## Facts

- Warsaw Studios, Inc. (Studios) operated a commercial photography business and leased two Manhattan locations; shareholders sought to discontinue a burdensome lease.
- Studios’ common stock was majority-owned by Warsaw & Co., Inc. (owned by J.J. Warsaw), with the remaining common held by 10 individuals; Warsaw & Co. also held all Studios’ preferred stock.
- The 10 individual shareholders formed Warsaw Photographic Associates, Inc. (Photographic), each buying 100 shares (1,000 shares total) for \$10,000; Warsaw & Co. did not own Photographic stock.
- Under a plan, Studios transferred substantially all assets and liabilities to Photographic but retained the burdensome lease.
- Photographic issued 100 additional shares in connection with the transfer, but the shares were issued directly to the 10 individuals (not to Studios) and in proportion to their preexisting Photographic ownership, not their Studios ownership.
- Studios later made an assignment for the benefit of creditors.
- Studios reported a final-year net operating loss (NOL) of \$363,948; Photographic claimed that NOL as a carryover deduction on the theory the transaction was a § 368(a)(1)(D) reorganization with § 381 succession.
- The Commissioner determined deficiencies for Photographic’s fiscal years ending June 30, 1974–1976 and disallowed the claimed NOL carryover.

## Issues

1. Whether Studios’ asset transfer to Photographic qualified as a § 368(a)(1)(D) reorganization, permitting § 381(a)(2) succession to Studios’ NOLs and a carryover basis under § 362.
2. If not a D reorganization, whether Photographic could increase asset bases by the fair market value of the Photographic shares issued in connection with the transfer.
3. Whether legal fees related to the transaction were amortizable as organizational expenditures under § 248 (including whether a valid § 248 election was made).
4. Whether a covenant not to compete was amortizable over its stated six-year term or over the shorter period during which payments were made (31 months).

## Decision

- The court held the transaction did not qualify as a § 368(a)(1)(D) reorganization because the statutory stock-distribution requirement tied to § 354 was not satisfied.
- Photographic was not entitled to succeed to Studios’ NOLs under § 381(a)(2), and the claimed NOL deduction was properly disallowed.
- Photographic was not permitted to step up the bases of acquired assets based on the purported stock issuance connected to the transfer.
- Legal fees attributable to acquiring Studios’ assets were treated as acquisition-related costs, not amortizable organizational expenditures under § 248 on the facts presented.
- The covenant not to compete was amortized over its stated six-year term, not the payment period.

## Legal Principles

- A § 368(a)(1)(D) reorganization requires, among other elements, that stock of the transferee be distributed in a transaction qualifying under § 354, § 355, or § 356; issuing transferee stock directly to transferor shareholders may fail this requirement when the statutory distribution step is not satisfied.
- The “meaningless gesture” concept may excuse literal completion of a stock distribution only where transferor and transferee ownership is identical in identity and proportion; it does not apply when a significant transferor owner is absent from the transferee and ownership percentages differ.
- Where an alleged reorganization fails, § 381 NOL succession and related carryover-basis consequences under § 362 are unavailable.
- Costs incurred to acquire another business’s assets are not organizational expenditures under § 248 merely because they are incurred near formation; characterization depends on their function and the statutory conditions for amortization.
- A covenant not to compete is amortized over the contractual term of the covenant when the agreement specifies a fixed duration, rather than the period over which payments are made.

## Conclusion

The Tax Court denied reorganization treatment because the transaction did not satisfy the statutory stock-distribution requirement and could not be excused as a mere formality given the non-identical ownership between transferor and transferee; as a result, the transferee could not claim the transferor’s NOLs or a basis increase, acquisition-related legal fees were not treated as § 248 organizational expenditures, and the noncompete covenant was amortized over its stated six-year term.


Warsaw Photographic Assocs., Inc. v. Comm’r, 84 T.C. 21 (1985)