Opinion ID: 374307
Heading Depth: 1
Heading Rank: 1

Heading: The Schaffan's Individual Tax Liability

Text: 2 In October 1970, Schaffan owned all the stock of Atlas and of Fletcher. Atlas was then engaged in the business of designing and selling products for the hobby industry, principally model railroads. Prior to 1960, Atlas also manufactured such products. In 1960, Fletcher was incorporated, acquired Atlas' plastic molding machines, and thereafter, conducted the manufacturing operations previously conducted by Atlas. Fletcher occupied one floor of a building, the balance of which was occupied by Atlas. Atlas was virtually the only customer of Fletcher. 3 During the 1960's, Atlas continually increased its purchase of foreign manufactured components, which were cheaper than those domestically manufactured. Eventually, Schaffan decided that the manufacturing operations being performed by Fletcher were no longer essential since the same quality components could be acquired at a lower cost from foreign sources. Accordingly, in October 1970, at the directors' and stockholders' meetings, it was voted that Fletcher liquidate in the manner permitted by section 337, 26 U.S.C. § 337 (1976). 4 On November 5, 1970, Fletcher transferred to Atlas all its machinery and equipment for an appraised price of $100,250, and all its inventory for its $14,600 cost. Fletcher's only accounts receivable were from Atlas, and these were paid in full. On November 19, 1970, Schaffan received from Fletcher a cash distribution of $482,246.82 which represented all of its remaining assets. Fletcher filed an appropriate Form 966 with the District Director of its intended section 337 liquidation, and filed final federal and state tax returns for the fiscal year ending November 30, 1970. Fletcher was formally dissolved in June 1971. 5 The machinery and equipment transferred to Atlas remained in place in the building otherwise occupied by Atlas. Fletcher's former employees were employed by Atlas, initially in its packing and shipping departments. The machinery and equipment, left in place, was idle for a time. However, by December 1970, Atlas began experiencing delivery and quality difficulties with its foreign suppliers, and to keep its inventory adequate, it soon started operating some of the Fletcher machines. By the end of 1971, all the machinery and equipment acquired from Fletcher were in operation. 6 On the Schaffan's 1970 federal income tax return they reported $400,000 as a distribution from Fletcher in complete liquidation under section 331, which provides that (a)mounts distributed in complete liquidation of a corporation shall be treated as in full payment in exchange for stock. 26 U.S.C. § 331 (1976). They claimed an adjusted basis of $10,000 for the Fletcher stock, and paid tax on a long-term capital gain of.$390,000. In the notice of deficiency, the Commissioner asserted that the amount distributed to Schaffan was actually $482,246.82 (an amount not contested by the taxpayer) and that the transaction was not a section 331-337 liquidation, but a reorganization within the meaning of 26 U.S.C. § 368(a)(1)(D). Section 368(a)(1)(D) provides that: 7 a transfer by a corporation of all or a part of its assets to another corporation (is a reorganization) if immediately after the transfer the transferor, or one or more of its shareholders (including persons who were shareholders immediately before the transfer), or any combination thereof, is in control of the corporation to which the assets are transferred; but only if, in pursuance of the plan, stock or securities of the corporation to which the assets are transferred are distributed in a transaction which qualifies under section 354, 355, or 356; . . . . 8 26 U.S.C. § 368(a)(1)(D) (1976). Whether the transaction is characterized as a section 368(a)(1)(D) reorganization or a section 337 liquidation, there is still no gain or loss recognized to Fletcher on the transfer of its machinery and equipment to Atlas. But if the transaction was a reorganization, the distribution by Fletcher to Schaffan would be covered by the boot provision of section 356, 26 U.S.C. § 356 (1976), and thus be treated as ordinary income rather than as a capital gain pursuant to section 331, 26 U.S.C. § 331(a) (1976). 9 Section 356(a)(2) provides that money distributed to stockholders in a reorganization shall, to the extent of the stockholders' gain, be treated as a dividend out of earnings and profits of the corporation. 26 U.S.C. § 356(a)(2) (1976). The Commissioner contends that when, as here, there is complete identity of shareholders in the two corporate parties to a D reorganization, the earnings and profits of both corporations should be taken into account to determine how much of the cash distributed by either is the equivalent of a dividend. The combined earnings and profits of Fletcher and Atlas exceeded $5 million, and thus the Commissioner proposes to treat the entire $482,246.82, less Schaffan's $10,000 basis for his Fletcher stock, as a section 356(a)(2) dividend. 2 10 The Tax Court held that the transaction was a D reorganization, and therefore section 356(a)(2) applied, but that the dividend treatment was authorized only to the extent of earnings and profits of Fletcher. It computed those earnings and profits as $440,342.56, and determined that the difference between that sum and $472,246.82 was taxable as a long-term capital gain. The Schaffans contend that the entire $472,262.82 was a long-term capital gain. The Commissioner contends it was all a section 356(a)(2) dividend. 11 We turn first to the Schaffan's contention. They point to the adoption by appropriate corporate resolution of a plan of complete liquidation of Fletcher within twelve months, to the accomplishment of both the disposition and distribution of Fletcher's assets within that time, and to Fletcher's dissolution. These events, they urge, were in full compliance with section 337, which provides for the nonrecognition of gain or loss on the sale of Fletcher's machinery and equipment to Atlas. Moreover, they argue that the distribution is in complete liquidation of Fletcher and should, therefore, be treated as in full payment in exchange for (Fletcher) stock pursuant to section 331, 26 U.S.C. § 331(a)(1) (1976). Taxpayers contend that in the absence of any proof of an intent to avoid taxes, it was error for the Tax Court to characterize the transaction as a D reorganization instead of a complete liquidation. 12 Our starting point is the text of section 368(a)(1)(D) quoted above. Clearly there was, as that section requires, a transfer by Fletcher of all or part of its assets in this case all its machinery, equipment and inventory were transferred to another corporation, Atlas. In addition, Schaffan, the sole stockholder of Fletcher, was in control of Atlas immediately after the transfer. No stock or securities of Atlas were distributed to Schaffan. But despite the language in section 368(a)(1)(D) to that effect, it has been held that a distribution is not necessary where the ownership of the transferor and transferee is identical because such a distribution would be a mere formality. 3 13 A distribution pursuant to section 368(a)(1)(D) must also qualify under section 354 or section 355 in order for section 356 to be applicable. Section 355, which concerns the distribution of stock and securities of a controlled corporation, does not come into play in the Fletcher-Atlas transaction. Section 354, however, is applicable to the facts in this case. It provides for the nonrecognition of gain or loss on an exchange of stock or securities solely for stock or securities. Where there is complete identity of ownership, section 354, like section 368(a)(1)(D), has been construed not to require the meaningless formality of such an exchange. 4 However, section 354(a): 14 shall not apply to an exchange in pursuance of a plan of reorganization within the meaning of section 368(a)(1)(D), unless 15 (A) the corporation to (Atlas) which the (Fletcher) assets are transferred acquires substantially all of the assets of the transferor of such assets . . . . 16 26 U.S.C. § 354(b)(1)(A). The substantially all requirement is chiefly determined by focusing on the transfer of the operating assets by the transferor, and not on the unneeded liquid assets such as cash and accounts receivable. 5 In light of the facts that all of Fletcher's assets except cash and accounts receivable went to Atlas, that Atlas had hired all of Fletcher's employees, that the operating assets never changed location, and were utilized within four months to manufacture the same products, we conclude that the substantially all assets requirement of section 354(b)(1)(A) was satisfied. 17 Section 354(b)(1)(B) requires, as well, that the distribution of securities in a D reorganization be in pursuance of a plan of reorganization. The transfer was certainly a part of an overall plan. The controlling shareholder chose to call the transaction a plan of liquidation. If what resulted was a plan of reorganization, the chosen label is not dispositive. 6 18 We conclude, as did the Tax Court, that the transaction which resulted in Fletcher's distribution of $482,246.82 to Schaffan met all the statutory requisites of a D reorganization. The Schaffans urge, however, that two nonstatutory requirements must be satisfied before a transaction, characterized by a taxpayer as a liquidation, may be treated as a reorganization: tax avoidance motive and a continuity of business enterprise. 7 19 The Tax Court, while expressing some skepticism about the absence of a tax avoidance motive in structuring the transaction, held that a finding of such a motive was not required. The Schaffans, in advancing their tax avoidance motive argument, rely on cases such as Gregory v. Helvering, 293 U.S. 465, 55 S.Ct. 266, 79 L.Ed. 596 (1935), which held that taxpayers cannot take advantage of the tax-free reorganization provisions of the Code in the absence of a business purpose for the transaction other than a purpose to avoid taxes. That requirement was imposed to prevent the resort to liquidation and reincorporation as a way of bailing out earnings and profits without appropriate payment of taxes. 20 There is no disagreement among the parties that a business purpose is required for a reorganization. 8 The Schaffans contend that there was a business purpose for liquidation as opposed to reincorporation, and that from this business purpose for liquidation one can infer a non-tax avoidance motive for the overall transaction. However, the liquidation-reincorporation doctrine is aimed at recharacterizing liquidations in light of the entire transaction, notwithstanding liquidation motives. 9 Thus the liquidation purpose alone, and therefore the inference of a non-tax avoidance motive from it, cannot by definition be dispositive, and certainly does not prevent the characterization of the transaction as a D reorganization. 10 21 The Treasury Regulations state the essence of the requirement as: 22 (t)he readjustments involved in the exchanges or distributions effected in the consummation (of a plan of reorganization) must be undertaken for reasons germane to the continuance of the business of a corporation a party to the reorganization. 23 26 C.F.R. § 1.368-2(g) (1979). The focus of the nonstatutory test is not, therefore, whether there were tax avoidance motives, but whether, objectively, there was continuity of business rather than termination of business. It is not significant that one party to the transaction was liquidated since that is a fairly common feature of a reorganization. 11 What is critical is whether the new corporation carries forward the business enterprise of the old. The continuity of interest concept is at the heart of the nonrecognition provisions. 12 24 Sometimes, a taxpayer will seek to establish that the reorganization took place, thus postponing payment of any tax. In other cases, especially where, as here, there is a distribution of liquid assets, the taxpayer will prefer to have the liquidation aspect separated from the rest of the transaction so as to qualify for capital gains treatment. In response, the Commissioner will seek to treat all the events as one transaction and thus characterize it as a reorganization in order to tax the distribution under section 356(a) at ordinary income rates. The subjective motivation of neither the taxpayer nor the Commissioner is relevant. The test must be whether, objectively, the transferee corporation, if it otherwise qualifies for reorganization treatment, has a continuity of business enterprise with the transferor corporation. Thus we agree with the Tax Court that there was no requirement that it find a tax avoidance motive in order to classify the transaction as a D reorganization. 25 While the Schaffans urge that there was no continuity of business enterprise, the record establishes otherwise. Schaffan testified: 26 The reason I had Fletcher Plastic's assets go to Atlas was, as I had explained, as a hedge so that should anything happen we've got insurance in the form of the machinery or the molds that we could again start manufacturing or could start manufacturing and not be totally without materials. 27 In late 1970, with the increased reliance by Atlas on foreign suppliers, Fletcher's business purpose was precisely the same as Schaffan described the purpose to be for the transfer. Fletcher was manufacturing much fewer components for Atlas than formerly, but was standing by to resume manufacturing if needed. After the transfer, its machinery and equipment remained in place, ready for use. Within four months, the machinery and equipment was placed in operation and within a year all of it was utilized to make the same products as formerly. Atlas retained all of Fletcher's employees. The business enterprise which Atlas conducted was substantially the same as that formerly conducted by Fletcher. Complete identity of business operations is not required. 13 The fact that Fletcher's former business, prior to the transfer, had been substantially curtailed by virtue of the availability of foreign supplies, is not dispositive. Schaffan's business purpose, to provide a hedge against interruption in supplies, carried forward the continuity of enterprise from Fletcher to Atlas. The Tax Court did not err in holding that the Fletcher-Atlas transaction provided the continuity of business enterprise referred to in the Treasury Regulations. 14 Since both the statutory requirements for a D reorganization and the nonstatutory continuity of business enterprise test are on this record satisfied, we must affirm the Tax Court's determination that there was a reorganization and that section 356(a) applies to the distribution of cash from Fletcher to Schaffan. 28 The Commissioner contends that while the Tax Court correctly held that section 356(a) applies, it erred in calculating the amount of Schaffan's gain which should be treated as a dividend. He relies on the interpretation of section 356(a)(2) by the Fifth Circuit in Davant v. Commissioner, 366 F.2d 874, 889 (5th Cir. 1966). In that case, faced with what it considered to be a D reorganization, the court held that where there was identity of stock interest in the two corporations, the distributing corporation and the acquiring corporation, the earnings and profits for purposes of section 356(a)(2) would be determined by the earnings and profits of both corporations. The Commissioner concedes that, in the absence of such identity of interest, the reference in section 356(a)(2) to the taxpayer's ratable share of the undistributed earnings and profits of the corporation is a reference to the undistributed earnings and profits of the distributing corporation. He insists, and the Davant court held, that the statutory language should, where stock ownership in both corporations is identical, be read to mean both corporations. 29 Neither the Commissioner nor the Davant opinion refer us to any legislative history which would support a rewriting of section 356(a)(2), and we see no policy reasons which support our doing so. It is true that Schaffan owns all the stock in both corporations, and that some of the funds distributed by Fletcher came from Atlas as a result of Atlas' purchase of machinery, equipment, and inventory. It is also true that because the transaction is treated as a reorganization the transfer from Fletcher to Atlas is not taxable. The tax-free nature of the transfer introduces the possibility that, by overvaluing the Fletcher assets, Schaffan could transfer earnings and profits out of Atlas. But thereby he would necessarily increase the earnings and profits of Fletcher, and thus the amount qualifying for section 356(a)(2) treatment. 30 If in the future we are faced with the situation where a single taxpayer causes a transfer of business assets at inflated prices from a corporation with accumulated losses to a corporation with earned surplus, thereby attempting to accomplish capital gains treatment for what should be ordinary income, we are confident that section 482, 26 U.S.C. § 482 (1976), which permits the Secretary to distribute, apportion, or allocate income among related corporations in order to prevent tax evasion, will be a sufficient weapon. The rewriting of section 356(a)(2) does not appear to be necessary. The Tax Court has also rejected Davant. 15 No other court has followed Davant, and we decline to do so. Thus we will affirm the Tax Court holding that the measure of the Schaffan's section 356 liability is the earnings and profits of Fletcher alone. 31