One of the most important things lawyers and clients should do in every merger & acquisition transaction is to read the documents, and be clear on the central facts of their transaction. This seems so profoundly simple and obvious that it seems that it would not need to be repeated. But a recent U.S. Tax Court case highlights the implications of not doing so.

In Makric Enterprises, Inc. v. Commissioner, TC Memo 2016-44 (Dkt. No. 1017-13, issued 03/9/2016), the taxpayers of Makric Enterprises, Inc. (Makric) sued the IRS to set aside a determination that the they collectively owed the IRS $2,839,780 and an accuracy-related penalty of $567,956 stemming from a relatively simple sale of the common stock of a parent company of its wholly owned subsidiary to a third-party purchaser.

Makric was the parent company, its subsidiary entity was Alpha Circuits, Inc. (Alpha), and the third party purchaser was TS3 Technology, Inc. (TS3).

The taxpayers were the sole shareholders of Makric. The essence of the transaction was that the taxpayers wanted to sell Alpha to TS3. They initially wanted to dissolve Makric and distribute its stock in Alpha so that they would be Alpha’s direct owners and the direct sellers of Alpha’s stock to TS3. But that plan was at some point found to be tax-inefficient so it was abandoned.

But for some inexplicable reason the taxpayers continued to believe that the sale was still to be structured where they were to sell their (indirectly owned) stock in Alpha to TS3, rather than of their stock in Makric to TS3. No one apparently clarified the failed deal structure with them; neither their attorneys, their accountants, or even their investment bankers. Multiple drafts of the Stock Purchase Agreement were exchanged between legal counsel, an investment adviser, the parties and the taxpayers/shareholders, and later to the taxpayers and their accounting firm. No one appeared to read the documents and coordinate them with the deal structure that the taxpayers thought they were adopting.

The attorneys for the taxpayers in fact structured the sale transaction so that the holding corporation, Makric, sold its stock of Alpha to TS3. The shareholders did not therefore sell their (indirectly owned) stock in Alpha to TS3. The accountants for the taxpayers reflected the sale of the taxpayers’ stock in Alpha; and not of Makric.

Of course, at some later point in time the IRS audited Makric and asked why Makric did not report the sale of its stock in Alpha. That is the ‘aha moment’ that the accountants learned that the transaction was incorrectly reported on the taxpayers’ tax returns.

The taxpayers argued that the substance of the transaction should govern because it was the parties’ intention that the taxpayers were to sell their stock in Alpha to TS3 and, alternatively, the Stock Purchase Agreement should be reformed because the parties made a mutual mistake.

The court disagreed and concluded that “the substance of [the] transaction was a sale of Makric and not Alpha” because the Stock Purchase Agreement, as interpreted by the court was unambiguously an agreement by Makric to sell its Alpha’s stock. As for the taxpayers’ attempt to reform the Stock Purchase Agreement the court determined that there was no mutual mistake because TS3, the purchaser, always believed that it was going to buy Alpha’s stock, which it did, albeit from Makric and not Makric’s shareholders. So, there was no mutuality of mistake. It was a unilateral mistake on the taxpayers’ part. The taxpayers may have been mistaken about the deal structure; but TS3 was not.

Curiously, Makric did not call as witnesses either its attorneys or the attorneys for TS3. The court noted this perhaps hinting that it would have considered their testimony as in its analysis.

All of this could have been avoided if either the taxpayers’ attorneys had spoken with their clients about the deal structure on an ongoing basis, or if the Recitals to the Stock Purchase Agreement had expressly described the deal structure for someone to have noticed them. Granted this assumes that someone would have bothered to read even the first page(s) of the Stock Purchase Agreement.

The takeaways here are: read the documents. And, if you are drafting the agreement – unless there is some overriding reason not to describe the transaction in detail in the Recitals – spend the extra few moments to set out the facts of the transactions in the Recitals. Another alternative favored by most transactional attorneys is to visually diagram the transaction, including its incidental steps and then circulate that diagram to the parties.