Caruth Corp. v. U.S.

• Court: U.S. Court of Appeals — Fifth Circuit
• Writing for the Court: Before GOLDBERG, HIGGINBOTHAM, and DAVIS; PATRICK E. HIGGINBOTHAM
• Citation: Caruth Corp. v. U.S., 865 F.2d 644 (5th Cir. 1989)
• Decision Date: 27 January 1989
• Docket Number: No. 88-1015,88-1015
• Parties: -716, 89-1 USTC P 9172 CARUTH CORPORATION, Plaintiff, W.W. and Mable P. Caruth, Plaintiffs-Appellees, v. UNITED STATES of America, Defendant-Appellant.

Page 644

865 F.2d 644

63 A.F.T.R.2d 89-716, 89-1 USTC P 9172

CARUTH CORPORATION, Plaintiff W.W. and Mable P. Caruth, Plaintiffs-Appellees, v. UNITED STATES of America, Defendant-Appellant.

No. 88-1015.

United States Court of Appeals Fifth Circuit.

Jan. 27, 1989.

Teresa E. McLaughlin, Gary Allen, Chief, William S. Rose, Jr., Richard Farber, Asst. Attys. Gen., Appellate Section, Tax Div., Dept. of Justice, Washington, D.C., for defendant-appellant.

Vester T. Hughes, Jr., David C. Kent, Cynthia M. Ohlenforst, Jay H. Hebert, Dallas, Tex., for plaintiffs-appellees.

Appeal from the United States District Court for the Northern District of Texas.

Before GOLDBERG, HIGGINBOTHAM, and DAVIS, Circuit Judges.

PATRICK E. HIGGINBOTHAM, Circuit Judge:

A taxpayer owns an appreciated asset. The asset's value is attributable largely to an imminent and inevitable payment of earnings. A few days before the payment is due, the taxpayer donates to charity the entire asset, with the right to any income upon it. We must decide if the inevitable payment is taxable as income to the donor. The IRS says that it is; the taxpayer says that it is not. The district court agreed with the taxpayer, reasoning that the taxpayer gave away an appreciated asset without ever himself realizing the appreciation upon it. 688 F.Supp. 1129 (N.D.Tex.1987). We affirm on the same grounds.

I

This case is complicated, but its basic contours are easily described. The case involves the interaction between a peculiar rule and a peculiar asset. The peculiar rule is this: as the tax code stood in 1978, a taxpayer could donate an appreciated asset to charity and obtain a deduction for the full, appreciated value of the asset while never taking the appreciation into his income stream. 26 U.S.C. Secs. 170(a), 170(b)(1)(C)(iv) (as amended in 1986, the Internal Revenue Code's alternative minimum tax provisions limit the ability to deduct the full value of appreciated assets. 26 U.S.C. Sec. 57(a)(6)). Thus a donor who owns appreciated stock would do much better to give the stock to charity than he would to sell the stock and donate the proceeds. If the donor purchased his stock for $10, and it is now worth $100, the donor gets a $100 deduction by handing the stock over to charity. He has no income from this transaction, even if the charity immediately sells the stock. On the other hand, if the donor were first to sell the stock, and then donate the proceeds, he would have a $100 deduction, but he would also have $90 in income. This is a peculiar rule.

The peculiar asset is this: shares of non-voting preferred stock in a highly successful corporation, which stock is callable at $100 per share with 30 days notice, and which stock however enjoys a pro-rata right to any dividend issued by the corporation to its shareholders. The matter is complicated further because the taxpayer owning all of the preferred stock also owned a controlling interest in the voting stock. Thus whether or not the corporation paid out a dividend was within the control of the preferred stock's owner. Like a goose that lays golden eggs only upon the command of its original owner, the preferred stock becomes considerably more valuable when "pregnant" with what soon must become income to somebody. With the declaration of a dividend, the asset appreciates suddenly, and then declines again to its par value (or below) when the dividend issues, as it must. This is a peculiar asset.

The interaction between the asset and the rule is this: the taxpayer in this case, soon after a dividend had been declared but a few days before the dividend record date, donated the preferred stock to charity. The charity held the stock on the record date, and so collected the dividend. The taxpayer claimed a charitable deduction for the enhanced value of the stock, "pregnant" with dividend. The IRS concedes the legitimacy of this deduction. But the taxpayer contends that the "pregnant" stock is an appreciated asset, and that because he gave away the appreciated value without first realizing it, he need not include the appreciation in his income stream. The IRS disagrees, contending that to the extent the asset's value is attributable to the imminent income payment, the increase in value is income chargeable to the taxpayer. The district court agreed with the taxpayer.

We, too, agree with the taxpayer. The details of our reasoning are presented below, but, again, it is possible to summarize the gist of our answer. The taxpayer has given away an appreciated asset, because he has parted with the asset as well as any income derivable from it. He has surrendered not just the golden egg but also the goose. It does not matter that the taxpayer may cause the corporation to redeem the surrendered stock--to, in effect, kill the goose--or that the taxpayer will himself determine when, if ever, the asset becomes "pregnant" with value again. That the goose's original owner may kill the goose or keep it from laying golden eggs certainly reduces the value of the goose to its new owner, but neither of these powers entitle the original owner to more golden eggs. If the taxpayer's corporation redeems the preferred shares, the taxpayer does not himself get the shares. If, after such a redemption, the taxpayer's corporation issues another dividend, his proportionate share will be less than it would have been were the preferred shares still outstanding and in his possession. So there is nothing fictitious about the taxpayer's claim to have parted with an income-producing asset, rather than merely an asset plus income produced.

II

The transaction contested in this case was a gift by taxpayers W.W. and Mabel Caruth to the Dallas Community Chest of preferred, non-voting stock in North Park Inn, Inc. ("North Park Incorporated"). The tax liability, if any were found, would be chargeable to both W.W. Caruth and his wife, Mabel. However, it was W.W. Caruth who transacted the business that gave rise to this litigation, and, for convenience, we will use "Caruth" to refer to both taxpayers, as well as to Mr. Caruth, in this opinion.

There is no controversy about the facts of the deal. We summarize Judge Buchmeyer's thorough description. In April 1978, Caruth owned most of the stock in North Park Incorporated. He owned 37.5 shares, or 75%, of the Class A Voting Common Stock. He owned 337.5 shares, or 75%, of the Class B Non-Voting Common Stock. Finally, he owned 1,000 shares, or 100%, of the Non-Voting Preferred Stock. The remaining shares of North Park Incorporated stock were owned by Caruth's nephews.

The rights and restrictions applicable to the preferred stock were described on the back side of the stock certificates. In relevant part, the description reads as follows:

The preferred stock is non cumulative, and the holders of the preferred stock shall be entitled only to share pro-rata with the holders of common stock in all dividends, when and as declared and made payable by the board of directors of the corporation. The corporation may at any time at the option of the board of directors, redeem the whole or any part of the outstanding preferred stock on any date after issuance by paying One Hundred Dollars ($100.00) for each share thereof. Notice of such election to redeem shall, not less than thirty days prior to the date upon which the stock is to be redeemed, be mailed to each holder of stock so to be redeemed at his address as it appears on the books of the corporation.... Stock redeemed pursuant to the provisions hereof, purchased, converted, or otherwise acquired shall not be reissued but shall be cancelled.

In 1978, Caruth also owned 100% of the shares of the Caruth Corporation, which he had started almost 40 years before and which was an active business. For some time before April of 1978, Caruth had been thinking about having North Park Incorporated declare dividends "in order to get money out of" this company. He planned to "wind down" the activities of North Park Incorporated because the manager of the North Park Inn hotel was "about to die." Caruth also wanted to buy the North Park Incorporated shares held by his two nephews, but they had refused--and he hoped he might reach agreement with the nephews if a substantial dividend were declared. On April 14, 1978, Caruth advised the Dallas Community Chest Trust Fund that he was "contemplating the gift of a substantial amount" of North Park Incorporated stock. No dividends had ever been paid by North Park before 1978. None were paid after 1978.

At the same time, Caruth was considering a "capital contribution" to the Caruth Corporation, which was having "more and more operations in Florida." Since the North Park Incorporated operations were being "wound down," that company did not need cash reserves--so Caruth knew he could make this "capital contribution" by giving North Park Incorporated stock to the Caruth Corporation and having North Park Incorporated declare a dividend.

Caruth did not get any legal advice from a tax specialist about these contemplated transactions. However, Caruth was knowledgeable about their tax consequences--he had a masters degree from Harvard and an undergraduate degree in accounting--and he was also aware of the possible, unfavorable impact of the "accumulated earnings tax" upon the capital reserves of North Park Incorporated.

Against this basic factual background the following events took place:

(i) On May 5, 1978, Caruth transferred his 337.5 shares of North Park Class B common stock (non-voting) to the Caruth Corporation.

(ii) On May 8, 1978, North Park Incorporated declared a dividend of $1,500 per share, payable on May 17, 1978 to those who were shareholders of record on May 15, 1978.

(iii) On May 9, 1978, Caruth donated his 1000 shares of North Park preferred (non-voting) to the Community Chest.

(iv) On the dividend record date, May 15, 1978, the Community Chest was the shareholder of record of the 1000 shares of preferred stock;...