J. E. Smothers and Doris Smothers v. United States of America
642 F.2d 894 (1981)
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Rule of Law:
For a transaction to be classified as a Type D reorganization, the 'substantially all of the assets' test is satisfied if the transferring corporation transfers its core operating assets constituting a continuing business enterprise, including key intangible assets like goodwill and employee expertise, regardless of the percentage of total book-value assets transferred.
Facts:
- J. E. and Doris Smothers wholly owned two corporations: Texas Industrial Laundries of San Antonio, Inc. (TIL) and Industrial Uniform Services, Inc. (IUS).
- TIL engaged in the industrial laundry business and owned its own laundry equipment.
- IUS was in the same business of renting industrial uniforms but did not own laundry equipment, instead contracting with another company for laundering services.
- The Smothers decided to dissolve IUS, and IUS adopted a plan of liquidation.
- Pursuant to the plan, IUS sold several non-liquid assets, representing about 15% of its net value, to TIL for cash at fair market value.
- The parties stipulated that none of the tangible assets sold by IUS to TIL were necessary to carry out IUS's business.
- Following the sale, IUS distributed its remaining assets, primarily cash and notes receivable, to the Smothers.
- Immediately after IUS's dissolution, TIL hired all of IUS's employees and continued to serve most of IUS's former customers.
Procedural Posture:
- J. E. and Doris Smothers treated a distribution from their dissolved corporation, IUS, as a long-term capital gain on their 1969 federal income tax return.
- The Internal Revenue Service (IRS) audited the return and recharacterized the transaction as a reorganization, treating the distribution as a dividend taxable at ordinary income rates.
- The IRS assessed a tax deficiency of $71,840.84 against the Smothers.
- The Smothers paid the deficiency and filed a civil action for a refund in the U.S. District Court for the Southern District of Texas (the court of first instance).
- The district court ruled in favor of the IRS, holding the transaction was a reorganization.
- The Smothers, as appellants, appealed the district court's judgment to the U.S. Court of Appeals for the Fifth Circuit.
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Issue:
Does a transaction in which one wholly-owned corporation sells approximately 15% of its total assets to a sister corporation before distributing its remaining assets to the common shareholders and dissolving constitute a 'D' reorganization under I.R.C. § 368(a)(1)(D) by meeting the 'substantially all of the assets' requirement?
Opinions:
Majority - Wisdom, Circuit Judge
Yes, the transaction constitutes a 'D' reorganization. The 'substantially all of the assets' requirement is not a mechanical percentage test but is met when there is a transfer of the continuing business enterprise. The purpose of the reorganization provisions is to prevent shareholders from withdrawing corporate earnings at capital gain rates while continuing the business in a modified corporate form, a scheme known as a liquidation-reincorporation. To maintain the integrity of the dividend provisions, the 'substantially all assets' test must be interpreted to refer to the operating assets of the business, not surplus liquid assets. For a service enterprise like IUS, its most important assets were intangible—its reputation, sales staff, and management—all of which were effectively transferred to TIL, which continued the same business under the same ownership. To treat this as a true liquidation would deny economic reality and make a mockery of the Internal Revenue Code.
Dissenting - Garza, Circuit Judge
No, the transaction does not qualify as a 'D' reorganization because it fails the plain language of the statute. 'Substantially all' means a large portion of the total assets, and 15% does not meet this standard. The majority improperly rewrites the statute to mean 'necessary operating assets' to plug a perceived loophole, a task that should be left to Congress. Even under the majority's flawed test, the transaction fails because the parties stipulated that none of the transferred assets were necessary for IUS's operations. The majority's reliance on the transfer of intangible assets is misplaced; employees and management services are not corporate assets that can be 'transferred.' The employees were free to seek employment anywhere after IUS ceased operations, and to penalize the Smothers because their other company hired them is unjust.
Analysis:
This decision solidifies a substance-over-form approach to the 'substantially all of the assets' test in D reorganizations, significantly curtailing the effectiveness of the liquidation-reincorporation technique for tax avoidance. By defining 'assets' to include the core operational components of a business, including intangibles, the court looked past the balance sheet to the economic reality of the transaction. This precedent gives the IRS a powerful tool to recharacterize distributions as dividends in cases where a business continues under common ownership but in a new corporate shell, especially in service-based industries where tangible assets are minimal.
