The following article is adapted and reprinted from the M&A Tax Report, Vol. 11, No. 10, May 2003, Panel Publishers, New York, NY.


By Robert W. Wood

Okay, so this is a silly title, but that should be nothing new to M&A Tax Report readers. Notwithstanding the staid world of the Internal Revenue Service (and the M&A field, too), a mirthful title in this publication should hardly be a surprise. In a decision smacking more of the independent contractor area than the tax-free reorganization provisions, the Tax Court has held in Jerry S. Payne v. Commissioner, T.C. Memo 2003-90, Tax Analysts Doc. No. 20037952, 2003 TNT 60-8, that a transfer of a topless dance club from one corporation to another qualified as a D reorganization, and that there was no distribution of boot taxable to the owner.

Just the Facts, Ma'am

The facts of the ruling are at least amusing, though if one can get beyond the titillating fact pattern, there is actually a lesson to be learned in this tiny transaction about boot and its tax treatment. Jerry Payne was a lawyer with a bit of an unusual practice. In exchange for legal services rendered, he wound up with control of a topless dance club. Fraught with the kind of problems that such businesses often have, the club was eventually ruled by the Service to have understated income and overstated deductions. Payne lost in the Tax Court, but more enlightened minds prevailed in the Fifth Circuit Court of Appeals.

The Fifth Circuit reversed the case, mostly on penalty issues, concluding that the Tax Court had erred in ruling that the IRS had proven fraud. Moreover, the Fifth Circuit concluded that the Tax Court had erroneously relied on a statutory fraud exception rather than the statute of limitations argument that Mr. Payne made to attempt to prevent a fraud penalty.

Payne's ownership of the club went back to 1988, when he received personal property interests in the club in satisfaction of legal fees. Payne leased his personal property back to the corporation, paying $10 and a promissory note for the remaining stock of the corporation. A new company (Newco) was incorporated in 1990, with Payne as the sole shareholder. Operation of the club was then transferred from Payne individually to Newco, which became the sublessee of both the premises and the personal property. A year later, in 1991, Newco sold all of the club assets for $1.1 million.

Expenses and More?

The years under audit revealed that Payne took various expenses, primarily for parking and interest. The IRS determined that the various payments received by Payne amounted to constructive dividends. The Tax Court generally found that the expenses were promotional in nature, and therefore were deductible by the company. The interesting issue, though, was the reorganization. The Tax Court found that the transfer of the club to the new company in 1990 was a tax-free reorganization under Section 368(a)(1)(D).

Moreover, the court found that there was no distribution of taxable boot to Mr. Payne. Why? The club was owned and operated by what was then Payne's wholly-owned corporation (2618, Inc.), not by Payne individually. The court specifically rejected the IRS' suggestion that Newco's sale of the assets less than three months after it acquired them indicated that they were sold as part of an overall plan to transfer the assets from 2618, Inc. to Newco. The court determined that Payne's efforts on behalf of the club were motivated by his desire to receive the legal fees.

Step Transactions?

Lately, we've talked a lot about step transaction doctrine so it may strike some readers as odd that the IRS didn't have more success here, seeking to integrate the transfer of assets from 2618, Inc. and the sale shortly thereafter by Newco.

Shake Your Booty?

I can't resist leaving this topic without pointing out that boot in reorganizations is always an interesting topic, and one that prompts at least some degree of taxpayer fear. Still, the whole enchilada (so to speak) is reorganization treatment, since most types of reorganizations do permit boot. I found it interesting, therefore, that this case also invoked the continuity of business enterprise doctrine.

The government argued that Newco's sale of its assets less than three months after it acquired them, indicating that those assets were sold as part of an overall plan to transfer assets from 2618 to Newco. The Tax Court noted (seemingly with some sympathy), that the taxpayer here was motivated all along by his desire to receive in cash his overdue legal fees. Indeed, the Tax Court said that his ongoing efforts to secure the permits for the club were doubtless motivated by a desire to make the club saleable.

However, the Tax Court said that the Service acknowledged that there was no direct evidence that the Newco sale of assets was part of an overall plan existing at the time of the transfer of the club's operation from 2618 to Newco. Significantly, the Tax Court said that it would not infer the existence of such a plan by reason of the proximity in time of the two transactions (whew!).

Plus, the Tax Court went on to say that the mere fact that the taxpayer may have contemplated selling the club at the time of the transfer from one company to the other does not require a finding that the transfer lacked continuity of business enterprise. The Tax Court cites Lewis v. Commissioner, 176 F.2d 646 (1st Cir. 1949). In Lewis, a corporation sold two of its three lines of business and, because it was temporarily unable to sell the third, placed the assets of the remaining business in a new corporation pending a sale (which occurred less than three years later), and then liquidated.

Because the transferee corporation continued to conduct the old business, the Tax Court and First Circuit sustained the finding that the transaction had a valid business purpose and that it qualified as a nondivisive D reorganization. That case was not one in which the intent was for the transferee corporation to immediately make a liquidating distribution of the assets received from the transferor corporation.

All's Well That Ends Well

Mr. Payne got paid his legal fees, his reorg treatment was upheld, and he even got to be a club owner for a little while and make a profit!

Boot or Booty?, Vol. 11, No. 10, The M&A Tax Report (May 2003), p. 7.