Maynard Hospital, Inc. v. Commissioner ( 1969 )

Maynard Hospital, Inc., et al., ^{Maynard Hospital, Inc. v. Commissioner}

Docket Nos. 4685-65, 3141-64, 3295-64, 3306-64, 3313-64, 378-65, 4814-65, 4684-65, 4686-65, 4687-65, 4688-65, 4689-65, 4690-65

United States Tax Court

52 T.C. 1006; 1969 U.S. Tax Ct. LEXIS 53;

September 25, 1969, Filed

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Decisions will be entered under Rule 50.

Maynard, a hospital, obtained in 1934 an exemption from Federal income tax as a charitable organization. In 1940 it transferred its pharmacy to its stockholder-trustees who operated the pharmacy for profit, selling certain drugs to Maynard for at least 10 percent in excess of the amount for which Maynard could have bought the drugs elsewhere. In the midfifties Maynard commenced paying salaries to certain of its stockholder-trustees. Maynard's strictly charitable services were less than 1 percent of the amount of its charged-for-services although it never turned down an emergency case because of inability to pay. Maynard filed Forms 990 or Forms 990-A for all years 1940 through 1960, reporting its income and expenses. The forms contained profit and loss statements and certain other information. The pharmacy, first as a corporation and later as a partnership, reported its taxable income and the tax was paid thereon. In 1960 the stockholders arranged a sale of Maynard's physical assets to Stewards, a charitable organization, for approximately $ 305,000. After this sale was arranged the stockholders voted to dissolve Maynard. In carrying out the dissolution, one of the stockholders was appointed liquidating trustee and the assets were transferred to the stockholders and the physical properties were transferred back to the liquidating trustee who sold them to Stewards for $ 308,000. The assets other than real property transferred to the stockholders had a value of approximately $ 368,000 and there were liabilities of Maynard's assumed by the stockholders of approximately $ 58,000. The stockholders allocated $ 159,000 of the sales price of the assets to the pharmacy. Held: (1) Maynard was not operated exclusively for charitable purposes. (2) Some of Maynards profits inured to the benefit of its private stockholders. (3) Maynard is not tax exempt for any of the years 1940 through 1960. (4) The value of the Maynard assets distributed to the stockholders was approximately $ 618,740 consisting of all the receipts from the sale of all assets transferred to the stockholders and the net value of the other assets transferred to the stockholders. (5) The transaction respecting the physical properties was in substance a sale of the physical assets by Maynard and a distribution of the amount received therefor to the stockholders. (6) The income reported by the pharmacy, first as a corporation and later as a partnership is properly includable in Maynard's income. (7) The Forms 990-A filed by Maynard for the taxable years 1954 through 1960 were filed in good faith. Therefore, under sec. 6501(g), I.R.C. 1954, the assessment of any tax against Maynard for the years 1954 through 1960 is barred by the statute of limitations. (8) Each stockholder of Maynard is liable as a transferee for income tax owed by Maynard to the extent of his prorata share of the distribution of Maynard's assets. (9) The distribution by Maynard to its stockholders is taxable to them as long-term capital gain to the extent that the amount thereof exceeds the stockholder's basis in his stock plus expenses of the sale.

R. B. Hooper, H. B. Jones, and William C. Rutherford, for the petitioners.

Richard H. M. Hickok and Gary C. Randall, for the respondent.

Scott, Judge.

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SCOTT

Respondent determined deficiencies against the corporate-petitioner, Maynard Hospital, Inc., for the years 1940 to 1960, inclusive, in the aggregate amount of $ 345,025.39 and deficiencies for the calendar year 1960 and transferee liabilities for taxes of Maynard Hospital, Inc., against the other petitioners as follows:

		Transferee
Petitioners	Deficiency	liability Maynard Hospital, Inc	$ 345,025.39
James E. Hunter and Nadine Hunter	110,278.70	$ 187,570.36
Estate of Gordon G. Thompson, Joel N. McFee,
executor	125,306.89	187,570.35
Glenn N. Rotton and Gail Rotton	121,387.41	187,570.36
Winnifred M. Glasgow	59,156.80	93,785.18
William A. Glasgow Trust, the Bank of California,
N.A., trustee	57,391.73	93,785.18
R. D. Forbes and Mary L. Forbes	108,473.50	187,570.35

The deficiencies against Maynard Hospital, Inc., result from respondent's retroactive revocation of its tax-exempt status for the entire 1940-60 period and his determination that the income of a pharmacy operated in conjunction with the hospital, but purportedly as a separate entity, is includable in Maynard Hospital's taxable income. Respondent determined that petitioners are liable for such deficiencies as distributees of Maynard Hospital's assets.

The deficiencies against the individual petitioners result from respondent's determination that liquidating distributions which they received as stockholders of Maynard Hospital are taxable to them as ordinary income rather than as capital gains.

The principal questions in issue are whether Maynard Hospital, Inc., was a tax-exempt organization and if not whether the income of the pharmacy should be included in its taxable income; the amount of the gains from the liquidating distributions and whether these amounts were capital gains or ordinary income to the stockholders; whether the stockholder-distributees are liable as transferees for any taxes of Maynard Hospital, Inc., and if so, in what amounts.

If we determine that Maynard was not a tax-exempt organization, the question of whether the statute of limitations is a bar to any assessments against Maynard Hospital, Inc., or the transferees arises.

The facts found below are substantially those set out in the hearing commissioner's report entered herein on May 10, 1968, with such corrections and additions as are deemed necessary after consideration of the objections filed by the parties to such report.

FINDINGS OF FACT

The stipulated facts are found accordingly.

Maynard Hospital, Inc., a liquidated corporation, for the calendar years 1940 through 1960 filed information returns, Forms 990 or 990-A, as a corporation exempt from Federal income taxes under section 501(c)(3), I.R.C. 1954, ^{I.R.C. 1939, with the collector of internal revenue or the district director of internal revenue at Tacoma, Wash. At the date of the filing of the petitions in this case, the principal address of Maynard Hospital, Inc., was c/o James E. Hunter, 4916 53d South, Seattle, Wash.}

James E. Hunter and Nadine N. Hunter, husband and wife who at the time of the filing of their petitions in this case were legal residents of Seattle, Wash., filed their joint Federal income tax return for the calendar year 1960 with the district director of internal revenue at Seattle, Wash.

Joel N. McFee, the acting executor of the Estate of Gordon G. Thompson, resided at the time of the filing of his petitions in this case in Seattle, Wash. He filed a Federal income tax return for the Estate of Gordon G. Thompson for the calendar year 1960 with the district director of internal revenue at Tacoma, Wash.

Glenn N. Rotton and Gail Rotton, husband and wife who were legal residents of Mercer Island, Wash., at the date of filing of their petitions in this case, filed their joint Federal income tax return for the calendar year 1960 with the district director of internal revenue at Tacoma, Wash.

Winnifred M. Glasgow, who at the time of the filing of her petitions in this case was a legal resident of Seattle, Wash., filed her individual Federal income tax return for the calendar year 1960 with the district director of internal revenue, Seattle, Wash.

The Bank of California, N.A., trustee for the William A. Glasgow Trust, is a national bank having its offices at 815 Second Avenue, Seattle, Wash. A U.S. fiduciary income tax return for the William A. Glasgow Trust was filed by the trustee for the calendar year 1960 with the district director of internal revenue at Tacoma, Wash.

R. D. Forbes and Mary L. Forbes, husband and wife who were legal residents of Seattle, Wash., at the date of the filing of the petitions in this case, filed their joint Federal income tax return for the calendar year 1960 with the district director of internal revenue at Tacoma, Wash.

The petitioners, other than Maynard Hospital, Inc., were in 1960 at the date of the dissolution of Maynard Hospital, Inc., the stockholders of that corporation. They are also, along with James E. Hunter as trustee for Maynard Hospital, Inc., the defendants in a suit which was instituted by a complaint filed on July 21, 1967, in the Superior Court of the State of Washington in and for the County of King, No. 682978. The plaintiff in the case in the Superior Court of King County, Wash., is the State of Washington on the relation of John J. O'Connell, attorney general. *64 On July 31, 1968, an amended complaint was filed in the State court alleging that Maynard Hospital, Inc., was formed as a Washington State charitable corporation, that the stock of the corporation was issued to the original trustees and their successors for management purposes only, and that the assets of Maynard Hospital, Inc., under the laws of the State of Washington, constituted the corpus of a charitable trust or were impressed with a charitable trust for the benefit of the people of the State of Washington. The complaint also alleged that the defendants had received proceeds which were allocated to the sale of assets of an alleged partnership, First Hill Co., and that this allocation of a portion of the assets received from the sale of properties of Maynard Hospital, Inc., was arbitrary and without any legal or proper basis in fact and that in reality the equitable title to the assets was in Maynard Hospital, Inc. For a second complaint the amended complaint alleged that throughout the period from July 1, 1940, through September 22, 1961, the defendants had received as dividends or other income from a corporation or partnership known as First Hill Co. a total amount of $ 240,287.87 in violation of their fiduciary relationship to Maynard Hospital, Inc., as its trustees. An answer basically denying the allegations of the amended complaint and also alleging certain affirmative defenses such as laches was filed on September 23, 1968. On November 19, 1968, a stipulation of facts was filed in the case in the Superior Court of the State of Washington for King County, and on December 18, 1968, the case came on for trial on the basis of the stipulation and certain admissions and submissions under a pretrial determination. Subsequent to the trial the judge of the Superior Court of the State of Washington in and for the County of King entered his findings of fact and conclusions of law and on April 25, 1969, in accordance with the findings of fact and conclusions of law previously entered, entered a judgment that the plaintiff's first claim against each of the defendants was sustained to the extent of $ 105,522 for each of the defendants except the Bank of California, N.A., as trustee for the William A. Glasgow Trust, and Winnifred M. Glasgow, and was sustained to the extent of $ 52,761.01 as to each of those defendants. This determination was based on a finding that the amount of $ 71,340.69 was reasonable consideration for the sale of the assets of First Hill Co. and that the difference between such sum and the $ 159,018.42 allocated to First Hill Co. by the defendants should have been allocated to the sale of the assets of Maynard Hospital, Inc., and the conclusion that the plaintiff, acting on behalf of the people of the State of Washington, was entitled to recover from the defendants the amounts of the assets and proceeds from the sale of assets of Maynard Hospital, Inc., distributed to them in the total amount of $ 527,610.05. The judgment permitted a reduction in the amount determined against the Forbeses and the Rottons for the amount which they had paid for their stock in Maynard Hospital, Inc. The judgment further ordered and decreed that the plaintiff take nothing on the second claim against the defendants and further ordered and decreed that, "the amounts of this judgment against defendants on plaintiff's first claim shall be immediately paid into this court for further disposition under the court's equitable jurisdiction to make such further order or orders as are necessary to carry out the purpose of the founders of Maynard Hospital, Inc., under the judicial doctrine of cy pres."

On May 26, 1969, each of the defendants in the case in the Superior Court of the State of Washington in and for the County of King filed a notice of appeal to the Supreme Court of the State of Washington from the judgment entered by the Superior Court of King County, and on June 2, 1969, the plaintiff in the Superior Court of King County filed a notice of cross-appeal from the judgment of the County Court.

Organization and Early History of Maynard Hospital, Inc.

Maynard Hospital, Inc., hereinafter sometimes called Maynard, was organized as a charitable corporation on March 14, 1933, by a group of Seattle doctors to take over another Seattle hospital, Martha Washington Hospital. It was organized as a joint-stock company under section 3863, Revised Code of Washington (now sec. 24.08.01, Rev. Code Wash.), in the name of Hospital Holding Co. The name was changed in 1936 to Maynard Hospital, Inc.

The founders and original stockholders were:

William A. Glasgow, M.D., a general practitioner

James E. Hunter, M.D., an internist

E. Weldon Young, M.D., a general practitioner

H. J. Wyckoff, M.D., an orthopedic surgeon

Gordon G. Thompson, M.D., an obstetrician and gynecologist

J. C. Moore, M.D., a general surgeon

Maynard's original capital stock was 100 shares par value $ 1 each, of which 16 2/3 shares were issued to each of the founders. No consideration was paid by the founders for these shares. The articles of incorporation provide, in part, as follows:

ARTICLE III

The objects and purposes for which this corporation is formed are:

To carry on the business of a hospital, surgery, sanatorium, drug store and other institutions for the care and treatment of the sick, aged, infirm and other persons; and to establish and maintain a school for the training of nurses for the care of the sick;

To accept public donations or private charity for the support, in whole or in part, of the corporation, and to devote all of its income and profits, after paying the expenses thereof, to the purpose of this corporation;

* * * *

To do any and all things necessary and proper to carry out any or all of the foregoing objects.

It was further provided that the corporation's affairs would be managed by a board of directors to be elected by the stockholders annually. The six founders were elected the active trustees. The Mayor of Seattle and the Chairman of the Board of County Commissioners of King County, Wash., were also named ex-officio trustees but they took no active part in the conduct of the hospital and their names were later dropped. Four of the stockholder-trustees were chosen to serve as officers of the corporation, without compensation, as follows: William A. Glasgow, president; James E. Hunter, vice president; Gordon G. Thompson, treasurer; H. J. Wyckoff, secretary.

By an amendment to the charter dated October 11, 1933, Maynard's capital stock was increased to 10,000 shares, par value $ 10 each. However, the new shares were never issued and in May 1934, the charter was further amended to reduce the authorized capital stock back to 100 shares par value $ 1 each. The amended charter provided in part as follows:

The capital stock of this corporation shall be $ 100.00, divided into 100 shares of the par value of $ 1.00 per share and that no part of the net earnings of the Company shall ever inure to the benefit of, or be payable to, any individuals and that said company, which is organized and operated as a charitable company under the laws of the State of Washington, shall be so operated during its entire period of existence.

Maynard's bylaws contained, at all times here material, the following provisions:

This corporation was organized as a charitable organization under the laws of the State of Washington relating to charitable organizations, and under the provisions of such Act a charitable organization may have stock, for the purpose of management, but not for profit, and it is the intention of this organization that no stockholder shall receive any remuneration of any kind or character whatsoever upon any shares of stock issued by this corporation, in accordance with the laws of the State of Washington.

The organization of Maynard to take over Martha Washington Hospital was suggested to Maynard's founders by the receiver for Home Savings & Loan Association of Seattle (hereinafter called the association) which had made loans to the hospital. The hospital was unable to meet its payments on the loans and the association had foreclosed on its mortgage. Later the association also became financially involved and was put under receivership operations.

All of Maynard's organizers except J. C. Moore had previously been associated as members of the executive staff of another Seattle hospital, Minor Hospital, which was having to close down because of an untenantable building and lack of financial support. Maynard's founders felt that there was a civic need for a modern general hospital in Seattle and that Martha Washington Hospital, with proper management and staffing, would meet that need.

On March 24, 1933, Maynard entered into an agreement with the association whereby it leased the hospital assets including land, building, fixtures, and furnishings for a period ending October 1, 1933, with an option to purchase the entire property on or before that date for $ 135,485. Maynard immediately took possession and on September 21, 1933, exercised its option to purchase the property. It agreed to pay the purchase price at the rate of $ 1,000 per month with interest on the unpaid balance at 6 percent. The total purchase price was to be paid within 15 years. Of the purchase price of $ 135,485 Maynard allocated $ 125,000 to the real property and the balance to the personal property.

Maynard made its installment payments to the association's receiver through December 1936, reducing its obligation to $ 118,000. At about that time an offer was made by the association to Maynard that if Maynard could obtain cash of $ 85,000 from another source and would pay this amount in cash to the association, the association would discount the $ 118,000 indebtedness by $ 16,000, deed the property to Maynard, and take a mortgage from Maynard as security for payment of the remaining $ 17,000 due it. Maynard borrowed the $ 85,000 cash from the Washington Mutual Savings Bank on a note payable at the rate of $ 1,000 per month, with interest at 5 percent. The loan was secured by first mortgages on Maynard's property and an insurance policy on the life of its president, William A. Glasgow, for $ 15,000. The policy was obtained and paid for by Maynard. Maynard gave the association a second mortgage to secure payment of the remaining $ 17,000 indebtedness which indebtedness was payable at the rate of $ 200 per month.

The balance due on the purchase price of the hospital properties was paid by Maynard on June 11, 1939, and the balance due the Washington Mutual Savings Bank was paid in September 1943, leaving Maynard's assets free of encumbrance. On May 31, 1940, when a sufficient amount of the bank loan was paid that the bank no longer required the security of the insurance policy on the life of Glasgow, that policy was assigned to Glasgow.

At the time Maynard acquired the hospital properties they consisted of a fairly sound building, completed in 1929, and a parking area consisting of several combined lots, for use by the doctors and staff employees. The hospital building was in good condition but needed new and more modern equipment.

To finance Maynard's early operations its directors agreed at a meeting held in December 1933 that each of them would advance to the hospital $ 75 per month for operating expenses. These advances were made until near the end of 1934 when, because of improved financial conditions, they were no longer needed. Maynard treated the advances as loans and on May 1, 1936, gave each of the stockholders its interest-bearing promissory note for $ 1,200, representing the principal amount of their advances. These notes were paid with interest.

In 1935 Maynard's stockholders entered into the first of a series of buy-sell agreements with respect to their Maynard stock. The stock was to be placed in escrow for a period of 10 years and could not be sold without the written approval of a majority of trustee-stock holders, who were to have the right of refusal of the shares offered for sale. The shares could be sold only to Seattle physicians approved by the trustees. The same conditions applied to the shares of any deceased stockholders. The buy-sell agreement was continued by renewals executed July 1940, 1949, 1950, and 1952. In the last three renewal agreements a fixed price was set on the transfer of the stock in the amounts, respectively, of $ 12,500, $ 25,000, and $ 35,000 for each stockholder's interest. The purpose of the buy-sell agreement was to prevent the incursion of undesirable stockholders and to insure continuity of the hospital's high standards.

The Trustee-Stockholders

Maynard's original six founders are all deceased except James E. Hunter. He is now 76 years of age and has been retired since he suffered a stroke in 1964.

Glasgow was the prime mover in Maynard's organization. He served as president and as a trustee of Maynard until his death in 1956. He was adept in financial matters and took over most of the responsibility for Maynard's finances. In addition to carrying on his regular personal practice, Glasgow devoted an average of about 2 hours a day to administrative work for the hospital. He was usually the first doctor to arrive at the hospital in the morning and was often there in the evening. He always took a sort of paternal interest in the hospital.

On his death in 1956 Glasgow left his one-half community property interest in Maynard stock, 10 shares (there were then only five trustee-stockholders), to the Bank of California, N.A., in trust for his widow. It was valued for estate tax purposes at $ 17,500. His wife continued in ownership of her 10 shares until Maynard's liquidation in 1960.

Hunter served as Maynard's vice president until 1956 when he succeeded Glasgow as president. He served as president and also as chairman of the house committee until the dissolution of Maynard in 1960 and was appointed liquidating trustee for Maynardand the stockholders. He spent an average of about 4 hours a day in the service of the hospital while carrying on his regular practice. He was also president of the Seattle Hospital Council which represented all of the major Seattle hospitals.

Young served as Maynard's Chief of Staff until his death in 1940 at which time his Maynard stock was distributed to the remaining stockholders. He resigned as a trustee after an illness in 1939.

Wyckoff served as Maynard's secretary until his death in 1948. He was also in charge of the pharmacy until its incorporation in 1940. In August 1949, Wyckoff's interests in Maynard and First Hill Co. (the pharmacy partnership hereinafter more fully described) were purchased by Rotton, who was a doctor of medicine, for $ 15,000. This amount was paid over to Wyckoff's widow.

Moore was a general surgeon but for a number of years specialized in thyroid operations. He retired a few years after his association with Maynard and on October 9, 1936, was replaced as a stockholder and trustee by another general surgeon, R. D. Forbes, who paid $ 5,500 for Moore's 16 2/3 shares of Maynard's stock.

Forbes had been practicing general surgery in Seattle since 1908. He was widely recognized as one of the leading surgeons in the Northwest. His association with Maynard brought the hospital considerable prestige and numerous patients. He retired from active practice in 1950 but retained his shares of stock in Maynard and continued as a trustee until Maynard was liquidated in 1960.

Rotton served as vice president of Maynard after the death of Glasgow in 1956 and as head of the obstetrical department after the death of Thompson in 1957.

The remaining original stockholder-trustee, Thompson, headed the obstetrical department until his death in 1957. His interest in First Hill Co. was reported in his estate tax return at a valuation of $ 15,000, and his 20 shares of stock in Maynard at $ 1,000. On examination by respondent's agents the value of the two interests was raised to $ 25,000. Joel N. McFee was named executor of his estate and as such is the petitioner in docket No. 4688-65. The Bank of California, petitioner in docket No. 378-65, is trustee of the William A. Glasgow Trust.

Maynard's stockholder-trustees were all dedicated to the work of the hospital and sought to protect and advance its standing in the community.

The Pharmacy

Shortly after its organization in 1933, Maynard installed a pharmacy as part of its operations. It employed a pharmacist at $ 125 per month plus 60 percent of the profits on "out-patients" prescriptions. The pharmacy occupied two rooms on the first floor of the hospital. It was under the management of Wyckoff.

Early in 1940 the trustees decided that in order to enable them to obtain some profit from the overall operations, they would separate the pharmacy from the hospital and operate it as an independent for-profit business. A new corporation was organized for that purpose under the name of "First Hill Corporation," with a capital stock of 200 shares no par value and capitalization of $ 500. The trustees, then consisting of Glasgow, Hunter, Thompson, Wyckoff, and Forbes, each subscribed $ 100 for 50 shares of stock. The amount subscribed was not paid in but was set up on the books. On June 30, 1940, the account was credited with a dividend of $ 500 declared by the corporation, not paid in cash but used to satisfy the subscription for stock. Hunter was named president and Forbes vice president of the company.

The trustees had in mind that the operations of the pharmacy might be extended to furnishing drugs to the public generally and not just the hospital and its patients but this was never in fact done. It was contemplated that the pharmacy might be moved to a new location near the site of the hospital building but it was never moved from the rooms in the hospital.

As of July 1, 1940, First Hill Corp. purchased the pharmacy's assets at book value for $ 5,464 payable at the rate of $ 200 a month and rented the pharmacy space from the hospital for $ 50 per month including utilities. The purchase price of the inventory was later paid out of pharmacy profits. First Hill Corp. paid its stockholders dividends of $ 5,000 for 1940 (declared in 1940 but paid in 1941), $ 5,000 for 1941, and $ 3,000 for 1942.

As of December 30, 1942, First Hill Corp. was dissolved and a partnership, First Hill Co., was formed to operate the pharmacy. The partnership was composed of the five former stockholders who acquired equal shares in the partnership. The partnership then continued to operate the pharmacy in the space rented from the hospital until after Maynard's liquidation in 1960. Most of the business consisted of sales to the hospital. In the liquidation of First Hill Corp. there was a liquidating dividend to the stockholders of $ 7,254.42 consisting basically of inventory in the amount of $ 6,861.11 and accounts receivable of $ 215.99.

First Hill Corp. filed separate corporate income tax returns and later the partnership, First Hill Co., filed information returns of partnership income. The partners each reported his share of partnership income thoughout the existence of the partnership.

When following the death of Wyckoff in 1948, his interests in Maynard and First Hill Co. were purchased by Rotton, a doctor of medicine, Rotton, on September 16, 1949, paid First Hill Co. $ 3,000 which was credited to a suspense account in the partnership books. On September 20, 1949, First Hill Co. paid $ 750 to each of the other four partners and debited the payments to the suspense account, thereby closing the account. The balance in Wyckoff's account, $ 2,889.95, was paid to Wyckoff's widow.

There was an agreement among the First Hill Co. partners that they would have the right to purchase any deceased partner's interest at the net value thereof, and the partners also had the right and obligation to purchase the shares of any partner desiring to withdraw from the partnership.

In February 1953 the partnership agreement was amended to permit the acceptance as a limited partner of any person to whom a deceased partner had bequeathed his partnership interest. Glasgow's partnership interest in First Hill Co. passed to his estate on his death in 1956.

Hospital Operations

Most of the administrative duties of Maynard's management were handled by the trustees who never received any compensation for their services as trustees. A hospital manager was employed who took care of the daily purchases of supplies and collection of bills, under the trustees' instructions, and a superintendent of nurses was also employed. The trustees passed upon the acceptability of members of the medical staff and supervised the performance of their duties. Maynard's by laws prohibited the payment of compensation to trustees and officers. The trustees who also served as officers were compensated for their services as officers after amendment to the bylaws in 1953. In February of that year compensation was authorized for the president, vice president, and treasurer in the respective amounts of $ 300, $ 200, and $ 150 per month. However, Rotton, who served as vice president from 1956 to 1960 neither claimed nor received any compensation. On November 8, 1939, Young who served as chief of staff until his death in 1940 was voted compensation of $ 7,500 for his past services and 1940 services to Maynard.

Maynard never paid any amounts designated as dividends to its stockholders.

Most of Maynard's patients were brought to the hospital by its trustees and staff physicians. All such patients were charged the usual hospital fees except that there was provision made by action of the trustees that the trustees and their dependents were to be treated at the hospital free of charge, such free service including rooms, surgery, and X-ray. It was also provided that the staff physicians and their dependents were to be given private rooms at ward rates and also a 20-percent discount on all other charges. The same rates were available to members of King County Medical Society and their dependents after October 1936.

The pharmacy purchased drugs from wholesalers and manufacturers in the name of the hospital and received the usual hospital discount of 15 percent. The drugs so purchased were paid for by check of First Hill Co. The pharmacy supplied drugs to the hospital to be supplied to patients, referred to as floor-stock drugs, and prescription drugs to patients. It also supplied the drugs used by the hospital which could not be identified with any patients, which were referred to as free floor stocks. The patients were usually charged the prices recommended by the King County Pharmaceutical Board, which included a markup of about 60 percent of the wholesale prices plus a prescription fee usually of $ 1.25. The floor-stock drugs furnished the patients, for which there was a charge, were billed to them on charge slips made out by the nurses. The pharmacy billed the hospital for patients' prescriptions at the retail price less a 25- to 35-percent discount. For the floor-stock drugs furnished to patients at a charge, it billed the hospital for the drugs so charged to patients at retail plus 10 percent and for free floor-stock drugs at the end of each month the pharmacy billed the hospital at cost plus 10 percent. The hospital billed the patients for the drugs furnished them and paid the pharmacy for such drugs less, in the case of prescription drugs furnished directly to patients, the 25- to 35-percent discount allowed to the hospital. The pharmacy placed the 10-percent overcharge to the hospital on floor-stock drugs to be furnished to patients for the purpose of compensating the pharmacy for the loss by the failure of a nurse to bill a patient or for waste and pilferage of the floor-stock drugs supplied the hospital since only the drugs billed by the nurses to the patients were billed by the pharmacy to the hospital. Maynard's trustees occasionally purchased drugs from the pharmacy at cost. The pharmacy purchased alcohol and narcotics under licenses held by the hospital. It also claimed an exemption from taxation on alcohol on the basis of an exemption permit which was in the name of Maynard Hospital. The Alcohol and Tobacco Tax Division of the Internal Revenue Service audited the purchase of tax-exempt alcohol approximately once a year. The records of the Alcohol and Tobacco Tax Division of Internal Revenue Service reflected the ownership of the pharmacy from 1940 through 1960 as being Maynard Hospital. The pharmacy used the license to purchase narcotics granted to Maynard.

At a directors meeting held April 17, 1952, two younger nonstockholders, Carl Helwig and Bernard P. Mullen, were elected trustees.

From September 1936, Maynard maintained one ward bed for free medical services for the inmates of the Masonic Home or for any injured transient Masons requiring hospitalization. In January 1949, the hospital declined to accept old-age pensioners or recipients of public relief because of lack of space and facilities. No patients were ever turned away from the hospital because of their inability to pay, if room for them was available. The acceptance of charity patients had to be approved by the hospital house committee except for emergencies. The expenses attributable to charity services were recorded in Maynard's books from year to year. A compilation made from incomplete records shows charitable expenses amounting to $ 71,976.18 for the entire period of Maynard's operations, 1933 to 1960, inclusive. No record of charity expenses were found for some of the years. The free services which Maynard rendered to its trustees and stockholders and their dependents and to members of the staff for the entire period of its existence, as recorded in Maynard's books, amounted to $ 170,826.35.

The figures shown in Maynard's books do not reflect all of its charitable services or the expenses incident thereto. Many patients who were not entered as charity patients and who were billed at regular rates were found to be unable to pay and their bills were reduced or entirely forgiven. The hospital had a policy of charging off all unpaid bills at the end of the year.

Maynard's net income for each of the years 1933 to 1940, of which about one half was attributable to the pharmacy while it was operated by the hospital, was as follows:

	Net
Year	income
1933	$ 6,666
1934	711
1935	15,781
1936	15,848
1937	10,119
1938	8,533
1939	10,450
1940	9,509

The following table shows the net income of the hospital and the pharmacy, separately, and the pharmacy's distributions to stockholders and partners over the 1941-60 period:

Year	Maynard	First Hill	First Hill
	net profit	net profit	distributions
1941	$ 14,543	$ 8,973	$ 5,000
1942	25,803	6,422	10,254
1943	24,783	10,531	7,500
1944	23,765	11,501	8,500
1945	9,309	13,020	13,500
1946	22,537	18,129	13,500
1947	11,498	17,057	17,250
1948	9,353	14,649	18,500
1949	9,869	9,383	16,794
1950	36,951	12,958	8,000
1951	34,186	15,163	15,000
1952	18,890	12,660	15,000
1953	17,793	14,243	13,250
1954	961	16,692	16,000
1955	26,191	21,934	19,500
1956	(2,453)	22,023	22,750
1957	23,634	15,037	18,000
1958	30,642	24,313	21,503
1959	58,046	22,902	20,750
1960	17,643	21,042	20,500

Liquidation and Sale of Maynard Hospital, Inc.

About the middle of the 1950's Maynard's trustee-stockholders began to consider selling the hospital. Two of the trustees were partially retired and others were contemplating retirement. They undertook to interest some of the younger Seattle doctors in taking over the hospital but, chiefly for financial reasons, the younger doctors declined. Following is an excerpt from the minutes of a meeting of the stockholders held October 30, 1951:

The president brought up for consideration the matter of securing some desirable and capable doctors as new acquisitions to the Board of Trustees. There followed a general and lengthy discussion of this subject which has been given a great deal of attention and become a matter of increasing concern over the past few years. It was pointed out that of the five present members of the Board, three of them have been with the hospital since its inception, and the fourth since shortly after that time, and of these four, two have now substantially retired and the other two are very desirous that something be done to relieve them of the pressure of continuous attention to the affairs of the hospital. It was pointed out that an institution of this kind requires both business management and professional consideration from those in charge, and these demands necessitate continuous availability and attention. After eighteen years of such service, the trustees feel that it is necessary both to their own health and comfort and to the continued success of the hospital that new blood be brought in to the organization to carry on these responsibilities.

The hospital was in need of more space and modern equipment to maintain its competitive position with other Seattle hospitals. As early as 1946 architects were called in to draw up plans for building expansion and renovation and thereafter such plans were submitted, with cost estimates in excess of $ 1 million. Maynard's cash reserve at that time amounted to about $ 200,000. The trustees were unwilling to incur the new financial responsibility which the modernization program would require. They decided that it would be best to sell the hospital, provided they could find a prospective buyer that would continue its operation as a general hospital and maintain its high standards. There were several prospective purchasers. One of them, to whom the hospital was eventually sold, was Stewards Foundation. This was a nonprofit organization which had been organized by members of the Christian Church in the Chicago area. Originally it had been engaged in financing and reestablishing deteriorating churches of all denominations on a nationwide scale. Recently, it had started acquiring and operating hospitals, such as Maynard.

A formal purchase and sale agreement between Maynard's stockholders and Stewards Foundation (hereinafter called Stewards) was executed on July 27, 1960. Under the terms of the agreement Stewards agreed to purchase all of the land, building, furniture, equipment, and other chattels then owned and used by both the hospital and the pharmacy for $ 305,000. Of that amount $ 150,000 was allocated by the stockholders of Maynard to the assets and business of First Hill Co. exclusive of the value of inventory of drugs and other merchandise; $ 100,000 to the parking lot; and $ 55,000 to the Maynard Hospital, Inc., site.

The agreement provided in part as follows:

The parties recognize and agree that there is included in the assets of the Hospital as set forth in paragraph 1 hereinabove, which shall be transferred to the Purchaser in consideration solely of the representations, warranties and undertakings of the Purchaser as set forth in paragraph 5 hereof, nursery facilities, emergency surgery and other hospital improvements exceeding, as to the original cost thereof, the sum of Sixty Thousand Dollars ($ 60,000), and hospital equipment exceeding, as to the original cost thereof, the sum of Fourteen Thousand Two Hundred Dollars ($ 14,200), which construction improvements and equipment equal or exceed, in original cost thereof, the aggregate total of all gifts, bequests, grants, endowments and other types of donations which have been received by Maynard Hospital during the period of its operation and which the Purchaser agrees to accept for use in connection with and application to, the charitable purposes herein set forth. * * *

* * * *

That as to the property described in paragraph 1 as belonging to Maynard, the Owners contemplate sale thereof as the prospective owners of that property through liquidation of Maynard and that this agreement is not a commitment of Maynard, but is, instead, the personal commitment of each Owner to the extent of his interest in said property.

It was further provided in the agreement that the purchase price would be increased by the amount of any prepaid insurance and taxes at the time of closing the sale. The assets which Maynard had purchased with Ford Foundation grant funds consisted of a nursery and emergency surgery facilities which were to be transferred to Stewards Foundation without monetary consideration.

On September 22, 1960, Maynard's stockholders adopted a resolution authorizing its dissolution and the sale of its assets. The stockholders at that time were: Hunter, Forbes, Rotton, and the estate of Thompson, each owning 20 shares and the widow and executor of the estate of Glasgow, each owning separately, 10 shares. To carry out the liquidation, Hunter was named trustee both for Maynard and for the stockholders.

On September 30, 1960, the following steps in Maynard's liquidation took place:

(1) A copy of the liquidating resolution and plan for liquidation was filed with the secretary of state of Washington;

(2) Maynard transferred all of its assets to Hunter as its liquidating trustee;

(3) As trustee for Maynard, Hunter transferred beneficial interests in the assets to the stockholders pro rata;

(4) The stockholders transferred their individual interests in Maynard to Hunter as their liquidating trustee and appointed Hunter as managing partner of First Hill Co.;

(5) As trustee for Maynard, Hunter distributed to the stockholders prorata cash, bonds, and accounts receivable in the aggregate amount of $ 368,692.99 subject to liabilities of $ 58,622.99;

(6) As trustee for the stockholders, Hunter conveyed to Stewards all of the remaining assets of Maynard including land, building equipment and supplies, tradename, and goodwill.

The partners in First Hill Co. on September 30, 1960, executed a bill of sale to Stewards of the assets of the partnership except cash and accounts receivable.

The assets conveyed to Stewards by the liquidating trustees consisted of Maynard's real estate, the hospital furnishings and supplies, and the pharmacy inventory. The hospital furnishings and supplies were valued at $ 34,000 and pharmacy inventory at $ 9,000. First Hill Co. ceased operations and was finally dissolved on July 1, 1961.

In 1959 Maynard's stockholders had an appraisal of its properties made by a professional appraiser. The appraisal, dated March 20, 1959, showed a value for the hospital building, based on replacement cost new less depreciation, of $ 422,000. The land including the hospital site and parking lot was valued at $ 133,000.

Maynard's financial report prepared by its certified public accountants showed at December 31, 1959, plant and equipment of a net value (cost less depreciation) of $ 329,922.44, earned surplus of $ 602,415.04, and donated surplus of $ 62,908.50.

In addition to the approximately $ 310,000 net assets ($ 368,000 less liquidating liabilities of $ 58,000) of Maynard's distributed to the stockholders in final settlement of the transaction with the Stewards the stockholder trustees received from the sale of the hospital and pharmacy properties, including all equipment, supplies, and inventories, a net amount of $ 308,728.73 of which they allocated $ 159,018.42 to the pharmacy properties and inventories.

As of September 30, 1960, Maynard's balance sheet showed an earned surplus of $ 502,368.34 and a donated surplus of $ 62,908.50.

Tax Exemption

Maynard was granted Federal income tax exemption as a charitable organization June 8, 1934. Thereafter, from time to time the Commissioner of Internal Revenue reaffirmed Maynard's tax-exempt status.

In 1942 the Appeals Council of the Social Security Board ruled that Maynard was not entitled to tax-exempt status and so notified the collector of internal revenue at Tacoma. Wash. After further review of Maynard's operations, its tax-exempt status was again confirmed by the Commissioner. The conflict between the Social Security Board and the Commissioner was referred to the Attorney General of the United States who in 1942 issued an opinion supporting the position of the Commissioner.

In January 1943, conferences between representatives of the Bureau of Internal Revenue and the Social Security Board were held in Washington and by letter dated May 31, 1943, the Office of the Chief Counsel of the Bureau of Internal Revenue notified the Deputy Commissioner of Internal Revenue that it was reaffirming Maynard's tax-exempt status. The letter states in part:

Finally, in spite of the fact that the articles of incorporation of the instant corporation fail to mention how the assets of this institution are to be distributed upon dissolution, this will not defeat its claim for exemption under section 101(6), supra. The statute requires only that no part of the net earnings of the corporation shall inure to the benefit of any private stockholder or individual * * *

For the years 1941 to 1960 Maynard filed information returns (Forms 990 and, after 1951, 990A) as an exempt corporation, those for each of the years 1954 through 1960 being filed prior to May 15 of the year following that covered by the return. The returns contained profit-and-loss statements and balance sheets. The returns for the years 1952 through 1960 showed that all Maynard's stock was owned by individuals and the returns for 1958, 1959, and 1960 showed that a salary of $ 3,600 was paid to Hunter who was stated on the returns to be one of "the creators of the organization." The returns for the years 1941, 1942, and 1943 specifically designated the yearly disbursements to First Hill Co. showing the name of the company followed by the word, "pharmacy." None of the returns indicated that any amendments had been made to Maynard's articles of incorporation or bylaws since its last return was filed and on the returns that contained the question whether any such changes not reported to respondent had been made the answer of "no" was given.

The return for the year 1943 showed the receipt of "rent" in the amount of $ 364.32 and the return for the year 1946 showed the receipt of $ 5,499.99 as "rent and miscellaneous." None of the other returns showed any receipts under the designation "rent" although this designation appeared on each return. The return for the year 1950 contained the statement that "No free services are rendered to said stockholder physicians, and they do not make, nor have they ever made any charge for the services they render to said Maynard Hospital, Inc. for managing said company and said hospital."

Attached to the return (Form 990A) filed by Maynard for 1960 were copies of the minutes of the stockholders meeting of September 22, 1960, authorizing the liquidation of the corporation and a plan for liquidation conforming generally to the transaction relating to the final liquidation as described above.

In their returns for 1960, each of Maynard's stockholders reported as long-term capital gains the distributions received in the liquidation of Maynard as follows:

Stockholder	Amount	Cost and	Gain
	realized	expenses
Hunter	$ 91,956.07		$ 91,956.07
Thompson estate	120,900.97	$ 27,800.00	93,100.97
Rotton	91,956.06	15,110.05	76,846.01
Winnifred Glasgow	45,924.77	17,500.00	28,424.77
Glasgow Trust	45,978.03	17,500.00	28,478.03
Forbes	91,956.06	5,500.00	86,456.06

The amounts realized were computed by considering the total amount realized from the liquidation of Maynard to be $ 459,780.31 composed of the $ 310,070 net liquidation assets distributed to the stockholders and the $ 149,710.31 of the amount received from Stewards which the stockholders allocated to the Maynard properties.

The liquidating distributions of First Hill Co. were reported by petitioners in 1961 as follows:

Stockholder	Amount	Cost and	Gain
	realized	expenses
Hunter	$ 28,944.13		$ 28,944.13
Thompson estate
Rotton	28,944.90		28,944.90
Winnifred Glasgow	14,472.07	$ 6,250	8,222.07
Forbes	28,944.13		28,944.13
Glasgow Trust	14,472.07	6,250	8,222.07

In the deficiency notices to petitioners, respondent determined that in the liquidation of Maynard the stockholders each received ordinary income, not capital gains, in the amount of $ 187,570 ($ 93,785 each for Winnifred M. Glasgow and the William E. Glasgow Trust, successors to Glasgow's one-fifth interest). The increase in the amounts of the distributions resulted from respondent's valuation of the assets which Maynard's liquidating trustee conveyed to the stockholders at $ 937,851, consisting of land and buildings of a value of $ 555,000 and other assets of $ 382,851.

Respondent, in the deficiency notice to Maynard dated May 7, 1965, revoked Maynard's tax-exemption retroactively for the 1940-60 period and determined income tax deficiencies against Maynard amounting in the aggregate to $ 345,025.39. These deficiencies were based on including the pharmacy income in Maynard's income. Respondent further determined that the information returns filed by Maynard for the years 1954 to 1960, inclusive, were not filed in good faith and that the deficiencies for those years are not barred by the statute of limitations.

In his notices to the Maynard stockholders, each dated May 7, 1965, respondent determined that they are liable as transferees for the deficiencies of Maynard to the extent of the value of the assets which they received in Maynard's liquidation.

OPINION

The principal question to be decided is whether Maynard was a tax-exempt organization. This determination will affect not only the issue of the deficiencies determined against the corporation and the liabilities of the stockholders as transferees of such deficiencies but also the issue of whether the amounts received by the stockholders upon liquidation of Maynard were ordinary income or capital gain. If Maynard was a nonexempt taxable corporation owned by its stockholders, the question of the taxability of the distributions to the stockholders might be treated differently than it would be if Maynard was a charitable corporation in which the stockholders had no equitable interest but held the stock merely for management purposes. See Estate of Grace M. Scharf, 38 T.C. 15">38 T.C. 15 (1962), affd. 316 F. 2d 265 (C.A. 7, 1963).

Maynard was ruled tax-exempt by the Commissioner over its entire existence, 1933 through 1960. *98 First, in 1934 and from time to time thereafter, the Commissioner ruled, after reviewing Maynard's status, that it was entitled to tax exemption as a charitable organization. One of such rulings was made in 1943 after a conflict had arisen between the Commissioner and the Social Security Board regarding Maynard's status as a tax-exempt organization. The Social Security Board had ruled, after a public hearing in a matter involving the applicability of the Social Security Act to Maynard's employees, that Maynard was not a tax-exempt organization and that its employees were subject to the provisions of the Social Security Act. The matter was referred to the U.S. Attorney General who, on November 2, 1943, wrote a letter to the President of the United States supporting the Commissioner. The letter stated that in the opinion of the Attorney General the Commissioner's ruling granting Maynard's exemption was in accordance with the consistent policy of the Bureau of Internal Revenue of exempting hospitals not operated for profit, and with the intent of Congress.

The exemption was revoked by the Commissioner retroactively to 1940, nearly 5 years after Maynard had been completely liquidated and its assets distributed to its shareholders. The revocation was contained in the notice of deficiencies herein, dated June 7, 1965.

The law is clear that the Commissioner may reverse his earlier rulings and revoke Maynard's tax exemption retroactively, if the exemption was granted or continued as the result of an error of law. See Automobile Club of Michigan v. Commissioner, 353 U.S. 180 (1957), and Sonora Community Hospital, 46 T.C. 519">46 T.C. 519 (1966), affirmed per curiam 397 F. 2d 814 (C.A. 9, 1968). See also Lorain Avenue Clinic, 31 T.C. 141 (1958), in which we upheld respondent's retroactive revocation of the exemption of the taxpayer organization even though the revocation was made after the taxpayer's dissolution and was for all years of its existence. However, the long lapse of time between the earlier rulings granting Maynard's exemption and the revocation ruling, the fact that Maynard had ceased to exist and its assets had all been distributed 5 years prior to the notice of revocation and the further fact that from early 1940, when the pharmacy was seperated from the hospital, there had been no substantial changes in the operations of the hospital are matters to be considered in determining whether respondent abused his discretion in revoking the ruling retroactively. ^{*100 contributions for general use. Its charitable services accounted for only a small portion of its total services to the public. According to its books and records, the actual costs of its charities were less than 1 percent of its total expenses. However, this does not cover all of what might be regarded as the hospital's charitable services. Patents who were found to be unable to pay their bills often had them reduced or entirely canceled. Patients were never refused admission because of their inability to pay. In short, except for its dealings with the pharmacy, First Hill Co., which we will discuss further, Maynard seems in its daily operations to have followed the same practices as many other hospitals; that is, charging patients who were able to pay at the usual rates, reducing, or not pressing, collections from needy patients, and not turning away patients because they were unable to pay.}

Respondent in his notice of deficiency did not state his reason for revoking Maynard's exemption. In his argument he lists such items as salaries paid to some of the stockholders, free services to the doctor stockholders and their families, the small amount of charitable services rendered, and the siphoning off of hospital profits to the pharmacy as changes in its operation of which he had had no previous knowledge. The record indicates that his change of position as to Maynard's tax-exempt status may to some extent have been prompted by the final distribution of Maynard's accumulated "tax free" earnings to stockholders. In Mill Lane Club, Inc., 23 T.C. 433">23 T.C. 433 (1954), we held that a tax-exempt social luncheon club did not lose its exemption for the year it dissolved and sold its assets and distributed the proceeds left after payment of debts to its members. We said that the liquidating sale of the assets was not a profit-making transaction but was a singular event in the club's history and pointed out that the fact that the charter of a social club provided for the distribution of its assets to its members upon dissolution did not destroy the exempt status of the social club. We held that the distributions to members of a social club under the circumstances present in the Mill Lane Club case could not properly be classified as "net earnings."

Respondent argues that the stockholders from the beginning, or at least from 1940 obtained or kept Maynard's exemption by making false representations to the Bureau of Internal Revenue, or by withholding vital information concerning Maynard's organization and operations. He points out that he was never informed of changes in Maynard's charter or bylaws or operations and that he did not know of certain payments to stockholders and free services rendered to them by Maynard. Respondent stresses the restrictive buy-and-sell agreements between the stockholders and the purchase and sale of Maynard's shares by them, the "diversion" of the pharmacy income from Maynard to the trustees, and, finally, the distribution of tax-free accumulated earnings to the stockholders as the primary justification of his retroactive revocation of Maynard's tax exemption. The principal "diversion" of income to the trustees, as charged by respondent, was the spin-off of the pharmacy and pharmacy income to them. Respondent contends that the pharmacy's earnings were at all times the income of the hospital.

We agree with respondent that the "spin-off" of the pharmacy from the hospital was for the benefit of the trustee-stockholders rather than the hospital. After the pharmacy was transferred to First Hill Co., a separate corporate entity, it was no longer owned by the hospital as a matter of form. However, it used the tradename "Maynard Hospital Pharmacy" throughout its existence. It was strictly a money-making enterprise. It kept making purchases of drugs in the name of the hospital at the usual hospital discount, kept its alcohol tax exemption and narcotics license in the hospital's name, and obtained all its income from the hospital or hospital patients. Part of that income was from selling drugs and supplies referred to as free floor stocks to the hospital at a price of 10 percent over the price the hospital would have been required to pay had it bought the drugs and supplies directly. The 10-percent markup on free floor stocks was a direct diversion through the pharmacy of funds of the hospital for the benefit of the doctor-stockholders. The balance of the drug sales did not constitute quite as direct diversion of hospital profits to the pharmacy but the result was in substance the same. The sales made to patients of prescription drugs were all sales to hospital patients. Such sales had been made by the hospital pharmacy prior to the time the pharmacy was transferred to the stockholder-trustees. The floor-stock drugs for which the patients were charged were billed by the pharmacy at retail plus 10 percent to account for any loss that might result from spilling or other reasons. Apparently there was a 25- to 35-percent discount from the retail price given to the hospital for the sales to patients of prescription drugs, thereby to some extent splitting the profit from the sale of these drugs to patients between the hospital and the pharmacy. It is not clear whether this discount applied to floor-stock drugs, and if so, whether the 10-percent increase to account for loss was applied before or after the discount. However, these drugs were bought by the pharmacy at wholesale in the name of the hospital and at the hospital discount. Except for the organization of the pharmacy as a separate entity, the entire profit on the sale of prescription and floor-stock drugs to patients would have gone to the hospital.

The evidence is clear that the primary reason for the organization of the pharmacy as a separate entity was to permit the stockholder-trustees to obtain some income from the hospital operation. The stockholder-trustees attempted to justify the receipt of this income by claiming that it was less than they should have received as compensation for their services to the hospital. However, it is questionable whether such services entitled them to compensation in the amounts they received in distributions from the pharmacy. The evidence shows that Forbes, apparently from about 1950 until Maynard's dissolution in 1960, rendered no services to Maynard except as a trustee but continued to receive his distribution from the pharmacy income. The evidence further shows that from 1956 through 1960 Glasgow's estate received its distributable portion of the pharmacy income although it rendered no services to the hospital or pharmacy and apparently from Wyckoff's death in 1948 until the sale of his Maynard stock to Rotton in August 1949, Wyckoff's estate received its prorata distribution of income. Also, the pharmacy interest, both under the agreements between Maynard's stockholders and in practice, went to any person to whom Maynard stock was transferred without reference to services contributed by each person to Maynard. The distribution of the pharmacy's income was in substance much like the payment of a dividend on the Maynard stock.

The Commissioner apparently had no specific notice of the change in operations when the pharmacy was separated from the hospital. He did have indirect notice when the pharmacy filed separate income tax returns, first as a corporation and later a partnership, and by the notations of payments made by the hospital to the pharmacy on the Forms 990 filed by the hospital for the years 1941 through 1943. The failure of Maynard to furnish respondent with changes in its bylaws and to specifically answer certain questions on the Forms 990 and 990A which it filed, and particularly its failure to indicate specifically on those forms its transfer of the pharmacy to its stockholder-trustees to be operated for their profit, may have caused respondent to overlook the changes in Maynard's operations. The fact that the pharmacy used Maynard's alcohol-tax exemption and that the pharmacy continued to purchase drugs in Maynard's name might even have been affirmatively misleading to respondent. Under the facts of this case, we conclude that respondent did not abuse his discretion in retroactively revoking his ruling granting Maynard an exemption. Petitioners do not specifically so contend; they argue that respondent's action was "unfair and unreasonable," in that petitioners were handicapped in obtaining evidence because of the passage of time. In Lorain Avenue Clinic, supra, a similar contention was regarded as an appeal for equitable consideration and not as support for the proposition that respondent had abused his discretion in retroactively revoking an exemption. See also Kenner v. Commissioner, 318 F. 2d 632 (C.A. 7, 1963), affirming a Memorandum Opinion of this Court.

The only statutory authorization for granting tax exemption to hospitals is the general provisions of section 501(c)(3). Like any other charitable organization, hospitals must be organized and operated exclusively for charitable purposes as distinguished from private gain. An organization is not exempt merely because it operates a hospital devoted to the treatment and care of patients. ^*108

The cases involving the tax exemption of hospitals have been decided on the facts in each particular case. The exemption has been denied where the hospitals were operated to a considerable extent for the benefit of the founders or owners. See Sonora Community Hospital, supra, where the clinic was operated, to a considerable extent, for the benefit of its two founding doctors, and Lorain Avenue Clinic, supra, where the clinic was operated by a close family group designated "trustees" and substantially all of its profits were distributed regularly to them and associated doctors. In both those cases there was a minimum of charitable services. To the same effect is Kenner v. Commissioner, supra, where substantially all of the funds of the hospital were expended for the benefit of its founder and owner.

There is no dispute that the stockholders at all times regarded their interests in Maynard as a valuable property right. They gave those interests a fixed price in buy-and-sell agreements and in several instances actually bought and sold them. The prices ascribed to the shares by the stockholders themselves increased as did the corporation's net worth. In 1935 Moore sold his interest to Forbes for $ 5,500. In 1940 a price of $ 12,500 for a one-fifth interest was fixed and in 1948 Wyckoff's interest was purchased by Rotton at that price. While these transfers were made not solely for income realization but also for the purpose of perpetuating the organization and maintaining its services and standing as a community hospital, the evidence indicates that the stockholder-trustees expected that eventually they or their estates would realize income from the sale or transfer of their interests in Maynard or the final distribution of its assets to them.

There is evidence that there was some intention on the part of the stockholders to use the accumulated profit for improvement and expansion of the hospital. The trustees had architectural plans for such improvements prepared sometime before they decided to sell the hospital. The estimated costs were more than $ 1 million. Maynard's accumulated surplus was never more than about one-half of that amount and its free assets which could have been used for hospital improvements far less. However, there was never any commitment that this would be done. One of the reasons why the trustees decided to sell was their reluctance at their advanced ages to assume the new financial responsibilities which they would incur in modernizing the hospital.

Much of the argument in this case concerns whether there was "bad faith" on the part of the stockholder-trustees in the various actions they took to assure some monetary return from their investment of their time and energy on behalf of Maynard. In our view it is not necessary that the record show "bad faith" on the part of the stockholder-trustees to justify respondent's revocation of Maynard's exemption. All that is necessary is that it show that some of the Maynard operations were not "exclusively" for charitable purposes or that some of its "net earnings" inured to the benefit of its stockholders. This the record does show. While the payment of reasonable salaries for services rendered by the doctor-stockholders would not necessarily be considered net earnings inuring to their benefit, the situation here presents a different picture.

It is doubtful, too, whether an organization's operation can be "exclusively" for charitable purposes, within the meaning of section 501(c)(3) when its income is being accumulated to increase directly the value of the interests of the stockholders which they expect, eventually, to receive beneficially. The payment of hospital funds to the stockholders through their pharmacy partnership was in substance a direct "inuring" of "net earnings" of the hospital to the benefit of such stockholders. That the payments may not have been made with fraudulent intent or even in "bad faith" is not determinative.

Maynard's transfer of the pharmacy business to the corporation set up and owned by the stockholder-trustees and the sale by that corporation, and later the partnership which succeeded to the corporation's business, of drugs to Maynard for prices in excess of the amounts Maynard would have paid directly for such drugs was the siphoning off of Maynard's income for the benefit of its stockholder-trustees. When this fact is considered together with the many other facts here present, such as the buy-and-sell stock agreement and the small amount of charitable work done by Maynard, we conclude that Maynard was not operated "exclusively" for charitable purposes during the years 1940 through 1960 and therefore is not entitled to exemption from tax under section 501(c)(3) and its predecessor section, I.R.C. 1939, for those years.

We need not pass on the legality under the law of the State of Washington of the distribution of Maynard's assets to the shareholders to determine whether Maynard is exempt from Federal income tax. There is presently pending before the courts of the State of Washington an action brought by the State to recoup the distributed assets. *115 the laws of the State of Washington and whether its net assets upon its dissolution were impressed with a public trust is not determinative of whether it is exempt from Federal income tax under section 503(a). Sonora Community Hospital, supra, and Lorain Avenue Clinic, supra.

Having concluded that Maynard was a taxable corporation for the years 1940 through 1960 we must further determine whether respondent correctly included in its taxable income the income of the pharmacy and whether assessment of deficiencies for the years 1954 through 1960 is barred by the statute of limitations.

After its separation from the hospital, no tax exemption was claimed for the pharmacy. Its income was separately reported and taxed, first as corporate earnings, and later as income to the partners. None of the stockholders rendered any substantial service to the pharmacy operation and only one rendered any services on a regular basis.

As we have pointed out in discussing the distribution of the pharmacy income to the stockholder-trustees, there was no "business purpose" for operating the pharmacy as a separate entity from the hospital except to siphon off some of the income from the total operation for the benefit of the stockholder-trustees. The $ 50-per-month rental was apparently nominal. Except possibly for 1 year it was not separately shown on Maynard's Forms 990 or Forms 990-A, although a place was provided thereon for listing rents. The alcohol exemption regularly used by the pharmacy was in the name of the hospital. The only purpose served by the so-called separate entity of the pharmacy was to permit the equivalent of dividends to be paid to the stockholder-trustees by Maynard. The pharmacy income was in substance Maynard's income and is taxable to Maynard.

As to the statute of limitations, the evidence is that Maynard filed information returns Forms 990 and 990-A for the year 1941 and all later years which contained complete profit-and-loss statements and balance sheets. The Commissioner contends that some of the returns bore false statements and did not contain all of the information for which they were designed. He complains that the returns did not inform him of the changes in Maynard's bylaws relating to the pharmacy and the payments to the stockholders. However, some of the information which the returns failed to disclose was available to the Commissioner from other sources. For instance, the pharmacy filed its own income tax returns. We have stated in fair detail in our findings some of the various statements and omissions to which respondent refers.

Section 6501(a) provides that except as otherwise provided, any income tax must be assessed within 3 years from the date of the filing of the returns. Section 6501(c)(3)Section 6501(g)*119 which is applicable only to 1954 and subsequent years, there being no counterpart of the provisions of this section in the 1939 Code, provides that if a taxpayer "determines in good faith that it is an exempt organization and files a return as such under section 6033 * * * such return shall be deemed the return of the organization for purposes of this section."

On the basis of the evidence in this case we conclude that Maynard did determine in "good faith" for each of the years 1954 through 1960 that it was an "exempt organization" and that the Forms 990-A it filed for the years 1954 through 1960 were sufficiently accurate to constitute the "returns * * * under section 6033" referred to in section 6501. See Knollwood Memorial Gardens, 46 T.C. 764">46 T.C. 764, 793-794 (1966). We, therefore, hold that assessment of tax against Maynard is barred by the statute of limitations for the years 1954 through 1960 since the notice of deficiency was mailed more than 3 years after the filing by Maynard of its returns for each of these years. However, the assessment of the liability for tax of Maynard for the taxable year 1960 against the transferees is not barred since under the provisions of section 6901(c)(1) respondent is allowed 1 year after the expiration of the period of limitations for assessment against the transferor, Maynard, to assess the liability against the transferees of Maynard. Maynard filed its return for the calendar year 1960 on May 15, 1961, and therefore the statute of limitations for assessment against Maynard expired on May 15, 1964. Respondent mailed his notice of transferee liability to each of the transferees of Maynard on May 7, 1965, which was within 1 year after the expiration of the period of limitations for assessment against Maynard.

Petitioners do not contend that the assessment of any tax against Maynard is barred by the statute of limitations for the years 1940 through 1953. Since we have concluded that Maynard is not exempt from tax and that the earnings of First Hill are properly includable in Maynard's income, it is necessary to decide whether Maynard's stockholders are liable for Maynard's taxes for the years 1940 through 1953 as transferees, and if so, the extent of their liability.

Petitioners contend that the $ 159,018.42 which was allocated to First Hill from the amount received from the sale of the Maynard assets should not be considered as a part of the Maynard assets transferred to the Maynard stockholders in determining transferee liability. From our discussion of the relationship of Maynard and First Hill, it is apparent that we consider the entire amount received in 1960 from the sale of the Maynard assets to belong to Maynard. The clear inference from the record is that the allocation of part of the receipts from the sale of the Maynard assets to First Hill was made to enable the stockholders to retain as great a portion of the distribution as possible if they were required to turn the amount received from the Maynard assets over to some other charity or to the State of Washington. Whatever may be the final outcome of the State Court contest with respect to the distribution in 1960 of the Maynard assets to the stockholders, we conclude that for Federal income tax purposes all the distribution to the stockholders in the net amount of approximately $ 618,728 was from assets of Maynard. Each stockholder is therefore liable as a transferee of Maynard for taxes due by Maynard for the years 1940 through 1953 and for the year 1960 to the extent of his prorata proportion of the amount of the distribution unless, as petitioners contend, the holding of the Superior Court of the State of Washington for King County that the assets of Maynard were impressed with a trust for use of a public charity causes the individual petitioners not to be transferees. *123 its assets were distributed in kind to its stockholders and that the stockholders then sold the land and buildings, together with hospital supplies and pharmacy inventories having a value of not less than $ 550,000, to Stewards at a ficticious, or unrealistic, price of $ 305,000. Respondent therefore contends that the total value of the assets transferred by Maynard to its stockholders was $ 937,851.59 and that each stockholder is chargeable with his prorata portion of such amount, both for the determination of his transferee liability and his taxable gain from the distribution.

Our view is that in substance there was a liquidating sale by Maynard of its fixed assets to Stewards and a distribution of the proceeds of the sale, along with other cash and bonds, to the stockholders. The purported distribution of the assets in kind to the stockholders was a matter of mere form. Maynard's transfer of its assets to Hunter as liquidating trustee, Hunter's transfer of beneficial interests therein to the stockholders, the individual stockholders' transfer of their interest in Maynard back to Hunter as their trustee, and Hunter's transfer of the assets to Stewards, were all part of the same liquidating plan and all took place simultaneously. A binding agreement for the sale of the hospital properties, setting forth all of the terms and conditions of the sale, had been entered into by the stockholders and Stewards before any of the transfers ever took place. In the field of taxation substance must prevail over form, Commissioner v. Court Holding Co., 331">324 U.S. 331 (1945), and the rule works for the benefit of the taxpayer as well as the Government. Frank Ciaio, 47 T.C. 447">47 T.C. 447, 457 (1967). See also Alameda Realty Corporation, 42 T.C. 273 (1964).

Petitioners state that under the holding of the Superior Court of the State of Washington in and for the County of King, they are liable to pay into the court substantially all the amounts received from the liquidation of Maynard to be disposed of by further order of the court in accordance with the impressing of the funds with a trust for a public charitable purpose. For this reason they contend that they cannot be considered to the transferees of Maynard for Federal income tax purposes.

We have very much abbreviated the voluminous documents comprising the pleadings, stipulations, findings of fact, conclusions of law, and judgments in the case in the Superior Court of King County, Wash., in our Findings of Fact. However, these documents are stipulated into the record by the parties by a second supplemental stipulation of facts, and are incorporated in full in our findings by our finding of the facts as stipulated. It is clear from the whole proceedings that the judgment of the Superior Court was directed at the net assets of Maynard in the hands of the various petitioners. It is also clear that to the extent that Maynard was liable for Federal income taxes, there existed a prior claim on its assets, thereby reducing the amount of its assets properly distributable to anyone, whether it be petitioners or the State, to be turned over to some appropriate charity. Therefore, in our view the petitioners are transferees of the assets of Maynard to the extent of $ 618,798.73 and each stockholder is liable as a transferee of Maynard to the extent of his prorata proportion of the amount of the distribution.

There is no dispute between the parties as to the proportion of the distribution from Maynard applicable to each stockholder. There is nothing inconsistent in a corporation being dedicated to a charitable purpose under State laws and therefore being obligated to have all its earnings, or accumulation of earnings, and its assets, or increment in value of its assets when sold, being dedicated to the public use and impressed with a trust for a public charity, and the same corporation being subject to Federal income tax because its stockholders actually managed and operated it in such a manner as to have a substantial portion of the corporate earnings inure to their own benefit. As is apparent from this record, the State court action was not commenced until 2 years after the deficiency notice determining deficiencies against Maynard was mailed by respondent and almost 2 years after the filing of the petitions in the case of Maynard and the various transferees of Maynard.

The State court case has not been finally determined but is on appeal. Perhaps the disposition of the funds ordered to be paid into the State court by Maynard's stockholders can be resolved between the parties. In any event in our view the obligation for taxes to the Federal Government existed at the time of the dissolution of Maynard. Since the stockholder-petitioners actually took all of the funds of Maynard upon its dissolution, they became transferees of the assets of Maynard for Federal income tax purposes.

The final issue is whether the stockholders' portions of the distribution over their costs of Maynard's stock are taxable to them as ordinary income or as capital gain. Respondent apparently does not question the amount of costs and expenses which petitioners reported as applicable to their combined interests in Maynard and First Hill Co.

Respondent contends that Maynard was a charitable corporation under the laws of the State of Washington and that its stock was held by its stockholders for management purposes only. Respondent further contends that even though section 331(a) provides that "amounts distributed in complete liquidation of a corporation shall be treated as in full payment in exchange for the stock" such section does not operate to cause a distribution in liquidation of a charitable corporation to be a capital gain. Respondent relies on Estate of Grace M. Scharf, supra, in which we stated at page 28 as follows:

There is nothing in the record to establish that the membership certificates in Belmont were property. The clear import of the bylaws is that the certificates, insofar as they evidence membership in Belmont, granted a privilege to and imposed a responsibility upon the holders to serve a charitable institution. n4 [Footnote omitted.]

Initially, certainly the stock issued to petitioners in the instant case was intended to be for the purpose of their management of Maynard and the initial intent was that Maynard would be operated as a charitable organization exempt from Federal income tax under the predecessor of section 501(c)(3). However, at least by 1940 when the stockholder-trustees of Maynard in form separated out the pharmacy in order to be able to obtain for their own benefit funds from the operation of Maynard, they began to manage and operate Maynard partially for their own benefit. They always viewed their stock as a valuable asset having a money value to them. As early as 1936 there was a purchase of Maynard's stock. The facts in this case show that at least from 1940, and probably as early as 1936, the stockholder-trustees of Maynard treated their stock as an asset of value to them. They set a sales value on it and they used it to in form separate out a pharmacy business so that the overall operation of the hospital and pharmacy could produce income for their personal benefit. The treatment by Maynard's stockholders over a period of at least 20 years of their stock as an equity interest in the corporation was an important consideration in our determination that Maynard is not entitled to exemption from Federal income tax. On the basis of the record in this case, we conclude that the Maynard stock should be viewed as property in the hands of the stockholder-trustees for Federal income tax purposes. It follows that the distribution in complete liquidation of Maynard should, under section 331(a), be considered as in full payment for the stock. Since each stockholder-petitioner had held his stock for more than 6 months, his gain on the distribution is long-term capital gain.

There is nothing in the Scharf case to indicate that the membership certificates there involved had ever been treated by the individual owners as giving them proprietary rights in the corporation. The membership certificates had been used for management purposes until they were sold. In our view when we have determined that an organization is not a tax-exempt charity but a taxable corporation operated for private gain over almost the entire period of its existence, it should follow that the gain to the stockholders upon the liquidation of that corporation should be taxable to them as capital gain and not as ordinary income. We do not consider Estate of Grace M. Scharf, supra, as applicable to the situation here present. We hold that petitioners properly reported the liquidating distribution as capital gain.

Decisions will be entered under Rule 50.

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Footnotes

• 1. Cases of the following petitioners are consolidated herewith: James E. Hunter and Nadine N. Hunter, docket No. 3141-64; Estate of Gordon G. Thompson, Joel N. McFee, Executor, docket No. 3295-64; Glenn N. Rotton and Gail Rotton, docket No. 3306-64; Winnifred M. Glasgow, docket No. 3313-64; William A. Glasgow Trust, the Bank of California, N.A. Trustee, docket No. 378-65; R. D. Forbes and Mary L. Forbes, docket No. 4814-65; Glenn N. Rotton, Transferee, docket No. 4684-65; Winnifred M. Glasgow, Transferee, docket No. 4686-65; R. D. Forbes, Transferee, docket No. 4687-65; Estate of Gordon G. Thompson, Transferee, Joel N. McFee, Executor, docket No. 4688-65; William A. Glasgow Trust, the Bank of California, N.A. Trustee, Transferee, docket No. 4689-65; and James E. Hunter, Transferee, docket No. 4690-65.↩

• 1. The transferee liability is based on the $ 345,025.39 of taxes determined against Maynard Hospital, Inc., with interest to Sept. 22, 1960, totaling $ 176,338.95, making a total of $ 521,364.34 of taxes and interest for which respondent determined the transferees to be liable.↩

• 2. All references are to the Internal Revenue Code of 1954 unless otherwise indicated.↩

• 3. The original complaint in the Superior Court for the State of Washington, King County, was received at the trial of this case as petitioners' Exhibit 82. Subsequent to the filing of the report of the Commissioner in this case petitioners filed a motion to reopen the record for the purpose of admitting the amended complaint, answer to amended complaint, findings of fact and conclusions of law with the attached stipulation of facts, the judgment, and the notices of appeal and cross-appeal. To complete the record in this case, and particularly in view of the argument of the parties as to the effect of the State court proceedings on the transferee liability of the Maynard Hospital, Inc., stockholders, this motion was granted.

• 4. Maynard's tax-exemption was originally granted under the predecessor to sec. 501(c)(3), I.R.C. 1954, and continued under that section which provides exemption for:

  (3) Corporations, and any community chest, fund, or foundation, organized and operated exclusively for religious, charitable, scientific, testing for public safety, literary, or educational purposes, or for the prevention of cruelty to children or animals, no part of the net earnings of which inures to the benefit of any private shareholder or individual, no substantial part of the activities of which is carrying on propaganda, or otherwise attempting, to influence legislation, and which does not participate in, or intervene in (including the publishing or distributing of statements) any political campaign on behalf of any candidate for public office.

• 5. Sec. 7805(b), I.R.C., provides:

  (b) Retroactivity of Regulations or Rulings. -- The Secretary or his delegate may prescribe the extent if any, to which any ruling or regulation, relating to the internal revenue laws, shall be applied without retroactive effect.↩

• 6. Respondent's Rev. Rul. 56-185, 1 C.B. 202">1956-1 C.B. 202, states in this regard:

  The only ground upon which a hospital may be held to be exempt under section 501(c)(3) of the Code is that it is organized and operated primarily for educational, scientific or public charitable purposes. Usually, the ground for exemption is that it is organized and operated for public charitable purposes. The Supreme Court of the United States in Helvering v. Susan D. Bliss et al., 293 U.S. 144">293 U.S. 144Ct. D. 884, C. B. XIII-2, 191 (1934), held that the provisions of law granting exemption of income devoted to charity are liberalizations of the law in the taxpayer's favor, were begotten from motives of public policy, and are not to be narrowly construed. Thus, in regard to hospitals and similar organizations, the Internal Revenue Service takes the position that the term "charitable" in its legal sense, and as it is used in section 501(c)(3) of the Code contemplates an implied public trust constituted for some public benefit, the income or beneficial interest of which may not inure to the benefit of any private shareholder or individual.

  In order for a hospital to establish that it is exempt as a public charitable organization within the contemplation of section 501(c)(3), it must, among other things, show that it meets the following general requirements:

  1. It must be organized as a nonprofit charitable organization for the purpose of operating a hospital for the care of the sick. A nonprofit hospital chartered only in general terms as a charitable corporation can meet the test as being organized exclusively for charitable purposes. See Commissioner v. Battle Creek, Inc., 126 Fed (2d) 405.

  2. It must be operated to the extent of its financial ability for those not able to pay for the services rendered and not exclusively for those who are able and expected to pay. It is normal for hospitals to charge those able to pay for services rendered in order to meet the operating expenses of the institution, without denying medical care or treatment to others unable to pay. The fact that its charity record is relatively low is not conclusive that a hospital is not operated for charitable purposes to the full extent of its financial ability. It may furnish services at reduced rates which are below cost, and thereby render charity in that manner. It may also set aside earnings which it uses for improvements and additions to hospital facilities. It must not, however, refuse to accept patients in need of hospital care who cannot pay for such services. Furthermore, if it operates with the expectation of full payment from all those to whom it renders services, it does not dispense charity merely because some of its patients fail to pay for the services rendered.

  * * * *

  4. Its net earnings must not inure directly or indirectly to the benefit of any private shareholder or individual. This includes the use by or benefit to its members of its earnings by way of a distribution of profits, the payment of excessive rents or excessive salaries, or the use of its facilities to serve their private interests. If provision is made in the bylaws for dividends, exemption will not be allowed even though no dividends have been declared. Exemption will not be defeated, however, merely because the shareholders or members might possibly at some future date share in the assets upon dissolution in the absence of a case of mal fides where there appears to be a plan on the part of the shareholder or individual to acquire assets on the dissolution of the corporation.

• 7. The original complaint in this action was filed on July 21, 1967. After the filing of an amended complaint, an answer thereto, and a stipulation of facts, the Superior Court of the State of Washington for King County held that Maynard was a charitable organization under the laws of the State of Washington and the receipts from the disposition of its assets upon dissolution should be turned over to another public charity but that the pharmacy was a for-profit business organization under the laws of the State of Washington. The King County Court determined that less than one-half the portion of the sales price which the stockholders allocated to the pharmacy was in fact in payment for the assets of the pharmacy. The decision of the King County Court has been appealed by all parties to the Supreme Court of the State of Washington.↩

• 8. SEC. 6501. LIMITATIONS ON ASSESSMENT AND COLLECTION.

  (c) Exception. --

  * * * *

  (3) No return. -- In the case of failure to file a return, the tax may be assessed, or a proceeding in court for the collection of such tax may be begun without assessment, at any time.↩

• 9. SEC. 6501(g) Certain Income Tax Returns of Corporations.

  (1) Trusts or Partnerships. -- If a taxpayer determines in good faith that it is a trust or partnership and files a return as such under subtitle A, and if such taxpayer is thereafter held to be a corporation for the taxable year for which the return is filed, such return shall be deemed the return of the corporation for purposes of this section.

  (2) Exempt Organizations. -- If a taxpayer determines in good faith that it is an exempt organization and files a return as such under section 6033, and if such taxpayer is thereafter held to be a taxable organization for the taxable year for which the return is filed, such return shall be deemed the return of the organization for purposes of this section.

• 10. Of course, if the tax liability of Maynard for the years 1940 through 1953 with interest thereon as provided by law was less than the value of the assets transferred to a particular transferee, the limiting factor on the liability of each transferee would be the tax liability of Maynard. It appears from the record that the tax liability of Maynard for the years 1940 through 1953 with interest to Sept. 22, 1960, and the tax liability of Maynard for the year 1960, as determined by respondent is $ 392,697.65. This amount is much greater than the value as determined by respondent of the assets transferred to any one transferee. Respondent is entitled to a determination of the full liability against each transferee and therefore it is necessary for us to find the exact value of the assets transferred to each transferee even though respondent is not entitled to collect from all transferees an amount in excess of Maynard's total liability plus interest as provided by law.↩