## Facts

- J. E. Smothers and Doris Smothers wholly owned two closely held corporations: Texas Industrial Laundries of San Antonio, Inc. (TIL) and Industrial Uniform Services, Inc. (IUS).
- TIL operated an industrial uniform rental and laundering business and owned laundry equipment; IUS rented uniforms but outsourced laundering and owned no laundry equipment.
- In 1969, the Smotherses decided to dissolve IUS and, on November 1, 1969, IUS adopted a plan of liquidation intended to comply with I.R.C. § 337.
- On November 30, 1969, IUS sold certain operating assets to TIL for cash at fair market value; the assets were about 15% of IUS’s net worth and were stipulated not to be essential to IUS’s operations.
- After the sale, IUS distributed its remaining assets—primarily cash and accounts receivable—to the Smotherses.
- After IUS dissolved, TIL rehired IUS’s employees and continued serving most or all of IUS’s former customers, effectively continuing IUS’s business.
- The Smotherses reported the distribution as a liquidating distribution under I.R.C. § 331 and reported long-term capital gain.
- The IRS recharacterized the transaction as a Type D reorganization under I.R.C. § 368(a)(1)(D) and treated the shareholder distribution as dividend-equivalent “boot” taxable as ordinary income under I.R.C. § 356.
- The taxpayers paid the deficiency and filed a refund suit; the district court ruled for the government, and the taxpayers appealed.

## Issues

1. Whether IUS’s dissolution, coupled with its asset sale to TIL and TIL’s continuation of IUS’s business, constituted a liquidation taxable under I.R.C. § 331 or a Type D reorganization under I.R.C. § 368(a)(1)(D).
2. Whether the “substantially all the assets” requirement for a Type D reorganization can be satisfied where only a small percentage of balance-sheet assets are transferred but the operating business is effectively continued by the related transferee.
3. If a Type D reorganization occurred, whether the shareholders’ receipt of cash and receivables should be treated as dividend-equivalent ordinary income under I.R.C. § 356 rather than capital gain from liquidation.

## Decision

- The Fifth Circuit affirmed the district court’s judgment for the United States and denied the refund.
- The court held the transaction qualified as a Type D reorganization under I.R.C. § 368(a)(1)(D).
- The court held the shareholder distribution was properly treated under the reorganization provisions as dividend-equivalent “boot” taxable as ordinary income (to the extent of earnings and profits), not as a liquidating distribution producing capital gain.

## Legal Principles

- A transaction may be treated as a Type D reorganization when a corporation transfers “substantially all” of its business to another corporation under common control pursuant to a reorganization plan, even if structured in the form of a liquidation.
- “Substantially all” for § 368(a)(1)(D) can be evaluated qualitatively by focusing on the transfer of the operating business enterprise (including employees, customers, and other intangible value), not solely by a quantitative comparison of asset values.
- Where the acquiring related corporation continues the transferor’s business with continuity of ownership, courts may apply substance-over-form to classify the transaction as a reorganization rather than a liquidation for tax purposes.
- In a qualifying reorganization, shareholder receipts of cash or other property may be taxed under I.R.C. § 356 as dividend-equivalent ordinary income to the extent of the transferor’s earnings and profits.

## Conclusion

Because TIL, owned by the same shareholders, continued IUS’s business by taking over its workforce and customers, the court treated the dissolution and related asset transfer as a Type D reorganization satisfying the “substantially all” requirement in a business-enterprise sense, making the shareholders’ distributions taxable as dividend-equivalent ordinary income rather than capital gain from a liquidation.


Smothers v. United States, 642 F.2d 894 (5th Cir. 1981)