Fink v. C.I.R.

• Decision Date: 30 April 1986
• Docket Number: No. 84-1806,84-1806
• Citation: 789 F.2d 427
• Parties: -1315, 54 USLW 2608, 86-1 USTC P 9385 Peter R. FINK; Karla S. Fink, Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.
• Court: U.S. Court of Appeals — Sixth Circuit

Page 427

789 F.2d 427

57 A.F.T.R.2d 86-1315, 54 USLW 2608, 86-1

USTC P 9385

Peter R. FINK; Karla S. Fink, Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.

No. 84-1806.

United States Court of Appeals Sixth Circuit.

Argued Oct. 25, 1985.

Decided April 30, 1986.

Mark K. Wilson Hill, Lewis, Adams, Goodrich & Tait, Detroit, Mich. Timothy John Smith, argued, for petitioners-appellants.

Fred T. Goldberg, Jr., Cheif Counsel, Robert P. Ruwe, Glenn L. Archer, Jr., Michael L. Paup, David Pincus, argued, Asst. Atty. Gen. Tax Div. Appellate Section Dept. of Justice, Washington, D.C., for respondent-appellee.

Before KRUPANSKY and MILBURN, Circuit Judges, and JOINER, Senior District Judge ^*.

MILBURN, Circuit Judge.

Peter R. Fink and Karla S. Fink ("taxpayers") appeal from a decision of the United States Tax Court determining deficiencies in taxpayers' federal income taxes for 1976 and 1977. The taxpayers claimed that their non-pro rata surrender of stock to the issuing corporation entitled them to an ordinary loss under section 165 of the Internal Revenue Code (the "Code"), 26 U.S.C. Sec. 165. The Tax Court held that a non-pro rata surrender of shares to the issuing corporation to improve its financial position is not an event that permits the recognition of loss and constitutes, instead, a contribution to the corporation's capital. For the reasons that follow, we reverse.

I.

Taxpayers were the principal stockholders of Travco Corporation. Throughout the 1970's, the largest part of Travco's business involved the manufacture and sale of motor homes, recreational vehicles, and their component parts. The energy crisis of 1973 and 1974 caused a decline in the market for motor homes and recreational vehicles, resulting in a decline in earnings and a weakening of Travco's financial condition.

At the time of the energy crisis and following, Travco enjoyed a line of credit with Manufacturers National Bank of Detroit of $3,000,000 to $3,400,000. Because of Travco's weakened financial condition, Manufacturers National became concerned about Travco's ability to repay its borrowings. During 1976 Manufacturers National put pressure for repayment upon Travco. Travco's attempts to obtain new capital were unsuccessful, and late in 1976 Travco entered into negotiations with a new lender, City National Bank of Detroit. As a condition of extending credit, City National required Travco to obtain $900,000 of new capital, $700,000 of equity and $200,000 of subordinated debt.

On December 22, 1976, Mr. Fink surrendered to Travco 116,146 shares of Travco's common stock having a total basis of $197,781.64. Mrs. Fink surrendered to Travco 80,000 shares of Travco common stock having a total basis of $191,257.61. No other shareholders surrendered any shares.

The purpose of the stock surrender was to improve Travco's financial position, to preserve its business, and to increase the attractiveness of the corporation to outside investors. The number of shares surrendered to the corporation was calculated to reduce the number of outstanding shares below 1.4 million and thus allow a new investor to acquire control of Travco by investing $700,000 in new $1.00 par value preferred stock convertible into 1.4 million shares of Travco common.

Prior to offering the new preferred stock to Travco's shareholders, Travco's directors passed a resolution authorizing the issuance of preferred stock to Mr. Fink, Mrs. Fink and Elise Fink (Mr. Fink's mother), if the other shareholders declined the offer. On February 25, 1977, after being unable to sell the stock to other persons, Travco sold $700,000 of its convertible preferred stock to Mr. and Mrs. Peter R. Fink and Elise M. Fink, and $200,000 of subordinated indebtedness to the same stockholders.

On their 1976 joint return, taxpayers claimed an ordinary loss of $197,781.64, representing the basis of the 116,146 shares of Travco stock surrendered by Mr. Fink. On their 1977 joint return, taxpayers claimed as a miscellaneous deduction an ordinary loss of $191,257.61, representing the basis of the 80,000 shares of Travco stock that Mrs. Fink surrendered to the corporation. The Commissioner disallowed the claimed deductions, and the Tax Court affirmed.

In the Tax Court, the taxpayers relied on a long line of cases, culminating in Smith v. Commissioner, 66 T.C. 622 (1976), rev'd sub nom. Schleppy v. Commissioner, 601 F.2d 196 (5th Cir.1979), holding that a shareholder's non-pro rata surrender of stock to the issuing corporation results in an immediate ordinary loss. Following the Fifth Circuit's reversal of Smith in Schleppy, the Tax Court, in Frantz v. Commissioner, 83 T.C. 162 (1984), aff'd, 784 F.2d 119 (2d Cir.1986), overruled its prior line of cases and held that a non-pro rata stock surrender should be treated as a non-deductible contribution to capital. In the instant case, the Tax Court held in favor of the Commissioner on the basis of Frantz.

II.

In Frantz, the taxpayer owned 65% of the common stock and 13% of the preferred stock of Andree Biallot, Ltd. ("ABL"). In an effort to attract outside investors, the taxpayer contributed to the corporation his ABL preferred stock and his notes and accounts receivable representing debts owed him by ABL. This transfer was made without a proportionate surrender by other stockholders. Taxpayer claimed an ordinary loss deduction in the amount of the basis in the stock. The Commissioner disallowed the loss, and the Tax Court affirmed. Frantz held that a non-pro rata surrender of shares to the issuing corporation to improve its financial position should be characterized as a contribution to capital resulting in the basis of the surrendered shares being added to the basis of the shares retained.

In Frantz the Tax Court determined the crucial question to be "whether the surrender constitutes a loss 'incurred in any transaction entered into for profit' within the meaning of section 165(c)(2)." 83 T.C. at 179. The Tax Court recognized that resolution of this issue required it to decide which of two competing views of stock ownership was applicable to this situation. Under the "fragmented view" of stock ownership each share of stock is considered a separate investment. A shareholder who surrenders shares to the issuing corporation is considered to have finally disposed of the particular shares surrendered. The surrender of the shares closes the transaction, and the shareholder is entitled to an immediate ordinary loss. See Frantz, 83 T.C. at 180. Under the "unitary view" of stock ownership the "stockholder's entire investment is viewed as a single indivisible property unit." Frantz, 83 T.C. at 188 (Parker, J., dissenting). The surrendering shareholder is recognized as having surrendered stock for the benefit of stock retained. The transaction remains open, and the surrendering shareholder must add the basis of the surrendered shares to the basis of the stock retained. Frantz, 83 T.C. at 180-81.

Frantz adopted the "unitary view" of stock ownership and concluded that the stock surrender did not constitute a loss event under section 165(c)(2) because there was no "closed transaction." According to Frantz, a non-pro rata stock surrender constitutes an open, non-taxable transaction in the nature of a capital contribution. Thus, whether the taxpayer suffered a recognizable loss could not be determined until there was a disposition of the retained shares. The Tax Court stated its decision as follows:

This conclusion ... necessarily follows from a recognition of the purpose of the transfer, that is to bolster the financial position of [the issuing corporation] and, hence, to protect and make more valuable petitioner's retained shares, and a consequent inability to fit the transaction within the statutory language authorizing a deduction for "losses incurred in any transaction entered into for profit."

83 T.C. at 181.

Relying on Schleppy, the Second Circuit affirmed the Tax Court's decision in Frantz. Frantz v. Commissioner, 784 F.2d 119 (2d Cir.1986). The court upheld treatment of the taxpayer's non-pro rata surrender as a non-deductible capital expenditure "[b]ecause the overall change in the taxpayer's interest in [the corporation] was miniscule compared with the taxpayer's retained interest in the company." Frantz, at 125. The court, however, cautioned that its holding "should not be construed as governing surrenders by a stockholder of more substantial equity interests that could truly be viewed as resulting in an immediate loss." Frantz, at 126.

Prior to Frantz, the Tax Court consistently held that non-pro rata stock surrenders gave rise to an immediate ordinary loss. See, e.g., Smith v. Commissioner, 66 T.C. 622, 650 (1976); rev'd sub nom. Schleppy v. Commissioner, 601 F.2d 196 (5th Cir.1979); J.K. Downer v. Commissioner, 48 T.C. 86, 91 (1967); Estate of Foster v. Commissioner, 9 T.C. 930, 934 (1947); Miller v. Commissioner, 45 B.T.A. 292, 299 (1941). In Foster the Tax Court stated the general rule that "when a stockholder surrenders part of his stock to improve the financial condition of the corporation he sustains a deductible loss, measured by the basis of the stock surrendered, less the resulting improvement in the value of the stock retained." 9 T.C. at 934. In Downer the Tax Court held that a taxpayer's transfer of a portion of his stock to an employee of the corporation for the purpose of inducing the employee to render services to the corporation resulted in an immediate deductible loss. 48 T.C. at 91. The decisions in Downer and Foster were premised on the "fragmented view" of stock ownership and both decisions explicitly refused to characterize the transfers as contributions to capital. Downer, 48 T.C. at 91; Foster, 9 T.C. at 934. In Smith the Tax Court reaffirmed its holdings in Foster and Downer. The Tax Court stated:

It is well established that where a stockholder of a corporation surrenders some of his stock...