It is not uncommon for parties to a contract to be dissatisfied with something they agreed to in the contract. When the provision involves tax consequences to the contracting parties, an unhappy party may seek some self help relief from the IRS by claiming a tax position that is inconsistent with the provision of the contract. The classic case is a sale of a business where the seller and buyer have opposing tax positions as to whether to allocate a portion of the purchase price to covenant not to compete or to good will. Assuming buyer and seller are in roughly the same tax sitution: (1) the buyer preferring more rapid tax benefit from payments to the seller will prefer to allocate to covenant not to compete; and (2) the seller preferring no tax cost (return of capital) or lower tax cost (capital gain) will prefer allocating to good will. In their contract they will negotiate and make an allocation, which in theory should be consistent with the economics and their relative bargaining positions. The expectation then is that they will report and pay tax consistent with the allocation. (Of course, if the parties are not in the same tax position (such as a buyer having a tax picture that makes him indifferent as to whether he gets a current tax benefit or future tax benefit), the situation is ripe for tax gamesmanship.)
The issue raised here is whether one of the parties can achieve a tax result inconsistent with his agreement. The general principle of tax law is that the realities govern the tax treatment. Under this principle, one might think, if an amount allocated by the parties to covenant not to compete (or consulting) is really for good will, the parties cannot make it so by contract and the real deal should prevail for tax purposes. On the other hand, administrative considerations suggest that the IRS should have not to go behind tax related provisions of a contract to discover the real deal and, thus, that tax consequences should be governed by the contract, at least where the IRS does not assert otherwise; it certainly does not offend notions of fairness to require a party to report and pay tax consistent with the deal he described in the contract he signed. So, balancing these considerations, courts have created a judicial principle requiring a party seeking to disavow his own contract to prove entitlement to do so by "strong proof." Strong proof is well beyond the normal civil tax standard of preponderance of the evidence, and at least one court has described "strong proof" as generally the same as "clear and convincing evidence," which is a standard used in the law generally and also in the tax law (i.e., the IRS must prove civil fraud for purposes of the fraud penalty and unlimited statute of limitations by clear and convincing evidence). There are various formulations of what precisely that party must proof to that heightened proof level. Some courts say that the party must prove facts sufficient that, in a law suit between the parties to the contract to reform the contract, the contract could have been reformed. Other courts say that the party must prove that there was a meeting of the minds between the contracting parties that is not consistent with the words they used in the contract. (This latter standard obviously suggests some manipulation by the parties and potentially criminal conduct in doing so.)
This strong proof rule applies only to a party seeking a tax benefit inconsistent with the contract. The IRS is not bound by the strong proof rule, may determine that the contract provision is not the real deal and may seek additional tax from one of the parties accordingly.
Jack Townsend has recently supplemented his Tax Procedure Book to deal with this issue in more detail. Readers interested in further discussion and citation of authority may download that portion of the Tax Procedure Book by clicking here.