I could not pass up the Tax Court decision in the case of Michael Tseytin. There are some big dollars in the underlying transaction – over $23 million in cash proceeds in a merger with a total value of $54 million. Mr. Teseytin controlled US Strategies Inc which in turn controlled two Russian Federation limited liability companies which owned and operated Pizza Hut and Kentucky Fried Chicken franchises throughout the Russian Federation. The merger was with AmRest which now operates over 850 restaurants in 12 countries.
The notion of Pizza Hut in Russia really intrigues me.
As does Russian Kentucky Fried Chicken.
It Is All About The Basis
The pain of being a tax blogger. Sadly, the case does not really get into any of that nifty stuff. It is about basis, which I find fascinating, but unless you are a tax geek like me, you may not. So it goes.
Mr. Tseytin was facing a deficiency of $30,478 and an accuracy penalty of $6,096. He on the other hand was seeking to reduce the tax on his originally filed return ($3,780,522) by over $1.3 million. It’s all about basis and how it is applied.
Before the merger Mr. Tseytin owned 75% of USSI. He had zero basis. In order to do the deal he needed to own 100%. He actually ended up paying the minority shareholder a premium – $14 million for 25% of the company that would be valued in the merger at $54 million.
Here is the deal on a merger. You figure out your gain counting both the stock you receive and the cash you receive. Then you recognize gain to the extent that you received cash. If you don’t have much basis relative to the total deal, your recognized gain will likely end up being the cash received which was $23,099,420. The confusion comes from there being two blocks of stock.
Four Different Answers
On his initial return Mr. Tsetyn computed that $5,977,733 of cash was attributable to the $14 million cost basis in the 25% of the stock that he had just acquired. That had him taxed on $17,121,687.
On his amended return, he kind of forgot about the AmRest stock that he had received. He split the proceeds on a per share basis between the two blocks which ended up creating a short-term loss on the 25% bringing his net down to $9,099,320.
The IRS on the other hand remembered about the AmRest stock and figured a loss of $527,297 on the 25% block as opposed to the $8,255,245 claimed on the amended return. To add insult to injury, the loss is not deductible, because the merger is a non-recognition transaction leaving Mr. Tsetyn taxed on $17,324,565.
At trial, he made another argument, which at least in my mind has some merit. He argued that he never really owned that 25% block so it should be viewed that $14,000,000 of the cash proceeds went to the other shareholder and that he should be taxed on the net cash of $9,099,420 (Why it is $100 different from the amended return, I will leave to you as a bonus question.) I really like that answer, because it really is the net cash that he received. Too bad for Mr. Tsetyn that I’m not a Tax Court judge.
Substance Over Form Is A One Way Street
The reason Mr. Testyn’s new argument doesn’t work is a kind of heads I win, tails you lose rule when it comes to “substance over form”. The IRS can argue that what you said you did – the form – is not what actually happened – the substance. You can’t generally do that yourself, because you got to choose the form, so you are stuck with it.
This rule, among other things, seeks to prevent taxpayer challenges to the form of an agreement that, if successful, would nullify the reasonably predictable tax consequences for other parties to the agreement, grant a unilateral reformation of the contract with a resulting unjust enrichment, or permit a party to use the tax laws to obtain relief from an unfavorable agreement.
Petitioner has not challenged the agreements before us on the grounds of fraud, mistake, undue influence, duress, or the like. Under the Danielson rule petitioner is prohibited from challenging the form of the transactions before us.
Even if petitioner were not bound by the form of the transactions he entered into, the stipulated evidence convincingly supports the conclusion that petitioner purchased the Archer shares from Archer on his own behalf and then transferred them to AmRest.
The disallowance of the loss seems rather harsh, but apparently the IRS had the stronger technical argument.
Other Coverage
Lew Taishoff posted on the case with the title – Secret Agent.
Mike claims, for the first time, that he acted as agent for the BVI, and that he was a mere conduit for cash he paid the BVI, as he got reimbursed the cash by the Dutchmen. That crashes at the Nat’l Alfalfa fence: choose whatever form you want to do your business, but once you choose you’re stuck with it. The BVI never were part of the acquisition deal with the Dutchmen; they negotiated nothing and signed nothing.
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