The following article is adapted and reprinted from the M&A Tax Report, Vol. 10, No. 12, July 2002, Panel Publishers, New York, NY.


By Robert W. Wood

Assume for a moment that you are a judge of the Court of Federal Claims. The taxpayer presents the facts of an acquisition, and moves for summary judgment that the transaction qualifies as a reorganization under Section 368. The IRS not only disagrees, but also moves for summary judgment that this transaction was clearly a cash sale, fully taxable.

You twirl your black robes and frown. Perhaps your expected response is to deny both motions, given the restrictive standards that apply to evaluating summary judgment motions. After all, summary judgment is supposed to be granted only if there is no genuine issue of material fact.

As it happens, here the Court of Federal Claims did rule as to both motions that there was a genuine issue of material fact on whether the two companies' merger and later sale of one company's stock for cash was a cash purchase or a reorganization. Still, the polar positions of the taxpayer and the Service make this case a good one for illustrating the underpinnings of the reorganization rule, as modified by our old friend, the step transaction doctrine.

Doing the Deal

In NovaCare, Inc. v. United States, No. 97-234T, Tax Analysts Doc. No. 2002-7410, 2002 TNT 65-6 (Fed. Cl. March 25, 2002), the court was faced with these competing summary judgment motions based on a fairly garden variety transaction. Much of the problem, though, arguably arose from a reporting glitch. NovaCare, Inc. merged with Rehab Systems Company in 1991. In 1995, NovaCare sold all of the Rehab stock to HealthSouth for cash. Before the 1991 merger, most of the Rehab stock was owned by five founders and nine limited partnerships and corporations. NovaCare made an offer to acquire Rehab for NovaCare stock. NovaCare formed an acquisition subsidiary, and Rehab negotiated a merger that was executed in 1992.

Under the merger agreement, Rehab stockholders received a certain number of shares of NovaCare stock for each Rehab share they held. Rehab duly merged with the acquisition subsidiary, and then continued as a NovaCare subsidiary. The Rehab shareholders (the limited partnerships, corporations and five founders) signed representations stating that they intended the merger to qualify as a tax-free reorganization, and that the deal met the continuity of interest requirements. By late 1992, the Rehab shareholders had transferred 5.2 million shares of NovaCare, constituting 87% of the shares received in the merger.

In 1995, NovaCare sold Rehab to HealthSouth. NovaCare's 1995 tax return reflected this sale, with the assumption that the merger was a tax-free reorganization under Section 368. NovaCare consequently used a carryover basis for the Rehab stock, and realized a gain on the sale.


Then, NovaCare scratched its corporate head. Hold on a minute, it said ruefully. NovaCare filed a refund claim for 1995, claiming a stepped-up basis to determine its gain or loss. With the higher basis included in the refund claim, NovaCare claimed that it realized a loss on the sale.

Predictably, the IRS denied the refund claim. NovaCare then filed suit, and filed a motion for a partial summary judgment. The government filed a cross-motion for summary judgment.

If you think this amended return and refund claim wasn't worth doing, just consider the numbers. This "wait-we-really-think-this-wasn't-a-reorganization" stance resulted in a eensy-weensy refund of $31,976,787. Thus, it was certainly worth NovaCare's while to get down in the mud and fight about continuity and the step transaction doctrine.

A Rose by Any Other Name?

So was this a reorganization? Or was it a sale? The Court of Federal Claims noted that the NovaCare/Rehab merger would produce a carryover basis if the transaction qualified as a reorganization. If the merger was treated as a taxable purchase, in contrast, NovaCare would be entitled to a stepped-up basis in its stock and would realize a loss (as claimed in the refund claim). NovaCare argued that due to the sell-off of stock by former Rehab shareholders, there was simply no continuity. The court, though, was not impressed with the cases cited by NovaCare for this seemingly unextraordinary proposition.

Indeed, the court referred to Federal Circuit authority regarding the step transaction doctrine. According to the Court of Federal Claims, the Federal Circuit recognizes two tests for when separate incidents may be collapsed into a single transaction. One is the end result test. The other is the interdependence test.

The end result test basically asks one to look at the end result of the entire series of transactions, and ask if this is what the parties were trying to achieve, without regard to the potentially meaningless steps interposed between the beginning and the end. Subjective intent, according to the court in NovaCare, is especially relevant under the end result test, because it allows the court to determine whether the taxpayer directed a series of transactions to an intended purpose. (Somehow that's supposed to sound nefarious, I guess.)

The interdependence test, though similar, focuses upon each step in the series of events, and asks whether those steps were interdependent on the other steps. Reviewing the case law, the Court of Federal Claims found — in its view under either test — that more than post-merger sales would be required to disrupt continuity of interest. Thus, the court denied NovaCare's motion for partial summary judgment.

On some level (for me, it emanates from somewhere around my gut), I have always felt that these supposedly different "tests" for applying the step transaction doctrine just don't add up. These two tests considered by the NovaCare court, together with the various other idices floating around in the cases, just aren't wholly distinct. For the record, the major tests (I prefer to think of them as factors) are:

1. the degree of interdependence of the steps (referred to by the court in NovaCare as the interdependence test;

2. the extent of any binding commitments;

3. the elapsed time between the various steps; and

4. the end result or intention of the parties test.

The latter figures prominently in the NovaCare opinion, though ultimately it doesn't sway the court to find the step transaction doctrine invoked by the taxpayer there applicable. For a recent summary of the step transaction doctrine, see Wood, "Revisiting the Step Transaction Doctrine," Vol. 10, No. 5, The M&A Tax Report, Dec. 2001, p. 1. The binding commitment notion is probably best illustrated by McDonald's of Illinois, 688 F.2d 520 (2d Cir. 1922), where there were merely pre-reorganization sale negotiations, and a sale occurred shortly after the reorganization. Not surprisingly, McDonald's of Illinois features prominently in the NovaCare opinion.

Of course, McDonald's of Illinois got a much better result than NovaCare was able to achieve. Like NovaCare, McDonald's was stuck by the IRS and the Tax Court with a carryover basis (reorganization treatment), and argued in the appellate court (in the Seventh Circuit) for purchase treatment. The appeals court reversed the Tax Court in McDonald's, and gave relief. Bear in mind, though, that McDonald's had treated the transaction from the very beginning as a taxable purchase. That, it seems to me, is a huge difference between McDonald's of Illinois and NovaCare.

What I can't figure out is how the step transaction doctrine seems to be coming up a lot more lately than it used to. We recently commented about Revenue Rulings 2001-26, 2001-23 I.R.B. 1297, and 2001-46, 2001-42 I.R.B. 1. Both involve the step transaction doctrine. See Vol. 10, No. 5, The M&A Tax Report (Dec. 2001, p. 8). See also Wood, "Step Transaction Doctrine and Mergers," Vol. 10, No. 6, M&A Tax Report (Jan. 2002, p. 6). Both administratively and in the case law, the step transaction doctrine, literally a venerable old shoe, just keeps turning up.

Offense or Defense?

Can a taxpayer — especially on an amended return — ever really successfully invoke the step transaction doctrine? The other McDonald's cases cited in the NovaCare case include Penrod v. Commissioner, 88 T.C. 1415 (1987) and Estate of Elizabeth Christian v. Commissioner, T.C. Memo 1989-413 (1989). In the Penrod case, another McDonald's franchisee acquisition deal, the IRS sought to apply the step transaction doctrine to integrate the acquisition and sale of stock. The Tax Court concluded that the merger and subsequent sale were not steps in a plan, and ruled for the Penrod shareholders. In Estate of Elizabeth Christian, which also involved a purchase of franchises by McDonald's Corporation, the shareholders were insisting on tax-free treatment, and the Tax Court upheld that treatment — over the IRS' objections about the applicability of the step transaction doctrine.

NovaCare may have lost the battle, but not yet the war. Fortunately for the taxpayer in NovaCare, the court also denied the IRS' motion, noting that the IRS had (also) misinterpreted the step transaction doctrine. The IRS in its motion argued that the only way a plaintiff could prevail would be to establish that at the time of the merger, a sufficient number of the Rehab shareholders actually intended to sell their shares after the merger (to disrupt continuity of interest). The court's opinion denying the two summary judgment motions states that the government incorrectly narrows the scope of inquiry to the intent of the Rehab shareholders alone. The court concluded that there was still a genuine issue of material fact being disputed: the intent of the parties at the time of the merger.

Step Transaction Redux

What all of this says about the step transaction doctrine is important. True, it is possible to read too much into the court's comments, since the predictable result on cross motions for summary judgment is to grant neither. Still, what I find most interesting about this is the enormously uphill battle that a taxpayer faces who is attempting to invoke (rather than defend against) the step transaction doctrine. There is some old tax homily about using the step transaction doctrine as a sword rather than a shield (or something like that).

Metaphors and homilies aside, how likely is it that a taxpayer who structures a transaction in one way can prevail in the later argument that the structure should really be collapsed? To tax lawyers, it almost seems sacrilegious (or at least seems at odds with customary professional pride) to be arguing that something which might have been structured another way should be treated as if the structure had been different. True, taxpayers occasionally attempt to invoke the doctrine, and can win. Anyone keeping score out there?

Sale vs. Reorganization: Eye of the Beholder?, Vol. 10, No. 12, The M&A Tax Report (July 2002), p. 5.