APPRAISED VALUE DETERMINES
CORPORATE GAIN
UNDER IRC SEC. 311

By David L. Silverman, JD, LLM, Law Offices of David L. Silverman

The Tax Court, deciding in favor of the IRS, held in Pope & Talbot, Inc., v. Com, 104 TC __, No. 29 (May 8, 1995), that a corporation which distributed discrete partnership units of property composed of timber and resort interests in the Northwest, must recognize distribution gain under IRC Sec. 311(d) as if it had instead sold the entire interest to a single hypothetical purchaser. The taxpayer had argued that the fair market value (FMV) of the distributed property for purposes of determining IRC Sec. 311 gain must be equal to the sum of the distributed partnership interests, which were publicly traded on the date of distribution.

The Facts

The commissioner proposed an $18.7 million deficiency determination against Pope & Talbot (P&T) for the 1985 and 1986 taxable years, alleging that P&T had incorrectly calculated the corporation's gain under IRC Sec.31(d). [IRC Sec. 311(d) was amended in 1986 and is now IRC Sec. 311(b).]

P&T had, in 1985, contributed its timber, land development, and resort business to a newly formed Delaware limited partnership. Immediately thereafter, the partnership interests (units) were distributed pro rata to P&T's shareholders. The transaction was similar to a IRC Sec. 355 spin-off, except that the equity interests were those of a newly created partnership.

The units were publicly traded on the Pacific Stock Exchange at $11.50 on the date of distribution. Based on this price, P&T had calculated the FMV of the sum of distributed partnership units (factoring in distributed partnership debt) to be $40.3 million. Each shareholder was issued a Form 1099 reflecting those figures for purposes of reporting IRC Sec. 301 dividend gain.

In calculating its $40.3 million corporate gain, P&T advanced a legal theorem referred to throughout its legal brief as the "equality principle," This theorem provided as follows:

The FMV of the property for purposes of calculating P&T's gain under IRC Sec. 311, was unknown. However, the FMV of distributed property for purposes of calculating shareholder gain under IRC Sec. 301, was known to be $40.3 million. P&T then postulated that (3) the FMV of the distributed partnership units for purposes of IRC Sec. 301 must equal the FMV of the same property for purposes of IRC Sec. 311. Therefore, P&T concluded, (4) the FMV of the distributed property for purposes of IRC Sec. 311 was $40.3 million.

P&T, in its Memorandum in Support of Motion for Summary Adjudication, moved for an order ruling that the FMV of the distributed property for purposes of determining P&T's amount realized under IRC Sec. 311(d) was equal to the FMV of the property distributed to its shareholders under IRC Sec. 301. P&T then asserted that the inviolability of the equality principle was demonstrated by the "symmetrical" nature of IRC Secs. 301, 311, and 1001. By reason of this symmetry, P&T concluded that the term FMV was identical for purposes of IRC Secs. 301, 311, and 1001.

The IRS also moved for summary adjudication, requesting an order finding that P&T's gain on the distribution of the timber and resort properties was to be determined as if P&T had sold its interest in those properties at FMV on the date of distribution. The IRS disputed the legitimacy of P&T's equality principle, insisting that the price of the partnership units was irrelevant in determining gain. The IRS calculated the gain on distribution to be $115 million, based on the FMV of the underlying resort and timber properties.

The Court's Decision on the Motions

The Tax Court, per Judge Ruwe, issued an order on May 8, 1995, denying P&T's motion and granting the IRS's motion. The court's opinion (which accompanied the order) characterized the issue before it as one of "first impression," and found resort to the legislative history of the statute necessary since the court was unable to "achieve...certainty based on the language of the statute." After reviewing the legislative history of IRC Sec. 311, the court observed the following:

It is apparent that the purpose underlying IRC Sec. 311(d) was to tax the appreciation in value that occurred while the corporation held the property and to prevent a corporation from avoiding tax on the inherent gain by distributing such property to its shareholders...It follows that we must focus on the value of the Washington properties as owned by petitioner and value them as if petitioner had sold them at fair market value at the time of distribution.

The court also remarked that "theoretically" the partnership could have sold the property at fair market value and then distributed the proceeds. If this had been done, the court continued, the shareholders would then have been able to realize a "proportionate share" of the full FMV of the property distributed. The court failed, however, to elaborate upon the legal significance of this theoretical observation, a failure made even more puzzling given the court's acknowledgement (in a footnote dropped in the same paragraph) that "the board of directors that recommended the plan owed a fiduciary duty to act in the best interests of the shareholders."

P&T's equality principle, which powered the taxpayer's argument for summary adjudication, failed to impress the court, which remarked dryly:

The value of what the shareholders received is not before us, and we express no view on that question. However, we do not view the potential lack of symmetry as sufficient reason to abandon our interpretation of IRC Sec. 311(d).

Similarly, the court found unpersuasive P&T's argument that the plain meaning of IRC Sec. 311(d) mandated that distributions of property to shareholders be valued by reference to the property received by each shareholder. The court's opinion instead resonated with the oratory that P&T should not, as a policy matter, be permitted to avoid those taxes that would have been reported had the transaction been structured as a straight sale and distribution.

Analysis of the Tax Court's Decision

The Tax Court's resort to legislative interpretation appears to have been precipitous. Arguably, the language of the statute was sufficiently clear and comprehensive such that a fair reading of its words compelled a decision adverse to the IRS. Assuming, arguendo, that resort to legislative history was warranted, it is still difficult to justify the court's decision on policy or purpose grounds since P&T's transactions appeared not to transgress the purpose of the statute or offend public policy.

In support of P&T's position, the phrase in IRC Sec. 311 requiring gain recognition "as if the property distributed had been sold at the time of the distribution" seemingly admits little of ambiguity, and neither requires nor permits the commissioner (or the court) to substitute other hypothetical property. The property distributed, after all, was actually partnership units. Moreover, in light of the fact that the partnership units were publicly traded on the date of distribution, it would seem difficult to argue that the value of property distributed did not approximate the sum of the market value of those interests.

The result-oriented approach which the court seemed to employ is also unsettling primarily because the tribunal seems to have invoked judicial license to read out of existence, sub silentio, perhaps the two most crucial words in the statute as they applied to the instant case: "property distributed."

Having reached the point of divining Congress' statutory intent, the court apparently felt justified in reaching the conclusion that Congress would have imposed tax on the appraised value timber and resort properties, rather than the actual value of the distributed partnership units. The court, however, offered no concrete rationale for taxing the hypothetical, rather than the real, distribution on policy grounds, except for its oblique observation that the purpose of the statute was to prevent a corporation from avoiding tax on inherent gain.

Taxing P&T on a deemed transaction rather than on the transaction as executed would seem to require a positive finding that P&T structured a sham transaction, or at least one lacking in a bona fide business purpose. There is no indication, however, that the commissioner asserted this or this was the case. In fact, given the type of property involved, and the corporation's apparent objective in availing itself of the limited partnership form to distribute the timber and resort interests, it would seem almost beyond cavil that the transaction was imbued with a legitimate business purpose.

P&T's distribution of partnership units also likely did not run afoul of the "step transaction" doctrine. Under that doctrine, the IRS may ignore intermediate steps in a multistep transaction, most often where the transaction in question lacks economic substance and is motivated by tax avoidance. However, the IRS did not argue that P&T's contribution of the properties into a limited partnership or the subsequent distribution of those units was devoid of economic substance or motivated by an intent to avoid taxes.

The Tax Court's decision is difficult to square with the literal words of the statute. A fair reading of the statute seems to provide little basis for the court's transmutation, for tax purposes, of the distribution of partnership units into a hypothetical sale. The court's resort to interpreting the statute's legislative history appears to have been wholly unwarranted. Assuming that resort to legislative history could somehow be justified, the decision to tax P&T on a deemed sale is still incomprehensible on policy grounds, since the distribution of partnership units was clearly motivated by a valid business purpose and was not devoid of economic substance. *

Editor:

Edwin B. Morris, CPA

Rosenberg, Neuwirth & Kuchner

Contributing Editors:

Richard M. Barth, CPA

Stephen P. Valenti, CPA