Davant v. Commissioner of Internal Revenue

Four families (shareholders) (plaintiffs) owned all the stock of the South Texas Rice Warehouse Company (Warehouse), which dried, cleaned, and stored rice. The rice was obtained from a brother corporation, South Texas Water Company (Water), which was owned in the same proportion by the same families as Warehouse. Water owned and rented land and provided irrigation for rice farming on that land as well. Water’s lessees used Warehouse’s services for processing and storing the rice produced on Water’s land. The books and records of Water and Warehouse were kept separate but were prepared in the same office. The shareholders consulted an attorney regarding a plan to transfer Warehouse’s assets to Water for $700,000 and then to liquidate Warehouse. The attorney suggested a plan in order to receive capital gains tax treatment on the income. Under the plan, the shareholders sold all the stock of Warehouse to the attorney’s son, Homer Bruce Jr., who obtained a bank loan of $914,200 to pay for the stock. Water then purchased the shares of Warehouse from Bruce Jr.; Water paid $700,000 of its earnings and profits toward the loan. The remainder of the loan was paid using part of the $230,000 of earnings and profits in the cash reserves of Warehouse after it was liquidated. Bruce Jr. received $15,583.30 for his participation; the bank received $152.37 in interest. All the transactions were completed within one hour on the same day. These transactions had no effect on the operations of Warehouse, which continued under Water with no interruption. Shareholders reported the amount received from Bruce Jr. to purchase Warehouse shares as capital gains. The commissioner of the Internal Revenue Service (defendant) assessed additional tax, claiming that the income was a dividend taxable at ordinary tax rates. The shareholders appealed to the United States Tax Court, which held that the transaction was a corporate reorganization and that part of the shareholders’ income was taxable as ordinary income. Both the shareholders and the commissioner appealed to the United States Court of Appeals for the Fifth Circuit.