Judge Halpern Synthesizes Taxpayer and IRS Burdens when Seeking a Tax Result Based on Substance Rather than Form (5/31/21)

In Complex Media Inc. v. Commissioner, T.C. Memo. 2021-14 (as revised 3/31/21), TN here and TC Dkt entry 87 here, in a 103 page opinion, Judge Halpern had some interesting discussion on issues important to tax procedure fans.  I won’t try to slice and dice the entire opinion but will just point out the discrete parts that caught my attention.

1. “This Court has never accepted the Danielson rule. And, because the cases before us are not appealable to the Third Circuit (or to any other appellate court that has accepted the Danielson rule), the Golsen doctrine does not require us to apply that rule here.”  (Slip Op. 53-54.)

2. More interesting is the Court’s discussion as to the different burdens when the IRS and the taxpayer seeks to avoid the form of the transaction.  The key excerpt is (Slip Op. 63-64):

In sum, as our caselaw has evolved, it has become more hospitable to taxpayers seeking to disavow the form of their transactions. While we no longer reject those arguments out of hand, as we did in Swiss Oil Corp., J.M. Turner & Co., and Television Indus., we have repeatedly indicated that taxpayers may face a higher burden than the Commissioner does in challenging transactional form. On occasion, as in Glacier State Elec. Supply, we have suggested that the taxpayer's higher burden might be an evidentiary one. But we have not identified specific factual questions that should be subject to a higher burden than that imposed by Rule 142(a) or articulated the quantum of evidence necessary to meet that burden. [*64] Nor have we offered a clear justification for imposing on the taxpayer a higher burden to prove facts relevant to the disavowal of form than the generally applicable preponderance of the evidence standard.

Therefore, we now conclude that the additional burden the taxpayer has to meet in disavowing transactional form relates not to the quantum of evidence but instead to its content--not how much evidence but what that evidence must show by the usual preponderance. The Commissioner can succeed in disregarding the form of a transaction by showing that the form in which the taxpayer cast the transaction does not reflect its economic substance. For the taxpayer to disavow the form it chose (or at least acquiesced to), it must make that showing and more. In particular, the taxpayer must establish that the form of the transaction was not chosen for the purpose of obtaining tax benefits (to either the taxpayer itself, as in Estate of Durkin, or to a counterparty, as in Coleman) that are inconsistent with those the taxpayer seeks through disregarding that form. When the form that the taxpayer seeks to disavow was chosen for reasons other than providing tax benefits inconsistent with those the taxpayer seeks, the policy concerns articulated in Danielson will not be present.

I have revised the relevant discussion in my Federal Tax Procedure book working draft to be published in August.  I link here a pdf of the discussion with the changes redlined.  Note that the page numbers and footnote numbers will be different in the final version published in August.

JAT comments:

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

In Hartman v. United States, 694 F. 3d 96 (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.