Gerdau Macsteel, Inc. v. Commissioner

• Decision Date: 30 August 2012
• Docket Number: 139 T.C. No. 5,Docket No. 12642-01
• Court: U.S. Tax Court
• Parties: GERDAU MACSTEEL, INC. & AFFILIATED SUBSIDIARIES, Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent

GERDAU MACSTEEL, INC. & AFFILIATED SUBSIDIARIES, Petitioners

v.COMMISSIONER OF INTERNAL REVENUE, Respondent

139 T.C. No. 5

Docket No. 12642-01

UNITED STATES TAX COURT

Filed August 30, 2012

Q and its subsidiaries are an affiliated group (Ps). During Ps' taxable year ended Oct. 31, 1997 (TYE 1997), Ps actively pursued Q's making of two sales expected to result in millions of dollars in taxable capital gains for TYE 1997 and TYE 1998. Ps' outside accountants (D), mindful of the expected gains, approached Ps with an idea that D promoted to create a multimillion-dollar tax loss to shelter the gains for Federal income tax purposes. Q has a group benefits plan under which Q provides health and welfare benefits to its eligible employees and their dependents. Q's subsidiaries included two inactive corporations, QS and QW. In order to report a desired tax loss of approximately $38 million to shelter Ps' taxable gains from Federal income tax, Ps entered into a series of interrelated transactions in late October 1997 that included, among others, a recapitalization of QW (renamed QHMC), and Q's transfer to QS (and then QS' transfer to QHMC in exchange for newly issued class C stock) of $38 million and the assumption of certain contingent liabilities (i.e., Q's obligations to pay medical plan benefits (MPBs) under Q's benefits plan) which Ps valued at$37,989,000. Ps reported that the transfers qualified for nonrecognition under I.R.C. sec. 351(a) and that QS' basis in the class C stock was determined by taking into account the $38 million transferred to QHMC but not the value of the MPBs. Each share of class C stock was entitled to receive annual dividends of $9.50 and was not allowed to receive any other dividend. Upon the class C stock's redemption, which QHMC and the class C shareholders could respectively cause five and seven years after the stock's issuance, the class C shareholders were entitled to receive for each share the greater of $125 or an amount equal to the lesser of a percent of any cumulative cost savings in MPBs or of QHMC's book net equity. The transactions were structured in such a way that it was highly likely when the class C stock was issued that the class C stock would be redeemed within the five- and seven-year periods and that the redemption payment would be $125 per share. Shortly after the transfer to QHMC, QS sold its class C stock to a former employee of a Q subsidiary for $11,000 (the difference between $38 million and $37,989,000). Ps claimed that QS realized a $37,989,000 short-term capital loss on the sale, and Ps used that loss to offset Ps' unrelated capital gains totaling a similar amount.

After the transactions, Q continued to process claims for MPBs, and Q's handling of the claims transferred to QHMC was the same as the handling of claims with respect to individuals whose MPBs were not transferred to QHMC. QHMC's reimbursements to Q for claims were made through intercompany entries recorded on Q's books as a receivable due from QHMC and on QHMC's books as a payable. QHMC lent the $38 million to a subsidiary of Ps, and QHMC eventually reimbursed Q for the MPBs when QHMC received payments on the loan.

Held: The class C stock is nonqualified preferred stock under I.R.C. sec. 351(g) because it "does not participate in corporate growth to any significant extent" within the meaning of I.R.C. sec. 351(g)(3)(A). Accordingly, pursuant to the agreement of the parties, Ps are not entitled to deduct the claimed capital loss.

Held, further, the transactions underlying the claimed capital loss lacked economic substance. Accordingly, $352,251 in fees incurred to effect the transactions is not deductible as an ordinary and necessary business expense under I.R.C. sec. 162.

Held, further, in accordance with Heasley v. Commissioner, 902 F.2d 380 (5th Cir. 1990), rev'g T.C. Memo. 1988-408, and Todd v. Commissioner, 862 F.2d 540 (5th Cir. 1988), aff'g 89 T.C. 912 (1987), which we follow under Golsen v. Commissioner, 54 T.C. 742, 757 (1970), aff'd, 445 F.2d 985 (10th Cir. 1971), Ps are not liable for the 40% accuracy-related penalty under I.R.C. sec. 6662(h) that R determined applied to any underpayment of tax attributable to the disallowed claimed capital loss.

Held, further, Ps are liable for the 20% accuracy-related penalty under I.R.C. section 6662(a) to the extent of the underpayment of tax attributable to the disallowed claimed capital loss, and Ps are liable for that 20% accuracy-related penalty to the extent of the underpayment of tax attributable to the disallowed deduction for the fees.

Jasper G. Taylor III, Lawrence Kalinec, Richard L. Hunn, Shawn R. O'Brien, and Stephen M. Feldhaus, for petitioners.

Dennis M. Kelly and Jill A. Frisch, for respondent.

CONTENTS

FINDINGS OF FACT ............................................. 12

I. Preliminary Matters ..................................... 12

II. Quanex .............................................. 12

III. Petitioners Expectation of Realizing Millions of Dollars in Taxable Capital Gains During TYE 1997 and TYE 1998 ......... 14

IV. The Plan .............................................16

A. Background ........................................ 16

B. Health Care Offerings ................................ 16

C. Health Care Cost Management Strategies .................17

1. Background ................................... 17

2. CS ..........................................18

a. Background .............................. 18

b. Quanex's Introduction to CS ................. 18

c. CS Fee Arrangements ...................... 20

V. D&T................................................20

VI. Other Relevant Quanex Employees/Officers ..................22

A. Rose ............................................. 22

B. Parikh ............................................ 22

C. Royce ............................................ 23

VII. Liability Management Companies .......................... 25

A. Overview .......................................... 25

B. Rev. Rul. 95-74 ..................................... 25

C. D&T's Matrix......................................26

1. Background ................................... 26

2. DDCL ....................................... 26

3. Singer Promotes DDCL-Type Transaction to Quanex .... 30

VIII. Sales of LaSalle and Tube Group ..........................31

A. LaSalle Sale ........................................ 31

B. Tube Group Sale .................................... 33

IX. Engaging D&T To Structure QHMC Transactions..............33

X. Developing QHMC Transactions...........................38

A. Quanex's First Proposal to CS..........................38

B. D&T's First Outline of Proposed Joint Venture Transactions ... 40

C. WW..............................................42

1. In General .................................... 42

2. FASB 106 ....................................43

3. WW's First Present Value Calculation of Quanex's Health Care Benefits ............................ 44

D. D&T's Revisions To Proposed Transaction ................ 47

1. August 6-7, 1997, Revisions.......................47

2. August 13, 1997, Revisions and Cashflow Analysis.....51

3. August 22, 1997, Revisions .......................54

E. Quanex's Negotiations With CS.........................55

F. WW's Present Value Calculation Revisions ................ 60

G. Patrick Wannell.....................................63

1. Background ...................................63

2. Wannell and Health Care Costs at LaSalle ............ 64

3. Quanex's Offer to Wannell ........................ 65

H. D&T's Revised Cashflow Model........................67

XI. Executing QHMC Transactions ............................ 71

A. Quanex's October 21-22, 1997, Board Meeting.............71

B. October 23, 1997 .................................... 75

1. QW Recapitalization ............................75

2. Amendment and Restatement of QW's Certificate of Incorporation ....................... 76

a. Background .............................. 76

b. Dividend Rights ........................... 77

c. Preferences Upon Liquidation.................78

d. Voting Rights ............................. 80

e. Call Rights ............................... 80

f. Put Rights ................................ 81

3. Quanex's Transfer of QW Stock and Cash to QHMC in Exchange for Class A and Class B Stocks and

Election of Directors ............................ 82

4. Quanex's Transfer of Cash and MPB Obligations to QS in Exchange for QS Stock ..................... 83

C. October 24, 1997 .................................... 84

1. Consulting Agreement Between Quanex and CS ........ 84

2. CS' Transfer of Cash to Quanex in Exchange for Class B Stock ....................... 86

3. Class B Directors ............................... 88

D. October 25, 1997 .................................... 88

1. CS' Transfer of Cash to QHMC in Exchange for Class C Stock ....................... 88

2. QS' Transfer of Cash and MPBs to QHMC in Exchange for Class C Stock ....................... 89

3. MPB Selection ................................. 90

4. Class C Director ................................ 92

E. October 28, 1997: QHMC's Transfer of Cash to Piper in Exchange for Promissory Note ................... 92F. October 30, 1997: QS' Transfer of Class C Stock to Wannell In Exchange for Cash .......................... 94

XII. Posttransaction Activities ................................ 95

A. D&T's Draft Opinion ................................95

B. 1997 Return ........................................ 98

1. Background ................................... 98

2. Income ....................................... 99

3. Enclosed Statements............................100

a. Overview ............................... 100

b. Statement 20 ............................100

c. Statement 22.............................101

d. Statement 23 ............................ 101

e. Statement 24.............................101

4. Deduction of Fees ............................. 102

C. WW's 1999 Valuations..............................103

D. D&T's 1999

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