Cherry v. United States

• Decision Date: 03 February 1967
• Docket Number: Civ. No. 64-377,64-378,66-1163.
• Citation: 264 F. Supp. 969
• Court: U.S. District Court — Central District of California
• Parties: Ray K. CHERRY and John H. Hadley, Plaintiffs, v. UNITED STATES of America, Defendant. Ray K. CHERRY, John H. Hadley, A. G. Harrold and Max B. Elliott, Plaintiffs, v. UNITED STATES of America, Defendant. UNITED STATES of America, Plaintiff, v. LORAINE PARK HOMES, a California corporation, Flower Street Investments, Inc., a California corporation, Ben Lomond Homes, Inc., a California corporation, HAQ Investments, Inc., a California corporation, Coast Investment Company, a California corporation, Alosta Corporation, a California corporation, Ray K. Cherry, John H. Hadley, A. G. Harrold, and Max B. Elliott, Defendants.

264 F. Supp. 969

Ray K. CHERRY and John H. Hadley, Plaintiffs, v. UNITED STATES of America, Defendant.

Ray K. CHERRY, John H. Hadley, A. G. Harrold and Max B. Elliott, Plaintiffs, v. UNITED STATES of America, Defendant.

UNITED STATES of America, Plaintiff, v. LORAINE PARK HOMES, a California corporation, Flower Street Investments, Inc., a California corporation, Ben Lomond Homes, Inc., a California corporation, HAQ Investments, Inc., a California corporation, Coast Investment Company, a California corporation, Alosta Corporation, a California corporation, Ray K. Cherry, John H. Hadley, A. G. Harrold, and Max B. Elliott, Defendants.

Civ. Nos. 64-377, 64-378, 66-1163.

United States District Court C. D. California.

February 3, 1967.

Adam Y. Bennion, Mackay, McGregor & Bennion, Hilbert P. Zarky and Mitchell, Silberberg & Knupp, Los Angeles, Cal., for plaintiffs in Civ. 64-377 and Civ. 64-378, and defendants in Civ. 66-1163.

Manuel L. Real, U. S. Atty., and Loyal E. Keir and Jerry R. Stern, Asst. U. S. Attys., Los Angeles, Cal., for the United States.

DECISION, FINDINGS OF FACT, AND CONCLUSIONS OF LAW

HAUK, District Judge.

Two actions against the United States for refund of Federal corporate income taxes erroneously and illegally assessed, collected by the Government and overpaid by the individual taxpayer plaintiffs as shareholders and transferees of three dissolved corporations; and one counteraction by the United States against the said individual taxpayers, the three dissolved corporations and three holding companies who were the distributees of the assets of the dissolved corporations.

These controversies, consolidated for trial, arise over the proper tax treatment to be accorded to the taxpayers under a series of transactions whereby three predecessor corporations built and sold tract homes under long-term contracts of sale, reporting income on the installment basis; then, while the contracts of sale were still in force, the individual shareholders of these predecessor corporations sold their stock therein to three other successor corporate holding companies which thereupon liquidated the predecessor corporations, distributed the residential installment sales contracts and obligations by refinancing and deeding out the properties to the home buyers, and reported their income by applying a stepped-up tax basis tied to the purchase price of the stock.

In the first two actions, the individual taxpayers seek refunds totaling approximately $400,000, on the theory that under the applicable provisions of the Internal Revenue Code of 1954 then in force, and since the predecessor corporations were 80 percent subsidiaries of the successor holding companies when the predecessor corporations were liquidated and when the installment obligations were distributed to the successor holding companies, no gain or loss should have been recognized to the successor holding companies; and further, since no such gain or loss should have been recognized to the successor holding companies upon such liquidation and distribution, no gain or loss should be recognized to the predecessor corporations.

In the counteraction, the Government seeks recovery against the individual taxpayers and also against all of the defendants either directly or as transferees of one another for the full amount of the refunds sought by the individual plaintiffs in their actions against the Government. But only in the event the individual taxpayers receive judgment under the first two actions does the Government press its counteraction.

After ten-day, non-jury trial the Court makes its decision, findings of fact and conclusions of law in favor of plaintiffs in the first two actions and of defendants in the counteraction, ordering judgment for the taxpayers and against the Government.

APPEARANCES For the Plaintiffs in No. 64-377-AAH ADAM Y. BENNION and MACKAY Civil and No. 64-378-AAH McGREGOR & BENNION Civil, and the Defendants Los Angeles, California in No. 66-1163-AAH Civil: and HILBERT P. ZARKY and MITCHELL SILBERBERG & KNUPP Los Angeles, California For the Defendant in No. 64-377-AAH MANUEL L. REAL, United States Civil and No. 64-378-AAH Attorney, and LOYAL E. KEIR and Civil, and for the JERRY R. STERN, Assistant United Plaintiff in No. 66-1163-AAH States Attorneys, Los Angeles, California Civil:

The first two actions in this case were brought by the individual taxpayer plaintiffs against the United States for the recovery, by way of refund, of approximately $400,000 in Federal corporate income taxes which it is claimed were erroneously and illegally assessed and later collected by the Government and overpaid by the taxpayers as shareholders and transferees of three dissolved corporations. Jurisdiction is based on 28 U.S. C.A. § 1340¹ and § 1346(a) (1)².

The third action, a sort of counteraction, virtually in the nature of a counterclaim or cross-claim, is brought by the United States against the aforesaid three dissolved corporations, against the same individual taxpayers as shareholders and transferees of the three dissolved corporations, and against three successor holding companies, as well as against the individual taxpayers and the three dissolved corporations as transferees of the successor holding companies. The Government seeks recovery of the identical sums which the individual taxpayers seek in their refund actions, but only in the event the refund actions are successful. In this counteraction, jurisdiction is based upon 28 U.S.C.A. § 1340³, and § 1345⁴ along with 26 U.S.C.A. § 7401⁵ and § 7402(a)⁶, the alleged transferee liability being founded upon 26 U.S.C.A. § 6901(a) (1)⁷

The tax controversies of these three actions, consolidated for trial, arose from the fact that three corporations, namely Loraine Park Homes, Ben Lomond Homes, Inc., and Coast Investment Company (sometimes, for convenience, called the predecessor corporations), had built and sold tract homes to purchasers under long-term contracts of sale and had reported their income on the installment basis. At a time when each of the predecessor corporations still had unreported installment income, the shareholders, desirous of obtaining capital gain treatment, sold their shares of stock to new corporate entities, namely Hartford Builders, Inc. (which later sold to Flower Street Investments, Inc.), HAQ Investments, Inc., and Alosta Corporation, (sometimes, for convenience, called the successor corporations or holding companies). The successor holding companies promptly proceeded to liquidate their newly acquired subsidiaries and, thereafter, made a disposition of the remaining installment obligations in a manner more fully described hereafter. The successor corporations thereupon reported their income by applying to these installment obligations a new stepped-up tax basis tied to the price of the stock. The United States seeks to hold the predecessor corporations (and their former shareholders as transferees) for increased tax liabilities on the theory that the predecessor corporations should be taxed with the full amount of the installment obligations not previously taxed. Alternatively, it seeks to hold the successor holding companies (and the former stockholders of the predecessor corporations as alleged transferees of the successor corporations) for increased tax liabilities on the theory that the successor corporations did not acquire a new stepped-up tax basis in the assets which they acquired upon liquidation of their subsidiaries.

The individual taxpayer plaintiffs contend that, under the applicable provisions of the Internal Revenue Code of 1954 in force at all times material to the litigation, they are entitled to recover the overpaid taxes. Relying upon Section 332 of the Code⁸, they assert that the predecessor corporations were 80 percent subsidiaries of the successor holding companies when the predecessor corporations were liquidated and when the tract home contract sale installment obligations were distributed to the successor holding companies; and that, therefore, no gain or loss should have been recognized to the successor holding companies.

Then turning to Section 453(d) (4) (A)⁹ they contend that since no gain or loss should be recognized to the successor holding companies upon such liquidation and distribution, it follows that no gain or loss should be recognized to the predecessor corporations.

The Government on the other hand contends that the predecessor corporations, and therefore the individual taxpayers as transferees thereof, were properly taxed because the transactions between the predecessor corporations, the individual taxpayers as shareholders and transferees, and the successor holding companies were sham, and that the successor holding companies were mere funnels or conduits through which the installment obligations owned by the predecessor corporations flowed into the hands of the refinancing agencies—California Federal Savings and Loan Association of Los Angeles, and Mutual Savings and Loan Association of Pasadena—resulting in tax avoidance or tax evasion schemes that provided the form but not the substance of actual stock sales and liquidations which, says the Government, were in truth and in fact mere contrivances to bail out corporate earnings at capital gains rates and were, therefore, within the interdiction of Section 269 of the Revenue Code denying tax allowances in corporate acquisitions made to evade or avoid income tax.¹⁰

Upon this theory, the Government in its counteraction seeks recovery of the full amount of any tax refund that the individual taxpayers may recover in their two actions. Alternatively, the Government seeks to recover taxes from the successor holding companies (as well as the predecessor corporations as transferees of the successor holding companies and the individual taxpayers as transferees of both) on the theory that the successor holding companies did not acquire a new stepped-up...