Limitations on taxpayers' ability to disavow tax consequences of contract terms.

AuthorKeenan, John

A fundamental principle of federal income taxation is that the tax consequences of a transaction are determined based on its substance rather than its form. To this end, the government has the ability to look beyond the form of a transaction to its economic substance in determining its tax consequences.

Taxpayers have also asserted the substance-over-form argument to disavow the tax consequences of contracts into which they entered. Often these taxpayers bargained away tax advantages as part of the underlying transaction and then attempted to reclaim the tax benefits by recharacterizing the transaction for tax purposes on their income tax return. While the government is entitled to look through the form of a transaction to its economic substance, taxpayers are generally not allowed to disavow the form of their transactions.

Much of the case law addressing this issue developed in the purchase price allocation context. Consider the following scenario: A seller of stock agrees with the buyer to allocate a portion of the purchase price to a covenant not to compete, which is amortizable to the buyer but taxable to the seller as ordinary income. The seller subsequently takes the position that the entire purchase price should be treated as a capital gain, arguing that the agreement to allocate a portion of the purchase price to a covenant not to compete bore no relationship to economic reality.

The circuit courts have split on the issue of when a taxpayer should be able to disavow the form of his or her transaction and assert that the substance of the transaction controls. Some courts have adopted the "strong proof" standard and others the more strict Danielson standard. In a recent case, the New Hampshire District Court applied the strong-proof standard and ruled that a former consulting partner at Ernst & Young U.S., LLC (E&Y), who agreed to exchange her interest in E&Y for stock in Cap Gemini, S.A. (Cap Gemini), was bound by the valuation of her Cap Gemini restricted shares specified in the exchange transaction documents (see Berry, No. 06-CV-211-JD (D.N.H. 10/2/08)).

The Danielson Standard

The Danielson standard has been adopted by the Third, Fifth, Sixth, Eleventh, and Federal Circuits (with some acceptance in the Second Circuit). In Danielson, 378 F.2d 771 (3d Cir. 1967), the stock purchase agreement entered into by the seller and the purchaser allocated a portion of the purchase price to a covenant not to compete. When filing his individual...

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