S. Tulsa Pathology Lab. v. Comm'r

*85 MARVEL, Judge: Respondent determined a deficiency in petitioner's Federal income tax of $ 1,926,232 for taxable year ended June 30, 1994.

The issues for decision are: (1) Whether, pursuant to a plan of reorganization under section 368(a)(1)(D), ¹ petitioner's distribution to its shareholders of stock of a controlled corporation qualified as a nontaxable distribution under section 355; and (2) if the distribution did not qualify as a nontaxable distribution under section 355, whether the fair market value of the distributed stock for purposes of calculating petitioner's gain under section 311(b)(1) is measured by the price paid for the stock by a third-party purchaser on the distribution date or by the alleged value of the controlled corporation's assets*8 on the day before the distribution.

             FINDINGS OF FACT

Some of the facts have been stipulated and are so found. We incorporate the stipulation of facts herein by this reference.

South Tulsa Pathology Laboratory, Inc. (petitioner), is, and was for all relevant periods, an Oklahoma professional corporation, which had its principal place of business in Tulsa, Oklahoma, when it filed its petition in this case. Petitioner was incorporated as an Oklahoma professional corporation in July 1968. Petitioner was owned by seven physicians (shareholders). For all relevant periods, petitioner was classified as a "C" corporation for Federal corporate income tax purposes and had a fiscal year ended June 30 for tax and financial reporting*9 purposes.

Since its incorporation, petitioner has provided pathology-related medical services to hospitals and medical professionals in northeastern Oklahoma. Until 1993, petitioner offered both anatomic pathology and clinical pathology medical services to its customers (anatomic business and clinical business, respectively). Petitioner's anatomic business included examination and diagnosis of pathology of human tissue and provision of consulting diagnostic assistance to physicians in northeastern Oklahoma. Petitioner's anatomic business services were performed by its physician shareholders and/ or other licensed physicians. Petitioner's clinical business included performance of laboratory tests on body fluids and tissue samples obtained from hospitals and medical professionals throughout northeastern Oklahoma. Petitioner's clinical business services were performed by nonphysician employees of petitioner at a laboratory and three "draw" facilities in Tulsa, Oklahoma.

Beginning in 1970, and continuing through 1992, petitioner received several offers from competing clinical pathology laboratories to purchase its clinical business. *10 These offers were always rejected by petitioner's shareholders and management. In 1993, however, petitioner's shareholders decided to sell the clinical business to a large national clinical laboratory because they believed the growth of large national clinical laboratories and the implementation of managed health care during the early 1990s would force petitioner out of the clinical business over the next few years. Petitioner's shareholders, however, decided they wanted to *87 continue to own and operate the anatomic business using the corporate name, "South Tulsa Pathology Laboratory, Inc.", under which they had practiced for 25 years.

In August 1993, petitioner was approached by representatives of two national laboratory chains, Smith Kline Laboratories (Smith Kline) and National Health Laboratories, Inc. (NHL), each of which expressed an interest in purchasing petitioner's clinical business. Both Smith Kline and NHL were large, publicly traded corporations that provided clinical laboratory services to hospitals, physicians, and clinics throughout the United States.

Sometime in the fall of 1993, petitioner decided to pursue a sale of its clinical*11 business to NHL. On September 20, 1993, petitioner and NHL entered into a confidentiality agreement to provide for the disclosure by petitioner to NHL of certain confidential information. Under the confidentiality agreement, petitioner agreed to disclose certain financial and business information necessary and appropriate in any negotiations conducted by the parties.

After petitioner made the disclosures pursuant to the confidentiality agreement, petitioner agreed to sell its clinical business to NHL. Before October 5, 1993, petitioner and NHL negotiated the sale of the clinical business and agreed to structure it as a sale of the stock of a yet-to-be-incorporated clinical laboratory company that would be capitalized with the clinical business and spun off ² from petitioner. Thereafter, NHL delivered to petitioner a letter of intent, dated September 30, 1993, concerning the purchase by NHL of all outstanding stock of that newly incorporated clinical laboratory company. After both parties signed the letter of intent, petitioner's shareholders believed there was a commitment by NHL to buy and a commitment by petitioner to sell petitioner's clinical business. ³ As of October 5, 1993, petitioner*12 *88 and NHL had negotiated and agreed to the essential terms of the sale. ⁴

On October 5, 1993, petitioner formed Clinpath, Inc. (Clinpath), an Oklahoma general business corporation. Pursuant to a subscription agreement between petitioner and*13 Clinpath, dated October 6, 1993, petitioner agreed to purchase 14,399 shares of the common stock of Clinpath, representing 100 percent of the issued shares of Clinpath.

On October 29, 1993, petitioner and its shareholders entered into a reorganization agreement in which they agreed, among other things, that: (1) Petitioner shall contribute all of its clinical laboratory assets to Clinpath in exchange for 14,399 shares of Clinpath stock issued to petitioner; and (2) after the exchange of petitioner's clinical laboratory assets for Clinpath stock, petitioner promptly shall distribute all of the Clinpath stock to petitioner's shareholders in proportion to their ownership of stock in petitioner. Also, on October 29, petitioner transferred the clinical laboratory assets, including goodwill, to Clinpath, and Clinpath transferred 14,399 shares of its common stock to petitioner. Petitioner's adjusted basis in the Clinpath stock it received equaled $ 105,015, its adjusted basis in the clinical laboratory assets it transferred to Clinpath in exchange for the stock.

On October 30, 1993, petitioner distributed 100 percent of the Clinpath stock to petitioner's shareholders in proportion to their*14 stock ownership. Clinpath conducted no business during the period from October 5, 1993, the date of Clinpath's incorporation, through October 30, 1993.

Pursuant to an acquisition agreement dated October 30, 1993, on October 30, 1993, immediately following the distribution of Clinpath stock to petitioner's shareholders, Clinpath shareholders ⁵ transferred all of the issued and *89 outstanding Clinpath stock to NHL in exchange for $ 5,530,000. The purchase price paid by NHL for the Clinpath stock was negotiated and agreed upon by unrelated parties at arm's length.

As a condition precedent to the sale, NHL demanded that each of Clinpath's physician-shareholders execute covenants*15 not to compete, dated October 30, 1993. The covenants not to compete provided that each of the physician-shareholders agreed not to compete with NHL in the clinical laboratory business anywhere within the 918 area code of the State of Oklahoma for 5 years, except as provided in the contract. NHL paid each of the physician-shareholders $ 10,000, or a total of $ 70,000, in exchange for the covenants not to compete. The total consideration, consisting of covenant payments and the purchase price of the Clinpath stock, was $ 5,600,000. The consideration allocated to the covenants not to compete was negotiated and agreed upon by unrelated parties at arm's length. ⁶

*16 Neither petitioner nor its shareholders retained any ownership interest in Clinpath after October 30, 1993.

Petitioner had accumulated earnings and profits of at least $ 236,347 as of its taxable year beginning July 1, 1993. Petitioner did not prove whether petitioner and Clinpath had current earnings and profits as of October 30, 1993.

                OPINION

Section 361(a) provides that "No gain or loss shall be recognized to a corporation if such corporation is a party to a reorganization and exchanges property, in pursuance of the plan of reorganization, solely for stock or securities in another corporation a party to the reorganization." Section 368(a)(1) defines reorganization for purposes of section 361 to include:

     *90 (D) a transfer by a corporation of all or a part of its

   assets to another corporation if immediately after the transfer

   the transferor, or one or more of its shareholders (including

   persons who were shareholders immediately before the transfer),

   or any combination thereof, is in control*17 of the corporation to

   which the assets are transferred; but only if, in pursuance of

   the plan, stock or securities of the corporation to which the

   assets are transferred are distributed in a transaction which

   qualifies under section 354, 355, or 356; * * *

The above-described transaction, commonly referred to as a "D" reorganization, is sometimes used to divide an existing corporation on a tax-deferred basis into more than one corporation for corporate business purposes. In order for a divisive D reorganization to qualify for tax-deferred treatment at the corporate level under section 361, however, there must be a qualifying distribution of stock under section 355.

In this case, petitioner divided its existing business into two parts by way of a spinoff. It transferred its clinical business to a newly formed subsidiary, Clinpath, in exchange for 100 percent of Clinpath's stock. Petitioner then immediately distributed the Clinpath stock to its shareholders in a transaction petitioner claims met the requirements of section 355.

If a spinoff does not qualify under section 355, it could result in a taxable dividend to the distributing corporation's shareholders*18 under section 301 to the extent of corporate earnings and profits and in tax to the distributing corporation computed in accordance with sections 311(b)(1) and 312. Secs. 355(c), 361(c). Section 311(b)(1) provides that, if a corporation distributes property to a shareholder in a transaction governed by sections 301 through 307 and the fair market value of such property exceeds its adjusted basis in the hands of the distributing corporation, then gain shall be recognized to the distributing corporation as if such property were sold to the distributee at its fair market value. Section 312(b) provides that, on a distribution of appreciated property by a corporation with respect to its stock, earnings and profits of the corporation are increased by the excess of the fair market value of the property over its basis.

The primary issue in this case is whether petitioner's spinoff of Clinpath qualified as a valid reorganization under section 368(a)(1)(D). Respondent claims it did not so qualify *91 because the distribution of Clinpath's stock to petitioner's shareholders did not qualify as a nontaxable distribution under section 355. Respondent asserts that the spinoff*19 of Clinpath and the subsequent sale of Clinpath stock to NHL were, in reality, a prearranged sale by petitioner of its clinical business which failed to qualify as a reorganization under section 368 and a nontaxable distribution of stock to petitioner's shareholders under section 355. Consequently, respondent contends petitioner realized and must recognize gain on the distribution of Clinpath stock. Sec. 311(b)(1). Petitioner disagrees, urging us to conclude that it structured the spinoff of its clinical business and the subsequent sale of Clinpath's stock for legitimate corporate business purposes and that the spinoff satisfied the requirements of sections 368(a)(1)(D) and 355. Therefore, petitioner contends, it is not required to recognize gain on the distribution of Clinpath stock to its shareholders.

Respondent also argues that, in calculating the gain to petitioner under section 311(b)(1) as a result of the failed reorganization, the fair market value of the Clinpath stock must be measured by the price paid by NHL for that stock. Petitioner agrees that the amount of corporate gain, if any, resulting from the distribution is based on the excess of the fair market value of the*20 Clinpath stock over petitioner's basis in the stock but argues that the fair market value of the stock must be measured by the underlying value of the clinical business's assets contributed by petitioner to Clinpath on October 29, 1993.

In order to resolve these disputes, we must first decide whether the distribution of Clinpath stock to petitioner's shareholders met the section 355 requirements. We conclude that it did not for the reasons set forth below.

Section 355(a)(1) permits a nontaxable distribution by a corporation to its shareholders of stock in a controlled corporation if the distribution meets four statutory requirements: (1) Solely stock of a controlled corporation is distributed to shareholders with respect to their stock in the distributing corporation; (2) the distribution is not used principally as a device for the distribution of earnings and profits *92 of the distributing corporation or the controlled corporation or both; (3) the requirements of section 355(b) (relating to active businesses) are satisfied; and (4) all of the controlled corporation's stock held by the distributing corporation, or an amount constituting control, is distributed.*21 Sec. 355(a)(1). In addition to these statutory requirements, the regulations under section 355 require that the distribution have an independent corporate business purpose and that there be continuity of proprietary interest after the distribution. Sec. 1.355-2(b) and (c), Income Tax Regs.

Respondent argues that the distribution of Clinpath stock to petitioner's shareholders failed to satisfy the requirements of section 355 because: (1) The distribution of Clinpath stock was a device for the distribution of earnings and profits in violation of section 355(a)(1)(B); (2) the spinoff of Clinpath lacked a valid corporate business purpose as required by section 1.355-2(b), Income Tax Regs.; and (3) the prearranged sale of Clinpath stock on the same date as the distribution of Clinpath stock to petitioner's shareholders violated the continuity of proprietary interest requirement of section 1.355-2(c), Income Tax Regs. Petitioner, on the other hand, argues that the transaction met all the requirements of section 355 and related regulations. We examine the parties' arguments below.

A transaction*22 fails to qualify under section 355 if that transaction is used principally as a device for the distribution of the earnings and profits of the distributing corporation, the controlled corporation, or both. Sec. 355(a)(1)(B); see also sec. 1.355-2(d)(1), Income Tax Regs. We analyze whether a transaction was used principally as a device for distributing earnings and profits by examining all the facts and circumstances, including, but not limited to, the presence of the device factors listed in section 1.355- 2(d)(2), Income Tax Regs., and the presence of the nondevice factors listed in section 1.355-2(d)(3), Income Tax Regs.

Petitioner essentially concedes that there is evidence of device as described in section 1.355-2(d)(2), Income Tax Regs.; however, it argues that a lack of substantial earnings and profits, sec. 1.355-2(d)(5), Income Tax Regs., and a corporate *93 business purpose, sec. 1.355-2(d)(3), Income Tax Regs., outweigh any evidence of device.

     1. Device Factors

Section 1.355-2(d)(2), Income Tax Regs.*23 , identifies the following factors as evidence that a transaction was a device for the distribution of a corporation's earnings and profits: (1) Pro rata distribution among the shareholders of the distributing corporation and (2) subsequent sale or exchange of stock of the distributing or the controlled corporation. Our analysis of these factors is set forth below.

A distribution that is pro rata or substantially pro rata among shareholders of the distributing corporation is more likely to be used principally as a device and is evidence of device. Sec. 1.355-2(d)(2)(ii), Income Tax Regs. Petitioner does not dispute that the Clinpath stock was distributed pro rata to petitioner's shareholders. The parties stipulated that pursuant to the reorganization agreement, petitioner would and did distribute all the Clinpath stock to its shareholders in proportion to their stock ownership in petitioner. This factor is evidence of device.

A sale or exchange of the distributing or controlled corporation's stock after a distribution is also evidence of device. Sec. 1.355-2(d)(2)(iii)(A), Income Tax Regs. Generally, the greater the percentage of*24 stock sold and the shorter the period of time between the distribution and the sale or exchange, the stronger the evidence of device. Id. On brief, petitioner concedes "100% of Clinpath's stock was sold to NHL, and the distribution and the subsequent sale of stock occurred on" October 30, 1993.

In addition, a sale or exchange negotiated or agreed upon before the distribution is substantial evidence of device. Sec. 1.355-2(d)(2)(iii)(B), Income Tax Regs. On brief, petitioner concedes that "there is no question that the sale of the Clinpath stock to NHL was prearranged prior to the spin-off transaction in which the clinical laboratory assets of Petitioner were transferred to Clinpath." Indeed, the sale of Clinpath stock to NHL was discussed, negotiated, and agreed upon by NHL and petitioner and was anticipated by both parties well before the distribution. Sec. 1.355- 2(d)(2)(iii)(D), *94 Income Tax Regs. This factor is substantial evidence of device.

We conclude, based on a review of the applicable factors, that the facts and circumstances of this case present substantial evidence of device within the meaning of section 355(a)(1)(B).

     2. Nondevice*25 Factors and Absence of Earnings and

       Profits

In order to overcome the substantial evidence of device, petitioner argues that: (1) Although both petitioner and Clinpath had some accumulated earnings and profits during the periods in question, these amounts were not significant enough to warrant the conclusion that the spinoff of Clinpath was a device in contravention of section 355(a)(1)(B), and (2) several compelling corporate business purposes drove the entire transaction.

        a. Earnings and Profits

Section 1.355-2(d)(5), Income Tax Regs., specifies three types of distributions that ordinarily do not present the potential for tax avoidance and will not be considered to have been used principally as a device for the distribution of earnings and profits even if there is other evidence of device. A distribution that takes place at a time when neither the distributing nor the controlled corporation has earnings or profits is one of the distributions described in section 1.355-2(d)(5), Income Tax Regs., and is the only type of distribution thus described that petitioner argues applies in this*26 case.

A distribution ordinarily is considered not to have been used principally as a device if: (1) The distributing and controlled corporations have no accumulated earnings and profits at the beginning of their respective taxable years; (2) the distributing and controlled corporations have no current earnings and profits as of the date of the distribution; and (3) no distribution of property by the distributing corporation immediately before the separation would require recognition of gain resulting in current earnings and profits for the taxable year of the distribution. Sec. 1.355-2(d)(5)(ii), Income Tax Regs. Petitioner claims that the distribution at issue here satisfies these requirements.

*95 In its opening brief, petitioner concedes, "that the balance sheet for * * * [petitioner] as of June 30, 1993, reflected current and accumulated earnings and profits of $ 252,928.64, for both the anatomic and clinical pathology portions of * * * [petitioner's] business." ⁷ Petitioner argues, however, that:

*27      While petitioner concedes that it and Clinpath had some

   earnings and profits during the periods in question, these

   amounts were not meaningful and certainly do not provide a basis

   for a "bailout" of these earnings and profits amounts in

   order to avoid dividend treatment to Petitioner's shareholders.

Respondent disagrees, contending that the presence of any earnings and profits precludes petitioner from utilizing section 1.355-2(d)(5)(ii), Income Tax Regs., and that there is no credible evidence that petitioner lacked accumulated or current earnings and profits on the distribution date.

We agree with respondent for several reasons. First, petitioner reported it had over $ 230,000 of accumulated earnings and profits as of July 1, 1993, and petitioner did not introduce any evidence to prove that it had no current earnings and profits as of October 30, 1993. Section 1.355-2(d)(5)(ii)(A) and (B), Income Tax Regs., emphasizes that a distribution ordinarily will not be considered to have been used principally as a device if the distributing and controlled corporations have "no accumulated earnings and profits*28 at the beginning of their respective taxable years" and "no current earnings and profits as of the date of the distribution". (Emphasis added.) Section 1.355- 2(d)(5)(ii), Income Tax Regs., does not provide a safe harbor for corporations with "insignificant" or "minimal" earnings and profits, as petitioner contends.

Second, petitioner ignores the fact that the spinoff enabled it to claim that the substantial gain on the distribution of Clinpath stock to its shareholders, which ordinarily would have increased its current and accumulated earnings and profits, need not be recognized for corporate income tax purposes or reflected in the calculation of its earnings and profits as of October 30, 1993 and at yearend. Respondent argues that, if the spinoff of Clinpath did not qualify for tax-free treatment under sections 368 and 355, the distribution *96 of Clinpath stock to petitioner's shareholders would be taxable under section 311(b) and, therefore, would have generated substantial current earnings and profits to petitioner under section 312(b) as of October 30, the date of the distribution.

Neither party disputes that, if the spinoff of Clinpath does not qualify as a tax-free transaction*29 under sections 368 and 355, petitioner must realize and recognize substantial gain as of the date of distribution, sec. 311(b)(1), which will substantially increase petitioner's earnings and profits, sec. 312(b). Nevertheless, petitioner dismisses the prospect that it would have substantial current earnings and profits as a result of the spinoff ⁸ and overlooks what respondent describes as "the conspicuous fact that the corporate profits petitioner's shareholders clearly intended to bail out were the anticipated profits of the prearranged sale." Despite petitioner's efforts to suggest otherwise, we simply are not convinced that the decision to structure this transaction as a spinoff and subsequent stock sale was prompted by NHL; NHL usually structured its acquisitions as asset sales to minimize its exposure to liabilities that can arise from the purchase of an active business. Petitioner's protestations notwithstanding, the spinoff of Clinpath followed immediately by a prearranged sale of the Clinpath stock on the same day appears to have been designed to eliminate the corporate-level tax that would have been due had petitioner sold its clinical business to NHL directly or distributed*30 its clinical business to its shareholders prior to any sale.

For the reasons set forth above, petitioner has failed to prove that it did not have accumulated or current earnings and profits as of the date of the distribution within the meaning of section 1.355-2(d)(5)(ii), Income Tax Regs.

        b. Corporate Business Purpose

The presence of a valid corporate business purpose may trump a conclusion that the transaction was*31 used principally *97 as a device for the distribution of earnings and profits. Sec. 1.355- 2(b)(4),(d)(3)(ii), Income Tax Regs.Section 1.355-2(b)(2), Income Tax Regs., defines "corporate business purpose" as a "real and substantial non-Federal tax purpose germane to the business of the distributing corporation, the controlled corporation, or the affiliated group * * * to which the distributing corporation belongs."

The stronger the evidence of device, such as the presence of the device factors specified in section 1.355-2(d)(2), Income Tax Regs., the stronger the corporate business purpose required to prevent the conclusion that the transaction was used principally as a device. Sec. 1.355-2(d)(3), Income Tax Regs. The assessment of the s