Levin v. CIR

• Decision Date: 11 October 1967
• Docket Number: 31380.,68,Dockets 31379,No. 67,67
• Parties: Beatrice LEVIN, Petitioner, v. COMMISSIONER OF INTERNAL REVENUE, Respondent.
• Court: U.S. Court of Appeals — Second Circuit

385 F.2d 521 (1967)

Beatrice LEVIN, Petitioner, v. COMMISSIONER OF INTERNAL REVENUE, Respondent.

Nos. 67, 68, Dockets 31379, 31380.

United States Court of Appeals Second Circuit.

Argued September 26, 1967.

Decided October 11, 1967.

Newton D. Brenner, New Haven, Conn. (Allen H. Duffy, Stephen L. Saltzman, New Haven, Conn., of counsel), for petitioner.

Louis M. Kauder, Atty., Dept. of Justice (Richard C. Pugh, Acting Asst. Atty. Gen., Meyer Rothwacks, Gilbert E. Andrews, Attys., Dept. of Justice, of counsel), for respondent.

Before MOORE, SMITH and KAUFMAN, Circuit Judges.

IRVING R. KAUFMAN, Circuit Judge:

The perils of acting without competent tax advice¹ are demonstrated anew, if further evidence be needed, by this petition to review a decision of the Tax Court, 47 T.C. 258 (1966), holding that distributions in 1960, 1961, 1962, and 1963 to the taxpayer in redemption of her stock in a family corporation were "essentially equivalent to a dividend" within the meaning of section 302(b) (1) of the Internal Revenue Code of 1954, and hence taxable at ordinary income rates.² We affirm the decision of the Tax Court.

The evidence, as found by the Tax Court,³ established that Mrs. Levin's family corporation, the Connecticut Novelty Corporation, Inc., commenced operations as a partnership between her husband and her brother, Joseph Levine. In its early years the business centered on the wholesale distribution of "fireworks," but it shifted exclusively to retail jewelry after the state prohibited their use in 1951. Taxpayer succeeded to her husband's interest in the business upon his death in 1940. Thereafter, her brother Joseph came to live with her and her son Jerome, and became a "second father" to him. She relied heavily on Joseph's advice in business matters.

Following incorporation of the business in 1948, its 1300 outstanding single class common shares were held as follows: Joseph Levine, 650 shares; Mrs. Levin, 649 shares; Jerome Levin, 1 share.⁴ The three stockholders also constituted the board of directors and officers of the corporation until Joseph Levine's death in April 1962, when Jerome's wife became a director. Taxpayer was secretary and treasurer until 1959, when she limited her office in the company to secretary.

Jerome was employed full time in the business since graduating from high school in 1944. In 1957 he contemplated marriage and discussed his status in the company with his mother and uncle in order to learn "where he stood" in the business. He insisted on this so that if it became necessary he could embark on another career while still young. Thereafter, Joseph and the taxpayer agreed to give him a greater participation in the business ownership and management. As a result the existing stock was cancelled and 1300 new shares of common stock were issued and distributed in this manner: Joseph, 485 shares; taxpayer 484 shares; Jerome, 331 shares. Jerome gave no consideration for the 330 additional shares.

Within a few years Jerome sought outright ownership of the business and to retire his uncle and mother. But he desired to accomplish this by a method which would make provision for them during the balance of their lives. Accordingly, on January 19, 1960, a plan was devised whereby the corporation would redeem the stock of taxpayer and Joseph at $200 per share. Pursuant to this plan Joseph and taxpayer executed identical agreements with the corporation. She was to receive $7000 per year without interest beginning April 1, 1960 until $96,800⁵ was paid. Upon default the unpaid balance would become due upon the "seller's" election. As an alternative, the corporation was given the option to pay the entire or any part of the purchase price at any time. After the plan was consummated, Jerome conducted the business with "a greater freedom of action." But out of "respect and sentiment," as we are told, Joseph and taxpayer were retained as directors and officers of the corporation.

Coincidentally, the taxpayer and Joseph became eligible for social security benefits. But, they continued to perform services for the corporation and to receive salaries while at the same time taxpayer accepted a cut in her salary to $1200 per year, the maximum amount then permitted to be earned without a reduction in her social security benefits. See 42 U.S.C. § 403 (1964 ed.).

The dispute before us arises from taxpayer's treatment of the $7000 payments. In the taxable years in question, 1960 through 1963, she reported the compensation from the corporation under the 1960 agreement as long-term capital gains.⁶ The Commissioner treated the payments as essentially equivalent to dividends and accordingly determined deficiencies for all the years in question.⁷

I.

The difference between a stock redemption that is essentially equivalent to a dividend and one that is not is grounded on a long history in the tax law. The distinction was essential because without it the tax on dividends at ordinary income rates could easily be defeated by the simple expedient of issuing more stock to the shareholders, who then would "sell" back their new shares to the corporation. It would then be asserted that the proceeds of this alleged sale were taxable at capital gains rates because they represented proceeds from the "sale" of a capital asset. To eliminate this patent loophole, Congress early provided that such distributions would receive capital gain treatment only if they were "not essentially equivalent to a dividend." See generally 1 Mertens, Law of Federal Income Taxation § 9.99 (Oliver ed. 1962).

But this simplistic formula created more problems than it solved for the courts were then called upon to answer the elusive question as to when a distribution was or was not "essentially equivalent to a dividend." At first it was generally believed that, in view of its history, the provision was aimed only at distributions motivated by a tax avoidance purpose. Accordingly, if a distribution served a "business purpose," the courts held it was not essentially equivalent to a dividend. This rationale was becoming increasingly difficult to apply, however, and it came to its demise in 1945 when, in interpreting an analogous statutory provision, the Supreme Court ruled that motive had little relevancy. The Court then adopted a more objective "net effect" test, under which the question of dividend equivalency depended on whether the distribution in redemption of stock had the same economic effect as a distribution of a dividend would have had. Commissioner v. Estate of Bedford, 325 U.S. 283, 65 S.Ct. 1157, 89 L.Ed. 1611 (1945).⁸ In time this test also proved ephemeral; some courts developed many criteria to determine the "net effect" of a distribution,⁹ while in determining "net effect" we differed and relied primarily on changes in "basic rights of ownership."¹⁰ However, most cases have been resolved on their own facts and circumstances.¹¹

Until 1954 the "not essentially equivalent to a dividend" test, with all its perplexing problems, had been the sole statutory guide in this area. But the draftsmen of the 1954 Internal Revenue Code, faced with "the morass created by the decisions,"¹² attempted to clarify the standards and thus to make more precise the dividing line between stock redemptions that qualified for capital gains treatment and those that did not by adding objective tests, see § 302(b) (2)-(4), and rules defining constructive ownership, see § 318.

Since the "not essentially equivalent to a dividend" test is no longer applied in a vacuum, it is impossible to interpret it without examining the statutory scheme of which it is now a part. Section 302(a) provides that a stock redemption¹³ shall be treated as an "exchange" if it falls into any one of the categories of § 302(b).¹⁴ These categories are: (1) a redemption that is "not essentially equivalent to a dividend" under § 302(b) (1); (2) a "substantially disproportionate" redemption under § 302(b) (2); (3) a complete redemption terminating the shareholder's interest in the corporation under § 302(b) (3).¹⁵ Section 302 (b) (2) contains an exact mathematical formula to determine whether the disproportion is "substantial." The test in § 302(b) (3) is not mathematical, but it is stated with equal clarity. The shareholder must redeem all of his actually and constructively owned stock to qualify for capital gain treatment under this provision, and § 302(c) (2) provides that if certain clear-cut conditions are met the family attribution rules of § 318(a) will not apply in determining whether the shareholder has disposed of all his stock.

Mrs. Levin concedes that she fails to meet the requirements of either § 302 (b) (2) or § 302(b) (3),¹⁶ and so she relies on § 302(b) (1).¹⁷ Our task of interpretation and reasoned elaboration cannot be adequately performed if we examine each provision as if it existed in a vacuum. The Code draftsmen hopefully expected that the preciseness of the tests set out in the new provisions, § 302(b) (2) and § 302(b) (3), would serve to relieve the pressure on the "not essentially equivalent to a dividend" test re-enacted as § 302(b) (1). The new requirements, if carefully observed, provided safe harbors for taxpayers seeking capital gain treatment. As a result, their enactment permitted more accurate and long range tax planning.

The legislative history of § 302 (b) (1) supports the view that it was designed to play a modest role in the statutory scheme. As originally passed by the House of Representatives, no provision was made for the "not essentially equivalent to a dividend" test; reliance was placed entirely on provisions similar to § 302(b) (2) and § 302(b) (3). Thereafter the Senate Finance Committee added § 302(b) (1) and explained its action as follows:¹⁸

While the House bill set forth definite conditions under which stock may be redeemed at capital-gain rates, these rules appeared unnecessarily restrictive, particularly in the case of redemptions

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