| ||Dethroning King Enterprises |
Jeffrey L. Kwall* and Kristina Maynard**
*Kathleen and Bernard Beazley Professor of Law, Loyola University Chicago School of Law; Of Counsel, Michael Best & Friedrich LLP; Bucknell University, B.A., 1977; The Wharton School, M.B.A., 1981; University of Pennsylvania Law School, J.D., 1981.
**Associate, Honigman Miller Schwartz and Cohn LLP; Eastern Michigan University, B.B.A., 1996; Loyola University Chicago School of Law, J.D., 2003. The authors wish to thank Jenny Brendel, Tom Caldwell, Glenn Coven, Jack Cummings, Dick Fine, Marty Ginsburg, Tim Schally, and Bob Schnur for helpful comments on earlier drafts. Thanks also to Elissa Koch, Colleen Quinlisk, Joseph Rebman, and Jennifer Trout for student assistance. This project was supported by a Loyola University Chicago School of Law Summer Research Grant.
Although the Code is generally thought to encompass the law of federal income taxation, a rich common law also exists. Much of this common law is grounded on the doctrine of substance-over-form, a doctrine that most would concede is both appropriate and desirable. The alternative to this doctrine—a system relying entirely on form—would manifest the virtues of predictability and certainty. Nevertheless, few would argue that formalities devoid of substance should control tax results. If nothing else, fairness dictates looking beneath the surface to ensure that the substance of a transaction is true to its form.
Notwithstanding the appeal of the substance-over-form doctrine, its application is fraught with risk. The use of the doctrine involves a venture into an uncertain world, as divining the substance of a transaction often entails ascertaining the intentions of the parties. Attempting to determine intent is a messy business that must be pursued with caution and restraint, for unless the taxpayers' motives are apparent, tribunals will be compelled to engage in speculation that can lead to an arbitrary result. An arbitrary result is indeed inferior to following the road mapped by the documents.
The step-transaction doctrine is a common application of the substance-over-form principle in federal taxation. Under the step-transaction doctrine, a series of purportedly independent steps are amalgamated into a single event when that result is appropriate. Various views exist as to how closely connected the steps must be for the doctrine to be applied. The most liberal approach is premised on the subjective intentions of the parties. Under this end-result test, separate steps will be combined if the parties intended from the outset to achieve the outcome that ultimately results.
The step-transaction doctrine is often applied to multi-step corporate acquisitions. After a corporation is purchased, the buyer might unilaterally opt to consolidate the acquired enterprise with the buyer's other operations. If the step-transaction doctrine is applied to integrate the consolidation with the earlier purchase, the tax consequences of that purchase might be modified. Allowing the consolidation to alter the buyer's tax consequences is not problematic because the act of consolidating is within the buyer's control. It is an entirely different matter, however, when connecting the buyer's consolidation to the prior purchase alters the seller's tax consequences. Under these circumstances, the step-transaction doctrine should not be applied unless, at the time of the sale, the seller knew or should have known that the buyer would subsequently consolidate the acquired enterprise in a manner that could change the seller's tax consequences. Yet, in a situation where no connection existed between the seller and the buyer's later unilateral consolidation of the acquired enterprise, the United States Court of Claims in King Enterprises v. Commissioner applied the step-transaction doctrine to modify the tax consequences to the seller.
In 1959, King Enterprises, Inc. and the ten other shareholders of Tenco, Inc. transferred all the stock of Tenco to Minute Maid Corporation in exchange for cash, promissory notes and Minute Maid stock. In form, a taxable stock sale had occurred. Seven months later, however, Tenco, which had become a subsidiary of Minute Maid, was merged upstream into Minute Maid. When Minute Maid acquired the Tenco stock, none of the Tenco shareholders, including King Enterprises, could have known that this later merger would occur. Minute Maid itself had given little more than a passing thought to such a merger. Nevertheless, at King Enterprises' behest, the United States Court of Claims applied the step-transaction doctrine and treated the stock sale and later merger as a single transaction, namely, as a merger of Tenco into Minute Maid while Tenco was owned by King Enterprises and its ten co-shareholders. As such, the court treated King Enterprises as participating in a merger, rather than a stock sale. This treatment reduced the amount of King Enterprises' taxable gain from over $1,000,000 to roughly $80,000. Thus, an action by the buyer (the upstream merger of Tenco into Minute Maid) of which the seller (King Enterprises) was unaware when it sold its Tenco shares, dramatically reduced the seller's tax liability.
The King Enterprises decision is untenable. It is patently wrong to permit a buyer's post-acquisition action to affect the seller's tax consequences when, at the time of the sale, the seller could not have known that the buyer would take the specific action that changed the seller's tax consequences. The case stands as a dangerous and unpredictable precedent for both taxpayers and the government. Until recently, King Enterprises has remained dormant, never followed and rarely cited in more than three decades. In 2001, however, the Service resurrected the case in two significant public pronouncements. The stage is now set for the case to wreak future havoc.
It is the thesis of this Article that the tax consequences to one party to a transaction should not be changed by a subsequent unilateral act of another party when the first party neither knew, nor should have known, that the later act would occur. To further this end, King Enterprises should be relegated to an historical footnote. Rather than citing the case in important rulings, the Service should explicitly reject the case. Moreover, courts addressing step-transaction controversies should take every opportunity to criticize the case and state that it will not be followed. If the Court of Appeals for the Federal Circuit ever confronts the issue, it should overrule the case and cleanse the tainted jurisprudence for which its predecessor (the United States Court of Claims) is responsible. To ensure that the case will not lead a misguided court to reach a future indefensible result, Congress should overrule the case.
Part II examines the King Enterprises decision and reveals the lack of a connection between King Enterprises and the upstream merger of Tenco into Minute Maid. Part III critiques the case and demonstrates that it represents an unfortunate aberration in step-transaction doctrine jurisprudence. Part IV identifies how this dangerous precedent might victimize innocent taxpayers and whipsaw the government. Part V explores the body of law supporting the recent Service rulings that potentially revitalize the case and demonstrates that King Enterprises is not a necessary foundation for these rulings. Finally, Part VI delineates the steps that should be taken to dethrone King Enterprises.