Opinion
Docket No. 17990-81
February 10, 1986
Tax Analysts Citation: 86 TNT 30-163 Parallel Citations: T.C. Memo. 1986-58 Principal Code Reference: Section 368(a)(1)(B)
Summary
STEP TRANSACTION DOCTRINE DOES NOT APPLY TO STOCK SWAP; EXCHANGE CLASSIFIED AS `B' REORGANIZATION
Maurice M. Weikel, a dentist, acquired a patent for dental amalgam, a substance used to fill teeth. His license entitled him to manufacture, market and sell the alloy in the U.S. under the trade name "Dispersalloy." In 1970, Weikel incorporated American Silver and Mercury Producers for the purpose of manufacturing dental alloys. The firm was never activated, however, because the business was not profitable and Weikel wished to utilize the losses it generated. Sales of the alloy increased in 1973 after the publication of several research papers which gave the product a favorable evaluation. In 1973, Weikel began negotiations with the Dental Products Division of Johnson Johnson (JJ), a New Jersey firm which wanted to market Dispersalloy. Sales of the product increased, and Weikel decided to revitalize his inactive corporation. At the suggestion of JJ, he incorporated on October 10, 1973 under the name of Dispersalloy, Inc., because it was felt that the name was well-known and would be more effective for marketing purposes. Furthermore, Weikel's tax counsel suggested that, in light of the negotiations with JJ, prospective marketers of Dispersalloy would probably desire a "pooling of interests," which required that the business be incorporated. On March 1, 1974, the transaction between JJ and Weikel was closed. Weikel delivered all the outstanding stock in Dispersalloy to JJ.
On April 30, 1974, JJ delivered to Weikel 48,898 shares of its unregistered voting common stock valued at $4,368,058. Dispersalloy filed a U.S. corporate income tax return for a first fiscal year beginning November 1, 1973 and ending February 28, 1974. JJ treated the transaction as a taxable purchase of assets and placed the fair market value of the assets on its books at the value of what it received in the exchange. JJ continued to operate Dispersalloy, Inc. for two years and seven months after the agreement with Weikel was closed. The IRS assessed a deficiency against Weikel and his wife in the amount of $1,750,273 for tax year 1974. The Service contended that Weikel's tax-free transfer of the assets of his business to Dispersalloy, Inc. was one step in a prearranged plan to transfer the assets to JJ in exchange for stock. The Service argued that the step transaction doctrine applied to render the transaction a taxable purchase of the assets of the business by JJ. Weikel argued that the transaction was a tax-free reorganization under section 368(a)(1)(B) of the Code. Dispersalloy, Inc., he contended, was not a sham corporation and conducted business for almost three years after the transaction occurred. He further argued that no binding agreement existed for the exchange of Dispersalloy's stock until several months after its incorporation and that the incorporation was for a valid business purpose. Tax Court Judge Drennen has held that the transaction was a tax-free reorganization under section 368(a)(1)(B) of the Code. The court cited Vest v. Commissioner, 57 T.C. 128 (1971), aff'd. in part, rev'd. on another issue 481 F.2d 238 (5th Cir. 1973), cert. denied 414 U.S. 1092 (1973), as authority for its holding. First, the court stated, the incorporation of Dispersalloy, Inc. was a transaction with independent economic significance. The court noted the testimony of Weikel's tax advisor that the business was incorporated to effectuate a pooling of interests and that sound tax planning "required that the business be operated in corporate form" in view of the profits generated. The court distinguished the case of West Coast Marketing Corp. v. Commissioner, 46 T.C. 32 (1966), relied upon by the Service, by noting that in West Coast Marketing, the sale of assets was arranged prior to the formation of the corporation whose stock was exchanged by the taxpayer. The court noted that Weikel had evidenced an intention to incorporate the business as early as 1970. Finally, the court stated, Dispersalloy, Inc. continued to operate for nearly three years after its acquisition by JJ. None of the three step transaction doctrine tests was satisfied by the facts of the Dispersalloy transaction, the court said. The court was not convinced, it stated, that the "end result" of the transaction was to be a sale of the assets of the sole proprietorship. Under the "interdependence test," the court found "it is clear that petitioners intended to incorporate whether or not they finalized an agreement with JJ for an exchange of stock." Finally, the court noted that the transaction could not be found to have satisfied the "binding commitment" test, because no agreement between Weikel and JJ existed before the incorporation of Dispersalloy, Inc.
Full Text
In 1967, petitioner, a dentist, acquired a patent for a dental amalgam called Dispersalloy. In September 1973, petitioner formed a corporation, Dispersalloy, Inc., and transferred his patent to it in exchange for all its stock. In January 1974, petitioner and Johnson Johnson executed an agreement and Plan of Reorganization of the Dispersalloy Corporation under which petitioner transferred all of his stock in Dispersalloy, Inc. to Johnson Johnson in exchange for Johnson Johnson stock.
HELD: Dispersalloy, Inc, was organized for a substantial business purpose.
HELD, FURTHER: The exchange of Dispersalloy, Inc. stock by petitioner for stock of Johnson Johnson qualifies as a tax-free reorganization under sections 354(a)(1) and 368(a)(1)(B), I.R.C.
HELD, FURTHER: The step-transaction doctrine does not apply to make the transaction taxable. West Coast Marketing Corp. v. Commissioner, 46 T.C. 32 (1966), distinguished.
LAURENCE L. PILLSBURY, for the petitioners.
KAREN NICHOLSON SOMMERS, for the respondent.