Saturday, September 15, 2012

The Danielson Rule: Holding a Taxpayer to his Bargain (9/15/12)

In Hartman v. United States, ___ F.3d ___ (Fed. Cir. 2012), here, the Federal Circuit applied the constructive receipt rule to tax a service partner when he received shares in a corporation in return for services.  I use a simple example based on the Hartmann facts to illustrate the setting.
Example: Service partner A (Partner A) received 1,000 shares in Corporation X (a spin-off from the partnership).  The shares have a value of $1,000,000.  Under the contract signed at the time, partner A agreed that (i) the value of his shares is $1,000,000, (ii) he will report $1,000,000 ordinary income for tax purposes, (iii) 25% of the shares, 250 shares in this example, would be sold immediately to permit the partner to pay the resulting income tax obligation, (iv) the remaining 75% of the shares (750 shares in this example) would be subject to forfeiture as "liquidated damages," but the amount of the shares subject to such forfeiture would decline over a 5 year period in the event Partner A left the employment of Corporation X or was terminated for cause; and (v) from day one, Partner A received any dividends with respect to the stock and could vote the stock -- i.e., Partner A had all the accouterments of ownership of the stock except that it was subject to the forfeiture provisions.  Partner A reported ordinary income in the year as agreed of $1,000,000 and paid a resulting tax of $250,000 which was funded from the 25% of the shares sold.  Shortly after the next year commenced, Corporation A had a reversal of its fortunes and its stock declined in value by 50%.  This meant that Partner A had paid tax on the 750 remaining shares at a value of $750,000 but now they were worth only $375,000.  So, Partner A wanted to claim that the 750 shares were not constructively received for tax purposes and therefore that the only tax consequences were with respect to the 250 shares sold in the year and that taxation of the remaining shares must be in a future year as the restrictions on his stock lapsed.
From a substantive tax perspective, the reason for the shape of the agreement in the first place was to lock in the ordinary income from receipt of the shares at the inception -- in Partner A's case, $1,000,000 of ordinary income -- so that the expected future major accretions in value would be taxed as capital gain.  These expectations were upset because the value of the stock went down, which, if the phenomenon continued, would mean that Partner A got ordinary income taxed in full at the inception with a subsequent capital loss of limited tax benefit.  This basic phenomenon occurred in many cases after the internet bubble in the late 1990s burst.

The constructive receipt doctrine is a substantive tax doctrine that I will not further explore here.  Suffice it to say that the Federal Circuit applied the doctrine to tax Partner A with ordinary income on all of the shares in the first year, just as Partner A had originally reported the income (and consistently with his agreement to so report it).  What I want to address here is the Government's assertion of the so-called "Danielson Rule" that, if applicable would require Partner A to report consistent with his agreement regardless of whether the constructive receipt doctrine applied.  The Court of Appeals declined to decide that issue because it resolved the case on the merits of the constructive receipt doctrine.  The Danielson Rule applies where the substantive rule may not apply and, when it applies, it requires the taxpayer to report tax consistent with the agreement he entered regardless of the substantive tax treatment that might otherwise apply.  The Federal Circuit described the Danielson rule as follows:
[A] party can challenge the tax consequences of his agreement as construed by the Commissioner [of Internal Revenue] 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.
A classic application of the Danielson Rule is where a purchaser and a seller of a business, who have competing tax positions with regard to payments between them, allocate, say, agree to a purchase and sale of a business worth $5,000,000, but allocate $4,000,000 to the purchase of the business and $1,000,000 to a covenant not to compete.  (Actual negotiations are rarely this crisp, so that the parties may have bargained over sharing the tax benefit to the buyer and the tax cost to the seller would receive from this allocation, say by making the purchase price $4,100,000 rather than $4,000,000, but that nuance is not necessary for the illustration of the Danielson Rule).  The Danielson Rule would say that the IRS can rely upon that allocation in taxing the $1.000,000 to the seller as ordinary income pursuant to the covenant not to compete, even if the seller could claim that the real value of the consideration for the assets was $5,000,000 and for the covenant was $0.  If the seller were to attempt to do so, under the Danielson Rule, the IRS can hold the seller to the allocation in the agreement except if the seller can make some extra level of proof that the allocation is not appropriate.

A nuance presented in Hartmann, which the Federal Circuit acknowledged but ducked, was whether Danielson was a rule intended to apply to just the allocation stated in the agreement and not to the tax consequences if stated in the agreement.  The tax consequences in Hartmann were stated in the agreement, and there really was not an allocation issue.  The Claims Court at the trial level had concluded as follows:
Although the Claims Court recognized the Danielson Rule as "binding" in this circuit, it concluded that the rule is limited only to situations where "a taxpayer challenges express allocations of monetary consideration," rather than a situation where, as in this case, a taxpayer challenges how a transaction should be treated for tax purposes, and refused to apply the rule.
The Federal Circuit said, in effect, that while there might be some issue as to precisely whether the agreement covered the tax consequences, it need not address the issue because it determined on the substance that the taxpayer's initial reporting in the first year was appropriate.

I will use the balance of this  blog to cut and paste the discussion from my Federal Tax Procedure book on the Danielson and related concepts, which I present under the caption "The Strong Proof Rule" (footnotes omitted):

e. The Strong Proof Rule.
The courts have fashioned a judicial “strong proof” requirement when a party to a contract seeks to avoid the tax consequences that apply to a provision in the contract as to which the parties to the contract have opposing tax interests.  The classic instance is a contract selling a business with an allocation of some of the purchase price to a covenant not to compete and/or to good will.  All other things being equal, the portion of the purchase price allocable to the covenant not to compete is ordinary income to the seller and is an ordinary deduction to the purchaser.  Similarly, the portion of the purchase price allocable to good will is capital gain or return of capital to the seller and is a capital expenditure to the purchaser who amortizes that cost over a period of years rather than deducting immediately.  In these cases, so long as the parties report consistently with the contract provision, the Government is not whipsawed by, for example, the seller claiming capital gain and the purchaser claiming an ordinary deduction.  The parties themselves are in the best position to know what the real deal is and, when they make the allocation in the contract, the purpose of the “strong proof” rule is to permit the IRS to rely upon the parties’ allocation without concern that one or the other will unilaterally seek to change the tax consequences and whipsaw the Government.  Although there is a general tax theory that a party’s tax consequences is determined by the real deal rather than words in a contract that do not reflect the real deal, the strong proof rule is designed to encourage the parties to state the real deal in the contract rather than seeking to disavow unilaterally their own contract terms.  In these circumstances, a court will require the party seeking such unilateral relief to go beyond the preponderance of the evidence standard and show “strong proof” that some allocation other than provided in the contract should control. 
There are at least two formulations of the strong proof rule.  The first formulation of the rule is that “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.”  (This is sometimes referred to as the Danielson rule, named for the first major case in which it applied.)  Other courts impose a perhaps less rigorous but still quite substantial version of the rule – that the proponent must prove that both parties actually intended a different allocation than they put in the contract.  (I must confess that they appear to be the same, but courts do not think they are.)  I have stated only the parameters of the rule, and cannot in this text develop it’s nuances in application.  One nuance, however, that was addressed by a court applying the second formulation is that the party’s evidence must have persuasive power closely resembling the “clear and convincing” evidence required to reform a written contract on the ground of mutual mistake. 
The bottom line is that the practitioner should caution the client to insure that the real deal is stated in the agreement and that he will likely be bound by the provisions of the agreement.  The real deal for this purpose has two layers – first the contract should certainly state the parties’ actual agreement; that is, they should have no side oral, wink-wink or other types of agreement inconsistent with the contractual provision.  (Indeed, under the second version of the rule a taxpayer may be admitting a crime if he were to assert that the intent of the parties as to a contract provision having tax consequences was different than the parties stated in the contract.)  The real deal second layer is an objective test apart from the parties’ intent and meeting of the minds – what does the real objective economic circumstance indicate that the real deal was?  For example, if there is no reason whatever for the seller to stay involved in a business or to possibly compete against the purchaser, the parties’ allocation of a material portion of the purchase price to a consulting contract or covenant not to compete will lack economic substance even apart from having to discern their subjective intent and meeting of the minds.  Of course, these separate aspects of the real deal tend to converge in the real world, but they are different conceptual aspects that may come into play. 
Note that the rule applies to the parties to the contract.  The rule does not apply to the IRS.  The IRS may, upon review of the overall context, decide that the contract does not state the real deal and tax one or both parties consistent with the IRS determination of the real deal.  A moment’s reflection should show why that has to be the case; otherwise, parties could manipulate the tax consequences of their contract.  When the IRS challenges the contract provision, the party seeking to have the provision govern for tax purposes will be required to show under the regular preponderance of the evidence rule that the contract correctly states the real deal.   
As a further nuance, if the IRS does propose to adjust the tax consequences of one party and the other party is aware of the IRS proposal, the other party should protect his ability to claim the refund that would result from a consistent adjustment.  I hope you have spotted a conceptual problem where these rules could overlap to create an injustice that might permit the IRS to tax both sides inconsistently.  For example, say the IRS asserts a deficiency against a buyer, denying his deductions as payments are made because the covenant not to compete lacks economic effect.  If the IRS is successful, provided the seller reported consistently with the contract (ordinary income), the seller has likely over-paid his tax because the income should be capital gain or return of capital rather than ordinary income to him.  So, assuming the seller has protected his refund statute of limitations, must the seller meet the strong proof rule in order to get a refund and, if he cannot, can the parties be whipsawed and the Commissioner collect tax twice on inconsistent theories?  That may conceptually be an issue, but the IRS will work to avoid whipsawing taxpayers.  (You should note that this possible whipsaw of taxpayers can conceptually occur even under the normal burden of proof rules where the taxpayer bears that burden; the trier – whether the IRS or a court or jury – would be in a state of equipoise, not knowing who should win; under the formulation of the burden of persuasion rules, both parties could conceptually lose, but I suspect that under those circumstances the first deciding court would strive to make a decision on the basis of the burden of persuasion, thus avoiding the inequity.) 
Finally, the context of this discussion is where the taxpayer seeks to disavow the consequences of a form he or she has chosen and argue that the substance – and thus the tax consequence – is different than the form.  However, in many tax contexts the form determines the substance and different forms can have different tax consequences even if they might, practically, be substantively similar.  In any event, in some contexts when the issue is raised, close analysis will show that in fact the substance – at least the substance for tax purposes – is sufficiently consistent with the form that the taxpayer’s argument fails for that reason alone.

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