Opinion
No. Civ. H-84-1008 (PCD).
November 6, 1989.
Everett E. Newton, John C. Yavis, Jr., H. Kennedy Hudner, Murtha, Cullina, Richter Pinney, Hartford, Conn., for plaintiff.
Leslie C. Ohta, Asst. U.S. Atty., AUSA U.S. Atty's. Office, New Haven, Conn., Jerome A. Busch, Terri E. Schapiro, U.S. Justice Dept. Tax Div., Deborah S. Meland, Joseph Cammarata, U.S. Justice Dept., Washington, D.C., for defendant.
RULING ON CROSS-MOTIONS FOR SUMMARY JUDGMENT
Plaintiff, filer of consolidated tax returns for 1978 and 1979 for itself and affiliated corporations, 26 U.S.C. § 1504(a), Internal Revenue Code of 1954, Treasury Regulations § 1.1502-77, claims refunds of deficiencies assessed but paid, with accrued interest, $1,427,927 for 1978 and $814,650 for 1979. The claims, denied by the IRS, were based on:
(a) disallowed amortization deductions claimed with respect to employment contracts and covenants not to compete;
(b) IRS allocation of consideration paid with respect to amounts received on the liquidation of subsidiaries;
(c) disallowance of claimed business expenses, losses, amortization or depreciation pertaining to assets received on the liquidation of subsidiaries; and
(d) deductibility denied for a loss allegedly resulting from a payment made on cancellation of an obligation of the taxpayer under a currency exchange contract.
In 1978 and 1979, plaintiff purchased the stock of three corporations and immediately liquidated all three, receiving the assets of the acquired corporations in the process. Plaintiff alleges that the IRS improperly disallowed amortization of employment contract and covenants not to compete.
All of plaintiff's claims were resolved in favor of the government in a summary judgment motion granted by Judge Blumenfeld, 697 F. Supp. 591 (D.Conn. 1988). On appeal, it was held to have been error to preclude plaintiff from putting on the record the contracts pertinent to (a) above. The case was remanded for consideration of the contracts in relation to the deductions based thereon. Barnes Group, Inc. v. United States, 872 F.2d 528, 532 (2d Cir. 1989). Pending and herein decided are the government's motion for summary judgment, supplemented under date of June 22, 1989, with respect to plaintiff's claim of entitlement to the amortization deductions, and plaintiff's cross-motion, which raises that issue, but also renews its claims:
(a) that "the acquired companies' adjusted stock basis [must be allocated] proportionately among all of the assets received in liquidation" and
(b) "that the capitalizations of earnings method [properly values] good will for purposes of allocation under Treasury Regulations § 1.334-1(c)(4)(viii) if the employment contracts and covenants not to compete must be treated as having no net asset value."
Barnes' Cross-Motion for Summary Judgment (July 21, 1989) at 2. Judge Blumenfeld denied Barnes' motion, thus those matters were decided against plaintiff and judgment entered. Thereafter, the Court of Appeals reached only the claim of error in the refusal to permit plaintiff to submit the contracts to the court, the other questions not being reached. 872 F.2d at 531. The remand was "for further proceedings in which the contracts themselves should be received." Id. at 532. Thus, the only issues to be considered on remand are:
(a) when the contracts were entered into;
(b) whether the contracts were conditioned on the sale of the companies; and
(c) the purpose for which the contracts were formed.
Accordingly, there is no basis for the undersigned to consider other than the propriety of the amortization deductions. The additional questions raised by plaintiff were previously decided by Judge Blumenfeld and there is no charge in the remand to reconsider them.
Facts
It appears that plaintiff, in 1978 and 1979, acquired all the stock of Globe Industries, Inc. ("Globe"); The Chanenson Corporation ("Chanenson"); and Pioneer Products, Inc. ("Pioneer") (collectively "the purchased companies").
The agreement with respect to Globe was reached with its shareholders Howard and Arnold Kaufman and Alan Wilkening, on December 17, 1977, to be closed by March 15, 1978. The Globe stock purchase contract precludes any contract after December 16, 1977 obliging the company for more than $20,000 and for a term of more than one year. Plaintiff's Exhibit 1, ¶ 7(f). In a draft of the Globe stock agreement, dated November 18, 1977, ¶ 9(j), the three shareholders were required to enter employment contracts with plaintiff on terms satisfactory to plaintiff. Defendant's Exhibit B. The executed contract obliged the shareholders to a best efforts clause which included preservation of the officers and employees of Globe. Id., ¶ 7(h). It also precluded them from competing with plaintiff, or divisions, or any of its subsidiaries for five years. Id., ¶ 13. On December 16, 1977 also, the three shareholders and three Globe employees executed employment contracts with Globe for a term of three years, provided that, if the plaintiff does not consummate the acquisition on or before March 15, 1978, "this agreement shall be of no force and effect." Defendant's Exhibit C. See also Defendant's Exhibits D, E, F and G. On March 7, 1978, plaintiff acquired all of the Globe stock, liquidated the company, received all of its assets, and assumed all of Globe's liabilities. Defendant's Exhibit H. Plaintiff claims deductions for amortization attributable to the six employment contracts, with the covenants not to compete, that were valued at a total of $3,000,000, Defendant's Exhibit I, on the theory that they were amortizable assets received in liquidation.
The Chanenson stock purchase agreement was executed on December 15, 1978. Defendant's Exhibit J. Earlier drafts of that agreement were conditioned on that company's shareholders contracting for their employment with plaintiff on terms agreeable to plaintiff. Defendant's Exhibit K. The executed Chanenson stock agreement required employment agreements executed by and with Chanenson, Defendant's Exhibit J, ¶ 9(g), and contained a five year covenant not to compete. One shareholder and one employee executed employment contracts, which provided for three year terms of employment, non-competition agreements in favor of Chanenson, Barnes or its subsidiaries during employment and for two years thereafter and that the agreements would be of no force or effect if Barnes did not effectuate the acquisition. Defendant's Exhibits L, M. On February 27, 1979, plaintiff consummated the Chanenson acquisition, liquidated the company, received all its assets and assumed its liabilities. Defendant's Exhibits E, N. Plaintiff's claim is based on the appraised value of the employment contracts with the covenants not to compete — $427,000. Defendant's Exhibit D.
On October 11, 1979, plaintiff executed a purchase agreement for the stock of Pioneer, which required employment contracts with Pioneer in a form previously initialed with plaintiff and a five year covenant not to compete. Defendant's Exhibit P, ¶¶ 2, 9(h), 14. On that same day, one shareholder and one employee executed employment contracts with Pioneer with similar terms to those described above. Defendant's Exhibits Q, R. On November 8, 1979, plaintiff acquired all of Pioneer's stock, liquidated that company, received all of its assets and assumed all its liabilities. Defendant's Exhibit S. Plaintiffs' claim of deductibility is not based on an independent appraisal of the employment contracts with the covenants, but on a value ascribed by Barnes' employees of $2,220,000. Barnes' Supplemental Statement of Material Facts, ¶¶ 35, 37.
These agreements, by endorsement on them by Barnes, were expressly approved as to form by Barnes.
The stock purchase agreements allocated no consideration to the contracts nor the covenants. The values ascribed were based on the estimated effect of the continued employment on earnings, the amount of which was then capitalized. The resulting amounts were then amortized in the tax returns separate from good will. The shareholders received a share of the sale price proportioned to their shareholding, with nothing additional as compensation for the contracts/covenants. The employment contracts provided for employment effective only upon consummation of the stock purchase agreements. The covenants in the stock purchase agreements track the language of the covenants in the employment contracts.
The issues are controlled by the documents as their legal significance is only otherwise effected by inferences to be drawn therefrom. Though a broadside is leveled at the government's documentation, plaintiff concedes its authenticity and adds nothing to the record other than the conclusory affidavits of the company's officers and the appraisal reports. Thus, the record is conclusive and, as will be discussed below, permits resolution of both sides' motions for summary judgment as a matter of law with no real issues of fact. The only reasonable inferences do not, as discussed herein, create any question of fact which might be resolved in favor of plaintiff's claims. Thus, both parties' motions can be decided as questions of law.
See Plaintiff's Memorandum of July 21, 1989, at 6.
Plaintiff's attack on prior drafts based on the parole evidence rule is unfounded. The question here is not a matter of contract construction. Prior drafts are relevant to the history, evaluation, and circumstances of the contracts. They can have probative value. The parole evidence rule is inapplicable.
The three acquired companies were essentially service companies which distributed products to large volume retail outlets. None manufactured or significantly processed the products. Each depended on various sources for the products and their ability to retain customers, each subject to the rigors of competitive markets. The assets of each consisted of inventories of fungible products and property used in the distribution. The value of each lay in the capacity to generate income from sales, buying low, selling high. The ability to hold sources and customers was based largely on the relationships between key officers and employees of the companies and key persons at their suppliers and customers. Barnes argues that the purchase of the three companies was intended to penetrate the market each served, a purpose that would not have been achieved unless the persons who could provide such entree came to Barnes with the companies and under employment contracts including non-competition clauses.
While it is claimed that each of the companies had their own reasons for the contracts, those reasons are of no significance. The contracts and covenants were executed at the instigation of Barnes, thus for its purposes and not for purposes of the acquired companies apparent at that time. That this is the only reasonable inference as to purpose is shown by the fact that the form of the contracts had to meet the approval of plaintiff, that the contracts and covenants were contingent on the consummation of the stock sale to Barnes, and that companies were to go out of existence at the time of the sale. The value, at the time of the sale, is dependent on the circumstances then, not what might occur in the future. No continuing purpose of the acquiring companies can be found in the contracts or covenants. No explanation is given as to why, if Barnes wanted to preserve the continuity and relationships of the personnel of the acquired companies, the contracts and covenants could not have been executed directly with Barnes.
Procedure
Plaintiff claimed deductions for the amortizement of the several contracts and covenants which the IRS disallowed. Barnes paid the resulting assessed deficiencies and now seeks a refund of taxes claimed to have been overpaid. 28 U.S.C. § 1346(a)(1).
As Judge Blumenfeld found the deductions invalid, "the issue of whether all tangible assets are eligible for an unlimited step-up in basis pursuant to Treasury Regulation § 1.334-1(c)(4)(viii) is not reached, as there is no excess purchase price to be allocated." Barnes, 697 F. Supp. at 595 n. 5. That issue would only be reached here if plaintiff prevails in this instance. Barnes' claim that the residual method is not appropriate for valuing good will if the contracts/covenants were not assets received in liquidation was rejected by Judge Blumenfeld. Id. at 594-95. It was not specifically mentioned by the Court of Appeals and the government, which has not briefed the issue, contends the matter is not before this court as not specifically referred to in the remand. In this, the court concurs.
Discussion
Whether the plaintiff could lawfully claim the deductions depends on whether the contracts and covenants were assets with definable value to the acquired companies. The questions posed by the Court of Appeals on remand are:
(a) Were the contracts entered into prior to the acquisitions?
(b) Were the contracts conditioned upon the sales of the companies?
(c) If they were entered into prior to, and were not conditioned upon, the acquisitions, Barnes, 872 F.2d at 532, did the acquired companies have substantial business purposes for the contracts and covenants?
In direct response, it is found:
(a) The contracts and covenants were executed essentially simultaneous with the executions of the stock purchase agreements, but prior to the consummation of the acquisitions.
(b) The contracts and covenants were conditioned upon the consummation of the acquisitions and thus would have had no viability except for the acquisitions.
(c) Even though the findings made above, as required by the Court of Appeals, make unnecessary the consideration of the third question, each of the contracts and covenants was not entered into for any real purpose of the respective acquired company.
A. Contract/Covenant Execution
The employment contracts were described as required by the stock purchase contracts and thus might be argued to have been intended as conditions precedent to the latter, particularly since the implementation of the latter was contemplated in each case as occurring within a short period of the contract execution. However, the execution of each employment contract occurred on the same date as the execution of the stock purchase contract. Thus, however minimally, the contracts and covenants can be said to have come into existence, if not at the same moment, a short time prior to the stock agreements. However, they then had no substance because the period of employment would commence "on the day of the acquisition by Barnes Group, Inc. . . . of all the outstanding stock of the [acquired] Company." Defendant's Exhibits C-G, L, M, Q, R. Thus, the contracts had no force or effect until consummation of the stock acquisition or after the closing date if the acquisition failed.
B. Conditional Nature of the Contracts/Covenants
It is apparent from earlier and final drafts of each of the stock purchase agreements that the impetus for the employment contracts and covenants came from Barnes. Each employment contract, though dated contemporaneously with the stock agreement, was, in two respects, conditioned upon the stock purchase agreement. Each acquiring company, with slight variances in language of no material difference, undertook to provide employment, which the employee agreed to provide, for a period "beginning on the day of the acquisition by Barnes Group, Inc. . . . of all the outstanding stock of the Company, provided that if for any reason the acquisition is not consummated on or before March 15, 1978 this agreement shall be of no force and effect." Defendant's Exhibits C-G, L, M, Q, R. Thus, not only was the company's undertaking to provide employment deferred to a future date, it was also contingent on the occurrence of the acquisition by a specific buyer, Barnes, not merely of that contract employee's stock, but of all the outstanding stock. Thus, but for the actual acquisition of all of the acquired company's stock by the specified date, the undertaking of the company was inchoate. It was dependent upon, it was conditioned on, not the existence of the stock agreement, but on the consummation thereof. Thus, the employee had nothing but a conditional offer of employment until the stock acquisition was completed.
Any obligation of the company evaporated on the closing date if the stock acquisition failed. Thus, the reality of any right enforceable by the employee was subject to both a condition precedent and a condition subsequent, the stock acquisition consummation. Thus, it must be said that without question the employment agreement was doubly conditioned on the stock agreement.
C. Existence of a Business Purpose of the Acquired Companies in the Employee Contracts/Covenants
As the Court of Appeals directed consideration of this factor if the employment contracts existed before the stock agreements (found to be the case on their face by the barest of margins) and if the employment contracts were not conditioned on the sales of the companies (above found to have been the case), consideration of this factor would appear to be unnecessary. In a super-abundance of causation, the acquired companies, having a purpose in the contracts/covenants, will be discussed. Of course, the existence of such a purpose is a question of corporate conception of such a purpose. Such a view could come from any number of company officers or employees. Indeed, plaintiff has provided documents from some of the officers/employees involved, attesting to just such a purpose. Yet the entire record unquestionably demonstrates that the contracts did not come into existence to serve any purpose of the respective acquired companies. The following reasons substantiate this finding, without question:
This is partially seen as appropriate since plaintiff has attempted to cast the issue in terms of its acquisition for the purpose of serving its purposes of viable contracts.
1. Over its history and existence, each acquiring company appears to have seen no need, purpose, benefit or advantage to such contracts/covenants until prompted by Barnes and executed same only when the stock agreement was, or was imminently to be, executed. It is illogical, and incredible, that if the acquiring companies thought such a purpose would be achieved by the creation of such agreements, they would do so only on the eve of a sale.
2. A purpose beneficial to the acquiring company is hardly served when such an agreement is signed on the eve of the dissolution of the company which was clearly planned and contemplated. After dissolution, such an agreement could not conceivably serve any purpose of the company.
3. In the period between the execution of the agreement and the consummation of the stock agreement, the acquired company obtained no rights, nothing of value. The company gave nothing and had nothing until the stock acquisition was complete. That sequence hardly served any purpose of the company.
4. The employer provided no consideration or obligation until the stock acquisition was complete from which it would follow that the employee could, for lack of consideration, have no obligation until that time either.
5. Any purpose of the company could hardly be found in an agreement which had no force or effect until the moment of the acquisition of the company's stock. To have value, to guaranty the availability of employee's services, to ensure continuity of the company's business, the undertaking had to be real. Only enforceable rights would give rise to any accrual of such value or benefits. A company cannot be found to have created such value or benefit or served its purposes by a contract until it actually comes into force and effect. The contract here gave no assurance it would ever come into effect or become enforceable if it was at all. The delay in the force and effectiveness of the agreement not only served no purpose of the company while it was unenforceable, but the delay totally destroyed the credibility of any assertion of a company purpose, since the delay served no purpose than that of Barnes.
6. An employment agreement which evaporated with the closing date if the acquisition was not consummated demonstrates the lack of any advantage, benefit, right or entitlement which fostered a purpose of the company. No ongoing purpose of the company is served by an agreement which, without coming into effect, is vitiated by an event, the failure of consummation of the stock acquisition, which has nothing to do with the ongoing conduct of the company's business. The affiant's suggestion to the contrary, only in the continuation of the company after the acquisition, is so extremely and totally at odds with the reality of the effect or impact (more accurately the lack of same) of the contracts on the companies as to present not the slightest support for plaintiff's claim. If the employments were to serve the companies' purposes, they would have been made effective immediately and without being cut off by an event unrelated to the companies' interests (the stock sales inured to the benefit of the stockholders). Cast as they were, they served no purpose of the companies which were never obliged and only the purposes of Barnes which did accrue the benefits, since the reciprocal obligations became real only when Barnes acquired the stock.
The employment contracts thus had no substance nor value during the lifetime of the companies, nor specifically up to the time of the stock acquisition. Since the liquidation then occurred immediately, the springing into life of the contracts just in time for Barnes to acquire them precludes any finding of value by reason of their serving any purpose of the company.
What Barnes acquired from the employees it did not acquire from the companies. As the obligations of the employees and the acquiring companies were contingent on the acquisition, no obligation arose until the acquisition. Restatement (Second) of Contracts § 225. As the companies were under no commitment, nor were the employees, until Barnes acquired the stock and, since Barnes' immediate liquidation of each company was necessarily previously planned as part of the acquisition, the benefit of the employment obligations came into existence at the orchestration of Barnes, precisely at the same time as Barnes' ownership of the companies' stock commenced and simultaneously with the liquidation. Thus, if the employment contracts had any vitality to pass to Barnes upon liquidation, it was fleetingly short and, as orchestrated by Barnes, was of no real benefit to the acquired company but was most clearly for the benefit of Barnes alone (including the tax benefit if sustained). It follows that there was in reality no asset of any value in the contracts in existence for any significant amount of time to be received by Barnes in the liquidation.
Plaintiff argues that the contracts were binding and thus had value, even if they did not require performance until the acquisition was completed. It does not mention the extinguishing of the obligation if the acquisition was not completed. The argument is that Barnes could have continued the companies and thus obtained the benefits of the contracts through the companies. What this argument ignores is that there is no purpose of the companies served when the contracts generate no benefit unless the acquisitions were completed and they are voided if the acquisitions are not completed. Thus, the enforceability of the contracts is tied to consummation of a transaction which has nothing to do with the companies' ongoing business purposes. Thus, the contracts could only have been intended to serve the purposes of Barnes, the party to the transaction on which the contracts were contingent. If this were not enough to preclude a finding of purpose which serves the companies' interest, there is the further fact that the companies were planned to be liquidated, a plan that was formulated prior to the contracts and was carried out simultaneously with the completion of the acquisitions.
It is of course true that the mere fact that tax benefits would flow from a plan does not invalidate the plan, for a taxpayer is entitled to plan, organize and structure his business so as to minimize the taxes payable. Helvering v. Gregory, 69 F.2d 809, 810 (2d Cir. 1934), aff'd, 293 U.S. 465, 55 S.Ct. 266, 79 L.Ed. 596 (1935). Nonetheless, when there is, in reality, no substance to the transaction in its entirety, that is the controlling consideration. Chisholm v. Commissioner, 79 F.2d 14, 15 (2d Cir.), cert. denied, 296 U.S. 641, 56 S.Ct. 174, 80 L.Ed. 456 (1935). If there is a sound, legitimate purpose of each acquired company served, the fact that a purpose of or benefit to Barnes is also involved is not controlling. Plaintiff's reliance on KFOX, Inc. v. United States, 510 F.2d 1365, 206 Ct.Cl. 143 (1975), where employment contracts of key employees had non-competition clauses, is inapposite. That case does not square with the facts here, for there no claim was made, nor was it shown, that those contracts were, as here, contingent on the Barnes' stock acquisitions. So also in Concrete Pipe Prod. Co. v. United States, 76-1 U.S. Tax Case (CCH), p. 9115; 37 A.F.T.R.2d (P-H) 399 (E.D.Va. 1975), the contracts, though part of an acquisition, created real, purposeful, enforceable obligations, which were not contingent on the acquisition being consummated. In sustaining the contracts as valid, Judge Hoffman distinguished Meredith Broadcasting Co. v. United States, 405 F.2d 1214, 186 Ct.Cl. 1 (1968) (contracts cancelable) and United States Indus. Alcohol Co. v. Helvering, 137 F.2d 511, 512-14 (2d Cir. 1943), where the contracts, being "easily cancelable or avoidable," made "impossible the assignment of a definite life." Apart from the acquisition contract, the employment contracts had no viability and it is thus impossible, as a matter of law, to attribute any value to contracts which served no business purpose of the acquired companies "independent of the sale of the company." Barnes, 872 F.2d at 532. It is the substance of the transaction that determines its tax consequences. See Commissioner v. Court Holding Co., 324 U.S. 331, 334, 65 S.Ct. 707, 708, 89 L.Ed. 981 (1945).
The facts of the contracts, the nature of the companies and Barnes' purpose in acquiring them are not in dispute. The contracts are unambiguous and thus summary judgment is not improper. Tokio Marine Fire Ins. Co. v. McDonnell Douglas Corp., 617 F.2d 936, 940 (2d Cir. 1980); see Wards Co. v. Stamford Ridgeway Associates, 761 F.2d 117, 120 (2d Cir. 1985). The parties, in support of their cross-motions for summary judgment, suggest the absence of any issue of fact and urge granting their respective motions. The question is whether the contracts had an existence, a viability arising from mutual and reciprocal obligations prior to the acquisition as to be of value to the acquired companies. That question requires resolution of no disputed facts. It is solely a question of whether the contracts had any existence as to give them value when they were contingent on the acquisition and immediately became the property of Barnes when the liquidation occurred immediately upon the acquisition. The non-competition obligation of the shareholders arose from the stock agreement in which such was provided and thus query the value of such an obligation arising from another source. Of course, the parties here sought to structure the agreements to everyone's advantage taxwise. Thus, no value was assigned to the non-competition obligation in the stock agreement as that would have accrued a tax liability to the selling shareholders. It follows that the only purpose was Barnes', which required the agreements to increase its tax benefits. As Barnes was free to directly enter the agreements in issue, the acquired companies had no substantial business purpose except to accommodate Barnes. This view is further buttressed by Barnes' failure to allocate value to the non-competition agreement in the stock purchase contract, an allocation which would have had adverse tax consequences for the shareholders.
In short, plaintiff has not sustained its burden of showing its entitlement to the disallowed deductions as a matter of law, while the government has satisfied its burden of showing there is no genuine issue of material fact that the contracts, absent any purpose of the acquired companies being therein served, had no amortizable value to pass to Barnes. See Celotex Corp. v. Catrett, 477 U.S. 317, 106 S.Ct. 2548, 91 L.Ed.2d 265 (1986). The deductions were properly disallowed.
SO ORDERED.