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Hughes, Inc., Petitioner v. Commissioner of Internal Revenue, RespondentHughes, Inc. v. CommissionerDocket No. 10741-84
United States Tax Court January 4, 1988; As Amended February 4, 1988; As amended January 6, 1988 January 4, 1988, Filed*1
Decision will be entered for the petitioner .Held , petitioner is not liable for the accumulated earnings tax because earnings and profits were not accumulated beyond the reasonable needs of its business.Charles H. Egerton Paul Mandelkern John S. Winkler Whitaker,Judge .WHITAKER*1 In a statutory notice of deficiency dated January 20, 1984, respondent determined the following deficiencies in petitioner's Federal income tax:
TYE Dec. 31 -- Amount 1979 $ 24,530 1980 21,049 1981 33,652 The issue for decision is whether petitioner is liable for the accumulated earnings tax imposed by section 531. 1
*2 FINDINGS OF FACT
Some of the facts have been stipulated and are so found. Petitioner is a Florida corporation whose principal *2 place of business is and has been in Orlando, Florida.
Petitioner's sole shareholders upon incorporation were Russell S. Hughes, Harry C. Hughes, and Romania S. Hughes. In 1959, Romania S. Hughes transferred all of her shares in petitioner to Russell S. Hughes and Harry C. Hughes, brothers, so that each then held 50 percent of petitioner's stock. On December 18, 1973, 2 the Hughes brothers transferred their shares of petitioner's stock in equal portions to their sons. Thereafter, and throughout the years in issue, the company was owned equally by David H. Hughes, Vincent S. Hughes, Russell V. Hughes, and Sun First National Bank of Orlando (through its nominee FABCO Co.) as trustee for Donald Richard Hughes.
During the years in issue the officers of petitioner were:
Russell V. Hughes, president
Vincent S. Hughes, vice president*3
David H. Hughes, secretary/treasurer
During the years in issue, petitioner leased 16 separate parcels of improved real property to Hughes Supply. The revenue from these leases was approximately 80 percent of petitioner's revenue during those years. The leased properties included executive offices, branch facilities (warehouses, sales and administrative offices, and parking and storage areas), a utility warehouse, and a garage and trucking terminal. Petitioner also leased a facility to Southern *3 Lighting Mfg. Co., a wholly owned subsidiary of Hughes Supply. A typical facility was 20,000 to 30,000 square feet, with an area of 1 to 3 times that size in paved parking and outside storage.
Hughes*4 Supply was founded as a general partnership in Orlando, Florida, in 1928. The business was incorporated in 1947, and Russell S. Hughes, Harry C. Hughes, and Romania S. Hughes, who were the sole partners, became the sole shareholders. Russell S. Hughes and Harry C. Hughes held a majority of the stock until the first public offering of 350,000 shares in 1970. Since that time, Hughes Supply has been a publicly held corporation with one class of stock actively traded in the over-the-counter market. The corporation's total net sales exceeded $ 100 million during each year in issue.
In June 1976, Hughes Supply was notified, pursuant to the requirements of the Securities and Exchange Commission, that 5.6 percent of its outstanding stock had been purchased by the employee retirement plan of Consolidated Electrical Distributors, Inc. (CED), a closely held Delaware corporation whose principal office was in Los Angeles, California.
A Schedule 13D had been filed, as is required to be filed when a person has acquired 5 percent or more of the voting stock of a public company. The Schedule 13D discloses information concerning the identity of the person making the acquisition of the shares, *5 the source of funds used in the acquisition, the number of shares owned, and the purpose for which the acquisition is being made. In the Schedule 13D, the retirement plan indicated that the Hughes Supply stock was acquired for investment purposes.
In subsequent years, CED, its affiliates, and its shareholders acquired and held shares of Hughes Supply stock as follows:
Date of SEC Number of Schedules 13D Hughes Supply shares Total shares Percentage owned and amendments owned by CED 3 outstanding by CED group 6/24/76 81,200 1 1,444,000 5.6 3/30/77 130,300 1,340,822 9.7 6/10/77 141,300 1,345,714 10.5 10/07/77 180,000 1,343,283 13.4 11/04/77 202,300 1,339,735 15.1 12/12/77 209,300 1,341,666 15.6 3/08/78 227,800 1,342,368 16.97 11/16/78 397,600 1,351,166 29.4 2 11/09/79 620,700 2,032,908 30.5 3/07/80 628,200 2,032,908 30.9 5/30/80 646,750 2,032,908 31.8 12/22/82 655,750 2,032,908 32.25 *4 As the Schedules 13D were filed, some of the Hughes family members became concerned about whether the *6 acquisitions of stock were merely for investment. CED was a competitor of Hughes Supply in the electrical materials distribution business and was known as a national company that grew primarily through the acquisition of other companies. CED had 11 branches in Florida at the time the Hughes Supply stock was acquired. A takeover by CED threatened the welfare of Hughes Supply which also, in turn, potentially threatened the viability of the leases petitioner held with Hughes Supply.
CED's chairman of the board of directors, Keith Colburn, met with David Hughes several times regarding the stock purchases. At first he told Mr. Hughes that CED bought Hughes Supply stock because it was undervalued. Later, in 1977, Mr. Colburn and his father proposed that the Hughes family join them in taking Hughes Supply private with the two families each owning one-half of the company. The Hughes family rejected this idea.
Hughes Supply's general counsel, Robert Blackford, also*7 a director of the corporation, monitored the stock purchases. When CED's interest exceeded 10 percent of the total stock issued, he discussed responses to a hostile tender offer, such as filing litigation and alleging violations of the antitrust laws. He also advised David Hughes to contact a New York law firm specializing in mergers, acquisitions, and takeovers. In November 1977, David Hughes contacted an attorney in the New York firm. The *5 attorney met with Mr. Hughes, as president of Hughes Supply, and two financial advisors to discuss the situation. They explained their concerns and the attorney explained to them the "state of play." He addressed generally what things should be considered so Mr. Hughes could determine whether to retain his law firm. Hughes Supply subsequently paid the firm $ 40,000 as a retainer for their advice in terms of defensive measures.
The attorney reviewed documents provided by Hughes Supply, including its charter, bylaws, annual reports, other public filings, and proxy statements. He also reviewed the CED Schedule 13D filings and other background information he received on CED. Based on this information he concluded that despite reporting*8 that it was making acquisitions for investment, CED was involved in a "creeping acquisition." He found significant the continually increasing stock purchases at increasing price levels, a pattern seen in a creeping acquisition. He also noted that CED had made other acquisitions, they were in a related line of business, and that they were putting a lot of money into one particular situation. These factors were generally not indicative of a passive investment, and he viewed CED as a threat to the control of Hughes Supply.
In December 1977, the attorney met with David Hughes and Mr. Blackford again. He advised them with respect to the paths they could follow in reacting to CED's continuing acquisition of shares. He proposed issuing additional shares of Hughes Supply stock into "friendly hands" to increase capitalization of the company and dilute CED's position; increasing the Hughes' family interest to acquire 51 percent or as close to 51 percent as possible to assure that control would be retained by the family; litigating, i.e., challenging CED's disclosures and preventing future acquisitions; or selling the company to a third party. No action was taken by Hughes Supply that year.
*9 David Hughes met with the attorney for the final time about a year later to discuss the status of the situation, however no further contact was made and the law firm's retainer was not renewed.
Based on the advice obtained, the strategy agreed upon in defense of a takeover was to try to purchase additional shares of Hughes Supply stock from the public sector and *6 place them in "friendly hands." 4*10 A number of events took place, 5 including, in January 1979, petitioner's purchase of 43,500 shares of Hughes Supply stock in the following allotments:
Number of shares Price per share Purchase price 42,500 $ 21 $ 892,500 1,000 19 19,000 911,500 The purchase price was paid with $ 36,500 of available cash from petitioner, $ 375,000 borrowed from Sun Bank on a demand note basis, and $ 500,000 borrowed from Sun Bank on a 10-year note secured by a mortgage on a portion of petitioner's real properties. The 43,500 shares of Hughes Supply stock served as collateral for the demand note.
*11 Petitioner received an additional 21,750 shares of Hughes Supply stock on June 15, 1979, pursuant to a 3-for-2 stock split effective May 15, 1979.
In June and July 1980, petitioner acquired a total of 8,000 additional shares of Hughes Supply stock in three *7 separate transactions for a total purchase price of $ 141,902. One hundred thousand dollars of the consideration for these purchases was borrowed from Sun Bank and the remaining balance of $ 41,902 was paid from petitioner's available cash assets.
Fifteen additional shares of Hughes Supply stock were acquired by petitioner on June 4, 1981, for $ 341.25, bringing the total holdings of Hughes Supply stock to 73,265 shares. These acquisitions, in conjunction with the other increases in stockholdings by "friendly" parties, helped assure that control of Hughes Supply would be retained.
By late 1982, the CED group was satisfied with the return on the Hughes Supply investment. On December 10, 1982, Edmundson International, Inc., a subsidiary of CED which owned the Hughes Supply stock, 6 entered into a stock purchase agreement whereby Hughes Supply redeemed all 655,750 shares of Hughes Supply common stock held by Edmundson for*12 a total purchase price of $ 16,393,750, or a per share purchase price of $ 25. The redemption was closed December 29, 1982. Pursuant to the terms of the agreement, Edmundson, for itself and its affiliates, agreed not to purchase in the aggregate, directly or indirectly, 2 percent of any class of equity securities of Hughes Supply within the 5-year period from the closing date.
On January 27, 1983, Hughes Supply's stock underwent another 3-for-2 stock split, increasing the number of shares held by petitioner from 73,265 to 109,897.
On April 15, 1983, Hughes Supply made a public offering of 850,000 shares of its stock. As part of this offering, 75,000 of petitioner's shares of Hughes Supply stock were sold.
Additional Investments After the first public offering*13 of its stock, Hughes Supply decided to own directly any new warehouses or other facilities it required rather than lease them from petitioner to avoid any appearance of impropriety. The previous leases *8 between petitioner and Hughes Supply were maintained in accordance with their terms, and the relationship between the two businesses continued in the same manner. Twelve of the leases were renewed for 10 years in 1978 and two were under 5-year leases from 1978 to 1983. In this respect, petitioner, as lessor, expanded its facilities leased to Hughes Supply as follows from 1970 to 1982:
Location Expansion Ft. Pierce (a) 5,000 sq. ft. addition to warehouse (b) 5,000 sq. ft. addition to warehouse Ft. Myers 7,000 sq. ft. addition to warehouse and paved area Naples 5,000 sq. ft. addition to warehouse and paved area Venice (a) 7,000 sq. ft. warehouse (b) Outside storage (c) Paving and fencing St. Petersburg 12,000 sq. ft. addition to warehouse Clearwater (a) Paved area (b) Paved area (c) Addition to warehouse Orlando (a) Relocation of garage and maintenance facility (b) 30,000 sq. ft. addition to warehouse (c) Outside storage Winter Haven (a) 5,000 sq. ft. warehouse (b) Showroom *14 When Hughes Supply went public and it was decided that it would acquire its own facilities, petitioner began investing in other activities. In 1974, petitioner acquired a 60-acre citrus grove adjacent to groves already operated by the Russell Hughes family. The grove was operated throughout the years in issue, and was later sold in 1982.
Petitioner also developed property adjacent to the Orlando Executive Airport as hangar facilities. These buildings were under lease during the years in issue to Red Lobster Corp., Florida Gas Co., 7 Purolator Courier Corp., Sun Bank, and Hughes Supply.
Petitioner acquired an airplane in 1977 for approximately $ 250,000 which it leased primarily to Hughes Supply, but also chartered to other parties during the years in issue.
In February 1977 for $ 102,000, petitioner purchased a 60-percent interest in and acted as general manager of a general partnership known as Town & Country Properties. The partnership owned and operated*15 a 96-unit apartment *9 complex in Winter Park, Florida. A management firm was employed by petitioner to collect the rents and assist with day-to-day responsibilities. Petitioner remained a partner throughout 1979 and for a portion of 1980, when the apartment complex was sold at a substantial profit.
Petitioner contributed $ 56,000 in exchange for a 20-percent partnership interest in Virginia Hall, Ltd., in 1977. Virginia Hall, Ltd., was engaged in the business of owning and operating a residential apartment complex in one of the more exclusive neighborhoods of Winter Park. Petitioner remained a partner throughout the years in issue and continued to hold the interest at the time of trial.
In 1979, an 8-percent interest in Nob Hill Properties, Ltd., was purchased by the corporation for $ 54,000, which interest was held throughout the years in issue. The arrangement was similar to the Town & Country partnership, and the Nob Hill property was in the same general area.
In the latter part of 1981, petitioner's board of directors considered an investment of 5 percent of Highlands Golf Investments, Inc., in Highlands, North Carolina, along with the purchase of four residential lots*16 in the Highlands project. The 5-percent interest was purchased in 1982 for $ 150,000 and the lots for $ 225,000. David Hughes had considered the investments personally before recommending them to the board.
In 1982, petitioner also traded in its airplane and purchased a new plane for a total cost of $ 347,750. In addition, $ 86,958 was expended for a 24-year old wooden fishing boat to be used as a commercial fishing boat. The boat was chosen after looking at other possible boats over a period of 1 to 1 1/2 years.
Financial Information On its Federal income tax returns for the years in issue, petitioner reported the following assets:
*17Assets 1979 1980 1981 Cash $ 8,133 $ 363 $ 23,596 Trade notes and accounts receivable 3,179 3,776 17,974 Government obligations 13,946 1,942 Other current assets Prepaid insurance -- general 8,857 Prepaid life insurance 9,560 9,560 9,560 Prepaid interest 29,839 20,005 14,089 Other investments Cash surrender value of life insurance 72,141 91,950 1 3,507 Convest Energy 476 Town & Country Properties 38,011 Virginia Hall, Ltd. (14,717) (46,880) (69,385) Nob Hill Properties 22,002 (12,158) (48,407) Land held for future development 26,922 26,922 26,922 Hughes Supply, Inc., common stock (cost) 8 911,500 1,052,875 1,053,216 Buildings and other depreciable assets (less accumulated depreciation) 1,244,520 1,155,980 1,104,329 Land 669,690 674,062 674,062 Intangible assets (less accumulated amortization) 10,549 10,194 9,839 Total assets 3,040,662 3,000,595 2,821,244 *18 *10 The following reflects the liabilities, stockholder equity, and retained earnings of petitioner as of December 31 of the years in issue:
Liabilities and equity 1979 1980 1981 Current maturity of mortgage note $ 15,696 $ 17,339 $ 19,155 Demand note 375,000 365,000 165,000 Dividends and taxes payable, accrued interest and other current notes and liabilities 144,558 110,619 111,469 Total current liabilities 535,254 492,958 295,624 Long-term debt 1 901,244 764,658 666,572 Total liabilities 2 1,436,498 1,257,616 962,196 Capital stock 102,000 102,000 102,000 Retained earnings 1,502,164 1,640,979 1,757,048 Total 3,040,662 3,000,595 2,821,244 *11 The principal payments made by petitioner on its outstanding indebtedness during 1979 through 1982 were:
Debt 1979 1980 1981 1982 Mortgage note $ 4,894.08 $ 15,695.86 $ 17,339.42 $ 19,155.09 Demand note 0 10,000.00 200,000.00 10,000.00 Other debt 160,495.59 220,414.25 70,719.68 291,884.72 Total 165,389.67 246,110.11 288,059.10 321,039.81 *19 The principal balance on petitioner's outstanding debt at the end of years 1979 through 1982 was as follows:
Debt 1 1979 1980 1981 1982 Mortgage note $ 495,106 $ 479,410 $ 462,071 $ 442,916 Demand note 375,000 365,000 165,000 155,000 Other debt 481,927 361,513 290,793 696,962 Total 1,352,033 1,205,923 917,964 1,294,878 The following were petitioner's working capital needs (operating capital) for one business cycle during the years at issue:
Year Working capital needs 1979 $ 60,300 1980 38,100 1981 28,800 During the years 1979-82, petitioner made the following capital expenditures: *12
Amount of Year expenditure Description 1979 $ 41,016 Purchase of property contiguous to existing Venice, Florida, facility leased to Hughes Supply for additional parking ($ 30,000 of which represented by note and mortgage) 1,227 Legal fees for quiet title action pertaining to Central Ave. property Orlando leased to Hughes Supply 16,408 Addition to airplane hangar leased to Sun B 9,175 Improvements to airplane hangar leased to Florida Gas Co. 53,610 Addition to Winter Haven facility leased to Hughes Supply 10,295 Acquisition of additional parcel (Central Avenue, Orlando) for lease to Hughes Supply 131,731 Total new capital expenditures 1980 35,776 New engines for 1978 Piper Navajo Chieftan airplane 4,358 Purchase of used pickup truck 1,788 New citrus trees for citrus grove 4,372 Cost of perfecting title to, and clearing, Venice property leased to Hughes Supply 46,294 Total new capital expenditures 1981 71,600 Additions to Ft. Pierce facility leased to Hughes Supply 1,150 New roof for hangar leased to Sun Bank 1,250 New roof for Southern Lighting facility leased to Hughes Supply 2,630 New roof for hangar leased to Florida Gas 76,630 Total new capital expenditures 1982 150,000 Cost of 5-percent share of Highlands Golf Investments, Inc., Highlands, North Carolina 225,000 Cost of four residential lots in Highlands, North Carolina 86,958 Commercial fishing boat 347,750 Purchase of new airplane for lease to Hughes Supply (price net of trade-in value of old plane but after payoff of $ 80,000 debt owed on old plane) 809,708 Total new capital expenditures *20 Petitioner made the following dividend distributions:
Years Amount per year 1946-73 none 1974 $ 10,000 1975 10,000 1976 10,000 1977 none 1978 30,000 1979 10,000 1980 16,000 1981 10,000 1982 10,000 1983 30,000 1984 90,000 *13 During the years in issue, petitioner made no loans to its shareholders, to any relatives of any of its shareholders, or to any corporations or other entities owned or controlled by its shareholders or their relatives.
The officer-compensation history of petitioner is as follows:
Years Officers Compensation 1976-79 Russell V. Hughes, president $ 20,000 Vincent S. Hughes, vice president 10,000 David H. Hughes, secretary/treasurer 10,000 1980-82 Russell V. Hughes, president 30,000 Vincent S. Hughes, vice president 20,000 David H. Hughes, secretary/treasurer 20,000 Statutory Notice of Deficiency On September 20, 1983, respondent notified petitioner, pursuant to section 534(b), that the proposed notice of deficiency included an amount with respect to the accumulated earnings tax imposed by section 531. In response, petitioner submitted a statement to respondent, pursuant to section 534(c), setting forth the following*21 grounds on which petitioner relied to establish that the earnings and profits of the corporation were not permitted to accumulate beyond the reasonable needs of the business during the years involved:
1. Need to diversify the Taxpayer's business as a result of being a "one customer" business.
2. Need to purchase stock of the Taxpayer's principal customer to assist in preventing an unfriendly takeover that would jeopardize this source of business.
3. Need to retain earnings to provide for the retirement of long term debt of the Taxpayer.
4. Need to expand and repair existing facilities.
5. Need to provide adequate working capital.
In addition to setting forth the specific grounds, petitioner explained in detail the reasons for the purchases of Hughes Supply stock and the amounts expended for the purchases. In the statement, petitioner also explained the *14 need to diversify its holdings based on the decision by Hughes Supply to acquire its own new facilities of the type leased from petitioner when needed, to avoid the appearance of impropriety between the related corporations. In this regard, petitioner described the properties purchased in the diversification effort. 9
*22 Petitioner further set forth its specific capital expenditures for the years 1979-81 10 which were directly related to its trade or business, and described anticipated investments and the amounts thereof, such as the Highlands, North Carolina, properties and the charter fishing boat.
Total indebtedness and current assets were set forth for each year in issue as well; however, no reference was made to amounts required for working capital.
Respondent considered petitioner's statement and determined that it was insufficient to establish that any part of petitioner's earnings and profits for the taxable years 1979, 1980, and 1981 were kept for the reasonable needs of its business. In the statutory notice which was subsequently issued, respondent made the following computations:
*23 *15Computation of Accumulated Taxable Income 1979 1980 1981 Taxable income $ 127,514 $ 193,374 $ 156,136 Add: (a) Special deductions disallowed 1. Dividends received by corporations 11,093 16,618 22,417 138,607 209,992 178,553 Less: (b) Federal income taxes paid or accrued 39,408 51,764 52,573 (c) Excess of long-term capital gains over short-term capital losses minus tax on net capital included in income 0 65,685 0 Taxable income as adjusted 99,199 92,543 125,980 Less: (d) Dividends paid deduction 10,000 16,000 10,000 1. Dividends paid during taxable year current earnings and profits retained 89,199 76,543 115,980 Less: Accumulated earnings credit (see below) 0 0 0 Accumulated taxable income 89,199 76,543 115,980 Computation of Accumulated Earnings Credit 1979 1980 1981 1. Minimum accumulated earnings credit $ 150,000 $ 150,000 $ 150,000 2. Less: Accumulated earnings as of close of prior year 1,413,716 1,502,164 1,640,979 3. Allowable minimum credit under sec. 535(c)(2) 0 0 0 4. Current earnings and profits determined to be retained for reasonable needs of business 0 0 0 5. Less: Deduction for long-term capital gains 0 65,685 0 6. Allowable credit under sec. 535(c)(1) 0 0 0 7. Accumulated earnings credit (greater of line 3 or 6) 0 0 0 On February 15, 1985, petitioner filed a motion for ruling on burden of proof with respect to accumulation of earnings and profits, which motion was taken curia advisari valt.
OPINION
A corporation formed or availed of for the purpose of avoiding the income tax with respect to its shareholders, by permitting earnings and profits to accumulate instead of being divided or distributed, is subject to the accumulated earnings tax imposed by section 531. Sec. 532(a). The accumulated earnings tax is a means of discouraging the accumulation of corporate earnings not*24 needed in the conduct of a business. See
Ivan Allen Co. v. United States , 422 U.S. 617">422 U.S. 617Ivan Allen Co. v. United States, supra at 626*16 For the accumulated earnings tax to apply, tax avoidance need not be the sole or even the dominant purpose for the accumulation. Shareholder tax avoidance may be but one of several purposes.
United States v. Donruss Co ., 393 U.S. 297">393 U.S. 297Helvering v. National Grocery Co ., 304 U.S. 282">304 U.S. 282Bahan Textile Machinery Co. v. United States , 453 F.2d 1100">453 F.2d 1100Snow Manufacturing Co. v. Commissioner , 86 T.C. 260">86 T.C. 260Bremerton Sun Publishing Co. v. Commissioner , 44 T.C. 566">44 T.C. 566The accumulated earnings tax is not imposed where a corporation has accumulated its earnings beyond the reasonable needs of its business but lacks the proscribed purpose.
Snow Manufacturing Co. v. Commissioner, supra ; Pelton Steel Casting Co. v. Commissioner , 28 T.C. 153">28 T.C. 153251 F.2d 278">251 F.2d 278 (7th Cir. 1958), cert. denied356 U.S. 958">356 U.S. 958 (1958). Furthermore, if it is determined that the corporation was formed or availed of for the proscribed purpose, the tax is applied only to that portion of the corporation's earnings and profits which exceeds the corporation's reasonable needs. Sec. 535(a) and (c). SeeBremerton Sun Publishing Co. v. Commissioner, supra ; John P. Scripps Newspapers v. Commissioner , 44 T.C. 453">44 T.C. 453Whether a corporation has permitted its earnings and profits to accumulate beyond its reasonable business needs and whether the corporation was availed of for tax-avoidance purposes are both questions of fact.
Helvering v. National Grocery Co., supra ; Bremerton Sun Publishing Co. v. Commissioner, supra at 582Snow Manufacturing Co. *17 at 269Atlantic Properties, Inc. v. Commissioner , 62 T.C. 644">62 T.C. 644519 F.2d 1233">519 F.2d 1233 (1st Cir. 1975);Faber Cement Block Co. v. Commissioner , 50 T.C. 317">50 T.C. 317Burden of Proof Initially we will address petitioner's motion regarding the burden of proof. Generally, petitioner bears the burden of proving that it was not formed or availed of for the proscribed purpose. Rule 142(a);
American Metal Products Corp. v. Commissioner , 34 T.C. 89">34 T.C. 89287 F.2d 860">287 F.2d 860 (8th Cir. 1961);Pelton Steel Casting Co. v. Commissioner, supra .In order to place the burden of proof on respondent under section 534(c), petitioner's statement:
must constitute more than mere notice of an intent to prove the reasonableness of the accumulation. Rather, the taxpayer must show its hand by stating with clarity and specificity the grounds on which it will rely to prove reasonable business needs, and by setting out the facts (not the evidence, *28 but more than conclusions of law) that, if proven, support the alleged business needs for the accumulation. [Rutter v. Commissioner , 81 T.C. 937">81 T.C. 937The Fifth Circuit 12 has stated the following with respect to section 534(c):
*18 We think § 534's language indicates that the statement simply serves a notice function. Whether the "grounds" divulged in the statement subsequently prove convincing is irrelevant to this function. But just as the statement is not supposed to be legally sufficient on the question of definiteness, neither is it supposed to be a substitute for testimony at trial. Here, MFC sufficiently "showed its hand." We hold that this is all*29 that § 534 requires. [
Motor Fuel Carriers, Inc. v. Commissioner , 559 F.2d 1348">559 F.2d 1348In this case, respondent argues that the statement filed by petitioner alleging justification for its accumulation of earnings and profits is insufficient to place the burden of proof on him because, with the exception of the fourth ground for which expenditures were set out that were subsequently stipulated to by respondent, the assertions set forth in the statement are "vague, indefinite, and incomplete," and thus*30 fail to provide facts sufficient to show the basis of the asserted grounds.
After examining the statement submitted by petitioner and considering respondent's arguments on brief concerning the claimed insufficiency of the statement, we have concluded that petitioner sufficiently set forth specific facts which, if proven, would support the alleged business needs for the accumulation with respect to grounds two, three, and four only. See
Chatham Corp. v. Commissioner , 48 T.C. 145">48 T.C. 145In contrast, with respect to grounds one and five, petitioner failed to allocate the specific amounts needed to purchase assets to diversify its business and required for operating capital. The only amount provided was the cost of one of the partnership interests.
In order to sufficiently "show its hand" petitioners must, when*31 appropriate, provide details with respect to amounts *19 so that respondent is not required to guess as to what they may be. Without these facts the statement is insufficient to place the burden of proof on respondent. We do not consider this requirement to conflict with the opinion expressed by the Fifth Circuit in
Motor Fuel Carriers, Inc . In that case, the Fifth Circuit distinguished "between the substantive § 533(a) inquiry as to whether the taxpayer's plan is definite and the procedural § 534 inquiry as to whether his statement suffices 'to show the basis' of his claim of a need for earnings."559 F.2d at 1351-1352 . We are concerned with whether sufficient facts were provided in petitioner's section 534(c) statement to show the basis of the asserted grounds rather than with whether petitioner's grounds subsequently prove to be convincing. 13 Petitioner has not provided adequate facts unless the amount of working capital required to meet its business needs is set forth in the statement when appropriate. Otherwise respondent has no way of comparing needs with earnings and profits in order to determine whether he will issue a statutory *32 notice.Based on the foregoing, the burden of proving that petitioner accumulated its earnings and profits beyond the reasonable needs of the business is on respondent with respect to grounds two, three, and four, and is on petitioner with respect to grounds one and five. 14
Were earnings and profits permitted to accumulate beyond the reasonable needs of petitioner's business *33 The critical factor in determining whether a corporation has accumulated its earnings and profits beyond the reasonable needs of its business is not the monetary size of the accumulated earnings and profits but the corporation's liquid position and the relation of that position to current *20 and anticipated needs.
Faber Cement Block Co. v. Commissioner , 50 T.C. 317">50 T.C. 317*34 In this case, the parties both agree that to determine whether petitioner accumulated its earnings and profits beyond the reasonable needs of the business, the net liquid assets of the corporation must be compared to its business needs. 16 However, they disagree with respect to which assets are to be considered liquid assets and with respect to the reasonable needs of the business.
*35 Respondent contends that petitioner's net current assets greatly exceeded the business needs of the corporation in the years in issue and that therefore petitioner had no need to accumulate its current earnings and profits. To demonstrate the unreasonable accumulation respondent relies on the following computations:
Year ending Dec. 31 -- 1979 1980 1981 Net fair market value petitioner's $ 942,529 $ 1,125,637 $ 1,108,099 Hughes Supply stock 17 Other current assets per petitioner's 88,690 116,032 149,426 definition Value of orange grove (sales price -- 1982) 92,355 92,355 92,355 Value of partnership interests (cost) 212,000 100,000 110,000 Total current assets 1,355,574 1,444,024 1,459,880 Less: Current liabilities (535,254) (492,958) (295,624) Net current assets 800,320 951,066 1,164,256 Less: Business needs (capital expenditures plus operating cycle needs) (192,031) (84,394) (104,738) Excess (unreasonable accumulation) 608,289 866,672 1,059,518 *36 *21 Because petitioner's accumulation of earnings and profits exceeded petitioner's total reasonable business needs as well as the minimum accumulated earnings credit provided in section 535, respondent maintains that all of petitioner's earnings and profits accumulated for the taxable years 1979, 1980, and 1981 are subject to the accumulated earnings tax.
Petitioner, on the other hand, contends that it had no net current or liquid assets during the years in issue, and thus it had no accumulated surplus from which to satisfy current business needs. Furthermore, since petitioner had no net liquid assets as of the end of each of the years in issue, it was required to retain its current earnings to satisfy the reasonable needs and reasonably anticipated business needs for each of those years. Therefore, petitioner maintains, it is entitled to a credit under section 535(c) equal to its current earnings for each of the years in issue. To demonstrate this position, petitioner relies on the following computations:
*37Assets: 1979 1980 1981 Cash $ 8,133 $ 363 $ 23,596 Accounts receivable 3,179 3,776 17,974 Government obligations 0 13,946 1,942 Other current assets 48,256 29,565 23,649 Other liquid investments 18 476 0 0 Total current assets 60,044 47,650 67,161 Current liabilities (535,254) (492,958) (295,624) Net liquid assets (working capital) (475,210) (445,308) (228,463) Reasonable needs: Operating capital for one business cycle 60,300 38,100 28,800 Capital expenditures for expansion 80,000 80,000 80,000 Airplane engine replacement 36,000 0 0 New airplane 0 0 348,000 Commercial fishing boat 0 0 87,000 Five-percent share of Highlands Golf Investments, Inc. 0 0 150,000 Four residential lots at Highlands, N.C. 0 0 225,000 Long-term debt repayment 977,033 840,923 752,864 Total reasonable needs 1,153,333 959,023 1,671,664 Current earnings 88,448 138,815 116,069 *22 From the positions set forth above, it is apparent that the pivotal issue in this case is whether petitioner's assets are liquid or current assets and thus available to meet petitioner's business needs. Respondent contends that the Hughes Supply stock, the orange grove, and the partnership interests all should be considered liquid assets because they bear no relation to petitioner's business and because they are readily marketable or convertible into cash. Furthermore, respondent argues, the orange grove was treated as a liquid asset when petitioner persuaded the bank that*38 it could repay the demand note, funds from which were used to purchase the Hughes Supply stock.
Petitioner contends that none of these assets were readily marketable and, furthermore, because the assets are business related, they should not be considered current assets which could be disposed of to meet the needs of the business. Petitioner maintains that the Hughes Supply stock was purchased because of the feared takeover and that the other assets were purchased as part of petitioner's plan to diversify its business and holdings. For the reasons below we agree with petitioner.
Generally, a current asset includes items representing the equivalent of cash. 19 However, not all assets readily convertible *23 into cash should be considered current assets. 20*40 For example, investments in marketable securities which bear some relationship to a corporation's business are considered a proper business application of funds and may be accumulated with impunity.
Cheyenne Newspapers, Inc. v. Commissioner , 494 F.2d 429">494 F.2d 429Bremerton Sun Publishing Co. v. Commissioner , 44 T.C. 566">44 T.C. 566Crow v. Commissioner , 79 T.C. 541">79 T.C. 541We recognize that petitioner's purchase of stock benefited the Hughes family members who were shareholders of both corporations. However, if the stock was not purchased by petitioner, it is very likely that CED would have purchased it as it became available. As we have already indicated, if CED controlled the largest block of Hughes Supply stock, the impact on Hughes Supply and petitioner would very likely have been negative. We are convinced that this is not a situation where the funds which were used to purchase the stock could have been distributed to the family members who *41 in turn could have bought the Hughes Supply stock as it became available. Rather, we are persuaded that the family members were not in a position to purchase the stock, and instead caused petitioner, which had sufficient assets available to secure financing, to borrow the funds *24 with which to purchase the stock in order to maintain a sufficient margin of controlling shares. 23
We are also persuaded that the orange grove and partnership interests purchased in 1977 and 1979 24 were purchased as part of petitioner's efforts to diversify its business. When Hughes Supply ceased to lease new properties from petitioner, the officers and directors of the corporation identified the need to diversify and chose*42 to invest in projects which appeared to be sound business investments. There is no indication that these investments were made to benefit petitioner's shareholders personally. 25 Rather it appears, from the evidence presented, that petitioner had a need to diversify and chose to do so by purchasing interests in residential real estate and by purchasing the orange grove. 26 Furthermore, we do not consider these assets "liquid," or readily convertible into cash, as respondent suggests. Based on the foregoing, we find that the orange grove and partnership interests are not current assets.
*43 Having determined that the Hughes Supply stock, the orange grove, and the partnership interests purchased in 1977 and 1979 are not current assets, petitioner was, as claimed, in a net nonliquid position during the years in issue. None of those assets were available from which to fund the reasonable needs of the business. 27 Moreover, upon comparing petitioner's current earnings and profits for each year, taking into account, successively, accumulations in *25 each of the years before the Court, with the undisputed portion of petitioner's reasonable needs for those years, it is apparent that the current earnings were insufficient to meet those needs. 28*45 We therefore hold that petitioner accumulated its earnings and profits during the years in issue to meet the reasonable needs of its business. Where a taxpayer can show that all of its current earnings were accumulated for the reasonable needs of the business, there is no accumulated earnings tax since the accumulated earnings credit eliminates the amount against which the tax is imposed. See, e.g.,
Magic Mart, Inc. v. Commissioner , 51 T.C. 775">51 T.C. 775Faber Cement Block Co. v. Commissioner *44 .50 T.C. 317">50 T.C. 317 , 336 (1968). 29To reflect the foregoing,
Decision will be entered for the petitioner .Footnotes
1. All section references are to the Internal Revenue Code of 1954, as amended and in effect during the years in issue, and all Rule references are to the Tax Court Rules of Practice and Procedure.↩
2. The parties stipulated that the transfer took place on Dec. 18. We note however that in petitioner's statement to respondent for purposes of sec. 534(c) the date of transfer was Dec. 16.↩
3. This figure includes shares owned by CED affiliates.↩
1. Approximate number.↩
2. As corrected by amended Schedule 13D dated 11/12/79.↩
4. Apparently this further action was not discussed with the New York attorney. In 1980, however, Hughes Supply retained a brokerage firm to advise, among other things, with respect to appropriate courses of action, if any, in response to acquisitions or dispositions of major portions of its stock.↩
5. In addition to the purchase of Hughes Supply stock by petitioner, the total number of shares available in a Hughes Supply stock option plan that had been created in 1973 for principal officers and executives was raised from 65,000 to 97,500 in 1978. The number of available shares were increased to 200,000 in 1982. Options to purchase were exercised as follows:
Fiscal year Number of shares 1973-76 0 1/28/77 822 1/27/78 0 1/26/79 11,007 1/25/80 17,857 1/30/81 17,896 1/29/82 34,617 1/28/83 11,808 Hughes Supply retired 306,000 shares of its treasury stock in 1980.
In 1981, Hughes Supply adopted a trusteed Employee Stock Ownership Plan (ESOP) to which it issued 30,000 shares of new stock. On Dec. 31, 1981, the ESOP owned 53,769 shares.
In addition, the Hughes Supply Profit Sharing Plan purchased shares of Hughes Supply stock. The plan owned the following shares on the dates indicated:
Dec. 31 -- Number of shares 1979 78,443 1980 119,122 1981 119,122 During 1981, Hughes Supply acquired by merger the Marbut Co., a closely held corporation with eight business locations in Georgia. In connection with the merger, 124,160 new shares of Hughes Supply stock were issued to Marbut Co. stockholders in 1981.↩
6. Edmundson International, Inc. is a wholly owned subsidiary of CED engaged in the same business. At some point between the Nov. 9, 1979, Schedule 13D filing and the Mar. 7, 1980, Schedule 13D filing Edmundson became the owner of the Hughes Supply stock.↩
7. The successor to Florida Gas Co. is Continental Resources.↩
1. Net of outstanding loans.↩
8. The parties stipulated that because petitioner was an affiliate of Hughes Supply during the years at issue, as that term is defined in subsec. (a)(1) of SEC rule 144, the sale of Hughes Supply stock by petitioner in brokers transactions or by market makers was subject to the requirements contained in that rule. Alternatively, petitioner could have sold its Hughes Supply stock through a private placement or a registered offering. Due to the size of petitioner's Hughes Supply stock holding and the Federal securities law limitations imposed upon the sale of the Hughes Supply stock held by petitioner as an affiliate of Hughes Supply, the net fair market value of all of petitioner's Hughes Supply stock, if sold in a single transaction to an entity or individual not affiliated or associated with it or with Hughes Supply, would have been 90 percent of the over-the-counter value of the stock, or $ 942,529, $ 1,125,637, and $ 1,108,099, as of Dec. 31, 1979, 1980, and 1981, respectively.↩
1. Long-term debt includes the following amounts as the non-current portion of the mortgage note: 1979, $ 479,410; 1980, $ 462,071; $ 1981, $ 442,916.↩
2. Does not include $ 108,345.90 borrowed against certain life insurance policies owned by petitioner.↩
1. Does not include $ 108,345.90 borrowed against certain life insurance policies owned by petitioner.↩
9. With respect to these properties, the only amount referenced was the $ 102,000 paid in 1977 for a 60-percent interest in a partnership which acquired and operated a residential apartment complex.↩
10. See page 12
supra↩ .11.
Eden v. Commissioner , T.C. Memo. 1987-101, 53 T.C.M. (CCH) 195">53 T.C.M. 195↩12. The 11th Circuit, to which this case is appealable, has not ruled with respect to the sufficiency of the contents of a statement made pursuant to sec. 534(c). However, in
Bonner v. City of Prichard , 661 F.2d 1206">661 F.2d 1206↩13. See
Michael DiPeppino, Inc. v. Commissioner , 83 T.C. 979">83 T.C. 97914. Although petitioner did not set out the amounts required as working capital in the sec. 534(c) statement, the parties have stipulated to the amount of working capital necessary during the years in issue, and both parties included those amounts in their determination of reasonable needs.
Notwithstanding our discussion of the sufficiency of the sec. 534(c) statement, because the facts with respect to the amounts expended and retained are not in dispute and have all sufficiently been made a part of this record, our decision in this case is not based on burden of proof.↩
15. This entails examining the nature and availability of the prior years' accumulated surplus. When a corporation retains its accumulated surplus in the form of liquid assets, such surplus is available to meet business needs. If this surplus meets the current and reasonably anticipated needs of the corporation, there is a strong indication that any accumulation of profits of the current year is beyond the reasonable needs of the business.
Atlantic Properties, Inc. v. Commissioner , 62 T.C. 644">62 T.C. 644519 F.2d 1233">519 F.2d 1233 (1st Cir. 1975);Edward B. Wolf, Inc. v. Commissioner , T.C. Memo. 1987-562, 54 T.C.M. (CCH) 1053">54 T.C.M. 1053↩16. In
Snow Manufacturing Co. v. Commissioner , we noted that accumulated earnings and profits and net liquid assets are distinct concepts in tax law.86 T.C. 260">86 T.C. 260 , 278 (1986). Accumulated earnings and profits is the historical net increase in a corporation's assets above stockholders' contributions to capital, while net liquid assets or working capital is the excess of current assets over current liabilities.86 T.C. at 278 . InSnow Manufacturing Co . the net liquid assets exceeded accumulated earnings and profits. We held that where net liquid assets exceed accumulated earnings and profits, net liquid assets are reflected in the full amount of accumulated earnings and profits, and that therefore reasonable needs of the business should be compared with accumulated earnings and profits.86 T.C. at 279 . We noted however that, in some cases (such as this case), where accumulated earnings and profits exceed net liquid assets, reasonable business needs have been compared against net liquid assets.86 T.C. at 279 n. 18 ., citing for example,Alma Piston Co. v. Commissioner , T.C. Memo. 1976-107579 F.2d 1000">579 F.2d 1000 (6th Cir. 1978);Bardahl Manufacturing Corp. v. Commissioner , T.C. Memo. 1965-200↩17. See note 8
supra↩ .18.
↩ 1979 1980 1981 Other investments per Schedule L on Form 1120 $ 1,056,335 $ 1,112,709 $ 965,853 Less nonliquid investments: Hughes Supply stock (911,500) (1,052,875) (1,053,216) Partnership interest (45,296) 0 0 Cash surrender value of life insurance (72,141) ( 91,950) (3,507) Land held for future development ( 26,922) (26,922) (26,922) Total liquid investments 476 0 0 19.
Suwannee Lumber Manufacturing Co. v. Commissioner , T.C. Memo 1979-477">T.C. Memo 1979-477Bardahl Manufacturing Corp. v. Commissioner , T.C. Memo. 1965-200↩20. See
Bremerton Sun Publishing Co. v. Commissioner , 44 T.C. 566">44 T.C. 566John P. Scripps Newspapers v. Commissioner , 44 T.C. 453">44 T.C. 453Suwannee Lumber Manufacturing Co. v. Commissioner, supra Faber Cement Block Co. v. Commissioner , 50 T.C. 317">50 T.C. 317Bardahl Manufacturing Corp. v. Commissioner, supra↩ .21. Because we find that the stock was purchased for a business purpose, we will not address petitioner's arguments with respect to the restrictions on the marketability of the stock.↩
22. Even though most of the Hughes Supply leases were renewed for 10-year periods during the years in issue, there is no guarantee that CED would have continued to renew them. Given the fact that petitioner was essentially a "one customer" business, we are convinced that steps taken to sustain the business relationship were warranted.↩
23. In this respect, we note that it appears that respondent is essentially trying to argue that petitioner borrowed itself into a situation where it became subject to the accumulated earnings tax. We do not see how this would be consistent with a purpose of accumulating earnings to avoid tax to shareholders.↩
24. In determining the liquidity of the corporation during the years in issue, we have not considered the assets acquired in 1982, the acquisition of which petitioner claims was reasonably anticipated in 1981.↩
25. Compare
Bardahl Manufacturing Corp. v. Commissioner, supra↩ .26. We note in this regard that petitioner admittedly did not regularly reflect in the records of the corporation, such as minutes from the board of directors meetings, evidence of the plan to diversify. However, it is clear from the fact that the investments were made and were retained that the plan to diversify was contemplated and implemented. Under these circumstances the plan to diversify holdings has been demonstrated. Compare
Guarantee Abstract & Title Co. v. United States , 696 F.2d 793">696 F.2d 793John P. Scripps Newspapers v. Commissioner, supra↩ at 46927. The utilization of working capital by a business for the purpose of purchasing fixed assets decreases the amount of funds otherwise available for operating purposes.
Bremerton Sun Publishing Co. v. Commissioner , 44 T.C. 566">44 T.C. 56628. Sec. 537 defines reasonable needs of the business.
Sec. 1.537-1(a), Income Tax Regs. , provides that an accumulation of earnings and profits (including the undistributed earnings and profits of prior years) is in excess of the reasonable needs of the business if it exceeds the amount that a prudent businessman would consider appropriate for the present business purpose and the reasonably anticipated future needs of the business. The need to retain earnings must be directly connected with the needs of the corporation itself and must be for bona fide business purposes.Sec. 1.537-2(a), Income Tax Regs. , provides that whether a particular ground or grounds for the accumulation of earnings and profits indicate that the earnings and profits have been accumulated for the reasonable needs of the business is dependent upon the particular circumstances of the case.Here the parties both included in petitioner's reasonable needs amounts for working capital, and the capital expenditures related to the business in each year. In addition, the parties stipulated to the amount of debt that was paid during the years in issue. See
sec. 1.537-2(b)(3) and(4), Income Tax Regs. Comparing these needs to current earnings, without even considering the needs contested by the parties, such as anticipated expenditures and amounts to satisfy debt, it is obvious that the earnings were not accumulated beyond the needs of petitioner's business.1979 1980 1981 Current earnings and profits retained (per statutory notice) $ 89,199 $ 76,543 $ 115,980 Needs of business: Operating capital 60,300 38,100 28,800 Capital expenditures 131,731 46,294 76,630 Principal payments (actually made on indebtedness) 165,389 246,110 288,059 Total 357,420 330,504 393,489 We do not, by this comparison, mean to imply that other amounts would not be considered reasonable needs, such as the entire amount of the demand note (see, e.g.,
Motel Associates v. Commissioner , T.C. Memo. 1986-426↩29. Having reached this conclusion, there is no need to address respondent's additional arguments with respect to whether petitioner was formed or availed of for the proscribed purpose.
Magic Mart, Inc. v. Commissioner , 51 T.C. 775">51 T.C. 775
Document Info
Docket Number： Docket No. 10741-84
Citation Numbers： 90 T.C. 1, 1988 U.S. Tax Ct. LEXIS 1, 90 T.C. No. 1
Judges： Whitaker
Filed Date： 1/4/1988
Precedential Status： Precedential
Modified Date： 1/13/2023