Davis v. United States
| Decision Date | 15 September 1967 |
| Docket Number | Civ. A. No. 4479. |
| Citation | 274 F. Supp. 466 |
| Court | U.S. District Court — Middle District of Tennessee |
| Parties | Maclin P. DAVIS and Edith U. Davis v. UNITED STATES of America. |
William Waller and Robert G. McCullough, Waller, Lansden, Dortch & Davis, Nashville, Tenn., for plaintiffs.
Gilbert Merritt, U. S. Atty., Nashville, Tenn., and H. Stennis Little, Dept. of Justice, Washington, D. C., for defendant.
This civil action was instituted by Maclin P. Davis1 (hereinafter the taxpayer) against the United States of America (hereinafter the government) for a refund of income taxes and interest paid in response to an assessment by the Internal Revenue Service. The controversy arises out of a redemption at par of certain shares of preferred stock owned by taxpayer which the Internal Revenue Service treated as a dividend distribution to which § 301 of the Internal Revenue Code applies. Taxpayer maintains that this distribution constituted a redemption "not essentially equivalent to a dividend" within the meaning of § 302(b) (1) and thus qualifies as a distribution "in exchange for the stock" under § 302(a). The cause is now before the court on the motions of both parties for summary judgment.
In April, 1945, taxpayer and E. B. Bradley organized the Tennessee Foundry and Machine Company (hereinafter the corporation) for the purpose of manufacturing steel castings. Prior to incorporation, taxpayer had entered into negotiations with the Reconstruction Finance Corporation (hereinafter the RFC) and the First American National Bank of Nashville, Tennessee, for the purpose of obtaining a $95,000 loan to the corporation. The prospective lenders agreed to make the loan if certain terms and conditions were met. The main prerequisite was that the incorporators provide the corporation with an additional $25,000 working capital either by making a loan evidenced by a subordinated deferred note or by purchasing preferred or additional common stock.
Bradley, who had received 50 percent of the common stock in exchange for property transferred to the corporation, was unable or unwilling to invest additional capital but insisted on retaining 50 percent of the voting power. Consequently, the only methods of raising this additional capital considered by taxpayer were purchasing preferred stock or taking subordinated debentures in exchange for a loan. Taxpayer decided the former was preferable, giving as his reason that this would be more desirable than an outright loan from a balance sheet standpoint. Taxpayer contends that the sole purpose of this transaction was to enable the corporation to obtain the RFC loan, and that all concerned were in agreement that this stock would be held only until the loan was repaid at which time it would be redeemed.
Upon approval of the loan application by the RFC, taxpayer purchased 1,000 shares of 6 percent preferred stock at par value of $25 per share as authorized by the charter of the corporation. Thus, as of the date of incorporation or shortly thereafter, the outstanding shares were held as follows:
Shareholder Common - % Preferred - %
E. B. Bradley 500 - 50
Maclin P. Davis 250 - 25 1,000 - 100
Edith U. Davis 250 - 25
Due to financial difficulties encountered by the corporation, the loan was refinanced in 1946. The principal was increased to $110,000 and the maturity date was extended.
In 1952, taxpayer purchased the 500 shares of common stock owned by Bradley and in 1959 he transferred 250 of these shares to his son, M. P. Davis, Jr., and 250 shares to his daughter, Edith D. Whiteman. Consequently, at the time of the redemption in question the ownership of the outstanding shares of the corporation was as follows:
Shareholder Common - % Preferred - %
Maclin P. Davis 250 - 25 1,000 - 100
Edith U. Davis 250 - 25
M. P. Davis, Jr. 250 - 25
Edith D. Whiteman 250 - 25
The original loan agreement provided that, as long as any part of the loan was outstanding, no dividends could be paid without first obtaining the prior written consent of the Bank and the RFC. In 1960, permission was granted to declare dividends on the outstanding stock. Consequently, semi-annual dividends in the amount of $750 were paid on the preferred stock beginning on October 5, 1960.
On September 23, 1963, after final payment on the loan had been made,2 the board of directors of the corporation resolved to redeem the preferred stock by accepting taxpayer's offer to transfer these shares in exchange for the sum of $25,000. On October 1, 1963, taxpayer surrendered the certificate representing the stock and was paid $25,000.
Taxpayer, characterizing the distribution as a return of capital, did not report this amount as income in his 1963 return on the theory that no gain had been realized because his basis in the preferred stock was equal to the amount received. After an audit, the Internal Revenue Service concluded that the amount received pursuant to the redemption constituted a distribution of property within the meaning of § 301 and thus was essentially equivalent to a dividend and taxable as ordinary income. Upon the Commissioner's denial of a claim for a refund, this action was commenced.
The general rule of § 301 is that a distribution by a corporation to a shareholder with respect to his stock is treated as a dividend to the extent of the corporation's earnings and is includable in the recipient's gross income, unless the distribution can be brought within an exception to this rule. The relevant exception here is found in the provisions of § 302 dealing with distributions in redemption of stock.
Under § 302(a), corporate redemptions are to be treated as distributions in part or full payment for the stock redeemed if the transaction comes within one of the four subdivisions of § 302(b). Section 302(b) (1) provides that a redemption which "is not essentially equivalent to a dividend" falls within the protective scope of § 302(a). Thus, if a redemption qualifies under § 302(b) (1), the distribution is treated as a payment in exchange for stock under § 302(a) with the result that it is not includable in gross income as a dividend and any amount realized on the redemption is entitled to capital gains treatment.
The determinative issue, therefore, is whether the amount received by taxpayer pursuant to the redemption in question is "essentially equivalent to a dividend" and thus taxable as ordinary income.
However, before the basic issue of dividend equivalency can be decided, the preliminary question of the bearing of the § 318(a) family attribution rules upon § 302(b) (1) must be resolved.
The government contends that the attribution rules are automatically applicable on the ground that § 302(c) (1) specifically provides that § 318(a) "shall apply in determining the ownership of stock for purposes of this section." If the attribution rules are applicable, taxpayer must be regarded as the constructive owner of all of the outstanding stock of the corporation and the redemption must be characterized as basically pro rata.
Taxpayer, in assuming a contrary position, reasons that the language of § 318 (a), which provides that it is applicable only to "those provisions of this subchapter to which the attribution rules * * * are expressly made applicable," precludes applicability to § 302(b) (1) because § 318(a) is relevant to § 302(b) only for the purpose of determining stock ownership and § 302(b) (1), unlike the other subdivisions of § 302(b), does not expressly refer to stock ownership, but rather speaks in terms of the effect of the redemption. Thus, it is argued that the "non-fact" of constructive ownership is not properly a part of the factual inquiry into the effect of the distribution required by § 302(b) (1).
Taxpayer further asserts that the legislative history of § 302(b) (1) also precludes automatic applicability of the attribution rules. In support of this contention, taxpayer argues that § 302(b) (1) was intended to incorporate existing law as to whether a redemption is essentially equivalent to a dividend3 and that under § 115(g) of the 1939 Code the ownership of the remaining stock was only one element in a primarily factual determination.
Although taxpayer's contentions are not without some persuasiveness,4 the court is of the opinion that the weight of authority supports the government's position that the attribution rules apply under § 302(b) (1). See, e. g., Commissioner of Internal Revenue v. Berenbaum, 369 F.2d 337 (10th Cir. 1966); Levin v. Commissioner, 47 T.C. 258 (1966); Bittker and Eustice, Federal Income Taxation of Corporations and Shareholders, 292 (2d ed. 1966). For the purpose of determining dividend equivalency, therefore, ownership of all of the outstanding common stock of the corporation is attributable to the taxpayer with the effect that the distribution was essentially pro rata. Consequently, corporate ownership cannot be regarded as affected in any substantial way by the transaction.
However, dividend equivalency does not necessarily follow from the court's conclusion that the attribution rules are applicable under § 302(b) (1).
While the words "not essentially equivalent to a dividend" are not further defined by Congress, it is clear that the intent of Congress in enacting § 302(b) (1) was that the "test for determining whether a redemption was `essentially equivalent to a dividend' should be the same as the test utilized in interpreting and applying the same words in § 115 (g) (1) of the 1939 Code." Kerr v. Commissioner of Internal Revenue, 326 F.2d 225, 230 (9th Cir. 1964). Some attention, therefore, must be given to the tests developed under the 19...
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United States v. Davis
...the Code. Taxpayer paid the resulting deficiency and brought this suit for a refund. The District Court ruled in his favor, 274 F.Supp. 466 (D.C.M.D. Tenn. 1967), and on appeal the Court of Appeals affirmed. 408 F.2d 1139 (C.A.6th Cir. 1969). The Court of Appeals held that the $25,000 recei......
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UNITED STATES V. DAVIS
...the Code. Taxpayer paid the resulting deficiency, and brought this suit for a refund. The District Court ruled in his favor, 274 F.Supp. 466 (D.C.M.D.Tenn.1967), and, on appeal, the Court of Appeals affirmed. 408 F.2d 1139 (C.A. 6th The Court of Appeals held that the ,000 received by taxpay......