Fehrs v. United States

• Decision Date: 21 June 1977
• Docket Number: No. 85-75.,85-75.
• Citation: 556 F.2d 1019
• Parties: Edward J. and Violette FEHRS v. The UNITED STATES.
• Court: U.S. Claims Court

556 F.2d 1019

Edward J. and Violette FEHRS v. The UNITED STATES.

No. 85-75.

United States Court of Claims.

May 18, 1977.

As Modified June 21, 1977.

William A. Cromartie, Chicago, Ill., attorney of record for plaintiff; Michael M. Conway and Hopkins, Sutter, Mulroy, Davis & Cromartie, Chicago, Ill., of counsel.

William C. Rapp, Court of Claims Section, Tax Div., U.S. Dept. of Justice, with whom was Acting Asst. Atty. Gen. Myron C. Baum, Washington, D.C., for defendant. Theodore D. Peyser, Jr., Donald H. Olson and Kenneth R. Pike, Washington, D.C., of counsel.

Before COWEN, Senior Judge, and NICHOLS and BENNETT, Judges.

ON PLAINTIFFS' MOTION FOR SUMMARY JUDGMENT AND DEFENDANT'S CROSS-MOTION FOR PARTIAL SUMMARY JUDGMENT

COWEN, Senior Judge:

Plaintiffs have moved for summary judgment in the amount of $20,954.83, together with interest and costs as provided by law, representing federal income taxes and interest paid by them on income received in their taxable year ended December 31, 1966. Plaintiffs assert that their income in that year, which was assessed at ordinary income rates, should instead have been taxed as capital gains. Defendant opposes the plaintiffs' motion, arguing that the tax assessment was correct as a matter of law but that a trial is necessary to determine the correct earnings and profits of the distributing corporation formerly owned by plaintiffs in order to allocate the distribution between ordinary income and capital gain. Even if we accept plaintiffs' position, defendant argues that a trial is necessary to determine whether the transactions underlying this suit were motivated principally by the purpose of avoiding income taxes. For the reasons set forth below, we grant plaintiffs' motion in part, but remand the case for further proceedings on the tax-avoidance issue.

The financial transaction which gives rise to this controversy may be briefly described. In 1964 the plaintiffs owned all 1,380 outstanding shares of the Fehrs Rental Corporation (Rental). On December 21, 1964, Mr. Fehrs gave 241 shares of the corporation to his wife, son-in-law, two daughters and grandchildren.¹ About 2 months later, on February 28, 1965, the plaintiffs' daughters formed the Fehrs Finance Company (Finance Company) for the purpose of purchasing the commercial paper generated by Rental; plaintiffs' two daughters were Finance Company's sole shareholders.

On March 1, 1965, Mr. and Mrs. Fehrs transferred all their remaining stock to the newly formed Finance Company in return for Finance Company's promise to pay them perpetual annuities of $70,000 a year, of which $62,000 was to be paid to Mr. Fehrs and $8,000 was to be paid to Mrs. Fehrs. On the same day, Finance Company sold the stock back to Rental, in exchange for $100,000 and an unsecured promissory note for $625,000. Thus, after the transactions were complete, the Fehrs had divested themselves of all their Rental stock; the amount of Rental stock had been greatly reduced, and the 221 remaining Rental shares had been placed exclusively in the hands of the Fehrs' daughters, son-in-law, and grandchildren. Finance Company had been given substantial working capital and remained in the daughters' hands. Mr. Fehrs retained no managerial or voting interest in either corporation after the transactions were completed.

All of the transactions were accomplished upon advice of counsel and after careful planning. The stated purposes of the deal were: (1) to permit Mr. Fehrs to retire upon a satisfactory income while leaving Rental Corporation "in the family"; and (2) to create adequate working capital for the incipient Finance Company.

In their joint tax returns for 1966, Mr. and Mrs. Fehrs reported the annuity payments received from Finance Company as a "long-term capital gain received in current year." The Internal Revenue Service disagreed, arguing that the annuities represented a "distribution essentially equivalent to a dividend," which is taxable as ordinary income rather than as capital gain. As to Finance Company, the Service categorized the transaction as a "sham" which was in fact a redemption by Rental which gave Finance Company a zero basis in the Rental stock. Therefore, the Service taxed the entire sale proceeds as capital gains received by Finance Company.

Finance Company disagreed, and on May 1, 1972, it sued in the Tax Court to set aside the deficiency determined by the Service. Although Mr. and Mrs. Fehrs had also contested the assessment against them, they were not parties to the suit. The issues decided by the Tax Court were defined only after "a good deal of confusion." Initially, the Internal Revenue Service had contended that the "transfer of stock by Mr. and Mrs. Fehrs was in part a sale and in part a gift to the shareholders" of Finance Company and had assessed a gift tax on the transfers. Also, the assessment by I.R.S. of capital gains tax against Finance Company was without citation to any specific code section. Not until the opening argument at trial did the I.R.S. finally clarify its position by contending that the Finance Company had a zero basis in its Rental stock because of the application of section 304(a) of the Internal Revenue Code. Fehrs Finance Co. v. Comm'r of Internal Revenue, 58 T.C. 174, 182-83 (1972).

Section 304(a) of the Internal Revenue Code, also known as the "brother-sister corporation" provision, requires that where the same persons are "in control" of each of two corporations, and one corporation acquires stock in the other from the persons in control, the transaction is "treated as a redemption" and is considered a "contribution to capital" of the acquiring corporation. Thus, although the Fehrs did not sell their stock to Rental, but to Finance, the transaction was treated as if Rental had originally redeemed its own stock,² and since the stock given to Finance Company was a "contribution to capital," Finance received a zero basis in its Rental stock. Although Finance Company was formally an independent corporation not controlled by the Fehrs, plaintiffs were deemed to be in "constructive control" of Finance Company due to the application of section 318 of the Internal Revenue Code, which "attributes" to a taxpayer the stock of his children and grandchildren.³ Finance Company vigorously disputed the application of these sections to the transaction, but the court held that under the attribution rules, the Fehrs were in control of both Finance and Rental and that section 304 applied to make the entire resale proceeds of Rental stock capital gains in Finance's hands. Fehrs Finance Co., supra at 183.

Finance Company presented two other challenges to the tax assessment by I.R.S. First, the company argued that since the application of section 304 qualifies the transaction as a redemption, the rules of section 302 apply. Section 302(b) provides that a redemption will be treated as an "exchange" if the transaction is "not essentially equivalent to a dividend," or is a "substantially disproportionate redemption" with respect to the shareholder. If the transaction had been treated as an exchange under sections 302(b)(1) and (2), it would have meant that Finance received a basis in the Rental stock equal to the price paid the Fehrs, thus greatly reducing the extent of its capital gain. However, the Tax Court found that the transaction was essentially equivalent to a dividend and also that there was not a substantially disproportionate reduction of interest by the Fehrs (relying again, upon the attribution rules to determine the extent of the Fehrs' interest in Rental, before and after the sale).

Finance Company had one remaining argument. If it could show that the redemption had been "in complete redemption of all of the stock of the corporation" owned by Fehrs, then Finance could obtain "exchange" treatment and receive the stepped-up basis. I.R.C. § 302(b)(3). For such a complete termination of interest, the normal attribution rules do not apply if:

(i) immediately after the distribution the distributee has no interest in the corporation (including an interest as officer, director, or employee), other than an interest as a creditor,

(ii) the distributee does not acquire any such interest (other than stock acquired by bequest or inheritance) within 10 years from the date of such distribution, and

(iii) the distributee, at such time and in such manner as the Secretary or his delegate by regulations prescribes, files an agreement to notify the Secretary or his delegate of any acquisition described in clause (ii) and to retain such records as may be necessary for the application of this paragraph. — I.R.C. § 302(c)(2)(A)(i-iii)

Since it appeared clear that the Fehrs had qualified under the first two requirements of this provision (section 302(c)(2)(A)(i) and (ii)), the only question remaining was whether they had filed the required agreement. Treasury Regulation section 1.302-4(a), requires that the agreement be filed as part of the income tax return "for the year in which the distribution * * * occurs."⁴ Unfortunately for Finance Company's position, Mr. and Mrs. Fehrs had filed no such agreement, even up until the time the Tax Court issued its decision. The court felt this failure to file was determinative, stating that:

* * * since the agreement required by section 302(c)(2)(A)(iii) has not been filed by Mr. and Mrs. Fehrs, the attribution rules of section 318 are applicable, and the redemption of their stock does not qualify as an exchange under section 302(b)(3). Fehrs Finance Co., supra, at 190.

Thus Finance Company had lost all its arguments and the Tax Court rendered a decision in favor of the Government.

Immediately after the Tax Court decision, the Fehrs filed the agreement with the I.R.S. office in their local district. The agreement was accepted by the I.R.S. District Office on October 4, 1972. Soon thereafter, Finance Company appealed to the Eighth Circuit Court of Appeals, which upheld the Tax Court...