CIR v. Berenbaum

• Decision Date: 02 December 1966
• Docket Number: No. 8561.,8561.
• Citation: 369 F.2d 337
• Parties: COMMISSIONER OF INTERNAL REVENUE, Petitioner, v. Zelie BERENBAUM and Harriet Berenbaum, Respondents.
• Court: U.S. Court of Appeals — Tenth Circuit

369 F.2d 337 (1966)

COMMISSIONER OF INTERNAL REVENUE, Petitioner, v. Zelie BERENBAUM and Harriet Berenbaum, Respondents.

No. 8561.

United States Court of Appeals Tenth Circuit.

December 2, 1966.

Jack S. Levin, Atty., Dept. of Justice, Washington, D. C. (Mitchell Rogovin, Asst. Atty. Gen., Meyer Rothwacks, Harry Baum, Anthony Zell Roisman and Lee A. Jackson, Attys., Dept. of Justice, with him on the brief), for petitioner.

Joseph Berenbaum, Denver, Colo., for respondents.

Before PICKETT and SETH, Circuit Judges, and CHRISTENSEN, District Judge.

SETH, Circuit Judge.

The Commissioner filed notices of deficiency against the taxpayer and others in connection with their income tax returns for 1959 and 1960. He determined that redemptions of preferred shares of stock in a closely held corporation from the taxpayer and others were essentially equivalent to the distribution of taxable dividends under § 302(b) (1) of the 1954 Internal Revenue Code.

The Tax Court considered the two redemptions and held that one was essentially equivalent to a dividend but that the other was not. The Commissioner is the petitioner here and seeks review of the decision of the Tax Court as to the redemption held not essentially equivalent to a dividend.

The general purpose of § 302(b) (1) of the 1954 Code is to tax distributions made by corporations to their stockholders in redemption of stock whenever such distributions or payments are essentially equivalent to a dividend. The Code also provides that any distribution to a shareholder is assumed to be out of earnings and profits to the extent they exist.

The record shows that the corporation here concerned, National Real Estate & Management Co., was a family-owned corporation and before 1956 had one hundred shares of common stock outstanding. Eighty per cent of these shares were owned by the taxpayer and the remaining twenty per cent by his two brothers. In 1956 the corporation sought approval as an FHA mortgage company, but in order to qualify it was necessary that capitalization or net worth of the corporation be in excess of $100,000. To meet this requirement the company issued in that year heretofore authorized but unissued nonvoting preferred stock; 620 shares of this class of stock were issued for cancellation of purported indebtedness in the amount of about $38,000 which the books of the corporation showed owing to certain stockholders and a family partnership, and partly for an additional capital contribution of $14,000. Of these 620 shares, 425 shares were issued to the taxpayer and 195 to the family partnership. The minutes of the meeting of the directors which authorized the issuance of this stock recited that the corporation had the right to redeem such stock when its capitalization exceeded $100,000.

The company was thereafter approved as an FHA mortgage company and thereafter earnings were accumulated, but no dividends were paid on the preferred or the common stock. Some time in 1957 the company's net worth dropped below the FHA minimum requirement, and seventy additional preferred shares were issued to the taxpayer upon payment of the sum of $7,000 and forty additional shares to the family partnership for $4,000. Thus the taxpayer then owned eighty per cent of the common stock, and 495 of 730 shares of preferred stock of the corporation.

In January 1960 the corporate net worth including the preferred stock was over $139,000, and in that month the corporation redeemed one hundred shares of preferred stock from the taxpayer for the sum of $10,000. This is the redemption in question here. The taxpayer did not report this receipt on his income tax return, and the Commissioner held that the redemption was essentially equivalent to a dividend and filed the deficiency notices. The Tax Court found otherwise and held that the distribution was not taxable as a dividend. The Tax Court in so deciding held that the percentage of ownership of the preferred stock was reduced in a sufficient amount by the redemption to justify its holding, and secondly that the taxpayer did not receive by the redemption of the preferred stock the amount he would have received had the corporation made a distribution of the same amount as a dividend on common stock. It appears that the Tax Court applied these two standards in reaching its decision. The Tax Court also found that no debts were owed in fact by the corporation to the recipients of the preferred stock to exchange for the issuance of such stock.

Prior to the 1960 redemption in question the corporation had redeemed forty preferred shares held by the family partnership.

The Commissioner here urges that the Tax Court was in error as a matter of law in the application of the standards it used in determining dividend equivalence in that the standards were too limited, and further that the standards used were erroneously applied.

In consideration of the standards to be applied, it should be borne in mind that the taxpayer at all pertinent times owned outright eighty per cent of the common stock of the corporation which was the only voting stock, and owned over seventy per cent of the preferred stock. It also appears that the taxpayer and his father and brothers owned all preferred and common stock of the corporation individually or through the family partnership composed of the taxpayer, his father, and two brothers. It should also be borne in mind that although the corporation had earnings and profits at various times, no dividends were ever paid by the corporation. Shortly before the 1960 redemption here in question, the accumulated corporate earnings and profits amounted to something more than $69,000, of which some $39,000 was available for dividend distribution without affecting the required $100,000 net worth. Earnings and profits in 1960 were substantial and the corporation continued to operate profitably, but did not declare a dividend thereafter.

This court in two cases has described the standards or tests to be used in examining corporate distributions of the general type here involved. The first of these cases is Jones v. Griffin, 216 F.2d 885 (10th Cir.), which concerned the section of the 1939 Code comparable to the section applicable here. The court then had before it the redemption of preferred stock of an unusual nature. These shares had a first lien on the assets of the corporation and had voting rights. There arose some disagreement among the stockholders, and it was not possible to secure bank financing unless the preferred shares with their lien priority were cancelled. All the preferred shares were redeemed and the corporation continued to operate thereafter apparently upon the same scale as before. As a result of the redemption, however, there was a substantial rearrangement of the position of the stockholders relative to control. A former controlling shareholder was reduced to a minority position, one shareholder was eliminated, and other substantial changes resulted. This court in Jones stated the criteria to be used in determining the issues now before us:

"* * * But certain criteria are recognized for determining the question. These include the past record of the corporation in respect to the distribution of dividends, whether at the time of the distribution the corporation had large earnings and profits in excess of the distribution, whether any substantial change in the proportionate ownership and control of the corporation resulted from the distribution, whether the corporation manifested a policy of contraction in its operations, whether the corporation continued to operate at a profit, and whether the transaction was initiated or motivated by the stockholders. * * *"

Applying the standards set forth in Jones to the facts in the case before us, it can be seen that the distribution here in...