Dunn v. C. I. R.

• Citation: 615 F.2d 578
• Decision Date: 30 January 1980
• Docket Number: D,No. 45,45
• Parties: 80-1 USTC P 9187 Herbert A. DUNN and Georgia E. Dunn, Appellees, v. COMMISSIONER OF INTERNAL REVENUE, Appellant. ocket 79-4038.
• Court: United States Courts of Appeals. United States Court of Appeals (2nd Circuit)

Page 578

615 F.2d 578

80-1 USTC P 9187

Herbert A. DUNN and Georgia E. Dunn, Appellees, v. COMMISSIONER OF INTERNAL REVENUE, Appellant.

No. 45, Docket 79-4038.

United States Court of Appeals Second Circuit.

Argued Oct. 4, 1979.

Decided Jan. 30, 1980.

Ernest J. Brown, Washington, D. C. (M. Carr Ferguson, Asst. Atty. Gen., Gilbert E. Andrews, William A. Friedlander, and Michael J. Roach, Attys., Tax Division, Dept. of Justice, Washington, D. C., of counsel), for the Commissioner, appellant.

Robert M. Tyle, Rochester, N. Y. (Kaufman, Kenning, Tyle & D'Amanda, Rochester, N. Y., of counsel), for appellees.

Before VAN GRAAFEILAND and KEARSE, Circuit Judges, and DOOLING, ^* District Judge.

DOOLING, District Judge:

The Commissioner appeals from a decision of the Tax Court (Theodore Tannenwald, Jr., Judge) holding that amounts received by appellee taxpayer, Georgia Dunn, ¹ in 1970 and 1971 from Bresee Chevrolet Co., Inc. ("Bresee") were received in complete redemption of all her stock in Bresee, and that immediately after the distribution she had no interest in Bresee as an officer, director, employee or otherwise, other than an interest as a creditor. In consequence, the Tax Court held, the amounts the taxpayer received were capital gains and not dividends, as the Commissioner contended.

When the redemption transaction was entered into the taxpayer owned 249 of the 500 shares of Bresee, her son William Dunn owned 149 shares and each of her married daughters owned 51 shares. In May 1970 taxpayer contracted to "sell or redeem from" Bresee her 249 shares of the company's stock for $335,154 payable $100,000 on June 1, 1970, and the balance with 5% interest over a period of ten years. Bresee redeemed the taxpayer's stock on the June 1, 1970, closing date; she was then paid the $100,000, and in 1971 was paid $45,260.34.

In general a corporation's distribution of money or any other property to a shareholder with respect to the corporation's stock is treated as a dividend to be included in the shareholder's gross income to the extent of the earnings and profits of the corporation. ² Code §§ 301(a), (c), 316(a), 317(a). However, basically a corporation's distribution in redemption ³ of its own stock is treated as in part or full "payment in exchange for the stock," taxable to the extent only of any capital gain. Code § 302(a). Section 302 treats redemptions as exchanges within Section 302(a) if they qualify under one of the four subsections of Section 302(b): the subsection under which the taxpayer's transaction has been held to qualify is subsection (b)(3) which provides

(3) Termination of shareholder's interest

Subsection (a) shall apply if the redemption is in complete redemption of all of the stock of the corporation owned by the shareholder.

And Section 302(a) applies, ⁴ through Section 302(b)(3), when, as Section 302(c)(2)(A)(i) requires (i) immediately after the distribution the distributee has no interest in the corporation (including an interest as officer, director, or employee), other than an interest as a creditor . . . .

Thus, if after the redemption the taxpayer retained an interest in Bresee other than as a creditor, the 1970 and 1971 payments to her would be treated as taxable dividends to the extent of Bresee's earnings. Code § 302(d).

I

Bresee had been established by taxpayer's father, and taxpayer acquired the stock from her father by inheritance, apparently in 1936. Bresee was the largest Chevrolet dealer between Buffalo and Albany. The appellee Herbert A. Dunn was never a director or stockholder of Bresee; he had been in the automobile business since 1925 essentially as a salesman, and he had been general manager and for a time, until 1951, president of Bresee. In about 1951, however, taxpayer's son William B. Dunn became president of Bresee, and, at about the same time, apparently with the encouragement of General Motors Corporation ("GM"), the grantor of the Bresee franchise, the taxpayer transferred 125 shares of her stock to her son, and, following that, made yearly gifts of stock to her three children until they owned a majority of the stock.

There was testimony that GM wanted William Dunn to own a majority of the stock. By 1970 appellee Herbert Dunn was seventy-seven years old and taxpayer was seventy-three. The taxpayer wished to spend most of her time in Florida, and she did not want to have any business responsibilities. Appellee Herbert Dunn, while continuing as a salesman with Bresee, also planned to spend part of each winter in Florida.

Judge Tannenwald found on ample evidence that the taxpayer wished to dispose of her stock because she had been advised that it created a liquidity problem from an estate planning point of view, and because she and her husband wanted additional income, as they advanced in age, and Bresee had not paid any dividends except in one year. In the negotiations between the taxpayer and Bresee each party was represented by separate counsel.

Such were the general circumstances when the taxpayer entered into the May 27, 1970, Stock Purchase Agreement (the "Agreement") with Bresee. In the Agreement the taxpayer agreed to sell or redeem from Bresee, and Bresee agreed to purchase or redeem from the taxpayer the 249 shares of the capital stock of Bresee that she owned for $335,154, to be paid $100,000 on June 1, 1970, and the balance by Bresee's executing and delivering, payable to the taxpayer, a promissory note in the amount of $235,154 with interest at 5% a year; the note was payable $55,154 and one year's interest on June 1, 1971, and the balance in ten installments of $23,311.80 payable on June 1 of each year through 1981. The Agreement recited that Bresee operated as a Chevrolet franchise subject to all of the terms of the franchise agreement with GM, and that among the franchise terms was one requiring Bresee to maintain a certain "Owned Net Working Capital" in order to retain the dealership. The Stock Purchase Agreement stated that the parties understood that the Owned Net Working Capital requirement would prohibit Bresee's paying any principal or interest under the Agreement if payment would reduce Owned Net Working Capital to an amount less than required by the franchise agreement or unless payment permitted the dealer to retain at least 50% of net after tax profits to be added to surplus. It was then agreed, with respect to payment of principal or interest under the Agreement, or on the accompanying ten year promissory note, that

. . . if . . . the making of any payment thereunder would result in a violation of both said requirements, then and in such event, the due date of such payment or the part thereof which would result in such violation, shall be postponed until such date as when said payments or a part thereof can be made and still meet either the requirement in regard to "Owned Net Working Capital" or the requirement in regard to retention of 50% of net profits after taxes.

On June 1, 1970, Bresee redeemed all 249 of taxpayer's shares and paid taxpayer $100,000. After the redemption the taxpayer was not an officer, director, or employee of Bresee and through the date of trial had not acquired any stock in Bresee. After the redemption Bresee had 221 shares of stock outstanding, 143 of which were owned by William Dunn; each of his two married sisters owned 39 shares.

Thereafter, in a new "Minimum Capital Standard Agreement" in effect for a year from November 1, 1970, between Bresee and GM it was agreed that the Minimum Owned Net Working Capital required by Bresee was $736,266, that Bresee had established or would at once establish its actual owned net working capital at $329,569, and that until Bresee's actual owned net working capital equalled the minimum, Bresee would retain 75% of its after tax net profits in the business. The GM agreement provided that

. . . to arrive at a dealer's actual owned net working capital at any given time, that is the net working capital available to the dealership which has been supplied by investment and earnings, all current asset reserves and all liabilities should be deducted from the total current assets . . . . Obligations secured by a mortgage on land and buildings used in the Dealership Operations are not deducted from total assets in determining actual owned net working capital. (Emphasis in original.)

The mortgage exception was put on the ground that dealers were not required to own the dealership premises, so that an equity in them represented a use of funds that would otherwise be available for working capital purposes.

On June 1, 1971, Bresee's financial condition was such that payment of the $55,154 and interest would have violated the GM Minimum Capital Standard Agreement, and, accordingly, the payments were in part "postponed" under the above quoted terms of the Stock Purchase Agreement. The taxpayer received only $45,260.34 in principal, and she received no interest in June 1971. The balance of the principal payment due on June 1, 1971, was paid in June 1972, and the interest of $11,757.70 due on June 1, 1971, was paid in September 1974. After June 1, 1971, no payments on principal were either timely made or made during the taxable year when due. Payments of $23,311.80, the agreed annual payment amount, were made about a year or more late, on June 18, 1973, May 29, 1974, October 15, 1975, and July 27, 1976. At the time each payment was made, Bresee was in violation of the Minimum Capital Standard Agreement, although its net working capital was increasing each year.

While GM was not advised of each payment as it was made, it did receive monthly balance sheets and profit and loss statements; it did not object to Bresee's payments to the taxpayer. There was testimony, but Judge Tannenwald made no finding on this point, that before the redemption transaction Bresee never met the working capital requirement.

The "Termination of shareholder's interest" provision Section 302(b)(3), which...