U.S. v. Fletcher, 08-2173.

• Decision Date: 10 April 2009
• Docket Number: No. 08-2173.,08-2173.
• Citation: 562 F.3d 839
• Parties: UNITED STATES of America, Plaintiff-Appellee, v. Michael J. and Cynthia T. FLETCHER, Defendants-Appellants.
• Court: U.S. Court of Appeals — Seventh Circuit

562 F.3d 839

UNITED STATES of America, Plaintiff-Appellee, v. Michael J. and Cynthia T. FLETCHER, Defendants-Appellants.

No. 08-2173.

United States Court of Appeals, Seventh Circuit.

Argued October 30, 2008.

Decided April 10, 2009.

Francesca U. Tamami (argued), Department of Justice, Tax Div., Appellate Section, Washington, DC, for Plaintiff-Appellee.

George N. Vurdelja, Jr., Harrison & Held, LLP, Chicago, IL, Kenneth R. Boiarsky (argued), Kenneth R. Boiarsky, P.C., El Prado, NM, for Defendants-Appellants.

Before EASTERBROOK, Chief Judge, and RIPPLE and TINDER, Circuit Judges.

EASTERBROOK, Chief Judge.

Ernst & Young spun off its information-technology consulting group in 2000. Cap Gemini, S.A., a French corporation, bought this business and became Cap Gemini Ernst & Young, a multinational firm. Today it is known as Capgemini, and we use that name for the firm after the 2000 acquisition.

Consulting partners of Ernst & Young received shares in Capgemini in exchange for their partnership interests in Ernst & Young. This was not a like-kind exchange, so it was a taxable event for the partners. Because Ernst & Young and its partners expected shares in the new business to appreciate, they wanted all of the income to be recognized in 2000. That way any appreciation would be taxed as a capital gain. But Cap Gemini wanted to ensure the partners' loyalty to the new business; a consulting group depends on its staff, and if they left after taking the stock the business might be crippled. Transferring the shares in installments might address these subjects but also would make the transfers look like ordinary income — and, if the shares appreciated in the meantime, the partners would receive fewer. Ernst & Young and Cap Gemini decided that a transfer of all of the shares in 2000, subject to what amounted to an escrow, would preserve the tax benefits while serving business objectives. So the shares received in the transaction were restricted for almost five years: if a partner quit, was fired for cause, or went into competition with the new business, some or all of the shares could be forfeited.

Ernst & Young, Cap Gemini, and the partners agreed by contract that they would report the transaction as a partnership-for-shares swap in 2000, fully taxable in that year. The agreed-on characterization allowed Capgemini to take depreciation deductions, see 26 U.S.C. § 197, starting in 2000, and ensured consistent tax treatment of all parties. The Commissioner of Internal Revenue might have challenged the parties' characterization, see 26 U.S.C. § 269, but decided to accept it. Approximately 25% of the shares were sold in 2000 to generate cash that the partners used to pay their taxes; the remainder of the shares were held by Merrill Lynch subject to instructions from Capgemini until restrictions lapsed. Each ex-partner had a separate account for this purpose.

Cynthia Fletcher, one of Ernst & Young's consulting partners, voted for the transaction, signed the contract, moved to Capgemini, and received 16,500 shares in that business as payment for her partnership interest. The market value of these shares on the day the sale closed was about $2.5 million. Only 12,375 shares were deposited in the restricted account; the rest were sold for $653,756, which was distributed to Fletcher to cover taxes. In February 2001 Capgemini sent Fletcher a Form 1099-B reflecting that she had received $2,478,655 in stock, taxable at ordinary-income rates (save for some $91,000 attributable to § 751 property), from the sale of her partnership interest. She and her husband Michael (they filed a joint return) reported this income as received in 2000, just as her contract with Capgemini required. The couple's gross income for 2000 was reported as $3,733,180, on which they paid $972,121 in income tax.

Had the market price of stock in Capgemini risen, as the parties anticipated, that would have been a good outcome for Fletcher and the other ex-partners. But although Capgemini traded above 300 a share early in 2001, by 2003 it was below 50, where it has remained. (So far in 2009 it has traded for about 25.) This made the deal look bad in retrospect; the partners would have been better off had distribution of the stock been deferred. Fletcher quit in 2003. Although she left before the five years required by the contract, Capgemini waived its rights and directed Merrill Lynch to lift all restrictions on the stock in her account. Fletcher then filed an amended tax return for 2000. She now took the position that only the $653,756 distributed from the account was income in 2000. On her new view of matters, the rest of the income was not received until 2003, and the amount was much reduced in light of the lower market price of Capgemini shares in 2003. Apparently without checking how other taxpayers affected by the 2000 transaction had been treated, the Internal Revenue Service paid Fletcher a refund of about $387,000 plus interest. Contending that this refund had been mistaken, the United States filed this suit to get the money back. Similar litigation is pending in many other district courts — some suits by the United States, some by ex-partners who want refunds.

The IRS's principal argument is that Fletcher and the other ex-partners are bound by their own characterization of the transaction as one in which all shares were received in 2000. Having adopted this characterization with the goal of minimizing taxes, they must adhere to it even though market movements have made it disadvantageous, the United States insists. It relies principally on CIR v. Danielson, 378 F.2d 771 (3d Cir.1967), which held just this, and on a Danielson-like remark in Comdisco, Inc. v. United States, 756 F.2d 569, 577 (7th Cir. 1985): "[A] taxpayer generally may not disavow the form of a deal." Some courts have allowed taxpayers to disregard their own forms when "strong proof" shows that the economic reality was something else. See, e.g., Leslie S. Ray Insurance Agency, Inc. v. United States, 463 F.2d 210, 212 (1st Cir.1972); Ullman v. CIR, 264 F.2d 305, 308 (2d Cir.1959). We used the "strong proof" formulation in Kreider v. CIR, 762 F.2d 580, 586-87 (7th Cir.1985), though without mentioning either Comdisco or Danielson. The district court concluded that it was unnecessary to choose between these approaches (or their variants), because on any standard the parties set out to ensure that all income was recognized in 2000 — and although the Commissioner has some power to recharacterize transactions so that they match economic substance, taxpayers can't look through the forms they chose themselves in order to improve their tax treatment with the benefit of hindsight. See Gregory v. Helvering, 293 U.S. 465, 55 S.Ct. 266, 79 L.Ed. 596 (1935). See also Joseph Bankman, The Economic Substance Doctrine, 74 S. Cal. L.Rev. 5 (2000); Saul Levmore, Recharacterizations and the Nature of Theory in Corporate Tax Law, 136 U. Pa. L.Rev. 1019 (1988); David A. Weisbach, Formalism in the Tax Law, 66 U. Chi. L.Rev. 860 (1999). So the district court entered summary judgment for the United States and ordered Fletcher to repay the refund. 2008 WL 162758, 2008 U.S. Dist. LEXIS 3555 (N.D.Ill. Jan. 15, 2008).

Fletcher argues that she didn't "really" agree to the structure that Ernst & Young and Cap Gemini (and most of her partners) wanted in 2000. If she had voted no and refused to sign, she maintains, she would have been excluded from the economic benefits and might have been fired. If this is so, then she had a difficult choice to make; it does not relieve her of the choice's consequences. Hard choices may be gut-wrenching, but they are choices nonetheless. Even naïve people baffled by the fine print in contracts are held to their terms; a sophisticated business consultant who agrees to a multi-million-dollar transaction is not entitled to demand the deal's benefits while avoiding its detriments. The argument that Fletcher can avoid the terms as a matter of contract law is frivolous. All that matters now are the tax consequences of the contracts she signed.

That a transaction's form determines taxation is (or at least should be) common ground among the parties. If private parties structure their transaction as a sale of assets, they can't later treat it for tax purposes as if it had been a merger. CIR v. National Alfalfa Dehydrating & Milling Co., 417 U.S. 134, 94 S.Ct. 2129, 40 L.Ed.2d 717 (1974). Cf. Landreth Timber Co. v. Landreth, 471 U.S. 681, 105 S.Ct. 2297, 85 L.Ed.2d 692 (1985) (same principle in securities law). Parties who structure their transaction as a sale and leaseback can't treat it as a mortgage loan for tax purposes — though the Commissioner may be able to recharacterize it so that the tax treatment matches its economic substance. See Frank Lyon Co. v. United States, 435 U.S. 561, 98 S.Ct. 1291, 55 L.Ed.2d 550 (1978). If Cap Gemini transfers stock in 2000, cash-basis taxpayers such as Fletcher can't treat the income as received in 2001 or 2003, even though it would have been child's play to do the deal so that the income was received in those years.

The United States treats Fletcher as if she were trying to report an asset sale as a merger, or income received in 2000 as if it had been received in 2003. This is not, however, the sort of argument that Fletcher advances. She does not want to proceed as if the deal had different terms. She argues instead that the deal's actual terms have tax consequences different from those that her contracts with Ernst & Young and Cap Gemini required her to report in 2000. An example makes this clear. Suppose that Cap Gemini had deposited stock in the Merrill Lynch accounts in annual installments from 2000 through 2004, and that the parties had agreed to report that all income from the partnership-for-stock sale had been received in 2000 because the closing occurred that year. That agreement would not affect taxation. Private parties can contract...