MARTIN ICE CREAM COMPANY, Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 1477-93
UNITED STATES TAX COURT
Filed March 17, 1998
110 T.C. No. 18
A and his son M were shareholders of MIC, an S corporation that distributed ice cream products to supermarket chains, independent grocery stores, and food service accounts. MIC‘s supermarket business was largely attributable to the close personal relationships that A had developed and maintained for decades, beginning before the creation of MIC in 1971, with the owners and managers of the supermarket chains. Since 1974, MIC had distributed the ice cream products of HD, pursuant to an oral agreement entered into
- Held: The benefits of the personal relationships developed by A with the supermarket chains and A‘s oral agreement with the founder of HD were not assets of MIC that were transferred by MIC to SIC and thereafter sold by SIC to HD; A was the owner and seller of those assets.
- Held, further, respondent‘s attempt to apply Commissioner v. Court Holding Co., 324 U.S. 331 (1945), to regard MIC as the seller of assets to HD is rejected because the final sale to HD was on terms that were negotiated with HD by A and SIC that were significantly different from the terms of the earlier proposed transaction under negotiation between MIC and HD.
- Held, further, MIC‘s distribution of SIC stock to A was not entitled to nonrecognition of gain under
sec. 355, I.R.C. , because SIC was not engaged in the active conduct of a trade or business after the distribution of SIC stock to A. - Held, further, although MIC‘s transfer of intangible assets to SIC in exchange for SIC stock was entitled to nonrecognition of gain under
sec. 351, I.R.C. , the immediate distribution of SIC stock in redemption of A‘s stock in MIC was a distribution of appreciated property undersecs. 311(b) and317(b), I.R.C. , on which recognized gain in the amount of $141,000 is taxable to MIC undersec. 1374, I.R.C. - Held, further, MIC is not liable for a negligence addition to tax under
sec. 6653(a), I.R.C. , but is liable for a substantial understatement addition undersec. 6661, I.R.C.
Frank Agostino, Alan G. Merkin, Mary Ann Perrone, and Susan M. Flynn, for petitioner.
BEGHE, Judge: Respondent determined the following deficiency and additions to tax:
| Additions to Tax | |||
| Year | Deficiency | Sec. 6653(a)(1) | Sec. 6661 |
| 1988 | $477,816 | $23,891 | $119,454 |
In so doing, respondent determined that Martin Ice Cream Co. (MIC or petitioner) recognized taxable gain of $1,430,340 on the distribution of stock of its newly created subsidiary, Strassberg Ice Cream Distributors, Inc. (SIC), to one of petitioner‘s two shareholders, Arnold Strassberg (Arnold), in redemption of his 51-percent stock interest in petitioner. Shortly before trial, we granted respondent‘s motion for leave to amend answer to allege that a subsequent sale of assets to the Häagen-Dazs Co., Inc. (Häagen-Dazs), by Arnold and SIC should be attributed to petitioner under Commissioner v. Court Holding Co., 324 U.S. 331 (1945).
We reject respondent‘s attempt to apply Court Holding, although we uphold respondent‘s original determination that petitioner recognized gain on the redemption of Arnold‘s stock in petitioner. We find that petitioner‘s gain is substantially less than the gain determined by respondent. We reject respondent‘s imposition of an addition to tax under
FINDINGS OF FACT
Some of the facts are stipulated and are so found. MIC is a New Jersey corporation whose principal place of business was Bloomfield, New Jersey, when it filed its petition.
MIC was incorporated in 1971 as a wholesale ice cream distributor, with Martin Strassberg (Martin) as its sole shareholder. MIC was a C corporation from 1971 through 1986. On December 30, 1986, MIC filed with the Internal Revenue Service a Form 2553, Election by a Small Business Corporation, which took effect on November 1, 1987. As a
Soon after World War II, Arnold, Martin‘s father, a high school mathematics teacher, began a part-time business after school hours, selling ice cream products wholesale to stores in Newark, New Jersey. During summer vacations, Arnold expanded his coverage to small stores and ice cream parlors on the Jersey Shore. By 1960, Arnold had incorporated his own company, Arnold‘s Ice Cream, and was engaging full time in the wholesale distribution of ice cream. In the 1960‘s, Arnold began to develop relationships with the owners and managers of several supermarket chains when he conceived an innovative packaging and sales campaign that used bright colors and catchy slogans to market ice cream products to supermarkets for resale to consumers. Ice cream had hitherto been sold by supermarkets to consumers as an undifferentiated product in large containers and multiserving packages with plain brown wrappers. Arnold subsequently developed other packaging ideas for ice cream products that helped supermarkets sell ice cream products under their private labels. Even with different kinds of packaging, supermarkets marketed ice cream to consumers mainly on the basis of price. In the late 1960‘s, Arnold had a falling-out with his major supplier, Eastern Ice Cream, which forced Arnold‘s Ice Cream into bankruptcy.
In 1971, Martin and Arnold organized MIC as a part-time business, with one delivery truck, distributing ice cream to small grocery stores and food service accounts (restaurants, hotels, and clubs) in northern New Jersey. Martin joined the business after having completed virtually all requirements for a Ph.D. in statistics and after spending several years doing operations research and statistical analysis as an employee of large corporations. In 1975, Martin began working in the ice cream distribution business full time. During most of the 1970‘s, Arnold owned no stock in MIC because he wished to avoid the claims of creditors of Arnold‘s Ice Cream. In 1979, Arnold became a 51-percent shareholder in MIC, and Martin‘s interest was reduced to 49 percent. At no time did Arnold or Martin have an employment agreement with MIC.
In 1974, Ruben Mattus (Mr. Mattus), the founder of Häagen-Dazs, asked Arnold to use his ice cream marketing
Arnold, as the first distributor of Häagen-Dazs ice cream to supermarkets, sparked a revolution in the retail sale of ice cream. Arnold and Häagen-Dazs tapped a hitherto hidden demand for a super-premium ice cream in supermarkets by consumers who were willing to pay higher prices for higher quality. By the late 1970‘s, MIC was distributing ice cream products, including Häagen-Dazs ice cream, to four major supermarket chains, Pathmark, Shop Rite, Foodtown, and Acme in New York, New Jersey, Connecticut, and Pennsylvania (the supermarkets) and to smaller grocery stores. However, neither Arnold nor MIC ever entered into a written distribution agreement with Häagen-Dazs or Mr. Mattus.
Arnold was so successful that in the late 1970‘s or early 1980‘s Mr. Mattus invited Arnold to become his partner in a planned expansion of Häagen-Dazs’ supermarket sales to the West Coast. Arnold declined the offer and continued to use MIC as his corporate vehicle to distribute Häagen-Dazs products in New Jersey and adjacent areas.
Martin did not support or participate in Arnold‘s efforts to expand ice cream distribution to the supermarkets. Martin disliked the social activities necessary to developing and sustaining personal relationships with supermarket owners and managers--activities that Arnold thrived on. Martin preferred to manage day-to-day operations at the MIC warehouse, arriving at work as early as 3 to 4 a.m. to supervise the loading of MIC‘s delivery trucks for delivery to the supermarkets
In 1985, the Borden Co. (Borden) retained Arnold to use his contacts with the supermarkets to put Borden‘s ice cream products into supermarket freezers. Arnold worked as a broker for Borden, personally earning commissions on Borden‘s sales of ice cream products to supermarkets, rather than as a distributor buying from the manufacturer and reselling to retailers. MIC did not participate in Arnold‘s work for Borden. Arnold had the ability to--and did--put Borden‘s ice cream products into supermarket freezers at a time when many of his original contacts from the 1960‘s and earlier had passed from the scene. By 1988, Arnold no longer had a business relationship with Borden.
At some time in the early to mid-1980‘s, Ben and Jerry‘s, a competitor of Häagen-Dazs in the manufacture and marketing of super-premium ice cream, asked Arnold to help obtain supermarket freezer space for its products. Häagen-Dazs had not objected to Arnold‘s work for Borden but told him that he could not continue to distribute Häagen-Dazs ice cream products if he were to distribute Ben and Jerry‘s ice cream products. Arnold thereupon terminated further contact with Ben and Jerry‘s.
In 1983, the Pillsbury Co. (Pillsbury) purchased Häagen-Dazs from Mr. Mattus. Pillsbury promptly initiated а business plan to consolidate the distribution of Häagen-Dazs ice cream products into its own distribution centers, with the goal of delivering directly to retail stores, especially large supermarket chains. Pillsbury believed it could deliver a uniformly higher quality product to supermarkets at lower cost than independent distributors whose refrigeration equipment was not as reliable. Pillsbury believed that ensuring high quality was vital to its basic corporate strategy of continuing
Another important component of the Häagen-Dazs corporate strategy was to enter into written distribution contracts, explicitly terminable at will by Häagen-Dazs on short notice, with distributors that it was not ready to buy out. Since 1974, MIC, like other regional distributors, had distributed Häagen-Dazs products on the basis of Arnold‘s original oral agreement with Mr. Mattus. After its acquisition by Pillsbury, Häagen-Dazs always maintained that distributors such as MIC did not have enforceable rights to continue to distribute Häagen-Dazs ice cream. In June 1988, the U.S. District Court, Northern District of California, MDL docket No. 682, ordered summary judgment in favor of Häagen-Dazs against a terminated distributor who had distributed ice cream products for a direct competitor.3 The grounds were that the termination did not violate antitrust laws and that the oral agreement with the distributor did not prevent termination at will.4
In late 1985 or early 1986, representatives of Häagen-Dazs first approached the Strassbergs about acquiring direct access to Arnold‘s relationships with the supermarkets and removing him as a middleman in the chain of distribution. Häagen-Dazs also wanted to forestall competitors, such as Ben and Jerry‘s, from using Arnold‘s contacts and knowledge to gain access to the supermarkets. Häagen-Dazs also did not want to leave distributors like Arnold, who had been with Häagen-Dazs since the early days of Mr. Mattus, without adequate reward for the role they had played in bringing Häagen-Dazs to prominence. Also, because Arnold was a high-profile, well-respected ice cream distributor, Häagen-Dazs did not wish to alienate Arnold and risk having him stir up the other independent distributors before Häagen-Dazs was ready to take similar steps against them. Häagen-Dazs believed that these various relationships, personal to
During the early to mid-1980‘s, Arnold and Martin had increasingly vocal disagreements over the future direction of MIC. Arnold wished to expand the supermarket business, and Martin wished to expand the small store business. They were unable to agree on which course to take or otherwise to agree on coordinating their different business objectives.
Martin was concerned about MIC‘s overdependence on a small number of large supermarket accounts. He felt that a diversified customer base of small independent stores with higher gross profits carried less risk. Martin was concerned about the smaller profit margins of the supermarket business and also felt that the small stores had a better record of paying MIC‘s invoices in full and on time.
Arnold attributed Martin‘s disparagement of the supermarket business to his dislike of the process of developing and maintaining the personal relationships with the managers and owners of the supermarkets that was needed to maintain access to supermarket freezer space. Arnold believed that the small volume of sales generated by each of the independent stores did not justify the effort to acquire and service their accounts.
Arnold and Martin each blamed the other‘s approach to management of his own line of the business for MIC‘s not being more profitable during the mid-1980‘s.
From 1985 through 1988, Arnold‘s and Martin‘s disagreements intensified, especially in the aftermath of Arnold‘s promotion of MIC‘s failed investment in a warehouse facility in central Newark that would have substantially expanded MIC‘s capability to distribute ice cream to the supermarkets, just as Häagen-Dazs was building its own large distribution facility in the Bronx. MIC‘s share of the total cost of the Newark facility would have been about $2.5 million. In 1987 or
By 1988, Martin no longer wanted to work with Arnold, and Arnold felt that Martin was pushing him to retire. They were looking for a way to end their constant strife over the future direction of petitioner. Their disagreement had made them both receptive to the first overture from Häagen-Dazs in May 1986. At that time, Arnold and Martin began consulting with their attorney, Russell L. Hewit (Mr. Hewit), concerning the negotiations with Häagen-Dazs.5 Arnold was the primary negotiator in the talks with Häagen-Dazs. To that end, Arnold executed a series of confidentiality agreements. In March 1987, the initial talks broke down because the parties could not agree on the price for the business with the supermarkets.
To memorialize the termination of discussions, Mr. Hewit sent Häagen-Dazs a letter dated April 7, 1987, stating that he understood Häagen-Dazs to have made an initial offer of $3 million for “the Haagen-Dazs portion of the business“. In a letter dated April 16, 1987, Häagen-Dazs replied that it had not offered $3 million, and that the distribution rights under discussion were worth approximately $1 million. Despite the breakdown in formal negotiations, the parties remained in contact. On January 8, 1988, Arnold signed a new confidentiality agreement.
On May 4, 1988, the MIC board of directors, consisting of Martin, Arnold, and Mr. Hewit, and Arnold and Martin as MIC‘s shareholders, adopted and approved resolutions to form a subsidiary of MIC, to be called SIC. Later that month, negotiations resumed between Häagen-Dazs and Arnold and Martin regarding the possible sale of Arnold‘s supermarket distribution rights.
As with the earlier negotiations, Arnold took the lead in the negotiations with Häagen-Dazs. Between May 13 and May 23, 1988, Arnold and Martin met at least three times with Häagen-Dazs representatives. On May 16, 1988, Hewit wrote a letter to Charles McGill, vice president--acquisitions, for Pillsbury, stating that, on May 13, proposals for Häagen-Dazs to buy MIC‘s “supermarket and food servicе business
On May 19, 1988, the parties discussed the outlines of an agreement to sell the supermarket and food service distribution business to Häagen-Dazs. On May 23, 1988, Mr. Hewit wrote another letter to Mr. McGill detailing the terms discussed in the meetings, including an overall price of $1.5 million for that business, $350,000 in additional contingent payments payable over 3 years, and annual payments of $150,000 to Arnold for 3 years, and of $50,000 to Martin for 5 years in return for consulting services and covenants not to compete in the retail super-premium ice cream distribution business, except as MIC and Martin would continue to distribute ice cream to stores other than the supermarket chains. Mr. Hewit‘s letter did not refer to any allocation of the total price between distribution rights as such and the business records related to those rights, or even refer to any such records. Häagen-Dazs had derived the total price it was willing to pay from a formula based upon MIC‘s annual sales of Häagen-Dazs products to the supermarkets.
On May 31, 1988, SIC‘s certificate of incorporation was filed with the New Jersey secretary of state, and SIC was organized as a wholly owned subsidiary of MIC. On June 2, 1988, Stan Oleson of Pillsbury sent Mr. Hewit a draft “Agreement for Purchase and Sale of Assets” and other associated draft documents. The Agreement documents listed Arnold, Martin, MIC, and SIC collectively as “Sellers” and provided for the purchase of any and all of Sellers’ distribution rights, “including but not limited to supermarket and food service distribution rights, if any” and their cancellation by the “Buyer“. On June 6, 1988, Mr. Hewit replied to Mr. Oleson with a letter containing a number of modifications to the proposed agreements, chief among which was elimination of all references to Martin and MIC as parties to the proposed sale so as not “to increase the risk that thе 355 Exchange will be collapsed“. During the negotiations that culminated in the signing on July 8 of a sale agreement between Arnold and SIC as sellers and Häagen-Dazs as buyer, Mr. Hewit did not draft
On June 14, 1988, Beth L. Bronner, vice president for strategic and business development for Häagen-Dazs, replied to Mr. Hewit‘s letter of June 6, stating that Häagen-Dazs had “incorporated, where possible, the suggested changes in your redraft and letter of June 6. However, many of the points in your letter reflected a transaction materially different from the one we believed we had negotiated with your clients“. Ms. Bronner‘s letter stated that Häagen-Dazs had incorporated “your proposed exclusion of Martin Strassberg and * * * [MIC] from the Purchase Agreement,” although it created “an important issue with which we must deal” in light of Häagen-Dazs’ main objective of obtaining “any and all distribution rights” of both Arnold and Martin and their respective companies. Ms. Bronner proposed to resolve this issue through a separate “side agreement” in which Martin and MIC “would clearly acknowledge” that all rights to distribute “Häagen-Dazs products have been transferred to * * * [SIC] and that he * * * [Martin] claims no rights to distribute Häagen-Dazs.”6
Mr. Hewit sought advice from two tax attorneys, Charles E. Falk, an attorney-C.P.A. with an LL.M. in taxation from New York University School of Law, and Martin‘s brother-in-law, Jan Neiman, an attorney practicing tax law in Miami Beach, Florida, on the tax structuring of the transactions creating SIC and distributing its stock to Arnold.7 Mr. Hewit sought their advice to ensure that he properly drafted all documents necessary to effect the separation of Martin and MIC from Arnold and SIC. There is no evidence in the record that Mr. Hewit considered trying to obtain a private letter ruling from the Internal Revenue Service, or that he rendered
On June 15, 1988, Arnold, Martin, and Mr. Hewit executed documents providing for the transfer of MIC‘s interests in the supermarket business and associated customer and pricing lists from MIC to SIC and the exchange of Arnold‘s stock in MIC for the stock of SIC (the split-off). The first of these documents, entitled “Agreement“, provided for the transfer of all of the Corporation‘s [MIC‘s] rights to distribute Haagen-Dazs Ice Cream products to supermarket chains (Pathmark, Shop Rite, Foodtown and Acme) and food service accounts (restaurants, hotels and clubs), and the business records of said distributorship, including but not limited to customer lists and pricing lists, to the Subsidiary * * * for the purpose of transferring to Arnold all of the outstanding shares of the Subsidiary in exchange for the surrender by Arnold of all of his shares of the Corporation, in a transaction intended to qualify as a tax-free split-off under Internal Revenue Code Section 355, as amended * * *
A second document, dated June 15, 1988, also entitled “Agreement“, stated that Martin and Arnold were operating separate businesses that were formerly jointly operated by MIC, and that both Arnold and Martin “wish to assure a smooth transition so that neither party loses customers or employees as a result of * * * misunderstanding“. The document further stated that
Following the Exchange, * * * [MIC] shall cooperate with * * * [SIC] and provide such assistance that is reasonably necessary for * * * [SIC] to conduct its business, provided that the rendering of such services does not unduly interfere with the conduct of * * * [MIC]‘s business.
* * * * * * *
[SIC] shall pay to and reimburse * * * [MIC] for all costs incurred by * * * [MIC] in providing such services.
This agreement provided, among other things, that MIC would continue to deliver ice cream from its warehouse to SIC‘s supermarket accounts after the June 15 transactions separating MIC and SIC. MIC did continue to do so until the closing of Arnold‘s and SIC‘s sale of assets to Häagen-Dazs on July 22.
On June 15, 1988, the MIC board of directors, consisting of Arnold, Martin, and Mr. Hewit, adopted a resolution, which
On June 20, 1988, Arnold and Mr. Hewit signed a directors’ resolution of SIC, submitting to Arnold, as sole shareholder of SIC, an offer by Häagen-Dazs to “purchase all of the rights of the Corporation [SIC] to distribute Haagen-Dazs ice cream products“. Arnold then signed a shareholder‘s resolution to authorize SIC to enter into negotiations with Häagen-Dazs. In an undated memorandum, Arnold disclosed his customer list to Häagen-Dazs, most likely in response to a June 30 letter from Ms. Bronner.
In a letter to Mr. Hewit, dated July 1, 1988, Richard Wegener, a Pillsbury attorney, summarized changes made “to the various distributor agreements” pursuant to negotiations that had taken place the previous week. Mr. Wegener stated that, in the wake of those negotiations, Häagen-Dazs “clearly * * * [had its] work cut out concerning the financial issues raised by Section 4.5 of the proposed agreement.” Mr. Wegener exhorted Arnold “to get out * * * on the table” all relevant information required to complete that section, which was a warranty and representation by Arnold and SIC concerning sales of Häagen-Dazs ice cream products to supermarkets by MIC and SIC for the period of June 1, 1987, to
On July 8, 1988, Arnold, individually, and as president of
SIC, and Ms. Bronner, on behalf of Häagen-Dazs, signed an “Agreement For Purchase and Sale of Assets” by Arnold and SIC, as “Sellers”, in which the parties agreed to the terms of the sale and related documents. Notwithstanding that the documents effectuating the split-off provided only for the transfer of supermarket and food service distribution rights and records to SIC, the Arnold-SIC-Häagen-Dazs agreement recited that SIC “owns all of the rights to distribute Häagen-Dazs product which were or may have been owned by Martin Strassberg and [MIC],” and purported to provide, consistent with the Häagen-Dazs first draft, for the purchase of all distribution rights including but not limited to supermarket rights.8 This agreement specifically stated that “Buyer is not purchasing assets relating to the ‘non-banner’ business of * * * [MIC], the former parent of [SIC],”9
and allocated the stated $1.5 million price to be paid at the closing, $300,000 to “Records” and $1,200,000 to “Sellers’ Rights”. There is no evidence in the record of any negotiation over this allocation or of any of the considerations that led Häagen-Dazs to allocate the purchase price in this fashion.
Unlike prior drafts of the purchase agreement in the record, the agreement as executed on July 8, 1988, between Häagen-Dazs and SIC and Arnold contains an Article 2.4 that
On July 20, 1988, Touche Ross & Co. submitted an audit report to Häagen-Dazs, stating that the audited sales were less than represented by Arnold and SIC. As late as July 21, Mr. Hewit was still negotiating with Häagen-Dazs on behalf of petitioner concerning the list of accounts that MIC would continue to service after the sale.
On July 22, 1988, Arnold and representatives of Häagen-Dazs closed the sale to Häagen-Dazs. The employees of MIC who had reported to Arnold before June 15 continued to do so until that date. Arnold thereupon notified MIC in writing that SIC no longer required the services of MIC in delivering ice cream products to the supermarkets or in otherwise servicing their accounts.11 SIC then paid MIC for services rendered. MIC’s customers had not been notified of any changes in its business until they were notified of the sale of the supermarket distribution business to Häagen-Dazs.
The closing documents contained an amendment to the purchase agreement--signed July 22 after receipt of the Touche Ross & Co. audit of the supermarket sales figures--stating that during the 12-month period ending May 31, 1988, the sales of Häagen-Dazs products to the four supermarket chains, food service accounts, and independent supermarkets
The bill of sale, signed by Arnold individually and as president of SIC, listed the items acquired from SIC as all existing customer lists, price lists, historicаl sales records, promotional allowance and rebate records, “and other business records as requested by Buyer, and the goodwill associated therewith”.
Arnold also signed an “Assignment of Rights”, which referenced--and transferred to Häagen-Dazs--the rights described supra, in two capacities: first, as president of SIC, and second, as an individual; there was no allocation of the consideration paid for the rights as between Arnold and SIC.12
Ms. Bronner also signed the Assignment of Rights on behalf of Häagen-Dazs. Arnold signed a “Consulting and Non-Competition Agreement” with Häagen-Dazs, for which he was to be paid $150,000 annually for a period of 3 years. Martin also signed a “Consulting and Non-Competition Agreement” with Häagen-Dazs, for which he was to be paid $50,000 annually for a period of 5 years.
Finally, Häagen-Dazs entered into three nonexclusive distribution agreements with petitioner for its continued distribution of Häagen-Dazs ice cream products to specified small independent stores and food service accounts in a limited geographical area.
On March 3, 1989, petitioner filed a Form 1120S for 1988, reporting gross sales of $6,021,394 and an ordinary loss of $278. Rudolph Bergwerk signed the return as preparer. MIC’s
On April 10, 1989, SIC filed Form 1120S for its tax year 1988, which included a statement disclosing the sale of assets by SIC, including records and goodwill for $286,068 and the “right to distribute the product of buyer for $1,144,272”.13 The statement also disclosed that Arnold, as sole stockholder distributee, would report the gain on his personal income tax return for taxable year 1988. On July 14, 1989, Arnold caused SIC to be dissolved under New Jersey law.
For each tax year thereafter through 1995, MIC reported the following losses and gross sales as cоmpared with 1988 and earlier years:
| Year | Gross Sales | Taxable Income | Retained Earnings |
|---|---|---|---|
| 19861 | $8,488,491 | $68,728 | $551,383 |
| 19872 | 1,137,298 | 284 | 551,676 |
| 19883 | 6,021,394 | (278) | 551,398 |
| 1989 | 4,718,087 | (316,793) | 238,541 |
| 1990 | 5,532,675 | (58,153) | 180,388 |
| 1991 | 5,882,632 | (122,534) | 59,654 |
| 1992 | 5,518,248 | (75,726) | (16,072) |
| 1993 | 6,032,463 | (69,622) | (85,694) |
| 1994 | 5,619,756 | (201,778) | (287,472) |
| 1995 | 5,472,912 | (49,396) | (336,868) |
1 Tax year Nov. 1, 1986-Oct. 31, 1987.
2 Tax year Nov. 1, 1987-Dec. 31, 1987.
3 Supermarket distribution rights and records sold to Häagen-Dazs July 22, 1988.
- The intangible assets embodied in Arnold’s oral agreement with Mr. Mattus and personal relationships with the supermarket owners and managers were never corporate assets of petitioner. Until the sale to Häagen-Dazs on July 22, 1988, Arnold was the sole owner of those assets, whose use he had hitherto made available to petitioner. Accordingly, neither any transfer of rights in those assets to SIC nor their sale or other disposition to Häagen-Dazs is attributed to petitioner.
- The fair market value of the SIC stock distributed by petitioner to Arnold in redemption of his stock in petitioner was $141,000.
- Immediately after the distribution of the stock of SIC to Arnold, and thereafter, SIC did not engage in the active conduct of a trade or business.
OPINION
1. Assets Transferred by MIC
Respondent advances two alternative grounds in support of the original determination that the $1,430,340 consideration received by Arnold and SIC measures the gain realized and recognized by petitioner: First, Arnold negotiated the sale of assets on behalf of MIC, and MIC should therefore be regarded as the true seller of the assets under the principle of Commissioner v. Court Holding Co., 324 U.S. 331 (1945); alternatively, the amount paid by Häagen-Dazs to SIC and Arnold measures the gain realized and recognized by petitioner on the redemption of Arnold’s stock in petitioner, a split-off that fails to qualify for nonrecognition of corporate gain under
We disagree with respondent‘s overall position, insofar as it is predicated on the assumption or conclusion that petitioner owned assets with a value of $1,430,340 that were sold to Häagen-Dazs. Petitioner never owned all the assets sold to Häagen-Dazs. The record shows, and we have found as facts, that Arnold, acting on his own behalf and as agent for SIC, of which he was the sole shareholder, entered into a contract to sell Häagen-Dazs two distinctly different types of assets: The first, and much more valuable, was the intangible assets
Arnold built the business of wholesale distribution of super-premium ice cream to supermarkets on the twin foundations of his personal relationships with the supermarket owners, the development of which preceded the creation of petitioner by some years, and his personal, handshake understanding with Mr. Mattus, which continued with Häagen-Dazs after its sale to Pillsbury. In developing his supermarket distribution business, Arnold changed the way ice cream was marketed to customers in supermarkets. The success of the venture depended entirely upon Arnold. Mr. Mattus’ offer to go into business with Arnold distributing Häagen-Dazs ice cream products on the West Coast attests to the value that Mr. Mattus, Häagen-Dazs, and later, Pillsbury, placed on Arnold’s position in the market, which retained considerable value as late as June 1988, when petitioner distributed the SIC stock to Arnold in redemption of his stock in petitioner.
Ownership of these intangible assets cannot be attributed to petitioner because Arnold never entered into a covenant not to compete with petitioner or any other agreement--not even an employment agreement--by which any of Arnold’s distribution agreements with Mr. Mattus, Arnold’s relationships with the supermarkets, and Arnold’s ice cream distribution expertise became the property of petitioner. This Court has long recognized that personal relationships of a shareholder-employee are not corporate assets when the employee has no employment contract with the corporation. Those personal assets are entirely distinct from the intangible corporate asset of corporate goodwill. See, e.g., Estate of Taracido v. Commissioner, 72 T.C. 1014, 1023 (1979) (where sole shareholder was sine qua non of corporation‘s success, corporation‘s goodwill did not include the personal qualities of its sole shareholder); Cullen v. Commissioner, 14 T.C. 368, 372 (1950) (personal ability, personality, and reputation of
In the case at hand, as in MacDonald v. Commissioner, supra, petitioner never obtained exclusive rights to either Arnold’s future services or a continuing call on the business generated by Arnold’s personal relationships with the supermarket owners and the rights under his agreement with Mr. Mattus; petitioner never had an agreement with Arnold that would have caused those relationships and rights to become petitioner’s property. Even if there had been such an agreement, and the record shows that there was none, the value of these relationships and rights would not have become petitioner’s property in toto. In 1974, Mr. Mattus sought Arnold as his agent to create a substantial presence for Häagen-Dazs ice cream in supermarkets after Mr. Mattus had been able to achieve only minimal market penetration through his own efforts. Mr. Mattus wanted what Arnold had already created in the 1960‘s when he operated Arnold’s Ice Cream--the critical relationships with key supermarket owners and managers and the marketing know-how necessary to put ice cream products in supermarket freezers. See, e.g., Coskey’s Television & Radio Sales & Serv., Inc. v. Foti, 602 A.2d 789, 795 (N.J. Super. Ct. App. Div. 1992) (“What * * * [the employee] brought to his employer, he should be able to take away.”). The record shows that, at most, petitioner had only the benefit of the use of these assets while Arnold was associated with petitioner--which contributed heavily to the profitability of petitioner during the years before the split-off.
Our conclusion that the rights under the oral agreement with Mr. Mattus, the personal relationships with supermarket owners and managers and the ice cream distribution expertise, belonged to Arnold rather than petitioner is confirmed by the disparity between the sales price paid by Häagen-Dazs to Arnold and SIC and the value of petitioner as an ongoing business just before the split-off. The sales figures
Our conclusion is not impaired by the fact that the corporate documents created by Mr. Hewit to accomplish the transfer of some of petitioner’s assets to SIC and the distribution of SIC stock to Arnold purported to transfer supermarket distribution rights owned by petitioner.14 We have already found that petitioner never owned the rights under Arnold’s oral agreement with Mr. Mattus, nor his personal relationships with the supermarkets or his ice cream distribution expertise; petitioner merely had the benefits of the use of those assets during the years up to the split-off. What petitioner did not own, petitioner could not transfer; these documents transferred only that which belonged to MIC--the business records generated by the supermarket business that were subsequently transferred by petitioner to SIC in exchange for its stock.15 Accordingly, we find that the sale to Häagen-Dazs of Arnold’s supermarket relationships and distribution rights cannot be attributed to petitioner. All that is
2. MIC Is Not the Deemed Seller of Assets to Häagen-Dazs Under Court Holding
Respondent argues that Arnold began and completed the negotiatiоns with Häagen-Dazs for the sale of distribution rights on behalf of petitioner. Respondent would have us believe that all essential terms fixed by the negotiations had been settled before Mr. Hewit informed Häagen-Dazs that SIC and Arnold would be the named sellers of the assets in the purchase agreement and instructed Häagen-Dazs to omit all references to Martin and petitioner from the purchase agreements. Respondent urges the Court to apply the principle of Commissioner v. Court Holding Co., 324 U.S. 331 (1945),16 to find that petitioner is the true seller of the assets, and that SIC is a mere conduit whose existence and participation in the sale to Häagen-Dazs should be ignored for Federal income tax purposes. Respondent‘s argument implies that petitioner constructively received the proceeds from the sale of assets to Häagen-Dazs, and then constructively distributed those proceeds to Arnold in redemption of his stock in petitioner.17
Any analysis of Court Holding would be incomplete without an examination of United States v. Cumberland Pub. Serv. Co., 338 U.S. 451, 455 (1950). In Cumberland Pub. Serv. Co., corporate assets were distributed in liquidation and thereafter sold by the corporation‘s shareholders. Unlike Court Holding, the corporation at no time entered into negotiations to make the sale itself. Instead the shareholders first offered to sell the buyer their stock; after the buyer rejected their offer, they conducted on their own behalf all the negotiations to sell the assets to the buyer. The Supreme Court concluded that the shareholders were the sellers of the assets and refused to find that, in substance, the corporation was the actual seller.
Court Holding and Cumberland Pub. Serv. together support a narrow rule or holding on the genuineness of corporate liquidations. In Court Holding, the Supreme Court upheld this Court‘s factual finding that the liquidation of the corporation
Court Holding and Cumberland Pub. Serv. also provide a broader principle that helps to explain why a corporate liquidation is respected in one setting and disregarded in another.18 The substance of a transaction can be found in the negotiations leading up to the closing. Where the negotiations have culminated in an understanding that is inconsistent with the form of the final transaction, that form is said to be inconsistent with the substance, and the substance must prevail. Such is the case whеn a corporation negotiates all the terms and conditions of a sale of its assets, and then, at the last minute, distributes assets to its shareholders and the shareholders’ names are conveniently inserted as sellers; the substance of the negotiations will prevail, and the corporation will be regarded as the seller for Federal income tax purposes.
This Court and others have acknowledged this broader principle of what Court Holding and Cumberland Pub. Serv. stand for.19 Where shareholders are found to have negotiated the sale of corporate assets independently, on their own behalf, the form of the transaction is respected, and the corporation is not recast as the seller, notwithstanding that some negotiations were carried on by the shareholders before the liquidation. See, e.g., Bolker v. Commissioner, 81 T.C. 782 (1983), affd. 760 F.2d 1039 (9th Cir. 1985); Doyle Hosiery Corp. v. Commissioner, 17 T.C. 641 (1951); Amos L. Beaty & Co. v. Commissioner, 14 T.C. 52 (1950).20 Where a corporation
Arnold, on behalf of himself as well as petitioner, began negotiations with Häagen-Dazs with respect to the sale of distribution rights in January 1988. On May 4, 1988, MIC adopted corporate resolutions authorizing the creation of a wholly owned subsidiary to be called SIC. Over the following weeks, Arnold, Mr. Hewit, and representatives of Häagen-Dazs continued to negotiate the price and terms of a sale of distribution rights by MIC to Häagen-Dazs. On May 31, 1988, SIC was organized as a wholly owned subsidiary of MIC. On June 6, 1988, in response to the Häagen-Dazs first draft of purchase agreement, which provided for the sale of all distribution rights, Mr. Hewit informed Häagen-Dazs that Martin and MIC would not be parties to the sale transaction. In a letter sent to Mr. Hewit dated June 14, 1988, Ms. Bronner stated that Häagen-Dazs, as requested by Mr. Hewit, would eliminate references to Martin and MIC from the purchase agreement, but she insisted that Häagen-Dazs had to acquire “any and all” of the distribution rights owned by Martin, Arnold, and their respective companies. On June 15, 1988, MIC executed documеnts providing for the transfer of supermarket chain and food service distribution rights, and business
The facts of this case are distinguishable from those of Court Holding. In Court Holding and other cases applying its holding, such as Waltham Netoco Theatres, Inc. v. Commissioner, supra, the change in the identity of the sellers took place at the last minute. In such cases, the only difference in whether the corporation or all its shareholders are regarded as the seller(s) lies in whether the
proceeds of the sale to which the shareholders become entitled will be decreased by the amount of the corporate level tax imposed. In the present case, the change in the identity of the sellers, namely the removal of Martin and MIC, resulted in a significant economic change that was independent of any change in tax consequences. Once SIC, wholly owned by Arnold, was designated as the seller, along with Arnold, a situation was created in which all proceeds of the sale would come under the control of Arnold, to the exclusion of Martin and MIC.22
The change in the identity of the sellers was not a “last minute” change in a deal that had already been consummated, or whose terms had been completely negotiated. Rather, it signaled the birth of a new deal significantly different
Not only are the facts of this case distinguishable from those of Court Holding, but they also fall under the rubric of Cumberland Pub. Serv., where the taxpayer corporation did not negotiate a sale of assets. As in Cumberland Pub. Serv., we focus on the “negotiation substance” of the transaction to determine whether it is consistent with its form. This requires us to first identify the transaction, whose negotiations we examine. Where, as here, a change in the identity of a seller occurs during the negotiation process, and that change has business purposes and economic effects that are independent of any tax consequences, then the transaction is transformed and a new transaction arises. In then determining whether the form of the new transaction is consistent with its substance, the only negotiations that are relevant are those that occur after the identity of the seller has changed.
After SIC became a party to the sale transaction, replacing petitioner, the transaction was transformed. In determining whether the form of the transaction is consistent with its substance, we focus on the negotiations that occurred once SIC became the named seller in the proposed new transaction. Petitioner took no part in these subsequent negotiations for the sale of distribution rights, and therefore the final form of the transaction is consistent with its substance. We accordingly deny respondent‘s attempt to apply Court Holding to treat petitioner as a seller of assets to Häagen-Dazs.
3. Split-Off Did Not Qualify Under Section 355
Respondent determined that petitioner failed to satisfy several of the requirements for nonrecognition of gain under
The determination of whether a trade or business is actively engaged in is a factual question requiring an examination of all the facts and circumstances. Under
consists of a specific existing group of activities being carried on for the purpose of earning income or profit from only such group of activities, and the activities included in such group must include every operation which forms part of, or a step in, the process of earning income or profit from such group. * * *
By requiring that a trade or business be actively conducted,
SIC used petitioner‘s employees in all of its operational activities. Petitioner was retained as an independent contractor by SIC. Petitioner and Martin‘s agreement with SIC and Arnold stated that MIC would provide all services “reasonably necessary” for SIC to carry on during an interim period while it made alternative arrangements. Pursuant to that agreement, drivers employed by MIC made all the deliveries to SIC‘s supermarket accounts during the interim 6-week period. Other than perhaps Arnold, its sole shareholder, SIC had no employees.
SIC used petitioner‘s tangible assets in all of its operational activities. After the distribution, petitioner continued to own all the refrigerated trucks and storage facilities required to operate both the small store and supermarket businesses. During the period between the split-off and the sale to Häagen-Dazs, trucks owned by MIC made all the deliveries to the supermarkets, and the MIC warehouse and refrigeration facilities were used to store the Häagen-Dazs ice cream products until they could be delivered to the supermarkets. The supermarket customers themselves were largely unaware until the closing of the transactions with Häagen-Dazs on July 22 that Martin and MIC had parted company from Arnold and SIC.
4. Petitioner‘s Gain Recognized on Distribution of SIC Stock
Because petitioner‘s transfer of assets to SIC and distribution of SIC stock to Arnold do not qualify for nonrecognition of gain under
a. MIC‘s Transfer of Assets to SIC
Under The June 15, 1988, transfer of assets by MIC to SIC, solely in exchange for the stock of SIC, is a nonrecognition event under In Rev. Rul. 68-298, 1968-1 C.B. 139, a corporation transferred property to a newly created subsidiary in exchange for all the stock of the subsidiary, whereupon the transferor distributed 25 percent of the transferee corporation‘s stock to a shareholder in complete redemption of the shareholder‘s stock in the transferor. The Commissioner ruled that the transferor had maintained its controlling interest under While the transfer of assets by MIC to SIC was a nonrecognition event for Federal income tax purposes, the subsequent distribution of SIC stock to Arnold by MIC was not. The rules of subchapter C determine whether and to what extent an S corporation recognizes gain on the distribution of property in redemption of its stock. S. Rept. 100-445, at 66 (1988); see also Eustice & Kuntz, Federal Income Taxation of S Corporations, par. 8.02[1][a], at 8-24, par. 13.06[2], at 13-40 (3d ed. 1993). The distribution of SIC stock to Arnold in exchange for his stock in petitioner was a distribution of property under therefore recognized the gain that it realized on the distribution of SIC stock in redemption of Arnold‘s stock in petitioner, measured by the excess of fair market value over the basis of the SIC stock distributed. Petitioner presented no evidence to establish the adjusted basis of assets transferred to SIC in the We next determine the fair market value of the appreciated property that petitioner distributed to Arnold--the SIC stock. To ascertain the fair market value of property, whether for income tax purposes or for estate tax purposes, Champion v. Commissioner, 303 F.2d 887, 892-893 (5th Cir. 1962), revg. and remanding on other grounds T.C. Memo. 1960-51, we must determine “the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts.” United States v. Cartwright, 411 U.S. 546, 551 (1973); Our task is made all the more difficult by the lack of any direct evidence in the record of the market value of the SIC stock. However, we may approximate the value of the SIC stock by determining the fair market value of Arnold‘s previously held stock in MIC, inasmuch as the taxable event at issue is the distribution by MIC of SIC stock in redemption of Arnold‘s stock in MIC. See United States v. Davis, 370 U.S. 65, 72 (1962); Philadelphia Park Amusement Co. v. United States, 130 Ct. Cl. 166, 126 F. Supp. 184, 189 (1954); Spruance v. Commissioner, 60 T.C. 141, 157 (1973), affd. without published opinion 505 F.2d 731 (3d Cir. 1974); Williams v. Commissioner, T.C. Memo. 1997-326. Respondent did not submit an expert‘s report valuing the SIC stock, arguing that this is not a valuation case. In respondent‘s view, the intervening transfer of property by MIC to SIC and exchange of SIC stock for Arnold‘s MIC stock are to be disregarded, and petitioner held, under the Court Holding theory, to be the constructive seller of all property sold to Häagen-Dazs, having a fair market value of $1,430,340, as established by the price paid by Häagen-Dazs for assets purchased less than 6 weeks later. Similarly, respondent argues, even if respondent loses on the Court Holding theory, that the price paid in the Häagen-Dazs sale is the best evidence of the value of the assets transferred from MIC to SIC and of the value of Arnold‘s MIC stock that was redeemed. For reasons previously discussed, we have rejected respondent‘s overall position equating petitioner‘s gain with the total amount of the consideration paid by Häagen-Dazs in the purchase and sale transaction. Petitioner submitted an expert witness report that valued Arnold‘s share of MIC as an ongoing business prior to the June 15 transfer at $141,000. Rudolph Bergwerk, a certified public accountant, prepared the report for petitioner. Expert opinions can aid the Court in understanding an area of specialized training, knowledge, or judgment, such as valuation. Perdue v. Commissioner, T.C. Memo. 1991-478. While we may accept an expert‘s opinion in its entirety, Buffalo Tool & Die Manufacturing Co. v. Commissioner, 74 T.C. 441, 452 (1980), we are not bound to do so, Silverman v. Commissioner, supra, and may selectively use any portion of the report and testimony in determining fair market value of property, IT&S of Iowa, Inc. v. Commissioner, 97 T.C. 496, 508 (1991); Parker v. Commissioner, 86 T.C. 547, 562 (1986). Respondent urges the Court to reject Mr. Bergwerk‘s report in its entirety on the ground that he was a “hired gun“. Cf. Estate of Mueller v. Commissioner, T.C. Memo. 1992-284. Experts are not supposed to be “hired guns“; they lose their usefulness and credibility to the extent to which they become mere advocates for the side that hired them. Estate of Halas v. Commissioner, 94 T.C. 570, 577 (1990); Buffalo Tool & Die Manufacturing Co. v. Commissioner, supra at 452. Mr. Bergwerk is a certified public accountant who had an ongoing professional relationship with petitioner as petitioner‘s tax return preparer from 1982 through 1985. Mr. Bergwerk prepared personal income tax returns for Martin and Arnold during this same period. He also represented petitioner before the IRS in the audit that preceded the issuance of the deficiency notice at issue in this case. Respondent argues that these prior relationships so infect Mr. Bergwerk‘s report with bias that we should completely disregard it. The mere existence of the relationships does not automatically disqualify Mr. Bergwerk as petitioner‘s expert. See, e.g., Estate of Bennett v. Commissioner, T.C. Memo. 1993-34 (appraiser was a longtime family adviser and was a coexecutor of the estate). Nor is Mr. Bergwerk automatically disqualified by his lack of formal qualifications as an appraiser. Id. (citing In Estate of Halas v. Commissioner, supra at 578, we stated that an “appraiser‘s duty closely corresponds to the public duty of an auditor or certified public accountant.” On the basis of the nature of the report, which we discuss infra, Mr. Bergwerk‘s professional qualifications as a certified public accountant, and the testimony of Mr. Bergwerk, we are satisfied that Mr. Bergwerk was not acting as a mere advocate for petitioner, but as an appraiser with a duty to the Court. Id. at 577. However, we do not ignore or disregard this prior and continuing relationship between Mr. Bergwerk and petitioner, Arnold, and Martin and weigh it in the balance of whether--and the degree to which--to accept Mr. Bergwerk‘s expert opinion. Mr. Bergwerk stated that he had based his report on the methodology set forth in Rev. Rul. 59-60, 1959-1 C.B. 237, modified by Rev. Rul. 65-193, 1965-2 C.B. 370, and Rev. Rul. 68-609, 1968-2 C.B. 327, and amplified by Rev. Rul. 77-287, 1977-2 C.B. 319, Rev. Rul. 80-213, 1980-2 C.B. 101, and Rev. Rul. 83-120, 1983-2 C.B. 170. We follow the principles set forth in Rev. Rul. 59-60, supra, which we recognize as having been “widely accepted as setting forth the appropriate criteria to consider in determining fair market value“, Estate of Newhouse v. Commissioner, 94 T.C. 193, 217 (1990), to the extent they represent a correct approach to the valuation of closely held corporations, see Stark v. Commissioner, 86 T.C. 243, 250-251 (1986). Mr. Bergwerk‘s report characterized petitioner as an undiversified company engaged in a single line of business, the wholesale distribution of ice cream products, which was highly dependent on weather and time of year. Petitioner also had “an unhealthy concentration” of its business in Häagen-Dazs products. Despite such drawbacks, the company had expanded its gross sales substantially in the 5 years before the distribution of SIC stock. Mr. Bergwerk opined that the potential for further growth was limited because of the ability of supermarkets and ice cream manufacturers to eliminate independent wholesale distributors from business.28 Mr. Bergwerk expressly considered each of the faсtors set forth in Rev. Rul. 59-60, 1959-1 C.B. at 238-239, as a basis for valuation of closely held corporations. In arriving at his valuation of MIC as an ongoing business, Mr. Bergwerk assigned relative weights to the three valuation factors that he found persuasive--50 percent to capitalized earnings, 30 percent to petitioner‘s dividend-paying capacity, and 20 percent to petitioner‘s book value--and then averaged the factors in accordance with those relative weights. In so doing, he appropriately gave primary consideration to petitioner‘s earnings history, as recommended by Rev. Rul. 59-60, sec. 5, 1959-1 C.B. at 242, and estimated petitioner‘s fair market value as an ongoing business prior to the separation of the business lines to be $276,509, and Arnold‘s 51-percent share, which was redeemed upon distribution of SIC stock, to be $141,000. Mr. Bergwerk used the same three factors and approach used in Bader v. United States, 172 F. Supp. 833 (S.D. Ill. 1959), a case decided prior to the issuance of Rev. Rul. 59-60, supra, which also averaged the results of the factors. Mr. Bergwerk did not discount his valuation on account of lack of marketability, as did the court in Bader, nor did he provide an explanation of why he used the particular weights he Despite the problems we have with Mr. Bergwerk‘s report, we find that Mr. Bergwerk‘s estimate of the fair market value of petitioner just prior to the transactions in issue provides a reasonable upper limit on the value of petitioner as of June 1988; we adopt Mr. Bergwerk‘s figure, in the absence of countervailing expert opinion and testimony from respondent. Of the three valuation factors used by Mr. Bergwerk, the highest amount was book value as of October 31, 1987, $552,061.29 In calculating the capitalized earnings of petitioner at $331,394, Mr. Bergwerk estimated the earning capacity of petitioner as $53,023 per year after taxes, based on a weighted average of the 5 years of operations ending on October 31, 1987,30 and a price-earnings ratio of 6.25:1, the same as used by this Court in Estate of Little v. Commissioner, T.C. Memo. 1982-26, to determine the value of a closely held, diversified corporation engaged in light manufacturing. Mr. Bergwerk discounted the price-earnings ratio because of the corporate shortcomings noted above, the dependence of the business on Arnold‘s personal relationships with the supermarkets, and the lack of a second tier of management. Mr. Bergwerk opined that the corporation had no goodwill because the rate of return on tangible assets did not exceed 10 percent, a rate of return on tangible assets suggested by Rev. Rul. 68-609, 1968-2 C.B. 327. Under the approach of Rev. Rul. 68-609, supra, any return in excess of 10 percent would be attributable to goodwill or other intangibles for tax purposes. See also Financial Valuation: Businesses and Business Interests, par. 16.4[7], at 16-10 (Zukin ed. 1990). However, petitioner did have some intangibles in the form of customer lists and pricing lists. Petitioner transferred those business records pertaining to the supermarket distribution Mr. Bergwerk determined that petitioner had no dividend-paying capacity, using the methodology that this Court used in Bardahl Manufacturing Corp. v. Commissioner, T.C. Memo. 1965-200, to determine reasonable business needs for retained earnings. He therefore assigned a fair market value of zero to MIC as an ongoing business on the basis of this lack of dividend-paying capacity. In so doing, Mr. Bergwerk disregarded an explicit instruction in Rev. Rul. 59-60, 1959-1 C.B. at 241, which points out that, where an actual or effective controlling interest in a corporation is to be valued, the dividend factor is not a material element, since the payment of such dividends is discretionary with the controlling stockholders. The individual or group in control can substitute salaries and bonuses for dividends, thus reducing net income and understating the dividend-paying capacity of the company. It follows, therefore, that dividends are less reliable criteria of fair market value than other applicable fаctors. Even though a valuation derived from dividend-paying capacity is an inappropriate factor in this case, the relative lack of dividend-paying capacity cannot be entirely ignored in that it shows the extent to which petitioner was undercapitalized in those years--a factor that negatively affects petitioner‘s fair market value.31 Under the circumstances of this case, use of book value would tend to overvalue petitioner, especially in light of the effect of the relatively low--and dropping--ratio of net income to sales during the mid-1980‘s on the value of petitioner and the relative lack of dividend-paying capacity, which shows the precarious nature of petitioner‘s financial health. Capitalized earnings at a 6.25:1 price/earnings ratio, $331,394, also over- values petitioner to the extent that it does Although Mr. Bergwerk discussed petitioner‘s overreliance on Häagen-Dazs as its major supplier, he did not expressly take into account the negative effect on marketability--and hence fair market value--of Häagen-Dazs’ effective veto over any sale to an unrelated third party. Because of the tenuous nature of petitioner‘s distribution rights--if any--to Häagen-Dazs products, Häagen-Dazs could effectively stop a sale of petitioner, if it did not approve of the buyer, by threatening to stop supplying petitioner with its product. The withdrawal of Häagen-Dazs as a supplier would leave petitioner as little more than a collection of physical assets and a distribution network with nothing to distribute. Häagen-Dazs’ cold shoulder to Mr. Hewit‘s overture in his May 16, 1988, letter concerning the possible sale of the nonbanner business to an unrelated third party, and the abandonment of any further effort to sell by Martin, is probative, not only of the effect of Häagen-Dazs’ veto on petitioner‘s marketability--and its market value--but also of the likelihood that Häagen-Dazs would have used such a veto. Another factor having a depressing effect on fair market value is the lack of value that Häagen-Dazs attached to petitioner as an ongoing business concern. This is demonstrated by the refusal of Häagen-Dazs to consider buying any of petitioner‘s assets beyond a few business records that documented the sales to the supermarkets. Despite petitioner‘s investment in refrigerated trucks and warehouse facilities during the mid-1980‘s--which contributed to the anemic position of its net current assets and its inability to pay dividends--Häagen-Dazs still considered petitioner‘s physical plant and equipment to be substandard for purposes of distributing Häagen-Dazs ice cream. We must also consider the effect of petitioner‘s being a small, family-owned business on the sale by either Arnold or Martin of his interest in petitioner without the sale of the other interest. While we do not assign a precise value to this discount factor, the closely held nature of petitioner and the reluctance of a third party to buy into a family-owned business, especially one with the handicaps we have just recited, could serve only to decrease the market value of the interest for sale. Most importantly, petitioner‘s earnings in the years preceding the split-off were substantially attributable to Arnold‘s oral agreement with Mr. Mattus and his relationship with the supermarkets. As we have found, the supermarket distribution rights were personal to Arnold and did not belong to petitioner. The assumption underlying a capitalization of earnings approach is that, barring adverse developments, the historical earnings will continue. Therefore, in valuing petitioner as of the time of the split-off, which marks the parting of the ways between petitioner and Arnold, an adverse development indeed, it makes no sense to assume that petitioner‘s earnings would continue at the same level in the future, or even that there would be no more than a pro rata reduction of such earnings by reason of Arnold‘s departure. Under the circumstances of this case, where there was a heavy investment in physical assets during a period when the corporation had been unable to pay dividends, an absence of a second tier of management, a lack of diversification in business, an overdependence on one supplier, Häagen-Dazs, and on one primary “rainmaker“, Arnold, who was leaving, the risk of petitioner‘s being completely eliminated from business as an independent wholesale distributor, the effective veto Häagen-Dazs had over any sale to a third party, the fact that petitioner is a closely held, family-owned business, and the declining ratio of net income to sales, we find that a value of $276,509 is the upper limit to a fair estimate of the value of petitioner immediately prior to the transactions at issue. Respondent‘s determination of the value of assets sold to Häagen-Dazs by SIC, and the corresponding value of SIC stock distributed to Arnold, is presumptively correct, and the burden of proving a lower value rests on petitioner. Rule 142(a); Frazee v. Commissioner, 98 T.C. 554, 562 (1992); Pessin v. Commissioner, 59 T.C. 473, 480 (1972). In the present case, respondent did not present the testimony or report of an expert upon which to consider an alternative valuation. Petitioner, on the other hand, did present the report and testimony of Mr. Bergwerk, and has thereby effectively rebutted respondent‘s original determination. Although Mr. Bergwerk‘s methodology was flawed, his conclusion is only erroneous insofar as his $276,509 value for petitioner results in an overstatement of the fair market value of the SIC stock distributed to Arnold. Petitioner has carried its burden of reducing respondent‘s determination of $1,430,340 to $141,000 (51 percent of the value of petitioner) but has not carried the burden of reducing the value any further. See Hess v. Commissioner, 24 B.T.A. 475, 478 (1931) (Court adopted taxpayer‘s asserted value where the Cоmmissioner introduced no evidence to rebut taxpayer‘s expert testimony, citing Baldwin v. Commissioner, 10 B.T.A. 1198 (1928)); cf. Anselmo v. Commissioner, 80 T.C. 872, 886 (1983), affd. 757 F.2d 1208 (11th Cir. 1985); Estate of Trompeter v. Commissioner, T.C. Memo. 1998-35. Taking into account Mr. Bergwerk‘s valuation conclusion, we find that the fair market value of Arnold‘s 51-percent interest in petitioner, which petitioner redeemed for all of SIC‘s stock, was $141,000.32 SEC. 1374(a). General Rule.--If for a taxable year of an S corporation-- (1) the net capital gain of such corporation exceeds $25,000, and exceeds 50 percent of its taxable income for such year, and (2) the taxable income of such corporation for such year exceeds $25,000, There is hereby imposed a tax (computed under subsection (b)) on the income of such corporation. * * * * * * * (d) Determination of Taxable Income.--For purposes of this section, taxable income of the corporation shall be determined under (1) the deduction allowed by (2) the deductions allowed by part VIII of subchapter B (other than the deduction allowed by In order for Second, petitioner is deemed to have held the SIC stock for more than 1 year. Respondent acknowledged that petitioner‘s transfer of assets in exchange for the stock of SIC qualified for nonrecognition under Petitioner‘s long-term capital gain of $141,000, resulting from petitioner‘s distribution of SIC stock in redemption of Arnold‘s stock in petitioner, is petitioner‘s only capital gain in 1988. Accordingly, petitioner had “net capital gain” (as defined in For taxable year 1988, In United States v. Boyle, 469 U.S. 241, 251 (1985), the Supreme Court held that “When an accountant or attorney advises a taxpayer on a matter of tax law, such as whether In this case, Martin, as president of petitioner, and Arnold both relied on legal advice from Mr. Hewit throughout thе protracted negotiations with Häagen-Dazs. Even though Mr. Hewit never gave a written tax opinion to petitioner or Arnold or Martin, Martin and petitioner were entitled to rely and proceed on the assumption that the transactions at issue were nontaxable to petitioner because of the way Mr. Hewit had structured the transactions and drafted the documents effecting the transactions that separated the two business lines. Mr. Hewit, in turn, sought advice from third-party tax professionals on how to structure a tax-efficient solution to resolve the growing dispute between Martin and Arnold over the future direction of petitioner as an ice cream distributor. Like the advice sought by the taxpayer in Sim-Air, USA, Ltd. v. Commissioner, supra at 201, the advice that petitioner sought from Mr. Hewit, who in turn also sought expert advice, was subject to section 355, a complex section of the Code.34 We find that Martin and petitioner acted as ordinarily prudent business persons would under the circumstances and that petitioner is not liable for an addition to tax under For tax year 1988, The amount of the understatement * * * shall be reduced by that portion of the understatement which is attributable to- - (i) the tax treatment of any item by the taxpayer if there is or was substantial authority * * *, or (ii) any item with respect tо which the relevant facts affecting the item‘s tax treatment are adequately disclosed in the return or in a statement attached to the return. Petitioner failed to disclose on its 1988 return or in a statement attached to the return, as required by Substantial authority is defined in less stringent than a “more likely than not” standard (that is, a greater than 50-percent likelihood of being upheld in litigation), but stricter than a reasonable basis standard (the standard which, in general, will prevent imposition of the penalty under With respect to the issue of whether Commissioner v. Court Holding Co., 324 U.S. 331 (1945), controls the transactions in question, petitioner has prevailed and thus had substantial authority for its position with respect to the form of the transactions. Petitioner has not prevailed on the issue of whether section 355 confers nonrecognition of gain realized in the split-off. Petitioner must therefore demonstrate that substantial authority supports the positions taken on the income tax return with respect to those transactions. Gallade v. Commissioner, 106 T.C. 355, 367 (1996); We find no evidence in the record that petitioner ever requested a waiver. Accordingly, as we noted in Alondra Indus., Ltd. v. Commissioner, T.C. Memo. 1996-32, and Brown v. Commissioner, T.C. Memo. 1992-15, “we cannot find that respondent abused his discretion when the petitioner Even if petitioner had requested a waiver, we would hold that petitioner has not established that respondent would have committed an abuse of discretion in refusing the request. In this case, petitioner would have been required to show that reliance on the professional advice of Mr. Hewit was reasonable and that petitioner acted in good faith under the circumstances. Accordingly, we sustain respondent‘s determination that petitioner is liable for the Decision will be entered under Rule 155.b. Distribution of SIC Stock to Arnold in Redemption of His Stock in Petitioner
c. Amount Realized on Distribution of SIC Stock
5. Additions to Tax
a. Negligence
b. Substantial Understatement
Notes
The Agreement enumerated the “Sellers’ Rights” as
Any and all of Seller’s rights and the rights of any corporations or entities owned or controlled by Sellers obtained from Buyer, its predecessors, its customers or others to distribute the products of Buyer within the states of New York, New Jersey, Pennsylvania, Massachusetts, Delaware, Connecticut and elsewhere including but not limited to supermarket and food service distribution rights, if any (the “Sellers’ Rights”) * * *. Upon Closing of the transactions contemplated herein, any and all of such Sellers’ Rights obtained by Sellers from Buyer or its predecessors shall be cancelled.
“Non-banner” business was defined by the Agreement as “independent convenience stores and delis that have no more than two cash registers * * * ‘independent’ shall mean a firm which operates from one to ten stores”.
The Agreement provided that if the audited supermarket sales were greater than $4 million but less than $4,700,000, then there would be a downward adjustment to the purchase price equal to:
[1 - (audited sales figures/$4,700,000)] x $2,350,000.
The Agreement allocated 81 percent of the downward adjustment to the purchase price to be paid at closing and 19 percent to the contingent annual payments payable to Arnold over the following 3 years.
Martin testified that MIC and SIC delayed changing how product was delivered to the supermarket customers in order to get through the busy summer season.
Subsequent to trial, respondent submitted to the Court a facsimile of the face of a Häagen-Dazs check to SIC in the amount of $1,430,340, accompanied by an affidavit that Häagen-Dazs issued the check to SIC as payment due at the closing of the sale of assets purportedly sold by SIC to Häagen-Dazs. We do not admit the facsimile and affidavit into evidence; there is sufficient evidence in the record to support a finding that SIC received the entire payment from Häagen-Dazs. However, because we decide this case as we do, initial receipt of payment by SIC instead of Arnold does not determine the Federal tax treatment to petitioner of the transactions at issue.
This statement attached to the SIC Form 1120S indicates that the downward adjustment of $69,660 to the purchase price paid by Häagen-Dazs at closing was allocated between the distribution rights and business records of SIC in the same proportions as the relative amounts of the preadjustment allocation of the purchase price to be paid at the closing--80 percent, or $55,728, to the distribution rights, and 20 percent, or $13,932, to the business records. The closing documents do not set forth or otherwise contain any reference to the allocation between distribution rights and business records of the reduction in the price paid at closing.
We note that the record contains no documents that actually transfer assets from MIC to SIC in exchange for SIC stock. The record contains only the MIC corporate resolutions stating the intention to make such transfer. However, we are satisfied by those corporate resolutions and testimony by Arnold, Martin, and Mr. Hewit that such a transfer did occur, in the sense that petitioner transferred to SIC the records of the supermarket business and whatever rights petitioner had in that business.
Petitioner may have had some residual rights to distribute Häagen-Dazs ice cream, but they were independent of Arnold’s supermarket relationships and his value as a middleman. To the extent that they existed at all, they were in relationship to Häagen-Dazs’ ability to terminate petitioner as a distributor. Häagen-Dazs was certainly interested in acquiring those rights as it rationalized and consolidated its wholesale distribution network as one of the assets it was buying from Arnold and SIC. However, in light of the summary judgment by the District Court, Northern District of California, in favor of Häagen-Dazs against a similarly situated distributor, the value of those rights in the event of termination by Häagen-Dazs was highly speculative at best.
Shortly after issuance of Rev. Rul. 96-30, 1996-1 C.B. 36, respondent first raised this theory with petitioner in a stipulation conference held on June 19, 1996, and was given leave to incorporate it in an amended answer filed less than 3 weeks before trial. Generally, when the Commissioner makes allegations in an amended answer requiring the presentation of different evidence, then the Commissioner “has introduced a new matter” or a new issue that requires the shifting of the burden of proof to the Commissioner as to the new matter or issue. Achiro v. Commissioner, 77 T.C. 881, 890 (1981); see also Seagate Tech. Inc. & Consol. Subs. v. Commissioner, 102 T.C. 149, 169 (1994).
Because the determination of the applicability of Commissioner v. Court Holding Co., 324 U.S. 331 (1945), required respondent to present evidence of the events leading up to the sale of assets which is different from the evidence showing that the requirements of sec. 355 were not met, we issued an order shifting the burden of proof to respondent on the Court Holding issue. However, we decide the issue on a preponderance of the evidence; therefore, the allocation of the burden of proof does not determine the outcome. See Kean v. Commissioner, 91 T.C. 575, 601 n.40 (1988) (citing Deskins v. Commissioner, 87 T.C. 305, 323 n.17 (1986)).
Implicit in respondent‘s Court Holding argument is the view that SIC‘s ownership of the assets transferred to it by MIC, and Arnold‘s ownership of SIC stock were too transitory to be recognized for tax purposes. However, we need not grapple with the transitory nature of SIC and the tax consequences of such a designation on the transactions in the case at hand. Respondent acknowledges that if we decide that Court Holding does not apply to attribute the sale to petitioner, then the transaction should be regarded as a sec. 351 transfer from MIC to SIC, followed by a taxable redemption of Arnold‘s shares in petitioner, thereby acknowledging the existence of SIC for Federal income tax purposes under respondent‘s alternative argument. See infra pp. 46-49.
See Isenbergh, “Musings on Form and Substance in Taxation”, 49 U. Chi. L. Rev. 859, 871-874 (1982), for a discussion of the narrow and broad interpretations.
The Supreme Court noted in Central Tablet Manufacturing Co. v. United States, 417 U.S. 673, 680 (1974), that its earlier decisions in Court Holding and United States v. Cumberland Pub. Serv. Co., 338 U.S. 451, 455 (1950), “created a situation where the tax consequences were dependent upon the resolution of often indistinct facts as to whether the negotiations leading to the sale had been conducted by the corporation or by the shareholders.” See also Bolker v. Commissioner, 81 T.C. 782, 799 (1983), affd. 760 F.2d 1039 (9th Cir. 1985).
There is some discussion in the above-cited cases concerning whether shareholders who are corporate officers or directors can negotiate a sale of assets in corporate solution on their own behalf, rather than on the corporation‘s behalf, especially when the negotiations take place before the corporation resolves to liquidate the assets that are to be sold.
Although Commissioner v. Court Holding Co., supra, deals with corporations that distribute assets to their shareholders in complete liquidation, the Commissioner has recently applied its conduit theory to sec. 355 distributions. In Rev. Rul. 96-30, 1996-1 C.B. 36, D, a publicly traded corporation, distributes the stock of C, its wholly owned subsidiary, to its shareholders in a spin-off. C then enters into negotiations with Y, an unrelated corporation, and is merged into Y, after a vote to do so by C’s shareholders, under a plan that meets all the requirements of sec. 368(a)(1)(A). Rev. Rul. 96-30, supra, specifically cites the complete lack of negotiations regarding the acquisition of C by Y before the spin-off as the determining factor in respecting the form of the transactions under Commissioner v. Court Holding Co., supra, in addition to the shareholder vote cited in Rev. Rul. 75-406, 1975-2 C.B. 125. Although respondent did not cite Rev. Rul. 96-30, supra, on brief, see supra note 16.
While Rev. Rul. 96-30, supra, indicates that a complete lack of negotiations before the spin-off will prevent the recasting of transactions under Court Holding, situations where there have been some, or even substantial, negotiations are not addressed. Nor does Rev. Rul. 96-30, supra, deal with a non pro rata distribution such as a split-off, as in the case at hand.
For purposes of this part, stock shall be treated as redeemed by a corporation if the corporation acquires its stock from a shareholder in exchange for property, whether or not the stock so acquired is cancelled, retired, or held as treasury stock.
Respondent argues that petitioner, under the rule of Commissioner v. Danielson, 378 F.2d 771 (3d Cir. 1967), vacating and remanding 44 T.C. 549 (1965), cannot unilaterally vary the terms of a contract for tax purposes and must therefore abide by the terms of the sale to Häagen-Dazs in determining the value of assets distributed to SIC and, in turn, the value of SIC stock distributed to Arnold.
As we stated in Hospital Corp. of Am. v. Commissioner, T.C. Memo. 1996-559:
As we understand the Danielson rule, it is not applicable where the parties have not established the fair market value of the property at the time agreement is adopted because, under those circumstances, there is no agreement to which a party may be held. See Campbell v. United States, 228 Ct. Cl. [661,] 675-677 (1981); * * * see also Commissioner v. Danielson, 378 F.2d 771, 778 [(3d Cir. 1967)] (“it would be unfair to assess taxes on the basis of an agreement the taxpayer did not make“). Furthermore, the Danielson rule is not applicable if the contract is ambiguous. See North American Rayon Corp. v. Commissioner, 12 F.3d [583,] 589 [(6th Cir. 1993), affg. T.C. Memo. 1992-610] (“the Danielson rule does not apply if there is no contract between the parties or if the contract is ambiguous“).
* * *
The allocation by the sale agreement of the $1,430,340 sales price paid by Häagen-Dazs to SIC and Arnold between “Sellers’ Rights“, $1,144,272, and the records, $286,068, is not an agreement made by petitioner as to the value of SIC stock. At best it is an ambiguous indication. Furthermore, because petitioner was not a party to the transaction with Häagen-Dazs, the Danielson rule does not apply.
MIC cannot be held to an allocation that it did not bargain for with a party with opposing interests in an arm‘s-length negotiation. Neither MIC, SIC, nor Arnold actively negotiated the allocation with Häagen-Dazs. It remained unchanged from the June 2 draft agreement through the closing of the sale on July 22. See Particelli v. Commissioner, 212 F.2d 498, 501 (9th Cir. 1954), affg. a Memorandum Opinion of this Court dated Feb. 20, 1952; Berry Petroleum Co. & Subs. v. Commissioner, 104 T.C. 584, 615 (1995).