Pacific Magnesium v. Westover

• Decision Date: 18 October 1949
• Docket Number: No. 8685.,8685.
• Citation: 86 F. Supp. 644
• Court: U.S. District Court — Southern District of California
• Parties: PACIFIC MAGNESIUM, Inc. v. WESTOVER.

86 F. Supp. 644

PACIFIC MAGNESIUM, Inc. v. WESTOVER.

No. 8685.

United States District Court S. D. California, C. D.

October 18, 1949.

Frank P. Doherty, Melvin D. Wilson, Los Angeles, Cal., for the plaintiff.

James M. Carter, United States Attorney, E. H. Mitchell and Edward R. McHale, Assistant U. S. Attorneys, Eugene Harpole, Robert D. Scott and James B. Pettus, Special Attorneys, Bureau of Internal Revenue, all of Los Angeles, Cal., for the defendant.

YANKWICH, District Judge.

Prior to November 20, 1944, P. H. Sheedy was sole stockholder of Pacific Magnesium, Inc., the plaintiff, then known as Socal Magnesium, Inc., under certificates issued to him in his own name, as trustee and to another corporation of which he was the sole stockholder. He was also the sole stockholder, either in his own name or as beneficiary under a trust, of Socal Foundry, to be referred to as Socal. Throughout the year 1944, Sheedy was president and director of both corporations. Frank Gaines had, prior to June, 1944, been an officer, director and general manager of both corporations. On November 20, 1944, he was not an officer or director of either. On that day, an agreement was entered into by Sheedy and Gaines, by which Sheedy sold to Gaines a $14,000.00 note of Socal, held by Sheedy, and all the Socal shares. Gaines paid $56,000.00 in cash and promised to cause Socal to accept $4,000.00 in settlement of a debt of $39,335.07 owed to Socal by the plaintiff.

The Preamble of the Agreement contained the following reference to this obligation:

"Whereas, Socal Foundry claims that Socal Magnesium, Inc. is indebted to it in the approximate amount of Thirty-nine Thousand, Three Hundred Thirty-five and 07/100th Dollars ($39,335.07), not including the amount due Socal Foundry for Socal Magnesium, Inc., herein referred to as the Permanent Mold Account in the approximate sum of Six Thousand Six Hundred Ninety and 48/100ths Dollars ($6690.48) and not including the amount due Socal Foundry by Socal Magnesium, Inc., known as Inventory of Metal Account, in the approximate amount of Nine Hundred Four and 40/100ths Dollars ($904.40)"

After reciting the reciprocal undertakings of the parties, the Agreement contained this promise by Gaines as to the claim:

"(d) To cause Socal Foundry to compromise and settle its claim against Socal Magnesium, Inc. in the aforesaid amount of Thirty-nine Thousand Three Hundred Thirty-five and 07/100ths Dollars ($39,335.07) by payment by Socal Magnesium, Inc. to Socal Foundry for the sum of Four Thousand Dollars ($4,000) and Mr. Gaines personally agrees that he will save and hold Mr. Sheedy and Socal Magnesium, Inc., its officers, stockholders and directors wholly and completely harmless from any and all liability, claims or demands of whatever nature arising from or which may accrue to or be asserted against Socal Magnesium, Inc. by reason of said compromise and settlement of said claim;"

To carry into effect the Agreement, Gaines and his nominees were, on the same day, elected directors and officers of Socal in the place of Sheedy and his nominees.

To carry into effect the promises in the Agreement relating to the liquidation of the debt, the following Resolution was adopted by the new directorate:

"Whereas Socal Magnesium Inc., a California corporation, is indebted to this corporation in the approximate sum of $39,335.07, not including the amount due by said Socal Magnesium Inc. to this corporation on its Permanent Mold Account or Inventory of Metal Account, and "Whereas it is the belief of the directors of this corporation that said Socal Magnesium Inc. is unable to pay its said debt and that if this corporation can obtain the sum of $4000.00 from said Socal Magnesium Inc. in settlement of said debt, that it would be a wise and proper thing to do.

"Now Therefore, Be It Resolved that this corporation accept from Socal Magnesium Inc. the sum of $4000.00 as payment in full of all monies and other things of value that may be due and owing to this corporation from Socal Magnesium Inc., except that this does not pertain to the account known as Permanent Mold Account and the account known as Inventory of Metal Account now owing to this corporation as aforesaid. "Resolved Further that the President and Secretary of this corporation be and they are hereby authorized and directed to execute a General Release in the name of and for and on behalf of this corporation, and to affix the corporate seal thereto, releasing said Socal Magnesium Inc. from the payment of any monies owing to this corporation, except as aforesaid, in consideration of the payment of $4000.00 by Socal Magnesium Inc. to this corporation."

The balance sheet of the plaintiff as of October 13, 1943, listed the debt owed to Socal in full as a liability. Its balance sheet of December 31, 1949, showed a cancellation of the debt. The result was achieved in this manner. The plaintiff paid Socal $4000.00 in cash, credited capital surplus with $35,335.07, and debited a similar amount to "accounts payable Socal Foundry". In this manner, the plaintiff's excess of assets over liabilities, exclusive of the capital stock, showed an increase of $35,335.07. Plaintiff had a clear net worth both before and after the transaction, and on December 31, 1944, showed an earned surplus of $7,789.99. Socal deducted on its 1944 return a loss of $35,335.07 on account of the cancellation of the debt, which the Commissioner allowed as a loss. However, because of other deductions, it derived no tax benefit from this allowance. In its income and excess profit tax return, for the year, plaintiff claimed a deduction in the amount of $35,335.07. The Commissioner disallowed this, and on October 15, 1947, he proposed a deficiency of $36,353.39 in excess profits tax for the calendar year 1944, claimed to be due from the plaintiff. The plaintiff paid the deficiency, with interest from March 15, 1945, amounting to $5816.38. A timely claim for refund, filed on March 12, 1948, in the amount of $30,487.39, with interest in the amount of $4877.98, was denied.

By this action, the plaintiff seeks to recover the amount of such claim under Internal Revenue Code, Sec. 3772.¹

I The Corporate Entity Cannot Be Disregarded

We have to determine whether, as found by the Commissioner, the transaction resulted in taxable income under Section 22 of the Internal Revenue Code² or whether, as claimed by the plaintiff, the cancellation of its debt by Socal was a gift or capital contribution to the plaintiff by its sole stockholder.³

We advert to the fact that the Agreement, upon which the transaction is bottomed, was not entered into by either corporation. It was an agreement between Sheedy and Gaines relating to the sale and acquisition of the Socal stock which Sheedy controlled in his individual capacity or as trustee. Neither corporation, as an entity, had any stock in the other. More particularly, the plaintiff did not own any of the Socal stock which was sold to Gaines. The debt, which was adjusted, was not Sheedy's, but the plaintiff's. Socal and not Sheedy cancelled the debt, and the benefit accrued to plaintiff and not to Sheedy.

These facts are of prime importance, because the entire argument of the plaintiff seems to be predicated upon the proposition that, as Sheedy owned and controlled both corporations, there was a fusion between the individual and the corporations, the corporations, as the cases say, "were shams", the distinction between them and Sheedy should be entirely obliterated and disregarded, and whatever the corporations did, should be attributed to Sheedy, who controlled them, and vice versa. On this assumption, the plaintiff insists that the transaction amounted to "a transfer of money from one pocket of Mr. Sheedy to another".

The difficulty with the argument is that a corporation and its stockholders are distinct entities. And the taxpayer who has chosen to use the corporate form for business purposes is not free to disregard it, in order to receive the tax benefit to which he might have been entitled as an individual. The reason is obvious. Having clothed himself in corporate garb, he cannot shed the cloak at will, in order to claim tax benefits to which he is not entitled in his corporate capacity. Otherwise put, a person who has chosen whatever benefit comes from the corporate form, must be ready to accept both the tax advantages and disadvantages which flow from it.⁴ In extraordinary circumstances, the corporate entity may be disregarded, especially when the corporation has no life of its own and is merely a limited instrument to achieve a single, definite object. But this will not be done in the ordinary circumstances, where the corporation has a distinct being, in order to give to it a tax benefit from a transaction in which it did not participate in its corporate capacity. And this is especially true when, as here, and regardless of sole ownership of its stock, the business actually had been carried on under the corporate form. As said by the Supreme Court:

"The doctrine of corporate entity fills a useful purpose in business life. Whether the purpose be to gain an advantage under the law of the state of incorporation or to avoid or to comply with the demands of creditors or to serve the creator's personal or undisclosed convenience, so long as that purpose is the equivalent of business activity or is followed by the carrying on of business by the corporation, the corporation remains a separate taxable entity."⁵

The distinction between Sheedy, the individual and controlling stockholder of the two corporations, and the corporate entities, is evident in the very contract from which the controversy stems. Change of liabilities was to follow the transfer of stock in Socal. After their assumption by the new directorate, there is, in the contract between Sheedy and Gaines, a distinct undertaking to save harmless not only Sheedy as an individual, but the plaintiff as...