Reef Corporation v. CIR

• Decision Date: 15 December 1966
• Docket Number: No. 22836.,22836.
• Citation: 368 F.2d 125
• Parties: REEF CORPORATION, Petitioner, v. COMMISSIONER OF INTERNAL REVENUE, Respondent. COMMISSIONER OF INTERNAL REVENUE, Petitioner, v. REEF CORPORATION, Respondent.
• Court: U.S. Court of Appeals — Fifth Circuit

368 F.2d 125 (1966)

REEF CORPORATION, Petitioner, v. COMMISSIONER OF INTERNAL REVENUE, Respondent.

COMMISSIONER OF INTERNAL REVENUE, Petitioner, v. REEF CORPORATION, Respondent.

No. 22836.

United States Court of Appeals Fifth Circuit.

October 25, 1966.

Rehearing Denied December 15, 1966.

COPYRIGHT MATERIAL OMITTED

Homer L. Bruce, William C. Griffith, Robert J. Piro, Houston, Tex., for petitioners. Baker, Botts, Shepherd & Coates, Houston, Tex., of counsel.

Mitchell Rogovin, Chief Counsel, I. R. S., John B. Jones, Jr., Act. Asst. Atty. Gen., Lee A. Jackson, Atty., Dept. of Justice, Hu S. Vandervort, Jr., Atty., I. R. S., Richard M. Roberts, Act. Asst. Atty. Gen., Harry Baum, Fred R. Becker, Attys., Dept. of Justice, Washington, D. C., for appellee.

Before RIVES and BELL, Circuit Judges and FULTON, District Judge.

BELL, Circuit Judge.

This appeal is from a decision of the Tax Court reported as Reef Corporation v. Commissioner, T.C.Memo. 1965-72 and CCH Dec. 27309(M). It involves income taxes. Reef Corporation appeals from the disallowance of a stepped-up basis of depreciation, and of interest on corporate indebtedness. The Commissioner, by way of a cross-appeal, contends that the Tax Court erred in not holding that the transaction which is the subject matter of the litigation constituted a corporate reorganization under § 368(a) (1) (F) of the Internal Revenue Code of 1954, as amended. 26 U.S.C.A. § 368 (a) (1) (F). Additional taxes would be due under such a holding. We affirm the Tax Court on the appeal and reverse on the cross-appeal.

The facts giving rise to the controversy must be stated in some detail to form a frame of reference for the questions to be decided. Reef Fields Gasoline Corporation (Reef Fields) was organized as a Texas Corporation on July 30, 1951 to operate a casinghead gas plant. It was formed by two groups of people, hereinafter known as the Butler group and the Favrot group. The Butler group operated the company. The Favrot group had no operational responsibilities. The Butler group owned 21,328 shares of the 40,800 outstanding shares of common stock in the corporation and the Favrot group owned the remaining 19,472 shares.

In 1958 the Butler group determined to buy out the Favrot group. After discussions between the groups, a plan was formulated whereby the stockholders of Reef Fields would approve a plan of liquidation whereunder Reef Fields would sell its operating assets to a new corporation to be formed in exchange for cash and notes of the new corporation. The Favrot group would receive cash and notes while the Butler group would receive only notes. The Butler group rejected this plan after seeking legal advice and learning that the transaction would result in the payment of taxes by them when they were in fact receiving no cash with which to pay the taxes.

An alternative plan was devised and executed. The Butler group formed Reef Corporation (new Reef) under Delaware law on December 15, 1958. They received all of the common stock of new Reef in exchange for a portion of their stock in Reef Fields. On the same day Reef Fields contracted to sell its properties to new Reef for its notes. All of the stock in Reef Fields was to be sold to a third party who was, in turn, to carry out the sale of the assets of Reef Fields to new Reef. To accomplish this the Favrot group then sold all of its Reef Fields stock to the third party, George Strong, Trustee, a Houston attorney, taking his notes in exchange therefor. As part of the plan, these notes were to be repaid by Strong as payments were made to him by new Reef. The Favrot group also received cash from Strong which was made possible by a simultaneous loan to him from Reef Fields. The cash came from the proceeds of a long-term life insurance company loan which was made contemporaneously by Reef Fields and assumed at the end of the transaction by new Reef. Some of the proceeds of the loan were used to pay prior loans of Reef Fields. Next, the Butler group sold their remaining shares in Reef Fields to Strong in return for his notes. New Reef then sold its Reef Fields stock which had been obtained from the Butler group to Strong in return for the notes of Strong and this placed all of the stock of Reef Fields in Strong. The next step was the acquisition of Reef Fields assets by new Reef, and the assumption by new Reef of the liabilities of Reef Fields. New Reef issued its notes to represent its indebtedness to Reef Fields. Reef Fields then distributed the notes received from new Reef together with cash on hand to Strong, its sole stockholder. Strong pledged the Reef Corporation notes to the Butler group, Favrot group and new Reef, respectively, pro rata for the stock sold to him and he was relieved of any liability on his personal notes. Reef Fields was dissolved on April 27, 1959. This plan was satisfactory to the Butler group because the taxes due on the sale of Reef Fields stock was payable on an installment basis as payment was received from Strong.

Strong had business connections with the Favrot group and received only nominal consideration for his services. His entire role was to execute one part in an overall plan to redeem the stock of the Favrot group to the end that sole control of the business of Reef Fields would be vested in the Butler group. The business which had been operated by Reef Fields until February 28, 1959 when its properties were formally transferred to new Reef continued to be operated without interruption by new Reef. The management and the employees were the same, and even the pension-trust and profit-sharing plans of Reef Fields were transferred to and adopted by new Reef.

Reef Fields, which filed its income tax returns on an accrual basis and whose fiscal year ran from July 1 to June 30, filed an income tax return for the short taxable period July 1, 1958 to the date of dissolution, April 27, 1959. It reported a non-taxable gain on the sale of its properties to new Reef and claimed a deduction for reincorporation expenses. The Commissioner disallowed the return on the basis that new Reef was the successor in name to Reef Fields and thus the return should have been for the full fiscal year. This position, rejected by the Tax Court, was based on the premise that the transaction resulted in a reorganization under § 368(a) (1) (F).

Reef Corporation (new Reef), the petitioner, which had adopted the accrual method and the July 1 to June 30 fiscal year, filed an income tax return covering the short period December 15, 1958, the date of its incorporation, to June 30, 1959. The sum of $66,208.75 was deducted as interest payments on the new Reef notes payable to Strong for repayment to the Butler group. Depreciation was computed on the basis of the cost of the assets to new Reef and not on the basis of the cost of the assets to Reef Fields. The Tax Court disallowed the interest payments, and held that the depreciation basis was the cost of the assets to Reef Fields.

There are three assignments of error by petitioner. It is contended that the Tax Court erred in refusing to recognize the sale by the various Reef Fields stockholders to Strong; in concluding that the tranaction in question was a reorganization under § 368(a) (1) (D) with the result that new Reef did not receive a stepped-up basis on the assets purchased from Reef Fields for depreciation purposes; and in disallowing the interest paid to Strong by new Reef to the extent that the payment covered interest due on Strong's notes to the Butler group for the reason that the sums on which the interest was paid constituted capital or an equity investment rather than debt.¹ The Commissioner contends on his appeal that the Tax Court erred in holding that the transaction did not constitute a reorganization under § 368(a) (1) (F), and in thus holding that the notice of deficiency to petitioner as the successor in name to Reef Fields Gasoline Corporation for a full fiscal year was invalid.

I.

Petitioner's first contention, if sustained, would carry the day and obviate the necessity of considering the errors assigned on the basis of the corporate reorganization statute, § 368(a) (1) (D) and (F). 26 U.S.C.A. § 368(a) (1) (D) and (F). If the sale to Strong by the Reef Fields stockholders is considered bona fide for tax purposes, and the sales contract between the corporations disregarded, the subsequent sale to new Reef might result in new Reef being entitled to a stepped-up basis for depreciation. 26 U.S.C.A. §§ 167(f), 1011, 1012.

We affirm the holding of the Tax Court insofar as it disregarded the role of Strong without further discussion. He was a mere conduit in a preconceived and prearranged unified plan to redeem the stock of the Favrot group in Reef Fields. His activity was but a step in the plan. He carried out a sales contract already entered into between the corporations. He assumed no risk, incurred no personal liability, paid no expenses and obtained only bare legal title to the stock. There was an insufficient shifting of economic interests to Strong. It is settled that under such circumstances substance must be given effect over form for federal tax purposes. The holding of the Tax Court in this regard was not clearly erroneous. Cf. Commissioner of Internal Revenue v. Court Holding Company, 1945, 324 U.S. 331, 65 S.Ct. 707, 89 L.Ed. 981; Hindes v. United States, 5 Cir., 1964, 326 F.2d 150; United States v. General Geophysical Company, 5 Cir., 1961, 296 F.2d 86; Pebble Springs Distilling Company v. Commissioner of Internal Revenue, 7 Cir., 1956, 231 F.2d 288. And see Davant v. Commissioner of Internal Revenue, 5 Cir., 1966, 366 F. 2d 874, decided this date, where we disregarded a sale to a third party brought in merely to serve as a conduit between two corporations having the same stockholders in the sale of assets by one to the other.

New Reef places primary reliance on the case of Commissioner of Internal Revenue v. Brown, 1965, 380 U.S....