In New Capital Fire, Inc. v. Commissioner, T.C. Memo. 2021-67, the Tax Court held that capital gains from a merger are reportable on the acquirer’s (petitioner) return, not on the target entity’s return, and the petitioner is estopped from changing the reporting because the target entity had not previously reported it and relied upon the statute of limitations baring assessment in a closed year.
The court applied the well-established doctrine of equitable estoppel. This doctrine permits a court to rule based on fairness where a party acted unjustly. A party cannot act wrongly, and then take advantage of its own wrongdoing. The court said that the taxpayer in New Capital Fire knowingly misrepresented facts relating to the merger such that the IRS did not know or have reason to know the correct facts until the assessment statute expired.
The underlying tax issue
The underlying issue revolved around a merger. Capital Fire merged into New Capital Fire in 2002. New Capital Fire then sold the assets it had received in the merger.
Generally, in a merger treated as a tax-deferred corporate reorganization the acquiring corporation takes a carryover basis in the assets it receives in the merger, increased by any gain the transferor recognizes on the exchange. Refer to section 362. Accordingly, to the extent that Capital Fire recognized gain on the merger, New Capital Fire could increase its basis in the assets it acquired in the merger.
Initially, Capital Fire and New Capital Fire claimed that the merger qualified as a tax-free reorganization (an ‘F reorganization’ – a mere change in form), and so Capital Fire would not need to recognize gain, while New Capital Fire would take a carryover basis in Capital Fire’s assets. Accordingly, New Capital Fire would recognize gain on its sale of the assets based on the assets’ fair market value (FMV) less their carryover bases. New Capital Fire initially reported this gain on its tax return.
The IRS, however, determined that the merger was actually taxable and it did not qualify under the reorganization provisions. According to the IRS, Capital Fire should have recognized gain on its transfer of assets to New Capital Fire. Capital Fire contested that determination in the Tax Court, and the court ruled in 2017 that the statute of limitations barred assessment of that deficiency (the court therefore did not reach the substance of the issue of whether the merger was a taxable event). Please refer to RSM Tax Alert regarding that ruling.
Once the Tax Court ruled that Capital Fire’s 2002 tax year was closed, New Capital Fire amended its petition and reversed all of its positions. It now claimed that the merger was a taxable event and that Capital Fire should have recognized the gains. This is what the IRS had argued, but now the statute of limitations barred assessment against Capital Fire. Consequently, under the amended petition, New Capital Fire would receive the assets with a stepped–up basis and the IRS would not be able to assess tax against Capital Fire’s gain.
The Doctrine of Equitable Estoppel
Although New Capital Fire claimed its original position was an ‘innocent mistake’, the Tax Court applied the doctrine of equitable estoppel and ruled that New Capital Fire may not change its reporting of the Capital Fire asset basis it had acquired in the merger.
Following the Goslen Rule, the court applied the equitable estoppel doctrine as interpreted by the Court of Appeals for the Second Circuit. The doctrine requires four elements:
- The taxpayer made a false representation or engaged in a wrongful misleading silence;
- The error originated in a statement of fact and not mistake of law;
- The IRS did not know the correct facts; and
- The IRS was adversely affected by the taxpayer’s acts or statements.
In applying the factors, the court determined that New Capital Fire had knowingly misrepresented facts relating to the first merger, had concealed that the merger occurred in two steps, and had misled the IRS through wrongful misleading silence. The court noted that New Capital Fire’s reporting “was not an innocent mistake but a deliberate and purposeful representation that was a part of a broader scheme to avoid tax on the built-in gains.”
The court added that the IRS did not know or have reason to know the correct facts before the limitations period expired for Capital Fire’s 2002 tax year. Furthermore, the court said that the IRS would be adversely affected if New Capital were permitted to change its reporting because the court had previously ruled that the statute of limitation barred the IRS from assessing tax against Capital Fire. This would result in both New Fire and Capital Fire escaping tax on the asset sale, an inequitable result under these facts.
Taxpayers should consult with their tax advisors before taking positions in a merger or any other transaction that could trigger application of the equitable estoppel doctrine.