Grabowski Trust v. Commissioner

Stanley F. Grabowski Trust for Ronald Grabowski, United Bank and Trust Company, Trustee, et al., 1 Petitioners v. Commissioner of Internal Revenue, Respondent Grabowski Trust v. Commissioner Docket Nos. 6018-68, 6019-68, 6020-68 United States Tax Court 58 T.C. 650; 1972 U.S. Tax Ct. LEXIS 87; July 19, 1972, Filed *87 Decisions will be entered for the respondent. Stanley and Helen Grabowski owned an 80.2-percent interest in the common stock of Stanley Plating Co., Inc. The Grabowskis had established trusts for three of their children and the trusts invested in Stanley Plating Co., Inc., preferred stock. This preferred stock was later redeemed by the company. Held, the distributions to the trusts in redemption of the preferred stock held by the trusts were "essentially equivalent to a dividend" under the language of sec. 302(b)(1) of the Code. The 80.2-percent common stock interest of the Grabowskis is attributed to their children and then, in turn, attributed to the trusts in which the children were beneficiaries by virtue of the constructive ownership rules of sec. 318 of the Code. The redemption did not cause a "meaningful reduction" in the proportionate constructive interest which the trusts held in Stanley Plating Co., Inc. Further, the trusts' constructive right to share in the earnings of the company was not altered by the redemption and the trusts' constructive right to share in the company's assets upon liquidation was actually enhanced by the redemption. David I. Pollowitz, for the *88 petitioners. Robert B. Dugan, for the respondent. Irwin, Judge. IRWIN *650 OPINION Respondent determined deficiencies with respect to these consolidated cases for the taxable year ended February 28, 1965, in the following amounts: Docket No. 6018-68 $ 4,886.95 Docket No. 6019-68 4,830.52 Docket No. 6020-68 4,886.95 *651 All of the facts have been stipulated and are found accordingly. Petitioner, trustee for the three trusts in question here, had its principal place of business at 200 Main Street, Bristol, Conn., at the time the petitions herein were filed. The Stanley Plating Co., Inc., was incorporated on October 1, 1947, with an authorized capital stock of $ 50,000 of common stock. At the time of incorporation, the stock issued and ownership thereof was as follows: Relationship to Number of Stanley F. Grabowski shares Stanley Grabowski [110] Helen Grabowski Wife [109] Michael Grabowski Brother [12] Louis Grabowski Brother [12] In treasury stock [195] Total [438] Stanley Plating Co., Inc., amended its capital structure on March 31, 1955, after which its capital stock consisted of: 36,000 shares of common stock, at $ 2.50 par value $ 90,000 30,000 shares of class A preferred stock, at $ 1 par value 30,000 30,000 shares of class B preferred stock, at $ 1 par value 30,000 150,000 On *89 April 1, 1955, a common stock dividend of 11 shares on every one then outstanding was declared. An amount of $ 75,075 was transferred from earned surplus to common stock to effect said stock dividend. The subscribers to class A preferred and class B preferred, however, contributed new considerations for their stock. Under the provisions of amended certificate of incorporation, the preferences, privileges, voting power, restrictions, or qualifications of class A preferred, class B preferred, and common stock were as follows: Class A Preferred 1. Dividend rights. -- The holders shall be entitled to receive from surplus or net profits as and when declared by the board of directors noncumulative dividends upon such shares at the rate of 6 percent per annum and no more, payable in preference and priority to the declaration or payment of any dividends upon common stock. 2. Voting rights. -- Nonvoting. 3. Rights on dissolution. -- Upon dissolution, after payment in full *652 of the par value of the class B shares plus any dividends declared on class B shares but unpaid thereon, then the class A shares shall be paid in full the par value of the shares held by them plus any dividends declared but *90 unpaid thereon. 4. Rights of corporation to retire stock. -- Directors can retire at any time by paying par value and dividends declared but unpaid in current year. Class B Preferred 1. Dividend rights . -- The holders shall be entitled to receive from surplus or net profits, after full noncumulative dividends on class A shall have been declared and paid or set apart for payment, noncumulative dividends, as and when declared by the board of directors upon such shares, at the rate of 6 percent per annum. During any 1 year, after class A and class B and common shall have received a dividend of 6 percent then class B shall participate with the common in any additional dividends declared by the board of directors. 2. Voting rights. -- Nonvoting. 3. Rights on dissolution. -- Upon dissolution, the holders shall be paid in full the par value of the shares held by them plus dividends declared but unpaid thereon before any amount shall be distributed among the holders of any other class of stock. 4. Rights of corporation to retire stock. -- Directors can retire at any time by paying par value and dividends declared but unpaid in the current year. Common Stock 1. Dividend rights. -- The holders *91 shall be entitled to a 6-percent dividend after class A and B are paid 6 percent. Then to participate with class B on any additional dividends during any such year. 2. Voting rights. -- All voting rights. 3. Rights on dissolution. -- Upon dissolution after paying class A and B par value plus current year dividends declared but unpaid the balance of the net assets. On December 28, 1951, Stanley F. Grabowski created an irrevocable trust for his son Ronald, known as the Stanley F. Grabowski Trust for Ronald Grabowski. The corpus consisted of $ 5,500 in cash. On December 28, 1951, Stanley F. Grabowski created an irrevocable trust for his son David, known as the Stanley F. Grabowski Trust for David Grabowski. The corpus consisted of $ 5,500 in cash. *653 The trusts for Ronald and David Grabowski each invested $ 5,200 in the class A preferred stock and $ 10,000 in the class B preferred stock of Stanley Plating Co., Inc., on May 31, 1957. On April 24, 1962, Helen Grabowski (wife of Stanley Grabowski) created an irrevocable trust for her daughter Janet Grabowski. The corpus of said trust consisted of 5,200 shares of the class A preferred stock and 10,000 shares of the class B preferred stock *92 of Stanley Plating Co., Inc. On September 22, 1964, the shareholders of Stanley Plating Co., Inc., voted to redeem the class A and class B preferred stock issued and outstanding commencing on November 2, 1964. Said redemption at par value was completed prior to December 31, 1964. As of September 30, 1964, and December 31, 1964, Stanley Plating Co., Inc., had assets, liabilities, and capital in the following amounts: Assets Sept. 30, 1964 Dec. 31, 1964 Cash $ 163,531.22 $ 152,112.07 Notes and accounts receivable 88,704.05 76,835.89 Inventories 45,060.89 42,801.19 Other current assets 28,061.69 22,021.01 Loans to stockholders 3,861.21 1,011.40 Other investments 20,230.43 20,230.43 Buildings and other fixed depreciable assets 229,959.86 231,206.01 Land (net of any amortization) 22,101.32 22,101.32 Other assets 45,527.83 48,471.47 Total assets 647,038.50 616,790.79 Liabilities and capital Accounts payable $ 15,265.14 $ 13,101.63 Mortgages, notes, and bonds payable in less than 1 year 13,076.56 92,197.44 Other current liabilities 124,818.57 110,705.94 Loans from stockholders 5,124.36 5,124.36 Mortgages, notes, and bonds payable in 1 year or more 70,762.68 Other liabilities 12,856.56 2,457.00 Capital stock: (a) Preferred stock 50,600.00 (b) Common stock 81,900.00 81,900.00 Paid-in or capital surplus Surplus reserve 106,920.77 108,211.20 Earned surplus and undivided profits 165,713.86 203,093.22 Total liabilities and capital 647,038.50 616,790.79 *93 *654 On November 1, 1964, the issued and outstanding capital stock of Stanley Plating Co., Inc., was held by the following persons: Relationship to Number of Percent Shareholder Stanley F. shares ownership Grabowski Common stock Stanley F. Grabowski 13,200 40.3 Helen M. Grabowski Wife 13,080 39.9 Michael Grabowski Brother 2,760 8.4 Louis Grabowski Brother 2,760 8.4 Walter Grabowski Brother [480] 1.5 Joseph Kowalec Brother-in-law [480] 1.5 Total common stock 32,760 100.0 Class A preferred Stanley F. Grabowski 2,000 9.8 Trust for Ronald Grabowski Son 5,200 25.2 Trust for David Grabowski Son 5,200 25.2 Trust for Janet Grabowski Daughter 5,200 25.2 Michael Grabowski Brother 1,022 4.9 Louis Grabowski Brother 1,022 4.9 Walter Grabowski Brother [178] .9 Joseph Kowalec Brother-in-law [178] .9 Charles Grabowski Brother [100] .5 Various others (five at 100 each) [500] 2.5 Total class A preferred 20,600 100.0 Class B preferred Trust for Ronald Grabowski Son 10,000 33.3 Trust for David Grabowski Son 10,000 33.3 Trust for Janet Grabowski Daughter 10,000 33.3 Total class B preferred 30,000 100.0 From March 31, 1955, the date of amended articles of incorporation, through 1960 the corporation did not pay dividends on any class of stock. From January 1, 1961, through the date of redemption of the preferred *94 class A and B stock, dividends on the respective classes of stocks were as follows: Common $ 20,527.56 Class A preferred 4,944.00 Class B preferred 11,235.00 Total 36,706.56 The total amount distributed in redemption of the two classes of Stanley Plating Co., Inc., preferred stock was $ 50,600. The trusts (for Ronald, David, and Janet) each received $ 15,200 during their taxable year ended February 28, 1965, from Stanley Plating Co., Inc., in redemption of said preferred stock, consisting of $ 5,200 for class A and $ 10,000 for class B preferred stock of Stanley Plating Co., Inc. The only issue here involved is whether the amount received in payment for said preferred stock is essentially equivalent to a dividend *655 within the meaning of the Internal Revenue Code of 1954. There is no question that should we find the distribution herein essentially equivalent to a dividend, that Stanley Plating Co., Inc., had sufficient earnings and profits available for distribution in such a fashion. Distributions to shareholders out of a corporation's earnings and profits are generally treated as taxable dividends under sections 3012 and 316 3*96 of the Internal Revenue Code of 1954. With respect to distributions *95 made by a corporation in redemption of its stock, however, section 302(b) provides for certain exceptions to this general dividend treatment. Under section 302(b), dividend treatment can be avoided if the redemption is not essentially equivalent to a dividend (subsec. (b)(1)); if the redemption is substantially disproportionate (subsec. (b)(2)); if the redemption completely terminates the shareholder's stock interest in the corporation (subsec. (b)(3)); or if the redemption is of stock issued in conjunction with certain railroad reorganizations (subsec. (b)(4)). Subsections (b)(2) and (b)(4) are clearly inapposite here because the attribution rules of section 318 prevent the necessary reduction in voting power required by (b)(2) and the redeemed stock was not issued in one of the specified railroad reorganizations. The subsection (b)(3) complete-termination exception could only have applied in this fact pattern had a waiver of the family attribution rules (required by section 302(c)(2)(A)(iii)) been validly and legally filed by the petitioner-trustee in this case. No attempt to do so was made, however, hence this safe harbor of section 302 (b)*97 is not before this Court for scrutiny. The redemption of the trusts' preferred stock, therefore, must be treated under the "essentially equivalent to a dividend" language of section 302(b)(1). In testing for dividend equivalency under this subsection, the Supreme Court in United States v. Davis, 397 U.S. 301 (1970), has now approved application of the "strict net effect" test, an approach which had been adopted by a number of circuits 4 and had *656 been urged by the respondent as the proper standard to consider in such situations. 5 This test considers whether the shareholders would have received the identical payments had the redemption been a dividend. In essence, the test measures whether the distribution has altered the shareholder's control over the corporation or the shareholder's rights to future earnings. Ballenger v. United States, 301 F. 2d 192 (C.A. 4, 1962); Himmel v. Commissioner, 338 F. 2d 815 (C.A. 2, 1964); Levin v. Commissioner, 385 F. 2d 521 (C.A. 2, 1967). Davis made clear that (1) the attribution rules of section 318 must apply in testing for dividend equivalency under section 302 (b) (1); (2) redemptions of stock of a sole shareholder (whether an "actual" or "constructive" *98 sole shareholder) are always "essentially equivalent to a dividend" under this subsection; (3) a business purpose motivating the redemption is irrelevant in testing dividend equivalency; and (4) the exception to dividend treatment proffered by this subsection will only obtain if the redemption results in a "meaningful reduction of the shareholder's proportionate interest in the corporation." When the "strict net effect" test is applied in this case we find that (1) the redemption caused no reduction in the trusts' proportionate constructive interest in Stanley Plating Co., Inc.; (2) had this distribution been instead a dividend, the trusts would have received more than they did in the actual redemption; and (3) the redemption caused an increase in the trusts' constructive interest in the net worth of the company. In light of these results, therefore, we must conclude that the distributions in question were "essentially equivalent to a dividend" under section 302(b)(1) of the Code and the respondent's determination must be sustained. Immediately *99 prior to and subsequent to the redemption the trusts did not actually own any of the common stock of Stanley Plating Co., Inc. However, each of the trusts constructively owned an 80.2-percent interest in the common stock of that company. The constructive ownership is the result of the application of section 318(a)(1)(A) which states, "An individual shall be considered as owning the stock owned, directly or indirectly, by or for * * * (ii) his * * * parents," and section 318(a)(3)(B)(i) which states, "Stock owned, directly or indirectly, by or for a beneficiary of a trust * * * shall be considered as owned by the trust." 6 Each child, therefore, would be deemed the owner of his parents' 80.2-percent interest in the Stanley Plating common stock, which, in turn, would be attributed to the trusts by way of the children-beneficiaries. The redemption of the Stanley Plating preferred *657 stock, however, in no way reduced this proportionate constructive interest which the trusts were deemed to own. With sufficient earnings and profits available for distribution to the shareholders and an absence of any reduction, let alone a meaningful reduction in the trusts' proportionate constructive interest, *100 this very important Davis requirement is not satisfied. Further, had the amount distributed in redemption herein been instead distributed as a dividend, each of the trusts would have received more, actually and constructively, than they did via the actual redemption and their relative interest in the net worth of the company would not have been enhanced. Each of the trusts received, actually and constructively, 34.1 percent of the $ 50,600 redemption distribution. Hypothetically, a dividend in the amount of $ 50,600 would have caused each of the trusts to receive, actually and constructively, 58.5 percent of the dividend distribution. 7*101 This reveals, therefore, that the trusts did *658 not, as a result of the redemption, receive significantly more than they would have received if the amount had been paid out as a dividend. The situation herein, consequently, is not akin to Himmel, supra, where it was found in a multiclass capitalization situation that the taxpayer would have received significantly less of a distribution had a dividend, and not a redemption, occurred. In Himmel, the fact that the taxpayer received more than he would have in a hypothetical dividend distribution was a significant factor which the court considered in concluding that the redemption was a sale. The instant case differs; it is on par with the *102 situation in Levin, supra, where the redemption resulted in the taxpayer receiving less than she would have received of a hypothetical dividend and where this Court found Himmel inapplicable. Also, on September 30, 1964, prior to redemption, each of the trusts in the instant case had a $ 301,537.77 interest, actual and constructive, in the net worth of the company. On December 31, 1964, after the redemption, that interest was enhanced to $ 315,349.94. 8*103 So, the *659 redemption herein caused no significant alteration in this interest either. We do not decide whether compliance with the formula espoused in Himmel would necessarily satisfy the "meaningful reduction of the shareholders' proportionate interest" requirement of Davis. It is enough that such compliance is a minimum condition established by Davis and that such condition has not been met. Moreover our decision that the redemption in this case is essentially equivalent to a dividend is not mitigated by whatever business purpose the company achieved through the redemption. This consideration is no longer relevant. United States v. Davis, supra.The petitioner has correctly noted that the trusts are not sole shareholders (actual or constructive) in the company and that a not insubstantial minority interest exists. This distinction from Davis, however, in this situation, does not lead to a different result. The 80.2-percent constructive interest herein is one which dominates and controls the policies of the company. This measure of control is sufficient to determine the payment of dividends and to cause the redemption of stock for corporate ends. We cannot ignore the crucial fact that this proportionate constructive *104 interest held by the trusts is not meaningfully reduced by the redemption. Decisions will be entered for the respondent. Footnotes 1. Cases of the following petitioners are consolidated herewith: Helen M. Grabowski Trust for Janet Grabowski, United Bank & Trust Co., Trustee, docket No. 6019-68; and Stanley F. Grabowski Trust for David Grabowski, United Bank & Trust Co., Trustee, docket No. 6020-68.↩ 2. SEC. 301. DISTRIBUTIONS OF PROPERTY. (a) In General. -- Except as otherwise provided in this chapter, a distribution of property (as defined in section 317(a)↩) made by a corporation to a shareholder with respect to its stock shall be treated in the manner provided in subsection (c). 3. SEC. 316. DIVIDEND DEFINED. (a) General Rule. -- For purposes of this subtitle, the term "dividend" means any distribution of property made by a corporation to its shareholders -- (1) out of its earnings and profits accumulated after February 28, 1913, or (2) out of its earnings and profits of the taxable year (computed as of the close of the taxable year without diminution by reason of any distributions made during the taxable year), without regard to the amount of the earnings and profits at the time the distribution was made. Except as otherwise provided in this subtitle, every distribution is made out of earnings and profits to the extent thereof, and from the most recently accumulated earnings and profits. To the extent that any distribution is, under any provision of this subchapter, treated as a distribution of property to which section 301↩ applies, such distribution shall be treated as a distribution of property for purposes of this subsection. 4. Northup v. United States, 240 F. 2d 304 (C.A. 2, 1957); Ferro v. Commissioner, 242 F. 2d 838↩ (C.A. 3, 1957). 5. Rev. Rul. 57-353, 1957-2 C.B. 223↩. 6. Cf. Thomas G. Lewis, 35 T.C. 71 (1960), where this Court utilized the attribution rules in determining that a redemption of a portion of an estate's stock in cancellation of a decedent stockholder's indebtedness was a redemption essentially equivalent to a dividend under sec. 302(b)↩. 7. Total distribution Allocation of hypothetical dividend of $ 50,600 among classes of stock Par Value Class A $ 20,600 x 6% = $ 1,236 Class B 30,000 x 6% = 1,800 Common 81,900 x 6% = 4,914 Total Amount of hypothetical dividend to be divided between class B preferred and the common stock (these two classes sharing in excess distribution after each class has received its 6-percent dividend) Allocation of hypothetical dividend to each trust Par value Class A 1 $ 7,200 x 6% $ 432.00 Class B 10,000 x 6% 600.00 Common 2 65,700 x 6% 3,942.00 Trust's share of excess distribution allocable to class B 3 6,795.72 Trust's share of excess distribution allocable to common 4 17,854.77 Total distribution to each trust Percentage of hypothetical dividend to each trust Percentage of actual redemption received by each trust Total distribution $ 50,600 Allocation of hypothetical dividend of $ 50,600 among classes of stock Par Value Class A $ 20,600 x 6% = $ 1,236 Class B 30,000 x 6% = 1,800 Common 81,900 x 6% = 4,914 Total 7,950 Amount of hypothetical dividend to be divided between class B preferred and the common stock (these two classes sharing in excess distribution after each class has received its 6-percent dividend) 42,650 Allocation of hypothetical dividend to each trust Par value Class A 1 $ 7,200 x 6% Class B 10,000 x 6% Common 2 65,700 x 6% Trust's share of excess distribution allocable to class B Trust's share of excess distribution allocable to common Total distribution to each trust $ 29,624.49 Percentage of hypothetical dividend to each trust 5 58.5 Percentage of actual redemption received by each trust 6↩ 34.1 8. Shareholders' equity as of 9/30/64 (immediately prior to the redemption) Capital stock: (a) Preferred $ 50,600.00 (b) Common 81,900.00 Paid-in or capital surplus Surplus reserve 106,920.77 Earned surplus and undivided profits 165,713.86 405,134.63 Allocation on liquidation: Class A preferred $ 20,600.00 Class B preferred 30,000.00 Total Allocation to common Interest of each trust in the above allocations: Class A preferred Class B preferred Common 80.2% x $ 354,534.63 Total prior to redemption Shareholders' equity as of 12/31/64 (immediately following completion of the redemption) Capital stock: (a) Preferred (b) Common 81,900.00 Paid-in or capital surplus Surplus reserve 108,211.20 Earned surplus and undivided profits 203,093.22 393,204.42 Interest of each trust after completion of the redemption: ($ 393,204.42 x 80.2%) Shareholders' equity as of 9/30/64 (immediately prior to the redemption) $ 405,134.63 Capital stock: (a) Preferred (b) Common Paid-in or capital surplus Surplus reserve Earned surplus and undivided profits Allocation on liquidation: Class A preferred Class B preferred Total 50,600.00 Allocation to common 354,534.63 Interest of each trust in the above allocations: Class A preferred 1 $ 7,200.00 Class B preferred 10,000.00 Common 80.2% x $ 354,534.63 2↩ 284,337.77 Total prior to redemption 301,537.77 Shareholders' equity as of 12/31/64 (immediately following completion of the redemption) 393,204.42 Capital stock: (a) Preferred (b) Common Paid-in or capital surplus Surplus reserve Earned surplus and undivided profits Interest of each trust after completion of the redemption: ($ 393,204.42 x 80.2%) 315,349.94 Footnotes [_FN2] 5,200 actually owned plus 2,000 by attribution from Stanley F. Grabowski. [_FN1] $ 65,700 = 26,280 (number of shares of common constructively owned by each trust) x $ 2.50 (par value, each share of common). [_FN5] 10,000/62,760 x 42,650 = $ 6,795.72 (62,760 = number of shares of common and class B preferred shares sharing in the hypothetical excess distribution of $ 42,650). [_FN6] 32,760/62,760 x 42,650 = $ 22,262.84 x 80.2% = $ 17,854.77. [_FN3] $ 29,624.49/$ 50,600.00 = 58.5%. [_FN4] $ 17,200/$ 50,600 = 34.1% ($ 17,200 = $ 5,200 from redemption of class A preferred + $ 2,000 from redemption of Stanley F. Grabowski's class A preferred constructively attributed to each trust + $ 10,000 from redemption of class B preferred). [_FN7] 5,200 actual; 2,000 by attribution. [_FN8] By attribution.