Campbell v. United States

144 F.2d 177, 32 A.F.T.R. (P-H) 1173, 1944 U.S. App. LEXIS 2773

Opinions

MARIS, Circuit Judge.

The pending appeals, which were argued together, present the same legal question, namely, whether the undistributed earnings of two predecessor corporations (accumulated after February 28, 1913, and not distributed up to the time of a successor company’s acquisition of the predecessors’ businesses and assets as a result of a tax-free reorganization) may be included in determining whether cash distributions made by the successor company in later years to its stockholders were taxable in full as dividends paid out of its earnings and profits within the meaning of Sec. 115(a) of the Revenue Acts of 1932 and 1934, 26 U.S.C.A. Int.Rev.Acts, pages 520, 703, the successor company’s net earnings from the time of its incorporation being insufficient to provide for the distributions in question.

The facts which, as stipulated, were found by the court below disclose the following situation.

Sharp & Dohme, Inc. (hereinafter referred to as the New Company) was incorporated in July 1929 with an authorized capital stock consisting of preferred and common shares. On August 6, 1929, pursuant to a contract of June 28, 1929, between bankers and the stockholders of a previously existing corporation of the same name (hereinafter referred to as the Old Company), the New Company acquired the° business and assets of the Old Company, subject to its liabilities, in exchange for a certain amount of cash and a portion of the preferred and common shares of the New Company’s capital stock. In accordance with the contract the preferred shares given in exchange were issued directly to the stockholders of the Old Company and the common shares and cash were issued to the Old Company and by it distributed pro rata to its stockholders. To obtain the cash necessary for the purpose, the New Company sold to the bankers a portion of its remaining common shares and, through the bankers, sold to clients of the latter, a portion of the remaining preferred shares.

When the contract plan had been fully carried out, the stockholders of the Old Company were in possession of the agreed upon cash distribution and 46% of the common and 37% of the preferred capital stock of the New Company then outstanding and the latter was in possession of the entire business and assets of the Old Company. Although the transaction qualified as a reorganization under Sec. 112(i) (1) (A) of the Revenue Act of 1928, 26 U.S.C.A. Int.Rev.Acts, page 379, for the purpose of determining that no gain or loss was to be recognized from the Old Company’s transfer of its assets and the exchange of securities, the stockholders of the Old Company were taxable by virtue of Sec. 112(c) to the extent of the gain realized on account of the cash received by them in the exchange. See Starr v. Commissioner, 4 Cir., 1936, 82 F.2d 964, 966, certiorari denied 298 U.S. 680, 56 S.Ct. 948, 80 L.Ed. 1401.

Prior to the sale and transfer of the Old Company’s assets and business to the New Company, the former had accumulated large earnings and profits since February 28, 1913 which remained undistributed.

On October 7, 1929, pursuant to a contract of September 24, 1929, between the New Company and H. K. Mulford Company (an unrelated company hereinafter referred to as Mulford), which superseded a contract of August 2, 1929, between stockholders of Mulford and the bankers, the New Company acquired the business and assets of Mulford, subject to its liabilities, in exchange for a certain amount of cash and a portion of the preferred and common shares of the remaining authorized capital stock of the New Company. The cash and stock were distributed pro rata to the stockholders of Mulford in complete redemption and cancellation of the outstanding shares of stock of that company.

As in the case of the Old Company,'the New Company’s acquisition of the business and assets of Mulford in exchange for stock and cash was in a reorganization which resulted in a tax-free exchange except for the cash distributed to the stockholders of Mulford. The stipulated effect of the Mulford transaction was identical with the result attained in the case of the Old Company.

Prior to the sale and transfer of Mulford’s assets and business to the New Company, Mulford also had accumulated large earnings and profits since February 28, 1913 which remained undistributed.

Both plaintiffs are holders of preferred shares of the New Company¹ and in 1933 and 1934 received cash distributions on account of their stock which each respectively returned as taxable dividends² for the years in question. Subsequently each filed a claim for refund on the ground that a portion of the income so reported as taxable dividends constituted a return of capital by the distributing corporation which was, therefore, rightly to be reflected in reduction of the cost base of the taxpayers’ stock and not as taxable income.

As appears by the stipulation, the earnings of the New Company from the time of its incorporation in 1929 were insufficient to provide in full for the distributions which it made to its stockholders in 1933 and 1934. It is also stipulated that the total distributions made by the New Company on account of its preferred shares through the year 1934 did not equal the cost base of the stock of either of the plaintiffs. Consequently, no gain or loss to them was to be recognized as upon a sale or other disposition of their stock. The Commissioner rejected the claims for refund and the taxpayers severally brought the suits here involved for the recovery of the portions of the taxes which, allegedly, were improperly assessed and collected. The court below, holding that the distributions were dividends from accumulated earnings of the distributing company, entered the judgments for the defendant from which the plaintiffs respectively took the present appeals.

A literal reading of the Revenue Acts of 1932 and 1934 would seem to call for the conclusion that the district court was in error. Although distributions of money or property made by a corporation to its stockholders may be distributed as dividends, only those distributions are taxable as dividends which are made by the corporation “out of its earnings or profits accumulated after February 28, 1913."³

The Commissioner successfully contended in the district court that the earnings or profits of the Old Company and of Mulford must be treated as the earnings or profits of the New Company. He urges that the rule is that where, following a tax-free reorganization, the successor corporation makes distributions to its stockholders in excess of its earnings from the time of its incorporation, the accumulated surplus earnings of the predecessor corporations at the time of the reorganization are to be treated as having been carried over to the successor corporation in determining the extent to which such distributions are taxable as dividends.

This rule was first enunciated in Commissioner v. Sansome, 2 Cir., 1932, 60 F.2d 931, certiorari denied Sansome v. Burnet, 287 U.S. 667, 53 S.Ct. 291, 77 L.Ed. 575, was adopted in this circuit⁴ and has been followed in every circuit in which the question has been determined.⁵

It is, therefore, necessary to examine the Sansome case in order to determine whether it does enunciate as a principle of law the doctrine contended for by the Commissioner and whether that doctrine is applicable to and determinative of the question before us. The pertinent facts in that case were as follows:

Corporation A transferred all its assets to newly created Corporation B with additional charter powers. Corporation B assumed all existing obligations of Corporation A and issued all its shares directly to the stockholders of Corporation A without change in the proportion of their holdings. Thereafter Corporation A dissolved. Corporation B operated without profit for little more than a year. It then discontinued business and made payments to its stockholders in partial liquidation. The total of these distributions was less than the sufplus and undivided profits of Corporation A at the time it transferred its assets to Corporation B.

The Commissioner treated these payments as dividends. The taxpayer claimed the right to apply the payments to amortize his cost and to pay a tax upon only so •much as exceeded his cost. The Board of Tax Appeals held that the payments were not dividends because they were not made out of the earnings or profits of the distributing corporations. The Circuit Court of Appeals reversed. Judge Learned Hand, speaking for the court, said: (60 F.2d at page 933) “ * * * a corporate reorganization which results in no ‘gain or loss’ under section 202(c) (2) * * * does not toll the company’s life .as continued venture under section 201, and that what were ‘earnings or profits’ of the original, or subsidiary, company remain, for purposes of distribution, ‘earnings or profits’ of the successor, or parent, in liquidation.”

The gist of the decision was that where a new company takes over in place of the old, with assets, liabilities and stockholders unchanged, and where no tax results from such a reorganization, the new company is but the alter ego of the old and the change in corporate form cannot be permitted to freeze into capital the undistributed earnings of the old company. The .court, believing it unlikely that Congress would permit stockholders to postpone indefinitely their tax liability upon moneys which they received out of earnings and profits of their corporation merely because of a reorganization effected to secure additional charter powers, construed the revenue acts as prohibiting such a result.

In the cases now before us new stockholders, including Mrs. Newbold, the plaintiff in No. 8225, who paid cash for their shares, came into the corporate set-up as a result of the reorganization. In fact the proportionate ownership of the stockholders of the Old Company and of Mulford in the New Company was reduced to a fraction of their interests in the former companies. The identity of proprietary interest which existed in the Sansome case and motivated the court to disregard the corporate entities and treat the earnings of the predecessor corporation as though they were earnings of the successor corporation is, therefore, completely lacking. We think that for this reason alone the doctrine of the Sansome case, which by judicial construction operates to transfer earnings from the corporation which earned them to its successor in reorganization, is inapplicable. Most of the cases in which the Sansome doctrine has been applied dealt with reorganizations such as the one which took place in the Sansome case, in which the old stockholders ended up by owning the same enterprise in the same proportions.⁶ We are aware that it has also been applied to transfers of corporate assets which, while constituting tax-free reorganizations within the meaning of the revenue act, none the less involved the introduction of new capital and new stockholders into the corporate picture with consequent changes in the proportionate interests of the old stockholders in the enterprise.⁷ We cannot accede to such an extension of the San-some doctrine,⁸ however, because it involves the contradictory concept of a corporation buying profits with money contributed by new stockholders, whereas profits by their nature must be realized from other transactions and may not themselves be acquired by purchase.

If it be suggested that the New Company did not acquire any new capital in the reorganization and that the money which it distributed to old stockholders came from the sale of New Company shares to which the old stockholders were entitled, it may be answered that even if the facts support this theory we would not be at liberty thus to isolate one step in what the Circuit Court of Appeals for the Fourth Circuit in Starr v. Commissioner of Internal Revenue, 82 F.2d 964(1936), certiorari denied 298 U.S. 680, 56 S.Ct. 948, 80 L.Ed. 1401, held to be in reality but a single transaction constituting a reorganization within the meaning of Section 112(i) (1) of the Revenue Act of 1928. In that case it was held that the money received by the old stockholders was received by them in connection with a reorganization and was, therefore, taxable under Section 112(c) to the extent that it represented gain to them upon the entire exchange involved in the reorganization. To hold that this money was received by the old stockholders for the sale of shares of New Company stock owned by them would subj ect it to taxation only to the extent that it represented a gain over the cost basis of the particular shares sold, a wholly different theory from that adopted in the Starr case. Such a holding would thus in effect overrule the decision of the Circuit Court of Appeals for the Fourth Circuit which we are satisfied was correct.

The doctrine of the Sansome case that the accumulated earnings of the predecessor corporation in a tax-free reorganization shall be deemed carried over to the successor corporation for the purpose of distribution to its stockholders as dividends cannot apply to a situation where the accumulated earnings of the predecessor corporation have been distributed to its stockholders at the time of the reorganization. Obviously earnings cannot at one and the same time be distributed to the stockholders of the predecessor corporation and transferred to the successor corporation. We think that in the present cases it must be held that the accumulated earnings of the Old Company and of Mulford were distributed to the stockholders of the old companies. Such a conclusion is called for by a provision of the Revenue Act of 1928 which was in force when the reorganization took place.

Section 112(c) of that Act provided:

“(c) Gain from Exchanges not Solely in Kind. (1) If an exchange would be within the provisions of subsection (b) (1), (2), (3), or (5) of this section if it were not for the fact that the property received in exchange consists not only of property permitted by such paragraph to be received without the recognition of gain, but also of other property or money, then the gain, if any, to the recipient shall be recognized, but in an amount not in excess of the sum of such money and the fair market value of such other property.

“(2) If a distribution made in pursuance of a plan of reorganization is within the provisions of paragraph (1) of this subsection but has the effect of the distribution of a taxable dividend, then there shall be taxed as a dividend to each distributee such an amount of the gain recognized under paragraph (1) as is not in excess of his ratable share of the undistributed earnings and profits of the corporation accumulated after February 28, 1913. The remainder, if any, of the gain recognized under paragraph (1) shall be taxed as a gain from the exchange of property.”

As we have already pointed out the reorganization involved the receipt by the stockholders of the Old Company and Mulford of money which under the facts was taxable to them under Section 112(c). In each case the distribution exceeded the total accumulated earnings of the old companies. If this distribution had “the effect of the distribution of a taxable dividend” within the meaning of paragraph (2) of Section 112(c) it must be treated as in law a distribution to the stockholders of the entire amount of those earnings.

In Love v. Commissioner, 3 Cir., 1940, 113 F.2d 236, this court was called upon to construe Section 203(d) of the Revenue Act of 1926, 26 U.S.C.A. Int.Rev.Acts, page 150, the precursor of Section 112(c) of the Revenue Act of 1928. We there held that when cash was distributed in a reorganization to the stockholders of the predecessor company that part of the amount thus distributed which equalled the accumulated earnings of the predecessor corporation had the effect of a taxable dividend and was accordingly taxable as such. It is true that in the Love case the cash was paid to the stockholders of the old company directly from the assets of that company, while in the present cases the payments to the old stockholders were made with cash furnished by the New Company. We consider this an immaterial distinction, however. In Commissioner v. Owens, 5 Cir., 1934, 69 F.2d 597, Rose v. Little Inv. Co., 5 Cir., 1936, 86 F.2d 50, and Commissioner v. Forhan R. Corp., 2 Cir., 1935, 75 F.2d 268, the authorities which we cited with approval in the Love case, the payments to the stockholders were in each case made out of moneys supplied by the successor company.

As we have seen, the accumulated earnings of the Old Company amounted to $2,801,117.15. Since cash in the amount of $9,790,062.50 was distributed to the then common stockholders of the Old Company the distribution was a taxable dividend to the full extent of the accumulated earnings. The same is true of the distribution to the stockholders of Mulford. That company had accumulated earnings of $1,748,397.52 and the distribution amounted to $3,709,-003.50 in cash. Whether these 'distributions, to the extent of the accumulated earnings of the old companies, were actually taxed as dividends to the old stockholders does not presently appear. But even if we assume that they were not so taxed by the Commissioner, his error in that regard would not justify us in disregarding the plain mandate of the statute and thus perpetuating the same error here. It may be suggested that the rule of Section 112(c) (2) should not be applied to stamp these distributions as made out of the earnings of the old companies because under the ordinary rules of corporation law and accounting they would not be so treated. The answer to this is that the rule of the Sansome case is equally at war with corporate law and accounting. If it be contended that the one rule calls for the bypassing of corporate forms and procedures and the recognition of a fictional situation, it is clear that the other does also and that if the application of the two rules appear to conflict, the judge-made fiction of the Sansome case must yield to the express statutory fiction of Section 112(c) (2).

It must, therefore, be held that by August, 1929 all the accumulated earnings of the Old Company had been distributed as dividends to its then stockholders and by October, 1929 all the accumulated earnings of Mulford had been distributed to its then stockholders. It follows that when in 1933 and 1934 the New Company made distributions in cash to its stockholders the source of these payments could not have been the accumulated earnings of the Old Company and of Mulford since at that time the earnings of both had long since' been distributed. It is conceded that the New Company’s own earnings accumulated since its organization in 1929 were not sufficient to cover the entire amount of the distributions made to its stockholders in 1933 and 1934 and which are here in controversy. We conclude that these distributions, to the extent that they did not represent undistributed earnings accumulated by the New Company since its organization, were not made out of the earnings or profits of the-New Company within the meaning of the Revenue Acts. It follows that these distributions to the extent indicated were not taxable as dividends.

The judgments of the district court are reversed, and the causes are remanded for further proceedings not inconsistent with, this opinion.

1 The plaintiff Campbell acquired his shares in the New Company in exchange for Mulford stock which he held, while the plaintiff Newbold acquired her shares in the New Company by purchase.

2 The tax return for the plaintiff New-bold for the year 1933 showed no income subject to tax. However the Commissioner subsequently assessed a deficiency in tax with interest which she paid in an amount in excess of the refund which she now seeks.

3 Section 115(a) of the Revenue Acts of 1932 and 1934.

4 Corrigan v. Commissioner, 3 Cir., 1939, 103 F.2d 1010, certiorari denied 308 U.S. 576, 60 S.Ct. 91, 84 L.Ed. 482, decided on the authority of Baker v. Commissioner, 2 Cir., 1936, 80 F.2d 813; Barnes v. United States, D.C.E.D.Pa., 1938, 22 F.Supp. 282.

5 Georday Enterprises v. Commissioner, 4 Cir., 1942, 126 F.2d 384; Murchison’s Estate v. Commissioner, 5 Cir., 1935, 76 F.2d 641; United States v. Kauffmann, 9 Cir., 1933, 62 F.2d 1045.

6 United States v. Kauffmann, 9 Cir., 1933, 62 F.2d 1045; Murchison’s Estate v. Commissioner, 5 Cir., 1935, 76 F.2d 641; Harter v. Commissioner, 2 Cir., 1935, 79 F.2d 12; Baker v. Commissioner, 2 Cir., 1936, 80 F.2d 813; Corrigan v. Commissioner, 3 Cir., 1939, 103 F.2d 1010, certiorari denied 308 U.S. 576, 60 S.Ct. 91, 84 L.Ed. 482; Barnes v. United States, D.C.E.D.Pa., 1938, 22 F.Supp. 282.

7 Crocker v. Commissioner, 1934, 29 B.T.A., 773.

8 Mertens in Vol. 1, § 9.58, pp. 509, 510 of his text on Law of Federal Income Taxation says:

“It has been implied, however, that the general principle of ‘inherited’ earnings or profits applies wherever there is a ‘nontaxable’ reorganization. It may be misleading, however, to state its scope in such general terms. Assuming that the provision in the statute taxing corporate distributions of ‘its earnings of profits’ is capable of requiring the inclusion of the earnings or profits of predecessor corporations, it would still seem to be necessary to draw'distinctions based on the type and character of the reorganization in each case. Possibly a different conclusion may be applicable where there has been merely an exchange by the parent corporation of its stock for stock of the subsidiary in a tax-free reorganization than applies in a case in which the reorganization involves the acquisition by the new company of the old company’s assets with other substantial changes in the corporate structure. The test should not be the ‘tax-free’ character of the so-called reorganization; any such general test would confuse the issue and give rise occasionally to absurd results in the various types of situations arising under our complex exchange and reorganization provisions. The proper test is whether there is substantial identity of the several corporations and continuity of proprietary interests.”