Tax Court Allows Taxpayer to Disregard Form of Transaction Under Step Transaction Doctrine

(Parker Tax Publishing February 2021)

The Tax Court held that a corporation that acquired a partnership's assets in exchange for the issuance of its stock, which was partially redeemed for cash immediately thereafter along with the promise of an additional cash payment, could use the step-transaction doctrine to treat the subsequent amounts paid and promised as additional consideration for the acquired assets. The court reasoned that any tax planning involved in structuring the transactions at issue was focused on insulating the partnership's continuing partners from the consequences of redeeming one partner's interest and not on the achievement of a tax benefit inconsistent with allowing the corporation to increase its bases in the assets acquired from the partnership. Complex Media, Inc. v. Comm'r, T.C. Memo. 2021-14.

Background

In 2009, Complex Media, Inc. (CMI) acquired the assets of a magazine and internet media business (i.e., the transferred business) from Complex Media Holdings, LLC (CMH). CMH was organized in 2008 as a holding company for two limited liability companies that, between them, had previously conducted the transferred business.

The acquisition by CMI was the result of a search for financing to fund further development of the magazine and internet media business. Eventually, CMH identified OnNetworks, Inc. (ONI), as a potential investor. ONI had raised about $19 million through the issuance of stock but had lost most of its initial funding in pursuit of an unsuccessful business venture. However, by early 2009, ONI had about $6.3 million in cash left--less than the amount to which its preferred shareholders were entitled to receive upon a liquidation of the corporation. During negotiations over a business combination involving CMH and ONI, friction developed between ONI preferred shareholders and Seth Gerszberg, one of CMH's partners. The other partners urged Gerszberg to withdraw from the business to allow the intended transaction to go forward, but they lacked the funds to buy him out. Negotiations ultimately coalesced around a plan under which a portion of ONI's remaining cash would be used to redeem Gerszberg's interest in CMH, and the remainder used as operating capital for the transferred business.

Around November 29, 2009, the parties came to an agreement (CM & JV agreement) and CMH contributed to CMI the assets of the transferred business in exchange for 4,999,000 shares of CMI common stock. Immediately thereafter, under a stock repurchase agreement, CMI redeemed 1,875,000 of the common shares held by CMH in exchange for $2.7 million in cash and CMI's obligation to make an additional payment of $300,000 on January 3, 2011. Under a unit purchase agreement between CMH and Gerszberg, CMH paid the cash and assigned its right to the additional payment to Gerszberg in redemption of Gerszberg's interest in CMH.

CMH's 2009 tax return did not reflect its receipt from CMI of $2.7 million in cash and the right to the additional $300,000 payment. The only income items shown on CMH's return other than gross profit from the sale of goods were a bad debt recovery and interest income. CMH reported amortization expense of $4,808 attributable to carryover bases of trademarks and a domain name. The amortization CMI reported on its returns included $4,808 of amortization attributable to carryover bases of the same assets. CMI claimed an additional $200,000 of amortization in respect of an intangible asset acquired on November 25, 2009, with a basis of $3 million (i.e., the $2.7 million immediate cash payment plus the $300,000 deferred payment).

In notices of deficiency, the IRS disallowed CMI's deduction for amortization of the intangible assets it acquired from CMH. The IRS later conceded that $4,808 of the deduction claimed for each year was allowable, leaving $200,000 of amortization at issue for each year. CMI challenged the notices in the Tax Court. The issues before the Tax Court were (1) whether the tax consequences to CMI of its acquisition of the assets of the transferred business had to be determined in accordance with the form of that transaction as delineated in the CM & JV agreement; (2) if not, whether the transaction could be recharacterized under the step transaction doctrine to include the $2.7 million in cash and the $300,000 deferred payment in the total consideration paid for the transferred assets; and (3) if the transaction should be so recharacterized, the portion of the resulting gain recognized by CMH that was allocable to amortizable Code Sec. 197 intangibles, entitling CMI to increase its tax bases in those assets and allowing it annual amortization deductions beyond those attributable to the bases of those assets in CMH's hands.

Comm'r v. Danielson, 378 F.2d 771 (3d Cir. 1967), involved a situation where shareholders of a target corporation sold their stock and entered into a covenant not to compete with the purchaser, but later argued that the purported allocation of the consideration did not reflect the real agreement of the parties. The Third Circuit held that the tax consequences of such an agreement can be challenged only by providing proof of its unenforceability because of mistake, undue influence, fraud, or duress. The Third Circuit worried that allowing a party to attack a contract provision for tax purposes would be, in effect, to grant a unilateral reformation of the contract with a resulting unjust enrichment.

The IRS argued that under Danielson, CMI was prohibited from challenging the express terms and contractual provisions of the agreements and the Tax Court was precluded from admitting or considering contradictory or supplemental testimony. According to the IRS, CMI could not treat the cash and deferred payment right as taxable boot because (1) the agreement provided that the sole consideration to which CMH was entitled in exchange for the transferred assets was 4,999,000 shares of CMI's common stock, and (2) under the stock repurchase agreement, CMH received the $2.7 million cash and $300,000 deferred payment right in redemption of 1,875,000 shares of CMI's common stock. The IRS variously described CMI as bound by either the terms of the relevant agreements or the form of the transactions carried out under the agreements.

Tax Court's Analysis

The Tax Court held that CMI was not precluded from seeking to disavow the form of its transactions and that CMI's issuance and immediate redemption of 1,875,000 shares had no economic substance and could be disregarded under the step transaction doctrine, with the cash and deferred payment right treated as additional consideration for the transferred assets. With respect to the IRS's reliance on Danielson, the court noted that it has never accepted the Danielson rule, and that this case was not appealable to the Third Circuit or to any other circuit that has adopted the Danielson rule.

The court found that while CMI could not invoke grounds that would render its contracts unenforceable or call into question the IRS's interpretation of those contracts, it was not prevented from disavowing the form of the transactions implemented under them. For a taxpayer to disavow the form it chose, the court said, it must establish that the form of the transaction was not chosen for the purpose of obtaining tax benefits that are inconsistent with those the taxpayer seeks through disregarding that form. According to the Tax Court, 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.

The court said that the parties had an obvious nontax reason for structuring the transactions as they did: CMI could not have paid CMH $2.7 million in cash in exchange for the assets it received from CMH because it did not have any cash until after the exchange. The court found that, to the extent the structuring of the transactions involved tax planning, that planning seemed to have been focused on insulating CMH's continuing partners from any adverse tax consequences from the redemption of Gerszberg's interest. It therefore concluded that CMI should be allowed to invoke the substance-over-form doctrine.

Next, the court found that under the step transaction doctrine, the issuance and immediate redemption of 1,875,000 shares of CMI's common stock should be disregarded because the issuance of stock subject to an obligation that it be immediately redeemed has no economic substance. The court reasoned that if CMH had sought a tax benefit from respecting the separate steps of the issuance and immediate redemption of those shares, the IRS would surely invoke the step transaction doctrine to collapse those steps, and the court would likely have upheld the IRS's position. In the court's view, because CMI met its burden for applying the doctrine in its favor, the same result should obtain. By application of the step transaction doctrine, the court concluded that CMI should be treated as having acquired the assets of the transferred business in exchange for 3,124,000 shares of its common stock, $2.7 million in cash, and an obligation to make an additional payment of $300,000 on January 3, 2011.

The Tax Court further held that, under Code Sec. 351, CMH recognized gain to the extent of the $2.7 million cash it received and the fair market value of its right to the additional $300,000 payment. The court found that the recognized gain increased CMI's bases in the transferred assets under Code Sec. 362(a). The court further held that, when assets transferred in a Code Sec. 351 exchange with taxable boot constitute a trade or business, the residual method of allocation prescribed by Code Sec. 1060 can be used to allocate the boot among the transferred assets. Consequently, the court found that CMH's gain in amortizable Code Sec. 197 intangibles, and the corresponding increase in asset bases allowed to CMI, was determined by subtracting from the agreed total asset value the estimated values of those assets other than amortizable Code Sec. 197 intangibles.

For a discussion of the requirements for nonrecognition on the transfer of property to a corporation under Code Sec. 351, see Parker Tax ¶45,105. For a discussion of the rules for amortizing Code Sec. 197 intangibles, see Parker Tax ¶95,110.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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