I know we promised that the last article would be the final installment of Huddleston Tax Weekly before the return of our XVI Amendment series. Surprisingly, we fibbed a bit. We’d like to sneak in just one more – and now we really promise, just one more – article prior to our return to that series. If this frustrates you, that’s understandable, but hopefully whatever frustration comes to the surface will immediately dissolve after you know what topic to which this article will be devoted: the important case of Gregory v. Helvering (1935). Though not the most well-known financial case, this Great Depression-era piece of litigation is fascinating for a number of reasons. Perhaps the most notable reason for its appeal is its relevance to more modern financial scandals.
In 2017, we have become accustomed to seeing all sorts of financial scandals. Some of these scandals, like the Enron scandal, can be very elaborate and involve complex accounting fraud, insider trading and other kinds of high-brainpower underhandedness. Every trend, no matter its size or significance, can be traced to a single source, and the case of Gregory v. Helvering stands as a legitimate candidate for the forerunner to much of the financial trickery present in recent decades. And this is not necessarily because the taxpayer in Gregory v. Helvering aimed to abuse the law in a nefarious way; the facts of the case, as they’ve come down to us, do not allow for such a conclusion. But in this case we do see an attempt to transact in such a manner that the form of the law is obeyed but its spirit is ignored. And this creative maneuvering is something that we see again and again in the modern era.
Let’s look at the details of this case to get a better sense of why it foreshadows many recent financial scandals.
The taxpayer owned a company – United Mortgage Corporation – and this company held 1000 shares of another company’s stock (Monitor Securities Corporation). The taxpayer wished to sell this stock but also wished to minimize (or ideally eliminate) the potential tax liability of such a sale. Toward this end, the taxpayer established a new company, Averill Corporation, and then transferred the 1000 shares of Monitor to Averill. The taxpayer then transferred the 1000 shares of Monitor to herself, and then quickly dissolved Averill. The Averill entity clearly had no other function aside from acting as a conduit through which to distribute the shares to the taxpayer. The taxpayer contended that the series of actions which occurred fell under section 112 of the Revenue Act of 1928 as a corporate “reorganization.” If what occurred were in fact reorganization under section 112, the gain realized by the taxpayer would not be taxable.
The relevant subsections of 112 were (g) and (i). Subsection (g) stated that distributions of stock on reorganization to a shareholder in a corporation which was a party to the reorganization will not result in gain (to the receiving shareholder). Subsection (i) lays out a definition of reorganization.
The court (Supreme Court of the U.S.) ruled that a legitimate reorganization had not occurred and that the deficiency assessed by the IRS was correct. Even though the taxpayer had apparently satisfied every element of section 112, the court reasoned that section 112 did not apply because the Averill Corporation was clearly a “dummy company” in the sense that it served no other purpose than to eliminate the tax liability which would have normally followed the stock distribution. Hence, though the taxpayer took steps to fall under section 112, what had actually occurred was a dividend, because there was no substance underlying the creation of the Averill Corporation.
What we have here, therefore, is a fascinating early example of creative business maneuvering. The taxpayer either received expert counsel on section 112, or was familiar with section 112 by way of independent research, and the taxpayer established the dummy company for the specific purpose of falling within the meaning of this statute. And even though the steps taken by the taxpayer would seemingly bring the transaction under section 112, the court was not willing to let this type of trickery slide under the judicial radar. In some ways, Gregory v. Helvering represents the embryonic form of more heinous modern trickery, such as the kind perpetrated by Enron’s CFO, Andrew Fastow.
Although what happened here is dwarfed by comparison to modern scenarios, it’s still interesting to see the roots of what goes on around us today.
Image credit: Investment Zen
Readers who enjoyed this piece should consider viewing our presentation on business formation. This presentation was given by our principal and founder, John Huddleston