Commissioner of Internal Revenue v. George M. Gross and Anna Gross, (And Ten Other Consolidated Petitions for Review) ( 1956 )

LUMBARD, Circuit Judge.

These are appeals from a decision of the Tax Court, 23 T.C. 756, involving alleged income tax deficiencies in excess of $3,000,000 for the years 1948 and 1949. These eleven cases, all involving distributions to various members of the Gross and Morton families, who were common stockholders of certain building corporations, were consolidated both in the Tax Court and for review here. The facts as stipulated by the parties and found by the Tax Court may be summarized as follows:

Alfred Gross, George Gross, and Lawrence Morton were experienced builders who collaborated in the construction of several housing projects. The first such project, located in Baltimore County, Maryland, and completed in 1944, was operated through four Maryland corporations — First Mars Homes, Inc., Second Mars Homes, Inc., Third Mars Homes, Inc., and Fourth Mars Homes, Inc.— which were controlled by these three men and their families. The project was financed through mortgages insured by the Federal Housing Administration (FHA).

The next project developed by the taxpayers was Glen Oaks Village, located ini Queens County, New York, and constructed in two parts. Part I, consisting of 576 apartments covering about 25 acres, was erected by Glen Oaks Village, Inc., a New York corporation organized on April 8, 1947, and controlled by the Gross and Morton families. Glen Oaks Village, Inc. rented the land from the Permanent Land Corporation, also controlled by the Gross and Morton families, for an initial term of 50 years at a rental equal to 4 percent of the land value as appraised by the FHA. Temporary financing was obtained under a building loan agreement with the Bank of Manhattan Company; and the resulting mortgage, which finally totaled $4,652,-000, was fully insured by the FHA. Upon completion of the project in 1948, the mortgage was taken over by the Prudential Insurance Company of America, which paid a premium of 3% per cent of the principal amount of the mortgage to Glen Oaks Village, Inc.

Simultaneously with the development of Part I of Glen Oaks Village, another corporation, Seton Realty Corporation, was organized to develop a shopping center. In 1948 and 1949 this corporation and the Permanent Land Corporation, which owned the land for Part I of Glen Oaks Village, borrowed substantial sums from insurance companies, secured by mortgages on their realty. These corporations had no mortgages insured by the FHA.

Part II of Glen Oaks Village, consisting of 2,352 apartments covering approximately 100 acres, was constructed in a manner substantially similar to Part 1. In order to facilitate financing and because the FHA was allowed to insure •mortgages only up to $5,000,000 while :the cost of Part II was expected to approach $20,000,000, -Part II was constructed through ten separate corporations. Again two Gross-Morton corporations which owned the land conveyed separate parcels of realty, to Permanent 'Land Corporations #2, #3, #4, #6, #7, #9, #11, #12, #13, and #15. Each of these ‘corporations gave a lease on its realty to a correspondingly numbered Glen Oaks Village Corporation, and each Glen Oaks Village Corporation secured temporary financing from the Bank 'of Manhattan Company and permanent financing from the- Prudential Insurance Company or (in the case of Corporations #12, #13, and #15) from the New York State Employees’ Retirement System. Each mortgage was fully insured by the FHA.

On October 19, 1949 each of the Permanent Land Corporations executed bonds secured by first mortgages on its land in favor of the Teachers Insurance and Annuity Association of America and received mortgage proceeds. The Permanent Land Corporations had no mortgages insured by the FHA.

Glen Oaks Shopping Center, Inc., is a New York corporation organized in 1948 to develop a shopping center for Part II of Glen'Oaks Village. It had no transactions with the FHA.

George Gross, the president, Alfred .Gross, the secretary, and Lawrence Morton, the treasurer, of each of the Glen Oaks Village and Permanent Land Corporations, directed the planning, financing, and building of Glen Oaks Village. None of the three devoted his entire time to the project. None of them received salaries from any of these corporations during 1948 or 1949. In 1950 each received compensation of $25,000 from Glen Oaks Shopping Center, Inc.

In 1948 and 1949 the four Mars Home Corporations, the eleven Glen Oaks Village and eleven. Permanent Land Corporations, and the Seton Realty Corporation, made pro-rata cash distributions in excess of $6,000,000 to their common stockholders, the eleven members of the Gross and Morton families here con- . cerned.¹ Prior to making these distributions each of the corporations wrote up on its books the value of its real estate by an amount equal to or in excess of its distribution. The amounts of the write-ups were credited to a “Surplus Arising from Realty Appreciation.”

To the very substantial extent that these distributions were not out of normal earnings and profits of the corporations they came from the following sources:

In the case of the four Mars Home Corporations, from cash resulting from the build-up of depreciation reserves. In the case of the eleven Permanent Land Corporations, from mortgage moneys, i. e., moneys borrowed by the corporations secured by mortgages on their land. In the case of the eleven Glen Oaks Village Corporations and Seton Realty Corporation, from (1) current gross rentals from tenants, (2) premiums received on bonds issued by the corporations to Prudential Insurance Company and New York State Employees’ Retirement System, and (3) the excess of moneys borrowed for construction purposes, secured by FHA-insured mortgages, over the cost of construction.

The reasons for the surplus of mortgage moneys received by each of the Glen Oaks Village operating companies over the cost of construction and development were set forth in the following letter of October 27, 1949, from Glen Oaks Village, Inc., to the Comptroller of the Federal Housing Administration:

“With reference to the distribution made on December 15, 1948, we wish to submit the following information.

“Although the cash outlay made by the company is less than the estimate made by you of the normal current cost to reproduce the property, this difference is explained by the fact that no payment was made for some expenses usually incurred in a building operation. These expenses included, among other things, the following.

“1. Builder’s and architect’s fees normally paid to a general contractor.

“2. Sub-contractors’ fees and retailers overhead and profit where materials were procured directly by us through large scale cash purchases.

“3. Free use of heavy building equipment.

“4. Transfer, at original cost, of inventories of material, top soil, etc., on hand.

“If these items had been paid for in cash by the company at prevailing prices at the time of delivery, and if the amount so paid had been added to the cash outlay by the company, the total amount paid would probably have exceeded your estimate of replacement cost.

“By following this procedure we left the excess funds in the company during construction and thereby remained in a far better financial position than if we had withdrawn the funds. Maintaining this liquid position at all times during the operation, particularly when prices of material and labor were rising daily, was our best guarantee of successful completion of the project.

“This procedure resulted in cash on hand in the corporation on completion of the project. We made capital distribution of the surplus.”

It was stipulated and the Tax Court found that the surplus of mortgage moneys over the costs of construction was made possible for the reasons stated in this letter.

We are of course aware that the propriety of the distribution of these “windfall profits” has been seriously questioned. See Senate Hearings before Committee on Banking and Currency, 83rd Cong., 2nd Sess., FHA Investigation (1954). But as the Tax Court pointed out, no question of the legality or propriety of these transactions is' raised in these proceedings. We are concerned only with the tax consequences of the distributions.

No contention has been made that the cash distributions received by the petitioners are tax free. Moreover, to the extent that the distributing corporations had earnings or profits of the current year or prior years, it is agreed that the, distributions are taxable as ordinary income. The question is whether the distributions in excess of these amounts are taxable as ordinary income, as the Commissioner contends, or whether they are taxable under § 115(d) of the Internal Revenue Code of 1939, 26 U.S.C.A. § 115 (d) as capital gains, to the extent that they exceed the basis of petitioners’ stock.

The Commissioner conceded before the Tax Court and on this appeal that the earnings or profits of the corporations were not increased by reflecting on the books the appreciation in value of the realty. He also conceded that the borrowing of money and giving of mortgages to secure the loans did not constitute a realization of income, taxable or non-taxable, by the corporations.

The Tax Court held that to the extent that the distributions exceeded the current and accumulated earnings and profits of the corporations they were taxable only under § 115(d), and that they should therefore be applied first against the basis of the stock and the excess taxed as long-term capital gain.

The applicable statutory provisions leave little doubt that the Tax Court reached the proper result. Section 22(e) of the Internal Revenue Code of 1939, 26 U.S.C.A. § 22(e) provides that “Distributions by corporations shall be taxable to the shareholders as provided in section 115.” Section 115(a) defines dividends for tax purposes in such a way as to exclude distributions not out of accumulated “earnings or profits” or cur-j-pnt “earnings or profits”. Section 115 (d), on which the taxpayers rely, provides (with exceptions not relevant here) that any distribution which is not a dividend shall be applied against the basis of the shareholder’s stock and the excess shall be taxed as capital gain. This language appears to be precisely applicable to the case at bar.

The Commissioner, however, contends that there is something about the distributions in this case which requires us to look outside the provisions of § 115 and bring into play § 22(a) which provides for the inclusion in taxable income of “gains or profits and income derived from any source whatever.” It is argued that we are faced here with an anticipatory distribution of future profits and that it is anomalous to tax such distributions as capital gains when a distribution made after the realization of these future profits would undoubtedly be taxed as ordinary income. It is then contended that § 115(d) was meant to apply only to distributions which impair capital, and that since the distributions here neither impaired capital nor came out of earnings and profits, they cannot be dealt with under § 115. Thus the Commissioner claims that § 22(a) governs.

The Commissioner’s argument that the distribution of these mortgage windfalls is an “anticipation of future profits” obscures the fact that the basic problem here is merely a somewhat novel manifestation of the much mooted question whether unrealized appreciation in value can be the source of a distribution taxable as ordinary income. It makes little difference whether the cash which was distributed came from “mortgage windfalls,” or mortgage proceeds, or from some other source. The real source of the distributions was the appreciation in the value of the property. If the appreciation had not taken place and been recognized on the books, and the corporations had distributed mortgage proceeds or mortgage “windfalls” there could not be a clearer case of capital impairment. The obtaining of $100,000 in cash by incurring a concomitant liability of $100,000, secured by a mortgage, certainly creates no surplus. And if the corporation immediately distributes $50,-000 to its shareholders without having any pre-existing surplus, its capital is surely impaired. When the corporation’s liabilities are deducted from its assets, its net worth is an amount less than its paid-in capital. Under these circumstances state law would prohibit the payment of a dividend. New York Stock Corporation Law, McK.Consol.Laws, c. 59, § 58. The only thing which made a distribution possible here under New York law was the creation of a surplus by writing up the corporations’ assets to reflect appreciation in the value of their real estate. Randall v. Bailey, 1942, 288 N.Y. 280, 43 N.E.2d 43.

Thus the question here is the familiar one whether a distribution made out of unrealized appreciation in the value of the corporations’ assets is taxable as ordinary income. This question is one which has customarily been resolved within the framework of § 115. Thus the crucial question has been whether an unrealized appreciation in value increases a corporation’s “earnings and profits.” See C. I. R. v. Hirshon Trust, 2 Cir., 1954, 213 F.2d 523, 526-27, certiorari denied 348 U.S. 861, 75 S.Ct. 85, 99 L.Ed. 679; C. I. R. v. Godley’s Estate, 3 Cir., 1954, 213 F.2d 529, 530-33, certiorari denied 348 U.S. 862, 75 S.Ct. 86, 99 L.Ed. 679; C. I. R. v. Timken, 6 Cir., 1944, 141 F.2d 625, 630; Andrews, “Out of Its Earnings and Profits”: Some Reflections on the Taxation of Dividends, 69 Harv.L.Rev. 1403, 1430-32 (1956); 1 Mertens, Law of Federal Income Taxation, §§ 9.49, 9.50; Paul, Ascertainment of “Earnings or Profits” for the Purpose of Determining Taxability of Corporate Distributions, 51 Harv.L.Rev. 40, 51-64 (1937). But if a corporate distribution of unrealized appreciation were taxable as ordinary income under § 22(a), then it would be unnecessary to inquire whether such unrealized appreciation increases earnings and profits. Nevertheless the Commissioner now urges that this problem must henceforth be dealt with outside § 115. We see no reason at this late date to adopt so drastic a change in approach to the problem, especially since the treatment suggested by the Commissioner finds no support in, and is indeed inconsistent with, the language of the statute. Section 115(d) does not say that only capital impairment distributions are taxable as capital gains; it ,says that all distributions other than dividends are taxable as capital gains. And dividends are clearly defined as distributions out of earnings and profits. It is true that the heading of § 115(d) is “Other distributions from capital”, but this heading is not a part of the statute and cannot alter its provisions. See Act of Feb. 10, 1939, § 6, 53 Stat. la, 76th Cong., 1st Sess., 1939, 26 U.S.C.A. (I.R.C.1939) preceding section 1; Nor does the Commissioner’s position find any support in C. I. R. v. Ilirshon Trust, supra, or C. I. R. v. Godley’s Estate, supra. Both of these eases involved distributions of property by corporations which had earnings and profits sufficient to cover the property’s basis. In both cases it was held that in these circumstances the distributions were “out of earnings or profits” and that the entire value of the property was therefore taxable as dividends. These cases are obviously no authority for the proposition that a distribution not out of earnings or profits can be taxed as ordinary income.

Moreover, to hold that these distributions are taxable as ordinary income would create an anomalous situation where the same corporate earnings might twice provide a source of taxable dividends. When the presently unrealized appreciation in value is ultimately realized, either by sale of the property or by the receipt of rentals over a period of years, it will increase earnings and profits and provide a source of taxable dividends. See U. S. Treas. Reg. § 1.-312-6 (b) (1955); Reg. 118, § 39.115 (a)-2(b); Reg. Ill, § 29.115-3; I.R.C, 1939, § 115(e); C. I. R. v. Wheeler, 1945, 324 U.S. 542, 545, 65 S.Ct. 799, 89 L.Ed. 1166, rehearing denied 325 U.S. 892, 65 S.Ct. 1182, 89 L.Ed. 2004; 1 Mertens, Law of Federal Income Taxation §§ 9.-34, 9.43. But if we tax the distribution of unrealized appreciation and also use the realization of the appreciation to increase earnings and profits at a later date, we tax the same earnings twice as ordinary income to the stockholders.

For all these reasons we are unable to accept the Commissioner’s argument that a corporate distribution not out of earnings and profits may be used as ordinary income. It may well be that the earnings and profits requirement is subject to criticism and that a more satisfactory method of taxing corporate distributions could be devised. See e. g. Andrews, op. cit., supra at pp. 1433-39; cf. Cohen, Surrey, Tarleau and Warren, A Technical Revision of the Federal Income Tax Treatment of Corporate Distributions to Shareholders, 52 Col.L.Rev. 1, 6-7 (1952). But we must work within the framework which Congress has provided.²

The Commissioner conceded from the beginning, and still concedes, that there has been no increase in earnings and profits either by reason of the write-up on the corporate books to reflect unrealized appreciation or by reason ' of the borrowing of money secured in part by that appreciation. There are not here such unusual circumstances as would justify our reversing the Tax Court on the basis of an argument which was not made before it. Helvering v. Cement Investors, Inc., 1942, 316 U.S. 527, 535, 62 S.Ct. 1125, 86 L.Ed. 1649; Helvering v. Wood, 1940, 309 U.S. 344, 348-349, 60 S.Ct. 551, 84 L.Ed. 796; Kamen Soap Products Co. v. C. I. R., 2 Cir., 1956, 230 F.2d 565, 567. But even if the Commissioner had made these arguments there is no reason to believe that he would have prevailed. It seems well settled that unrealized appreciation does not increase “earnings and profits”. See C. I. R. v. Hirshon Trust, supra, 213 F.2d at page 527; C. I. R. v. Godley’s Estate, supra, 213 F.2d at page 532; C. I. R. v. Timken, supra, 141 F.2d at page 630; Mertens, Law of Federal Income Taxation § 9.49; Andrews, op. cit. supra at 1405; Albrecht, “Dividends” and “Earnings or Profits,” 7 Tax.L.Rev. 157, 182 (1952); Paul, op. cit. supra at 51-64. And we have held that the mortgaging of property for an amount in excess of its basis does not result in a realization of income even when the mortgagor is not personally liable to repay the loan. Woodsam Associates, Inc., v. C. I. R., 2 Cir., 1952, 198 F.2d 357.

The Commissioner makes a sub^ sidiary argument that some portion of the amounts received by George Gross,; Alfred Gross, and Lawrence Morton must be deemed to'represent salaries and fees for the services which'they'rendered, and that this portion is taxable as ordinary income.. We think the Tax Court properly disposed of this contention. The distributions were made pro-rata to all the stockholders. The officers,of. a corporation are not compelled to take salaries for the services they render. They may donate their services to the corporation if they choose to do so.

There is nothing in the stipulated facts which indicates that these distributions were anything other than the corporate distributions to shareholders which they purported to be. The fact that the distributions were made pro-rata to all stockholders, even though most of them rendered no services, negates the idea that they represented compensation for services rendered. There is nothing in the record which indicates that any of these shareholders were not bona-fide shareholders. Under these circumstances there is no basis for reversing the Tax Court’s finding that no part of the distributions represented compensation impersonal services.

The judgment of the Tax Court is affirmed.

1 . Glen Oaks Shopping Center, Inc. also made a distribution of undivided interests in land in 1949; but the Commissioner conceded in the Tax Court that the taxpayers properly accounted for this distribution.

2 . Congress has reaeted to the situation presented by this case by enacting § 312 (j) of the Internal Revenue Code of 1954, 26 U.S.C.A. § 312(j), applicable to distributions made after June 22, 1954. This section provides that where a corporation, at the time of making a distribution to its shareholders, has outstanding a loan insured by any agency of the United States and the amount of the loan exceeds the adjusted basis of the property constituting the security for the loan, the corporation’s earnings and profits shall be increased by the amount of such excess. If this section had been enacted prior to the distributions made-in this ease it would make taxable a» ordinary dividends the amounts distributed by those of the corporations-which had ITIA insured loans. It would not affect the distributions by the corporations which did not have such loans. The Senate Finance Committee expressly stated that the enactment of this section was not to give rise to any inference as to the law applicable to previously pending cases. Sen.Rop. No. 1622, 83rd Cong., 2d Sess., p. 251.