Waterman Steamship Corp. v. Commissioner

United States Court of Appeals for the Fifth Circuit · 1970 · Corporations

CorporationsFederal income taxSubstance over formDividendsStock salesConsolidated returnsintercorporate dividendpurchase price

Facts

McLean initially offered Waterman $3,500,000 in cash for all stock of Waterman's subsidiaries, Pan-Atlantic and Gulf Florida. Waterman rejected that offer and counterproposed a sale for about $700,180 after the subsidiaries declared and arranged payment of about $2,800,000 in dividends to Waterman, which would avoid taxable gain if treated as an intercompany dividend on a consolidated return. On January 21, 1955, Pan-Atlantic declared a $2,799,820 dividend to Waterman, paid by promissory note because it lacked sufficient cash, and shortly thereafter Waterman sold the subsidiary stock to McLean's corporation for $700,180. Within ninety minutes, the new Pan-Atlantic board borrowed funds from McLean and Securities and used those funds to pay Waterman the amount of the note, so that Waterman received the full $3,500,000 contemplated from the start.

Issue

When a parent corporation structures the sale of subsidiary stock so that the subsidiary first issues a promissory note labeled as a dividend and then, after the sale, pays that note with funds supplied by the buyer, should the payment be treated for federal tax purposes as a tax-free intercorporate dividend or as part of the purchase price for the stock?

Rule

For federal tax purposes, a court looks to the functional economic substance of a transaction rather than its formal labels or time sequence. Where a series of closely related steps is part of a prearranged unitary plan and a purported dividend is financed by the buyer and routed through the subsidiary solely as a means of paying the seller for stock, the distribution will be treated as part of the purchase price rather than as a dividend.

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Lake Harbor Logistics, a parent corporation in New Orleans, agrees in principle to sell all stock of its wholly owned subsidiary, Crescent Dock Services, to Rivermark Holdings for $12 million. At Lake Harbor's insistence, the deal is restructured so Crescent first issues Lake Harbor a $5 million note labeled a dividend, although Crescent lacks cash; one hour after closing, Rivermark loans Crescent $5 million, and Crescent immediately pays the note to Lake Harbor.

For federal tax purposes, the $5 million is most likely treated as

Explanation. The majority held that when a purported dividend is one transitory step in a prearranged stock-sale plan, and the buyer supplies the funds while the subsidiary merely serves as a conduit, the payment is treated as purchase price rather than a dividend. Formal sequencing and labels do not control. The fact that declaration occurred before title passed is not dispositive when, in substance, no real dividend existed.