Berghash v. Commissioner
43 T.C. 743; 1965 U.S. Tax Ct. LEXIS 118 (1965)
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Rule of Law:
A transaction involving the sale of corporate assets to a new corporation followed by the liquidation of the old corporation does not constitute a corporate reorganization under IRC § 368(a)(1)(D) or (F) if there is a significant shift in proprietary interest, such that the original shareholders fail to meet the 80% control requirement of the new corporation.
Facts:
- Hyman Berghash owned 198 of the 200 shares of Delavan-Bailey Drug Co., Inc. ('old corporation').
- Sidney Lettman, the manager of the drugstore, threatened to resign unless Berghash sold him a 50-percent interest in the business.
- Because Lettman could only afford to invest $25,000, which was insufficient to purchase half of the valuable old corporation, the parties devised a plan using a dormant corporation, Dorn's Drugs, Inc. ('new corporation').
- Berghash and Lettman agreed that Lettman would purchase 100 shares (a 50% stake) of the new corporation for $25,000 cash.
- The old corporation sold its operating assets (inventory, fixtures, and goodwill) to the new corporation in exchange for the remaining 100 shares (the other 50% stake) and a promissory note.
- The old corporation adopted a plan of complete liquidation and distributed all its assets—including the 100 shares of the new corporation's stock and the promissory note—to Berghash.
- The new corporation changed its name to Delavan-Bailey Drug Co., Inc. and continued the drugstore business, owned 50% by Berghash and 50% by Lettman.
Procedural Posture:
- Hyman and Rose Berghash reported the proceeds from the liquidation of Delavan-Bailey as long-term capital gain on their 1957 joint income tax return.
- Delavan-Bailey Drug Co., Inc. reported the gain on the sale of its assets on its final return but claimed the gain was not recognized under IRC § 337.
- The Commissioner of Internal Revenue issued a notice of deficiency to the Berghashes, determining that they had received dividend income and long-term capital gain.
- The Commissioner also issued a notice of deficiency to Delavan-Bailey Drug Co., Inc., determining that it must recognize long-term capital gain on the sale of its assets.
- The Berghashes and Delavan-Bailey Drug Co., Inc. filed petitions in the Tax Court of the United States, challenging the Commissioner's determinations.
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Issue:
Does a transaction in which a corporation sells its operating assets to a new corporation, of which the original sole shareholder owns only 50%, and then liquidates, qualify as a tax-free corporate reorganization under IRC § 368(a)(1)(D) or (F), thereby treating the shareholder's liquidating distribution as a dividend?
Opinions:
Majority - Withey, Judge
No, the transaction does not qualify as a tax-free reorganization because there was a substantial change in proprietary interest and a failure to meet the statutory control requirements. The court found that the transaction was motivated by a bona fide business purpose—retaining a key employee—and was not a sham. It failed to qualify as an 'F' reorganization ('a mere change in identity, form, or place of organization') because Berghash's ownership interest was drastically reduced from nearly 100% to 50%, which is too significant a shift. The transaction also failed to qualify as a 'D' reorganization because the shareholders of the old corporation (Berghash) did not have 'control' of the new corporation immediately after the transfer. Under IRC § 368(c), 'control' requires at least 80% stock ownership, and Berghash only owned 50%. Therefore, the transaction is properly characterized as a sale of assets followed by a complete liquidation, meaning the shareholder's gain is treated as capital gain under § 331, and the liquidating corporation recognizes no gain on its asset sale under § 337.
Analysis:
This case establishes a significant precedent in the 'liquidation-reincorporation' doctrine by reinforcing the strict statutory requirements for reorganization status. It clarifies that a substantial shift in ownership, such as a 50% reduction, prevents a transaction from being classified as a mere change in form (an F reorganization). More importantly, it affirms that the 80% control test for D reorganizations is a bright-line rule that will be strictly applied. The decision gives taxpayers confidence that courts will respect the form of a transaction that has a legitimate business purpose, even if it results in favorable tax outcomes, and limits the IRS's ability to recharacterize such transactions as reorganizations to impose dividend treatment.
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