Could a restaurant company avoid tax by transferring businesses to a new corporation for initial stock, then transferring that stock to a related company for consideration?

Plain-English summary

A nationwide restaurant-chain company transferred certain businesses and assets, but not liabilities, to newly created EHR for its initial 10 shares at $100 par each. The same day, it transferred those shares to MHI, a corporation in which it held 81 percent. MHI supplied restaurant-liability assumption, notes-payable satisfaction, cash, and a promissory note totaling $13,646,477.

The hearing officer treated the dependent steps as one transaction. In substance, the restaurant businesses and assets were transferred for the related corporation's consideration; the new corporation's stock was only the indicia of ownership. The initial-stock rule for a commencing corporation did not protect a transfer carried out as part of moving corporate assets to another party for consideration.

The recommendation also rejected an alternate attempt to treat the assets as transferred directly from earlier owner IID. It recommended redetermination without adjustment, while requiring verification of who paid restaurant liabilities and from what funds if further proceedings occurred.

The source chronology is irreconcilable. Its transaction narrative places contracts and closings in 1970, while the last paragraph says EHR arose about November 20, 1974—one day after the signed recommendation—and IID merged August 30, 1974. This page preserves the conflict rather than inventing corrected dates.

Protest measures, consideration, missing business-purpose exhibit, citations, and outcome

The September 18 Van Nuys hearing covered August 31, 1970 through March 18, 1973. The protested transfer carried a $2,422,627 state-and-local measure, $433,419 BART measure, and $1,004,468 SCRT measure. These are labeled measures, not tax dollars. The source supplies no rates, tax, allocation workpaper, penalty, interest, payment, claim amount, or reconciliation to the transaction consideration.

The taxpayer said it held title to and operated a nationwide restaurant chain. It closed a December 1970 deal transferring specified businesses and assets, with unspecified exceptions, to EHR for ten initial shares with $100 par value. A separate same-date contract then transferred those shares to MHI. No restaurant, asset schedule, exception, value, title, agreement, invoice, stock certificate, par-value support, or closing record is included.

At the second transfer, the taxpayer owned 81 percent of MHI and owed it substantial currently due notes payable. The representative's schedule listed $5,000,544 of restaurant liabilities, $5,676,040 of notes-payable payment, $647,109 cash by check, and a $1,440,784 promissory note, totaling $13,646,477. The source supplies no creditor, liability ledger, existing note, cancellation or satisfaction, check, new note terms, payment, accounting entry, or valuation.

Audit treated restaurant fixed assets as tangible-personal-property sales and measured a deficiency by transfer value. The taxpayer argued the EHR transfer independently qualified under Annotated Letter Ruling 395.1820 and the MHI stock exchange moved no tangible property. CDTFA's live 395.1820 entry says a transfer to a commencing corporation solely for stock can qualify even below 80 percent of assets, while cash, notes or assumed liabilities are taxable consideration. No supporting 395.1820 opinion is linked there.

The taxpayer said separate agreements had good business purposes stated in an October 3, 1974 supplemental memorandum attached hereto and incorporated herein. The official PDF contains no attachment or memorandum. The record therefore does not supply those asserted purposes, evidence, authorship, or supporting documents.

Hearing Officer W. E. Burkett applied substance-over-form and dependent-step doctrines. He found the taxpayer sought both to divest restaurant businesses and accompanying liabilities and to satisfy notes due MHI. The taxpayer did not intend independently to give income-producing businesses to EHR while retaining current obligations and long-term debt, so EHR stock was transitory ownership evidence rather than the economic consideration.

The cases printed are Commissioner v. Court Holding Co., 324 U.S. 331; United States v. Cumberland, 338 U.S. 451; Ashland Oil Refinery Co. v. Commissioner, 99 F.2d 588; Roeding Securities Inc. v. U.S., 176 F. Supp. 844; Morgan v. Helvering, 117 F.2d 334; Kinney v. U.S., 358 F.2d 738; and W. E. Hall Co. v. Franchise Tax Board, 260 Cal. App. 2d 179. All reporter citations resolved. However, 176 F. Supp. 844 is Roebling Securities Corporation v. United States, not the Roeding Securities name printed by the Board. The official passage remains verbatim below.

The commencing-corporation rule was not intended to shelter a transfer forming part of a third-party asset disposition for consideration. MHI's economic payment bought the restaurant businesses; EHR stock was the indicia of their ownership.

Audit had not determined who actually paid restaurant liabilities or where the funds came from because the records were unavailable. Burkett doubted creditor-acceptance necessity, observed that MHI's assumption did not appear to relieve the taxpayer, and required verification if proceedings continued. No creditor consent, novation, release, payment, source-of-funds record, or follow-up appears.

The alternate theory said IID's merger made the asset transfer effective August 30, 1970, and contracts were prospective but recited that effective date before a December 30, 1970 close. The conclusion instead says EHR did not exist until about November 20, 1974, IID merged August 30, 1974, and the taxpayer operated the businesses between them. November 20 falls after the September hearing and November 19 recommendation. It also prints ERH once. The source supplies no merger certificate, effective-time provision, contract, corporate record, operational ledger, or explanation resolving any date or name conflict.

Burkett recommended redetermining without adjustment. The Reviewed for Audit and adjacent date lines are blank, and the signed date line prints 11/19/741. No final redetermination, review, Board action, tax, payment, claim, appeal, or outcome is supplied.

The live annotation preserves the restaurant chain, asset/no-liability transfer, initial stock, same-day MHI exchange, assumed liabilities, step doctrine, taxable result, and date. It omits the hearing and protest measures; all share and consideration figures; 81-percent relationship and notes due; audit measure; 395.1820 provenance; missing business-purpose memorandum; creditor-payment uncertainty; citation list and defective case name; alternate merger and chronology conflict; recommendation posture; missing records; and absent final outcome.

What this means for you

Businesses restructuring through related corporations

Initial-stock and stock-transfer steps may be viewed together when they are interdependent parts of moving operating assets for liabilities and other consideration.

Accountants and tax professionals

Trace every same-day agreement, share, liability assumption, debt satisfaction, cash payment, note, creditor release, source of funds, effective date, merger record, asset value, local measure, and temporary ownership. Reconcile chronology and verify the missing business-purpose evidence before treating formal sequencing as substantive.

Common questions

Q: Was the first transfer solely for newly issued stock when viewed alone?
A: Yes in form, but the hearing officer refused to isolate it from the same-day stock exchange and consideration.

Q: What consideration did the related corporation provide?
A: $5,000,544 of restaurant liabilities, $5,676,040 of notes-payable payment, $647,109 cash, and a $1,440,784 promissory note, totaling $13,646,477.

Q: Did 81-percent ownership of the related corporation establish exemption?
A: No. The recommendation treated the overall transaction as a transfer of the restaurant businesses for consideration.

Q: Did the recommendation accept the retroactive merger theory?
A: No. It found the businesses had been operated by the petitioner in the intervening period and rejected that alternate contention.

Q: Were the three protested figures tax amounts?

A: No. The source labels them state-and-local, BART, and SCRT measures and gives no rates or resulting tax.

Q: Did the source include the stated good-business-purpose memorandum?

A: No. It says the October 3 memorandum was attached and incorporated, but the official PDF does not contain it.

Q: Had MHI's liability assumption released the taxpayer?

A: Burkett said it appeared not to; who paid creditors and from what funds remained unverified.

Q: Can the 1970 and 1974 dates be reconciled from this source?

A: No. The final paragraph even places EHR's creation one day after the recommendation date.

Q: Did the Board finally adopt redetermination without adjustment?

A: The source does not say.

Citations and references

• California Revenue and Taxation Code § 6006.5(b)
• Annotated Letter Ruling 395.1820
• Commissioner v. Court Holding Co., 324 U.S. 331
• United States v. Cumberland Public Service Co., 338 U.S. 451
• Commissioner v. Ashland Oil & Refining Co., 99 F.2d 588
• Source-printed Roeding Securities Inc. v. U.S., 176 F. Supp. 844; reporter resolves to Roebling Securities Corporation v. United States
• Morgan v. Helvering, 117 F.2d 334
• Kinney v. United States, 358 F.2d 738
• W. E. Hall Co. v. Franchise Tax Board, 260 Cal. App. 2d 179
• October 3, 1974 supplemental memorandum, contracts, assets, stock, liabilities, notes, check, creditor records, merger documents, audit workpapers, calculation, final redetermination, review, Board action, payment, claim, appeal, and outcome records — described or implicated but not included

Verbatim support

From the official November 19, 1974 W. E. Burkett recommendation:

Where a transaction is carried out in a series of steps, each dependent and conditional on the other, then the essential nature of the transaction is to be viewed as a whole for tax purposes

We, therefore, conclude that in substance the consideration given by MHI was in exchange for the entire restaurant businesses.

The means by which these creditors were satisfied remains undetermined to this date.

It is recommended that the taxes be redetermined without adjustment.

Source

• Annotated Legal Opinions collection: CDTFA Annotated Legal Opinions
• Live annotation: Annotation 395.2000
• Original supporting opinion: 395.2000 PDF

Original ruling text

STATE OF CALIFORNIA
BOARD OF EQUALIZATION

In the Matter of the Petition
for Redetermination Under the
Sales and Use Tax Law
I--- I---, INC.
dba C--- P--- F--- C--- S--Petitioner

395.2000

) DECISION AND RECOMMENDATION
)
OF HEARING OFFICER
)
)
Account No. SX -- XX XXXXXX
)
)
)
)

This matter came on regularly for hearing in Van Nuys, California, on September 18, 1974. Appearing for the taxpayer were Mr. W--- F--- D---, attorney, and Mr. M--- M. D---, assistant secretary. Messrs. Tibbetts and Vener appeared for the board. Protested Item (Period 8/31/70 to 3/18/73)

Transfer of tangible personal
Property to EHR Corporation

State & Local
Tax

BART

SCRT

$2,422,627

$433,419

$1,004,468

Contentions of Taxpayer
1.

The transfer did not involve a sale of tangible personal property.

2.
In any event the transfer qualifies as an exempt transfer by I--- I--- of D---, Inc., effective as of August 30, 1974. Summary of Petition The taxpayer is a corporation which held title to and operated a chain of restaurants nationwide. In December of 1970 the taxpayer closed a deal whereby certain of its restaurant businesses and assets (but not the liabilities), with certain exceptions not pertinent here, were transferred to EHR, a new corporation created by the taxpayer. In form the transfer was made in

I--- I---, Inc.

-4-

November 19, 1974
395.2000

exchange for the initial issue of EHR stock (10 shares, par value $100 each). Thereafter, but on the same date, the taxpayer closed a transaction entered into by a separate contract whereby the 10 shares of stock which it received from EHR was transferred to M--- H---, Inc. (MHI) in exchange for the assumption of the liabilities of the restaurant businesses, and other considerations. At the time of this transfer the taxpayer owned 81 percent of the stock of MHI, but it owed MHI a substantial amount on a notes payable currently due. The consideration passing from MHI to the taxpayer as a result of this transfer has been detailed by the taxpayer’s representative as follows: C--- P--- (CP) restaurant liabilities Notes payable payment Cash (by check) Promissory note Total value of consideration

$ 5,000,544.00
5,676,040.00
647,109.00
1,440,784.00
$13,646,477.00

The audit staff determined that the transfer of the fixed assets of the restaurants constituted a sale of tangible personal property and computed a deficiency measured by the transfer value of the assets. It is the taxpayer’s contention that each transfer was carried out separately for a good business purpose and that no tax is due. Its representative reasons that no tax is due on the transfer of the assets to EHR because the transfer of the assets was made to a commencing corporation solely in exchange for stock (Annotated Letter Ruling No. 395.1820). It is further contended that no tax is due on the stock transfer with MHI because such transfer did not involve any tangible personal property. The stated business reasons for carrying out the transfers by the separate agreements is set forth in a supplemental memorandum submitted by the taxpayer’s representative on October 3, 1974, a copy of which is attached hereto and incorporated herein by reference. Other information: The audit staff has not yet determined which entity paid the liabilities of the restaurant businesses and from what source the funds were provided to pay these amounts. The auditor was advised that these records were not currently available. As a second and independent ground for exemption, it is contended that the transfer was actually effective on August 30, 1970, at which time the former owner of the restaurants, I--- I--of D---, Inc. (IID) was merged into the taxpayer. While each of the contracts speak in terms of prospective action, both recite that they were to be effective as of 8-30-70. The transfers in question were closed on December 30, 1970.

I--- I---, Inc.

-4-

November 19, 1974
395.2000

Analysis and Conclusions
It is well settled that the incidence of taxation to a transfer of property depends on the substance of the transaction, and is not controlled solely by the means employed to transfer the title (Commissioner v. Court Holding Co., 324 U. S. 331). Nevertheless, a taxpayer may carry out his business transactions in a fashion calculated to minimize the tax liability so long as the transfer has business substance and is not a mere sham (See U.S. v. Cumberland, 338 U.S. 451). Where a transaction is carried out in a series of steps, each dependent and conditional on the other, then the essential nature of the transaction is to be viewed as a whole for tax purposes ( Ashland Oil Refinery Co. v. Commissioner, 99 Fed.2d 588). A transaction may not be separated or “atomized” unto its components by either the taxpayer or the taxing agency (Roeding Securities Inc. v. U.S., 176 Fed. Sup. 844; Morgan v. Helvering, 117 Fed.2d 334; Kinney v. U. S., 358 Fed.2d 738). A transitory ownership of corporate stock is not necessarily of legal significance (Ashland Oil Refinery Co. v. Commissioner, supra; also W. E. Hall Co. v. Franchise Tax Board, 260 Cal.App.2d 179). In the instant case, it seems to us that the taxpayer’s objective in entering into the intercompany agreements was twofold: (1) it sought to divest the corporation of the restaurant businesses, and the liabilities which accompanied them; and (2) it desired to obtain satisfaction of the notes payable obligation due to the related corporation, MHI. While the transfer of the businesses was carried out, in form, by a separate agreement, it is apparent that this transfer was not independent of the exchange with MHI. It is manifestly clear that the taxpayer did not desire to independently deliver these income-producing businesses to a separate corporation and retain the current obligations and the long-term debt. As we view it, the substance of the transaction involved an agreement by the taxpayer to transfer the entire businesses and assets to the new corporation in exchange for MHI’s promise to assume the liabilities, cancel the note payable balance, and the other stated considerations. We, therefore, conclude that in substance the consideration given by MHI was in exchange for the entire restaurant businesses. Having purchased the entire restaurant businesses, and assumed the liabilities, it was entitled to the indicia of their ownership, the corporate stock. The ruling relating to the exemption of a transfer to a commencing corporation in exchange for its initial issue of stock was not intended to provide a means of tax avoidance. Its use is not authorized where the transfer was carried out as part of a transaction involving transfer of ownership of the corporate assets to a third party for a consideration. As an aside, we also observe that the assumption of the business liabilities of the restaurants by MHI probably was not required “to obtain ready acceptance of the existing CP division creditors”. The taxpayer was liable for the business obligations of the restaurant division before the transfer, and insofar as we are aware, it remained liable for the debts after the transfer was completed. The fact that MHI expressly assumed the obligation would not operate

I--- I---, Inc.

-4-

November 19, 1974
395.2000

to relieve the taxpayer from the liabilities. Nor can we see that the approval of the CP creditors would have been required for the transfer of the liabilities to EHR (or MHI for that matter). The means by which these creditors were satisfied remains undetermined to this date. In the event any further proceedings are required, this verification must be undertaken and reported on. We are unable to accept the alternate contention that the transfer of the assets was made directly from IID to ERH and thus qualified for exemption under Revenue and Taxation Code section 6006.5(b). There is ample evidence that EHR did not come into existence until about November 20, 1974, and that the merger of IID was completed on August 30, 1974. In the intervening period the businesses were in fact operated by this taxpayer. Recommendation It is recommended that the taxes be redetermined without adjustment.

________
W. E. Burkett, Hearing Officer

11/19/741
______
Date

Reviewed for Audit:

Principal Tax Auditor

Date