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THE BUSINESS PURPOSE DOCTRINE AND CORPORATE
REORGANIZATIONS AND RECAPITALIZATIONS

by

THoMAS N. TARiEAu

*
There is no part of the Internal Revenue Code which deals
with the tax treatment of transactions with more particularity than
do the reorganization provisions. With a high degree of articula-
tion the steps necessary to obtain tax deferment are spelt out.
Nevertheless, statutory interpretation, which frequently, with jus-
tice, can be called judicial legislation, has created a large and shift-
ing body of law outside the terms of the statute. A taxpayer relying
on the use of Section 112 to avoid present tax on a corporate read-
justment may well say with Macbeth:
And be these juggling fiends no more believ'd,
That palter with us in a double sense;
That keep the word of promise to our ear,
And break it to our hope.
During recent years the hopes have been most often shattered by
recourse to the business purpose doctrine.
Despite the fact that the doctrine has its genesis in the Gregory
case,' decided by the Supreme Court almost 15 years ago, no men-
tion is made in the Internal Revenue Code either of tax avoidance
per se or the necessity of a business purpose. The Gregg report,
which is the famous gloss on the Revenue Act of 1924, indicates the
desire, at the time of the consideration of the modern reorganiza-
tion provisions, to permit ordinary business transactions to go
forward without being affected by present taxes. The statute itself,
however, was silent and has remained silent, despite a thorough
* Firm: Partner of Willkie, Owen, Farr, Gallagher & Walton, (New York). Mem-
ber of the New York Bar. Member of various committees on taxation of American
Bar Association and New York State Bar, including Council of Taxation Section of
American Bar Association. Formerly, member of faculty, New York University and
Columbia University.
I Gregory v. Helvering, 293 U.S. 465, 14 AFTR 1191 (1935).
247
248 CORPORATE REORGANIZATIONS
overhauling of the reorganization provisions in 1934, a considera-
tion of tax loopholes in 1937, and frequent amendments to the Sec-
tions in other revenue measures.
If one looks for further light on the doctrine of business purpose
in the Treasury Regulations, one would find that since Regulation
86, issued in 1934, there is required, among other conditions, that
a reorganization (a) must be an ordinary and necessary incident
of the conduct of the enterprise; and (b) must be undertaken for
reasons germane to the continuance of the business of a corpora-
tion, a party to the reorganization. The Treasury Regulations,
which contain conditions and limitations nowhere explicitly men-
tioned in the statute, must find their support, therefore, in judicial
decisions. It should also be pointed out that in 1934, when Congress
re-examined the reorganization provisions, the subcommittee of the
Committee on Ways and Means, which had devoted its time to a
consideration of the problem, recommended the abolition of the
reorganization provisions. It was the Treasury that came to the
taxpayer's rescue and suggested that tax avoidance might be pre-
vented if broad regulatory powers were given to the Treasury. The
full Committee eventually did not follow the suggestions of the
subcommittee, nor did it take too kindly to the Treasury recom-
mendationi, but the Courts came to the rescue with the Gregory
case.
The facts of the Gregory case are so well known that only a
brief mention of them is necessary. In that case the taxpayer owned
all of the stock of the United Mortgage Corporation, which, in
turn, held among its assets the 1,000 shares of the stock of Monitor
Securities Corporation. Wishing to sell the Monitor shares, and yet
unwilling to pay the tax on them as a dividend, if distributed to her
by the United Mortgage Corporation, the taxpayer organized the
Averill Corporation. Three days after its organization, in return
for the transfer to it of all of the Monitor shares, Averill issued all
of its stock to the taxpayer. Three days after that, Averill was dis-
solved and the Monitor shares were received by the taxpayer as a
liquidating dividend and then sold. It was found that Averill never
transacted any business and was never intended to perform any
transaction except to convey the Monitor shares to the taxpayer.
The Tax Court-then the Board of Tax Appeals-held to the literal
language of the statute and decided that the so-called reorganiza-
tion was tax-free, saying, "A statute so meticulously drafted must
 CORPORATE REORGANIZATIONS 249
be interpreted as a literal expression of the taxing policy, and leaves
only the small interstices for judicial consideration. . . ."
Judge Learned Hand wrote the opinion for the Second Circuit
Court of Appeals which reversed the Board.2 This opinion started
out by saying that the Circuit Court agreed with the Board and
the taxpayer that "a transaction, otherwise within an exception of
the tax law, does not lose its immunity because it is actuated by a
desire to avoid, or if one choose, to evade, taxation." This state-
ment was, however, largely what Randolph Paul so aptly terms
" 'mandarin courtesy' toward old dogma. . . ." Judge Hand then
went on to say
"Nevertheless, it does not follow that Congress meant to
cover such a transaction, not even though the facts answer
the dictionary definitions of each term used in the statutory
definition. It is quite true, as the Board has very well said,
that as the articulation of a statute increases, the room for
interpretation must contract; but the meaning of a sentence
may be more than that of the separate words, as a melody
is more than the notes, and no degree of particularity can
ever obviate recourse to the setting in which all appear, and
which all collectively create. The purpose of the section is
plain enough; men engaged in enterprises-industrial, com-
mercial, financial, or any other-might wish to consolidate,
or divide, to add to, or subtract from, their holdings. Such
transactions were not to be considered as 'realizing' any
profit, because the collective interests still remained in solu-
tion. But the underlying presupposition is plain that the
readjustment shall be undertaken for reasons germane to the
conduct of the venture in hand, not as -an ephemeral inci-
dent, egregious to its prosecution. To dodge the shareholders'
taxes is not one of the transactions contemplated as corpo-
rate 'reorganizations.'
"

The Supreme Court, in affirming the decision of the Second

Circuit Court of Appeals, reiterated that if a reorganization in
reality was effected, the ulterior purpose of the taxpayer will be
disregarded, but it found that there was no corporate reorganiza-
tion since the whole undertaking was merely an elaborate and
devious form of conveyance masquerading as a corporate reorgani-

269 F.2d 809, 13 AFTR 806 (1934).

250 CORPORATE REORGANIZATIONS
tion. It characterized the whole series of transactions as "an opera-
tion having no business or corporate purpose. . . ."
The Gregory case has been widely cited on the business purpose
point, but the language of the decision and the extent to which the
language would apply to facts other than those presented to the
Court has led to a vast amount of argument. The business purpose
doctrine thus enunciated for the first time in the Gregory case has
gradually proliferated through all parts of the statute and is now
being mentioned in sections as widely different from the reorgani-
zation sections as Section 102. After the decision of the Court in
the Gregory case the Courts have attempted to spell out in more
detail the precise meaning of the business purpose doctrine. It may
be advisable to consider the development of the doctrine up to the
time of the decision of the Supreme Court in the Adams and Baz-
ley cases.
Soon after the decision in the Gregory case the Second Circuit
Court of Appeals in the Chisholm case 3 had occasion to re-examine
the business purpose doctrine. Judge Learned Hand pointed out
that the Supreme Court was "solicitous to reaffirm the doctrine
that a man's motive to avoid taxation will not establish his liability
if the transaction does not do so without it." He went on to say
"The question always is whether the transaction under
scrutiny is in fact what it appears to be in form; a marriage
may be a joke; a contract may be intended only to deceive
others; an agreement may have a collateral defeasance. In
such cases the transaction as a whole is different from its
appearance. True, it is always the intent that controls; and
we need not for this occasion press the difference between
intent and purpose. We may assume that purpose may be
the touchstone, but the purpose which counts is one which
defeats or contradicts the apparent transaction, not the pur-
pose to escape taxation which the apparent, but not the
whole, transaction would realize."
Judge Hand then went on to state that if, in the Gregory case, the
Averill Corporation had continued in existence, the incorporators
would have escaped the tax, saying, "they would have escaped
whatever other aim they might have had, whether to avoid taxes,
or to regenerate the world." The doctrine that tax immunity is not
3
Chisholm v. Comm., 79 F2d 14, 16 AFTR 585 (1935).
 CORPORATE REORGANIZATIONS 251
lost by the presence of a tax avoidance desire is thus tied up with
the doctrine that a business purpose is present if the corporate
reorganization results in a corporation that continues business. In
other words, if the new corporation or corporations created by the
plan of reorganization have a sufficient vitality to continue actively
in corporate business, then the corporate business purpose is justi-
fied and the transaction is not to be considered merely an unreality.
Corporate reorganizations which were consummated solely for
the purpose of obtaining a saving in corporation taxes, through
means of an interest deduction obtained through an exchange of
new bonds for old stock, were held to be not in violation of the
business purpose doctrine in such cases as Annis Furs, Inc.4 Where
the corporations continued in existence, corporate reorganizations
were held to be good even though the only purpose of the corporate
reorganization was to enable some stockholders to get one type of
stock interest and other stockholders to receive another." Another
case where a corporate reorganization was recognized, though it
was for the purpose of giving their stockholders more readily mar-
ketable securities, was the Bass case."
In recent years further question has arisen as to whether the
business purpose doctrine requires that there be a "corporate busi-
ness purpose" as distinguished from the business purpose of the
shareholders. This expression, "business purpose of the corpora-
tion," originated in Judge Harron's opinion in the Humko Com-
pany case.7 In that case Judge Harron said
"the arrangement was for the purpose of giving each stock-
holder some independent means outside of their proprietory
interest in petitioner as evidenced from stock ownership. If
that was the purpose, it does not aid petitioner. It has been
said frequently that arrangements to suit the personal con-
venience of shareholders cannot be held to relate to the
business and business purposes of a Corporation, where no
business purpose to the Corporation is served."
This doctrine of business purpose of the corporation was re-
iterated in the Wellhouse case,8 where the Court said
4 2 T.C. 1096 (1943).
5 Elmer W. Hartzell, 40 B.T.A. 492 (1939).
6 Edith B. Bass, 45 B.TA. 1117 (1941), rev's'd. 129 F.2d 300, 29 AFTR 819 (C.C.A.
1st, 1942).
7 The Humko Co., 2 T.C. Memo. 1121 (1943).
8 Louis Wellhouse, Jr., 3 T.C. 363 (1944).
252 CORPORATE REORGANIZATIONS
"Under the well-crystallized doctrine of Gregory v. Helver-
ing, 293 U.S. 465 [14 AFTR 1191], there must be corporate
business purpose in the transaction."
In the Wellhouse case the reorganization involved was a recapitali-
zation, where the preferred and common stock was issued for old
common for the purpose of enabling stockholders to pay off their
debt.
The Adams and Bazley cases, which followed the Wellhouse
case, are so well known that I shall try to be brief in my reference
to their facts. In the Bazley case the taxpayers, husband and wife,
owned all but one share of the 1,000 shares of common stock out-
standing. The corporation had an earned surplus at the time of the
recapitalization of about $850,000. Under the recapitalization plan
the holders of the common stock were to receive in place of the
1,000 old shares, 5,000 shares of new common and $400,000 prin-
cipal amount of 6 per cent debenture bonds. The bonds were call-
able in whole or in part and had a term of 20 years. The reason
given in the Bazley case for the transaction involving the issuance
of the additional common stock and debenture bonds was that the
original shareholders, by obtaining debenture bonds for their stock-
holdings, would receive a security which was much less fluctuating
and more readily marketable than their own common stock, par-
ticularly in case it was necessary for a deceased shareholder's estate
to liquidate his investment in the corporation in order to meet
inheritance taxes or for other purposes. Moreover, if it became
necessary to sell some portion of their investment in the corpora-
tion, the debenture bonds could be sold without reducing the Baz-
ley family stock control of the corporation. Finally, it was said that
a contemplated entry into a risky road-building contract made it
desirable to put the original stockholders in possession of bonds
which would place them in a position of sharing with creditors to
the extent of the debenture issue.
In the Adams case the taxpayer was the president and principal
stockholder of the Newark Theatre Building Corporation. He
owned 5,903 shares out of a total of 5,914 shares issued and out-
standing. Petitioner and his brother were originally engaged in
business together and at one time both individuals had guaranteed
the indebtedness of the Newark Theatre Building Corporation
which was secured by a mortgage on its property. Subsequently,
when the petitioner became the principal stockholder of the New-
 CORPORATE REORGANIZATIONS 253
ark Corporation, his brother repeatedly demanded that he be re-
lieved of liability on the indebtedness. The Prudential Insurance
Company, which held the mortgage, declined to release the brother,
and the taxpayer foresaw the necessity of making other financial
arrangements when the Prudential mortgage matured. Under a
plan of reorganization which was adopted by the corporation,
petitioner surrendered his 5,903 shares of $100 par value stock and
received for each share one share of no par stock and one $50 de-
benture bond. The surplus account of the corporation was not
affected. The earnings and profits of the corporation available for
dividends at the time of the recapitalization were about $165,000.
The reasons given, according to the Tax Court case, for the re-
capitalization and the issuance of bonds was (1) a belief that the
existence of the debenture bonds available for use as collateral
would facilitate the refinancing of the corporation's mortgage in-
debtedness then impending; (2) taxpayer had a desire to give some
securities of the corporation to his two sons who were associated
with him in the business of the corporation without surrendering
any of his stock control over the company (he did give them about
16 per cent of his debenture bonds); (3) the recapitalization per-
mitted the saving of corporate income taxes resulting from the
right of the corporation to deduct interest paid on the bonds;
finally, (4) a saving of the New Jersey franchise tax resulted from
the decrease in the amount of stock.
The Tax Court, in the Bazley case,9 held that though there was
a technical recapitalization, formal compliance was not sufficient
to make it a tax-free reorganization. It felt that the real issue was
whether it had been satisfactorily established that there was a true
business purpose for the operation by which new stocks and bonds
were issued for the old stock. It found no legitimate corporate
business purpose but merely a desire to create a more desirable
type of security for the stockholders. Such a desire is not sufficient
to show a legitimate corporate purpose within the doctrine of
Gregory v. Helvering. It can be seen that the Tax Court was fol-
lowing the same approach with respect to corporate business pur-
pose as it did in the Wellhouse case.
In the Adams case ' 0 the decision was substantially similar. The
reasons given to support a corporate purpose were held to be in-
9 Bazley, 4 T.C. 897 (1945).
10 Adams, 5 T.C. 351 (1945).
254 CORPORATE REORGANIZATIONS
sufficient and the Conmissioner's determination that the amount
of distributed bonds constituted a dividend was upheld.
The Third Circuit Court of Appeals sustained the action of the
Commissioner in both of these cases, holding that the bonds dis-
tributed were substantially equivalent to distributions of taxable
dividends. In the Bazley case," the Circuit Court affirmed, relying
largely on the absence of a substantial business purpose. In the
Adams case 12 the Tax Court was affirmed on the basis of the con-
clusion reached in the Bazley case and with some reliance on the
doctrine in Dobson.13
The Supreme Court granted certiorari in these cases and held
them for a considerable time after argument before rendering a
decision.
The Adams and Bazley cases were covered in a single opinion
by Mr. Justice Frankfurter.1 4 In considering, in his opinion, the
nature of a recapitalization, Justice Frankfurter stated that the
Treasury Regulations shed only limited light on what the term
means. He said, however, one thing is certain,
"Congress did not incorporate some technical concept,
whether that of accountants or of other specialists, into Sec-
tion 112(g), assuming that there is agreement among spe-
cialists as to the meaning of recapitalization."
He then went on to say that as used in Section 112(g), defining
corporate reorganizations, the term must draw its meaning from
its use in that Section. It must be construed as he says with refer-
ence "to the presuppositions and purposes of Section 11 2 (g)." In
discussing the purpose of Section 11 2 (g) the opinion goes on to say
that it was
"not the purpose of the reorganization provision to exempt
from payment of a tax what as a practical matter is realized
gain. . . . But there are circumstances where a formal dis-
tribution, directly or through exchange of securities, repre-
sents merely a new form of the previous participation in an
enterprise, involving no change of substance in the rights
and relations of the interested parties one to another or to
the corporate assets. As to these, Congress has said that they
1x 155 F2d 237, 34 AFTR 1318 (1946).
155 F2d 246, 34 AFTR 1327 (1946).
1a Dobson v. Comm., 320 U.S. 489, 31 AFTR 773 (1943).
'1 331 US. 737, 35 AFTR 1190 (1947).
 CORPORATE REORGANIZATIONS 255
are not to be deemed significant occasions for determining
taxable gain."
From this language it seems almost necessary to draw the conclu-
sion that if there is a change of substance in the rights and rela-
tions of the interested parties to the corporate assets, no reorgani-
zation within the meaning of the statute has been effected. It is
interesting to compare this language with that of the opinion of
the majority in Helvering v. Minnesota Tea Company," at 386,
where it is stated, in considering the reorganization thereunder
granted, "True it is that the relationship of the taxpayer to the
assets conveyed was substantially changed, but this is not inhibited
by the statute." The Court, in the Adams and Bazley cases, then
said that Congress did not attempt the definition of recapitaliza-
tion and that it would not attempt to do so, but the meaning of the
term could be built up by a recognition of what does not come
within the concept. One thing that does not come within the con-
cept of recapitalization is anything which does not partake of the
characteristics of a reorganization which underlie the purposes of
Congress in postponing tax liability.
Up to this point, in the pinion, the Court, without expressly
saying so, seems to be implying that what is necessary is the busi-
ness purpose test which was considered by the Circuit Court and
the Tax Court. However, in the latter part of the opinion, in dis-
cussing the case in detail, the Court said that though there was, in
a sense, a recapitalization of the Bazley corporation in that "the
symbols that represented its capital were changed, so that the fiscal
basis of its operations would appear very differently on its books,"
the form of the transaction is not controlling. It then uses signifi-
cant language, saying
"In the case of a corporation which has undistributed
earnings, the creation of new corporate obligations which
are transferred to stockholders in relation to their former
holdings, so as to produce, for all practical purposes, the
same result as a distribution of cash earnings of equivalent
value, cannot obtain tax immunity because cast in the form
of a recapitalization-reorganization. The governing legal
rule can hardly be stated more narrowly. To attempt to do
so would only challenge astuteness in evading it."

15 Helvering v. Minnesota Tea Co., 296 US. 378, 16 AFTR 1258 (1935).
256 CORPORATE REORGANIZATIONS
There are several things to notice about this statement of
Justice Frankfurter. In the first place, the statement deals with
corporate obligations that are the equivalent of cash. In the second
place, the statement makes no mention of business purpose but
rather seems to deal with the so-called "effect" test familiar to
Section 115(g) cases.
The silence of the Supreme Court in the Adams and Bazley
cases with respect to the business purpose test becomes even more
significant when one has been furnished with a transcript of the
oral argument presented in the Bazley case. The transcript dis-
closes very clearly that the matter of corporate business purpose
was thoroughly argued and discussed at considerable length by
government counsel, taxpayer counsel, and the Bench. Government
counsel stated very clearly that it was his position in the argu-
ment that the reorganization provisions are limited to transactions
which facilitate the corporate business. Consequently, the complete
silence of the Court at this point certainly would seem to indicate
that it does not care to approve the doctrine. It did not even pass
upon the applicability of the Treasury Regulations and the busi-
ness purpose test there prescribed, but only said that the regula-
tions "shed only limited light." Moreover, in approving the results
reached by the Tax Court and the Circuit Court of Appeals, the
Supreme Court stated that it could find no misconception of law,
saying,
"and since we can find no misconception of law on the part
of the Tax Court and the Circuit Court of Appeals, what-
ever may have been their choice of phrasing, the applica-
tion of the laws to the facts of this case must stand."
This seems to be a left-handed way of disapproving the reasoning
of the lower courts.
Since the decision in the Adams and Bazley cases, the distinc-
tion between a corporate business purpose and the business purpose
of the stockholders has come into play in several cases in the Cir-
cuit Court of Appeals.
In the Heady case 16 the founder of the corporation owned 888
shares of 1,000 no par common stock. He was killed in an accident
in December, 1938. His will directed that the stock be held no
longer than necessary for its sale; he did not desire that the estate

16 Heady v. Comm., 162 F.2d 699, 35 AFTR 1551 (C.C.A. 7th, 1947).
 CORPORATE REORGANIZATIONS 257
continue to run his business. The Court directed his executor to
offer the stock for sale; the bids received were far below the fair
book value of the stock; and the Court ordered the executor to
hold the stock and continue to run the company until further
order. But the business was of the type that depended for its
success primarily upon the particular experience and skill of the
manager. The most desirable manager that the executor could
locate refused to take the position without the right to buy an
interest in the corporation over a period of time. The corporation
reorganized in June, 1939, issuing new common of lower par value,
and debentures, all of which were issued to the decedent's estate.
The Tax Court found "no corporate business purpose" in the re-
organization, and upheld the Commissioner's assessments of a tax
on the exchange of the securities.
The Circuit Court of Appeals, in sustaining the Tax Court,
mentioned that the'Tax Court had found an absence of corporate
business purpose. The opinion, however, after discussing the tax-
payer's argument that the Tax Court had unduly extended the
scope of the Gregory decision in applying it to the given case,
seemed to rely more on the "effect test" as indicated by the Su-
preme Court in the Adams and Bazley cases.
In the Survaunt case 17 two shareholders, Survaunt and Hart-
well, owned all of the stock of National Typesetting Company
equally. Survaunt died in July, 1940, at a time when both he and
Hartwell had outstanding personal notes amounting to approxi-
mately $30,000 which were past due and unpaid. The holders of
the notes were insisting upon payment and Survaunt's executrix,
his widow, could not pay them, for the estate assets consisted
almost entirely of Survaunt's stock in National Typesetting Com-
pany. Missouri law would not permit the company to assume the
liability of the notes, so it was decided that National Typesetting
Company be dissolved. National Typesetting Company did dis-
solve on December 30, 1940 and National Typesetting Corporation
was organized to commence business on December 21, 1940. Na-
tional Typesetting Corporation received all the equipment and
other assets previously owned by National Typesetting Company.
On its organization it issued its new stock, plus a corporate note,
which was endorsed over to the creditors. The Commissioner in-
sisted (1) that this entire transaction was a reorganization within
1 Survaunt v. Comm., 162 F.2d 753, 35 AFTR 1557 (C.C.A. 8th, 1947).
258 CORPORATE REORGANIZATIONS
the terms of the Internal Revenue Code, and, therefore, that
Survaunt's estate and Hartwell could not claim the loss incurred
in the initial alleged liquidation; and (2) that National Type-
setting Corporation, in valuing its assets, would have to use the
old basis of National Typesetting Company. The Tax Court up-
held the Commissioner and the Eighth Circuit affirmed. In the
course of its opinion, the Court said
"We think the petitioners fail correctly to interpret the
opinion of the Supreme Court in the Gregory case. The
opinion carefully points out that the character of a reorgani-
zation proceeding under Section 112(g) depends not upon
the motive of the stockholders but upon 'what was done.'
The plan of reorganization must comprehend, and the new
corporation created, must, when consummated, carry on in
whole or in part the corporate business of the old corpora-
tion. The motive of the stockholders is immaterial, if a
reorganizationof the corporate business is, in fact, accom-
plished. In the Gregory case the new corporation did not
comply with these requirements of the statute. It never
transacted any business connected with or related to the
business enterprise carried on by the old corporation. In the
present cases the situation was entirely different. The new
Corporation here not only took title to the assets of the old
Company, it continued to carry on the same identical corpo-
rate business which had been operated by the Company
since its organization in 1927. It would in fact be difficult to
conceive the reorganization of a corporation in which the
stockholders did not have some 'personal reason' for effect-
ing a change in the corporate affairs." (Author's italics.)
The opinion in the Survaunt case indicates that, so far as the
Eighth Circuit Court of Appeals is concerned, the corporate busi-
ness purpose doctrine is invalid and apparently the test to be used
is "the continuance of the business," which was relied on in so
many cases prior to the Adams and Bazley cases.
The most recent pronouncements on the doctrine are found in
the several Lewis cases decided by the Tax Court and the Fifth
Circuit Court of Appeals. In the Lewis cases, similar to the Sur-
vaunt case, the taxpayer argued the absence of a corporate business
purpose to justify his position that the transaction was not a re-
 CORPORATE REORGANIZATIONS 259
organization. Briefly stated, the facts were that the taxpayer was a
stockholder of a corporation which took part of its assets and
segregated them into a new corporation in exchange for all of the
stock of the new corporation. The old corporation then liquidated
and the taxpayer received stock of the new corporation and other
assets of the old corporation in liquidation. The taxpayer treated
the transaction as an ordinary liquidation and reported gain as on
the receipt of a liquidating dividend. The Commissioner took the
position that a reorganization was involved and that the boot
received was to be taxed as an ordinary dividend. The Fifth Circuit
Court of Appeals, in its decision in Lewis, et al. Trustees 18 stated
that the taxpayer's chief argument was directly to the point that
there was an absence of the necessary "business purpose" laid down
by Gregory v. Helvering. It then went on to say:
"The 'business purpose' requirement for Section 112(g)
reorganizations has often been used to defeat taxpayer con-
tentions for postponement of taxes under the tax-free ex-
change provisions of Section 112(b). See Electrical Securi-
ties Corp. v. Commissioner, 92 F.2d 593 [20 AFTR 279]
(C.C.A. 2d, 1937); Helvering v. Elkhorn Coal Co., 95 F.2d
752 [20 AFTR 1308] (C.C.A. 4th, 1938); cert. den., 305
U.S. 605 (1938). Ordinarily, as in the Gregory case, the use
of the transferee company to avoid taxes and its immediate
dissolution are sufficient to indicate that the transaction
was not 'required by business exigencies,' was not a 'neces-
sary incident of the conduct of the enterprise,' and was not
undertaken for 'reasons germane to the continuance of the
business.' But immediate dissolution of the transferee corpo-
ration does not necessarily indicate a Gregory situation if
there were business reasons for its creation. Lea v. Commis-
sioner, 96 F.2d 55 [21 AFTR 85] (C.C.A. 2d, 1938). Usually,
however, the continuance of the business in the hands of the
transferee (or by a reorganized company in the case of a
recapitalization) is deemed sufficient indication of the re-
quired 'business purpose' and the Treasury Regulations
quoted above list this as a requirement for the statutory
reorganization. On the other hand, the court in the Electri-
cal case applied the Gregory doctrine where the existence of
the transferor was ephemeral despite continuation of the
18 Lewis et al. Trustees v. Comm., 160 F.2d 839, 35 AFTR 1057 (C.C.A. 5th, 1947).
260 CORPORATE REORGANIZATIONS
business by the transferee. But the immediate liquidation
and dissolution of the transferor is frequently part of the
plan of reorganization and does not prevent the reorganiza-
tion from being within the statute if the transaction con-
forms to the statutory definition and 'business purpose' is
found. See Commissioner v. Whitaker, 101 F.2d 640 [22
AFTR 500] (C.C.A. 1st, 1938); Helvering v. Schoellkopf,
100 F.2d 415 [22 AFTR 121] (C.C.A. 2d, 1938); Gross v.
Commissioner, 88 F.2d 567 [19 AFTR 158] (C.C.A. 5th,
1937). It can therefore be readily observed that the 'business
purpose' requirement is not necessarily satisfied by a finding
that the purpose of the exchange was the continuation of
the business in the hands of the transferee since every de-
cision depends on the particular facts in each case."
The opinion was, therefore, remanded to the Tax Court for a
determination of whether or not the requisite business purpose was
present.
In its second determination, reported in Estate of John B.
Lewis,1 9 the findings of the Tax Court, in discussing the purposes
of the stockholders, contain the following:
"When the Hercules Powder Co. refused to buy the
entire business, the petitioners, who were stockholders and
directors of the old company, decided to continue the opera-
tion of the chemical manufacturing business until such time
as that branch of the business could be sold for a fair price.
However, they did not want to leave a large amount of
unneeded capital, comprising cash and other liquid assets,
at the risk of the operating business. They also wanted to
take out these liquid assets in such a way as to incur the
minimum tax. Advice of counsel was sought in the matter.
They hoped that by organizing a new company and trans-
ferring the operating assets to it, they could put themselves
in a position where, by dissolving and liquidating the old
company and distributing its assets, they could get the
liquid assets in their hands and incur only a capital gains
tax. So they decided upon this plan."
It thus appears that the business purposes here involved were
clearly those of the stockholders.
1o 10 T.C. 137 (1948).
 CORPORATE REORGANIZATIONS 261
In its opinion, the Court pointed out the fallacy of the distinc-
tion between a corporate business purpose and a business purpose
of the stockholders. The Court said:
"Besides, we think the petitioners misconceive the law
in arguing that the new company was organized solely for
the convenience of the stockholders, and, hence, there was
no advantage to either corporation and therefore no statu-
tory reorganization. In almost every instance, corporations
are organized for the convenience of the stockholders in con-
ducting business. Such is the purpose of their existence. To
say that a corporation, as such, can have motives and pur-
poses apart from its stockholders, the collective group of
individuals who own it, is to indulge in metaphysical reason-
ing which has no proper place in such practical matters as
taxation. And to say that what is advantageous to the stock-
holders collectively in the conduct of the enterprise is of no
advantage to the corporation, is utterly unrealistic. In the
Survaunt case, supra, the District Court observed that it
would be 'difficult to conceive the reorganization of a corpo-
ration in which the stockholders did not have some 'personal
reason' for effecting a change in the corporate affairs. . .

.
We have no doubt that the petitioners' desire to take a sub-
stantial part of their investment out of the business in such
a way as to incur the least amount of tax largely influenced
the choice of the particular plan which was adopted and
carried out. Obviously, they thought that the result of the
course determined upon would be that they would have to
pay only a capital gains tax, and that they would avoid
dividend tax or the tax incident to a partial liquidation.
Does this mean, then, as the petitioners argue, that there
was no business purpose in what was done-no business pur-
pose in organizing the new company to carry on the busi-
ness? We think it clearly does not. Certainly the Gregory
case did not turn upon the motive of the stockholder. The
Supreme Court said that 'the question for determination is
whether what was done, apart from the tax motive, was the
thing which the statute intended.' It seems to us this funda-
mental test is reiterated in the Supreme Court's latest ex-
pression on the subject of reorganizations, Bazley v. Com-
missioner, 331 U.S. 737 [35 AFTR 1190] (1947). There the
262 CORPORATE REORGANIZATIONS
Supreme Court expressed no approval of the distinction
which the lower courts [the Tax Court and the Third Cir-
cuit Court of Appeals] had attempted to draw between
stockholder business purposes and corporate business pur-
poses. In substance, it said that the lower courts had reached
the right result, 'whatever may have been their choice of
phrasing.' The only mention of 'business purpose' in the
entire opinion is in the resum6 of the Tax Court's findings.
In the light of the Bazley opinion and in that of Gregory,
the important inquiry is, not so much as to the motives and
purposes of the stockholders or the corporation, but as to
the effect of what was done. Was the thing done the kind of
transaction with which Section 112(g) 'in its purpose and
particulars, concerns itself'? Here, we are of the opinion
that the transfer of operating assets from the old company
to the new, so that the new company might carry on the
business, was that kind of transaction."
The Lewis case has recently (September 7, 1948) been appealed to
the Circuit Court of Appeals. 2 0 On the same day that the Lewis
case was decided on remand, the Tax Court promulgated Estate of
Elise W. Hill.2 1 By this case, the Tax Court put another nail into
the coffin of the "corporate business purpose" doctrine.
In 1936, Elise W. Hill was a stockholder in Timber Securities
Co. (hereinafter called Timber), a family personal holding com-
pany with a portfolio of about $35,000,000 of investments. With
the advent of personal holding company surtaxes, the three Weyer-
haeuser brothers who managed Timber felt that it would be unwise
to continue with so large a portfolio of investments. Approximately
56 per cent of the assets of Timber, which produced about 90 per
cent of its income, were of a kind easily divisible and distributable
pro rata to the stockholders. It was therefore decided to transfer
the remaining 44 per cent of Timber's assets to Bonners Ferry
Lumber Co. (hereinafter called Bonners) in exchange for all of
Bonners' stock and to liquidate Timber and distribute its assets,
together with Bonners' stock, to the Timber stockholders. This
plan was adopted and carried out in October, 1936. Bonners there-
after continued to manage the assets transferred to it, and made

20 P-H Fed. Tax Serv., 1948 ¶ 71,112.

21 10 T.C. 138 (1948).
 CORPORATE REORGANIZATIONS 263
new acquisitions and investments and reinvestments. It is still a
personal holding company.
In seeking to have the gain on the distribution of Timber's
assets to the stockholders taxed at capital gains rates as a distri-
bution in complete liquidation under Section 115(c) of the Rev-
enue Act of 1936, the taxpayer contended that there was no busi-
ness purpose to support a reorganization under Section 112(g).
In denying the taxpayer's contention, the Tax Court said,
"Moreover, the transaction was brought about largely
because of a change in the tax laws which adversely affected
personal holding companies. The result of the plan which
was adopted and carried out was that the readily divisible
assets, which produced about 90 per cent of Timber's income,
were taken out of the business and divided pro rata among
the stockholders, thereby relieving the income produced by
those assets from the burden of personal holding company
surtax. It is difficult to find any lack of sound business pru-
dence in such a transaction. As for the other assets which
were not readily divisible, the parties in interest no doubt
determined that the advantages to be derived from contin-
ued corporate management of those assets outweighed the
disadvantage of personal holding company surtax on the
income which such assets produced. In any event, however,
the motive behind the transaction is not determinative, but
the inquiry, rather, is as to whether what was done is the
type of thing with which the reorganization provisions of
the statute were concerned. Gregory v. Helvering, 293 U.S.
465 [14 AFTR 1191]; cf. Bazley v. Commissioner, 331 U.S.
737 [35 AFTR 1190]. . .
.

Little need be added to what we have said in Estate of

John B. Lewis, 10 T. C. 137, decided this day, on the ques-
tion as to whether there is a statutory reorganization in the
type of .situation here involved. The facts in that case are
quite similar to those here."
It is interesting to note that the ordering of one's affairs so as
to prevent the burden of certain taxes on the company was -con-
sidered to be an act of "sound business prudence."
In the course of its opinion in the Hill case, the Tax Court dis-
tinguished another recent case, 22 that of the Standard Realization
22 10 T.C. 94 (1948).
264 CORPORATE REORGANIZATIONS
Co. In this case, the Standard Rice Co. distributed cash and un-
divided interests in three mills as a liquidating dividend to its
shareholders. They immediately exchanged the cash and mills for
all shares of the taxpayer, a corporation organized for the sole pur-
pose of selling the mills. The taxpayer sold the mills within a few
months to purchasers who had never negotiated with the Standard
Rice Co. The taxpayer was thereafter liquidated and dissolved.
In its income tax returns the taxpayer reported the cost of the mills
to it from the Standard Rice Co. at the same figures as the selling
prices of the mills to the purchasers. Thus no gains were reported.
Under the view that the taxpayer had acquired the property in a
reorganization as defined in Section 112 (g) (1) (D) of the Code,
the Commissioner determined that the taxpayer had received a
long term capital gain on the sale of each mill.
In holding that there was no reorganization within the mean-
ing of Section 112 (g) (1) (D), the Tax Court said:
"It is thus apparent that, even though Rice did transfer
the mills to petitioner, channeling them through its share-
holders, and even though Rice's shareholders were immedi-
ately thereafter in control of the transferee, as contemplated
by Section 112 (g) (1) (D), no business was reorganized or
continued thereby and no business was ever intended. But
to warrant an application of Section 112 (g) (1) (D), it
must appear that there was a transfer to petitioner: . .

.
made 'in pursuance of a plan of reorganization . . . of cor-
porate business'; and not as a transfer of assets by one cor-
poration to another in pursuance of a plan having no rela-
tion to the business of either . . .' (Gregory v. Helvering,
supra). As held by the Supreme Court in the Gregory case,
the liquidation of a part of the transferor's assets by the
transferee is not such a purpose. It is true that petitioner
sold assets and distributed the proceeds to its shareholders,
while in the Gregory case the transferee merely distributed
the assets in kind. Yet the sole object of the transfer in each
case: 'was the consummation of a preconceived plan, not to
reorganize a business or any part of a business but to trans-
fer (assets). . . .'
"

As pointed out above, StandardRealization Co., supra, was dis-

tinguished in Estate of Elise W. Hill, supra. In the latter case, the
Tax Court said,
 CORPORATE REORGANIZATIONS 265
"Unlike the new companies in George D. Graham, 37
B.T.A. 623, and StandardRealization Co., 10 T. C. 94 (April
29, 1948), Bonners was not availed of merely to complete
the orderly liquidation of the assets transferred to it. It has
continued to carry on a part of the business which Timber
formerly conducted. It has acquired and disposed of new
securities and made reinvestments. Under these circum-
stances, we think it may not be said that there was no
business purpose in the transaction."
As a result of these latest cases the Tax Court apparently com-
pletely disavowed the corporate business purpose doctrine first
enunciated by Judge Harron in the Humko Company case. It is
interesting to note that there is no mention made in either the
Lewis case or the Hill case of the Tax Court's responsibility for the
birth of the doctrine.
As a result of the recent history of the business purpose doctrine
there is a question as to whether it has much vitality left. The very
vagueness of the term and the uncertainty as to its content makes
it difficult to determine whether the Tax Court, after the Lewis
and the Hill cases, adheres to the doctrine at all. To the extent
that the term means the business purpose to the corporation, its
unrealistic character is bound to render it difficult of application.
As was so well pointed out by Judge Goodrich in his dissenting
opinion in the Bazley case, a corporation is merely a device that
shareholders use to carry on their business as a group, and conse-
quently it is, as a practical matter in many transactions, impossible
to separate a shareholder's interest from a corporate interest. In
his dissenting opinion, Judge Goodrich concluded by saying
"Suppose a case in which the common shareholders arrange
. for the reclassification of a part of their holdings as non-
voting stock in order that they may sell it or give it away
without endangering their voting control. This would be a
perfectly proper business purpose of the stockholders involv-
ing not a trace of tax avoidance but it would not benefit the
business of the corporation as such. We do not think that
there is any authority for the proposition that such a recapi-
talization would not be within both the letter and the spirit
of Section 112."
266 CORPORATE REORGANIZATIONS
This dissenting opinion went unheeded but certainly it is very per-
suasive. Any requirement of business purpose to the corporation as
necessary to obtain a tax-free readjustment under Section 112
would freeze existing corporate structures and prevent stockholders
from so arranging their affairs that they can split up or otherwise
alter their present stock interest. It seems essential to the proper
use of the corporate device that shareholders be permitted to split
up or rearrange their old stock interest so that, if they wish to sell
part of their interest, it is in form acceptable to the market. Market
conditions vary from time to time. Whereas in boom times common
stock may be sold, at other times the market pattern demands pre-
ferred stock or convertible preferred stock. Whether a corporation
is closely held or whether it is a publicly owned company, the
stockholder should have the right to split his investment into a
convenient form in order to sell, without incurring more liability
than the capital gains tax realized on the sale.
It is easy to criticize the business purpose doctrine. More diffi-
cult is the task of determining whether there is a need for such a
doctrine. A striking example of why it is not so simple to discard
it is involved in a consideration of tax-free corporate recapitaliza-
tions. From the very inception of the reorganization provisions of
1921, the definition of reorganization included within its terms a
corporate "recapitalization." The statute itself unfortunately fur-
nishes no definition of the term "recapitalization," and for more
than 20 years little light was thrown on its meaning either by
Treasury Regulations, or rulings, or by Court decisions.
Prior to the decisions of the Supreme Court in Koshland v.
Helvering,28 and in Helvering v. Gowran,2 4 all stock dividends were
assumed to be immune from tax, and the relationship of corporate
recapitalizations to stock dividends did not come to the fore. Of
these cases, however, the previous immunity of all stock dividends
from tax was lost. The question then arose whether the recapitali-
zation provisions could be used to accomplish the same purpose as
a taxable stock dividend without the incurring of a present tax. If
one looks solely to the "effect" test, many recapitalizations would
be taxable since they had the effect of dividends even though there
might have been a pressing business purpose for the recapitaliza-
tion.
28 298 U.S. 441, 17 AFTR 1213 (1936).
24 302 U.S. 238, 19 AFTR 1226 (1937).
 CORPORATE REORGANIZATIONS 267

Under Section 112(b) (2) common stock can be exchanged for

common stock of the same corporation tax free, and preferred stock
for preferred stock of the same corporation tax free. Clearly, under
this Section the exchange of common stock for preferred stock, or
preferred for common, is taxable. Could the recapitalization pro-
visions be used to negative the effects of these limitations on
exchanges contained in Section 112(b) (2)b, even if a business pur-
pose were present?
If one looks purely to the "effect" test, many business trans-
actions would be impeded because of the resemblance of the eco-
nomic effect of the reorganization to taxable exchanges or taxable
dividends. If one disregards the economic effects and looks purely
to the literal wording of the statute, the loophole possibilities be-
come so great that the statute itself is in danger. In corporate
recapitalizations, for instance, loophole possibilities exist in bail-
out cases. If a sole stockholder of a corporation received in a recap-
italization, or has the corporation pay out as a dividend, preferred
stock, which is immediately sold and shortly afterward redeemed
by the corporation, the sole stockholder has received what is in
effect a cash dividend at capital gains rates. Last December several
Treasury rulings were issued dealing with the receipt by a taxpayer
of preferred stock tax free as a stock dividend or pursuant to a
corporate reorganization. The Treasury made its rulings as to the
tax-free character of the transaction depend upon whether the pre-
ferred stock so received is sold by the receiving stockholder or if it
is subject to redemption by reason of a sinking fund. The trend
of thesVTrasury rulings seems to be in the direction of the
economic effect of the transaction and to that extent these rulings
can be said to follow the line suggested by the Adams and Bazley
cases. The effect of these rulings is, however, to prevent many
corporate reorganizations and recapitalizations which could be jus-
tified as a matter of sound business policy. A slavish adherence
to the letter of the statute exalts form above substance and gives
us the problem presented in Gregory v. Helvering. A disregard of
the letter of the statute and a consideration only of the economic
effects leads to a practical abrogation of the reorganization provi-
sions. The proper function of the business purpose doctrine is to
prevent us from going to either of the two extremes. Such a doc-
trine would be one that would permit the recognition of tax-free
reorganizations if the strict language of the statute has been fol-
268 CORPORATE REORGANIZATIONS
lowed pursuant to a business purpose, either of the stockholder or
of the corporation, not inconsistent with the general purpose of the
reorganization provisions.
Admittedly, the test is vague but clearly it would cover such
situations as where the corporations used have a mere ephemeral
existence and no substantial life as in the case in Gregory v. Hel-
vering. It would also cover the situation where the sole purpose
of corporate recapitalization, for instance, was to make the yearly
dividend distribution in the form of a recapitalization rather than
in the form of an ordinary dividend. Where the recapitalization
distribution, because of the surrounding circumstances, is clearly
nothing more than a cash distribution in a disguised form, then
the benefits of the statute should be denied. If a corporation is
being milked of its assets in the guise of a reorganization, it would
be difficult to deny that tax avoidance rather than business purpose
is present. On the other hand, a reclassification or a rearrangement
of stockholder interest, for more ready marketability to the stock-
holders of their stock, although not necessarily a business purpose
of the corporation, is, in my opinion, a proper business purpose of
the stockholders. There will be many situations where the appli-
cation of a business purpose doctrine will probably be difficult. Its
abandonment, however, would inevitably lead to either a misuse
of the tax-free provisions of the Code, which might eventually
result in their repeal, or it would find the courts resorting to other
tests even less palatable to taxpayers.