Herbert v. Riddell

• Decision Date: 28 February 1952
• Docket Number: No. 13096.,13096.
• Citation: 103 F. Supp. 369
• Court: U.S. District Court — Southern District of California
• Parties: HERBERT v. RIDDELL.

103 F. Supp. 369

HERBERT v. RIDDELL.

No. 13096.

United States District Court, S. D. California, Central Division.

February 28, 1952.

COPYRIGHT MATERIAL OMITTED

George T. Altman, Gang, Kopp & Tyre, Martin Gang, Los Angeles, Cal., Edward E. Colton, New York City, for plaintiff.

Walter S. Binns, U. S. Atty., E. H. Mitchell, Edward R. McHale, Asst. U. S. Atty., Eugene Harpole, Frank W. Mahoney, Sp. Attys., Bureau of Internal Revenue, Los Angeles, Cal., for defendant.

YANKWICH, Chief Judge.

By this action the plaintiff, F. Hugh Herbert,—to be referred to as Herbert,— seeks to recover $15,214.68 and $4,167.91 interest or a total of $19,382.59 as a refund of federal income taxes paid on a deficiency assessment for the year 1945, and $129,299.97 and interest in the amount of $27,662.44, or a total of $156,962.41 on a deficiency assessment for the year 1946. Involved also is the failure to allow deductions for alimony payments, and to allow to the plaintiff an increase on the cost basis of $11,000 upon the sale of his residence in 1946, by reason of permanent improvements made upon the property.

The fundamental problem in the case turns upon the rejection by the Treasury Department as to both years of the Abbott-Herbert Corporation as a distinct entity and the disregard by the Department for taxation purposes of its subsequent liquidation. These grounds were frankly stated in the 30-day letter of the Treasury Department, and presents the important question involved in this case. Such forthrightness is appreciated. The more so as the conclusion was arrived at,—as will appear further on in the discussion,—on an interpretation of undisputed facts.

The same pattern was followed in the trial of this case. The Government presented no oral testimony. The only live witnesses who testified in the case were the witnesses for the taxpayer, including the taxpayer himself. The Government's case consisted chiefly of cross examination of the witnesses and of certain documentary evidence which they introduced. They seek to justify the action of the Treasury Department on the basis of the inferences which they say can be drawn from the testimony in the case and the documentary evidence introduced.

As this is not a review of a tax court decision,¹ the trial judge has the great freedom of drawing his own inferences from the facts before him. And his most important function is the right to disregard even uncontradicted testimony, if, from the manner and attitude of the witnesses, or from the inherent improbability of their story, or because the witness' declarations are contradicted by his acts as expressed by contemporaneous declarations or documentary evidence, it carries no conviction to him.²

So this case, more than the average tax case, turns not so much on a question of law, but on the application of certain fundamental principles promulgated by our highest courts to certain facts and a proper appraisal of the facts.

We begin by referring to the principles of law which govern cases of this character.

I The Taxpayer's Right to Reduce Tax Liability

In these days when, through nation-wide agitation, there is constant talk of "tax loop-holes" (to which counsel for the Government referred during the oral argument), it is well to point to the fact that the Supreme Court of the United States ever since the question came before it in 1874,³ has insisted that a taxpayer may legally and honorably take means to minimize his tax. The case about to be referred to is of great importance. It arose under the Internal Revenue Act of 1864, which required certain instruments to be stamped.⁴ It is an historical fact that the period following the War between the States brought about the broadest exercise of taxing power by the Government. In the case mentioned, defendant Isham was tried on an information which charged him with violation of the statute. He was the superintendent of a mine in the State of Michigan. In behalf of the Company, he issued drafts in denominations of from $1 to $10. These drafts were sent to Isham from the New York Office in blank. He signed them as he drew them. The paper circulated as currency at local stores. And when merchants accumulated a number of them ranging from $1,000 to $2,000, they were sent to New York for redemption, or Isham took them up and gave the holder a draft on New York for the total amount. The question arose whether the form adopted was made with the intent to avoid the stamp tax. The Judges of the Circuit Court disagreed. That and other questions were certified to the Supreme Court. In ordering the information dismissed, the Court attacked, in outspoken language, the problem of evasion and said distinctly that the mining company could pay its debts in this manner even if it were apparent that the object was to avoid the tax. Mr. Justice Hunt, speaking for a unanimous court, said: "It is said that the transaction proved upon the trial in this case, is a device to avoid the payment of a stamp duty, and that its operation is that of a fraud upon the revenue. This may be true, and if not true, in fact, in this case, it may well be true in other instances. To this objection there are two answers: 1st. That if the device is carried out by the means of legal forms, it is subject to no legal censure. To illustrate. The Stamp Act of 1862 imposed a duty of two cents upon a bank check when drawn for an amount not less than twenty dollars. A careful individual, having the amount of twenty dollars to pay, pays the same by handing to his creditor two checks of ten dollars each. He thus draws checks in payment of his debt to the amount of twenty dollars, and yet pays no stamp duty. This practice and this system he pursues habitually and persistently. While his operations deprive the government of the duties it might reasonably expect to receive, it is not perceived that the practice is open to the charge of fraud. He resorts to devices to avoid the payment of duties, but they are not illegal. He has the legal right to split up his evidences of payment, and thus to avoid the tax. The device we are considering is of the same nature."⁵

The principle has been reaffirmed repeatedly by the Supreme Court and by the Courts of Appeals.⁶ In one of these cases, the Supreme Court, in 1935, epitomized the principle in a sentence which has been quoted approvingly ever since: "The legal right of a taxpayer to decrease the amount of what otherwise would be his taxes, or altogether avoid them, by means which the law permits, cannot be doubted".⁷

Despite the fact that in these cases, it is constantly urged that the motive to avoid taxation is important, the fact remains that, as Judge Learned Hand has stated, the Supreme Court "has never, so far as we can find, made that purpose the basis of liability".⁸

The same opinion gives the true criteria by which to determine whether a transaction is real or not for taxing purposes: "The question always is whether the transaction under scrutiny is in fact what it appears to be in form; a marriage may be a joke; a contract may be intended only to deceive others; an agreement may have a collateral defeasance. In such cases the transaction as a whole is different from its appearance. True, it is always the intent that controls; and we need not for this occasion press the difference between intent and purpose. We may assume that purpose may be the touchstone, but the purpose which counts is one which defeats or contradicts the apparent transaction, not the purpose to escape taxation which the apparent, but not the whole, transaction would realize."⁹

II The Taxpayer's Choice of Business Structure

In seeking to achieve certain business or tax results, the taxpayer is free to choose the form in which he will do business. When he does so, he must accept the tax consequences, whether he contemplated them or not.¹⁰ And if, having chosen a form, he actually carries on the business under the structure adopted, the Government cannot deprive him of the benefit of the chosen form, except upon a showing that the form is unreal or sham. These concomitant principles have been well summarized by the Supreme Court: "A taxpayer is free to adopt such organization for his affairs as he may choose and having elected to do some business as a corporation, he must accept the tax disadvantages.

"On the other hand, the Government may not be required to acquiesce in the taxpayer's election of that form for doing business which is most advantageous to him. The Government may look at actualities and upon determination that the form employed for doing business or carrying out the challenged tax event is unreal or a sham may sustain or disregard the effect of the fiction as best serves the purposes of the tax statute."¹¹

So the Treasury Department is not, —as seems to have been assumed in this suit from a misreading of this decision,— free to disregard the corporate entity where a tax benefit would result to the taxpayer. Conditions must exist which warrant the conclusion that a particular organization served no actual business purpose. Nor, in doing so, can the Treasury Department, when dealing either with two corporate entities, or with a group of individuals and a corporate entity, seize upon common ownership or control as the sole determinant. That criterion adopted by the Supreme Court early in the history of income taxation¹² has been repudiated by recent cases.¹³ In the latest case on the subject, decided in 1949,¹⁴ the Supreme Court has said specifically that that criterion no longer is determinative of taxability or non-taxability. "Complete ownership of the corporation, and the control primarily dependent upon such ownership—the important ingredients of the Southern Pacific case— are no longer of significance in determining taxability."¹⁵

For, regardless of the motivation to reduce taxation and of ownership, if the assumption of a particular form, such as the corporate form, is followed by...