54 T.C. 59">*59 The Commissioner determined a deficiency of $ 48,372.16 in petitioners' income tax for 1964. The only issue is whether distributions by Medco Electronics Co., Inc., to its shareholders were liquidating distributions under sections 331 and 346, I.R.C. 1954, or whether such distributions were incident to a corporate reorganization and were taxable as dividends under section 356(a)(2).

FINDINGS OF FACT

The parties have stipulated certain facts, which, together with the attached exhibits, are incorporated herein by this reference.

Petitioners, Mark E. and Loveta S. DeGroff, are husband and wife; they were married in 1949. They filed a joint Federal income tax return for the calendar year 1964 with the district director of internal revenue in Oklahoma City, Okla., and resided in Tulsa, Okla., at the time the petition was filed in this case.

54 T.C. 59">*60 For a number of years Mr. DeGroff has been engaged in various activities relating to the invention, promotion, and exploitation of various therapeutic devices. Mrs. DeGroff has been active in such enterprises, in control of office management, bookkeeping, sales records, billing, and the like. In 1949, Mr. 1970 U.S. Tax Ct. LEXIS 228">*232 DeGroff invented a device known as the Medcolator. The Medcolator is an electrical muscle stimulator. It is designed to perform electrodiagnosis, stimulation of innervated and denervated muscles, ion transfer, and medical galvanism. Between 1949 and April 1, 1955, the Medcolator was marketed by a partnership formed by the DeGroffs.

On April 1, 1955, petitioners incorporated Medco Products Co., Inc. (Medco Products), under the laws of the State of Oklahoma for the purpose of marketing electrical therapeutic equipment. At that time Medco Products assumed the task of marketing the Medcolator. On the same date, petitioners also incorporated Medco Products Mfg. Corp. (Medco Mfg.) under the laws of the State of Oklahoma for the purpose of manufacturing the equipment sold by Medco Products. Initially, the Medcolator was the only product handled by either corporation. Mr. and Mrs. DeGroff each owned 50 percent of the capital stock of both Medco Products and Medco Mfg., and served, respectively, as president and vice president of both corporations. Mr. DeGroff's principal efforts on behalf of Medco Products were devoted to product development, promotion, and sales, while his wife's 1970 U.S. Tax Ct. LEXIS 228">*233 duties were primarily related to running Medco Products' business office.

Medco Products established a network of exclusive distributorships to market the Medcolator. Each distributor was given a portion of the United States throughout which he had the exclusive right to sell the Medcolator. The distributors themselves purchased the Medcolator units from Medco Products and then sold the units to physicians, hospitals, and clinics. The distributors earned a 50-percent "commission" or profit on each sale.

By 1955, the Medcolator was threatened by competition from therapeutic devices which used "ultrasound" ¹ rather than electrical stimulation. In an effort to meet this competition, Mr. DeGroff developed a unit which combined the therapies of ultrasound and electrical stimulation. On November 16, 1955, petitioners incorporated Medco Electronics Co., Inc. (Medco Electronics), under the laws of the State of Oklahoma for the purpose of marketing the combination unit under the trade name "Medco-sonlator." The DeGroffs each owned 50 percent of its outstanding capital stock and served respectively as its president and vice president. Like the Medcolator, the Medco-sonlator was manufactured1970 U.S. Tax Ct. LEXIS 228">*234 by Medco Mfg.

54 T.C. 59">*61 During Medco Electronics' first few years, Mr. DeGroff devoted a major portion of his time toward making the Medco-sonlator a commercially acceptable product. Much of his effort was devoted to exhibiting and demonstrating the Medco-sonlator at medical meetings and conventions throughout the country.

In marketing the Medco-sonlator, Medco Electronics used the same network of independent distributors employed by Medco Products; however, at least in some situations, a portion of an existing territory was carved out and assigned to a "division manager." The independent distributors continued to receive a 50-percent commission or profit, as in the case of the Medcolator, but the division managers, or salesmen, received a commission of only 33 1/3 percent. Thus the distribution network, as modified for Medco Electronics, enabled the DeGroffs to market the Medco-sonlator through an expanded sales force and at partly reduced commission rates when sales were made 1970 U.S. Tax Ct. LEXIS 228">*235 by employees rather than independent distributors. The Medcolator, however, continued to be marketed by Medco Products exclusively through the old distributors. The parties have stipulated that a total of 966 Medco-sonlators were sold during Medco Electronics' fiscal year ended November 30, 1963, as follows:

A certain amount of training was necessary before the distributors and division managers were able to demonstrate the Medco-sonlator to prospective customers. Thus, as Mr. DeGroff developed the distribution network, he instructed the distributors and division managers in the operation of the machine. As a result he was gradually able to shift the burden of displaying the machines throughout the country to the distributors and division managers.

On January 31, 1957, Mr. DeGroff filed an application for a patent covering the Medco-sonlator, patent No. 2,830,578, entitled "Electro-Sonic Apparatus," was issued to him on April 15, 1958. On May 1, 1958, he granted to Medco Electronics an exclusive license to "make and sell" and 1970 U.S. Tax Ct. LEXIS 228">*236 a nonexclusive license to "use" devices embodying the patented invention. The license agreement gave Medco Electronics the right to sublicense under the agreement. With respect to assignability, it provided:

54 T.C. 59">*62 VI. ASSIGNABILITY:

This agreement and the license granted hereunder are personal to the parties. This agreement shall be binding upon and inure to the benefit of the parties and to their successors in interest, heirs, assigns and transferees.

Furthermore, Medco Electronics was given the right to bring suit and recover damages on the patent covering the Medco-sonlator.

The agreement contained no requirement for the payment of royalties, and in respect of "consideration," it provided simply that --

LICENSEE agrees to pay LICENSOR Ten Dollars ($ 10.00) and other valuable consideration for the rights granted herein, and said other consideration being in part that it will provide an extensive commercial promulgation of the apparatus embodied in said Patent aforesaid, and will exercise its best endeavors to continually market and sell the apparatus under the Patent aforesaid.

The license agreement also declared that it would remain in effect for the life of the patent, 1970 U.S. Tax Ct. LEXIS 228">*237 but that in the event of Medco Electronics' failure to comply with its covenant to market the Medco-sonlator, DeGroff was given the right to cancel the agreement on 60 days' written notice.

Despite the exclusive nature of the agreement, Medco Mfg. rather than Medco Electronics made or assembled the Medco-sonlator and continued to do so at the time of the trial herein. No evidence of a sublicense agreement between Medco Electronics and Medco Mfg. was offered at the trial herein.

During the years following the organization of Medco Electronics, DeGroff developed a number of other therapeutic devices. Each was assembled or manufactured by Medco Mfg. and marketed by Medco Products. ² Medco Products also marketed two therapeutic devices manufactured by another enterprise and an aviation fuel gauge which DeGroff developed in 1968. All of the independent distributors selling the Medco-sonlator also sold at least some of these devices on behalf of Medco Products.

1970 U.S. Tax Ct. LEXIS 228">*238 Medco Products and Medco Electronics shared the same general business office and the same office employees. Under Mrs. DeGroff's direction the office handled the standard "home office" operations of both corporations, such as correspondence, processing of orders, purchasing, billing, bookkeeping, and banking. Separate books, bank accounts, invoices, bills, and stationery were used in the operations of each corporation. However, orders written or telephoned in to the office for either corporation's products were all handled identically, except that the office workers used the invoices, bills, and stationery of the corporation marketing the product ordered.

54 T.C. 59">*63 With the exception of officers' salaries, payroll taxes, and sales commissions, Medco Products paid all salary and office expenses on behalf of both corporations. At the end of each month, Medco Products billed Medco Electronics for its prorata share of these expenses, based upon its percentage of total sales for that month.

Neither Medco Products nor Medco Electronics carried any inventory. Equipment was obtained from Medco Mfg. only as it was sold.

The same advertising agency was employed by both corporations. It1970 U.S. Tax Ct. LEXIS 228">*239 billed them jointly, and the bill was paid by Medco Products. Although the Medco-sonlator was not always advertised together with Medco Products' wares, Medco Products billed Medco Electronics for the advertising according to its percentage of their joint sales.

By 1963, the Medco-sonlator had received FCC approval and had become successfully established both medically and commercially. The absence of these considerations had theretofore been thought to justify the marketing of this device through a separate corporation. In these circumstances and in view of the fact that the continued existence of Medco Electronics required them to maintain separate records and to print separate bills, invoices, and stationery on its behalf, the DeGroffs decided that Medco Electronics should cease to do business and that Medco Products should market the Medco-sonlator thereafter. The corporate affairs of Medco Electronics were ordinarily conducted loosely on an informal basis, and there are no minutes reflecting the DeGroffs' decision.

On November 30, 1963, at the close of its fiscal year, Medco Electronics ceased marketing the Medco-sonlator. On that date it had accumulated earnings and profits1970 U.S. Tax Ct. LEXIS 228">*240 of $ 124,030. Its balance sheet, as reflected by its books, was as follows:

54 T.C. 59">*64 Thus, on November 30, 1963, Medco Electronics held accounts receivable totaling $ 92,730.90 and an account payable to Medco Products of $ 99,236.91. In order to satisfy part of its debt to Medco Products it transferred all of its accounts receivable to Medco Products. The remaining $ 6,506.01 debt was satisfied by a $ 30,000 "advance" to Medco Mfg. and a transfer to Medco Products of Medco Mfg.'s resulting obligation in return for cash and elimination of the remaining debt.

More specifically, the parties have stipulated that the cash balance of $ 70,653.74 was reduced to $ 59,893.49 as follows:

1970 U.S. Tax Ct. LEXIS 228">*241 The accounts receivable of $ 92,730.90 were disposed of as follows:

During 1964, the DeGroffs received distributions totaling $ 124,530 from Medco Electronics, consisting of $ 59,893.49 in cash and cancellation of the $ 64,636.51 debt due from shareholders, as reflected 54 T.C. 59">*65 on the balance sheet of November 30, 1963. The cash distributions were made as follows:

The amount due from the DeGroffs was canceled on an unspecified date in 1964.

Medco Electronics was not1970 U.S. Tax Ct. LEXIS 228">*242 formally dissolved. Rather, its charter was simply allowed to lapse by nonpayment of the State franchise tax.

In addition to assets appearing on its balance sheet as of November 30, 1963, Medco Electronics had a valuable intangible asset, a going-concern value, in the successful operation of the business of selling a product which enjoyed public acceptance through an established sales distribution network. Its sales record for its fiscal years 1956-63 is shown in the following table:

At the time its business was transferred to Medco Products, Medco Electronics made no attempt to assign its license agreement or 1970 U.S. Tax Ct. LEXIS 228">*243 to grant any sublicense under it. Neither DeGroff alone nor the DeGroffs together ever formally granted Medco Products any rights under it.

After November 30, 1963, the Medco-sonlator was marketed solely by Medco Products. However, there was no substantial change in the daily operations of the business. Although the independent distributors were not contractually obligated to continue to sell the Medco-sonlator, the distributors and other sales personnel who had marketed the Medco-sonlator on behalf of Medco Electronics continued to sell it on Medco Products' behalf. The office employees who had previously processed orders for the Medco-sonlator continued to do so just as they had before. The only change was that the invoicing, billing, correspondence, and advertising was performed in the name of Medco 54 T.C. 59">*66 Products rather than Medco Electronics. Moreover, since advertising circulars for the Medco-sonlator both before and after November 30, 1963, featured the trade name, "Medco-sonlator," rather than the name of Medco Electronics or Medco Products, it appears that the transfer had little, if any, effect on the promotion of the Medco-sonlator. In fact, a 1964 advertising 1970 U.S. Tax Ct. LEXIS 228">*244 circular with respect to the Medco-sonlator and other products erroneously referred to them merely as "Manufactured by Medco Products Co., Inc.," and an earlier circular with respect to another product was issued in the name of "Medco Electronics Company, Inc., Division/Medco Products Co., Inc.," an erroneous designation. The corporate names were used loosely and the identity of the particular corporate entity promoting the sale of the Medco-sonlator does not appear to have played any significant role in its success.

During 1964 DeGroff devoted 10 to 15 percent of his time to promotion of the Medco-sonlator. Between 1964 and 1968 the Medco-sonlator accounted for over 60 percent of Medco Products' dollar sales. Its sales of each of its products for each year of its existence through the year ended November 30, 1968, were as follows: 54 T.C. 59">*67

54 T.C. 59">*68 On their joint Federal income tax return for the calendar year 1964, the DeGroffs reported $ 122,296.58 as long-term capital gain from the "liquidation of Medco 1970 U.S. Tax Ct. LEXIS 228">*246 Electronics Co., Inc." That amount consisted of the $ 124,530 received from Electronics, less $ 500, the basis of their capital stock, and less $ 1,733.42 additional income taxes assessed against Medco Electronics after November 30, 1963, and paid personally by the DeGroffs.

In his notice of deficiency, the Commissioner determined that the transfer of assets from Medco Electronics to Medco Products constituted a reorganization of the two corporations and that therefore the net distribution of $ 122,296.58 was taxable to the DeGroffs as ordinary income rather than capital gain.

OPINION

Petitioner Mark E. DeGroff is an inventor who has been engaged in the development and exploitation of therapeutic devices. The first such device of any consequence was the so-called Medcolator, which was marketed by a partnership in which DeGroff and his wife each had a 50-percent interest. In 1955 he invented another device named the Medco-sonlator, and in that year three corporations were organized, the stock in each of which was owned equally by both spouses. One was a manufacturing corporation (Medco Mfg.) which produced the Medcolator, the Medco-sonlator, and various other devices invented by 1970 U.S. Tax Ct. LEXIS 228">*247 DeGroff. The second was a selling corporation (Medco Products), which promoted and sold the Medcolator and other products invented by DeGroff, except the Medco-sonlator. The third was also a selling corporation (Medco Electronics), which promoted and sold the Medco-sonlator. Although separate records were kept for each corporation, their affairs in respect of one another appear to have been conducted in an informal and rather loose manner. The term "Medco" was the unifying descriptive word that characterized the entire enterprise, and the great bulk of the gross receipts was attributable to products which embodied that term in their names. The Medco-sonlator turned out to be the most profitable product, and the DeGroffs decided informally to combine the activities of both selling corporations in a single corporation as of the close of November 30, 1963, the end of the fiscal year of both Medco Products and Medco Electronics. The unification was achieved by having Medco Products take over all of the activities and functions of Medco Electronics as of December 1, 1963. No formal transfer was made, but all the functions and activities of Medco Electronics were continued without1970 U.S. Tax Ct. LEXIS 228">*248 a break by Medco Products in an identical manner with the same personnel. The only change was a purely formal one in that invoices and other 54 T.C. 59">*69 records were issued in the name of Medco Products, and bank accounts and other records were maintained in the name of but a single corporation, Medco Products.

At the time of the combination of both these corporations Medco Electronics had accumulated earnings and profits in the amount of $ 124,030, and, in connection with the merger of their activities, the DeGroffs received distributions in the full amount of such surplus. Had there been no transfer of Medco Electronics' functions to Medco Products, there is no serious question that such distributions would have been treated as dividends to the DeGroffs, taxable as ordinary income. Is a different result called for merely because such earnings and profits were siphoned out of the enterprise in the manner described above? We hold that the answer must be in the negative and that the determination of deficiency must be sustained.

Petitioners' contention is that there was a liquidation of Medco Electronics and that the amount received by them represents merely payment for their Medco1970 U.S. Tax Ct. LEXIS 228">*249 Electronics stock, with the consequence that the net profit reflected therein is taxable only at the more favorable capital gains rates. They rely upon sections 331(a) and 346(a)(1) of the 1954 Code. ³ If the transaction herein were indeed simply a liquidation of Medco Electronics their position would be impregnable. But this case involves much more than a mere "liquidation." For, simultaneously with the "liquidation," the entire business of Medco Electronics was transferred to Medco Products, a corporation in which the stock was owned in the same proportions by the same persons who owned the stock of Medco Electronics, and the entire corporate business of Medco Electronics was thereafter carried on by Medco Products without interruption in an identical manner. In the light of the facts appearing in this record we agree with the Government that there was here a corporate reorganization rather than a mere liquidation and that the distributions to the stockholders in connection therewith must be treated as taxable dividends where such distributions are 54 T.C. 59">*70 supported by accumulated corporate earnings and profits. Cf. John G. Moffatt, 42 T.C. 558">42 T.C. 558,1970 U.S. Tax Ct. LEXIS 228">*250 affirmed 363 F.2d 262 (C.A. 9), certiorari denied 386 U.S. 1016">386 U.S. 1016; Davant v. Commissioner, 366 F.2d 874 (C.A. 5), affirming in this respect 43 T.C. 540">43 T.C. 540, 43 T.C. 540">568-572, certiorari denied 386 U.S. 1022">386 U.S. 1022, rehearing denied 389 U.S. 893">389 U.S. 893; James Armour, Inc., 43 T.C. 295">43 T.C. 295.

1970 U.S. Tax Ct. LEXIS 228">*251 The statute is complicated, but a careful study thereof leads to the foregoing conclusion. The critical provisions are set forth in sections 354(a) and (b), 356(a)(1) and (2), and 368(a)(1) of the Code. Section 368(a)(1) ⁴1970 U.S. Tax Ct. LEXIS 228">*252 contains the definition of a reorganization, and sections 354 and 356, ⁵ to the extent relevant here, spell out the operative 54 T.C. 59">*71 consequences of a reorganization. In terms of the present case, the Government contends, and we hold, that there was a "reorganization" under section 368(a)(1)(D), with the result that under section 356(a)(2), an exchange in a reorganization having the effect of the distribution of a dividend must be treated as a dividend to the extent recognized and to the extent that it is supported by undistributed corporate earnings and profits.

1970 U.S. Tax Ct. LEXIS 228">*253 If there were a reorganization as defined in section 368(a)(1)(D), as contended by the Government, we have no doubt that the distributions before us must be treated as a dividend under section 356(a)(2), and we reject petitioners' suggestion that Moffatt, Davant, and Armour⁶ may not represent sound law in this connection. We accept these cases on this issue and proceed to consider petitioners' principal contention herein that there was no reorganization under section 368(a)(1)(D).

Section 368(a)(1)(D) provides:

SEC. 368. DEFINITIONS RELATING TO CORPORATE REORGANIZATIONS.

(a) Reorganization. --

(1) In general. -- For purposes of parts I and II and this part, the term "reorganization" means --