Hurst v. Comm'r of Internal Revenue

• Decision Date: 03 February 2005
• Docket Number: No. 15792–02.,15792–02.
• Citation: 124 T.C. No. 2,124 T.C. 16
• Parties: Richard E. and Mary Ann HURST, Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent
• Court: U.S. Tax Court

124 T.C. 16

124 T.C. No. 2

Richard E. and Mary Ann HURST, Petitioners

v.COMMISSIONER OF INTERNAL REVENUE, Respondent

No. 15792–02.

United States Tax Court.

Feb. 3, 2005.

In 1997, as part of their retirement planning, Ps sold their stock in R Corp. to H Corp. H Corp. redeemed 90 percent of P-husband's stock in H Corp., and P-husband sold the remainder to his son and two third parties. Both the redemption and stock sales provided for payment over 15 years and were secured by the shares of stock being redeemed or sold. Ps continued to own H Corp.'s headquarters building, which they leased back to H Corp. P-wife continued to be an employee of H Corp. after the redemption, and she and her husband continued to receive medical insurance through her employment. All the agreements—stock purchase and redemption, lease, and employment contract—were cross-collateralized by P-husband's H Corp. stock and contained cross-default provisions.

Held:

1. The sale and redemption of the H Corp. stock qualifies as a termination redemption under sec. 302(b)(3), I.R.C. None of the cross-default and cross-collateralization provisions made P-husband's post-transaction interest one “other than an interest as a creditor.”

2. R's contention that Ps' sale of their R Corp. stock should be analyzed under sec. 304's rules governing sales of stock between corporations under common control must be rejected for lack of evidence because it was raised only in posttrial briefing and is a “new matter” rather than a “new argument.”

3. P-wife is a “2–percent shareholder” under section 1372, I.R.C., because the rules of section 318, I.R.C., attribute to her the ownership of the H Corp. stock of both her husband and son during 1997; accordingly, the H Corp. health insurance premiums are includible in her income, subject to a deduction of a percentage of their amount under section 162(1)(1)(B), I.R.C.

Terry L. Zabel, for petitioners.

Bryan E. Sladek, for respondent.

HOLMES, J.

Richard Hurst founded and owned Hurst Mechanical, Inc. (HMI), a thriving small business in Michigan that repairs and maintains heating, ventilating, and air conditioning (HVAC) systems. He bought, with his wife Mary Ann, a much smaller HVAC company called RHI; and together they also own the building where HMI has its headquarters.

When the Hursts decided to retire in 1997, they sold RHI to HMI, sold HMI to a trio of new owners who included their son, and remained HMI's landlord. Mary Ann Hurst stayed on as an HMI employee at a modest salary and with such fringe benefits as health insurance and a company car.

The Hursts believe that they arranged these transactions to enable them to pay tax on their profit from the sale of HMI and RHI at capital gains rates over a period of fifteen years. The Commissioner disagrees.

FINDINGS OF FACT

The Hursts were married in 1965, and have two children. Mr. Hurst got his first job in the HVAC industry during high school, working as an apprentice in Dearborn. He later earned an associate's degree in the field from Ferris State College. After serving in the military, he moved back to Detroit, and eventually gained his journeyman's card from a local union. In 1969, he and his wife made the difficult decision to move their family away from Detroit after the unrest of the previous two years, and they settled in Grand Rapids where he started anew as an employee of a large mechanical contractor.

In April 1979, the Hursts opened their own HVAC business, working out of their basement and garage. Mr. Hurst handled the technical and sales operations while Mrs. Hurst did the bookkeeping and accounting. The business began as a proprietorship, but in November of that year they incorporated it under Michigan law, with Mr. Hurst as sole shareholder of the new corporation, named Hurst Mechanical, Inc. (HMI). In 1989, HMI elected to be taxed under subchapter S of the Code, and that election has never changed.¹ The firm grew quickly, and after five years it had about 15 employees; by 1997, it had 45 employees and over $4 million in annual revenue.

After leaving the Hursts' home, HMI moved to a converted gas station, and then to a building in Comstock Park, Michigan. When the State of Michigan bought the Comstock Park building in the mid–1990s, the company moved again to Belmont, Michigan, in a building on Safety Drive. The Hursts bought this building in their own names and leased it to HMI. In early 1994, the Hursts bought another HVAC business, Refrigerator Man, Inc., which they renamed R.H., Inc. (RHI). Each of the Hursts owned half of RHI's stock.

In 1996, with HMI doing well and settled into a stable location, the Hursts began thinking about retirement. Three employees had become central to the business and were to become important to their retirement plans. One was Todd Hurst, who had grown up learning the HVAC trade from his parents. The second was Thomas Tuori. Tuori was hired in the mid–1980s to help Mary Ann Hurst manage HMI's accounting, and by 1997 he was the chief financial officer of the corporation. The last of the three was Scott Dixon, brought on in 1996, after Richard Hurst came to believe that HMI was big enough to need a sales manager. Dixon anticipated the potential problems posed by the Hursts' eventual retirement so, before joining the firm, he negotiated an employment contract that included a stock option. His attorney also negotiated stock option agreements for Tuori and Todd Hurst at about the same time. These options aimed to protect Dixon and the others if HMI were sold.

In late 1996, Richard Hurst was contacted by Group Maintenance American Corporation (GMAC). GMAC was an HVAC consolidator—a company whose business plan was to buy small HVAC businesses and try to achieve economies of scale—and it offered to buy HMI for $2.5 million. Mr. Hurst told Tuori, Dixon, and Todd about GMAC's offer, and they themselves confirmed it—only to learn that GMAC had no interest in keeping them on after a takeover. Convinced they were ready to run the business, they approached Mr. Hurst in May 1997 with their own bid to buy his HMI stock, matching the $2.5 million offered by GMAC. Mr. Hurst accepted the offer, confident that the young management team he had put together would provide a secure future for the corporation he had built up over nearly twenty years.

Everyone involved sought professional advice from lawyers and accountants who held themselves out as having expertise in the purchase and sale of family businesses. The general outline of the deal was soon clear to all. The Hursts would relinquish control of HMI and RHI to Tuori, Dixon, and Todd Hurst, and receive $2.5 million payable over fifteen years. HMI, Inc. would continue to lease the Safety Drive property from the Hursts. The proceeds from the sale of the corporations and the rent from the lease would support the Hursts during their retirement. Mrs. Hurst would continue to work at HMI as an employee, joining the firm's health plan to get coverage for herself and her husband. Tuori, Dixon, and Todd Hurst would own the company, getting the job security they would have lacked had HMI been sold.

Everything came together on July 1, 1997: HMI bought 90 percent of its 1000 outstanding shares from Mr. Hurst for a $2 million note. Richard Hurst sold the remaining 100 shares in HMI to Todd Hurst (51 shares), Dixon (35 shares), and Tuori (14 shares). The new owners each paid $2500 a share, also secured by promissory notes. HMI bought RHI from the Hursts for a $250,000 note.² (All these notes, from both HMI and the new owner, had an interest rate of eight percent and were payable in 60 quarterly installments.) HMI also signed a new 15–year lease for the Safety Drive property, with a rent of $8,500 a month, adjusted for inflation. The lease gave HMI an option to buy the building from the Hursts, and this became a point of some contention—described below—after the sale. And, finally, HMI also signed a ten-year employment contract with Mrs. Hurst, giving her a small salary and fringe benefits that included employee health insurance.

If done right, the deal would have beneficial tax and nontax effects for the Hursts. From a tax perspective, a stock sale would give rise to long-term capital gain, taxed at lower rates than dividends.³ And by taking a 15–year note, rather than a lump sum, they could qualify for installment treatment under section 453, probably letting them enjoy a lower effective tax rate.

There were also nontax reasons for structuring the deal this way. HMI's regular bank had no interest in financing the deal, and the parties thought that a commercial lender would have wanted a security interest in the corporations' assets. By taking a security interest only in the stock, the Hursts were allowing the buyers more flexibility should they need to encumber corporate assets to finance the business.

But this meant that they themselves were financing the sale. And spreading the payments over time meant that they were faced with a lack of diversification in their assets and a larger risk of default. To reduce these risks, the parties agreed to a complicated series of cross-default and cross-collateralization provisions, the net result of which was that a default on any one of the promissory notes or the Safety Drive lease or Mrs. Hurst's employment contract would constitute a default on them all. Since the promissory notes were secured by the HMI and RHI stock which the Hursts had sold, a default on any of the obligations would have allowed Mr. Hurst to step in and seize the HMI stock to satisfy any unpaid debt.

As it turned out, these protective measures were never used, and the prospect of their use seemed increasingly remote. Under the management of Todd Hurst, Dixon, and Tuori, HMI boomed. The company's revenue increased from approximately $4 million annually at the time of the sale to over $12 million by 2003. Not once after the sale did any of the new owners miss a payment...