Textron, Inc. v. U.S., 76-1446

• Decision Date: 04 January 1977
• Docket Number: No. 76-1446,76-1446
• Citation: 561 F.2d 1023
• Parties: 77-2 USTC P 9539 TEXTRON, INC., Plaintiff, Appellee, v. UNITED STATES of America, Defendant, Appellant. . Heard
• Court: U.S. Court of Appeals — First Circuit

Page 1023

561 F.2d 1023

77-2 USTC P 9539

TEXTRON, INC., Plaintiff, Appellee, v. UNITED STATES of America, Defendant, Appellant.

No. 76-1446.

United States Court of Appeals First Circuit.

Heard Jan. 4, 1977.

Decided June 23, 1977.

Gary R. Allen, Atty., Tax. Div., Dept. of Justice, Washington, D. C., argued, with whom Scott P. Crampton, Asst. Atty. Gen., Myron C. Baum, Acting Asst. Atty. Gen., Lincoln C. Almond, Providence, R. I., U.S. Atty., Gilbert E. Andrews and Richard Farber, Atty., Tax Div., Dept. of Justice, Washington, D. C., were on brief, for defendant, appellant.

Peter J. Rothenberg, New York City, argued, with whom Edwards & Angell, Providence, R. I., Paul, Weiss, Rifkind, Wharton & Garrison, New York City, Richard M. Borod, Providence, R. I., Morris B. Abram, Adian W. DeWind, Kevin J. O'Brien, and Steven E. Landers, New York City, were on brief, for plaintiff, appellee.

Before COFFIN, Chief Judge, CAMPBELL, Circuit Judge, and BOWNES, ^* District Judge.

COFFIN, Chief Judge.

In the 1950's Textron, Inc. had a wholly owned subsidiary, Hawaiian Textron, Inc. (Hawaiian). Hawaiian ran passenger ships between Hawaii and the West Coast and lost enormous sums of money in the process. In 1959, creditors foreclosed on its assets. Textron's six million dollar investment in Hawaiian's stock and debt became worthless, with one possible exception: Hawaiian's huge losses could be used to reduce its taxable corporate income in future years. Because Hawaiian had no income prospects, a second, profitable corporation would have to be merged into Hawaiian's empty shell to take advantage of its potential deductions. In 1959, the district court found, Textron had no specific plan to make use of this aspect of Hawaiian. In 1960, however, Hawaiian's name was changed to Bell Aerospace Corp., and, using Textron's funds, the renamed corporation acquired a successful business from Bell Aircraft.

Bell Aerospace made money, and it carried forward the old Hawaiian losses, amounting to some $6,745,000. At first the Internal Revenue Service (Service) disallowed any carry-over between two such different businesses. But in 1963 the Service reversed itself, ruling that a failing corporation may go into a new line of business and still carry forward losses from its earlier activity, so long as the owners of the corporation remain substantially the same. Rev. Ruling 63-40, 1963-1 C.B. 41. After the Service's change of position, Bell Aerospace used Hawaiian's losses to reduce its taxes for 1960, 1961, and 1962.

Just prior to the rehabilitation of Hawaiian, Textron had tried another way to make the best of its bad investment in Hawaiian. It took a six million dollar deduction in 1959, claiming that Hawaiian's stock and debt became worthless to it in that year. The Service disallowed the deductions and assessed a deficiency. Textron paid and sued for a refund. In the district court and on appeal, the government has advanced only one argument that Hawaiian's stock was not worthless in 1959 because the shell had potential value as a source of carry-over losses. The district court rejected this argument, as do we.

Ordinarily, bad debts and worthless stocks may be deducted only in the year in which they become wholly worthless. See 26 U.S.C. §§ 165(g)(3), 165(a), & 166(a)(1). See also 26 C.F.R. 1.165-4(a) (1976). By any ordinary definition, Hawaiian's stock was quite worthless, as the district court found, in 1959. The shell together with the losses could not be marketed to others, 26 U.S.C. §§ 269 & 382, see infra ; and while it was within Textron's power to rehabilitate the subsidiary, and, if profits were generated, deduct the tax losses on future tax returns, this contingency first required the infusion of brand new assets into what was a shell without assets an initiative which created a wholly new ball game and certainly could not retroactively create value in 1959.

The government would have us cure what it perceives as an abuse of the tax laws by adopting its special definition of worthlessness. ¹ But Congress has already considered the abuse of high loss corporate shells. The remedy it chose does not call into question the deduction Textron seeks. ² At one time, there was a large traffic in tax shells like Hawaiian, but Congress has now decreed that the buyer of such shells cannot take advantage of their tax attributes. 26 U.S.C. §§ 269 & 382. Thus, a failed company may have tax value today, but only if it has a large and healthy owner who is eager to acquire a second, more profitable business.

The Service has apparently made the argument it urges on us only once before. See Becker v. United States, 308 F.Supp. 555 (D.Neb.1970). There the taxpayers' closely held corporation failed in 1956, and the taxpayers took a worthless stock deduction. In 1957, the corporation acquired a new and profitable business, which used the old business's losses to offset its income. The Service argued that this showed the stock had not been worthless in 1956. The court rejected that claim:

"If this Court adopts the government's theory in this case every taxpayer, at least every taxpayer who has the control of a closely held corporation, knowledge of the tax advantages and a desire to utilize these advantages, will be unable to take a deduction for worthless securities. As stated before, under this theory the tax advantages to his holdings would prevent his declaring those holdings as worthless. This Court does not believe, where the only evidence of some potential value remaining in a stock is carryforward losses and the knowledge and desire to utilize them, that the taxpayer should be prevented from declaring the stock worthless. If taxpayer allowed 1956 to pass because of a desire to utilize the previous losses the only evidence during 1957 or any subsequent year of worthlessness would be futile attempts to make use of previous losses by forming a new corporation. As previously stated taxpayer must not only prove a stock is worthless but that it became worthless in the year in which the loss is taken. There would be no objective evidence of worthlessness for subsequent years as is present in 1956." Id. at 557.

We are inclined to agree with the Becker court, for if we were to adopt the Service's position we would introduce great uncertainty into this corner of tax law. A taxpayer who owned the bulk of a failed corporation's stock would be hard-pressed to determine when his stock became worthless. If he guessed wrong, he might well forfeit his deduction. See, e. g., Keeney v. Commissioner of Internal Revenue, 116 F.2d 401 (2d Cir. 1940). The year in which the stock lost all value would depend on such vague and subjective factors as the taxpayer's ability and desire to acquire another business. If the taxpayer lacked either desire or ability, the stock would be worthless when the corporation went under. Otherwise, it would continue to have worth for an uncertain period. ³ Some taxpayers might keep a loss shell, hoping to find a use for it, only to suffer unrelated losses that reduced their ability to obtain a second corporation. Under the Service's approach, they would have to decide whether their setback was so severe that the loss shell had suddenly become truly worthless. Other taxpayers, hoping to take advantage of their loss shell, might acquire a second corporation that unexpectedly loses money. The shell's carryover losses will be worthless to the taxpayers, but under the Service's theory, they and the courts will have to decide just when the shell lost all value.

The Service might very well become the ultimate victim of the doctrine it now advocates. If a corporation has a bad year, primarily because one of its subsidiaries goes under, it will probably prefer to take its worthless stock deduction later. Under the Service's approach, the corporation may do so, simply by going through the motions of seeking a second business for its shell. When the time for a deduction is more propitious, the "search" may be abandoned and the shell dissolved. The Service will have trouble proving that the corporation's heart was not in the hunt. A rule with so much uncertainty and room for abuse should not be judicially created to close a loophole that is apparently used so seldom. Admittedly, Textron has turned its Hawaiian sow's ear into a silk purse and filled it at Treasury expense. But this is a matter that should be cured by statute or regulation, not by a far reaching retroactive court decision. ⁴

The dissent, agreeing that the Service's approach must fail, introduces a theory that the Service has advanced diffidently at best. ⁵ The dissent would brand as a "double deduction" Textron's worthless stock and debt claim and Bell Aerospace's carry-over loss deductions. We have grave doubts about the dissent's casual eliding of the distinction between parent and subsidiary. They are separate taxpayers. In the absence of a consolidated return, cf. Ilfeld Co. v. Hernandez, 292 U.S. 62, 54 S.Ct. 596, 78 L.Ed. 1127 (1934), treating the two corporations as one may not be justified. But cf. Marwais Steel Co. v. Commissioner of Internal Revenue, 354 F.2d 997 (9th Cir. 1965). It is no answer to invoke the maxim that substance must prevail over form. Textron's subsidiary was never a sham corporation lacking any substantial business purpose. In the first place, we are not inclined to adopt a policy of ignoring the distinction between parent and subsidiary in all tax cases. In the second place, corporate taxation is an area of careful planning, planning that will be seriously disrupted if courts simply ignore separate entities whenever it seems "fairer" to do so. We decline to inject so massive and unsettling a dose of "equity" into the tax laws without a clear invitation from the Service and a careful exploration of the issue by both sides.

Moreover, attaching the label "double deduction" is not the end of analysis. We cannot decide this case by simply...