Smith v. Commissioner , 49 T.C. 476 ( 1968 )

Joe L. Smith, Jr., and Nancy R. Smith, Petitioners v. Commissioner of Internal Revenue, Respondent

Smith v. Commissioner

Docket No. 1502-66

United States Tax Court

49 T.C. 476; 1968 U.S. Tax Ct. LEXIS 179;

February 14, 1968, Filed

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Decision will be entered under Rule 50.

In order to improve the corporate balance sheet in connection with an application for a television station pending before the FCC, a corporation in 1954 temporarily transferred to its majority stockholder, the petitioner, a $ 40,000 corporate obligation owed to a third party. Petitioner also received additional common stock in the corporation as consideration for his agreement to assume the corporate obligation. In 1961, when it was deemed appropriate to restore the $ 40,000 obligation to the corporation, the following steps were taken: (1) The corporation issued $ 40,000 in debentures to petitioner in exchange for 800 shares of its common stock; (2) petitioner delivered his $ 40,000 check to the creditor in exchange for the outstanding promissory note in that amount; and (3) petitioner transferred the debentures to the creditor in exchange for his $ 40,000 check. Held, under these circumstances, the redemption of stock from petitioner in 1961 was not essentially equivalent to a dividend within the meaning of sec. 302(b)(1) of the 1954 Code.

Robert B. Yorty, for the petitioners.

Robert A. Roberts, for the respondent.

Mulroney, Judge.

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MULRONEY

Respondent determined a deficiency in petitioners' income tax for 1961 in the amount of $ 19,315.21. The issue is whether a corporate distribution of its debentures in the amount of $ 40,000 to Joe L. Smith, Jr., in 1961 in exchange for 800 shares of the corporation's common stock constituted a redemption equivalent to a dividend within the meaning of section 302 of the 1954 Internal Revenue Code. ^{*182 Commission to construct a UHF television station in Charleston, W. Va. The corporation planned to finance the construction of the television station from its retained earnings, from long-term financing with equipment manufacturers, and from two banks, the Beckley National Bank and the Charleston National Bank. Actually, the corporation borrowed money from the Beckley National Bank. The Charleston television station began operations in September 1953.}

On May 28, 1953, Smith, Inc., borrowed $ 40,000 from one John H. McCulloch, a close friend of the petitioner's family. McCulloch issued a check in that amount payable to Smith, Inc., and it was endorsed by petitioner in his capacity as president of the corporation. The cash receipts journal of the corporation showed the receipt of $ 40,000 on May 28, 1953, and a credit of a note payable to McCulloch in that amount. The corporation's notes payable account in its general ledger recorded under date of June 13, 1953, an obligation of $ 40,000 payable to McCulloch. The corporation prepaid in May 1953 1 year's interest to McCulloch on the loan at the rate of 4 1/2 percent.

Smith, Inc., did not issue a promissory note to McCulloch as evidence of the indebtedness. As security for the loan made by him, McCulloch requested and received petitioner's personal promissory note dated July 1, 1953, in the amount of $ 40,000.

In March 1954, Smith, Inc., had an application for a permit to construct a VHF television station in Beckley, W. Va., pending before the Federal Communications Commission. A competing application for the same facilities had been filed by one Robert R. Thomas, Jr. Pursuant to its procedures in effect at that time, the Commission notified Smith, Inc., by a letter dated April 8, 1954, that a hearing would be necessary to determine which of the two applicants was best qualified to receive a grant of authority to construct and operate the proposed station. The Commission's letter of April 8, 1954, to Smith, Inc., also raised questions as to the corporation's financial qualifications to construct, own, and operate the proposed television station, stating in part as follows:

A review of your application has raised questions concerning the following matters:

(1) It appears from your application that you plan to finance the construction and operation of the proposed television station, in part, from existing capital in the amount of $ 70,000. In this connection, it is noted that your balance sheet of October 31, 1953 indicates that you had on that date a negative net current position of $ 180,668 and, therefore, it cannot be determined that you have available funds in the amount of $ 70,000 from existing capital.

(2) You indicate that you also contemplate the use of two bank loans which total $ 240,000, but it appears that you have already used $ 100,000 of these loan credits for the construction of Station WKNA-TV, Charleston, West Virginia. This indicates that you have a balance of available credit in the amount of $ 140,000, which amount will be required to meet your current obligations, leaving none of such funds available for the proposed obligations under the instant application, including equipment payments, loan curtailment, probable increased cost of tower now shown as 588 feet above ground and working capital during the first year of operation.

(3) While you indicate that deferred payment credit in the amount of $ 202,923 will be available to you, you have not submitted a copy of a letter from an equipment manufacturer agreeing to extend such credit and indicating the terms of payment.

The balance sheet of Smith, Inc., as of October 31, 1953, showed current assets in the amount of $ 112,474.40, other assets, $ 5,489.42, fixed assets, $ 403,173.04, and deferred charges, $ 25,615.41. Current liabilities were shown in the amount of $ 278,170.60, accrued liabilities, $ 24,970.76, other liabilities, $ 140,000, capital stock, $ 72,000, and surplus and profit in the amount of $ 31,610.91. The current liabilities consisted of notes payable, $ 157,713.23, notes payable -- RCA, $ 108,652.83, accounts payable -- WJLS, $ 106.69, and accounts payable -- WKNA, $ 11,697.85.

In reply to the Commission's letter of April 8, 1954, Smith, Inc., filed an amendment to its application on April 23, 1954, which included a rearranged balance sheet for the corporation as of April 22, 1954. On the revised balance sheet the notes payable to RCA in the amount of $ 108,652.83 and to the Beckley National Bank in the amount of $ 60,000 were listed as "Long-Term Debt" rather than "Current Liabilities." The revised balance sheet showed total current assets in the amount of $ 116,666.91 and total current liabilities in the amount of $ 30,555.38. The current liabilities consisted of notes payable, $ 15,919.12, and accounts payable, $ 14,636.26.

On April 21, 1954, Smith, Inc., issued 347 shares of its common stock to Joe L. Smith, Sr., for $ 25,000 and 347 shares of its common stock to Hulett C. Smith (petitioner's brother) for $ 25,000. Also on that date, Smith, Inc., issued 1,250 shares of its common stock to petitioner for $ 90,000. The consideration given by petitioner for these shares was $ 50,000 in cash and his agreement "to take care of" the corporation's obligation to McCulloch in the amount of $ 40,000. The corporation's notes payable account in its general ledger reflected the elimination of this $ 40,000 liability from the books of the corporation under date of April 24, 1954. Petitioner made the subsequent payments of interest on the $ 40,000 obligation to McCulloch until 1961. Petitioner made no payments on principal during this period.

In May 1954, Smith, Inc., and Robert R. Thomas, Jr., entered into an agreement under which Smith, Inc., was paid $ 5,000 as reimbursement for part of the costs incurred by it to prosecute its application to construct a television station in the Beckley, W. Va., area and was also given an option to purchase a 40-percent interest in the new television station if the application of Robert R. Thomas, Jr., was granted. Under the agreement, Smith, Inc., withdrew its own competing application then pending before the Federal Communications Commission, and the application of Robert R. Thomas, Jr., was granted by the Commission in June 1954. Smith, Inc., never exercised its option to acquire an interest in the new television station because of objections interposed by Robert R. Thomas, Jr., and a subsequent court action brought by Smith, Inc., was compromised and settled.

Smith, Inc., closed its television station in Charleston, W. Va., in February 1955. In 1957 Smith, Inc., sold its Charleston radio station and realized a gain of about $ 106,000. The proceeds of this sale were used to pay off obligations incurred by the corporation in connection with its unsuccessful television operation in Charleston. Smith, Inc., continued to operate its radio station in Beckley, W. Va. The corporation reported the following taxable income before net operating loss deductions during the years 1953 through 1961:

Year	Amount
1953 $ 18,864.32
1954	(152,213.68)
1955	(46,699.09)
1956	(35,350.03)
1957 55,953.95
1958	($ 58,881.49)
1959	(34,386.60)
1960	55,138.30
1961	100,558.41

Late in 1958 Smith, Inc., acquired the majority of the stock in Biggs, Johnston & Withrow, Inc., a publishing firm in Beckley, W. Va., and on December 31, 1959, the newly acquired firm was merged into Smith, Inc. During 1960 Smith, Inc., realized a profit of approximately $ 77,000 from its printing operation and a loss of approximately $ 25,000 from its broadcasting operation.

On January 1, 1961, the outstanding stock of Smith, Inc. was owned by the following individuals:

	Shares
Petitioner	2,570
Hulett C. Smith	720
Joe L. Smith, Sr	263 1/2
Christine C. Smith	263 1/2
O. F. Cook	6
R. L. Trump	6

A meeting of the board of directors of Smith, Inc., was held on January 13, 1961, and the minutes of the meeting state in part as follows:

The President then announced that during the construction of WKNA-TV he had personally borrowed $ 40,000.00 from John H. McCulloch, with which he purchased stock in the corporation. The President stated that at all times he felt that the loan was a corporate one rather than a personal one, but that he had continued to carry it and pay interest on the obligation rather than attempt to transfer it to the company during the years the company was in financial difficulty. Now that it appears the company is in a position to assume the obligation, the President proposed that it be transferred to the corporation and that, in turn, the President would surrender to the corporation stock in the corporation with a book value of $ 40,000.00. The holder of the obligation has agreed to accept five year six per cent debentures of the corporation and to surrender the personal note.

In order to clarify the exchange, it was suggested that the debentures be issued to the President, Joe L. Smith, Jr., in exchange for his personal stock valued at $ 40,000.00 and that he, in turn, transfer the debentures to John H. McCulloch for the surrender by McCulloch of Smith's note.

It was pointed out that by the surrender of the $ 40,000.00 in corporate stock by Smith that it might be necessary to request the permission of the Federal Communications Commission to transfer control of the radio stations inasmuch as Smith no longer would have positive control. Smith pointed out that he had made arrangements to acquire additional stock from Joe L. Smith, Christine C. Smith and others, including the First Beckley Corporation, to whom stock was to be issued in settlement of a debt of the corporation to First Beckley Corporation, and also by the repayment to Smith of a loan of $ 8,500.00, due Smith by the corporation.

Additionally, the corporation was negotiating with Christine C. Smith to pay a loan from her in the amount of $ 10,000.00 by the issuance of additional stock, which in turn would be acquired by Joe. L. Smith, Jr.

On January 24, 1961, Smith, Inc., issued 194 shares of its common stock to the First Beckley Corp. in satisfaction of the Smith, Inc., debt of $ 9,700. These 194 shares were purchased by petitioner from the First Beckley Corp. simultaneously with their issuance. On the same date, Smith, Inc., issued 200 shares of its common stock to Christine C. Smith, petitioner's mother, in repayment of her loan of $ 10,000 to the corporation. These 200 shares were purchased by petitioner from his mother simultaneously with their issuance. Also, on January 24, 1961, Smith, Inc., issued 170 shares of its common stock to petitioner in satisfaction of a loan previously made by him to the corporation in the amount of $ 8,500.

On January 27, 1961, petitioner acquired 263 1/2 shares of Smith, Inc., common stock from his mother, Christine, and the same amount of Smith, Inc., common stock from his father, Joe L. Smith, Sr.

On February 1, 1961, Smith, Inc., issued $ 40,000 in face amount of its debentures to petitioner in exchange for 800 shares of its common stock. On or about February 1, 1961, petitioner delivered his personal check in the amount of $ 40,000 to McCulloch, receiving in exchange his promissory note dated July 1, 1953, in the amount of $ 40,000. On the same date, petitioner transferred the Smith, Inc., debentures having an aggregate face value of $ 40,000 to McCulloch in exchange for McCulloch's personal check in the amount of $ 40,000.

On February 2, 1961, the following individuals owned the outstanding stock of Smith, Inc.:

	Shares
Petitioner	2,861
Hulett C. Smith	720
O. F. Cook	6
R. L. Trump	6

No dividends were formally declared by Smith, Inc., during the period from August 1, 1948, to April 30, 1967.

Respondent determined that the distribution of debentures in the face amount of $ 40,000 to petitioner in 1961 was taxable as a dividend under the provisions of sections 301, 302, and 316.

OPINION

Petitioner contends that the distribution of the debentures by Smith, Inc., to him in exchange for 800 shares of the corporation's common stock constituted a redemption "not essentially equivalent to a dividend" within the meaning of section 302(b) (1) and therefore qualified as a distribution "in exchange for the stock" under section 302(a). The question whether a distribution is essentially equivalent to a dividend turns upon the facts and circumstances of each case. Kerr v. Commissioner, 326 F. 2d 225 (C.A. 9, 1964), affirming 38 T.C. 723">38 T.C. 723 (1962).

In resolving this factual question of dividend equivalence, the courts have developed the following criteria: Was there a bona fide corporate business purpose for the distribution; did the corporation adopt any plan of business contraction or did the transaction actually result in a contraction of the corporate business; was the distribution initiated by the stockholder or by the corporation; was the proportionate ownership of stock by the stockholders changed; what were the amounts, frequency, and significance of dividends in the past; and was there a sufficient accumulation of earned surplus to cover the distribution or was it partly from capital? Kerr v. Commissioner, supra;Genevra Heman, 32 T.C. 479 (1959), affd. 283 F. 2d 227 (C.A. 8, 1960).

Petitioner's position is that where both the issue and redemption of stock are dictated by reasons associated with a legitimate corporate business purpose, there being no indication of a tax evasion scheme or a corporate dividend policy evidencing a pattern of tax avoidance, then the redemption of such stock is not essentially equivalent to a dividend. Petitioner cites Keefe v. Cote, 213 F. 2d 651 (C.A. 1, 1954), and Estate of Henry A. Golwynne, 26 T.C. 1209">26 T.C. 1209 (1956), in support of this general proposition.

In Keefe v. Cote, supra, the taxpayer was the majority stockholder and an executive officer of a corporation which in 1936, because of a cash shortage, paid taxpayer only a portion of his annual salary in cash and issued a note to him for the balance. During 1937 the corporate officers found that the presence on the corporation's books of the note payable to the principal officer and stockholder reflected adversely on the corporation's credit standing and it was therefore decided to issue him 248 shares of stock in exchange for the cancellation of the promissory note. It was understood that the corporation would redeem these shares when it could do so conveniently. In 1944 the corporation redeemed from the taxpayer the 248 shares issued to him in 1937.

The Court of Appeals for the First Circuit concluded that the 248 shares were originally issued to serve the important corporate purpose of improving its balance sheet and credit position and that the subsequent redemption of these shares was merely the final step in carrying out the original corporate purpose. Accordingly, the appellate court held that the redemption of the stock was not essentially equivalent to a dividend within the meaning of section 115(g) of the 1939 Internal Revenue Code.

In Estate of Henry A. Golwynne, supra, the factual situation was similar to that in Keefe v. Cote, supra.The decedent was president and sole stockholder of a corporation which, because of its lack of cash, paid the decedent a portion of his salary for the years 1942 through 1945 by issuing him its promissory notes. In order to improve its credit standing, the corporation in 1944 and in 1946 issued a total of 450 shares of preferred stock to decedent in exchange for promissory notes held by him. In 1948 the corporation redeemed 200 shares of the preferred stock and in 1949 an additional 75 shares of such preferred stock were redeemed. This Court held that Keefe v. Cote, supra, was controlling and that because the issuance as well as the redemption of the preferred stock was part of the evident corporate purpose of strengthening the corporation's credit position, the redemption of the stock was not essentially equivalent to a dividend within the meaning of section 115(g) of the 1939 Internal Revenue Code.

We believe that Keefe v. Cote, supra, and Estate of Henry A. Golwynne, supra, are controlling here. Actually respondent bases his whole case on the contention that the loan was to petitioner individually and at no time a corporate obligation. We are convinced from all the evidence that the McCulloch loan of $ 40,000 in 1953 was made to Smith, Inc., and not to the petitioner individually. McCulloch's check in that amount was made payable to the corporation, it was endorsed by petitioner as president of the corporation, the loan was recorded on the corporate books as a note payable to McCulloch, and in May 1953 the corporation prepaid a year's interest on the loan.

In connection with a pending application by Smith, Inc., for a permit to construct a VHF television station in Beckley, W. Va., the Federal Communications Commission in a letter to the corporation in April 1954 raised questions concerning the corporation's financial qualifications to construct and operate the proposed television station. The Commission pointed out that the corporation's balance sheet as of October 31, 1953, showed a "negative net current position of $ 180,668" which threw doubt on the corporation's ability to finance any portion of the proposed station from existing capital.

To remedy this situation Smith, Inc., took several steps which included (1) the issuance of additional shares of its common stock to petitioner and to other members of his family; (2) the assumption by petitioner of the $ 40,000 corporate obligation to McCulloch in exchange for stock; and (3) the shifting of certain other corporate obligations from current to long-term liabilities on the corporate balance sheet. Petitioner testified that when the $ 40,000 corporate obligation was assumed by him there was never any intention that he would ever pay the obligation. Instead, it was understood that the corporation itself would repay McCulloch after the Charleston television station, which had begun operations in September 1953, became a successful operation. In other words, the assumption by petitioner of the obligation was never intended to be anything but a temporary measure undertaken to improve the corporation's financial statements.

However, the Charleston television station proved unsuccessful and it was closed down in February 1955. Smith, Inc., incurred heavy operating losses during the period 1955 through 1959 and it was not until 1961, after Smith, Inc., had acquired a profitable printing firm, that it was felt that the McCulloch obligation could be restored to the corporation and that arrangements should be made to repay McCulloch. Accordingly, the following steps were taken on or about February 1, 1961: (1) Smith, Inc., issued $ 40,000 in debentures to petitioner in exchange for 800 shares of its common stock; (2) petitioner delivered his personal check for $ 40,000 to McCulloch in exchange for petitioner's promissory note dated July 1, 1953, in the amount of $ 40,000; and (3) petitioner transferred the corporate debentures in the face amount of $ 40,000 to McCulloch in exchange for McCulloch's personal check in the amount of $ 40,000.

The only effect of these transactions, which must be viewed together, was to restore to Smith, Inc., the $ 40,000 obligation it owed to McCulloch prior to the time when petitioner assumed such obligation in 1954. The redemption of petitioner's stock merely was the final step taken in the completion of the corporation's original purpose in the issuance of such shares. Petitioner did not enjoy any monetary or other economic benefit as a result of these transactions.

It should also be noted that petitioner, at about the same time that the corporation redeemed 800 shares of stock from him, acquired more than that number of Smith, Inc., shares of stock from various sources, so that his stock interest in the corporation was not diminished by the redemption and, in fact, was increased.

We hold, under the particular circumstances of this case, that the redemption of stock from petitioner in 1961 was not essentially equivalent to a dividend within the meaning of section 302(b) (1).

Decision will be entered under Rule 50.

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Footnotes

• 1. All section references will be to the 1954 Internal Revenue Code↩, as amended, unless otherwise noted.

• 1. Includes gain on sale of capital assets in the amount of $ 23,037.52.↩

• 2. Includes gain on sale of capital assets in the amount of $ 106,090.97.↩