Upham v. Commissioner

Samuel A. Upham, Petitioner v. Commissioner of Internal Revenue, Respondent. Estate of George F. Clark, The Northern New York Trust Company, Executor, and Minnie F. Clark, Executrix, Petitioners, v. Commissioner of Internal Revenue, Respondent

Upham v. Commissioner

Docket Nos. 4022, 4129

United States Tax Court

4 T.C. 1120; 1945 U.S. Tax Ct. LEXIS 190;

April 12, 1945, Promulgated

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Decisions will be entered under Rule 50.

In 1941 a corporation of which petitioners were stockholders, purchased 40 percent of its outstanding shares at a price of $ 160 per share and thereupon canceled and retired the shares so purchased. At the time of the purchase and retirement of the shares the corporation's capital was substantially larger than was necessary for the needs of the business and it was expected that the corporation would be liquidated at some time in the future. Held, the distribution to the stockholders was in partial liquidation and was not made "at such time and in such manner" as to be essentially equivalent to a taxable dividend within the meaning of section 115 (g) of the Internal Revenue Code.

Howard F. Farrington, C. P. A., for the petitioners.

Francis S. Gettle, Esq., for the respondent.

Harron, Judge .

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HARRON

The respondent determined deficiencies in income tax for the year 1941, as follows: Samuel A. Upham, Docket No. 4022, $ 84,139.92, and estate of George F. Clark, Docket No. 4129, $ 32,482.44.

Both petitioners claim refunds. These proceedings have been consolidated. The only issue for determination is whether distributions made by the Brownville Paper Co. in 1941 to petitioners, who are stockholders, were distributions in partial liquidation of the company, or were distributions taxable as dividends.

Petitioners filed their returns with the collector for the twenty-first district of New York.

FINDINGS OF FACT.

Some of the facts have been stipulated. The stipulation of facts is incorporated herein by reference and is adopted as part of the findings of fact.

The Brownville Paper Co. was incorporated under New York law on March 9, 1893, with a capital stock of $ 18,000, consisting of 180 shares of the par value of $ 100 per share. On January 29, 1897, the capital was increased to $ 25,000, consisting of 250 shares of the par value of $ 100 each. On March 8, 1910, the capital was increased to $ 100,000 by the issuance of a stock dividend, and after such dividend, the capital consisted of 1,000 shares of the par value of $ 100 each. On December 31, 1920, the 1,000 shares of capital stock outstanding had a book value of $ 1,009,902.13. On January 5, 1921, the corporation declared and paid a stock dividend of 5 shares for 1 share, and thereupon, the sum of $ 909,902.13 was transferred on the corporation's books from the surplus account to capital stock account. The stock was also changed from par value to no par value stock, and the number of shares was increased from 1,000 to 5,000 shares. These shares continued outstanding until March 26, 1941, when the corporation purchased 2,000 shares for retirement under arrangements hereinafter set forth. Since March 26, 1941, the outstanding stock has consisted of 3,000 no par value shares.

Samuel A. Upham has been an officer of Brownville since 1893, and president since 1910. He has been a director for many years. George F. Clark was secretary and treasurer of the corporation until 1927 and a director until his death. He died on March 14, 1941. In 1941 the respective ages of Upham and Clark were 74 years and 84 years.

The stock of Brownville was held during 1941 as follows:

			Shares owned
	Shares owned	40% reduction	after Mar.
	Jan. 1, 1941	Mar. 26, 1941	26, 1941
Samuel A. Upham	2,520	1,008	1,512
Estate of George F. Clark, deceased	1,032	412.8	619.2
Minnie F. Clark	287	114.8	172.2
Elizabeth S. Upham	241	96.4	144.6
Howard Root	80	32	48
Seymour M. Jones	37	14.8	22.2
James H. Lingenfelter	200	80	120
Robert L. Pease	201	80.4	120.6
Estate of George C. Sherman	201	80.4	120.6
Elizabeth Wise	201	80.4	120.6
Total	5,000	2,000.0	3,000.0

Root, Jones, Lingenfelter, and Pease were employees of the corporation.

Early in 1938 Upham and Clark, who together owned over 70 percent of the outstanding stock, discussed plans for turning over the business to the employees. The business of the corporation had contracted considerably from the volume of business during the period from 1920 to 1930, and it was contemplated that the business should be liquidated in the future. On February 11, 1938, Upham sent the following letter to the Northern New York Trust Co.:

By the terms of my last Will and Testament, dated and executed January 10, 1938, The Northern New York Trust Company, of Watertown, N. Y., and Florence W. Upham, my wife, were nominated and appointed to be executors and trustees of my said Will.

Paragraph "Sixth" of said Will provides that my executors and trustees may continue to hold and operate any going business which I may own or be financially interested in at the time of my decease until such time as in their judgment it is for the best interest of my estate to dispose of the same.

Recently, I have discussed with the trust officers of your institution, the details of a plan I have in mind to accomplish the liquidation of the Brownville Paper Company and the sale of the assets of the Company to certain of the employees. Briefly, this plan is as follows:

The Brownville Paper Company shall be liquidated so that the stockholders of the Company shall receive in liquidation and in exchange for their stock, the sum of One Hundred and Sixty Dollars ($ 160.00) per share, either in cash, securities and/or three percent (3%) bonds as hereinafter described.

The plant and sufficient cash for working capital shall be sold to a new corporation to be formed by the employees. The new corporation will pay for the purchase of the plant by a bond issue bearing interest at three percent (3%) and the lives of the six employees owning stock in the new corporation shall be insured for the benefit of the bond issue in the total amount of said issue.

The salaries of said employees shall be limited to their present salaries as long as the bond issue remains unpaid and sixty percent (60%) of the net income of the new corporation each year shall be applied to amortize and pay off the bonds. The remaining forty percent (40%) can be placed in surplus or used for plant improvement.

It is my desire that Mr. Pease, Mr. Lingenfelter, Mr. Root and Mr. Jones shall each own fifteen percent (15%) of the stock of the new corporation and that Mr. Soper and Mr. Horr shall each own seven and one-half percent (7 1/2%) of the stock thereof.

The remaining twenty-five percent (25%) of the stock shall, if legally possible, be set up in trust for the benefit of the other employees of the new corporation and the dividends on this trusteed stock shall be paid once a year as a bonus, based upon the percentage of the total annual earnings of each employee, to those employees (exclusive of the six stockholders) who have been in the employ of the Company for the five years preceding the dividend payment. Upon a sale or liquidation of the trusteed stock the trust shall be terminated and said employees shall receive proportionate shares of the corpus determined herein provided for the dividend payments.

It is my wish, in the event anything should happen to me before this proposed sale takes place, that my executors and trustees in their sole discretion, if they deem it advisable, shall not place the Brownville Paper Company on the open market for sale to the highest bidder, but shall effect the liquidation and sale of said Company to the employees of the Company as above outlined.

It is my intention that this letter shall not be a mandatory requirement that my executors and trustees sell the Brownville Paper Company to the employees, but that the whole matter is entirely in the sole discretion of my executors and trustees, and their decision as to what is for the best interest of my estate shall be final and conclusive and shall not be subject to question.

Clark sent a similar letter to the Northern New York Trust Co. on February 21, 1938.

In July 1940 Upham conferred with the attorney for the corporation about the formulation of a plan whereby the business of the corporation could be carried on by the employees, and in 1941 it was decided that a portion of the stock should be retired. Part of the corporation's capital had been held for plant expansion, but, in view of the contraction of business and the contemplated liquidation of the corporation, the original plan for expansion was abandoned.

At a special meeting of the board of directors of the corporation, held on March 25, 1941, the following resolution was adopted:

Whereas, the owners and holders of all the common capital stock of this corporation have duly consented in writing that the corporation may purchase and retire two thousand (2,000) shares of its said capital stock at a price of not to exceed One Hundred Sixty Dollars ($ 160) per share, and each of said owners and holders has agreed to assign, transfer and convey to the corporation two-fifths of his or her holding of said stock, upon receipt of said purchase price of One Hundred Sixty Dollars ($ 160) per share; and

Whereas, the corporation can legally make such purchase of two thousand shares of its said stock from its excess current assets and it is for the best interests of the corporation that such purchase and retirement be made at this time;

Now, Therefore, Be It Resolved that this corporation purchase from each of its stockholders, at the price of One Hundred Sixty Dollars ($ 160) per share, two-fifths of the common capital stock of this corporation owned by each of its said stockholders, constituting a total of two thousand (2,000) shares, and that said stock be retired upon the delivery thereof.

Further Resolved that the proper officers of the corporation be and they hereby are authorized, directed and empowered to effect such purchase from each of said stockholders at the price aforesaid, to pay therefor upon delivery of the said stock, and to issue to each stockholder a new certificate or certificates for the remainder of the stock still owned by him or her.

On March 26, 1941, 2,000 shares of the capital stock were called in and the word "cancelled" was written across the face of the stock certificates, which were thereupon pasted in the stock book. Through an oversight on the part of either the officials or the attorney of the corporation, a certificate of reduction of the shares of capital stock was not filed with the Secretary of State of the State of New York until August 1944. The oversight was discovered in 1943 and steps were taken immediately to file the certificate. However, it was then discovered that the corporate charter, which was for a period of 50 years, had automatically expired and before the certificate of reduction of stock could be filed it was necessary to revive the corporation. Through circumstances beyond the control of the corporation, it was unable to file the certificate of reduction until August 8, 1944.

Under the reduction of the capital stock, as of March 26, 1941, 2,000 shares were retired, for which $ 320,000 was paid, and that amount was entered on the corporation's books as a credit to cash and a charge to capital stock. The capital stock was reduced by the amount of $ 320,000. Prior to the reduction of the capital stock the balance in the capital account was $ 1,009,902.13. After the reduction of the capital stock the balance in the capital account was $ 689,902.13. The corporation did not have sufficient cash to make the payment of $ 320,000 and, as a result, it sold securities out of its investment portfolio to obtain $ 320,000. Some of these securities were sold at a loss. As a result of the sale of the securities, the value of the corporation's investment portfolio was reduced from $ 352,163.82 to $ 26,975.69. Because of the war, there has been no further retirement of the stock of the corporation. The corporation's plan of ultimate liquidation has not been abandoned, but merely deferred.

The distribution of the stock dividend on January 5, 1921, was induced by sound business purposes. The capital stock of $ 100,000 as of December 31, 1920, was inadequate in view of the large increase of business which took place between 1913 and 1920. Net sales had increased from $ 271,488.82 in 1913 to $ 1,183,577.48 in 1920; net income before income taxes had increased from $ 8,479.15 in 1913 to $ 391,351.80 in 1920; accounts receivable had increased from $ 27,432.75 in 1913 to $ 126,721.09 in 1920; and inventories had increased from $ 43,608.93 in 1913 to $ 218,251.26 in 1920.

The following table shows the net income, surplus, and dividend payments of the corporation for the calendar years 1913 to 1941, inclusive:

	Surplus at			Surplus at
Year	beginning	Net income	Dividends paid	end of
	of year			year
1913	$ 134,350.57	$ 8,479.15	$ 6,000.00	$ 136,829.72
1914	136,829.72	6,323.94	5,250.00	137,816.83
1915	137,816.83	18,696.78	3,750.00	152,660.43
1916	152,660.43	163,049.31	34,000.00	281,508.96
1917	281,508.96	209,331.69	69,500.00	381,647.93
1918	381,647.93	176,803.39	21,500.00	629,747.49
1919	629,747.49	160,830.58	25,000.00	719,749.87
1920	719,749.87	391,351.80	60,000.00	910,663.32
1921	910,663.32	102,841.99	30,000.00	939,810.31
1922	939,810.31	196,220.04	120,000.00	92,791.66
1923	92,791.66	214,878.58	120,000.00	187,670.24
1924	187,670.24	192,761.03	140,000.00	211,712.27
1925	211,712.27	187,154.71	120,000.00	257,195.75
1926	257,195.75	222,238.70	170,000.00	282,025.84
1927	282,025.84	181,011.86	155,000.00	285,741.02
1928	285,741.02	171,644.60	107,500.00	323,966.70
1929	323,966.70	187,008.11	280,000.00	212,104.68
1930	212,104.68	110,070.54	75,500.00	234,009.53
1931	234,009.53	43,705.89	30,424.00	240,390.90
1932	240,390.90	(18,454.33)	19,351.80	202,584.77
1933	202,584.77	42,208.57	12,653.10	229,640.24
1934	229,640.24	73,703.82	stock 7,600.00	239,649.74
			47,234.00
1935	239,649.74	67,188.88	23,750.00	275,063.69
1936	275,063.69	70,156.86	48,000.00	288,022.71
1937	288,022.71	72,795.06	58,000.00	294,088.13
1938	294,088.13	524.41	33,750.00	260,862.54
1939	260,862.54	72,852.52	75,000.00	251,957.43
1940	251,957.43	88,453.03	53,500.00	265,586.38
1941	265,586.38	118,458.39	43,700.00	302,043.58
Total		3,532,289.90	1,995,962.90

Surplus Jan. 1, 1921	$ 910,663.32
Less depreciation adjustment	761.19
Transfer to capital stock	909,902.13

The stock ownership of the corporation has remained the same since March 26, 1941, except for two minor changes.

On his income tax return for the taxable year petitioner Samuel A. Upham treated the distribution made in March 1941 as a distribution in partial liquidation, subject to the provisions relating to a short term capital gain taxable at 100 percent of such gain.

Petitioner Samuel A. Upham paid the deficiency in tax of $ 84,139.92 on April 20, 1944. The estate of George F. Clark paid the deficiency in tax of $ 32,482.44 on May 11, 1944.

The distribution of $ 320,000 to the stockholders of the Brownville Paper Co. on March 26, 1941, was intended to be made and was made in retirement of 2,000 shares of the corporation's outstanding stock. The retirement of those shares served a sound business purpose in adjusting the corporation's capital to the current volume of business, which had been reduced considerably from that done in the period from 1920 to 1930. The distribution of $ 320,000 in the taxable year was a distribution in partial liquidation and was not a taxable dividend.

OPINION.

The question of whether a distribution in connection with the retirement of a portion of corporate stock is a taxable dividend or a distribution in partial liquidation depends upon the particular facts of each individual case. For this reason, most of the cases cited by both respondent and the petitioners are inapplicable, since they rest upon a combination of elements all of which are not present in this proceeding. As a result an extended discussion of these cases would not be helpful in the disposition of this case.

Although respondent argues that the cash distribution to petitioners in the taxable year constituted a taxable dividend under section 115 (a) and (b) of the Internal Revenue Code, his principal reliance is upon section 115 (g) of the code. The petitioners maintain that these subsections are inapplicable under the particular facts of the case, since in their view the distribution was in partial liquidation of their stock under the definition set forth in section 115 (i), with the gain from such distribution taxable under section 115 (c).

Section 115 governs distributions by corporations. A dividend is defined as "any distribution made by a corporation to its shareholders * * * (1) out of its earnings or profits accumulated after February 28, 1913, or (2) out of the earnings or profits of the taxable year (computed as of the close of the taxable year without diminution by reason of any distributions made during the taxable year), without regard to the amount of the earnings and profits at the time the distribution was made." Sec. 115 (a). Every distribution is presumed to be made out of earnings or profits to the extent thereof, and from the most recently accumulated earnings or profits. Sec. 115 (b). The pertinent portion of section 115 (c) provides that "amounts distributed in partial liquidation of a corporation shall be treated as in part or full payment in exchange for the stock." Section 115 (g) deals with redemption of stock and states that "If a corporation cancels or redeems its stock * * * at such time and in such manner as to make the distribution and cancellation or redemption in whole or in part essentially equivalent to the distribution of a taxable dividend, the amount so distributed * * * shall be treated as a taxable dividend." Section 115 (i) defines a partial liquidation as a "distribution by a corporation in complete cancellation or redemption of a part of its stock, or one of a series of distributions in complete cancellation or redemption of all or a portion of its stock."

Respondent apparently argues that the distributions were taxable to petitioner under section 115 (a) and (b) on the ground that there was not a complete cancellation or redemption of the company's stock so as to make the distribution a partial liquidation under the definition set forth in section 115 (i). Although admitting that 40 percent of the company's stock was called in and canceled, he contends that the stock was not completely canceled until August 8, 1944, when the certificate of reduction was filed with the Secretary of State of the State of New York. He argues that during the period from March 26, 1941, to August 8, 1944, the canceled stock was equivalent to treasury stock and could have been reissued by the company.

We have found as a fact that the shares acquired by the company during the taxable year were acquired for the purpose of their retirement. The evidence in the record completely supports that finding. Not only was there direct evidence to that effect from the company's officers and the company attorney, but the resolution of March 25, 1941, expressly provided that the stock be purchased and "retired upon the delivery thereof." In this respect, this proceeding is distinguishable from Alpers v. Commissioner, 126 Fed. (2d) 58, upon which respondent relies. In that case there was no evidence of any purpose on the part of the corporation to retire the shares which were purchased from the corporation's stockholder. Here the certificate of reduction was not filed until August 8, 1944, because of an oversight on the part of the company's officers. Approximately two years later the oversight was discovered and steps were immediately taken to file the certificate. Thereafter, due to unfortunate circumstances, the certificate could not be filed until August 8, 1944. However, the fact that the formal filing was delayed until that time did not confer a right of reissue upon the company. See Fry v. Helvering, 128 Fed. (2d) 737; distinguishing Alpers v. Commissioner, supra.

We think a fair construction of all the evidence warrants the conclusion that the Brownville Paper Co. did in fact completely redeem and cancel part of its stock in 1941. In that year it called in and canceled 2,000 shares or 40 percent of its total outstanding stock. It paid $ 160 per share or a total of $ 320,000, which it charged to its capital stock account. Petitioners contend that $ 160 was the fair market value of each share of stock at the date of the redemption, and respondent does not deny that fact. Under the circumstances, it is plain that the distribution falls within section 115 (c), unless the cancellation or redemption was essentially equivalent to the distribution of a taxable dividend within the meaning of section 115 (g).

In determining the applicability of section 115 (g), it is important to carefully examine the circumstances surrounding the transaction in order to ascertain the real purpose of the distribution. It is apparent that if the redemption was merely a step in a plan to distribute earnings and profits to stockholders or if it was designed for the benefit of stockholders, the time and manner of the distribution would be essentially equivalent to a taxable dividend. See Flanagan v. Helvering, 116 Fed. (2d) 937, and cases therein cited. However, if the redemption was dictated by the reasonable needs of the corporate business, section 115 (g) would not apply. Commissioner v. Champion, 78 Fed. (2d) 513; Commissioner v. Quackenbos, 78 Fed. (2d) 156; John P. Elton, 47 B. T. A. 111.

In this proceeding we think the retirement of part of the corporate shares in the taxable year served a sound business purpose. The two chief stockholders of the corporation were of advanced years and contemplated the liquidation of the corporation, with the plant to be sold to a new corporation to be formed by the employees. The business of the corporation had reached its peak in 1920, at the time when the shares of the stock were changed from par value to no par value and the stock dividend was paid. Prior to the issuance of the stock dividend as of December 31, 1920, the capital of the corporation consisted of 1,000 shares of the par value of $ 100 each, which was wholly inadequate for the volume of business being done by the corporation at that time. The book value of each share of stock in 1920 was over $ 1,000. The net sales, accounts receivable, and inventories in 1920 had increased over 400 percent from 1913. Net income had increased from $ 8,479.15 in 1913 to $ 391,351.80 in 1920. Under the circumstances, the issuance of the stock dividend as of December 31, 1920, was an exercise of reasonable business judgment on the part of the officers and directors of the corporation. Thereafter, the business of the corporation continued very good until 1931. In the 11-year period from 1920 to 1930, inclusive, the average annual net income of the corporation was $ 196,107.45. Presumably, the volume of business done in those years was in line with the capital of the company. However, after 1930 the business began to contract and in the 11-year period from 1931 to 1941, inclusive, the average annual net income was $ 57,417.55, or less than one-third of the previous period's average annual net income. Moreover, part of the capital of the corporation consisted of assets which were set aside for the extension of plant facilities, but in view of the contraction of business and the proposed ultimate liquidation of the corporation, the officers and directors decided to abandon the contemplated expansion. In that situation, there was a realization on the part of the officers and directors of the corporation that its capital was in excess of its needs, and to that extent unprofitable. We can not say, under these circumstances, that the decision of the corporation to retire part of its stock was unreasonable. Redemption under such conditions is not essentially equivalent to the distribution of a taxable dividend within the meaning of section 115 (g). Commissioner v. Champion, supra;Commissioner v. Cordingley, 78 Fed. (2d) 118; Commissioner v. Quackenbos, supra;John P. Elton, supra.Respondent's determination on this issue is reversed. Since petitioners claim refunds, accordingly,

Decisions will be entered under Rule 50.