Waterman S.S. Corp. v. Commissioner
50 T.C. 650, 1968 U.S. Tax Ct. LEXIS 88 (1968)
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Rule of Law:
A pre-sale distribution from a subsidiary to its parent corporation will be respected as a dividend for tax purposes, rather than part of the purchase price, if the parent company retains legal and equitable ownership of the stock when the dividend is formally declared and paid, even if the sale was structured to achieve tax advantages and the buyer provides the funds to satisfy the dividend payment after the sale is complete.
Facts:
- Malcom P. McLean wished to acquire Pan-Atlantic Steamship Corp. and Gulf Florida Terminal Co., which were wholly owned subsidiaries of Waterman Steamship Corp.
- On December 20, 1954, McLean offered to purchase the stock of both subsidiaries from Waterman for $3,500,000 cash.
- Waterman's board rejected the offer, wanting to first receive a dividend of approximately $2.8 million from Pan-Atlantic to reduce the tax consequences of a sale.
- On December 23, 1954, Waterman counter-offered to sell the stock for $700,000, but only after Pan-Atlantic declared a dividend of approximately $2,800,000 to Waterman.
- At 12:00 p.m. on January 21, 1955, Pan-Atlantic's board declared a dividend of $2,799,820 to Waterman, its sole stockholder, and issued a promissory note for that amount.
- At 1:00 p.m. on January 21, 1955, after the dividend was declared and the note delivered, Waterman executed a final agreement to sell the stock of both subsidiaries to McLean's nominee, McLean Securities Corp., for $700,180.
- At 1:30 p.m. on January 21, 1955, after the sale closed, Pan-Atlantic's new board authorized the company to borrow funds from McLean and Securities to pay off the promissory note held by Waterman.
- Ultimately, the funds provided by McLean's entities were used to satisfy the note, and Waterman received a total of approximately $3.5 million from the combined transaction.
Procedural Posture:
- Waterman Steamship Corp. filed a consolidated corporate income tax return, eliminating the $2,799,820 distribution from Pan-Atlantic as a tax-free intercompany dividend and reporting a capital gain based only on the $700,180 sales price.
- The Commissioner of Internal Revenue (Respondent) issued a notice of deficiency, determining that the $2,799,820 was functionally part of the purchase price and re-characterizing it as a long-term capital gain.
- Waterman's successor corporation (Petitioner) challenged the deficiency by filing a petition in the Tax Court of the United States.
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Issue:
Does a pre-sale distribution from a subsidiary to its parent company, structured as a dividend but funded by the eventual purchaser, constitute part of the taxable capital gain from the sale of the subsidiary's stock?
Opinions:
Majority - Scott, J.
No. The distribution does not constitute part of the taxable capital gain from the sale; it was a legitimate intercompany dividend. The form of a transaction will be respected when it has legal substance and is not a sham, even if motivated by tax avoidance. Crucially, Waterman was the legal and equitable owner of the Pan-Atlantic stock at the time the dividend was declared and the note was issued, as no binding contract for sale had yet been executed. The Supreme Court in United States v. Cumberland Pub. Serv. Co. affirmed that taxpayers may choose the more tax-advantaged form for a transaction, and Waterman permissibly chose to receive a dividend before selling its stock at a lower price. The fact that the buyer subsequently arranged financing for the note's payment does not retroactively alter the character of the dividend, which was properly declared and paid to the rightful owner.
Dissenting - Tannenwald, J.
Yes. The purported dividend was, in substance, part of the purchase price and should be taxed as a capital gain. The majority exalted form over substance, failing to recognize that no true dividend occurred. The promissory note was merely a 'piece of paper' serving a temporary purpose, as Pan-Atlantic had no cash to pay it; the funds came directly from the buyer, McLean, as part of the single, integrated transaction to pay a total of $3.5 million. When the transaction was complete, Pan-Atlantic was no richer or poorer, which demonstrates that this was not a distribution of corporate earnings but a conduit for the purchase price, analogous to the transaction disregarded in Gregory v. Helvering.
Analysis:
This case is a significant taxpayer victory that reinforces the principle that the form of a transaction will often be respected if the legal formalities are meticulously observed. It provides a clear roadmap for corporate sellers to 'strip' earnings and profits from a subsidiary via a pre-sale dividend to a parent, effectively converting what would be taxable capital gain into a tax-free intercompany dividend. The decision underscores the critical importance of timing: the dividend must be declared and paid before a legally binding contract of sale is executed. The dissent's strong substance-over-form argument, however, highlights the continuing tension in this area of tax law and demonstrates that courts can and do disagree on where to draw the line between legitimate tax planning and an impermissible sham.
