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April 14, 1967

Commercial Industries Corp., Plaintiff,
United States of America, Defendant

Coolahan, District Judge.

The opinion of the court was delivered by: COOLAHAN

COOLAHAN, District Judge:

This is a civil action for refund of income taxes and interest assessed against and paid by the plaintiff, Commercial Industries Corp., [Commercial], for the calendar years of 1956, 1957 and 1958, in the amounts set out in the margin. *fn1" Jurisdiction is premised on 28 U.S.C. §§ 1340, 1346.

 The ultimate issue presented is whether the Commissioner of Internal Revenue properly disallowed the net operating loss carry-overs claimed as deductions by the plaintiff in its returns for those years, where such attempted carry-overs represent the net operating losses of a predecessor company, Seyer Silk Dyeing & Finishing Company, during the years 1951 through 1954.

 The Government brings this motion for summary judgment. For the reasons given below the motion will be denied.

 Since the chronology of events has been stressed by both sides in regard the applicable Tax Code provisions, a brief history of the matter will be useful. For purposes of this motion the Government is willing to assume the following facts.

 Seyer Silk Dyeing & Finishing Co. [Seyer] was organized in 1931, and was engaged in the business of dyeing and finishing fabrics at its plant in Haledon, New Jersey.

 On October 6, 1953, all the stock of Seyer was sold by the Seyer family to four individuals - Oliver Lazare, Bruno Herman, Samuel Fire, and Arthur Rhodes - for $320,513.65. The last three named individuals were at that time associated in the ownership and operation of Nina Dye Works Company, Inc. [Nina], which was engaged in the same business of dyeing and finishing fabrics at its plant in York, Pennsylvania. Oliver Lazare, a customer of Nina, was invited to join in the purchase of Seyer by the owners of Nina.

 Shortly after the purchase of the Seyer stock, the new owners voted to discontinue their own dyeing and finishing, allegedly on the ground that the machinery and equipment of Seyer was in poor condition and not capable of profitable operation. The machinery was sold, *fn2" but contact with Seyer's customers was retained; their orders for fabric were then obtained; and the actual dyeing and finishing was farmed out to other companies on a commission basis.

 On May 24, 1954, seven months after the Seyer Company had been purchased, the other three owners bought Lazare's share of the Seyer stock for $140,949.88, representing a $34,000.00 gain to Lazare over his share of the original purchase price.

 Thereafter, Seyer continued to accept orders on a commission basis for dyeing and finishing by other companies, until September, 1955.

 Seyer incurred net operating losses during the years 1951 through 1954 which are set out in the margin. *fn3" In 1955 the three remaining owners of Seyer decided to merge it with Nina, whose shares they owned in the same proportion as the shares of Seyer. Nina had continued to do its own dyeing and finishing up to the merger when its machinery and equipment were sold prior to the consummation. The mechanics of the merger were simply that Seyer acquired the assets and liabilities of Nina and changed its name, effective as of September 8, 1955, to Commercial Industries Corp. From that date on, the Government contends, the income of the new corporation was derived principally from rents, interests, dividends, and commissions. There was also a side transaction involving a third corporation which is not pertinent to this motion. *fn4"

 The net operating losses listed above for Seyer were claimed by Commercial as deductions in the years 1955 through 1958 as noted. *fn5" These deductions were claimed under Section 172 of Internal Revenue Code of 1954. *fn6"

  These deductions were disallowed by the Commissioner who assessed deficiencies for those years. The deficiencies were paid, timely claim for refund filed, and the present action commenced.


 The Government argues that the attempted carryover is governed by the Internal Revenue Code [I.R.C.] of 1939 and the case law thereunder, which it claims prohibits the deductions. It maintains that such carryovers are precluded by Libson Shops, Inc. v. Koehler, 353 U.S. 382, 1 L. Ed. 2d 924, 77 S. Ct. 990 (1957), and later cases applying that decision. Discussed more fully below, the Libson line of cases teaches that net operating losses cannot be carried forward (or back) to other tax years under Section 122 of the 1939 Code (predecessor of § 172, I.R.C. 1954, supra) if there is an intervening substantial discontinuity between the business enterprise sustaining the losses and the enterprise which claims the deduction.

 Plaintiff's reply is twofold. It feels that the availability of the carryover is governed not by the 1939 Code, but by the 1954 Code, under which it alleges that the carry-over deductions were permissible. Alternatively, should the 1939 Code be deemed controlling, the plaintiff argues that the reasoning in Libson and its progeny are inapposite.

 I find that plaintiff is incorrect as to the applicable Code, but I concur with its alternative argument that even under the 1939 Code the Government is not entitled to summary judgment.

 Analysis of both issues has been somewhat obscured by several diversionary disputes. First, while it would seem obvious, it is necessary to emphasize that this is the defendant's motion; as movant, the Government is free to rely upon, or eschew, whichever grounds and theories it chooses. There were three points in the life of the Seyer Corporation which the Government claims resulted in substantial discontinuity of the business enterprise: (1) the 1953 100% change of stock ownership; (2) Seyer's shift to farming out dyeing and finishing on a commission basis; and (3) the 1955 statutory merger of Nina into Seyer with a concomitant change of the latter's name to Commercial Industries. Nonetheless, the Government made it absolutely clear that for purposes of this motion it relies solely upon the complete change of beneficial ownership in 1953 as precluding the carryover. *fn7" Plaintiff's emphasis on the occurrence of the statutory merger in a 1954 Code year is understandable, since the many cases relied on by the Government involved mergers, acquisitions, or comparable reorganizations. Still, the defendant need not rely on the effect of the merger for purposes of this motion if it chooses not to. Hence my analysis of both the applicable Code and of the ultimate issue on the deduction is confined to the precise ground which is advanced, and, therefore, much of plaintiff's reference to the merger in regard to the applicability of the 1954 Code is not relevant. *fn8"

 Second, plaintiff stresses the legitimate business purpose of the original stock purchase and urges that the Code provisions dealing with acquisition of corporate control made to avoid Federal income tax do not apply. § 129 (I.R.C. 1939); § 269 (I.R.C. 1954). This too is an assault on open doorways, since the Commissioner did not rely on that provision in denying the deduction. *fn9"


 Turning to the question of which Code governs, I repeat that the merger of Nina into Seyer is not relied on for this motion. Despite plaintiff's admirable persistence on this point, its claim that "the operative transaction is . . . the statutory merger which occurred on September 8, 1955", is simply incorrect.

 Plaintiff's second point is merely a justification for "applying subsequently enacted laws to determine the tax consequences of a pre-enactment transaction. . . ." However, plaintiff focuses on only two dates for testing the availability of a carryover, namely, the loss year and the tax year. The cases demonstrate that a tripartite analysis is necessary. The three relevant dates are: (1) the loss year; (2) the year in which the deduction is claimed or tax year; and (3) the year in which a discontinuity allegedly occurred in the corporate chain between the loss and the deduction. Of course under particular facts, the "discontinuity year" may be identical with either the "loss year" or the "tax year". But it is the "discontinuity year" which is critical, since it is the tax significance which the corporate combinations or transaction then had that determines whether the Libson gloss on Section 122 controls or whether the carryover is governed by the provisions of the 1954 Code which partially repeal Libson.10

 Here not only the pertinent losses occurred in 1939 Code years, *fn11" but the event which purportedly cut off the carryover privilege occurred in 1953; its tax treatment and significance are determined under the 1939 Code. Allied Central Stores, supra; Fawick Corp. v. Commissioner, 342 F.2d 823 (6th Cir., 1965); Humacid Co., 42 T.C. 894 (1964); Norden-Ketay v. Commissioner, 319 F.2d 902 (2nd Cir., 1964) cert. denied, 375 U.S. 953, 84 S. C. 444, 11 L. Ed. 2d 313. Cf. Frederick Steel Co. v. Commissioner, 375 F.2d 351 (6th Cir., 1967) *fn12"

 Plaintiff's third point is based on Subsection 172(e) of the 1954 Code. It cites American Bank and Trust Co. v. United States, 333 F.2d 416 (5th Cir., 1964) for the proposition that § 172(e) requires the availability of loss carryovers for deduction in 1954 Code tax years to be determined under Section 172 of that Code. The reliance on Subsection (e) and on the American Bank case is misplaced. *fn13" The pertinent subsection of § 172 in regard to the "availability" of pre-1954 Code year losses for deduction in 1954 Code years is § 172(g)(1) which indicates that their deductibility is governed by the 1939 Code. See Norden-Ketay, supra, 319 F.2d at 904.

 The possible effect of the change in stock ownership in 1953, then, must be considered in the context of the restrictions placed on § 122 of the 1939 Code, by the Libson Shops line of decision to which I now turn.


 The Government's theory in regard to the 1953 stock purchase is appealingly simple. It posits an independent requirement of continuity in stock ownership, wholly apart from the context of a corporate merger or reorganization. Under this view, that requirement, though unmentioned in Libson Shops where no such problem existed, has somehow acquired a life of its own from the cases interpreting Libson. Extrapolating from those and earlier decisions, the Government argues that continuity of beneficial ownership is the sina qua non for using the loss carryover and should be the focus of initial inquiry. *fn14" It concludes that a substantial change (or at least the 100 per cent change in Seyer's ownership) suffices, without more, to cut off the carryover.

 According to the Government, since the provisions of § 122 were intended to benefit stockholders rather than the formal corporate entities, where the beneficial ownership changes, the rationale for the carryover privilege ceases. See Newmarket Mfg. Co. v. United States, 233 F.2d 493 (1st Cir., 1956).

 True, Libson Shops notes that § 122 was designed to enable a business to average its lean and its lush years. Further, Libson Shops approvingly cites the Newmarket case, which earlier had observed that this intent looked ultimately to the "flesh and blood" shareholders behind the legal abstraction of the corporate taxpayer. Both these references, however, must be read against the tortuous history of Section 122's judicial treatment and the several factors which the courts had then, and have since, considered.

 This history has been fully detailed elsewhere. See especially Wisconsin Central R.R. Co. v. United States, 155 Ct. Cl. 781, 296 F.2d 750 (1961) cert. denied 369 U.S. 885, 8 L. Ed. 2d 286, 82 S. Ct. 1157; Julius Garfinckel & Co. Inc. v. Commissioner, 335 F.2d 744 (2nd Cir., 1964) cert. denied, 379 U.S. 962, 13 L. Ed. 2d 556, 85 S. Ct. 651. The earliest Supreme Court decision pegged the carryover privilege to the requirement that the taxpayer claiming the deduction be the same corporate legal entity as the taxpayer which actually had incurred the losses. New Colonial Ice Co., Inc. v. Helvering, 292 U.S. 435, 78 L. Ed. 1348, 54 S. Ct. 788 (1934); Helvering v. Metropolitan Edison Co., 306 U.S. 522, 83 L. Ed. 957, 59 S. Ct. 634 (1939). *fn15" Under this approach, carryovers were permitted even though the type of business and the stock ownership had changed, as long as the charter had not. E.g. Alprosa Watch Co., 11 T.C. 240 (1948).

 Finally, a year before Libson Shops, the First Circuit permitted a carryback of losses incurred by a successor corporation to offset prior profits of its parent which had been statutorily merged into the subsidiary. Newmarket Mfg. Co. v. United States, supra. The court listed the continuity of stock ownership as one of the several factors which justified by-passing the "same taxpayer" hurdle, but also emphasized that even absent the merger the carryback would have been permissible. *fn16"

  In Libson, the same shareholders owned 17 separate corporations; each of 16 carried on retail clothing businesses, while the 17th provided them with management services. The retail stores were merged into the management company, which thereafter conducted all the businesses as a single enterprise. Three of the retail shops had incurred net operating losses prior to the consolidation and continued to lose after it. The taxpayer's attempt to offset their pre-merger losses against the post-merger profits netted by the overall operation was rejected.

 Following the First Circuit's lead, the Court side stepped the earlier test of identity between the taxpayer and the loss corporation. Emphasizing economic realities, it stressed that the profits had been earned by identifiable business units different from those which had suffered losses. *fn17" Moreover, the Court noted that without the consolidation there could have been no use of the carryover since the three losing units had no post-merger profits. It was in this context that the Court cited the Newmarket, Koppers and Stanton Brewery cases as meeting the "continuing enterprise" test. *fn18"

 The varied situations presented in the decisions following Libson Shops have included many kinds of corporate changes: some involved discontinuity in the identity of the taxpayer; some a discontinuity in the line of endeavor; some a change of beneficial ownership; and some the juxtaposition of one business unit's losses against the profits of another. More often than not, they have involved a combination of more than one type of discontinuity.

 Nevertheless, I have concluded that in each instance it was some basic change in the structure of the loss corporation as an identifiable business unit, either through formal reorganization or through interaction with other corporations, which precipitated the Commissioner's scrutiny. In those cases where the carryover or carryback ultimately was denied, the Libson test of business enterprise continuity was applied primarily because the profits and the losses were earned by sufficiently different business units, and it was only the merger or reorganization which created an opportunity for their set-off.

 In the case of reorganization, Libson Shops was followed where the restructured corporation was a substantially different business unit from the one which had incurred losses. Huyler's v. Commissioner, 327 F.2d 767 (7th Cir., 1964); Willingham v. United States, 289 F.2d 283 (5th Cir., 1961); Wisconsin Central R.R. Co. v. United States, 155 Ct. Cl. 781, 296 F.2d 750 (1961). *fn19" Libson Shops was distinguished in a reorganization which preserved the prior loss corporation as an identifiable business unit whose post-reorganization losses were carried back to offset its pre-reorganization profits. F. C. Donovan, Inc. v. United States, 261 F.2d 470 (1st Cir., 1958). *fn20"

 In Donovan, there was no danger, warned of in Libson, that a windfall might arise solely because of the corporate reshuffle. The court noted that if the parent and subsidiary had not combined in a reorganization, but "had continued their operations in almost any other way than that which they chose, the claimed net operating loss carry-back would have been allowed." 261 F.2d at 474-475. The Government cites a passage in Donovan reconciling that decision with the court's earlier Newmarket opinion. But the Government's selective emphasis plainly ignores the thrust of the reference which hardly suggests that either Newmarket or Donovan turned on ownership alone. *fn21"

 In the more complicated field of mergers between previously unrelated corporations, the post- Libson decisions have similarly wrestled with the concept of "continuity of business enterprise." But here again, the common thread is their emphasis on the heart of Libson, namely the prohibition of matching the losses of one identifiable business unit against the profits of another.

 The Court of Appeals in this Circuit has held that when a new profit making business is merged into the surviving shell of a loss corporation, the latter may not carry over its pre-merger losses to post-merger profits attributable to the new business. Commissioner v. Virginia Metal Products, 290 F.2d 675 (3rd Cir., 1961). Stripped of intermediate complications, that matter involved merger of a losing window screen and furnace equipment business [Winfield Corp.] and the successful multi-company Virginia Metal Corporation. Virginia acquired Winfield's stock, sold its assets, and placed one of Virginia's profitable companies into Winfield's shell. The court followed Libson, adding in dictum that the case before it was even stronger for the Commissioner because of the added factors of discontinuity in the line of business and in the ownership. (Taking a view not accepted by all students of Libson, the court assumed that there a single line of endeavor, i.e. women's retail clothing, was involved).

 Any assumption, however, that Virginia Metal Products was premised upon the discontinuity in ownership is belied by the fact that the two decisions primarily relied on were applications of Libson involving no change of ownership. *fn22"

 The same result has been reached in other merger cases, both where a profit company was merged into the mere shell of a loss corporation, J. G. Dudley Co., supra; Federal Cement Tile, supra; and where the loss corporation's original business was continued, but the post-merger profits were attributable to the engrafted business unit. Fawick Corp., supra. *fn23" Like Virginia Metal Products, these decisions teach only that the Libson test of continuity between the loss operation and the profit one applies even if the loss corporation survives the merger and, hence, is technically still the "same taxpayer."

 The fullest treatment of the relationship between stock continuity and the carry-over privilege appears in a series of Second Circuit decisions: Norden-Ketay, supra; Julius Garfinckel & Co. v. Commissioner, 335 F.2d 744, (2nd Cir., 1964); Allied Central Stores, Inc., supra. In Norden-Ketay, since the surviving taxpayer was the original loss corporation, the Court first considered the variance between the profit business and the loss business, and then considered the change in stock ownership as a second factor bearing on the "continuity of the business enterprise." *fn24" But the full passage discussing continuity of ownership shows that it was explored as a possible saving grace, which might preserve the carry-over otherwise precluded by the merger. *fn25" Thus, the Court of Appeals in Norden-Ketay prefigured the problem, spelled out in Garfinckel the following year, of whether continuity of ownership could be an ameliorating fact in situations where Libson was prima facie applicable.

 This was made clear by Judge Friendly's thoughtful review of Libson and its aftermath in Garfinckel. Julius Garfinckel & Co. had acquired all the stock of Brooks Brothers (a profit corporation) by 1947, and about 58 per cent of DePinna (a loss corporation) in 1950; both companies retailed men's wear. In 1952 Garfinckel caused Brooks Brothers to be merged into DePinna, the latter remaining as the surviving corporate entity, but changing its name to Brooks Brothers, Inc. Garfinckel thereby acquired approximately 95 per cent of the consolidated company.

 Unlike the situation in Norden-Ketay, the loss corporation had not been a mere shell at the time of merger, both companies had been in the same business, and there was substantial overlap of stock ownership; unlike Libson, the loss corporation was the surviving entity. Thus, Judge Friendly found himself faced with a question left undecided by those two cases:


"When a corporation which has incurred losses but is still actively engaged in business acquires by consolidation another corporation with a history of profits in the same business, does § 122 permit the consolidated corporation to deduct pre-consolidation losses from post-consolidation profits derived solely from operations of the acquired corporation - this in a context in which a single stockholder owned 58% of the common stock of the loss corporation and 100% of the common stock of the profit corporation during the period of the losses and, by virtue of the consolidation, owned 95% of the stock of the surviving corporation? With some hesitation, we have concluded that Libson requires a negative answer." 335 F.2d at 745.

 Judge Friendly then reviewed the difficult questions raised by Libson when the loss corporation was the survivor and found it "hard to draw an intelligible line between a case where a corporation has provided itself with new assets to establish a new business and another where it has bought a business already established." *fn26" He hypothesized a continuum of situations varying as to the pre-merger relationship of the corporations; the method of combination or acquisition; and the degree to which the original loss corporation, whether acquired or acquiring, was merely a shell. *fn27" The important point is the plain assumption that as a common denominator each situation involved a combination or reshuffle of several businesses.

 In short, the Court seemed to contemplate the possibility that the pre- Libson results in Newmarket and Metropolitan Edison might be appropriate if the taxpayer could show sufficient ameliorating facts such as continuity of beneficial ownership and proof that the loss company was more than a shell. If anything is clear, it is that the carryover was not denied, as the Government contends "solely" because of the change in stock ownership. *fn28"

  Shortly after the decision in the Garfinckel case, the Second Circuit denied the loss carry-over to profits arising after a consolidating merger of several department stores, since the revenues had been generated by different units than those suffering the pre-merger losses. Allied Central Stores, Inc. supra. Even though all three stores had been wholly owned by a common parent corporation prior to their merger, the court held that "[The] regrouping of subsidiaries which have been treated as separate entities, with resultant changes in stated capital, total assets, and net worth, has an effect on 'continuity'". 339 F.2d at 504.

 Reviewing all the above discussed decisions, I conclude that the correct legal analysis is the exact reverse of the Government's position. That is, the minimum requirement for denying the privilege is that there be some substantial change between the business unit involved in the loss years and that unit which creates the profits; even then, if there is anything left of Judge Friendly's dictum in Garfinckel after the Supreme Court's denial of certiorari and the subsequent decision in Allied, the privilege may not be forfeit in appropriate cases of continuity in stock ownership.

 None of the post- Libson decisions, either singly or collectively, stand for the proposition that change in ownership alone suffices. To hold that such a discontinuity within a single company, otherwise unchanged, eliminates § 122 would be not only to extend the already much-criticized Libson Shops doctrine, but also to open a Pandora's box of difficulties in determining when sufficiently substantial and permanent stock transfers had occurred. *fn29" I shall decline the opportunity. Defendant's motion is denied.

 Let an appropriate order be submitted.


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