                       118 T.C. No. 5



                UNITED STATES TAX COURT



SOUTH TULSA PATHOLOGY LABORATORY, INC., Petitioner v.
     COMMISSIONER OF INTERNAL REVENUE, Respondent



Docket No. 18557-98.             Filed January 28, 2002.



     P agreed to sell a portion of its business
(clinical business) to N, a third party, pursuant to a
prearranged sale that was structured as a spinoff. P’s
basis in the clinical business’s assets was $105,015.
On Oct. 29, 1993, P transferred the clinical business
to a newly incorporated entity, S, in exchange for all
of S’s stock, pursuant to sec. 368(a)(1)(D), I.R.C.,
and, on Oct. 30, 1993, P distributed the stock to P’s
shareholders in a transaction it claimed satisfied the
requirements of sec. 355, I.R.C. On the same day as
the distribution of S’s stock to P’s shareholders, S’s
shareholders sold all of S’s stock to N for $5,530,000.
P had accumulated E & P as of the beginning of its
taxable year and failed to prove that P and S did not
have current E & P as of Oct. 30, 1993. Although P
conceded that the spinoff followed immediately by the
prearranged stock sale constituted evidence that the
transaction was a device to distribute E & P within the
meaning of sec. 355(a)(1)(B), I.R.C., and sec. 1.355-
                                - 2 -

     2(d), Income Tax Regs., P claimed it had valid
     corporate business purposes for structuring the
     transaction as it did which overcame the evidence of
     device. Alternatively, P argued that, even if the
     spinoff did not meet the requirements of secs. 355 and
     368, I.R.C., the value of S’s stock for purposes of
     calculating the gain P must recognize under sec.
     311(b)(1), I.R.C., should be calculated based on the
     value of the assets transferred to S and not on the
     price paid for S’s stock by N.
          1. Held: There is substantial evidence that the
     spinoff was a device to distribute E & P, which is not
     overcome by substantial evidence of nondevice or by
     evidence that P and S lacked current and accumulated E
     & P. Consequently, the spinoff does not qualify for
     tax deferral under secs. 368 and 355, I.R.C., and P’s
     gain must be determined in accordance with sec.
     311(b)(1), I.R.C.
          2. Held, further, sec. 311(b)(1), I.R.C.,
     requires P to recognize gain on the distribution of S’s
     stock as though the stock were sold to P’s shareholders
     at its fair market value. In this case, the best
     evidence of the fair market value of S’s stock on the
     distribution date is the price paid for the stock by N
     on that same date.



     Thomas G. Potts, for petitioner.

     Elizabeth Downs, for respondent.



     MARVEL, Judge:    Respondent determined a deficiency in

petitioner’s Federal income tax of $1,926,232 for taxable year

ended June 30, 1994.

     The issues for decision are:   (1) Whether, pursuant to a

plan of reorganization under section 368(a)(1)(D),1 petitioner’s

     1
      All section references are to the Internal Revenue Code in
effect for the year in issue, and all Rule references are to the
                                                   (continued...)
                                - 3 -

distribution to its shareholders of stock of a controlled

corporation qualified as a nontaxable distribution under section

355; and (2) if the distribution did not qualify as a nontaxable

distribution under section 355, whether the fair market value of

the distributed stock for purposes of calculating petitioner’s

gain under section 311(b)(1) is measured by the price paid for

the stock by a third-party purchaser on the distribution date or

by the alleged value of the controlled corporation’s assets on

the day before the distribution.

                          FINDINGS OF FACT

     Some of the facts have been stipulated and are so found.     We

incorporate the stipulation of facts herein by this reference.

I.   Petitioner’s Business in General

     South Tulsa Pathology Laboratory, Inc. (petitioner), is, and

was for all relevant periods, an Oklahoma professional

corporation, which had its principal place of business in Tulsa,

Oklahoma, when it filed its petition in this case.   Petitioner

was incorporated as an Oklahoma professional corporation in July

1968.    Petitioner was owned by seven physicians (shareholders).

For all relevant periods, petitioner was classified as a “C”

corporation for Federal corporate income tax purposes and had a



     1
      (...continued)
Tax Court Rules of Practice and Procedure.   Monetary amounts are
rounded to the nearest dollar.
                               - 4 -

fiscal year ended June 30 for tax and financial reporting

purposes.

      Since its incorporation, petitioner has provided pathology-

related medical services to hospitals and medical professionals

in northeastern Oklahoma.   Until 1993, petitioner offered both

anatomic pathology and clinical pathology medical services to its

customers (anatomic business and clinical business,

respectively).   Petitioner’s anatomic business included

examination and diagnosis of pathology of human tissue and

provision of consulting diagnostic assistance to physicians in

northeastern Oklahoma.   Petitioner’s anatomic business services

were performed by its physician shareholders and/or other

licensed physicians.   Petitioner’s clinical business included

performance of laboratory tests on body fluids and tissue samples

obtained from hospitals and medical professionals throughout

northeastern Oklahoma.   Petitioner’s clinical business services

were performed by nonphysician employees of petitioner at a

laboratory and three “draw” facilities in Tulsa, Oklahoma.

II.   Petitioner’s Decision To Sell Its Clinical Business

      Beginning in 1970, and continuing through 1992, petitioner

received several offers from competing clinical pathology

laboratories to purchase its clinical business.   These offers

were always rejected by petitioner’s shareholders and management.

In 1993, however, petitioner’s shareholders decided to sell the
                                - 5 -

clinical business to a large national clinical laboratory because

they believed the growth of large national clinical laboratories

and the implementation of managed health care during the early

1990s would force petitioner out of the clinical business over

the next few years.   Petitioner’s shareholders, however, decided

they wanted to continue to own and operate the anatomic business

using the corporate name, “South Tulsa Pathology Laboratory,

Inc.”, under which they had practiced for 25 years.

III. Sale of Clinical Business to NHL

     In August 1993, petitioner was approached by representatives

of two national laboratory chains, Smith Kline Laboratories

(Smith Kline) and National Health Laboratories, Inc. (NHL), each

of which expressed an interest in purchasing petitioner’s

clinical business.    Both Smith Kline and NHL were large, publicly

traded corporations that provided clinical laboratory services to

hospitals, physicians, and clinics throughout the United States.

     Sometime in the fall of 1993, petitioner decided to pursue a

sale of its clinical business to NHL.   On September 20, 1993,

petitioner and NHL entered into a confidentiality agreement to

provide for the disclosure by petitioner to NHL of certain

confidential information.   Under the confidentiality agreement,

petitioner agreed to disclose certain financial and business

information necessary and appropriate in any negotiations

conducted by the parties.
                               - 6 -

     After petitioner made the disclosures pursuant to the

confidentiality agreement, petitioner agreed to sell its clinical

business to NHL.   Before October 5, 1993, petitioner and NHL

negotiated the sale of the clinical business and agreed to

structure it as a sale of the stock of a yet-to-be-incorporated

clinical laboratory company that would be capitalized with the

clinical business and spun off2 from petitioner.   Thereafter, NHL

delivered to petitioner a letter of intent, dated September 30,

1993, concerning the purchase by NHL of all outstanding stock of

that newly incorporated clinical laboratory company.    After both

parties signed the letter of intent, petitioner’s shareholders

believed there was a commitment by NHL to buy and a commitment by

petitioner to sell petitioner’s clinical business.3    As of

October 5, 1993, petitioner and NHL had negotiated and agreed to

the essential terms of the sale.4


     2
      A spinoff is described as a “pro rata distribution by one
corporation of the stock of a subsidiary”. Bittker & Eustice,
Federal Income Taxation of Corporations and Shareholders, par.
11.01[1][e], p. 11-6 (7th ed.).
     3
      Ordinarily, NHL purchased clinical laboratory businesses
through an asset sale. In this case, NHL agreed to structure its
purchase of the clinical business as a stock sale only if it
could acquire a “clean” corporation. A “clean corporation” was
defined by the parties as one in which no clinical laboratory
tests had been performed that could subject the purchaser (NHL)
to any potential liability.
     4
      Petitioner conceded in its brief that “the sale of the
Clinpath stock to NHL was prearranged prior to the spin-off
transaction”.
                               - 7 -

     A.   Spinoff of Clinpath, Inc.

     On October 5, 1993, petitioner formed Clinpath, Inc.

(Clinpath), an Oklahoma general business corporation.     Pursuant

to a subscription agreement between petitioner and Clinpath,

dated October 6, 1993, petitioner agreed to purchase 14,399

shares of the common stock of Clinpath, representing 100 percent

of the issued shares of Clinpath.

     On October 29, 1993, petitioner and its shareholders entered

into a reorganization agreement in which they agreed, among other

things, that:   (1) Petitioner shall contribute all of its

clinical laboratory assets to Clinpath in exchange for 14,399

shares of Clinpath stock issued to petitioner; and (2) after the

exchange of petitioner’s clinical laboratory assets for Clinpath

stock, petitioner promptly shall distribute all of the Clinpath

stock to petitioner’s shareholders in proportion to their

ownership of stock in petitioner.      Also, on October 29,

petitioner transferred the clinical laboratory assets, including

goodwill, to Clinpath, and Clinpath transferred 14,399 shares of

its common stock to petitioner.   Petitioner’s adjusted basis in

the Clinpath stock it received equaled $105,015, its adjusted

basis in the clinical laboratory assets it transferred to

Clinpath in exchange for the stock.

     On October 30, 1993, petitioner distributed 100 percent of

the Clinpath stock to petitioner’s shareholders in proportion to
                               - 8 -

their stock ownership.   Clinpath conducted no business during the

period from October 5, 1993, the date of Clinpath’s

incorporation, through October 30, 1993.

     B.   Sale of Clinpath Stock to NHL

     Pursuant to an acquisition agreement dated October 30, 1993,

on October 30, 1993, immediately following the distribution of

Clinpath stock to petitioner’s shareholders, Clinpath

shareholders5 transferred all of the issued and outstanding

Clinpath stock to NHL in exchange for $5,530,000.    The purchase

price paid by NHL for the Clinpath stock was negotiated and

agreed upon by unrelated parties at arm’s length.

     As a condition precedent to the sale, NHL demanded that each

of Clinpath’s physician-shareholders execute covenants not to

compete, dated October 30, 1993.   The covenants not to compete

provided that each of the physician-shareholders agreed not to

compete with NHL in the clinical laboratory business anywhere

within the 918 area code of the State of Oklahoma for 5 years,

except as provided in the contract.    NHL paid each of the

physician-shareholders $10,000, or a total of $70,000, in

exchange for the covenants not to compete.    The total


     5
      Before completing the sale to NHL, petitioner’s
shareholders transferred 244 shares of the Clinpath stock they
received from petitioner to the profit-sharing plan of
petitioner’s business manager. Consequently, the Clinpath
shareholders consisted of petitioner’s shareholders and the
profit-sharing plan.
                                 - 9 -

consideration, consisting of covenant payments and the purchase

price of the Clinpath stock, was $5,600,000.    The consideration

allocated to the covenants not to compete was negotiated and

agreed upon by unrelated parties at arm’s length.6

      Neither petitioner nor its shareholders retained any

ownership interest in Clinpath after October 30, 1993.

IV.   Petitioner’s Earnings and Profits as of October 30, 1993

      Petitioner had accumulated earnings and profits of at least

$236,347 as of its taxable year beginning July 1, 1993.

Petitioner did not prove whether petitioner and Clinpath had

current earnings and profits as of October 30, 1993.

                                OPINION

I.    The Statutory Framework

      Section 361(a) provides that “No gain or loss shall be

recognized to a corporation if such corporation is a party to a

reorganization and exchanges property, in pursuance of the plan

of reorganization, solely for stock or securities in another

corporation a party to the reorganization.”    Section 368(a)(1)

defines reorganization for purposes of section 361 to include:


      6
      In connection with the sale of Clinpath stock, petitioner
and NHL executed a consulting agreement, dated Oct. 30, 1993,
providing for a continuing business relationship between
petitioner and NHL for 5 years. The consulting agreement
reflected the desire of both petitioner and NHL to partner with
each other to increase the competitive position of both entities
in northeastern Oklahoma with respect to both clinical and
anatomic pathology services.
                               - 10 -

            (D) a transfer by a corporation of all or a part
       of its assets to another corporation if immediately
       after the transfer the transferor, or one or more of
       its shareholders (including persons who were
       shareholders immediately before the transfer), or any
       combination thereof, is in control of the corporation
       to which the assets are transferred; but only if, in
       pursuance of the plan, stock or securities of the
       corporation to which the assets are transferred are
       distributed in a transaction which qualifies under
       section 354, 355, or 356; * * *

The above-described transaction, commonly referred to as a “D”

reorganization, is sometimes used to divide an existing

corporation on a tax-deferred basis into more than one

corporation for corporate business purposes.    In order for a

divisive D reorganization to qualify for tax-deferred treatment

at the corporate level under section 361, however, there must be

a qualifying distribution of stock under section 355.

       In this case, petitioner divided its existing business into

two parts by way of a spinoff.    It transferred its clinical

business to a newly formed subsidiary, Clinpath, in exchange for

100 percent of Clinpath’s stock.    Petitioner then immediately

distributed the Clinpath stock to its shareholders in a

transaction petitioner claims met the requirements of section

355.

       If a spinoff does not qualify under section 355, it could

result in a taxable dividend to the distributing corporation’s

shareholders under section 301 to the extent of corporate

earnings and profits and in tax to the distributing corporation
                               - 11 -

computed in accordance with sections 311(b)(1) and 312.   Secs.

355(c), 361(c).   Section 311(b)(1) provides that, if a

corporation distributes property to a shareholder in a

transaction governed by sections 301 through 307 and the fair

market value of such property exceeds its adjusted basis in the

hands of the distributing corporation, then gain shall be

recognized to the distributing corporation as if such property

were sold to the distributee at its fair market value.    Section

312(b) provides that, on a distribution of appreciated property

by a corporation with respect to its stock, earnings and profits

of the corporation are increased by the excess of the fair market

value of the property over its basis.

II.   The Parties’ Arguments

      The primary issue in this case is whether petitioner’s

spinoff of Clinpath qualified as a valid reorganization under

section 368(a)(1)(D).   Respondent claims it did not so qualify

because the distribution of Clinpath’s stock to petitioner’s

shareholders did not qualify as a nontaxable distribution under

section 355.   Respondent asserts that the spinoff of Clinpath and

the subsequent sale of Clinpath stock to NHL were, in reality, a

prearranged sale by petitioner of its clinical business which

failed to qualify as a reorganization under section 368 and a

nontaxable distribution of stock to petitioner’s shareholders

under section 355.   Consequently, respondent contends petitioner
                               - 12 -

realized and must recognize gain on the distribution of Clinpath

stock.   Sec. 311(b)(1).   Petitioner disagrees, urging us to

conclude that it structured the spinoff of its clinical business

and the subsequent sale of Clinpath’s stock for legitimate

corporate business purposes and that the spinoff satisfied the

requirements of sections 368(a)(1)(D) and 355.    Therefore,

petitioner contends, it is not required to recognize gain on the

distribution of Clinpath stock to its shareholders.

     Respondent also argues that, in calculating the gain to

petitioner under section 311(b)(1) as a result of the failed

reorganization, the fair market value of the Clinpath stock must

be measured by the price paid by NHL for that stock.    Petitioner

agrees that the amount of corporate gain, if any, resulting from

the distribution is based on the excess of the fair market value

of the Clinpath stock over petitioner’s basis in the stock but

argues that the fair market value of the stock must be measured

by the underlying value of the clinical business’s assets

contributed by petitioner to Clinpath on October 29, 1993.

     In order to resolve these disputes, we must first decide

whether the distribution of Clinpath stock to petitioner’s

shareholders met the section 355 requirements.    We conclude that

it did not for the reasons set forth below.
                                - 13 -

III. Section 355 Distribution

     Section 355(a)(1) permits a nontaxable distribution by a

corporation to its shareholders of stock in a controlled

corporation if the distribution meets four statutory

requirements:   (1) Solely stock of a controlled corporation is

distributed to shareholders with respect to their stock in the

distributing corporation; (2) the distribution is not used

principally as a device for the distribution of earnings and

profits of the distributing corporation or the controlled

corporation or both; (3) the requirements of section 355(b)

(relating to active businesses) are satisfied; and (4) all of the

controlled corporation’s stock held by the distributing

corporation, or an amount constituting control, is distributed.

Sec. 355(a)(1).   In addition to these statutory requirements, the

regulations under section 355 require that the distribution have

an independent corporate business purpose and that there be

continuity of proprietary interest after the distribution.    Sec.

1.355-2(b) and (c), Income Tax Regs.

     Respondent argues that the distribution of Clinpath stock to

petitioner’s shareholders failed to satisfy the requirements of

section 355 because: (1) The distribution of Clinpath stock was a

device for the distribution of earnings and profits in violation

of section 355(a)(1)(B); (2) the spinoff of Clinpath lacked a

valid corporate business purpose as required by section 1.355-
                             - 14 -

2(b), Income Tax Regs.; and (3) the prearranged sale of Clinpath

stock on the same date as the distribution of Clinpath stock to

petitioner’s shareholders violated the continuity of proprietary

interest requirement of section 1.355-2(c), Income Tax Regs.

Petitioner, on the other hand, argues that the transaction met

all the requirements of section 355 and related regulations.     We

examine the parties’ arguments below.

     A.   Nondevice Requirement of Section 355(a)(1)(B)

     A transaction fails to qualify under section 355 if that

transaction is used principally as a device for the distribution

of the earnings and profits of the distributing corporation, the

controlled corporation, or both.   Sec. 355(a)(1)(B); see also

sec. 1.355-2(d)(1), Income Tax Regs.    We analyze whether a

transaction was used principally as a device for distributing

earnings and profits by examining all the facts and

circumstances, including, but not limited to, the presence of the

device factors listed in section 1.355-2(d)(2), Income Tax Regs.,

and the presence of the nondevice factors listed in section

1.355-2(d)(3), Income Tax Regs.

     Petitioner essentially concedes that there is evidence of

device as described in section 1.355-2(d)(2), Income Tax Regs.;

however, it argues that a lack of substantial earnings and

profits, sec. 1.355-2(d)(5), Income Tax Regs., and a corporate
                                 - 15 -

business purpose, sec. 1.355-2(d)(3), Income Tax Regs., outweigh

any evidence of device.

          1.    Device Factors

     Section 1.355-2(d)(2), Income Tax Regs., identifies the

following factors as evidence that a transaction was a device for

the distribution of a corporation’s earnings and profits:   (1)

Pro rata distribution among the shareholders of the distributing

corporation and (2) subsequent sale or exchange of stock of the

distributing or the controlled corporation.   Our analysis of

these factors is set forth below.

     A distribution that is pro rata or substantially pro rata

among shareholders of the distributing corporation is more likely

to be used principally as a device and is evidence of device.

Sec. 1.355-2(d)(2)(ii), Income Tax Regs.   Petitioner does not

dispute that the Clinpath stock was distributed pro rata to

petitioner’s shareholders.   The parties stipulated that pursuant

to the reorganization agreement, petitioner would and did

distribute all the Clinpath stock to its shareholders in

proportion to their stock ownership in petitioner.   This factor

is evidence of device.

     A sale or exchange of the distributing or controlled

corporation’s stock after a distribution is also evidence of

device.   Sec. 1.355-2(d)(2)(iii)(A), Income Tax Regs.   Generally,

the greater the percentage of stock sold and the shorter the
                              - 16 -

period of time between the distribution and the sale or exchange,

the stronger the evidence of device.   Id.   On brief, petitioner

concedes “100% of Clinpath’s stock was sold to NHL, and the

distribution and the subsequent sale of stock occurred on”

October 30, 1993.

     In addition, a sale or exchange negotiated or agreed upon

before the distribution is substantial evidence of device.     Sec.

1.355-2(d)(2)(iii)(B), Income Tax Regs.   On brief, petitioner

concedes that “there is no question that the sale of the Clinpath

stock to NHL was prearranged prior to the spin-off transaction in

which the clinical laboratory assets of Petitioner were

transferred to Clinpath.”   Indeed, the sale of Clinpath stock to

NHL was discussed, negotiated, and agreed upon by NHL and

petitioner and was anticipated by both parties well before the

distribution.   Sec. 1.355-2(d)(2)(iii)(D), Income Tax Regs.   This

factor is substantial evidence of device.

     We conclude, based on a review of the applicable factors,

that the facts and circumstances of this case present substantial

evidence of device within the meaning of section 355(a)(1)(B).

                2.   Nondevice Factors and
                     Absence of Earnings and Profits

     In order to overcome the substantial evidence of device,

petitioner argues that:   (1) Although both petitioner and

Clinpath had some accumulated earnings and profits during the

periods in question, these amounts were not significant enough to
                             - 17 -

warrant the conclusion that the spinoff of Clinpath was a device

in contravention of section 355(a)(1)(B), and (2) several

compelling corporate business purposes drove the entire

transaction.

                    a.   Earnings and Profits

     Section 1.355-2(d)(5), Income Tax Regs., specifies three

types of distributions that ordinarily do not present the

potential for tax avoidance and will not be considered to have

been used principally as a device for the distribution of

earnings and profits even if there is other evidence of device.

A distribution that takes place at a time when neither the

distributing nor the controlled corporation has earnings or

profits is one of the distributions described in section 1.355-

2(d)(5), Income Tax Regs., and is the only type of distribution

thus described that petitioner argues applies in this case.

     A distribution ordinarily is considered not to have been

used principally as a device if:   (1) The distributing and

controlled corporations have no accumulated earnings and profits

at the beginning of their respective taxable years; (2) the

distributing and controlled corporations have no current earnings

and profits as of the date of the distribution; and (3) no

distribution of property by the distributing corporation

immediately before the separation would require recognition of

gain resulting in current earnings and profits for the taxable
                                - 18 -

year of the distribution.    Sec. 1.355-2(d)(5)(ii), Income Tax

Regs.    Petitioner claims that the distribution at issue here

satisfies these requirements.

     In its opening brief, petitioner concedes, “that the balance

sheet for * * * [petitioner] as of June 30, 1993, reflected

current and accumulated earnings and profits of $252,928.64, for

both the anatomic and clinical pathology portions of * * *

[petitioner’s] business.”7   Petitioner argues, however, that:

          While petitioner concedes that it and Clinpath had
     some earnings and profits during the periods in
     question, these amounts were not meaningful and
     certainly do not provide a basis for a “bailout” of
     these earnings and profits amounts in order to avoid
     dividend treatment to Petitioner’s shareholders.

Respondent disagrees, contending that the presence of any

earnings and profits precludes petitioner from utilizing section

1.355-2(d)(5)(ii), Income Tax Regs., and that there is no

credible evidence that petitioner lacked accumulated or current

earnings and profits on the distribution date.

     We agree with respondent for several reasons.    First,

petitioner reported it had over $230,000 of accumulated earnings

and profits as of July 1, 1993, and petitioner did not introduce

any evidence to prove that it had no current earnings and profits

as of October 30, 1993.    Section 1.355-2(d)(5)(ii)(A) and (B),


     7
      Petitioner also reported on its Federal income tax return
for the taxable year beginning July 1, 1993, that it had
accumulated earnings and profits of $236,347 as of July 1, 1993.
                              - 19 -

Income Tax Regs., emphasizes that a distribution ordinarily will

not be considered to have been used principally as a device if

the distributing and controlled corporations have “no accumulated

earnings and profits at the beginning of their respective taxable

years” and “no current earnings and profits as of the date of the

distribution”.   (Emphasis added.)   Section 1.355-2(d)(5)(ii),

Income Tax Regs., does not provide a safe harbor for corporations

with “insignificant” or “minimal” earnings and profits, as

petitioner contends.

     Second, petitioner ignores the fact that the spinoff enabled

it to claim that the substantial gain on the distribution of

Clinpath stock to its shareholders, which ordinarily would have

increased its current and accumulated earnings and profits, need

not be recognized for corporate income tax purposes or reflected

in the calculation of its earnings and profits as of October 30,

1993 and at yearend.   Respondent argues that, if the spinoff of

Clinpath did not qualify for tax-free treatment under sections

368 and 355, the distribution of Clinpath stock to petitioner’s

shareholders would be taxable under section 311(b) and,

therefore, would have generated substantial current earnings and

profits to petitioner under section 312(b) as of October 30, the

date of the distribution.

     Neither party disputes that, if the spinoff of Clinpath

does not qualify as a tax-free transaction under sections 368 and
                              - 20 -

355, petitioner must realize and recognize substantial gain as of

the date of distribution, sec. 311(b)(1), which will

substantially increase petitioner’s earnings and profits, sec.

312(b).   Nevertheless, petitioner dismisses the prospect that it

would have substantial current earnings and profits as a result

of the spinoff8 and overlooks what respondent describes as “the

conspicuous fact that the corporate profits petitioner’s

shareholders clearly intended to bail out were the anticipated

profits of the prearranged sale.”   Despite petitioner’s efforts

to suggest otherwise, we simply are not convinced that the

decision to structure this transaction as a spinoff and

subsequent stock sale was prompted by NHL; NHL usually structured

its acquisitions as asset sales to minimize its exposure to

liabilities that can arise from the purchase of an active

business.   Petitioner’s protestations notwithstanding, the

spinoff of Clinpath followed immediately by a prearranged sale of

the Clinpath stock on the same day appears to have been designed

to eliminate the corporate-level tax that would have been due had


     8
      Petitioner acknowledges that dividends paid to its
shareholders result “in a fairly significant double income tax
liability, and is the primary reason that * * * [petitioner]
distributes most or all of its income to its employee
shareholders and other employees prior to year end”, presumably
as deductible compensation. Petitioner claims, however, that its
practice of distributing income “virtually assures that there
would be little or no corporate income tax liability * * *
irrespective of the ultimate outcome of the spin-off
transaction.”
                              - 21 -

petitioner sold its clinical business to NHL directly or

distributed its clinical business to its shareholders prior to

any sale.

      For the reasons set forth above, petitioner has failed to

prove that it did not have accumulated or current earnings and

profits as of the date of the distribution within the meaning of

section 1.355-2(d)(5)(ii), Income Tax Regs.

                     b.   Corporate Business Purpose

     The presence of a valid corporate business purpose may trump

a conclusion that the transaction was used principally as a

device for the distribution of earnings and profits.     Sec. 1.355-

2(b)(4),(d)(3)(ii), Income Tax Regs.   Section 1.355-2(b)(2),

Income Tax Regs., defines “corporate business purpose” as a “real

and substantial non-Federal tax purpose germane to the business

of the distributing corporation, the controlled corporation, or

the affiliated group * * * to which the distributing corporation

belongs.”

     The stronger the evidence of device, such as the presence of

the device factors specified in section 1.355-2(d)(2), Income Tax

Regs., the stronger the corporate business purpose required to

prevent the conclusion that the transaction was used principally

as a device.   Sec. 1.355-2(d)(3), Income Tax Regs.    The

assessment of the strength of the business purpose must be made

based upon all the facts and circumstances, including, but not
                                - 22 -

limited to:   (1) The importance of achieving the purpose to the

success of the business; (2) the extent to which the transaction

is prompted by a person not having a proprietary interest in

either corporation, or by other outside factors beyond the

control of the distributing corporation; and (3) the immediacy of

the conditions prompting the transaction.   Sec. 1.355-2(d)(3)(i)

and (ii), Income Tax Regs.

     Petitioner identifies three purported corporate business

purposes for the disputed distribution:   (1) Increased

competition caused by a changing economic environment that

favored the larger, national laboratories; (2) Oklahoma State law

restricting the ownership of petitioner to licensed physicians or

physician-owned entities licensed to practice medicine within

Oklahoma; and (3) NHL’s requirement that each of petitioner’s

physician-shareholders sign binding and enforceable covenants not

to compete in the clinical laboratory business.   Respondent

contends there was no valid corporate business purpose for the

distribution.   We consider each of the purported corporate

business purposes below.

                           i.   Increased Competition

     The first purported corporate business purpose asserted by

petitioner is that the changing economic environment in the

clinical laboratory market in 1993 favored the large, national

laboratories over the smaller clinical laboratories, such as
                              - 23 -

petitioner’s.   This environment, petitioner contends, was caused

by increasing competition from national clinical laboratories,

delivery of service issues, and development of alliances between

large health insurance companies and national clinical

laboratories.   Petitioner argues that, based upon these economic

factors, its shareholders and employees became convinced that

petitioner’s clinical laboratory would be forced out of business

within a few years.   This belief led the shareholders to sell the

clinical business to NHL and “partner” with NHL to enhance the

competitive position of their remaining anatomic business.

     We do not question, and respondent does not dispute, that

the economic factors cited by petitioner may have forced it out

of the clinical business within a few years.   Although these

factors may have been the impetus behind the decision to sell the

clinical business in the first instance, such factors do not

demonstrate a corporate business purpose for petitioner’s

decision to distribute the Clinpath stock to its shareholders

before selling the stock to NHL.   A transfer of the clinical

laboratory assets directly to Clinpath would have sufficed to

achieve petitioner’s desired result; i.e., to create a new

company containing solely the assets of the clinical business in

order to sell the clinical business with minimum liability to the

buyer.   Minimizing the effect of the economic factors cited by

petitioner, however, did not require the nearly simultaneous
                               - 24 -

distribution of Clinpath stock to its shareholders.   The purpose

of separating the clinical laboratory assets in preparation for

the sale to NHL and shielding NHL from liability was achieved as

soon as the clinical business was contributed to Clinpath by

petitioner in exchange for Clinpath stock.   See generally sec.

1.355-2(b)(5), Example (3), Income Tax Regs.

     The changing economic environment, therefore, does not by

itself constitute a valid corporate business purpose for the

distribution of Clinpath stock to petitioner’s shareholders or

constitute evidence of nondevice.

                         ii.   Petitioner’s Status as a
                               Professional Corporation

     The second purported corporate business purpose arises from

petitioner’s claim that Oklahoma State law mandated the final

structure of the spinoff transaction.   Petitioner essentially

argues that it was constrained from selling, and NHL was

prevented from purchasing, petitioner’s stock because

petitioner’s status as a professional corporation prevented NHL

from owning any interest in it.

     Petitioner’s argument concerning its status as a

professional corporation is without merit.   Even if petitioner

were precluded from selling its stock to nonphysicians as

petitioner contends, such a bar would justify only petitioner’s

decision to transfer its clinical business to a separate general

business corporation, i.e., Clinpath; it would not lend support
                              - 25 -

to petitioner’s decision to distribute Clinpath stock to

petitioner’s shareholders.   Indeed, petitioner could have sold

the Clinpath stock directly to NHL without first transferring the

Clinpath stock to its shareholders.9

     We conclude, therefore, that petitioner’s status as a

professional corporation does not provide a valid corporate

business purpose for the distribution of Clinpath’s stock to

petitioner’s shareholders and is not evidence of nondevice.

                          iii. Covenants Not To Compete

     The third purported corporate business purpose cited by

petitioner is NHL’s requirement that each of Clinpath’s

physician-shareholders sign a binding and enforceable covenant

not to compete.   Relying upon Bayly, Martin & Fay, Inc. v.

Pickard, 780 P.2d 1168 (Okla. 1989), petitioner contends that

representatives for both petitioner and NHL believed that a

covenant not to compete would be enforced under Oklahoma State

law only if it were entered into in connection with the sale of

goodwill or the dissolution of a partnership.   Petitioner



     9
      Pulliam v. Commissioner, T.C. Memo. 1997-274, a case on
which petitioner relies, is distinguishable because the spinoff
and subsequent prearranged sale of some of the distributed stock
involved in Pulliam could not have been structured as a direct
sale of stock between the distributing corporation and the third-
party purchaser (a former employee). We concluded that the
structure of the transaction was compelled by applicable State
law, which prohibited a corporation from owning a funeral
business, and by the need to structure the stock sale as an
installment sale.
                               - 26 -

contends that the final structure of the transaction as a sale of

Clinpath stock by Clinpath’s shareholders, and not by petitioner,

was mandated by NHL’s desire to obtain from the shareholders

valid and enforceable covenants not to compete.     Therefore, a

corporate business purpose existed for the distribution of

Clinpath stock to the shareholders.

     We do not agree.   Even if we were to conclude that NHL’s

desire to obtain enforceable covenants not to compete qualified

as a corporate business purpose of either petitioner or Clinpath,

as section 1.355-2(b)(2), Income Tax Regs., requires, we would

still reject petitioner’s argument.     Okla. Stat. Ann. tit. 15,

sec. 217 (West 1986 and Supp. 2000), provides that “Every

contract by which any one is restrained from exercising a lawful

profession, trade or business of any kind, otherwise than as

provided by Sections 218 and 219 of this title, is to that extent

void.”   Oklahoma State courts interpret Okla. Stat. Ann. tit. 15,

sec. 217, to prohibit only unreasonable restraints on the

exercise of a lawful profession, trade, or business.     Bayly,

Martin & Fay, Inc. v. Pickard, supra at 1172; Crown Paint Co. v.

Bankston, 640 P.2d 948, 952 (Okla. 1981); Bd. of Regents v. Natl.

Collegiate Athletic Association, 561 P.2d 499, 508 (Okla. 1977).

The majority rule is that reasonable restrictions will be

enforced.    Bayly, Martin & Fay, Inc. v. Pickard, supra at 1170-

1171.    Even unreasonable contracts in restraint of trade, which
                             - 27 -

are normally void and unenforceable under Oklahoma State law, are

enforceable if they fall within one of the two statutorily

created exceptions to the general rule–-covenants given in

connection with the sale of goodwill or covenants given in

connection with the dissolution of a partnership.   Okla. Stat.

Ann. tit. 15, secs. 218 and 219 (West 1986 and Supp. 2000);

Bayly, Martin & Fay, Inc. v. Pickard, supra at 1170.   Assuming

the covenants in this case were reasonable and/or were given in

connection with the sale of goodwill, it was unnecessary to first

distribute the Clinpath stock to petitioner’s shareholders.10

Petitioner has failed to demonstrate either that the covenants in

question were unreasonable or that they were not adequately tied

to the sale of goodwill under Oklahoma State law.

     We conclude, therefore, that NHL’s demand for binding and

enforceable covenants not to compete does not constitute a

corporate business purpose within the meaning of section 1.355-

2(d)(3)(ii), Income Tax Regs., and, therefore, is insufficient to

overcome the substantial evidence of device in this case.11


     10
      Petitioner in its posttrial briefs appears to concede that
the sale of Clinpath involved the sale of both “practice
goodwill” inherent in the going concern value of the clinical
business and “professional goodwill” possessed by petitioner’s
physician-shareholders.
     11
      Even if we were to conclude that any of the alleged
corporate business purposes satisfied the requirements of sec.
1.355-2(d)(3)(ii), Income Tax Regs., we would still conclude
that, under the balancing test required by the regulations, the
                                                   (continued...)
                              - 28 -

                3.   Conclusion

      There is substantial evidence of device in this case, which

is not overcome by substantial evidence of nondevice or by proof

that petitioner and Clinpath lacked current or accumulated

earnings and profits.   We hold, therefore, that the distribution

of Clinpath stock failed to satisfy the requirements of section

355(a)(1).12

IV.   Tax Treatment of the Distribution of Clinpath Stock

      Section 311(a) provides that, except as provided in section

311(b), no gain or loss shall be recognized to a corporation on a

nonliquidating distribution, with respect to its stock, of its

stock or property.   Section 311(b)(1), however, requires a

corporation to recognize gain on nonliquidating distributions of

appreciated property to its shareholders as though such property

were sold to the distributee at its fair market value.

      It is well settled that fair market value is the price at

which property would change hands between a willing buyer and a

willing seller, neither being under any compulsion to buy or sell

and both having reasonable knowledge of the relevant facts.


      11
      (...continued)
evidence of corporate business purpose was insufficient to
overcome the compelling evidence of device in this case.
      12
      Because we hold that the sec. 355(a)(1) requirement is not
met, we do not separately decide whether the independent
corporate business purpose requirement of sec. 1.355-2(b)(1),
Income Tax Regs., or the continuity of proprietary interest
requirement of sec. 1.355-2(c)(1), Income Tax Regs, has been met.
                              - 29 -

United States v. Cartwright, 411 U.S. 546, 551 (1973); Morris v.

Commissioner, 70 T.C. 959, 988 (1978).    The determination of fair

market value is a question of fact.    Hamm v. Commissioner, 325

F.2d 934, 938 (8th Cir. 1963), affg. T.C. Memo. 1961-347; Estate

of Newhouse v. Commissioner, 94 T.C. 193, 217 (1990).

     The parties agree that if we hold the distribution of

Clinpath stock to petitioner’s shareholders did not qualify as a

section 355 transaction, as we have, then the amount of corporate

gain resulting from the distribution is the excess of the fair

market value of the Clinpath stock in the hands of petitioner

over petitioner’s adjusted basis in the stock.   The parties do

not dispute that petitioner’s adjusted basis in the clinical

laboratory assets, and, accordingly, the Clinpath stock, was

$105,015.   The parties disagree, however, as to how the fair

market value of the Clinpath stock should be measured.

     Respondent contends that the fair market value of the

Clinpath stock petitioner received and distributed to its

shareholders on October 30, 1993, should be measured by the price

paid by NHL for the Clinpath stock.    NHL purchased the Clinpath

stock for $5,530,000 on the same day the stock was distributed to

petitioner’s shareholders.   Petitioner argues in effect that the

purchase price paid by NHL for the Clinpath stock was excessive

and urges us to conclude instead that the fair market value of

the Clinpath stock should be measured by the fair market value of
                                - 30 -

the clinical laboratory assets contributed by petitioner to

Clinpath.   At trial, Harry Joe Wells, Jr., an expert witness

called by petitioner, testified that the fair market value of the

clinical laboratory assets, including going-concern value, was

$1,040,000.     Petitioner contends that the Clinpath stock could

not possess a value in excess of the fair market value of its

underlying clinical laboratory assets, given Clinpath’s status as

a new corporation with no operating history; therefore, the focus

of section 311(b) in this case should be the fair market value of

the clinical laboratory assets.     Petitioner relies upon our

decision in Pope & Talbot, Inc. v. Commissioner, 104 T.C. 574,

579 (1995), affd. 162 F.3d 1236 (9th Cir. 1999), the first of

three decisions involving Pope & Talbot, Inc.,13 as support for

its position.    Hereinafter, for clarity, we shall refer to the

relevant decision as Pope & Talbot, Inc. I.

     In Pope & Talbot, Inc. I, the taxpayer corporation, pursuant

to a plan of distribution, transferred its timber and land

development properties and related assets located in the State of

Washington (collectively referred to as the Washington

properties) to a newly formed Delaware limited partnership

(partnership).    The partnership’s initial partners were two newly

formed corporate general partners, which initially were owned


     13
      See also Pope & Talbot, Inc. v. Commissioner, T.C. Memo.
1997-116, supplemented by T.C. Memo. 1997-399, affd. 162 F.3d
1236 (9th Cir. 1999).
                              - 31 -

equally by two of the taxpayer’s principal shareholders.     Upon

transfer of the Washington properties to the partnership, the

managing general partner made a pro rata distribution of the

interests in the partnership (partnership units) to the

taxpayer’s shareholders on the basis of one partnership unit for

each 5 shares of common stock.   The taxpayer was not a partner in

the partnership and received no partnership units.

     The issue decided in Pope & Talbot, Inc. I was whether gain

from the distribution of appreciated property under former

section 311(d),14 the predecessor to section 311(b)(1), is

determined as if the taxpayer had sold the Washington properties

in their entirety for their fair market value, or by reference to

the value of the property interests, i.e., the partnership units,

received by each shareholder. We concluded that gain from the

distribution of appreciated property under former section 311(d)

must be determined as if the taxpayer had sold the Washington

properties for their fair market value on the date of the

distribution.   Pope & Talbot, Inc. v. Commissioner, supra at 584.

     We reached our conclusion by examining the language and

purpose of former section 311(d).   Former section 311(d), like

section 311(b)(1), required gain to be calculated “as if the

property distributed had been sold at the time of the


     14
      Sec. 311(d)(1) was amended and recodified as sec.
311(b)(1) by the Tax Reform Act of 1986, Pub. L. 99-514, sec.
631(c), 100 Stat. 2272.
                               - 32 -

distribution.”    Pope & Talbot, Inc. v. Commissioner, supra at

577.    Because we were unable to answer with certainty the

question of what property interest had to be valued under former

section 311(d) after examining the statutory language, we

examined the legislative history and concluded that “the purpose

underlying section 311(d) was to tax the appreciation in value

that had occurred while the distributing corporation held the

property and to prevent a corporation from avoiding tax on the

inherent gain by distributing such property to its shareholders.”

Pope & Talbot, Inc. v. Commissioner, supra at 579.

       We face a different dispute from that decided by this Court

in Pope & Talbot, Inc. I.    In Pope & Talbot, Inc. I, we only

decided what property interest had to be valued for purposes of

section 311(d).    In this case, the parties agree that the

property distributed by petitioner to its shareholders was the

Clinpath stock.    The disagreement in this case relates only to

the valuation of that stock for purposes of section 311(b).

Although petitioner urges us to apply Pope & Talbot, Inc. I as a

limitation on our analysis of the fair market value of the

Clinpath stock, we must reject petitioner’s plea because

valuation was not the issue decided in Pope & Talbot, Inc. I.

Thus, our decision in Pope & Talbot, Inc. I is distinguishable.

       In order to calculate the gain that petitioner must

recognize under section 311(b)(1), we must decide the fair market
                                - 33 -

value of the Clinpath stock in the hands of petitioner as if such

property were sold to its shareholders at fair market value.

Sec. 311(b)(1).   Fair market value is defined for Federal tax

purposes as “the price at which the property would change hands

between a willing buyer and a willing seller, neither being under

any compulsion to buy or to sell and both having reasonable

knowledge of relevant facts.”    United States v. Cartwright, 411

U.S. at 551 (quoting sec. 20.2031-1(b), Estate Tax Regs.).    In

general, the best evidence of fair market value is “actual sales

made in reasonable amounts and at arm’s length within a

reasonable time before or after the date for which a value is

sought.”   Morris v. Commissioner, 70 T.C. at 988; see also Estate

of Fitts v. Commissioner, 237 F.2d 729 (8th Cir. 1956), affg.

T.C. Memo. 1955-269.

     In this case, there was an actual third-party sale of the

Clinpath stock to NHL on the same day as the distribution of the

Clinpath stock to petitioner’s shareholders.   Petitioner

contends, however, that the fair market value of the Clinpath

stock as of October 30, 1993, cannot exceed the fair market value

of the clinical business’s assets contributed to Clinpath by

petitioner.   Petitioner introduced into evidence a report by

Harry Joe Wells, Jr., which it claims valued “selected” assets as

of October 30, 1993, but which, in reality, purported to value

the clinical business as a “going business” as of October 29,
                                - 34 -

1993.     The Wells report, using an indirect method of valuation,

concluded that the value of the clinical business was only

$1,040,000, including the alleged value of corporate goodwill.

Citing our decisions in Norwalk v. Commissioner, T.C. Memo. 1998-

279, and Martin Ice Cream Co. v. Commissioner, 110 T.C. 189

(1998), petitioner contends that the $4,490,000 difference

between the value determined in the Wells report and the purchase

price paid for the Clinpath stock is attributable to professional

goodwill generated by and belonging to its physician-

shareholders.15

     We reject the Wells report because it did not value the

property distributed to petitioner’s shareholders as of the date

of distribution as required by section 311.     Instead, the Wells

report valued “selected” assets of petitioner as of October 29,

1993, the day before the Clinpath stock was distributed to

petitioner’s shareholders and then sold to NHL pursuant to a

prearranged deal.     The Wells report did not consider the

prearranged stock sale to NHL, did not focus on the relevant

date, and did not value the Clinpath stock.




     15
      Petitioner’s expert witness, on the other hand, testified
that the difference between the purchase price paid by NHL and
the value reconstructed in his report was paid for NHL’s own
“synergy”. Petitioner’s expert could not and did not explain why
NHL would pay over $4 million for a synergy NHL allegedly
created.
                              - 35 -

     We also reject the Wells report and petitioner’s argument

because they are simply not credible.    Neither the Wells report

nor petitioner’s argument reconciles the conclusions reached

regarding the value of the assets contributed to Clinpath

($1,040,000) and the amount of professional goodwill attributable

to the physician-shareholders ($498,000) with what actually

transpired in this case.   In an arm’s-length sale negotiated

prior to October 29, 1993, between NHL and the physician-

shareholders who had adverse interests, NHL paid $5,530,000 for

the Clinpath stock and $70,000 for the covenants not to compete

with the seven physician-shareholders.   Neither petitioner nor

its expert witness credibly explained how their positions on

valuation reconcile with these facts.    The physician-shareholder

who testified at trial did not admit that the covenants not to

compete had been undervalued in the negotiations or agree that

Clinpath’s physician-shareholders had collectively

mischaracterized over $4,000,000 of the amount they received from

NHL as proceeds from the sale of capital assets rather than as

ordinary income attributable to the covenants.

     There is a compelling reason why we ordinarily view an

actual and contemporaneous sale between unrelated parties having

adverse interests as the best evidence of the fair market value

of property-–ordinarily, it is credible evidence.    See Morris v.

Commissioner, supra.   In this case, the relevant sale is even
                              - 36 -

more credible because the sale involved the very asset we are

required to value by section 311(b)(1), and the sale took place

on the valuation date specified in section 311(b)(1); i.e., the

date the Clinpath stock was distributed to petitioner’s

shareholders.

     We hold, therefore, that the fair market value of the

Clinpath stock on the date it was distributed to petitioner’s

shareholders equaled $5,530,000, the price negotiated and agreed

upon as the stock’s sale price to NHL.16   We also hold that

petitioner realized and must recognize gain of $5,424,985,

calculated by subtracting petitioner’s adjusted basis in the

stock, $105,015, from the fair market value of the Clinpath

stock, $5,530,000.

     We have considered the remaining arguments of both parties

for results contrary to those expressed herein and, to the extent

not discussed above, find those arguments to be irrelevant, moot,

or without merit.




     16
      In his notice of deficiency, the Commissioner determined
petitioner’s gain to be $5,494,985. This amount was calculated
by subtracting petitioner’s basis in the Clinpath stock,
$105,015, from the total consideration of $5,600,000 paid by NHL.
The portion of the sale price allocated to the covenants not to
compete, $70,000, was not subtracted from petitioner’s gain as
determined in the notice of deficiency. On brief, respondent
conceded that the $70,000 represented the fair market value of
the covenants not to compete and was not part of the value of the
14,399 shares of Clinpath stock.
                        - 37 -

To reflect the foregoing,


                                  Decision will be entered

                             under Rule 155.
