Warsaw Photographic Associates, Inc. v. Commissioner
84 T.C. 21; 1985 U.S. Tax Ct. LEXIS 134; 84 T.C. No. 3 (1985)
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Rule of Law:
For a transaction to qualify as a non-divisive 'D' reorganization under § 368(a)(1)(D), the acquiring corporation's stock must be transferred to the transferor corporation and then distributed to its shareholders as required by statute. The judicial exception that waives this formal requirement applies only when the stock ownership of the transferor and transferee corporations is identical.
Facts:
- Warsaw Studios, Inc. (Studios), a commercial photography business, was financially struggling due in large part to a burdensome lease and excessive payroll.
- Warsaw & Co., Inc. owned all of Studios' preferred stock and approximately 80% of its common stock. The remaining common stock was owned by ten employee-shareholders in varying, unequal amounts.
- The ten employee-shareholders formed a new corporation, Warsaw Photographic Associates, Inc. (petitioner), each contributing $10,000 to become equal 10% shareholders in the new entity.
- Petitioner entered into an agreement to acquire substantially all of Studios' operating assets, including equipment, goodwill, and a favorable lease, while leaving behind the burdensome lease.
- As part of the consideration, petitioner paid cash, assumed certain liabilities, and issued 100 shares of its stock directly to its own ten shareholders (who were also the minority shareholders of Studios), bypassing Studios entirely.
- The 100 shares were issued to the ten shareholders in proportion to their ownership in the petitioner (10 shares each), not in proportion to their varied ownership stakes in Studios.
- Three weeks after the asset transfer, Studios made a general assignment for the benefit of creditors, having retained cash and accounts receivable to pay them.
Procedural Posture:
- The Commissioner of Internal Revenue (Respondent) determined income tax deficiencies against Warsaw Photographic Associates, Inc. (Petitioner) for its taxable years 1974, 1975, and 1976.
- Petitioner challenged the determination by filing a petition in the United States Tax Court.
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Issue:
Does a transfer of assets from one corporation to another qualify as a tax-free 'D' reorganization under § 368(a)(1)(D) when the acquiring corporation's stock is issued directly to the transferor's shareholders, rather than to the transferor corporation itself, and the shareholders of the two corporations are not identical?
Opinions:
Majority - Chabot, Judge
No, the transaction does not qualify as a 'D' reorganization. To qualify, the transaction must meet the formal statutory requirements of § 368(a)(1)(D) and § 354, which mandate that the acquiring corporation's stock be transferred to the transferor corporation and then distributed by the transferor to its shareholders. While courts have created a narrow exception to this formal requirement, it applies only in cases where the ownership of both corporations is identical, rendering the formal transfer a 'meaningless gesture.' Here, the ownership was not identical: Warsaw & Co., Inc. owned 80% of Studios but none of petitioner, and the minority shareholders held unequal interests in Studios but equal interests in petitioner. Because the transaction failed to meet the literal requirements of the statute and did not fall within the narrow judicial exception, it cannot be treated as a tax-free reorganization.
Analysis:
This decision reinforces the principle of strict construction for statutory requirements governing tax-free reorganizations. The court clarified that the judicial exception dispensing with the formal stock transfer and distribution is narrowly confined to situations of identical shareholder ownership. This case serves as a crucial precedent for tax planners, demonstrating that courts will not permit taxpayers to achieve the benefits of a reorganization while deviating from the prescribed statutory form, especially when shareholder continuity is imperfect. The ruling emphasizes that even if a transaction achieves the substantive business goals of a reorganization, failure to adhere to the explicit procedural steps laid out in the Internal Revenue Code will result in the transaction being treated as a taxable sale.
