Opinion
Docket No. 429-67.
1969-04-16
ARTHUR D. MCDONALD AND JESSIE L. MCDONALD, PETITIONERS v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT
H. Milton Innerfield, for the petitioners. Ferdinand J. Lotz III, for the respondent.
H. Milton Innerfield, for the petitioners. Ferdinand J. Lotz III, for the respondent.
1. The petitioner, who owned all of the outstanding nonvoting preferred stock of E & M and substantially all of its outstanding common stock, entered into an agreement with Borden, under which E & M redeemed his preferred stock at par and thereafter Borden acquired all of E & M's outstanding stock in exchange for its own stock. Held, the redemption of the petitioner's preferred stock was not essentially equivalent to a dividend.
2. The petitioner failed to show that he is entitled to any part of a deduction for legal fees disallowed by the respondent.
SIMPSON, Judge:
The respondent determined a deficiency of $26,545.90 in the petitioners' income tax for the taxable year ending December 31, 1961. There are two issues for decision: (1) Whether a redemption of stock by a corporation pursuant to a plan for the acquisition of such corporation is essentially equivalent to a distribution of a dividend; and (2) whether, on the facts presented, a legal fee is deductible under section 212 of the Internal Revenue Code of 1954
or under any other section of that Code.
All statutory references are to the Internal Revenue Code of 1954, unless otherwise indicated.
FINDINGS OF FACT
Some of the facts have been stipulated, and those facts are so found.
At trial, it appeared that par. 9 of the joint stipulation contained an error regarding dividends paid by E & M Enterprises, Inc. The correct facts were brought out at trial and agreed to by the parties. Such correction to the stipulation will be reflected in these Findings of Fact.
The petitioners, Arthur D. and Jessie L. McDonald, are husband and wife and resided at Middleport, N.Y., at the time the petition was filed in this case. They filed their joint Federal income tax return for the year ending December 31, 1961, using the cash receipts and disbursements method of accounting, with the district director of internal revenue, Buffalo, N.Y. Arthur D. McDonald will be referred to hereinafter as the petitioner.
E & M Enterprises, Inc. (E & M), whose place of business was and is in Middleport, N.Y., was organized on January 9, 1947. E & M was the successor by a tax-free incorporation of a partnership in which the petitioner as one of two equal partners had a tax basis of $43,600, For his share of the partnership assets, the petitioner received in exchange 10 shares of the common stock of E & M with a par value and basis in the petitioner's hands of $10 per share and 435 shares of E & M's 870 noncumulative, nonvoting preferred stock with a par value and basis in the petitioner's hands of $100 per share. Upon incorporation, the petitioner's equal partner, William L. Carnegie, received 435 shares of the preferred stock and 10 shares of the common stock in exchange for his interest in the partnership. At the same time, the petitioner's brother, Stanley D. McDonald, who worked for, but had no interest in, the partnership, received 1 share of the common stock.
On April 3, 1948, the petitioner entered into an agreement with E & M regarding the disposition of his preferred stock. This agreement provided that on the petitioner's death, E & M would purchase such stock at its book value. It further provided that in the event the petitioner desired to sell such stock during his life, he was required to notify E & M, which was given an option to purchase such stock at its then book value. A similar agreement was executed between Mr. Carnegie and E & M. In 1954, E & M redeemed all of Mr. Carnegie's stock, preferred and common, and his interest was eliminated. Thereafter, and until the transactions with the Borden Co. hereinafter described, the petitioner owned all of the stock of E & M except for Stanley's one share of common. The petitioner continued to be, as he had been before the termination of Mr. Carnegie's interest, the dominant figure in E & M's operations.
E & M was engaged in the manufacture of tools, dies, and special equipment. From 1958 to 1961, its volume of business was approximately $1 million per year. It employed an average of 65 to 70 people, reaching a peak of 92 people, and had an average weekly payroll of $8,000. E & M's operations required substantial amounts of cash, much of which was obtained by loans from the Marine Trust Co. of Middleport.
From the date of its incorporation until April 21, 1961, E & M paid formal dividends on its preferred stock in the total amount of $11,745. Such dividends were paid at the rate of 6 percent on the 870 shares of preferred stock outstanding prior to the redemption of Mr. Carnegie's interest, and were paid in quarterly amounts of $1,305 for nine quarters from April 1951 through April 1953. After April 1953, no formal dividends were paid on the preferred stock.
In late 1960, the Borden Co., a large corporation whose one class of stock was listed on the New York Stock Exchange, expressed an interest in acquiring some of E & M's assets. Though the petitioner discussed an asset purchase with Borden, no offer on such terms was ever made. In March 1961, after auditing E & M's books and viewing its legal documents, Borden made a verbal offer to purchase the petitioner's preferred and common stock and Stanley's common stock in exchange for 5,500 shares of Borden's common stock. Although the petitioner accepted such offer, it was never consummated. After the March offer, Borden's representatives took copies of E & M's records back to Borden's New York City office. In early April, Borden submitted to the petitioner an offer to purchase the E & M stock for Borden stock— a proposed ‘Plan of Reorganization.’ This plan was accepted and executed by the petitioner, Stanley, E & M, and Borden on April 12, 1961. It recited the existence of the April 3, 1948, agreement between the petitioner and E & M and provided that prior to closing the petitioner would offer to E & M, and E & M would redeem, his 435 shares of preferred stock for its book value of $43,500. The plan further provided that on closing, the petitioner would transfer his 10 shares of E & M common stock in exchange for 4,399 shares of Borden's common stock, and that Stanley would transfer to Borden his 1 share of E & M common stock in exchange for 440 shares of Borden's common stock. The difference between the 5,500 shares of Borden common stock originally offered for the business and the 4,839 shares agreed on in the plan represents the amount of $43,500 to be paid to the petitioner by E & M in redemption of his preferred stock. Closing was set for April 28, 1961.
During the discussions concerning the plan, the petitioner pointed out to Borden that E & M did not have sufficient cash to carry out the redemption. As a result, on Borden's recommendation, the petitioner had E & M obtain a short-term bank loan from the Marine Trust Co. of Middleport in the amount of $60,000 on April 21, 1961. This transaction was not reflected in the plan of reorganization. Of this loan, $43,500 was to be used to effectuate the redemption of the petitioner's stock, and the balance was to be used to satisfy bonus and back-pay obligations of E & M. At the time the loan was made, the bank had a copy of the April 12 agreement and knew that Borden was shortly to assume ownership of E & M.
On April 21, 1961, E & M, pursuant to the terms of the April 3, 1948, agreement, elected to and did redeem the 435 shares of the petitioner's preferred stock for $43,500, an amount equal to the petitioner's basis in that stock. As of that date, E & M had earnings and profits of not less than $237,149.29. After the redemption, the petitioner's 10 shares and Stanley's 1 share of E & M's common stock constituted all the outstanding stock of the company.
On April 28, 1961, the deal was closed in New York City. The petitioner exchanged his 10 shares of E & M's common stock for 4,399 shares of Borden's common stock, and Stanley exchanged his 1 share of E & M's common for 440 shares of Borden common. Borden thereupon took over the operations of the company and continued to run it to the date of the trial in this case. The petitioner was retained as an employee of E & M until December 1962, and thereafter continued to do odd jobs at Borden's request.
At the closing, Borden gave the petitioner a check in the amount of $96,000 payable to E & M for deposit with the Marine Trust Co. of Middleport. Of that amount, $60,000 was used to pay off the April 21 bank loan, and the balance was used for operating cash.
Prior to the reorganization, E & M paid the petitioner approximately $40,000 a year as salary and bonus. He had no need for the cash received on the redemption of his preferred stock. The petitioner in 1961 wanted to sell his business to Borden but was indifferent as to whether he received 5,500 shares of Borden stock or received $43,500 in cash from E & M on redemption plus the 4,399 shares of Borden stock. Both the idea of redemption of the E & M preferred stock and the idea of obtaining a bank loan to accomplish it originated with Borden. To the date of the trial in this case, the petitioner continued to hold the 4,399 shares of Borden stock received in the transaction.
On his tax return for 1961, the petitioner reported the redemption of his preferred stock in E & M as the sale or exchange of a capital asset held for more than 6 months in which the amount received, $43,500, equaled his basis in such stock, giving rise to no gain or loss. He reported the exchange of his E & M common stock for Borden common stock as a tax-free exchange.
In 1961, the petitioner paid $832.94 to the law firm of Lewis, Sims, and May, Esqs., for various legal services rendered to him, The bulk of such legal fees was for services in connection with the exchange of stock with Borden. No part of such fees was shown to be paid for services giving rise to an income tax deduction in 1961.
OPINION
We are presented with the vexing problem of deciding whether a redemption of corporate stock in the circumstances of this case should be treated as a sale or as the distribution of a dividend. The respondent considers the redemption of the petitioner's preferred stock and his exchange of E & M common stock for the Borden stock to be separate transactions and therefore concedes that the exchange constituted a tax-free reorganization within the meaning of section 368(a)(1)(B). Therefore, we do not have before us any issue as to the propriety of treating the exchange with Borden as tax free. Instead, he attacks the petitioner's treatment of the redemption as a sale of his preferred stock. Accordingly, we will dispose of the case on the basis of the issue so presented.
Under section 302(a), a redemption is to be treated as a sale of the stock if any one of the tests in subsection (b)(1), (2), (3), or (4) is satisfied. The petitioner agrees that there has not been a complete termination of his interest within the meaning of section 302(b)(3); rather, he contends that the plan of reorganization of which the redemption was a part resulted in such a termination of his interest as to indicate that the redemption was not essentially equivalent to a dividend within the meaning of section 302(b)(1).
In a forlorn attempt to provide some certainty in this area of the law, the House, when it passed section 302, provided definite tests for determining when a redemption would be treated as a sale, such as those tests now appearing in paragraphs (2) and (3) of section 302(b). However, the Senate found those tests to be too restrictive and restored the not essentially equivalent to a dividend test. At the same time, the Senate added section 302(b)(5) which provides in part:
In determining whether a redemption meets the requirements of paragraph (1), the fact that such redemption fails to meet the requirements of paragraph (2), (3), or (4) shall not be taken into account. * * *
Furthermore, when the Senate restored the dividend equivalency test, it used essentially the language of section 115(g) of the 1939 Code and stated that it intended to reinstate the existing tests as to whether a redemption is essentially equivalent to a dividend. S. Rept. No. 1622, to accompany H.R. 8300 (Pub. L 591), 83d Cong., 2d Sess., p. 44 (1954). Under section 115(g), a substantial change in ownership or a termination of interest was indicative that a redemption was not the equivalent of a dividend. Sec. 29.115-9, Regs. 111; Northup v. United States, 240 F.2d 304 (C.A. 2, 1957). Thus, section 302(b)(5) and the legislative history make clear that a redemption resulting in a substantial change in ownership or a termination of interest may qualify under section 302(b)(1) even though it does not come within the precise terms of section 302(b)(2) or (3).
The petitioner seeks to bring his case within the rationale of Zenz v. Quinlivan, 213 F.2d 914 (C.A.. 6, 1954), decided under the 1939 Code. In that case, the taxpayer, who owned all the stock of a corporation, wished to sell it. She found a purchaser who was interested in acquiring the business of the corporation but did not wish to purchase all its stock; accordingly, they agreed upon a plan under which the purchaser bought part of her stock, and thereafter the remainder was redeemed by the corporation. The court held that since the redemption terminated her interest in the corporation, it was not essentially equivalent to a dividend. The respondent agrees that a redemption under the circumstances involved in the Zenz case constitutes a termination of interest within the meaning of section 302(b)(3). Rev. Rul. 55-745, 1955-2 C.B. 223. In addition, we think that the Zenz rationale is still applicable in determining whether a redemption is essentially equivalent to a dividend within the meaning of section 302(b)(1).
In Zenz, the shareholder sold her stock in a taxable transaction, and after the sale and redemption, she had no continuing interest in the business. The respondent argues that since the acquisition by Borden was a tax-free reorganization, the petitioner must have had a continuity of interest, and that since he had a continuity of interest, his interest was not terminated within the Zenz doctrine. We think that this reasoning substitutes fiction for fact.
The record in this case establishes clearly that the redemption was merely a step in the plan of Borden for the acquisition of E & M, so that it is the results of the plan that are significant to us. Howard P. Blount, 51 T.C. 1023 (1969); see United States v. Carey, 289 F.2d 531, 532 fn. 2 (C.A. 8, 1961). Before the reorganization, the petitioner owned virtually all of the stock in, and had complete control over, E & M. For all practical purposes, his direct interest in E & M was terminated after the reorganization. He continued to serve E & M as an employee for a short time and as a consultant, but those services appear to have been minimal. By means of the redemption and stock swap, he had liquidated his interest in his company; he had cash and the marketable securities of a large publicly held company and virtually no control or influence whatever over the destiny of the Borden Co; or E & M. Thus, the fact is that the petitioner's investment was changed radically as a result of the completion of the plan of reorganization, even though the exchange of stock may have been tax free.
Our ultimate objective in applying section 302 is to determine whether the redemption so alters the shareholder's interest in the corporation as to resemble a sale or whether it merely distributes corporate earnings with no significant alteration of his interest in the corporation. Obviously, when a redemption results in a complete termination of the shareholder's interest, it is clear that the redemption is not the equivalent of a dividend. Zenz v. Quinlivan, supra. Moreover, when the redemption results in a substantial reduction in the interest of a shareholder, the change is also indicative that the redemption is not merely a dividend. Northup v. United States, supra. In applying section 302, it is immaterial whether the redemption resulted in an absolute termination of the shareholder's interest, if it resulted in such a substantial change in his interest as to indicate that it was not the equivalent of a dividend. Nor does it make any difference under section 302 whether the exchange of E & M and Borden stock was taxable or tax free or whether the redemption preceded the exchange. See United States v. Carey, supra; Bittker & Eustice, Federal Income Taxation of Corporations and Shareholders 295 (2d ed. 1966); 1 Mertens, Law of Federal Income Taxation, sec. 9.104, p. 234. Had there been a redemption which reduced the petitioner's interest from that of 90 percent to 10 percent of the stock of the corporation, no one would contend that the redemption was a dividend. Yet, the change wrought in the petitioner's investment by the reorganization plan was at least as extensive.
We have found that the petitioner did not care whether he received all Borden stock or some Borden stock and some cash for his E & M stock and that it was Borden who suggested and decided upon the redemption of his preferred stock. This finding is based upon the evidence offered by the petitioner. The respondent asks us not to believe the testimony. However, we cannot find the petitioner's testimony to be incredible per se— that is, we cannot say that it is beyond the pale of believability, and the respondent has produced no evidence that contradicts the petitioner's testimony. We wonder why he did not call as a witness the Borden representative in these negotiations, if his version of what happened differs from the petitioner's testimony; instead, the respondent asks us, even though the evidence is not inconsistent, to conclude that the petitioner perjured himself. Under these circumstances, we accept as true the petitioner's description of the negotiations.
The petitioner accepted the original proposal by Borden under which he would have received only Borden stock— no cash, and he was willing to go through with the reorganization irrespective of whether he received all stock or some stock and some cash. These circumstances make it indisputably clear to us that this was not a redemption arranged by the petitioner to withdraw corporate earnings at capital gains rates. We do not mean to imply that if the petitioner had suggested the form of the acquisition, our holding would necessarily be different; we will leave the decision of that case to a later date, when it is presented to us.
The respondent gives as a reason for his position that a decision in favor of the petitioner would allow him to withdraw substantial corporate earnings at no tax (or, if his basis in the redeemed stock were less than the amount distributed, at capital gains rates). That may be true, but such result does not require us to hold that the distribution is a dividend. Zenz v. Quinlivan, supra. Taking into account all the circumstances of this case, we conclude that the redemption and the reorganization effected such a substantial change in the petitioner's interest in E & M as to establish that the redemption was not essentially equivalent to a dividend.
Our disposition of the case makes it unnecessary for us to consider the many other arguments raised by the parties with regard to the characterization of the redemption.
The petitioner deducted $832.94 on his tax return as amounts paid for legal services in 1961, and the respondent disallowed the deduction in full. The petitioner now concedes that ‘a substantial part’ of this amount was related to legal services incident to the reorganization and is nondeductible, but contends that some part thereof was attributable to estate planning and general business advice and is therefore deductible. The record is absolutely barren of evidence as to what amount if any was spent for deductible legal advice, and we must hold for the respondent on this issue.
Decision will be entered under Rule 50.