Gunther v. C.I.R., 89-1872

• Citation: 909 F.2d 291
• Decision Date: 06 August 1990
• Docket Number: No. 89-1872,89-1872
• Parties: -5375, 90-2 USTC P 50,434 H. Dale GUNTHER and Marie M. Gunther, et al., Appellees, v. COMMISSIONER OF INTERNAL REVENUE, Appellant.
• Court: United States Courts of Appeals. United States Court of Appeals (7th Circuit)

Page 291

909 F.2d 291

66 A.F.T.R.2d 90-5375, 90-2 USTC P 50,434

H. Dale GUNTHER and Marie M. Gunther, et al., Appellees, v. COMMISSIONER OF INTERNAL REVENUE, Appellant.

No. 89-1872.

United States Court of Appeals,

Seventh Circuit.

Argued Jan. 18, 1990.

Decided Aug. 6, 1990.

James M. Neis, Thomas P. Fitzgerald, Susan Cisle, Charles C. Murphy, Crane C. Hauser, Kimball R. Anderson, Winston & Strawn, Chicago, Ill., for petitioners-appellees.

James I.K. Knapp, Dept. of Justice, Tax Div., Gary R. Allen, Robert S. Pomerance, Kenneth L. Greene, Dept. of Justice, Tax Div., Appellate Section, Peter K. Scott, I.R.S., Ernest J. Brown, Dept. of Justice, Tax Div., Appellate Section, Washington, D.C., for respondent-appellant.

Before BAUER, Chief Judge, COFFEY, Circuit Judge, and ESCHBACH, Senior Circuit Judge.

BAUER, Chief Judge.

The Internal Revenue Service appeals from a decision by the United States Tax Court holding that appellees did not owe additional taxes for 1981 despite changes in the corporate structure of two closely-held corporations which they wholly-owned and controlled. In 1981, the appellees reorganized their businesses by exchanging all of their stock in one corporation for stock and debentures from the second corporation. The Internal Revenue Service considered the transaction to be governed by 26 U.S.C. Sec. 304(a) and thus argued that the debentures were taxable as dividends. The appellees believed that the transaction was instead controlled by 26 U.S.C. Sec. 351 and, therefore, the debentures were not taxable until they were sold or retired. The Tax Court determined that while both Sec. 304(a) and Sec. 351 applied to the transaction, Sec. 351 was controlling and therefore the debentures were not taxable as dividends under Sec. 304(a). For the following reasons we affirm.

I.

Two brothers, H. Dale Gunther and Gene Gunther, owned all of the common stock of both Gunther Construction Co. ("Construction") and Galesburg Builders Supply Company ("Builders"). Their children owned all of the non-voting, preferred shares of these companies. Construction, or its predecessors, has been a highway and heavy construction business since about 1920. Builders, or its predecessors, has been in the business of supplying building materials for the same amount of time. Builders' principal product is ready-mix concrete. Construction relies solely on Builders for this concrete in its projects and accounts for roughly 15 percent of Builders' revenues. The Gunthers considered this relationship between Builders and Construction critical to their ability to compete successfully for highway contracts against other paving contractors. The Gunthers were successful competitors. In 1980, Construction had earnings and profits of more than $569,000 and Builders had earnings and profits of $527,998.

Late in the summer of 1980, according to their own statements, the Gunthers decided to protect the future viability of Builders by making it a wholly-owned subsidiary of Construction. Construction's tax consultants, Peat, Marwick, Mitchell & Co., recommended that in order to avoid tax liability, the Gunthers should transfer their Builders stock to Construction in exchange for stock and debentures from Construction. According to the consultants, this would be considered a tax-free exchange of property under Sec. 351 of the Tax Code. On January 2, 1981, the Gunthers transferred all of their Builders stock to Construction in exchange for additional shares of Construction stock and 17 percent debentures due in 11 years and 1 day. Dale and Gene Gunther each received debentures in the amount of $270,000. The children received smaller amounts in proportion to their total shares. The total value of all the bonds issued to the Gunthers was $569,000, not coincidentally the same amount as Constructions' earnings and profits for that year.

The Internal Revenue Service ("IRS" or "Service") became concerned when the Gunthers did not report any gain or loss from the transaction on their 1980 tax returns. The IRS determined after an audit that the transfer was subject to Sec. 304(a)(1) of the Code. This section provides that if one or more persons control, directly or indirectly, at least 50 percent of each of two corporations, a transfer of stock in one corporation in return for property of the other is treated as a distribution in redemption of the acquiring corporation's stock. Thus, according to the IRS's reading of the Code, the bonds issued by Construction were to be treated as dividends issued to the Gunthers and taxable in 1980 as capital gains. Not surprisingly, the Gunthers petitioned the Tax Court for a redetermination of these alleged deficiencies. The Gunthers contended that Sec. 351, not Sec. 304(a), should apply to the transaction. Section 351(a) provides that no gain or loss shall be recognized if (1) property is transferred to a corporation by one or more persons solely in exchange for stock or securities in that corporation and (2) immediately after the exchange the transferors of the property are in control of at least 80 percent of either the voting control or total shares of the corporation. The Gunthers argued that because the bonds issued by Construction were securities and because the family controlled 100 percent of the resulting corporation, the exchange was tax-free under this provision of the Code.

In a thoughtful and detailed 44-page opinion for a thirteen judge majority of the Tax Court, Judge Chabot wrote that while both sections could apply, Sec. 351 was controlling. Judge Chabot based this conclusion on the plain language of both sections, their legislative histories, and previous decisions by the Tax Court, namely Haserot v. Commissioner, 41 T.C. 562 (1964). Judge Chabot reviewed the logic behind the Haserot decision and concluded that its analysis was still valid. Four judges, however, dissented from the opinion, stating that Sec. 304(a) was more appropriate under these circumstances and that applying Sec. 351 would lead to absurd results. The IRS filed a timely notice of appeal and now asks this court to adopt the views of the dissent rather than those of the majority of the Tax Court.

II.

This appeal presents a single issue to this court: when both Sec. 304(a) and Sec. 351 are applicable to a given transaction, which section is controlling? Despite the Tax Court's careful treatment of this issue below, this is purely a question of law and our review here is plenary. As we have stated before, "we owe no special deference to the Tax Court's legal views." Prussner v. United States, 896 F.2d 218, 224 (7th Cir.1990). See also Commissioner v. Hendrickson, 873 F.2d 1018, 1022 (7th Cir.1989); Merit Life Ins. Co. v. Commissioner, 853 F.2d 1435, 1438 (7th Cir.1988). We will disturb the Tax Court's findings of fact, however, and its application of law to those facts, only if they are clearly erroneous. Hendrickson, 873 F.2d at 1022; see also Yosha v. Commissioner, 861 F.2d 494, 499 (7th Cir.1988).

There is no real dispute between the parties that this transaction falls within the terms of both Sec. 304(a) and Sec. 351. Nor could there be any. Section 304(a) ¹ treats sales of stock between corporations controlled by the same person or persons as distributions in redemption of the acquiring corporation's stock. Thus, the Code protects against attempts to disguise distributions or dividends as mere sales of stock. Section 304(c)(1) defines "control" as the "ownership of stock possessing at least 50 percent of the total combined voting power of all classes of stock entitled to vote or at least 50 percent of the total value of shares of all classes of stock." And under Sec. 304(c)(2), this ownership may be constructive ownership if the familial or partnership relationships are present as provided by Sec. 318(a). Here the Gunthers, the brothers and the family as a whole, held the 50 percent control of both Construction and Builders as required by Sec. 304(c)(1), and thus the terms of Sec. 304(a) are satisfied. ²

The tax consequences of Sec. 304(a) are governed by Secs. 302 and 301. Under Sec. 302(d), a transaction is to be controlled by Sec. 301 if that transaction is essentially equivalent to a dividend. As the Tax Court determined, the Gunthers' transaction was properly characterized as essentially equivalent to a dividend since there was no reduction in control or ownership after the exchange of Builders and Construction stock. Thus, Secs. 302(d) and 301 are applicable. Section 301 provides:

(a) In General.--Except as otherwise provided in this chapter, a distribution of property (as defined in section 317(a)) made by a corporation to a shareholder with respect to its stock shall be treated in the manner provided in subsection (c).

. . . . .

(c) Amount taxable.--In the case of a distribution to which subsection (a) applies--

(1) Amount constituting dividend.--That portion of the distribution which is a dividend (as defined in section 316) shall be included in gross income.

Therefore, if the Gunthers' transaction is controlled by Sec. 304(a), as explained by Secs. 302 and 301, the Construction debentures issued to the Gunthers in exchange for the Builders stock, would be considered as dividends and taxed as capital gains in the year of the transaction.

However, the Gunthers' exchange of Builders stock for Construction stock and debentures also falls under the plain terms of Sec. 351. In direct opposition to Secs. 304, 302 and 301, Sec. 351(a) provides:

No gain or loss shall be recognized if property is transferred to a corporation by one or more persons solely in exchange for stock or securities in such corporation and immediately after the exchange such person or persons are in control (as defined in section 368(c)) of the corporation.

Section 368(c) defines "control" of a corporation for purposes of Sec. 351 as "ownership of stock possessing at least 80 percent of the total combined voting power of all...