The Upside to a Downstairs Merger

Can Retail Ventures Inc., the parent of shoe retailer DSW, be eliminated in a tax-efficient way?

Willens 05-17-10

Witness the decades-old case of Commissioner v. Estate of Gilmore1, in which a holding company called WFI owned a majority of the stock of an operating company, known as WWC. On October 28, 1935, the directors of each company executed an “agreement of merger and consolidation” in connection with which the operating company was to be the surviving entity. The agreement was duly filed with the Secretary of State of New Jersey, and the taxpayers — shareholders of WFI — surrendered their stock to the surviving company and received its shares in return. At the time, the Internal Revenue Service asserted that the transaction was taxable on the gain received from the exchange. However, the Board of Tax Appeals disagreed, and the Court of Appeal for the Third Circuit upheld the board’s decision.

At issue was whether the merger constituted a reorganization. The IRS argued that while the definitions of the term “merger” required that there be a “transfer of property,” there was no transfer of property in the surrender by the holding company to the operating company.

However, the court rejected the IRS’s argument that there was no merger, saying that the term “statutory merger or consolidation,” as used in the predecessor to Section 368(a)(1)(A), meant a merger or consolidation completed as per of the corporation laws of a state, territory, or the District of Columbia. In this case, the merger was effected according to the laws of New Jersey.

The court said it found no provision under New Jersey statutes that called for the transfer of property as a merger pre-requisite. Were the IRS’s contention valid, it would follow that a “pure” holding company could never be a party to a merger: no statute or decision of New Jersey stands for that proposition. Accordingly, the transaction at issue was a merger.

Whether a transaction qualifies as a reorganization does not turn alone upon compliance with the literal language of the statute. Rather, requisite to a reorganization are two conditions: (1) a continuity of the business enterprise under the modified corporate form, and (2) a continuity of interest on the part of those persons who were the owners of the enterprise prior to the transaction. In the Gilmore case, the court concluded that there was a continuity of interest of all prior owners of the merged corporation, and that none of the proprietary interests in the merged corporation was converted into cash or other property.

But the IRS asserted that the result to be reached through the merger (elimination of the holding company) could have been reached more directly by an out and out liquidation which would have been taxable. In the view of the IRS, if there are two (or more) ways of accomplishing a legitimate business result — one that creates a taxable transaction, the other being a tax-efficient transaction — then a taxpayer is equally subject to tax if it chooses the tax-efficient method, unless there is an adequate business reason for making that choice.

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