ON APPEAL FROM THE UNITED STATES DISTRICT COURT FOR THE WESTERN DISTRICT OF PENNSYLVANIA (C.A. No. 76-0425)
Before Adams, Rosenn and Sloviter, Circuit Judges.
This appeal is brought by federal taxpayers*fn1 to recover $293,904.63 in federal income taxes, plus interest, levied on income gained from a sale of unimproved real estate and the contemporaneous yet separate assignment of a package of agreements to lease premises to be developed on that land. The taxpayers claim that the district court erred in upholding the government's determination that, for federal income tax purposes, the taxpayers were bound by the form of the transaction which allocated the major portion of the total sale proceeds to the assignment of the leases. Alternatively, the taxpayers dispute the district court's conclusion that they failed to satisfy their burden of proving that the government erred in deciding that 35 percent of the income recognized from the assignment of the leases was attributable to leases held for less than six months, and thus subject to short-term rather than long-term capital gain treatment. Because we find no error in the district court's decision on either issue, we affirm.
After purchasing approximately 57 acres of real estate near Pittsburgh, Pennsylvania, in 1952, William F. Sullivan decided to develop a shopping center on the site. In order to obtain financing for the proposed center, Sullivan secured agreements with several large department stores whose presence was deemed essential in order to attract smaller businesses as tenants. The initial agreement reached was with Gimbel Brothers, Inc., whereby Sullivan conveyed 12.094 acres of the property in question to Gimbels in exchange for Gimbels' promise to build and to maintain for twenty-five years at its own expense a retail store at that location, provided that Sullivan develop a shopping center on the rest of the site. Subsequently, Sullivan entered into long-term agreements with a number of other large retailers to lease premises yet to be constructed as part of the proposed development.
Despite his success in assembling these various lease agreements, Sullivan nevertheless encountered difficulty in securing financing for the project. At this point, Sullivan was approached by Samuel M. Hyman of the West Penn Realty Company on behalf of a group of investors interested in acquiring the property from Sullivan. On July 3, 1962, Sullivan and East Arlington, Inc., a corporation owned by his wife and son that had acquired a minor interest in the 57 acre tract, entered into an informal agreement to convey the land and to assign all leases then executed with prospective tenants to the group represented by Hyman. The total consideration was to be $1,500,000, of which $250,000 was allocated to the land and $1,250,000 to the leases. This informal agreement was later reduced to writing in three documents. On July 19, 1962, Sullivan and East Arlington, Inc. executed an "Assignment of Leases" by which they assigned to the purchasers all of their interest in leases presently signed and executed, as well as any future leases that they might procure pertaining to the proposed shopping center, in consideration of $1,250,000.
As of that date, the purchasers apparently not only became entitled to any rent due in the future under the leases but also assumed all obligations under them, and the prospective lessees were so notified. Subsequently, on August 31, 1962, a second assignment of leases, which substantially reiterated the provisions of the earlier assignment, was executed, together with a deed transferring the land in question. In addition to reciting a separate consideration of $250,000 for the fee interest, the deed stated that the conveyance of land was to include all "improvements, privileges, hereditaments and appurtenances whatsoever thereunto belonging or in anywise appertaining, and the reversion and remainders, rents, issues and profits thereof; and all the estate, right, title, interest, property, claim and demand whatsoever . . ." of the seller. Although Hyman testified that he paid Sullivan "what he asked" for the land and leases, Hyman also stated that the total purchase price was based on a percentage of the expected return on the leases. Apparently, it was Hyman's idea to classify the assignment of the lease package separately from the conveyance of the fee interest, and to allocate the total purchase price between them.
In conformance with the structure of this transaction, Sullivan treated the assignment of the lease package and the conveyance of the real estate as sales of separate assets on his federal income tax return for 1962. He reported the entire gain from the sale of each of those assets as a long-term capital gain, and elected installment sale treatment. At the time in question, income derived from sale of short-term capital assets assets held for less than six months was taxable as ordinary income, while gain derived from sales of long-term capital assets assets held for at least six months was taxed at fifty percent of ordinary rates. Upon audit, however, the Internal Revenue Service (I.R.S.) denied installment-sale treatment and took the position that whatever portion of the $1,250,000 gain recognized on the sale of the leases was allocable to leases other than those executed at least six months prior to the sale would be considered a short-term rather than a long-term capital gain. Further, the I.R.S. determined that 35 percent of the total gain recognized on the sale of the entire package of leases was attributable to leases executed within six months of the transaction, and thus subject to taxation as ordinary income.
Sullivan paid the additional tax assessed, but ultimately filed the present refund action against the government seeking to recast the transaction as the sale of a single capital asset held for more than six months, rather than as a sale of two separate assets. Alternatively, Sullivan claimed that the government's determination regarding the value of the leases executed within six months of the sale was erroneous. After a trial without a jury, the district court held that the I.R.S. properly treated the assignment of the lease package as a sale of an asset separate from the conveyance of the property, inasmuch as the parties had so structured their transaction. Additionally, the court held that the taxpayers did not meet their burden of showing that the government erred in treating 35 percent of the income from the sale of the lease package as short-term capital gain. On appeal, Sullivan claims that the district court erred in reaching these determinations.
In holding that Sullivan was bound for federal income tax purposes by the form and terms of the agreement, the district court relied specifically on the rule of law enunciated by this Court, sitting in banc, in Commissioner v. Danielson, 378 F.2d 771 (1967).*fn2 Danielson involved the purchase and sale of a small loan company. At the purchasers' request, the parties to the transaction expressly agreed to allocate a specific portion of the purchase price to covenants not to compete executed by the selling stockholders. Although the amount a buyer of a business pays the seller for such a covenant is ordinary income to the covenantor and an amortizable item for the covenantee, each selling stockholder nevertheless reported the entire amount received by him as proceeds from the sale of a capital asset. The Commissioner disallowed capital gains treatment to that portion of the gain corresponding to the consideration for the covenant not to compete. Upon the taxpayers' appeal from the imposition of tax deficiencies, the Tax Court ruled in favor of the taxpayers and found in effect that the covenants were neither genuinely bargained for nor realistically significant. Although the Tax Court's factual findings were accepted, we nevertheless reversed its judgment and held that the taxpayers were bound by the form and terms of their agreement as construed for federal income tax purposes by the Commissioner. In so holding, we expressly adopted the following rule of law: "a party can challenge the tax consequences of his agreement as construed by the Commissioner only by adducing proof which in an action between the parties would be admissible to alter that construction or to show its unenforceability because of mistake, undue influence, fraud, duress, etc." 378 F.2d at 775.
Perhaps the most persuasive of the reasons set forth in support of this new rule was that it would alleviate problems for the Commissioner in the collection of taxes and in the administration of the tax laws. 378 F.2d at 775.*fn3 In the past, parties to purchase and sales agreements were encouraged to interpret the allocation of the purchase price in the way that minimized their tax liability. Since parties to such transactions were free to advocate mutually conflicting tax characterizations of their agreement, the Commissioner was frequently compelled to assess inconsistent deficiencies against parties to the same transaction in order to protect total tax revenue. Moreover, the prior law "encourage(d) parties unjustifiably to risk litigation after consummation of a transaction in order to avoid the tax consequences of their agreements." 378 F.2d at 775. As a result, the Commissioner was often confronted with the necessity for litigation against both the buyer and the seller in separate suits, in which the Commissioner took divergent positions so as to avoid two adverse judgments. By allowing the government to adopt as conclusive a result agreed to by the parties, Danielson provided a more efficient system that also greatly reduced the possibility of litigation, such as this case, aimed at revising the parties' bargained agreement.*fn4
An additional justification for the rule adopted in Danielson was that allowing a party unilaterally to vary his agreement for tax purposes, absent evidence that would negate it in an action between the parties, "would be in effect to grant at the instance of a party, a unilateral reformation of the contract with a resulting unjust enrichment." 378 F.2d at 775. It is not unreasonable to expect that the parties to a transfer of a business or of property will determine the financial aspects of their transaction with reference to the tax effects engendered by the terms of the agreement. As we pointed out in Danielson, the presumed tax consequences of a transaction are not only "important, taxwise, both to the buyer and the seller," but also "(may) help to determine the total amount a purchaser is willing to pay for such a purchase." 378 F.2d at 775. But if one party should successfully attack an allocation, and the Commissioner then acts to protect the government's position by challenging the tax consequences claimed by the other party to the agreement, the former would be unjustly enriched at the expense of the latter who might find that he has lost a bargained-for benefit. Finally, Danielson also reflected our concern that permitting taxpayers to attack the form of their transaction for tax purposes "would nullify the reasonably predictable tax consequences" of purchase and sale agreements. 378 F.2d at 775. By fostering an increased predictability that the parties' ...