Kerr v. CIR

• Decision Date: 03 January 1964
• Docket Number: No. 18371.,18371.
• Citation: 326 F.2d 225
• Parties: Thomas KERR and Barbara Kerr, Petitioners, v. COMMISSIONER OF INTERNAL REVENUE, Respondent.
• Court: U.S. Court of Appeals — Ninth Circuit

326 F.2d 225 (1964)

Thomas KERR and Barbara Kerr, Petitioners, v. COMMISSIONER OF INTERNAL REVENUE, Respondent.

No. 18371.

United States Court of Appeals Ninth Circuit.

January 3, 1964.

Black & Apicella, John P. Apicella and Guy J. Rappleyea, Portland, Or., for petitioners.

Louis F. Oberdorfer, Asst. Atty. Gen., Lee A. Jackson, Melva M. Graney, Ralph A. Muoio, and Meyer Rothwacks, Attys., Dept. of Justice, Washington, D. C., for respondent.

Before CHAMBERS and BARNES, Circuit Judges, and BEEKS, District Judge.

BARNES, Circuit Judge:

This is a petition for review of a decision of the Tax Court in favor of the Commissioner. 38 T.C. 723. The Tax Court had jurisdiction of the cause under Section 6213.¹ This court has jurisdiction of this petition pursuant to Section 7482.

The taxpayer, Thomas Kerr,² owned all of the stock of two corporations. On October 24, 1955, he transferred the stock of one to the other for a note with face value of $50,000. There are two issues: (1) Was the $50,000 note taxable to him as a distribution essentially equivalent to a dividend under §§ 302, 304, and other related sections of the 1954 Code? (2) If we answer this question in the affirmative, are §§ 302 and 304 constitutional?

I — FACTS

In 1947, taxpayer organized the Helix Milling Company (hereinafter "Helix") for the purpose of engaging in the business of milling and selling flour. All of the outstanding stock of Helix was acquired by taxpayer in exchange for the mill property, and taxpayer has been the corporation's president, chief executive officer, and a director, since the date of incorporation.

After its incorporation and until early 1955, Helix was operated by succeeding unrelated corporations under an arrangement whereby the latter corporations handled the financing and operation of Helix in return for a share of the profits. In early 1954, in an effort to improve and stabilize its income and to expand its operations, Helix commenced construction of a modern grain elevator as an adjunct to its flour mill. To finance this facility, Helix borrowed $200,000 from the United States National Bank of Portland ("bank") on a ten-year loan secured by a first mortgage on the grain elevator. The taxpayer gave his personal guaranty as an additional security for the construction loan.

Toward the latter part of 1954 a corporation (Cargill, Incorporated) which had been operating and financing Helix stated that it planned to withdraw its support, and taxpayer made banking arrangements to secure funds to liquidate the debts which Helix owed the withdrawing corporation. In order to obtain loans from the bank, taxpayer executed personal notes totalling $150,000 and pledged as security for the loans his expected inheritance from the estate of a deceased relative. After taxpayer received the money from the bank, he loaned it to Helix in return for five percent demand promissory notes.

Due to the fact that several months elapsed between the time Helix first purchased the wheat and the time it received the proceeds from the sale of its flour, Helix usually found itself in a tight working-capital position. Thus, Helix found it necessary to borrow money from the bank for working-capital purposes. The bank considered Helix as a marginal credit risk, and required personal guaranties from the taxpayer for most of the loans.

In January, 1955, taxpayer was faced with the loss of his employment with Cargill, Inc., which had been operating and financing Helix, and he realized that he would have to seek other means of livelihood. Taxpayer then organized the Kerr Grain Corporation (hereinafter "Kerr Grain") for the purpose of engaging in the grain brokerage and grain storage business. All of the outstanding stock was acquired by taxpayer for $50,000 in cash, and at all times pertinent to this proceeding taxpayer has been the president and the chief executive officer of the company. In forming Kerr Grain, taxpayer was hopeful that the corporation would be able to obtain business from the Federal Government, and he was aware that in the absence of such business the corporation would experience difficulty.

Following its organization, Kerr Grain, lacking sufficient working capital to finance its operations, was forced to seek outside financing. The bank extended it a credit ceiling of $150,000, and as in case of Helix, and for the same reasons, the bank required the personal guaranty of the taxpayer as security. Helix also advanced various sums to Kerr Grain, and paid its office expenses until August 1955.

As of June 30, 1955, Helix had an earned surplus of $130,051. For the fiscal year ended June 30, 1955, Helix sustained a net loss of $12,198.89, and taxpayer alleges that Helix continued to sustain losses up to and including October of 1955.

Kerr Grain got off to a shaky start, and sustained a net loss of $1,886.40 for its first fiscal period which ended June 30, 1955 (the first six months of operation), but soon began to improve and as of October 1955, it had a net profit of $113,393.38.

On October 24, 1955, following discussions with his attorneys, accountants, and with representatives of the bank, taxpayer submitted a proposal to the board of directors of Helix providing for the sale of his stock in Kerr Grain to Helix for $50,000. The board voted to accept taxpayer's proposal. Following the acceptance, taxpayer conveyed all the outstanding stock of Kerr Grain to Helix and received, in return, a promissory note for $50,000 payable in installments of $10,000 per year and bearing interest at the rate of five per cent on the unpaid balance. The note was secured by a pledge to taxpayer of the Kerr Grain stock. Taxpayer's basis for the stock on October 24, 1955, was $50,000. The stock had a book value on that date in excess of $100,000 and a fair market value in excess of $50,000. Helix' earned surplus then was in excess of $50,000.

At the board meeting of October 24, 1955, taxpayer also informed the directors of Helix that the bank had granted Helix an open line of credit in the amount of $100,000 and a $50,000 additional line of secured credit. At no time did the bank request that taxpayer transfer his Kerr Grain stock to Helix or that the two companies be consolidated. Nor did the bank require the transfer as a condition precedent to future financing. However, representatives of the bank did agree with taxpayer during earlier discussions that the contemplated stock transfer "may have `certain advantages — both credit-wise and tax-wise'." After the stock sale, the bank continued to require taxpayer's personal guaranty on all operating loans it made, both to Helix and to Kerr Grain.

Following the sale of Kerr Grain stock to Helix, no curtailment of either corporation's activity was undertaken. In fact, following the sale, Kerr Grain expanded its business quite materially while Helix maintained its business on a fairly even keel until 1957 when it, too, expanded its operations.

Neither Helix nor Kerr Grain declared or paid a dividend prior to December 14, 1955. On December 14, 1955, Kerr Grain declared and paid a dividend of $33,500 to Helix. On the same date Helix paid an identical dividend to taxpayer, charging it to an account designated as "Notes Payable to Thomas Kerr." (Taxpayer alleges that the note payable referred to here was not the $50,000 note received by petitioner in exchange for the Kerr Grain Corporation stock, but, as shown by Exhibit 5-E, was one of the notes representing part of the $150,000 loaned to Helix by the bank through taxpayer.)

Kerr Grain also declared a dividend in the amount of $16,500 on June 27, 1956. On the same day the board of directors of Helix passed resolutions providing for the payment of bonuses totalling $13,500 to several of the Helix employees.

No statement or information was submitted on taxpayer's income tax return for the year 1955 with regard to the transfer of the Kerr Grain stock to Helix. (Ex. 1-A.) The Commissioner's determination that the $50,000 of notes received by the taxpayer from Helix was taxable as dividend income was sustained by the Tax Court. This appeal followed.

II — THE LAW

Relevant sections of the Code.

In general, a distribution of property by a corporation to the extent of its earnings and profits is treated as a dividend and is includible in the shareholder's gross income. Sections 316(a) and 301(a) and (c). An exception to this general rule is found in § 302(a) and (b) dealing with distributions in redemption of stock.³ Under § 302(b) (1) a redemption is not includible in gross income as a dividend if the redemption is "not essentially equivalent to a dividend." Thus, if the redemption qualifies under this exception, the distribution is treated as payment in exchange for stock under § 302(a), and since stock is generally a capital asset, the gain would be treated as a capital gain.

On the other hand, if the redemption does not qualify under this exception of § 302(b), then § 302(d) provides that the redemption shall be treated as a distribution of property to which § 301 applies and be taxed at ordinary income rates. Ordinarily a redemption occurs when a corporation acquires its stock from a shareholder in exchange for property. Section 317(b). However, in 1954 Congress added a new provision to the Code, § 304(a) (1),⁴ which was designed⁵ to expand the provisions of § 115(g) of the 1939 Code (relating to stock redemptions essentially equivalent to dividends) so as to include cases of so-called "brother-sister" corporations. That section provides that, for purposes of § 302, if one or more persons are in control of each of two corporations, and in return for property, one of the corporations acquires stock in the other corporation from the person or persons so in control, then such property shall be treated as a distribution in redemption of the stock of the acquiring corporation.

In this case, taxpayer was in control of both corporations, and one of the...