Honbarrier

*301 RUWE, JUDGE: Respondent determined a deficiency in Archie L. and Louise B. Honbarrier's Federal income tax for 1993 in the amount of $ 2,090,149. Respondent determined a deficiency in Colonial Motor Freight Line, Inc.'s (Colonial) Federal income tax for 1993 in the amount of $ 27,374.

The sole issue for decision is whether*72 the merger of Colonial into Central Transport, Inc. (Central), on December 31, *302 1993, qualifies as a tax-free reorganization within the meaning of section 368(a)(1)(A). ¹

FINDINGS OF FACT

Some of the facts have been stipulated and are so found. The stipulation of facts, first supplemental stipulation of facts, and the attached exhibits are incorporated herein by this reference. Mr. and Mrs. Honbarrier resided in High Point, North Carolina, at the time they filed their petition. At the time Central filed its petition as successor to Colonial, its principal place of business was High Point, North Carolina.

COLONIAL

Colonial was incorporated in 1941. Colonial was a trucking company that operated as a common carrier of packaged freight. The company principally transported furniture manufactured*73 in North Carolina. Colonial hauled freight in conventional van trailers pulled by highway tractors.

Colonial held an operating authority granted by the Interstate Commerce Commission (ICC) and an operating authority granted by the State of North Carolina. These authorities granted Colonial contract and common carrier status between specified points and places within the United States and North Carolina for the transportation of packaged freight.

When the trucking industry was deregulated at the Federal level in the 1980's, Colonial was subjected to competition from small individual truckers, with low overhead costs. As a result, Colonial's ICC operating authority became worthless, and the company experienced significant business reversals.

Colonial operated at a loss in the late 1980's. On its Federal income tax returns ² for 1987 and 1988, Colonial reported ordinary losses from trade or business activities as follows:

*74 *303     Year         Loss

    ____       __________

    1987       $ 1,291,408

    1988        2,245,186

            __________

     Total      3,536,594

In 1988, as a result of its financial losses, Colonial stopped hauling freight and began selling its operating assets. By December 31, 1990, Colonial had sold all of its operating assets, except for the ICC and North Carolina operating authorities, for cash and cash equivalents. On August 21, 1992, Colonial sold its North Carolina authority for $ 5,000 but retained its ICC authority.

Colonial invested the proceeds from the sale of its operating assets almost exclusively in tax-exempt bonds and a municipal bond fund. Colonial held 18 tax-exempt bonds, 16 of which were purchased in 1990 and 1991, and 2 of which were purchased in 1992. One bond was redeemed in 1991, and three bonds were redeemed in 1992 and 1993. Colonial continued to hold the remaining 14 bonds as of the end of 1993.

As of October 31, 1993, 2 months prior to the merger, Colonial held approximately $ 7.35 million in tax-exempt bonds and a municipal bond*75 fund and approximately $ 1,500 in cash. On December 31, 1993, Colonial liquidated one of its tax-exempt bonds and its municipal bond fund. The proceeds of this liquidation together totaled more than $ 2,550,000. As a result, Colonial's cash position increased significantly.

Immediately prior to the merger of Colonial into Central on December 31, 1993, ³ Colonial's assets and liabilities consisted of the following:

Assets           Tax Basis      Fair Market Value

______           __________      _________________

Cash           $ 2,413,839        $ 2,413,839

Tax-exempt bonds      4,549,146         4,549,146

Interest and dividends

receivable          37,800          37,800

ICC authority        ¹ -0-          ² -0-

Alex Brown*76 and Sons

 Account

   Cash            1,482           1,482

   Money funds        18,926          18,926

   Tax-exempt bonds     300,000          300,000

             __________        __________

 Total           7,321,193         7,321,193

Liabilities

___________

Federal and State income

tax payable                     (76,142)

                         _________

 Total                       7,245,051

*304 The only expenses incurred by Colonial in 1993, other than Federal and State income taxes and the State intangible*77 tax, were professional fees of $ 900 and office supplies of $ 8,733.

From 1985 to December 31, 1993, Mr. Honbarrier owned 100 percent of Colonial's issued and outstanding shares. From 1988 through 1993, Mr. Honbarrier was the sole director of Colonial. On December 31, 1993, Mr. Honbarrier's Colonial stock (245 shares) had a tax basis of $ 291,506.

CENTRAL

Central was incorporated under the laws of North Carolina in 1951. From 1951 through 1997, Central was a trucking company that operated as a bulk carrier of liquid and dry chemicals. ⁴ Some of the chemicals that Central hauled were toxic. Central transported bulk chemicals in tanker trailers pulled by tractors.

Central held operating authorities issued by the ICC, various States, and Canada. These authorities granted Central*78 contract and common carrier status for the transportation of bulk chemicals, including liquid or dry toxic chemicals, in tanker trailers between points and places within the United States, various States, and Canada. Central faced minimal competition because of the expensive equipment required to engage in the tanker trucking business.

*305 Central was an S corporation. ⁵ Central was highly successful in its bulk chemical hauling business, realizing net ordinary income from 1991 through 1996 as follows:

    Year          Amount

    ____         __________

    1991         $ 2,399,057

    1992          2,321,825

    1993          3,242,161

    1994          8,239,741

    1995          7,043,522

    1996   *79        6,046,232

              __________

     Total        29,292,538

The yearend balances in Central's accumulated adjustments account ⁶ reported on Central's Federal income tax returns for the years 1991 through 1996 show undistributed earnings as follows:

    Year        Account Balance

    ____        _______________

    1991         $ 8,378,797

    1992          9,893,868

    1993         10,693,387

    1994          7,333,838

    1995          6,449,973

    1996          6,592,738

On several occasions, Charles L. Odom, a certified public accountant and Mr. Honbarrier's tax and financial adviser, recommended that Central make distributions*80 to shareholders if such funds were not needed in Central's business. In a memorandum to attorney Charles Lynch, dated November 5, 1993, Mr. Odom stated: "Central has $ 10 million in undistributed S Corp earnings and would like [to] make a significant distribution to shareholders, but needs its capital for expansion and replacement of aging equipment."

Unlike Colonial, Central did not invest in tax-exempt bonds. Central held passive investments in the form of short-term liquid investments, such as certificates of deposit, because it needed cash and cash equivalents to operate its business. As of yearend 1991 through yearend 1996, Central *306 held cash and short-term investments in the following amounts:

    Yearend       Amount

    _______      __________

     1991      $ 5,621,829

     1992       5,688,948

     1993       11,924,102

     1994       10,658,199

     1995       9,363,012

     1996       11,999,759

For its taxable years 1991 through 1996, Central declared distributions to its shareholders as follows:

*81     Year          Amount

    ____         __________

    1991           -0-

    1992         $ 1,000,000

    1993          7,000,000

    1994          7,540,000

    1995          8,333,838

    1996          6,449,974

              __________

     Total        30,323,812

Both Central and Colonial had a long history of operating debt free, in accordance with Mr. Honbarrier's conservative business policy of avoiding debt. Central never incurred either long-term or short-term debt.

Central pursued a 5-year capital expansion program for updating equipment. From 1993 through 1996, Central made expenditures on property and equipment as follows:

    Year         Expenditure

    ____         ___________

    1993         $ 8,481,534

    1994          5,764,211

    1995          6,600,730

    1996          4,806,384

       *82        __________

     Total        25,652,859

The majority of these expenditures were for power units (i.e., tractors) and stainless steel tankers. These expenditures were made on a debt-free basis from Central's available funds.

From 1982 through 1997, all of Central's stock was owned by Mr. and Mrs. Honbarrier and their children, Gary L. *307 Honbarrier and Linda Embler. During the same period, Central had only four directors, consisting of Mr. and Mrs. Honbarrier and their two children.

MERGER OF COLONIAL INTO CENTRAL

On December 31, 1993, Colonial merged into Central in accordance with the laws of North Carolina. Central was the surviving corporation. Prior to the merger, Mr. Odom requested that Mr. Lynch research the income tax implications of a merger. On November 5, 1993, 7 weeks before the merger, Mr. Odom made the following handwritten notes:

   ALH Oks merger of Col. & Central, payout to Cen. shareholders

   -- if tax free

   -- need bus. purpose

On November 11, 1993, after researching the matter, Mr. Lynch sent Mr. Odom a memorandum identifying the following possible business reasons for the merger: (1) Obtaining Colonial's*83 ICC operating rights to expand Central's business; (2) reducing and simplifying operating procedures and expenses by utilizing Central's existing staff and facilities; (3) reducing administrative expenses due to projected increased revenue without increasing overhead expenses; and (4) use of Colonial's cash to permit Central to expand and capitalize on the operating rights acquired from Colonial.

In a letter dated November 12, 1993, Mr. Odom forwarded a copy of Mr. Lynch's memorandum to Mr. Honbarrier and stated the following:

   Since Colonial has no intention of returning to the

   transportation industry, its intangible assets (ICC Authority),

   which would be lost on liquidation, could benefit another

   company within that industry. It seems to me that a merger could

   benefit both Central and Colonial. Central would be acquiring

   valuable rights for current and future use, as well as a

   substantial addition to its working capital. Colonial would no

   longer be required to maintain records and manage its

   investments, file separate income tax returns and whatever other

   administrative duties are now required.

*84 On November 16, 1993, Mr. Honbarrier telephoned Mr. Odom to tell him to proceed with the merger. Mr. Honbarrier's approval of the merger was forwarded to Mr. Lynch by Mr. Odom on the same day.

*308 On December 22, 1993, Colonial and Central entered into an Agreement and Plan of Merger of Colonial with and into Central (Merger Agreement) providing for a merger of Colonial into Central to occur 1 second before midnight on December 31, 1993. On December 22, 1993, the shareholders and directors of Central unanimously approved the merger. The directors and shareholders' written consent provided, in part, as follows:

   WHEREAS, Colonial Motor Freight Line, Incorporated, has certain

   Interstate Commerce Commission operating authorities which the

   Corporation wishes to acquire for current and future use as well

   as Colonial's substantial working capital in order to permit it

   to make use of Colonial's ICC authority;

As previously stated, Colonial's ICC operating authority had no value, and Central never used the ICC operating authority acquired from Colonial in the merger. Central never operated as a packaged-freight carrier.

For purposes of the merger,*85 Mr. Odom determined that the premerger value of Central's stock was $ 417.45 per share. He then determined that the net asset value of Colonial, which was being acquired by Central, was $ 7,442,660 ⁷ and that the number of Central shares necessary to compensate Mr. Honbarrier for his Colonial stock was 17,840 shares. Pursuant to the merger, Mr. Honbarrier's 245 shares of Colonial stock were exchanged for 17,840 shares of Central stock. The merger changed Central's shareholder ownership as follows:

          Before Merger:        After Merger:

                Percent            Percent

          Shares    Ownership     Shares    Ownership

          ______    _________ *86     _______    _________

Mr. Honbarrier    65,484     72.0396     83,324     76.6268

Mrs. Honbarrier     300     0.3300       300     0.2760

Gary L. Honbarrier  12,558     13.8152     12,558     11.5486

Linda Embler     12,558     13.8152     12,558     11.5486

 Total        90,900    100.0000     108,740    100.0000

On December 22, 1993, the board of directors of Central also declared a $ 7 million distribution payable to its shareholders on December 31, 1993. The shareholder distribution was allocated on a pro rata basis among the shareholders based on their stock ownership in Central on December 22, 1993. The *309 amounts to be distributed to the various shareholders were as follows:

   Shareholder       Allocable Amount of Distribution

   ___________       ________________________________

   Mr. Honbarrier          $ 5,042,772

   Mrs. Honbarrier            23,102

   Gary L. Honbarrier          967,063

   Linda Embler        *87      967,063

    Total               7,000,000

With the exception of the amount allocable to Mr. Honbarrier, all of the declared distributions were paid by check on December 31, 1993. Central made the $ 5,042,772 distribution to Mr. Honbarrier in two parts. The first part was paid via a $ 493,626 check drawn on Central's account on December 31, 1993. Thus, the cash distributions made to Mr. Honbarrier and the other shareholders on December 31, 1993, totaled $ 2,450,854. ⁸ The second part of the distribution to Mr. Honbarrier was made on January 3, 1994, and consisted of $ 4,549,146 in tax-exempt bonds. ⁹ The tax-exempt bonds distributed to Mr. Honbarrier on January 3, 1994, were the same bonds acquired by Central from Colonial in the merger.

*88 For Federal income tax purposes, petitioners treated the merger as a tax-free reorganization within the meaning of section 368(a)(1)(A) and treated the $ 7 million distribution as a payment of previously taxed income reflected in Central's accumulated adjustments account.

OPINION

As a general rule, any gain recognized on the sale or exchange of property is taxable. However, the Internal Revenue Code provides that certain transactions may occur in such a way that ownership interests are exchanged, yet no taxable event is deemed to have taken place. One instance where nonrecognition is provided involves corporate reorganizations that come within the provisions of section 368. The *310 income tax regulations explain the rationale behind the reorganization provisions as follows:

   Under the general rule, upon the exchange of property, gain or

   loss must be accounted for if the new property differs in a

   material particular, either in kind or in extent, from the old

   property. The purpose of the reorganization provisions of the

   Code is to except from the general rule certain specifically

   described exchanges incident to such readjustments of corporate

*89    structures made in one of the particular ways specified in the

   Code, as are required by business exigencies and which effect

   only a readjustment of continuing interest in property under

   modified corporate forms. Requisite to a reorganization under

   the Code are a continuity of the business enterprise under the

   modified corporate form, and (except as provided in section

   368(a)(1)(D)) a continuity of interest therein on the part of

   those persons who, directly or indirectly, were the owners of

   the enterprise prior to the reorganization. * * *

   [Sec. 1.368-1(b), Income Tax Regs.]

Shareholders generally do not recognize gain or loss when stock in a corporation that is a party to a reorganization is, pursuant to a plan of reorganization, exchanged solely for stock in another corporation that is a party to the reorganization. See sec. 354(a)(1). Section 368(a)(1)(A) defines a reorganization as "a statutory merger or consolidation". A statutory merger or consolidation is one effected pursuant to the corporate laws of the United States, a State, a territory, or the District of Columbia. *90 See sec. 1.368-2(b)(1), Income Tax Regs. The merger of Colonial into Central meets this literal requirement. Petitioners argue that they are entitled to tax-free treatment under the Code because the merger was a complete and valid transaction for State law purposes.

It has long been held that qualification as a merger under State law is not, by itself, sufficient to qualify as a reorganization under section 368(a)(1)(A). Courts have interpreted section 368 as imposing three additional requirements for a merger to be treated as a reorganization under section 368(a)(1)(A). These are: (1) Business purpose; (2)continuity of business enterprise; and (3) continuity of interest. See Gregory v. Helvering, 293 U.S. 465, 79 L. Ed. 596, 55 S. Ct. 266 (1935); Wortham Mach. Co. v. United States, 521 F.2d 160 (10th Cir. 1975); Cortland Specialty Co. v. Commissioner, 60 F.2d 937 (2d Cir. 1932); Atlas Tool Co. v. Commissioner, 70 T.C. 86, 100 (1978), affd. 614 F.2d 860 (3d Cir. 1980). Following judicial precedent, the regulations also require that there be a business purpose for the transaction, continuity of business enterprise, and continuity*91 *311 of interest, in order for a merger to qualify as a reorganization under section 368(a)(1)(A). See sec. 1.368-1(b), Income Tax Regs.; T.D. 7745, 1981-1 C.B. 134. Failure to comply with any one of these requirements will preclude treatment as a tax-free reorganization within the meaning of section 368(a)(1)(A).

Respondent argues that the merger failed to meet the continuity of business enterprise requirement necessary to qualify the merger as a tax-free reorganization within the meaning of section 368(a)(1)(A). ¹⁰The continuity of business enterprise requirement was first expressed in Cortland Specialty Co. v. Commissioner, supra. See Laure v. Commissioner, 653 F.2d 253, 258 (6th Cir. 1981). This requirement is now embodied in section 1.368-1(b), Income Tax Regs., and described in paragraph (d) of the same section. These regulations are based on an interpretation of judicial precedents which articulate the continuity of business enterprise doctrine. See T.D. 7745, 1981-1 C.B. 134. The basic concept behind the continuity of business enterprise requirement is that the receipt of*92 a new ownership interest in an entity that retains none of the business attributes of the shareholder's former corporation is more closely akin to a sale or liquidation than to a mere adjustment in the form of ownership. See Laure v. Commissioner, supra at 258.

Under the income tax regulations, a transaction constitutes a tax-free reorganization only if there is "a continuity of the business enterprise under the modified corporate form". Sec. 1.368-1(b), Income Tax Regs. Continuity of business enterprise requires that the acquiring corporation either continue the acquired corporation's historic business or use a significant portion of the acquired corporation's historic business assets in a business. See sec. 1.368-1(d)(2), Income Tax Regs.*93 In essence, the acquiring corporation must retain a link to the business enterprise of the acquired corporation by continuing the acquired corporation's business or by using the acquired corporation's business assets in a business. See Berry Petroleum Co. v. Commissioner, 104 T.C. 584, 635- 636 (1995), affd. 142 F.3d 442 (9th Cir. 1998). In this case, as explained below, we find that Central neither continued *312 Colonial's historic business nor used a significant portion of Colonial's historic business assets in Central's business operations.

1. CONTINUATION OF ACQUIRED CORPORATION'S HISTORIC BUSINESS

In general, a corporation's historic business is the business it has conducted most recently. See sec. 1.368-1(d)(3)(iii), Income Tax Regs. Petitioners contend that there is a continuity of Colonial's trucking business because Central is also in the trucking business. We disagree.

Colonial terminated its business of hauling packaged freight in 1988. ¹¹ It then began selling its operating assets. From 1988 forward, Colonial had no customers. By the end of 1990, Colonial had essentially disposed of its trucking operation assets for cash*94 and cash equivalents. The only trucking assets Colonial retained were its ICC and North Carolina operating authorities. The ICC operating authority had become worthless, and Colonial sold its North Carolina operating authority in 1992 for $ 5,000. For 3 years prior to the merger, Colonial's assets consisted principally of tax- exempt bonds and a municipal bond fund. ¹² During the 3-year period prior to the merger, Colonial held 18 tax-exempt bonds, 16 of which were purchased in 1990 and 1991, and 2 of which were purchased in 1992. One bond was redeemed in 1991, and three bonds were redeemed in 1992 and 1993. Colonial continued to hold the remaining 14 bonds as of the end of 1993.

*95 Colonial stopped hauling freight approximately 5 years prior to the merger, had essentially sold all of its operating assets 3 years prior to the merger, and for 3 years prior to the merger kept most of its assets in tax-exempt bonds and a municipal bond fund. We conclude that Colonial had abandoned its trucking business well before the merger. ¹³ Colonial's most recent business type activity was acquiring and *313 holding tax-exempt bonds and a municipal bond fund. This was Colonial's historic business at the time of the merger for purposes of determining whether there was a continuity of business enterprise. See, e.g., Abegg v. Commissioner, 50 T.C. 145 (1968), affd. 429 F.2d 1209 (2d Cir. 1970). ¹⁴

*96 As of October 31, 1993, 2 months prior to the merger, Colonial held approximately $ 7.35 million in tax-exempt bonds and a municipal bond fund and approximately $ 1,500 in cash. On December 31, 1993, Colonial liquidated one of those bonds and its municipal bond fund for more than $ 2,550,000. As a result, Colonial's cash position increased significantly.

The fair market value of the tax-exempt bonds held directly by Colonial totaled $ 4,549,146 just before the merger on December 31, 1993. Three days after the merger, Central distributed these same tax-exempt bonds to Mr. Honbarrier. ¹⁵ This distribution occurred on January 3, 1994. ¹⁶ The last tax-exempt bond acquired by Central in the merger was worth $ 300,000 and held in the Alex Brown and Sons account. This bond was liquidated by Central 4 months after the merger. Unlike Colonial, Central did not invest in tax- exempt bonds. Central placed its money in short-term liquid investments, such as certificates of deposit because it needed cash and cash equivalents to operate its business. Thus, we conclude that Central did not continue Colonial's business of holding tax-exempt bonds and municipal bond funds.

*97 2. SIGNIFICANT USE OF ACQUIRED CORPORATION'S BUSINESS ASSETS

Continuity of business enterprise can also be satisfied if the acquiring corporation uses a significant portion of the acquired corporation's historic business assets in a business. See sec. 1.368- 1(d)(4)(i), Income Tax Regs. A corporation's historic *314 business assets are the assets used in its historic business. See sec. 1.368- 1(d)(4)(ii), Income Tax Regs. Business assets may include stock and securities. See id. In general, the determination of the portion of the corporation's assets considered "significant" is based on the relative importance of the assets to the operation of the business. See sec. 1.368-1(d)(4)(iii), Income Tax Regs. However, all other facts and circumstances, such as the net fair market value of those assets, will be considered. See id.

Colonial's historic business assets were its tax-exempt bonds and municipal bond fund. It was never intended that Colonial's tax-exempt bonds and municipal bond fund be held by Central and, after the merger, Central did not use those assets in its business. On the day of the merger, Colonial liquidated a tax-exempt bond and its municipal bond*98 fund for more than $ 2.5 million in cash. On the same day, Central made a cash distribution to Central's shareholders in the total amount of $ 2,450,854. ¹⁷ Three days after the merger, tax-exempt bonds totaling $ 4,549,146 that had been held by Colonial were distributed to Mr. Honbarrier. ¹⁸ The remaining tax-exempt bond, valued at $ 300,000, which was held in an account with Alex Brown and Sons, was liquidated 4 months later.

*99 As a result of the transactions surrounding the merger, all of Colonial's investments in tax-exempt bonds and the municipal bond fund were disposed of and Colonial ceased to exist. We find that Central did not use a significant portion of Colonial's historic business assets in a business.

3. CONCLUSION

Central did not continue either Colonial's historic business or use a significant portion of Colonial's historic business *315 assets in a business. As a result, Central did not satisfy the continuity of business enterprise requirement. See sec. 1.368-1(b), Income Tax Regs.

We hold that the merger of Colonial into Central was not a tax-free reorganization within the meaning of section 368(a)(1)(A). Because this merger did not qualify as a reorganization under section 368(a)(1)(A), Mr. Honbarrier's exchange of Colonial stock for valuable consideration was a taxable event. Colonial's assets had a net fair market value of $ 7,245,051 ¹⁹ at the time Colonial was merged into Central. Petitioners acknowledge that Mr. Honbarrier received full fair market value for his stock in Colonial. ²⁰ Mr. Honbarrier must therefore recognize capital gain of $ 6,953,545, which*100 is equal to the excess of the fair market value of assets he received for his Colonial stock ($ 7,245,051) over his basis ($ 291,506). ²¹

*101 In the notice of deficiency to Colonial, respondent determined that Colonial had a gain on the sale or exchange of its assets in the merger transaction. However, respondent now agrees that Colonial did not realize any gain because the fair market value of its assets equaled its tax basis in those assets.

Decision will be entered under Rule 155 in docket No. 9053-97.

Decision will be entered for petitioner in docket No. 9054-97.