BALLOU CONST. CO. v. United States

• Decision Date: 04 August 1981
• Docket Number: No. 79-4138.,79-4138.
• Citation: 526 F. Supp. 403
• Parties: BALLOU CONSTRUCTION COMPANY, INC., as Transferee of Salina Sand Company, Inc., Plaintiff, v. UNITED STATES of America, Defendant.
• Court: U.S. District Court — District of Kansas

526 F. Supp. 403

BALLOU CONSTRUCTION COMPANY, INC., as Transferee of Salina Sand Company, Inc., Plaintiff, v. UNITED STATES of America, Defendant.

No. 79-4138.

United States District Court, D. Kansas.

August 4, 1981.

Tom W. Hampton of Hampton, Royce, Engleman & Nelson, Salina, Kan., for plaintiff.

G. Scott Nebergall, Trial Atty., Tax Division-Dept. of Justice, Washington, D. C., James P. Buchele, U. S. Atty., Topeka, Kan., Karen Humphreys, Topeka, Kan., Asst. U. S. Atty., for defendant.

MEMORANDUM AND ORDER

ROGERS, District Judge.

This is an action for the recovery of federal income taxes paid by Ballou Construction Company, Inc. hereinafter referred to as "Ballou", as the transferee of Salina Sand Company, Inc. hereinafter referred to as "Salina Sand", for the taxable period ended March 31, 1977. The facts are not in dispute and both parties have moved for summary judgment. Oral argument was had and the court is now prepared to rule.

FACTS

Salina Sand was organized under the laws of the State of Kansas in September, 1955. During the course of its existence, Salina Sand was engaged in the business of extracting, processing, and selling sand and gravel from various sand and gravel pits located in Saline County, Kansas. Salina Sand kept its books and filed its income tax returns on the basis of an accrual method of accounting, with a fiscal and taxable year beginning on July 1, and ending on June 30, except for its final fiscal period which began July 1, 1976, and ended March 31, 1977.

On March 1, 1977, the shareholders of Salina Sand entered into an agreement to sell all of their stock in the company for a purchase price of $750,000. The purchaser of the stock was the plaintiff, Ballou, also a Kansas corporation. Salina Sand remained in operation through March 31, 1977. On the following day, Salina Sand was liquidated and dissolved pursuant to section 332.¹ Pursuant to the plan of liquidation, Salina Sand transferred all of its assets to Ballou, effective March 31, 1977, and Salina Sand was thereupon dissolved in accordance with the laws of the State of Kansas. Salina Sand filed its final tax return for the period July 1, 1976, to March 31, 1977.

One of the assets owned by Salina Sand at the time of liquidation was identified as "Sand Deposit in Place." This asset represented the amount of sand which Salina Sand had processed through the first stage of mining,² but which had not yet produced income in the normal course of business. Under Salina Sand's method of accounting, the costs of removing overburden were deducted as they incurred; income however was not realized until the sand or gravel was sold.³

Upon liquidation, the asset "Sand Deposit in Place"⁴ was transferred to Ballou. Pursuant to section 334(b)(2), Ballou claimed a stepped-up basis in the assets received from Salina Sand by allocating the purchase price of the Salina Sand stock proportionately to the assets received based on their respective fair market value. The asset "Sand Deposit in Place" was allocated a basis of $100,000. Subsequently Ballou took business expense deductions totalling $100,000 as a part of the cost of goods sold, representing its utilization of the asset "Sand Deposit in Place."

In the examination of the final income tax return of Salina Sand, the Commissioner of Internal Revenue determined that Salina Sand had realized additional gross income in the amount of $20,000 for recovery of the costs of removing overburden which had been deducted by Salina Sand. In other words, the Commissioner decided that Salina Sand had deducted certain costs incurred in the acquisition of the sand and gravel in place but had not recognized any income on the disposition of such sand and gravel in place as a result of the liquidation and dissolution of Salina Sand. The Commissioner determined that such a "tax benefit" must be recognized by Salina Sand in its final tax period. Therefore, the Commissioner increased the taxable income of Salina Sand for its final taxable period by $20,000 and such adjustment in the taxable income resulted in a federal income tax deficiency of $9,600. The deficiency together with the interest thereon was subsequently paid by Ballou, as the transferee of Salina Sand, and this action was brought to recover such amount and interest.

DISCUSSION

The primary issue to be determined in this matter is whether the tax benefit rule should be applied in corporate liquidations governed by section 336. Section 336 provides:

Except as provided in section 453(d) relating to the disposition of installment obligations, no gain or loss shall be recognized to a corporation on the distribution of property in partial or complete liquidation. (emphasis supplied.)

The liquidation of Salina Sand was effected by distributing Salina Sand's assets to its sole shareholder, the plaintiff, in exchange for its stock, which was then retired. As to Salina Sand, the liquidation was thus governed by the general nonrecognition provisions of section 336.

The tax benefit rule provides that "if an amount deducted from gross income in one taxable year is recovered in a later year, the recovery is income in the later year." 1 Mertens, Law of Federal Income Taxation, § 7.34, at 111 (1974 ed.). The rule is of judicial origin. See Block v. Commissioner, 39 B.T.A. 338 (1939), aff'd sub nom., Union Trust Co. v. Commissioner, 111 F.2d 60 (7th Cir. 1940), cert. denied, 311 U.S. 658, 61 S.Ct. 12, 85 L.Ed. 421 (1940); Alice Phelan Sullivan Corp. v. United States, 381 F.2d 399 (Ct.Cl.1967). However, the rule has been indirectly sanctioned and acknowledged in section 111 of the Internal Revenue Code with respect to bad debts, prior taxes, and delinquency amounts. The Treasury Regulations on Income Tax have broadened the rule of § 111 to include "all other losses, expenditures, and accruals made the basis of deductions from gross income for prior taxable years...." Treas. Reg. § 1.111-1(a).

It is defendant's position that Salina Sand received a tax benefit because it deducted the costs of removing the overburden from the asset "Sand Deposit in Place" and did not recognize income on the disposition of such sand and gravel in place as a result of its subsequent liquidation and dissolution. Defendant contends that unless Salina Sand is required to recapture its prior deduction under the tax benefit rule, the cost of the asset will have been deducted twice, once by Salina Sand before any income was recognized from the property and once by Ballou as a portion of its costs of goods sold. Plaintiff argues primarily that the tax benefit rule should not be applied in the instant case because Salina Sand had no "recovery" of its expense deduction for the removal of overburden from the asset "Sand Deposit in Place" since it distributed its assets directly to Ballou and received nothing in exchange.

Plaintiff relies upon Commissioner v. South Lake Farms, Inc., 324 F.2d 837 (9th Cir. 1963), for support in this action. In that case, South Lake Farms, Inc., was engaged in farming. In 1956, it incurred certain expenses in planting and cultivating a cotton crop and in preparing land for the raising of barley. Prior to harvesting the cotton crop and planting the barley crop, the stock of the corporation was sold to another corporation in an arm's length transaction. After the sale of the stock, but prior to the harvesting of the cotton crop or the planting of the barley crop, the purchasing corporation liquidated its newly acquired subsidiary. On its final income tax return, South Lake Farms, Inc., deducted the expenses incurred in preparing the land for the barley crop and in raising the cotton crop. No income was reported, however, because unharvested crops could not be inventoried and the cotton crop was harvested after liquidation. Pursuant to section 334(b)(2), the assets received by the purchasing corporation on the liquidation acquired a basis equal to the purchase price of the stock. The Commissioner determined that both the unharvested cotton crop and the cost of preparing the land for the barley crop should be recognized as income to the liquidated corporation. In the Tax Court, the case was decided adversely to the Commissioner. Commissioner v. South Lake Farms, Inc., 36 T.C. 1027 (1961).

On appeal, the Commissioner raised for the first time the question of the applicability of the tax benefit rule. The Ninth Circuit Court of Appeals rejected the Commissioner's contention that the tax benefit rule should be applied and stated:

Essentially, the Commissioner's position is that the old corporation got a "tax benefit" by deducting these expenses, all of which had been incurred or paid before liquidation. Such deduction was proper when taken. The contention is that because the price of the stock of the old corporation, which was sold to the new corporation, was fixed in part on the basis of the value of the cotton crop, and of the preparation of the land for a barley crop, and because an actual allocation of a portion of that price was made to those items, for the purpose of fixing the new corporation's basis under section 334, the old corporation received an amount equivalent to, and sufficient to offset, the expenses that it had incurred, and hence was no longer entitled to the "tax benefit" of the deduction of those expenses.

One immediate difficulty with this contention is that the old corporation received nothing. It was the stock of the old corporation that was sold, and the stockholders who got the money. The price that they got was higher because of the values added to the old corporation's assets by the expenditures that were made in preparing the barley lands and in preparing, planting, and growing the cotton crop. No doubt they paid tax on the increased grain. Nowhere in the Code do we find an intent that gains of the stockholders were to be attributed to the corporation, much less that they were to be treated as ordinary income to the

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