## Facts

- Bazley and his wife owned all but one share of a closely held family corporation with 1,000 outstanding $100-par shares and earned surplus of $855,783.82.
- In 1939 the corporation adopted a “plan of reorganization” styled as a recapitalization.
- Each old share was exchanged for five new no-par shares (stated value $60 each) plus corporate debenture bonds; total debentures issued had face value $400,000, payable in ten years and callable at any time.
- Bazley exchanged 798 shares and received 3,990 new shares and debentures with face amount $319,200.
- Bazley claimed the debentures were received in a tax-free reorganization exchange (recapitalization) and therefore produced no recognized gain.
- In a companion case (Adams), a similarly controlled corporation issued debentures proportionally to shareholders in a recapitalization; accounting treatment differed, but shareholders likewise received debentures tied to accumulated earnings.
- The Commissioner treated the debentures as taxable income; the Tax Court sustained the deficiencies, characterizing the transactions as dividend equivalents rather than legitimate reorganizations; courts of appeals affirmed.

## Issues

1. Whether the recapitalizations qualified as tax-free “reorganizations” under the Internal Revenue Code provisions governing recapitalizations and nonrecognition exchanges, so that debentures received were nonrecognition “securities” exchanged solely for stock or securities.
2. Whether, despite formal recapitalization steps, the proportional issuance of debentures to shareholders functioned as a distribution of corporate earnings equivalent to a cash dividend and was therefore taxable income.

## Decision

- The Supreme Court affirmed the judgments sustaining the deficiencies.
- The Court held the transactions were not tax-free reorganizations for nonrecognition purposes.
- The Court held the taxpayers were liable for income tax on the full value of the debentures received, treating the debentures as distributions of earnings in substance.

## Legal Principles

- Reorganization nonrecognition provisions do not exempt from tax a transaction that, as a practical matter, realizes gain through a distribution of corporate earnings.
- A “recapitalization” qualifies for reorganization nonrecognition only if it bears the characteristics that justify deferring tax, rather than merely changing form.
- Creating corporate obligations and transferring them to shareholders pro rata, when it produces substantially the same result as a cash distribution of accumulated earnings, is taxable and does not become immune merely because labeled a recapitalization.
- In evaluating purported reorganizations, courts look to the economic substance; book entries and formal structure do not control when the transaction effectively distributes earnings.

## Conclusion

The Court treated pro rata debenture issuances in closely held corporations, structured as recapitalizations but functioning as distributions of accumulated earnings, as taxable dividend-equivalent income rather than nonrecognition reorganization exchanges.


Bazley v. Comm’r, 331 U.S. 737 (1947)