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T.C. Memo. 1997-274
UNITED STATES TAX COURT
CLARK D. AND JANIS L. PULLIAM, Petitioners v.,
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 12923-95. Filed June 17, 1997.
Robert J. Schuckit and Richard O. Kissel II, for
petitioners.
Russell D. Pinkerton for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
- 2 -
DAWSON, Judge:1 Respondent determined a deficiency of
$245,732 in petitioners' Federal income tax for 1992, and an
accuracy-related penalty of $49,146 under section 6662(a)2 and
6662(b)(2) for a substantial understatement of income tax.
The principal issue for decision is whether the distribution
by Pulliam Funeral Homes, P.C. (Homes) to petitioner Clark D.
Pulliam of 1,000 shares of common stock in Pulliam Deckard
Funeral Chapel, P.C. (Chapel) on January 1, 1992, constituted a
distribution on which no gain or loss is recognized under the
provisions of section 355. The resolution of this issue depends
upon whether the spin-off of Chapel from Homes was used
principally as a device for the distribution of earnings and
profits of Homes in contravention of section 355(a)(1)(B). If
the spin-off of Chapel from Homes was not used principally as a
device for the distribution of earnings and profits, a new and
alternative issue, not determined in the notice of deficiency and
not pleaded in respondent's answer but first raised by respondent
at trial and on brief, is whether Homes distributed enough stock
1
With the consent of counsel for the parties, the Chief
Judge reassigned this case, after the death of Judge Irene F.
Scott, to Judge Howard A. Dawson, Jr., for disposition on the
existing record.
2
All section references are to the Internal Revenue Code
in effect for the year in issue, and all Rule references are to
the Tax Court Rules of Practice and Procedure, unless otherwise
indicated.
- 3 -
in Chapel to constitute control within the meaning of section
368(c), as required by section 355(a)(1)(D).
The notice of deficiency sent to petitioners determined
that, in the event it is decided that Mr. Pulliam did not receive
dividends of $789,500 from Homes, 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 on their
Federal income tax return for that year.3 This alternative
determination was not placed in issue by petitioners. Likewise,
petitioners did not allege errors in their petition with respect
to the disallowance of a personal exemption deduction, an
adjustment to itemized/standard deductions, and the assertion of
an accuracy-related penalty under section 6662(a).
FINDINGS OF FACT
Some of the facts have been stipulated and are so found.
The stipulation of facts and supplemental stipulation, together
with attached exhibits, are incorporated herein by this
reference.
Clark D. Pulliam and Janis L. Pulliam (petitioners) resided
in Robinson, Illinois, at the time they filed their petition in
this case.
3
According to Mr. Pulliam's testimony, the $40,000 was
omitted from petitioners' Federal income tax return, but it was
later reported and an advance payment was made on the deficiency
determined for 1992.
- 4 -
Pulliam Funeral Homes, P.C. (Homes) is a corporation
chartered in the State of Illinois and doing business in Crawford
County, Illinois. The business was founded in 1947 by Troy L.
Pulliam, Jr. It was incorporated as a professional service
corporation in 1974. Troy L. Pulliam, Jr., was the sole owner of
Homes' stock from 1974 until his death in 1976. His son, Clark
D. Pulliam (Mr. Pulliam), purchased all the stock of Homes in
1976, and since that time he has been the sole shareholder,
director, and president of Homes. Mr. Pulliam is a licensed
funeral director and embalmer in the State of Illinois. He has
served as coroner of Crawford County, Illinois. He is a
decorated Air Force veteran who served in Vietnam.
Prior to January 1, 1992, Homes operated three funeral homes
located in the rural eastern Illinois towns of Robinson, Oblong,
and Hudsonville. Robinson has a population of about 7,200 and
Oblong has a population of about 1,600. Oblong is located
approximately 8 miles west of Robinson. The main offices of
Homes are located in Robinson, where Mr. Pulliam has his personal
office and manages all the Homes sites. All three of the funeral
homes are modern, well-maintained facilities.
Homes is a successful and profitable business. In 1991 Mr.
Pulliam was paid a salary of $181,400. Prior to 1992, Homes had
not paid any dividends, and it had unappropriated retained
earnings of $1,112,445 on December 31, 1991.
- 5 -
On December 31, 1991, Mr. Pulliam owed Homes $219,337. The
loans made to him had no stated interest rate and were payable on
demand. They were used primarily to finance petitioners' new
residence. They began building their new residence after
completing the building and remodeling of Homes' funeral
facilities.
The Oblong funeral home of Homes was originally built as a
residence in 1920 and was converted to a funeral parlor in 1939.
The last major renovation of the Oblong facility occurred in
1986.
The Oblong funeral home was given excellent appearance and
maintenance ratings in the appraisal made by Vandelyn R. Pine,
dated January 9, 1992.
The total number of funeral services conducted during the
years 1986 through 1991 at the Oblong facility was as follows:
1986 1987 1988 1989 1990 1991
53 75 54 51 44 56
The number of funeral services conducted at the Oblong facility
averaged between 60 and 70 funerals per year during the years
1992 and 1993.
Earl L. Deckard (Mr. Deckard), a licensed funeral director
and embalmer in Illinois, was employed by Homes or Chapel from
November 1980, until mid-1994. He worked at the Robinson
facility through 1985, and then worked at the Oblong facility for
the remainder of his employment.
- 6 -
From 1985 through 1989, Mr. Deckard lived in the upper level
of the Oblong facility. He then moved into his own home.
Beginning in 1985, he was the resident manager and embalmer at
Oblong where he was in charge of day-to-day operations of the
funeral home. He was the only full-time employee at the Oblong
facility, although it had a part-time secretary and a part-time
receptionist. Mr. Deckard also assisted at Homes' other
facilities on an as needed basis.
Mr. Deckard was a key employee of Homes. He was well
connected in both the Oblong and Robinson communities. He was
raised in Oblong, graduated from high school there, and was a
member of the community club, village board, and the police and
fire commission. He was also a member of a large church.
Prior to 1991, Mr. Deckard had spoken to Mr. Pulliam about
acquiring a financial interest in the Oblong facility. But Mr.
Pulliam was not then interested in selling any of his ownership
in Homes or Oblong until his son, David, had an opportunity to
choose his vocation. Mr. Deckard was not interested in any
minority ownership in Homes. He later so indicated in writing
that he "had absolutely no interest in a minority interest in
Pulliam Funeral Home, P.C.". Also prior to 1991, Mr. Pulliam and
Mr. Deckard had some disagreements regarding the operation of the
Oblong facility. Consequently, in early 1991, Mr. Deckard
purchased property adjacent to his residence on which he intended
to construct and operate his own funeral home in Oblong.
- 7 -
Mr. Pulliam discovered that Mr. Deckard had purchased the
property in Oblong and that he planned to construct and operate a
funeral home in competition with Homes. This would have caused
Homes to lose a key employee. Homes would also have lost
business in the small market area of Oblong and vicinity, and it
would have had an adverse impact on its profits.
Upon learning of Mr. Deckard's intent, Mr. Pulliam summarily
terminated his employment in July 1991. He then requested his
attorney, Max Tedford (Mr. Tedford), to prepare a formal
termination letter to Mr. Deckard.
After Mr. Deckard's employment was terminated, Mr. Pulliam
experienced some problems in the Oblong facility. He and Mr.
Tedford discussed what could be done to rectify the situation.
Mr. Tedford advised him and suggested that a negotiation meeting
with Mr. Deckard be arranged.
A meeting was held in July 1991 in Mr. Tedford's office,
attended by Mr. Pulliam, Mr. Deckard, and their wives. An
informal agreement was reached whereby Mr. Deckard would acquire
an ownership interest in the Oblong facility and would be
reemployed at a salary and bonus. The corporate minutes of
Homes, dated July 2, 1991, stated as follows:
The sole stockholder and director of Pulliam Funeral
Homes, PC., conducted a special meeting of said
Corporation at the Corporate offices at 1005 West Main
St., Robinson, Illinois, for the purpose of considering
an offer from long-time employee Earl L. Deckard to
purchase an interest in the business of Oblong,
Illinois. After consideration, it was decided that Mr.
- 8 -
Deckard could purchase up to 49% of the Oblong
location, after a spin-off from Pulliam Funeral Homes,
P.C., into Pulliam-Deckard Funeral Chapel, P.C., in
which Clark D. Pulliam would be the sole stockholder,
and from which up to 49% of the stock could be sold to
Earl L. Deckard.
It was decided to use Vanderlyn R. Pine and Associates
to do the appraisal and all fees and costs associated
with the spin-off and sale would be borne by the buyer
and seller on a 51-49 split.
It was further agreed that January 1, 1992 would be the
preferred target date to coincide with Calendar year-
end and that progress towards that sale would be easily
accomplished.
A sale price to be established by appraisal will be
agreed to in writing by the parties and all accounting
and legal matters resolved prior to sale.
After the July meeting, Mr. Pulliam provided his
accountants, Kemper CPA Group, and his lawyer, Mr. Tedford, with
information and data, and requested that they plan the
transactions and prepare the necessary written agreements.
Mr. Pulliam, his attorney, and his accountants agreed on the
spin-off and other transactions before the formation of Chapel
and the distribution of all its stock to Mr. Pulliam. He
selected and contacted the appraiser, Vanderlyn R. Pine. He was
billed for the $5,950.76 appraisal fee. He contacted and hired
the attorney, Mr. Tedford, and the accountants, Kemper CPA Group.
Mr. Tedford had three conferences with Mr. Pulliam between
December 2, 1991, and February 28, 1992. Mr. Tedford had no
contacts with Mr. Deckard during that period. All of the
agreements were prepared by Mr. Tedford. All of the agreements
- 9 -
were structured by Mr. Tedford and the accountants. Mr. Deckard
was unrepresented in the transactions.
A Spin-off Agreement executed by Mr. Pulliam and Mr..
Deckard on January 1, 1992, provided, in pertinent part, as
follows:
WHEREAS, PULLIAM FUNERAL HOMES, P.C. is currently
engaged in the funeral business in Crawford County,
Illinois, and
WHEREAS, CLARK D. PULLIAM is the sole shareholder
of PULLIAM FUNERAL HOMES, P.C. and
WHEREAS, PULLIAM FUNERAL HOMES, P.C. proposes to
transfer to PULLIAM DECKARD FUNERAL CHAPEL, P.C. the
real estate and improvements, and other assets set
forth on Exhibit A attached, heretofore used by it in
that portion of its business operation situated in
Oblong, Illinois, in return for all the issued and
outstanding shares of PULLIAM DECKARD FUNERAL CHAPEL,
P.C. and to simultaneously transfer to CLARK D.
PULLIAM, the sole shareholder of PULLIAM FUNERAL HOME,
P.C. all of said outstanding and issued shares of
PULLIAM DECKARD FUNERAL CHAPEL, P.C. and
WHEREAS, PULLIAM FUNERAL HOME, P.C. and PULLIAM
DECKARD FUNERAL CHAPEL, P.C. are desirous of entering
into an agreement for the purpose of securing the
transfer to PULLIAM DECKARD FUNERAL CHAPEL, P.C. of the
above-described assets of PULLIAM FUNERAL HOMES, P.C.
and the ultimate transfer to the sole shareholder of
PULLIAM FUNERAL HOMES, P.C. * * * of the issued and
outstanding shares of PULLIAM DECKARD FUNERAL CHAPEL,
P.C.
NOW, THEREFORE, in consideration of mutual
covenants and undertakings of the respective parties
hereto, it is agreed as follows:
1. PULLIAM FUNERAL HOMES, P.C. does hereby agree
to transfer into PULLIAM DECKARD FUNERAL CHAPEL, P.C.,
effective January 1, 1992, all of those assets more
particularly identified on Exhibit A which is attached
hereto and incorporated herein by this reference.
2. Simultaneous with the transfer of the assets
as provided for in paragraph 1 above, PULLIAM DECKARD
FUNERAL CHAPEL, P.C. agrees to transfer to PULLIAM
FUNERAL HOMES, P.C. all of the issued and outstanding
shares of stock of PULLIAM DECKARD FUNERAL CHAPEL,
- 10 -
P.C., which in turn will transfer said shares to its
sole shareholder, CLARK D. PULLIAM.
3. It is the intention of all parties hereto
that no gain or loss for income tax purposes will be
recognized in that said transaction shall constitute a
"spin-off" pursuant to Section 355 of the Internal
Revenue Code and accordingly it is agreed that the
value of the assets transferred shall be their tax
basis value as determined by Kemper CPA Group.
An Agreement dated February 28, 1992, to be effective
January 1, 1992, was signed by Mr. Pulliam and Mr. Deckard. The
Agreement incorporated a Stock Purchase Agreement and an
Employment Agreement. The Agreement also provided, in pertinent
part, as follows:
WHEREAS, PULLIAM owns 100 percent (1000 shares) of
the common stock of PULLIAM DECKARD FUNERAL CHAPEL,
P.C., an Illinois Corporation; and
WHEREAS, DECKARD desires to purchase from PULLIAM,
and PULLIAM desires to sell to DECKARD 49 percent (490
shares) of the common stock of PULLIAM DECKARD FUNERAL
CHAPEL, P.C., an Illinois Corporation.
NOW, THEREFORE, in consideration of the mutual
covenants and undertakings of the respective parties
hereto, it is agreed as follows:
1. DECKARD agrees to purchase from PULLIAM, and
PULLIAM agrees to sell to DECKARD 49 percent (490
shares) of the common stock of PULLIAM DECKARD FUNERAL
CHAPEL, P.C., an Illinois Corporation, for the sum of
$789.00 per share, for a total of $386,610, payable by
DECKARD to PULLIAM as follows:
A. $40,000 upon execution of this Agreement,
the receipt and sufficiency of which is hereby
acknowledged.
B. The remaining balance of $346,610,
together with interest thereon at the rate of 10
percent per annum amortized over a period of 15 years,
shall be paid by DECKARD to PULLIAM in equal annual
installments of $45,570.13, which includes principal
and interest, beginning March 15, 1993, and the same
amount on the same date of each year thereafter until
March 15, 2002, at which time the entire remaining
balance of principal and interest owing under this
Agreement must be paid in full. Payment shall be
- 11 -
applied first to pay interest and then to reduce
principal.
* * * * * * *
D. Concurrently with the execution of this
Agreement, PULLIAM shall deliver the stock being sold
to DECKARD to The First National Bank in Robinson as
escrow agent, said stock to be endorsed in blank for
transfer. Said escrow agent shall hold the stock being
sold until satisfactory proof has been furnished to the
escrow agent that the purchase price hereunder,
together with interest as herein provided, has been
fully paid, and upon satisfactory proof of payment of
the purchase price in full shall deliver such stock to
DECKARD. If DECKARD shall fail to make any installment
payment when due and shall not correct such failure
within 90 days thereafter, following notice by PULLIAM,
then at the option of PULLIAM this Agreement shall be
terminated. Upon termination, the parties shall cause
a portion of the stock covered by this Agreement to be
transferred to DECKARD, said portion being the amount
which DECKARD has made principal payments on based upon
a price per share of $789.00 excluding any fractional
shares. The balance of the stock shall be transferred
to PULLIAM. The escrow agent may conclusively rely on
the Affidavit of PULLIAM that DECKARD is in default
hereunder and of PULLIAM's election to terminate this
Agreement. It is understood and agreed by all parties
hereto that the escrow agent assumes no personal
liability except for fraud knowingly committed. The
escrow agent shall be entitled to a reasonable fee for
his services under this Agreement. The cost of such
fee shall be shared equally by PULLIAM and DECKARD and
shall be paid directly to the escrow agent as and when
billed.
E. So long as DECKARD shall not be in
default under the provisions of this Agreement, he
shall have all of the voting and other customary rights
of a shareholder of record with respect to the stock
being purchased from PULLIAM. In the event DECKARD
shall be in default under the provisions of this
Agreement, then his voting and other rights shall cease
and such rights shall be vested in PULLIAM..
F. During the term of this Agreement,
neither DECKARD nor PULLIAM shall take any action to
cause any additional shares of common capital stock of
the Corporation to be issued.
* * * * * * *
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3. All costs relating to the formation and
organization of PULLIAM DECKARD FUNERAL CHAPEL, P.C.,
an Illinois Corporation, including but not limited to
all documents preparation expenses, all legal fees,
accounting fees, real estate and income taxes,
appraisal fees, postage, fax charges, federal express
costs, travel expenses and all other costs incurred
shall be paid by the parties on a prorata basis in
relation to their respective stock ownership. Any of
said expenses paid in advance by PULLIAM or PULLIAM
FUNERAL HOMES, P.C. shall likewise be reimbursed to
PULLIAM or to PULLIAM FUNERAL HOMES, P.C. on said
prorata basis.
4. DECKARD agrees not to compete with PULLIAM or
PULLIAM FUNERAL HOMES, P.C., under the same terms and
conditions as are contained in Paragraph 7 of the
EMPLOYMENT AGREEMENT attached hereto and incorporated
herein by this reference as Exhibit B. For a period of
three years from the date of this agreement, PULLIAM,
individually and on behalf of PULLIAM FUNERAL HOMES
P.C., agrees not to compete with PULLIAM DECKARD
FUNERAL CHAPEL, P.C., for funeral business in Oblong,
Illinois.
* * * * * * *
13. This agreement shall be governed by the laws
of the State of Illinois.
The $789 per share fair market value of Chapel's stock was
based on the appraisal report of Vanderlyn R. Pine dated January
9, 1992, which determined that the total fair market value of the
Oblong facility was $789,500. The net taxable basis of the
Oblong facility was $227,274.09 as of December 31, 1991. Chapel
had total assets of $301,871, total liabilities of $43,124.56,
and retained earnings of $258,746.44 as of December 31, 1992,
according to a financial statement prepared by the Kemper CPA
Group.
On January 1, 1992, a spin-off of Homes' assets and
liabilities with respect to the Oblong funeral home was
- 13 -
consummated. Chapel was incorporated as a professional
corporation to accept transferred assets and liabilities from
Home. A professional service corporation license was issued to
Chapel by the State of Illinois.
On January 1, 1992, Homes received 1,000 shares of Chapel
common stock, and on the same date distributed the 1,000 shares
of Chapel stock to Mr. Pulliam as its sole shareholder. Also on
January 1, 1992, the 1,000 shares of Chapel common stock were
surrendered by Mr. Pulliam in exchange for two certificates: No.
2 for 510 shares and No. 3 for 490 shares.
On March 6, 1992, Mr. Pulliam transferred certificate No. 3
to the First National Bank of Robinson as escrow agent pursuant
to the Agreement and Stock Purchase Agreement between him and
Mr. Deckard. Mr. Pulliam received the initial $40,000 payment
from Mr. Deckard in 1992 pursuant to the Agreement.
By the terms of the Employment Agreement Mr. Deckard was to
provide management and other services as funeral director and
assist in the overall operation and supervision of the Oblong
facility, and to preserve and increase its goodwill. His
compensation was $39,000 per year. It contained, among other
provisions, a covenant not to compete with Chapel for a period of
3 years after the termination of his employment. It also
contained a non-solicitation clause and a covenant for the
protection of confidential information.
- 14 -
Homes and Chapel were engaged immediately after the
distribution in the active conduct of the funeral business.
The funeral business was actively conducted by Homes
throughout the 5-year period ending on the date of the
distribution.
In 1993 Mr. Deckard paid his first annual installment of
$45,570.13 to Mr. Pulliam under the Agreement. Petitioners
timely paid taxes on that installment payment.
Mr. Deckard defaulted in 1994 on the installment sale. His
employment by Chapel then ended. He demanded that Mr. Pulliam
return the payments he had made, but later settled for $5,000.
After defaulting, Mr. Deckard abided by his covenant not to
compete with Chapel, which prevented him from working as a
funeral director in Oblong. Mr. Pulliam reacquired almost all of
Chapel's common stock as the result of Mr. Deckard's default
under the terms of paragraphs 1 D and E of their Agreement.
At all times after Chapel was created as a professional
corporation, Mr. Pulliam was president and majority owner of
Chapel's stock, and was in ultimate control of its operations.
In the notice of deficiency respondent determined that Mr.
Pulliam received dividends of $789,500 from Homes, which were not
reported on petitioners' Federal income tax return for 1992.
Therefore, their taxable income was increased $789,500.
OPINION
- 15 -
A corporation generally must recognize gain on the sale or
distribution of appreciated property, including stock of a
subsidiary. However, distributions of subsidiary stock in
divisive transactions governed by section 3554 are tax-free to
4
SECTION 355. DISTRIBUTION OF STOCK AND SECURITIES OF A
CONTROLLED CORPORATION.
(a) Effect on Distributees.-
(1) General Rule.-If-
(A) a corporation (referred to in this section as the
"distributing corporation")-
(i) distributes to a shareholder, with respect to
its stock, or
(ii) distributes to a security holder, in exchange
for its securities,
solely stock or securities of a corporation (referred to
in this section as "controlled corporation") which it
controls immediately before the distribution,
(B) the transaction was not used principally as a
device for the distribution of the earnings and profits
of the distributing corporation or the controlled
corporation or both (but the mere fact that subsequent
to the distribution stock or securities in one or more
of such corporations are sold or exchanged by all or
some of the distributees (other than pursuant to an
arrangement negotiated or agreed upon prior to such
distribution) shall not be construed to mean that the
transaction was used principally as such a device),
(C) the requirements of subsection (b) (relating to
active businesses) are satisfied, and
(D) as part of the distribution, the distributing
corporation distributes-
(i) all of the stock and securities in the
controlled corporation held by it immediately before
the distribution, or
(ii) an amount of stock in the controlled
corporation constituting control within the meaning
of section 368(c), and it is established to the
satisfaction of the Secretary that the retention by
the distributing corporation of stock (or stock and
securities) in the controlled corporation was not in
pursuance of a plan having as one of its principal
purposes the avoidance of Federal income tax,
(continued...)
- 16 -
both the distributing corporation and to the distributee
shareholders.
There are four basic statutory requirements that must be
satisfied to have a tax-free corporate division under section
355. They are: (1) Solely stock or securities of a controlled
corporation must be distributed to shareholders with respect to
their stock in the distributing corporation or to security
holders in exchange for the distributing corporation's
securities; (2) the distribution must not be used principally as
a device for distributing earnings and profits; (3) the active
business requirement of section 355(b) must be met; and (4) all
of the controlled corporation's stock and securities held by the
distributing corporation, or enough to constitute control of the
controlled corporation, must be distributed. In addition to the
statutory requirements, a corporate business purpose requirement
and a continuity of proprietary interest requirement apply to
spin-offs. Secs. 1.355-1(b), 1.355-2(b) and (c), Income Tax
Regs.
Petitioners' Contentions
Petitioners contend that the spin-off by Homes of the Chapel
stock to Mr. Pulliam qualifies as a tax-free distribution
pursuant to section 355. They argue that there were strong
4
(...continued)
then no gain or loss shall be recognized to (and no amount
shall be includable in the income of) such shareholder or
security holder on the receipt of such stock or securities.
- 17 -
corporate business purposes for Homes to create Chapel because it
wanted to protect itself from any possible competition by Mr.
Deckard in the funeral business in the Oblong area, and it wanted
to reemploy Mr. Deckard as a key employee to operate and manage
the Oblong facility. They also argue that Homes had to
distribute Chapel's stock to Mr. Pulliam because it was believed
that Illinois law required funeral homes to be professional
service corporations having shareholders who are licensed by the
State of Illinois as funeral directors and embalmers. Thus,
petitioners maintain that both of these corporate business
purposes are strong evidence of nondevice which overcomes the
evidence that there was principally a device for the distribution
of the earnings and profits of Homes or Chapel or both.
Respondent's Contentions
To the contrary, it is respondent's position that this
transaction fails to qualify as a tax-free distribution of stock
under section 355 and the applicable regulations. Respondent
argues that there was no corporate business purpose for the
distribution by Homes of Chapel stock to Mr. Pulliam, and that
there was no compelling reason to distribute Chapel's stock to
Mr. Pulliam other than to distribute substantial earnings and
profits of Homes to Mr. Pulliam without being subject to the
dividend provisions of section 301. It is further argued that,
when Homes distributed the Chapel stock, Illinois law relating to
funeral homes did not require that Chapel be a professional
- 18 -
service corporation, whose shareholders are licensed funeral
directors and embalmers, rather than a regular corporation.
Thus, respondent contends that various devices present here
clearly show that the transaction was used principally as a
device for the distribution of Homes' earnings and profits. In
addition, respondent asserts that the business objectives of
Homes could have been satisfied without a distribution to Mr.
Pulliam either by having Mr. Deckard purchase 49 percent of the
Chapel stock from Homes or by having Mr. Deckard purchase newly
issued Chapel stock from Chapel.
Device and Nondevice
At the outset it is important to note that, after a spin-
off, a shareholder can sell or exchange stock in either the spin-
off corporation or the distributing corporation in a transaction
qualifying for capital gains treatment. The shareholder will get
this favorable capital gains treatment even though he continues
to hold stock representing part of his investment. Therefore,
under certain circumstances, a spin-off can be used to avoid the
ordinary income tax treatment imposed on dividends to bail out
corporate earnings. Although the differences between the
treatment of capital gains and ordinary income have narrowed
since section 355 was first enacted, capital gains treatment
continues to be preferable in certain respects. Because of
continuing Congressional concern that a spin-off might be used to
avoid the tax on dividends, section 355(a)(1)(B) provides that a
- 19 -
spin-off cannot qualify as tax-free if it is used principally as
a "device" to distribute earnings and profits.
Whether the distribution in this case qualifies as tax-free
under section 355 turns upon the answer to the narrow question of
whether the device factors present in the transaction outweigh
the nondevice factors. If the device factors are predominant,
the spin-off cannot qualify as tax-free because it has been used
principally as a device for the distribution of earnings and
profits of the distributing corporation (Homes) or the controlled
corporation (Chapel) or both. On the other hand, if the
nondevice factors are strong enough to overcome the device
factors, the spin-off will qualify as tax-free. Sec. 1.355-
2(d)(2) and (3), Income Tax Regs. The determination must be
based on all the facts and circumstances. Sec. 1.355-2(d)(1),
Income Tax Regs.
Device Factors
A sale of stock after a spin-off is "evidence of device".
Sec. 1.355-2(d)(2)(iii)(A), Income Tax Regs. A subsequent sale
of stock pursuant to an arrangement negotiated or agreed upon
before the distribution is "substantial evidence of device".
Sec. 1.355-2(d)(2)(iii)(B), Income Tax Regs. In this case it was
clearly prearranged that, after the spin-off of stock in Chapel
to Mr. Pulliam, he would make an installment sale of 490 shares
of that stock to Mr. Deckard. Thus, there is substantial
evidence of device.
- 20 -
Generally, the greater the percentage of the stock sold
after the distribution, the stronger the evidence of device. In
addition, the shorter the period of time between the distribution
and the sale, the stronger the evidence of device. Sec. 1.355-
2(d)(2)(iii), Income Tax Regs. Here 49 percent of Chapel's stock
was sold to Mr. Deckard, and the distribution and the sale of
stock were both deemed to have taken effect as of January 1,
1992. In no event did the sale take place later than March 6,
1992, when 490 shares of Chapel stock were placed in escrow with
the First National Bank of Robinson pursuant to the Agreement and
Stock Purchase Agreement between Mr. Pulliam and Mr. Deckard.
Mr. Pulliam, through his attorney and accountants,
completely dominated, controlled, and arranged the creation of
Chapel and the transfer of all of its shares directly to himself.
By contrast, Mr. Deckard was unrepresented and did not
significantly influence the structuring of the transaction or the
preparation of the legal documents.
Nondevice Factors
Among nondevice factors is a corporate business purpose.
Sec. 1.355-2(d)(3)(ii), Income Tax Regs. Since any spin-off must
have a corporate business purpose to qualify as tax-free, this
nondevice factor will always be present to some extent in any
qualifying spin-off. Under the balancing approach adopted in the
regulations, the stronger the evidence of device, the stronger
the corporate business purpose that is necessary to prevent a
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determination that the transaction was used principally as a
device. Id. Factors that are relevant in weighing the strength
of the business purpose include: (1) The importance of achieving
the purpose to the success of the business; (2) the extent to
which the transaction is prompted by a person not having a
proprietary interest in either corporation, or by other outside
factors beyond the control of the distributing corporation; and
(3) the immediacy of the conditions prompting the transaction.
Sec. 1.355-2(d)(3)(ii)(A),(B) and (C), Income Tax Regs. As
reflected in our findings of fact, two strong corporate business
purposes for the spin-off are present in this case. If Mr.
Deckard had carried out his plans to build and operate a funeral
home in Oblong in competition with Homes it would have divided
the funeral business in that area, thus having an adverse impact
on Homes' profits. In addition, the services of an experienced
funeral director and key employee (Mr. Deckard) would have been
lost to the Homes organization. These purposes were vitally
important to the continued success of Homes' business. The
transaction was prompted by the actions of Mr. Deckard, who had
no proprietary interest in Homes at that time. The immediate
possible threat of competition to Homes in Oblong prompted the
transaction.
Independent Corporate Business Purposes
Section 1.355-2(b)(1), Income Tax Regs., provides an
affirmative requirement that a spin-off have one or more
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corporate business purposes. This is independent of the device
test. The requirement limits tax-free treatment under section
355 to spin-offs motivated by non-tax business reasons, and thus
prevents tax avoidance opportunities from arising. Id. Section
1.355-2(b)(2), Income Tax Regs., defines a corporate business
purpose as a real and substantial non-Federal tax purpose germane
to the distributing corporation, the controlled corporation, or
the affiliated group to which the distributing corporation
belongs. Although respondent maintains that a purely shareholder
purpose will not support a tax-free spin-off, there are some
situations in which a shareholder purpose may be so intertwined
with a corporate business purpose that it is not practical to
separate the two. In such a case, the transaction is considered
carried out for a corporate business purpose. Sec. 1.355-
2(b)(2), Income Tax Regs. See Estate of Parshelsky v.
Commissioner, 303 F.2d 14 (2d Cir. 1962), reversing and remanding
34 T.C. 946 (1960), on remand T.C. Memo. 1963-187, holding that a
shareholder non-tax purpose may be an adequate business purpose
for a spin-off. See also Rafferty v. Commissioner, 452 F.2d 767
(1st Cir. 1971), affg. 55 T.C. 490 (1970), and Wilson v.
Commissioner, 353 F.2d 184 (9th Cir. 1965), reversing and
remanding 42 T.C. 914 (1964), which approached the business
purpose issue from different theoretical bases. In Rafferty,
evidence of lack of business purpose was considered by the Court
of Appeals as bearing on the "device" requirement. In Wilson,
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the Court of Appeals assumed that a spin-off must satisfy an
independent business purpose test. However, both courts reached
the same practical result; i.e., a spin-off with a strong bailout
potential will qualify under section 355 only if compelling
business purposes for the spin-off can be shown.
In this case, as we have previously indicated, independent
corporate business purposes existed for the transaction. The
protection against competition and the retention of a key
employee are both strong and compelling business purposes, not
only for Homes but also for Mr. Pulliam, its sole shareholder.
Respondent stresses that there must be a business purpose
not only for dividing the business into separate corporations,
but also for direct ownership of the corporations by the
shareholders. See Estate of Parshelsky v. Commissioner, 303 F.2d
at 20; Bonsall v. Commissioner, 317 F.2d 61, 65 (2d Cir. 1963),
affg. T.C. Memo. 1962-151. Petitioners assert that they believed
Illinois law required Chapel's shareholders to be individuals,
who were licensed funeral directors and embalmers, rather than a
corporation, and therefore it was necessary to create Chapel as a
professional service corporation with Mr. Pulliam owning its
stock before the installment sale of 490 shares to Mr. Deckard.
Respondent disputes this assertion as being incorrect and
misleading. It is argued that Illinois law did not require Homes
to distribute Chapel's stock to Mr. Pulliam, but it could have
held the stock in Chapel and sold 490 shares directly to Mr.
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Deckard. Thus, respondent argues, "the unnecessary use of a
professional service corporation, coupled with the specious
argument that a professional service corporation was required by
Illinois law, demonstrates an obvious attempt to structure the
transaction to avoid the provisions of section 355(a)(1)(B)".
We agree with petitioners. Mr. Pulliam's attorney and
accountants reasonably believed that it was necessary to create
Chapel as a professional service corporation, and in our judgment
their belief was well founded. It is unlawful for any person to
practice, or attempt to practice, funeral directing and embalming
in the State of Illinois without being licensed by that State.
225 Ill. Comp. Stat. 41/5-5 and 41/10-5 (West 1993). No
corporation, partnership, or association of individuals, as such,
shall be issued a license as a licensed funeral director and
embalmer. However, nothing in the Illinois Funeral Directors and
Embalmers Licensing Act restricts licensees from forming
professional service corporations under the Illinois Professional
Service Corporation Act or from having these corporations
registered for the practice of funeral directing. 225 Ill. Comp.
Stat. 41/15-50 (West 1993). Therefore, the only way to
incorporate Chapel was through a professional service
corporation. A professional corporation means a corporation
organized under the Illinois Professional Service Corporation Act
solely for the purpose of rendering one category of professional
service, and which has as its shareholders only individuals who
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are duly licensed by the State of Illinois. 805 Ill. Comp. Stat.
10/3.4 (West 1993). No corporation organized under the Illinois
Professional Service Corporation Act may issue any of its capital
stock to anyone other than an individual who is duly licensed.
805 Ill. Comp. Stat. 10/11. In order to open, operate, or
maintain an establishment under the Professional Service
Corporation Act, the corporation must have a certificate of
registration. One requirement for obtaining the certificate of
registration is that the shareholders must be licensed. 805 Ill.
Comp. Stat. 10/12 (West 1993).
Although unlicensed owners of funeral directing and
embalming establishments are allowed under 225 Ill. Comp. Stat
41/1-20 (West 1993), the unlicensed owner is not allowed to
"engage in any form of funeral directing and embalming". 225
Ill. Comp. Stat. 41/1-20(b) (West 1993). In addition, 805 Ill.
Comp. Stat. 10/4 (West 1993) provides that the provisions of the
Professional Service Corporation Act do not repeal, modify, or
restrict provisions of law that regulate several professions
"except insofar as such laws are in conflict with the provisions
of this Act [the Professional Service Corporation Act]". This
language indicates that the Professional Service Corporation Act
controls in any real or perceived conflict between the Illinois
code provisions regarding unlicensed owners. Hence unlicensed
ownership of a professional service corporation engaged in
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funeral directing seems to be barred by 805 Ill. Comp. Stat.
10/15 (West 1993).
Arguably under these Illinois corporate requirements, we
think that initially only Mr. Pulliam (and later Mr. Deckard)
could have held Chapel's stock. Homes could not have done so.
Consequently, Homes' distribution of Chapel's stock to Mr.
Pulliam had a definite business purpose.
Section 1.355-2(b)(3), Income Tax Regs., states that a
distribution is not carried out for a valid corporate business
purpose if the business purpose can be achieved through a
nontaxable transaction that does not involve the distribution of
stock of a controlled corporation and which is neither
impractical nor unduly expensive. In the circumstances of this
case we think the corporate business purpose of bringing Mr.
Deckard back as a key employee of the Oblong facility and
providing him with a minority interest in Chapel could not have
been achieved without an installment sale because of Mr.
Deckard's financial condition and the Illinois Professional
Corporation Act requirement that licensed individuals be the
stockholders of Chapel. Homes could not have owned the Chapel
stock during the installment sale. Consequently, we reject
respondent's arguments that the business objectives of Homes
could have been achieved in a nontaxable transaction without a
distribution of Chapel stock to Mr. Pulliam.
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Both parties have cited and relied on various revenue
rulings. We have considered them, but find that they are
factually distinguishable from this case. Hence we have placed
no reliance on them in reaching our conclusion.
We also find Example (1) of section 1.355-2(d)(4), Income
Tax Regs., to be distinguishable from the facts of the instant
case. In Example (1) corporation X, whose stock was owned solely
by individual A, distributed the stock of Y, a wholly owned
subsidiary of X, to A, so that individual B, a key employee,
could afford to purchase stock in X. After the distribution of
the Y stock, A sold some of his X stock to B. Because X could
have issued additional shares to give B an equivalent interest in
X, the sale of X stock by A is deemed to be substantial evidence
of device, and the transaction is considered to be used
principally as a device. Here, by contrast, no additional stock
could have been issued by Homes because Mr. Deckard did not want
Homes' stock, Homes could not be a stockholder of Chapel under
Illinois law, Mr. Pulliam and Homes would not sell Homes' stock
to Mr. Deckard, and, in any event, Mr. Deckard could not afford
to purchase any meaningful amount of Homes' stock. The entire
distribution in Example (1) of section 1.355-2(d)(4), Income Tax
Regs., was made so that the key employee could afford to buy
stock in the distributing corporation, as opposed to the
controlled corporation in this case. As a result, the fact
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pattern in Example (1) is different from the situation present in
the instant case.
Conclusions
Based on all the facts and circumstances present in this
record, we conclude, on balance, that the strong corporate
business purposes and nondevice factors outweigh and overcome the
device factors, so that the distribution by Homes of Chapel stock
to Mr. Pulliam qualifies as tax-free under section 355. However,
we sustain respondent's determination that petitioners are
taxable on the $40,000 received in 1992 from Mr. Deckard on the
installment sale of 49 percent of Chapel's stock, which they did
not report on their Federal income tax return for that year.
Petitioners are also liable for the accuracy-related penalty
under section 6662(a) with respect to the $40,000 omitted from
their 1992 return.
Respondent raised a new and alternative issue for the first
time at trial and on brief. That issue is whether Homes, in
substance, distributed enough stock in Chapel to constitute
control within the meaning of section 368(c), as required by
section 355(a)(1)(D). This was not an issue or ground contained
in the notice of deficiency or in respondent's answer to the
petition. Respondent filed no amendment to the answer raising
this issue. Petitioners have opposed the untimely raising of
this issue. We agree with petitioners. We conclude that the
issue is not properly before us and therefore we need not
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consider it. Rule 31(a) specifically provides that "The purpose
of the pleadings is to give the parties and the Court fair notice
of the matters in controversy and the basis for their respective
positions." See also Rule 36(b); Seligman v. Commissioner, 84
T.C. 191, 197-199 (1985), affd. 796 F.2d 116 (5th Cir. 1986);
Barber-Greene Americas, Inc. v. Commissioner, 35 T.C. 365, 390
(1960); Kaplan v. Commissioner, 21 T.C. 134, 147 (1953).
To reflect uncontested determinations and our conclusions
with respect to the disputed issues,
Decision will be entered
under Rule 155.