Wortham Machinery Co. v. U.S.

• Decision Date: 18 August 1975
• Docket Number: No. 74-1481,74-1481
• Citation: 521 F.2d 160
• Parties: 75-2 USTC P 9665 WORTHAM MACHINERY COMPANY, a Wyoming Corporation, et al., Plaintiffs-Appellants, v. The UNITED STATES of America, Defendant-Appellee.
• Court: U.S. Court of Appeals — Tenth Circuit

Page 160

521 F.2d 160

75-2 USTC P 9665

WORTHAM MACHINERY COMPANY, a Wyoming Corporation, et al Plaintiffs-Appellants, v. The UNITED STATES of America, Defendant-Appellee.

No. 74-1481.

United States Court of Appeals Tenth Circuit.

Aug. 18, 1975.

Carl L. Lathrop, of Lathrop, Uchner & Mullikin, P. C., Cheyenne, Wyo., for plaintiffs-appellants.

David English Carmack, Washington, D. C. (Scott P. Crampton, Asst. Atty. Gen., Gilbert E. Andrews and Bennet N. Hollander, Attys., Tax. Div., Dept. of Justice, and Richard V. Thomas, U. S. Atty., of counsel, on the brief), for defendant-appellee.

Before LEWIS, Chief Judge, and BREITENSTEIN and BARRETT, Circuit Judges.

BREITENSTEIN, Circuit Judge.

This is a suit for refund of federal income taxes. The problems arose out of the transfer of assets by one corporation to another. The main issues are (1) the right of the transferee to deduct transferor's net operating loss, (2) the right of the transferee to a bad debt deduction for advances to the transferor, and (3) the taxability as constructive dividends of payments made by transferee to its controlling stockholders. Except for specific items conceded by the government, the district court after trial without a jury held for the government, see Wortham Machinery Company v. United States, D.Wyo., 375 F.Supp. 835, and the taxpayers have appealed. We affirm.

I

Plaintiff-appellant Wortham Machinery Company is a family-owned, Wyoming corporation. Plaintiff-appellant James W. Norris had 32.34% Of the stock. His wife Jeannette is named as a plaintiff-appellant because she and James filed joint income tax returns. Before his death William A. Norris, Jr., owned 30.99% Of the stock. Plaintiff-appellant Carroll is the executor of William's estate. The remaining stock is owned by other family members.

Wortham was a Wyoming distributor for products of Caterpillar Tractor Company. William Norris and others incorporated in California Madera Manufacturing Company which was in the business of making and selling hydraulic ditchers and forklift attachments. Madera was established as a separate entity because (1) Caterpillar opposed the conduct of other business by its distributors, (2) the retailing and manufacturing businesses were incompatible, (3) the business approaches of Madera and Wortham were different, and (4) Wortham did not wish to register to do business in California, the residence of those who became Madera's employees.

Madera had a short and unprofitable existence. It made, but did not sell, one hydraulic ditcher, and made two forklift attachments, one of which was sold. It stopped manufacturing in November, 1966, and had no employees after May, 1968. In the winter of 1966-1967 Madera arranged for an $85,000 bank loan to consolidate advances made by William Norris. Madera's three stockholders pledged their Madera stock to the bank as security for the loan. James and William Norris personally guaranteed payment of the loan. The bank's rights in the pledged Madera stock were assigned to them equally. The note was payable in monthly installments of $3,000. These payments were made by Wortham from February, 1967, through July, 1969.

In December, 1968, Madera transferred all of its assets and liabilities to Wortham in exchange for 20 shares of Wortham's common stock. At the time of the exchange the fair market value of Madera's assets was $19,537 and its liabilities amounted to $40,331. The book value of the 20 shares of Wortham stock was $1,600. These 20 shares were equally divided between James and William Norris in exchange for their Madera shares.

II

The first question is the right of Wortham to deduct in its tax return for the year ending June 30, 1969, the $108,421 net operating loss of Madera incurred before Wortham's assumption of Madera's liabilities and assets.

Section 361 provides that no gain or loss shall be recognized if a party to a corporate reorganization exchanges property "solely for stock" in another party to the reorganization. Section 368(a)(1)(C) provides, among other things, that "reorganization" means "the acquisition by one corporation, in exchange solely for all or a part of its voting stock * * *, of substantially all of the properties of another corporation * * *." Section 381 relates to carryovers in certain corporate acquisitions and § 382 imposes special limitations on net operating loss carryovers. The application of §§ 381 and 382 to our factual situation requires a § 361 type transfer in connection with a § 368 reorganization. In this regard it should be noted that in the enactment of §§ 381 and 382 among the objectives of Congress was the prevention of the avoidance of tax liability by "paper reorganizations." See World Service Life Insurance Company v. United States, 8 Cir., 471 F.2d 247, 251; United States v. Fenix and Scisson, Inc., 10 Cir., 360 F.2d 260, 266, cert. denied 386 U.S. 1036, 87 S.Ct. 1474, 18 L.Ed.2d 599; and H.Rep.No.1337, 83d Cong. 2d Sess., 3 U.S.Cong.News '54 4025, 4067.

In considering subsection (g) of § 112 of the 1928 Revenue Act, a predecessor of § 368, the Court said in Gregory v. Helvering, 293 U.S. 465, 469, 55 S.Ct. 266, 267, 79 L.Ed. 596, that the section did not include "a transfer of assets by one corporation to another in pursuance of a plan having no relation to the business of either." The effect of Gregory is to exclude from pertinent tax statutes commercial transactions "entered upon for no other motive but to escape taxation." Commissioner of Internal Revenue v. Transport Trading & Terminal Corporation, 2 Cir., 176 F.2d 570, 572, cert. denied338 U.S. 955, 70 S.Ct. 493, 94 L.Ed. 589. The business purpose criterion announced in Gregory is embodied in Treas.Reg. 26 C.F.R. § 1.368-1(b) and (c), and 26 C.F.R. § 1.368-2(g). Bazley v. Commissioner of Internal Revenue, 331 U.S. 737, 741, 67 S.Ct. 1489, 1491, 91 L.Ed. 1782, says that it is not enough for the transaction to meet the "inert language" of the statute but the reorganization must partake of those characteristics "which underlie the purpose of Congress in postponing tax liability." Taxpayer has the burden to prove business purpose. David's Specialty Shops v. Johnson, S.D.N.Y., 131 F.Supp. 458, 460.

The questioned transaction was within the "inert language" of § 368(a)(1)(C) because Wortham acquired all of Madera's assets in exchange for some of Wortham's stock. At the time Madera had no business; it had stopped production of the equipment for which it had been organized because there was no demand for that equipment. All of the factors which influenced the separate incorporation of Madera still existed except for employee location which was no longer pertinent because Madera had no employees. Wortham acquired one hydraulic ditcher and one forklift attachment which it tried to sell. True, Wortham acquired certain patents but there is no showing that it ever tried to make any use of them. Indeed, the only attraction shown by the record for the acquisition of Madera was the net operating loss carryover which Wortham used in its tax return to reduce its tax liability.

The district court said that "there appears no valid business purpose for the reorganization." 375 F.Supp. at 839. Taxpayers say that the court erred, first, because the government took the issue of tax avoidance out of the case when it conceded the inapplicability of § 269 which provides for the disallowance of tax benefits resulting from acquisitions made to evade or avoid income tax. By its own terms that section is inapplicable when the acquired corporation is controlled by stockholders of the acquiring corporation. James and William Norris each owned 50% Of the Madera stock and each were Wortham stockholders. See § 269(a)(2). Taxpayers are not helped by Hawaiian Trust Company Limited v. United States, 9 Cir., 291 F.2d 761. That case is factually and procedurally distinguishable from the instant case. The government's concession with regard to § 269 has nothing to do with the issue of business purpose in the questioned transaction.

Next, taxpayers say that the holding...