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Aetna Screw Products Co. v. Borg

OPINION FILED MARCH 24, 1983.

AETNA SCREW PRODUCTS COMPANY, PLAINTIFF AND COUNTERDEFENDANT-APPELLEE,

v.

PHILIP BORG, DEFENDANT AND COUNTERPLAINTIFF-APPELLANT.



Appeal from the Circuit Court of Cook County; the Hon. Joseph M. Wosik, Judge, presiding.

JUSTICE LINN DELIVERED THE OPINION OF THE COURT:

Rehearing denied May 3, 1983.

Plaintiff, Aetna Screw Products Company (Aetna), brought an action in the chancery division of the circuit court of Cook County seeking a declaratory judgment that defendant, Philip Borg, owed Aetna $145,359.92 pursuant to a tax indemnification agreement between the parties. Borg counterclaimed for reformation of the tax indemnification clause of the contract. Following a bench trial, the trial court held that Borg had not proved his counterclaim for contract reformation and that he owed Aetna $173,900.81 in damages and interest for breaching the tax indemnification provision of the contract governing the sale of Borg's stock to Aetna.

Borg appeals, claiming that the trial court erred by (1) denying his counterclaim for reformation, (2) denying his demand for a jury trial, (3) limiting his discovery, (4) enforcing an illegal contract, (5) ruling against him on several specific evidentiary matters, and (6) entering judgment against him in the amount of $173,900.81.

We affirm in part, reverse in part, and remand with directions.

FACTS

In 1963, Philip Borg and Frank Valerio formed Aetna Screw Products Company, a corporation which distributed screw products. Borg and Valerio each owned 50% of Aetna's stock and fully participated in all phases of the company's operations. Two years later the two men also formed Bor-Val, a partnership whose sole business was to purchase screw products from Aetna and package them according to the particular specifications of one of Aetna's largest accounts. Both businesses operated from the same location.

Aetna, whose fiscal year ended each June 30, used the accrual method of accounting, recording income and expenses at the time the right to or liability for payment accrued regardless of when the money actually was received or paid. Bor-Val, on the other hand, was a calendar year taxpayer utilizing a cash basis of accounting, recording income and expenses at the time money actually was received or disbursed.

Aetna's inventory procedure was to record each purchase of products on inventory cards and then to subtract the quantity and cost of each lot sold as it was removed from stock. For several years prior to 1974, Aetna prepared its tax returns by taking inventory quantities from the cards, calculating the appropriate value, reducing that figure, and using the reduced value in calculating net profits and income tax. When the reduced closing inventory was subtracted from the combined opening inventory and cost of additions to inventory, the result was an apparently higher cost of goods sold than was actually the case. When this artificially high cost figure was subtracted from gross profits, the result was an artificially low net profit figure, which in turn resulted in artificially low income taxes. Testimony at trial established that as a result of continuing this practice for several years, Aetna had written down its inventory nearly 50% and therefore had underpaid its taxes by a substantial amount.

In addition to writing down its reported inventory, Aetna also reduced its taxes in one year by recording income from the Bor-Val partnership in a manner inconsistent with its established accounting method. Instead of recording the income when the right to it accrued, Aetna recorded income from Bor-Val when payment was received. This improper deferral of income further reduced Aetna's net profits and therefore taxes for one year.

In 1974, Valerio and Borg agreed to terminate their business relationship; Valerio bought out Borg's entire interest, paying $104,000 for the liquidation of the Bor-Val partnership, $98,000 for the profit-sharing plan, and $453,500 for Borg's 50% stock interest in Aetna. In total, Borg received over $650,000.

As originally drafted, the written contract setting forth the terms of the sale did not contain any provision for Borg's sharing in any additional tax liability. The final negotiations concerning the sale took place at a meeting between Borg, Valerio, Alfred Cowan, Aetna's accountant, and Fred Carman, the attorney who drafted the contract of sale. At that meeting, each clause of the purchase agreement was read aloud and discussed, and the following clause was added:

"4. Additional Income Taxes

Borg shall be responsible to Aetna for one-half of any additional U.S. or Illinois income taxes, together with interest and penalties thereon, if any, (collectively referred to as a `tax deficiency') which Aetna may be required to pay with respect to any of its fiscal years ending on or before June 30, 1974. Aetna shall be deemed to be required to pay such tax deficiency whether as a result of decision by court, or by agreement between Aetna and the Internal Revenue Service. Aetna shall promptly notify Borg of the amount of such tax deficiency and shall furnish him with written evidence of the details thereof. Borg shall pay Aetna one-half of the amount of such tax deficiency within 30 days after being notified thereof."

Although the four participants in the contract meeting testified to seriously conflicting versions of the discussion concerning the above clause, all at least agreed that the tax indemnification paragraph was included in the contract by general concurrence. At the conclusion of the December 30, 1974, meeting, Borg and Valerio executed the final version of the agreement.

Within the next year, Sheldon Drobny replaced Cowan as Aetna's accountant and conducted a complete review of the corporation's entire financial structure. He advised Valerio that the cushion of understated inventory should be eliminated to avoid potential criminal tax charges. An outside tax consultant advised Valerio to follow certain Internal Revenue Service guidelines and revenue rulings and file either a request to change Aetna's accounting method ...


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