Withey, Judge:
Respondent determined the following deficiencies in the income tax of petitioners for the year 1958:
Doclcet. No. Petitioners Deficiency
93586 3. Milton and Wanda M. Sorem_-_$17, 790. 06
94707 R. W. and Margaret Boogaart_ 18, 550. 09
Pursuant to petitioners’ motion, both cases were consolidated for trial.
The sole issue for decision is whether the transfer by petitioners1 Boogaart and Sorem of all of the stock of four corporations of which they were the sole owners to Boogaart Supply Co., Inc., of which they were major stockholders, in exchange for cash and cancellation of indebtedness is to be categorized as a distribution in redemption of stock within the meaning of section 802(a) of the Internal Revenue Code of 1954 2 or as a distribution of property to which section 301 of that Code applies.
FINDINGS OF FACT
Some of the facts were stipulated by the parties. Their stipulation, together with attached exhibits, is incorporated herein by reference.
J. Milton Sorem and Wanda M. Sorem are husband and wife residing in Concordia, Kans. Their joint return for the year 1958, made on the cash basis and for the calendar year period, was filed with the district director of internal revenue, Wichita, Kans. R. W. and Margaret Boogaart are also husband and wife and presently reside in Buenos Aires, Argentina. For the calendar year 1958 their joint return, made on the cash basis, was filed with the director of international operations, Washington, D.C.
Petitioners Sorem and Boogaart are brothers-in-law. In 1935, they, together with M. Boogaart, B. W. Boogaart’s father, formed a partnership, known as the Boogaart Supply Co. and sometimes hereinafter called the partnership, for the purpose of engaging in the retail grocery business in the northwestern Kansas area. Subsequent to its formation the business of the partners prospered, and by 1949 the partnership owned outright four retail grocery stores located at Concordia, Clay Center, Marysville, and Washington, Kans., and had varying interests in several other grocery outlets in the surrounding area.
During the formative period 1935 to 1949 the partnership had engaged only in the retail aspect of the grocery business. However, by 1949 it was becoming increasingly apparent that expansion was necessary in order to meet the growing competition of national grocery chains with their direct lines of supply to manufacturers. The partners therefore decided to enter the wholesale grocery business with a view to obtaining similar access to manufacturers for their stores. To this end the partnership, in 1949, caused the formation of the Boogaart Supply Co., Inc. (sometimes hereinafter called the corporation), a Kansas corporation to which the partnership contributed $240,000 capital in exchange for stock.
At the beginning, the corporation dealt only in the sale at wholesale of dry nonperishable groceries. However, consistent with their expansion policy, the partners, between 1952 and 1957, acquired or caused to be formed a number of subsidiary companies to engage in the sale or production at wholesale of frozen and fresh foods, ice cream, dairy products, bakery products, drugs, housewares, eggs, and meat and poultry products, all of which subsidiary wholesale companies they eventually transferred to the corporation in exchange for corporate stock.
In 1956 M. Boogaart, the patriarch of the Boogaart-Sorem group, died. R. W. Boogaart and J. Milton Sorem thereafter acquired in equal shares M. Boogaart’s partnership interest from the Boogaart estate, each having to borrow the necessary funds from third parties in order to make up the purchase price. R. W. was able to repay his loan with moneys received by him as an heir of M. Boogaart. However, J. Milton Sorem repaid his loan by borrowing $30,000 from the corporation, a debt he continued to owe the corporation until sometime in 1959.
So successful bad been the partners’ operation of tbeir business that in 1957 the services of E. W. Boogaart were requested by the International Basic Economy Corp., a Rockefeller Foundation group, to organize and operate American-style supermarkets in Italy. As a result of E. W.’s decision to accept this offer, which would require his absence from the United States for an extended period of time, the partnership determined to cease operation of the four retail grocery stores located at Concordia, Clay Center, Marysville, and Washington, Kans., in the partnership form. Accordingly, on April 1, 1957, the partnership incorporated each of the four grocery stores and received 100 percent of their stock.
Despite rapid and extensive growth the expansion of various Boogaart interests had been hampered by a lack of sufficient working capital during the period 1950 to 1958. Neither the corporation nor the partnership had open credit with banks; all borrowings had been on a first mortgage secured note basis upon which the partners were individually liable. The Boogaart Supply Co., Inc., had raised, in 1954 and 1955, $370,000 through the public sale of debentures. By 1958, however, the need for still further capital to finance, among others, building of a new meat warehouse and new retail outlets for which ground had already been obtained was becoming acute. Additionally, some $90,000 in debentures which had been issued in 1954 were to reach maturity within a period of months.
Investment counsel was consulted by the corporation. It was determined that debt financing by means of debentures as a method of securing capital was inadvisable due to the already overburdened debt structure of the corporation at this time. Investment counsel advised equity financing by means of a public sale of stock, but cautioned— in fact required as terms of any prospective underwriting — that the balance sheet picture of the corporation be improved by the addition to the corporation as subsidiaries of the four profitable grocery stores still owned by the partnership. Accordingly, it was proposed to the corporation that it acquire from the partnership the four grocery store corporations by means of acquiring their stock in exchange for Boogaart Supply Co., Inc., stock. Consequently, a stock-for-stock offer was made to the partnership, but petitioner Sorem, being still indebted to the corporation for $30,000 which he had borrowed in 1957, was unwilling to transfer his partnership interest in the four grocery stores in exchange for corporate stock. He was agreeable, however, to a redemption of his stock interest for cash, and it was therefore determined that the corporation would purchase the grocery store stock from petitioners.
On September 26, 1958, all the stock of the four grocery store corporations, registered in the name of the Boogaart Supply Co. part-, nership, was transferred to petitioners J. Milton Sorem and E. W. Boogaart in equal shares, so that after the transfer each of the petitioners held in his own name 50 percent of the outstanding stock of each of the four grocery store corporations. The partnership thereafter continued in existence, collecting remaining accounts receivable, paying remaining liabilities, and generally winding up its affairs, until April 1959. Petitioner Sorem filed the final partnership return on behalf of Boogaart Supply Co.
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Withey, Judge:
Respondent determined the following deficiencies in the income tax of petitioners for the year 1958:
Doclcet. No. Petitioners Deficiency
93586 3. Milton and Wanda M. Sorem_-_$17, 790. 06
94707 R. W. and Margaret Boogaart_ 18, 550. 09
Pursuant to petitioners’ motion, both cases were consolidated for trial.
The sole issue for decision is whether the transfer by petitioners1 Boogaart and Sorem of all of the stock of four corporations of which they were the sole owners to Boogaart Supply Co., Inc., of which they were major stockholders, in exchange for cash and cancellation of indebtedness is to be categorized as a distribution in redemption of stock within the meaning of section 802(a) of the Internal Revenue Code of 1954 2 or as a distribution of property to which section 301 of that Code applies.
FINDINGS OF FACT
Some of the facts were stipulated by the parties. Their stipulation, together with attached exhibits, is incorporated herein by reference.
J. Milton Sorem and Wanda M. Sorem are husband and wife residing in Concordia, Kans. Their joint return for the year 1958, made on the cash basis and for the calendar year period, was filed with the district director of internal revenue, Wichita, Kans. R. W. and Margaret Boogaart are also husband and wife and presently reside in Buenos Aires, Argentina. For the calendar year 1958 their joint return, made on the cash basis, was filed with the director of international operations, Washington, D.C.
Petitioners Sorem and Boogaart are brothers-in-law. In 1935, they, together with M. Boogaart, B. W. Boogaart’s father, formed a partnership, known as the Boogaart Supply Co. and sometimes hereinafter called the partnership, for the purpose of engaging in the retail grocery business in the northwestern Kansas area. Subsequent to its formation the business of the partners prospered, and by 1949 the partnership owned outright four retail grocery stores located at Concordia, Clay Center, Marysville, and Washington, Kans., and had varying interests in several other grocery outlets in the surrounding area.
During the formative period 1935 to 1949 the partnership had engaged only in the retail aspect of the grocery business. However, by 1949 it was becoming increasingly apparent that expansion was necessary in order to meet the growing competition of national grocery chains with their direct lines of supply to manufacturers. The partners therefore decided to enter the wholesale grocery business with a view to obtaining similar access to manufacturers for their stores. To this end the partnership, in 1949, caused the formation of the Boogaart Supply Co., Inc. (sometimes hereinafter called the corporation), a Kansas corporation to which the partnership contributed $240,000 capital in exchange for stock.
At the beginning, the corporation dealt only in the sale at wholesale of dry nonperishable groceries. However, consistent with their expansion policy, the partners, between 1952 and 1957, acquired or caused to be formed a number of subsidiary companies to engage in the sale or production at wholesale of frozen and fresh foods, ice cream, dairy products, bakery products, drugs, housewares, eggs, and meat and poultry products, all of which subsidiary wholesale companies they eventually transferred to the corporation in exchange for corporate stock.
In 1956 M. Boogaart, the patriarch of the Boogaart-Sorem group, died. R. W. Boogaart and J. Milton Sorem thereafter acquired in equal shares M. Boogaart’s partnership interest from the Boogaart estate, each having to borrow the necessary funds from third parties in order to make up the purchase price. R. W. was able to repay his loan with moneys received by him as an heir of M. Boogaart. However, J. Milton Sorem repaid his loan by borrowing $30,000 from the corporation, a debt he continued to owe the corporation until sometime in 1959.
So successful bad been the partners’ operation of tbeir business that in 1957 the services of E. W. Boogaart were requested by the International Basic Economy Corp., a Rockefeller Foundation group, to organize and operate American-style supermarkets in Italy. As a result of E. W.’s decision to accept this offer, which would require his absence from the United States for an extended period of time, the partnership determined to cease operation of the four retail grocery stores located at Concordia, Clay Center, Marysville, and Washington, Kans., in the partnership form. Accordingly, on April 1, 1957, the partnership incorporated each of the four grocery stores and received 100 percent of their stock.
Despite rapid and extensive growth the expansion of various Boogaart interests had been hampered by a lack of sufficient working capital during the period 1950 to 1958. Neither the corporation nor the partnership had open credit with banks; all borrowings had been on a first mortgage secured note basis upon which the partners were individually liable. The Boogaart Supply Co., Inc., had raised, in 1954 and 1955, $370,000 through the public sale of debentures. By 1958, however, the need for still further capital to finance, among others, building of a new meat warehouse and new retail outlets for which ground had already been obtained was becoming acute. Additionally, some $90,000 in debentures which had been issued in 1954 were to reach maturity within a period of months.
Investment counsel was consulted by the corporation. It was determined that debt financing by means of debentures as a method of securing capital was inadvisable due to the already overburdened debt structure of the corporation at this time. Investment counsel advised equity financing by means of a public sale of stock, but cautioned— in fact required as terms of any prospective underwriting — that the balance sheet picture of the corporation be improved by the addition to the corporation as subsidiaries of the four profitable grocery stores still owned by the partnership. Accordingly, it was proposed to the corporation that it acquire from the partnership the four grocery store corporations by means of acquiring their stock in exchange for Boogaart Supply Co., Inc., stock. Consequently, a stock-for-stock offer was made to the partnership, but petitioner Sorem, being still indebted to the corporation for $30,000 which he had borrowed in 1957, was unwilling to transfer his partnership interest in the four grocery stores in exchange for corporate stock. He was agreeable, however, to a redemption of his stock interest for cash, and it was therefore determined that the corporation would purchase the grocery store stock from petitioners.
On September 26, 1958, all the stock of the four grocery store corporations, registered in the name of the Boogaart Supply Co. part-, nership, was transferred to petitioners J. Milton Sorem and E. W. Boogaart in equal shares, so that after the transfer each of the petitioners held in his own name 50 percent of the outstanding stock of each of the four grocery store corporations. The partnership thereafter continued in existence, collecting remaining accounts receivable, paying remaining liabilities, and generally winding up its affairs, until April 1959. Petitioner Sorem filed the final partnership return on behalf of Boogaart Supply Co. for its fiscal year ended April 4, 1959, on or about June 11, 1959.
On September 27,1958, the corporation purchased all of the stock of the four grocery stores from Sorem and Boogaart at book value for a total price of $88,349.62, one-half of that sum or $44,174.81 being paid to each of the petitioners.3 Immediately after the transfer, Boogaart Supply Co., Inc., had actually outstanding 5,536 shares of its own stock. Of this number, 2,476 were owned directly by R. W. Boogaart and 2,092 by J. Milton Sorem. Boogaart’s two children owned together 390 shares and the same number were owned together by Sorem’s two children. Five unrelated key employees owned directly 188 shares. In addition, 1,012 authorized but not issued shares were under fixed option in varying amounts to the same key employees. The stock option agreements contemplated that each option holder would exercise his option in January of each year so as to purchase about 30 previously unissued shares of the stock of Boogaart Supply Co., Inc., each year for a period of 5 years upon payment of $160 per share. Neither Sorem nor Boogaart held any of these options to purchase additional stock.
The direct and constructive ownership of the stock of the four grocery store corporations prior to the distribution made on September 27,1958, and the direct and constructive ownership of such stock immediately after the distribution were as follows:
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The direct and constructive ownership of the stock of Boogaart Supply Co., Inc., prior to the distribution made on September 27,1958, and the direct and constructive ownership of such stock immediately after the distribution were as follows:
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On September 27,1958, tbe accumulated earnings and profits of each of the four grocery store corporations whose stock was purchased on that date by Boogaart Supply Co., Inc., from petitioners J. Milton Sorem and R. W. Boogaart were as follows:
Boogaart of Concordia, Inc_$19, 650.69
Boogaart of Clay Center, Inc_ 18, 570.82
Boogaart of Marysville, Inc-, — ------—_ 26,632.39
Boogaart of Washington, Inc- 1, 895.72
Total_ 66,749.62
None of the above-listed corporations have ever paid any dividends since the date of incorporation.
On September 29,1958, Boogaart Supply Co., Inc., had accumulated surplus of $236,373.18. It has paid no dividends since the time of its incorporation.
Prior to its acquisition of the four grocery stores on September 27, 1958, the corporation had no open credit with any bank. After the acquisition the corporation was able to secure an open line of credit with the Harris Trust and Savings Bank at Chicago in the amount of half a million dollars. This line of credit has been utilized by the corporation in the construction of new supermarkets, providing, as it does, short-term cash to meet immediate construction costs while long-term financing, less easy to secure, is being worked out.
In their income tax returns for 1958, petitioners Sorem and Boo-gaart reported the distribution received by each of them as consideration for the sale of stock, taxable as long-term capital gain.
In his notice of deficiency, the respondent has determined that the distributions to petitioners Sorem and Boogaart on September 27, 1958, in exchange for all of the stock of the four grocery store corporations constitutes a dividend distribution taxable to them as ordinary income.
ULTIMATE FINDING
The distributions made by Boogaart Supply Co., Inc., to petitioners on September 27,1958, constituted distributions essentially equivalent to a dividend.
OPINION
Respondent contends that the amounts received — in the form of cash and cancellation of indebtedness — by petitioners, as a result of the transfer of their stock in the four grocery stores, constitute the essential equivalent of a dividend distributed by the Boogaart Supply Co., Inc., and are therefore taxable at ordinary income rates. Petitioners urge that the transaction be viewed as a redemption by the corporation of their grocery store stock and that the amounts received in exchange for such stock be entitled to capital gains treatment.
It is admitted by petitioners that the facts as presented place the transaction in question squarely within the provisions of section 304 4 of the Code. Under that section, and by virtue of section 302(d),5 the amounts received by petitioners from the corporation are treated as distributions of property to which section 301,6 requiring ordinary income treatment, applies, unless as to one or both of petitioners such amounts can be categorized under section 302(a) as received “in exchange for the stock.” See sec. 1.304-2, Income Tax Eegs. Section 302(a) categorization may he obtained by meeting one or more of the tests provided by section 302(b).
Petitioners concede that the specific requirements for qualifying the transaction under section 302(b) (3) or (4) are not met by either of them. They also concede that, as to petitioner Boogaart, the redemption was not one which was substantially disproportionate within the meaning of section 302(b) (2). However, it is argued that, as to petitioner Sorem, the tests under section 302(b) (2), both as to reduction of stock ownership in the “issuing corporations” (the four grocery stores) to less than 50 percent of the total combined voting stock,7 and as to reduction of his proportionate interest in those corporations by more than 20 percent,8 are net.
The percentage and proportionate reduction tests of section 302(b) (2) (B) and (C) are required9 to be applied with reference to the stock of the “issuing corporations,” taking into account the constructive ownership rules of section 318.10 Immediately prior to the redemption, petitioners Boogaart and Sorem each owned directly 50 percent of the stock of the “issuing corporations.” Immediately after the redemption, Boogaart Supply Co., Inc., the “acquiring corporation,” owned 100 percent of that stock, and directly, neither of the petitioners owned any stock in the four grocery store corporations. However, by virtue of section 318(a)(2)(C),11 petitioners, as shareholders of Boogaart Supply Co., Inc., are to be regarded as owning stock in its four subsidiaries in proportion to their percentage of actual and constructive stock ownership in Boogart Supply Co., Inc. Since it received 100 percent of the stock of the four grocery store corporations as a result of the transfer, petitioners’ after-redemption interest in those corporations may be determined simply by reference to their after-redemption interest in Boogaart Supply Co., Inc.
On September 27,1958, immediately after the redemption, Boogaart Supply Co., Inc., had outstanding actually and constructively 6,548 share of its stock.12 Petitioner Sorem owned directly 2,092 of those shares. He concedes that an additional 390 shares are considered as owned by him constructively under section 318(a) (l) (A) (ii) and (a)(4)(A). He denies, however, that amy shares of stock owned directly or constructively by petitioner Boogaart are attributable to him. We disagree.
After the redemption petitioner Boogaart held directly and constructively a total of 2,86613 shares, all of which are considered as being actually owned by him. Sec. 318(a) (4) (A). Boogaart and Sorem were 50-percent partners in the Boogaart Supply Co. partnership which we have found as a matter of fact continued to exist until April 4, 1959.14 Section 318(a)(2)(A) provides that stock owned directly or indirectly by a partner shall be considered as being owned by the partnership. Boogaart’s 2,866 shares are therefore considered as being owned by the Boogaart Supply Co. partnership. Concomitantly, stock owned by a partnership is considered under section 318(a) (2) (A) as being owned proportionately by its partners. Sorem, as a 50-percent partner, consequently is considered as owning one-half the shares owned by the partnership, or 1,433 shares. This amount, plus his own actual and constructive ownership of 2,482 shares gives him a total of 3,915 out of 6,548 shares actually and constructively outstanding. Proportionately, Sorem is therefore considered as owning, after the redemption, 59.8 percent of the stock of the “issuing corporations.” Prior to the distribution Sorem owned directly 50 percent of the outstanding stock of the four grocery store corporations, and indirectly he owned one-half of the 50-percent stock interest held by Boogaart pursuant to section 318(a) (2) (A), totaling 75 percent of the outstanding stock of the four “issuing corporations,” directly and constructively. Since section 302(b) (2) (B), in conjunction with section 304(b) (1), limits “substantially disproportionate” redemptions to those redemptions immediately after which the redeemed shareholder owns less than 50 percent of the total combined voting stock of the “issuing corporations,” it follows that petitioner Sorem, owning 59.8 percent of such stock, cannot qualify for “substantially disproportionate” treatment.
Inasmuch as the redemption was not “substantially disproportionate” within the meaning of section 302(b) (2) as to either of the petitioners, we now turn to a consideration of whether, as to one or both of them, the redemption was one which was “not essentially equivalent to a dividend” within the purview of section 302(b) (1).
Although with the enactment of the Internal Bevenue Code of 1954 the statutory framework treating corporate distributions was completely recast,15 section 302 (b) (1) retains the flexible test used under prior law concerning distributions “not essentially equivalent to a dividend.” Therefore the evidentiary criteria useful in determining under subsection (b) (1) the dividend or nondividend character of a particular distribution wbicb. fails to qualify as a sale or exchange of stock under one of the three “automatic” tests contained in section 302(b) (2), (3), or (4), remain substantially the same as those which were found helpful by the courts in determining dividend equivalence under prior law. Thomas Kerr, 38 T.C. 723. In making the factual inquiry concerning the presence or absence of dividend equivalence under section 302(b) (1), we are precluded by section 302(b) (5) from taking into account the failure of the distribution in question to qualify as a sale or exchange of stock under any of the three specific tests set forth in section 302 (b) (2), (3), or (4).
It is the petitioners’ contention that the record establishes the existence of a corporate purpose sufficient to justify characterizing the distribution in question as consideration paid them for the purchase of their stock in the four grocery store corporations. Both the four retail grocery stores owned by petitioners and their wholesale grocery supplier were in a state of business expansion during 1958 but were handicapped by a lack of working capital. During the summer of 1958 petitioners’ investment counsel advised them that any further underwriting of corporate stock or bond issues would need to be accompanied by the acquisition by Boogaart Supply Co., Inc., of the four grocery stores in order to improve its financial picture. Petitioners claim that the acquisition by Boogaart Supply Co., Inc., of the stock of the four grocry store corporations during 1958 and the distribution of cash or its equivalent to each of them was necessary in order to improve its capital structure on its balance sheet and to strengthen its credit position.
It is true that after the consummation of the transaction here in question Boogaart Supply Co., Inc., was able to secure a half-million-dollar line of credit with a Chicago bank which it utilized in expanding its business. In order to better its credit position and apparently also to facilitate administrative control over the integrated Sorem-Boogaart interests, Boogaart Supply Co., Inc., acquired all the stock of the four grocery store corporations which were thenceforth operated as subsidiaries of the wholesale supplier. While the record thus discloses a business purpose underlying the realinement of the corporate structure of the related wholesale and retail grocery businesses, we are unable to conceive how the distribution by Boogaart Supply Co., Inc., of $88,349.62 in cash or its equivalent served in any way to improve its balance sheet or strengthen its credit position. We cannot accept the conclusion which is implicit in petitioners’ contention that a corporate purpose to obtain fresh capital would be served by a pro rata distribution of surplus to each of its two majority shareholders. In the absence of any evidence indicating a corporate purpose consistent with a distribution of accumulated surplus, we are convinced that the principal if not the sole purpose for the distribution here involved was a shareholder purpose. The real purpose sub-served by the distribution in question, insofar as petitioner Sorem is concerned, appears to have been the cancellation of his indebtedness to the corporation. Only if the payment of the distribution in question to petitioners on September 27, 1958, is viewed as a dividend can it be regarded as in futherance of a normal corporate function.
Inasmuch as the distribution made to each of the petitioners on September 27,1958, does not appear to have been made in furtherance of any corporate purpose but, on the contrary, appears to have been made merely for a stockholder purpose, and in view of the failure of the four grocery store corporations to pay any dividends, and their accumulations of earnings and profits, together with the absence of any substantial lessening of control over the combined enterprises, we are of the opinion that these payments constitute distributions essentially equivalent to a dividend, and we so hold. Cf. Thomas G. Lewis, 35 T.C. 71; Ferro v. Commissioner, 242 F. 2d 838, affirming a Memorandum Opinion of this Court; Genevra Heman, 32 T.C. 479, affd. 283 F. 2d 227.
Reviewed by the Court.
Decisions will be entered under Rule 50.
Bruch and Drennen, JJ., dissent.