconditional and legally enforceable obligation to pay a principal sum that constituted "indebtedness" under Section 163. The IRS concluded that IRC Section 483 was inapplicable because Colorcon "did not have a contract to purchase BPSI stock from the DB Trust".

The Court of Federal Claims granted summary judgment for Colorcon, finding that the 1999 short-form merger was a sale or exchange under a contract for Section 483 purposes. The court noted that the government (IRS) ultimately conceded that a short-form merger could give rise to a payment obligation triggering Section 483. The court found that the $191 million payment was made solely "in lieu" of BPSI’s obligation to compensate the DB Trust for shares redeemed in 1999. Since the payment was deferred more than one year and the merger did not provide for adequate stated interest, Section 483 applied, requiring Colorcon to impute and deduct the interest.

This parallel litigation illustrates the Commissioner’s practice of taking inconsistent positions against both the buyer and the seller in related transactions to ensure tax recovery, as the IRS argued against Section 483 application for the buyer (Colorcon) while simultaneously assessing a deficiency against the seller (DB Trust) based on the application of Section 483.

Prepared with assistance from NotebookLM.