Millar v. C. I. R., Docket No. 5884-72

• Decision Date: 12 August 1976
• Docket Number: Docket No. 5884-72,Docket No. 5889-72,Docket No. 5888-72,Docket No. 5892-72,No. 75-2296,Docket No. 5885-72,Docket No. 5893-72,75-2296
• Citation: 540 F.2d 184
• Parties: 76-2 USTC P 9611 Gavin S. MILLAR, Appellant, v. COMMISSIONER OF INTERNAL REVENUE. (Tax Court) John R. JAMISON and Suzon G. Jamison, Appellants, v. COMMISSIONER OF INTERNAL REVENUE. (Tax Court) Philip D. RODGERS and Elizabeth C. Rodgers, his wife, Appellants, v. COMMISSIONER OF INTERNAL REVENUE. (Tax Court) Philip R. JAMISON and Helen L. S. Jamison, his wife, Appellants, v. COMMISSIONER OF INTERNAL REVENUE. (Tax Court) James L. TENLEY and Betty J. Tenley, his wife, Appellants, v. COMMISSIONER OF INTERNAL REVENUE. (Tax Court) Robert K. CONRAD and Jane H. Conrad, his wife, Appellants, v. COMMISSIONER OF INTERNAL REVENUE. (Tax Court)
• Court: U.S. Court of Appeals — Third Circuit

Page 184

540 F.2d 184

76-2 USTC P 9611

Gavin S. MILLAR, Appellant, v. COMMISSIONER OF INTERNAL REVENUE. (Tax Court Docket No. 5884-72)

John R. JAMISON and Suzon G. Jamison, Appellants, v. COMMISSIONER OF INTERNAL REVENUE. (Tax Court Docket No. 5885-72)

Philip D. RODGERS and Elizabeth C. Rodgers, his wife, Appellants, v. COMMISSIONER OF INTERNAL REVENUE. (Tax Court Docket No. 5888-72)

Philip R. JAMISON and Helen L. S. Jamison, his wife, Appellants, v. COMMISSIONER OF INTERNAL REVENUE. (Tax Court Docket No. 5889-72)

James L. TENLEY and Betty J. Tenley, his wife, Appellants, v. COMMISSIONER OF INTERNAL REVENUE. (Tax Court Docket No. 5892-72)

Robert K. CONRAD and Jane H. Conrad, his wife, Appellants, v. COMMISSIONER OF INTERNAL REVENUE. (Tax Court Docket No. 5893-72)

No. 75-2296.

United States Court of Appeals, Third Circuit.

Argued June 11, 1976.

Decided Aug. 12, 1976.

Edmund W. Ridall, Jr., McCann, Garland, Ridall & Burke, Pittsburgh, Pa., for appellants.

Scott P. Crampton, Asst. Atty. Gen., William Estabrook, III, Gilbert E. Andrews, Michael L. Paup, Libero Marinelli, Jr., Attys., Tax Div., Dept. of Justice, Washington, D.C., for appellee.

Before SEITZ, Chief Judge, and ALDISERT and GARTH, Circuit Judges.

OPINION OF THE COURT

SEITZ, Chief Judge.

This is an appeal from a decision of the Tax Court which held that the petitioner taxpayers realized taxable gain in the form of cancellation of indebtedness upon the surrender of their stock in Grant County Coal Corporation ("Grant County") to R. H. Jamison in complete satisfaction of their non-recourse obligations to him secured by the same, even though their stock had a fair market value of zero at the time of surrender. This case thus raises an issue left open by the Supreme Court's landmark decision in Crane v. Commissioner, 331 U.S. 1, 14 n. 37, 67 S.Ct. 1047, 91 L.Ed. 1301 (1947). In addition, two of the petitioners contest the entry of a negligence penalty against them pursuant to 26 U.S.C. § 6653(a) for failure to report as income the gain on the surrender of the Grant County stock and to recapture certain investment credits previously applied by them to reduce their income tax liability.

The relevant facts as found by the Tax Court or stipulated to by the parties may be briefly stated. The petitioners are relatives and/or close business associates of R. H. Jamison, a prominent Western Pennsylvania coal-mine operator. In 1964, Jamison organized Grant County for the purpose of developing a West Virginia strip-mining operation and caused it to issue its stock to the petitioners and four others for no consideration on their part. In order to provide the corporation with working capital, Jamison advanced $500,000 to Grant County's shareholders ¹ in amounts proportionate to their interest in the corporation. Each shareholder then executed a demand, non-recourse note payable to Jamison in the amount previously advanced to him. These notes were secured solely by the shareholders' Grant County stock. Thereafter, the shareholders contributed the funds advanced to them by Jamison to the capital of Grant County which used them to commence mining operations.

The anticipated profits from the Grant County venture never materialized. Instead, the corporation suffered net operating losses of nearly $600,000 in the years 1964 through 1966. By the beginning of 1967, these continuing losses had left Grant County on the verge of bankruptcy and rendered the shareholders' stock therein valueless. At this point in time, Jamison demanded payment on the shareholders' notes. When no such payments were forthcoming, he notified them that he was foreclosing on their stock. Shortly after the foreclosure, Grant County went into bankruptcy.

Despite the absence of profits during the period of Grant County's operation, each of its shareholders secured significant tax benefits from his ownership of Grant County stock. Shortly after its incorporation, Grant County's shareholders had filed an election with the Internal Revenue Service ("I.R.S.") to have Grant County taxed as a small business corporation under Subchapter S of the Internal Revenue Code ("I.R.C."). As a result, its net operating losses passed through to its shareholders in proportion to their interest in the corporation and they were entitled to, and did, claim such losses as deductions in computing their personal tax liability. Likewise, the investment tax credits earned by Grant County under 26 U.S.C. § 38, during this period passed through to its shareholders because of its status as a Subchapter S corporation. In addition, Grant County paid the interest due on each shareholder's note to Jamison. The shareholders, in turn, claimed these interest payments as deductions on their personal tax returns under 26 U.S.C. § 163.

For the petitioners herein, these interest and operating loss deductions enabled them to shelter from federal taxation nearly $298,000 in income earned from outside sources and the investment tax credits claimed reduced their income tax liability by approximately $40,000. However, it should be noted that both the operating loss and interest deductions claimed by the shareholders had the necessary effect of reducing their adjusted bases in the Grant County stock in an amount equal to the deductions taken.

On their 1967 tax returns, none of the petitioners reported any gain on the transfer of their stock to Jamison nor did they recapture any of the investment tax credits claimed in prior years. The Commissioner of the I.R.S., however, determined that the petitioners had realized taxable gain on the foreclosure in the amount by which their discharged indebtedness exceeded their adjusted bases in the Grant County stock. He also determined that the investment credits were subject to recapture. Accordingly, he entered tax deficiencies against the...