On Feb. 2, 2021, the Tax Court issued a Memorandum Decision for the case of Complex Media, Inc. v. Commissioner. The case originated from a 2015 IRS notice to Complex Media, Inc. (CMI) that stated that CMI had deficiencies in its Federal income tax for calendar years 2010 to 2012. The IRS was disallowing amortization deductions on intangible assets that it had acquired from Complex Media Holdings, LLC (CMH).
Fact pattern of the Complex Media case
The parties to the transaction at issue in the case (the transaction) were CMI, a newly formed corporation; CMH, a partnership primarily holding two limited liability companies (LLCs) actively engaged in business (the transferred business); and OnNetworks, Inc. (ONI), an entity that had cash that it was looking to invest in CMH. One of CMH’s partners, Mr. Gerszberg, was not interested in the transaction, and sought to exit his investment in CMH. However, prior to the transaction, CMH did not have the funds to redeem his partnership interest.
Prior to the transaction, the LLCs of CMH transferred to it direct ownership of the assets of the transferred business. The transaction was consummated in two steps, with each step occurring simultaneously: 1) CMI formed a transitory subsidiary that merged into ONI, with ONI surviving, and with the preferred shareholders of ONI exchanging their stock for preferred shares of CMI; and 2) CMH contributed to CMI the assets of the Transferred Business in exchange for shares of CMI’s common stock. Immediately after the transaction and as part of the overall transaction, CMI redeemed a portion of its shares held by CMH for $3.0 million, paid as $2.7 million upfront and $300,000 to be paid at a set future date. CMH used the cash to redeem out all of Mr. Gerszberg’s partnership interest. On their respective tax returns, both CMI and CMH included disclosure statements treating the transaction as a section 351 transaction. CMI reported the $3.0 million as taxable boot in the section 351 transfer, thereby creating an intangible asset amortizable over 15 years. However, CMH failed to include either the $2.7 million or $300 thousand payments as income on its return.
The IRS challenged the deductions associated with the intangible, contending that CMI could not treat the cash and deferred payment rights as taxable boot in a section 351 exchange. IRS took the position that the terms of the agreements it entered into treated the redemption as a separate transaction and that taxpayers must be bound by the form of their transactions.
Application of Law
The Tax Court explored the issue of whether or not the payment made by CMI to CMH should be considered boot in a section 351 transaction.
The Court discussed relevant case law, including the Danielson case (Commissioner v. Danielson, 378 F.2d 771 (3rd Cir. 1967)). The Court in that case determined that parties should be bound to the tax consequences of the agreements they enter into, unless they can show that the agreement should be altered or voided due to mistake, undue influence, fraud, duress, etc. This is often referred to as the nondisavowal principle, in that the taxpayer cannot disavow the form in which their transactions were structured. The Court further referenced the ‘strong proof’ standard, set forth in Ullman v. Commissioner (264 F.2d 305 (2d Cir. 1959)). Under this standard, a taxpayer may prove that it need not be bound to the tax consequences of the form of its agreements, but only if it has ‘strong proof’ that the agreement does not comport with actual economic reality. CMI argued that none of the policy concerns that underpin the Danielson case and the strong proof standard applies here, as all of the parties had treated the transaction as a section 351 transaction with boot. The Court agreed, and further held that it was not required to apply the Danielson rule, as it never had and because the instance case was not appealable to the Third Circuit. The Court found it dispositive that the nondisavowal principle is based upon the idea that a taxpayer’s ability to suggest an alternative transaction, that would have a more favorable tax result that the transaction carried out is not enough to entitle the taxpayer to the more favorable treatment.
The Court then turned to the question of whether a taxpayer is permitted to apply the step transaction doctrine, thereby disavowing the form of its transaction. The Court questioned if the substance-over-form doctrine is as available to a taxpayer as it is to the IRS Commissioner, or if a taxpayer has a greater showing to use that doctrine. The Court concluded that it could not justify imposing on the taxpayer a higher burden of proof than the general preponderance of the evidence standard. In order to utilize the substance-over-form doctrine, a taxpayer must show the same evidence as the Commissioner would, with the same requirement of a general preponderance of the evidence. However, a taxpayer must also show that the form of the transaction was not chosen for the purpose of obtaining tax benefits that are inconsistent with the tax benefits the taxpayer is seeking from disavowing the form. The taxpayer must show that the form was chosen for reasons other than providing those inconsistent tax benefits.
Upon review of the facts, the Court found that the parties could have structured the transaction in another form, namely acquiring the assets for stock and a note, and then calling the note for repayment immediately, but did not do so. Instead, the step-up in basis in corporate assets was an “afterthought” and was likely only determined by CMI’s accountants when they began to prepare the relevant tax return.1 The Court found that the circumstances of the case “give us no reason to think that the goals of the tax planning encompassed achievement of a tax benefit to any party that would be inconsistent with allowing petitioner a step-up in the bases of the assets it acquired from CMH.”2 The only tax planning that appeared to have done was related to preventing CMH’s continuing partners from recognizing gain from the redemption of Mr. Gerszberg’s interest. The transaction was structured in the form that it was because CMH needed to receive cash before it could redeem out Mr. Gerszberg’s partnership interest. Therefore, CMI is permitted to use the substance-over-form doctrine and step-transaction doctrine.
In applying the step-transaction doctrine, the Court found that the step-transaction doctrine requires them to disregard the issuance and immediate redemption of 1,875,000 shares of CMI common stock. Because it was immediately redeemed, these shares had no economic substance. The Court found it dispositive that the taxpayer is merely asking that the Court collapse two offsetting steps, rather than asking the Court to create new steps or create a transaction that did not actually occur. Therefore, the Court concludes that CMI will be treated as acquiring the assets of the transferred business in exchange for 3,124,000 shares of common stock, $2.7 million in cash and an obligation to make an additional payment of $300,000. CMI is therefore able to take annual amortization deductions on the resultant step-up in the basis of its assets. It is clear from this ruling that the Tax Court was not willing to give substance to stock that was ‘born to die’ and treat that stock as outstanding.
The Court also noted that if it were to allow a taxpayer to utilize the substance-over-form doctrine, the Commissioner could be whipsawed by one party being taxed on the form and another party being taxed on substance. In this case, CMH failed to report as section 351 taxable boot its receipt of $2.7 million in cash plus the right to receive $300,000. The Court found that “CMH did not report the transaction in a manner inconsistent with the petitioner’s claimed step-up in asset basis. Again, the partnership did not report the transaction at all.”3 It would seem that the IRS’ fatal mistake in the prosecution of this case was that it went after the wrong party. In hindsight, it perhaps should have audited CMH for failure to report the income from the receipt of boot in a section 351 transaction.
It should be noted that the Court has a lengthy discussion of the question if section 351 applied at all. The Transaction was structured as the simultaneous merger of CMI’s acquisition subsidiary into ONI and CMH’s contribution to CMI of assets. The Court said that a section 351 transaction may not have occurred because ONI’s preferred shareholders did not contribute property to CMI, but instead their stock in ONI was converted into preferred stock of CMI in the merger of CMI’s acquisition subsidiary into ONI. CMI received its common stock in ONI not from the preferred shareholders of ONI, but by conversion in the merger of its common stock into its acquisition subsidiary (refer to, for example, Rev. Rul. 90-95, where the existence of a transitory merger subsidiary was disregarded under the step-transaction doctrine. Refer also to Rev. Rul. 67-448, where an acquirer used a newly-formed subsidiary to acquire a target, through the merger of the subsidiary with and into target. The transitory subsidiary’s existence was ignored, and the transaction was treated as the acquisition by the buyer the target stock). This position by the Court is at odds with prior jurisprudence, where a section 351 transaction has been structured in this manner. Nonetheless, the Court did not challenge the treatment of the transaction as a section 351 transaction as neither CMI nor the IRS challenged this, and it would only be to CMI’s advantage to have the transaction treated as a taxable purchase and sale rather than a section 351 transaction.
After making its determination with respect to the section 351 transaction, the case goes on to explore the valuation of the deferred payment right, but we will not be delving into that discussion for purposes of this analysis.
1Complex Media, Inc., TC Memo 2021-14, 73.
3Complex Media, Inc., TC Memo 2021-14, 68.