Today first-time guest blogger and my colleague at Villanova Professor Joy Mullane presents the first of a two-part post on the recent 11th circuit case Peterson v Commissioner. Joy and I have taught together at Villanova in both the Law School and Graduate Tax Program for the last decade. Over the last two years, Joy has brought her considerable teaching talents to work with me and others on developing Villanova’s online graduate tax program. A former clerk on the 11th Circuit, Joy is a thoughtful teacher who has written on the intersection of tax and executive compensation. In the first of a two-part post, Joy sets up the intersection of the so-called Danielson rule and the substantive issue in Peterson involving the consequences of post-retirement payments that Ms. Peterson received following retiring from a very successful career with Mary Kay, the cosmetics powerhouse that has over 3.5 million “independent beauty consultants” selling cosmetics around the world. The Danielson rule as Joy explains serves in most instances to bind the taxpayer to the form that the taxpayer has chosen for the transaction or transactions in question. The Peterson case involves Mary Kay’s payments of hundreds of thousands of dollars to Ms. Peterson following her retirement with the consequences turning on whether the payments were treated as payments in respect of Ms. Peterson’s prior trade or business (and thus subject to employment taxes) or a sale of her domestic and foreign business to the cosmetics giant. In tomorrow’s post, Joy digs deeper into the majority and dissenting opinions and offers observations, including views on how this case may herald an expansion of the Danielson rule. Les
A divided Eleventh Circuit panel recently issued a decision in Peterson v. Commissioner that contained a unique application of the Danielson rule. It is an interesting case from both a substantive and procedural perspective, involving issues of first impression in the Eleventh Circuit. The principal substantive issue was the tax characterization of certain payments. Procedurally, the majority decided the case by initially relying on the Danielson rule in a factual setting that departs from the typical Danielson scenario, before nevertheless proceeding to a consideration of the underlying substantive issues.
When the judicially-created Danielson rule applies, it binds parties to the form of their transaction regardless of the underlying substance. (CIR v. Danielson, 378 F.2d 711 (3d Cir. 1967)(en banc)). The Eleventh Circuit, in Peterson, explained the rule as follows (citing its own precedent, Plante v. CIR, 168 F.3d 1279, 1280-81 (11th Cir. 1999)):
When a taxpayer characterizes a transaction in a certain form, the Commissioner may bind the taxpayer to that form for tax purposes. This is the rule: “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 [to the agreement] would be admissible to alter that construction or to show its unenforceability because of mistake, undue influence, fraud, duress, et cetera.”
There are two primary justifications for the Danielson rule. The first is that it enforces the original expectations of the parties, preventing one party from attempting a unilateral, post-consummation reform of the contract. Secondly, it prevents whipsaw situations.
The typical scenario in which the Danielson rule applies involves parties agreeing to structure a transaction in a particular form, and then one of the parties subsequently challenges the tax characterization of that form based on the underlying substance of the transaction. For example, assume someone sells a business and the contract allocates a larger portion of the proceeds to a non-compete covenant (ordinary income to the seller) and a smaller portion to the sale of capital assets (capital gain income to the seller). If the seller subsequently disputes the allocation, claiming that the true nature of the transaction (i.e., its economic substance) was predominantly a sale of capital assets, the Danielson rule would step in to prevent the disavowal of the agreed upon contract allocation.
The facts of the Peterson case departed from the paradigmatic example. In Peterson, the taxpayer (Ms. Peterson) was an independent contractor associated with Mary Kay. Ms. Peterson made the irrevocable election to participate in two post-retirement payment programs offered by Mary Kay. There was no upfront agreement as to allocations, labels, or characterizations of those payments. Both of the contract agreements, however, contained a unilateral amendment clause. That clause allowed Mary Kay to “amend, modify or terminate” the agreements “at any time and in any manner.” Mary Kay subsequently exercised its rights to unilaterally amend its agreements in a manner that for the first time explicitly characterized the nature of the post-retirement payments as deferred compensation; the amendments made no substantive changes.
Ms. Peterson disputed the deferred compensation characterization and the resulting tax consequences (payments subject to self-employment tax), and instead took the position that the payments were either made in consideration for ending her association with Mary Kay or her agreement not to compete (neither of which are subject to self-employment tax). The Commissioner asserted a tax deficiency for self-employment tax (among others things), and Ms. Peterson ended up in Tax Court. Ultimately, a majority of an Eleventh Circuit panel concluded that the Danielson rule applied to bind Ms. Peterson to the characterization provided by the amended agreements, while the dissent objected to the rule’s use in the context of a post-hoc unilateral modification to which Ms. Peterson could not meaningfully consent.
No other court has applied the Danielson rule under these circumstances. If Peterson is allowed to stand, it would be a significant expansion of the scope of the Danielson rule.
Tomorrow, I will consider the court’s approach to the issues in some detail and provide some observations about the case.
For Part 2 of this post, see here.