Commissioner of Internal Revenue v. Snite

• Decision Date: 15 November 1949
• Docket Number: No. 9768,9769.,9768
• Citation: 177 F.2d 819
• Parties: COMMISSIONER OF INTERNAL REVENUE v. SNITE (two cases).
• Court: U.S. Court of Appeals — Seventh Circuit

177 F.2d 819 (1949)

COMMISSIONER OF INTERNAL REVENUE v. SNITE (two cases).

Nos. 9768, 9769.

United States Court of Appeals Seventh Circuit.

November 15, 1949.

Hon. Theron L. Caudle, Assistant Attorney General, Irving I. Axelrad, Assistant to Assistant Attorney General, U. S. Department of Justice, Ellis N. Slack, A. F. Prescott, Special Assistants to Attorney General, for petitioner.

John E. Shea, George E. McMurray, Jr., Washington, D. C., Joseph E. Newton, Chicago, Ill., for respondent.

Before MAJOR, Chief Judge, and DUFFY and LINDLEY, Circuit Judges.

LINDLEY, Circuit Judge.

The Tax Court decided that the purchase price paid by a family corporation to two of its principal stockholders, husband and wife, for a portion of their stock sold to the company in 1942 and 1943, did not constitute a distribution essentially equivalent to a taxable dividend under Section 115(g) of the Internal Revenue Code, 26 U.S.C.A. § 115(g). Upon review, the commissioner makes no assault upon the findings of fact but urges that, upon their proper construction, the decision was erroneous.

The Local Loan Company, incorporated in Delaware, July 1, 1928, had, at the outset, a capital structure of 20,000 shares of common stock, increased in 1934 to 50,000. No question of adequacy of the consideration paid by the taxpayers for their shares is presented. During 1935 they created two irrevocable trusts, known in the record as the "Funded Insurance" and the "Living" trusts. To the first named, the husband transferred insurance policies of the face amount of $675,000 and the wife, 3000 shares of stock. To the second, the husband transferred 3000 shares. The primary beneficiaries in each instance were the taxpayers' two children; the trustees, their daughter, her husband and Griffin, executive vice-president of the company. On December 22, 1941, the husband delivered 840 additional shares to the "Living" and the wife, 400 shares to the "Funded Insurance" trust.

Certain important employees of the company expressed their eagerness to acquire interests in the corporate enterprise. They proposed that the company purchase some of its own stock from the taxpayers, place it in the corporate treasury and then make it possible for the employees to buy it. This specific procedure was suggested because the employees feared that the death of Mr. Snite, prior to completion of purchase directly from him under options covering a future period, would frustrate their purpose, whereas an option on the part of the company to buy the shares from it would afford them full protection in case of Snite's death. The employees' urgent argument eventually prevailed over the persistent reluctance of Snite, who, finally, in 1942 agreed to the proposal. Under the arrangement as finally adopted, each taxpayer was to sell to the corporation 1000 of its shares held by him at $150 per share, which, in turn, the company was to make available to employees Griffin and Murphy at the same price. On December 17, 1942, the directors adopted a resolution providing for the purchase of 1000 shares from each taxpayer at $150, to be retained as treasury stock of the corporation and "to be used in such manner as the Board of Directors may hereafter determine." The stock was delivered on December 28, 1942, and, contemporaneously, each taxpayer received a corporate check for $150,000. Each share at that time was worth somewhat in excess of $150. The next year a similar resolution was adopted, under which the company purchased 360 shares from the husband and 1140 from the wife. Certain loans were made by husband and wife to the company, but their details and their discharge, we think, are unimportant. The company carried the shares acquired from the taxpayers as treasury stock. It was not cancelled but was held as an asset of the corporation.

Because of the Stabilization Act of 1942, 50 U.S.C.A.Appendix, § 961 et seq., the executive orders promulgated thereunder and the regulations issued by the commissioner, salary increases were forbidden without government approval until the limitations were finally removed in August, 1945. During the war years the employees applied no further pressure for completion of the options, as accountants advised them that, inasmuch as the value was in excess of $150 a share, the excess might be held to constitute additional income under both the wage and revenue laws, and that the purchase of stock directly from the taxpayers at $150 per share might be considered a subterfuge to evade salary limitations and income taxes. The employees were convinced that the sale of the stock by the taxpayers to the company and placing it in the corporate treasury satisfied their immediate objective, and anticipated that the purchased stock would be made available for purchase by them after salary restrictions had been withdrawn by the government. Later, in August, 1946, the directors authorized issuance of options to purchase the shares at a price of $150 a share. Only a small part has as yet been transferred to the employees.

The company was prosperous; it was engaged in the small loan business, holding cash in each of the years in question of approximately one million dollars, and receivables, in excess of nine million dollars. It borrowed substantial amounts of money to invest in additional receivables and declared cash dividends out of liberal earnings from year to year. In view of an increase in receivables from $9,064,403 to $11,017,346 out of surplus and profits and plans to expand, a reduced dividend was declared in 1944.

Each taxpayer reported the sale of the stock. The undisputed cost basis was $28.725 and $28.7175 per share. They accounted for a net gain upon each sale, as a long term capital gain subject to tax. The commissioner, however, ruled that the entire proceeds of sale constituted ordinary income under Sections 22(a) and 115(g) of the code, 26 U.S.C.A. §§ 22(a), 115(g).

Upon review, the Tax Court held that the facts of record precluded any conclusion that the transactions had the essential effect of dividends and that, on the contrary, they were, as the taxpayers had reported them, sales of capital assets. The commissioner contends here that the court erred in failing to hold that the entire proceeds received by the taxpayers from the company in 1942 and 1943 in return for sale of a portion of their holdings in the company were ordinary income, rather than proceeds of sales of capital assets. He insists that, absent a liquidation motive, a redemption of stock out of earnings and profits is always a dividend, and that whether cash distributed has the effect of a taxable dividend is merely a question of whether the distribution comes out of earnings and profits.

Section 115(g) of the Internal Revenue Code is as follows: "If a corporation cancels or redeems its stock (whether or not such stock was issued as a stock dividend) at such time and in such manner as to make the distribution and cancellation or redemption in whole or in part essentially equivalent to the distribution of a taxable dividend, the amount so distributed in redemption or cancellation of the stock, to the extent that it represents a distribution of earnings or profits accumulated after February 28, 1913, shall be treated as a taxable dividend."...