Tax Court Recasts Transaction at Taxpayer’s Behest

Complex Media Inc. could recast its tax planning in a reorganization of media-related holdings, because the form of the transaction that the company sought to disavow was chosen for other than tax benefits.

The IRS disallowed amortization deductions claimed in relation to the transaction. Complex Media subsequently sought to recast the transaction in a manner that would allow the deductions in Complex Media, Inc. v. Commissioner, T.C. Memo. 2021-14.

Complex Media was formed in May 2009 to reorganize media-related holdings. Complex Media Holdings LLC (CMH) was organized in January 2008 to serve as a holding company for two limited liability companies that, between them, had previously conducted the “transferred business.”

CMH acquired from its two subsidiaries direct ownership of the assets of the transferred business. The “CM and JV Agreement” provided for the simultaneous occurrence of two events: (1) the merger of Complex Media’s acquisition subsidiary with and into OnNetworks Inc., and (2) CMH’s contribution to Complex Media of the assets of the transferred business.

In exchange for those assets, CMH was entitled to receive 4,999,000 shares of Complex Media’s common stock. In the merger, the former holders of preferred stock in the surviving corporation (OnNetworks) exchanged that stock for 2,731,808 preferred shares in Complex Media. OnNetworks’ previously outstanding common stock was canceled in the merger for no consideration.

The stock repurchase agreement provided for CMH’s sale of 1,875,000 of Complex Media’s common shares back to Complex Media in exchange for $3 million in cash, with $2.7 million to be paid at closing on Nov. 25, 2009, and an additional payment of $300,000 to be made on Jan. 3, 2011. Under the unit purchase agreement, partner Seth Gertzberg sold his interest in CMH back to the partnership in exchange for the consideration CMH was entitled to receive in redemption of 1,875,000 shares of Complex Media’s common stock—that is, an immediate payment of $2.7 million in cash and the partnership’s assignment to Gertzberg of its right to the additional future cash payment. Each of Complex Media’s common shares was entitled to one vote. Complex Media’s preferred stock was convertible into its common stock; and the preferred stock carried voting rights equal to those of the common stock into which it was convertible.

The amortization Complex Media reported in its return for each of the years in issue included $4,808 of amortization attributable to carryover bases of CMH’s assets. Complex Media’s returns claimed an additional $200,000 in respect of an “intangible asset” acquired on Nov. 25, 2009, with an unadjusted cost or basis of $3 million. The IRS disallowed Complex Media’s amortization deductions.

Amortizable Section 197 Intangibles

Tax code Section 197(a) allows taxpayers amortization deductions in respect of intangible assets that qualify as “amortizable Section 197 intangibles.” A taxpayer can recover its adjusted basis in an amortizable Section 197 intangible over 15 years beginning with the month of acquisition.

Section 351(a) provides: No gain or loss shall be recognized if property is transferred to a corporation by one or more persons solely in exchange for stock in such corporation and immediately after the exchange such person or persons are in control (within the meaning of Section 368(c)) of the corporation. If a shareholder receives non-stock consideration in an exchange that would otherwise qualify under Section 351(a), the shareholder cannot recognize any loss, but has to recognize any realized gain in an amount not in excess of the boot the shareholder receives. The transferee corporation’s basis in property received in a Section 351 exchange is “the same as it would be in the hands of the transferor, increased in the amount of gain recognized to the transferor on such transfer.” See Section 362(a).

Control ‘Immediately After’

CMH transferred property to Complex Media in exchange for common stock of Complex Media. But CMH was not, by itself, in control of Complex Media immediately after the exchange. Moreover, in applying the control requirement, case law required the court to take the effects of a redemption into account. CMH was not free to determine whether to keep 1,875,000 shares. Therefore, the court said, “we must take the redemption into account in determining whether CMH was in control” of Complex Media immediately after the exchange. See Intermountain Lumber Co. v. Commissioner.

Complex Media’s position that the control test was met rested on the proposition that the OnNetworks preferred shareholders were “transferors” in the transaction along with CMH. Complex Media concluded that the two transferors owned 100% of the outstanding stock of Complex Media.”

Contrary to Complex Media’s characterization of the transaction, OnNetworks’ preferred shareholders did not actually contribute any property to Complex Media. The stock in OnNetworks was converted into preferred stock of Complex Media in the merger of Complex Media’s acquisition subsidiary into OnNetworks.

Complex Media cited Revenue Ruling 67-448 for the proposition that “where a parent corporation forms a transitory merger subsidiary which merges into a target corporation, with the target surviving, and the parent then issues its stock to the former shareholders of the target, the transaction is treated as an acquisition by the parent of the stock of the target.”

Complex Media, the court said, failed to acknowledge material differences between the facts posited in Rev. Rul. 67-448 and those of its transaction. The stock that Complex Media ended up with—OnNetworks common stock—was not the type of stock held by those OnNetworks shareholders who participated in the merger. Although, the court said it was not convinced that Complex Media’s acquisition of the assets of the transferred business was part of an exchange to which Section 351 applied, “we will treat it as such in disposing of the cases before us.”

It followed that Complex Media stepped into CMH’s shoes in regard to the amortization of any amortizable Section 197 intangibles included in the transfer. The remaining issue was whether Complex Media was entitled to annual amortization of more than $4,808 in respect of amortizable Section 197 intangibles included among the assets of the transferred business by reason of an increase in the bases of those assets reflecting gain CMH recognized in the exchange.

Disavow Form?

The amortization deductions Complex Media claimed in respect of the assets it acquired from CMH rested on Complex Media’s disavowal of the form of the transactions. Under the form of the transaction, CMH’s transfer of the assets of the transferred business and Complex Media’s redemption of some of the common shares CMH was entitled to receive for those assets were separate transactions. The court said if it allowed Complex Media to disavow the form prescribed by the agreements, it would treat Complex Media as having acquired the assets in exchange for common shares and cash. Under that characterization of the transaction, Complex Media’s bases in the amortizable Section 197 intangibles included among the transferred assets would have been increased by that portion of CMH’s recognized gain attributable to those assets.

The IRS argued that Complex Media could not treat the cash and deferred payment right as boot in the Section 351 exchange. The agency described Complex Media as bound by the form of the transactions carried out under the agreements. According to the IRS, the “Danielson rule” prohibited Complex Media from challenging the express terms and contractual provisions of the agreements. See Commissioner v. Danielson. The court disagreed. “Since none of the policy considerations behind either the Danielson and the ‘strong proof’ rules are implicated, neither rule applies.” Complex Media was not attempting to change the terms of its transaction to obtain a tax treatment it did not bargain for with the other contracting parties. The court turned to the question of whether Complex Media was bound by the form of its transactions.

“A taxpayer’s ability to posit an alternative transaction that would have reached a more favorable tax result than a transaction actually carried out is not enough to entitle the taxpayer to the more favorable treatment,” the court said citing Commissioner v. Nat’l Alfalfa Dehyd. & Milling Co., which established only that Complex Media could not justify the claimed amortization deductions merely by observing that it would have been entitled to a step-up in the bases of the transferred assets had the cash and deferred payment right been boot in the Section 351 exchange.

In Schmitz v. Commissioner and Throndson v. Commissioner, the court suggested that the substance-over-form doctrine is equally available to taxpayers and the IRS. “As our case law has evolved, it has become more hospitable to taxpayers seeking to disavow the form of their transactions,” the court said. “[T]he additional burden the taxpayer has to meet in disavowing transactional form relates not to the quantum of evidence but instead to its content—not how much evidence but what that evidence must show…For the taxpayer to disavow the form...it must establish that the form of the transaction was not chosen for the purpose of obtaining tax benefits...that are inconsistent with those the taxpayer seeks through disregarding that form. When the form that the taxpayer seeks to disavow was chosen for reasons other than providing tax benefits inconsistent with those the taxpayers seeks, the policy concerns articulated in Danielson will not be present.”

If the transaction were taxed in accordance with its form, the redemption of Complex Media’s stock would be tested for dividend equivalence under Section 302, the court said. The redemption would be treated as a distribution of property to which Section 301 applies. By contrast, if the issuance and immediate redemption were disregarded, CMH would have recognized its realized gain to the extent of the value of the non-stock consideration it received. The court agreed with Complex Media that its attempt to disavow the form of its transaction raised no “whipsaw” potential. CMH did not report the transaction in a manner inconsistent with Complex Media’s claimed step-up in basis. The parties had an obvious non-tax reason for structuring the transactions as they did: Complex Media could not have paid CMH $2.7 million in cash in exchange for the assets it received from CMH, because it did not have any cash until after the exchange. Complex Media should be allowed to invoke the substance-over-form doctrine, the court said.

Step Transaction Doctrine

The court said, when applied, the doctrine required it to disregard the issuance and immediate redemption of 1,875,000 shares of Complex Media’s common stock. “The issuance of stock subject to an obligation that it be immediately redeemed has no economic substance.”

“If the step transaction doctrine has any potency, it necessarily applies to combine a first step that occurs when a preexisting obligation requires the immediate execution of a second step that undoes the first,” the court said. Complex Media asked only that the court collapse two offsetting steps. Complex Media was not asking that it invent new steps, or “synthesize” a transaction that did not, in fact, occur…The step transaction doctrine has more than enough elasticity to disregard the issuance and immediate redemption of 1,875,000” of Complex Media’s common stock. Therefore, by application of that doctrine, the court concluded that Complex Media “should be treated as having acquired the assets of the transferred business in exchange for shares, cash, and an obligation to make an additional payment.”

Basis in Intangibles

CMH’s failure to report the gain did not affect Complex Media’s bases in the assets. By its terms, Section 362(a) allows the transferee corporation in a Section 351 exchange to increase its bases in transferred assets by “the amount of gain recognized to the transferor,” without regard to whether the transferor reports that recognized gain.

A transferor who receives taxable boot in addition to stock of the transferee corporation must determine gain on an asset-by-asset basis. The IRS said in Rev. Rul. 68-55 that cash or other taxable boot should be allocated among the various assets in proportion to their relative fair market values. The transferor then must recognize gain in respect of each asset equal to the lesser of that asset’s realized gain or the value of the boot allocable to the asset.

Complex Media was not entitled to the full $3 million step-up in the bases of amortizable Section 197 intangibles that it claimed. The gain CMH was required to recognize under Section 351(b) was necessarily less than $3 million. The partnership’s right to receive $300,000 in a little over a year was not worth the full $300,000 future payment. In addition, the allocation of part of the cash and the value of the deferred payment right to assets other than amortizable Section 197 intangibles would reduce the gain recognized from CMH’s transfer of amortizable Section 197 intangibles and thus the resulting step-up in the bases of those assets. In allocating the boot Complex Media paid among the assets it received, the court assigned to goodwill and other Section 197 intangibles any excess of the $8 million agreed total value of the transferred assets over the estimated value of specifically identifiable assets that did not qualify as Section 197 intangibles.

The court believed it more appropriate to value the deferred payment right by discounting it at the underpayment rate established under Section 6621(a)(2) rather than at the applicable federal rate. The total value of the boot paid was $2.99 million. The court valued the Section 197 intangibles at $7.62 million. Because the amortizable Section 197 intangibles were worth 95.21% of the total asset value, the court assigned to those assets the same percentage of the boot CMH received in the Section 351 exchange. The court treated $2.85 million of the boot as allocable to amortizable Section 197 intangibles. The court treated CMH as having recognized gain in amortizable Section 197 intangibles equal to the full $2.85 million of boot allocable to those assets and allow Complex Media a corresponding increase to the bases of those assets.” Complex Media was allowed amortization deductions for each of the years in issue in respect of amortizable Section 197 intangibles acquired from CMH of $194,479 (i.e., $4,808 plus $2,845,063 divided by 15).

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.

Author Information

Robert Willens is president of the tax and consulting firm Robert Willens LLC in New York and an adjunct professor of finance at Columbia University Graduate School of Business.

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