Commissioner v. Danielson

OPINION OF THE COURT

SEITZ, Circuit Judge.

This is the decision on various petitions of the Commissioner of Internal Revenue to review a decision of the Tax Court of the United States determining the tax treatment of certain payments-which were recited in certain covenants-not to compete to be the consideration for such covenants. That court decided that the amount explicitly allocated as-payment for each selling stockholder’s covenant not to compete should not, for tax purposes, be treated as having been received for such covenants. The correctness of this ruling under the particular facts is of ever-increasing concern because of the frequent use of such covenants in connection with the sales of businesses.

The taxpayers¹ were stockholders in Butler County Loan Company (“Loan”), which was engaged in the small loan business and, through a subsidiary, in the consumer finance and discount business in Butler, Pennsylvania. The husband of taxpayer, Helen Sherman, had been its successful manager until his-death in 1958. Thereafter, one Shukiswas brought in to run the business and. was given an option to buy 100 shares of the Loan’s stock. He later exercised an option to buy 10 shares;

In 1959, the stockholders decided to-solicit offers to purchase what was then. a declining business. On November 2, 1959, Thrift Investment Corporation (“Thrift”) offered in writing to buy all the common stock of Loan for $374 per share and “our usual non-compete agreement in the Butler area”. The amount of Thrift’s offer was higher than it would otherwise have been because Thrift “passed on” to the selling stockholders part of the favorable tax benefits which it inferred would accrue to it because the amount paid over and above the actual value of the stock was amortizable.²

All the stockholders but Shukis accepted Thrift’s offer. He notified Thrift that he was exercising his option to buy 90 additional shares. He apparently was willing to sell only if he was treated as holding 10.0 shares.

On the same day that it heard from Shukis, November 5, 1959, Thrift forwarded to the President of Loan copies of the proposed agreement of purchase and copies of the non-competition agreement. The proposed covenant not to, compete restrained the stockholders from •engaging in the small loan business around Butler, Pennsylvania for approximately six years. However, it permitted them to own stock of any small loan corporation. The agreement contained a blank, which was presumably to be filled in later, representing that part of the total consideration which was to be allocated to the covenant not to compete.

Because of Shukis’ action, a dispute arose between him and the other stockholders. Nevertheless, the settlement was fixed for November 16, 1959. At that time all the stockholders were present along with representatives of Thrift. All the stockholders except Shukis had one attorney. He had his own counsel present.

Thrift made it clear, of course, that the stockholder dispute would not cause it to increase the offering price for all outstanding shares. Thus, the cost of issuing any additional shares to Shukis would have to be shouldered by the other stockholders. Protracted negotiations took place that day between Shukis and the other stockholders. They finally reached a settlement. Thrift thereupon completed the agreements with Shukis and then with the other stockholders, the taxpayers herein.

Thrift allocated $152 per share to the covenant not to compete and $222 to the contract for the sale of stock. These figures were inserted in the documents. Some question was then raised by the taxpayers as to the tax treatment they would receive on the $152 per share allocated to the covenant. As found by the, Tax Court, the Thrift officials explained that the allocations were to Thrift’s tax advantage but they did not tell the stockholders that they (the stockholders) would receive capital gains treatment. Nor did Thrift make any attempt to explain to the stockholders that such amounts would be taxable to them as ordinary income. After a brief discussion with their own attorney concerning the allocation, the stockholders here involved, on the advice of their own counsel, signed the documents. Each payment check from Thrift contained the notation that it represented the con sideration for both the sale of the stock and the agreement not to compete.

Each taxpayer reported the entire amount received by him as proceeds from the sale of capital assets.^{2 3} The Commissioner disallowed that portion which corresponded to the consideration recited in the covenant not to compete and issued a notice of deficiency. The taxpayers then petitioned for a redetermination of the deficiency. The Tax Court ruled in favor of the taxpayers on the present issue, 44 Tax Court 549 (1965), thus permitting the consideration allocated to the covenants to be taxed at capital gains rates rather than as ordinary income. It found in effect that the taxpayers produced strong proof that the covenants were not realistically bargained for by the parties and that the amounts allocated thereto by Thrift were in reality that part of the purchase price of the stock which represented a premium on corporate receivables.

The Commissioner filed these petitions for review and this is the decision thereon.

The Commissioner argues here, as he did before the Tax Court, that where the parties to a transaction involving the sale of a business have entered into a written agreement spelling out the precise amount to be paid for a covenant not to compete, they should not then be permitted, for tax purposes, to attack such provision except in cases of fraud, duress or undue influence.

The taxpayers counter by saying that such an approach would dignify form at the expense of substance and that the substance of this transaction, as found by the Tax Court, shows that the amounts allocated in the agreements for the covenants had no independent basis in fact or arguable relationship with business reality.

We address ourselves to the soundness of the rule contended for by the Commissioner because we are satisfied that if it is basically not acceptable then the factual findings of the Tax Court would compel us to affirm its decision in favor of these taxpayers. We say this because we think we could not, on this record, disturb the Tax Court’s findings that the covenants were not fully restrictive in view of the wording and also because these particular stockholders were not realistically in a position to compete. In contrast, if the Commissioner’s proposed rule is accepted, the factual findings of the Tax Court would require us to reverse its decision. This is so because after Thrift first evidenced its intention to make an allocation to the covenants not to compete the taxpayers had almost two weeks in which to investigate the tax consequences. Nevertheless, they entered into the agreement on the advice of their own counsel. The present record does not reveal that the taxpayers lacked a full understanding of the terms of the agreement or that the purchaser engaged in fraud, duress, or undue influence. We do not understand either the Tax Court or the dissent to view the facts any differently.

We note at the outset that it is almost as important to delineate some of the matters which are not before us as it is to determine the applicable legal principle. First, since we are dealing with an issue as to the applicability of the correct legal principle, we are not concerned with the “clearly erroneous” rule. Compare Commissioner of Internal Revenue v. Duberstein, 363 U.S. 278, 80 S.Ct. 1190, 4 L.Ed.2d 1218 (1960). “[T]he question here is not one of ‘fact,’ but consists rather of the legal standard required to be applied to the undisputed facts of the case.” United States v. General Motors Corp., 384 U.S. 127, 141, 86 S.Ct. 1321, 1328, 16 L.Ed.2d 415 (1966).

Next, we are not here involved with a situation where the Commissioner is attacking the transaction in the form selected by the parties, e. g., Schulz v. C. I. R., 294 F.2d 52 (9th Cir. 1961). Where the Commissioner attacks the formal agreement the Court involved is required to examine the “substance” and not merely the “form” of the transaction. This is so for the very good reason that the legitimate operation of the tax laws is not to be frustrated by forced adherence to the mere form in which the parties may choose to reflect their transaction. Gregory v. Helvering, 293 U.S. 465, 55 S.Ct. 266, 79 L.Ed. 596 (1935); C. I. R. v. Court Holding Co., 324 U.S. 331, 65 S.Ct. 707, 89 L.Ed. 981 (1945). In contrast, the Commissioner here is attempting to hold a party to his agreement unless that party can show in effect that it is not truly the agreement of the parties. And to allow the Commissioner alone to pierce formal arrangements does not involve any disparity of treatment because taxpayers have it within their own control to choose in the first place whatever arrangements they care to make.

We turn, then, to a consideration of the principle advanced by the Commissioner. We begin by noting that the determination as to whether a covenant not to compete was actually executed is important, taxwise, both to the buyer and the seller. A tax challenge aside, the amount a buyer pays a seller for such a covenant, entered into in connection with a sale of a business, is ordinary income to the covenantor and an amortizable item for the covenantee. Ullman v. Commissioner of Internal Revenue, 264 F.2d 305 (2nd Cir. 1959). Indeed, the presumed tax consequences of the transaction may, as here, help to determine the total amount a purchaser is willing to pay for such a purchase. Therefore, to permit a party to an agreement fixing an explicit amount for the covenant not to compete to attack that provision for tax purposes, absent proof of the type which would negate it in an action between the parties, would be in effect to grant, at the instance of a party, a unilateral reformation of the contract with a resulting unjust enrichment. If allowed, such an attack would encourage parties unjustifiably to risk litigation after consummation of a transaction in order to avoid the tax consequences of their agreements. And to go behind the agreement at the behest of a party may also permit a party to an admittedly valid agreement to use the tax laws to obtain relief from an unfavorable agreement.

Of vital importance, such attacks would nullify the reasonably predictable tax consequences of the agreement to the other party thereto. Here the buyer would be forced to defend the agreement in order to amortize the amount allocated to the covenant. If unsuccessful, the buyer would lose a tax advantage it had paid the selling-taxpayers to acquire. In the future buyers would be unwilling to pay sellers for tax savings so unlikely to materialize.

Finally, this type of attack would cause the Commissioner considerable problems in the collection of taxes. The Commissioner would not be able to accept taxpayers’ agreements at face value. He would be confronted with the necessity for litigation against both buyer and seller in order to collect taxes properly due. This is so because when the Commissioner tries to collect taxes from one party he may, as here, dispute the economic reality of his agreement. When the Commissioner turns to the other party, there will likely be the arguments that the first party, as here, received consideration for bearing the tax burden resulting from the sale and that the covenants did indeed have economic reality.

For these reasons we adopt the following rule of law: 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, etc. Because of the importance of our conclusion as to the proper rule of law here applicable, we deem it appropriate to consider other cases which have been decided in this particular field.

We first consider the case law in this Circuit. The first was Mathews v. C. I. R., 311 F.2d 795 (1963). This was a per curiam opinion filed in January 1963. It affirmed the decision of the Tax Court without discussion ⁴ In that case the sole stockholder sold the corporate stock and assets for a fixed consideration and also agreed to execute a covenant not to compete for a stipulated additional amount. In his tax return the selling-taxpayer attempted to treat the payment for the covenant as a payment for a capital asset rather than ordinary income. The Commissioner challenged such treatment and the Tax Court apparently decided that petitioner did not sustain the required burden for upsetting the allocation in that it found that the covenant had independent substance which could be equated with the payment therefor. The rule here advanced was apparently not raised.

The second case in this Circuit is Levine v. C. I. R„ 324 F.2d 298 (1963). There the agreement, which included covenants not to compete, recited that in computing the purchase price an explicitly stated valuation was placed on the covenants. The selling partners (taxpayers) apparently did not consider any of such proceeds as payment for the covenants because they did not report any part as ordinary income for tax purposes. The Commissioner claimed that it was all paid for the covenant. The Tax Court found as an ultimate fact that half of the amount was paid for good will and half for the covenant. See 21 T.C.M. 363.

In the review proceedings, this Court was apparently not confronted with the contention here advanced that the taxpayer should be held to the allocation set forth in the agreement because of the wording of the agreement itself. Rather, the Court in affirming concerned itself solely with the question of the propriety of the Tax Court’s allocation as between good will and the covenant not to compete.

In turning to other Circuits we find that one of the leading cases is the Second Circuit opinion in Ullman v. C. I. R., 264 F.2d 305 (1959). There the selling-taxpayers, for tax purposes, treated the amounts specifically allocated in their agreements for their covenants not to compete as part of the purchase price for their stock. Before the Tax Court, the Commissioner successfully resisted this treatment on the facts, with the consequence that the consideration for the covenant was treated as income. The Second Circuit, in upholding the Tax Court, applied the rule “that when the parties to a transaction such as this one have specifically set out the covenants in the contract and have there given them an assigned value, strong proof must be adduced by them in order to overcome that declaration.” 264 F.2d 305, 308.

The first case of importance in the Fifth Circuit is Barran v. C. I. R., 334 F.2d 58 (1964). There the Court applied the rule of the Second Circuit in the Ullman case. However, a reading of the second footnote in that case leaves it unclear whether the Court refused to apply the rule we have formulated or merely found it unnecessary to consider it under the facts of that case. Its findings suggest that the latter construction of the footnote is probable. See also Balthrope v. C. I. R., 356 F.2d 28 (5th Cir. 1966); Montesi v. C. I. R., 340 F.2d 97 (6th Cir. 1965).

There are several cases in this field decided by the Ninth Circuit. The first is Rogers v. United States of America, 290 F.2d 501 (1961). There the Court affirmed the action of the trial court in refusing the covenantor’s request to go behind the covenant and the consideration allocated thereto. Explicit reliance was placed on Hamlin’s Trust v. Commissioner of Internal Revenue, 209 F.2d 761 (10th Cir. 1954), which we shall later consider. The Court noted that “Third parties may question the resolutions of parties to a contract, but in the absence of fraud it is not ordinarily open to the bargainers to do so.” 290 F.2d 501.

The case of Schulz v. C. I. R., 294 F.2d 52 (9th Cir. 1961), is inapplicable because the attack on the consideration received for the covenant was made by the Commissioner.

The next Ninth Circuit case is Annabelle Candy v. C. I. K, 314 F.2d 1 (1962). In that case the execution of a covenant was required by the terms of the agreement but no specific amount was allocated to the covenant on the face of the writing. There the taxpayer-purchaser was attempting to make an allocation for tax purposes, in contrast to the reverse situation here where the taxpayers are attempting to dispute an allocation for tax purposes. It is of moment to note that in the opinion the Court stated as follows:

“In the purchase agreement involved in the case before us, there is no allocation of consideration to the covenant not to compete. While this is pretty good evidence that no such allocation was intended it is not conclusive on the parties as would be the case if there had been an express affirmance or disavowal in the agreement.” 314 F.2d 1, 7.

Thus, while the case is distinguishable from the situation involved here, the Court appears to suggest the same ap-' proach to the tax determination process that we have adopted.

The last Ninth Circuit case is Yandell v. United States of America, 315 F.2d 141 (1963). There the Court upheld the trial court’s decision that the written agreement concerning a covenant not to compete with a stipulated consideration therefor was binding on the covenantor for tax purposes. The Court noted that it did not have to consider the applicability of the rule here advanced.

We come finally to the important Tenth Circuit Court opinion in Hamlin’s Trust v. C. I. R, 209 F.2d 761 (1954). The Commissioner places heavy reliance on this opinion in the present petitions for review. The Hamlin case arose in the same way as the cases now before us except that the Tax Court found that the amount allocated in the agreement for the covenants not to compete was to be treated as ordinary income. On review, in affirming the Tax Court, the Court held the taxpayers to their agreement despite some evidence which was quite similar to that found here.

We interpret the language of the Hamlin’s Trust case as reflecting in substance the principle here espoused even though we concede that the evidence may have called for the same result no matter what the rule.

By way of generalization, we note that in none of the cases discussed in which the taxpayer attacked the formal agreement was there any factual situation which warranted a finding, apart from the writing, that the taxpayer had sustained his burden of strong proof. However, we are here confronted with that very situation because of the factual findings of the Tax Court which we accept. Even in these circumstances, we are inclined to believe that the “strong proof” rule would require that the taxpayer be held to his agreement absent proof of the type which, would negate it in an action between the parties to the agreement. If our belief is unwarranted then we nevertheless conclude that a taxpayer who enters into a transaction of this type to sell his shares and executes a covenant, not to compete for a consideration specifically allocated to the covenant may not, absent a showing of fraud, undue influence and the like on the part of the other party, challenge the allocation for tax purposes. We so conclude even though the evidence, as here, would support a finding that the explicit allocation had no independent basis in fact, or arguable relationship with business reality. Such evidence can have no independent legal significance in cases where-the consideration is allocated by the parties in their agreement. It would be relevant, but not conclusive, evidence-only if some attack is made on the written agreement by a party claiming that, because of fraud, etc., it is not his conscious agreement.

If it is assumed that the taxpayers-were unaware of the tax consequences when they consciously accepted the allocation to the covenants not to compete— although the Tax Court did not make a . finding to that effect — the following observations from Hamlin’s Trust v. C. I. R., 209 F.2d 761, 765 (10th Cir.1954), are pertinent:

“ * * * It is true that there was very little discussion of the suggested: allocation [to the covenant not to compete]. But the effectiveness tax-wise of an agreement is not measured by the amount of preliminary discus^ sion had respecting it. It is enough if parties understand the contract and understandingly enter into it. The proposed change in the contract was, clear. All parties participating in the conference agreed to it. The owners of stock present signed the written contract at the time and others signed it later. It is reasonably clear that the sellers failed to give consideration to the tax consequences of the provision, but where parties enter into an agreement with a clear understanding of its substance and content, they cannot be heard to say later that they overlooked possible tax consequences. While acting at arm’s length and understandingly, the taxpayers agreed without condition or qualification that the money received should be on the basis of $150 per share for the stock and $50 per share for the agreement not to compete. Having thus agreed, the taxpayers are not at liberty to say that such was not the substance and reality of the transaction.”

In any event, it is not improbable that the selling-taxpayers in the end would have entered into such an agreement even though they fully understood the tax consequences of the allocation. This is so because had they insisted on elimination of the covenants not to compete Thrift would not have offered them as high a purchase price for their stock.

There are of course a few circumstances in which taxpayers have been permitted to escape taxation based on ■their own conscious agreements. In Helvering v. F. & R. Lazarus & Co., 308 U.S. 252, 60 S.Ct. 209, 84 L.Ed. 226 , (1939), the Supreme Court noted that one who must “bear the burden of exhaustion of capital investment” is entitled to a deduction for depreciation regardless of the fact that the taxpayer by agreement designated another as the legal owner. Similarly, in Bartels v. Birmingham, 332 U.S. 126, 67 S.Ct. 1547, 91 L.Ed. 1947 (1947), the Supreme Court stated that “in the application of social legislation” such as the Social Security Act, “it is the total situation that controls” liability for employment taxes re- . gardless of the fact that the taxpayer by agreement designated itself as the employer.

In contrast, in the present situation . there is no discernible policy which would require that the incidence of taxation fall upon a particular individual. As a result of the circumstances that an amount allocable to a covenant not to compete is amortizable by the buyer and ordinary income to the seller, it generally does not matter what amount is allocated. And where a loss of tax revenues from one taxpayer cannot be retrieved entirely from another because of differentials in tax brackets or other factors the Commissioner may challenge the allocation as not reflecting the substance of the transaction.

We find, therefore, no reason why the Commissioner may not treat as ordinary income of the taxpayers that part of the total consideration which was explicitly allocated to covenants not to compete with the buyer. Of course, it would be unfair to assess taxes on the basis of an agreement the taxpayer did not make. Compare Helvering v. Tex-Penn Oil Co., 300 U.S. 481, 57 S.Ct. 569, 81 L.Ed. 755 (1937). Many factors may be relevant to the search for the agreement which the parties consciously made, including the business reality of the transaction. However, under the rule here adopted, if either of the parties to a covenant not to compete attempted, in an action against the other, to avoid or alter the agreement he would have a heavy burden of showing fraud, duress, undue influence and the like under what may loosely be called common-law principles. In such a situation the parol evidence rule could come into play to restrict the type of evidence the attacking party might adduce. Thus, a question arises whether this contemplated application of the parol evidence rule is precluded in tax controversies.

First, 26 U.S.C. § 7453 of the Internal Revenue Code makes applicable the District of Columbia rules of evidence in Tax Court proceedings. However, even if parol evidence would be admissible in a District of Columbia tax case like the present, the statute would not make such a rule controlling here because under the modern view the parol evidence rule is a rule not of evidence but of substantive law. 3 Corbin on Contracts, Sec. 573.

Second, there is language in some federal tax cases to the effect that the parol evidence rule does not apply to controversies between the Commissioner and a party to the contract. Landa v. C. I. R., 92 U.S.App.D.C. 196, 206 F.2d 431 (1953); Scofield v. Greer, 185 F.2d 551 (5th Cir. 1950). But we prefer to follow those decisions which hold that the Commissioner may assert the parol evidence rule in circumstances such as the present.

“That by some other form of instrument the rights of the United States would have been different is beside the question. The parties abide by this instrument as they made it. The law, and not their wish or understanding, must control its legal effect on the incidence of taxation.” Pugh v. C. I. R., 49 F.2d 76, 79 (5th Cir. 1931).

See also Sherman v. C. I. R., 76 F.2d 810 (9th Cir. 1935); Jurs v. C. I. R., 147 F.2d 805 (9th Cir. 1945); Gaylord v. C. I. R., 153 F.2d 408 (9th Cir. 1946); C. I. R. v. Dwight’s Estate, 205 F.2d 298 (2nd Cir. 1953); Campbell v. Lake, 220 F.2d 341 (5th Cir. 1955); Clark v. United States, 341 F.2d 691 (9th Cir. 1965).

Even if the parol evidence rule were not applicable in tax controversies of the type under consideration, examination of all the evidence adduced in this case reveals nothing to demonstrate that the contract as written was not the taxpayers’ conscious agreement.

Therefore, the decision of the Tax Court which disallowed the Commissioner’s assessments must be vacated. The case is remanded to the Tax Court so that the parties may be afforded a further opportunity to produce evidence in accordance with the principles expressed in this opinion.

1 . The several taxpayers here involved kept their books and filed their income tax returns on a calendar year basis for 1959, the tax year here involved.

2 . The Tax Court found as a fact that “Thrift decided to offer the stockholders of Butler Loan the book value of its assets plus 6 times excess earnings as an inducement to sell. This sum ($60,000) was divided by 55 per cent to reflect the tax effects which would accrue to Thrift if the amount were amortizable by them.” 44 T.C. 549, 552 (1965). The Tax Court noted that “$60,000 -4- 55% = $109,000. An official of Thrift testified that it was that company’s policy to offer slightly less than the maximum amount in initial negotiations.” Idem.

3 . Thrift amortized that part of the payment which had been allocated to the covenant not to compete and the Commissioner has preserved his position with respect to that matter, presumably pending this determination.

4 . It cites the Tax Court opinion as appearing in 36 T.C. 483, whereas it is found in 20 T.C.M. 1565.