284 F.2d 737 (4th Cir. 1960), 8059, Mountain State Steel Foundries, Inc. v. C.I.R.

Docket Nº:8059.
Citation:284 F.2d 737
Party Name:MOUNTAIN STATE STEEL FOUNDRIES, INC., Petitioner and Cross-Respondent, v. COMMISSIONER OF INTERNAL REVENUE, Respondent and Cross-Petitioner.
Case Date:November 07, 1960
Court:United States Courts of Appeals, Court of Appeals for the Fourth Circuit

Page 737

284 F.2d 737 (4th Cir. 1960)

MOUNTAIN STATE STEEL FOUNDRIES, INC., Petitioner and Cross-Respondent,


COMMISSIONER OF INTERNAL REVENUE, Respondent and Cross-Petitioner.

No. 8059.

United States Court of Appeals, Fourth Circuit.

November 7, 1960

Argued April 26, 1960.

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Joseph W. Kiernan, Washington, D.C. (Robert P. Smith, D. A. Baker, and Smith, Ristig & Smith, Washington, D.C., on brief), for petitioner and cross-respondent.

Harold M. Seidel, Atty., Dept. of Justice, Washington, D.C. (Howard A. Heffron, Acting Asst. Atty. Gen., and Lee A. Jackson and Harry Baum, Attys., Dept. of Justice, Washington, D.C., on brief), for respondent and cross-petitioner.

Arthur J. Goldberg, Gen. Counsel, Elliot Bredhoff, Assoc. Gen. Counsel, United Steelworkers of America, Carolyn E. Agger, Sheldon S. Cohen, and Stevenson, Paul, Rifkind, Wharton & Garrison, Washington. D.C., on brief, for United Steelworkers of America as amicus curiae.

Before SOBELOFF, Chief Judge, and SOPER and HAYNSWORTH, Circuit judges.

HAYNSWORTH, Circuit Judge.

Deficiencies of income tax for the fiscal years 1951-1954 were asserted against this corporate taxpayer upon (1) the disallowance of deductions for interest paid upon notes given in part payment of the purchase price of the stock of dissident stockholders upon the ground that the stock purchase agreement impaired the capital of the corporation and was invalid under state law, and (2) the assessment of the penalty tax of § 102 of the 1939 Code, 26 U.S.C.A. § 102 of the 1939 that by the redemption of the stock the corporation had been availed of for the purpose of avoiding surtaxes upon its remaining shareholders by accumulation of earnings. In an unreviewed decision, the single judge of the Tax Court sustained the commissioner upon both questions.

Since we are of the opinion there was no income tax deficiency, we do not consider the Tax Court's computation of the undistributed section 102 net income a computation with which both parties find fault.

The transaction which gave birth to these problems was consummated in an effort to resolve difficulties arising out of the death of a partner in an antecedent partnership. The story should start with the beginning.

Ben Miller and Harold F. Stratton, of Parkersburg, West Virginia, were the principal partners in a partnership engaged in manufacturing steel castings. Miller died in 1945, and his widow and two daughters then became owners of his fifty per cent interest in the partnership, the other fifty per cent interest being owned by Stratton, his sister and two nephews.

On July 1, 1947, the business was incorporated. Mountain State Steel Foundries, Inc., the taxpayer acquired all of the partnership assets in exchange for which it issued one thousand shares of its common stock, having a par value of $100 each, to the Millers 1 and a like number of shares to the Strattons. It assumed all of the partnership obligations.

The Millers were not happy with the situation. Except that Mrs. Miller was a member of the Board of Directors, they took no active part in the conduct of the business, but felt the need of larger and more certain income than prospective dividends would provide. The business is said to have been subject to wide fluctuations in earnings. Additionally, the Strattons, who were active in the business and derived income from it through salaries, were interested in expanding and improving the business and its fixed assets and in utilizing a portion of current earning in good years for that purpose.

This conflict in the interests of the stockholders led Mrs. Miller to demand that the business be sold. Stratton sought to find a purchaser for all of the stock or the corporate assets on a basis which would enable the stockholders to realize $1, 700, 000. Later, he reduced his asking price to $1, 500, 000. Some people

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were interested in the plant, but not at those prices.

In 1950, an accountant, who did work for the taxpayer and its stockholders, suggested to Mrs. Miller that the corporation might buy the Miller stock if she and her daughters would accept payment over a substantial number of years. Mrs. Miller thought well of the idea, and approached the Strattons about it. An agreement was then worked out for the corporation to purchase all of the Miller stock at a price of $450, 000, payable $50, 000 in cash and the balance, with interest at four per cent per annum, payable in level payments of $11, 000 each six months until April 1, 1977 and of $5, 000 each six months thereafter until April 1, 1994. 2

The corporation has met its maturing obligations under these notes. The interest increment of its payments during its fiscal years 1951-1954, respectively, was $11, 969.99, $15, 757.00, $15, 504.77 and $15, 242.37. On its income tax returns for those years it deducted those amounts as interest paid.

The Commissioner disallowed these deductions on the theory that the purchase of the stock impaired the capital of the corporation in violation of § 3051 (31-1-39) of the West Virginia Code of 1955 and that, because of that statute, the obligations with respect to which the interest was paid were unenforceable and invalid. He further imposed the § 102 tax on the theory that, since the Strattons might have bought the stock, had the Millers been willing to accept their personal obligations, and declared additional dividends to provide them with funds to meet their individual obligations, the corporate redemption of the Miller stock established, during each of the tax years, a use by the Strattons of the corporation for the avoidance of personal surtaxes by corporate accumulation of income.

After the Tax Court approved the Commissioner's theories on both aspects of the case, the taxpayer brought an action in the state court against the Millers seeking a declaratory judgment as to its obligations. This proceeding resulted in a decree of the Circuit Court of Wood County, West Virginia, in which it was held that the redemption of the stock did not impair the capital of the corporation within the meaning of § 3051 of the West Virginia Code and that the corporate notes were valid and enforceable. On the basis of this decree, the taxpayer sought leave to file a motion for further trial in the Tax Court. This was denied for lack of merit, apparently on the ground that the state court action was collusive or not really adversary. It does appear that the taxpayer's position in the state court action was that its officials believed the notes to be valid, binding obligations, but that no further payments would be made on them until the court determined and declared the rights and duties of the parties. Honestly, it hardly could have taken any other position.

The Interest Deduction

By statute, 3 West Virginia has authorized a corporation organized under her

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laws, other than a banking institution, to purchase, hold and sell shares of its own capital stock. There is a proviso, however, that funds and property of the corporation may not be used to purchase its own shares if the use would impair the capital of the corporation.

The Tax Court was apparently of the opinion that the net worth of the corporation should have been reduced by the full amount of the purchase price as soon as the repurchase agreement was entered into and that the question of impairment should be determined by reference to book figures without regard to the real value of the assets. The Circuit Court for Wood County, West Virginia, on the other hand, held that the real value of the assets, which it found to be substantially more than the book figures, was crucial under the statute. The Commissioner finds the entries in the books so authoritarian that he conceded on argument that if the taxpayer had written up the value of its fixed assets on the basis of an appraisal in line with the testimony in this case and in the state court proceeding, there would have been no capital impairment. He does not question the disparity between real and book values; to him, it is the failure to have recorded the real value on the books which occasioned the asserted impairment of the capital.

We think a determination of the substantive rights of creditors, stockholders and the corporation, in the application of this statute, should not be so circumscribed by managerial decision to make or withhold particular entries on the books or by the accounting procedures followed by management, procedures which may, or may not, have been realistic or enlightened. Write ups by appraisal are frequently suspect. As a practice they are now usually frowned upon. The suggestion is startling that such a ministerial act, which alters the real situation not in the least, could enlarge corporate power to purchase its stock.

When the legislature spoke of impairment of capital, we think it had a more objective standard than a computation which is the product of years of financial history of an enterprise. If write ups by appraisal be subject to criticism in the world of corporate finance, a blind acceptance of book values as real is much more vulnerable. An overstatement of assets because of a failure to charge off obsolescent equipment should not enlarge the power of the corporation to buy its stock, nor should an understatement because of appreciation in values and the decline in the worth of money restrict it.

Corporate power to purchase its own stock has been frequently abused. 4 Done by corporations conducting faltering businesses, it has been employed to create preferences to the detriment of creditors and of the other stockholders. It was to protect and preserve the margin of safety supplied by the real value...

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