knowledge as a business asset
Martin Ice Cream Co. v. Commissioner, 110 T.C. 189 (1998)
(Knowledge as a business asset)
Travis A. Wise
November 20, 2001
Martin Ice Cream Co. v. Commissioner
Father was the primary developer and entrepreneur of an ice cream distribution business, which he incorporated with his son. Haagen-Dazs negotiated the purchase of various intangible assets and business records from the business. Subsequent to the negotiations but prior to the purchase, the distribution business was split off into Subsidiary. Father exchanged his Martin Ice Cream stock for all of the stock in Subsidiary. Subsidiary then sold its intangible assets to Haagen-Dazs. Subsidiary recognized $1.4M in income, which Father reported on his personal return, and dissolved Subsidiary.
Because Subsidiary never operated an active business after the split-off, the tax court denied tax-free treatment under Sec. 355. The distribution of the stock from Martin’s Ice Cream to Father was therefore a taxable transaction. Martin’s transfer of intangible assets to Subsidiary was entitled to nonrecognition under Sec. 351. However, Martin’s distribution of Subsidiary’s stock to Father in redemption of Father’s stock in Martin was a distribution of appreciated property, and the corresponding gain was taxable to Martin.
Father and Son were shareholders of Martin Ice Cream Company (“MIC”). MIC distributed private label ice cream products to supermarkets. The success of the business was largely attributable to the close personal relationships Father had developed and maintained with the supermarkets for decades. (Martin Ice Cream Co. v. Commissioner, 110 T.C. 189, 189 (1998)).
Haagen-Dazs (“HD”) initiated negotiations with MIC to acquire MIC’s rights to distribute HD’s ice cream to supermarkets. HD was attempting to consolidate distribution operations, and eliminate third-party distributors. HD was accomplishing this by buying up the distribution rights and business records from the third-party distributors. (Id.).
During negotiations with HD, Father and Son created SIC, a wholly-owned subsidiary of MIC. MIC then transferred all of MIC’s rights to distribute HD ice cream to supermarkets to SIC, in exchange for stock in SIC in a purported Section 351 transaction. MIC then distributed the SIC stock to Father, in exchange for Father’s stock in MIC, in a purported Section 355 transaction. The SIC stock was later valued at $141,000. This left Son as the sole shareholder of MIC, which contributed distributing non-HD ice cream to smaller stores; and Father as the sole shareholder of SIC, which owned the intangible rights to distribute HD ice cream. (Id. at 192).
Within a month after the intangible assets were transferred from MIC to SIC, SIC sold the intangible assets to HD for approximately $1.5 million. SIC received the proceeds of the sale, which it distributed to Father. (Id. at 202).
Issues & Conclusions
1. Who owned the intangible assets: Father or MIC?
Father owned the intangible assets. The assets were never owned by MIC.
2. Does the split-off of SIC from MIC qualify as a Section 355 tax-free distribution?
The split-off does not qualify as a Section 355 tax-free distribution because SIC failed to carry on an active trade or business after the distribution.
3. Does the transfer of assets from MIC to SIC qualify as a Section 351 tax-free distribution?
The transfer of intangible assets from MIC to SIC qualifies for nonrecognition, but the distribution of SIC stock to Father is a taxable redemption of stock, which MIC will have to recognize.
Law & Analysis
1. Ownership of Intangible Assets
The intangible assets in question are (1) the rights of Father under oral agreements with HD and the supermarkets to distribute the ice cream; and (2) the business records created by MIC during Father’s development of the distribution business, and transferred by MIC to SIC. (Id. at 207).
Case law has established that personal relationships of a shareholder-employee are not corporate assets when the employee has no employment contract with the corporation (MacDonald V. Commissioner, 3 T.C. 720, 1944).
In this case, there was no employment agreement or non-competition agreement between Father and MIC. Nor was there any other agreement transferring those intangible assets from Father to MIC. Therefore, the court held that the ownership of these intangible assets cannot be attributed to MIC. The fact that MIC initially entered into the negotiations with HD did not attribute ownership of the assets to MIC. (Martin, supra, at 207).
2. Qualification Under Section 355 For Tax-Free Distribution
Section 355 generally allows a corporation to make a tax free distribution of stock to its shareholders. To qualify, the shareholders must be in control of the corporation immediately following the distribution. Additionally, the company must be engaged in an “active trade or business” immediately after the distribution (§355(b)).
A corporation is treated as engaged in a trade or business immediately after the distribution if it consists of a specific existing group of activities being carried on for profit. (Reg. § 1.355-1).
The court held that MIC’s distribution of SIC stock to Father did not qualify for nonrecognition under Section 355(c) because SIC was not engaged in the active conduct of a trade or business immediately after the distribution. In fact, SIC received no operating assets from MIC in the transfer, and subsequent to the transfer had no means by which to carry on the distribution business apart from contracting with MIC to carry on the operations. (Id. at 217).
3. Qualification under Section 351 for Tax-Free Distribution
Section 351 provides that a transfer of property to a corporation in exchange for its stock will not be a taxable event, provided that immediately after the transfer the transferor is in control (as defined by §368(c)) of the transferee.
The transfer of intangible assets from MIC to SIC in exchange for stock in SIC qualifies for nonrecognition under Section 351(a). Immediately after the transfer, MIC received all the stock of SIC, which it immediately distributed to Father. The Court decided that subsequent transfers to shareholders should not be taken into account in determining if the transferee was in control immediately after the transfer. (Id. at 218).
Therefore, the transfer of assets from MIC to SIC was tax-free. However, the distribution of SIC stock to Father from MIC was not tax-free.
The distribution of SIC stock to Father in exchange for his stock in MIC was a distribution of property under Section 317(a), amounting to a redemption by MIC of its stock held by Father. Since the repeal of the General Utilities doctrine, Section 311(b) now provides that a corporation recognizes gain to the extent that the fair market value of the distributed property exceeds its basis in the hands of the distributing corporation. MIC therefore recognized gain on the distribution of the SIC stock in redemption of Father’s stock in MIC, measured by the excess of the fair market value over the basis of the SIC stock distributed. (Id. at 219).
To determine the fair market value of the SIC stock, the court would generally look to an arm’s length transaction price (Id. at 220). In this case, MIC submitted a report by an expert witness which used the valuation factors set forth in Rev. Rul. 59-60 and determined that the value of the Father’s share of the MIC stock was $141,000. (Id. at 231). The stock had an adjusted basis of $0, and therefore MIC had a gain of $141,000.
Therefore, MIC had to recognize a gain on the distribution of SIC’s stock to Father, which was appreciated property.
When a corporation distributes appreciated property to a shareholder, the amount of gain is taxable to the distributing corporation, even if the underlying transactions triggering the distribution are nonrecognition events.