118 T.C. No. 5
UNITED STATES TAX COURT
SOUTH TULSA PATHOLOGY LABORATORY, INC., Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 18557-98. Filed January 28, 2002.
P agreed to sell a portion of its business (clinical business) to N, a third party, pursuant to a prearranged sale that was structured as a spinoff. P’s basis in the clinical business’s assets was $105,015. On Oct. 29, 1993, P transferred the clinical business to a newly incorporated entity, S, in exchange for all of S’s stock, pursuant to sec. 368(a)(1)(D), I.R.C., and, on Oct. 30, 1993, P distributed the stock to P’s shareholders in a transaction it claimed satisfied the requirements of sec. 355, I.R.C. On the same day as the distribution of S’s stock to P’s shareholders, S’s shareholders sold all of S’s stock to N for $5,530,000. P had accumulated E & P as of the beginning of its taxable year and failed to prove that P and S did not have current E & P as of Oct. 30, 1993. Although P conceded that the spinoff followed immediately by the prearranged stock sale constituted evidence that the transaction was a device to distribute E & P within the meaning of sec. 355(a)(1)(B), I.R.C., and sec. 1.355- - 2 -
2(d), Income Tax Regs., P claimed it had valid corporate business purposes for structuring the transaction as it did which overcame the evidence of device. Alternatively, P argued that, even if the spinoff did not meet the requirements of secs. 355 and 368, I.R.C., the value of S’s stock for purposes of calculating the gain P must recognize under sec. 311(b)(1), I.R.C., should be calculated based on the value of the assets transferred to S and not on the price paid for S’s stock by N. 1. Held: There is substantial evidence that the spinoff was a device to distribute E & P, which is not overcome by substantial evidence of nondevice or by evidence that P and S lacked current and accumulated E & P. Consequently, the spinoff does not qualify for tax deferral under secs. 368 and 355, I.R.C., and P’s gain must be determined in accordance with sec. 311(b)(1), I.R.C. 2. Held, further, sec. 311(b)(1), I.R.C., requires P to recognize gain on the distribution of S’s stock as though the stock were sold to P’s shareholders at its fair market value. In this case, the best evidence of the fair market value of S’s stock on the distribution date is the price paid for the stock by N on that same date.
Thomas G. Potts, for petitioner.
Elizabeth Downs, for respondent.
MARVEL, Judge: Respondent determined a deficiency in
petitioner’s Federal income tax of $1,926,232 for taxable year
ended June 30, 1994.
The issues for decision are: (1) Whether, pursuant to a
plan of reorganization under section 368(a)(1)(D),1 petitioner’s
1 All section references are to the Internal Revenue Code in effect for the year in issue, and all Rule references are to the (continued...) - 3 -
distribution to its shareholders of stock of a controlled
corporation qualified as a nontaxable distribution under section
355; and (2) if the distribution did not qualify as a nontaxable
distribution under section 355, whether the fair market value of
the distributed stock for purposes of calculating petitioner’s
gain under section 311(b)(1) is measured by the price paid for
the stock by a third-party purchaser on the distribution date or
by the alleged value of the controlled corporation’s assets on
the day before the distribution.
FINDINGS OF FACT
Some of the facts have been stipulated and are so found. We
incorporate the stipulation of facts herein by this reference.
I. Petitioner’s Business in General
South Tulsa Pathology Laboratory, Inc. (petitioner), is, and
was for all relevant periods, an Oklahoma professional
corporation, which had its principal place of business in Tulsa,
Oklahoma, when it filed its petition in this case. Petitioner
was incorporated as an Oklahoma professional corporation in July
1968. Petitioner was owned by seven physicians (shareholders).
For all relevant periods, petitioner was classified as a “C”
corporation for Federal corporate income tax purposes and had a
1 (...continued) Tax Court Rules of Practice and Procedure. Monetary amounts are rounded to the nearest dollar. - 4 -
fiscal year ended June 30 for tax and financial reporting
purposes.
Since its incorporation, petitioner has provided pathology-
related medical services to hospitals and medical professionals
in northeastern Oklahoma. Until 1993, petitioner offered both
anatomic pathology and clinical pathology medical services to its
customers (anatomic business and clinical business,
respectively). Petitioner’s anatomic business included
examination and diagnosis of pathology of human tissue and
provision of consulting diagnostic assistance to physicians in
northeastern Oklahoma. Petitioner’s anatomic business services
were performed by its physician shareholders and/or other
licensed physicians. Petitioner’s clinical business included
performance of laboratory tests on body fluids and tissue samples
obtained from hospitals and medical professionals throughout
northeastern Oklahoma. Petitioner’s clinical business services
were performed by nonphysician employees of petitioner at a
laboratory and three “draw” facilities in Tulsa, Oklahoma.
II. Petitioner’s Decision To Sell Its Clinical Business
Beginning in 1970, and continuing through 1992, petitioner
received several offers from competing clinical pathology
laboratories to purchase its clinical business. These offers
were always rejected by petitioner’s shareholders and management.
In 1993, however, petitioner’s shareholders decided to sell the - 5 -
clinical business to a large national clinical laboratory because
they believed the growth of large national clinical laboratories
and the implementation of managed health care during the early
1990s would force petitioner out of the clinical business over
the next few years. Petitioner’s shareholders, however, decided
they wanted to continue to own and operate the anatomic business
using the corporate name, “South Tulsa Pathology Laboratory,
Inc.”, under which they had practiced for 25 years.
III. Sale of Clinical Business to NHL
In August 1993, petitioner was approached by representatives
of two national laboratory chains, Smith Kline Laboratories
(Smith Kline) and National Health Laboratories, Inc. (NHL), each
of which expressed an interest in purchasing petitioner’s
clinical business. Both Smith Kline and NHL were large, publicly
traded corporations that provided clinical laboratory services to
hospitals, physicians, and clinics throughout the United States.
Sometime in the fall of 1993, petitioner decided to pursue a
sale of its clinical business to NHL. On September 20, 1993,
petitioner and NHL entered into a confidentiality agreement to
provide for the disclosure by petitioner to NHL of certain
confidential information. Under the confidentiality agreement,
petitioner agreed to disclose certain financial and business
information necessary and appropriate in any negotiations
conducted by the parties. - 6 -
After petitioner made the disclosures pursuant to the
confidentiality agreement, petitioner agreed to sell its clinical
business to NHL. Before October 5, 1993, petitioner and NHL
negotiated the sale of the clinical business and agreed to
structure it as a sale of the stock of a yet-to-be-incorporated
clinical laboratory company that would be capitalized with the
clinical business and spun off2 from petitioner. Thereafter, NHL
delivered to petitioner a letter of intent, dated September 30,
1993, concerning the purchase by NHL of all outstanding stock of
that newly incorporated clinical laboratory company. After both
parties signed the letter of intent, petitioner’s shareholders
believed there was a commitment by NHL to buy and a commitment by
petitioner to sell petitioner’s clinical business.3 As of
October 5, 1993, petitioner and NHL had negotiated and agreed to
the essential terms of the sale.4
2 A spinoff is described as a “pro rata distribution by one corporation of the stock of a subsidiary”. Bittker & Eustice, Federal Income Taxation of Corporations and Shareholders, par. 11.01[1][e], p. 11-6 (7th ed.). 3 Ordinarily, NHL purchased clinical laboratory businesses through an asset sale. In this case, NHL agreed to structure its purchase of the clinical business as a stock sale only if it could acquire a “clean” corporation. A “clean corporation” was defined by the parties as one in which no clinical laboratory tests had been performed that could subject the purchaser (NHL) to any potential liability. 4 Petitioner conceded in its brief that “the sale of the Clinpath stock to NHL was prearranged prior to the spin-off transaction”. - 7 -
A. Spinoff of Clinpath, Inc.
On October 5, 1993, petitioner formed Clinpath, Inc.
(Clinpath), an Oklahoma general business corporation. Pursuant
to a subscription agreement between petitioner and Clinpath,
dated October 6, 1993, petitioner agreed to purchase 14,399
shares of the common stock of Clinpath, representing 100 percent
of the issued shares of Clinpath.
On October 29, 1993, petitioner and its shareholders entered
into a reorganization agreement in which they agreed, among other
things, that: (1) Petitioner shall contribute all of its
clinical laboratory assets to Clinpath in exchange for 14,399
shares of Clinpath stock issued to petitioner; and (2) after the
exchange of petitioner’s clinical laboratory assets for Clinpath
stock, petitioner promptly shall distribute all of the Clinpath
stock to petitioner’s shareholders in proportion to their
ownership of stock in petitioner. Also, on October 29,
petitioner transferred the clinical laboratory assets, including
goodwill, to Clinpath, and Clinpath transferred 14,399 shares of
its common stock to petitioner. Petitioner’s adjusted basis in
the Clinpath stock it received equaled $105,015, its adjusted
basis in the clinical laboratory assets it transferred to
Clinpath in exchange for the stock.
On October 30, 1993, petitioner distributed 100 percent of
the Clinpath stock to petitioner’s shareholders in proportion to - 8 -
their stock ownership. Clinpath conducted no business during the
period from October 5, 1993, the date of Clinpath’s
incorporation, through October 30, 1993.
B. Sale of Clinpath Stock to NHL
Pursuant to an acquisition agreement dated October 30, 1993,
on October 30, 1993, immediately following the distribution of
Clinpath stock to petitioner’s shareholders, Clinpath
shareholders5 transferred all of the issued and outstanding
Clinpath stock to NHL in exchange for $5,530,000. The purchase
price paid by NHL for the Clinpath stock was negotiated and
agreed upon by unrelated parties at arm’s length.
As a condition precedent to the sale, NHL demanded that each
of Clinpath’s physician-shareholders execute covenants not to
compete, dated October 30, 1993. The covenants not to compete
provided that each of the physician-shareholders agreed not to
compete with NHL in the clinical laboratory business anywhere
within the 918 area code of the State of Oklahoma for 5 years,
except as provided in the contract. NHL paid each of the
physician-shareholders $10,000, or a total of $70,000, in
exchange for the covenants not to compete. The total
5 Before completing the sale to NHL, petitioner’s shareholders transferred 244 shares of the Clinpath stock they received from petitioner to the profit-sharing plan of petitioner’s business manager. Consequently, the Clinpath shareholders consisted of petitioner’s shareholders and the profit-sharing plan. - 9 -
consideration, consisting of covenant payments and the purchase
price of the Clinpath stock, was $5,600,000. The consideration
allocated to the covenants not to compete was negotiated and
agreed upon by unrelated parties at arm’s length.6
Neither petitioner nor its shareholders retained any
ownership interest in Clinpath after October 30, 1993.
IV. Petitioner’s Earnings and Profits as of October 30, 1993
Petitioner had accumulated earnings and profits of at least
$236,347 as of its taxable year beginning July 1, 1993.
Petitioner did not prove whether petitioner and Clinpath had
current earnings and profits as of October 30, 1993.
OPINION
I. The Statutory Framework
Section 361(a) provides that “No gain or loss shall be
recognized to a corporation if such corporation is a party to a
reorganization and exchanges property, in pursuance of the plan
of reorganization, solely for stock or securities in another
corporation a party to the reorganization.” Section 368(a)(1)
defines reorganization for purposes of section 361 to include:
6 In connection with the sale of Clinpath stock, petitioner and NHL executed a consulting agreement, dated Oct. 30, 1993, providing for a continuing business relationship between petitioner and NHL for 5 years. The consulting agreement reflected the desire of both petitioner and NHL to partner with each other to increase the competitive position of both entities in northeastern Oklahoma with respect to both clinical and anatomic pathology services. - 10 -
(D) a transfer by a corporation of all or a part of its assets to another corporation 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; * * *
The above-described transaction, commonly referred to as a “D”
reorganization, is sometimes used to divide an existing
corporation on a tax-deferred basis into more than one
corporation for corporate business purposes. In order for a
divisive D reorganization to qualify for tax-deferred treatment
at the corporate level under section 361, however, there must be
a qualifying distribution of stock under section 355.
In this case, petitioner divided its existing business into
two parts by way of a spinoff. It transferred its clinical
business to a newly formed subsidiary, Clinpath, in exchange for
100 percent of Clinpath’s stock. Petitioner then immediately
distributed the Clinpath stock to its shareholders in a
transaction petitioner claims met the requirements of section
355.
If a spinoff does not qualify under section 355, it could
result in a taxable dividend to the distributing corporation’s
shareholders under section 301 to the extent of corporate
earnings and profits and in tax to the distributing corporation - 11 -
computed in accordance with sections 311(b)(1) and 312. Secs.
355(c), 361(c). Section 311(b)(1) provides that, if a
corporation distributes property to a shareholder in a
transaction governed by sections 301 through 307 and the fair
market value of such property exceeds its adjusted basis in the
hands of the distributing corporation, then gain shall be
recognized to the distributing corporation as if such property
were sold to the distributee at its fair market value. Section
312(b) provides that, on a distribution of appreciated property
by a corporation with respect to its stock, earnings and profits
of the corporation are increased by the excess of the fair market
value of the property over its basis.
II. The Parties’ Arguments
The primary issue in this case is whether petitioner’s
spinoff of Clinpath qualified as a valid reorganization under
section 368(a)(1)(D). Respondent claims it did not so qualify
because the distribution of Clinpath’s stock to petitioner’s
shareholders did not qualify as a nontaxable distribution under
section 355. Respondent asserts that the spinoff of Clinpath and
the subsequent sale of Clinpath stock to NHL were, in reality, a
prearranged sale by petitioner of its clinical business which
failed to qualify as a reorganization under section 368 and a
nontaxable distribution of stock to petitioner’s shareholders
under section 355. Consequently, respondent contends petitioner - 12 -
realized and must recognize gain on the distribution of Clinpath
stock. Sec. 311(b)(1). Petitioner disagrees, urging us to
conclude that it structured the spinoff of its clinical business
and the subsequent sale of Clinpath’s stock for legitimate
corporate business purposes and that the spinoff satisfied the
requirements of sections 368(a)(1)(D) and 355. Therefore,
petitioner contends, it is not required to recognize gain on the
distribution of Clinpath stock to its shareholders.
Respondent also argues that, in calculating the gain to
petitioner under section 311(b)(1) as a result of the failed
reorganization, the fair market value of the Clinpath stock must
be measured by the price paid by NHL for that stock. Petitioner
agrees that the amount of corporate gain, if any, resulting from
the distribution is based on the excess of the fair market value
of the Clinpath stock over petitioner’s basis in the stock but
argues that the fair market value of the stock must be measured
by the underlying value of the clinical business’s assets
contributed by petitioner to Clinpath on October 29, 1993.
In order to resolve these disputes, we must first decide
whether the distribution of Clinpath stock to petitioner’s
shareholders met the section 355 requirements. We conclude that
it did not for the reasons set forth below. - 13 -
III. Section 355 Distribution
Section 355(a)(1) permits a nontaxable distribution by a
corporation to its shareholders of stock in a controlled
corporation if the distribution meets four statutory
requirements: (1) Solely stock of a controlled corporation is
distributed to shareholders with respect to their stock in the
distributing corporation; (2) the distribution is not used
principally as a device for the distribution of earnings and
profits of the distributing corporation or the controlled
corporation or both; (3) the requirements of section 355(b)
(relating to active businesses) are satisfied; and (4) all of the
controlled corporation’s stock held by the distributing
corporation, or an amount constituting control, is distributed.
Sec. 355(a)(1). In addition to these statutory requirements, the
regulations under section 355 require that the distribution have
an independent corporate business purpose and that there be
continuity of proprietary interest after the distribution. Sec.
1.355-2(b) and (c), Income Tax Regs.
Respondent argues that the distribution of Clinpath stock to
petitioner’s shareholders failed to satisfy the requirements of
section 355 because: (1) The distribution of Clinpath stock was a
device for the distribution of earnings and profits in violation
of section 355(a)(1)(B); (2) the spinoff of Clinpath lacked a
valid corporate business purpose as required by section 1.355- - 14 -
2(b), Income Tax Regs.; and (3) the prearranged sale of Clinpath
stock on the same date as the distribution of Clinpath stock to
petitioner’s shareholders violated the continuity of proprietary
interest requirement of section 1.355-2(c), Income Tax Regs.
Petitioner, on the other hand, argues that the transaction met
all the requirements of section 355 and related regulations. We
examine the parties’ arguments below.
A. Nondevice Requirement of Section 355(a)(1)(B)
A transaction fails to qualify under section 355 if that
transaction is used principally as a device for the distribution
of the earnings and profits of the distributing corporation, the
controlled corporation, or both. Sec. 355(a)(1)(B); see also
sec. 1.355-2(d)(1), Income Tax Regs. We analyze whether a
transaction was used principally as a device for distributing
earnings and profits by examining all the facts and
circumstances, including, but not limited to, the presence of the
device factors listed in section 1.355-2(d)(2), Income Tax Regs.,
and the presence of the nondevice factors listed in section
1.355-2(d)(3), Income Tax Regs.
Petitioner essentially concedes that there is evidence of
device as described in section 1.355-2(d)(2), Income Tax Regs.;
however, it argues that a lack of substantial earnings and
profits, sec. 1.355-2(d)(5), Income Tax Regs., and a corporate - 15 -
business purpose, sec. 1.355-2(d)(3), Income Tax Regs., outweigh
any evidence of device.
1. Device Factors
Section 1.355-2(d)(2), Income Tax Regs., identifies the
following factors as evidence that a transaction was a device for
the distribution of a corporation’s earnings and profits: (1)
Pro rata distribution among the shareholders of the distributing
corporation and (2) subsequent sale or exchange of stock of the
distributing or the controlled corporation. Our analysis of
these factors is set forth below.
A distribution that is pro rata or substantially pro rata
among shareholders of the distributing corporation is more likely
to be used principally as a device and is evidence of device.
Sec. 1.355-2(d)(2)(ii), Income Tax Regs. Petitioner does not
dispute that the Clinpath stock was distributed pro rata to
petitioner’s shareholders. The parties stipulated that pursuant
to the reorganization agreement, petitioner would and did
distribute all the Clinpath stock to its shareholders in
proportion to their stock ownership in petitioner. This factor
is evidence of device.
A sale or exchange of the distributing or controlled
corporation’s stock after a distribution is also evidence of
device. Sec. 1.355-2(d)(2)(iii)(A), Income Tax Regs. Generally,
the greater the percentage of stock sold and the shorter the - 16 -
period of time between the distribution and the sale or exchange,
the stronger the evidence of device. Id. On brief, petitioner
concedes “100% of Clinpath’s stock was sold to NHL, and the
distribution and the subsequent sale of stock occurred on”
October 30, 1993.
In addition, a sale or exchange negotiated or agreed upon
before the distribution is substantial evidence of device. Sec.
1.355-2(d)(2)(iii)(B), Income Tax Regs. On brief, petitioner
concedes that “there is no question that the sale of the Clinpath
stock to NHL was prearranged prior to the spin-off transaction in
which the clinical laboratory assets of Petitioner were
transferred to Clinpath.” Indeed, the sale of Clinpath stock to
NHL was discussed, negotiated, and agreed upon by NHL and
petitioner and was anticipated by both parties well before the
distribution. Sec. 1.355-2(d)(2)(iii)(D), Income Tax Regs. This
factor is substantial evidence of device.
We conclude, based on a review of the applicable factors,
that the facts and circumstances of this case present substantial
evidence of device within the meaning of section 355(a)(1)(B).
2. Nondevice Factors and Absence of Earnings and Profits
In order to overcome the substantial evidence of device,
petitioner argues that: (1) Although both petitioner and
Clinpath had some accumulated earnings and profits during the
periods in question, these amounts were not significant enough to - 17 -
warrant the conclusion that the spinoff of Clinpath was a device
in contravention of section 355(a)(1)(B), and (2) several
compelling corporate business purposes drove the entire
transaction.
a. Earnings and Profits
Section 1.355-2(d)(5), Income Tax Regs., specifies three
types of distributions that ordinarily do not present the
potential for tax avoidance and will not be considered to have
been used principally as a device for the distribution of
earnings and profits even if there is other evidence of device.
A distribution that takes place at a time when neither the
distributing nor the controlled corporation has earnings or
profits is one of the distributions described in section 1.355-
2(d)(5), Income Tax Regs., and is the only type of distribution
thus described that petitioner argues applies in this case.
A distribution ordinarily is considered not to have been
used principally as a device if: (1) The distributing and
controlled corporations have no accumulated earnings and profits
at the beginning of their respective taxable years; (2) the
distributing and controlled corporations have no current earnings
and profits as of the date of the distribution; and (3) no
distribution of property by the distributing corporation
immediately before the separation would require recognition of
gain resulting in current earnings and profits for the taxable - 18 -
year of the distribution. Sec. 1.355-2(d)(5)(ii), Income Tax
Regs. Petitioner claims that the distribution at issue here
satisfies these requirements.
In its opening brief, petitioner concedes, “that the balance
sheet for * * * [petitioner] as of June 30, 1993, reflected
current and accumulated earnings and profits of $252,928.64, for
both the anatomic and clinical pathology portions of * * *
[petitioner’s] business.”7 Petitioner argues, however, that:
While petitioner concedes that it and Clinpath had some earnings and profits during the periods in question, these amounts were not meaningful and certainly do not provide a basis for a “bailout” of these earnings and profits amounts in order to avoid dividend treatment to Petitioner’s shareholders.
Respondent disagrees, contending that the presence of any
earnings and profits precludes petitioner from utilizing section
1.355-2(d)(5)(ii), Income Tax Regs., and that there is no
credible evidence that petitioner lacked accumulated or current
earnings and profits on the distribution date.
We agree with respondent for several reasons. First,
petitioner reported it had over $230,000 of accumulated earnings
and profits as of July 1, 1993, and petitioner did not introduce
any evidence to prove that it had no current earnings and profits
as of October 30, 1993. Section 1.355-2(d)(5)(ii)(A) and (B),
7 Petitioner also reported on its Federal income tax return for the taxable year beginning July 1, 1993, that it had accumulated earnings and profits of $236,347 as of July 1, 1993. - 19 -
Income Tax Regs., emphasizes that a distribution ordinarily will
not be considered to have been used principally as a device if
the distributing and controlled corporations have “no accumulated
earnings and profits at the beginning of their respective taxable
years” and “no current earnings and profits as of the date of the
distribution”. (Emphasis added.) Section 1.355-2(d)(5)(ii),
Income Tax Regs., does not provide a safe harbor for corporations
with “insignificant” or “minimal” earnings and profits, as
petitioner contends.
Second, petitioner ignores the fact that the spinoff enabled
it to claim that the substantial gain on the distribution of
Clinpath stock to its shareholders, which ordinarily would have
increased its current and accumulated earnings and profits, need
not be recognized for corporate income tax purposes or reflected
in the calculation of its earnings and profits as of October 30,
1993 and at yearend. Respondent argues that, if the spinoff of
Clinpath did not qualify for tax-free treatment under sections
368 and 355, the distribution of Clinpath stock to petitioner’s
shareholders would be taxable under section 311(b) and,
therefore, would have generated substantial current earnings and
profits to petitioner under section 312(b) as of October 30, the
date of the distribution.
Neither party disputes that, if the spinoff of Clinpath
does not qualify as a tax-free transaction under sections 368 and - 20 -
355, petitioner must realize and recognize substantial gain as of
the date of distribution, sec. 311(b)(1), which will
substantially increase petitioner’s earnings and profits, sec.
312(b). Nevertheless, petitioner dismisses the prospect that it
would have substantial current earnings and profits as a result
of the spinoff8 and overlooks what respondent describes as “the
conspicuous fact that the corporate profits petitioner’s
shareholders clearly intended to bail out were the anticipated
profits of the prearranged sale.” Despite petitioner’s efforts
to suggest otherwise, we simply are not convinced that the
decision to structure this transaction as a spinoff and
subsequent stock sale was prompted by NHL; NHL usually structured
its acquisitions as asset sales to minimize its exposure to
liabilities that can arise from the purchase of an active
business. Petitioner’s protestations notwithstanding, the
spinoff of Clinpath followed immediately by a prearranged sale of
the Clinpath stock on the same day appears to have been designed
to eliminate the corporate-level tax that would have been due had
8 Petitioner acknowledges that dividends paid to its shareholders result “in a fairly significant double income tax liability, and is the primary reason that * * * [petitioner] distributes most or all of its income to its employee shareholders and other employees prior to year end”, presumably as deductible compensation. Petitioner claims, however, that its practice of distributing income “virtually assures that there would be little or no corporate income tax liability * * * irrespective of the ultimate outcome of the spin-off transaction.” - 21 -
petitioner sold its clinical business to NHL directly or
distributed its clinical business to its shareholders prior to
any sale.
For the reasons set forth above, petitioner has failed to
prove that it did not have accumulated or current earnings and
profits as of the date of the distribution within the meaning of
section 1.355-2(d)(5)(ii), Income Tax Regs.
b. Corporate Business Purpose
The presence of a valid corporate business purpose may trump
a conclusion that the transaction was used principally as a
device for the distribution of earnings and profits. Sec. 1.355-
2(b)(4),(d)(3)(ii), Income Tax Regs. Section 1.355-2(b)(2),
Income Tax Regs., defines “corporate business purpose” as a “real
and substantial non-Federal tax purpose germane to the business
of the distributing corporation, the controlled corporation, or
the affiliated group * * * to which the distributing corporation
belongs.”
The stronger the evidence of device, such as the presence of
the device factors specified in section 1.355-2(d)(2), Income Tax
Regs., the stronger the corporate business purpose required to
prevent the conclusion that the transaction was used principally
as a device. Sec. 1.355-2(d)(3), Income Tax Regs. The
assessment of the strength of the business purpose must be made
based upon all the facts and circumstances, including, but not - 22 -
limited to: (1) The importance of achieving the purpose to the
success of the business; (2) the extent to which the transaction
is prompted by a person not having a proprietary interest in
either corporation, or by other outside factors beyond the
control of the distributing corporation; and (3) the immediacy of
the conditions prompting the transaction. Sec. 1.355-2(d)(3)(i)
and (ii), Income Tax Regs.
Petitioner identifies three purported corporate business
purposes for the disputed distribution: (1) Increased
competition caused by a changing economic environment that
favored the larger, national laboratories; (2) Oklahoma State law
restricting the ownership of petitioner to licensed physicians or
physician-owned entities licensed to practice medicine within
Oklahoma; and (3) NHL’s requirement that each of petitioner’s
physician-shareholders sign binding and enforceable covenants not
to compete in the clinical laboratory business. Respondent
contends there was no valid corporate business purpose for the
distribution. We consider each of the purported corporate
business purposes below.
i. Increased Competition
The first purported corporate business purpose asserted by
petitioner is that the changing economic environment in the
clinical laboratory market in 1993 favored the large, national
laboratories over the smaller clinical laboratories, such as - 23 -
petitioner’s. This environment, petitioner contends, was caused
by increasing competition from national clinical laboratories,
delivery of service issues, and development of alliances between
large health insurance companies and national clinical
laboratories. Petitioner argues that, based upon these economic
factors, its shareholders and employees became convinced that
petitioner’s clinical laboratory would be forced out of business
within a few years. This belief led the shareholders to sell the
clinical business to NHL and “partner” with NHL to enhance the
competitive position of their remaining anatomic business.
We do not question, and respondent does not dispute, that
the economic factors cited by petitioner may have forced it out
of the clinical business within a few years. Although these
factors may have been the impetus behind the decision to sell the
clinical business in the first instance, such factors do not
demonstrate a corporate business purpose for petitioner’s
decision to distribute the Clinpath stock to its shareholders
before selling the stock to NHL. A transfer of the clinical
laboratory assets directly to Clinpath would have sufficed to
achieve petitioner’s desired result; i.e., to create a new
company containing solely the assets of the clinical business in
order to sell the clinical business with minimum liability to the
buyer. Minimizing the effect of the economic factors cited by
petitioner, however, did not require the nearly simultaneous - 24 -
distribution of Clinpath stock to its shareholders. The purpose
of separating the clinical laboratory assets in preparation for
the sale to NHL and shielding NHL from liability was achieved as
soon as the clinical business was contributed to Clinpath by
petitioner in exchange for Clinpath stock. See generally sec.
1.355-2(b)(5), Example (3), Income Tax Regs.
The changing economic environment, therefore, does not by
itself constitute a valid corporate business purpose for the
distribution of Clinpath stock to petitioner’s shareholders or
constitute evidence of nondevice.
ii. Petitioner’s Status as a Professional Corporation
The second purported corporate business purpose arises from
petitioner’s claim that Oklahoma State law mandated the final
structure of the spinoff transaction. Petitioner essentially
argues that it was constrained from selling, and NHL was
prevented from purchasing, petitioner’s stock because
petitioner’s status as a professional corporation prevented NHL
from owning any interest in it.
Petitioner’s argument concerning its status as a
professional corporation is without merit. Even if petitioner
were precluded from selling its stock to nonphysicians as
petitioner contends, such a bar would justify only petitioner’s
decision to transfer its clinical business to a separate general
business corporation, i.e., Clinpath; it would not lend support - 25 -
to petitioner’s decision to distribute Clinpath stock to
petitioner’s shareholders. Indeed, petitioner could have sold
the Clinpath stock directly to NHL without first transferring the
Clinpath stock to its shareholders.9
We conclude, therefore, that petitioner’s status as a
professional corporation does not provide a valid corporate
business purpose for the distribution of Clinpath’s stock to
petitioner’s shareholders and is not evidence of nondevice.
iii. Covenants Not To Compete
The third purported corporate business purpose cited by
petitioner is NHL’s requirement that each of Clinpath’s
physician-shareholders sign a binding and enforceable covenant
not to compete. Relying upon Bayly, Martin & Fay, Inc. v.
Pickard, 780 P.2d 1168 (Okla. 1989), petitioner contends that
representatives for both petitioner and NHL believed that a
covenant not to compete would be enforced under Oklahoma State
law only if it were entered into in connection with the sale of
goodwill or the dissolution of a partnership. Petitioner
9 Pulliam v. Commissioner, T.C. Memo. 1997-274, a case on which petitioner relies, is distinguishable because the spinoff and subsequent prearranged sale of some of the distributed stock involved in Pulliam could not have been structured as a direct sale of stock between the distributing corporation and the third- party purchaser (a former employee). We concluded that the structure of the transaction was compelled by applicable State law, which prohibited a corporation from owning a funeral business, and by the need to structure the stock sale as an installment sale. - 26 -
contends that the final structure of the transaction as a sale of
Clinpath stock by Clinpath’s shareholders, and not by petitioner,
was mandated by NHL’s desire to obtain from the shareholders
valid and enforceable covenants not to compete. Therefore, a
corporate business purpose existed for the distribution of
Clinpath stock to the shareholders.
We do not agree. Even if we were to conclude that NHL’s
desire to obtain enforceable covenants not to compete qualified
as a corporate business purpose of either petitioner or Clinpath,
as section 1.355-2(b)(2), Income Tax Regs., requires, we would
still reject petitioner’s argument. Okla. Stat. Ann. tit. 15,
sec. 217 (West 1986 and Supp. 2000), provides that “Every
contract by which any one is restrained from exercising a lawful
profession, trade or business of any kind, otherwise than as
provided by Sections 218 and 219 of this title, is to that extent
void.” Oklahoma State courts interpret Okla. Stat. Ann. tit. 15,
sec. 217, to prohibit only unreasonable restraints on the
exercise of a lawful profession, trade, or business. Bayly,
Martin & Fay, Inc. v. Pickard, supra at 1172; Crown Paint Co. v.
Bankston, 640 P.2d 948, 952 (Okla. 1981); Bd. of Regents v. Natl.
Collegiate Athletic Association, 561 P.2d 499, 508 (Okla. 1977).
The majority rule is that reasonable restrictions will be
enforced. Bayly, Martin & Fay, Inc. v. Pickard, supra at 1170-
1171. Even unreasonable contracts in restraint of trade, which - 27 -
are normally void and unenforceable under Oklahoma State law, are
enforceable if they fall within one of the two statutorily
created exceptions to the general rule–-covenants given in
connection with the sale of goodwill or covenants given in
connection with the dissolution of a partnership. Okla. Stat.
Ann. tit. 15, secs. 218 and 219 (West 1986 and Supp. 2000);
Bayly, Martin & Fay, Inc. v. Pickard, supra at 1170. Assuming
the covenants in this case were reasonable and/or were given in
connection with the sale of goodwill, it was unnecessary to first
distribute the Clinpath stock to petitioner’s shareholders.10
Petitioner has failed to demonstrate either that the covenants in
question were unreasonable or that they were not adequately tied
to the sale of goodwill under Oklahoma State law.
We conclude, therefore, that NHL’s demand for binding and
enforceable covenants not to compete does not constitute a
corporate business purpose within the meaning of section 1.355-
2(d)(3)(ii), Income Tax Regs., and, therefore, is insufficient to
overcome the substantial evidence of device in this case.11
10 Petitioner in its posttrial briefs appears to concede that the sale of Clinpath involved the sale of both “practice goodwill” inherent in the going concern value of the clinical business and “professional goodwill” possessed by petitioner’s physician-shareholders. 11 Even if we were to conclude that any of the alleged corporate business purposes satisfied the requirements of sec. 1.355-2(d)(3)(ii), Income Tax Regs., we would still conclude that, under the balancing test required by the regulations, the (continued...) - 28 -
3. Conclusion
There is substantial evidence of device in this case, which
is not overcome by substantial evidence of nondevice or by proof
that petitioner and Clinpath lacked current or accumulated
earnings and profits. We hold, therefore, that the distribution
of Clinpath stock failed to satisfy the requirements of section
355(a)(1).12
IV. Tax Treatment of the Distribution of Clinpath Stock
Section 311(a) provides that, except as provided in section
311(b), no gain or loss shall be recognized to a corporation on a
nonliquidating distribution, with respect to its stock, of its
stock or property. Section 311(b)(1), however, requires a
corporation to recognize gain on nonliquidating distributions of
appreciated property to its shareholders as though such property
were sold to the distributee at its fair market value.
It is well settled that fair market value is the price at
which property would change hands between a willing buyer and a
willing seller, neither being under any compulsion to buy or sell
and both having reasonable knowledge of the relevant facts.
11 (...continued) evidence of corporate business purpose was insufficient to overcome the compelling evidence of device in this case. 12 Because we hold that the sec. 355(a)(1) requirement is not met, we do not separately decide whether the independent corporate business purpose requirement of sec. 1.355-2(b)(1), Income Tax Regs., or the continuity of proprietary interest requirement of sec. 1.355-2(c)(1), Income Tax Regs, has been met. - 29 -
United States v. Cartwright, 411 U.S. 546, 551 (1973); Morris v.
Commissioner, 70 T.C. 959, 988 (1978). The determination of fair
market value is a question of fact. Hamm v. Commissioner, 325
F.2d 934, 938 (8th Cir. 1963), affg. T.C. Memo. 1961-347; Estate
of Newhouse v. Commissioner, 94 T.C. 193, 217 (1990).
The parties agree that if we hold the distribution of
Clinpath stock to petitioner’s shareholders did not qualify as a
section 355 transaction, as we have, then the amount of corporate
gain resulting from the distribution is the excess of the fair
market value of the Clinpath stock in the hands of petitioner
over petitioner’s adjusted basis in the stock. The parties do
not dispute that petitioner’s adjusted basis in the clinical
laboratory assets, and, accordingly, the Clinpath stock, was
$105,015. The parties disagree, however, as to how the fair
market value of the Clinpath stock should be measured.
Respondent contends that the fair market value of the
Clinpath stock petitioner received and distributed to its
shareholders on October 30, 1993, should be measured by the price
paid by NHL for the Clinpath stock. NHL purchased the Clinpath
stock for $5,530,000 on the same day the stock was distributed to
petitioner’s shareholders. Petitioner argues in effect that the
purchase price paid by NHL for the Clinpath stock was excessive
and urges us to conclude instead that the fair market value of
the Clinpath stock should be measured by the fair market value of - 30 -
the clinical laboratory assets contributed by petitioner to
Clinpath. At trial, Harry Joe Wells, Jr., an expert witness
called by petitioner, testified that the fair market value of the
clinical laboratory assets, including going-concern value, was
$1,040,000. Petitioner contends that the Clinpath stock could
not possess a value in excess of the fair market value of its
underlying clinical laboratory assets, given Clinpath’s status as
a new corporation with no operating history; therefore, the focus
of section 311(b) in this case should be the fair market value of
the clinical laboratory assets. Petitioner relies upon our
decision in Pope & Talbot, Inc. v. Commissioner, 104 T.C. 574,
579 (1995), affd. 162 F.3d 1236 (9th Cir. 1999), the first of
three decisions involving Pope & Talbot, Inc.,13 as support for
its position. Hereinafter, for clarity, we shall refer to the
relevant decision as Pope & Talbot, Inc. I.
In Pope & Talbot, Inc. I, the taxpayer corporation, pursuant
to a plan of distribution, transferred its timber and land
development properties and related assets located in the State of
Washington (collectively referred to as the Washington
properties) to a newly formed Delaware limited partnership
(partnership). The partnership’s initial partners were two newly
formed corporate general partners, which initially were owned
13 See also Pope & Talbot, Inc. v. Commissioner, T.C. Memo. 1997-116, supplemented by T.C. Memo. 1997-399, affd. 162 F.3d 1236 (9th Cir. 1999). - 31 -
equally by two of the taxpayer’s principal shareholders. Upon
transfer of the Washington properties to the partnership, the
managing general partner made a pro rata distribution of the
interests in the partnership (partnership units) to the
taxpayer’s shareholders on the basis of one partnership unit for
each 5 shares of common stock. The taxpayer was not a partner in
the partnership and received no partnership units.
The issue decided in Pope & Talbot, Inc. I was whether gain
from the distribution of appreciated property under former
section 311(d),14 the predecessor to section 311(b)(1), is
determined as if the taxpayer had sold the Washington properties
in their entirety for their fair market value, or by reference to
the value of the property interests, i.e., the partnership units,
received by each shareholder. We concluded that gain from the
distribution of appreciated property under former section 311(d)
must be determined as if the taxpayer had sold the Washington
properties for their fair market value on the date of the
distribution. Pope & Talbot, Inc. v. Commissioner, supra at 584.
We reached our conclusion by examining the language and
purpose of former section 311(d). Former section 311(d), like
section 311(b)(1), required gain to be calculated “as if the
property distributed had been sold at the time of the
14 Sec. 311(d)(1) was amended and recodified as sec. 311(b)(1) by the Tax Reform Act of 1986, Pub. L. 99-514, sec. 631(c), 100 Stat. 2272. - 32 -
distribution.” Pope & Talbot, Inc. v. Commissioner, supra at
577. Because we were unable to answer with certainty the
question of what property interest had to be valued under former
section 311(d) after examining the statutory language, we
examined the legislative history and concluded that “the purpose
underlying section 311(d) was to tax the appreciation in value
that had occurred while the distributing corporation held the
property and to prevent a corporation from avoiding tax on the
inherent gain by distributing such property to its shareholders.”
Pope & Talbot, Inc. v. Commissioner, supra at 579.
We face a different dispute from that decided by this Court
in Pope & Talbot, Inc. I. In Pope & Talbot, Inc. I, we only
decided what property interest had to be valued for purposes of
section 311(d). In this case, the parties agree that the
property distributed by petitioner to its shareholders was the
Clinpath stock. The disagreement in this case relates only to
the valuation of that stock for purposes of section 311(b).
Although petitioner urges us to apply Pope & Talbot, Inc. I as a
limitation on our analysis of the fair market value of the
Clinpath stock, we must reject petitioner’s plea because
valuation was not the issue decided in Pope & Talbot, Inc. I.
Thus, our decision in Pope & Talbot, Inc. I is distinguishable.
In order to calculate the gain that petitioner must
recognize under section 311(b)(1), we must decide the fair market - 33 -
value of the Clinpath stock in the hands of petitioner as if such
property were sold to its shareholders at fair market value.
Sec. 311(b)(1). Fair market value is defined for Federal tax
purposes as “the price at which the property would change hands
between a willing buyer and a willing seller, neither being under
any compulsion to buy or to sell and both having reasonable
knowledge of relevant facts.” United States v. Cartwright, 411
U.S. at 551 (quoting sec. 20.2031-1(b), Estate Tax Regs.). In
general, the best evidence of fair market value is “actual sales
made in reasonable amounts and at arm’s length within a
reasonable time before or after the date for which a value is
sought.” Morris v. Commissioner, 70 T.C. at 988; see also Estate
of Fitts v. Commissioner, 237 F.2d 729 (8th Cir. 1956), affg.
T.C. Memo. 1955-269.
In this case, there was an actual third-party sale of the
Clinpath stock to NHL on the same day as the distribution of the
Clinpath stock to petitioner’s shareholders. Petitioner
contends, however, that the fair market value of the Clinpath
stock as of October 30, 1993, cannot exceed the fair market value
of the clinical business’s assets contributed to Clinpath by
petitioner. Petitioner introduced into evidence a report by
Harry Joe Wells, Jr., which it claims valued “selected” assets as
of October 30, 1993, but which, in reality, purported to value
the clinical business as a “going business” as of October 29, - 34 -
1993. The Wells report, using an indirect method of valuation,
concluded that the value of the clinical business was only
$1,040,000, including the alleged value of corporate goodwill.
Citing our decisions in Norwalk v. Commissioner, T.C. Memo. 1998-
279, and Martin Ice Cream Co. v. Commissioner, 110 T.C. 189
(1998), petitioner contends that the $4,490,000 difference
between the value determined in the Wells report and the purchase
price paid for the Clinpath stock is attributable to professional
goodwill generated by and belonging to its physician-
shareholders.15
We reject the Wells report because it did not value the
property distributed to petitioner’s shareholders as of the date
of distribution as required by section 311. Instead, the Wells
report valued “selected” assets of petitioner as of October 29,
1993, the day before the Clinpath stock was distributed to
petitioner’s shareholders and then sold to NHL pursuant to a
prearranged deal. The Wells report did not consider the
prearranged stock sale to NHL, did not focus on the relevant
date, and did not value the Clinpath stock.
15 Petitioner’s expert witness, on the other hand, testified that the difference between the purchase price paid by NHL and the value reconstructed in his report was paid for NHL’s own “synergy”. Petitioner’s expert could not and did not explain why NHL would pay over $4 million for a synergy NHL allegedly created. - 35 -
We also reject the Wells report and petitioner’s argument
because they are simply not credible. Neither the Wells report
nor petitioner’s argument reconciles the conclusions reached
regarding the value of the assets contributed to Clinpath
($1,040,000) and the amount of professional goodwill attributable
to the physician-shareholders ($498,000) with what actually
transpired in this case. In an arm’s-length sale negotiated
prior to October 29, 1993, between NHL and the physician-
shareholders who had adverse interests, NHL paid $5,530,000 for
the Clinpath stock and $70,000 for the covenants not to compete
with the seven physician-shareholders. Neither petitioner nor
its expert witness credibly explained how their positions on
valuation reconcile with these facts. The physician-shareholder
who testified at trial did not admit that the covenants not to
compete had been undervalued in the negotiations or agree that
Clinpath’s physician-shareholders had collectively
mischaracterized over $4,000,000 of the amount they received from
NHL as proceeds from the sale of capital assets rather than as
ordinary income attributable to the covenants.
There is a compelling reason why we ordinarily view an
actual and contemporaneous sale between unrelated parties having
adverse interests as the best evidence of the fair market value
of property-–ordinarily, it is credible evidence. See Morris v.
Commissioner, supra. In this case, the relevant sale is even - 36 -
more credible because the sale involved the very asset we are
required to value by section 311(b)(1), and the sale took place
on the valuation date specified in section 311(b)(1); i.e., the
date the Clinpath stock was distributed to petitioner’s
shareholders.
We hold, therefore, that the fair market value of the
Clinpath stock on the date it was distributed to petitioner’s
shareholders equaled $5,530,000, the price negotiated and agreed
upon as the stock’s sale price to NHL.16 We also hold that
petitioner realized and must recognize gain of $5,424,985,
calculated by subtracting petitioner’s adjusted basis in the
stock, $105,015, from the fair market value of the Clinpath
stock, $5,530,000.
We have considered the remaining arguments of both parties
for results contrary to those expressed herein and, to the extent
not discussed above, find those arguments to be irrelevant, moot,
or without merit.
16 In his notice of deficiency, the Commissioner determined petitioner’s gain to be $5,494,985. This amount was calculated by subtracting petitioner’s basis in the Clinpath stock, $105,015, from the total consideration of $5,600,000 paid by NHL. The portion of the sale price allocated to the covenants not to compete, $70,000, was not subtracted from petitioner’s gain as determined in the notice of deficiency. On brief, respondent conceded that the $70,000 represented the fair market value of the covenants not to compete and was not part of the value of the 14,399 shares of Clinpath stock. - 37 -
To reflect the foregoing,
Decision will be entered
under Rule 155.