French v. Commissioner

Thomas J. and Eleanore G. French, Petitioners, v. Commissioner of Internal Revenue, Respondent. Ruth E. Gebhardt, Petitioner, v. Commissioner of Internal Revenue, Respondent French v. Commissioner Docket Nos. 54417, 54418 United States Tax Court 26 T.C. 263; 1956 U.S. Tax Ct. LEXIS 194; May 15, 1956, Filed *194 Decisions will be entered for the respondent. In 1948 petitioners borrowed money from a corporation to purchase the stock of the majority stockholder and at that time they executed their non-interest-bearing notes to the corporation in the amount of the loans. In 1950 petitioners surrendered a proportional part of their stock to the corporation which then canceled their outstanding notes. Held, this redemption and cancellation of stock was at such time and in such manner as to be essentially equivalent to a taxable dividend within the meaning of section 115 (g), 1939 Code. John C. Reid, Esq., for the petitioners. Paul E. Waring, Esq., for the respondent. Johnson, Judge. JOHNSON *263 Respondent determined deficiencies in the income tax of petitioners for the year 1950 as follows: *195 Docket No. Petitioners Deficiency 54417 Thomas J. and Eleanore G. French $ 12,623.28 54418 Ruth E. Gebhardt 17,099.48 The question presented for our decision is whether petitioners received a distribution essentially equivalent to a taxable dividend, within the meaning of section 115 (g) of the Internal Revenue Code of 1939, when, in the year 1950, they transferred to a corporation of which they were the sole stockholders certain shares of stock in that corporation and the corporation canceled notes of petitioners payable to the corporation. FINDINGS OF FACT. Certain of the facts were stipulated, and are so found. Petitioners Thomas J. and Eleanore G. French are husband and wife, and reside in Dallas, Pennsylvania. They filed a joint income tax return for the year 1950 with the collector of internal revenue at Scranton, Pennsylvania. Petitioner Ruth E. Gebhardt resides in Wilkes-Barre, Pennsylvania, and she filed an individual income tax return for the year 1950 with the collector at Scranton. Thomas J. French and Ruth E. Gebhardt are sometimes hereinafter referred to as petitioners. Prior to 1946, a business called Cooper-Smith Lumber Company was operated as a sole*196 proprietorship by C. Arch Smith. It was in the business of "manufacturing" lumber (operating a sawmill), and *264 selling lumber and materials at wholesale. On June 24, 1946, the business was incorporated with an authorized capital of $ 50,000, consisting of 1,000 shares of $ 50 par value stock. At that time, 881 shares were issued to Smith for the net assets of the proprietorship, which had a net book value of $ 44,050. One share was issued to each petitioner, for which each paid $ 50 cash. French was a salesman for Cooper-Smith Lumber Company and Ruth E. Gebhardt was bookkeeper and office manager. C. Arch Smith died on November 17, 1947, leaving a will which read, in pertinent part, as follows: Item IV. I give to Ruth E. Gebhardt, of the City of Wilkes-Barre, Pa., and to T. J. French, of Dallas, Pa., the equal right to purchase all or so much of my stock of the Cooper-Smith Lumber Co., Inc., a Pennsylvania corporation, as they or either of them may wish to purchase, at the book value of said stock as of the first of the month during which they or either of them give notice to my Executors hereinafter named of their or of his or her intention to purchase said stock. * *197 * * On March 18, 1948, Cooper-Smith Lumber Company had cash of $ 66,665.52, and other assets having a net book value and fair market value of $ 20,000, and the book value of the stock was $ 86,665.51. On that day, Thomas J. French and Ruth E. Gebhardt each executed an agreement with the executors of Smith's estate for the purchase of Cooper-Smith stock, which read, in part, as follows: In consideration of One Dollar and the sale and delivery of said 440 1/2 shares of common stock of Cooper-Smith Lumber Company, a Pennsylvania corporation, by the parties of the first part [executors] to the party of the second part [taxpayer], the party of the second part agrees to pay the sum of $ 43,332.76 in the manner following: $ 33,332.76 within one day after the delivery of said stock and the balance of $ 10,000.00 as follows: * * * That same day, the board of directors of Cooper-Smith, consisting of French and Ruth, passed the following resolutions: Whereas, At a meeting of the stockholders of the Company held on the 18th day of March, 1948, it was duly resolved that the Company loan to Ruth E. Gebhardt, on her personal note, the sum of $ 33,332.75, without interest, payable within six years, *198 and that the Company loan to T. J. French, on his personal note, the sum of $ 33,332.76, without interest, payable within six years, and further that the Board of Directors and the officers of the Company designated by the Board of Directors be authorized to issue checks to Ruth E. Gebhardt and T. J. French for said sums and to take such other action as may be necessary in the premises; Now, Therefore, Be it Resolved, That T. J. French, President, be and is hereby authorized to draw a check of the Company in the sum of $ 33,332.75, payable to Ruth E. Gebhardt, and to deliver the same to her upon delivery of a note signed by the said Ruth E. Gebhardt agreeing to pay to the Company the said sum of $ 33,332.75 within six years from date thereof, without interest. Be it Further Resolved, That Ruth E. Gebhardt, Treasurer, be and is hereby authorized to draw a check of the Company in the sum of $ 33,332.76, payable to *265 T. J. French, and to deliver the same to him upon delivery of a note signed by the said T. J. French agreeing to pay to the Company the sum of $ 33,332.76 within six years from date thereof, without interest. Pursuant to the above resolutions, Cooper-Smith issued*199 checks in the amounts of $ 33,332.76 to French and $ 33,332.75 to Ruth. French and Ruth each gave Cooper-Smith a personal note for $ 33,332.76, payable in 6 years without interest. The checks issued by Cooper-Smith were deposited by petitioners in their respective personal checking accounts at the Second National Bank in Wilkes-Barre. Petitioners delivered their personal checks (in the same amounts respectively as the checks issued to them by Cooper-Smith), and their notes for $ 10,000, payable in installments over 3 years, with interest at 6 per cent, to the executors of Smith's estate. The executors of Smith's estate thereupon transferred 440 1/2 shares of Cooper-Smith common stock to French and a like amount to Ruth. The checks issued by Cooper-Smith to petitioners, and deposited by them as above described, and the personal checks of petitioners to the executors cleared through the petitioners' respective personal checking accounts at the Second National Bank of Wilkes-Barre. During the latter part of 1948, pursuant to stockholders' and directors' resolutions, the authorized capital stock of Cooper-Smith Lumber Company was increased from $ 50,000 par value to $ 150,000 par*200 value, and on December 15, 1948, a stock dividend of 1 234/883 shares of common stock for each share of common stock outstanding was issued. The corporation accounts were adjusted by transferring the par value of the common stock so issued (a total of $ 55,850) from surplus to capital account. At December 31, 1948, the par value of the stock outstanding was $ 100,000. During 1949 and 1950, French and Ruth made payments of principal and interest on their $ 10,000 notes to the executors of Smith's estate, and these note obligations were finally discharged on November 30, 1950. From March 18, 1948, to December 31, 1950, Cooper-Smith Lumber Company carried on its books in an account called "Due from Officers" a debit item of $ 66,665.52, representing the sum of the two checks, each in the amount of $ 33,332.76, which had been issued to French and Ruth on March 18, 1948. The pertinent portion of the minutes of a meeting of the board of directors of Cooper-Smith, held November 14, 1950, at which this account was discussed, is as follows: Mr. French called attention to the question of the realization in cash as a result of discussion about the collectability last July when a temporary*201 loan was negotiated with the Second National Bank. He pointed out that there was some question as to the ultimate realization in the collection of $ 66,000.00, and proposed that consideration be given to the payment to the Company by the offer of the equivalent amounts of common stock in satisfaction of this asset item. *266 It was apparent that if the Company would accept the Company's capital stock in payment it would doubtless improve the financial condition of the Company in future negotiations regarding the bank financing. It appeared to be likewise apparent that the makers of the notes would be unable to meet obligation prior to maturity date. Therefore, it was agreed that before the close of business December 31, 1950 that the Company accept in full payment and cancellation of $ 66,000.00 of personal notes upon receipt of the equivalent book value of common stock shares in payment thereof. On December 31, 1950, French and Ruth each transferred to Cooper-Smith Lumber Company 436 shares of the stock of that company, which then had a book value of $ 33,000.84, plus $ 331.91 in cash. The "Due from Officers" account was then balanced out on the corporate books. The transaction*202 was recorded in the journal of Cooper-Smith Lumber Company as follows: Dec. 31, 1950 Treasury stock 43,600.00 Surplus 22,401.68 Accounts receivable -- T. J. French 33,000.84 Accounts receivable -- R. E. Gebhardt 33,000.84 To record acceptance of 872 shares of common stock offered by T. J. French and Ruth E. Gebhardt in satisfaction of open account and the issuance of Treasury stock certificates for same shares as per minutes of Directors. A certificate for the 872 shares of its stock, issued out of shares received by Cooper-Smith from French and Ruth, was issued in the name of Cooper-Smith Lumber Company, and was carried as treasury stock. Thereafter, petitioners each held 564 shares of stock, and the corporation held 872 shares. A summary of the changes in the corporation's surplus and capital stock accounts is as follows: Earned surplus Capital stock Capital stock issued at incorporation June 24, [1946] $ 44,150.00 Earnings -- period June 24, 1946 to December 31, 1947 $ 42,712.45 Earnings -- 1948 34,872.35 Earnings -- 1949 11,972.02 Earnings -- 1950 17,671.72 Total earnings -- period June 24, 1946 to December 31, 1950 $ 107,228.54 Stock dividend December 15, 1948 (55,850.00) 55,850.00 Acquisition of stock from French and Gebhardt (22,401.68) 1 (43,600.00) Balances December 31, 1950 $ 28,976.66 2 $ 56,400.00 *203 In the year 1948, petitioners each borrowed $ 33,332.76 from Cooper-Smith which each then used to make a downpayment on the purchase price of the stock. When the corporation canceled the notes of petitioners *267 evidencing this indebtedness upon surrender by petitioners of 436 shares each of Cooper-Smith stock, a distribution was effected which was essentially the equivalent of a taxable dividend. OPINION. The respondent has determined that the cancellation of petitioners' notes to Cooper-Smith and the concurrent retirement by the corporation of a part of petitioners' stock occurred at such time and in such manner as to be essentially the equivalent of a taxable dividend within the meaning of section 115 (g) of the Internal Revenue Code of 1939, and in support of his determination relies principally upon Wall v. United States, (C. A. 4, 1947) 164 F. 2d 462; Lowenthal v. Commissioner, (C. A. 7, 1948) 169 F. 2d 694, affirming a Memorandum Opinion of this Court, and Woodworth v. Commissioner, (C. A. 6, 1955) 218 F. 2d 719,*204 affirming a Memorandum Opinion of this Court. The cancellation of stockholder indebtedness under circumstances substantially similar to those in the instant case was held in the Woodworth case to fall within the ambit of section 115 (g). In that case, the principal shareholder of the Buckeye Stamping Company executed a written agreement to sell her shares in the corporation to the members of a purchasing syndicate. Thereafter, the members of the syndicate were able to acquire the shares of the minority stockholders. Subsequently, the principal shareholder and her attorney resigned as directors and a new board was elected, consisting principally of syndicate members. This board ratified the purchase of the majority block of shares by Buckeye, and payment was made by a cashier's check to Buckeye (representing the proceeds of a sale of some securities and other assets held by Buckeye) which was endorsed to the vendor, and two other cashier's checks which apparently represented the balance of Buckeye's quick assets, plus the proceeds of two loans to Buckeye. The vendor surrendered her shares to the corporation, which subsequently issued such shares to the syndicate members*205 in exchange for their notes. The syndicate members, over the course of the next 2 years, reduced their note obligations at various times, but then, upon advice of counsel that there was some question of the legality of issuing shares for notes under the laws of Ohio, each surrendered 75 per cent of his shares of stock to the corporation, which thereupon canceled all the notes due from them. Upon these facts, it was held that the syndicate members had received the equivalent of a dividend under section 115 (g). 1 In Lowenthal v. Commissioner, supra, after acquiring most of the shares in a corporation, the three purchasers borrowed money from the *268 corporation to repay their respective debts to the vendor. The cancellation by the corporation of the stockholders' indebtedness to it upon*206 proportionate surrender of stock by the shareholders was held to fall within section 115 (g). Petitioners raised a number of arguments to the effect that section 115 (g) has no application as to them. They argue that, on the facts before us, we should find that they purchased a corporation which had been drained of cash by the vendors, that they merely acquired the operating assets of Cooper-Smith, and that, at the time of the purchase, they thought they were acquiring the assets of the corporation for $ 20,000 and that the notes executed by them to Cooper-Smith were just "paper work" incident to the acquisition, and consequently were of no particular significance. They argue that if they did not in fact borrow money from the corporation in 1948, there can have been no taxable cancellation of indebtedness in 1950. We have considered all the facts -- that the will of C. Arch Smith permitted petitioners to purchase the stock of Cooper-Smith at book value, and that such book value was $ 86,665.51 at the time of the purchase, that the contract of purchase recited a consideration of $ 43,332.76 due from each purchaser, that petitioners signed the minutes of the meeting of the board *207 of directors authorizing the loans to themselves, and that they executed notes to the corporation which were carried as assets on the corporate books for 2 1/2 years thereafter -- and we have made an ultimate finding that petitioners in fact incurred obligations to the corporation, which finding is dispositive of this argument. Petitioners testified that they did not intend to repay their debts to the corporation, but the intent not to repay a similar obligation did not prevent the application of section 115 (g) in Lowenthal v. Commissioner. Petitioners argue that they were mere conduits for transmitting the cash from the corporation to the vendors at the time of the sale, and rely upon Minnesota Tea Co. v. Helvering, 302 U.S. 609. There, a corporation transferred some of its assets to another corporation in exchange for stock and cash. Under section 112 (d) of the Revenue Act of 1928, cash or other property received by a corporation in a reorganization and distributed by it pursuant to the plan of reorganization was not taxable to the corporation. The corporation distributed the cash to its shareholders with the proviso that the shareholders*208 pay certain of its outstanding obligations. In holding that, to the extent the cash distributed to the shareholders was used by them to discharge corporate obligations, it was income to the corporation, the Supreme Court said that the shareholders were a mere conduit between the corporation and its creditors. In the instant case, however, the cash loaned by Cooper-Smith to petitioners was used by them to discharge their own obligations, not those of the corporation. *269 Petitioners urge us to look through form to substance. They argue that "What actually happened in the present case is the same thing which happened in Zenz v. Quinlivan, 213 F. 2d 914 * * *." In Zenz v. Quinlivan, the sole shareholder in a corporation sold part of her stock to a purchaser, and at some time thereafter the corporation purchased her remaining stock. The Court of Appeals for the Sixth Circuit held that this redemption was not essentially the equivalent of a taxable dividend to the vendor because the redemption completely extinguished the vendor's interest in the corporation. In the instant case, petitioners did not purchase only a part of the vendor's*209 stock, and the corporation did not redeem the rest of it; petitioners bought all of such stock. Zenz v. Quinlivan is not in point. A taxpayer is at liberty to minimize his taxes in any way which the law permits, Pat O'Brien, 25 T. C. 376, but once he has selected a legal means of achieving a certain purpose, the form which he has selected is generally determinative of the tax consequences of his actions, Goetze Gasket & Packing Co., 24 T. C. 249; Woodruff v. Commissioner, 131 F. 2d 429. After having discussed Zenz v. Quinlivan and having concluded that the taxpayers in the case at bar could so have arranged their affairs as to bring themselves within the rule of the Zenz case, the court said, in Woodworth v. Commissioner, supra, that it can be argued that to permit the decision of the Tax Court to stand is to permit form to triumph over substance. Yet, to the extent here implied, it is form which often must prevail, when the delicate question involved is whether the extraction of a corporation's earned surplus has been accomplished*210 at less than the rates taxed upon ordinary income. * * * Upon consideration of all the facts, and particularly the facts that the cancellations of indebtedness herein effected a distribution to petitioners in proportion to their shareholdings, and that there was no evidence of contraction of the business after the redemption (see J. Paul McDaniel, 25 T. C. 276), we have concluded and found as a fact that the 1950 transactions herein were essentially the equivalent of taxable dividends under section 115 (g). Petitioners point to the fact that the minutes of the November 14, 1950, directors' meeting authorizing the redemption and cancellation indicate that the purpose of canceling the stockholders' notes in exchange for stock was to improve the corporation's credit position, and that this evidences a business purpose for the redemption. However, there is no evidence that the corporation was not in fact able to obtain credit with the stockholders' notes outstanding; those same minutes of the directors' meeting recited that the corporation had negotiated a loan with the Second National Bank. There is no proof of business purpose for the redemption sufficient*211 to overcome the presumptive correctness, that this was a section 115 (g) redemption, attaching to respondent's *270 statutory notices of deficiency. Petitioners also point to the fact that the redeemed stock was held as treasury stock and urge that this factor should prevent the application of section 115 (g). However, after the redemption, the petitioners retained their identical proportional interests in the corporation. Under such circumstances, we do not regard the fact that the stock was carried as treasury stock as of any particular significance. Wall v. United States, supra; cf. Smith v. United States, (Ct. Cl.) 130 F. Supp. 586. Decisions will be entered for the respondent. Footnotes 1. Reflected in Treasury Stock account.↩ 2. Exclusive of stock issued to Cooper-Smith Lumber Co.↩ 1. The finding of this Court that the vendor in fact sold her stock to the syndicate, and not to the corporation, serves to remove a seeming distinction between that case and the instant one.↩