Baumer v. U.S.

• Decision Date: 25 September 1978
• Docket Number: EIGHTY-EIGHT,Nos. 76-3187,s. 76-3187
• Citation: 580 F.2d 863
• Parties: 78-2 USTC P 9725 Erwin G. BAUMER and Clara S. Baumer, Plaintiffs-Appellees, Cross-Appellants, v. UNITED STATES of America, Defendant-Appellant. SEVENGREENWOOD AVENUE CORPORATION, Plaintiff-Appellee, v. UNITED STATES of America, Defendant-Appellant. to 76-3189.
• Court: U.S. Court of Appeals — Fifth Circuit

Page 863

580 F.2d 863

78-2 USTC P 9725

Erwin G. BAUMER and Clara S. Baumer, Plaintiffs-Appellees, Cross-Appellants, v. UNITED STATES of America, Defendant-Appellant.

SEVEN EIGHTY-EIGHT GREENWOOD AVENUE CORPORATION, Plaintiff-Appellee, v. UNITED STATES of America, Defendant-Appellant.

Nos. 76-3187 to 76-3189.

United States Court of Appeals, Fifth Circuit.

Sept. 25, 1978.

John W. Stokes, U. S. Atty., Atlanta, Ga., Gilbert E. Andrews, Act. Chief, Appellate Sect., Dept. of Justice, Washington, D. C., John A. Townsend, Myron C. Baum, Acting Asst. Atty. Gen., Gary R. Allen, Francis J. Gould, Attys., Tax Div., Dept. of Justice, Washington, D. C., for defendant-appellant.

Alex P. Gaines, Robert H. Hishon, Atlanta, Ga., for plaintiffs-appellees.

Appeals from the United States District Court for the Northern District of Georgia.

Before WISDOM, GOLDBERG and RUBIN, Circuit Judges.

GOLDBERG, Circuit Judge:

This appeal presents a novel variation of the recurrent problem of determining the tax consequences of transactions between closely held corporations and their shareholders. Here a corporation granted an option to purchase a one-half interest in a parcel of real estate to the son of the corporation's sole shareholder for nominal consideration. In the proceedings below, the district court held that the grant of this option resulted in a constructive dividend from the corporation to the father, measured by the ascertainable value of the option.

The government argues on appeal that the option was simply a device for shifting to the son half of the corporation's gain on the subsequent sale of the property to a third party purchaser. Accordingly, for federal tax purposes the option itself should be ignored and the transaction treated as a sale of the entire property by the corporation to the ultimate purchaser accompanied by the distribution of a constructive dividend to the father. The government contends that the value of this dividend should be the difference between the price paid by the son to exercise the option (the "exercise price") and the actual fair market value of the property interest acquired by the son. In the alternative, the government argues that even if the district court correctly held that no tax is owed by the corporation and that the grant of the option, rather than the sale of the property to son, gave rise to the constructive dividend to the father, the court erred in its valuation of the benefit conferred by the option.

The father, son, and corporation ("taxpayers") cross appeal from the judgment of the district court. They maintain that the option was granted to the son in an arm's-length transaction and that the district court erred in treating the option as a constructive dividend by the corporation to the father.

We find that the record supports the district court's conclusion that the grant of the option constituted neither an arm's-length transaction, on the one hand, nor an illusory event designed to shift the corporation's gain on the ultimate sale of the property to the son on the other. On these issues we affirm the decision of the district court. However, treating the grant of the option itself as a constructive dividend, we substantially agree with the government that the district court erred in its valuation of the benefit conferred on the son. We therefore remand the actions involving the son and the father for redetermination of the value of the constructive dividend.

I. The Transaction

The facts of this case are largely undisputed, although the proper characterization of these facts is far from clear. Taxpayer Erwin G. Baumer ("Father") is the father of taxpayer Erwin H. Baumer ("Son"), and, during the period in question, was the sole shareholder of taxpayer Seven Eighty-Eight Greenwood Avenue Corporation ("Corporation"), a Georgia corporation which owned and leased real estate in the Atlanta, Georgia area. ¹ Son is a real estate attorney. In early 1965, Son became interested in purchasing a parcel of residential property on Piedmont Road in Atlanta. In November, 1965, Son was offered the Piedmont property for $175,000. Father, who was knowledgeable about property in the area, advised Son not to accept the offer. ² Son followed this advice.

Shortly thereafter, in January, 1966, Father was advised that an attractive investment property on Piedmont Road was for sale. This turned out to be the same property that Son had been interested in just a few months earlier. Corporation accepted an offer to purchase the property for $174,000 in late January, 1966. The property was then zoned for residential use.

The district court found that the value of the Piedmont property for residential use was somewhat less than $175,000, but noted that at the time of the purchase, the neighborhood was ripe for transition to commercial use. While the court could not determine whether the actual fair market value of the property was in excess of $175,000, it did find that the realization of any potential value in excess of $175,000 depended upon favorable rezoning to commercial uses.

When Father informed Son of this transaction, Son requested that the Corporation sell him an interest in the property. Father agreed, and the Board of Directors authorized Corporation to sell Son a one-half interest in the property. Father testified that he made this offer because he had originally advised Son against purchasing what Father later considered to be an attractive investment property. Subsequently, the proposed transaction was modified and a written option was executed by Corporation and accepted by Son in early May, 1966. The exercise price of the option for purchase of a one-half interest in the property was set at $88,000, approximately one-half interest of the corporation's cost basis, plus 51/2 percent interest calculated from the effective date of the option, February 7, 1966. ³ The stated term of the option was one year from the effective date. The option was exercisable immediately and without conditions, and the option privilege was assignable by Son. The stated consideration for the option privilege was $10.00, which Son did not recall actually paying.

The district court found that Father and Son intended to use the Piedmont property to develop a motel. Son, who had substantial legal experience in zoning matters, began investigating the possibility of rezoning the property for commercial use. Upon discovering that the property could not be rezoned unless sewer services were provided, Son located an adjacent parcel of real estate on Old Ivy Road which had access to sewer facilities. According to the district court's findings, Son's efforts were inspired by the fact that "he considered that he had an interest in the property." In August, 1966, Corporation purchased the Old Ivy property for $25,000.

Because of this purchase, the combined properties became eligible for rezoning to a commercial classification. Consequently, the value of the Piedmont property was substantially increased. On January 12, 1967, approximately one month prior to the termination of the original options, the corporation granted Son an amended option which covered both the Piedmont and Old Ivy properties; set a new exercise price of $100,000, approximately one-half of Corporation's purchase price for the two properties, plus 51/2 percent interest; and extended the period during which the option could be exercised until June 30, 1969. The amendment further provided that the option privilege was assignable by Son. The stated consideration for these modifications was $10.00, which Son did not recall having paid.

In January 1967, Pope & Carter Co., Inc. ("Pope & Carter"), an Atlanta real estate brokerage company, informed Father that it was interested in purchasing the Piedmont-Old Ivy property. After negotiations participated in by Father, Son, and Pope & Carter, Corporation granted Pope & Carter an option to purchase the combined properties. This option, which took effect on January 25, provided in relevant part that: (1) Pope & Carter was required to expend reasonable time and effort to obtain favorable C-1 zoning, which would permit motel use; (2) the option would remain open for six months without the payment of a cash consideration and could be extended for up to six additional months by paying Corporation $3,000 per month; (3) the option purchase price was $500,000; (4) any option extension payments were to be applied against the purchase price; and (5) the option was assignable. Pope & Carter was aware of Son's interest in the property when it negotiated this option.

Pursuant to its obligations under the option, Pope & Carter expended substantial time and money to obtain the desired zoning. The results were encouraging and beginning in July, 1967, Pope & Carter exercised its right to purchase monthly extensions on its option. At the end of the one year option period, the Pope & Carter option was extended from January 24, 1968 through April 24, 1968 for a consideration of $1,000 per month. From April 24, 1968 through December 27, 1968, additional extensions were granted for the nominal consideration of $1 per month "in view of the impending favorable zoning action."

On December 4, 1968, Pope & Carter's rezoning application was approved, ⁴ with certain conditions, with respect to the Piedmont property. The Old Ivy property was not rezoned. Two days later, Son exercised his amended option on the Piedmont-Old Ivy properties. On December 18, Son purchased a one-half undivided interest in the properties and tendered to Corporation a note for $114,501.23, bearing interest at 61/2 percent. Nine days later, on December 27, Pope & Carter exercised its option to purchase the properties. The district court found that the fair market value of the properties at that time at least equalled Pope & Carter's exercise price of $500,000. The sale was closed on July 1, 1969, with an assignee of Pope & Carter actually making...