Koch v. Commissioner of Revenue

• Decision Date: 09 February 1993
• Docket Number: No. 90-P-1147,90-P-1147
• Citation: 33 Mass.App.Ct. 707,605 N.E.2d 301
• Parties: William I. KOCH v. COMMISSIONER OF REVENUE.
• Court: Appeals Court of Massachusetts

Page 301

605 N.E.2d 301

33 Mass.App.Ct. 707

William I. KOCH v. COMMISSIONER OF REVENUE.

No. 90-P-1147.

Appeals Court of Massachusetts Suffolk.

Argued Jan. 22, 1992.

Decided Dec. 18, 1992.

Further Appellate Review Granted Feb. 9, 1993.

Eric A. Smith, Asst. Atty. Gen., for Commissioner of Revenue.

Edward F. Hines, Jr., Boston (Douglas W. Salvesen, with him), for taxpayer.

Before PERRETTA, KASS and IRELAND, JJ.

IRELAND, Justice.

If, in 1983, William I. Koch (William), rather than twenty-five Delaware S-corporations established by him, had sold all of William's stock in Koch Industries, Inc. (KII), to that company, William would have owed the Commonwealth $14,799,125 (plus interest) in income tax. William, however, attributed the gain on the sale of that stock to the S-corporations, of which he was the sole stockholder, and reported no Massachusetts tax due in connection with the sale of the stock. The Commissioner of Revenue (commissioner) attributed the sale to William and assessed a tax on the gain to him.

From that assessment, William sought an abatement, which was deemed denied by reason of the commissioner's inaction. See G.L. c. 58A, § 6, and c. 62C, § 39. An appeal to the Appellate Tax Board followed. That forum made findings of fact and concluded that William had effectively transferred his shares in KII to the Delaware S-corporations prior to the sale of those shares to the third party. Consequently, the board decided, William had not received payment for his KII shares and owed no State income tax for the capital gain attributable to the amount that KII paid for them. The commissioner sought judicial review in this court under G.L. c. 58A, § 13.

We conclude that: (1) the execution of a stock sale agreement on Saturday, June 4, 1983; (2) the placing of William's KII shares in escrow on the following Sunday, June 5, 1983; (3) the organization of the S-corporations in Delaware on June 8 and 9, 1983; (4) the assignment by William of his shares in KII on those dates; and (5) the closing of the sale on June 10, 1983, constituted a single integrated transaction executed in prearranged steps and that, as a matter of substance, William was the seller of the stock. Accordingly, the commissioner rightly assessed a tax to William and the decision of the Appellate Tax Board is to be reversed.

We summarize the facts found by the board, with some supplement from undisputed portions of the record. William, a Massachusetts resident, reported on his 1983 Federal tax return a capital gain of $275 million, ¹ which he attributed to twenty-five corporations incorporated in Delaware and elected tax treatment under Subchapter S of the Internal Revenue Code. He excluded the gain from his Massachusetts tax return. ² The commissioner disallowed William's exclusion of the gain and assessed him $19 million, which included interest. Before applying for an abatement, William paid the assessment under protest.

KII is a closely held corporation founded by William's father. After their father's death, William's brother Charles, who was chief executive officer, controlled one faction; William belonged to the other. The sale of William's stock came about through settlement of a stockholders' derivative action launched by the William group.

KII, during the time in question, had holdings in oil, other energy sources, and real estate and was unusually profitable. It had assets of $3.5 billion and very little debt. Despite the company's great worth and abundant revenues, it paid small dividends. The stock could not be easily transferred. KII's articles of incorporation required a twenty-day waiting period for the transfer of shares and gave the company a right of first refusal over the sale of stock. Additional handicaps to setting a share price for KII stock were that the stock was not publicly traded and that the company did not distribute financial information.

William and Charles disagreed with some heat about how the company should be run. William thought Charles should share information and a larger measure of control with other stockholders; according to William, Charles ran KII as if it were a one-man company. Certain of the corporation's business practices troubled William. It disturbed him that the United States Department of Energy was investigating the company for violations of Federal price-control laws and that KII had been indicted and pleaded guilty to criminal charges of stacking a lottery for oil leases. The company had also been accused of fraud in several civil suits. ³

These concerns caused increasing friction between the two brothers. At length, Charles attempted to remove William from offices he held at KII. William responded by forming a stockholders' coalition that had a slight majority of voting stock. The majority was based on its ability to vote stock the First National Bank of Wichita held in trust for William and another shareholder. Charles was cotrustee of one trust that held a portion of that stock. As a director and major depositor, Charles had strong influence with the bank, and he used that power to induce the bank to revoke the proxies it had given William to vote the shares of stock it held in trust for him. According to William's testimony, Charles threatened, "If they don't revoke the proxies, we'll have Koch Industries buy that little bank."

After the failed coup, Charles fired William as an employee of KII, although William still remained a director. Enraged by an account of the family quarrel in Fortune magazine that compared him to the fictional television personality, J.R. Ewing, Charles responded to perceived leaks of privileged information by forming an executive committee of his supporters, which took over the remaining decision-making responsibilities of KII's board of directors. William's faction sued Charles, KII, and other stockholders to force them to share power. The complaint also asserted claims of mismanagement. KII counterclaimed for libel arising out of the Fortune article.

During a protracted period of discovery, KII surprised the plaintiffs' counsel with an offer to settle the case by buying the stock held by the dissident group. On June 4, 1983, the company agreed to repurchase the outstanding stock for $1.2 billion, and both sides agreed to drop their claims. The closing was to take place within ninety days or within forty-eight hours of written notice from the company. KII was required to place a nonrefundable $200 million deposit in escrow.

On June 8 and 9, William set up a number of corporations to spread the risk of investments he planned to make in energy, real estate, and high technology. He chose the form available under Subchapter S of the Internal Revenue Code in order to avoid the double taxation, first on corporate earnings and second on distributions to the stockholder, which ordinarily attends corporate income and distributions. Since most of his investments would be outside of Massachusetts, William set up the companies in Delaware because of that State's favorable corporate laws. In response to William's request, KII agreed to waive its restrictions on the transfer of its stock. Charles and William amended the purchase and sale agreement to allow William to assign his interest in his stock to the S-corporations so long as he and the S-corporations remained jointly and severally liable for performance of the agreement, William was the sole stockholder of the S-corporations, and William remained the principal seller. KII, in assenting to the amendment, added the qualification that no action by the S-corporations would be necessary to transfer the shares at closing.

KII assented to the amendment in writing "as of" June 8. ⁴ By this time, William's stock certificates had been gathered from the Wichita bank, were endorsed in blank by William and delivered to the escrow agent, as agreed. On the morning of June 9, William executed assignments of shares of KII stock to the newly-formed Delaware corporations in exchange for stock in each of those corporations. Later that day, after he had completed the assignments, he learned that KII had elected to close on the agreement the following day. William had "no idea" that KII would close so soon. The company's announcement "came as a complete surprise" to him. ⁵

The closing did take place on June 10, and William instructed the escrow agent to wire the proceeds to the Delaware S-corporations. The stock certificates had been in the escrow agent's hands and were not physically delivered to the Delaware S-corporations. The closing took place as contemplated in the original purchase and sale agreement.

1. Standard of review. Our review of the findings of the Appellate Tax Board will be limited to questions of law. "The decision of the board shall be final as to findings of fact." G.L. c. 58A, § 13, as appearing in St.1973, c. 1114, § 5. The credibility of witnesses, weight of evidence, and inferences to be drawn from evidence are matters for the board. Cummington School of the Arts, Inc. v. Assessors of Cummington, 373 Mass. 597, 605, 369 N.E.2d 457 (1977). We may, however, consider whether, as matter of law, the evidence is sufficient to support the board's findings. Assessors of Weymouth v. Curtis, 375 Mass. 493, 499, 378 N.E.2d 655 (1978). ⁶

2. The proper legal standard. The commissioner claims that, as matter of law, the evidence does not support the board's finding that the S-corporations, and not William, sold the stock. ⁷ The commissioner may look behind a taxpayer's formal characterization of a transaction and determine that it is "unreal or a sham." Brown, Rudnick, Freed & Gesmer v. Assessors of Boston, 389 Mass. 298, 304-305, 450 N.E.2d 162 (1983), quoting from Higgins v. Smith, 308 U.S. 473, 477, 60 S.Ct. 355, 357, 84 L.Ed. 406 (1940). Having made that determination, the government may disregard the effect of the "fiction." Id. 389 Mass. at 304, 450 N.E.2d 162.

The form-over-substance...