Reed v. C.I.R., 83-1253

CourtUnited States Courts of Appeals. United States Court of Appeals (1st Circuit)
Citation723 F.2d 138
Docket NumberNo. 83-1253,83-1253
Parties83-2 USTC P 9728 John E. REED, Petitioner, Appellant, v. COMMISSIONER OF INTERNAL REVENUE, Respondent, Appellee.
Decision Date05 December 1983

Page 138

723 F.2d 138
83-2 USTC P 9728
John E. REED, Petitioner, Appellant,
No. 83-1253.
United States Court of Appeals,
First Circuit.
Argued Oct. 3, 1983.
Decided Dec. 5, 1983.

Page 139

John M. Peterson, Jr., San Francisco, Cal., with whom Baker & McKenzie, San Francisco, Cal., was on brief, for petitioner, appellant.

Melvin E. Clark, Jr., Atty., Tax Div., Dept. of Justice, Washington, D.C., with whom Glenn L. Archer, Jr., Asst. Atty. Gen., Michael L. Paup, and Richard W. Perkins, Attys., Tax Div., Dept. of Justice,

Page 140

Washington, D.C., were on brief, for respondent, appellee.

Before CAMPBELL, Chief Judge, GIBSON * and TIMBERS **, Senior Circuit Judges.

FLOYD R. GIBSON, Senior Circuit Judge.

John E. Reed appeals from the United States Tax Court's decision sustaining the Commissioner's determination of a $71,412.68 deficiency in Reed's 1973 federal income tax. On appeal to this court, Reed, a cash basis taxpayer, claims the Tax Court erred as a matter of law in ruling that he recognized a long-term capital gain from the sale of 80 shares of stock in 1973, when the stock purchaser deposited the stock sales proceeds into an escrow account, rather than in 1974, when the escrowee disbursed the sales proceeds to Reed. Reed urges that the escrow account was a valid income deferral device because: 1) the account was set up under a bona fide agreement between Reed and the stock purchaser providing for deferred payment of the sales proceeds; 2) Reed was not entitled to receive any incidental benefits from the escrow account in 1973; and 3) the escrowee was not Reed's agent. We agree with Reed's contentions and therefore reverse the Tax Court's assessment of the $71,412.68 deficiency.

I. Background

The parties have stipulated to most of the relevant facts. Reed acquired stock in Reed Electromech Corporation (Electromech) in 1963, when he headed up an investor group which organized Electromech to purchase the assets of another corporation. In 1967, Reed and several of his fellow Electromech shareholders (the selling stockholders) entered into an agreement with Joseph Cvengros, also an Electromech shareholder, granting Cvengros an option to purchase the selling stockholder's stock, or to cause the selling shareholders to purchase Cvengros' stock. The agreement, as amended on October 16, 1973, 1 set a $3,300 per share price, for an aggregate price of $808,500.00, and provided that if Cvengros failed to exercise his purchase option by November 27, 1973, the selling shareholders could purchase all of Cvengros' stock at the set per share price. 2 The amended agreement further provided that whether Cvengros purchased the selling stockholder's stock, or vice versa, the closing would be on December 27, 1973, at which time the stock and purchase price were to be delivered.

Page 141

On November 23, 1973, Cvengros exercised his option to purchase the Electromech stock held by the selling shareholders. Shortly thereafter, Reed and his fellow selling shareholders became concerned about the federal income tax implications of a sale in 1973. Reed, in particular, wanted to defer closing until 1974 so that he would have time to make an orderly sale of certain securities ("loss securities"), the capital loss from which he desired to write-off against the capital gain on the Electromech sale. Reed was understandably reluctant to sell the loss securities prior to the December 27 closing, fearing that Cvengros' outside financing might fall through before the closing, thus preventing the Electromech stock sale. On the other hand, Reed believed that after the December 27 closing there would not be enough time remaining in 1973 to properly identify and sell these loss securities in that year. Hence, Reed wanted to postpone closing until January of 1974.

Nevertheless, Cvengros and his financial backer insisted on the December 27, 1973 closing, apparently because the financial backer wanted the stock transaction reflected on his 1973 books. In early December 1973, Reed 3 and Cvengros, desiring to accomodate all involved, orally agreed to modify the purchase-sale agreement to provide that: 1) Reed and the other selling shareholders would not be entitled to receive payment for their stocks until January 3, 1974; and 2) Reed would remain on Electromech's Board of Directors after the stock sale. Both Reed and Cvengros considered the deferred payment provision to be part of the purchase/sale agreement and legally binding. Reed, in fact, indicated that he would not have gone through with the sales transaction if Cvengros had not agreed to the deferred payment provision.

This oral modification was memorialized in a written escrow agreement, executed by Reed and Cvengros immediately prior to the closing on December 27, 1973. Under the terms of the escrow agreement, the stock sales proceeds were to be paid by Cvengros to the escrowee (the American National Bank and Trust Company) at the December 27, 1973 closing and the escrowee was then to make disbursements of the sales proceeds to a number of selling shareholders, including Reed, on January 3, 1974. Under the agreement, these selling shareholders were not entitled to receive interest, investment income or any other incidental benefits (e.g., bank letter of credit) on the sales proceeds while they were in escrow. The agreement provided for no conditions precedent, other than the passage of time, to the January 3, 1974 payment.

At the closing on December 27, 1973, the following events occurred: 1) Cvengros' financial backer loaned and delivered to Cvengros a cashier's check in the amount of $808,500 payable to the order of Cvengros; 2) Cvengros endorsed and delivered the $808,500 check to the escrowee; and 3) the selling shareholders delivered their Electromech stock to Cvengros. The escrowee subsequently disbursed the sales proceeds pursuant to the escrow agreement instructions; hence Reed did not actually receive his share of the proceeds until January 3, 1974. Reed realized a long-term capital gain of $256,000 on the sale of his Electromech stock. This gain was reported on his 1974 Federal Income Tax Return.

In the Tax Court, the Commissioner argued that Reed recognized a taxable gain from the sale in 1973 rather than in 1974 because: 1) he constructively received the income from the stock sale in 1973; 2) he received an economic benefit (or cash equivalent) in 1973; and 3) the escrow arrangement lacked economic reality, other than as a tax deferral device. Reed, a cash basis taxpayer, claimed the gain was taxable in 1974 because he did not actually or constructively receive payment in 1973. He urged then, as he does now, that the escrow arrangement was a valid income deferral device because it was part of a bona fide modification of the purchase-sale agreement with Cvengros. Under that modification,

Page 142

Reed was not entitled to receive any payment until January 3, 1974.

The Tax Court, while recognizing that a cash basis taxpayer such as Reed could postpone income recognition by a bona fide agreement providing for deferred payment, nevertheless held that "when, upon receipt of the [purchased stocks], the buyer deposits the full purchase price in an escrow account to be paid to the seller at a later date and no condition other than the passage of time is placed on the seller's right to receive the escrow funds, courts have held that the seller recognizes income when the buyer deposits funds with the escrowee." Reed v. Commissioner, Tax Ct.Mem.Dec. (P-H) (p 82,734) (1983) (citations omitted). The court emphasized that because nothing could have prevented Reed's receipt of the funds once they were deposited with the escrowee, Reed recognized income when Cvengros deposited the funds in escrow in 1973.

II. Discussion

The Commissioner argues that the Tax Court's ruling is supported by three separate doctrines: the constructive receipt doctrine, the economic benefit doctrine, and the doctrine that receipt of income by the taxpayer's agent is receipt by the taxpayer. Though these doctrines invariably overlap, as evidenced by the Tax Court's apparent reliance on a hybrid of the constructive receipt and economic benefit doctrines, we will address each separately.

A. Constructive Receipt

The Commissioner contends Reed constructively received the stock sales proceeds when they were deposited in the escrow account on December 27, 1973. A cash basis taxpayer such as Reed is required to recognize income from the sale of property in the taxable year in which he actually or constructively receives payment for the property. 26 U.S.C. Sec. 451(a) (1954); Treas.Reg. Sec. 1.451-1(a). Treasury Regulation Sec. 1.451-2(a) explains the constructive receipt doctrine as follows:

Income although not actually reduced to a taxpayer's possession is constructively received by him in the taxable year during which it is credited to his account, set apart for him, or otherwise made available so that he may draw upon it at any time, or so that he could have drawn upon it during the taxable year if notice of intention to withdraw had been given. However, income is not constructively received if the taxpayer's control of its receipt is subject to substantial limitations or restrictions.

(Emphasis added).

Thus, under the constructive receipt doctrine, a taxpayer recognizes taxable income when he has an unqualified, vested right to receive immediate payment. Ross v. Commissioner, 169 F.2d 483, 490 (1st Cir.1948); Amend v. Commissioner, 13 T.C. 178, 185 (1949); Metzer, Constructive Receipt, Economic Benefit and Assignment of Income: A Case Study in Deferred Compensation, 29 Tax L.Rev. 525, 531 (1974). However, a taxpayer-seller has the right to enter into an agreement with the buyer that he, the seller, will not be paid until the following year. Schniers v. Commissioner, 69 T.C. 511, 516 n. 2, 517-18 (1977). As long as the deferred...

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