## Facts

- Four related families owned all stock of two corporations: South Texas Rice Warehouse Co. (“Warehouse”) and South Texas Water Co. (“Water”), and also owned a related farming partnership.
- Warehouse operated a rice drying/cleaning/storage business; Water owned ricelands and an irrigation canal system used to support the rice operations associated with Warehouse.
- The shareholders sought a plan to move Warehouse’s business to Water and extract value with capital-gain treatment.
- Shareholders sold all Warehouse stock to a lawyer’s son, Homer Bruce, Jr., who financed the purchase with a bank loan of $914,200 and functioned as an intermediary.
- Water then acquired the Warehouse shares from Bruce and used $700,000 of Water’s earnings and profits to retire a substantial portion of Bruce’s bank loan.
- Warehouse was then liquidated; roughly $230,000 of Warehouse cash (reflecting Warehouse earnings and profits) was used to pay off the remainder of Bruce’s loan.
- The steps occurred in about one hour; Warehouse’s business continued under Water without interruption.
- Shareholders reported their receipts as capital gain from the sale of stock; the IRS recharacterized the proceeds as distributions of corporate earnings and profits taxable as dividends.
- The Tax Court found a corporate reorganization and held that part of the shareholders’ income was taxable as a dividend; the Commissioner cross-appealed seeking a larger dividend amount.

## Issues

1. Whether the integrated steps constituted a corporate reorganization under I.R.C. § 368(a)(1), and if so, whether it qualified as a type D and/or type F reorganization.
2. Whether amounts received by shareholders through the intermediary and loan repayments were properly treated as capital gain from a stock sale or as dividend income (including dividend-equivalent “boot” under I.R.C. § 356(a)(2)).
3. Whether the “substantially all” requirement for a type D reorganization was satisfied where significant cash was distributed/used to retire acquisition debt.

## Decision

- The Fifth Circuit affirmed in part and reversed in part, largely agreeing with the Commissioner.
- The court held the transaction constituted both a type D reorganization and a type F reorganization under § 368(a)(1).
- The court held that $700,000 sourced from Water’s earnings and profits and routed through the steps to the shareholders was taxable as dividend income, not capital gain.
- The court treated the $700,000 either as a dividend separate from the reorganization or, alternatively, as boot in the reorganization taxable as a dividend under § 356(a)(2) to the extent of earnings and profits.
- The court rejected the argument that distributions of cash prevented D reorganization treatment, focusing the “substantially all” inquiry on the transfer of operating assets.

## Legal Principles

- Courts may collapse formally separate steps into one transaction where the steps are part of a prearranged, integrated plan and an intermediary is used to disguise the substance.
- A rapid, intermediary-financed “stock sale” followed immediately by acquisition and liquidation can be treated as a corporate reorganization when ownership control and the operating business effectively continue.
- In a § 368(a)(1)(D) reorganization, “substantially all” primarily concerns the transfer of operating assets; distribution of cash does not necessarily defeat reorganization status.
- Cash extracted from corporate earnings and profits in connection with a reorganization may be treated as a dividend, including as dividend-equivalent boot under § 356(a)(2), rather than as capital gain.

## Conclusion

The Fifth Circuit treated the one-hour, intermediary-based stock sale and liquidation as an integrated D/F reorganization and recharacterized $700,000 funded by corporate earnings and profits as dividend income (or dividend-equivalent boot), increasing ordinary-income treatment beyond the Tax Court’s allocation.


Davant v. Comm’r of Internal Revenue, 366 F.2d 874 (5th Cir. 1966)