What is the Danielson Rule?

In the recent case of Watts v. Comm’r, T.C. Memo. 2020-143, the Tax Court cited to the Danielson rule in holding for the IRS. So, what is the Danielson rule?

The Danielson rule came from Commissioner v. Danielson, 378 F.2d 771, 775 (3d Cir. 1967) and says that parties are bound by the form of their transaction regardless of the underlying substance. As explained by the Eleventh Circuit  in Peterson v. Commissioner, 117 AFTR 2d 2016-1815,  “[w]hen a taxpayer characterizes a transaction in a certain form, the Commissioner may bind the taxpayer to that form for tax purposes.  This is a rule: ‘a party can challenge the tax consequences of his agreement as construed by the Commissioner 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, et. cetera.’ ”

In Watts, the issue was whether the taxpayers correctly characterized losses related to their disposal of partnership interests as ordinary, rather than capital losses.  In its initial decision, the Tax Court agreed with the IRS that the losses should be capital.  The taxpayers appealed to the 11^th Circuit, which vacated the Tax Court decision and remanded the case to the trial court for further determination.  However, in its remand order the 11^th Circuit suggested that the Tax Court determine whether the Danielson rule applied.

Not surprisingly, the Tax Court took the 11^th Circuit’s suggestion and determined that the Danielson rule was applicable and again decided in favor of the IRS.  The court said, “[t]he 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.” The court rejected the taxpayers’ arguments that relevant provisions of the purchase agreement should be disregarded and pointed out that the taxpayers “did not adduce proof that the … agreement would be unenforceable because of mistake, undue influence, fraud, duress, or the like, as required under the Danielson rule.”

The lesson from Watts and Danielson is that a taxpayer who attempts to disavow the tax consequences of an arm’s length agreement will face a significant uphill battle.

For questions related to this or any other civil tax or criminal tax related matter, please feel free to contact Joel Crouch at (214) 749-2456 or jcrouch@meadowscollier.com.