McKinley Corp. of Ohio v. Commissioner

McKinley Corporation of Ohio, a Corporation, Petitioner, v. Commissioner of Internal Revenue, Respondent McKinley Corp. of Ohio v. Commissioner Docket No. 78001 United States Tax Court 36 T.C. 1182; 1961 U.S. Tax Ct. LEXIS 66; September 29, 1961, Filed *66 Decision will be entered under Rule 50. Distribution to petitioner purchasing corporate stock, after acquisition by it of beneficial and legal title thereto, held dividend to petitioner notwithstanding that sums so acquired were availed of for payment of part of purchase price; petitioner held, further, to be a personal holding company by reason of its receipt of such dividend; failure to file personal holding company return for such year held, further, on the facts, not to subject petitioner to addition to tax for failure to file. Germantown Trust Co. v. Commissioner, 309 U.S. 304 (1940), followed. Joseph J. Lyman, Esq., for the petitioner. Frank W. Hardy, Esq., for the respondent. Opper, Judge. OPPER *1182 Respondent has determined a deficiency against petitioner of $ 409,159.89 in personal holding company surtax, and an addition to *1183 tax of $ 102,289.97 for failure to file a Form 1120H, Return for a Personal Holding Company, for the year 1952. The issues remaining to be decided are (1) whether an amount distributed to petitioner as an integral part of petitioner's acquisition of the corporation making the distribution is a dividend to petitioner, with the consequence that petitioner thereby became a personal holding company within the meaning of section 501 of the 1939 Code, and (2) if so, whether petitioner is liable for the addition to tax under section 291(a) of the 1939 Code for failure*68 to file a personal holding company tax return, Form 1120H, without reasonable cause. FINDINGS OF FACT. The stipulated facts are hereby found accordingly. The McKinley Corporation of Ohio (hereinafter called petitioner) was organized under the laws of Ohio on January 15, 1952, and maintained its principal office in Cleveland, Ohio. It filed its income tax return (Form 1120) for the calendar year 1952 with the district director of internal revenue, Cleveland, Ohio. K. McKinley Smith (hereinafter called Smith) is the president of petitioner and owner of the 100 shares of its authorized and outstanding stock. Smith paid $ 10 per share in cash for the stock. The consideration fixed and recorded on the corporate records was $ 4,250 per share. In November 1951, Smith first learned of the opportunity to purchase the Ohio Piston Company (hereinafter called Piston). Piston was organized under the laws of Ohio in 1921. On December 31, 1951, eight shareholders (hereinafter called the Hendershott group) owned all the 376 outstanding shares of $ 100-par-value common stock. Piston was engaged in the business of manufacturing machined pistons and made substantial profits throughout the years. *69 The income tax returns of Piston disclosed the following distributions to stockholders from accumulated earned surplus since 1944: Balance Yearend Distribution earned surplus $ 239,011.20 — 1944 — None. 177,754.63 — 1945 — None. 409,190.27 — 1946 — None. 380,845.01 — 1947 — $ 115,250 for redemption of stock and $ 152,700 in dividends. 344,332.41 — 1948 — $ 86,450 charged against surplus for redemption of capital stock and $ 25,450 in dividends. 369,499.83 — 1949 — $ 1,880 dividends. 383,339.34 — 1950 — $ 1,880 dividends. 587,791.46 — 1951 — $ 1,880 dividends. Howard Hendershott, a Cleveland attorney, was a shareholder in Piston and represented the Hendershott group in the negotiations for the sale of the Piston stock to Smith. The Hendershott group was *1184 aware of the fact that neither Smith nor petitioner had the available money to consummate the sale. On December 31, 1951, a written agreement was entered into for the sale of the 376 shares of stock, at a total price of $ 655,100 plus an amount equal to two-thirds of the net profits of Piston for the months of November and December 1951. This sales agreement provided, in part: 2. Payment for such shares of Common*70 Stock shall be made by delivery to Sellers by Purchaser on the closing date of the following: (a) The sum of $ 417,600.00 by bank cashier's check payable to Lawyers Title Insurance Corporation, Cleveland, Ohio. (b) Purchaser's notes or debentures, and/or, at Purchaser's option, the notes or debentures of a realty corporation organized to acquire the real estate of [Piston], endorsed by Purchaser, form and provisions of said notes or debentures to be approved by Howard E. Hendershott, Attorney representing the Sellers, in the amount of $ 237,500.00 plus an amount equal to two-thirds (2/3) of the Net Profits of [Piston] * * * for the months of November and December, 1951 * * *. The notes or debentures to be issued to Sellers shall be secured by a [second] real estate mortgage on the real estate presently owned by [Piston] * * * and a chattel mortgage on the machinery and equipment of [Piston], the form and provisions of said real estate mortgage and chattel mortgage to be approved by Howard E. Hendershott, Attorney for the Sellers. 3. The delivery of the certificates for such 376 shares of Common Stock shall be made to Lawyers Title Insurance Corporation no later than 10:00 A.M. on*71 January 18, 1952, and shall be at such earlier date as may be mutually agreed upon by the parties. The cashier's check in the amount of Four Hundred Seventeen Thousand Six Hundred Dollars ($ 417,600.00) shall be delivered to Lawyers Title Insurance Corporation no later than 10:00 A.M. on January 18, 1952, with instructions to deliver said check to Howard E. Hendershott immediately upon delivery of the aforesaid certificates properly endorsed in blank with endorsements guaranteed by a bank or trust company. The certificates of stock shall then be held by Lawyers Title Insurance Corporation until the Purchaser shall have complied with the provisions of Paragraph 2(b) hereof. It is understood and agreed that until said notes, debentures and mortgages shall have been approved and filed that actual possession, control, and title to the stock of said Company shall not pass to the Purchaser and shall be held in escrow by Lawyers Title Insurance Corporation. 4. The [Hendershott group] hereby represent and warrant * * *. * * * * (b) That they own or control, and on the closing date will transfer, or cause to be transferred, to the Purchaser, title to said 376 shares of Common Stock * * * *72 of [Piston]. * * * * 5. * * * * * * * (e) That there shall be deposited with the Purchaser on the closing date resignations of all of the officers and directors of [Piston] * * *. 6. It is understood and agreed that on or as soon as practicable after the closing date herein provided, Purchaser will cause a mortgage to be placed on the land, buildings, and machinery now owned by [Piston] in the amount of $ 237,500.00 plus or minus the amount as herein provided for in Paragraph 2(b) hereof, to be delivered to Sellers, as mortgagees, and evidenced by and payable *1185 at the times and in the manner of the notes or debentures set forth in Paragraph 2(b) above and until said mortgage or mortgages are recorded and is a good second mortgage upon the real estate and a good first chattel mortgage upon the machinery and equipment of the Company, Lawyers Title Insurance Corporation shall hold as security for said notes or debentures the issued and outstanding stock of [Piston]. All rights and obligations of Smith under the contract of sale of December 31, 1951, were assigned to petitioner prior to January 17, 1952. Petitioner was organized on January 15, 1952, for the purpose of this *73 assignment and to acquire the property of Piston so that it could execute the required mortgages. The actual closing date for the transaction was January 17, 1952. Smith had negotiated with a factoring organization, A. J. Armstrong Company, and its subsidiaries, Academy Factors Corporation (hereinafter called Factors) and City Industrial Company (hereinafter called Industrial), in order to supply the needed cash. At a meeting in Hendershott's office, the following steps were taken to finance the sale: Factors issued two checks totaling $ 502,000, one to the Lawyers Title Insurance Corporation for the Hendershotts for $ 417,000 and the second to Piston for $ 85,000 as consideration for transferring legal title to Piston's real estate and equipment to petitioner. The balance of $ 600 was paid by petitioner to the Hendershott group in cash at the settlement. As security for the $ 502,000, the petitioner was required to execute a note with Smith's personal endorsement, dated January 17, 1952, to Factors for $ 537,000. The difference of $ 35,000 was a bonus to Factors for its participation in the transaction. For added control, Factors required petitioner and Piston each to open a *74 bank account in the Chase National Bank in New York City. These accounts were used to pay off simultaneously the note given by petitioner to Factors as follows: On January 17, 1952, Piston borrowed $ 378,000 from Industrial, pledging its accounts receivable and its inventory therefor. Smith signed the agreement as president of Piston. This amount was deposited in the Chase account on January 17 and an additional $ 167,500 was transferred from Piston's Cleveland account to the Chase account by January 18. Piston then transferred $ 545,200 from its Chase account to petitioner's Chase account by means of two checks, the first for $ 375,000, dated January 17, and the second for $ 170,200, dated January 18. Petitioner, in turn, gave Factors two checks, one dated January 17 for $ 370,000 and another dated January 18 for $ 167,456, making a total of $ 537,456 in cancellation of the note for $ 537,000 made on January 17, 1952, and interest of $ 456. Concurrently, Piston executed a deed and bill of sale to the realty and machinery and equipment of Piston to petitioner. Thereafter, also on January 17, petitioner executed notes in the amount of *1186 $ 289,900, secured by mortgages*75 on the property so transferred, and caused the mortgages to be filed at the recorder's office at 9:57 on the morning of the 17th, as required by the Hendershott group. Hendershott held the stock on January 17 and did not transfer it to Lawyers Title Insurance Corporation but delivered it directly to petitioner upon performance by it. Arrangements for the exchange of funds were completed before January 17. The officers and directors of Piston tendered written resignations dated the 17th of January and Smith and his associates replaced them. All of the checks and some contracts and corporate papers were executed by these replacements several days before January 17. Smith became director, as well as president, of Piston. Corporate minutes and corporate records, in addition to Factors' contracts, were dated January 17, 1952, but were signed after that date. Bernard Wind, the certified public accountant auditing the books and preparing petitioner's tax return at that time, was uncertain as to the accounting treatment of the distribution from Piston. Petitioner initially entered the receipt of the two checks from Piston as a $ 545,200 credit to an Ohio Piston Company account. This*76 was immediately adjusted by a debit of $ 9,035.91 to reflect the actual value of Piston's assets on petitioner's books. In March 1952, an adjusting entry was made on petitioner's books, indicating the receipt of a dividend from Piston in the amount of $ 536,176, and the balance in the Piston account was correspondingly reduced. In April, Hyman Friedman, Smith's attorney, drew up corporate minutes for a purported corporate meeting on January 17, 1952. No meeting had been held. These minutes read in part as follows: Minutes of the meeting of the Board of Directors of THE OHIO PISTON COMPANY, held at the Leader Building, Cleveland, Ohio, on the 17th day of January, 1952. There were present at said meeting all of the directors of said corporation, to wit: K. McKINLEY SMITH KENNETH M. SMITH, JR. GLORIA E. SMITH The President of the corporation, K. McKinley Smith, acted as Chairman and the Secretary of said corporation acted as Secretary. The Secretary presented to the Board the report of the auditors of said corporation as of December 31st, 1951 from which report it was shown that the corporation has a present earned surplus in excess of the sum of $ 536,176.00. Upon motion duly made, *77 seconded and unanimously carried, it was Resolved, that a cash dividend in the sum of $ 1,426.00 a share on each of the 376 shares of stock of said corporation, to wit, a total dividend of $ 536,176.00 be and the same hereby is declared out of said surplus, payable on the 17th day of January, 1952 on the close of business on the 17th day of January, 1952 and Resolved, that the Treasurer of the corporation be and is hereby authorized and directed to mail or deliver checks for the payment of said dividend to the *1187 stockholders of record as the same shall appear on the books of the corporation on the date above specified. As a final adjustment, an $ 11.91 entry was made in April 1952, to close out this balance in the Piston account and make it agree with the amount of the dividend as recorded in the minutes. Piston, on its Federal income tax return (Form 1120) filed for the calendar year 1952, reported in "Schedule M -- Reconciliation of Net Income and Analysis of Earned Surplus and Undivided Profits" a cash distribution to stockholders charged to earned surplus during the taxable year 1952 in the amount of $ 536,176. Petitioner's 1952 income tax return included the $ 536,176*78 as dividend income and deducted the 85 percent dividend-received credit in determining the income tax for the year. The dividend from Piston constituted more than 80 percent of petitioner's gross income for the calendar year 1952. On petitioner's 1952 corporate tax return, question 6, Is the corporation a personal holding company within the meaning of section 501 of the Internal Revenue Code? was answered "No" and question 8(b), [Did] any corporation, individual, partnership, trust or association at any time during the taxable year own 50 percent or more of the corporation's voting stock? was answered "Yes, K. McKinley Smith, 75%." Smith owned 100 percent of the stock, but the firms of Friedman & Friedman and Wind & Wind had a 25 percent interest in the stock of the corporation as payment for services. Wind & Wind prepared and signed this return, and Smith, on Wind's advice, signed the return. Petitioner failed to file a personal holding company return (Form 1120H) for the year 1952. Respondent determined that, by reason of the fact that more than 80 percent of petitioner's gross income for the calendar year 1952 was dividend income, and more than 50 percent in value of *79 its outstanding stock was owned by not more than five individuals, petitioner is a personal holding company within the meaning of section 501 of the Internal Revenue Code of 1939 and is liable for the surtax under section 500 of the 1939 Code. In addition, respondent determined that petitioner is liable for an addition to the surtax equal to 25 percent thereof under the provisions of section 291(a) of the Internal Revenue Code of 1939 for failure to file a personal holding company return, Form 1120H, without reasonable cause. OPINION. Petitioner's reliance on the principle of "substance over form" seems to us without foundation on this record. Laying *1188 to one side the proposition that the form adopted by the taxpayer may be accepted by respondent, even though some other method, less severe in its tax consequences, might have been employed, Higgins v. Smith, 308 U.S. 473 (1940), and that it is not ordinarily permissible for a petitioner to disclaim for tax purposes what he has actually done, especially when the means employed was purposely chosen to produce some other benefit, Sheldon Bldg. Corp. v. Commissioner, 118 F. 2d 835, 836*80 (C.A. 7, 1941), affirming a Memorandum Opinion of this Court; Kaufmann v. Commissioner, 175 F. 2d 28, 31 (C.A. 3, 1949), affirming 11 T.C. 483 (1948), we think the present facts show that what was accomplished was precisely what the parties intended. We may accept petitioner's premise that the former stockholders of Piston were concerned with the possible application of the unreasonable earnings accumulation provisions of section 102 of the 1939 Code, and that they desired to find a buyer for their stock in order to achieve a capital gains result in place of the ordinary income treatment which would have been accorded the distribution of a dividend. We may also recognize, with petitioner, its lack of cash which made the purchase impossible out of its own resources or those of its sole stockholder. What seems to us impossible to overlook is the ingenious method by which the parties, including petitioner and its sole stockholder, managed to create a true sale and to supply petitioner, aided by the stockholder's cooperation, with the necessary funds. This latter essential ingredient of the transaction was accomplished by*81 petitioner's arranging to obtain a loan from a third party, for which petitioner and its stockholder were alone liable. It was repaid by petitioner. It was secured by collateral to which petitioner was taking title and in which, at the time, petitioner had the sole beneficial interest. See Jaeger v. Hardy, 48 Ohio St. 335, 27 N.E. 863 (1891); Coggshal v. Marine Bank Co., 63 Ohio St. 88, 57 N.E. 1086 (1900); Butcher v. Kagey Lumber Co., 164 Ohio St. 85, 128 N.E. 2d 54 (1955). That petitioner in order to obtain the cash with which to make repayment of this loan resorted to the expedient of having Piston declare a dividend to it is of no more consequence than if the funds had not been borrowed in the first place, or than if, as occurred to some extent, the funds to repay the first loan had been obtained by another borrowing. What is controlling is that on the one hand petitioner received a dividend, treated it as such, and in fact, so reported it on its income tax return; and, on the other, that the former stockholders sold stock which*82 petitioner bought before the distribution was made. Petitioner insists that the contract of December 31, 1951, was a contract to sell and not in itself a sale. See, e.g., J. T. Wurtsbaugh, 8 T.C. 183*1189 (1947). Assuming this to be so, it is of no help to petitioner. The contract provided for a closing at which the stock would be delivered against payment of cash and the execution of certain notes. The closing date was fixed at 10 a.m. on January 18, 1952, or such earlier date as might be mutually agreed upon. That earlier date was January 17. Upon delivery of the check which took place on the morning of January 17, the contract provided that the shares of stock, endorsed in blank, 1 be delivered to a title company as escrow agent, which was required upon the delivery and recording of the notes and mortgages to transfer "actual possession, control, and title to the stock" to petitioner. Even before this was done and upon delivery of the check, the escrow would have become a trustee with the duty to deliver the stock upon completion of the conditions and petitioner became the beneficial owner thereof. Northern Trust Co. of Chicago v. United States, 193 F. 2d 127*83 (C.A. 7, 1951), certiorari denied 343 U.S. 956; Gordon v. Bartlett, 62 Ohio App. 295, 23 N.E. 2d 964, 969 (1938). If there had been nothing more, the distribution of January 17 would still have been made to petitioner and not to the former owners. See Rupe Investment Corporation, 30 T.C. 240, 255 (1958), affd. 266 F. 2d 624 (C.A. 5, 1959). Cf. Steel Improvement & Forge Co., 36 T.C. 265 (1961). But in addition, as our findings show, the notes were delivered on the morning of January 17 and the necessary mortgages were received by the recorder's office at that time. With this action, the final condition for the passage of title had been performed, the contract was fully executed, and petitioner was, in fact, the legal as well as the beneficial owner. That this was the understanding*84 of the parties is demonstrated by the immediate assumption of actual control by petitioner and indirectly by its sole shareholder. While it is true that Hendershott, the attorney for the sellers, himself held the stock instead of delivering it to the title company in conformity with the contract, there can be little question, under the circumstances, that he could not have failed to conform to the provisions of the contract. H. H. Miller Industries Co. v. Roman, 37 Ohio App. 71, 174 N.E. 141 (1930); De Moss v. Conart Motor Sales, 34 Ohio Op. 535, 72 N.E. 2d 158 (C.P. 1947). The reality as well as the form of the transaction was hence a completed sale of the stock to petitioner and a distribution by Piston to petitioner after petitioner became Piston's shareholder. Although it may be, as petitioner repeatedly insists, that the ultimate recipient of most of the cash was the selling group and that in a sense all of the complicated intervening transactions were for their benefit, it was the sellers as vendors of the stock who were benefited and not that group as stockholders. On the other*85 hand, the distribution *1190 was likewise for the benefit of petitioner and this benefit was received, as we have already concluded, in its capacity as stockholder. Petitioner was liable for the payments called for by the contract, as it was, in addition, the maker and obligor on the note for the borrowed purchase price. Any payment made to discharge these obligations would clearly be for petitioner's benefit, 2Frithiof T. Christensen, 33 T.C. 500 (1959); Northern Trust Co. of Chicago v. United States, supra, entirely aside from the fact that, by means of the total transaction including the payment of its liability, petitioner became the owner of the stock of an apparently prosperous corporation. *86 The conclusion that the distribution was made to petitioner, that the stock had already been sold to it, and that it was consequently a dividend since there were earnings and profits to support it, 3 leads inevitably to the result that the petitioner was a personal holding company and that in that respect the determination was correct. As petitioner itself says in its brief: If the entire distribution of January 17, 1952 was in fact made to petitioner, we must determine whether it was taxable as dividend income. As dividend income it would have been personal holding company income in excess of 80% of petitioner's gross income. It would follow that the personal holding company surtax assessed by respondent would have been proper. Petitioner should accordingly have filed a personal holding company tax return on Form 1120H. Sec. 39.508-1, Regs. 118. That it did not do so, however, *87 does not necessarily subject it to the addition to tax for failure to file which was imposed by respondent. Here, unlike Hatfried, Inc. v. Commissioner, 162 F. 2d 628 (C.A. 3, 1947), reversing on this issue a Memorandum Opinion of this Court, all of the essential information indicating that petitioner was a personal holding company appeared on the face of petitioner's income tax return.4 Not only was the fact disclosed that over 80 percent of petitioner's income was derived from dividends, but the question, [Did] any * * * individual * * * at any time during the taxable year own 50 percent or more of the corporation's voting stock? was answered "Yes, K. McKinley Smith, 75%." And while the personal holding company tax itself was not there computed, that could readily have been done from the information which did appear upon the income tax return. It is accordingly impossible to regard it as no return for purposes of the personal holding company tax. *1191 Germantown Trust Co. v. Commissioner, 309 U.S. 304 (1940); cf. Commissioner v. Lane-Wells Co., 321 U.S. 219 (1944).*88 In the face of these disclosed facts, petitioner's answer that it was not a personal holding company was no more than an innocent misstatement of a legal conclusion. As respondent himself contends in attempting to show the incompetence of petitioner's advisers: The return itself reflected the dividend of $ 536,176.00 and anyone with even a smattering knowledge of tax law should have recognized that petitioner was a personal holding company. Insofar as the addition to tax for failure to file is concerned, the determination is disapproved. The foregoing disposition of the principal issue makes it unnecessary to consider the claim for income tax refund advanced in the petition, which in any event, however, appears to have been abandoned. Decision will be entered under Rule 50. Footnotes 1. Uniform Stock Transfer Act, Ohio Rev. Code Ann., secs. 1705.01, 1705.04↩. 2. This is the reverse of a situation where accounts and bills receivable and other securities were "assets of the corporation expressly reserved for distribution to the retiring stockholders." (Emphasis added.) T. C. Power & Brother, 6 B.T.A. 835, 841 (1927). See also T. J. Coffey, Jr., 14 T.C. 1410↩ (1950). 3. Petitioner's brief states: "Ohio Piston Company had sufficient accumulated earnings to distribute $ 537,456.36 on January 17, 1952."↩ 4. The Hatfried↩ case erroneously stated that all material information was included in the return. Assuming this premise, which is justified here, that case is additional authority for the present result.