## Facts

- Southwest Natural Gas Company acquired all assets of Peoples Gas & Fuel Corporation through a merger carried out under Delaware law.
- Peoples’ shareholders received mixed consideration consisting of Southwest stock, Southwest bonds, cash, and assumption of certain obligations.
- The equity component was minimal; most consideration to Peoples’ shareholders was cash and debt instruments rather than Southwest stock.
- Southwest reported the transaction as a tax-free “reorganization” under Internal Revenue Code of 1939 § 112(g)(1)(A), seeking nonrecognition treatment.
- The Commissioner determined tax deficiencies for 1941–1942, treating the transaction as a taxable sale.
- The Tax Court sustained the deficiencies, concluding the transaction failed the federal “continuity of interest” requirement; Southwest sought review.

## Issues

1. Whether a transaction completed as a statutory merger under state law qualifies as a “reorganization” under I.R.C. § 112(g)(1)(A) without regard to continuity of interest.
2. Whether Peoples’ shareholders retained a sufficient continuing proprietary (equity) interest in the combined enterprise to satisfy the continuity-of-interest requirement for nonrecognition.
3. Whether the transaction should be treated for federal tax purposes as a tax-free reorganization or as a taxable sale producing recognized gain.

## Decision

- The Fifth Circuit affirmed the Tax Court’s decision sustaining the Commissioner’s deficiencies.
- The court held that compliance with state merger statutes does not alone establish a federal tax “reorganization” under § 112(g)(1)(A).
- The court applied the continuity-of-interest doctrine to statutory mergers claimed under § 112(g)(1)(A).
- The court found insufficient continuity of interest because Peoples’ shareholders were largely cashed out or received bonds rather than retaining a substantial equity stake.
- The transaction was properly characterized as a taxable sale rather than a tax-free reorganization.

## Legal Principles

- Federal reorganization treatment under I.R.C. § 112(g) depends on substance, not only the form or label of a state-law merger.
- A “statutory merger or consolidation” within § 112(g)(1)(A) still requires continuity of proprietary interest by the transferor’s shareholders.
- Continuity of interest requires that transferor shareholders receive a substantial equity interest in the continuing enterprise; predominately cash or debt consideration indicates a sale.
- Nonrecognition under § 112 is aimed at transactions that recast continuing ownership interests rather than transactions that liquidate those interests for cash equivalents.

## Conclusion

Because Peoples’ shareholders received primarily cash and bonds and retained only a minimal equity stake in Southwest, the merger lacked continuity of proprietary interest and was taxable as a sale rather than a nonrecognition reorganization under § 112(g)(1)(A).


Sw. Nat. Gas Co. v. Comm’r, 189 F.2d 332 (5th Cir. 1951)