Shelton v. Comm'r of Internal Revenue

• Decision Date: 16 August 1995
• Docket Number: No. 17901-92.,17901-92.
• Parties: James M. SHELTON, Petitioner, v. COMMISSIONER OF INTERNAL REVENUE, Respondent.
• Court: U.S. Tax Court

105 T.C. 114

105 T.C. No. 10

James M. SHELTON, Petitioner,

v.COMMISSIONER OF INTERNAL REVENUE, Respondent.

No. 17901-92.

United States Tax Court.

Aug. 16, 1995.

Sander W. Shapiro, Michael L. Cook, Ira A. Lipstet, Austin, TX, and J. Andy Norval, for petitioner.

T. Richard Sealy III, Austin, TX, for respondent.

On June 22, 1981, P's wholly owned corporation sold stock of another corporation (E) to a third corporation (W) in exchange for a 20-year promissory note (Note). The stock of E served as collateral for the sale. Pursuant to the liquidation of J the note was distributed to P, and P reported the sale on the installment method. On Mar. 31, 1983, E sold its assets to an unrelated third party for cash and the assumption of liabilities. On the same day, E and W adopted plans of liquidation pursuant to sec. 337, I.R.C. On Mar. 31, 1984, pursuant to the liquidations, the assets of E and W, consisting primarily of cash from the sale of E's assets, were distributed to the shareholders of W (P's daughter and two trusts set up for P's grandchildren). Pursuant to various agreements entered into by the parties, the W shareholders assumed liability on the Note and, upon liquidation of the E stock, the cash proceeds from the sale of E's assets were substituted as the collateral for the Note. R determined that P should have recognized the remaining amount of the installment gain as a result of the sale of E's assets and the liquidation of E and W, because the sale of the assets followed by the liquidation of the underlying stock was a second disposition by a related party within the meaning of sec. 453(e)(1), I.R.C.

1. Held: The liquidation of E was a disposition within the meaning of sec. 453(e)(1), I.R.C. Held, further, the 2-year period under sec. 453(e)(2), I.R.C., was tolled as a result of the sale of E's assets and the adoption of the plan of liquidation. Held, further, P is deemed to have received payment on the Note to the extent of the amount realized by W on the liquidation of E.

2. Held, further, P is not liable for an addition to tax under sec. 6661, I.R.C., because R abused her discretion in not waiving such addition. PARR, Judge:

Respondent determined a deficiency in petitioner's Federal income tax and addition to tax for 1984 in the amounts of $2,899,796 and $724,949, respectively.

The issue for decision is whether petitioner received additional income on an installment obligation as a result of a liquidation of the corporate stock that was the subject of the installment sale and that was also the collateral for the installment sale. If we determine that petitioner had additional income, then we must decide whether petitioner is liable for the addition to tax for substantial understatement of Federal income tax pursuant to section 6661(a).¹

FINDINGS OF FACT

Some of the facts have been stipulated and are so found. The stipulation of facts, first supplemental stipulation of facts, and attached exhibits are incorporated herein by this reference. At the time the petition was filed, petitioner resided in El Paso, Texas.

On June 30, 1980, petitioner owned all of the stock of JMS Liquidating Corporation (JMS), a Texas corporation formerly known as Cashway Building Materials, Inc. On that date, JMS adopted a plan of liquidation under section 337. JMS owned 97 percent of the stock of El Paso Sand Products, Inc. (EPSP), a Texas corporation. EPSP owned the stock of El Paso Sand Products Construction Division, Inc., Vowell Construction Company, and El Paso Rock Quarries, Inc., which in turn owned the stock of Valley Concrete Company, Inc. All the entities were Texas corporations.

On June 22, 1981, JMS sold all of its EPSP stock to Wallington Corporation (Wallington), for $17,460,000, to be paid by a 20-year promissory note (the Note).² Petitioner's adult son and adult daughter (Carroll Shelton Maxon³) had acquired the stock of Wallington in 1976. At the time of the sale, Wallington's stock was owned by petitioner's son, Carroll Shelton Maxon, Allyson Jones Trust #1 (AJT) (a trust established for the benefit of Allyson Jones, a minor daughter of Carroll Shelton Maxon), and Caroline Jones Trust #1 (CJT) (a trust established for the benefit of Caroline Jones, a minor daughter of Carroll Shelton Maxon). Initially, Luther Jones was trustee of the trusts.⁴

Pursuant to the Agreement of Purchase and Security Agreement, the Note was secured by the stock of EPSP. The Security Agreement provided that the security interest would also apply to any proceeds of the collateral.

Pursuant to the liquidation of JMS on June 25, 1981, the Note was distributed to petitioner. In 1982 and 1983, Wallington paid to petitioner the installments due on the Note. On March 31, 1983, Wallington and its subsidiaries (including EPSP) adopted a plan of liquidation pursuant to section 337. On the same day, EPSP sold most of its assets, including all of its operating assets, to Material Service Corporation (MSC), a wholly owned subsidiary of General Dynamics, Inc., for $35,000,000 in cash and assumption of $4,000,000 of liabilities.

On or about March 15, 1984, EPSP and Wallington liquidated and distributed all of their remaining assets to Wallington's shareholders in exchange for their outstanding stock. In addition, the shareholders assumed substantially all the liabilities of the corporations, including the indebtedness on the Note. At the time of the distribution, the assets distributed consisted of cash in the amount of $33,382,614, plus stocks, bonds, real estate, joint venture interests, and miscellaneous personal property. At the time of the distribution, the shareholders of Wallington were Carroll Shelton Maxon, CJT, and AJT.

Petitioner reported the gain realized on the sale of EPSP on the installment method. The gain realized on the sale was $16,442,074. On his 1984 Federal income tax return, petitioner reported installment gain from the sale in the amount of $502,216, which was the amount of gain attributable to $533,308 in principal payments made on the Note multiplied by the gross profit ratio of 94.17 percent. Respondent determined that petitioner should have recognized the remaining amount of the installment gain in 1984 upon the liquidation of Wallington and EPSP.

OPINION

Respondent advances several theories why petitioner should have recognized income on the installment obligation as a result of the liquidation transaction that occurred during tax year 1984. Should we sustain respondent on any of her arguments, the deficiency will be upheld. Respondent's arguments are as follows: (1) the sale of assets followed by a liquidation of the underlying stock was a second disposition of the property by a related person within the meaning of section 453(e)(1); (2) petitioner constructively received the balance due under the installment obligation when stock, the subject of the installment obligation and held as collateral, was liquidated for cash; (3) petitioner received a payment on the installment obligation within the meaning of section 15A.453-1(b)(3)(i), Temporary Income Tax Regs., when the cash proceeds from the liquidation became the collateral for the installment obligation; and (4) a deemed disposition occurred because the terms of the installment obligation were materially changed as a result of the liquidation. ⁵

Generally, gain from the sale of property is taxed to the seller in the year of the sale. Secs. 61(a)(3), 1001(c). However, section 453 provides an exception to this rule, allowing income from an installment sale to be reported in the year payment is received. Secs. 453(a), 1001(d); see also Estate of Silverman v. Commissioner, 98 T.C. 54, 62 (1992); Pozzi v. Commissioner, 49 T.C. 119, 127 (1967). The purpose of the installment method of reporting income is to alleviate the hardship on taxpayers who would otherwise recognize the entire gain on a sale, but who did not receive sufficient cash to pay the tax. Under the installment method, the tax due is matched with the payments to be received, rather than forcing the taxpayer to advance the tax payments prior to actually receiving the sale proceeds. Commissioner v. South Tex. Lumber Co., 333 U.S. 496, 503 (1948); Oden v. Commissioner, 56 T.C. 569, 573 (1971); Pozzi v. Commissioner, supra at 126.

Second Disposition of Property by a Related Person

Respondent argues that the liquidation of EPSP resulted in a second disposition of the property by a party related to petitioner within the meaning of section 453(e)(1); accordingly, petitioner had to recognize income with respect to the original installment obligation. Petitioner contends that a second disposition by a related person did not occur because (1) the liquidation of EPSP is not a disposition for purposes of section 453(e)(1); (2) more than 2 years had passed between the original installment sale and the liquidation of EPSP; and (3) the 2-year period was not tolled due to a substantially diminished risk of loss within the meaning of section 453(e)(2)(B).

Section 453(e) generally limits the use of the installment sale method in the case of second dispositions by related parties. Section 453(e) provides in pertinent part as follows:

Sec. 453(e). SECOND DISPOSITIONS BY RELATED PERSONS.--

(1) In General.--If--

(A) Any person disposes of property to a related person (hereinafter in this subsection referred to as the “first disposition”), and

(B) before the person making the first disposition receives all payments with respect to such disposition, the related person disposes of the property (hereinafter in this subsection referred to as the “second disposition”),

then, for purposes of this section, the amount realized with respect to such second disposition shall be treated as received at the time of the second disposition by the person making the first disposition.

The term “related person” is determined by reference to sections 453(f) and 318(a). Section 453(f) provides that for purposes of section 453, the...