Archie L. and Louise B. Honbarrier v. Commissioner , 115 T.C. No. 23 ( 2000 )

115 T.C. No. 23
UNITED STATES TAX COURT
ARCHIE L. AND LOUISE B. HONBARRIER, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
HONBARRIER, INC., FORMERLY CENTRAL TRANSPORT, INC., SUCCESSOR
TO COLONIAL MOTOR FREIGHT LINE, INC., Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent.
Docket Nos. 9053-97, 9054-97. Filed September 29, 2000.
H was the sole shareholder of P. P was engaged in
the business of hauling packaged freight in trucks.
Its trucking operations were terminated in 1988. By
1990, P had sold its operating assets. P invested the
proceeds from the sale of its operating assets in tax-
exempt bonds and a municipal bond fund.
C was a privately held trucking company that
operated as a bulk carrier of chemicals. The majority
of C’s stock was owned by H.
On Dec. 31, 1993, P was merged into C. Pursuant
to the merger, H received 17,840 shares of C stock for
his P stock. The value of the 17,840 shares was
determined to be equal to the net fair market value of
P’s assets. P and H treated the merger as a tax-free
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reorganization within the meaning of sec. 368(a)(1)(A),
I.R.C. R determined that the merger failed to meet the
continuity of business enterprise requirement necessary
to qualify as a tax-free reorganization within the
meaning of sec. 368(a)(1)(A), I.R.C.
Prior to the day of the merger, P’s assets
consisted of tax-exempt bonds, a municipal bond fund,
and $1,500 in cash. On the day of the merger, P
liquidated one of its tax-exempt bonds and its
municipal bond fund. As a result, P’s assets at the
time of the merger consisted of $2,415,321 in cash,
$4,849,146 in tax-exempt bonds, $37,800 in interest and
dividends receivable, and $18,926 in money funds. At
the time of the merger, C distributed $7 million to C’s
shareholders. This distribution was made with checks
totaling $2,450,854 and tax-exempt bonds worth
$4,549,146 that had been acquired from P. Within 4
months, C had disposed of the remaining tax-exempt bond
that it had acquired from P in the merger.
Held: In order for a merger to be a tax-free
reorganization within the meaning of sec. 368(a)(1)(A),
I.R.C., there must be continuity of the business
enterprise of the acquired corporation. See sec.
1.368-1(b), Income Tax Regs. Continuity of business
enterprise requires that the acquiring corporation
either continue the acquired corporation’s historic
business or use a significant portion of the acquired
corporation’s historic business assets in a business.
See sec. 1.368-1(d)(2), Income Tax Regs. C did not
continue P’s historic business or use a significant
portion of P’s historic business assets in a business.
Therefore, C did not satisfy the continuity of business
enterprise requirement for a tax-free reorganization.
As a result, H must recognize gain equal to excess of
the fair market value of the property that he received
for his P stock over his basis in his P stock.
Frederick Brook Voght and Shane T. Hamilton, for
petitioners.
Ross A. Rowley and Steven M. Webster, for respondent.
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RUWE, Judge: Respondent determined a deficiency in Archie
L. and Louise B. Honbarrier’s Federal income tax for 1993 in the
amount of $2,090,149. Respondent determined a deficiency in
Colonial Motor Freight Line, Inc.’s (Colonial) Federal income tax
for 1993 in the amount of $27,374.
The sole issue for decision is whether the merger of
Colonial into Central Transport, Inc. (Central), on December 31,
1993, qualifies as a tax-free reorganization within the meaning
of section 368(a)(1)(A).1
FINDINGS OF FACT
Some of the facts have been stipulated and are so found.
The stipulation of facts, first supplemental stipulation of
facts, and the attached exhibits are incorporated herein by this
reference. Mr. and Mrs. Honbarrier resided in High Point, North
Carolina, at the time they filed their petition. At the time
Central filed its petition as successor to Colonial, its
principal place of business was High Point, North Carolina.
Colonial
Colonial was incorporated in 1941. Colonial was a trucking
company that operated as a common carrier of packaged freight.
The company principally transported furniture manufactured in
1
Unless otherwise indicated, all section references are to
the Internal Revenue Code and income tax regulations in effect
for the year in issue, and all Rule references are to the Tax
Court Rules of Practice and Procedure.
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North Carolina. Colonial hauled freight in conventional van
trailers pulled by highway tractors.
Colonial held an operating authority granted by the
Interstate Commerce Commission (ICC) and an operating authority
granted by the State of North Carolina. These authorities
granted Colonial contract and common carrier status between
specified points and places within the United States and North
Carolina for the transportation of packaged freight.
When the trucking industry was deregulated at the Federal
level in the 1980's, Colonial was subjected to competition from
small individual truckers, with low overhead costs. As a result,
Colonial’s ICC operating authority became worthless, and the
company experienced significant business reversals.
Colonial operated at a loss in the late 1980's. On its
Federal income tax returns2 for 1987 and 1988, Colonial reported
ordinary losses from trade or business activities as follows:
Year Loss
1987 $1,291,408
1988 2,245,186
Total 3,536,594
In 1988, as a result of its financial losses, Colonial
stopped hauling freight and began selling its operating assets.
By December 31, 1990, Colonial had sold all of its operating
2
Colonial elected S corporation status in 1985. At the end
of 1992, Colonial’s S corporation status was terminated pursuant
to sec. 1362(d)(3). Colonial was a C corporation in 1993.
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assets, except for the ICC and North Carolina operating
authorities, for cash and cash equivalents. On August 21, 1992,
Colonial sold its North Carolina authority for $5,000 but
retained its ICC authority.
Colonial invested the proceeds from the sale of its
operating assets almost exclusively in tax-exempt bonds and a
municipal bond fund. Colonial held 18 tax-exempt bonds, 16 of
which were purchased in 1990 and 1991, and 2 of which were
purchased in 1992. One bond was redeemed in 1991, and three
bonds were redeemed in 1992 and 1993. Colonial continued to hold
the remaining 14 bonds as of the end of 1993.
As of October 31, 1993, 2 months prior to the merger,
Colonial held approximately $7.35 million in tax-exempt bonds and
a municipal bond fund and approximately $1,500 in cash. On
December 31, 1993, Colonial liquidated one of its tax-exempt
bonds and its municipal bond fund. The proceeds of this
liquidation together totaled more than $2,550,000. As a result,
Colonial’s cash position increased significantly.
Immediately prior to the merger of Colonial into Central on
December 31, 1993,3 Colonial’s assets and liabilities consisted
of the following:
3
The merger agreement provided that the merger would occur 1
second before midnight on Dec. 31, 1993.
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Assets Tax Basis Fair Market Value
Cash $2,413,839 $2,413,839
Tax-exempt bonds 4,549,146 4,549,146
Interest and dividends
receivable 37,800 37,800
1 2
ICC authority -0- -0-
Alex Brown and Sons
Account
Cash 1,482 1,482
Money funds 18,926 18,926
Tax-exempt bonds 300,000 300,000
Total 7,321,193 7,321,193
Liabilities
Federal and State income
tax payable (76,142)
Total 7,245,051
1
TheICC authority had no book value or tax basis.
2
Due to Federal deregulation of the trucking industry in the 1980's,
Colonial’s ICC operating authority became worthless.
The only expenses incurred by Colonial in 1993, other than
Federal and State income taxes and the State intangible tax, were
professional fees of $900 and office supplies of $8,733.
From 1985 to December 31, 1993, Mr. Honbarrier owned 100
percent of Colonial’s issued and outstanding shares. From 1988
through 1993, Mr. Honbarrier was the sole director of Colonial.
On December 31, 1993, Mr. Honbarrier’s Colonial stock (245
shares) had a tax basis of $291,506.
Central
Central was incorporated under the laws of North Carolina in
1951. From 1951 through 1997, Central was a trucking company
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that operated as a bulk carrier of liquid and dry chemicals.4
Some of the chemicals that Central hauled were toxic. Central
transported bulk chemicals in tanker trailers pulled by tractors.
Central held operating authorities issued by the ICC,
various States, and Canada. These authorities granted Central
contract and common carrier status for the transportation of bulk
chemicals, including liquid or dry toxic chemicals, in tanker
trailers between points and places within the United States,
various States, and Canada. Central faced minimal competition
because of the expensive equipment required to engage in the
tanker trucking business.
Central was an S corporation.5 Central was highly
successful in its bulk chemical hauling business, realizing net
ordinary income from 1991 through 1996 as follows:
Year Amount
1991 $2,399,057
1992 2,321,825
1993 3,242,161
1994 8,239,741
1995 7,043,522
1996 6,046,232
Total 29,292,538
4
Central sold substantially all its operating assets and the
right to operate under the name of Central Transport, Inc., in
1997. After the sale, Central ceased its motor carrier
operations and changed its name to Honbarrier, Inc.
5
An S corporation generally pays no income tax. Rather, the
corporate income is taxed to the shareholders on a pro rata
basis. See sec. 1366.
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The yearend balances in Central’s accumulated adjustments
account6 reported on Central’s Federal income tax returns for the
years 1991 through 1996 show undistributed earnings as follows:
Year Account Balance
1991 $8,378,797
1992 9,893,868
1993 10,693,387
1994 7,333,838
1995 6,449,973
1996 6,592,738
On several occasions, Charles L. Odom, a certified public
accountant and Mr. Honbarrier’s tax and financial adviser,
recommended that Central make distributions to shareholders if
such funds were not needed in Central’s business. In a
memorandum to attorney Charles Lynch, dated November 5, 1993, Mr.
Odom stated: “Central has $10 million in undistributed S Corp
earnings and would like [to] make a significant distribution to
shareholders, but needs its capital for expansion and replacement
of aging equipment.”
Unlike Colonial, Central did not invest in tax-exempt bonds.
Central held passive investments in the form of short-term liquid
investments, such as certificates of deposit, because it needed
cash and cash equivalents to operate its business. As of yearend
1991 through yearend 1996, Central held cash and short-term
investments in the following amounts:
6
The accumulated adjustments account reflects undistributed
earnings of Central on which Central’s shareholders had paid tax.
See sec. 1368.
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Yearend Amount
1991 $5,621,829
1992 5,688,948
1993 11,924,102
1994 10,658,199
1995 9,363,012
1996 11,999,759
For its taxable years 1991 through 1996, Central declared
distributions to its shareholders as follows:
Year Amount
1991 -0-
1992 $1,000,000
1993 7,000,000
1994 7,540,000
1995 8,333,838
1996 6,449,974
Total 30,323,812
Both Central and Colonial had a long history of operating
debt free, in accordance with Mr. Honbarrier’s conservative
business policy of avoiding debt. Central never incurred either
long-term or short-term debt.
Central pursued a 5-year capital expansion program for
updating equipment. From 1993 through 1996, Central made
expenditures on property and equipment as follows:
Year Expenditure
1993 $8,481,534
1994 5,764,211
1995 6,600,730
1996 4,806,384
Total 25,652,859
The majority of these expenditures were for power units (i.e.,
tractors) and stainless steel tankers. These expenditures were
made on a debt-free basis from Central’s available funds.
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From 1982 through 1997, all of Central’s stock was owned by
Mr. and Mrs. Honbarrier and their children, Gary L. Honbarrier
and Linda Embler. During the same period, Central had only four
directors, consisting of Mr. and Mrs. Honbarrier and their two
children.
Merger of Colonial into Central
On December 31, 1993, Colonial merged into Central in
accordance with the laws of North Carolina. Central was the
surviving corporation. Prior to the merger, Mr. Odom requested
that Mr. Lynch research the income tax implications of a merger.
On November 5, 1993, 7 weeks before the merger, Mr. Odom made the
following handwritten notes:
ALH Oks merger of Col. & Central, payout to Cen.
shareholders
- if tax free
- need bus. purpose
On November 11, 1993, after researching the matter, Mr.
Lynch sent Mr. Odom a memorandum identifying the following
possible business reasons for the merger: (1) Obtaining
Colonial’s ICC operating rights to expand Central’s business; (2)
reducing and simplifying operating procedures and expenses by
utilizing Central’s existing staff and facilities; (3) reducing
administrative expenses due to projected increased revenue
without increasing overhead expenses; and (4) use of Colonial’s
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cash to permit Central to expand and capitalize on the operating
rights acquired from Colonial.
In a letter dated November 12, 1993, Mr. Odom forwarded a
copy of Mr. Lynch’s memorandum to Mr. Honbarrier and stated the
following:
Since Colonial has no intention of returning to the
transportation industry, its intangible assets (ICC
Authority), which would be lost on liquidation, could
benefit another company within that industry. It seems
to me that a merger could benefit both Central and
Colonial. Central would be acquiring valuable rights
for current and future use, as well as a substantial
addition to its working capital. Colonial would no
longer be required to maintain records and manage its
investments, file separate income tax returns and
whatever other administrative duties are now required.
On November 16, 1993, Mr. Honbarrier telephoned Mr. Odom to
tell him to proceed with the merger. Mr. Honbarrier’s approval
of the merger was forwarded to Mr. Lynch by Mr. Odom on the same
day.
On December 22, 1993, Colonial and Central entered into an
Agreement and Plan of Merger of Colonial with and into Central
(Merger Agreement) providing for a merger of Colonial into
Central to occur 1 second before midnight on December 31, 1993.
On December 22, 1993, the shareholders and directors of Central
unanimously approved the merger. The directors and shareholders’
written consent provided, in part, as follows:
WHEREAS, Colonial Motor Freight Line, Incorporated, has
certain Interstate Commerce Commission operating
authorities which the Corporation wishes to acquire for
current and future use as well as Colonial’s
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substantial working capital in order to permit it to
make use of Colonial’s ICC authority;
As previously stated, Colonial’s ICC operating authority had
no value, and Central never used the ICC operating authority
acquired from Colonial in the merger. Central never operated as
a packaged-freight carrier.
For purposes of the merger, Mr. Odom determined that the
premerger value of Central’s stock was $417.45 per share. He
then determined that the net asset value of Colonial, which was
being acquired by Central, was $7,442,6607 and that the number of
Central shares necessary to compensate Mr. Honbarrier for his
Colonial stock was 17,840 shares. Pursuant to the merger, Mr.
Honbarrier’s 245 shares of Colonial stock were exchanged for
17,840 shares of Central stock. The merger changed Central’s
shareholder ownership as follows:
Before Merger: After Merger:
Shares Percent Ownership Shares Percent Ownership
Mr. Honbarrier 65,484 72.0396 83,324 76.6268
Mrs. Honbarrier 300 0.3300 300 0.2760
Gary L. Honbarrier 12,558 13.8152 12,558 11.5486
Linda Embler 12,558 13.8152 12,558 11.5486
Total 90,900 100.0000 108,740 100.0000
On December 22, 1993, the board of directors of Central also
declared a $7 million distribution payable to its shareholders on
December 31, 1993. The shareholder distribution was allocated on
a pro rata basis among the shareholders based on their stock
7
This figure includes $175,000 for Colonial’s ICC operating
authority. As we previously found, the ICC operating authority
had no value and should not have been included in Colonial’s net
asset value.
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ownership in Central on December 22, 1993. The amounts to be
distributed to the various shareholders were as follows:
Shareholder Allocable Amount of Distribution
Mr. Honbarrier $5,042,772
Mrs. Honbarrier 23,102
Gary L. Honbarrier 967,063
Linda Embler 967,063
Total 7,000,000
With the exception of the amount allocable to Mr.
Honbarrier, all of the declared distributions were paid by check
on December 31, 1993. Central made the $5,042,772 distribution
to Mr. Honbarrier in two parts. The first part was paid via a
$493,626 check drawn on Central’s account on December 31, 1993.
Thus, the cash distributions made to Mr. Honbarrier and the other
shareholders on December 31, 1993, totaled $2,450,854.8 The
second part of the distribution to Mr. Honbarrier was made on
January 3, 1994, and consisted of $4,549,146 in tax-exempt
bonds.9 The tax-exempt bonds distributed to Mr. Honbarrier on
January 3, 1994, were the same bonds acquired by Central from
Colonial in the merger.
For Federal income tax purposes, petitioners treated the
merger as a tax-free reorganization within the meaning of section
368(a)(1)(A) and treated the $7 million distribution as a
8
The cash and cash equivalents that Central received from
Colonial on Dec. 31, 1993, totaled $2,472,047.
9
The parties have stipulated that Mr. Honbarrier was in
actual or constructive receipt of his entire $5,042,772 share of
the distribution at the close of 1993.
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payment of previously taxed income reflected in Central’s
accumulated adjustments account.
OPINION
As a general rule, any gain recognized on the sale or
exchange of property is taxable. However, the Internal Revenue
Code provides that certain transactions may occur in such a way
that ownership interests are exchanged, yet no taxable event is
deemed to have taken place. One instance where nonrecognition is
provided involves corporate reorganizations that come within the
provisions of section 368. The income tax regulations explain
the rationale behind the reorganization provisions as follows:
Under the general rule, upon the exchange of property,
gain or loss must be accounted for if the new property
differs in a material particular, either in kind or in
extent, from the old property. The purpose of the
reorganization provisions of the Code is to except from
the general rule certain specifically described
exchanges incident to such readjustments of corporate
structures made in one of the particular ways specified
in the Code, as are required by business exigencies and
which effect only a readjustment of continuing interest
in property under modified corporate forms. Requisite
to a reorganization under the Code are a continuity of
the business enterprise under the modified corporate
form, and (except as provided in section 368(a)(1)(D))
a continuity of interest therein on the part of those
persons who, directly or indirectly, were the owners of
the enterprise prior to the reorganization. * * * [Sec.
1.368-1(b), Income Tax Regs.]
Shareholders generally do not recognize gain or loss when
stock in a corporation that is a party to a reorganization is,
pursuant to a plan of reorganization, exchanged solely for stock
in another corporation that is a party to the reorganization.
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See sec. 354(a)(1). Section 368(a)(1)(A) defines a
reorganization as “a statutory merger or consolidation”. A
statutory merger or consolidation is one effected pursuant to the
corporate laws of the United States, a State, a territory, or the
District of Columbia. See sec. 1.368-2(b)(1), Income Tax Regs.
The merger of Colonial into Central meets this literal
requirement. Petitioners argue that they are entitled to tax-
free treatment under the Code because the merger was a complete
and valid transaction for State law purposes.
It has long been held that qualification as a merger under
State law is not, by itself, sufficient to qualify as a
reorganization under section 368(a)(1)(A). Courts have
interpreted section 368 as imposing three additional requirements
for a merger to be treated as a reorganization under section
368(a)(1)(A). These are: (1) Business purpose; (2)continuity of
business enterprise; and (3) continuity of interest. See Gregory
v. Helvering, 293 U.S. 465 (1935); Wortham Mach. Co. v. United
States, 521 F.2d 160 (10th Cir. 1975); Cortland Specialty Co. v.
Commissioner, 60 F.2d 937 (2d Cir. 1932); Atlas Tool Co. v.
Commissioner, 70 T.C. 86, 100 (1978), affd. 614 F.2d 860 (3d Cir.
1980). Following judicial precedent, the regulations also
require that there be a business purpose for the transaction,
continuity of business enterprise, and continuity of interest, in
order for a merger to qualify as a reorganization under section
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368(a)(1)(A). See sec. 1.368-1(b), Income Tax Regs.; T.D. 7745,
1981-1 C.B. 134. Failure to comply with any one of these
requirements will preclude treatment as a tax-free reorganization
within the meaning of section 368(a)(1)(A).
Respondent argues that the merger failed to meet the
continuity of business enterprise requirement necessary to
qualify the merger as a tax-free reorganization within the
meaning of section 368(a)(1)(A).10 The continuity of business
enterprise requirement was first expressed in Cortland Specialty
Co. v. Commissioner, supra. See Laure v. Commissioner, 653 F.2d
253, 258 (6th Cir. 1981). This requirement is now embodied in
section 1.368-1(b), Income Tax Regs., and described in paragraph
(d) of the same section. These regulations are based on an
interpretation of judicial precedents which articulate the
continuity of business enterprise doctrine. See T.D. 7745, 1981-
1 C.B. 134. The basic concept behind the continuity of business
enterprise requirement is that the receipt of a new ownership
interest in an entity that retains none of the business
attributes of the shareholder’s former corporation is more
closely akin to a sale or liquidation than to a mere adjustment
in the form of ownership. See Laure v. Commissioner, supra at
258.
10
Respondent also argues that the merger did not have any
business purpose. Because we hold that the merger did not
satisfy the continuity of business enterprise requirement, we
need not address respondent’s alternative argument.
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Under the income tax regulations, a transaction constitutes
a tax-free reorganization only if there is “a continuity of the
business enterprise under the modified corporate form”. Sec.
1.368-1(b), Income Tax Regs. Continuity of business enterprise
requires that the acquiring corporation either continue the
acquired corporation’s historic business or use a significant
portion of the acquired corporation’s historic business assets in
a business. See sec. 1.368-1(d)(2), Income Tax Regs. In
essence, the acquiring corporation must retain a link to the
business enterprise of the acquired corporation by continuing the
acquired corporation’s business or by using the acquired
corporation’s business assets in a business. See Berry Petroleum
Co. v. Commissioner, 104 T.C. 584, 635-636 (1995), affd. 142 F.3d
442 (9th Cir. 1998). In this case, as explained below, we find
that Central neither continued Colonial’s historic business nor
used a significant portion of Colonial’s historic business assets
in Central’s business operations.
1. Continuation of Acquired Corporation’s Historic Business
In general, a corporation’s historic business is the
business it has conducted most recently. See sec. 1.368-
1(d)(3)(iii), Income Tax Regs. Petitioners contend that there is
a continuity of Colonial’s trucking business because Central is
also in the trucking business. We disagree.
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Colonial terminated its business of hauling packaged freight
in 1988.11 It then began selling its operating assets. From
1988 forward, Colonial had no customers. By the end of 1990,
Colonial had essentially disposed of its trucking operation
assets for cash and cash equivalents. The only trucking assets
Colonial retained were its ICC and North Carolina operating
authorities. The ICC operating authority had become worthless,
and Colonial sold its North Carolina operating authority in 1992
for $5,000. For 3 years prior to the merger, Colonial’s assets
consisted principally of tax-exempt bonds and a municipal bond
fund.12 During the 3-year period prior to the merger, Colonial
held 18 tax-exempt bonds, 16 of which were purchased in 1990 and
1991, and 2 of which were purchased in 1992. One bond was
redeemed in 1991, and three bonds were redeemed in 1992 and 1993.
Colonial continued to hold the remaining 14 bonds as of the end
of 1993.
Colonial stopped hauling freight approximately 5 years prior
to the merger, had essentially sold all of its operating assets 3
years prior to the merger, and for 3 years prior to the merger
kept most of its assets in tax-exempt bonds and a municipal bond
11
Colonial principally transported furniture manufactured in
North Carolina.
12
The passive income from these money management activities
caused Colonial to lose its S corporation status at the end of
its 1992 tax year pursuant to sec. 1362(d)(3). For the taxable
year 1993, Colonial was a C corporation and Central was an S
corporation.
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fund. We conclude that Colonial had abandoned its trucking
business well before the merger.13 Colonial’s most recent
business type activity was acquiring and holding tax-exempt bonds
and a municipal bond fund. This was Colonial’s historic business
at the time of the merger for purposes of determining whether
there was a continuity of business enterprise. See, e.g., Abegg
v. Commissioner, 50 T.C. 145 (1968), affd. 429 F.2d 1209 (2d Cir.
1970).14
As of October 31, 1993, 2 months prior to the merger,
Colonial held approximately $7.35 million in tax-exempt bonds and
a municipal bond fund and approximately $1,500 in cash. On
December 31, 1993, Colonial liquidated one of those bonds and its
municipal bond fund for more than $2,550,000. As a result,
Colonial’s cash position increased significantly.
The fair market value of the tax-exempt bonds held directly
13
We also note: (1) The type of trucking business conducted
by Central involving hauling solid and liquid (and sometimes
toxic) chemicals in expensive tanker trailers was different from
the operations previously conducted by Colonial; (2) Central
never operated as a packaged-freight carrier; and (3) Central
never used the ICC operating authority acquired from Colonial in
the merger.
14
We recognize that investment activity is not a trade or
business for some purposes. See Commissioner v. Groetzinger, 480
U.S. 23 (1987). However, investment activity has been recognized
as a historic business for purposes of the continuity of business
enterprise doctrine. See Abegg v. Commissioner, 50 T.C. 145
(1968), affd. 429 F.2d 1209 (2d Cir. 1970); see also T.D. 7745,
1981-1 C.B. 134, 139 (Investment operations may constitute a
historic business if the investment assets were not acquired as
part of a plan of reorganization).
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by Colonial totaled $4,549,146 just before the merger on December
31, 1993. Three days after the merger, Central distributed these
same tax-exempt bonds to Mr. Honbarrier.15 This distribution
occurred on January 3, 1994.16 The last tax-exempt bond acquired
by Central in the merger was worth $300,000 and held in the Alex
Brown and Sons account. This bond was liquidated by Central 4
months after the merger. Unlike Colonial, Central did not invest
in tax-exempt bonds. Central placed its money in short-term
liquid investments, such as certificates of deposit because it
needed cash and cash equivalents to operate its business. Thus,
we conclude that Central did not continue Colonial’s business of
holding tax-exempt bonds and municipal bond funds.
2. Significant Use of Acquired Corporation’s Business
Assets
Continuity of business enterprise can also be satisfied if
the acquiring corporation uses a significant portion of the
acquired corporation’s historic business assets in a business.
See sec. 1.368-1(d)(4)(i), Income Tax Regs. A corporation’s
historic business assets are the assets used in its historic
15
On Dec. 31, 1993, the date of the merger, Central made
$2,450,854 in cash distributions to Mr. Honbarrier and other
shareholders of Central.
16
The merger was effective on Dec. 31, 1993, at 1 second
before midnight. Dec. 31, 1993, fell on a Friday, and the tax-
exempt bonds totaling $4,549,146 were distributed to Mr.
Honbarrier on Jan. 3, 1994, which fell on a Monday. Mr.
Honbarrier testified that the bonds could not be signed over to
him until the bank opened on Monday, Jan. 3, 1994, even though
the merger was effective on Friday, Dec. 31, 1993.
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business. See sec. 1.368-1(d)(4)(ii), Income Tax Regs. Business
assets may include stock and securities. See id. In general,
the determination of the portion of the corporation’s assets
considered “significant” is based on the relative importance of
the assets to the operation of the business. See sec. 1.368-
1(d)(4)(iii), Income Tax Regs. However, all other facts and
circumstances, such as the net fair market value of those assets,
will be considered. See id.
Colonial’s historic business assets were its tax-exempt
bonds and municipal bond fund. It was never intended that
Colonial’s tax-exempt bonds and municipal bond fund be held by
Central and, after the merger, Central did not use those assets
in its business. On the day of the merger, Colonial liquidated a
tax-exempt bond and its municipal bond fund for more than $2.5
million in cash. On the same day, Central made a cash
distribution to Central’s shareholders in the total amount of
$2,450,854.17 Three days after the merger, tax-exempt bonds
totaling $4,549,146 that had been held by Colonial were
17
Both the merger and distribution were authorized on Dec.
22, 1993, and both transactions occurred on Dec. 31, 1993. We
are not convinced that Central would have made a $7 million
dividend absent the merger with Colonial in light of Central’s
needs for expansion and replacement of aging equipment and
Central’s practice of not borrowing money. Indeed, Central’s
yearend balances in its accumulated adjustments account (the
undistributed earnings on which tax has been paid by Central’s
shareholders) for 1991 and 1992 were $8,378,797 and $9,893,868,
respectively. Yet, Central made no distributions to shareholders
in 1991 and distributed only $1 million in 1992.
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distributed to Mr. Honbarrier.18 The remaining tax-exempt bond,
valued at $300,000, which was held in an account with Alex Brown
and Sons, was liquidated 4 months later.
As a result of the transactions surrounding the merger, all
of Colonial’s investments in tax-exempt bonds and the municipal
bond fund were disposed of and Colonial ceased to exist. We find
that Central did not use a significant portion of Colonial’s
historic business assets in a business.
3. Conclusion
Central did not continue either Colonial’s historic business
or use a significant portion of Colonial’s historic business
assets in a business. As a result, Central did not satisfy the
continuity of business enterprise requirement. See sec. 1.368-
1(b), Income Tax Regs.
We hold that the merger of Colonial into Central was not a
tax-free reorganization within the meaning of section
368(a)(1)(A). Because this merger did not qualify as a
reorganization under section 368(a)(1)(A), Mr. Honbarrier’s
exchange of Colonial stock for valuable consideration was a
taxable event. Colonial’s assets had a net fair market value of
18
The merger was not effective until 1 second before
midnight on Dec. 31, 1993. As a result, ownership in Colonial’s
assets could not pass to Central until then. However, on Dec.
27, 1993, Central instructed the financial institutions holding
Colonial’s bonds valued at $4,549,146 that those bonds were to be
transferred to Mr. Honbarrier effective Jan. 3, 1994. On Jan. 3,
1994, they were transferred to Mr. Honbarrier.
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$7,245,05119 at the time Colonial was merged into Central.
Petitioners acknowledge that Mr. Honbarrier received full fair
market value for his stock in Colonial.20 Mr. Honbarrier must
therefore recognize capital gain of $6,953,545, which is equal to
the excess of the fair market value of assets he received for his
Colonial stock ($7,245,051) over his basis ($291,506).21
In the notice of deficiency to Colonial, respondent
determined that Colonial had a gain on the sale or exchange of
its assets in the merger transaction. However, respondent now
agrees that Colonial did not realize any gain because the fair
market value of its assets equaled its tax basis in those assets.
Decision will be entered under
Rule 155 in docket No. 9053-97.
Decision will be entered for
petitioner in docket No. 9054-97.
19
$7,321,193 - $76,142 (tax liability) = $7,245,051
20
Mr. Honbarrier was provided with 17,840 shares of Central
stock, which petitioners determined had a value equal to the net
asset value of Colonial. In their brief, petitioners state: “At
the time of the merger, Mr. Honbarrier’s 245 shares of Colonial
stock were converted into 17,840 shares of Central stock, which
were equivalent in value to his Colonial shares.”
21
On brief, respondent proposes several substance-over-form
arguments. In light of our conclusion that the statutory merger
of Colonial into Central fails the continuity of business
enterprise requirement under sec. 1.368-1(b), Income Tax Regs.,
and therefore does not qualify as a tax-free reorganization
within the meaning of sec. 368(a)(1)(A), we need not decide or
address respondent’s various substance-over-form scenarios.