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Stella A. Schaevitz Trust v. Director

December 14, 1995


The opinion of the court was delivered by: Rimm

This case is before the court on stipulated facts and oral argument. Plaintiff, Stella A. Schaevitz Trust, appeals a final determination of the defendant, Director, Division of Taxation, dated September 21, 1992, denying a refund of New Jersey Gross Income Tax for the 1987 tax year in the amount of $9,363 plus interest. There are two issues before the court: (1) does the Director have the authority to review an Internal Revenue Service ("IRS") determination; and (2) what is the basis for stock sold when part of the purchase price is withheld pending a review of business results?


On or about December 19, 1986, Schaevitz Engineering ("SE"), a New Jersey corporation, merged with a wholly owned subsidiary of Lucas Industries, Inc. ("Lucas"), a Michigan corporation, as set forth in a "Proxy Statement." SE was the surviving corporation. The terms of the merger agreement provided that each share of SE common stock was converted into the right to receive up to a maximum of $27.34 in cash, subject to an escrow or holdback of $4.74961 a share. Article I, § 1.03, of the merger agreement provided that, "the first installment with respect to each Share shall be equal to the Per Share Amount less $4.74961 . . . ." Article I, § 1.01, of the merger agreement provided the formula used in determining the total "Per Share Amount," or the purchase price to be paid by Lucas. Pursuant to the agreement, approximately $22.59 per share was paid to SE shareholders upon surrender of their stock certificates.

Approximately $5,000,000 of the purchase price was deposited with an escrow agent. The payment of the escrow portion of the purchase price was contingent upon SE achieving an adjusted, consolidated net income before taxes of $3,000,000 for the 15 month period ending March 28, 1987. Article VI, § 6.03, of the merger agreement provided for a reduction in the purchase price based upon the amount of shortfall of the adjusted, consolidated net income goal. Annex D to the merger agreement, Part A at D-1, entitled "Procedures for Adjusted Income Statement," provided in part as follows:

The overriding principle and intention is that the adjusted consolidated income before taxes for the 15 month period ending 28 March 1987 represents a true and fair result for the period under review incorporating all normal recurring expenses. . . . It is agreed that the Company will not take any steps to inflate sales and/or profit before taxes by any of the following actions:

(1) Shipping or selling ahead of customer requirements during the period under review;

(2) Deferring expenditures relative to the period until the following period;

(3) Increasing inventory so as to increase overhead burden recovered in inventory except in the normal course of business;

(4) Changing the existing method of applying burden rates to inventory valuation; or

(5) Any other means or device outside normal, historic business practice.

At the time of the merger, there were 1,052,719 shares of SE common stock. Plaintiff owned 357,570 shares or 33.97% of SE common stock immediately prior to the merger. Stella A. Schaevitz and A. Robert Schaevitz, also known as Abraham R. Schaevitz, as co-executors and co-testamentary trustees of the estate of Herman Schaevitz, deceased (the "estate"), owned 270,875 or 27.72% of SE common stock. The beneficiaries of both plaintiff and the estate are Howard Schaevitz and Phyllis Howard. Individually, Howard Schaevitz owned 12,001 shares or 1.14%, Stella Schaevitz owned 88,891 shares or 8.44%, and A. Robert Schaevitz owned 13,174 shares or 1.25% of SE common stock. SE's Employee Stock Ownership Plan ("ESOP") held 169,210 or 16.07% of SE common stock. The balance of the shares were owned by various minority shareholders.

As the March 28, 1987 consolidated net income deadline approached, SE's consolidated net income was falling short of the mark. Consequently, in order to increase SE's consolidated net income, Stella Schaevitz, Howard Schaevitz and Phyllis Howard (hereafter collectively referred to as "shareholders") arranged to purchase certain "slow- and non-moving" inventory. A section of the merger agreement, entitled "Inventory Write-offs and Write-downs" defines "slow- and non-moving" inventory. The shareholders caused Measurement Systems and Sales, a corporation over which they had control, to effectuate the purchase on their behalf; and transfers were made from the personal accounts of the shareholders to Measurement Systems to provide funds for the purchase.

The purchase price of the inventory totalled $525,100. After the purchase, the inventory was stored in the garage of one of the shareholders. In 1987, following an audit called for in the merger agreement, $2.8497633 per share was released from escrow and paid to all the former SE shareholders.

On April 15, 1988, plaintiff filed a New Jersey Gross Income Tax Fiduciary Return, Form NJ-1041, for the 1987 tax year (the "1987 return"), reporting a net gain of $1,019,003.00 on the sale of 357,570 shares of SE stock. The stock had a zero cost basis to plaintiff for the payment from the escrow account. For 1987, the plaintiff reported and paid to New Jersey, tax in the amount of $37,753.

Late in 1989, representatives of Lucas discovered that the shareholders had purchased the inventory from SE, and they claimed that the purchase was in violation of the merger agreement. Lucas threatened to sue the shareholders if its demands were not met. The parties, after negotiation, arrived at a settlement. The settlement provided for the refund to Lucas of the escrow funds erroneously released to the "Schaevitz Family" to the extent of $200,000. According to the agreement, the "Schaevitz Family" did not include plaintiff. The settlement payment terms were as follows:

At the Closing, [Howard A.] Schaevitz, for himself and on behalf of the Schaevitz Family, shall pay to the Company , by cash, cashier's check or same day funds, the sum of $200,000 (the "Settlement Payment") as a refund of a portion of the conversion price paid by or on behalf of the Company for conversion of the Company stock pursuant to the Merger Agreement.

Neither party to this litigation has indicated whether this obligation was fulfilled. However, plaintiff's amended return does not indicate that plaintiff contributed to this refund, if made.

The settlement agreement also provided that the "Schaevitz Family" return the inventory to SE without further consideration. In accordance with this agreement, on October 6, 1989, Stella Schaevitz, Howard Schaevitz and Phyllis Howard executed a bill of sale for the inventory. With respect to the bill of sale, the three warranted that:

(1) the inventory is in the possession or control of Howard A. Schaevitz, Stella A. Schaevitz and Phyllis C. Howard and has not been sold to any third party; and

(2) the signatories to the Bill of Sale, Howard A. Schaevitz, Stella A. Schaevitz and Phyllis C. Howard have good and marketable title to the Inventory, free and clear of restrictions on or conditions to transfer or assignment, and free and clear of any liens, security interests, pledges, charges, equity claims, covenants, conditions or restrictions, except those claims which may be held by the company and Lucas and which shall be released as provided herein.

Sometime in 1989, after the inventory had been returned to SE, plaintiff paid a portion of the inventory purchase price to Stella Schaevitz in the amount of $111.51; to Howard Schaevitz in the amount of $128,413.35; and to Phyllis Howard in the amount of $128,413.35. There is no evidence of a formal agreement on the part of plaintiff to reimburse the family members. Plaintiff's attorney has indicated that he was not aware of any formal agreement; that it was most likely assumed that plaintiff would contribute to the purchase; and that no formal agreement was necessary because the shareholders essentially controlled plaintiff.

On May 18, 1990, plaintiff filed an amended U.S. Fiduciary Income Tax Return, Form 1041, for the 1987 tax year ("amended federal return"). Line 6 of the amended federal return reported a total capital gain of $310,513. Schedule D, "Capital Gains and Losses," provides the details of the SE stock sale, reporting a gross sales price of $1,019,003, a cost basis of $267,533 and a resulting long-term capital gain of $751,470. The amended return claimed a refund in the amount of $56,167. Plaintiff did not seek a reduction in the amount received in payment for the stock based on the refund of the $200,000 pursuant to the settlement agreement.

On audit, the IRS was originally disinclined to allow the refund claim. On October 25, 1991, in a letter to plaintiff's accountant, the IRS examiner assigned to the case wrote that "the settlement of the prospective lawsuit between Lucas and the Schaevitzs' was independent of, and unrelated to, the Lucas-Schaevitz purchase escrow agreement." The text of the letter is set forth in full:

I discussed the above case with the Group Manager this date. After sorting through all the ins and outs, twists and turns, we come to the Conclusion that the settlement of the prospective lawsuit between Lucas and the Schaevitz' was independent of, and unrelated to the Lucas-Schaevitz purchase-escrow agreement. The lawsuit was based upon Howard's civil, or possible criminal, attempt to fraudulently circumvent the escrow agreement, not upon any failure of sales to measure up to anticipation. This being the case there would be no grounds for adjustment to the basis as set forth in the amended 1041. To rule otherwise would be to reward the taxpayer for his fraud with a refund of income tax. Needless to say, we wouldn't want to put ourselves in this position. Do you agree?

On November 14, 1991, the same examiner concluded that the threat of lawsuit was the "reason behind the settlement and the reimbursement of funds paid pursuant thereto." The text of this letter is also set forth in full:

In response to yours of Nov. 6, if the settlement hadn't taken place and if a complaint would have been filed, it would have been filed setting forth various counts. The first count, as you indicated, would have been for breach of contract on the escrow agreement. The second count would have involved a tort action involving civil and/or criminal fraud. No plaintiff's counsel of any competence would draft a complaint based solely on a breach of contract count given the facts and circumstances in this case.

Clearly, therefore, the plaintiff would have had a cause of action grounded in fraud, which would have been the overiding impetus that were to ensure as a result of Howard's actions.

In Conclusion, this "dominating" force is the reason behind the settlement and the reimbursement of funds paid pursuant thereto. We must, therefore, recommend disallowance of your refund claim accordingly. If you are in accord with this, please have enclosed Form 3363 executed and returned. If not, please advise and we will close case unagreed. In either event, we thank you for your courtesy during the course of the audit.

However, on December 26, 1991, without further explanation and despite his prior correspondence, the IRS examiner permitted plaintiff to amend its basis in the SE stock and allowed the requested refund. In particular, Form 4549, entitled "Income Tax Examination Changes," reflects: at Line 1(a), a capital gain reduction in the amount of $267,533, the reduction representing basis in the SE stock; at Line 3, a corrected adjusted taxable income of $250,740; at Line 8, a corrected tax liability of $142,240; and at Line 18, an overpayment in the amount of $56,167.

Concurrent with its filing of an amended federal tax return, on May 22, 1990, plaintiff filed an amended Gross Income Tax Fiduciary Return, Form NJ-1041, for the 1987 tax year (the "amended return"), reporting a gain of only $751,470 on the sale of SE stock, and requesting a refund in the amount of $9,363. The reduction in net gain was the result of the plaintiff's reporting the stock as having a cost basis of $267,533. A statement attached to the amended return explained the circumstances of the stock sale, the inventory purchase and the subsequent settlement agreement. With regard to the settlement agreement, the explanation was as follows:

The buyers and the sellers have agreed, without the admission of liability by any of them, that it is desirable to resolve these disputes without recourse to litigation.

The sellers, therefore, have agreed to and have returned to the company certain inventory which they had purchased from the company which had a tax basis in the hands of the seller of $267,533, making the original purchase of inventory from the company a nullity and reflecting that sum as cost against the receipt of the released escrow funds in that year.

Because this dispute related directly to the release of escrow funds in 1987, the tax return, Form 1041, ...

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