UNITED STATES DISTRICT COURT FOR THE 

DISTRICT OF NEW HAMPSHIRE

Irwin and Margery Muskat

v. Civil No. 06-cv-30-JD

Opinion No. 2008 DNH 005

United States of America

O R D E R

Irwin and Margery Muskat seek a refund of income taxes paid

in 1998 on compensation Irwin Muskat received from Manchester

Acquisition Corporation ("MAC") as part of the transaction

involving the sale of the Muskats' business, Jac Pac Foods, Ltd.,

to MAC. The Muskats contend that they mistakenly characterized a

$1,000,000 payment under Irwin's noncompetition agreement as

ordinary income when it was actually payment for Irwin's personal

goodwill and should have been taxed at the long term capital gain

rate. 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 contends that

the payment was properly taxed as ordinary income.

In anticipation of trial, which is scheduled to begin on

January 23, the parties have filed trial briefs and requests for

findings of fact and rulings of law. The United States moves for

leave to designate a rebuttal expert witness or, alternatively,

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to limit the Muskat's expert witness testimony to opinions set

forth in his report. The United States also moves to exclude

irrelevant evidence, extrinsic evidence, and certain testimony by

the Muskats' expert witness. The Muskats object to the motions.

I. Applicable Standard

A taxpayer seeking a refund of income taxes bears the burden

of showing that the IRS's assessment was wrong. Webb v. I.R.S.,

15 F.3d 203, 205 (1st Cir. 1994). The parties dispute the

applicable standard for determining whether the $1,000,000 paid

to Irwin Muskat under the noncompetition agreement was

compensation for that agreement or, instead, was compensation for

a sale of Irwin's personal goodwill. 

The United States argues that because Muskat and MAC agreed

in the noncompetition agreement that the $1,000,000 payment was

consideration for that agreement, Muskat must provide "strong

proof" that they made an ancillary agreement that the payment was

for Irwin Muskat's personal goodwill. See Harvey Radio Labs.,

Inc. v. Comm'r of Internal Revenue, 470 F.2d 118, 120 (1st Cir.

1972) (following Leslie Ray Ins. Co. v. United States, 463 F.2d

210, 212 (1972)). The Muskats contend that the "strong proof"

rule does not apply because Irwin Muskat was not a party to the

Asset Purchase Agreement ("APA"), in which Jac Pac and MAC

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allocated, for tax purposes, $15,908,511 as payment for goodwill,

because the policy supporting the "strong proof" rule, which is

to avoid the "whipsaw" effect of contradictory tax positions,

does not apply in this case, and because the agreements are

ambiguous. Instead, the Muskats argue that the "economic

reality" test applies.

In Leslie Ray Ins. Co. v. United States, 463 F.2d 210, 212

(1972), the First Circuit considered the "Danielson rule" and the

"strong proof" rule but chose neither, concluding that the

plaintiff failed to allege that tax allocation was even

considered as part of the sales transaction. In Harvey Radio

Labs., Inc. v. Comm'r of Internal Revenue, 470 F.2d 118, 120 (1st

Cir. 1972), however, the First Circuit addressed the unresolved

issue in Leslie Ray and held that "strong proof" was required for

a taxpayer to vary an explicit or implied allocation of payment

in an agreement. Id. at 119. The First Circuit rejected the

"economic reality" test on behalf of a taxpayer, although not for

the Commissioner when challenging the taxpayer's allocation. Id.

at 120. The court did not explicitly reject the "Danielson rule"

("when the agreement of the parties specifically allocates a part

of the purchase price to a covenant not to compete, the parties

cannot, absent fraud, mistake, or duress, adduce parol evidence

to support tax treatment inconsistent with the terms of the

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agreement") but declined to "push to the extreme of that rule" or

to decide if that rule differed from the "strong proof" rule. 

Id. The First Circuit has not addressed this issue since 1972.

Although the precedent is old, the First Circuit adopted the

"strong proof" rule and explicitly rejected the "economic

reality" test for purposes of a taxpayer's challenge to a tax

decision. Harvey Radio, 470 F.2d at 119-120. In addition, the

court held that the "strong proof" rule applies even where the

policy concerns about the "whipsaw" effects of conflicting tax

consequences do not pertain. Id. The Muskats' argument that the

"strong proof" rule does not apply when the agreement is

ambiguous is not well-developed or persuasive. Therefore, the

"strong proof" rule is the standard that will be applied in this

case. Contrary to the United States's argument, however, "strong

proof" is not limited to evidence of other or ancillary

agreements but instead is "a rule of intention." Harvey Radio.

470 F.2d at 120. To prevail, the Muskats must show by "strong

proof" that Irwin Muskat and MAC intended that the disputed

$1,000,000 payment under the noncompetition agreement to be

compensation for Irwin's personal goodwill and not for the

promises made in the noncompetition agreement. 

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II. Motion for Leave to Designate an Expert Witness or to Limit

Expert Witness Testimony

The United States contends that the Muskats' expert witness,

George T. O'Brien, disclosed only three opinions in his expert

report but then offered nine opinions during his deposition. In

its motion, the United States asked for leave to designate its

own expert to rebut O'Brien's additional opinions or,

alternatively, to limit O'Brien's testimony to his original three

opinions. The Muskats argue that O'Brien has not added new

opinions but, instead, merely expressed his existing opinions in

different terms or phrasing during his deposition.

Parties are required to disclose their retained witnesses'

expert opinions. Fed. R. Civ. P. 26(a)(2)(B). Any changes in an

expert's disclosed opinions must be disclosed through

supplementation. Fed. R. Civ. P. 26(e); Macaulay v. Anas, 321

F.3d 45, 50 (1st Cir. 2003). Ordinarily, the sanction for

noncompliance, in the absence of substantial justification, is

mandatory preclusion of nondisclosed opinions. Fed. R. Civ. P.

37(c)(1); Santiago-Diaz v. Laboratorio Clinico Y De Referencia,

456 F.3d 272, 276 (1st Cir. 2006).

Several of the nine opinions given by O'Brien during his

deposition and cited as new opinions by the United States are

simply his observations about the circumstances of the sales

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transaction between Jac Pac and MAC, which are not matters of

expert opinion. At the final pretrial conference, counsel for

the United States argued that O'Brien disclosed his opinion that

the noncompetition agreement was "related to" Irwin Muskat

transferring his goodwill in Jac Pac to MAC but then changed that

opinion at his deposition to say that the noncompetition

agreement was a "sale of" Irwin Muskat's personal goodwill. At

least in the excerpt of deposition testimony quoted by the United

States in its motion, O'Brien only said that the noncompetition

agreement was related to the purchase of Irwin's goodwill. 

Although the language used is slightly different, the opinion

appears to be the same.

The United States has not shown that O'Brien offered new or

materially changed opinions during his deposition. As counsel

agreed at the final pretrial conference, however, O'Brien's

testimony at trial will be limited to the opinions he disclosed

in his report. The motion is denied.

III. Motion to Exclude

The United States moves to exclude all evidence pertaining

to the noncompetition agreement as irrelevant because the

witnesses' deposition testimony establishes that there was no

ancillary agreement or deal between the parties to establish that

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the payment under the noncompetition agreement was for Irwin

Muskat's personal goodwill. The United States also moves to

exclude O'Brien's testimony on the grounds that his opinions are

not relevant or reliable and that he is not qualified to give

opinions based on the Multiattribute Utility Model ("MUM") that

he used. The Muskats oppose the motion, arguing that the United

States's reliance on the "strong proof" rule is wrong, in the

alternative that their evidence is relevant under that rule, and

that O'Brien's opinions are admissible.

As is discussed above, the "strong proof" rule is the

standard that will be applied in this case. Under that rule,

however, relevant evidence is not as limited as the United States

argues. Instead, admissible evidence of the parties' intent with

respect to the payment of $1,000,000 to Irwin Muskat under the

noncompetition agreement is relevant to whether "strong proof"

exists to support the Muskats' theory that the payment was

intended to be for Irwin's personal goodwill.

O'Brien's expert report provides his analysis of the

comparative value of Irwin Muskat's personal goodwill and Jac

Pac's enterprise goodwill based on certain listed factors and the

percentages attributed to each factor by Irwin Muskat and Charles

Hungler, "former Senior Vice President of Finance." O'Brien used

the "Multiattribute Utility Model" or MUM analysis for that

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calculation. Based on the MUM analysis, which in turn is based

on the percentages attributed to each factor by Muskat and

Hungler, O'Brien concluded that 73.06% of the goodwill in the

transaction was related to Muskat while 26.94% was related to Jac

Pac. O'Brien then reviewed the parties' allocation of the

proceeds for the transaction on an IRS form and noted that

$15,908,511 was allocated to goodwill. He summarized the

provisions of the noncompetition agreement and noted that Muskat

was to receive a total of $3,955,599, with a $1,000,000 payment

on signing and the remainder in specified installments, in

consideration for the noncompetition agreement.

Based on that information, O'Brien made a finding that MAC

recognized the importance of Irwin Muskat to the value of Jac

Pac. O'Brien also noted the agreement that Muskat would invest

in MAC's parent company and Muskat's employment agreement with

MAC. O'Brien stated his opinion that the investment and

employment agreements "more that [sic] restricted and rewarded

Mr. Muskat for protecting company and transferring personal

Goodwill." Without further explanation, O'Brien then applied his

MUM analysis results to the amount allocated under the APA to

goodwill for tax purposes by Jac Pac and MAC, $15,908,511, and

concluded that $11,622,758 was attributable to Muskat's personal

goodwill while $4,285,753 was attributable to Jac Pac's goodwill. 

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The report then considered a different allocation based on a

percentage of revenues from customers, which resulted in a lower

amount of goodwill being allocated to Muskat.

O'Brien stated that the "incentive program" was added to the

Jac Pac and MAC transaction in November of 1997 to provide

substantial additional payments to Muskat. O'Brien gave his

opinion that the stock subscription and employment agreements

"cemented Mr. Muskat's commitment and obligation to protect Jac

Pac's Enterprise Goodwill." He also stated that the

noncompetition agreement "was related to Mr. Muskat's providing a

transfer of his Personal Goodwill which, according to his and

others' representations, he actively did as a condition prior to

sale and on a timely basis thereafter." 

The opinions O'Brien provides in his report and their

relevance to the issue in this case are opaque at best. In

particular, no apparent link exists between the $15,908,511 that

MAC and Jac Pac allocated as a payment for goodwill under the APA

and the $3,955,599 total amount paid to Muskat by MAC under the

noncompetition agreement or the $1,000,000 part of that payment

that is at issue here. Muskat was not a party to the APA and no

mention is made in the APA allocation of Muskat's personal

goodwill or of the noncompetition agreement. Based on the

information that is currently before the court, O'Brien's

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allocation of the $15,908,511 amount between Muskat's personal

goodwill and Jac Pac's enterprise goodwill appears to have no

relevance to the issue in this case.

As was discussed at the final pretrial conference, O'Brien

will not be permitted to testify about the meaning or purpose of

any of the agreements involved in the Jac Pac and MAC

transaction. In addition, he will not testify about the intent

of the parties with respect to those agreements and transactions. 

The relevance and admissibility of O'Brien's testimony about his

valuation of different aspects of the Jac Pac and MAC transaction

would be better assessed in the context of trial.

The United States also challenges O'Brien's qualifications

to make the valuations he presents. The Muskats will be afforded

an opportunity to qualify O'Brien prior to his testimony, and the

United States will have an opportunity to cross-examine. A

ruling on whether O'Brien is qualified to give his opinions based

on the "MUM" analysis, under Federal Rule of Evidence 702, will

be made at that time.

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Conclusion

For the foregoing reasons, the defendant's motion for leave

(document no. 20) is denied. The defendant's motion to exclude

(document no. 29) is granted to the extent that the plaintiffs'

expert witness will not be permitted to testify about the meaning

or purpose of the various agreements in this case or about the

intent of the parties and is otherwise denied without prejudice

to make appropriate objections at trial. The question of the

qualification of the plaintiffs' expert witness will be

determined at trial.

SO ORDERED.

____________________________

Joseph A. DiClerico, Jr.

United States District Judge

January 10, 2008

cc: Nathaniel J. Dorfman, Esquire

James E. Higgins, Esquire

Robert J. Kovacev, Esquire

T. David Plourde, Esquire

John-Mark Turner, Esquire

Karen Wozniak, Esquire

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