Yahoo’s Tax-Free Spinoff Plan Parallels a Historic Case

Perhaps the most quoted dictum from any tax case comes from Judge Learned Hand of the United States Court of Appeals for the Second Circuit in the 1934 case of Evelyn Gregory against Guy T. Helvering (then the commissioner of the I.R.S.):

Any one may so arrange his affairs that his taxes shall be as low as possible; he is not bound to choose that pattern which will best pay the Treasury; there is not even a patriotic duty to increase one’s taxes.

This passage might as well serve as the motto for the tax planning industry.

But the words are merely obiter dictum, a “remark by the way,” meaning that the passage was not essential to the court’s decision. As legal precedent goes, Judge Hand’s prose is neither here nor there.

The actual “holding” of the case — the part of the decision that establishes legal precedent for future cases — is that it was not enough for the taxpayer, Mrs. Gregory, to devise a plan to avoid taxes that complied with the literal words of the tax code. The deal was taxable because it was not what Congress had in mind when it wrote the rules.

It’s the court’s ultimate decision, not its dictum, that ought to make Yahoo’s shareholders nervous.

Yahoo’s plan to spin off Alibaba stock to its shareholders follows the same basic playbook as Mrs. Gregory’s old plan, making it vulnerable to the same kind of judicial attack.

Mrs. Gregory was the sole shareholder of the United Mortgage Corporation, which owned shares of another company, the Monitor Securities Corporation. Mrs. Gregory decided to sell the Monitor stock, which was worth about $1.8 million in today’s dollars.

If United Mortgage distributed the Monitor stock to Mrs. Gregory as a dividend, she would have recognized the value of the shares as ordinary income, which at the time was subject to a marginal tax rate of 24 percent.

Instead, United Mortgage contributed the Monitor stock to a new corporation, which I’ll call SpinCo. United Mortgage then distributed the SpinCo stock to Mrs. Gregory in what purported to be a tax-free reorganization. Three days later, Mrs. Gregory liquidated SpinCo and sold the Monitor stock, reporting the difference between her proceeds and her basis in the stock as a capital gain, which at the time was subject to a marginal tax rate of 12.5 percent. The tax planning saved her about $145,000 in taxes in today’s dollars.

The transactions met the literal requirements of the tax code as it was written then. Judge Hand ruled for the government, notwithstanding his dictum that it is perfectly O.K. to structure a deal in a way that minimizes taxes.

Judge Hand wrote that the deal Mrs. Gregory engineered fit the dictionary definitions of each term used in the statute. But, he explained, “the meaning of a sentence may be more than that of the separate words, as a melody is more than the notes, and no degree of particularity can ever obviate recourse to the setting in which all appear, and which all collectively create.”

Lawyers often bristle when judges read between the lines, find meaning in the penumbra, or say things like “a melody is more than the notes.” But judges in tax cases often find that literal compliance with the words of the tax code is not enough.

The purpose of the reorganization provisions, Judge Hand explained, is to allow shareholders to reorganize a business when the deal is undertaken “for reasons germane to the conduct of the venture in hand, not as an ephemeral incident, egregious to its prosecution.”

Yahoo’s planned spinoff of its Alibaba stake is parallel to Mrs. Gregory’s tax avoidance plan, just in modern-day clothes.

To be sure, the details differ. Today, qualified dividends are taxed at the same rate as capital gains, making the shareholder-level tax issues less important. Instead, the spinoff is structured to avoid Yahoo’s corporate tax on the appreciation of the value of Alibaba, something that would not have been taxable in Mrs. Gregory’s day.

As I wrote last week, the plan has a scintilla of substance: Yahoo plans to contribute a division, Yahoo Small Business, into SpinCo along with the Alibaba stock. The contribution of an “active trade or business” into SpinCo allows Yahoo to plausibly fit within the literal requirements of today’s tax code.

Although the notes are different, the melody is the same. Just as Judge Hand found the three-day life span of Mrs. Gregory’s SpinCo too ephemeral, a judge might find Yahoo Small Business too flimsy to carry the weight of the Alibaba shares.

There is, after all, no legitimate (nontax) business purpose for putting Yahoo Small Business into SpinCo. The whole point of the spinoff is to separate the Alibaba stock from Yahoo without paying tax, and everybody knows it. Yahoo Small Business is simply a sacrifice to the altar of tax planning.

There is another parallel between Yahoo’s tax planning and that of Mrs. Gregory’s. Mrs. Gregory sold her stock in 1928, before the stock market crash of 1929. By 1934, when Judge Hand drafted his decision, the Great Depression had overwhelmed the economy. Public scrutiny of tax avoidance had intensified as President Franklin D. Roosevelt sought money for his ambitious New Deal agenda.

In the weeks that Judge Hand drafted his decision, Andrew W. Mellon, the former Treasury secretary and one of America’s wealthiest businessmen, faced a criminal investigation for tax fraud.

And yet, many things remain the same. Income inequality today has returned to levels not seen since 1928. Just as Judge Learned Hand decided Mrs. Gregory’s case against the backdrop of the Great Depression, a judge today would decide Yahoo’s case against the backdrop of stagnant wages, the benefits of economic growth funneled to a wealthy elite and a perception that the rich, powerful and well advised play by a special set of tax rules.

No one especially wants to see $12 billion of tax liability turn on what a judge thinks about income inequality or the paradox of rising corporate profits and stagnant wages. Our tax system depends on the rule of law, not the rule of what the judge ate for breakfast today.

I expect that the I.R.S. will clear things up for Yahoo and similar deals within the next few months, before the Yahoo deal closes. The I.R.S. could, for example, announce that it is working on new guidance requiring a nontax business purpose for the contribution of an active trade or business to a controlled subsidiary as part of a plan of reorganization, and that any cash or investment securities contributed to a subsidiary must have a business purpose that is reasonably related to the financing needs of the subsidiary. Because there is no good business reason — apart from tax planning — for the Yahoo Small Business division to hold $40 billion of Alibaba stock, that would be the end of Yahoo’s tax-free spinoff.