Towanda Textiles, Inc. v. United States

• Decision Date: 03 February 1960
• Docket Number: No. 468-57.,468-57.
• Citation: 180 F. Supp. 373
• Parties: TOWANDA TEXTILES, INC., v. UNITED STATES.
• Court: U.S. Claims Court

180 F. Supp. 373

TOWANDA TEXTILES, INC., v. UNITED STATES.

No. 468-57.

United States Court of Claims.

February 3, 1960.

Bernard Weiss, New York City, for plaintiff.

Theodore D. Peyser, Jr., Washington, D. C., with whom was Asst. Atty. Gen. Charles K. Rice, for defendant.

James P. Garland and Lyle M. Turner, Washington, D. C., were on the brief.

WHITAKER, Judge.

This is a suit for the refund of an alleged overpayment of Federal income taxes for the plaintiff's tax year ending June 30, 1956. The record presents two legal issues which may be briefly summarized as follows:

Plaintiff was in voluntary liquidation when fire destroyed some of its property. The amount received from the insurance on the property exceeded the base thereof for the purpose of ascertaining gain or loss. The first question presented is whether the gain derived therefrom comes within the provisions of section 337 of the Internal Revenue Code of 1954, 26 U.S.C.A. § 337, which reads:

"Gain or loss on sales or exchanges in connection with certain liquidations

"(a) General rule.—If—

"(1) a corporation adopts a plan of complete liquidation on or after June 22, 1954, and

"(2) within the 12-month period beginning on the date of the adoption of such plan, all of the assets of the corporation are distributed in complete liquidation, less assets retained to meet claims, then no gain or loss shall be recognized to such corporation from the sale or exchange by it of property within such 12-month period."

The second question is whether legal and adjuster fees incurred in the collection of insurance proceeds from such involuntary conversion should be treated as ordinary and necessary business expenses, or as a capital expenditure incurred in the realization of the gain therefrom.

1. On September 9, 1955, plaintiff, through its board of directors, adopted a plan of complete liquidation, which was to be carried out within a year, whereby it was to sell all its assets and distribute the proceeds to its stockholders. Three days later, on September 12, 1955, plaintiff's principal manufacturing plant was destroyed by fire. The insurance proceeds therefrom amounted to $294,948.73, resulting in a gain of $174,668.65, but, in the collection of these proceeds, plaintiff incurred attorney fees and insurance adjuster fees amounting to $18,251.78. Shortly thereafter, plaintiff sold its remaining assets sustaining a capital loss of $13,221.56. On January 4, 1956, in furtherance of its plan of liquidation, it distributed the net proceeds to its stockholders, except for certain amounts retained to meet claims for accrued expenses and taxes.

The Commissioner of Internal Revenue, in determining plaintiff's income tax for the year of liquidation, included in plaintiff's income as capital gain the difference between the amount recovered under its insurance policy and the adjusted tax basis of the destroyed property, reduced by the attorney and adjuster fees incurred in collecting the insurance proceeds; but, on the other hand, he denied plaintiff the right to deduct the loss which plaintiff suffered by the sale of its other capital assets. He ruled that an involuntary conversion was not a sale or exchange of property within the meaning of section 337, but that the loss on the sale of the other assets did come within the terms of the section and could not be recognized.

The section should not be given a construction so illogical, not to say unjust, unless its language makes it imperative. We think it is an erroneous construction.

Prior to the enactment of the 1954 Internal Revenue Code, controversies were numerous over whether a sale of a corporation's assets on liquidation was made by the corporation or by the stockholders to whom the assets were allegedly distributed by the corporation before the sale. In many cases, if not in all, the Commissioner of Internal Revenue asserted that the sale had been made by the corporation before liquidation, and that it was liable for the gain derived therefrom, and that the stockholders were also liable for a tax on the proceeds of the sale, as if it had been distributed by the corporation as a liquidating dividend.

The question of the liability of the corporation for the tax on the gain was first presented to the Supreme Court in Commissioner of Internal Revenue v. Court Holding Co., 324 U.S. 331, 65 S.Ct. 707, 89 L.Ed. 981, and later in United States v. Cumberland Public Service Co., 338 U.S. 451, 70 S.Ct. 280, 94 L.Ed. 251. In the Court Holding Company case, the Court affirmed the finding of the Tax Court that the sale had been made by the corporation, and that it was liable for the tax, although the corporation had formally distributed to its stockholders the property sold. This resulted in a tax on the gain against the corporation, and also in a tax on the gain against the stockholders when the gain was distributed to them in the form of a liquidating dividend.

In the Cumberland Public Service Company case this court found that the physical assets had actually been distributed to the stockholders and that the stockholders had thereafter sold them and, hence, that the corporation was not liable for the tax on the gain. The Supreme Court adopted this finding and, on the basis of it, held that the corporation was not liable on the gain derived from the sale.

In the latter case the Supreme Court thus commented on the tax pattern laid down by Congress 338 U.S. 451, 70 S.Ct. 282:

"The oddities in tax consequences that emerge from the tax provisions here controlling appear to be inherent in the present tax pattern. For a corporation is taxed if it sells all its physical properties and distributes the cash proceeds as liquidating dividends, yet is not taxed if that property is distributed in kind and is then sold by the shareholders. In both instances the interest of the shareholders in the business has been transferred to the purchaser. Again, if these stockholders had succeeded in their original effort to sell all their stock, their interest would have been transferred to the purchasers just as effectively. Yet on such a transaction the corporation would have realized no taxable gain.

"Congress having determined that different tax consequences shall flow from different methods by which the shareholders of a closely held corporation may dispose of corporate property, we accept its mandate. It is for the trial court, upon consideration of an entire transaction, to determine the factual category in which a particular transaction belongs. Here as in the Court Holding Co. case we accept the ultimate findings of fact of the trial tribunal."

To correct the uncertainty of the existing law, Congress incorporated section 337 into the Internal Revenue Code of 1954. The purpose of this section was to exempt the corporation from liability for the tax on the gain on the sale of its assets and to take it into account only in computing the tax on the individual stockholders under section 331. This eliminated the possibility of double taxation of the stockholders and of a corporation selling its assets in order to liquidate, resulting from a failure to observe the proper formalities in effecting a disposition of the corporation's assets.

The purpose of the section is set out in House Report No. 1337, 83d Cong., 2d Sess., pages 38-39, A106-A109 (3 U.S. Code Cong. & Adm.News, 1954, pp. 4064, 4244-4247). We quote the following from page 4064 of 3 U.S.Code Cong. & Adm.News:

"(3) Court Holding Company.— Your committee's bill eliminates questions arising as a result of the necessity of determining whether a corporation in process of liquidating made a sale of assets or whether the shareholder receiving the assets made the sale. Compare Commissioner of Internal Revenue v. Court Holding Company (324 U.S. 331, 65 S.Ct. 707 89 L.Ed. 981), with United States v. Cumberland Public Service Company (338 U.S. 451, 70 S.Ct. 280 94 L.Ed. 251). This last decision indicates that if the distributee actually makes the sale after receipt of the property then there will be no tax on the sale at the corporate level. In order to eliminate questions resulting only from formalities, your committee has provided that if a corporation in process of liquidation sells assets there will be no tax at the corporate level, but any gain realized will be taxed to the distributee-shareholder, as ordinary income or capital gain depending on the character of the asset sold."

Also on page 4244, the Report states:

"* * * Accordingly, under present law, the tax consequences arising from sales made in the course of liquidation depend primarily upon the formal manner in which transactions are arranged. The possibility that double taxation may occur in such cases results in causing the problem to be a trap for the unwary."

The Senate Report is to the same effect. See pages 4679-4680.

The taxation of the gain derived from an involuntary conversion of the property into cash during liquidation is clearly contrary to the declared purpose of Congress in enacting the section, which was to avoid double taxation incident to the liquidation of a corporation, by exempting the corporation from liability for gain derived from the disposition of its capital assets, irrespective of whether or not certain formalities had been observed. Literally, an involuntary conversion is not a sale but what Congress had in mind was a conversion of a corporation's capital assets into cash, whether voluntary or involuntary, and the distribution of the cash to the stockholders. It is not conceivable that Congress would have drawn a distinction between a gain from a voluntary conversion and an involuntary one, had the possibility of an involuntary conversion during liquidation come to its attention. The purpose was to exempt the corporation from liability for the tax and to collect the tax from the stockholders alone. This being true, we must hold, in order to carry out the clear purpose of Congress, that an...