Tax Court Reallocates Business Sale Proceeds After Reviewing Different Allocations Exchanged in Negotiations

Scott E. Vincent
Vincent, Fontg & Hansen, L.L.C.
Kansas City

The Tax Court recently rejected allocations of the proceeds in a business sale by both the taxpayers and the Internal Revenue Service, and reallocated the sales proceeds base on the Court’s own analysis of the economic substance of the transaction. The court in Solomon v. Commissioner, T.C. Memo. 2008-102 (April 16, 2008), reviewed in detail the various communications and negotiations among the parties in connection with the allocation of the sales proceeds, including initially proposed allocations that were inconsistent with the ultimate return position taken by the taxpayers.

Background

The Solomon case involves the sale by Solomon Colors, Inc. (“Solomon Colors”) of its Mather ore division to Prince Manufacturing Co. (“Prince”) and related transfers of the company’s customer list as well as covenants not to compete from its key executives, Robert and Donna Solomon and Richard and Gina Solomon (the “Solomons”). Solomon Colors was in the business of selling red iron oxide ore (“Mather ore”) mined in Michigan and then processed in Illinois. The Solomon family had developed the business over the years, operating as a partnership as early as 1927 and then forming Solomon Colors in 1982. The court noted that the assets transferred to the corporation upon its formation (following liquidation of the partnership) did not include any intangible assets. The Solomons were responsible for managing customer relationships, and had been personally developing these relationships since as early as 1955.

Prince began discussions with the Solomons for acquisition of the Mather ore division in May 2000. Again, the court noted that the initial discussions did not address specific terms for the sale, non-compete agreements for any of the Solomons or a customer list. Further, the court noted that the initial agreements prepared by Solomon Colors’ counsel did not reference transfer of a customer list to Prince, and allocated the entire purchase price to the Mather ore division mill. As negotiations proceeded, the Solomons indicated to their counsel that Prince wanted to subject the Solomons to covenants not to compete and wanted each of them to sign the agreement in their individual capacity. The parties then proceeded to exchange, both internally and with each other, various communications regarding the potential tax structure and the most preferable allocation for tax and planning purposes. The court quoted some of these communications:

“When we look at Solomon, a manufacturer of products … as a practical matter, the ‘goodwill’ that is created is arguably more at the entity level, not so much at the individual shareholder/employee level. However, the above fact pattern demonstrates that at this point in time, the only thing that Prince is really buying is the customer relationship, because of the drastic changes we described.”

The Court then reviewed various purchase price allocations that the parties had prepared internally and also discussed and exchanged as part of the negotiations. Notably, some of the internal Solomon documents (obviously obtained by the IRS in discovery) included handwritten comments such as “Rich’s salary – be careful”, “pay dividend” and “shred all drafts.” The court also quoted multiple communications of tax advice referencing the sales price allocation.

The final transaction documents sold the Mather ore business to Prince for $100,000. The remainder of the sale proceeds were allocated to sale by Solomon Colors of the customer list ($550,000), sale by the Solomons (individually) of the customer list ($640,000), a Solomon Colors covenant not to compete ($150,000) and the Solomons’ individual covenants not to compete ($60,000).

Analysis and Holding

The IRS determined that Solomon Colors distributed partial interests in its customer list to the Solomons simultaneous with execution of the agreements, so that the Solomons realized taxable dividend income. The taxpayers argued that the portion of the customer list asset allocated to the Solomons individually in the sale represented the customer relationships and goodwill belonging personally to the Solomons and sold directly to Prince.

The Tax Court actually rejected both parties’ positions in the case. The court agreed that Solomon Colors received $550,000 in exchange for the customer list and $150,000 for the company’s covenant not to compete with Prince, both as stated in the agreements. However, the court found that, contrary to the allocation in the agreements, the Solomons did not receive anything for the sale of the customer list but received their total allocated proceeds of $525,000 and $165,000, respectively, in exchange for their covenants not to compete with Prince.

The court’s analysis focused initially on its review of the sale agreements. The court noted that the agreements referenced a customer list owned by Solomon Colors alone, and that the agreements made no specific reference to any customer list belonging to the Solomons individually. The agreements did state, however, that neither Solomon Colors nor any of the four Solomons would compete with Prince in the Mather ore business. The court also discussed a side agreement between Solomon Colors and Prince to work together after the sale of the Mather ore division to form a plan for the smooth transition of production and for Solomon Colors to refer its customers of the division to Prince. The side agreement did not require anything of either Robert Solomon or Richard Solomon in their personal capacities. Based on the agreement and the side agreement, the court concluded that, contrary to the IRS determination, neither Richard Solomon nor Robert Solomon sold any portion of Solomon Colors’ customer list to Prince, and found further that the proceeds of the sale allocable to Robert Solomon and Richard Solomon actually corresponded to the only consideration they provided in the transaction, their respective covenants not to compete.

The court went on to note that Prince never required that any of the purchase price be allocated to the customer list and that the customer list was apparently of little, if any, value to Prince. Importantly, the court stated that “the mere fact that exhibit A to the agreement states that Robert Solomon and Richard Solomon were compensated for their sale of the customer list does not mean that we have to respect that statement. See Garcia v. Commissioner, 80 T.C. 491, 498 (1983) (citing Commissioner v. Court Holding Co., 324 U.S. 331 (1945)).” The court went on to disregard the allocation in the Solomon agreements, stating that “we conclude it is inaccurate.” Based on this analysis, the court held that the $500,000 and $140,000 allocated to the Solomons’ sale of a customer list was actually attributable to their covenants not to compete.

Conclusions

The Solomon case provides a text book example of discoverable transaction communications and negotiations that arguably led to the court’s conclusions in the case. The taxpayers attempted to reach a tax-motivated allocation that was dramatically different from the initial allocations discussed by the parties, and they obviously engaged various parties in their discussions leading to discovery of these various discussions by the IRS. The case also demonstrates the Tax Court’s authority and inclination to allocate sale proceeds based on the court’s analysis of the economic substance of the transaction.