Commissioner of Internal Revenue v. Sullivan

210 F.2d 607, 4 Oil & Gas Rep. 2063, 45 A.F.T.R. (P-H) 373, 1954 U.S. App. LEXIS 4750

• Court: Court of Appeals for the Fifth Circuit
• Decided: February 23, 1954
• Docket: 14562_1
• Status: Published

Opinions

HOLMES, Circuit Judge.

These appeals involve income taxes for the calendar year 1943. They are in consolidated proceedings and were taken by the Commissioner from decisions of the Tax Court entered on August 11, 1952. Petitions for review were filed November 4, 1952. This court accordingly .has jurisdiction of the cases under Section 1141(a) of the Internal Revenue Code, as amended by Section 36 of the Act of June 25, 1948, 26 U.S.C.A. § 1141(a). Error is assigned on the part of the Tax Court in holding that certain distributions in kind were not essentially equivalent to a taxable dividend within the meaning of Section 115(g) of the Internal Revenue Code, 26 U.S.C.A. § 115(g), but that such distributions were taxable as in partial liquidation of the corporation as provided in Section 115(c) of said code.

The Texon Royalty Company, a Delaware corporation, made a distribution in kind on April 1, 1943, to its two sole stockholders in cancellation of 2,000 shares, or two fifths, of its capital stock. The income tax deficiencies asserted against the husbands of the two stockholders resulted from the fact that the tax returns of each couple were filed in accordance with the community property laws of Texas, in which state all parties resided. The question presented here is whether the redemption and cancellation of the stock was at such time and in such manner as to make the distribution essentially equivalent to a taxable dividend so as to be taxable to the recipients to the extent of Texon’s accumulated earnings and profits, instead of being treated as payment in exchange for the stock and subject only to a capital gains tax. In other words, was the distribution taxable under Section 115(g) or 115(c) of the Internal Revenue Code?

The Tax Court held that Section 115 (g) was inapplicable and, therefore, that the taxpayers’ entire gain on the distribution was taxable as a long-term capital gain. This holding was based primarily upon findings of fact, in substance as follows: Texon held a great many producing oil leases outside of the Agua Dulce oil field, which was a high pressure field. A suit for damages from a blowout which occurred in prior operations in that field was pending against Texon at the time of the distribution. The leases transferred needed to be developed, and they were transferred because Texon did not want to take the risk of developing them and because it did not have authority under its charter to drill wells. The same reasons prompted the distribution of its drilling equipment. Another reason was that this equipment could be used in the development of the oil properties transferred. The gas payment and the notes were included in the distribution in order to furnish the distributors with additional capital or credit to aid them in the development of the properties transferred, which was undertaken soon after the distribution. The drilling equipment was transferred by the stockholders to a corporation in connection with the development. The avoidance of taxes was not one of the reasons for the distribution.

The petitioner argues that, if the redemption of stock is made pro rata, any business purpose for the redemption thereof will usually be outweighed by the net effect of the transaction. The respondents contend that the Tax Court has weighed the evidence in this case with regard to the net effect of the transaction as well as to the business purposes of the corporation, and has found that the distribution was dictated by the reasonable needs of the corporate business, not merely to benefit the stockholders by giving them a share of the earnings of the corporation.

The Tax Court’s opinion expressly refers to its considering the net effect of the transaction; and we cannot say that it used the wrong test, or that there was any specific test for the issue before it. We agree that the pro rata redemption of stock will generally be considered as effecting a distribution essentially equivalent to a dividend distribution to the extent of the earnings and profits, but to hold that this is always true would nullify the regulation which sanctions it in some cases and says that the question depends upon the particular circumstances of each case. See Treasury Regulations 111, Secs. 29.115-5 and 29.115-9.

The so-called net-effect test is not a weighted formula by which to solve the issue before the court. The net effect of the transaction is not evidence or testimony to be considered; it is an inference to be drawn or a conclusion to be reached. It is not a solvent but a residuum; it is not a process but a product; it is not a means but an end; it is not a solution but a restatement of the statutory provision; it is the gist of the governing law of the case; it is not a balance for weighing the law against the facts; it is the law itself. “Net effect” is a paraphrase for “essentially equivalent.” It is just as if the statute read: “If a corporation redeems its stock in whole or in part, so that the net effect of the transaction is the same as the payment of a taxable dividend, the amount so distributed shall be treated as a taxable dividend.” The net-effect test is not a test but an attractive abbreviation of the statute, as to which we shall be bn safer ground if we stick to'the words of the statute: essentially equivalent.

The distribution of the high-pressure leases and the drilling equipment constituted a contraction of Texon’s business. When there is a contraction or shrinkage of corporate business, the need of a corporation for funds to carry on its former activities is largely eliminated. Following a contraction of its activities, and with surplus' funds on hand, good business and accounting practices dictated a redemption • of a portion of the corporation’s capital stock. Failure to reduce its capital would have resulted in the payment of unnecessary capital-stock taxes contrary to good business practices. There were other factual considerations that entered into the decisions of the Tax Court.

Strong as is the pro-rata factor in this case, it is not sufficient in itself to require or authorize us to set aside the findings of the Tax Court and invoke the application of Section 115(g). To do so would nullify the regulation that authorizes the complete retirement of any part of the stock, whether or not pro rata among the shareholders. In a number of cases, in applying the so-called net-effect test, some of which held the distribution taxable, the courts have called attention to the fact that there was no purpose on the part of the taxpayer to contract its business or narrow the scope of its operations. In Flanagan v. Helvering, Justice Vinson (later Chief Justice of the United States) said: “The corporation did not manifest any policy of contraction”. 73 App.D.C. 46, 116 F.2d 937, 939. See also Commissioner v. Babson, 7 Cir., 70 F.2d 304; Hyman v. Helvering, 63 App.D.C. 221, 71 F.2d 342; Commissioner v. Champion, 6 Cir., 78 F.2d 513; Smith v. United States, 3 Cir., 121 F.2d 692; Hirsch v. Commissioner, 9 Cir., 124 F.2d 24; Rheinstrom v. Conner, 6 Cir., 125 F.2d 790; Vesper Co. v. Commissioner, 8 Cir., 131 F.2d 200; Commissioner v. Snite, 7 Cir., 177 F.2d 819; Boyle v. Commissioner, 3 Cir., 187 F.2d 557; Commissioner v. Roberts, 4 Cir., 203 F.2d 304; Upham v. Commissioner, 4 T.C. 1120; Imler y. Commissioner, 11 T.C. 836; O’Brian v. Commissioner, Par. 51,373 P — H Memo T.C., 1141.

The decisions of the Tax Court are affirmed.

Affirmed.