Arnes v. Commissioner

102 T.C. No. 20, 102 T.C. 522, 1994 U.S. Tax Ct. LEXIS 22

• Court: United States Tax Court
• Decided: April 5, 1994
• Docket: Docket No. 23291-91
• Status: Published

Opinions

Fay, Judge:

This case is before the Court on the parties’ cross-motions for summary judgment pursuant to Rule 121.¹

By notice of deficiency dated October 8, 1991, respondent determined deficiencies in petitioner’s Federal income taxes as follows:

Year Deficiency

. $42,725 CD 00 <J

. 27,337 CD 00 00

FINDINGS OF FACT

John A. Arnes (petitioner) resided in Ellensburg, Washington, when he filed the petition.

Petitioner and his former wife, Joann Arnes (Joann), were married in 1970. After having worked for a number of years in McDonald’s restaurants and for McDonald’s Corp. (McDonald’s), petitioner developed an interest in operating his own McDonald’s franchise.

On October 8, 1979, petitioner and Joann entered into a license agreement with McDonald’s granting them a McDonald’s franchise in Ellensburg, Washington. After about a year, they formed Moriah Valley Enterprises, Inc. (Moriah), to own and operate the franchise, and 5,000 shares of Moriah stock were issued to petitioner and Joann jointly.

The articles of incorporation of Moriah include a right of first refusal, which states in relevant part as follows:

In the event any one or more of the shareholders of this corporation should desire to sell or transfer all or any part of his stock in the corporation and retire from the said business, * * * then the corporation shall have the option to purchase and acquire the whole of the stock interest of such party * * * so desiring to sell or transfer his interest. In the event the corporation does not exercise this option, the shareholders shall have a secondary option to purchase said shares at the same price contained in the corporation’s options; said secondary option of the shareholders to be computed on a basis of number of shares held on a pro rata basis. Nothing in this paragraph shall prevent the corporation and the shareholders from agreeing to terms and. conditions relating to the exercise of the foregoing option as to time within which to exercise the option, terms of payment, security for payment, methods of effecting transfer, and related matters. [Emphasis added.]

On August 5, 1981, McDonald’s executed a memorandum entitled “Change of Unit Ownership” recognizing and approving the assignment of the McDonald’s franchise to Moriah and also noting that petitioner and Joann were both 50-per-cent owners of Moriah.

Petitioner and Joann permanently separated in January 1987. McDonald’s wrote a letter dated January 14, 1987, to petitioner, which states in pertinent part:

In conjunction with your pending divorce, we would like to explain McDonald’s position concerning dissolution of the marriages of McDonald’s operators.

As you know, we are primarily concerned with the operation of the McDonald’s restaurant, and an essential element of good operations is 100% ownership of the equity and profits by the owner/operator on premises. Since all divorces include some sort of property settlement, we want to be assured that there is no joint ownership of the McDonald’s restaurant business by you and your wife after you divorce and the spouse who ends up with the business is operationally and financially qualified.

We have the right to consent to such a property settlement because it results in a change in the equity ownership of the business and changes the status of the former husband and wife to that of a partnership of unrelated parties. As you know, it has been a long-standing franchising policy of this company to refuse to franchise partnerships.

On December 16, 1987, petitioner and Joann surrendered their jointly held shares of Moriah stock and were each issued separate stock certificates representing 2,500 shares of Moriah stock. On December 17, 1987, petitioner and Joann entered into an agreement regarding property custody and support (the property settlement agreement), providing in part as follows:

The parties hereto shall cause the corporation owned by the parties known as Moriah Valley Corporation to redeem from wife 2,500 shares of stock (Certificate #4) that she owns, said shares being one-half of the issued stock. That the obligations of the corporation to pay wife in accordance with the provisions hereinafter set forth, shall be and are personally guaranteed by husband and the corporation shall execute any security documents and/or other instruments necessary to secure and perfect the security granted to wife for said obligation. The corporation shall pay to wife the sum of FOUR HUNDRED FIFTY THOUSAND DOLLARS ($450,000.00) for wife’s stock in the corporation. Of said sum, ONE HUNDRED TEN THOUSAND NINE HUNDRED EIGHTY-THREE AND 56/ 100ths DOLLARS ($110,983.56) shall be paid by the corporation by forgiving that certain Promissory Note dated April 17, 1987 in the principal sum of ONE HUNDRED FIVE THOUSAND DOLLARS ($105,000.00) that has accured [sic] interest of FIVE THOUSAND NINE HUNDRED EIGHTY-THREE AND 56/100ths DOLLARS ($5,983.56). That on the 2nd day of January, 1988, the corporation shall pay to wife the sum of TWENTY-FIVE THOUSAND DOLLARS ($25,000.00) and a like sum on the 1st day of May, 1988. That the balance of TWO HUNDRED EIGHTY-NINE THOUSAND SIXTEEN AND 44/100ths DOLLARS ($289,016.44) shall be paid by the corporation to wife and shall bear interest from January 1, 1988 at the rate of nine percent (9%) per annum and shall be paid through monthly installments of THREE THOUSAND SIX HUNDRED SIXTY-ONE AND 84/100ths DOLLARS ($3,661.84) per month commencing February 1, 1988. That said obligation shall be paid in full no later than January 1, 1998.

On December 28, 1987, Moriah and Joann entered into an agreement as to corporate stock providing for a redemption by Moriah of Joann’s stock, with Moriah’s obligation guaranteed by petitioner.

The property settlement agreement was filed with the Superior Court of Washington for Kittitas County and incorporated in the decree of dissolution of marriage by the court, entered on January 7, 1988.

On January 18, 1988, Joann, petitioner, and McDonald’s executed an assignment and consent to redemption of stock (the McDonald’s consent agreement). The McDonald’s consent agreement provided that Moriah would redeem Joann’s stock in accordance with the payment schedule set forth in the property settlement agreement and that petitioner would be the guarantor of Moriah’s payment obligations thereunder.

At all times during the divorce proceeding and during the negotiations relating to the redemption of Joann’s stock in Moriah, petitioner and Joann were each represented by an attorney.

On her Federal income tax return for 1988, Joann reported and paid the tax on capital gain arising out of the redemption. Joann subsequently claimed a refund of income tax on the ground that under section 1041 she was not required to recognize gain on the redemption because it should be deemed a nontaxable transfer of property from Joann to Moriah on behalf of petitioner, and then she initiated a refund suit in the U.S. District Court for the Western District of Washington. The District Court granted summary judgment in Joann’s favor in Arnes v. United States, 91-1 USTC par. 50,207 (W.D. Wash. 1991), concluding that section 1041 governed the income tax consequences of the transaction to Joann.

On February 10, 1992, petitioner filed his motion for partial summary judgment in this case. On March 9, 1992, respondent filed a motion to stay proceedings and also a response to petitioner’s motion for partial summary judgment, in part contending that the stay would conserve this Court’s time because the Court of Appeals for the Ninth Circuit’s decision in Joann’s case would be dispositive of this case. On March 19, 1992, petitioner filed his objection to respondent’s motion. By order dated July 8, 1992, we granted respondent’s motion. On August 12, 1992, petitioner filed a motion for reconsideration of order staying proceedings and also a memorandum in support of such motion, in part stating that it would be beneficial for the Court of Appeals for the Ninth Circuit to consider both Joann’s and petitioner’s cases simultaneously if respondent were to lose this case. On September 21, 1992, respondent filed a response to petitioner’s motion for reconsideration of order staying proceedings, objecting to petitioner’s motion. By order dated October 2, 1992, this Court denied petitioner’s motion.

Thereafter, the District Court’s decision in Joann’s case was argued before and affirmed by the Court of Appeals for the Ninth Circuit in Arnes v. United States, 981 F.2d 456 (9th Cir. 1992).

OPINION

Respondent argues that the decision in Arnes controls our decision here. Petitioner contends, to the contrary, that Moriah redeemed Joann’s stock and that no constructive dividend resulted to petitioner. We agree with petitioner and consider his motion first.

Summary judgment is appropriate where the record shows that there is no genuine issue as to any material fact and that a decision may be rendered as a matter of law. Rule 121(b); Sundstrand Corp. v. Commissioner, 98 T.C. 518, 520 (1992), affd. 17 F.3d 965 (7th Cir. 1994); Marshall v. Commissioner, 85 T.C. 267, 271 (1985). The burden of proof is on the moving party to show that no issue of material fact exists. We view the evidence in the light most favorable to the party opposing the motion. Blanton v. Commissioner, 94 T.C. 491, 494 (1990); Jacklin v. Commissioner, 79 T.C. 340, 344 (1982). A motion for summary judgment will be denied if there is any reasonable doubt as to the facts in issue. Hoeme v. Commissioner, 63 T.C. 18, 20 (1974).

The issue before us is whether Moriah’s redemption of Joann’s stock resulted in a constructive dividend to petitioner. If a corporation redeems stock that its remaining shareholder was obligated to buy, a constructive dividend results to the remaining shareholder. Wall v. United States, 164 F.2d 462 (4th Cir. 1947); Hayes v. Commissioner, 101 T.C. 593 (1993); Edler v. Commissioner, T.C. Memo. 1982-67, affd. 727 F.2d 857 (9th Cir. 1984). However, this rule is limited to those circumstances where the obligation of the remaining shareholder is both primary and unconditional. Enoch v. Commissioner, 57 T.C. 781 (1972); Priester v. Commissioner, 38 T.C. 316 (1962); Edenfield v. Commissioner, 19 T.C. 13 (1952); Edler v. Commissioner, supra.

In Edler v. Commissioner, 727 F.2d 857 (9th Cir. 1984), the Court of Appeals for the Ninth Circuit affirmed our decision that the taxpayer did not receive a constructive dividend when the corporation in which he was the majority shareholder redeemed the stock owned by his former spouse. In that case, an interlocutory divorce judgment had awarded the taxpayer all of the stock in the company and had ordered him to deliver a promissory note payable to the wife. A nunc pro tunc order was later entered, deleting reference to the husband’s obligation or to the enforcement and execution of this promissory note, and incorporating an agreement between the husband and wife, which read, in pertinent part, as follows:

whereunder * * * [the wife] would give up [her] money judgment position, recall the writ of execution, * * * and substitute, in the place and stead thereof, the delivery * * * of a minority shareholder position in Edler Industries, Inc., ON THE CONDITION that the corporation concurrently, redeem for cash, said minority shares * * * for the same amount of said money, to which * * * [the wife] is now entitled. [Id. at 858-859.]

After the modification, the husband had a secondary obligation to the wife to be fulfilled only if the corporation failed to redeem her stock.

The Court of Appeals expressed no doubt that the original agreement between the parties had created an obligation of the husband which would have resulted in a constructive dividend to him if the stock had been redeemed by the corporation. However, the court affirmed our holding that, under the nunc pro tunc modification, the husband did not have a primary and unconditional obligation, and that, therefore, there was no constructive dividend. In so doing, the Court of Appeals for the Ninth Circuit noted that, in the Tax Court, respondent had not questioned the ability of the divorce court to modify its own judgment and that it, therefore, would not consider, on appeal, whether, under Commissioner v. Estate of Bosch, 387 U.S. 456, 465 (1967), the Tax Court should not have given effect to the nunc pro tunc order. Edler v. Commissioner, supra at 859.

Despite respondent’s attempts to distinguish Edler, the undisputed facts in the case before us are even more compelling for concluding that petitioner did not have a primary and unconditional obligation to acquire Joann’s stock. From the inception, Moriah was obligated to redeem Joann’s stock; there was no nunc pro tunc order changing a prior obligation of petitioner. The rationale of Edler was not affected by the enactment of section 1041, and the case is still the law of the Court of Appeals for the Ninth Circuit, to which this case is appealable.

This conclusion is further supported by respondent’s own published position in Rev. Rui. 69-608, 1969-2 C.B. 42, 44. Situation 5 states:

A and B owned all of the outstanding stock of X corporation. An agreement between A and B provided that upon the death of either, X will redeem all of the X stock owned by the decedent at the time of his death. In the event that X does not redeem the shares from the estate, the agreement provided that the surviving shareholder would purchase the unredeemed shares from the decedent’s estate. B died and, in accordance with the agreement, X redeemed all of the shares owned by his estate.

In this case A was only secondarily liable under the agreement between A and B. Since A was not primarily obligated to purchase the X stock from the estate of B, he received no constructive distribution when X redeemed the stock.

This scenario is directly analogous to the case before us. Indeed, petitioner argues on brief that, in structuring the redemption of Joann’s Moriah stock, he had the right to rely on Edler v. Commissioner, supra, and Rev. Rul. 69-608, 1969-2 C.B. at 43, situation 5. See Estate of Henry v. Commissioner, 69 T.C. 665, 674-675 (1978). Petitioner and Joann owned all of the stock of Moriah. Their property settlement agreement provided that Moriah would redeem Joann’s shares, with Moriah’s obligation guaranteed by petitioner. Under applicable Washington State law, the property settlement agreement created at most a secondary obligation, which could only mature on Moriah’s default on its primary obligation. See National Bank of Washington v. Equity Investors, 81 Wash. 2d 886, 917, 506 P.2d 20, 39 (1973); Amick v. Baugh, 66 Wash. 2d 298, 303-308, 402 P.2d 342, 345-348 (1965). The McDonald’s letter did not create a primary and unconditional obligation on petitioner to acquire Joann’s shares.² Because petitioner was not primarily obligated to purchase Joann’s shares, he received no constructive distribution when Moriah redeemed the stock.

Respondent contends, under the principle of Golsen v. Commissioner, 54 T.C. 742 (1970), affd. 445 F.2d 985 (10th Cir. 1971), that the following statement by the Court of Appeals for the Ninth Circuit in Arnes v. United States, 981 F.2d at 459, controls our decision in the instant case:

John Arnes had an obligation to Joann Arnes that was relieved by Moriah’s payment to Joann. That obligation was based in their divorce property settlement, which called for the redemption of Joann’s stock. Although John and Joann were the sole stockholders in Moriah, the obligation to purchase Joann’s stock was John’s, not Moriah’s. Furthermore, John personally guaranteed Moriah’s note to Joann. Under Washington law, Joann could sue John for payment without suing Moriah. See Wash. Rev. Code Ann. § 62A.3-416(1) (West 1979). Thus, John was liable, with Moriah, for the payments due Joann.

Golsen v. Commissioner, supra, does not apply because Arnes v. United States, supra, does not address the legal issue here: whether there is a constructive dividend to petitioner. That case concerned the tax consequences to Joann under section 1041. Bonaire Dev. Co. v. Commissioner, 76 T.C. 789, 799-801 (1981), affd. on other grounds 679 F.2d 159 (9th Cir. 1982); Estate of Henry v. Commissioner, 69 T.C. 665, 674 (1978). We note that petitioner was not a party in Arnes, and Joann had a possibly³ adverse position to petitioner in that case.

Moreover, petitioner’s guarantee did not create a primary and unconditional obligation. Under Wash. Rev. Code Ann. sec. 62A.3-416(1) (West 1979), cited by the Court of Appeals for the Ninth Circuit, any obligation⁴ of petitioner would arise only after Moriah failed to make payments to Joann.⁵ Any obligation of petitioner implied in the property settlement agreement would be the same as would exist in any situation involving a divorce and a division of property and as existed in Edler v. Commissioner, 727 F.2d 857 (9th Cir. 1984), affg. T.C. Memo. 1982-67, after the nunc pro tunc modification. To the extent this is suggested by the Court of Appeals for the Ninth Circuit in Arnes v. United States, supra, we conclude that the obligation is not primary and unconditional, and the statement constitutes dictum.

Applying these standards to the record as a whole, and the undisputed facts therein, we conclude that petitioner demonstrated that there is no genuine issue of material fact that could establish that payments made by Moriah to Joann in redemption of her stock were constructive distributions by Moriah to petitioner that could properly be treated as dividends to him.

In hindsight, tactically, it might have been preferable if respondent had taken action to facilitate simultaneous consideration of petitioner’s and Joann’s cases by the Court of Appeals for the Ninth Circuit, instead of the course that was taken.

Petitioner’s motion for partial summary judgment will be granted. In view of our above conclusions, respondent’s motion for summary judgment will be denied in full. To reflect the foregoing,

An appropriate order will be issued.

Reviewed by the Court. Hamblen, Chabot, Cohen, Wright, Wells, Beghe, Chiechi, and Laro, JJ., agree with this majority opinion. Parr, J., concurs in the result only.

1 All Rule references are to the Tax Court Rules of Practice and Procedure, and all section references are to the Internal Revenue Code in effect for the years in issue, unless otherwise indicated.

2 The McDonald’s letter did not mandate the manner in which ownership of the franchise had to be redistributed or even to whom it had to be redistributed.

3 This majority opinion does not express an opinion as to whether the standard of “on behalf of” the spouse in sec. 1.1041-1T(c), Q&A-9, Temporary Income Tax Regs., 49 Fed. Reg. 34453 (Aug. 31, 1984), is the same as the primary and unconditional obligation rule applicable to a constructive dividend. Suffice it to say that our conclusion in this case is consistent with our conclusion in Blatt v. Commissioner, 102 T.C. 77 (1994), also a Court-reviewed opinion.

4 Under Washington State law, assuming facts most favorable to respondent, petitioner’s guarantee would be classified as an absolute guarantee. An absolute guarantee constitutes a promise to pay on default by the principal obligor. National Bank of Washington v. Equity Investors, 81 Wash. 2d 886, 917, 506 P.2d 20, 39 (1973); Amick v. Baugh, 66 Wash. 2d 298, 303-308, 402 P.2d 342, 345-348 (1965).

5 Indeed, Joann was paid to the extent of $110,983.56 on the cancellation of her note to Moriah; any obligation of petitioner under his guarantee would never arise to that extent.