Dunn Trust v. Commissioner

United States Tax Court
1986 U.S. Tax Ct. LEXIS 120, 86 T.C. No. 46, 86 T.C. 745 (1986)

ELI5:

Rule of Law:

Under section 355(a)(3)(B), stock of a controlled corporation distributed to shareholders is not treated as taxable "other property" even if the distributing corporation acquired stock of a subsidiary of the controlled corporation in a taxable transaction within the preceding five years. The statute's plain language applies only to the stock that is actually distributed, not to the assets held by the distributed corporation.

Facts:

The Edna Louise Dunn Trust owned 400 shares of common stock in American Telephone & Telegraph Co. (AT&T).
Pursuant to a court-ordered divestiture plan, AT&T was required to separate from its subsidiary Bell Operating Companies (BOCs).
One of the BOCs, Pacific Telephone & Telegraph Co. (Pacific), was not wholly owned by AT&T, with a minority of its voting stock publicly held.
In May 1982, less than five years before the divestiture, AT&T acquired the publicly held voting stock of Pacific through a merger that was a taxable transaction for the selling shareholders.
After gaining full control of Pacific, AT&T created a new holding company, Pacific Telesis Group (PacTel Group).
AT&T then contributed all of its Pacific stock to the new PacTel Group in a tax-free exchange for 100% of PacTel Group's stock.
On January 1, 1984, AT&T distributed the stock of PacTel Group and six other regional holding companies to its shareholders, including the Trust.

Procedural Posture:

The Commissioner of Internal Revenue determined a tax deficiency of $29.64 for the Edna Louise Dunn Trust's 1984 tax year.
The Commissioner asserted that a portion of the PacTel Group stock received by the Trust in the AT&T divestiture constituted taxable "other property" under section 355(a)(3)(B).
The Edna Louise Dunn Trust, as petitioner, filed a petition in the United States Tax Court challenging the Commissioner's deficiency determination.
The case was submitted to the Tax Court fully stipulated, meaning the parties agreed on the facts and asked the court to rule on the question of law.

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Issue:

Does section 355(a)(3)(B) require treating a portion of a controlled holding company's stock as taxable "other property" upon its distribution, when the distributing corporation acquired stock of the holding company's subsidiary in a taxable transaction within five years of the distribution?

Opinions:

Majority - Tannenwald

No. Section 355(a)(3)(B) does not require treating a portion of the distributed PacTel Group stock as taxable "other property" because the statute applies only to the stock of the controlled corporation that is actually distributed, which in this case was acquired in a tax-free transaction. The court reasoned that a literal reading of the statute supports the petitioner's position. The statutory language refers to stock of a "controlled corporation" acquired by the distributing corporation. The stock actually distributed was PacTel Group stock, which AT&T acquired in a tax-free exchange, not the Pacific stock that was acquired in a prior taxable transaction. The court rejected the IRS's argument that it should "look through" PacTel Group to the underlying Pacific stock, noting that while other parts of section 355 explicitly allow for such a look-through approach (e.g., the active business test), section 355(a)(3)(B) does not. The court further determined that the transaction did not thwart the legislative purpose of preventing a "bailout" of earnings and profits, as the Pacific stock acquired in the taxable transaction remained in corporate solution within PacTel Group and was not directly distributed to AT&T's shareholders. To adopt the IRS's interpretation would be to improperly expand the statute beyond its plain meaning and congressional intent.

Analysis:

This decision established a literal, and form-over-substance, interpretation of section 355(a)(3)(B), significantly impacting corporate tax planning for spinoffs. It confirms that a distributing corporation can effectively "cleanse" recently purchased subsidiary stock by contributing it tax-free to a newly formed holding company and then distributing the holding company's stock. The ruling provides a clear roadmap for structuring transactions to avoid the taxable boot rule, emphasizing the importance of the specific stock that is distributed. This precedent limits the IRS's ability to apply a broad "look-through" principle to this section, forcing it to rely on other doctrines, such as the "device" clause, to challenge transactions it views as abusive.

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