Estate of Diecks v. Commissioner

Estate of C. A. Diecks, Deceased, Moninda Diecks Coyle, Executrix, Petitioner v. Commissioner of Internal Revenue, Respondent Estate of Diecks v. Commissioner Docket No. 1398-72 United States Tax Court 65 T.C. 117; 1975 U.S. Tax Ct. LEXIS 50; October 23, 1975, Filed *50 Decision will be entered under Rule 155. Diecks (now deceased) owned 20 percent of the stock of Cable Vista. Cable Vista had built and operated a cable TV system. Before Cable Vista, a subch. S corporation, had reported any taxable income, Diecks and the other shareholders sold their stock at a substantial gain. Held: Although Cable Vista was a collapsible corporation, within the meaning of sec. 341(b), there was on the facts no net unrealized appreciation in Cable Vista's subsec. (e) assets (ordinary income assets), hence sec. 341(e)(1) applied to cause Cable Vista not to be considered collapsible for purposes of sec. 341(a)(1). Diecks' gain was long-term capital gain. Held, further, investment credit claimed by Diecks with respect to Cable Vista had to be recaptured on Diecks' sale of his stock. D. Michael Coyle, for the petitioner. Christopher Rhodes, for the respondent. Hall, Judge. HALL *117 Respondent determined deficiencies in petitioner's Federal income tax for the years 1965 and 1966 of *118 $ 2,467.23 and $ 4,887.24, respectively. All other issues having been settled, the only questions that remain for decision are: (1) Whether Clifford A. Diecks, now deceased, should have reported gain on the sale of stock in an allegedly collapsible corporation as ordinary income rather than capital*53 gain; and (2) Whether petitioner, by virtue of Clifford A. Diecks' shareholder interest in Cable Vista, Inc., must recapture the investment credit, claimed by the decedent as a shareholder of a subchapter S corporation, in the year the corporation's shareholders terminated its subchapter S status and sold their stock. FINDINGS OF FACT Some of the facts have been stipulated and are so found. Mrs. Moninda Diecks Coyle, executrix of the Estate of Clifford A. Diecks, resided in Elizabethtown, Ky., when she filed the petition on behalf of the estate. In 1950 five businessmen, including Clifford A. Diecks (Diecks), began operating a radio station in Elizabethtown, Ky. Walter D. Huddleston (Huddleston) was hired as operations manager in 1952. In 1957 Huddleston joined the other five businessmen in acquiring a second radio station in Lebanon, Ky. All six individuals were unrelated to each other. Shortly thereafter one of the original investors in the Elizabethtown station died. In 1960 the remaining four original investors and Huddleston purchased an advertising company. Huddleston was aware that cable television was a growing industry. He did some research in the area and then encouraged*54 his four business associates to explore the possibility of introducing cable television to Elizabethtown. After some investigation, the four business associates joined with Huddleston in incorporating Cable Vista, Inc. (Cable Vista), in May 1963 to operate a community antenna system. Its 500 outstanding shares were owned equally by the five individuals, and Huddleston undertook management of the Cable Vista operation. On June 18, 1963, the corporation duly elected to be taxed as a subchapter S corporation. Diecks was primarily in the lumber business. He also was involved in other businesses but Cable Vista represented his only interest in television. *119 On June 3, 1963, Cable Vista entered into a 10-year agreement with the municipal government of Elizabethtown which entitled Cable Vista to operate a television system in Elizabethtown. Cable Vista was to pay $ 100 to the City annually for this right. The agreement permitted Cable Vista to mount its central antenna on the town's main water tower, to run coaxial cables down city streets, to run its wires on utility poles (apparently on city property), and to install its own poles where necessary. The system was designed *55 to use a central antenna to receive signals from distant stations and relay the signals (which would be strengthened by amplifiers) through coaxial cables to tap wires into customers' homes. The system, as designed, would allow subscribers to receive nine channels instead of only two. The June 3, 1963, agreement was replaced by a 20-year franchise agreement dated October 18, 1965. The latter agreement, which was obtained through competitive bidding, provided that the corporation was to pay Elizabethtown a onetime fee of $ 100, plus 2 percent of its annual gross subscription revenues. The corporation sold subscriptions to the system to individual customers. A customer could subscribe for periods of a month, 6 months, or a year. The installation charge was generally $ 25, which covered installation costs. On occasion there would be promotional "hook-ups" for as little as $ 5 to encourage customers to subscribe to the system. In addition to the connection charge, customers paid a subscription fee of $ 3.50 per month which entitled them to continued use of the system. The monthly fees determined whether Cable Vista was a profitable operation. The fair market value of any subscription*56 agreement was equal at most to 1 year's income therefrom. While the maximum length of a contract was 1 year, some contracts were for a month or 6 months. The contracts could be renewed, but such renewal was uncertain at best and represented no more than the expectation that a customer would return. The gross income of Cable Vista from subscriptions for the year ended November 30, 1965, was $ 27,785.34. The cost to produce this income was $ 39,718.30. 1 Therefore, there was for that year an operating loss *120 of $ 11,932.96, and the value of that year's subscription contracts as distinguished from the value of the expectation of continued patronage, was zero. Since the basis for the contracts was also zero, there was on December 2, 1965, no unrealized appreciation or depreciation, hence no net unrealized appreciation in such contracts. *57 In addition to its Elizabethtown franchise, Cable Vista, through Huddleston's personal endeavors, obtained franchises for its cable television system in Vine Grove and Radcliff, Ky., on September 13, 1965, and September 21, 1965, respectively. These agreements were also for 20 years. Cable Vista paid Huddleston $ 10,000 for obtaining both franchises. Cable Vista then had 6,500 potential customers in the three areas. In 1965, Huddleston, while on some personal business, passed through Horse Cave, Ky. He saw a construction crew on the side of the road installing a community antenna system and he stopped to talk to them. He spoke to a Rex Walters, representative of the Ameco Co. of Phoenix, Ariz., who expressed an interest in acquiring Cable Vista. Huddleston suggested Mr. Walker visit him. Approximately 2 months later Huddleston received a telephone call from Ameco Co. representatives who asked to be quoted a sales price for Cable Vista. Huddleston thereafter met with the other shareholders of Cable Vista regarding selling Cable Vista. At the outset, three of the five were not interested in selling. Over a period of time, however, four did agree to sell, and the fifth, while*58 not eager to sell, agreed to go along with the group. At the time these sales discussions began, Huddleston realized there was a national movement toward cable television. Changes in technology were occurring, and if Cable Vista were to remain in business, it would have to engage in expensive improvements, possibly even rebuild the system completely. Huddleston also had just entered public office as a State senator and was extremely *121 busy. In addition, Huddleston was having employment problems with the engineer who worked with the television system. Sales discussions were initiated by the buyers. At no time did any shareholder of Cable Vista advertise his stock for sale. On or about November 19, 1965, the shareholders agreed to sell their stock for $ 152,500, payable in two annual installments, the first in the amount of $ 45,750 and the second in the amount of $ 106,750. The sales agreement also provided that the officers of the purchasing company would pay Cable Vista's debts to its shareholders of $ 37,500 ($ 7,500 per shareholder). The sales agreement allocated $ 5 of the purchase price to a covenant by the five sellers not to compete in "Hardin County, Ky. and *59 Ft. Knox." Diecks collected one-fifth of the sales proceeds, namely, $ 9,150 in 1965 and $ 21,350 in 1966. His gain was $ 8,935.89 in 1965 and $ 20,850 in 1966. He reported his gain as long-term capital gain, including the $ 1 allocated to his covenant not to compete. No issue has been raised as to the allocation to his covenant nor as to the proper treatment of the $ 1. The sales contract noted that Cable Vista had at least 647 customers on the date the agreement was signed. However, the record does not classify them based on the length of their subscriptions. Cable Vista's income and cash flow for the years in which Diecks owned stock were as follows: Year ended Nov. 30 -- — 1963 — — 1964 — — 1965 — Gross receipts $ 1,427.25 $ 21,133.69 $ 27,785.34 Net rents 195.00 520.00 673.25 Other income — 0 — — 0 — 37.57 Total income 1,622.25 21,653.69 28,496.16 Total deductions 5,856.68 52,332.56 40,021.45 Net loss for year (4,234.43) (30,678.87) (11,525.29) Add: depreciation 1,643.08 23,116.58 18,999.34 Net cash flow (2,591.35) (7,562.29) 7,474.05 As a shareholder in a subchapter S corporation, decedent Diecks claimed the benefit of *60 his share of the corporation's investment credits on his individual income tax return as follows: *122 Year claimed Amount — 1963 — $ 430.08 — 1964 — 382.03 — 1965 — 72.22 Total 884.33 Cable Vista revoked its subchapter S election for its taxable year beginning December 1, 1965. In accordance with the November 19, 1965, agreement, Diecks and the other shareholders transferred their stock to Ameco Co., which duly made the agreed payments therefor. OPINION 1. Collapsible Corporation Issue Respondent contends that Cable Vista was a collapsible corporation within the meaning of section 341, 2 and therefore that Diecks' gain on the sale of the Cable Vista stock is taxable as ordinary income rather than long-term capital gain. Petitioner argues that Cable Vista was not a collapsible corporation when Diecks sold his stock therein, and that if it were, the corporation came within the exception from application of the collapsible provisions provided in section 341(e)(1). *61 Section 341(a) provides that gain from the sale of stock of a collapsible corporation shall be considered as gain from the sale of property which is not a capital asset. Section 341(b) to the extent here relevant generally defines a collapsible corporation to mean a corporation that is formed or availed of principally for the production of property with a view to a sale or exchange of stock before it has realized a substantial part of the taxable income to be derived from that property, and a realization by the shareholders of the gain attributable to that property. 3 To be *123 "formed or availed of" for the proscribed purpose, it is not necessary that the stockholders be motivated by tax considerations. Braunstein v. Commissioner, 374 U.S. 65 (1963). *62 Petitioner concedes Cable Vista was formed or availed of principally for the manufacture, construction, or production of property, and we agree. Cable Vista was continuously involved in "manufacture, construction, or production of property" in that it was continuously in the process of laying cables and acquiring and connecting new customers to its system. The creation of both tangible property (the cable system) and intangible property (such as franchises and goodwill) are within the reach of section 341. Computer Sciences Corp., 63 T.C. 327, 346-347 (1974); FTS Associates, Inc., 58 T.C. 207 (1972). Petitioner argues that section 341 is inapplicable to a business where production is continuous, but cites no authority, nor do we know of any, that would support this proposition. While petitioner concedes that Cable Vista was formed or availed of principally for the production of property, petitioner argues that Cable Vista's shareholders did not have the requisite "view" to effect a sale before the corporation had realized a substantial part of the income to be derived from its property. The regulations provide that *63 the shareholders have the requisite view if such a sale "was contemplated, unconditionally, conditionally, or as a recognized possibility." Sec. 1.341-2(a)(2), Income Tax Regs. The regulations also provide that the collapsible view exists if formed at some time during construction, production, or purchase of the collapsible property. See FTS Associates, Inc., 58 T.C. at 212. Since production was continuous in this case, the requisite view was held by the shareholders at the time of sale. The shareholders sold their stock before Cable Vista realized a substantial part of the taxable income from the produced property. James B. Kelley, 32 T.C. 135 (1959), affd. 293 F. 2d *124 904 (5th Cir. 1961). Indeed, petitioner did not argue otherwise in view of the fact Cable Vista realized no taxable income at all prior to the sale of the stock. Finally, the shareholders realized gain attributable to the produced property upon the sale of the Cable Vista stock. Consequently, Cable Vista came within the definition of a collapsible corporation in section 341(b) at the time Diecks sold his shares in the*64 corporation. However, we conclude that Diecks' gain on the sale of his stock is not taxable as ordinary income because Diecks comes within the relief from section 341(a) provided in section 341(e). Section 341(e) was enacted to prevent section 341(a) from converting gain, which would have been taxable as capital gain if the property had been held in the shareholder's hands, into ordinary gain because a corporate structure was employed. S. Rept. No. 1983, 85th Cong., 2d Sess. (1958), 1958-3 C.B. 922, 952. Generally speaking, the collapsible corporation provisions are inapplicable if the net unrealized appreciation in the corporation's "subsection (e) assets" amounts to less than 15 percent of the corporation's net worth. In this case the "subsection (e) assets" include property which was neither a capital asset nor section 1231(b) property in the corporation's hands. 4 The only assets which were neither a capital asset nor a section 1231(b) asset were the subscription contracts in effect. These represented the right to earn income for services rendered or to be rendered for the duration of the contract. United States v. Bidson, 310 F. 2d 111 (5th Cir. 1962);*65 King Broadcasting Co., 48 T.C. 542 (1967). See also Commissioner v. P. G. Lake, Inc., 356 U.S. 260 (1958). There was no unrealized appreciation in the contracts. The expectation of renewal of the contract represented the expectation that a customer would return, and was a capital asset in the nature of goodwill, if any. Nelson Weaver Realty Co. v. Commissioner, 307 F. 2d 897, 901 (5th Cir. 1962), revg. and remanding in part and affg. in part 35 T.C. 937 (1961); Charles W. Miller, 56 T.C. 636, 649 (1971). The transmitting system was a section 1231(b) asset, and the franchises were either capital assets or section 1231(b) assets (depending on whether they were depreciable). *125 Section*66 341(e)(1) makes section 341(a)(1) inapplicable to a sale or exchange of stock if the net unrealized appreciation in the corporation's "subsection (e) assets" and in any corporate assets which would produce ordinary income if held by Diecks, does not exceed 15 percent of the corporation's net worth. Sec. 341(e)(1)(A) and (B). Diecks is a 20-percent shareholder, and therefore must look to his own businesses to determine whether any of Cable Vista's assets would have produced ordinary income if held by him at the time of the sale of stock. Diecks was primarily in the lumber business, but also had interests in other businesses. However, he was not in another television business or any other business which would have caused the assets of Cable Vista to be ordinary income assets in his hands. The corporation's net worth at time of sale equaled the sale price of $ 152,500. Sec. 341(e)(7). The net unrealized appreciation in "subsection (e) assets" (the subscription agreements) was zero (fair market value of zero over adjusted basis of zero). Sec. 341(e)(6). Therefore, the net unrealized appreciation in "subsection (e) assets" did not exceed 15 percent of the net worth of the company, *67 and Diecks was entitled to long-term capital gain treatment with respect to the sale of his stock in Cable Vista. In view of our decision under section 341(e), we need not reach the parties' arguments under section 341(d). 2. Investment Credit Recapture Cable Vista was a subchapter S corporation during its taxable years ending November 30, 1963, 1964, and 1965. Diecks, as a shareholder in Cable Vista, properly claimed investment credit with respect to property acquired and held by Cable Vista. On December 1, 1965, Cable Vista terminated its subchapter S election and the next day Diecks sold his stock in Cable Vista. The parties agree that if Diecks is subject to recapture of the investment credit in 1965 the amount of that recapture is $ 884.33. Generally, a taxpayer cannot claim an investment credit for property purchased by another. One exception to this general rule is that the shareholders of a subchapter S corporation can claim the credit for property purchased by the corporation. Sec. 1.48-5, Income Tax Regs. The question presented is whether Diecks must submit to recapture of part of the credit when the *126 subchapter S corporation revoked its subchapter S election*68 and the next day Diecks sold his stock in the corporation. We conclude that Diecks must recapture the investment credit claimed. Section 1.47-4(a)(2), Income Tax Regs., requires recapture by a shareholder of a subchapter S corporation when such shareholder disposes of all his stock in such company prior to the end of the estimated useful life of the investment credit property. Although these regulations were not promulgated until 1967, they have been given retroactive effect. Charbonnet v. United States, 455 F. 2d 1195 (5th Cir. 1972). The mere termination of the subchapter S election is not a disposition of the property. Sec. 1.47-4(d), Income Tax Regs. It is the corporation's status in the year the assets were acquired that governs who is entitled to the investment credit. Recapture by the shareholder occurs upon the sale of the stock even though the election was terminated before the disposition occurred. Charbonnet v. United States, supra. Decision will be entered under Rule 155. Footnotes 1. The cost included the following: Salary and wages $ 7,811.31 Rent 1,650.37 Taxes 727.30 Interest $ 2,090.09 Amortization 28.63 Depreciation * 18,696.19 Advertising 417.15 Other deductions 8,297.26 Total 39,718.30 * Transmitting equipment, trucks, building and small tools.↩ 2. All section references are to the Internal Revenue Code of 1954, as in effect during the years in issue.↩ 3. Sec. 341 provides in relevant part: (b) Definitions. -- (1) Collapsible corporation. -- For purposes of this section, the term "collapsible corporation" means a corporation formed or availed of principally for the manufacture, construction, or production of property * * * with a view to -- (A) the sale or exchange of stock by its shareholders (whether in liquidation or otherwise), or a distribution to its shareholders, before the realization by the corporation manufacturing, constructing, [or] producing * * * the property of a substantial part of the taxable income to be derived from such property, and (B) the realization by such shareholders of gain attributable to such property. (2) Production or purchase of property. -- For purposes of paragraph (1), a corporation shall be deemed to have manufactured, constructed, produced, or purchased property, if -- (A) it engaged in the manufacture, construction, or production of such property to any extent, (B) it holds property having a basis determined, in whole or in part, by reference to the cost of such property in the hands of a person who manufactured, constructed, produced, or purchased the property, or (C) it holds property having a basis determined, in whole or in part, by reference to the cost of property manufactured, constructed, produced, or purchased by the corporation.↩ 4. Since Cable Vista had no shareholders owning more than 20 percent in value of the corporation's stock, the other limitation in defining "subsection (e) assets" is not applicable.↩