Tax Court and Leading New York and Delaware Cases

Case Law Update February 2018

In this case law update, we review one U.S. Tax Court case that provides guidance regarding when is a bad debt business loss deductible and whether contributions of money to a business is equity or debt. In addition, we present several Delaware Court cases; one of them, a post-dissolution case where one NACVA member (and another inactive member) testified and the court addressed the S corporation tax affecting and availability of discounts for lack of marketability. The issues raised there are frequently raised in other dissolution actions and the reasoning provided by the court regarding the tax affecting should prompt additional commentary. The final three cases underscore the procedural matters that follow once an action is filed; namely, whether an affirmative defense or summary judgment is available, but they also underscore important compensation, drafting, and management issues that we as consulting and valuation professionals need to consider and address. The Magid case from New York underscores the importance of exit planning and addressing management, especially before the founders step aside or pass away.

In this case law update, we review one U.S. Tax Court case that provides guidance regarding when is a bad debt business loss deductible and whether contributions of money to a business is equity or debt.  In addition, we present several Delaware Court cases; one of them, a post-dissolution case where one NACVA member (and another inactive member) testified and the court addressed the S corporation tax affecting and availability of discounts for lack of marketability.  The issues raised there are frequently raised in other dissolution actions and the reasoning provided by the court regarding the tax affecting should prompt additional commentary.  The final three cases underscore the procedural matters that follow once an action is filed; namely, whether an affirmative defense or summary judgment is available, but they also underscore important compensation, drafting, and management issues that we as consulting and valuation professionals need to consider and address.  The Magid case from New York underscores the importance of exit planning and addressing management, especially before the founders step aside or pass away.

William J. Rutter v Commissioner, T.C. Memo. 2017-174 (September 7, 2017)

Issue:  Whether petitioner is eligible to take a bad business debt deduction under section 166(a).

Facts:  Petitioner, a world-renowned scientist in the field of biotechnology, a founder of Chiron Corp., one of the first publicly held biotechnology company, formed iMetrikus in 1999.  In 2002, he formed iMetrikus International (IM) and iMetrikus became a wholly-owned subsidiary of IM.

IM had an unusual capital structure.  Although petitioner was the driving force, he owned no common stock.  IM had 70 common shareholders, including some key employees and family members.  From the time of its funding, IM’s primary funding source was petitioner; he made cash advances.  Between February 2002 and May 2005, petitioner advanced to IM $22 million, only $3.4 million of these advances was covered by promissory notes.  Notwithstanding the latter, IM recorded all these advances as loans on its books, and these advances continued to accrue interest at seven percent.  IM failed to pay interest on the purported indebtedness after February 2002.  Petitioner continued to make cash infusions and a potential partnership with Google failed to materialize.

Between September and December 2009, Petitioner discussed with senior advisors claiming a bad debt loss deduction.  He was advised to write off the advances under a “first-in, first-out” approach.  Petitioner’s personal attorney prepared a promissory note to consolidate the $34.5 million of advances that petitioner did not plan to write-off.  In March 2010, Petitioner and IM executed a debt restructuring agreement and back dated these to December 31, 2009.

IM continued to operate at least through 2013 and in the interim, petitioner advanced another $37.75 million, again, evidenced by no promissory notes.

Petitioner’s 2009 return included a Schedule C where he reported $8.55 million bad business debt loss; no accrued interest was included in the $8.55 million write-down.  The Service denied the business bad debt deduction in full.

Petitioner retained a valuation expert that opined that IM’s fair market value (FMV) at the end of 2008 and 2009 were respectively $55.4 and $14.3 million.  The Service’s expert opined that there was no basis to claim a 74% reduction in FMV between those dates.

Issues Before the Court:

1. Whether petitioner’s advances to IM constituted debt or equity.
2. If advances constituted debt, and if the debt was held by “a taxpayer other than a corporation,” whether the debt was a business or nonbusiness debt under section 166(d).
3. If the debt was a business debt, whether the write-down should be characterized as involving a “wholly worthless” or “partially worthless” debt and whether petitioner satisfied the relevant requirements for claiming a deduction.

Held:

1. Advances characterized as equity. The court held, in part:

Section 166(a)(1) allows as a deduction any bona fide debt that becomes worthless within the taxable year.  For a nonbusiness bad debt held by a taxpayer other than a corporation, section 166(a)(1) does not apply, and the taxpayer is allowed a short-term capital loss for the taxable year in which the debt becomes completely worthless.  Sec. 166(d)(1);

***

A bona fide debt is a debt that arises from “a debtor-creditor relationship based upon a valid and enforceable obligation to pay a fixed or determinable sum of money.”  Kean v Commissioner, 91 T.C. 575, 594 (1988); sec. 1.166-1(c), Income Tax Regs.  A gift or contribution to capital is not considered a “debt” for purposes of section 166.  Kean, 91 T.C. at 594.  Whether a purported loan is a bona fide debt for tax purposes is determined from the facts and circumstances of each case.  See A.R. Lantz Co. v United States, 424 F.2d 1330, 1333 (9th Cir. 1970); Gross v Commissioner, 401 F.2d 600, 603 (9th Cir. 1968), aff’g T.C. Memo. 1967-31; Dixie Dairies Corp. v Commissioner, 74 T.C. 476, 493 (1980).

Advances made by an investor to a closely held or controlled corporation may properly be characterized, not as a bona fide loan, but as a capital contribution.  See Fin Hay Realty Co. v United States, 398 F.2d 694, 697 (3d Cir. 1968); – 15, Shaw v Commissioner, T.C. Memo. 2013-170, 106 T.C.M. (CCH) 54, 56, aff’d, 623 F. App’x 467 (9th Cir. 2015).  In general, advances made to an insolvent debtor are not debts for tax purposes but are characterized as capital contributions or gifts.  See Dixie Dairies Corp., 74 T.C. at 497; Davis v Commissioner, 69 T.C. 814, 835-836 (1978).  For an advance to constitute a bona fide loan, the purported creditor must expect that the amount will be repaid.  See CMA Consol., Inc. v Commissioner, T.C. Memo. 2005-16, 89 T.C.M. (CCH) 701, 724.

***

Our debt vs. equity determination does not depend merely on counting factors, but on evaluating the factors as a whole.  See Hardman, 827 F.2d at 1412.  Here, we find that eight of the 11 factors favor characterizing petitioner’s advances as equity, and several point very strongly in that direction.  Two factors slightly favor equity characterization or are neutral.  And just one factor favors debt characterization and does so only slightly.  Evaluating the factors overall, we find that petitioner’s advances, including the advances corresponding to his $8.55 million write-down, were equity investments and not debt.

 

Kristen C. Wright v Clinton A. Phillips, Court of Chancery, Civil Action No. 11536-VCG (December 21, 2017)

Issue:  The value of one-half interest in three separate businesses owned by divorced couple that continued ding business together, with each owning a 50 percent interest.

Facts:  The litigation involves a former married couple, who together owned a recycling and shredding business, pursued via three business entities.  The couple divorced in 2013 and jointly ran the businesses until they reached an impasse in 2015.  Petitioner, ex-wife, initially filed a complaint alleging breach of fiduciary duty by Respondent.  She sought his exclusion from the affairs of the business.  The parties each filed Motions for Order of Sale.  Then, the parties agreed that Respondent would purchase the Petitioner’s 50% in each jointly owned business.

The parties disagreed on the value of the companies.  Petitioner retained Charles Sterner, CPA, CVA, (Sterner) to value the businesses and concluded that the combined value of the businesses was $1,671,675 but revised the estimate in 2017 to $1,359,000.  Sterner accounted for the subchapter S corporation status of the companies by applying an individual tax rate of 14.5% instead of the C corporation rate of 31%, resulting in a $204,000 valuation increase.

The Respondent retained Dale Mitchell, CPA, (Mitchell).  Mitchell used Sterner’s assumptions in his calculations and valued the combined entities at $1,155,000.  Mitchell disagreed with the $204,000 increase.  The Respondent’s expert criticized the opposing expert’s report also on the basis that it failed to apply marketability and brokerage commission discounts and because Sterner added certain “synergies” to the overall value.

Issues Before the Court:

1. What is the value of a 50% interest in each of the S corporations?

Held:

The Court concurred with Petitioner’s argument that the companies’ status as S corporation adds value beyond that of a Delaware C corporation.  Petitioner justified the rate used based on “then-Vice Chancellor Strine’s explanation of the value of subchapter S status to justify the addition of 4.08% to the capitalization rate in Sterner’s reports.”  The Court found that the status “as S corporation has discrete value applicable here.  Accordingly, I find the amount attributable to the DG Companies’ status as S corporations—$204,000—should be included in the DG Companies valuation.”

As for the marketability discount, Mitchell applied a 20% marketability discount that also included a 10% brokerage commission, on the basis that failing to recognize these would result in the Petitioner receiving full benefit for the value of her shares but would result in passing her 50% share of those unrecognized costs on to Respondent.  The court included a 10% marketability discount and rejected the additional 10% brokerage fee reduction as “too speculative to be justified.”

As for the synergies, attributable to the absence of Petitioner from the business, the Court noted that there “is a certain irony in the Petitioner’s insistence that her removal from the business she helped build should increase their value, in an amount of which she is entitled to half.”  The Court opined that the “addition to the value of these businesses of any savings from the discharge of the Petitioner is too speculative to include here.”

The Court concluded that the fair value of the combined entities was $1,223.100.

 

In re Investors Bancorp, Inc., Stockholder Litigation, Delaware Supreme Court, No. 169, 2017 (Del. Supr. December 13, 2017; revised Dec. 19, 2017)

Issue:  Whether stockholder ratification of an equity incentive plan that provides a compensation package for directors is immune from challenge.

Facts:  Plaintiff’s filed a complaint alleging a breach of fiduciary duty by directors.

In 2015, shareholders approved the implementation of an Equity Incentive Plan (EIP).  Three days after stockholders approved the EIP, the Committee held the first of four meetings and eventually approved awards of restricted stock and stock options to all board members.  According to the complaint, these awards were not part of the final 2015 compensation package nor discussed in any prior meetings.  According to the complaint, the Board approved a total fair value to themselves of $51,653,997.

After the Company disclosed the awards, stockholders filed three separate complaints in the Court of Chancery alleging breaches of fiduciary duty by the directors for awarding themselves excessive compensation.  Following the filing of a consolidated complaint, the defendants moved to dismiss under Court of Chancery Rule 12(b)(6) for failure to state a claim and under Court of Chancery Rule 23.1 for failure to make a demand before filing suit.  The Court of Chancery granted both motions and dismissed the plaintiffs’ complaint.

Relying on the court’s earlier decisions in In re 3COM Corp. and Calma on Behalf of Citrix Systems, Inc. v Templeton, the court dismissed the complaint against the non-employee directors because the EIP contained “meaningful, specific limits on awards to all director beneficiaries” like the 3COM plan, as opposed to the broad-based plan in Citrix that contained a generic limit covering director and non-director beneficiaries.  The court also dismissed the claims directed to the executive directors because the plaintiffs failed to make a pre-suit demand on the board.

The Delaware Supreme reviewed the Court of Chancery decision dismissing the complaint de novo.

Issues Before the Court:

In this case, the Court addresses the limits of the stockholder ratification defense when directors make equity awards to themselves under the general parameters of an equity incentive plan.  In the absence of stockholder approval, if a stockholder properly challenges equity incentive plan awards the directors grant to themselves, the directors must prove that the awards are entirely fair to the corporation.  But, when the stockholders have approved an equity incentive plan, the affirmative defense of stockholder ratification comes into play.  Stated generally, stockholder ratification means a majority of fully informed, uncoerced, and disinterested stockholders approved board action, which, if challenged, typically leads to a deferential business judgment standard of review.

Held:

Here, the EIP approved by the stockholders left it to the discretion of the directors to allocate up to 30% of all option or restricted stock shares available as awards to themselves.  The plaintiffs have alleged facts leading to a pleading stage reasonable inference that the directors breached their fiduciary duties by awarding excessive equity awards to themselves under the EIP.  Thus, a stockholder ratification defense is not available to dismiss the case, and the directors must demonstrate the fairness of the awards to the Company.  We therefore reverse the Court of Chancery’s decision dismissing the complaint and remand for further proceedings consistent with this opinion.

 

Exelon Generation Acquisitions, LLC v Deere & Company, Delaware Supreme Court, No. 28, 2017 (Del. Supr. Dec. 18, 2017)

Issue:  Whether the trial court erred entering summary judgment for Deere and ordering Exelon to pay $14 million based on the earn-out provisions.

Facts:  Exelon Generation Acquisitions (Exelon) purchased Deere & Company’s (Deere) wind energy business.  Exelon agreed to make earn-out payments to Deere if it reached certain milestones in the development of three wind farm projects that were underway at the time of the sale.  One of the projects was not brought to fruition because of civic opposition.  But shortly afterwards, Exelon managed to acquire another nascent wind farm from a different developer; this location was 100 miles away but Exelon was able to persuade the local utility to transfer the Power Purchase Agreement there and this other wind farm was successful.

Deere caught wind of Exelon’s success with the new site (and its use of the Power Purchase Agreement) and filed suit to recover the earn-out payment, claiming that Exelon had simply relocated the project that was not started because civic unrest had traveled with it.  Exelon denied that it had relocated the project, contending that, after it was prevented from developing the Blissfiled Wind Project by forces beyond its control, it acquired and developed, at great expense, a new project in Gratiot County with different counterparties, developers, equipment manufacturers, landowners, townships, counties, and permits.

On cross-motions for summary judgment, the Superior Court sided with Deere’s interpretation of the Purchase Agreement and ordered Exelon to pay $14 million earn-out payment for successfully developing a windfarm in Gratiot County.

Issues Before the Court:

Whether the trial court erred granting Deere’s motion for summary judgment and dismissing that brought by Exelon.

Held:

Trial court’s grant of summary judgment in favor of Deere is reversed, and the case is remanded with instructions to enter judgment in favor of Exelon.

 

Magid v Magid, Supreme Court of New York, 2017 Slip Opinion 32603 (U) (December 12, 2017)

Issue:  Whether the court should grant plaintiff’s motion for summary judgment to dissolve the LLC, find that defendant breached his fiduciary duty by paying himself an annual management fee, and whether defendant breached the partnership agreement by allocating partnership funds to himself in the form of an annual management fee.

Facts:  In May 2015, M. Magid received $25,000,000 offer to buy investment property that was co-owned by other family members.  Plaintiff, M. Magid, wished to sell the property and defendants did not.

On June 8, 2015, M. Magid called a meeting of the partners to discuss whether MAM (a management company owned by a defendant), and by extension, L. Magid, defendant, should be removed as property manager and partner.  L. Magid objected to the meeting.  Ultimately, all other partners voted to remove MAM as property manager.  L. Magid, believing his consent was required for this removal, told the remaining partners that the meeting had been improperly convened, and that he would resort to court intervention if the partners attempted to oust him.

The sale fell through because of the acrimony and then M. Magid proposed refinancing the property in question.

The dysfunction continued and plaintiffs’ sought an Order dissolving the entity/partnership and giving plaintiffs the right to wind up the business by selling the premises and conducting a final accounting and distribution of partnership assets.

Holding:

1. Regarding the Order to judicially dissolve the business, the trial court opined that “defendants do not accurately identify the requirements to show a deadlock. While the cases cited by plaintiffs have largely concerned partnerships where the competing owners or ownership groups each held 50% of the partnership, defendants do not point to any authority stating that a 50/50 division is necessary for the court to find that a partnership is irretrievably deadlocked.”  Citing Hellenic Am. Educ. Foundation v Trustees of Athens Coll. In Greece, 116 AD3d 453, 454 (1^st 2014), the trial court denied the parties motion for summary judgment.  The latter case holds that sharp disputes of facts over misfeasance and existence of deadlock preclude the granting of summary judgment to either side.
2. Breach of Fiduciary Duty. Plaintiffs alleged that L. Magid breached his fiduciary duty to plaintiffs by misallocating partnership funds in order to pay himself an annual management fee; failing to tell other partners about other offers he received for the property; and unilaterally refusing to sell the building unless plaintiffs agreed to several concessions.  The Court disagreed noting that matters alleged are “matters covered by the [partnership agreement], accordingly, these alleged breaches cannot be the basis for plaintiffs claim.  Moreover, the claim regarding L. Magid/MAM’s management fee is duplicative of the breach of contract (third cause of action).”
3. Breach of Contract. Plaintiffs alleged that L. Magid breached the partnership agreement by allocating partnership funds to himself in the form of an annual management fee.   Magid argued that payment of a management fee to MAM for serving as property manager was permitted pursuant to the partnership agreement, but plaintiffs argued that L. Magid could not avoid the application of the provision that barred partners from receiving additional compensation for services to the partnership.  The trial court opined that “taken together, these provision suggests that it is improper for L. Magid to receive a fee for managing property.  To argue otherwise would render the [partnership agreement’s] prohibition on partners earning extra compensation for services to the partnership meaningless.”

Following entry of the Order, the trial court directed counsel to appear for a status conference.

Roberto H Castro, JD, MST, MBA, CVA, CPVA, CMEA, BCMHV, is an appraiser of closely held businesses, machinery, and equipment and Managing Member of Central Washington Appraisal, Economics & Forensics, LLC, which provides appraisal and litigation support services. Mr. Castro is also an attorney with a focus on business and succession planning with offices in Wenatchee and Chelan, WA. In addition, he is Technical Editor of QuickRead and writes case law columns for The Value Examiner.

Mr. Castro can be reached at (509) 679-3668 or by e-mail to either rcastro@cwa-appraisal.com or rcastro@rcastrolaw.com.