In a prior blog post, here, I discussed a Tax Court memorandum opinion in Watts v. Comm’r, 2020-144, in which the Tax Court cited to the Danielson rule in holding for the IRS. The last line of that blog post reads, “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.” Well, only a few months later, the taxpayer in another Tax Court memorandum opinion, Complex Media Inc. v. Commissioner, T.C. Memo 2021-14, prevailed in that uphill battle and convinced the Tax Court that the taxpayer could disavow and recharacterize the form of a transaction.
Readers of the prior blog post will recall that 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 Complex Media, Inc., the taxpayer, Complex Media, Inc. (CMI), was formed in 2009 as part of a plan to expand the business that published Complex magazine and other online content. A year earlier, Complex Media Holdings LLC (CMH) was organized to serve as a holding company for the two limited liability companies that had previously carried out the magazine and online business. To fund the expansion, CMH identified OnNetworks Inc. (ONI) as an investor. As the parties negotiated a business combination involving CMH and ONI, friction developed between ONI preferred shareholders and Seth Gerszberg, a CMH partner. The other CMH partners tried to get Gerszberg to withdraw from the business so the transaction could go forward, but they didn’t have enough money to buy out his interest. The parties eventually agreed to a plan under which a portion of ONI’s remaining cash would be used to redeem Gerszberg’s interest in CMH and the remainder would be used as operating capital for the transferred business. The deal went forward in 2009 as two transactions. First, CMH transferred its assets to CMI in exchange for 4,999,999 shares of CMI stock. Second, CMI immediately redeemed some of the shares held by CMH in exchange for $2.7 million in cash and an obligation to pay $300,000 to Gerszberg a year later. CMI claimed an increased basis of $3 million in intangible assets it acquired from CMH and amortized additional basis under section 197(a).
The IRS disallowed the amortization deductions and CMI petitioned the Tax Court for review. In its arguments to the Tax Court, CMI sought to disavow the form of the transactions and to instead treat the cash and deferred payment right as boot in a section 351 exchange. Citing to the Danielson rule, the IRS argued that CMI was bound by the terms of the relevant agreements or the form of the transactions carried out under the agreements.
In holding for the taxpayers the Tax Court said:
To the extent that the Danielson rule limits a taxpayer's eligibility to disavow the form of its transactions as well as the terms of the contracts that govern those transactions, however, the rule has no application to the cases before us, 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 the rule here.
In sum, petitioner's ineligibility to invoke grounds that would render its contracts unenforceable or call into question respondent's interpretation of those contracts does not prevent it from disavowing the form of the transactions implemented under them.
The Court then went on to hold that because any tax planning involved in structuring the transactions in issue were focused on insulating the partnership’s continuing partners from the consequences of the redemption of Gerzbert’s interest and not on the achievement of a tax benefit inconsistent with allowing CMI increased bases in the assets it acquired from the partnership, CMI was not precluded from seeking to disavow the form of its transactions.
For questions regarding this blog post or any other civil or criminal tax related matter, please feel free to contact Joel Crouch at (214) 749-2456 or firstname.lastname@example.org.