Kraut v. Commissioner ( 1974 )

Aaron Kraut and Iris Kraut, Petitioners v. Commissioner of Internal Revenue, Respondent; Harry Kraut and Marian Kraut, Petitioners v. Commissioner of Internal Revenue, Respondent

Kraut v. Commissioner

Docket Nos. 7663-70, 7664-70

United States Tax Court

62 T.C. 420; 1974 U.S. Tax Ct. LEXIS 83; 62 T.C. No. 48;

June 27, 1974, Filed

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Decisions will be entered under Rule 155.

In 1965 petitioners organized and became the sole stockholders of Nassau Plastic & Wire Corp. (Nassau) to manufacture wire to be used in Christmas decorations. Less than 1 year later, petitioners entered into an agreement to sell their Nassau stock to Cathedral of Tomorrow, a federally tax-exempt religious organization, which simultaneously agreed to liquidate Nassau. Nassau's assets consisted almost entirely of a secondhand automobile, $ 50,000 of receivables, and a 5-year lease of its single piece of machinery -- all subject to liabilities in excess of $ 36,000. The stated sales price was a flexible amount ranging from a minimum of $ 500,000 to a maximum of $ 3,500,000, and was payable primarily out of 75 percent of the business' net income for the ensuing 10 years. As employees, petitioners remained in control of the operation of the business. In the event of default, petitioners' sole recourse was the enforcement of a lien upon the business' assets. The lease agreement for the machine entitled the lessor, a corporation wholly owned by petitioners, to terminate the lease unilaterally after the expiration of its initial term. Held, this transaction amounted merely to the payment of a fee to Cathedral in return for lending its tax exemption to Nassau's earnings rather than the actual transfer of the business to Cathedral, and it therefore did not constitute a bona fide sale of a capital asset within the meaning of sec. 1222(3).

Sidney N. Solomon, Frederic Scheinfeld, and O. John Rogge, for the petitioners.

Stanley J. Goldberg and Walter C. Welsh, for the respondent.

Raum, Judge.

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RAUM

The Commissioner determined deficiencies in petitioners' 1967 income tax as follows:

Docket No.	Petitioners	Amount
7663-70	Aaron and Iris Kraut	$ 254,437.12
7664-70	Harry and Marian Kraut	258,544.82

The cases were consolidated for trial. At issue is whether an agreement by which two of petitioners purported to transfer the stock of their wholly owned corporation to a tax-exempt charitable organization in exchange primarily for a portion of the business' profits for a period of 10 years constituted a bona fide sale within the meaning of section 1222(3), I.R.C. 1954, thereby entitling petitioners to capital gains treatment in respect of the proceeds. In the event such a sale did occur, there is the further question whether those proceeds in excess of approximately $ 168,000 were capital gains.

FINDINGS OF FACT

The parties have filed a stipulation of facts which, together with its accompanying exhibits, is incorporated herein by this reference.

Petitioners Iris Kraut and her husband Aaron Kraut resided in Oceanside, N.Y., at the time they filed their petition herein; petitioners Marian Kraut and her husband Harry Kraut resided in Flushing, N.Y., at the time they filed their petition herein. Both pairs of petitioners timely filed joint Federal income tax returns for the year 1967 with the district director of internal revenue at Brooklyn, N.Y.

Aaron Kraut and his brother Harry together were in the business of developing and manufacturing electric wire of various types. For at least 20 years they had owned and acted as president and vice president, respectively, of Trio Wire & Cable Corp. (Trio), which was primarily concerned with the production of assorted types of wires and cables encased in plastic insulation. In addition to and as an offshoot of that business the Kraut brothers in or around 1960 formed a separate corporation, Christmas Wire Manufacturing Corp. (Christmas Wire), through which they hoped to penetrate the more specialized and very competitive market for wiring used in the manufacture of Christmas decorations. Although Trio itself did not produce such wire, it owned the necessary machine, an extruder, which Christmas Wire made use of. The extruder was housed in a leased building, one of three separate but interconnected buildings on Meserole Avenue in Brooklyn in which Trio carried on its business. That machine appears to have been the only item of equipment used in the production of the Christmas wire, and the record fails to show that any appreciable number of employees was engaged in its operation.

The heart of the manufacturing process for Christmas wire consisted of extruding a coat of plastic insulation around light gage wire. The Christmas decoration manufacturers who purchased the wire then attached light bulb sockets to it by means of small brass spurs on the sockets which punctured the plastic jacket and made contact with the electric wire inside. A major problem for manufacturers of such wire was the normally tough consistency of the plastic used which created difficulty in attaching the sockets and thus led to a high "rejection rate" in the decoration assembly process. As a result of various problems, primarily the rejection rate, the Kraut brothers brought production under Christmas Wire's name to an end sometime in the spring of 1965. Although the Krauts "sold" the Christmas Wire corporation at that time at a price not satisfactorily shown in the record, the purchaser never conducted operations at the Meserole Avenue location. The Krauts retained the use of Christmas Wire's premises as well as Trio's extruder which remained there. Within a very short time thereafter, possibly as little as several weeks and certainly no more than a few months, Harry and Aaron Kraut formed another corporation, Nassau Plastic & Wire Corp. (Nassau), which they intended would operate as an adjunct to Trio similar in fashion to Christmas Wire. As a matter of convenience, Nassau issued all of its stock, 200 shares, in equal amounts to Iris and Marian Kraut in return for their contributions to its capital of $ 100 apiece. Although neither Aaron nor Harry contributed to Nassau's capital, they nonetheless were the dominant figures in its activities, while their wives provided no services at all to it. Nassau occupied the same premises which Christmas Wire had previously used, and its only equipment was the extruder belonging to Trio which Trio had in the past supplied to Christmas Wire. Nassau required the extruder to manufacture Christmas wire with a new insulating material which, due to its easily penetrable consistency, promised to minimize the rejection problem associated with conventional plastic insulation. This new material was, however, "an unknown quantity," and its resistance to wear and decay over a period of several years was as yet unproven. Despite the new material's alleged superiority to the insulating material commonly in use at the time, the Krauts did not obtain, nor apparently did they apply for, a patent on it.

On its Federal income tax return for the fiscal year ended June 30, 1966, Nassau reported gross income of $ 26,189.84, which represented the difference between its sales of $ 492,305.16 and its cost of goods sold, $ 466,115.32. The cost of goods sold consisted entirely of merchandise bought for manufacture or sale; Nassau reported no expense for salaries and wages other than $ 2,600 paid to the Krauts, no expense for use of the extruder, nor any expense for the building in which it was kept. As of June 30, 1966, Nassau maintained no inventory whatsoever. After deducting the Krauts' salaries, taxes, depreciation on a car, and $ 5,913.40 of operating expenses, Nassau reported a taxable income of $ 15,831.56 and a resultant tax liability of $ 3,482.94.

At some time in the early part of 1966, Management Methods, an investment counseling and legal firm located in New York City, brought to Rev. Rex T. Humbard, its client, a proposal for the purchase of Nassau. Reverend Humbard was the pastor of the Cathedral of Tomorrow (Cathedral), a federally tax-exempt religious organization in Akron, Ohio. Its activities included conducting Sunday services, a Sunday school, and youth groups, as well as sponsoring the worldwide telecast of its church services and supporting an extensive missionary program. Among its assets, Cathedral owned two businesses, at least one of which it had acquired in an entirely debt-financed transaction. After expressing his preliminary interest in the proposal concerning Nassau, Reverend Humbard with his associates undertook to examine Nassau's business more closely.

Before the parties had entered a binding agreement, however, Iris and Marian Kraut executed an agreement with a party identified only as Wilson Mold & Die Corp. (Wilson), on May 31, 1966, purporting to sell to it their entire interest in Nassau, payments to commence on September 1, 1966. Beyond its participation in this contract, the record contains no evidence as to any and all particulars in respect of Wilson and its principals.

On the following day, June 1, 1966, Trio and Nassau executed an agreement whereby Trio leased to Nassau the extruder which Nassau had theretofore been using along with its accompanying apparatus. The lease was to run for a term of 5 years, to continue indefinitely thereafter but subject to termination by either party upon 60 days' written notice. Nassau agreed to pay Trio $ 500 per month. The lease further provided that:

The Lessor [Trio] shall at all times have free access to the machines for the purpose of inspection or observation, or to make alterations, repairs, improvements, or additions, or to determine the nature or extent of use of the machines.

Furthermore:

The machines shall be used only by operators in the direct employ of the Lessee [Nassau], and only in the factory now occupied by it at its principal place of business, and shall be used only for the purpose of insulating and spooling copper wire, made by or for the Lessee.

Iris and Marian Kraut signed on behalf of Nassau.

Shortly thereafter, before the time of its performance had arrived, Nassau and Wilson abandoned their purported contract of sale. In a separate three-cornered agreement dated June 15, 1966, only 15 days after the initial contract, Wilson assigned all of its rights and delegated all of its duties arising under the May 31, 1966, agreement to Cathedral; Iris and Marian Kraut agreed to release Wilson from the prior contract; and Cathedral convenanted to purchase Nassau's stock according to the following terms:

The Buyer [Cathedral] shall take all such action as may be required so that on or as of June 25, 1966 Nassau Plastic shall be liquidated and all of its assets distributed to the Buyer. Simultaneously with the execution of this Agreement, the Buyer, with the consent of the stockholders and directors of the Sellers [Iris and Marian Kraut], shall take steps forthwith to accomplish the following:

(a) Create a separate operating-manufacturing unit, owned by the Buyer, to be denominated and known as Nassau Plastic (hereinafter sometimes interchangeably referred to as "Nassau Plastic & Wire Co." * * *); the Buyer to file such documents with the proper governmental authorities as may be necessary to effectuate the same.

(b) The name of Nassau Plastic & Wire Corp. shall be changed forthwith, to such name as the Buyer may designate.

* * * *

The purchase price for all of the stock sold under this Agreement shall be not less than $ 500,000 (hereinafter called the "Minimum Price") nor more than $ 3 1/2 million (hereinafter called the "Maximum Price"). The purchase price shall be paid by the Purchaser to the Sellers at the following time in the following manner and to the extent set forth below:

(a) For the period from June 25, 1966 to July 1, 1966, 100% of the net income of the Corporation shall belong to the Sellers; the Purchasers shall receive credit for said amount toward the purchase price.

(b) $ 50,000 on or before August 1, 1966.

(c) For the balance of the year 1966 and in each of the years 1967 through 1976 terminating however on June 30, 1976 inclusive, unless the Maximum Price be paid in full prior thereto; commencing with the 15th day of October 1966 and on the 15th day of each January, April, July and October thereafter in respect to each preceding quarterly period from July 1, 1966 through June 30, 1976, an amount equal to 75% of the Corporations [sic] net income before Federal income taxes for each of such next preceding fiscal periods. In the event a loss occurs in any quarterly period, said loss shall be utilized as an offset in each of the succeeding quarterly periods (until said loss has been recouped) before payments to the Sellers are resumed.

(d) In any event and notwithstanding any provision in this Agreement with respect to the contingent deferral of installment payments of the Purchase Price, the full Minimum Price referred to above and any portion of the Maximum Price referred to above which Sellers may become entitled to receive shall be paid in full on or before July 15, 1976.

(e) The Purchaser may prepay at any time all or any part of the unpaid amount of the Maximum Price.

The terms of payment agreed to by Cathedral largely reflected the substance of Wilson's antecedent commitment, the one notable difference being that Wilson had agreed to pay 75 percent of its pretax earnings only through June 30, 1971, thereafter applying the same percentage to its after-tax income for the duration of the 10-year period.

The ultimate transaction did not contemplate any cash outlay by Cathedral, either at the outset or in the event of default. Although the terms of the contract provided for an initial $ 50,000 payment on August 1 irrespective of Nassau's profits, Nassau's assets at the time of the purported sale included $ 50,089.75 of notes and accounts receivable plus $ 2,323.36 in cash. In point of fact, petitioners permitted Cathedral to postpone that payment until mid-October 1966, by which time Nassau had generated sufficient cash flow from which Cathedral could pay petitioners. Even though Iris and Marian Kraut retained a security interest in all of the assets, business, and goodwill of Nassau, their interest was subject not only to prior liens, but to "the rights of present and future general creditors for obligations arising in the regular course of business, and liens, collateral or security for the loan or loans advanced or to be advanced by any bank." Moreover, it was stipulated that, in the event of Cathedral's default in payments or otherwise, enforcement of the security agreement would constitute the seller's exclusive remedy "and in no event shall the Sellers seek any deficiency judgment or other judgment for damages against the Buyer." In addition thereto, Cathedral agreed to employ both Harry and Aaron Kraut as its chief executive officers, Aaron in the capacity of production manager and internal office manager and Harry as sales manager. As such, Cathedral granted them full authority and responsibility to direct the business of Nassau in every respect. For such services, Cathedral agreed to pay them each $ 5,200 yearly, their employment to terminate on the day following the date of Cathedral's final payment to Iris and Marian.

At the time of this agreement, Nassau owned neither the building in which it operated nor the single piece of machinery with which it produced wire. Its interest in the machine consisted of the 5-year lease from Trio described above. On its tax returns for the year ending June 30, 1966, it listed total assets in the amount of $ 53,867.56, of which notes and accounts receivable amounted to $ 50,089.75; the remaining assets consisted of cash and an automobile. In the same return, it reported $ 36,575.99 in accounts payable while its capital account showed $ 200 in respect of its common stock.

Following the disposition of the stock, Nassau's operations continued at the same location with the same personnel using the same equipment, and apparently under the same or a very similar name. Harry and Aaron Kraut, as "Cathedral's employees," still managed the business. Under this arrangement the business met with early and quite remarkable success. Although on August 1 the business' cash flow apparently had been insufficient to provide Cathedral with the funds necessary to make the downpayment then due, on October 12 Harry Kraut drew two checks of $ 25,000 each on Nassau's account in favor of Cathedral which Reverend Humbard then endorsed as payable to Iris and Marian Kraut individually. During the remainder of 1966 Cathedral paid Iris and Marian an additional $ 97,500; in 1967 Cathedral paid them a total of $ 1,332,500, ^{*100 In each of their respective joint income tax returns for 1967, petitioners reported the receipt of $ 666,250 from Cathedral, of which they treated $ 27,720.83 as interest and from which they deducted collection expenses of $ 32,112.50, primarily brokers' commissions. They then listed the net amount of $ 606,416.67 in each return as long-term capital gains and computed their tax liability according to the alternative tax provided in section 1201(b). In each of his deficiency notices, the Commissioner determined:}

that $ 595,776.09 of the amount collected in 1967 pursuant to the sale of your shares of stock in Nassau Plastics & Wire Corp. to the Cathedral of Tomorrow, Inc. in 1966, payments to be made out of the profits of the company sold, constitutes ordinary income to you in 1967. * * *

In arriving at this amount, the Commissioner assigned to the stock of Nassau a selling price of $ 168,445.60, a value equal to 10 times the taxable income of Nassau for the taxable year ended June 30, 1966. Amount received in 1966 and 1967$ 1,480,000.00Less interest as reported56,904.161,423,095.84Amount deemed applicable to selling price of shares168,445.60Balance1,254,650.24Less expenses incurred in 196763,098.07Increase in ordinary income for 19671,191,552.1750% applicable to each shareholder595,776.09

OPINION

This case presents a factual variation of a common transaction, the heart of which is the debt-financed acquisition of a going business by a tax-exempt organization. Prior to the Tax Reform Act of 1969, churches described in section 501(c)(3), I.R.C. 1954, which were exempt from ordinary taxation were also singled out in section 511(a)(2)(A) for relief from taxation on so-called unrelated business taxable income. *103 This provision enabled a qualified church to receive the income from the operation of a trade or business, itself unrelated to the church's exempt purpose, without incurring tax liability on the proceeds, provided the business was not conducted as a separate corporate entity. *428 taxable business profits by "selling" the business to a church, which could then pass on a substantial portion of those untaxed profits to the seller as deferred payment of the purchase price, ultimately resulting in tax liability of the seller only for long-term capital gains.

In the case before us, the events of which transpired prior in time to the amendment of section 511(a)(2)(A), the Commissioner has challenged petitioners' decision to treat the payments received from Cathedral as long-term capital gains. He proposes two bases for this conclusion: First, that the totality of the dealings between the parties did not amount to a bona fide sale, without which long-term capital gain does not arise; *104 us that the Commissioner has erred.

It is a cardinal rule that, in characterizing a transaction for purposes of taxation, we are obliged to look beyond the form in which the parties have chosen to cast it and to draw our conclusions from that which we perceive to be the substance of the matter. Griffiths v. Commissioner, 308 U.S. 355">308 U.S. 355, 357-358; Higgins v. Smith, 308 U.S. 473">308 U.S. 473, 476; Jack E. Golsen, 54 T.C. 742">54 T.C. 742, 754, affirmed 445 F. 2d 985 (C.A. 10). In particular here we must determine whether the parties effected a true sale of Nassau's stock. In its benchmark decision in this area, Commissioner v. Brown, 380 U.S. 563">380 U.S. 563, the Supreme Court addressed itself to the relevant characteristics of a sale, stating (380 U.S. at 571):

"A sale, in the ordinary sense of the word, is a transfer of property for a fixed price in money or its equivalent," Iowa v. McFarland, 110 U.S. 471">110 U.S. 471, 478; it is a contract "to pass rights of property for money, -- which the buyer pays or promises to pay to the seller * * *," Williamson v. Berry, 8 How. 495">8 How. 495, 544. * * *

Inherent in the Court's understanding of a sale is the notion of movement through exchange, the idea that, at the conclusion of the sale, the buyer possess that which was the object of the sale. And, indeed, this comports well with the "common and ordinary meaning" of a sale. Commissioner v. Brown, supra at 571. On the strength of this definition, the Supreme Court characterized the transaction before it as a sale, and in so doing it underscored a variety of detail which impresses us as highly significant in analyzing the facts before us.

At the outset, the Court recognized the necessity of construing the term "sale" in a manner consistent with the purpose of the capital gains provisions of the Code. That purpose is (380 U.S. at 572) --

to afford capital gains treatment only in situations "typically involving the realization of appreciation in value accrued over a substantial period of time, and thus to ameliorate the hardship of taxation of the entire gain in one year." Commissioner v. Gillette Motor Co., 364 U.S. 130">364 U.S. 130, 134.

Unlike the facts in Brown, in which the transferred business had an adjusted net worth of $ 619,457.63 which included $ 448.471.63 of accumulated earnings, at the time of the present transaction Nassau's balance sheet showed total assets of $ 53,867.56, accumulated earnings of $ 12,348.62, and a net worth of only $ 12,548.62. Yet the purported sales price was a flexible figure between $ 500,000 and $ 3,500,000 as opposed to the correspondingly more realistic price of $ 1,300,000 in Brown. While the absence of accrued value is not conclusive with regard to the existence of a sale, it quite clearly demonstrates that the consideration here reflected whatever future income Nassau might produce rather than the typical capital gains situation "involving the realization of appreciation in value accrued over a substantial period of time" as was the case in Brown. <sup>Brown further stressed the express finding of the Tax Court that the price paid was within reasonable limits based on the earnings and net worth of the company. 380 U.S. at 572-574. In the context of a purchase to be financed entirely and exclusively from the earnings of the business acquired, this factor properly focuses attention upon what Justice Harlan referred to as the purchaser's "residual interest." Commissioner v. Brown, supra at 581 (concurring opinion). While Justice Harlan agreed with the majority's conclusion that a sale had occurred, he offered the following analysis which we deem to be especially helpful in the case before us:

the Government might more profitably have broken the transaction into components and attempted to distinguish between the interest which [the taxpayers] retained and the interest which they exchanged. The worth of a business depends upon its ability to produce income over time. What [the taxpayers] gave up was not the entire business, but only their interest in the business' ability to produce income in excess of that which was necessary to pay them off under the terms of the transaction. The value of such a residual interest is a function of the risk element of the business and the amount of income it is capable of producing per year, and will necessarily be substantially less than the value of the total business. Had the Government argued that it was that interest which [the taxpayers] exchanged, and only to that extent should they have received capital gains treatment, we would perhaps have had a different case.</sup>

It follows therefrom that to the extent the so-called sales price is excessive, albeit agreed upon, the purchaser's residual interest is correspondingly diminished. Despite inadequacies in the record before us, there is sufficient evidence to create serious doubt in our minds that Nassau's expected earnings even approximated, no less exceeded, the level necessary to render payments to the Krauts of $ 3,500,000. And to the extent the clouded record precludes us from making any specific finding with reasonable confidence in this respect, we find that petitioners have failed to sustain their burden of proving that the facts were otherwise.

In urging upon us the reasonableness of the contract price, petitioners have relied heavily upon Aaron Kraut's projection of Nassau's earnings from its new Christmas wire, which valuation is supported, they argue, by the fact that Wilson Mold & Die Corp., an allegedly nonexempt corporation subject to the constraints of taxation, agreed to substantially the same terms as did Cathedral in a contract to purchase Nassau. At trial, Aaron Kraut testified that, based upon the customer acceptance of Nassau's new wire and the growing backlog of unfilled orders in the first half of 1966, he expected Nassau to yield gross profits of $ 10 million during the ensuing 10 years. We, however, simply do not believe this evidence. Petitioners introduced neither documentary nor other specific evidence of Nassau's allegedly skyrocketing business of early 1966. And Aaron Kraut's narrowly selective and seemingly self-serving memory rendered his testimony wholly unsatisfactory. On the one hand, he repeatedly professed his complete ignorance even of Trio's and Nassau's most general financial concerns, such as the information in tax returns which he himself had signed, explaining that his brother Harry handled all financial matters while he was engaged exclusively in the production end of the business. ^{*431 Yet, with respect to the central question of the case, Nassau's earning capacity over a period of 10 years, he presumed to ask the Court to rest content entirely on the strength of his knowledge of that matter. The valuation of a business is a delicate and sophisticated calculation, the more so with only 1 year's operation from which to extrapolate, and we are hardly inclined to credit Aaron Kraut with the necessary knowledge or ability to lend the slightest probative value to his testimony.}

Insofar as Wilson is concerned, we are faced with unexplained silence. The record is barren of evidence with respect to Wilson. We do not know what business, if any, it conducted, who its principals were and what relationship, if any, existed between them and Cathedral or other persons involved in these transactions, and what negotiations, if any, preceded the signing of the contract. All we do know is that a party referred to as Wilson Mold & Die Corp. signed a contract to purchase Nassau's stock and 15 days later assigned the entirety of its interest in the contract to Cathedral. In the absence of any explanatory evidence (which was peculiarly within the control of petitioners) and in view of the two contracts' all too convenient timing, it is strongly suggestive the initial Wilson contract was merely a bootstrap effort to bolster petitioners' contention as to Nassau's fair market value, and we consequently must discount its evidentiary value.

In addition to petitioners' failure to produce credible evidence supporting the value they have tried to attach to Nassau, what evidence the record does provide in respect of this issue compels us to conclude that petitioners have failed to show that the contract price of as much as $ 3,500,000 was not grossly excessive. Nassau was a company which, in its 1 year of existence, had managed to generate profits of less than $ 16,000 before taxes, with total assets amounting to slightly more than $ 50,000 and a net worth of $ 12,548.62. Its only fixed asset was an automobile. Its sole product was still experimental in June of 1966, untested in actual use over a period of time. Most significantly, though, was the fact that the Krauts neither obtained, nor apparently did they apply for, a patent on the new wire of such allegedly explosive sales potential, nor was it shown that production depended on a trade secret. Petitioners offered no explanation for such omission. Even assuming, arguendo, that this wire possessed the marketing potential urged by petitioners, without the protection afforded by a patent (and without any convincing evidence showing that production of the wire was based on a secret process) Nassau's competitors could have appropriated such a valuable process and a corresponding share of the market for such wire.

The decision in Brown rested as well upon a finding that the transaction had effected a real change of economic benefit, that the tax-exempt organization involved there was motivated by the genuine prospect of owning outright the substantial assets of a business after paying the purchase price in full. The record does not support a similar conclusion in the instant case.

Cathedral had no prospect of ending up with the substantial assets of an active business simply because Nassau owned no manufacturing assets at the time of the purported sale. Nassau's only fixed asset was an automobile; it owned no manufacturing equipment, no building, no inventory. The single piece of machinery employed in production was the extruder which it leased from Trio. By the terms of that lease, Trio had the right to determine the nature or extent of use of the machine and Nassau could make no additions or alterations to the extruder without the permission of Trio. After the initial 5-year period ending on May 31, 1971, either party could unilaterally cancel the lease. In effect, the Kraut brothers, through their wholly owned corporation, Trio, had reserved the power to terminate the lease and to repossess Nassau's sole source of income at any time after May 31, 1971. In that event, there would have been small likelihood that Nassau's two key employees, Aaron and Harry Kraut, would have remained with Nassau and applied their skills to rebuilding the business around a new extruder, even if one were available. *433 On the other hand, although in Brown the Supreme Court rejected the argument that risk-shifting was an essential element of a bona fide sale, the transaction there nevertheless contemplated the payment by the exempt organization of a fixed price that was deemed to have a reasonable relationship to the subject matter of the sale. In the present case, however, the wholly unrealistic sales price coupled with the so-called sellers' remedy in the event of Cathedral's default makes it obvious that what we have here is a transaction designed, on the one hand, to insure Cathedral against any expense in the event Nassau failed to generate sufficient sales and, on the other hand, to provide the Krauts with the practical opportunity of recapturing the substance of Nassau's business in the event it proved profitable beyond the unrealistic level fixed in the contract. Our difficulty in discerning a sale in this arrangement is not that risk-shifting is absent; it is that nothing of substance has shifted other than a portion of the business' profits to Cathedral for a limited period of time. And the latter was merely the price that the Krauts paid for the opportunity of claiming capital gains treatment in respect to future speculative profits that might be realized by the enterprise. Petitioners have thus failed entirely to demonstrate that their arrangement with Cathedral contemplated the prospect of Cathedral retaining any residual interest in Nassau. It follows therefrom that the transaction lacked the essentials of an exchange upon the basis of which a sale might be founded.

In a recent decision of this Court, Louis Berenson, 59 T.C. 412">59 T.C. 412, appeal pending (C.A. 2), the majority refused to recognize the bona fides of a purported sale of a business to a tax-exempt organization. In distinguishing the holding in Brown, the Court found that the agreed-upon price was "grossly excessive," bearing no relationship to the value of the assets sold or to the earnings history of the business. The Court concluded therefrom that the sale was merely a sham. In the present case the facts are even stronger than those relied upon in Berenson. Not only have petitioners here failed to demonstrate that the agreed-upon price was not grossly excessive, but moreover they have not shown by satisfying evidence that Cathedral entertained even a remote prospect of actually acquiring anything of value. Cathedral's residual interest in Nassau was purely nominal, and we think the facts therefore fall within the rule of Kolkey v. Commissioner, 254 F. 2d 51 (C.A. 7), affirming 27 T.C. 37">27 T.C. 37.The Seventh Circuit there decided that when, in a debt-financed acquisition by an exempt organization, the sales price is so grossly inflated that the purchaser's prospect of finally owning the business outright is at best remote, the transaction does not amount to a sale. Likewise in the instant case, we are not persuaded that petitioners formulated the terms of payment for any purpose other than to secure this right to receive 75 percent of Nassau's profits throughout the specified period. It is our opinion that the transaction never contemplated the actual transfer to Cathedral of a going business in fact. Far from comprising a sale, this was quite plainly an agreement to pay Cathedral a fee in return for lending its exemption to Nassau's earnings. This is not to say that every debt-financed acquisition of a business by a charitable organization which is payable exclusively from its future earnings is a tainted sale. But the sweep of Commissioner v. Brown, 380 U.S. 563">380 U.S. 563, is not unlimited, and we do not believe that either the logic or the intent of the Court's decision there compels a finding for the petitioners before us. The Supreme Court itself in Brown recognized the appropriateness of a contrary result in cases like Kolkey, 380 U.S. at 574 fn. 7, and, in our view, there was here similarly lacking a bona fide sale.

Although our finding that petitioners have failed to prove the existence of a bona fide sale to Cathedral is conceptually sufficient to render the entire net proceeds of the transaction taxable as ordinary income to Iris and Marian Kraut, the decisions to be entered herein will necessarily be limited by the Commissioner's computation in the deficiency notices. The Commissioner there determined an amount, $ 168,445.60, applicable to the selling price of the stock of Nassau (on the theory that there was a bona fide sale only to the extent of that amount), and only the proceeds in excess thereof, after deducting collection expenses of $ 63,098.07, and interest of $ 56,904.16, were deemed to be ordinary income to each of the shareholders. In the proceedings in this Court, the Commissioner contended alternatively that the entire transaction was lacking in bona fides -- a conclusion which we have found to be valid and which would justify charging petitioners with the entire net proceeds undiminished by any so-called true selling price of $ 168,445.60. ^{*435 in the circumstances the redetermination of deficiencies herein will be limited accordingly. Sec. 6214(a); Rule 41(a) and (b), Tax Court Rules of Practice and Procedure. Cf. Commissioner v. Long's Estate, 304 F. 2d 136, 141-142 (C.A. 9), affirming an unreported Tax Court Opinion. We wish to add that in neither Commissioner v. Brown, 380 U.S. 563">380 U.S. 563, nor in Louis Berenson, 59 T.C. 412">59 T.C. 412, did the respective Courts have before them an allocation by the Commissioner to the purchase prices therein, and our conclusion in these proceedings that the entire transaction lacked bona fides should not be interpreted as being inconsistent with the propriety of making an allocation if the facts in a particular case are thought to justify such action.}

Due to concessions in another respect made prior to trial,

Decisions will be entered under Rule 155.

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Footnotes

• 1. This is a gross amount against which there should be charged $ 64,225, the related expenses of collection, leaving a net amount of $ 1,268,275.↩

• 2. Nassau's Federal income tax return for the year ended June 30, 1966, indicated taxable income of $ 15,831.56, which, multiplied by 10, equals only $ 158,315.60. The Commissioner, on brief, noted the discrepancy between this amount and the figure used in computing the deficiencies, but he does not now contend that the value of Nassau's stock should be limited to the lower figure.↩

• 3. Part III of subch. F of ch. 1 of the Income Tax Subtitle of the Internal Revenue Code, consisting of secs. 511 through 515, extends taxation to the business income of certain exempt organizations. The critical language therein is "unrelated business taxable income," a defined term denoting income from a trade or business carried on by the exempt organization but which trade or business is not substantially related to the organization's exempt purpose. Sec. 511(a)(1) contains the operative language of part III, imposing a tax on the unrelated business taxable income "of every organization described in paragraph (2)." Sec. 511(a)(2), as effective in 1967, provided in relevant part:

  (2) Organizations subject to tax. --

  (A) Organizations described in section 501(c) (2), (3), (5), (6), (14) (B) or (C), and (17), and section 401(a). -- The taxes imposed by paragraph (1) shall apply in the case of any organization (other than a church, a convention or association of churches, or a trust described in subsection (b)) which is exempt, except as provided in this part, from taxation under this subtitle by reason of section 401(a) or of paragraph (3), (5), (6), (14) (B) or (C), or (17) of section 501(c). Such taxes shall also apply in the case of a corporation described in section 501(c)(2) if the income is payable to an organization which, itself is subject to the taxes imposed by paragraph (1) or to a church or to a convention or association of churches. [Emphasis supplied.]

  The Tax Reform Act of 1969, sec. 121(a)(1), repealed the preferred status of churches in respect of unrelated business income by deleting the parenthetical exception in sec. 511(a)(2)(A).↩

• 4. Sec. 1.511-2(a)(3)(ii), Income Tax Regs.↩

• 5. SEC. 1222. OTHER TERMS RELATING TO CAPITAL GAINS AND LOSSES.

  For purposes of this subtitle --

  * * * *

  (3) Long-term capital gain. -- The term "long-term capital gain" means gain from the sale or exchange of a capital asset held for more than 6 months, if and to the extent↩

  such gain is taken into account in computing gross income.

• 6. In this respect, we regard the $ 3 million range within which the purchase price was allowed to vary as incompatible with a sale of Nassau's past accrued value and goodwill. Rather, it is highly suggestive of an arrangement by which the Krauts retained a most substantial interest in Nassau's future profits.↩

• 7. Another instance of Aaron Kraut's remarkably inconsistent memory arose in respect of the sale of Christmas Wire, an event no more than 8 years past at the time of trial. He at first professed to have no recollection whatever of the purchase price, but after persistent questioning by the Court, prompted by the witness' startling total lapse of recall, he finally testified that the price was somewhere between $ 100,000 and $ 1 million. We did not find him a credible witness and are unwilling to ground our findings on what is so obviously contrived testimony.

  We also mention that, although the Government had subpoenaed Harry Kraut to appear at trial, the Government's attorney explained that he had not sought to enforce the subpoena. Inasmuch as it was represented that Harry was scheduled to appear at a trial elsewhere at the same time, the Government attorney relied upon petitioners' counsel's assurance that Aaron was every bit as knowledgeable as Harry with respect to the details of Nassau's business. At trial, petitioners' counsel did not contest the accuracy of such representation, and we simply note that petitioners must bear the consequences of their failure to adduce credible evidence of Nassau's value.↩

• 8. The extruder here under discussion had been specially tooled for the production of this wire, and the record leaves in doubt whether an extruder adapted as such might be readily available for purchase or rental.↩

• 9. As noted above, pp. 426-427, the Commissioner attempted to fix a selling price in terms of 10 times indicated taxable income. But, as pointed out in fn. 2, supra, such taxable income was $ 15,831.56, and 10 times that amount would be $ 158,315.60. Moreover, the usual method of computing value in terms of a multiple of earnings is to use an after-tax↩ earnings figure, and if Nassau's $ 3,482.94 tax liability is subtracted from $ 15,831.56, there would remain net earnings of only $ 12,348.62. Accordingly, the 10 times earnings formula would yield a value of $ 123,486.20. It seems hardly likely that any greater multiple than 10 would be justified in the light of the fact that the stock was closely held, that the company's net assets were very modest in amount, that its only physical asset of any consequence was a secondhand automobile, that its successful operation obviously depended upon the continued management of the enterprise by the Krauts, that it had such a brief history, and that its sole product was untested over a sufficiently lengthy period.