Paparo v. Comm'r of Internal Revenue , Docket Nos. 4580-74
| Citation | 71 T.C. 692 |
| Decision Date | 29 January 1979 |
| Docket Number | 4581-74.,Docket Nos. 4580-74 |
| Parties | JACK PAPARO, INDIVIDUALLY and AS SURVIVING SPOUSE of KATHERINE PAPARO, DECEASED, PETITIONERS v. COMMISSIONER of INTERNAL REVENUE, RESPONDENTIRVING PAPARO and RENEE PAPARO, PETITIONERS v. COMMISSIONER of INTERNAL REVENUE, RESPONDENT |
| Court | United States Tax Court |
OPINION TEXT STARTS HERE
Petitioners sought to treat amounts distributed in redemption of their stock in related corporations as distributions in full payment in exchange for their stock under sec. 302(a), I.R.C. 1954. Held, the redemption of such stock from petitioners was “essentially equivalent to a dividend” treated as distributions of property to which sec. 301 applied. United States v. Davis, 397 U.S. 301 (1970). Laurence Goldfein and Arnold B. Panzer, for the petitioners.
Michael A. Menillo, for the respondent.
In these consolidated cases, respondent has determined the following deficiencies:
The sole issue for our decision is whether the amounts which Jack Paparo and Irving Paparo received in 1970 and 1971 from House of Ronnie, Inc., in exchange for their stock in Nashville Textile Corp. and Jasper Textile Corp., are taxable as capital gains under section 302,1 or as dividends under section 301.
Some of the facts have been stipulated and are so found.
Petitioner Jack Paparo (Jack) filed joint Federal income tax returns with his wife, Katherine Paparo (deceased 1971), for the years 1970 and 1971 with the District Director, Brooklyn, N.Y. He resided in Brooklyn, N.Y., at the time his petition herein was filed.
Petitioners Irving Paparo (Irving) and Renee Paparo2 are husband and wife and filed joint Federal income tax returns for the years at issue with the District Director, Brooklyn, N.Y. At the time they filed their petition herein, they resided in North Woodmere, N.Y.
Therefore, subsequent to this public offering, Jack owned directly and constructively 81.17 percent of the stock of House of Ronnie and Irving owned directly and constructively 74.15 percent of the stock of House of Ronnie. 7
House of Ronnie, Inc. (House of Ronnie), is a corporation incorporated in 1964 under the laws of the State of New York. During the years at issue, Jack was chairman of the board of directors and his son, Irving, was president and a director of that corporation. The equity capital of House of Ronnie consists of a single class of voting common stock which, from the date of its incorporation until July 1, 1969, was held 50 percent by Jack and 50 percent by Irving.
On July 1, 1969, Jack established an irrevocable trust to which he contributed 25 percent of his stock in House of Ronnie. The trust's beneficiaries were the settlor's spouse, Katherine, daughter Beatrice Rappaport (Beatrice), and son Irving, with the latter two individuals designated as trustees. At the same time, Irving established three identical trusts for the benefit of each of his three sons, Jack Paparo, Harvey Paparo, and Russ Paparo. Each trust corpus consisted of 8 shares of House of Ronnie stock which, in the aggregate, amounted to 12 percent of Irving's stock interest in House of Ronnie. Beatrice and Stanley Rappaport were the designated trustees of each trust.
The transfer of the House of Ronnie stock by Jack and Irving to their respective trusts resulted in Jack directly and constructively owning all of the outstanding stock of House of Ronnie and Irving directly and constructively owning 912;3 percent of the stock of House of Ronnie.3
Prior to 1971, House of Ronnie engaged in the business of designing and marketing women's clothes, all of which were fabricated by two captive suppliers, Nashville Textile Corp. (Nashville) and Jasper Textile Corp. (Jasper). These corporations were formed in the southeast during the respective years of 1964 and 1968 to ensure a stable inventory supply and a reduced labor cost. From the date of their incorporation until March 30, 1970, the outstanding common stock of both Nashville and Jasper was held by Jack Paparo, Irving Paparo, and Stanley Rappaport, in the respective amounts of 39, 39, and 22 percent. Stanley Rappaport (Stanley) is the son-in-law of Jack and brother-in-law of Irving. Since 1967, Stanley's occupation has been that of vice president and director of House of Ronnie.
The total shareholders' capital contribution to each corporation was $10,000, contributed by Jack and Irving. In addition to the capital contributed, Jack and Irving each personally guaranteed Nashville's long-term lease of its plant and equipment from the Development Authority of Nashville, Ga. Stanley contributed no capital to either Nashville or jasper.
The stock of these corporations was issued to Stanley for business reasons, albeit Jack and Irving considered the issuance as essentially a gift to Beatrice.4 In addition, Jack and Irving made all the management decisions concerning the activities of Nashville and Jasper. Jack, Irving, and effect until the sale of Nashville and Jasper to House of Ronnie in March 1970. These agreements provided, in relevant part:
The parties hereto agree to vote their shares so as to provide for the employment by the corporation of JACK, IRVING and STANLEY each under two year contracts, renewable thereafter from year to year and so long as each remains a stockholder of the corporation, at salaries to be determined in the sole discretion of JACK & IRVING. Such Contracts shall require that each employee devote such time and efforts to the business of the corporation as JACK and IRVING may determine. It is the understanding of the parties that so long as JACK and IRVING are stockholders of the corporation, all corporate acts shall require their unanimous assent and STANLEY agrees to vote his stock in the corporation according to the joint direction of JACK and IRVING. (Emphasis supplied.)
Serious problems began to develop after the establishment of Nashville and Jasper that affected House of Ronnie. As a marketing corporation, House of Ronnie owed its principal success to Irving. For example, Irving accounted for approximately 75 percent of the sales generated in 1969. The remainder of the sales were made by a company salesman and a manufacturer's representative. Once the two southeastern plants began operations, Irving devoted more time to production planning and less time to sales development. Jack and Irving recognized the pernicious effect that this would have on total sales, so they decided to shift Irving's marketing responsibilities to an independent sales organization.
Irving approached a successful sales organization, I. Amsterdam & Co. (I. Amsterdam), which acted as a manufacturer's representative specializing in women's apparel. I. Amsterdam was owned by Messrs. Aaron, Amsterdam, Perlman, and Schneider, and they also collectively owned 80 percent of the stock of Denise Lingerie Co. (Denise), a corporation producing women's apparel.
It was Irving's idea that if House of Ronnie could acquire Denise in exchange for its stock, House of Ronnie would gain not only Denise's manufacturing facilities but also an increased sales effort on the part of I. Amsterdam. This would be accomplished by giving the concerned shareholders of Denise an equity interest in the combined enterprise. Moreover, shareholders Aaron, Amsterdam, Perlman, and Schneider were dissatisfied with the financial performance of Denise and were interested in the possibility of an offer of acquisition from House of Ronnie.
Negotiations ensued for the acquisition of Denise by House of Ronnie in the early part of 1969. Perlman, acting for the other Denise shareholders, informed Irving that the acquisition proposal was appealing but that the Denise shareholders would not consider accepting stock in a privately held corporation in exchange for their shares. It was at this juncture in the negotiations that Irving took steps which resulted in House of Ronnie's initial stock offering to the public.
After discussions with several underwriters, the proposal of Smith, Jackson & Co., an underwriting firm specializing in new issues, was accepted. Steven Smith (Smith) was the partner of this firm actively engaged in the underwriting. He proposed, inter alia, that Nashville and Jasper be combined with House of Ronnie as a condition of the offering. Smith's primary reason for insisting that the manufacturing companies be combined with House of Ronnie was that the market for new stock issues in the garment industry was interested in companies that represented combined marketing and manufacturing operations. In addition, Smith believed that a potential conflict of interest would exist if Nashville and Jasper remained under separate ownership.5
To comply with the underwriter's recommendation, a contract was entered into by Jack, Irving, and Stanley during January 1970. It provided, inter alia, that they would sell all of their stock in Nashville and Jasper to House of Ronnie for a total of $800,000. The contract also stated that an effective registration statement for the House of...
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