Key Takeaways

  • The sale of business doctrine determines when federal securities laws apply to business transactions, especially involving stock sales.
  • Courts may reject the doctrine when the substance of a transaction classifies stock as a security under federal law.
  • Other doctrines like the continuity of business enterprise and unfinished business doctrines impact taxation and professional responsibilities.
  • The business purpose doctrine ensures that transactions have valid economic reasons beyond tax avoidance.
  • Understanding the nuanced application of each doctrine helps clarify their role in business sales, reorganizations, and attorney obligations.

Sale of business doctrine refers to a legal principle stipulating that a stock transfer attached to selling off a business doesn't amount to a transfer of securities. Although outmoded, many courts adopted this principle; however, it was rejected by the Supreme Court in (U.S. 1985) in the case of Landreth vs. Landreth Timber Co. 471 U.S. 681.

Rejection of the Sale of Business Doctrine

The Supreme Court rejected the doctrine in cases that involved the sale of stock in closely held corporations. The court held forth that applying the sale of business doctrine could result in arbitrary distinctions between the transactions that were covered by federal securities law and those that weren't.

Since the applicability of these laws would then depend on factors aside from the characteristics and type of instruments involved, the stock of a corporation could be regarded as a security to the seller — but not to the purchaser.

The Unfinished Business Doctrine and Professional Obligations

The unfinished business doctrine applies primarily to partnerships, especially law and professional firms. It holds that when a partner leaves or a firm dissolves, the revenue from uncompleted work belongs to the partnership rather than the departing partner. This doctrine has been particularly contentious in legal practices, where clients may choose to follow specific attorneys after a firm dissolves.

Courts differ in applying the doctrine. Some uphold it as a means to preserve the firm's value and ensure fair compensation among partners, while others reject it for impeding client autonomy and attorney mobility. For law firms, failing to plan for unfinished business liability can expose attorneys to significant financial claims after departure or dissolution.

Applicability of Federal Securities Law

Similarly, if a purchaser bought bits of stock through different transactions, the federal securities law could apply to some transactions; however, it won't be applicable in the transaction that gave control to the purchaser. Due to the primary purpose of the federal securities law in protecting investors, such distinctions don't make much sense.

Furthermore, the inability of the parties to ascertain if the federal securities law were applicable (at the time of transaction) neither served the purpose of the laws to protect investors nor allowed any compensation to the purchaser due to the additional risk of zero protection when negotiating such a transaction.

This notion has been adopted by several federal courts stipulating that sale of all the stocks of a closely-held corporation are exempt from the laws pertaining to federal securities.

The Business Purpose Doctrine in Tax Planning

The business purpose doctrine is a key principle in federal tax law, used by the IRS to invalidate transactions that lack substantial non-tax reasons. Even if a transaction technically complies with tax code provisions, it may be disregarded if it exists primarily to reduce tax liability without serving a legitimate business goal.

This doctrine is often invoked in the context of:

  • Corporate reorganizations
  • Tax-deferred mergers or acquisitions
  • Transfers involving Qualified Small Business Stock (QSBS)

For example, a transaction may qualify under Section 351 or Section 368 of the Internal Revenue Code, but the IRS may still deny its tax benefits if it concludes that the transaction lacks economic substance apart from tax avoidance. To withstand scrutiny, businesses must document genuine business motivations, such as market expansion, operational efficiency, or capital restructuring.

Delineating Between Stock and Securities

Under the Act, securities include all stock. This is unlike the case of promissory notes where the definition of securities includes “any note”, but doesn't mean that all notes automatically became securities. In virtually all cases, stocks are considered to be securities.

Some of the principal cases that set the standard for determining that stocks are securities were Landreth vs. Landreth Timber Co. and United Housing Foundation v. Forman, 421 U.S. 837-(1975). In the case of Forman, the shares in question were that of a non-profit corporation. When purchased, this stock gave the owner rights to rent a home in a housing cooperative. Since the stock didn't have the characteristics of a traditional investment stock, the court ruled that the stock wasn't a security.

Continuity of Business Enterprise Doctrine

The continuity of business enterprise (COBE) doctrine is another critical factor in determining the tax treatment of corporate mergers and acquisitions. Under this doctrine, a corporate reorganization must retain a significant portion of the target company's business operations to qualify for tax-deferred treatment.

The COBE requirement can be met in two ways:

  1. Asset Continuity: The acquiring corporation continues to use a substantial portion of the target’s assets in its business.
  2. Business Continuity: The acquirer continues the historical business of the target company.

If the acquiring firm immediately disposes of or discontinues the target's operations, the transaction may not qualify for favorable tax treatment under Sections 368 or 351. COBE ensures that reorganization provisions are applied only to legitimate business combinations, not to transactions disguised as sales for tax benefits.

Characteristics Depicting Stocks as Securities

The court ruled that these characteristics did not apply to the shares:

  • Transferability
  • The capacity for appreciation in value
  • The confer of voting right in proportion with the volume of shares bought
  • The rights to receive dividends, upon the apportionment of profits

Since the stock in question lacked these characteristics, the stock in United Housing Foundation v. Forman could not be regarded as a security.

Determining if a Stock is a Security

Due to the results of this case as well as that of WJ. Howey Co. vs. SEC (1946), which set forth the standard that any economic arrangement was a security only if it was also an investment contract, some Court of Appeal then ruled that economic nature of the sale of a stock should determine if the stock was a security or not.

By applying the reasoning which held on Howey's case regarding the control and management of a business, the courts concluded that the transfer of the majority of a closely-held corporation's stock could not be regarded as a transaction in securities under the sale of business doctrine.

However, the U.S. Supreme Court chose to apply the literalist approach stipulating that a corporation's stock is a security unless it lacked the characteristics described in the Forman case. This approach applied even in sales involving all the shares of a corporation. This means that the sale of stocks would always be considered as a sale of securities unless it was proven that there was no investment motive in selling the stock.

This ruling had practical implication for businesses since a business owner who wanted to sell his/her business had an additional incentive for structuring the transaction as a sale of assets, not a stock sale.

Frequently Asked Questions

  1. What is the sale of business doctrine?
    It refers to a legal principle used to determine whether a sale of a business—especially involving stock—is subject to federal securities laws.
  2. What business doctrine applies in law firm dissolutions?
    The "unfinished business doctrine" often applies, requiring profits from ongoing work at the time of dissolution to be shared among former partners.
  3. What is the business purpose doctrine?
    This tax doctrine invalidates transactions if they are solely for tax avoidance and lack genuine business intent.
  4. What role does the continuity of business enterprise doctrine play in mergers?
    It requires that the acquiring company continue significant business operations of the target to qualify for tax deferral.
  5. How do these doctrines relate to securities laws?
    They help determine whether a transaction is a genuine business investment or a formal sale that qualifies as a security, triggering SEC regulations.

If you need help with sale of business doctrine, you can post your legal need on the UpCounsel marketplace. UpCounsel accepts only the top 5% of attorneys/lawyers on its site. Attorneys on UpCounsel come from prestigious law schools like Yale Law and Harvard Law and usually have 14 years of legal experience, including work on behalf of or with companies like Airbnb, Menlo Ventures, and Google.