North American Rayon Corp. v. C.I.R.

• Decision Date: 03 February 1994
• Docket Number: No. 93-1114,93-1114
• Citation: 12 F.3d 583
• Parties: -492, 94-1 USTC P 50,014 NORTH AMERICAN RAYON CORPORATION, formerly known as North American Holding Corporation, NARCO, Petitioner-Appellant, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.
• Court: U.S. Court of Appeals — Sixth Circuit

Page 583

12 F.3d 583

73 A.F.T.R.2d 94-492, 94-1 USTC P 50,014

NORTH AMERICAN RAYON CORPORATION, formerly known as North

American Holding Corporation, NARCO, Petitioner-Appellant, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.

No. 93-1114.

United States Court of Appeals, Sixth Circuit.

Argued Nov. 8, 1993.

Decided Dec. 21, 1993.

Rehearing and Suggestion for Rehearing En Banc Denied Feb. 3, 1994.

H. Wynne James, III (briefed and argued), Heiskell, Donelson, Bearman, Adams, Williams & Kirsch, Nashville, TN, for petitioner-appellant.

Gary R. Allen, Acting Chief (briefed), Jonathan S. Cohen (argued), Ann Belanger Durney, Sally Schornstheimer, U.S. Dept. of Justice Appellate Section, Tax Div., Washington, DC, for respondent-appellee.

Before: MILBURN and BATCHELDER, Circuit Judges; and JOINER, Senior District Judge. ^*

MILBURN, Circuit Judge.

Petitioner North American Rayon Corporation ("North American") appeals the tax court's determination of deficiencies in income tax due from petitioner. On appeal, the issue is whether the tax court erred in holding that in determining taxpayer's basis for depreciation of assets purchased under an asset sale agreement, taxpayer is bound by the allocation of the purchase price set forth in the asset sale agreement. For the reasons that follow, we affirm.

I.

Beaunit Corporation operated a textile and fiber business. In 1978, Beaunit decided to liquidate its five or six operating divisions because it determined that it would be difficult to make a profit as a textile company. Although it sold or closed its polyester and nylon plants and three of its four rayon plants, Beaunit was unable to find another company interested in buying its remaining textile plant, a rayon manufacturing facility in Elizabethton, Tennessee, even though Beaunit offered to sell this plant for the amount of its liabilities. Beaunit then decided to create a corporation to purchase the Elizabethton facility. Petitioner North American was organized as a New York corporation in contemplation of purchasing the Elizabethton facility from Beaunit and Beaunit's wholly-owned subsidiary, Carter County Fibers, Inc. ¹ On October 30, 1978, petitioner executed an asset sale agreement with Beaunit and Carter County Fibers, by which it purchased the fixed assets and inventory of the Elizabethton facility.

At the time of the sale, petitioner and Beaunit were controlled essentially by the same individuals and were represented by the same law and accounting firms. The controlling stockholders of Beaunit were Roger White, Grant Wilson, Steve Timko, and Robert E. Smith. The principal stockholders of petitioner were White, Wilson, Timko, and Smith, each of whom controlled 12.75 percent of petitioner's common stock, and James Walker, a minority stockholder of Beaunit and president of its yarn division, who owned 24 percent of petitioner's common stock. Also receiving an ownership interest in petitioner were Charles Boulton, whom Smith solicited to become a stockholder in order to ensure that the sale would not be treated as a reorganization and that the loss realized by Beaunit on the sale would be recognized; Walter Heller & Company, a creditor of Beaunit, which received its interest in return for an early termination of its factoring agreement with Beaunit; and BVA Credit Corporation, which received its interest as an inducement to loan money to petitioner.

At the time of the asset sale to petitioner, Beaunit's directors were White, Timko, and Smith. White was Beaunit's president. The initial directors of petitioner were White, Timko, Smith, Wilson, Walker, and Boulton. Walker, who under Beaunit had management responsibility for the Elizabethton facility, became president of petitioner.

Under the terms of the asset sale agreement, the purchase price for the fixed assets was stated as $1,000,000, and the purchase price for the inventory was to be calculated by a formula provided in the agreement. The tax court found that

[i]t is unclear on this record how the total sale price was determined, or who in fact made the allocation of the sale price between inventory and the other assets in the Agreement. Petitioner's shareholders who were involved at the time of the transaction all were aware of the aggregate sale price, but there were no arm's-length negotiations between petitioner and Beaunit with respect to either the sale price or its allocation. It seems probable that the allocation was determined either by petitioner's and Beaunit's New York attorney or by their accountants.

J.A. 33.

A deduction is allowed for depreciation of property used in a trade or business. 26 U.S.C. Sec. 167(a). The property's basis for depreciation is the cost of the property. 26 U.S.C. Secs. 167(c), 1011(a), and 1012. On its income tax return for the taxable year ending September 30, 1979, petitioner did not use $1,000,000 as the fixed assets' basis for depreciation. Instead, petitioner allocated the total purchase price ($5,248,934.85) ² between the fixed assets and inventory according to their relative values. ³ Using this method, petitioner assigned $4,897,256.22 as the fixed assets' basis for depreciation. Petitioner's subsequent tax returns have been consistent with this allocation. However, Beaunit's allocation of purchase price on its tax return was consistent with the asset sale agreement.

On January 31, 1989, the Commissioner issued petitioner a notice of deficiency for the years 1980, 1982, 1984, and 1985 with respect to its depreciation deductions. On April 18, 1989, petitioner filed a petition in the tax court seeking a redetermination of the asserted deficiencies. At the trial, petitioner presented evidence that the agreement's price allocation was disproportionate to economic value and argued that it should be able to reallocate the purchase price to reflect economic reality. The Commissioner argued that petitioner was bound by the prices set forth in the asset sales agreement under the Danielson rule, which provides that "a party can challenge the tax consequences of his agreement as construed by the Commissioner only by adducing proof which in an action between the parties to the agreement would be admissible to alter that construction or to show its unenforceability because of mistake, undue influence, fraud, duress, etc." Commissioner v. Danielson, 378 F.2d 771, 775 (3d Cir.) (en banc), cert. denied, 389 U.S. 858, 88 S.Ct. 94, 19 L.Ed.2d 123 (1967). Petitioner introduced testimony regarding the commonality of shareholders and directors between petitioner and Beaunit at the time of the sale and argued that even under the Danielson rule, it was not bound by the agreement because it was the product of undue influence by Beaunit over petitioner.

On May 8, 1992, a tax court judge wrote a letter to counsel for the parties indicating that the tax court was inclined to rule in favor of petitioner. ⁴ However, on October 14, 1992, the tax court filed a memorandum findings of fact and opinion finding that there was no evidence of undue influence and holding that under the Danielson rule, petitioner is bound by the allocations set forth in the asset sale agreement. On November 12, 1992, petitioner moved for review of the opinion and for reconsideration. The tax court denied both motions. An agreed computation was entered, and on December 16, 1992, the tax court entered its decision in favor of the Commissioner ordering deficiencies in income tax due from petitioner. ⁵ This timely appeal followed.

II.

Petitioner argues that the Danielson rule is inapplicable to this case and, alternatively, that if the Danielson rule is applicable to this case, it does not bind petitioner to the price allocation in the asset sale agreement because the allocation was the result of undue influence by Beaunit. The tax court held that the record was devoid of any evidence of undue influence and that, in accordance with the Danielson rule, petitioner was bound by the allocation set forth in the agreement. A Court of Appeals reviews the tax court's findings of fact only for clear error and its findings of law de novo. E.g., Smith v. Commissioner, 926 F.2d 1470, 1474 (6th Cir.1991). The tax court's finding that the Danielson rule applied to this case was a finding of law and, therefore, subject to de novo review by this court.

A.

The Danielson rule provides that "a party can challenge the tax consequences of his agreement as construed by the Commissioner only by adducing proof which in an action between the parties to the agreement would be admissible to alter that construction or to show its unenforceability because of mistake, undue influence, fraud, duress, etc." Commissioner v. Danielson, 378 F.2d 771, 775 (3d Cir.) (en banc), cert. denied, 389 U.S. 858, 88 S.Ct. 94, 19 L.Ed.2d 123 (1967). Danielson involved a stock purchase agreement which allocated $152 per share as the price for the seller's covenant not to compete and $222 per share as the price for the stock. The issue was whether the selling shareholders could ignore the agreement's price allocation and treat the entire purchase price as capital gain from the sale of the stock. The selling shareholders argued that the $152 was, in economic reality, additional consideration for the stock, and therefore the form of the purchase price allocation should not be respected. Although the Third Circuit accepted the tax court's finding that the allocation was totally out of proportion to economic reality, it held that the shareholders were bound by the contract's allocation.

This court adopted the Danielson rule in Schatten v. United States, 746 F.2d 319, 321-22 (6th Cir.1984) (per curiam). In Schatten, a taxpayer argued that payments from her ex-husband should be nontaxable income because in economic reality the payments were for property settlement, even though the divorce settlement agreement specifically stated that she would treat the payments as ordinary income. This court would...