Ortmayer v. CIR, 12202.

• Decision Date: 15 April 1959
• Docket Number: No. 12202.,12202.
• Citation: 265 F.2d 848
• Parties: Carl G. ORTMAYER and Hilda B. Ortmayer, Husband and Wife, Petitioners, v. COMMISSIONER OF INTERNAL REVENUE, Respondent.
• Court: U.S. Court of Appeals — Seventh Circuit

265 F.2d 848 (1959)

Carl G. ORTMAYER and Hilda B. Ortmayer, Husband and Wife, Petitioners, v. COMMISSIONER OF INTERNAL REVENUE, Respondent.

No. 12202.

United States Court of Appeals Seventh Circuit.

April 15, 1959.

COPYRIGHT MATERIAL OMITTED

Donald P. Zedler, Milwaukee, Wis., for petitioners.

Charles K. Rice, Asst. Atty. Gen., David O. Walter, Atty., Tax Division, U. S. Dept. of Justice, Washington, D. C., Andrew F. Oehmann, Acting Asst. Atty. Gen., Lee A. Jackson, Atty., Dept. of Justice, Washington, D. C., for respondent.

Before MAJOR, SCHNACKENBERG and HASTINGS, Circuit Judges.

HASTINGS, Circuit Judge.

This petition for review of a decision of the Tax Court of the United States involves deficiencies of approximately $50,000 assessed against taxpayers, Carl G. and Hilda B. Ortmayer, for the year 1948.¹ It was found by the Tax Court that taxpayers had received taxable income through a distribution of debentures to them by the Cunningham-Ortmayer Company on July 2, 1948 and, further, that Carl G. Ortmayer had received taxable income in a second transaction on the same day in which his debts to that company were canceled.

Taxpayer² has been an officer of the Cunningham-Ortmayer Company (the company) since its incorporation in 1924 and was its president from 1941 to 1952. During the years 1946, 1947 and 1948 taxpayer had an annual salary of $30,000; and, in addition, he borrowed extensively from the company, these borrowings being recorded in an asset account as accounts receivable. The Tax Court found that on July 2, 1948 taxpayer was indebted to the company in the amount of $95,561.52 consisting of accounts payable of $65,561.52 and notes payable of $30,000.³

No taxable dividend was declared or paid by the company during the period from its incorporation to the date of the questioned transactions in this case. The company showed a profit during each of the years from 1942 through 1948.

Because of the nature of its business, the company required a substantial line of credit. For a period of years the Marine National Exchange Bank (the bank) had extended it credit of $100,000, the loans being secured by assignment of the company's accounts receivable. The company periodically submitted financial statements to the bank. In the spring of 1948, the bank expressed concern that current earnings of the company were being loaned to taxpayer rather than being retained as working capital. However, the bank neither requested the elimination of taxpayer's indebtedness to the company nor suggested a recapitalization. It did insist that there be no further loans of the company's earnings.

Subsequently, the company consulted its accountant on this matter and on June 30, 1948, at a special meeting of stockholders, a decision was made to change the capital stock of the company from 750 shares of $100 par value common stock (issued and outstanding) to 1,500 shares of $1.00 par value common (authorized) and to issue long-term debentures in an amount not to exceed $99,000.

On July 2, 1948 the stockholders surrendered to the company all 750 outstanding shares and these shares were canceled by the company. The stockholders also paid over $1.00 with each share so surrendered and the company thereupon issued, pro rata, 750 shares of $1.00 par value common stock and 750 six percent debentures. The debentures, in the face amount of $100 each, were for a ten-year term and were redeemable on any interest paying date at the option of the company. One such debenture was issued and delivered with each share of $1.00 par value common stock. The taxpayers who had owned 748 of the original 750 outstanding shares of stock thus received 748 of the new shares of stock plus 748 of the debentures. The fair market value of each share of new stock distributed by the company on July 2, 1948 was $350 and that of each debenture was $100.

This transaction did not better the financial position of the company for credit purposes. The bank continued to extend credit but required the assignment of accounts receivable which were the obligations of municipalities as security and would no longer accept, as security, accounts of individuals and corporations.

The Tax Court concluded that the pro rata distribution of the new stock and debentures was essentially equivalent to the distribution of a taxable dividend, within the meaning of Section 115(g) of the Internal Revenue Code of 1939,⁴ to the extent that the fair market value of the debentures exceeded the cash amount paid in by taxpayers. Taxpayers urge that the transaction was a nontaxable reorganization-recapitalization as provided in Sections 112(b)(3) and 112(g)(1)(E) of the Code.⁵

We agree with the Tax Court's determination that, as to the purported recapitalization, this case falls squarely within the Supreme Court's holding in Bazley v. Commissioner, 1947, 331 U.S. 737, 67 S.Ct. 1489, 91 L.Ed. 1782. See also Heady v. Commissioner, 7 Cir., 1947, 162 F.2d 699.

It is taxpayers' position that the instant case differs materially from Bazley in that the two transactions on July 2, 1948 were undertaken by this closely held corporation for the dominant business purpose of meeting the bank's objections to the then existing indebtedness to the corporation of the taxpayer.⁶ This contention must fail on the record in this case. The Tax Court's findings, supported by substantial evidence, indicate that the bank did not request recapitalization by the company; that the bank did not consider the new arrangement to have bettered the financial position of the company for credit purposes; that the transaction did not, in fact, in any way change the working capital position of the company; and that the benefit from the transaction went to the taxpayers who emerged with an unaffected equity in the company and with debentures having a fair market value of $74,800. As stated by the Supreme Court in Bazley: "Whether in a particular case a paper recapitalization is no more than an admissible attempt to avoid the consequences of an outright distribution of earnings turns on details of corporate affairs, judgment on which must be left to the Tax Court." Supra 331 U.S. at page 742, 67 S.Ct. at page 1491.

But apart from the simple and direct authority of Bazley, the position of the taxpayers is made further untenable by their apparent erroneous assumption that proof of a valid business purpose is alone adequate to establish that the distribution was not essentially equivalent to a taxable dividend. This court has held that the existence of a valid corporate purpose is only one of many factors to be considered, and that it is not necessarily the controlling factor. Commissioner of Internal Revenue v. Snite, 7 Cir., 1949, 177 F.2d 819, 823. "All the factors and all the circumstances should be considered and the net result determined therefrom." Ibid. See also United States v. Fewell, 5 Cir., 1958, 255 F.2d 496, 500; Earle v. Woodlaw, 9 Cir., 1957, 245 F.2d 119, 122; Ferro v. Commissioner, 3 Cir., 1957, 242 F.2d 838, 841, and Jones v. Griffin, 10 Cir., 1954, 216 F.2d 885, 887. It is also well-settled that it is not the motive of the parties but the net effect of the transaction which is relevant. McGuire v. Commissioner, 7 Cir., 1936, 84 F.2d 431, 432, certiorari denied 299 U.S. 591, 7 S.Ct. 118, 81 L.Ed. 435.

Finally, the question of applicability of Section 115(g) is primarily one of fact⁷ and, the Tax Court, having considered all the relevant factors and circumstances in determining the net effect of this transaction and its findings being supported by substantial evidence, we cannot say that it was chargeable with clear error in determining the distribution here involved to have been made at such time and in such manner as to make it essentially equivalent to the distribution of a taxable dividend.

In the second transaction on July 2, 1948 the taxpayer had all his debts to the company canceled and, in return, relinquished his right to salary due him of $11,000, transferred to the company 643 of the newly issued debentures (total market value $64,300) and agreed to the company's cancellation of a $20,851.76 balance which was credited to him in the capital loan account on the company's books as a result of advances he had made in the 1930's. Only two items in this transaction are in issue: First, whether notes payable of $30,000 of taxpayer to the company were any part of the indebtedness of taxpayer to the company and, second, whether the $20,851.76 balance of advances of taxpayer to the company represented loans or contributions to capital.

The $30,000 item represents company funds used by taxpayer to purchase 374 shares of the company's stock which were owned by one Ben A. Froeming when he died in 1945. Taxpayer entered into an agreement with the executors of the Froeming estate to purchase the shares for the $30,000, $10,000 being a down payment and $2,000 to be paid each month for ten months. Commissioner contends, and the Tax Court found that taxpayer borrowed the $30,000 to make the purchase. Taxpayer's position is that he bought the stock as trustee for the company.

The evidence shows that taxpayer, upon entering into the purchase agreement, executed eleven non-interest bearing notes payable to the company, one for $10,000 and ten for $2,000 each. The company issued its checks as payment became due, these checks being made payable to taxpayer who endorsed them over to the executors of the Froeming estate. The receipts signed by the executors each contained substantially the following language: "Received from C. G. Ortmayer (............... dollars) represented by check # .............. of Cunningham-Ortmayer Company." The transaction was recorded as a loan to taxpayer on the books of the company. No repayment of the amount was made to the company either before or on July 2, 1948.

There was no formal entry of assignment to taxpayer on the stock certificate formerly owned by Froeming but the...