Not knowing the details of a business transaction sounds preposterous on its face, especially when the ignorant taxpayer is the party which formulated the transaction. In the case of Makric Enterprises, Inc. v. Commissioner, TC Memo 2016-44, a failure to make sure that the right corporation was sold as part of the agreement literally proved costly to the taxpayers involved, to the tune of $2,839,780.
This tax matter involved two corporations. One of which was a holding company (Makric Enterprises, Inc.) which owned only one asset, the stock of a wholly owned subsidiary (Alpha Circuits, Inc.). A third party expressed interest in purchasing the business conducted by Alpha.
The individual shareholders initally formulated the sales agreement with the goal of having their gain on the disposition of Alpha taxed as a capital gain with tax paid only at the individual level. The corporation’s accountant examined the transaction and concluded that the sale as presently formulated would not achieve this desired result, further concluding it was uncertain whether the shareholders would inherit the holding period of the dissolved parent when they received the stock, or an entirely new holding period would begin, which would result in a large short-term capital gain.
The deal was restructured and instead of the buyer purchasing the subsidiary, it would purchase parent company (Makric) stock, which owned 100% of the subsidiary’s shares (Alpha). The agreement was redrafted showing Makric as the seller of the stock of Alpha—a “third structure” as the Tax Court referred to it, that was neither the original structure nor the one that the shareholders had requested be used after they became concerned about the holding period.
The deal was executed despite that its structure clearly did not accomplish the goal of a single gain that would be taxed at individual capital gain rates, rather, it created a gain in the C corporation parent. This subjected the gain to tax at a much higher rate and leaving the sellers with a corporation with cash in-hand which would create another tax at the shareholder level when they received payment from Makric. What a mess.
Although a seller’s representative reviewed the agreement intermittently and before its execution, he or she failed to realize that Makric was the seller of the stock. Even worse, the accountant, who was the individual that had first raised concerns about the deal’s structure, prepared Makric’s short period return without consulting the actual agreement, and instead worked from his understanding of how the agreement was supposed to be structured per Makric’s CFO. The accountant failed to show the sale of Alpha on Makric’s corporate’s return. He or she did indicate a sale of Makric stock on the shareholders’ individual returns, which showed long-term capital gains.
The Tax Court held that the stock purchase agreement unambiguously required the sale of a wholly owned subsidiary and the taxpayer was therefore barred from asserting that the transaction was, in substance, the sale of the parent company. As a result, the court determined the parent company recognized gain on the sale and upheld deficiencies and penalties.
Further, the court stated that reformation cannot provide a remedy where a buyer is mistaken about the tax consequences of a certain transaction. The agreement clearly held that the parent was selling stock of its subsidiary. The shareholders signing the agreement never raised any objections despite reviewing eleven drafts which was a a point in time after they agreed to change the structure of the transaction.
If you are about to engage in some business transaction and have questions about its tax consequences, call THE TAX EXPERTS at the Thorgood Law Firm www.thorgoodlaw.com. For a FREE consultation, please call 212-490-0704.
