Firstco, Inc. v. United States

• Decision Date: 27 April 1977
• Docket Number: Civ. A. No. J76-28(R).
• Citation: 430 F. Supp. 1193
• Court: U.S. District Court — Southern District of Mississippi
• Parties: FIRSTCO, INC., Plaintiff, v. UNITED STATES of America, Defendant.

430 F. Supp. 1193

FIRSTCO, INC., Plaintiff, v. UNITED STATES of America, Defendant.

Civ. A. No. J76-28(R).

United States District Court, S. D. Mississippi, Jackson Division.

April 27, 1977.

COPYRIGHT MATERIAL OMITTED

Leonard D. Van Slyke, Jr., Jackson, Miss., for plaintiff.

Robert E. Hauberg, U. S. Atty., Jackson, Miss., Jack D. Warren, Tax Div., U. S. Dept. of Justice, Washington, D. C., for defendant.

OPINION

DAN M. RUSSELL, Jr., Chief Judge.

Firstco, Inc., a Mississippi corporation, with its principal place of business in Jackson, Mississippi, filed this suit for the recovery of federal income taxes for the tax years ending December 31, 1972 and December 31, 1973. This Court has jurisdiction by virtue of 28 U.S.C. Section 1346(a). Plaintiff alleges that it timely filed its tax return for the tax year 1972 and paid an income tax in the sum of $154,375.00. It similarly filed its tax return for the tax year 1973 and paid no income tax as none was due. On or about November 3, 1975, the District Director of International Revenue assessed plaintiff with additional income taxes in the sum of $36,297.85 for the tax year 1972, and the sum of $13,551.73 for the tax year 1973. The additional taxes assessed for both years resulted from the imposition of an accumulated earnings tax pursuant to Section 531 of the Internal Revenue Code of 1954, 26 U.S.C. § 531.¹ Firstco promptly paid both assessments and filed a claim for a refund of each year's assessment on the following grounds:

"Taxpayer is not liable for the accumulated earnings tax as it was not formed or availed of for the purpose of avoiding the income tax with respect to its shareholders. Earnings were accumulated for the purpose of liquidating the interest of stockholders who wanted to redeem their shares, to provide for the repayment of outstanding loans and for other reasonable needs of the business including reasonably anticipated needs."

Upon disallowance by the Director of Firstco's claim for a refund for each of the tax years 1972 and 1973, Firstco filed its suit here alleging that the additional taxes were erroneously and illegally assessed and collected. Firstco seeks the recovery of the full sum of $49,849.58, being the total of the additional taxes assessed for the years 1972 and 1973, together with interest and costs.

Firstco claims that it was not formed or availed of for the purpose of avoiding any income tax with respect to its shareholders by permitting earnings and profits to accumulate instead of being divided and distributed,² nor to accumulate earnings and profits beyond the reasonable needs of its business.³ Firstco asserts that it reserved its earnings and profits from dividend distribution (1) for the redemption of stock from its shareholders, (2) for the repayment of business loans, and (3) in order to purchase new investments, the third reason being in addition to the reasonable or reasonably anticipated needs of its business as expressed in the claims for a refund.

The case was tried to the Court and is now ready for disposition.

Firstco was incorporated in May 1960, with an authorized capital stock of $500,000.00 consisting of 50,000 shares at $10.00 each. Although its charter listed a broad range of powers, according to its sole witness, Mr. John B. Tullos, president since 1974, Firstco was created as a morale builder for the employees of First National Bank of Jackson, Jackson, Mississippi, as a medium for permitting employees of the bank to pool their funds for the purchase of investments which would accrue to their benefit, a venture which very few FNB employees could have attempted on an individual basis. According to a pre-trial order entered herein, the corporation had as its business the buying and selling of stocks, the making of loans, and the operation of an insurance agency. Tullos added that capital appreciation was its goal. According to the original corporate by-laws, the ownership of stock was limited to full-time officers, employees, and directors of FNB, with a first option to the corporation to repurchase stock from a stockholder, within 30 days of his request, at net asset value as determined by the last quarterly evaluation. These bylaws also provided for dividends to be declared from the surplus or net profits at such times as the Board of Directors should direct and that no dividends be declared should such impair the capital of the corporation. In 1963 the by-laws were amended to limit ownership of stock to active and retired officers, employees and directors of FNB, and to provide that stockholders may sell their shares to other stockholders or to individuals eligible to become stockholders, and, if any stockholder should become ineligible for stock ownership through separation from the bank's services by death or otherwise, he or his estate shall be required to sell the stock to another stockholder, or to an individual eligible for stock ownership, or to the corporation within 60 days of his ineligibility. A new method for determining the value of redeemed shares was provided for, the details of which are not material to the issues herein. Also, the amended by-laws provided that eligible individuals could acquire stock on an installment plan by depositing with the corporation monthly multiples of $10.00, up to $100.00, to be converted into shares at the end of each calendar year.

From its incorporation up to the date of the trial, Firstco has paid no dividends. Although the by-laws provide for a Board of Directors composed of seven members, according to Tullos, he and two other stockholders comprised the management for the corporation and made all investment decisions, and, from the inception of the corporation, it was a management decision not to distribute earnings in dividends, a decision accepted by the board and to which no stockholder has registered an objection. The corporation has never acted as an investment broker, although authorized under its charter to do so. Nor does it pay brokerage commissions, nor any salaries to its officers or its management group. Although Tullos, as a banker (Executive Vice-President and Cashier of FNB), said that he was aware that undistributed dividends created a tax savings to individual stockholders, he strenuously denied that the corporation was availed of for such a purpose or that the Board of Directors had such a tax savings in mind in its constant decision through the years not to declare dividends.

Evidence on behalf of Firstco showed that at the end of 1972 there were 62 shareholders owning a total of 19,583 shares of stock, and at the end of 1973 there were 55 shareholders owning 19,462 shares of stock. No one person owned as much as 10% of the stock in either of the two calendar years. Tullos testified that the obligation of Firstco to redeem shares subjected the corporation to a tremendous potential liability should a large number of shareholders request redemptions within any given period. Specifically the funds needed by Firstco to redeem all outstanding shares in 1972 was $2,313,927.20. This sum represented 19,583 shares at a redemption price of $118.16 per share, set by the Board of Directors. In 1973 Firstco would have had to have on hand $2,078,630.40, this to redeem 19,712 shares at a value of $105.45 per share.⁴ Actually, according to Tullos, the 1972 redemptions amounted to only $140,861.07, and the 1973 redemptions to only $29,527.00. Nonetheless management did not consider it prudent to pay dividends in the absence of sufficient funds on hand to redeem all the shares.

Tullos also testified that the corporation initially borrowed huge sums of money, principally for two purposes — for the redemption of stock if it became necessary, and for the purchase of investments. Notes payable at the end of 1971 amounted to $2,167,000.00; at the end of 1972 they amounted to $1,910,000.00; and at the end of 1973, the second tax year involved, they amounted to $2,065,000.00. These notes were owed to two companies, Lamar Life Insurance Company, Jackson, and FNB. They were demand notes, bearing interest, hopefully at a cost less than the investment earnings. Tullos admitted that no demand was ever made for payment. From time to time these notes were reduced, added to or renewed. According to Tullos, the management of Firstco did not consider it prudent to pay a dividend as long as these notes were outstanding. Although it has no bearing on the Court's ultimate decision herein, Tullos testified that these notes have now been paid.

As to the third item advanced by plaintiff as a reasonably anticipated business need, that is, the retention of sums with which to buy new investments, Tullos stated that the three members of the management group, himself, R. M. Hearin, and R. B. Lampton,⁵ would decide timely investments to be made on behalf of Firstco. Funds for such investments came from funds on hand or borrowed funds. Tullos testified that the management group considered it necessary to retain from earnings the sum of $500,000.00 during each of the tax years involved herein for investment purposes.

From monthly comparative financial statements relative to Firstco's cash on deposit during the tax years involved, Tullos reported as follows:

                1972    Cash on Deposit    1973    Cash on Deposit
                 1/31      $ 39,231.79      1/31     ($287,267.12)
                 2/29        37,790.52      2/28         4,488.31
                 3/29        40,548.78      3/30        19,645.05
                 4/30        39,159.01      4/30       (19,078.75)
                 5/31        (4,957.27)     5/31       (37,433.50)
                 6/30         6,865.93      6/30      (211,258.51)
                 7/31        29,636.33      7/25        20,268.58
                 8/31        31,394.28      8/31        22,126.14
                

                1972    Cash on Deposit    1973    Cash on Deposit
                 9/30        45,354.98      9/30        42,940.64
                10/31        59,519.38     10/31         2,139.94
                11/30       (20,852.62)    11/30         2,355.15
                12/31      (303,016.49)    12/31        11,091.99
                

These figures...