Taxpayers Bear the Tax Consequences of Business Decisions

August 21, 2017

Form v. Substance

It is a basic precept of the tax law that the substance of a transaction, rather than its form, should determine its tax consequences when the form of the transaction does not coincide with its economic reality. This substance-over-form argument is a powerful tool in the hands of a taxing authority.

According to another basic precept of the tax law, a taxpayer will generally be bound, for purposes of determining the tax consequences of a transaction, by the form of the transaction that he has used to achieve a particular business goal; the taxpayer may not freely re-characterize a transaction.

That being said, a taxpayer may assert a substance-over-form argument under certain circumstances. In those situations, however, the taxpayer faces a higher than usual burden of proof; indeed, the taxpayer must adduce “strong proof” to establish his entitlement to a position that is at variance with the form of the transaction reported on the taxpayer’s return.

The case discussed below addressed the classic tax issue of form versus substance as the Third Circuit considered a taxpayer’s attempt at re-characterizing a transaction.[1]

The Ingredients

Taxpayer, a U.S. person, was the majority shareholder of a U.S. corporation (“Target”) that owned and operated two Russian LLCs that, in turn, owned and operated most of Russia’s Pizza Huts and KFCs. Another U.S. corporation (“Minority”) held the remaining Target shares.

In order to sell the company, Taxpayer planned to buy out Minority’s Target shares, and then transfer all the Target shares – including those just purchased – to the buyer, a European corporation (“Buyer”) that owned KFCs, Pizza Huts, and other fast-food restaurants throughout Europe.

In May of the year in question, Taxpayer agreed to “purchase”, for his “own account”, Minority’s stake in Target. At closing, Minority was to transfer its Target shares to Taxpayer and then, in the following month, Taxpayer would make a “deferred” payment of the purchase price to Minority.

“You better cut the pizza in four pieces because I’m not hungry enough to eat six.” – Yogi Berra

Taxpayer also entered into a Merger Agreement with Target and Buyer. Under the terms of this Agreement: (1) Taxpayer would ensure, at the closing, that he was the “record” owner of 100% of the Target stock, “free and clear of any restrictions”; (2) Taxpayer would transfer 100% of Target’s shares to Buyer; and (3) Buyer would transfer cash and Buyer stock to Taxpayer as consideration. The transaction was intended to qualify as a partially “tax-free” reorganization within the meaning of the Code.[2] [IRC Sec. 368, 367]

The two transactions went through as planned. In June of the year in question, Minority transferred its Target stock to Taxpayer. On July 2, the Target-Buyer merger closed, and Taxpayer transferred all the Target stock to Buyer. On July 3, Buyer paid Taxpayer over $23 million in cash and transferred over $30 million worth of Buyer stock, a total of nearly $54 million for all Target’s shares. Then on July 5, Taxpayer paid Minority $14 million for its stake in Target.

In two tax filings for the year in question, Taxpayer took two different approaches to the transaction. In his original return, Taxpayer reported tax liability of almost $3.8 million, and paid that amount to the IRS. Taxpayer subsequently amended his return, reported a lower tax liability, and requested a refund.

“Finger Lickin’ Good” – Not for the Taxpayer

The IRS audited Taxpayer, found that the originally-filed return was correct, and denied Taxpayer’s request for a refund. Taxpayer then petitioned the U.S. Tax Court for a redetermination. The Tax Court held for the IRS, and Taxpayer then appealed to the Third Circuit Court of Appeals.

Taxpayer Never Owned It?

Taxpayer challenged the IRS’s determination that he had to pay tax on the $14 million that he received from Buyer and immediately remitted to Minority. The question was whether the form of the transaction made Taxpayer liable for the gain on the Target stock that had been held by Minority.

The Court began by describing the so-called “Danielson rule”:

[W]hile a taxpayer is free to organize his affairs as he chooses, . . . once having done so, he must accept the tax consequences of his choice, whether contemplated or not, and may not enjoy the benefit of some other route he might have chosen to follow but did not.

A taxpayer who falls within the scope of this rule, the Court stated, is generally stuck with the form of his business transaction, and can make an argument that substance should prevail over that form only if a limited class of exceptions applies.

Taxpayer argued that he was never the substantive owner of the Minority block of stock and, therefore, should not be taxed on the $14 million portion of Buyer’s payment that Taxpayer passed to Minority.

However, according to the Court, none of the Danielson exceptions applied – Taxpayer was not defrauded into the transaction, for example – and the contracts signed by the parties explicitly stated that Taxpayer acquired ownership of Minority’s stock: he purchase it for his “own account” prior to selling it to Buyer; and even though the shares were in his hands for only a brief period of time, he was the “record” owner, “free and clear of any restrictions.”

Thus, under Danielson, Taxpayer had to bear the tax liability for owning all the Target shares. He could have hypothetically structured the deal so that he never acquired formal ownership of Minority’s shares, but he did not, and could not benefit from an alternative route now.

“Danielson” Policy Wasn’t Implicated?

Taxpayer argued that the Danielson rule should not apply because its policies were not implicated. According to Taxpayer, the purpose of the Danielson rule was “to prevent a taxpayer from having her cake and eating it too.” Taxpayer claimed that he realized no benefit from serving as Minority’s and Buyer’s go-between.

The Court countered that Taxpayer likely did benefit: by structuring the transaction so that he purchased Minority’s stock for his own account prior to the sale to Buyer, Taxpayer made the overall transaction simpler by ensuring that Buyer would deal with only one party, which likely reduced the deal’s transaction costs and litigation risk, increased the likelihood of the deal actually closing, and perhaps caused Buyer to pay a higher price than it otherwise may have.

In any case, the Court stated, the point of a bright-line rule like Danielson’s requires that judges enforce it without wading into policy analysis, ensuring that the rule’s application will be easy and predictable.


Taxpayer claimed that he was nothing more than Minority’s agent in selling Minority’s block of stock, and agents are not liable for the tax burden of their principals.

In responding to this claim, the Court explained that an agency relationship is created through “manifestation by the principal to the agent that the agent may act on his account” and the agent’s “consent” to the undertaking. The problem with this argument, the Court noted, is that the written agreement between Minority and Taxpayer stated in straightforward terms that Taxpayer purchased Minority’s shares for his own account; it did not mention an agency relationship, and none of the terms suggested that Taxpayer ever had an obligation to sell his newly-acquired shares to Buyer or anyone else; Taxpayer could have kept the stock for as long as he wanted, as long as he paid Minority its $14 million. That Taxpayer did encumber himself with an obligation to sell the Minority shares to Buyer arose out of the separate Merger Agreement to which Minority was not a party.

The food in Europe is pretty disappointing. I like fried chicken. But other than that Europe is great.” – Donnie Wahlberg

“Make it Great” – Not for the Taxpayer

The Court concluded that Taxpayer owned 100% of Target’s stock when he transferred Target to Buyer for a total consideration of $54 million, comprised of Buyer stock and cash, and he had to bear the tax burden for the entire payment, even the portion associated with the $14 million he remitted to Minority.

Taxpayer argued that if he must be taxed on the full $54 million from Buyer, he should be permitted to subtract from the gain on his original shares the amount that he “lost” on the sale of the Minority shares.

The Code provides that no gain or loss shall be recognized by a shareholder of a corporation if the shareholder’s stock in the corporation is exchanged, pursuant to a “plan of reorganization,” solely for stock in another corporation that is a party to the reorganization. [IRC Sec. 354]

Thus, a target corporation shareholder who receives only shares of stock in the buyer corporation in exchange for his shares of the target corporation stock, as part of a stock-for-stock merger transaction, does not recognize any of the gain or loss realized in the exchange.

This general rule has an exception for instances when a corporate reorganization involves a transfer of target stock in exchange for both stock of the acquiring corporation and other property or money (“boot”). In those transactions, gain must be recognized by the target shareholder to the extent of the boot received, but any losses realized by the target shareholder still fall within the scope of the general rule – they may not be recognized notwithstanding the receipt of boot by the target’s shareholder. [IRC Sec. 356]

Blocks of Target Stock

The Court explained that, in order to give content to the above recognition / nonrecognition rules, the IRS and the courts historically have analyzed multifaceted transactions according to their “separate units” of stock, so as to prevent a taxpayer from making an end-run around the non-recognition-of-loss rule by tucking his unit’s statutorily unrecognizable loss under the transaction’s broader recognizable gain; thus when an exchange transaction pursuant to a reorganization involves “separate units” of stock, each unit must be analyzed separately.

Taxpayer asked the Court to treat the two blocks of target stock – his block and Minority’s – as one unit, sold in one exchange. By doing so, Taxpayer hoped to subtract the loss realized on the Minority shares from the gain on his original shares (as he could have done if the transaction had not been structured as a partially tax-free reorganization). The Court rejected this request, finding that Taxpayer’s Target stock holdings were composed of two units: Taxpayer acquired one block of Target stock years before acquiring the second block, and he had a vastly different cost basis in the two blocks. Given that the blocks were separate, the Code’s reorganization provisions prohibited recognition of any loss realized by taxpayer in the Minority block.

Plop, Plop, Fizz, Fizz

Fried chicken and pizza aren’t the only things that can give a taxpayer heartburn. Unexpected tax liabilities are just as, if not more, likely to do so. Moreover, tax liabilities cannot be relieved by a simple antacid.

This part of almost every post on this blog must sound like the proverbial broken record. I apologize, but it cannot be said often enough. Before a taxpayer enters into a transaction, he has to be as certain as reasonably possible under the circumstances – risk can never be eliminated – that the transaction will accomplish the taxpayer’s desired business goal. Assuming that is the case, the taxpayer next has to analyze and quantify the tax cost associated with the transaction. This cost has to be added to the other deal costs, and weighed against the expected economic benefits. Depending upon the results of this analysis, the taxpayer may want to reconsider some of the proposed deal terms.

“Eschew obfuscation,” one of my high school physics teachers used to say. I have my own ironic saying: “avoid surprises.” Business owners should consult their tax advisers well before executing a letter of intent for a transaction – the foregoing analysis should not to be deferred until late in the game, because doing so could prove to be an expensive mistake.


[1] I have to confess that when I came across this decision, I had already started writing a post on why some LLCs make S-corporation elections. For those of you who know me, as soon as I saw the references to Pizza Hut and KFC, I completely forgot about the LLC.

[2] As we shall see, this reorganization treatment was at the crux of the Taxpayer’s position (see infra).