Owens v. C. I. R.

• Decision Date: 20 December 1977
• Docket Number: No. 76-1159,76-1159
• Citation: 568 F.2d 1233
• Parties: 78-1 USTC P 9144 E. Keith OWENS, Petitioner-Appellant, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.
• Court: U.S. Court of Appeals — Sixth Circuit

Page 1233

568 F.2d 1233

78-1 USTC P 9144

E. Keith OWENS, Petitioner-Appellant, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.

No. 76-1159.

United States Court of Appeals Sixth Circuit.

Argued April 11, 1977.

Decided Dec. 20, 1977.

Frank G. Pollock, Bloomfield Hills, Mich., Robert L. Schwartz, Dickinson, Wright, McKean, Cudlip & Moon, Detroit, Mich., for petitioner-appellant.

Michael L. Paup, Scott P. Crampton, Gilbert Andrews, Asst. Attys. Gen., Tax Div., U. S. Dept. of Justice, Washington, D. C., Jonathan S. Cohen, Stephen M. Gelber, Meade Whitaker, Chief Counsel, Internal Revenue Service, Washington, D. C., for respondent-appellee.

Before PHILLIPS, Chief Judge, PECK, Circuit Judge, and GREEN ^*, District Judge.

PECK, Circuit Judge.

Petitioner-appellant taxpayer perfected this appeal from a judgment of the Tax Court, which held that the taxpayer was liable for income tax deficiencies for the calendar years 1964 and 1965. The full Tax Court reviewed the case, and the judges split six to four, one not participating, in upholding respondent-appellee Commissioner's determination. Owens v. Commissioner, 64 T.C. 1 (1975). We affirm the Tax Court's decision as to the year 1965, but reverse as to the year 1964.

I

A detailed statement of facts in the present case is reported in the Tax Court's majority opinion. Owens v. Commissioner, supra, 64 T.C. at 2-11. The following is a recital of the salient facts.

In December, 1962, Mid-Western Investment Corporation (Mid-Western) was incorporated. Taxpayer was one of the incorporators and was the sole shareholder.

In October, 1963, Alexander Hamilton Life Insurance Company of America (Alexander Hamilton) was granted a preliminary charter by the State of Michigan's Insurance Department. Entitlement to a final charter was contingent upon the successful funding of the corporation. Taxpayer was again one of the incorporators.

From November, 1963, to April, 1964, Mid-Western underwrote the sale of the common stock of Alexander Hamilton, and Mid-Western earned sales commissions from that effort. Following the very successful sale of Alexander Hamilton stock, in May, 1964, Alexander Hamilton received its final charter. Taxpayer, as chief executive officer of Alexander Hamilton, became extremely busy with the management of that company.

In the fall of 1964, taxpayer went to the Detroit office of Lybrand, Ross Bros. & Montgomery (now Coopers & Lybrand and hereinafter referred to as Lybrand) for accounting, business investment, and tax planning advice. As a result of consultations, taxpayer caused Mid-Western to invest in cattle. In December, 1964, Mid-Western entered into four contracts for the purchase of cattle. In each contract, the seller of the cattle agreed to feed and maintain the livestock, and Mid-Western agreed to purchase feed, the cost of which was governed by a price negotiated by the parties. Pursuant to the four contracts, Mid-Western paid $212,885.00 for feed in 1964 and deducted that amount on its 1964 corporate income tax return. By July, 1965, all of the cattle had been sold, and Mid-Western had realized a net profit on the investment of $9,907.08. During this period of cattle investment, in January, 1965, taxpayer caused Mid-Western to elect Subchapter S status ¹ upon the advice of Lybrand.

In the spring of 1965, Lybrand became aware of two men in Florida, Manuel Rousseau and Enrique Santeiro, who had large net operating losses that they were interested in utilizing. Negotiations with Rousseau and Santeiro were begun for the sale to them of the Mid-Western stock. An agreement was deferred, however, until all the cattle in which Mid-Western had invested were sold. Taxpayer's accountants were concerned that collapsible corporation problems under 26 U.S.C. § 341 might arise if the sale of stock took place before all of the cattle were sold.

On August 20, 1965, over a month after all the cattle were sold by Mid-Western, the stock sale was consummated, and the Tax Court found as a fact that taxpayer agreed to the sale because his accountants recommended the action and because he was busy at Alexander Hamilton. Rousseau and Santeiro paid $262,842.26 for the stock, paid from funds borrowed from the Bank of Nova Scotia. In the sale agreement, Rousseau and Santeiro agreed to continue Mid-Western's Subchapter S election, which they did by filing timely shareholder consents.

On the same day as the sale of stock, however, a check payable to themselves for $299,822.62 was drawn on Mid-Western's checking account by Rousseau and Santeiro. The effect of the check was to reduce the balance in the account to zero. At the time of this withdrawal, the cash in the checking account constituted Mid-Western's only assets. Three days later, on August 23, 1965, Mid-Western adopted a formal resolution of liquidation. On September 7, 1965, Rousseau and Santeiro signed a certificate of dissolution of Mid-Western, which was filed December 23, 1965, with the Michigan Corporation and Securities Commission.

Mid-Western, on its 1965 tax return, reported taxable income of $245,650.31, $140,020.68 having been distributed to Rousseau and $105,629.63 having been distributed to Santeiro. On the 1965 joint tax return of taxpayer and his wife, they reported the sale of Mid-Western stock as resulting in.$246,925.00 of long-term capital gain.

In 1969, however, the Commissioner issued two notices of deficiency. In the first, taxpayer and his wife were informed that Mid-Western's 1965 undistributed Subchapter S income of $245,650.31 was taxable to them. ² In the second, taxpayer was informed that, as transferee of the assets of Mid-Western, he was liable for a $103,601.41 deficiency in Mid-Western's 1964 corporate income tax return.

Taxpayer sought review in the Tax Court, but there the Commissioner's determinations were upheld. Taxpayer now appeals to this Court.

II

The Tax Court decided that taxpayer did not prove that the August, 1965, transaction involving taxpayer and the two Florida men, Rousseau and Santeiro, was a bona fide sale and hence held that for the year 1965, taxpayer was taxable for Mid-Western's income; if the sale were to be disregarded, taxpayer was left as the sole shareholder of Mid-Western, a Subchapter S corporation which had undistributed income. ³ See 26 U.S.C. § 1373. The Tax Court based this determination on "gaps" in the evidence left by taxpayer as well as on the proofs put into evidence. The Tax Court stated that there was no evidence showing (1) that the advisers for Rousseau and Santeiro during the negotiations for the sale of taxpayer's Mid-Western stock were truly independent, (2) that the Bank of Nova Scotia required collateral for its loan to Rousseau and Santeiro so that they could buy the Mid-Western stock, (3) that the funds withdrawn by Rousseau and Santeiro from Mid-Western's bank account after the sale were put to any use, (4) that the taxpayer had an explanation for his decision to take the "cumbersome" route of selling his stock in order to divest himself of his interest in Mid-Western, rather than the "direct" route of distribution, (5) that Rousseau and Santeiro had any business purpose in acquiring Mid-Western, and (6) that there was a specific time when Rousseau and Santeiro conceived of the plan of liquidation and dissolution of Mid-Western. Consequently, the Tax Court determined that the "sale" was a cover for a distribution by Mid-Western of its assets to taxpayer, with a commission having been paid to Rousseau and Santeiro.

On appeal, taxpayer claims that the Tax Court, with the evidence before it, could not come to any other conclusion than that there was a bona fide sale in August, 1965. Taxpayer insists that the parties negotiated with each other at arm's length and took the necessary steps to transfer the ownership of the stock in a sales transaction. Taxpayer notes that both sides believed that they would profit from the deal. Taxpayer wanted to divest himself of his Mid-Western stock. Rousseau and Santeiro believed that they would gain exclusive control over a corporation and its assets without being taxable for the corporation's income because they intended to apply their net operating losses to offset Mid-Western's 1965 income distributed between them as Subchapter S corporation shareholders.

We begin with the principle that a taxpayer, working within the law, may legitimately seek to avoid taxes. "The legal right of a taxpayer to decrease the amount of what otherwise would be his taxes, or altogether avoid them, by means which the law permits, cannot be doubted." Gregory v. Helvering, 293 U.S. 465, 469, 55 S.Ct. 266, 267, 79 L.Ed. 596 (1935).

What the law does not permit a taxpayer to do in seeking to avoid taxes is to cast transactions in forms when there is no economic reality behind the use of the forms. "The incidence of taxation depends upon the substance of a transaction. . . . To permit the true nature of a transaction to be disguised by mere formalisms, which exist solely to alter tax liabilities, would seriously impair the effective administration of the tax policies of Congress." Commissioner of Internal Revenue v. Court Holding Co., 324 U.S. 331, 334, 65 S.Ct. 707, 708, 89 L.Ed. 981 (1945). See Gregory v. Helvering, supra, 293 U.S. 465, 55 S.Ct. 266, 79 L.Ed. 596; Union Planters National Bank v. United States, 426 F.2d 115, 117 (6th Cir.), cert. denied, 400 U.S. 827, 91 S.Ct. 53, 27 L.Ed.2d 56 (1970).

As the Tax Court and the taxpayer correctly analyze, taxpayer's tax liability for the 1965 income of Mid-Western depends upon whether the August, 1965, transfer of taxpayer's Mid-Western stock to Rousseau and Santeiro was in substance a sale or whether that transaction was a diversionary tactic, lacking economic substance, in a distribution of Mid-Western's assets to taxpayer. See Davant v. C.I.R., 366 F.2d 874, 880-82 (5th Cir. 1966), cert. denied, 386 U.S. 1022, 87 S.Ct. 1370, 18 L.Ed.2d 460 (1967)...