Pulliam v. Commissioner
1997 Tax Ct. Memo LEXIS 329, 1997 T.C. Memo. 274, 73 T.C.M. 3052 (1997)
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Rule of Law:
A corporate spin-off will not be considered a device for the distribution of earnings and profits under Section 355(a)(1)(B), even with substantial evidence of device such as a prearranged stock sale, if strong corporate business purposes and nondevice factors, including the necessity of the distribution due to state law requirements, outweigh the device factors.
Facts:
- Pulliam Funeral Homes, P.C. (Homes), an Illinois corporation doing business in Crawford County, Illinois, was founded in 1947 and has been solely owned by Clark D. Pulliam (Mr. Pulliam) since 1976.
- Homes operated three funeral homes, including one in Oblong, Illinois, was a successful and profitable business, and had not paid dividends prior to 1992, accumulating significant unappropriated retained earnings.
- Earl L. Deckard (Mr. Deckard), a licensed funeral director and embalmer, was a key employee of Homes, serving as resident manager and embalmer at the Oblong facility since 1985.
- Mr. Deckard expressed interest in acquiring a financial interest in the Oblong facility, but Mr. Pulliam was not interested in selling ownership in Homes, and Mr. Deckard explicitly stated he had no interest in a minority ownership in Homes.
- In early 1991, Mr. Deckard purchased property adjacent to his residence in Oblong with the intention of constructing and operating his own competing funeral home.
- Upon learning of Mr. Deckard's plans, Mr. Pulliam summarily terminated his employment in July 1991, but after experiencing problems at the Oblong facility, Mr. Pulliam and Mr. Deckard, with their wives, reached an informal agreement in July 1991.
- The agreement stipulated that Mr. Deckard would acquire an ownership interest in the Oblong facility and be reemployed, which involved a spin-off of the Oblong assets from Homes into a new professional service corporation, Pulliam Deckard Funeral Chapel, P.C. (Chapel), and a subsequent sale of up to 49% of Chapel's stock to Mr. Deckard by Mr. Pulliam.
- On January 1, 1992, Homes transferred the Oblong funeral home assets and liabilities to Chapel, receiving 1,000 shares of Chapel common stock, which it immediately distributed to Mr. Pulliam, its sole shareholder, who then sold 490 shares (49%) to Mr. Deckard in a prearranged installment sale effective the same date.
Procedural Posture:
- The Commissioner of Internal Revenue determined a deficiency of $245,732 in Clark D. and Janis L. Pulliam's Federal income tax for 1992, and an accuracy-related penalty of $49,146.
- The Commissioner's primary determination was that Mr. Pulliam received a taxable dividend of $789,500 from Pulliam Funeral Homes, P.C., due to the distribution of Chapel stock.
- The Commissioner also made an alternative determination that Mr. Pulliam received $40,000 in 1992 as a downpayment on an installment sale of 49 percent of his stock in Chapel, which petitioners did not report.
- Clark D. and Janis L. Pulliam filed a petition with the United States Tax Court, disputing the Commissioner's primary determination regarding the dividend.
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Issue:
Does a corporation's distribution of a subsidiary's stock to its sole shareholder qualify as a tax-free spin-off under Section 355, even when there is substantial evidence of a device to distribute earnings and profits (a prearranged sale of a significant portion of the distributed stock), if strong corporate business purposes exist that could not be achieved through a non-distributive transaction, particularly when state law necessitates the distribution?
Opinions:
Majority - Dawson, Judge
No, the distribution by Homes of Chapel stock to Mr. Pulliam did not constitute a device for the distribution of earnings and profits and thus qualifies as a tax-free spin-off under section 355, because the strong corporate business purposes and nondevice factors outweighed the device factors. The court acknowledged "substantial evidence of device" due to the prearranged sale of 49% of Chapel's stock immediately after the spin-off, which typically indicates an attempt to bail out corporate earnings at capital gains rates rather than ordinary dividend income rates. However, the court identified two strong corporate business purposes: 1) protecting Homes from competition by Mr. Deckard in the Oblong market, and 2) retaining Mr. Deckard as a key employee. These purposes were deemed vitally important to Homes' continued success and were prompted by Mr. Deckard's actions, an outside factor. Critically, the court found that Mr. Pulliam's attorneys and accountants reasonably believed Illinois law, specifically the Illinois Professional Service Corporation Act, required Chapel, as a professional service corporation, to have licensed individuals (like Mr. Pulliam and Mr. Deckard) as its shareholders, thereby precluding Homes from holding Chapel's stock during the installment sale. This legal constraint meant the distribution of Chapel stock to Mr. Pulliam was necessary to achieve the business purposes, as Homes could not have owned the stock itself and then sold it to Mr. Deckard, and Mr. Deckard did not want Homes' stock. This necessity, coupled with Mr. Deckard's inability to afford a meaningful interest in Homes, differentiated the case from scenarios where alternative non-distributive transactions could achieve the same business goals. The court therefore concluded that the strong corporate business purposes and the practical necessity imposed by state law outweighed the evidence of device. The court did, however, sustain the Commissioner's alternative determination regarding the unreported $40,000 down payment from the installment sale in 1992 and the associated accuracy-related penalty, as petitioners did not contest these issues.
Analysis:
This case offers significant insight into the "device" test under Section 355, particularly the balancing act between device evidence and corporate business purpose. It underscores that even substantial evidence of device (like a prearranged post-spin-off stock sale) can be overcome by compelling, immediate corporate business purposes, especially when state law imposes structural necessities for the transaction. The ruling demonstrates the importance of demonstrating that the distribution itself (not just the corporate division) is required to achieve the valid business purpose, and that no less tax-advantageous alternative could realistically achieve the same goal. Future cases involving a prearranged stock sale after a spin-off will need to present equally strong and unavoidable business justifications, potentially including specific regulatory or legal constraints, to satisfy the nondevice requirement.
