Limitations on Taxpayers’ Ability to Disavow Tax Consequences of Contract Terms

By John Keenan, J.D., and Julia Lagun, J.D., CPA, Deloitte Tax LLP, Washington, DC

Editor: John L. Miller, CPA

A fundamental principle of federal income taxation is that the tax consequences of a transaction are determined based on its substance rather than its form. To this end, the government has the ability to look beyond the form of a transaction to its economic substance in determining its tax consequences.

Taxpayers have also asserted the substance-over-form argument to disavow the tax consequences of contracts into which they entered. Often these taxpayers bargained away tax advantages as part of the underlying transaction and then attempted to reclaim the tax benefits by recharacterizing the transaction for tax purposes on their income tax return. While the government is entitled to look through the form of a transaction to its economic substance, taxpayers are generally not allowed to disavow the form of their transactions.

Much of the case law addressing this issue developed in the purchase price allocation context. Consider the following scenario: A seller of stock agrees with the buyer to allocate a portion of the purchase price to a covenant not to compete, which is amortizable to the buyer but taxable to the seller as ordinary income. The seller subsequently takes the position that the entire purchase price should be treated as a capital gain, arguing that the agreement to allocate a portion of the purchase price to a covenant not to compete bore no relationship to economic reality.

The circuit courts have split on the issue of when a taxpayer should be able to disavow the form of his or her transaction and assert that the substance of the transaction controls. Some courts have adopted the “strong proof” standard and others the more strict Danielson standard. In a recent case, the New Hampshire District Court applied the strong-proof standard and ruled that a former consulting partner at Ernst & Young U.S., LLC (E&Y), who agreed to exchange her interest in E&Y for stock in Cap Gemini, S.A. (Cap Gemini), was bound by the valuation of her Cap Gemini restricted shares specified in the exchange transaction documents (see Berry, No. 06-CV-211-JD (D.N.H. 10/2/08)).

The Danielson Standard

The Danielson standard has been adopted by the Third, Fifth, Sixth, Eleventh, and Federal Circuits (with some acceptance in the Second Circuit). In Danielson, 378 F.2d 771 (3d Cir. 1967), the stock purchase agreement entered into by the seller and the purchaser allocated a portion of the purchase price to a covenant not to compete. When filing his individual tax return, the seller ignored the purchase price allocation to the covenant not to compete set forth in the purchase agreement and treated the entire proceeds as a capital gain on his return. The seller argued that he could disavow the terms of the stock purchase agreement because the allocation to the covenant not to compete bore no relationship to economic reality. The Tax Court agreed with the seller and found that the covenant did not effectively preclude the seller from competing; thus, the seller appropriately ignored the purchase price allocation set forth in the stock purchase agreement and treated the entire proceeds as a capital gain on his return.

The Third Circuit vacated the Tax Court opinion and applied a more rigid standard, now referred to as the Danielson standard. The Third Circuit articulated the rule as follows:

[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, etc.

The Third Circuit justified its decision in Danielson on a number of policy grounds. Some of the rationales for precluding a taxpayer from arguing against the form of a transaction include:

  • The opportunity to plan the transaction so that the taxpayer controls the contractual form chosen;
  • Avoiding unjust enrichment of one of the parties due to unilateral contract modification;
  • Predictability of tax results; and
  • Avoiding whipsaw of the government (where both parties end up with the tax benefits in separate litigation).

The Strong-Proof Standard

The First, Fourth, Seventh, and Ninth Circuits have adopted the strong-proof standard. The Tax Court generally follows that standard unless the decision is appealable to a circuit that follows Danielson. Initially established in Ullman, 264 F.2d 305 (2d Cir. 1959), and Schulz, 294 F.2d 52 (9th Cir. 1961), the strongproof standard requires a taxpayer who wants to disavow the form of a transaction to demonstrate by strong proof that the contractual allocation lacked an independent basis in fact or economic reality.

Since the initial articulation of the strong-proof standard, courts have differed on its interpretation and application. While some cases look at whether the form of the transaction set forth in the agreement is supported by the economic reality, others focus on whether a taxpayer demonstrates strong proof of a contrary intention of the parties at the time of the transaction.

While the Danielson rule effectively bars a taxpayer from arguing against the terms set forth in contractual documents, the strong-proof standard allows a taxpayer the opportunity to disavow the contractual terms under certain circumstances. The taxpayer must satisfy a heightened burden of proof to be successful; however, the type of evidence required to meet the strong-proof threshold is often uncertain. A showing of strong proof has been interpreted as being proof by more than a preponderance of the evidence, but less than what is required under Danielson. As shown by the recent court case discussed below, satisfying the strong-proof standard can be a difficult task for taxpayers.

Taxpayer Bound by Stock Valuation Agreement

The transaction in Berry involved E&Y’s sale of its consulting practice to Cap Gemini, which was effectuated by E&Y consulting partners exchanging their interest in E&Y for stock in Cap Gemini. The transaction documents provided a valuation of the Cap Gemini shares received by the E&Y consulting partners and noted that all parties to the transaction agreed to treat the valuation and related issues consistently for federal income tax purposes. The transaction required the approval of 75% of the E&Y consulting partners and ultimately received 95% approval.

The taxpayer reported the transaction in accordance with the transaction documents on her 2000 federal income tax return but subsequently filed an amended return contending that the value of the received Cap Gemini stock was much lower than originally reported. The taxpayer claimed that she was not bound by the transaction documents because she was merely a “third party” to the transaction and had no real bargaining power.

The court rejected the taxpayer’s contention. Although several partners negotiated on behalf of all consulting partners, all the consulting partners were invited to participate in meetings and had the opportunity to vote on the transaction. Moreover, the court noted that the taxpayer did not provide any evidence that her employment would be negatively affected if she refused to sign the agreement or attempted to negotiate the terms.

The court held that the strong-proof rule applied because the taxpayer was clearly a party to the transaction agreement and affirmatively agreed to it by signing the documents. In this case, the taxpayer was unable to present strong proof to overcome the presumption that the valuation specified in the agreement should control for tax purposes. The court rejected the taxpayer’s contention that the actual value of the Cap Gemini shares was much lower: “Under the ‘strong proof’ rule, however, the actual value of stock is irrelevant. Rather, it is the value assigned to the stock in the transaction documents that controls, unless there is ‘strong proof’ that the parties intended to assign a different value.”


The lack of uniformity in the courts, with some circuits following the Danielson standard and others the strong-proof rule, continues to create uncertainty for taxpayers. One thing is certain: Where a taxpayer willingly enters into an arm’slength agreement, an attempt to disavow the tax consequences of that agreement is an uphill battle for the taxpayer regardless of which standard applies.

Editor Notes

John Miller is a faculty instructor at Metropolitan Community College in Omaha, NE. John Keenan is a tax director with Deloitte Tax LLP in Washington, DC. Julia Lagun is a manager with Deloitte Tax LLP in Washington, DC. The editor and Mr. Keenan are members of the AICPA Tax Division’s IRS Practice and Procedures Committee. For further information about this column, contact Mr. Miller at

This item does not constitute tax, legal, or other advice from Deloitte Tax LLP, which assumes no responsibility with respect to assessing or advising the reader as to tax, legal, or other consequences arising from the reader’s particular situation.

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