The Danielson Rule and The Substance-Over-Form Doctrine

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The Danielson Rule and The Substance-Over-Form Doctrine

A recent Tax Court decision turned on the so-called Danielson rule–a case that takes its name from the eponymous case of Commissioner v. Danielson, 378 F.2d 771, 775 (3d Cir. 1967).  The court’s decision discussed the contours of the rule, which governs a taxpayer’s invocation of the substance-over-form doctrine.  A summary of the key aspects of the case follows:

 

Watts v. Comm’r, T.C. Memo. 2020-143 | October 15, 2020 | Nega, J. | Docket Nos. 18882-13, 19973-13

Short Summary: On remand from the 11th Circuit, the Court re-examined whether the loss on petitioners’ interests in a partnership were capital losses.  Specifically, the Tax Court analyzed whether the Danielson rule should be applied.  The Court determined that it did.

Key Issues: Whether the Danielson rule applies in a scenario where  parties to a transaction expressly agree to a characterization of a transaction in a particular form or intentionally structure a transaction in a particular form for tax purposes, and it is intended to prevent any party from unduly enriching itself by claiming a unilateral alteration of the agreed-upon consequences after the consummation of the transaction?

Primary Holdings:

  • The Danielson rule applied so as to prevent the petitioners’ from reaping improper tax benefits on the transaction.

Key Points of Law:

  • In Danielson, the Court held that the invocation of the substance-over-form doctrine by taxpayers is restricted in certain circumstances. I.R. v. Danielson, 378 F.2d 771, 775 (3d Cir. 1967). Specifically, the Court held in Danielsonthat where an agreement regarding a transaction is unambiguous, the party cannot seek an argument for substance over form of a transaction.
  • If the contract is ambiguous, the Danielson rule does not apply.
  • The Danielson rule is applicable in situations where parties to a transaction expressly agree to a characterization of a transaction in a particular form or intentionally structure a transaction in a particular form for tax purposes, and it is intended to prevent any party from unduly enriching itself by claiming a unilateral alteration of the agreed-upon consequences after the consummation of the transaction.
  • Clauses in an agreement, such as clause that states the agreement constitutes the entire agreement between the parties, is taken into account in determining ambiguity, along with preambles and other descriptive agreement sections.
  • Generally, if an agreement is unambiguous, the party seeking a different treatment will need to prove that the agreement would be unenforceable because of mistake, undue influence, fraud, duress, or the like.

Insight: Watts reinforces the application of the Danielson rule, which states that a taxpayer cannot argue substance over form for a transaction where the agreement for a transaction unambiguously indicates how the transaction should be treated for tax purposes.. If a taxpayer intends to argue that the Danielson does not apply (and where the agreement is unambiguous), the taxpayer will need to provide evidence demonstrating that the agreement is unenforceable due to mistake, undue influence, fraud, or duress.