Tax Court Rejects IRS's Treatment of Option and Sale Agreements as a Sham Transaction

(Parker Tax Publishing June 2024)

The Tax Court held that a corporation was not liable for a deficiency as a result of an option agreement and a subsequent sale of land because the transaction was valid and not a sham transaction that should be disregarded for tax purposes. The court also rejected the IRS's argument that a partnership affiliated with the taxpayer that held an option to purchase the property was a mere conduit for the sale of the land and that the proceeds it received pursuant to the option should be imputed to the taxpayer corporation. Parkway Gravel, Inc. v. Comm'r, T.C. Memo. 2024-59.

Background

In 1948 two cousins, Eugene Greggo and Nicholas Ferrara, Sr., started a road construction company named Greggo & Ferrara, Inc. Six years later they incorporated Parkway Gravel, Inc. (Parkway), a Delaware sand-and-gravel mining company, which gave the cousins a means to obtain assorted materials necessary for road construction projects.

The sons of Eugene Greggo and Nicholas Ferrara, Sr., Vincent Greggo and Nicholas Ferrara, Jr., respectively, joined their fathers in the business during the 1960s. Vincent Greggo and Nicholas Ferrara, Jr. (Greggo and Ferrara), believed that the business should expand into real estate development, and they bought some houses from the company stock (slated for demolition) and developed them for sale in 1968. Inspired by this effort, Greggo and Ferrara entered into a general partnership named V&N in 1972. Over the next 50 years, Greggo and Ferrara did assorted work through V&N, often referred to as the "development arm" of their larger group of companies (referred to informally as the Greggo & Ferrara Group). The partners developed a mutually agreeable division of labor, with Greggo taking the lead on internal administrative matters while Ferrara focused on negotiations, daily operations, and business development.

In 1966, Parkway acquired a 58-acre parcel of land in New Castle, Delaware, commonly referred to as the Freeway Pit. Over the next few decades Parkway used this parcel as a borrow pit to supply material for road construction. After it had outlived its usefulness, materials and waste that had been dumped there were removed and the site was filled in and brought to a grade where the land could be developed. In 2006 Parkway began exploring the sale of the Freeway Pit. Parkway hired an appraiser who valued the property at $6.9 million given its industrial zoning.

In August 2006, Parkway granted to V&N the option to purchase the Freeway Pit for the appraised value of $6.9 million (Option Agreement). The Option Agreement listed the consideration as "Ten Dollars ($10.00) ... and other good and valuable consideration." In May 2007, Parkway and V&N entered into an agreement with real estate developer Keith Stoltz for the purchase of the Freeway Pit (2007 Sale Agreement). From 2007 to 2012, Parkway, V&N, and Stolz worked to obtain the requisite governmental approvals for rezoning and commercial development of the Freeway Pit. A firm hired by Stolz took the lead on the technical requirements while Ferrara, working through V&N, headed up efforts on the political front. Ferrara's labors were necessary because of his connections with county councilmen and Stoltz's unfavorable reputation from prior development in New Castle County. Ferrara lobbied members of the New Castle County Council and focused on building support with the public at large. He also negotiated with other governmental entities regarding other issues with the proposed development.

In August 2012, the New Castle County Council approved the development plan with commercial zoning. Later that year, Stoltz, Parkway, and V&N entered an agreement for the sale of the Freeway Pit for $11.1 million (2012 Sale Agreement). The 2012 Sale Agreement was structured such that Stolz paid V&N $4.2 million in exchange for the right to purchase the Freeway Pit, which V&N held pursuant to the Option Agreement. Stoltz then exercised the option rights to purchase the Freeway Pit from Parkway and paid Parkway the option price of $6.9 million.

Parkway used its portion of the sale proceeds, $6.9 million, to enter into a like-kind exchange under Code Sec. 1031. The replacement property selected as part of this exchange cost approximately $14 million, and Parkway assumed approximately $7 million in debt as part of that transaction. Through Code Sec. 1031 Parkway deferred payment of tax on the $6.9 million it received. On its 2012 partnership tax return, V&N reported the $4.2 million in sale proceeds as long-term capital gain and $4.13 million was then distributed to Greggo and Ferrara.

The IRS issued Parkway a notice of deficiency, determining a deficiency of $1,410,280 and a penalty of $282,056 under Code Sec. 6662(a) for 2013. Parkway took its case to the Tax Court. The issues for the court to decide were whether Parkway engaged in a sham transaction or otherwise assigned income in contravention of the terms of the transaction and thus had to recognize as income the $4.2 million received by V&N.

The IRS made various arguments regarding the validity of the Option Agreement and the subsequent 2012 Sale Agreement. According to the IRS, the Option Agreement lacked consideration and was therefore an invalid contract. The IRS further argued that Parkway disavowed the correct form of the Option Agreement and the 2012 Sale Agreement and incorrectly assigned to V&N a portion of the proceeds from the sale of the Freeway Pit. With respect to V&N's role in the transaction, the IRS argued that V&N served as a mere conduit for the sale of the Freeway Pit, and its proceeds should be imputed to Parkway. Through each argument, the IRS argued that the $4.2 million reported by V&N was income to Parkway.

Alternatively, the IRS alleged that the Option Agreement was a factual and economic sham and should be disregarded for tax purposes. The IRS contended that V&N did not pay any consideration in support of the Option Agreement and stood to benefit from the Option Agreement without any risk to itself. The IRS further asserted that Parkway did not stand to gain from the transaction, but rather signed away any potential future gain from appreciation in the Freeway Pit while continuing to bear the risk of ownership in the property.

Analysis

The Tax Court held that Parkway and V&N properly entered into the Option Agreement, receiving $6.9 million and $4.2 million in proceeds, respectively. As the transaction was valid and there was no deficiency, the court held that Parkway was not liable for a penalty under Code Sec. 6662(a).

The court found that, while the Option Agreement provided evidence of cash consideration, it was not the only consideration provided. The court noted that pursuant to other provisions in the Option Agreement, V&N worked to increase the value and marketability of the Freeway Pit. Through V&N, Ferrara lobbied members of the New Castle County Council to support the rezoning of the property. The court found that Ferrara also garnered support from the public at large and conducted negotiations with other governmental entities. The court observed that Parkway, V&N, and Stoltz viewed these efforts as essential for the sale of the Freeway Pit, serving to increase the value of the property and to improve Parkway's chance of selling it.

In addition, the court found no evidence that Parkway endeavored to disavow the transaction or assign any income. The $4.2 million was paid to V&N, the court noted, pursuant to rights it held under the Option Agreement and was therefore not Parkway's to assign. The court also noted that Parkway and V&N consistently complied with the plain reading of the terms of the 2012 Sale Agreement. Thus, the court found that Parkway neither assigned income to V&N nor disavowed the terms of the 2012 Sale Agreement. The court also rejected the IRS's contention that V&N was a mere conduit for the sale of the Freeway Pit. In the court's view, V&N participated in the sale of the Freeway in a significant manner; it made extensive efforts to rezone the property that ultimately proved essential for its sale.

The court rejected the IRS's sham transaction argument after finding that a substantial, nontax purpose motivated the Option Agreement and attainment of that purpose altered the parties' economic positions in a meaningful way. The court found that Parkway entered into the Option Agreement to take advantage of the development and rezoning services offered by Ferrara as a partner of V&N, in order to succeed in selling the Freeway Pit, while also respecting the Greggo & Ferrara Group's longstanding division of business lines among separate entities. The court found that, by entering into the Option Agreement and engaging V&N for real estate development work, an established area of its expertise, Parkway sought to maintain those divisions. Likewise, the court found that using V&N for the rezoning work took advantage of Ferrara's skill and connections in that area.

For a discussion of the assignment of income doctrine, see Parker Tax ¶70,105. For a discussion of the sham transaction doctrine, see Parker Tax ¶99,710.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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