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Intermountain Lumber Co. & Subsidiaries, etc. v. Commissioner

United States Tax Court
65 T.C. 1025; 1976 U.S. Tax Ct. LEXIS 154 (1976)
ELI5:

Rule of Law:

For the purposes of non-recognition of gain or loss under IRC § 351, a transferor of property to a corporation does not have 'control' immediately after the exchange if they are subject to a pre-existing, binding obligation to sell the shares received in the exchange, and this sale is an integral part of the incorporation transaction.


Facts:

  • Dee Shook, the primary incorporator of S & W Corporation, transferred property to the newly formed corporation in exchange for all of its stock.
  • As an integral part of the incorporation transaction, Shook executed a binding 'Agreement for Sale and Purchase of Stock' with Milo Wilson.
  • This agreement, executed before the property was formally deeded to S & W, obligated Shook to sell nearly half of his S & W shares to Wilson.
  • The agreement was structured as an installment sale, complete with interest payments on the unpaid principal, rather than as an option.
  • Wilson did not transfer any property to S & W upon its formation and thus could not be counted as a transferor for control purposes.
  • Following the execution of the agreement, Shook and Wilson held themselves out to third parties as the 'principal stockholders' and co-owners of S & W.
  • Subsequently, Intermountain Lumber Co. purchased all of S & W's stock from Shook and Wilson.

Procedural Posture:

  • Intermountain Lumber Co., as the parent of S & W Corporation, filed consolidated income tax returns claiming depreciation based on the fair market value of S & W's assets at the time of its formation.
  • The Commissioner of Internal Revenue (respondent) issued a notice of deficiency, asserting that the formation of S & W was a non-taxable § 351 exchange, which required S & W to use the incorporators' lower carryover basis for depreciation.
  • Intermountain (petitioner) challenged the deficiency by filing a petition in the United States Tax Court.

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Issue:

Does a transferor have 'control' of a corporation 'immediately after' an exchange for purposes of non-recognition treatment under IRC § 351 if, as part of the incorporation transaction, the transferor is subject to a binding agreement to sell shares that would drop their ownership below the 80% statutory threshold?


Opinions:

Majority - Unspecified

No. A transferor does not have the requisite control for § 351 non-recognition if they are under a pre-existing binding obligation to dispose of shares that drops their ownership below 80% immediately after the exchange. The determination of 'ownership' for control purposes depends on the transferor's obligations and freedom of action with respect to the stock. If the transferor has, as part of the transaction, irrevocably relinquished the legal right to decide whether to keep the shares, they lack ownership for § 351 purposes. Here, the court found the agreement between Shook and Wilson was a binding sale, not a mere option, based on the document's language, the provision for interest payments, and the parties' conduct. Because this sale was an integral part of the incorporation, the steps are viewed together. Shook was legally bound to transfer the shares to Wilson, meaning he lacked the necessary control 'immediately after' the exchange, making the transaction taxable.



Analysis:

This decision reinforces the application of the step-transaction doctrine to IRC § 351, clarifying the 'control immediately after' requirement. It establishes that a pre-existing, legally binding commitment to dispose of stock will break control, thereby distinguishing such a commitment from a mere preconceived plan or intention to sell, which would not. The ruling emphasizes a substance-over-form analysis, where the legal obligations and economic realities of the entire transaction, not just the formal sequence of events, determine the tax consequences. This provides a crucial distinction for tax planners, indicating that binding post-transfer sale agreements integrated with the initial formation will render the § 351 non-recognition treatment inapplicable.

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