Makric Enters. v. Comm'r

T.C. Memo. 2016-44
UNITED STATES TAX COURT
MAKRIC ENTERPRISES, INC., Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 1017-13. Filed March 9, 2016.
George W. Connelly, Jr., for petitioner.
Candace M. Williams, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
MORRISON, Judge: The respondent (the “IRS”) issued a notice of
deficiency to the petitioner, Makric Enterprises, Inc. (“Makric”), for its short tax
year April 1 to September 30, 2008. In the notice, the IRS determined an income-
tax deficiency of $2,839,780 and an accuracy-related penalty under section
-2-
[*2] 6662(a)1 of $567,956. The deficiency and the penalty relate to a September
2008 transaction that the IRS alleges was the sale by Makric of the stock of its
wholly owned subsidiary, Alpha Circuits, Inc. (“Alpha”). Makric contends that
the transaction should instead be treated as the sale of Makric stock by Makric’s
shareholders. Makric timely filed a petition under section 6213(a) for a
redetermination of the deficiency and the penalty. We have jurisdiction under
section 6214.
The two issues before the Court are:
(1) Did Makric sell the stock of Alpha in 2008? We hold that it did. In
particular: (a) we hold that the agreement that effected the transaction
unambiguously required the sale of Alpha, not Makric, and that therefore Makric
is barred from contending that the transaction was, in substance, the sale of
Makric, (b) we reject Makric’s argument that, in executing the agreement, the
parties to the agreement made a mutual mistake which justifies reformation of the
agreement, and (c) we hold that in substance the transaction was the sale of Alpha.
(2) Is Makric liable for an accuracy-related penalty under section 6662(a)?
We hold that it is.
1
Unless otherwise indicated, all section references are to the Internal
Revenue Code as in effect for the year at issue.
-3-
[*3] FINDINGS OF FACT
Some facts have been stipulated, and they are so found. Makric was a
Texas corporation. When it filed the petition in this case, its principal office was
in Texas.2 Makric was founded on June 28, 1996, by Mark Kisner and Rickey
Williams, the two original shareholders.3 Originally, Kisner and Williams each
owned 50% of the company’s shares.
Kisner and Williams created Makric to serve as the holding company for
Alpha, a contract manufacturer that they sought to acquire. Kisner and Williams
believed that using a holding company to acquire Alpha (rather than directly
acquiring Alpha) would enhance their flexibility to acquire additional companies
in the future. Makric acquired all of Alpha’s stock on July 8, 1996. Kisner and
Williams intended to have Makric hold Alpha for only several years, during which
time they believed Alpha could be made more profitable. Kisner and Williams
hoped to eventually dispose of Alpha for a gain. At the time Makric acquired
Alpha, Kisner and Williams were unsure of how they would ultimately dispose of
Makric’s interest in Alpha. However, their goal was always to dispose of
2
This case is therefore appealable to the U.S. Court of Appeals for the Fifth
Circuit unless the parties stipulate another circuit. See sec. 7482(b)(1)(B), (2).
3
The name “Makric” is a combination of letters of the names Mark Kisner
and Rickey Williams.
-4-
[*4] Makric’s interest in Alpha in a way that would cause any income they
realized from the sale to be treated as long-term capital gain.
Before the 1996 acquisition of Alpha by Makric, Kisner worked in the
electronics business for Texas Instruments. At some point, he left Texas
Instruments and assumed the role of CEO for both Makric and Alpha. In his
capacity as CEO of Alpha, he managed Alpha’s day-to-day operations. This
included overseeing its factory and the development of its products. Kisner also
served on the board of directors for Makric and served as chairman of Alpha’s
board of directors. He continued to serve as Alpha’s CEO and as a member of its
board until Makric sold Alpha in September 2008. The record does not indicate
whether Kisner remained on Makric’s board of directors after it sold Alpha.
Williams served as a director on the boards of both Makric and Alpha and
held those positions at the time Alpha was sold. He served as president of Makric
and was its president at the time Makric sold Alpha. He also served as Alpha’s
president from the time Makric purchased Alpha, in 1996, until sometime in 2001
(although he remained a member of Alpha’s board of directors after 2001). For
some or all of the time that he was the president of Alpha, he was involved with
Alpha on a day-to-day basis and handled the company’s financial affairs. The
-5-
[*5] record does not indicate whether Williams remained on Makric’s board of
directors after it sold Alpha.
Sometime before May 2004, Williams approached his friend Jim Wilson
about investing in Makric. Wilson had a business background in mezzanine
lending and private equity. On May 28, 2004, Wilson purchased half of
Williams’s 50% interest in Makric. After this purchase, Wilson was a 25%
shareholder in Makric, Williams was a 25% shareholder in Makric, and Kisner
remained a 50% shareholder in Makric. Wilson became a board member of both
Makric and Alpha and continued serving as a member of Alpha’s board until
Makric sold Alpha in 2008. The record does not indicate whether Wilson
remained a member of Makric’s board after it sold Alpha.
Kisner, Williams, and Wilson are referred to collectively as “Makric’s
shareholders”. At no time did any of them own a direct interest in Alpha. The
positions that Makric’s shareholders held in Makric and Alpha (and their
ownership percentages in Makric) until Alpha was sold in September 2008 are
summarized in the following table:
-6-
[*6] Corporation Kisner Williams Wilson
Makric CEO President
Member of Member of Member of
board board board (starting
2004)
50% Shareholder 25% Shareholder 25% Shareholder
after selling half (starting 2004)
his 50% interest
to Wilson in
2004
Alpha CEO President (1996-
2001)
Chairman of Member of Member of
board board board (starting
2004)
The record does not reveal that anyone besides Kisner, Williams, and Wilson
served on the board of directors of Alpha or Makric until the sale of Alpha in
September 2008.
In 2004, at the time Wilson acquired his interest in Makric, Makric’s
shareholders entered into a shareholders agreement. Among other things, the
shareholders agreement provided that
beginning three years from the date hereof, the Stockholders [i.e.,
Makric’s shareholders] and the Company [i.e., Makric] will engage
-7-
[*7] the services of one or more investment bankers for the sale of all of
the assets of or shares in the Company [i.e., Makric] * * *.[4]
Thus, the provision contemplated the potential sale of either (1) Alpha stock (the
“assets of” Makric) by Makric or (2) Makric stock (the “shares in” Makric) by
Makric’s shareholders.
Because Makric was the holding company for Alpha and had no operating
business of its own, those who did business with Alpha were generally unfamiliar
with Makric. Makric’s shareholders and advisers sometimes used the names
“Alpha” and “Makric” interchangeably or, more commonly, they used “Alpha” to
refer collectively to both Makric and Alpha. However, Makric’s shareholders
understood that they owned direct interests only in Makric, not in Alpha, that the
two corporations were separate and distinct, and that Alpha was Makric’s
subsidiary.
Sometime in 2007, Makric’s shareholders began making arrangements to
sell Alpha. To this end, on July 11, 2007, acting in their capacities as the directors
of Alpha, they signed a document entitled “Consent of Board of Directors in Lieu
of Annual Meeting”. As of this time, Kisner owned 50% of Makric, and Williams
and Wilson each owned 25% of Makric. The consent authorized, among other
4
The shareholders agreement is dated May 28, 2004.
-8-
[*8] things, the listing of Alpha for sale. The consent also authorized the hiring of
the investment bank Gulf Star Group Investment Bankers “to represent the
shareholders [meaning Makric’s shareholders] in the sale.” Gulf Star’s services
with respect to the sale of Alpha included finding buyers for Alpha.
At the time that Makric’s shareholders began making arrangements for the
disposition of Alpha, they contemplated the following two-step sale structure:
(1) Makric would be dissolved and its Alpha stock distributed to Makric’s
three shareholders (Kisner, Williams, and Wilson), and
(2) Kisner, Williams, and Wilson (now shareholders of Alpha) would sell
Alpha stock to a buyer.
It was originally thought that the two-step structure, whereby (1) Makric dissolves
and (2) Makric’s shareholders sell Alpha stock, would meet the tax objectives of
Makric’s shareholders, i.e., that the gains from the sale of Alpha would be treated
as long-term capital gain to Kisner, Williams, and Wilson.
Among the steps that Gulf Star undertook to find a buyer for Alpha was to
prepare a sales memorandum, which Gulf Star distributed to prospective buyers.
This memorandum indicated that the entity for sale was Alpha. It described
Alpha’s history, operations, management, and projected growth. It stated that
-9-
[*9] Alpha was owned by Makric, but that Makric was in the process of being
dissolved.
Gulf Star found several prospective buyers who expressed interest in buying
Alpha. On October 30, 2007, Southfield Capital Advisors, LLC (“Southfield”), a
private-equity firm, submitted a nonbinding indication of interest expressing
Southfield’s interest in purchasing Alpha. On February 6, 2008, Southfield
submitted a letter of intent regarding its potential purchase of Alpha and
expressing its intent to purchase Alpha from Williams, Wilson, and Kisner. The
letter did not mention Makric.5 In the letter, Southfield stated that it intended for
one of its affiliates, TS3 Technology, Inc. (“TS3”), to acquire Alpha. David
Brunson, the chairman of TS3, signed the letter of intent on behalf of Southfield.
Kisner signed the letter as CEO of Alpha and as a shareholder of Alpha. Williams
and Wilson both signed as shareholders of Alpha. By signing the letter of intent,
5
Kisner testified that another company, Main Street Capital, also submitted a
letter of intent regarding the purchase of Alpha. That letter is not in the record,
and the record does not otherwise reveal the precise terms offered in that letter.
We infer from the record, particularly from Kisner’s testimony, that Makric’s
shareholders never signed the letter of intent from Main Street Capital and decided
instead to pursue negotiations with Southfield. Kisner testified that Southfield’s
proposed terms, including its proposed purchase price, were more generous than
Main Street Capital’s. In its letter of intent, Southfield stated that it valued Alpha
at $16.5 million and made a “nonbinding confidential proposal” to pay that
amount for Alpha.
- 10 -
[*10] they agreed to the terms of the letter. These terms included, among other
things, the creation of an “exclusivity period” during which (1) Alpha would not
solicit offers or engage in negotiations with any other parties and (2) Alpha would
give Southfield “full and complete access to its books, records, contracts,
personnel [etc.]”. The letter of intent did not commit Southfield or TS3 to buying
Alpha.
Makric’s shareholders hired Gary Miller of the law firm Boyar & Miller to
represent them and Alpha in the sale. An engagement letter, dated February 15,
2008, authorized Miller to represent
Rickey G. Williams, Mark Kisner, James P. Wilson ( * * *
collectively the “Shareholders”) and Alpha Circuits, Inc. (the
“Company”), in connection with the proposed sale of 100% of the
stock of the Company owned by the Shareholders * * *.
The engagement letter did not mention Makric and thus seemed to assume
that Makric’s shareholders would own Alpha stock directly when it came time to
sell Alpha. Makric’s shareholders signed the letter in their individual capacities,
signifying their agreement to have Miller represent them in connection with the
sale of Alpha. Kisner signed the letter on behalf of Alpha, signifying Alpha’s
agreement to have Miller represent it in the sale.
- 11 -
[*11] Southfield’s representatives generally understood that Makric’s
shareholders intended to structure the sale in a way that would result in the income
realized by Makric’s shareholders upon the sale being characterized as long-term
capital gain for federal-income-tax purposes. Southfield and its representatives
were willing to structure the sale in a way that would meet the tax objectives of
Makric’s shareholders.
Consistent with the two-step sales structure originally preferred by Makric’s
shareholders, Southfield and Makric initially proceeded in negotiations with the
understanding that TS3 would purchase Alpha stock directly from Kisner,
Williams, and Wilson, who would directly hold Alpha stock following the
anticipated dissolution of Makric.
Early drafts of the stock purchase agreement also reflected the two-step sale
structure.6 Version 1 of the stock purchase agreement (dated February 22, 2008)
was drafted so as to be executed by the following parties: TS3, defined as the
“Buyer”, and Kisner, Williams, and Wilson, collectively defined as the “Sellers”.
The draft recited that “Sellers own all of the outstanding capital stock of Alpha
6
The record contains five drafts of the stock purchase agreement, which are
identified in the stipulation of facts as “Version 1” (dated February 22, 2008),
“Version 2” (undated), “Version 3” (undated), “Version 4” (dated March 3, 2008),
and “Version 5” (dated March 3, 2008).
- 12 -
[*12] Circuits, Inc. * * * (the ‘Company’)” and that “Sellers desire to sell, and
Buyer desires to buy, all of the outstanding capital stock of the Company.”
Section 2.1, “Purchase and Sale”, provided:
Sellers agree to sell to Buyer, and Buyer agrees to purchase from
Sellers, all of the issued and outstanding shares of common stock
* * * of the Company * * * (the “Shares”).
Section 2.5 of the draft, “Deliveries at the Closing”, provided: “Sellers will
deliver, or cause to be delivered to Buyer * * * certificates representing all of the
Shares”. This draft, as well as Versions 2 and 3 of the stock purchase agreement
(both undated), provided that Kisner, Williams, and Wilson would sell Alpha
stock to TS3, thus reflecting the assumption that Makric would dissolve before the
sale.
At some point, Makric’s shareholders determined that the two-step structure
would not meet their tax objectives, so they abandoned the structure. The
following stipulations by the IRS and Makric address the abandonment of the two-
step structure:
Initially, it was contemplated that the sale of Alpha would be effected
through Petitioner [i.e., Makric] being dissolved, the shares of Alpha
being distributed to the Shareholders [i.e., Kisner, Williams, and
Wilson], and the Shareholders directly selling the stock of Alpha to
the Buyer (the “Original Transaction Structure”).
* * * * * * *
- 13 -
[*13] In late 2007, the Shareholders raised concerns that under the
Original Transaction Structure it was unclear whether the
Shareholders’ holding period in Petitioner’s stock would “tack” onto
Alpha’s stock, thus jeopardizing the long-term capital gain treatment
the Shareholders required.
The Original Transaction Structure was rejected by the
Shareholders because they were concerned that under the Original
Transaction Structure long-term capital gain treatment could not be
guaranteed for them.
Makric’s shareholders next decided that they preferred an alternative sale structure
whereby Makric’s shareholders would sell their shares of Makric to TS3, so that
TS3 would acquire Alpha as a subsidiary of Makric. They determined that this
sale structure would meet the objective of having the income realized from the sale
treated as long-term capital gain.7 Kisner, who was the lead negotiator for Makric,
informed TS3’s representatives and/or advisers of the decision not to dissolve
Makric and to restructure the sale as the purchase of Makric by TS3. These
conversations took place at a meeting and during a conference call.8 The dates of
7
Kisner and Williams acquired their Makric stock in 1996. Wilson acquired
his Makric stock in 2004. Because they had held their Makric stock for more than
one year before they planned to sell Makric or Alpha, a taxable sale of their
Makric stock would have generated long-term capital gain to the shareholders.
See infra note 30.
8
Kisner credibly testified that he discussed the structure at a meeting and a
conference call with TS3’s representatives and advisers, including, we presume,
Brunson. Kisner also testified that TS3 agreed to the structure at the meeting and
(continued...)
- 14 -
[*14] this meeting and the conference call are unclear. On the morning of
February 28, 2008, Kisner and David Ronn, TS3’s lawyer, had the following email
exchange in which Ronn asked Kisner:
In the presentation[9] we received, it indicated that Makric was going
to be dissolved so that the three shareholders of Makric would then
own Alpha Circuits in the same manner that they owned MakRic
[sic]. Is that still going to occur or is MakRic [sic] going to be the
seller of Alpha Circuits.
Kisner responded to Ronn later that morning, stating:
MakRic [sic] didn’t get dissolved. The purchase will be MakRic
[sic] which owns 100% of Alpha’s shares.
Kisner’s response intended to explain to Ronn that TS3 would purchase Makric.
Kisner did not receive confirmation that Ronn received this email.
Soon after the email exchange, Ronn (who had written earlier drafts of the
stock purchase agreement) prepared a new draft (Version 4) of the stock purchase
agreement (dated March 3, 2008). This draft did not reflect the structure discussed
by Kisner in his February 28, 2008 email (i.e., the sale of Makric stock), nor did it
8
(...continued)
the conference call. As discussed infra p. 54, we believe that a representative of
TS3 assented to the structure, but we do not go so far as to find that this assent
constituted a final or unchanging expression of TS3’s intent.
9
Apart from what is stated in this email, the record does not indicate the
content of this “presentation” or who made the “presentation”.
- 15 -
[*15] reflect the original two-step structure of dissolving Makric and having
Makric’s former shareholders sell Alpha stock. Instead, the draft reflected a third
structure, under which Makric would sell Alpha stock to TS3 instead of
dissolving. The new draft identified the parties to the transaction as:
[TS3] (“Buyer”), MAKRIC Enterprises, Inc., a Texas Corporation
(“Seller”) and Mark Kisner (“Kisner”), Rickey Williams
(“Williams”), and Jim Wilson (“Wilson”) * * * (each individually an
“Owner”, and collectively, the “Owners”).
The draft recited:
WHEREAS, Seller [i.e., Makric] owns all of the outstanding
capital stock of Alpha Circuits Incorporated, a Texas corporation (the
“Company”).
WHEREAS, Owners [i.e., Makric’s shareholders] own 2,000
shares of the common stock of the Seller * * *.
WHEREAS, Seller [i.e., Makric] desires to sell, and Buyer [i.e.,
TS3] desires to buy, all of the outstanding capital stock of the
Company [i.e., Alpha] * * *.
Section 2.1, “Purchase and Sale of Shares at Closing”, provided:
Seller [i.e., Makric] agrees to sell to Buyer [i.e., TS3], and Buyer
agrees to purchase from Seller, all of the issued and outstanding
shares (the “Shares”) of common stock * * * of the Company [i.e.,
Alpha] (“Company Common Stock”).
Section 2.5, “Deliveries at Closing”, provided:
At the closing: (i) Seller [i.e., Makric] and Owners [i.e., Makric’s
shareholders], as the case may be, will deliver, or cause to be
- 16 -
[*16] delivered, to Buyer [i.e., TS3] * * * certificates representing all of the
Shares [of Alpha] * * *.
Ronn wrote a subsequent draft (Version 5), the relevant terms of which were
substantively identical to those of Version 4 described above. Kisner and Miller
reviewed each of these drafts, but Kisner did not realize that the drafts called for
the sale of Alpha by Makric.
Makric and the IRS have stipulated that after Version 5 there were eleven
more versions of the stock purchase agreement and that each of these versions
“list” Makric as the “Seller” of Alpha, TS3 as the “Buyer”, and Kisner, Wilson,
and Williams as “Owners” of Makric. We take this stipulation to mean that under
the terms of these eleven drafts, as with Version 4 and Version 5, Makric would
sell its stock in Alpha to TS3. Other than this stipulation, the record does not
reveal the terms of these eleven drafts of the stock purchase agreement. The drafts
themselves are not in the record.
Possibly around the time that Makric’s shareholders decided not to dissolve
Makric, Ronn and associates at his law firm began conducting a due diligence
inquiry into both Makric and Alpha.10 The information sought by Ronn’s firm
10
Due diligence refers to a prospective buyer’s investigation of a company
that the buyer seeks to acquire for the purpose of determining the company’s
assets and liabilities.
- 17 -
[*17] pertained to, among other things, the companies’ finances, personnel,
employment contracts, and litigation.
On September 30, 2008 (seven months after Kisner emailed Ronn informing
him that the transaction should be structured as the sale of Makric), Makric, TS3,
and Makric’s shareholders executed the stock purchase agreement. Kisner and
Miller reviewed the stock purchase agreement before the closing of the sale, but
Kisner did not realize the agreement called for the sale of Alpha by Makric. The
terms set forth in the stock purchase agreement were, in pertinent respects,
identical to the terms set forth in Version 4 and Version 5 of the draft stock
purchase agreement. The stock purchase agreement provided:
This Stock Purchase Agreement (this “Agreement”) is made as
of September 30, 2008, by and among TS3 Technology, Inc., a
Delaware corporation (“Buyer”), MAKRIC Enterprises, Inc., a Texas
corporation (“Seller”), and Mark A. Kisner (“Kisner”), Rickey
Williams (“Williams”), and James P. Wilson (“Wilson”) * * * (each
individually, an “Owner”, and collectively, the “Owners”).
In the section entitled “Recitals”, the stock purchase agreement
stated:
WHEREAS, Seller [i.e., Makric] owns all of the issued and
outstanding capital stock of Alpha Circuits, Incorporated, a Texas
corporation (the “Company”);
WHEREAS, Owners [i.e., Makric’s shareholders] own all of
the issued and outstanding stock of Seller [i.e., Makric]; and
- 18 -
[*18] WHEREAS, Seller [i.e., Makric] desires to sell, and Buyer [i.e.,
TS3] desires to buy, all of the outstanding capital stock of the
Company [i.e., Alpha] on the terms and subject to the conditions set
forth in this Agreement.
Section 2.1 of the stock purchase agreement, “Purchase and Sale” provided:
Seller [i.e., Makric] agrees to sell to Buyer [i.e., TS3], and Buyer
agrees to purchase from Seller, all of the issued and outstanding
shares (the “Shares”) of common stock * * * of the Company [i.e.,
Alpha] (“Company Common Stock”).
Section 2.5 of the stock purchase agreement, “Deliveries at the Closing” provided:
At the closing: (i) Seller [i.e., Makric] and Owners [i.e., Makric’s
shareholders], as the case may be, will deliver, or cause to be
delivered, to Buyer [i.e., TS3] * * * certificates representing all of the
Shares [i.e., all common stock of Alpha].
The stock purchase agreement was signed by Brunson (chairman of TS3), by
Williams (as president of Makric), and by Makric’s shareholders (as “Owners”) on
September 30, 2008.
The stock purchase agreement contained several provisions that referred to
Kisner, Williams, and Wilson by name, or that referred to them collectively as
Makric’s “Owners”. Among these provisions was Section 3, “Representations and
Warranties of Seller and Owner”, which made Makric and its “Owner[s]” liable
for various warranties and representations: “Seller [i.e., Makric] and each Owner
[i.e., Kisner, Williams, and Wilson], hereby represent and warrant jointly and
- 19 -
[*19] severally with respect to warranties covering Seller, and severally and not
jointly with respect to representations and warranties covering such Owner”.
Among these representations was a provision, Section 3.1, “Valid and Binding
Agreement”, that stated:
Each Owner [i.e., Kisner, Williams, and Wilson] is an individual and,
as such has the legal capacity to execute and deliver this Agreement,
and to perform his obligations hereunder to consummate the
transactions contemplated hereunder. This Agreement has been duly
executed and delivered by Seller [i.e., Makric] and constitutes the
valid and binding obligation of Seller, enforceable against it in
accordance with its terms * * *. The execution and delivery of this
Agreement, the performance by each Owner of his obligations
hereunder and the consummation by each Owner of the transactions
contemplated hereby have been duly authorized by all requisite action
on the part of each Owner.
Another provision, Section 3.5, “Brokerage Arrangements”, stated:
Except with regard to amounts due to Gulfstar Group upon the
Closing * * * no Person[11] will be entitled to receive any brokerage
commission * * * or similar compensation in connection with the
transactions contemplated by this Agreement based on any
Contract[12] made by or on behalf of Seller [i.e., Makric] or Owners
11
The agreement defined “Person” as: “any individual, corporation
(including any non-profit corporation), general or limited partnership, limited
liability company, joint venture, estate, trust, association, organization, labor
union, Governmental Entity or other entity.”
12
The agreement defined “Contract” as: “a contract, agreement,
commitment or binding understanding, whether oral or written, that is in effect as
of the date of this Agreement.”
- 20 -
[*20] [i.e., Kisner, Williams, and Wilson] for which Buyer [i.e., TS3]
or the Company [i.e., Alpha] is or could become liable or obligated.
There were three other representations and warranties in Section 3 of the stock
purchase agreement. Furthermore, Section 4 of the stock purchase agreement
provided that “Seller [i.e., Makric] and each Owner [i.e., Makric’s shareholders],
jointly and severally represent and warrant to Buyer [i.e., TS3] that, as of the
Closing Date”: Makric was duly organized, Makric was in compliance with its
organizational documents, Makric was not in violation of any law, Makric’s
financial statements represented fairly its financial position, there were no legal
claims against Makric, and all of Makric’s significant contracts were listed in the
agreement.
On the same day that the stock purchase agreement was executed, Makric’s
shareholders executed another document relating to the sale. This document,
entitled “Joint Written Consent of the Shareholders and Directors in Lieu of a
Special Meeting”, authorized Makric to sell its stock in Alpha to TS3. The
document began with this recital:
Whereas, Mark A. Kisner, Rickey Williams and James P.
Wilson (collectively, the “Shareholders”), own all of the issued and
outstanding capital stock of the “Corporation” [i.e., Makric];
- 21 -
[*21] Whereas, the Corporation owns all of the issued and
outstanding capital stock of the Alpha Circuits Incorporated, a Texas
Corporation (the “Company”);
Whereas, the Corporation desires to sell all of the outstanding
capital stock of the Company (the “Subject Stock”), to TS3
Technology, Inc. * * *.
Makric’s shareholders each signed this consent form twice: once in their
capacities as directors of Makric and once in their capacities as shareholders of
Makric. The record does not reveal who drafted this consent form. Neither
Kisner, Williams, nor Wilson closely reviewed this document before signing it.
Also on September 30, 2008, Kisner, as Makric’s CEO, signed a document
entitled “Written Consent of Sole Shareholder of Alpha Circuits Incorporated”.
This document stated:
RESOLVED, that immediately prior to the consummation [of] the
transaction contemplated by that certain Stock Purchase Agreement
between the MAKRIC Enterprises, Inc. (the “Sole Shareholder”), TS3
Technology, Inc. (the “Purchaser”) and the owners of the Sole
Shareholder, pursuant to which the Sole Shareholder has agreed to
sell all of the shares of the common stock of the Company (the “Stock
Purchase Agreement”), the resignations of the existing directors of
the Company [i.e., Alpha], Mark Kisner, Rickey Williams and James
P. Wilson, be and hereby are accepted by the Sole Shareholder.
Kisner did not closely review this document either before he signed it or when he
signed it. The record does not reveal who drafted this consent form. (We refer to
- 22 -
[*22] the two consent forms described above and the stock purchase agreement,
collectively, as the “transactional documents”.)
Neither Kisner, Miller, nor any of Makric’s other shareholders,
representatives or advisers objected to the terms set forth in the stock purchase
agreement. The stock purchase agreement and the several drafts that preceded it
provided that Makric would sell Alpha stock. Even so, Kisner reviewed the stock
purchase agreement and prior drafts and concluded that the documents provided
that Makric’s shareholders would sell their Makric stock. Ronn, TS3’s lawyer, did
not tell him otherwise.
The stock purchase agreement required the “Buyer”, i.e., TS3, to make four
types of payments.
First, TS3 was required to pay Alpha’s creditors the amounts set forth on
Schedule 4.9(e)(2) of the stock purchase agreement. There is no Schedule
4.9(e)(2) attached to the stock purchase agreement. Therefore, the amounts to be
paid to Alpha’s creditors cannot be determined from the text of the stock purchase
agreement.
Second, Section 9.2 of the stock purchase agreement required TS3 to pay
the transaction costs of the Seller (i.e., Makric) and the Owners (i.e., Makric’s
shareholders) described on Schedule 9.2 of the stock purchase agreement to the
- 23 -
[*23] extent that Makric and Makric’s shareholders set forth the amounts of these
costs on Schedule 9.2. Any such costs described on Schedule 9.2 had to be paid to
the “applicable vendor” listed on Schedule 9.2. There is no Schedule 9.2 attached
to the stock purchase agreement. Therefore, no payment was required of TS3 by
Section 9.2 of the stock purchase agreement.
Third, Section 2.6 of the stock purchase agreement required TS3, after the
closing, to make a payment to Makric if Alpha’s working capital at closing
exceeded the amount of working capital agreed upon in the stock purchase
agreement. Alternatively, if Alpha’s working capital at closing was less than the
amount of working capital agreed upon in the stock purchase agreement, Makric
would be required to make a reverse payment to TS3. Section 2.6 of the stock
purchase agreement defined what was meant by (1) Alpha’s working capital at
closing and (2) Alpha’s working capital agreed upon in the purchase agreement.
Both of these amounts were defined in part by reference to Schedule 2.6 of the
stock purchase agreement. There is no Schedule 2.6 attached to the stock
purchase agreement. Therefore, the amount of the working-capital-adjustment
payment (or reverse payment) cannot be determined from the stock purchase
agreement.
- 24 -
[*24] Fourth, TS3 was required to pay Makric an amount equal to:
the “Purchase – the amounts set forth on – “any expenses described
Price” Schedule 4.9(e)(2) on Schedule 9.2”
This amount was required to be delivered “by wire transfer of immediately
available funds to the accounts designated by Seller [i.e., Makric] to Buyer [i.e.,
TS3] no later than three Business Days prior to the Closing”, according to the
stock purchase agreement. The “Purchase Price” was defined by Section 2.2 of
the stock purchase agreement. Section 2.2 provided:
The aggregate purchase price (the “Purchase Price”) for the Shares
[i.e., the common stock of Alpha] is $16,500,000 million in cash paid
by Buyer, subject to adjustment pursuant to Section 2.6 of this
Agreement and any payments provided for in Section 9.2 of this
Agreement.
Section 9.2 provided that any expenses described on Schedule 9.2 “shall be paid
by Buyer [i.e., TS3] at Closing and the amounts so paid shall be offset against and
serve as a reduction of the amount of the Purchase Price paid by Buyer at
Closing.”
In summary, there are at least two impediments to determining how much
TS3 was required to pay under the stock purchase agreement. First, the amounts
set forth on Schedule 4.9(e)(2) cannot be determined because of the absence of
Schedule 4.9(e)(2). Second, the working-capital adjustment payment required by
- 25 -
[*25] Section 2.6 of the stock purchase agreement cannot be determined because
of the absence of Schedule 2.6. Despite these impediments to determining how
much TS3 was required to pay Makric under the stock purchase agreement, we
conclude that the amount required to be paid by TS3 under the stock purchase
agreement--and the amount actually paid by TS3--was $16.5 million. This
conclusion is justified by the particular circumstances of the case, which we
describe below.
In the notice of deficiency, the IRS had determined that Makric’s gain on
the sale of Alpha was $8,060,137. Makric does not contest that this is the correct
amount of gain in the event that it is determined to have sold Alpha. Furthermore,
Makric stipulated that its adjusted basis in Alpha stock was $8,439,863. Under the
Internal Revenue Code, Makric’s gain on the sale of Alpha is equal to the amount
realized from the sale minus its adjusted basis in Alpha stock. Sec. 1001(a).
- 26 -
[*26] Because it is undisputed that Makric’s gain is $8,060,137 and that Makric’s
adjusted basis is $8,439,863, the amount realized is $16.5 million.13 Therefore, we
conclude that Makric received $16.5 million for Alpha’s stock. It is apparent that
some of that amount ended up in the hands of Makric’s shareholders. However,
the record does not reveal the exact amount.
On January 27, 2009, John O’Brien of Gulf Star sent an email to Michael
Baudler, Makric’s CFO, to suggest that Makric file a short-year federal-income-
tax return for the period April 1 to September 30, 2008. O’Brien began his email
by stating that he had reviewed the stock purchase agreement. He claimed
(erroneously) that under the agreement, Makric’s shareholders had sold the stock
of Makric to TS3. He further claimed that under the agreement the “owners” (by
which he apparently meant Makric’s shareholders) were liable for the “pre-closing
13
The equation for computing Makric’s gain is:
gain = amount realized – adjusted basis
See sec. 1001(a). After the known values are substituted into the equation, the
equation becomes:
$8,060,137 = amount realized – $8,439,863
Rearranged, this is:
amount realized = $8,060,137 + $8,439,863
= $16,500,000
- 27 -
[*27] taxes” (by which he apparently meant Makric’s income-tax liability up to the
closing date of September 30, 2008). For this proposition, O’Brien explicitly
referred to Section 4.12 of the stock purchase agreement, a representation by
Makric and by Makric’s owners that all taxes payable by the “Company” (defined
as Alpha, not Makric as O’Brien assumed) were fully paid as of the closing date of
the stock purchase agreement. O’Brien’s email also claimed that the liability of
the “owners” for “pre-closing taxes” is “typically * * * handled through a return
filed for the year up until closing.” Thus, O’Brien’s email was a suggestion that
Makric file a return for a short year ending on September 30, 2008.
An accountant, Miles Harper of the firm Gainer, Donnelly & Desroches,
prepared Makric’s Form 1120, “U.S. Corporation Income Tax Return”, for the
short tax year April 1 to September 30, 2008 (the date of the sale). We sometimes
refer to this return as Makric’s “2008 short-year return”. The return was a
consolidated return that reported the consolidated income of Makric and Alpha.14
As of the time Harper prepared this return, he or his firm had been preparing
Makric’s returns for several years. Harper was familiar with Makric’s presale
14
A parent company and its wholly-owned subsidiary are permitted to file a
consolidated return reporting their consolidated income for the taxable year. Secs.
1.1502-2, 1.1502-76(b)(1), Income Tax Regs. They may do so even if the parent
sold the subsidiary during the taxable year. Sec. 1.1502-76(b)(5), Example (1)(c),
Income Tax Regs.
- 28 -
[*28] ownership structure and understood (a) that Makric’s shareholders had no
direct interest in Alpha and (b) that Alpha had been Makric’s subsidiary. Harper
was not directly involved in the negotiations leading to the sale of Alpha, though it
was Harper who first alerted Makric’s shareholders to the possibility that the
initial two-step structure might not meet the shareholders’ tax objectives. As
Harper understood the final transaction, TS3 purchased the stock of Makric from
Makric’s shareholders. He did not understand that Makric had actually sold its
interest in Alpha. His misunderstanding of the sale was based on conversations he
had with Makric’s CFO, Baudler. Harper did not read the stock purchase
agreement before, or at the time of, preparing Makric’s 2008 short-year return.
Believing that Makric had not sold Alpha, he did not report the sale of Alpha on
Makric’s return. In July 2009, Harper signed Makric’s 2008 short-year return. The
copy of the Form 1120 in the record is signed only by Harper as the “Preparer”.
The space above the line for “Signature of officer” is blank. We do not know
whether any of Makric’s officers reviewed the form.
Harper also prepared a Form 1120X, “Amended U.S. Corporation Income
Tax Return”, for Makric for the same tax year. The sole purpose of filing the
amended return was to claim a greater deduction for salary expenses than Makric
had claimed on the original return. The amended return also did not report the sale
- 29 -
[*29] of Alpha. The Form 1120X was signed by Harper as the “Preparer”, but the
space above the line for “Signature of officer” was blank. We do not know if any
of Makric’s officers reviewed the form.
Harper also prepared the Forms 1040, “U.S. Individual Income Tax Return”,
for Makric’s shareholders for the 2008 tax year. On the Schedule D, “Capital
Gains and Losses”, attached to each return, Harper reported that Kisner, Williams,
and Wilson each had a long-term capital gain from the sale of an asset described
on the return as “Alpha” (even though none of them owned Alpha stock). In
calculating the amount of gain each person realized, Harper subtracted what he
thought was each shareholder’s respective basis in Makric from what he thought
was the shareholder’s share of the proceeds received. Kisner’s return stated that
his basis in “Alpha” was $1,471,015 and his “sales price” for “Alpha” was
$8,250,000. Williams’s return stated that his basis in “Alpha” was $1,456,343 and
that his “sales price” for “Alpha” was $3,576,306. Wilson’s return stated that his
basis in “Alpha” was $1 million and that his “sales price” for “Alpha” was
$3,513,806.15 Harper would later testify that he used “Alpha” to designate Makric
15
Thus, the individual returns for Kisner, Williams, and Wilson suggest that
of the $16.5 million Makric received, $15,340,112 (i.e., $8,250,000 + $3,576,306
+ $3,513,806) ended up in the hands of Kisner, Williams, and Wilson. As
previously stated, we find that at least some of the $16.5 million ended up in their
(continued...)
- 30 -
[*30] stock because Makric was a holding company that held only Alpha stock.
This testimony was credible because the bases Harper used for “Alpha” were what
Harper thought were Makric’s shareholders’ respective bases in their Makric
stock.
Kisner and Wilson reviewed their individual returns and each saw that the
returns showed gain from the sale of “Alpha”. (Williams did not review his
individual return before he signed it.)
The IRS audited Makric’s 2008 short-year return and the 2008 individual
returns for Makric’s shareholders. The IRS questioned why Makric did not report
the sale of Alpha shares. It was at this time that Harper realized that he might
have prepared the returns incorrectly.
The IRS issued the notice of deficiency to Makric on November 8, 2012.
The IRS determined that Makric had a deficiency of $2,839,780 relating to its
failure to report the sale of Alpha. This deficiency was based on the IRS’s
determination that Makric sold its Alpha stock and should have reported a gain of
$8,060,137. In the notice, the IRS also determined an accuracy-related penalty of
$567,960 under section 6662(a). The IRS determined that the underpayment on
15
(...continued)
hands. See supra p. 26. The record does not reveal the exact amount.
- 31 -
[*31] which the penalty was based was a large corporation underpayment under
section 6621(c); such an underpayment is subject to a higher interest rate than the
rate normally charged on underpayments.
This case was tried in Houston, Texas. At trial, the parties jointly
introduced, and we admitted into evidence, an affidavit of Brunson, TS3’s
chairman. In it, Brunson swore to the following:
TS3 purchased all of the common stock of Alpha Circuits
Incorporated * * *. It was represented to TS3 that Alpha was owned
by Makric * * *.
In addition, it was my understanding that Messrs. Kisner, Williams
and Wilson insisted upon a structure for the sale that would produce
long term capital gain treatment of the proceeds for each of them for
federal income tax purposes. TS3 was agreeable to such a structure
and, based on Makric’s and its owners’ comments to the final
agreement, we thought the executed agreement met their goal.
It was my understanding at the time that Makric was not an operating
company, that it was a pure holding company, and that its only asset
was the stock of Alpha. Assuming due diligence had proven that
holding company status and if the sellers had provided us with
appropriate representations, warranties and indemnities regarding
Makric and its lack of operations, assets and liabilities, TS3 would
have been willing to purchase the stock of Makric.
On the basis of this affidavit, and on other parts of the record, we find that TS3’s
officers intended for TS3 to acquire the stock of Alpha through the stock purchase
agreement and thought that the stock purchase agreement effected this acquisition.
- 32 -
[*32] OPINION
1. Deficiency
With respect to determinations in the notice of deficiency, the taxpayer
generally bears the burden of proof. Tax Ct. R. Pract. & Proc. 142(a); Welch v.
Helvering, 290 U.S. 111, 115 (1933). The burden of proof is satisfied by a
preponderance of the evidence. Estate of Gilford v. Commissioner, 88 T.C. 38, 51
(1987). The taxpayer may, by introducing credible evidence and cooperating with
the IRS’s reasonable requests for information, shift the burden of proof to the IRS.
See sec. 7491(a)(1); Higbee v. Commissioner, 116 T.C. 438, 442 (2001). We
decide this case, as it relates to the amount of the deficiency, on a preponderance
of the evidence. Therefore, we need not determine who bears the burden of proof.
See Knudsen v. Commissioner, 131 T.C. 185, 189 (2008).
The issue before the Court concerns the tax consequences of the transaction
associated with the stock purchase agreement. The IRS contends that Makric, for
federal-income-tax purposes, should be treated as if it sold the stock of Alpha to
TS3. Under this view, Makric would recognize gain on the sale of Alpha stock.
Makric contends that Makric’s shareholders, for federal-income-tax purposes,
should be treated as if they had sold Makric stock to TS3. Under this view,
Makric would have no gain from the sale.
- 33 -
[*33] As described in detail below, the parties make various arguments in favor of
their respective positions. These arguments involve the following legal concepts:
! Texas state-law principles of interpreting contracts,
! the Texas state-law remedy of reformation of contracts on the
grounds of mutual mistake, and
! the federal tax principles of (1) substance-over-form and (2) the
Danielson rule.
The relevant aspects of each of these concepts are described below.
We begin by describing Texas state-law principles of interpreting contracts.
Interpreting a contract is “primarily” a matter of “ascertain[ing] the * * *
intentions of the parties as expressed in the written instrument”. Coker v. Coker,
650 S.W.2d 391, 393 (Tex. 1983). A threshold issue in contract interpretation is
whether the contract is unambiguous or ambiguous. A contract is unambiguous if
it is “so worded that it can be given a certain or definite legal meaning or
interpretation”. Id. A contract is ambiguous if “its meaning is uncertain and
doubtful or it is reasonably susceptible to more than one meaning, taking into
consideration circumstances present when the particular writing was executed”.
Lenape Res. Corp. v. Tenn. Gas Pipeline Co., 925 S.W.2d 565, 574 (Tex. 1996).
There are two types of contractual ambiguity: “patent” and “latent”. Nat’l Union
- 34 -
[*34] Fire Ins. Co. v. CBI Indus., Inc., 907 S.W.2d 517, 520 (Tex. 1995). “A
patent ambiguity is evident on the face of the contract”, id., “often as the result of
the use of inherently uncertain or conflicting words”, 11 Williston on Contracts,
sec. 33:43 (4th ed. 2015).16 A latent ambiguity exists if the contract is plain on its
face but is ambiguous in light of “some collateral matter.” Nat’l Union Fire Ins.
Co., 907 S.W.2d at 520. The Texas Supreme Court has given the following
example of a latent ambiguity: “[I]f a contract called for goods to be delivered to
‘the green house on Pecan Street,’ and there were in fact two green houses on the
street, it would be latently ambiguous.” Id. at n.4. The determination of whether a
contract is ambiguous is a matter of law. Id. In making the determination, courts
cannot consider extrinsic evidence of the parties’ intent. See Meridien Hotels, Inc.
v. LHO Fin. P’ship I, L.P., 255 S.W.3d 807, 816 (Tex. App.--Dallas 2008).
Extrinsic evidence, also known as “parol evidence”, is “evidence not contained in
the body of an agreement or other instrument”. 36 Tex. Jur., Evidence, sec. 316.
Extrinsic evidence of the parties’ intent includes:
16
For example, in Furmanite Worldwide, Inc. v. NextCorp., Ltd., 339
S.W.3d 326, 333 (Tex. App.--Dallas 2011), one provision of a contract provided
that the date of the agreement was August 31, 2006, but another provision
provided that the first year of the agreement was 2003, thus making it ambiguous
as to when the agreement took effect.
- 35 -
[*35] ! “expressions of the parties simultaneous with the making of the
contract”, Remington Rand, Inc. v. Sugarland Indus., 153 S.W.2d
477, 484 (Tex. 1941), and
! “evidence of declarations of the parties made out of court as to their
intentions as to future writings (such as instructions given for drafting
deeds or wills)”, Henry v. Powers, 447 S.W.2d 738, 743 (Tex. Civ.
App.--Houston [1st Dist.] 1969).
Although extrinsic evidence of the parties’ intent cannot be considered in
determining whether a contract is ambiguous, see Nat’l Union Fire Ins. Co., 907
S.W.2d at 521; Meridien Hotels, 255 S.W.3d at 806, Texas courts have held that
extrinsic evidence of the surrounding circumstances and the subject matter of the
contract may be considered to determine whether a latent ambiguity exists, Loaiza
v. Loaiza, 130 S.W.3d 894, 905 (Tex. App.--Fort Worth 2004) (“Although the
determination of whether a contract is ambiguous should be limited to an
examination of the language of the agreement, appellate courts may examine
extrinsic evidence of ‘surrounding circumstances’ or ‘the subject matter of the
contract’ to determine if a latent ambiguity exists.” (quoting Birmingham Fire Ins.
Co. v. Am. Nat’l Fire Ins. Co., 947 S.W.2d 592, 603 (Tex. App.--Texarkana 1997,
writ denied))).
- 36 -
[*36] If the contract is determined to be unambiguous, it is interpreted in
accordance with its provisions. Coker, 650 S.W.2d at 393. If a contract is
determined to be ambiguous, the next step is to determine the best interpretation,
i.e., which of the reasonable meanings of the ambiguous term or provision best
represents the parties’ intentions. See Nat’l Union Fire Ins. Co., 907 S.W.2d at
520. Determining the best interpretation is a matter of fact. Coker, 650 S.W.2d at
394 (“When a contract contains an ambiguity * * * the interpretation of the
instrument becomes a fact issue.”).17 In determining the best interpretation of an
ambiguous contract, extrinsic evidence of the parties’ intent may be considered.
Lenape Res. Corp., 925 S.W.2d at 574 (“If the written instrument is ambiguous,
the trier of fact may look to parol evidence to determine the parties’ intent.”); see
also Grimes v. Dike, 2006 WL 1918560, at *2 (Tex. App.--Tyler 2006) (“Parol
evidence is admissible to explain both latent and patent ambiguities.”).
We have referred to several rules regarding the consideration of extrinsic
evidence of the parties’ intent. We summarize these rules below:
17
Determining the best interpretation of an ambiguous contractual provision
is sometimes referred to as “resolving” or “explaining” the ambiguity. See, e.g.,
Exxon Corp. v. W. Tex. Gathering Co., 868 S.W.2d 299, 302 n.3 (Tex. 1993);
Lorino v. Crawford Packing Co., 175 S.W.2d 410, 416 (Tex. 1943).
- 37 -
[*37] Can extrinsic evidence of intent be considered to --
Type of ambiguity establish ambiguity? resolve ambiguity?
Patent ambiguity No Yes
Latent ambiguity No, but extrinsic evidence Yes
of surrounding
circumstances and subject
matter may be considered
We now describe the Texas state-law remedy of reformation of contracts on
the ground of mutual mistake. The remedy of reformation is an equitable
remedy.18 A suit to reform a contract can be brought in the Texas district courts,
which are general-jurisdiction trial courts with both legal and equitable powers.
Tex. Jur. 3d, Cancellation and Reformation, sec. 132 (1980) (“Reformation may be
sought in the district court.”); Dubai Petroleum Co. v. Kazi, 12 S.W.3d 71, 75
(Tex. 2000) (general jurisdiction); Texas Gov’t Code sec. 24.008 (West 2004)
(legal and equitable powers). Reformation can be the principal object of a suit or
18
According to Howard v. Young, 210 S.W.2d 241, 243 (Tex. Civ. App.--
Amarillo 1948, writ ref’d n.r.e.):
Courts of equity have always exercised jurisdiction over mutual
mistakes and granted the relief of reforming written instruments by
ascertaining the intent of the parties who executed them and
conforming the writing to the real contract which they intended to
make. * * * The purpose of doing so is to adjust the instrument to the
conditions of fact and make it effective to carry out the true purpose
which the parties intended to express. * * *
- 38 -
[*38] it can be ancillary to other claims for relief. Tex. Jur. 3d, Cancellation and
Reformation, sec. 132. A suit for the reformation of a contract requires joinder of
all parties to the contract and all other persons who have an interest in the
controversy. Beneficial Standard Life Ins. Co. v. Trinity Nat’l Bank, 763 S.W.2d
52, 56 (Tex. App.--Dallas 1988). One ground for reformation is a mutual mistake.
Gilbane Bldg. Co. v. Keystone Structural Concrete, Ltd., 263 S.W.3d 291, 300-
301 (Tex. App.--Houston [1st Dist.] 2007, no pet.) (“If a written contract fails to
reflect a party’s original agreement due to a mutual mistake, the court may reform
the contract to properly reflect the party’s true agreement.” (citing Cherokee Water
Co. v. Forderhause, 741 S.W.2d 377, 379 (Tex. 1987))). A mutual mistake
“occurs where the parties to an agreement have a common intention, but the
written contract does not reflect the intention of the parties due to a mutual
mistake.” Okon v. MBank, N.A., 706 S.W.2d 673, 675 (Tex. App.--Dallas 1986,
writ ref’d n.r.e.); see also Sun Oil Co. v. Bennett, 84 S.W.2d 447, 450 (Tex. 1935)
(a mutual mistake is “a mistake common to both parties”); Durham v. Luce, 140
S.W. 850, 854-855 (Tex. Civ. App.--Galveston 1911) (“[E]quity will only correct
a mistake in a deed when such mistake is the mutual mistake of all the parties to
the instrument[.]”). The existence of a mutual mistake can be proved by extrinsic
evidence of intent. Estes v. Republic Nat’l Bank, 462 S.W.2d 273, 275 (Tex.
- 39 -
[*39] 1970) (“[P]arol evidence is admissible to show that the writing, because of a
mutual mistake, incorrectly reflects the true agreement”). For mutual mistake to
be proven, the evidence must be “clear, exact, and satisfactory”. Id. (quoting Sun
Oil Co., 84 S.W.2d at 452) Finally, “facial ambiguity is not a requirement for
reformation”. 66 Am. Jur. 2d, Reformation of Instruments, sec. 6; see also Brinker
v. Wobaco Trust, Ltd., 610 S.W.2d 160, 164 (Tex. Civ. App.--Texarkana 1980,
writ ref’d n.r.e.) (“The fact that the written language is couched in unambiguous
language * * * will not preclude relief by reformation.”). Thus, a contract that is
clear on its face can still be reformed.
We now describe the federal tax principles implicated by the parties’
arguments. The substance-over-form doctrine is the principle that “[t]he substance
of the transaction rather than the form of the agreement must determine the tax
consequences to the parties.” Strutzel v. Commissioner, 60 T.C. 969, 976 (1973);
see Southgate Master Fund, L.L.C. v. United States, 659 F.3d 466, 479 (5th Cir.
2011) (“The substance-over-form doctrine allows a transaction to be re-
characterized so that its taxable form corresponds to its economic substance.”).
The substance-over-form doctrine can be invoked by either the government or the
taxpayer. Estate of Weinert v. Commissioner, 294 F.2d 750, 755 (5th Cir. 1961),
rev’g and remanding 31 T.C. 918 (1959). However, the Court of Appeals for the
- 40 -
[*40] Third Circuit in Commissioner v. Danielson, 378 F.2d 771, 775 (3d Cir.
1967), vacating and remanding 44 T.C. 549 (1965), held that the invocation of the
substance-over-form doctrine by taxpayers is restricted in certain circumstances.
Danielson determined the tax treatment of proceeds received by a company’s
shareholders in exchange for two things: (1) their stock of the company and (2)
their promise that after the sale they would not compete with the company (such a
promise is known as a noncompete covenant). Id. at 773. Their agreement with
the buyer stated that 41% of the price was for the noncompete covenant and 59%
was for the stock. Id. The shareholders contended that the entire price was in
“fact” and in “business reality” a payment for the stock. Id. at 774. They argued
that the 41%/59% allocation in the agreement should be disregarded for purposes
of determining the tax consequences of their receipt of the proceeds. Id.19 The
Third Circuit rejected the shareholders’ argument. Id. at 774-775, 778. The court
held:
[A] party can challenge the tax consequences of his agreement as
construed by the Commissioner only by adducing proof which in an
19
The portion of the price considered to be for the noncompete covenant
would be taxed as ordinary income to the shareholder. Schmitz v. Commissioner,
51 T.C. 306, 313 (1968), aff’d sub nom. Throndson v. Commissioner, 457 F.2d
1022 (9th Cir. 1972). The portion of the price considered to be for the stock
would be taxed more favorably as capital gain. Thus, it was in the shareholders’
interest to argue that the price should be considered payment for the stock.
- 41 -
[*41] action between the parties to the agreement would be
admissible to alter that construction of the contract or to show its
unenforceability because of mistake, undue influence, fraud, duress,
etc. * * *.
Id. at 775. The court further held that if the shareholders had attempted, in an
action against the buyer, “to avoid or alter the [sales] agreement * * * [they] would
have a heavy burden of showing fraud, duress, undue influence and the like under
what may loosely be called common-law principles”, id. at 778-779, and that
“examination of all the evidence adduced in this case reveals nothing to
demonstrate that the contract as written was not the taxpayers’ [i.e., the
shareholders’] conscious agreement”, id. at 779. The rule adopted by the Third
Circuit in Danielson, i.e., the “Danielson rule”, CMI Int’l, Inc. v. Commissioner,
113 T.C. 1, 4 (1999), can be thought of as having both a restrictive and a
permissive component. The restrictive component prevents the taxpayer from
asserting the substance-over-form doctrine. See Commissioner v. Danielson, 378
F.2d at 775; Michael Bailiff, “When (and Where) Does the Danielson Rule Limit
Taxpayers Arguing Substance over Form?”, 82 J. Tax’n 362, 362 (1995) (referring
to “Danielson’s nondisavowel principle that binds taxpayers to the form of their
transaction, regardless of its economic substance” (emphasis added)). The
permissive component recognizes that the taxpayer may rely on nontax legal
- 42 -
[*42] principles, such as the state-law principles regarding reformation of
contracts. See CMI Int’l, Inc. v. Commissioner, 113 T.C. 4 (“Where the terms
of a transaction are set forth in a written contract, the Danielson rule provides that
a party to the contract may disavow the form of such transaction only with
evidence that would allow reformation of the contract (e.g., to prove fraud or
duress).” (citing Commissioner v. Danielson, 378 F.2d at 775)). The Danielson
rule applies to a taxpayer’s argument only if the agreement in question is
unambiguous. Id. (“If the contract is ambiguous, however, the Danielson rule
does not apply.” (citing N. Am. Rayon Corp. v. Commissioner, 12 F.3d 583, 589
(6th Cir. 1993), aff’g T.C. Memo. 1992-610)). Although Danielson was an
opinion of the Third Circuit, the Fifth Circuit has applied the Danielson rule in
several cases including Spector v. Commissioner, 641 F.2d 376, 386 (5th Cir.
1981), rev’g 71 T.C. 1017 (1979), Smith v. Commissioner, 65 F.3d 37, 40 n.13
(5th Cir. 1995), aff’g T.C. Memo. 1994-149, and Insilco Corp. v. United States (In
re Insilco Corp.), 53 F.3d 95, 99 (5th Cir. 1995).
Having described these underlying legal principles, we now explain the
arguments made by the parties in general terms. Makric puts forward “two basic
theories”. First, Makric contends that under the substance-over-form doctrine, the
substance of the transaction in question is a sale by Makric’s shareholders of
- 43 -
[*43] Makric stock to TS3.20 Second, Makric seeks the remedy of “reformation”,
contending that evidence admissible under “state law” shows that “mutual mistake
existed in the drafting of documents by which the owners of Petitioner intended to
sell the stock of Petitioner as distinguished from selling the stock of Alpha”.
As to Makric’s substance-over-form argument, the IRS contends that the
Danielson rule applies and that therefore we cannot consider Makric’s substance-
over-form argument at all. In addition, the IRS contends that “the substance of
[the] transaction was a sale of Alpha, not Makric.” Makric takes the position that
the Danielson rule does not apply because, in its view, the stock purchase
agreement is ambiguous. As Makric contends:
Absent a showing of mutual mistake, taxpayers will be bound by the
terms of their unambiguous documents. Danielson v. Commissioner,
378 F.2d 771 (3d Cir. 1967), cert. denied, 389 U.S. 858 (1967).
However, the stock purchase agreement is replete with ambiguities, if
not outright errors.[21]
20
It argues: “[T]he doctrine of ‘substance over form’ should be applied to
reflect the transaction as the sale of Petitioner [i.e., Makric] to the buyer [i.e.,
TS3].”
21
We note that although Makric contends the stock purchase agreement is
ambiguous for the purpose of avoiding the Danielson rule, Makric does not
contend that under Texas principles of contract interpretation the best
interpretation of the stock purchase agreement is that the agreement is for the sale
of Makric stock.
- 44 -
[*44] The IRS contends that the stock purchase agreement is unambiguous. As
the IRS explained in its closing argument:
[W]hat is not at all ambiguous are the parties to the stock purchase
agreement * * *. The buyer: TS3. The seller: Makric, Petitioner.
Company: Alpha Circuits. Owners of seller: Kisner, Williams, and
Wilson. “Buyer desires to buy and seller desires to sell company.”
[paraphrasing stock purchase agreement]
As to Makric’s reformation argument, the IRS first contends that the Tax
Court is not the appropriate court to hear the argument. In its view, a reformation
action “is a state law action, and they would have to seek reformation of the
contract under state law.” Second, the IRS contends that Makric has not proven
that there was a mutual mistake about the contract. As the IRS argues:
Petitioner [i.e., Makric] has not alleged fraud or duress in these
negotiations, but there is likewise not a mutual mistake present in this
case. In order to establish that a mutual mistake occurred, Petitioner
must prove that both sides intended the sale to be of Makric. This
Petitioner has not done.
These are the parties’ contentions. We resolve these contentions as follows:
- 45 -
[*45] Holding Part of opinion
Makric’s substance-over-form argument is barred by the 1.A
Danielson rule because the stock purchase agreement, as
interpreted without recourse to extrinsic evidence of intent,
is unambiguously an agreement by Makric to sell Alpha
stock.
Limited by the Danielson rule to its alternative argument 1.B
that there was a mutual mistake regarding the stock
purchase agreement that would justify reformation of the
agreement under Texas law, Makric failed to make the
requisite showing of mutual mistake (a determination
taking into account extrinsic evidence of intent).
Even if Makric’s substance-over-form argument was not 1.C
barred by the Danielson rule, the evidence in the record
shows that the substance of the transaction is the sale by
Makric of Alpha stock.
A. Makric’s substance-over-form argument is barred by the Danielson
rule because the stock purchase agreement, as interpreted without
recourse to extrinsic evidence of intent, is unambiguously an
agreement by Makric to sell Alpha stock.
We turn first to Makric’s substance-over-form argument. Makric argues
that the substance of the transaction was described in Kisner’s email of February
28, 2008. This email described the transaction as the sale of Makric stock to TS3.
The IRS would have us refrain from considering Makric’s substance-over-form
argument altogether. In the IRS’s view, Makric is barred from advancing a
substance-over-form argument by the Danielson rule. See supra pp. 39-42
- 46 -
[*46] (discussing Danielson rule). Makric argues that Danielson is not applicable
to the instant case because the relevant portions of the stock purchase agreement
are ambiguous. See Commissioner v. Danielson, 378 F.2d at 775. Danielson is
not applicable where the underlying agreement is ambiguous. CMI Int’l, Inc. v.
Commissioner, 113 T.C. 4. Makric argues that the stock purchase agreement is
ambiguous with respect to who was selling (i.e., whether it was Makric or
Makric’s shareholders) and the stock being sold (i.e., whether it was the stock of
Makric or Alpha). Makric asserts that the agreement is both patently and latently
ambiguous.
First, Makric contends that there is a patent ambiguity in the agreement in
that Makric’s shareholders were parties to the agreement and that this suggests
(according to Makric) that the agreement called for the sale of Makric shares, not
Alpha shares. Makric’s reasoning ignores unambiguous terms of the stock
purchase agreement. Although Makric’s shareholders were parties to the stock
purchase agreement, the agreement does not require them to sell their shares of
Makric. Instead, the agreement unambiguously requires Makric to sell its shares
of Alpha. It provides that “Seller [i.e., Makric] agrees to sell to Buyer [i.e., TS3],
and Buyer agrees to purchase from Seller, all of the issued and outstanding shares
* * * of common stock * * * of the Company [defined as Alpha]”. The only
- 47 -
[*47] reasonable interpretation of this sentence is that Makric was to sell its Alpha
stock to TS3. The inclusion of Makric’s shareholders as parties to the stock
purchase agreement does nothing to diminish this interpretation of the agreement.
Section 3 of the stock purchase agreement, entitled “Representations and
Warranties of Seller and Owners”, provides: “Seller [i.e., Makric] and each
Owner [i.e., Makric’s shareholders] represent and warrant jointly and severally
with respect to warranties covering Seller [i.e., Makric]”. By this wording (and
similar wording in Section 4 of the stock purchase agreement), Makric’s
shareholders were presumably made liable to TS3 should certain warranties made
in the stock purchase agreement be found false. It is not surprising that Makric’s
shareholders would be required to sign an agreement that would impose such
liability on them. Ordinarily, only a party that executes a contract is liable for
breaching the contract. See Willis v. Donnelly, 199 S.W.3d 262, 271 (Tex. 2006)
(a shareholder who does not sign a contract entered into by a corporation is
ordinarily not liable for breach of such contract). If the reason for including
Makric’s shareholders as parties to the stock purchase agreement was instead to
impose on them an obligation to sell their Makric stock, one would expect the
agreement to have a provision requiring them to sell their stock. But there is no
such provision. Including Makric’s shareholders as parties to the stock purchase
- 48 -
[*48] agreement does not create ambiguity as to who was the seller (Makric) or
what stock was being sold (Alpha stock).
Second, Makric contends that there is latent ambiguity that is not readily
apparent on the face of the stock purchase agreement but that becomes apparent
upon review of collateral documents, including correspondence and tax returns of
Makric’s shareholders. As discussed supra pp. 33-35, latent ambiguity exists if
the contract is plain on its face but is ambiguous in the light of some collateral
matter. See Nat’l Union Fire Ins. Co., 907 S.W.2d at 520-522. Under Texas law,
a court may consider extrinsic evidence to determine whether a latent ambiguity
exists only if that evidence concerns the surrounding circumstances or the subject
matter of the agreement.22 See id. This is the type of extrinsic evidence that can
be relied on by Makric to show the stock purchase agreement is latently
22
Citing Estate of Craft v. Commissioner, 68 T.C. 249 (1977), aff’d, 608
F.2d 240 (5th Cir. 1979), Makric contends that the rule against extrinsic evidence
of the parties’ intent should not be invoked by someone who, like the IRS, was not
a party to the original transaction. Makric’s argument rests on a misunderstanding
of our holding in Estate of Craft. Estate of Craft did not hold that the IRS can
never invoke the rule against extrinsic evidence of the parties’ intent but, rather,
that the decision to exclude such evidence turns on state law. Id. at 264.
Specifically, Estate of Craft stated that “in those instances where we are called
upon to make a State law determination as to the existence and extent of legal
rights and interests created by a written instrument, we must look to that state’s
parol-evidence rule in deciding whether or not to exclude extrinsic evidence”. Id.
at 263. Estate of Craft, applying the relevant state rule, held that the taxpayer
could not introduce extrinsic evidence. Id. at 264.
- 49 -
[*49] ambiguous. See Loaiza, 130 S.W.3d at 905. However, the extrinsic
evidence relied on by Makric to show the stock purchase agreement is ambiguous
consists only of expressions of the parties and declarations of intentions as to
future writings. See Henry v. Powers, 447 S.W.2d at 743; Remington Rand, Inc.,
153 S.W.2d at 484. Specifically the extrinsic evidence relied on by Makric is: (1)
the February 28, 2008 email from Kisner to Ronn stating that the transaction
would be structured as the sale of Makric, (2) the January 27, 2009 email from
O’Brien of Gulf Star (Makric’s investment bank) characterizing the sale as that of
Makric, (3) testimony of Makric’s CEO, Kisner, that he reached an agreement with
representatives of TS3, under which TS3 would buy Makric stock, and (4)
Makric’s shareholders’ tax returns reporting a gain from the sale of Makric stock
(though described on the returns as “Alpha” stock). Under Texas law, this
extrinsic evidence may not be considered.23 We therefore hold that the relevant
portions of the stock purchase agreement are not latently ambiguous.24 We reject
23
As explained infra pp. 52-56, we do consider extrinsic evidence of intent
to evaluate Makric’s other legal theory that the stock purchase agreement was the
result of mutual mistake and can be reformed on that basis.
24
Even if we consider the extrinsic evidence proffered by Makric for the
purpose of determining whether the stock purchase agreement is ambiguous, this
evidence, in our view, does not lead to the conclusion that the stock purchase
agreement is ambiguous. See Commissioner v. Danielson, 378 F.2d at 779
(continued...)
- 50 -
[*50] Makric’s attempt to oppose the application of the Danielson rule on grounds
of contractual ambiguity, patent or latent.
Makric raises several other arguments as to why the Danielson rule should
not apply. It argues that we should hold that the Danielson rule applies only to
agreements concerning the allocation of monetary consideration. The Court of
Federal Claims followed this approach in Hartman v. United States, 99 Fed. Cl.
168, 181-182 (2011), aff’d on other grounds, 694 F.3d 96 (Fed. Cir. 2012).
However, we look to our own precedent and to the law of the U.S. Court of
Appeals for the circuit in which appeal of the case would lie.25 Here that circuit is
the Fifth Circuit. See supra note 2. The Fifth Circuit has not limited the
Danielson rule to the allocation of monetary consideration. See Spector v.
Commissioner, 641 F.2d 376 (holding taxpayer to the tax consequences of the
form of a partnership-exit agreement which structured the partner’s exit as a
24
(...continued)
(holding that the IRS was permitted to invoke the parol-evidence rule to exclude
certain evidence in that case and further holding that even if the IRS was barred
from invoking the parol-evidence rule, and the court could consider the evidence
in question, the additional evidence would not change the outcome of the dispute).
25
In Golsen v. Commissioner, 54 T.C. 742, 756-757 (1970), aff’d, 445 F.2d
985 (10th Cir. 1971), we held that we will follow the precedent of the U.S. Court
of Appeals for the circuit that will hear the appeal from the case (if the case is
appealed).
- 51 -
[*51] liquidation of his interest, and rejecting taxpayer’s argument that in
substance he had sold his partnership interest).
Makric next advances the argument that the Danielson rule should not apply
because no unjust result would attend if TS3 were treated as having bought Makric
rather than Alpha. We disagree with that argument. On the basis of the stock
purchase agreement, TS3 reasonably expected that it would be treated for tax
purposes as if it had purchased the stock of Alpha. See Commissioner v.
Danielson, 378 F.2d at 775.
Finally, Makric contends that the Danielson rule should not apply because
TS3 did not “specifically negotiate for” the sale of Alpha (as opposed to Makric).26
Even if we were to accept that Makric could avoid application of the Danielson
rule for this reason, we find untenable the position that TS3 did not believe it was
negotiating for the purchase of Alpha. TS3’s lawyers drafted the stock purchase
agreement and its prior versions, all of which contemplated TS3’s purchasing
Alpha. The affidavit from TS3’s Chairman, Brunson, makes clear that he believed
TS3 was agreeing to purchase Alpha specifically, not Makric. If TS3 had
26
Makric contends that the Fifth Circuit applied the Danielson rule in
Spector v. Commissioner, 641 F.2d 376 (5th Cir. 1981), rev’g 71 T.C. 1017
(1979), and Insilco Corp. v. United States (In re Insilco Corp.), 53 F.3d 95 (5th
Cir. 1995), only because in those cases “the taxpayer was trying to change a
provision that it had specifically negotiated with the other party.”
- 52 -
[*52] purchased Makric, TS3 would have been indirectly burdened with all of
Makric’s liabilities, not just Alpha’s liabilities. Makric’s liabilities would have
included Makric’s potential tax liability if it were to sell Alpha. If TS3 had
negotiated for the sale of Makric, rather than Alpha, it might have negotiated a
reduced price to account for the burden of Makric’s liabilities.
We hold that the Danielson rule bars Makric from contending that in
substance the stock purchase agreement is for the sale of Makric.
B. Limited by the Danielson rule to its alternative argument that there
was a mutual mistake regarding the stock purchase agreement that
would justify reformation of the agreement under Texas law, Makric
failed to make the requisite showing of mutual mistake (a
determination taking into account extrinsic evidence of intent).
Even when a taxpayer is restricted by the Danielson rule, a court may
reform an agreement if the relevant portions of the agreement were the result of a
mutual mistake. See Commissioner v. Danielson, 378 F.2d at 775. Makric
contends that the relevant portions of the stock purchase agreement (i.e., those
identifying the seller as Makric and the stock to be transferred as the stock of
Alpha) were the result of a mutual mistake. A mutual mistake is one common to
all parties, wherein each labors under the same misconception about a material
fact, the terms of the agreement, or the provisions of a written instrument designed
to embody such an agreement. Hardy v. Bennefield, 368 S.W.3d 643, 650 (Tex.
- 53 -
[*53] App.--Tyler 2012). The question of what the parties intended (and therefore
whether there was a mutual mistake) is a factual issue. See Milner v. Milner, 361
S.W.3d 615, 619 (Tex. 2012). In determining whether there was a mutual mistake,
extrinsic evidence is considered. Estes v. Republic Nat’l Bank of Dallas, 462
S.W.2d 273, 275 (Tex. 1970). A mutual mistake justifies reforming even an
unambiguous contract. Brinker, 610 S.W.2d at 164.
In support of its theory that the stock purchase agreement, in failing to
effect a sale of Makric stock, resulted from mutual mistake, Makric proffers two
principal pieces of evidence. First, Makric points to Kisner’s email instructing
Ronn, TS3’s lawyer, to structure the transaction so that TS3 would purchase
Makric, not Alpha. See supra p. 14. Second, Makric points to the testimony of its
president, Kisner, who was the lead negotiator for Makric. Kisner testified that he
reached an agreement with a representative of TS3 (presumably Brunson, TS3’s
chairman and lead negotiator) that Makric’s shareholders would sell Makric to
TS3. Both pieces of evidence could, if considered credible, tend to show that the
parties intended to sell Makric and that therefore the stock purchase agreement,
which effected the sale of Alpha, was the result of mutual mistake. We thus
consider this evidence.
- 54 -
[*54] We are unable to conclude that the two pieces of evidence described above
show that the pertinent portions of the stock purchase agreement were the result of
a mutual mistake. We consider first the email sent from Kisner to Ronn on
February 28, 2008. Kisner’s email shows that he intended, at one time, to
structure the transaction as the sale of Makric. And, as we have found, a
representative from TS3, at some time before the February 28, 2008 email, had
assented to that structure. See supra note 8. However, Kisner sent the email to
Ronn seven months before the parties executed the stock purchase agreement.
Over the course of those seven months, Kisner (with Miller, Makric’s lawyer)
reviewed several drafts of the stock purchase agreement, all of which contradict
the premise that the parties intended to exchange Makric stock, rather than Alpha
stock. Critically, the stock purchase agreement itself and several of its drafts
describe a sale structure by which TS3 would acquire Alpha, not Makric.
Additional documents, including those signed prior to the closing and at the
closing itself, are consistent with the premise that TS3 intended to acquire, and
Makric intended to sell, Alpha. For example, in 2007, Makric’s shareholders (in
their capacities as Alpha’s directors) signed a consent authorizing that Alpha be
listed for sale. See supra p. 7. The record contains no comparable document
listing Makric for sale. Makric’s shareholders (in their capacities both as directors
- 55 -
[*55] and shareholders of Makric) also signed a “Joint Written Consent of the
Shareholders and Directors in Lieu of a Special Meeting”, which unambiguously
authorized the sale of Alpha by Makric. See supra pp. 20-21. At the closing,
Kisner, in his capacity as CEO of Makric, signed a “Written Consent of Sole
Shareholder of Alpha Circuits Incorporated”, which also unambiguously
authorized the sale of Alpha by Makric. See supra p. 21. We consider these
documents more probative of the parties’ intent at the time they executed the stock
purchase agreement than Kisner’s single email, which he sent several months
before the transaction occurred. Other than the email, the only evidence that
supports the premise that TS3 intended to purchase Makric is Kisner’s testimony.
He testified that he and representatives of TS3 orally agreed to restructure the sale
such that TS3 would purchase Makric. He further testified that he emailed Ronn
only to put that agreement in writing. While we consider Kisner’s testimony
credible and find it plausible that each side’s negotiators, at some point, approved
the structure described by Kisner’s February 28, 2008 email, the weight of the
evidence, including the transactional documents (i.e., the stock purchase
agreement and the consent forms executed at the closing of the sale), indicates that
Makric and TS3 had agreed to a different structure by the time they executed the
stock purchase agreement. For these reasons, even if we were to conclude that the
- 56 -
[*56] extrinsic evidence proffered by Makric shows that Makric and TS3 may
have, at one point, reached an agreement to sell Makric, this evidence is
insufficient to show that the relevant portions of the stock purchase agreement
were the result of a mutual mistake.
The record does not reveal why the parties did not ultimately adopt the
structure Kisner described in his email to Ronn (TS3’s lawyer). The persons who,
presumably, could have explained this discrepancy were Ronn (TS3’s lawyer who
prepared the stock purchase agreement and its drafts) and Miller (Makric’s
lawyer). Makric did not call either lawyer as a witness. Regardless, the record
makes clear that the parties to the stock purchase agreement did not ultimately
adopt the structure described in Kisner’s email. Brunson, TS3’s chairman, stated
in his affidavit (see supra pp. 30-31) that TS3 might have been willing to purchase
Makric had TS3 undertaken the requisite steps, including an appropriate due-
diligence inquiry, for such a purchase; however, the affidavit also implies that the
parties did not take such steps.27 Brunson swore: “Assuming due diligence had
proven that holding company status [of Makric] and if the sellers had provided us
27
We found that TS3 started a due-diligence inquiry with respect to Makric.
See supra p. 16. However, we know very little about the inquiry. It is plausible
that TS3 would have more thoroughly investigated Makric had TS3 intended to
buy Makric rather than Alpha.
- 57 -
[*57] with appropriate representations, warranties, and indemnities regarding
Makric * * * TS3 would have been willing to purchase the stock of Makric.”
(emphasis added). Such due diligence might have revealed that Makric had
liabilities that TS3 did not wish to assume or which would have required an
adjustment to the amount that TS3 was willing to pay for Makric. Brunson’s
admission that TS3 never conducted the requisite due diligence indicates that TS3
never seriously contemplated purchasing Makric.28 Moreover, even if TS3 had
been amenable to purchasing Makric (as the affidavit suggests), neither the
ultimate transaction, nor the negotiations leading up to it, indicate that TS3
intended to purchase Makric at the time the parties reached a final agreement
about the sale.
Makric advances numerous additional theories as to why Makric’s
shareholders could not have possibly intended to authorize the sale of Alpha. For
example, Makric argues that, since Makric’s shareholders owned Makric stock, it
is only natural that they would have intended to sell Makric stock. This argument,
however, is contradicted by the fact that Makric originally planned to dissolve and
28
It is also possible that TS3 would have paid less for Makric (than it did for
Alpha) because Makric would have had a potential tax liability (attributable to
Makric’s built-in gain from its holding of Alpha stock) if it were to sell Alpha
after having been acquired by TS3. See supra p. 51.
- 58 -
[*58] distribute its Alpha stock to Kisner, Williams, and Wilson. Thus, as they
originally envisioned the transaction, Makric’s shareholders would have held and
sold Alpha stock to TS3. We reject the proposition that Makric’s shareholders
could have only intended a transaction in which they would sell their Makric
stock. Even if this proposition were true, it could show only that Makric was
mistaken about the contents of the stock purchase agreement. It says nothing
about TS3’s intent, which was to purchase Alpha.
Makric contends that the parties to the stock purchase agreement would
have agreed to the sale of Alpha only by mistake because the sale of Alpha was a
tax-inefficient way to structure the sale and because TS3 knew that Makric wanted
to structure the sale so that the gain from the sale would produce long-term capital
gain. We agree that structuring the transaction as the sale of Alpha may have been
relatively tax-inefficient. The tax consequences to Makric for selling Alpha stock
can be found in the notice of deficiency issued to Makric. The notice of
deficiency calculates that Makric’s tax liability increased $2,839,780 by its sale of
Alpha. Makric does not contest the correctness of this amount should the Court
determine that the transaction is treated as the sale of Alpha.29 By contrast, if the
29
Arguably $2,839,780 is not the only tax liability resulting from the sale of
Alpha. Makric’s shareholders appear to face a second layer of tax because they
(continued...)
- 59 -
[*59] transaction is treated as the sale of Makric shares, the tax consequences--at
least as reported by Makric’s shareholders (Kisner, Williams, and Wilson)--are
found on their individual tax returns. The shareholders reported that they should
be taxed on the gain from the sale of their Makric stock at the 15% tax rate
imposed on net long-term capital gain. See secs. 1(h), 1001, 1222.30 Using this
rate appears to result in an increased tax to the shareholders of only $1,711,913.
This is less than $2,839,780. The comparison between the two numbers may
illustrate the arguable tax inefficiency of selling Alpha rather than Makric. The
problem with Makric’s tax-efficiency argument is that it conceivably sheds light
only on Makric’s intent in signing the stock purchase agreement. TS3, by
contrast, thought that the form of the agreement it signed met the goals of
Makric’s shareholders. In his affidavit, see supra pp. 30-31, Brunson stated that
29
(...continued)
received at least some of the proceeds from this sale. Their receipt of proceeds
could be considered a constructive distribution from Makric. See generally secs.
301, 316 (corporate distributions to shareholders); United States v. Smith, 418
F.2d 589, 593 (5th Cir. 1969) (constructive distribution to shareholders treated as
actual distribution). A distribution (constructive or actual) may be taxed as
ordinary income, capital gain, a tax-free return of capital, or a combination of all
three. See sec. 306(c)(1), (2), and (3).
30
Net long-term capital gain equals long-term capital gains minus long-term
capital losses. Sec. 1222(7). A long-term capital gain is gain from the sale or
exchange of a capital asset held for more than one year. Sec. 1222(3).
- 60 -
[*60] he believed that the “structure for the sale would produce long term capital
gain treatment of the proceeds for each of them [i.e., each of Makric’s
shareholders] for federal income tax purposes.” If TS3 was wrong about this,31
that meant that TS3 made a mistake about the tax consequences of the agreement.
A mistake concerning the legal or tax consequences of an agreement is not the
type of mistake that reformation can remedy. See Hamlin’s Trust v.
Commissioner, 209 F.2d 761, 765 (10th Cir. 1954), aff’g 19 T.C. 718 (1953);
M. Weingold & Co. v. Commissioner, T.C. Memo. 1977-73, 36 T.C.M.
329, 335 (1977); Marsh v. Marsh, 949 S.W.2d 734, 745 (Tex. App.--Houston
[14th Dist.] 1997).
The IRS argues that this Court is not the proper court for Makric to seek
reformation of the stock purchase agreement. We need not address this contention
because, for reasons already explained, Makric has not shown that the relevant
31
This belief may have been incorrect. The sale of Alpha did produce long-
term capital gain, as Brunson said. Makric must recognize capital gain on the sale
of Alpha. Its resulting tax liability would be economically borne by Makric’s
shareholders. However, Makric’s shareholders received some of the proceeds of
the sale of Alpha by Makric. Therefore, they may be considered to have received
a constructive distribution from Makric. See supra note 29. The individual
shareholders arguably face their own tax liability from the constructive
distribution, in addition to the capital gain that Makric must recognize.
- 61 -
[*61] portions of the stock purchase agreement were the result of mutual
mistake.32 Makric has not advanced any other theory by which reformation is
justified. Thus, we conclude that the 2008 agreement should not be reformed to be
the sale of Makric stock.
C. Even if Makric’s substance-over-form argument was not barred by
the Danielson rule, the evidence in the record shows that the
substance of the transaction is the sale by Makric of Alpha stock.
Even if the merits of Makric’s substance-over-form argument should be
reached, despite the Danielson rule, the argument lacks merit. Makric argues that
the transaction was, in substance, the sale of Makric because Makric’s
shareholders intended to sell Makric. This premise would not give us a basis for
concluding that the substance of the transaction was the sale of Makric. Under the
substance-over-form doctrine, the tax consequences of a transaction are not
32
The IRS’s contention implicates Deshotels v. United States, 450 F.2d 961,
967 (5th Cir. 1971), in which the Fifth Circuit held that an unambiguous contract
cannot be reformed where a party to the contract offers only extrinsic evidence to
reform the contract and the other party to the contract is not a party to the case.
See also State Pipe & Nipple Corp. v. Commissioner, T.C. Memo. 1983-339, 46
T.C.M. 414, 415 (1983). Deshotels appears to be relevant to this case
because (1) Makric offers only extrinsic evidence (an email and testimony) to
prove mutual mistake about the stock purchase agreement, (2) the agreement is
unambiguous, and (3) the other party to the stock purchase agreement (TS3) is not
a party to this case. In our view, Deshotels serves as an alternative ground for our
holding that Makric has made an insufficient showing that a finding of a mutual
mistake is warranted.
- 62 -
[*62] necessarily governed by the intent of a party to that transaction. See PPL
Corp. v. Commissioner, 569 U.S. __, __, 133 S. Ct. 1897, 1905 (2013); Frank
Lyon Co. v. United States, 435 U.S. 561, 573 (1978). Here, the stock purchase
agreement and the circumstances surrounding its execution make plain that the
transaction was both in form and substance the sale of Alpha by Makric. The
relevant portions of the stock purchase agreement (i.e., the portions identifying the
seller and the stock that would be transferred) were not mere recitals, but were the
very substance of the underlying sale. See generally Mittleman v. Commissioner,
56 T.C. 171, 175-177 (1971), aff’d, 464 F.2d 1393 (3d Cir. 1972). Specifically,
the parties agreed to the following: “Seller [defined as Makric] agrees to sell to
Buyer [defined as TS3], and Buyer agrees to purchase from Seller, all of the issued
and outstanding shares (the ‘Shares’) of common stock * * * of the Company
[defined as Alpha]”. Makric has not invited our attention to any provision in the
stock purchase agreement that is inconsistent with this statement, nor are we aware
of any such provision. Upon execution of the stock purchase agreement, Makric
transferred Alpha stock to TS3, and Makric’s shareholders continued to own
Makric. Accordingly, we conclude that the transaction was, both in form and in
substance, the sale of Alpha stock by Makric.
- 63 -
[*63] Makric emphasizes that both Makric and TS3 were amenable to structuring
the transaction as a sale of Makric. Makric points to the affidavit from TS3’s
Chairman, Brunson, which stated that: (1) TS3 was aware that Makric’s
shareholders were trying to achieve a particular tax result, (2) TS3 would have
accommodated a sale structure that would have achieved that tax result, and (3) he
believed the sale was structured in a way that achieved that tax result. This
affidavit, however, does no more than show that the sale could have been
structured differently had the parties negotiated for and agreed to a different
structure. It does not alter the terms or substance of the agreement that the parties
in fact reached, the purchase of Alpha by TS3. See Pittsburgh Realty Inv. Trust v.
Commissioner, 67 T.C. 260, 275 (1976).33
2. Penalty
The IRS determined that Makric is liable for an accuracy-related penalty
under section 6662. Section 6662(a) and (b)(2) imposes a penalty equal to 20% of
an underpayment of tax that is attributable to a substantial understatement of
income tax. An understatement is defined as the excess of the correct amount of
tax over the amount of the tax which is shown on the return. Sec. 6662(d)(2)(A).
33
Our holding in part 1.C, that the substance of transaction was the sale of
Alpha stock by Makric, is an alternative to our main holding in part 1.A that
Makric is barred from asserting the substance-over-form doctrine.
- 64 -
[*64] In the case of a corporation, an understatement is substantial if (1) it exceeds
10% of the correct tax and (2) it exceeds $10,000. Sec. 6662(d)(1)(B).
Under section 7491(c), the IRS bears the burden of production with respect
to the section-6662(a) penalty. This means that the IRS “must come forward with
sufficient evidence indicating that it is appropriate to impose the relevant penalty.”
See Higbee v. Commissioner, 116 T.C. 446. The IRS has met that burden. The
understatement is equal to $2,839,780, which is $3,476,671 (the correct amount of
tax) minus $636,891 (the tax shown on the return). The understatement,
$2,839,780, exceeds $10,000. It also exceeds 10% of the correct amount of tax
(i.e., 10% of $3,476,671, or $347,667). Makric’s understatement is thus
substantial. See sec. 6662(d)(1)(B).
Even if an understatement is substantial, the section-6662 penalty is not
imposed on any portion of the underpayment with respect to which the taxpayer
acted with reasonable cause and in good faith.34 Sec. 6664(c)(1). The taxpayer
has the burden of showing that it acted with reasonable cause and in good faith.
Higbee v. Commissioner, 116 T.C. 449. Reasonable cause requires the taxpayer
to have exercised ordinary business care and prudence as to the disputed item--in
34
As the notice of deficiency determined, the amount of the underpayment in
this case is $2,839,780, the same as the amount of the understatement.
- 65 -
[*65] this case, gain from the sale of Alpha. See generally United States v. Boyle,
469 U.S. 241 (1985); Gould v. Commissioner, 139 T.C. 418, 459 (2012), aff’d,
552 F. App’x 250 (4th Cir. 2014).
The most important factor in determining good faith is the extent of the
taxpayer’s effort to report the correct amount of tax on the return.35 A taxpayer
may demonstrate good faith if it reasonably relied on the advice of a tax adviser.
Sec. 1.6664-4(b)(1), Income Tax Regs. To reasonably rely on the advice of a tax
adviser, however, the taxpayer must take reasonable steps to ensure that the tax
adviser has all of the relevant facts.36 A taxpayer that prepares its returns without
relying on the advice of a tax adviser can also demonstrate that its tax reporting
was in good faith, provided, however, that the taxpayer reasonably ensured that it
used correct information to prepare its return.37 Thus, whether a taxpayer relies on
35
The relevant regulation provides: “Generally, the most important factor is
the extent of the taxpayer’s effort to assess the taxpayer’s proper tax liability.”
Sec. 1.6664-4(b)(1), Income Tax Regs.
36
The regulation provides: “For example, the advice must not be based upon
a representation or assumption which the taxpayer knows, or has reason to know,
is unlikely to be true, such as an inaccurate representation or assumption”. Sec.
1.6664-4(c)(1)(ii), Income Tax Regs.; see also Neonatology Assocs., P.A. v.
Commissioner, 115 T.C. 43, 99 (2000) (taxpayer must provide necessary and
accurate information to the adviser), aff’d, 299 F.3d 221 (3d Cir. 2002).
37
The relevant regulation provides: “Circumstances that may indicate
(continued...)
- 66 -
[*66] a tax adviser or not, the taxpayer must reasonably ensure that its return is
based on correct factual assumptions.
Makric contends that its failure to report its gain on the sale of Alpha on its
2008 short-year return was in good faith because it relied on Harper to prepare the
return. Harper prepared Makric’s tax return for its short year 2008. The return did
not report gain from the sale of Alpha. This reporting is correct only if one
assumes that Makric did not sell Alpha. Setting aside the question of whether
Harper gave “advice” to Makric,38 one issue with Makric’s alleged reliance on
Harper relates to the source of Harper’s assumption that Makric did not sell Alpha.
37
(...continued)
reasonable cause and good faith include an honest misunderstanding of fact or law
that is reasonable in light of all of the facts and circumstances, including the
experience, knowledge, and education of the taxpayer.” Sec. 1.6664-4(b)(1),
Income Tax Regs. The regulation gives the following example of an honest
misunderstanding: “[R]eliance on erroneous information * * * inadvertently
included in data compiled by the various divisions of a multidivisional corporation
or in financial books and records prepared by those divisions generally indicates
reasonable cause and good faith, provided the corporation employed internal
controls and procedures, reasonable under the circumstances, that were designed
to identity such factual errors.” Id.
38
Harper did not give formal advice to Makric. He only prepared Makric’s
return. Therefore one might question whether Harper provided “advice” to
Makric. See sec. 1.6664-4(c)(2), Income Tax Regs. (defining advice for this
purpose as a communication setting forth the “analysis” and “conclusion” of the
professional tax adviser).
- 67 -
[*67] Harper was told that this assumption was correct by Baudler, Makric’s CFO.
The question we resolve, therefore, is whether Baudler took reasonable steps to
determine whether this assumption was correct.
On the record, we are not persuaded that Baudler took reasonable steps to
determine whether Makric had sold Alpha. Baudler was informed by an erroneous
email from O’Brien, one of Makric’s investment bankers, that the final agreement
was for the sale of Makric, not Alpha. We do not know whether Baudler relied on
O’Brien’s email to come to his conclusion that Makric sold Alpha. Even if he did,
we cannot say it was reasonable to do so.39 Perhaps Baudler should have read the
agreement himself or consulted a lawyer such as Miller. Another fact one might
consider is that Kisner, Makric’s CEO, thought that the stock purchase agreement
was for the sale of Makric (just as O’Brien thought). However, nothing shows that
Baudler relied on Kisner’s misunderstanding of the stock purchase agreement in
concluding that Makric had not sold Alpha. Even if Baudler had relied on Kisner,
we would not conclude that it was reasonable to so. Kisner was Makric’s CEO,
not Makric’s lawyer. Makric’s lawyer was Miller. It was Miller whom one would
39
The record reveals nothing about O’Brien’s capabilities and experience or
what Baudler knew about them.
- 68 -
[*68] expect to be in a position to understand the stock purchase agreement.40
Kisner testified that Miller did not tell him that the stock purchase agreement
provided for the sale of Alpha; however, the record is silent as to what Miller
affirmatively told Kisner or Baudler in regard to the agreement. Thus, we cannot
conclude that Baudler took reasonable steps to determine whether Makric had sold
Alpha before he told Harper that Makric had not sold Alpha.
Upon review of the record, we conclude that Makric has not shown that the
underpayment was the result of good faith and reasonable cause.
In reaching our conclusions, we have considered all arguments made by the
parties, and to the extent that we have not addressed them, we find them to be
moot, irrelevant, or without merit.
To reflect the foregoing,
Decision will be entered
for respondent.
40
Miller was largely absent during the later stages of the negotiations
between Makric and TS3 because he was injured in a car accident a few months
before the closing of the sale. His firm apparently remained involved in the
negotiations while he was absent, although the extent of its involvement is
unclear. Miller did review the stock purchase agreement and the drafts that
immediately preceded it (all of which called for the sale of Alpha to TS3). Neither
Miller nor anyone from his firm was called as a witness.