Keller Street Development Co. v. C. I. R.

• Decision Date: 23 September 1982
• Docket Number: No. 81-7335,81-7335
• Citation: 688 F.2d 675
• Parties: 82-2 USTC P 9601 KELLER STREET DEVELOPMENT COMPANY, et al., Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.
• Court: U.S. Court of Appeals — Ninth Circuit

Page 675

688 F.2d 675

82-2 USTC P 9601

KELLER STREET DEVELOPMENT COMPANY, et al., Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.

No. 81-7335.

United States Court of Appeals Ninth Circuit.

Argued and Submitted March 3, 1982.

Decided Sept. 23, 1982.

Robert J. Lowe, Kindel & Anderson, Los Angeles, Cal., argued, for petitioners-appellants; John W. Armagost, Los Angeles, Cal., on brief.

Kenneth L. Greene, Washington, D.C., argued, for respondent-appellee; Ann Belanger Durney, Washington, D.C., on brief.

Appeal from the United States Tax Court.

Before HUG, TANG and PREGERSON, Circuit Judges.

HUG, Circuit Judge:

I

OVERVIEW

Keller Street Development Company ("Keller") appeals the Tax Court's decision that certain monies, received by Keller as a result of a sale of assets and subsequent litigation, are to be treated as ordinary income. Keller sold a brewery to Maier Brewing Company ("Maier") in 1958. The day after the sale, Keller's minority shareholders brought a derivative suit. After ten years of litigation in the California courts, a final judgment was issued, detailing the terms of sale the court deemed necessary to make the transaction fair to all parties. One element of the new terms ordered by the court was a $2,432,175.45 sum designed to compensate Keller for the fact that Maier was holding, and had the benefit of, the brewery assets for the ten years of litigation.

Keller treated that amount as an adjustment in the sales price, hence, a capital gain. The Commissioner issued a deficiency notice, contending the sum was a substitute for ordinary income and should be taxed as such. The Tax Court held for the Commissioner. Keller Street Development Co. v. Commissioner, T.C.M. (CCH) 1978-350 (1978).

The result reached by the Tax Court is correct. We believe, however, that we must reconcile the analysis used to reach that result with the teachings of the Supreme Court and the law of this circuit. It is necessary, therefore, to discuss in some detail the issues presented by this case.

II

BACKGROUND

On June 28, 1958, Paul Kalmanovitz, Keller's majority owner, resigned from its board of directors in order to present an offer from Maier, wholly owned by Kalmanovitz, to buy Keller's brewery assets. Keller had virtually no credit at that time, and was facing serious cash flow problems. See Efron v. Kalmanovitz, 226 Cal.App.2d 526, 38 Cal.Rptr. 148, 153 (1964). Its minority shareholders wished to liquidate the company assets and obtain a cash distribution. Kalmanovitz, on the other hand, wished to continue the operation of the brewery. See Keller v. Commissioner, T.C.M. (CCH) 1978-350, at pg. 1453. He sought to do so through the use of Maier.

Maier offered Keller $7,708,605.25 for the brewery. That amount was broken down to six million dollars for capital assets, and $1,708,605.25 for accounts receivable and inventory. ¹ The terms of payment called for $100,000 cash, $200,000 upon transfer of certain brewer's licenses, and $300,000 per year for five years. During those five years, no interest was to be accrued. After the fifth year, the remaining principal would accumulate interest at the prime rate charged by Los Angeles banks. The total balance owed was to be due in the tenth year. The Keller board accepted the offer, and it was approved by a majority of the shareholders on the same day. Id.

The following day, June 29, 1958, Keller's minority holders filed a derivative action seeking rescission, challenging the sale as fraudulent and unfair.

After ten years of litigation, including two trips to the California Court of Appeal, a final judgment was filed by the superior court, redesigning the sale in a manner deemed more fair to the minority holders. The court found that the fair capital asset price for the brewery in 1958 was four million dollars. It made no finding as to a fair deferred price, other than to label the 1958 sale contract unfair and constructive fraud. In short, the court found the following amounts and adjustments to be fair:

Sale Price Owed to Keller

(A) $1,761,193.49 accounts receivable and inventory.

(B) $365,000 other rent.

(C) $6,300,000 brewery assets.

Credits Allowed to Maier (reducing sale price)

(A) $3,000,000 in payments made on 1958 agreement.

(B) $2,000,000 for improvements in assets not reflected in fair market value.

In addition to adjusting the terms of the sale, the court wished to compensate Keller for the loss of the use of the brewery during the ten years that it took to resolve the legal conflict. Because significant capital improvements by Maier made impossible any tracing of the value earned by the assets transferred in 1958, the court decided to apply an interest rate to the 1958 fair market value of those assets. As a result, an additional sum was found owed to Keller in the amount of $2,432,175.45. That amount was designated by the court as "reasonable compensation-to (Keller) for the use by (Maier), of such transferred brewery assets during the period subsequent to June 29, 1958 and as a substitute for such product or profit."

In addition to its quantitative analysis of the asset sale, the court ordered new terms of payment: Keller received a $558,373.94 cash payment, with the balance owed payable in $400,000 yearly installments. The court set the interest rate at seven percent for the first two years, and gave the parties the right to renegotiate the rate for the following years.

The court also ordered Keller, Maier, and Kalmanovitz to purchase, for $55 per share, any Keller stock tendered to them by the minority holders. The minority holders also received a $500,000 attorneys' fees award.

At issue in the case before us is the tax treatment of the $2,432,175.45 payment received by Keller as a substitute for "product or profit." Keller treated it as an adjustment in the amount received from the sale of a capital asset, and hence, reported a capital gain. The Commissioner believed that the amount should have been treated as ordinary income, and prevailed in the Tax Court.

The Tax Court's analysis began with a preliminary determination that the origin of Keller's tax claim was the minority holders' suit for rescission. It then looked at the "nexus between the origin of the claim settled and the basis upon which settlement was reached." Keller v. Commissioner, at 1461. It concluded that "the nexus ... is that of a claim of rescission with the $2,432,175.45 payment made as a direct result of the rescission." Id. at 1462. Because the rescission payment was required in order to compensate Keller for the loss of use of the brewery, and the revenue received from such use would have been treated as ordinary income, the Tax Court decided that the substitute payment in rescission must also be treated as ordinary income. Id. at 1463.

III

DISCUSSION

A. Standard of Review

The Tax Court's factual findings and inferences must be affirmed unless they are clearly erroneous. Estate of Skaggs v. Commissioner, 672 F.2d 756, 757 (9th Cir. 1982) (per curiam). In its application of law to the facts, "we consider that the tax court has exercised that degree of special expertise which Congress has intended to provide in that tribunal, and that this court should not overrule that body, unless some unmistakable question of law mandates such a decision." Sibla v. Commissioner, 611 F.2d 1260, 1262 (9th Cir. 1980).

The focus of our discussion will be a question of law; that is, the Tax Court's definition and application of the "origin of the claim" test. ² Even if we conclude that the Tax Court erred in applying the test, however, we may still affirm its ultimate result on any basis supported by the record. See United States v. Washington, 641 F.2d 1368, 1371 (9th Cir. 1981), cert. denied, --- U.S. ----, 102 S.Ct. 1001, 71 L.Ed.2d 294 (1982) (district court's result).

B. Origin of the Claim

Characterization of a transaction for taxation is a two step process. The initial step is to discover the origin of the claim from which the tax dispute arose. This attribution determination is critical to proper tax characterization because of the inherently factual nature of taxation. Once a transaction is placed in its proper context, the nature of that transaction becomes discernible, and its tax character may be identified. Thus, the second step, the actual tax characterization, is dependent upon the proper resolution of the preliminary attribution question.

Attribution through the "origin of the claim" test was first explained by the Supreme Court in United States v. Gilmore, 372 U.S. 39, 83 S.Ct. 623, 9 L.Ed.2d 570 (1963), and its companion case, United States v. Patrick, 372 U.S. 53, 83 S.Ct. 618, 9 L.Ed.2d 580 (1963).

Gilmore involved divorce litigation. The main issue in the divorce proceedings was the disposition of the husband's controlling interests in three corporations. The husband argued that his "primary purpose" in so vigorously litigating the divorce was to protect his capital investment in the corporations. That purpose, he asserted, allowed him to deduct his litigation expenses as expenditures for the conservation of property held for the production of income. See Section 23(a)(2) of the Internal Revenue Code of 1939.

The Court of Claims allocated the litigation expense between personal and income preservation motives, allowing a deduction for 80 percent of the expense. Gilmore v. United States, 290 F.2d 942 (Ct. Cl. 1961). The Supreme Court reversed.

Relying on Lykes v. United States, 343 U.S. 118, 72 S.Ct. 585, 96 L.Ed. 791 (1952), the Court rejected the notion that the attribution process is based on the consequences to the taxpayer if he fails in his defense of a legal action. Gilmore, 372 U.S. at 43-44, 46-48, 83 S.Ct. at 627-28. In other words, the Court rejected the notion that attribution is a forward-looking process. It held instead that "the characterization, as 'business' or 'personal,' of the litigation costs of...