Muskat v . USA 06-CV-30-JD 4/2/08 UNITED STATES DISTRICT COURT FOR THE DISTRICT OF NEW HAMPSHIRE
Irwin and Margery Muskat
v. Civil N o . 06-cv-30-JD Opinion N o . 2008 DNH 073 United States of America
DECISION
Irwin and Margery Muskat brought suit seeking a refund of
income taxes they paid in 1998. The Muskats contend that they
mistakenly characterized a $1,000,000 payment they received from
Manchester Acquisition Corporation ("MAC") as part of the sale of
the Muskats' business, Jac Pac Foods, Ltd., as ordinary income
when it was a payment for Irwin's personal goodwill and should
have been taxed at the long term capital gain rate.1 They contend that as a result of the mistake, they overpaid their
income taxes in 1998 by $203,434 and seek a refund pursuant to 26
U.S.C. § 7422. The United States asserts that the payment was
properly taxed as ordinary income.
A bench trial was held on January 23 and 2 4 , 2008. In his
opening statement at trial, the Muskats’ counsel raised a new
1 MAC is a subsidiary of Corporate Brand Foods America, Inc. (“CBFA”), which was formed for the purpose of being the entity to acquire Jac Pac. claim that the Muskats were entitled to a refund of $26,792 from
their 1998 taxes, which was assessed as a self employment tax.
The United States objected that the variance doctrine precluded
the Muskats’ new claim. The court directed the parties to file
memoranda on that issue. After the trial concluded, the Muskats
filed a brief on their claim for a refund of the self employment tax and moved for leave to amend their complaint to add the new
claim. The United States also filed a brief on the new claim and
filed an objection to the motion for leave to amend.
I. New Claim for a Refund of Self Employment Tax
In their complaint, the Muskats pled a claim for a tax
refund of $203,434 of the taxes they paid in 1998 on the theory
that the $1,000,000 paid by MAC to Irwin Muskat, under the
provisions of his noncompetition agreement, was actually a
payment for the sale of Irwin’s personal goodwill. As a payment for goodwill, the Muskats alleged, the $1,000,000 should have
been taxed as a long term capital gain. Although not explained
in the complaint, the $203,434 amount sought as a refund was
comprised of $176,652 paid as ordinary income tax, allegedly in
excess of the amount that would have been owed for long term
capital gain tax, and $26,782 in self employment tax, paid
2 because the $1,000,000 was treated as ordinary income subject to
self employment tax.
The Muskats’ new claim is that they are entitled to a refund
of $21,479 of the self employment tax paid in 1998 because
compliance with a noncompetition agreement is not carrying on a
trade or business as is required for self employment.2 See 26 U.S.C. §§ 1401 & 1402. As a result, they contend, they should
not have paid self employment tax on the $1,000,000 even if that
payment is assessed as ordinary income.
Although the Muskats sought a refund of the 1998 self
employment tax in their complaint, they did not assert the new
theory that a payment made under a noncompetition agreement is
not subject to self employment tax. The United States contends
that the Muskats are barred under the “variance doctrine” from
bringing the new claim because they did not raise it in their
administrative refund claim or in the complaint filed here. The Muskats seek leave to amend their complaint, after trial, to
include their new claim, and the government objects.
A. Variance Doctrine
2 The Muskats originally sought a refund of $26,782 for the self employment tax paid, but now agree with the government that the amount they claim should be $21,479.
3 By statute, a taxpayer is prohibited from bringing suit to
recover a tax refund or a credit “until a claim for refund or
credit has been duly filed with the Secretary, according to the
provision of law in that regard, and the regulations of the
Secretary established in pursuance thereof.” 26 U.S.C. §
7422(a). That provision requires administrative exhaustion,
which limits the jurisdiction of the district courts over civil
tax suits, as provided in 28 U.S.C. § 1346(a)(1). United States
v . Williams, 514 U.S. 5 2 7 , 533 (1995); United States v . Dalm, 494
U.S. 596, 601 (1990). Exhaustion, in this context, is defined by
the variance doctrine that prohibits a taxpayer from raising
claims in a suit for a tax refund that were not presented to the
IRS in the administrative proceeding. IA 80 Group, Inc. &
Subsidiaries v . United States, 347 F.3d 1067, 1074 (8th Cir.
2004); accord Western C o . of N . Am. v . United States, 323 F.3d
1024, 1034 (Fed. Cir. 2003); Appollo Fuel Oil v . United States, 195 F.3d 7 4 , 77 (2d Cir. 1999); McDonnell v . United States, 180
F.3d 7 2 1 , 722 (6th Cir. 1999).
A prohibited variance occurs when the taxpayer raises “a
ground for refund neither specifically raised by, nor included
within the general language o f , a timely claim for refund.” IA
80 Group, 347 F.3d at 1074. The taxpayer cannot “substantially
vary the legal theories and factual bases set forth in the tax
4 refund claim presented to the IRS.” Lockheed Martin Corp. v .
United States, 210 F.3d 1366, 1371 (Fed. Cir. 2000). An IRS
“claim is sufficiently specific if the basic issue is evident
from the record, and the IRS is aware of the nature of the
claim.” IA 80 Group, 347 F.3d at 1074.
In this case, the Muskats filed an amended 1998 return,
which served as their refund claim to the IRS. The Muskats
explained the changes in their 1998 return as follows:
“Taxpayers are amending their tax return to properly record the
allocation between the sale of goodwill and a covenant not to
compete. This change results in the reclassification of income
erroneously reported as fully ordinary income to the correct
allocation between ordinary income and capital gain.” Doc. 5 6 ,
Ex. 1 . The Muskats did not raise the new theory that the
$1,000,000, as payment under a noncompetition agreement, was not
subject to self employment tax in their IRS refund claim or in their complaint filed in this court.
The Muskats argue that the variance doctrine does not bar
their new claim because they sought a refund of the self
employment tax in the claim presented to the IRS, albeit under a
different theory. They contend that the IRS had notice of their
new self employment tax theory because they raised that theory in
their IRS claims for taxes paid in 2001 and 2002 and in a refund
5 claim for 1999 to 2001. They also contend that the United States
has conceded in their other proceedings for tax refunds that
payments under the noncompetition agreement are not subject to
The Muskats did not raise the new self employment tax theory
in their 1998 tax refund claim before the IRS, which divests the
court of jurisdiction to hear the claim. Even if the IRS were
deemed to have had sufficient notice of the new theory based on
the Muskats’ claims for refunds for other years, which is
unlikely, that claim was not pled in the Muskats’ complaint in
this case. To remedy that omission, the Muskats alternatively
move to amend their complaint to add the claim.
B. Motion for Leave to Amend the Complaint
The Muskats seek leave to amend their complaint under
Federal Rule of Civil Procedure 15(b), contending that an amendment to add the new theory to support their refund claim for
the self employment tax paid in 1998 is necessary to conform the
pleadings to the evidence and the issues at trial. The United
States objects to the motion.
“Rule 15(b) permits post-trial amendments to conform the
pleadings to the evidence ‘[w]hen issues not raised by the
pleadings are tried by express or implied consent of the
6 parties.’” Kenda Corp. v . Pot O’Gold Money Leagues, Inc., 329
F.3d 216, 232 (1st Cir. 2003) (quoting Fed. R. Civ. P. 15(b)).
When the opposing party does not expressly consent to trial of an
issue, “[c]onsent to the trial of an issue may be implied i f ,
during the trial, a party acquiesces in the introduction of
evidence which is relevant only to that issue.” Id. (internal
quotation marks omitted). An amendment under Rule 15(b) may be
allowed only when the opposing party will not be prejudiced.
United States v . Davis, 261 F.3d 1 , 59 (1st Cir. 2001).
The United States did not expressly consent to trial of the
self employment tax issue. The Muskats ignore the showing
required to show that the United States impliedly consented to
trial of the new self employment tax issue. Instead, the Muskats
focus exclusively on showing that the United States would not be
prejudiced by introducing the new claim at this late date.
Absent at least implied consent, however, Rule 15(b) does not apply. The United States objected to the new issue at trial.
No evidence was introduced that was relevant only to that issue.
Therefore, the United States did not consent to trial of the
issue by implication. The motion for leave to amend is denied.
7 II. Decision
The Muskats sought a refund of income tax they paid for 1998
on the $1,000,000 payment under the Noncompetition Agreement,
arguing that the payment was for Irwin Muskat’s personal goodwill
and should have been taxed as a long term capital gain rather
than ordinary income. The government opposed the refund. The
court denied the government’s motion for summary judgment based
on 26 U.S.C. § 1060 and, before trial, ruled that the applicable
legal standard, as established by First Circuit precedent, was
the “strong proof” rule. See Order, July 2 5 , 2007 (denying
summary judgment); Order, Jan. 1 0 , 2008 (deciding applicable
standard).
During the bench trial held on January 23 and 2 4 , 2008,
Irwin Muskat, George Gillett, and Leslie Charm testified as
witnesses. The deposition of Benjamin Warren was submitted, with
certain testimony stricken based on the parties’ objections. At the conclusion of the trial, the court gave the parties an
opportunity to file trial briefs on or before March 2 0 .
A. Findings of Fact
Jac Pac Foods, Ltd. was founded in 1933, as Granite State
Packing Company, by Irwin Muskat’s grandfather. Irwin Muskat
8 worked in all aspects of the family business, beginning when he
was a teenager. Granite State, based in Manchester, New
Hampshire, bought another meat company, Jac Pac, based in
Watertown, Massachusetts, in the 1960s, and their business grew
significantly. Muskat cultivated personal relationships with Jac
Pac’s customers and suppliers.
In 1987, when his uncle died, Muskat took over operational
control of the company, becoming the president, CEO, and a 37%
shareholder. Muskat continued his “hands on” management style,
maintaining his involvement in key accounts and his personal
relationships with customers and suppliers. After a fire at the
Granite State site, the Jac Pac operation was moved from
Watertown to a new facility in Manchester. By 1998, Jac Pac had
annual revenues of approximately $130,000,000.
During the late 1990s, Muskat earned $535,000 in salary and
bonuses at Jac Pac. He also had life insurance worth $4 million, partially paid for by Jac Pac. In addition, Muskat had a
deferred compensation plan that would provide him $200,000 per
year for ten years, which would be paid to his heirs in the event
of his death.
Irwin Muskat turned sixty in 1997 and began to consider
whether he wanted to continue working the long hours that he had
committed to Jac Pac. During that time, a large hamburger
9 producing company was driven into bankruptcy by the effects of an
e . coli outbreak caused by its products. That event was the
turning point in Muskat’s decision to sell Jac Pac.
George Gillett, the chairman and majority stockholder of
CBFA, contacted Muskat about purchasing Jac Pac. CBFA was in the
process of acquiring the assets of meat production and
distribution companies to build a larger company with the
intention of becoming an attractive acquisition for another
enterprise or to take the company public. Gillett and CBFA
valued Muskat’s relationships with customers, such as Wendy’s,
Burger King, Sisco, and Subway, and his relationships with
suppliers and distributors, all of which had contributed to Jac
Pac’s success. Gillett considered Muskat’s relationships with
his customers and suppliers to be extraordinary and would not
have acquired Jac Pac without Muskat’s continued participation in
the business. During the process that led to the sale of Jac Pac to
MAC/CBFA, Jac Pac and Muskat were represented by Leslie Charm, a
member of Jac Pac’s board of advisors; Peter Leberman, an
attorney; David Linton, an investment banker; and Muskat. CBFA
was represented by Gillett; Benjamin Warren, CBFA’s president,
CEO, and a minority shareholder; Jeffery Joyce; Jim McCoy, and
10 the law firm of Winston & Strawn, LLP. Negotiations about the
sale went on during the summer and fall of 1997.
In early November of 1997, Muskat, Jac Pac’s
representatives, and MAC/CBFA’s representatives met in Chicago to
negotiate the terms of the transaction. They discussed the
purchase price, the structure of the sale, Jac Pac’s payment of
dividends, an incentive stock option plan, the consideration to
be paid to Irwin Muskat, and Muskat’s role in the business after
it was sold. Muskat wanted to receive more compensation in the
transaction than his share of stock in Jac Pac would provide.
Muskat’s personal goodwill was not raised at the meeting. The
Chicago meeting concluded without an agreement, and the parties
continued to negotiate the terms of the transaction. Following
the meeting, letters indicated that the transaction would be
accomplished through a sale of assets with a purchase price of
$34 million. Gillett and MAC/CBFA offered Muskat, personally, $2,500,000
to be paid in three equal installments, with the allocation to be
worked out in a manner that was advantageous to Muskat for tax
purposes. In late December of 1997, Gillett and MAC/CBFA sent a
draft letter of intent that allocated the payments to a
noncompetition agreement and structured the payments in different
installments. Muskat responded with changed language, adding,
11 among other things, a provision that the payments would survive
Muskat’s death or disability. On January 8 , 1998, CBFA and
Muskat agreed to a letter of intent that included the
noncompetition agreement, with a survivability provision, and
also required Muskat to make an investment in CBFA and to enter a
three-year employment agreement with CBFA.
Gillett testified that in his business transactions he
preferred to operate in partnership with the owners of the
acquired businesses and to provide incentives of stock options,
bonuses, and deferred compensation to keep the executives in the
business. He also testified that the negative incentive of a
noncompetition agreement was necessary to protect against
problems that might arise later if the relationships and positive
incentives did not work out. Jac Pac’s advisor, Leslie Charm,
remembered that Gillett and Warren required a noncompetition
agreement. During January and February of 1998, the parties and their
representatives worked on drafts of the documents for the
transaction, which included the asset purchase agreement, the
noncompetition agreement, the employment agreement, and the
subscription agreement that required Muskat to invest in CBFA.
The noncompetition agreement was an essential element of the
transaction package.
12 Muskat became concerned that the nature of the transaction
had changed so that he would not receive the compensation that he
had been promised, and the deal nearly collapsed. Muskat
understood that he would receive a compensation package that had
the same value as the compensation he was receiving from Jac Pac
prior to the transaction with MAC/CBFA. The parties agreed to
allocate the purchase price differently so that Muskat would
receive more from the transaction. Warren and Gillett from
MAC/CBFA felt that it was important to have Muskat continue in
his role as CEO at Jac Pac and to use his relationships and
contacts for the benefit of the combined companies.
New draft documents were prepared. Muskat was offered an
additional $2,000,000 in compensation under the noncompetition
agreement. The next draft of the agreements reduced the
compensation under the noncompetition agreement, to reflect
reduced payments in the years 1999, 2000, and 2001. A subsequent draft reduced the compensation again by a small amount.
The asset purchase agreement was signed on March 3 1 , 1998.
That agreement allocated the asset purchase price to include
$15,908,511 for Jac Pac’s goodwill. The agreement required
Muskat and MAC/CBFA to execute a mutually satisfactory
noncompetition agreement, employment agreement, and subscription
agreement. The noncompetition agreement and other agreements
13 were signed on May 7 , 1998, as part of the Jac Pac transaction.
Under the subscription agreement, Muskat agreed to invest
$2,000,000 in CBFA. Under the employment agreement, Muskat was
entitled to salary and also to bonuses that were tied to certain
sales targets.
The noncompetition agreement provides that Muskat shall not . . . participate or engage in directly or indirectly (as an owner (other than as a passive investor), partner, employee, officer, director, independent contractor, consultant, advisor or in any other capacity calling for the rendition of services, advice, or acts of management, operation or control), any business that, during the Term, is competitive with the Business Conducted (as defined below) by the Company or any firm or corporation owned or controlled by CBFA (a “Related Entity”) within any geographic area in which the Company or any Related Entity does business.
The “Term” of the agreement, which was defined in relation to
Muskat’s employment agreement, extended for thirteen years. The
agreement prohibited Muskat from soliciting employees to leave the company and affiliate with a competitor and from diverting
business from the company. In consideration for the agreement,
Muskat would be paid a total of $3,955,599 in separate
installments, beginning with a $1,000,000 payment on the date of
the agreement. The agreement also provided that the obligation
of MAC/CBFA “to make the payments provided for herein shall
survive Muskat’s death or disability.”
Muskat has received the payments promised under the
14 noncompetition agreement. He also worked for CBFA as provided in
the employment agreement and invested in the company as the
subscription agreement required. When CBFA was purchased by
another company in 2000, Muskat continued his employment with the
new company and worked until 2004.
On their 1998 federal tax return, Irwin and Margery Muskat
identified the $1,000,000 dollar payment Irwin received under the
noncompetition agreement as ordinary income and paid income tax
and self employment tax on that amount. The Muskats filed an
amended tax return in 2002, characterizing the $1,000,000 payment
in 1998 as proceeds from the sale of Irwin Muskat’s personal
goodwill in Jac Pac. They claimed an overpayment of taxes for
1998 in the amount of $203,434. The IRS denied their request for
a refund.
B. Discussion and Rulings of Law
The Muskats argue that despite the provisions of the
noncompetition agreement, the payments under that agreement were
intended by the parties to purchase Irwin Muskat’s personal
goodwill. The Muskats claim that they are entitled to a tax
refund because as compensation for goodwill, the payment should
have been taxed as a capital gain. The government contends that
15 the Muskats are bound by the terms of the noncompetition
agreement and cannot now reconfigure the purpose of the agreement
for tax purposes. The government asserts that no tax refund is
due because the payment was ordinary income and because even if
the payment related to Irwin Muskat’s personal goodwill, he was
required to provide services to MAC/CBFA in connection with his
personal goodwill, making the payments ordinary income.
The parties disputed the applicable standard for deciding
whether the $1,000,000 payment under the noncompetition agreement
was for the purposes expressed in the agreement or was instead a
payment for Irwin’s personal goodwill. The Muskats argued that
the “economic reality test” applied. The government contended
that the First Circuit required “strong proof” to overcome the
parties’ expressed intent. The court ruled, based on older but
still extant First Circuit precedent, that the “strong proof”
standard applied. See Order, Jan. 1 0 , 2008 (doc. n o . 3 8 ) .
1. Noncompetition Agreement or Sale of Personal Goodwill
The noncompetition agreement provides that the consideration
paid is for Muskat’s promises made under the agreement. To
prevail on their personal goodwill claim, the Muskats must show
by "strong proof" that, despite the express terms of the
agreement, Irwin Muskat and MAC/CBFA intended the $1,000,000
16 payment to be compensation for Irwin's personal goodwill and not
for the promises made in the noncompetition agreement. Harvey
Radio Labs., Inc. v . Comm’r of Internal Revenue, 470 F.2d 1 1 8 ,
119-20 (1st Cir. 1972). The Harvey Radio standard requires
strong proof of the parties’ intentions when they entered into
the noncompetition agreement. Id. at 120.
The negotiation process that culminated in the sale of Jac
Pac to MAC/CBFA did not include a discussion of Irwin Muskat’s
personal goodwill, as such. Neither the noncompetition agreement
nor any other agreement in the transaction mentions Irwin
Muskat’s personal goodwill. Indeed, the concept of personal
goodwill as an asset, separate from business goodwill and from
the obligations imposed by the noncompetition agreement, in the
context of the sale of a business like Jac Pac is unclear. See,
e.g., Matter of Prince, 85 F.3d 3 1 4 , 320-23 (7th Cir. 1996)
(discussing value of orthodontist’s goodwill in his practice for purposes of bankruptcy valuation and attributing orthodontist’s
goodwill, his relationships with patients, as an asset of his
practice); Bruss C o . v . K & S Brokerage, Inc., 1992 WL 25375 at
*10 (N.D. Ill. 1992) (discussing personal goodwill of former
sales contractor for purposes of determining whether
nonsolicitation covenant was enforceable); In re Cooley, 87 B.R.
432, 443 (S.D. Tex. 1988) (goodwill of medical practice not
17 separate from personal goodwill of physician and could not be
sold separate from his services); Martin Ice Cream C o . v . C.I.R.,
110 T.C. 189, 206-07 (1998) (where family member operated as
principal of family business without an employment agreement or
noncompetition agreement, his oral agreement with customer and
personal relationships were his own asset and not an asset of the
business).
During the negotiation process, the parties were well-aware
of Jac Pac’s business goodwill, to which more than $15,000,000 of
the purchase price was allocated. Warren testified that he was
not aware of any goodwill in the transaction other than Jac Pac’s
goodwill. The noncompetition agreement defines “Goodwill” as an
asset of Jac Pac “including its goodwill and business as a going
concern.” The purpose of the noncompetition agreement was to
protect Jac Pac’s “Goodwill” in the transaction. Muskat
acknowledged in the agreement that the noncompetition provisions were “necessary to preserve and protect the proprietary rights
and the goodwill of [MAC] (including [Jac Pac’s goodwill]) and
the Related Entities as going concerns.” The consideration paid
under the agreement was expressly for the covenants not to
compete, with no mention of personal goodwill.
Muskat contends that the provisions of the noncompetition
18 agreement, including the long term of the agreement and the
survivability provision, were unusual and show that the agreement
was really a sale of his personal goodwill. He also contends
that given his age, his lack of interest in competing with
MAC/CBFA, his employment and investment in the company, and the
insurmountable difficulties that would be encountered in starting
a competing business, there was no need for a noncompetition
agreement. Because a noncompetition agreement was not necessary,
Muskat contends the compensation under the agreement was instead
paid for his personal goodwill.
The evidence shows that Gillett of MAC/CBFA included
noncompetition agreements in nearly all of his business
transactions because he believed that the protection such
agreements provide is important. He testified that he was
pleased to have the noncompetition agreement with Muskat to
protect his family’s interests in the business, although the agreement was not the central focus of the transaction with
Muskat and Jac Pac. Although Gillett was not particularly
concerned that Muskat would leave CBFA to start a competing
business, he nevertheless intended that the noncompetition
agreement with Muskat would protect CBFA shareholders and protect
Gillett’s family partnerships.
Gillett and Warren valued Muskat’s key relationships with
19 Jac Pac’s customers, suppliers, and distributors and his keen
business acumen. They knew that Muskat wanted to be paid more
than his stockholder share of the purchase price and that he
wanted his package from MAC/CBFA to include the same value as his
compensation package with Jac Pac. They felt that retaining
Muskat in the business was essential for the transaction, and they agreed to the increased amounts because it was necessary to
have Muskat recommend the transaction to Jac Pac’s board and the
other shareholders. Although the agreement accommodated Muskat’s
demand for additional compensation, MAC/CBFA did not pay more in
the transaction but instead merely reallocated the purchase
price.
The Muskats have persuasively shown that MAC/CBFA agreed to
allocate additional compensation to Irwin through the
noncompetition agreement. They have not provided strong proof that MAC/CBFA and Muskat intended the payments under the
noncompetition agreement to buy Muskat’s personal goodwill.
Therefore, the Muskats did not carry their burden of proof on
their claim that the $1,000,000 payment made in 1998 under the
noncompetition agreement was for the sale of Irwin Muskat’s
personal goodwill.
2. Sale of Asset or Payment for Personal Services
20 The government also argues that if the payments under the
noncompetition agreement were found to be something other than
compensation for the covenants in that agreement, those payments
were for personal services and not for the sale of an asset. The
Muskats’ claim was that the compensation agreed to in the
noncompetition agreement was for the sale of an asset, Irwin’s
personal goodwill. The court has concluded that the Muskats did not carry their burden of proof on that claim. As that resolves
the only claim raised in the complaint, no further analysis is
necessary.
Conclusion
For the foregoing reasons, the plaintiffs’ motion for leave
to amend their complaint (document n o . 48) is denied.
The court finds in favor of the government on the
plaintiffs’ only claim in this case that the $1,000,000 paid in
1998 under the noncompetition agreement was a payment for the
sale of Irwin Muskat’s personal goodwill.
21 The clerk of court shall enter judgment in favor of the
government and close the case.
SO ORDERED.
VJJoseph A. DiClerico, Jr. United States District Judge April 2 , 2008 cc: Nathaniel J. Dorfman, Esquire James E . Higgins, Esquire Robert J. Kovacev, Esquire Edward J. Murphy, Esquire T . David Plourde, Esquire John-Mark Turner, Esquire Karen Wozniak, Esquire