Opinion
Docket No. 89633.
1962-10-8
DAVID T. GRUBBS AND MARGARET S. GRUBBS, PETITIONERS, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.
Raymond R. Farrell, Esq., for the petitioners. Lawrence S. Kartiganer, Esq., and Karl M. Samuelian, Esq., for the respondent.
Raymond R. Farrell, Esq., for the petitioners. Lawrence S. Kartiganer, Esq., and Karl M. Samuelian, Esq., for the respondent.
Petitioner held stock in a California corporation operating a Ford dealership which had accumulated earnings but had never declared a dividend. Another stockholder, who had operated, as sole proprietor, a supervisory service for dealers, transferred this business to a new corporation, organized in Tennessee, for class A stock. The assets and franchise of the dealership were transferred to the new corporation for cash, which was distributed by the old corporation to all its stockholders (except one) for their stock and all the stockholders acquired class B stock in the new corporation. After these transactions the stockholders of the old corporation were in control of the new and had received their shares of the net earnings of the old. Held, the several transactions amounted to a reorganization within the terms of section 368 (a)(1)(D), I.R.C. 1954, and the distribution to the petitioner was essentially equivalent to a dividend to the extent of his share of the earnings of the old corporation.
BRUCE, Judge:
The respondent determined a deficiency in income tax of $29,501.10 for the calendar year 1957. The sole issue for decision is whether part of a distribution made in 1957 to David T. Grubbs is taxable as ordinary income rather than capital gain. Some facts are stipulated.
FINDINGS OF FACT.
The stipulation of facts and exhibits filed therewith are incorporated by this reference.
The petitioners, husband and wife, resided in Van Nuys, California, in the taxable year. They filed a joint Federal income tax return for 1957 with the director of internal revenue at Los Angeles. For convenience, David T. Grubbs will be referred to as the petitioner.
Valley Automotive Center, a California corporation, was organized in January 1953. At the time of its organization the petitioner acquired 50 shares and E. Robert Breech, Jr., hereinafter referred to as Breech, acquired 850 shares of 1,000 shares of stock which were issued. Subsequently, the petitioner acquired other shares. In August 1957 Breech held 350 shares, the petitioner held 175 shares of 733.75 shares outstanding, and 266.25 shares were held by the corporation as treasury stock. Fourteen other stockholders held 208.75 shares. The petitioner's stock was acquired at a cost of $27,766.75.
From 1953 until about September 3, 1957, the principal business of this corporation was the operation of a Ford dealership at Burbank, California. At no time during this period did it make loans to automobile dealers or dealerships. It filed corporation income tax returns for calendar years reporting the following amounts of income and Federal income tax:
+---------------------------------------------+ ¦ ¦Taxable income¦Federal ¦ +-------------------+--------------+----------¦ ¦Year ended Dec. 31-¦before federal¦income tax¦ +-------------------+--------------+----------¦ ¦ ¦income tax ¦ ¦ +-------------------+--------------+----------¦ ¦1953 ¦1 $13,586.86¦$4,076.06 ¦ +-------------------+--------------+----------¦ ¦1954 ¦118,316.62 ¦56,024.64 ¦ +-------------------+--------------+----------¦ ¦1955 ¦244,811.38 ¦121,801.92¦ +-------------------+--------------+----------¦ ¦1956 ¦2 202,696.60¦99,902.23 ¦ +-------------------+--------------+----------¦ ¦1957 ¦2 126,155.08¦60,100.64 ¦ +---------------------------------------------+
The corporation at no time formally declared and paid a dividend to stockholders.
The petitioner was president of the corporation and Breech was vice president. Both were directors. From 1955 until August 1957 the petitioners's salary was $1,000 per month, plus 15 percent of net profits before taxes.
As of April 1, 1957, Ford Motor Company signed a dealership agreement with the corporation, superseding prior similar agreements, which recited that it was entered into in reliance upon the representation that Breech and the petitioner would participate in the ownership, with percentages of interest of 47.7 and 23.9, respectively, and that the petitioner would have full managerial authority and responsibility.
The monthly net profit of the corporation before taxes and bonuses for the period January through August 1957 was as follows:
+-------------------------+ ¦Month ¦Amount ¦ +--------------+----------¦ ¦January ¦$36,205.10¦ +--------------+----------¦ ¦February ¦30,009.13 ¦ +--------------+----------¦ ¦March ¦28,635.45 ¦ +--------------+----------¦ ¦April ¦25,219.61 ¦ +--------------+----------¦ ¦May ¦22,323.25 ¦ +--------------+----------¦ ¦June ¦27,958.94 ¦ +--------------+----------¦ ¦July ¦21,542.08 ¦ +--------------+----------¦ ¦August ¦12,169.73 ¦ +--------------+----------¦ ¦Total profits ¦204,063.29¦ +-------------------------+
The balance sheet of the corporation as of August 31, 1957, showed the following amounts:
+-----------------------------------------------------+ ¦Cash and receivables ¦$401,764.06¦ ¦ +---------------------------+-----------+-------------¦ ¦Inventories ¦805,471.05 ¦ ¦ +---------------------------+-----------+-------------¦ ¦Prepaid items ¦17,577.26 ¦ ¦ +---------------------------+-----------+-------------¦ ¦Fixed assets ¦13,329.85 ¦ ¦ +---------------------------+-----------+-------------¦ ¦Other assets ¦31,125.00 ¦ ¦ +---------------------------+-----------+-------------¦ ¦Total assets ¦ ¦$1,269,267.22¦ +---------------------------+-----------+-------------¦ ¦Total liabilities ¦ ¦864,837.48 ¦ +---------------------------+-----------+-------------¦ ¦Stock outstanding ¦73,375.00 ¦ ¦ +---------------------------+-----------+-------------¦ ¦Retained earnings ¦268,876.78 ¦ ¦ +---------------------------+-----------+-------------¦ ¦ ¦ ¦342,251.78 ¦ +---------------------------+-----------+-------------¦ ¦Net profit after income tax¦ ¦62,177.96 ¦ +---------------------------+-----------+-------------¦ ¦Total net worth ¦ ¦404,429.74 ¦ +-----------------------------------------------------+
As of August 31, 1957, the capital stock was $73,375, paid-in surplus $8,939.85 and retained earnings $322,114.89. Of the paid-in surplus, the petitioner had paid $7,479.25.
On August 27, 1957, the directors of the corporation adopted a resolution to change the name of Valley Automotive Center to Breech Enterprises. A certificate of amendment accordingly was filed on September 3, 1957.
Dealer Operating Control Service, Inc., sometimes herein referred to as D.O.C.S., was incorporated in July 1957 under the laws of the State of Tennessee. Breech was president and David T. Grubbs was vice president. Both were directors. In August 1957 this corporation filed a certificate stating that on or about September 1, 1957, it would conduct an automobile and motor truck agency in Burbank, California, under the fictitious name of Valley Automotive Center, and stating that its principal place of business was in Los Angeles. D.0.C.S. was authorized to issue 1,000 shares of class A common stock and 2,000 shares of class B common. Each share had equal voting power. The articles of incorporation, as amended, authorized dividends on each class separately, based on the earnings of assets related to that class of stock.
Breech had from 1956 operated a Ford dealer supervisory business as a sole proprietor under the name Dealer Operating Control Service. His financial statement of this business as of August 31, 1957, was as follows:
+----------------------------------------------------------------+ ¦ASSETS: ¦ ¦ ¦ +-------------------------------------+-------------+------------¦ ¦Current Assets: ¦ ¦ ¦ +-------------------------------------+-------------+------------¦ ¦Petty Cash ¦ ¦$30.00 ¦ +-------------------------------------+-------------+------------¦ ¦Cash in Bank ¦ ¦48,877.35 ¦ +-------------------------------------+-------------+------------¦ ¦Cash held in Trust ¦ ¦8,214.00 ¦ +-------------------------------------+-------------+------------¦ ¦Accounts Receivable ¦ ¦1 2,197.32¦ +-------------------------------------+-------------+------------¦ ¦Prepaid Insurance ¦ ¦1 195.69 ¦ +-------------------------------------+-------------+------------¦ ¦Prepaid Rent ¦ ¦1 1,720.00¦ +-------------------------------------+-------------+------------¦ ¦Prepaid Deposits ¦ ¦1 973.00 ¦ +-------------------------------------+-------------+------------¦ ¦Total Current Assets ¦ ¦62,207.36 ¦ +-------------------------------------+-------------+------------¦ ¦Fixed Assets: ¦ ¦ ¦ +-------------------------------------+-------------+------------¦ ¦Furniture and fixtures ¦1 $6,217.73¦ ¦ +-------------------------------------+-------------+------------¦ ¦Less: Depreciation ¦1,604.92 ¦ ¦ +-------------------------------------+-------------+------------¦ ¦ ¦ ¦ ¦ +-------------------------------------+-------------+------------¦ ¦ ¦ ¦4,612.81 ¦ +-------------------------------------+-------------+------------¦ ¦Other assets: ¦ ¦ ¦ +-------------------------------------+-------------+------------¦ ¦Collateral loan ¦1 4,500.00 ¦ ¦ +-------------------------------------+-------------+------------¦ ¦Total Assets ¦71,320.17 ¦ ¦ +-------------------------------------+-------------+------------¦ ¦LIABILITIES: ¦ ¦ ¦ +-------------------------------------+-------------+------------¦ ¦Current Liabilities: ¦ ¦ ¦ +-------------------------------------+-------------+------------¦ ¦Accounts Payable ¦ ¦$3,250.00 ¦ +-------------------------------------+-------------+------------¦ ¦Notes Payable ¦ ¦8,214.00 ¦ +-------------------------------------+-------------+------------¦ ¦Accrued Payroll taxes ¦ ¦1,602.25 ¦ +-------------------------------------+-------------+------------¦ ¦Accrued Insurance ¦ ¦148.79 ¦ +-------------------------------------+-------------+------------¦ ¦Total Current Liabilities ¦ ¦13,215.04 ¦ +-------------------------------------+-------------+------------¦ ¦PROPRIETORSHIP: ¦ ¦ ¦ +-------------------------------------+-------------+------------¦ ¦E. Robert Breech, Jr ¦$19,613.27 ¦ ¦ +-------------------------------------+-------------+------------¦ ¦Net profit current year ¦38,491.86 ¦ ¦ +-------------------------------------+-------------+------------¦ ¦ ¦ ¦ ¦ +-------------------------------------+-------------+------------¦ ¦ ¦ ¦58,105.13 ¦ +-------------------------------------+-------------+------------¦ ¦Total Assets [ sic ] and Liabilities¦ ¦71,320.17 ¦ +-------------------------------------+-------------+------------¦ ¦ ¦ ¦ ¦ +----------------------------------------------------------------+
it was in full payment in exchange for his stock and the gain is taxable as capital gain. The respondent contends that the several transactions which accompanied the transfer of the Ford dealership from the old corporation to the new amount to a reorganization under which the stockholders of the old corporation exchanged their stock for stock in the new corporation and cash and that the exchange had the effect of the distribution of a dividend.
The stockholders of Valley Automotive Center had operated the dealership for over 4 years and the corporation had a substantial amount of undistributed earnings. If the stockholders distributed a dividend it would be taxable as ordinary income, but if they liquidated the corporation and ceased to carry on the business they could distribute the earnings in liquidation and treat their gains as capital gains. Hellmich v. Hellman, 276 U.S. 233 (1928). Although the petitioner says the business was declining, it is apparent that the stockholders considered it too profitable to abandon, for they continued it without interruption by transferring it to the new corporation, D.O.C.S., in which they acquired class B stock, which was voting stock, in substantially the same proportions as they had held the stock of the old corporation. There was no break in the continuity of the proprietary interest.
The purpose of the transactions of August and September 1957 was to enable the stockholders to withdraw the earnings of the old corporation without terminating their interests in the business. The dealership was carried on in corporate form at the same place, under the same name, with the same stockholders and the same manager, the petitioner, while the accumulated earnings of the old corporation were distributed pro rata to the stockholders.
The petitioner's contention would treat the redemption of the stock of the old corporation as an isolated transaction. But when the same stockholders continue to carry on the same business in corporate form through another corporation, the several steps may not be so isolated. The consequences of the rearrangement must be judged by the total effect. Where a redemption of stock is one of a series of steps in a reorganization, the treatment is governed by the provisions of law relating to reorganizations. Helvering v. Alabama Asphaltic Limestone Co., 315 U.S. 179 (1942); Richard H. Survaunt, 5 T.C. 665 (1945), affirmed on this issue 162 F.2d 753 (C.A. 8, 1947); William M. Liddon, 22 T.C. 1220 (1954), reversed on other grounds 230 F.2d 304 (C.A. 6, 1956), certiorari denied 352 U.S. 824 (1956).
The term ‘reorganization’ includes a transfer by one corporation of all or a part of its assets to another corporation if immediately thereafter the shareholders of the transferor are in control of the transferee. (Sec. 368(a) (1)(D), I.R.C. 1954.)
This is what happened here. This section further requires that stock or securities of the transferee be distributed in a transaction qualifying under section 354, 355, or 356.
Section 354
1Total assets transferred to Dealer Operating Control Service, Inc., at September 3, 1957: $15,803.74.
On August 30, 1957, the directors of Breech Enterprises resolved that the corporation purchase from its stockholders, with the exception of Breech, all their stock at $551.1819 per share. This figure was 1/733.75 of the sum of the stock, paid-in surplus and retained earnings, or $404,429.74. The stock was to be held as treasury stock. The directors also authorized sale of the net assets of the corporation to Dealer Operating Control Service, Inc., d.b.a. Valley Automotive Center. On September 3, 1957, the directors authorized assignment of the Ford Sales Agreement to D.0.C.S.
On August 30, 1957, the directors of D.O.C.S. authorized purchase of all the net assets of Breech Enterprises and acquisition of a Ford franchise sales agreement.
Pursuant to the foregoing authorizations, Breech Enterprises, as seller, and D.0.C.S. as buyer, entered into a written agreement for sale of the net assets and liabilities as recorded on the seller's financial statement dated August 31, 1957, the price to be the seller's recorded net worth of $404,429.74. The seller's financial statement as of August 31 showed the following figures:
+--------------------------------------------+ ¦Assets: ¦ ¦ +---------------------------------+----------¦ ¦Customer deposits ¦$14,989.41¦ +---------------------------------+----------¦ ¦Receivables ¦82,846.81 ¦ +---------------------------------+----------¦ ¦Securities ¦28,750.00 ¦ +---------------------------------+----------¦ ¦Inventories ¦98,621.09 ¦ +---------------------------------+----------¦ ¦Prepaid assets ¦17,577.26 ¦ +---------------------------------+----------¦ ¦Fixed assets ¦13,329.85 ¦ +---------------------------------+----------¦ ¦Deferred assets ¦31,125.00 ¦ +---------------------------------+----------¦ ¦Total assets ¦287,239.42¦ +---------------------------------+----------¦ ¦Liabilities ¦157,987.52¦ +---------------------------------+----------¦ ¦ ¦129,251.90¦ +---------------------------------+----------¦ ¦Cash retained by seller ¦275,177.84¦ +---------------------------------+----------¦ ¦Total selling price and net worth¦404,429.74¦ +--------------------------------------------+
All of the stockholders of Breech Enterprises except Breech turned in their stock to that corporation, representing 383.75 shares, leaving outstanding 350 shares held by Breech. Breech transferred to D.O.C.S. the assets and liabilities of his sole proprietorship operated under that name and received therefor 150 shares of class A stock. D.O.C.S. issued 750 shares of its class B stock to the stockholders of Breech Enterprises. Breech acquired 357.75 shares and Grubbs 179.25 shares. The 14 other stockholders of Breech Enterprises acquired the remaining 213 shares. Breech Enterprises issued checks in the total amount of $211,516.75 to its shareholders, except Breech, of which amount Grubbs received $96,456.83.
The foregoing transfers were effected during the period August 30 to September 13, 1957.
The asset and liability accounts as of August 31, 1957, on the books of Breech Enterprises were closed, and identical accounts were opened on the books of D.O.C.S., except that the net worth amounting to $404,429.74 was set up by D.O.C.S. as a ‘Vendor Clearing’ account. This account was closed by issuance of checks by D.O.C.S. to Breech Enterprises totaling $211,516.75 and setting up an account entitled ‘Note Payable— Breech Enterprises' in the amount of $192.912.99. No note was actually given. D.O.C.S. paid this account in January and February 1958 to Breech Enterprises, with interest. On the books of Breech Enterprises there was set up an asset account entitled ‘Vendee Clearing’ account of $404,429.74. This was cleared by debiting ‘Treasury Stock’ account with $211,516.75 and setting up an account entitled ‘Notes Receivable—Dealer Operating Control Service, Inc.‘ in the amount of $192,912.99.
After September 3, 1957, D.0.C.S. operated, under the name Valley Automotive Center, the Ford dealership previously operated under that name by the California corporation of that name at the same place. D.O.C.S. maintained two sets of books and records, one showing the operations of the automobile dealership division and one the operations of the dealer supervision division. It prepared separate monthly and annual statements for these two divisions. It filed a single income tax return.
During the period September 1, 1957, through December 31, 1959, Breech Enterprises made certain loans on notes at interest and without security, as follows:
+------------------------------------------------------+ ¦Borrower ¦Amount ¦Date ¦Date repaid¦ +--------------------+-------+-------------+-----------¦ ¦ ¦ ¦ ¦ ¦ +--------------------+-------+-------------+-----------¦ ¦Dixie Motors ¦$31,500¦Feb. 28, 1958¦Oct. 1958 ¦ +--------------------+-------+-------------+-----------¦ ¦Joplin Motor Sales ¦4,596 ¦Apr. 1, 1958 ¦Aug. 1958 ¦ +--------------------+-------+-------------+-----------¦ ¦E. Robert Breech Jr.¦50,000 ¦May 23, 1958 ¦Oct. 1958 ¦ +--------------------+-------+-------------+-----------¦ ¦San Jose Ford ¦110,000¦Feb. 1959 ¦Apr. 1959 ¦ +--------------------+-------+-------------+-----------¦ ¦Beacon—Edsel ¦10,000 ¦Mar. 10, 1959¦Dec. 1959 ¦ +--------------------+-------+-------------+-----------¦ ¦Downtown Ford Sales ¦43,060 ¦Apr. 30, 1959¦Jan. 1961 ¦ +--------------------+-------+-------------+-----------¦ ¦A. W. Haensli ¦80,000 ¦Dec. 1959 ¦Outstanding¦ +--------------------+-------+-------------+-----------¦ ¦ ¦ ¦ ¦ ¦ +------------------------------------------------------+
Breech Enterprises had interest income of $3,891.70 in 1958 and $3,721.29 in 1959.
During the last part of 1957 D.O.C.S. had the following monthly net profits, before bonuses and taxes, from each of its divisions:
+--------------------------------+ ¦Month ¦Supervision¦Ford ¦ +---------+-----------+----------¦ ¦ ¦service ¦dealership¦ +---------+-----------+----------¦ ¦ ¦ ¦ ¦ +---------+-----------+----------¦ ¦September¦$9,351.29 ¦$8,681.63 ¦ +---------+-----------+----------¦ ¦October ¦8,325.27 ¦19,230.08 ¦ +---------+-----------+----------¦ ¦November ¦9,043.81 ¦12,518.76 ¦ +---------+-----------+----------¦ ¦December ¦1,446.69 ¦(3,440.47)¦ +---------+-----------+----------¦ ¦ ¦ ¦ ¦ +--------------------------------+
The petitioner received no salary from Breech Enterprises after August 1957. He was vice president of D.O.C.S. and from September 1, 1957, received a salary of $1,000 per month plus 15 percent of the net profits before taxes of the dealership of which he was the general manager.
The Ford dealership transfer was consented to by the representative of Ford Motor Company. D.O.C.S. explained the change to the Ford representative as follows:
You also requested a copy of the minutes of the meeting changing from Breech Enterprises to Dealer Operating Control Service, Inc., DBA Valley Automotive Center. Actually, this is what took place. The name was never changed from Breech Enterprises to Dealer Operating Control Service, Inc. What happened is that a completely new corporation was set up under the name of Dealer Operating Control Service, Inc., and this corporation in turn filed a request for permission to do business as Valley Automotive Center.
We list the following stockholders and their percentage of interest in Valley Automotive Center.
+---------------------------+ ¦E. Robert Breech, Jr. ¦47.7¦ +----------------------+----¦ ¦David T. Grubbs ¦23.9¦ +---------------------------+
The above stockholders correspond to the interest reported on the current Ford Sales Agreement dated April 1, 1957, and there was no change in the stockholdings due to the re-organization.
In 1958 the petitioner became general manager of the dealer supervision division of D.0.C.S. His salary was then paid from the earnings of that division.
The transactions of August and September 1957, whereby assets and the Ford dealership were transferred to D.O.C.S. and the stock in the California corporation was surrendered and the stockholders received cash and acquired stock in D.O.C.S., were integral steps in a plan of reorganization.
The distribution of $96,456.83 by Breech Enterprises to the petitioner is taxable as a dividend to the extent of $76,985.46.
OPINION.
The sole issue is to determine the tax treatment to be accorded the distribution of $96,456.83 to the petitioner. He contends that this was a distribution in complete redemption of all his stock in the old corporation, and that it was not essentially equivalent to a dividend and that therefore, under section 302 of the Internal Revenue Code of 1954,