Parshelsky's Estate v. CIR

• Decision Date: 03 May 1962
• Docket Number: No. 9,Docket 26851.,9
• Citation: 303 F.2d 14
• Parties: ESTATE of Moses L. PARSHELSKY, Deceased, Lawrence A. Baker, Clarence G. Bachrach, Isidore Schwartz and Abraham Parshelsky, Executors, Petitioners, v. COMMISSIONER OF INTERNAL REVENUE, Respondent.
• Court: U.S. Court of Appeals — Second Circuit

303 F.2d 14 (1962) ESTATE of Moses L. PARSHELSKY, Deceased, Lawrence A. Baker, Clarence G. Bachrach, Isidore Schwartz and Abraham Parshelsky, Executors, Petitioners, v. COMMISSIONER OF INTERNAL REVENUE, Respondent.

No. 9, Docket 26851.

United States Court of Appeals Second Circuit.

Argued November 8, 1961.

Decided May 3, 1962.

Lawrence A. Baker, New York City (Winthrop, Stimson, Putnam & Roberts, New York City, Bachrach & Bisgyer, Brooklyn, N. Y., on the brief), for petitioners.

L. W. Post, Dept. of Justice, Washington, D. C. (Louis F. Oberdorfer, Asst. Atty. Gen., Lee A. Jackson, Harry Baum, Dept. of Justice, Washington, D. C., on the brief), for respondent.

Before LUMBARD, Chief Judge, and MEDINA and WATERMAN, Circuit Judges.

LUMBARD, Chief Judge.

The principal question to be decided is whether the distribution by a corporation to its sole shareholder of the shares of a newly organized subsidiary constituted a taxable dividend under § 115 (a) of the Internal Revenue Code of 1939, 26 U.S.C.A. § 115(a), or a tax-free-spin-off reorganization within § 112(b) (11) of the Code, 26 U.S.C.A. § 112(b) (11).¹ The Tax Court held that there was no business purpose for the exchange and thus the exchange was used principally as device for the distribution of earnings. 34 T.C. 946 (1960). We think that the Tax Court's inquiry into business purpose was too narrow since it evaluated only those reasons for the spin-off which benefited the corporation and ignored any valid shareholder non-tax-avoidance reasons which might be present. Consequently, we reverse and remand for further findings in accordance with the views expressed in this opinion.

I. Facts

Moses L. Parshelsky had been for many years, until his death, sole shareholder of Parshelsky Brothers, Inc., which operated a wholesale lumber and millwork business at Meserole Street and Morgan Avenue in Brooklyn, on property which it owned. This consisted of a one-story building with 50,000 to 60,000 square feet of floor area where the corporation stored all forms of wood trim for sale to local wholesalers and builders. Parshelsky was active in the management and conduct of the business and personally handled or supervised most of the office work.

During the Korean War inventory was difficult to procure and the unit volume of sales declined² while costs increased. Due to these factors net income declined markedly.³ By the end of the Korean conflict, the warehouse was 40% empty, and Parshelsky engaged in some discussions relevant to renting space to outsiders.

The corporation had built up its liquid assets and was improving its net asset position. Total current assets, more than one-half of which were United States Treasury notes, remained at approximately $1,400,000 from 1950 to 1954 while current liabilities fell from $181,000 to $16,000. In each of these tax years the corporation paid a tax for unreasonably accumulating its earnings.⁴ Parshelsky was advised by his attorney that, notwithstanding this surtax, his high personal tax rates made it advantageous not to distribute the corporate earnings.

Because of the decline in net profits and because in 1953 he was 79 years old, Parshelsky became concerned about the disposition of the business after his death. His will provided that certain of his key employees could purchase Parshelsky Brothers' inventory, fixtures, equipment, and customer lists at favorable prices and could use the real estate at a favorable rental.⁵ Although he hoped that his employees would carry on the business, he did not want his name to be connected with it.

After consultation with his attorney and his accountant Parshelsky caused a new corporation, Parshelsky Realties, Inc. (Realties), to be organized late in 1953. On January 4, 1954, Parshelsky Brothers transferred the real estate to Realties in exchange for all of the latter's capital stock which was immediately distributed to Parshelsky, the sole shareholder of Parshelsky Brothers. Simultaneously with the carrying out of this exchange, Realties leased the real estate back to Parshelsky Brothers for five years at an annual rental of $42,000 with an option to renew for an additional five years. The lease gave Parshelsky Brothers, the lessee, the right to sublease for its own account up to 50% of the floor space.

At trial Parshelsky's attorney testified that there were several reasons why Parshelsky did not want the real estate, worth $360,000, to remain in the Parshelsky Brothers' corporation. First, Parshelsky did not want the valuable real estate to remain subject to the hazards of the wholesale lumber and millwork business. Second, he wanted to put "the operating company Parshelsky Brothers in a position where it had a very much better chance of survival in operation when he relieved his employees who might take over the inventory of the problem of having to deal with the building." Third, he wanted his "successor in interest to continue to own and operate * * * this real estate regardless of whether Parshelsky Brothers survived, because he believed that it ought to be a very profitable thing." Finally, he wanted the real estate to be readily available to his executors as a separate asset of his estate.

Parshelsky retained all the stock in both Parshelsky Brothers and Realties until his death on March 13, 1955. In his will he made a number of specific bequests, most of which were to miscellaneous charities; he created a trust fund with a principal of $200,000 for the benefit of his only surviving relative, his brother Abraham, for life; and he left the residue of his estate and the remainder of his brother's trust fund to charity.

Parshelsky treated the receipt of Realties' stock as a tax-free corporate reorganization under 1939 Code § 112(b) (11) and thus reported no income therefrom. The Commissioner, on the other hand, has taken the view that § 112(b) (11) does not apply because of the absence of a "business purpose," has treated the distribution of the Realties stock as a $360,000 dividend, and thus has asserted a $311,637.89 deficiency against the Estate of Moses L. Parshelsky for the calendar year 1954. Parshelsky's executors made an unrelated claim for refund of income taxes allegedly overpaid on the 1954 return. Without mentioning the refund claim, a single judge of the Tax Court upheld the deficiency on the ground that since there was no corporate business purpose for the reorganization, the transaction was a device for the distribution of earnings and profits. 34 T.C. 946 (1960). The full Tax Court reviewed this decision without a dissent. The taxpayer appeals. Internal Revenue Code of 1954, § 7482, 26 U.S.C.A. § 7482.

We find that the distinction between corporate and shareholder benefit does not accord with the purpose of Congress in enacting § 112(b) (11). We hold that while corporate benefit is relevant to the application of the tax-free spin-off provision, shareholders' personal non-tax-avoidance reasons must also be considered.

II. Corporate and Shareholder Business Purpose

Because the first provision for tax-free spin-offs did not contain restrictions like those of § 112(b) (11) (A) and (B),⁶ a literal reading of the statute made it subject to abuse. By having an existing corporation transfer liquid assets to a new corporation, the stock of which would then be distributed to the existing corporation's shareholders who would liquidate the new corporation, the assets when liquidated would be taxed at capital gains rather than dividend rates. In the case of Gregory v. Helvering, 203 U.S. 465, 55 S.Ct. 266, 79 L.Ed. 596 (1935), the Supreme Court held that such a scheme was not a tax-free spin-off. The Gregory case has been accepted as laying down a general principle of tax law, that in order to fit within a specified provision of the Internal Revenue Code a transaction must not only comply strictly with the explicit requirements of the section, but it must also have a "business purpose" that falls within the spirit of the section.⁷

Many of the earlier cases in applying the business-purpose test to reorganizations gave credence only to those non-tax-avoidance purposes which benefited the corporations involved.⁸ This required a separation of the corporate reasons for the reorganization from those of the shareholders. Most of the more recent cases have rejected this approach in favor of an evaluation of all the non-tax-avoidance motives of both the corporations and shareholders involved.⁹ However, the regulations apparently lend support to the so-called "corporate-benefit test." Regs. 118, § 39.112(g)-2(g).

The rationale for this distinction between corporate purposes and shareholder purposes is not explicitly elucidated in the cases which adopted it. Partly it may rest upon a misconception of the business-purpose test, that is, an assumption that the words "business purpose" have independent significance relating to the business of the corporation rather than merely being a shorthand expression for the Gregory-type statutory interpretation process. Partly, however, it probably rests upon an interpretation of early legislative history of the tax-free reorganization provisions. They were enacted because Congress thought it unwise to tax "purely paper transactions," S.Rept. No. 617, 65th Cong., 3d Sess. 5 (1918); accord, H.R.Rept. No. 1337, 83rd Cong., 2d Sess. 34 (1954), that are "merely changes in form and not in substance," H.R.Rept. No. 704, 73rd Cong., 2d Sess. 13 (1934); Statement of the Changes Made in the Revenue Act of 1921 by H.R. 6715 and the Reasons Therefor (1924) 10, 13 (Gregg Statement),¹⁰ and because Congress thought that normal business readjustments should not be impeded by the imposition of an income tax. See H. R.Rept. No. 179, 68th Cong., 1st Sess. 13 (1924); Sen. Rept. No. 398, 68th Cong., 1st Sess. 14-15 (1924); Statement of the Changes Made in the Revenue Act of 1921 by H.R. 6715 and the Reasons Therefor (1924) 6 (Gregg Statement). The...