Attorney-at-Law

A CHALLENGE

In Uncategorized on 02/10/2021 at 19:02

Rarely is Judge James S (“Big Jim”) Halpern unable to demystify even the most devious corporate caper, but today he confesses it was a challenge in Complex Media, Inc., 2021 T. C. Memo. 14, filed 2/10/21.

As near as I can figure it, a partnership composed of a couple LLCs (hi, Judge Holmes) got bought out by a corporation with not enough cash to pay off its preferred shareholders if it liquidated. So the bought-out would stay in with the buyer-out via a new corporation, and the buyer-out would stump up enough cash to keep the new corporation going.

Needless to say, one of the basic tenets of partnership organization comes into play: whatever the other partners want, one partner doesn’t, whether it’s a business deal or what to order for lunch. So the buyer-out and the bought-outs do a tax-free incorporation, whereby the buyer-out contributes cash and the bought-outs contribute IP, some beat-up computers, and office furniture. Buyer-out and bought-outs get stock in the new corporation, plus some cash and receivables (but they’re not part of the equation until much later, maybe 90 pages in).

Some of the stock in the new corporation that the bought-outs get is immediately redeemed with the cash the buyer-out put in, and paid to the dissenting partner in redemption of his partnership interest.

Everything the bought-outs contributed is fully amortized, except the IP, which is Section 197 start-up fifteen-year amortizable. The new corporation (hereinafter “P”) claims a $3 million basis in the IP. IRS claims zero. Judge Big Jim starts out with the question whether the deal was a tax-free incorporation or a taxable sale. If a sale, the bought-outs would have gotten a much bigger gain, and P would have a much bigger basis in the IP; see 2021 T. C. Memo. 14, at p. 21, footnote 10. The FMV of the IP was way more than what P claimed on its 1120. So both sides want Section 351 treatment, the bought-out shareholders wanting to shield the gain, and IRS to claim P only has the Section 362(a) carryover basis from the bought-outs, way less than $3 million.

But there’s another problem. The deal is out of control. That is, the transferors (the bought-outs and the buyers-in) didn’t own 80% or more of P’s stock immediately after the transfer to P, as Section 351(a) requires, because the dissenting partner got enough stock, which he immediately redeemed for cash, to torpedo the control group. Caselaw says that if a transferee of shares is obligated to part therewith immediately after getting same, that transferee is out of control.

Clear? Thought not. Cheer up; it gets worse.

The buyer-out swapped its stock for a stock in P, but the stock it swapped was preferred, and what it got back is common. Remember, buyer-in didn’t have enough cash to pay its preferred shareholders their liquidation preferences. What they got in the swap was less than what they gave. And they needed the common shareholders to go along, although the commoners got nothing.

You ready to quit yet? I was, about half-an-hour ago. Judge Big Jim is also ready.

“Although we are not convinced that, as a matter of law, petitioner’s acquisition of the assets of the transferred business was part of an exchange to which section 351 applies, we will treat it as such in disposing of the cases before us. Petitioner is the only party that would benefit from a determination that its acquisition of those assets was a taxable purchase and sale rather than a section 351 exchange. And it has steadfastly maintained that the acquisition is covered by section 351. Moreover, the duty of consistency might prevent it from taking a contrary position.” 2021 T. C. Memo. 14, at pp. 30-31 (footnote omitted).

Hurray for consistency!

But if you think you’re confused, IRS’ counsel is, if you will pardon an arcane technical term, utterly fahrblundgit. Read 2021 T. C. Memo. 14, at pp. 32-35. If thereafter you reach for a Tylenol, welcome to the club.

Having reached this point, Judge Big Jim isn’t ready to quit. OK, so it’s a 351. But what if P now wants to claim it isn’t? Well, how about Danielson and Makric? And Tseytin? For Danielson and Makric, see my blogpost “RTFC,” 3/9/16. For Tseytin, see my blogpost “The Secret Agent?” 12/29/15. Maybe the Nat’l Alfalfa “you broke it, you own it,” rule isn’t an impenetrable barrier; and Judge Big Jim will tell you so in seventeen (count ’em, seventeen) pages of “somber reasoning and copious citation of precedent.”

And Judge Big Jim ends up with the words of a former President of Our Fair Country: “Yes, we can!”

“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… or to a counterparty…) 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.” 2021 T. C. Memo, 14, at p. 64.

And P meets the burden. Nobody is better or worse off if the form is disregarded, and the redemption deal is treated as separate from the Section 351 incorporation. There’s a business reason also: the buyer-in didn’t have the cash to do a straight buyout, and the bought-out wouldn’t take less than their outfit was worth. And the dissenting partner wanted out every which way.

So we have a step transaction analysis (copious and somber), finishing up with a Cohan approximation (ditto) that sends the parties off to a Rule 155 beancount, and me to a large whiskey.

As Mark Twain put it, “Well you’ve got to admire men that deal in ideas of that size and can tote them around without crutches.”

 

 

 

 

 

 

 

 

 

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