Stiles v. Comm'r of Internal Revenue

• Citation: 69 T.C. 558
• Decision Date: 10 January 1978
• Docket Number: Docket No. 3886-76.
• Parties: FRED M. STILES and JEAN M. STILES, PETITIONERS v. COMMISSIONER of INTERNAL REVENUE, RESPONDENT
• Court: United States Tax Court

69 T.C. 558

FRED M. STILES and JEAN M. STILES, PETITIONERS

v.COMMISSIONER of INTERNAL REVENUE, RESPONDENT

Docket No. 3886-76.

United States Tax Court

Filed January 10, 1978.

Petitioner, a cash basis taxpayer, elected to report the gain from the redemption of his corporate stock on the installment method. Petitioner received 25 percent of the redemption price in cash. At the redeeming corporations' option, the remaining 75 percent was placed into a trust for his benefit. The trust funds were payable to petitioner over several years and were to secure the redeeming corporations against any breaches reasonably anticipated of certain warranties and representations made by petitioner. Held: Petitioner did not constructively receive the trust funds or receive the economic benefit thereof in the year of sale. Therefore, petitioner properly elected the installment method of accounting. Held, further, petitioner was bound by his election under sec. 453 and could not later elect a cost recovery method of accounting with respect to the redemption. John D. Colliander, for the petitioners.

John O. Tannenbaum, for the respondent.

OPINION

TIETJENS, Judge:

Respondent determined a deficiency of $193,910.67 in petitioners' Federal income taxes for 1972. The issues are whether the redemption of petitioners' corporate stock qualifies as an installment sale under section 453,¹ and, if so, whether petitioners can now change to a cost recovery method of accounting after electing to report under the installment method.

This case was fully stipulated pursuant to Rule 122, Tax Court Rules of Practice and Procedure. The stipulation of facts and attached exhibits are incorporated herein by reference.

When they filed their petition, petitioners resided in Hampton, N. H. Petitioners filed their joint Federal income tax return for 1972 with the Director of the Internal Revenue Service Center in Andover, Mass. Petitioners used the cash receipts and disbursements method of accounting for 1972.

Until 1972, petitioner Fred M. Stiles (hereafter referred to as petitioner) and Charles Rosen were the equal owners of four companies. Two of the companies, Plywood Ranch Industries, Inc. (PRI), and Fort Kent Fence Co., Inc. (Fort Kent), are corporations. The other two, Retailers Realty Trust (Retailers), and Hyway Realty Trust (Hyway), are Massachusetts business trusts. Apparently petitioners and respondent have agreed to treat the trusts as corporations for purposes of this case. Cf. sec. 301.7701-4(b), Proced. & Admin. Regs.

During 1972, petitioner and Rosen sued each other because of disputes over the operations of their companies. In settlement of those disputes, they entered into an agreement in which petitioner would sell his entire interest in the four companies to the companies themselves. Thus the companies effectively agreed to redeem petitioner's stock. See sec. 317(b). The agreement was executed on August 16, 1972, and provided for a total redemption price of $900,000 ($400,000 from PRI, $10,000 from Fort Kent, $440,000 from Retailers, and $50,000 from Hyway). Apparently some adjustments were later made because the total consideration is stipulated to be $845,000 ($405,000 from PRI and $440,000 from Retailers). It is also unclear whether any separate consideration was paid for petitioner's stock in Fort Kent and Hyway. We presume that although those companies were part of the entire redemption transaction, the tax consequences of the redemption of petitioner's stock in them is not at issue here.

The redemption agreement contains several warranties and representations, most of which are not pertinent to our decision. However, paragraphs 22 and 23 of the agreement are pertinent and provide as follows:

22. UNDISCLOSED LIABILITIES. STILES represents that he has no knowledge of any obligations or liabilities which are binding upon or which may be imposed upon any of the purchasers, or their subsidiaries, which he has not brought to their attention, nor does he have any knowledge of any defaults in agreements to which the purchasers or their subsidiaries are parties which he has not called to their attention.

23. UNDISCLOSED AGREEMENTS. STILES represents that he has not and will not prior to the closing enter into on behalf of any of the undersigned purchasers or their subsidiaries without their knowledge and consent any of the following types of agreement or policy: any employment agreement; any insurance policy; any lease; any purchase order; any sales order; any agreement which adversely affects them or their financial condition, property or operations; or any other agreement not (a) fully performed prior to June 30, 1972 or (b) cancellable upon not more than 30-day notice.

Any of the redeeming companies could, at its option, require that up to 75 percent of the redemption price be placed in trust to secure “against any breach reasonably anticipated of paragraphs 22 or 23.” The option was in fact exercised, and $635,000 (approximately 75 percent) of the total redemption price of $845,000 was placed in trust.

The trust was established by PRI and Retailers as settlors, and petitioner selected Malden Trust Co. as trustee for the account. The trust agreement directed the trustee to invest the trust funds in insured savings accounts and certificates of deposit and in bonds or tax-exempt securities rated Baa or better. All trust income was to be accumulated for petitioner and paid to him at the end of the term of the trust. The trust agreement also directed the trustee to distribute to petitioner $120,000 of principal each year from 1973 to 1977 and the balance on September 20, 1978.

In accordance with the redemption agreement, the trust agreement provided that the funds were placed in trust to secure and satisfy the redeeming corporations' obligations to petitioner and to secure the redeeming corporations' rights under paragraphs 22 and 23 of the redemption agreement. The trust agreement also explicitly provided for the manner in which the trustee should proceed in the event that the redeeming corporations filed a claim against the trust for breach of their rights under paragraph 22 or 23 of the redemption agreement:

TRUSTEE shall from time to time set aside under an account designated for the purposes stated and consisting of funds not distributable for the time being, the amount deemed by the TRUSTEE to be reasonably necessary to secure the SETTLOR or the CO-SETTLOR, or both, against any violation by any seller of the terms of Paragraph 22 or 23 of the (redemption) * * * agreement * * *, upon receipt by the TRUSTEE of an application by either SETTLOR or CO-SETTLOR for such segregation of funds, supported by affidavits of all those who are alleged to know facts material to such application, and by affidavit of the applicant's managing officer that diligent search has been made to obtain all evidence material to the application, and accompanied by copies of any documents alleged to have been executed in violation of the purchase agreement or which may be otherwise pertinent to the alleged violation.

TRUSTEE shall cause such investigation as it deems appropriate to be made of any such allegation of violation, and may in its discretion retain the fund set aside hereunder pending the final disposition of any litigation resting on the same allegation or allegations; or it may, if it deems proper, on its own motion, act as arbiter of the controversy arising from such allegation, or through an officer, as one member of a board of three arbiters, the other two to be named by the parties to the controversy. The expenses of any investigation, arbitration or other action required as a result of an application under this paragraph shall be borne by the unsuccessful party in the litigation or arbitration; and TRUSTEE may in its own discretion require a bond to be posted by the applicant to secure the TRUSTEE and the sellers (under said purchase agreement) against loss and damage arising from an application found to be without merit, and for expenses incurred in investigation, arbitration, and defense against such allegation or application. TRUSTEE shall also have the power to determine in its discretion that any such application is without merit and to decline to segregate funds to secure the claim as requested and to investigate or take other action to determine the merits of the subject matter; and the TRUSTEE's determination shall in such case be conclusive so far as the security remedy afforded by this trust is concerned.

Funds shall be set aside for purposes described in this Paragraph 4 only from principal in the trust fund. No part of the income of the trust fund shall be so used.

All income realized by the Trustee from the trust shall be accumulated for or distributed to Fred M. Stiles in accordance with the provisions of Paragraph 6 hereinbelow and of the appended Schedule therein referred to.

This was the redeeming corporations' only means of security. The trust funds could not be otherwise attached by the redeeming corporations.

No claims were in fact ever filed.

Petitioner is entitiled to borrow from the trust. The loans can be made only with the consent of the redeeming corporations and only to the extent necessary to defray petitioner's income tax liabilities with respect to the redemption. It is not clear from the trust agreement whether the loans could be made interest free. However, because the loans could be made only with the consent of the redeeming corporations, and because the trustee was under an obligation to earn income on the trust funds generally, we think that such loans could not be made interest free. Cf. Harvard College v. Amory, 9 Pick. 446, 461 (Mass. 1830). See generally 2 A. Scott, Trusts, sec. 181 (3d ed. 1967), and 3 A. Scott, Trusts, sec. 255 (3d ed. 1967). In any event, petitioner has not borrowed any moneys from the trust, nor are we aware of any attempt by the petitioner to do so.

Petitioners...