Opinion
Docket No. 5147-65.
1967-08-22
HARRY F. CORNWALL AND BESS COVER CORNWALL, PETITIONERS v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT
David Sachs, for the petitioners. Paul H. Frankel, for the respondent.
David Sachs, for the petitioners. Paul H. Frankel, for the respondent.
1. The interest of a member of an association taxable as a corporation is to be treated as stock in determining whether a distribution from the association to the member is to be taxed as a dividend and a payment in retirement of a portion of a member's interest is to be treated as a redemption under sec. 317(b), I.R.C. 1954, by the association of a portion of the member's stock.
2. A distribution to a member of an association taxable as a corporation which is made to a member who does not hold a majority interest as a result of his request to withdraw from the association, is approved by the other members of the association, is substantially disproportionate to distributions to other members and reduces the interest of the member in the association by over 20 percent is a distribution not essentially equivalent to a dividend under sec. 302(b)(1), I.R.C. 1954, even though the distribution does not fully meet the provisions of sec. 302(b)(2) because voting as to certain management functions of the association was not shown to be by percentage interests.
SCOTT, Judge:
Respondent determined a deficiency in petitioners' income tax for the calendar year 1961 in the amount of $71,752.08. The issue for decision is whether the amount of a cash distribution made to one of petitioners by an association which is taxable as a corporation constituted ordinary income or long-term capital gain.
FINDINGS OF FACT
Some of the facts have been stipulated and are found accordingly.
Petitioners, husband and wife who resided at the time of the filing of the petition in this case in Westfield, N.J., filed their joint Federal income tax return for the calendar year 1961 with the district director of internal revenue at Newark, N.J.
Harry F. Cornwall, referred to hereinafter as petitioner, was engaged for many years in the insurance business. He was a member of Cornwall & Stevens, an insurance brokerage partnership. From some time prior to 1927 he has been a member of Lloyds, New York, an unincorporated, nonstock, underwriting association, operating under a certificate of authority from the superintendent of insurance of the Department of Insurance of the State of New York.
Lloyds, New York, referred to hereafter as Lloyds or the association, was organized in 1892 by three persons two of whom were petitioner's father and the father of Leighton H. Stevens. It has operated under its present name since 1909. Lloyds is engaged in the business of underwriting fire and allied lines, automobile physical damage, and inland marine risks. Lloyds is an association taxable as a corporation.
The brokerage firm, Cornwall & Stevens, sometimes referred to hereafter as the partnership, is engaged in the business of selling insurance. It is located in the same building as Lloyds and its address is the same as Lloyds. Approximately 70 percent of the business done by Lloyds comes from Cornwall & Stevens, which gives about half of its business to Lloyds. Originally all underwriters of Lloyds had been the participants in the brokerage business but this was not the situation in the years here involved and for some time prior thereto.
Under partnership agreements entered into on January 1, 1951, and again on January 1, 1956, the partners of Cornwall & Stevens were: Harry F. Cornwall, Dudley M. Moore, Leighton M. Stevens, Charles E. Seelig, William J. O'Hara, and John E. Johannesen. In 1957 petitioner ceased to be a partner in Cornwall & Stevens. Under a partnership agreement executed as of January 1, 1958, the partners of Cornwall & Stevens included all the prior partners except petitioner and William J. O'Hara, and, in addition, included Wayne D. Moore, a son of Dudley M. Moore.
The articles of association of Lloyds as of both July 1, 1957, and July 1, 1961, contain, among others, the following provisions:
Second Appointment of Attorneys. Each of the Underwriters hereto shall execute and deliver to the attorneys-in-fact and managers, a power of attorney * * * giving to said attorneys the necessary power and authority to transact on behalf of the underwriters the business referred to in the first paragraph hereof.
Fourth. Duties of Attorneys-in-Fact and Managers. The Attorneys-in-Fact and Managers shall have the power to take charge of all funds, assets and property * * * to direct the manner in which said property shall be kept or invested, used or applied, * * * ; to supervise and make payment of all claims for losses; to collect all premiums and generally to supervise and control the conduct of the insurance business herein referred to and safeguard the respective interest of the underwriters.
Fifth. Revocation of Power of Attorney. Withdrawal and Accounting. Each of the parties hereto shall be at liberty to revoke his Power of Attorney and to discontinue all further transaction of the business contemplated and such revocation shall become binding upon the said attorneys thirty (30) days from the receipt of notice in writing to that effect by said attorneys.
Upon the withdrawal or retirement of an underwriter for any cause, or upon the death of any underwriter, neither the underwriter nor in the event of his death his estate shall have any right, title or interest in or to the charter, rights, or franchise of this Association, * * * except the right to an accounting by the attorneys of all business done in his name, or on his behalf, and all moneys paid by the underwriter, including any contribution made to the surplus of the Association. But said surplus shall at all times be subject to the provisions of these Articles governing the same.
The account of such withdrawing, retiring or deceased underwriter shall not be closed until the end of the year next after the expiration of all risks in which he may have been concerned, and all sums to his credit in said accounting, and all moneys belonging to him in the hands of said attorneys, at the time being shall constitute a fund irrevocably pledged to the payment of all losses for which he or they may be or become liable, or for other indebtedness growing out of the transaction of the insurance business herein contemplated. The remaining underwriters may, however, upon proper provision being made for the assumption of said liability by any other or new underwriter taking the place of the underwriter withdrawing or dying, close the account of said underwriter at a date earlier than the date hereinabove fixed.
Sixth. Contributions to surplus. Each underwriter, upon becoming a member of the Association, and as a condition precedent to becoming an underwriter to said Association, shall contribute in cash, bonds, stocks or other securities approved by a majority of the underwriters, to the surplus of the Association a sum not less than Twelve Thousand Five Hundred ($12,500) Dollars, the intention being that the money so contributed by the underwriters and members shall constitute a surplus or reserve fund for the payment of losses, and shall under no circumstances be returnable in whole or in part to any member so contributing except in the event of the assignment of his interest and the assumption of the same by another underwriter as herein provided for.
Seventh. Limit of Liability. In every policy issued under the arrangements herein contemplated, all of the parties hereto at that time shall become insurers, and each underwriter shall be and become severally liable under each and every policy so issued for the following percentages: (The names and percentage of liability of each member is set forth in this paragraph of the Articles.)
Eighth. Interest of Underwriters in Association's Assets and Income. The interest of each underwriter of the Association in the assets, funds and property thereof and in all profits or emoluments arising from the operation of its business shall be governed both by the respective capital account credited to each underwriter as defined in Article Eleven herein and also by the amount of liability assumed by the respective underwriter as covered by Article Seven above.
Ninth. Compensation of Attorneys. The compensation of the Attorneys-in-Fact, managers and deputy attorneys, if any, shall be on an annual basis and agreed upon by the underwriters at their annual meeting referred to in Article Three above, or at such other time during the year as may be designated.
* * * * * * * * * * * * * * * * * * * * *
Eleventh. Underwriters' Accounts. There shall be kept a separate account for each underwriter and as soon as possible after the 31st of December of each year but not later than the following March 15, all of the accounts in connection with the business shall be made up and balanced. After such balance has been approved by the underwriters, same shall then be credited to or debited against the various underwriters' accounts. In making the allocation of this profit or loss, each underwriter's credit or debit shall be governed by the underwriter's liability assumed and also by his capital account as shown on the books of the Association. Withdrawals from underwriters' accounts may be made individually or collectively with the consent of the majority in interest of the underwriters as shown in Article Seven hereof. However, no withdrawal may be made which impairs the total of the withdrawing underwriter's contributed surplus, his proportion allocated to the maintenance of a guaranty fund, if any, and his proportion of any legal reserve or other liability which in the opinion of the Attorneys-in-Fact should be maintained. (Emphasis added.)
Lloyds holds an annual meeting and such special meetings as are required. Formal voting procedures are not observed. An agenda is presented to the members and agreement is reached orally. If unanimity is not to be had, the matter under discussion is held over for further consideration. If agreement is reached, it is usually signified by the members' executing the minutes of the meeting. A high degree of accord has existed among the associates and for many years no action has been taken without unanimous agreement of the members.
Lloyds earns its income from underwriting and investments. The income from underwriting is allocated to the capital accounts of the various members in accordance with their respective percentage liabilities, as set forth in the articles of association. The investment income is allocated to the members' capital accounts in the ratio of their respective capital interests. A member's share of liability and his capital interest are not necessarily identical. The names of the members of Lloyds, the underwriting percentage of each member and the capital account of each at the dates shown were as follows:
+-----------------------------------------------------------------------+ ¦ ¦Underwriting¦Capital account ¦ +-------------------------------------+------------+--------------------¦ ¦Underwriter ¦percentage ¦___________________ ¦ +-------------------------------------+------------+--------------------¦ ¦ ¦interest ¦ ¦ ¦ +-------------------------------------+------------+------------+-------¦ ¦ ¦ ¦Amount ¦Percent¦ +-------------------------------------+------------+------------+-------¦ ¦Jan. 1, 1957 ¦ ¦ ¦ ¦ +-------------------------------------+------------+------------+-------¦ ¦Leighton H. Stevens ¦35 ¦$720,968.22 ¦33.48 ¦ +-------------------------------------+------------+------------+-------¦ ¦Clift Cornwall (petitioner's brother)¦25 ¦563,087.03 ¦26.15 ¦ +-------------------------------------+------------+------------+-------¦ ¦Harry E. Cornwall ¦28 ¦710,531.83 ¦33.00 ¦ +-------------------------------------+------------+------------+-------¦ ¦Dudley M. Moore ¦7 ¦127,655.24 ¦5.93 ¦ +-------------------------------------+------------+------------+-------¦ ¦Wayne D. Moore ¦5 ¦31,099.94 ¦1.44 ¦ +-------------------------------------+------------+------------+-------¦ ¦ ¦100 ¦2,153,342.26¦100.00 ¦ +-----------------------------------------------------------------------+
July 1, 1957 Leighton H. Stevens 40 694,584.79 37.56 Clift Cornwell 25 545,294.16 29.49 Harry F. Cornwall 21 452,723.58 24.49 Dudley M. Moore 8 125,673.28 6.80 Wayne D. Moore 6 30,659.33 1.66 100 1,848,935.14 100.00
Jan. 1, 1961 Leighton H. Stevens 40 849,826.80 37.29 Clift Cornwall 25 635,863.15 27.90 Harry F. Cornwall 21 567,978,46 24.92 Dudley M. Moore 8 166,065.06 7.29 Wayne D. Moore 6 59,372.28 2.60 100 2,279,105.75 100.00
June 30, 1961 Leighton H. Stevens 40 $870,338.71 40.14 Clift Cornwall 25 665,252.18 30.68 Harry F. Cornwall 21 395,627.29 18.25 Dudley M. Moore 8 174,015.88 8.03 Wayne D. Moore 6 62,802.90 2.90 100 2,168,036.96 100.00
July 1, 1961 Leighton H. Stevens 37 1/2 870,338.71 38.38 Clift Cornwall 27 1/2 665,252.18 29.33 Harry F. Cornwall 16 395,627.29 17.44 Dudley M. Moore 8 174,015.88 7.67 Wayne D. Moore 6 62,802.90 2.77 Serena Merck 5 100,000.00 4.41 100 2,268,036.96 100.00
Jan 1, 1962 Leighton H. Stevens 55 948,646.09 38.56 Estate of Clift Cornwall (deceased Dec. 28, 1961) 712,623.37 28.97 Harry F. Cornwall 16 429,971.72 17.48 Dudley M. Moore 12 189,910.71 7.72 Wayne D. Moore 9 71,089.61 2.89 Serena Merck 8 107,729.04 4.38 100 2,249,970.54 100.00
July 1, 1962 Leighton H. Stevens 50 864,173.10 37.14 Estate of Clift Cornwall 594,785.97 25.56 Harry F. Cornwall 16 400,584.93 17.22 Dudley M. Moore 12 177,153.53 7.61 Wayne D. Moore 8 69,257.94 2.98 Serena Merck 8 100,627.45 4.33 L. Palmer Brown III 6 120,000.00 5.16 100 2,326,582.92 100.00
Dec. 31, 1962 Leighton H. Stevens 50 939,287.49 39.29 Estate of Clift Cornwall 508,861.39 21.28 Harry F. Cornwall 16 433,052.07 18.11 Dudley M. Moore 12 193,122.55 8.08 Wayne D. Moore 8 76,935.20 3.22 Serena Merck 8 110,120.28 4.61 L. Palmer Brown III 6 129,335.53 5.41 100 2,390,714.51 100.00
Jan. 1, 1963 1 Leighton H. Stevens 44 910,136.37 36.47 Estate of Clift Cornwall 480,189.95 19.24 Harry F. Cornwall 10 200,000.00 8.02 Dudley M. Moore 9 189,822.96 7.61 Wayne D. Moore 6 76,674.99 3.07 Serena Merck 5 110,575.64 4.43 L. Palmer Brown III 6 127,677.14 5.12 John N. Gilbert, Jr 5 100,000.00 4.01 Herbert C. Durkee 5 100,000.00 4.01 H. Fletcher Eggert, Jr 10 200,000.00 8.02 100 2,495,077.05 100.00
Gilbert, Durkee, and Eggert were accepted as members as if Jan. 1, 1963. Lloyds distributed $206,275.22 to petitioner in March 1963 and his interest was decreased as if Jan. 1, 1963.
except as otherwise provided by statute, a distribution of money or other property made by a corporation to a shareholder with respect to its stock is a dividend includable in a taxpayer's gross income to the extent made out of the earnings and profits of the corporation. One of the exceptions is that set forth in section 302(a) which provides where a corporation redeems its stock within the meaning of section 317(b) and if section 302(b)(1), (2), (3), or (4)
FN Other differences in the capital accounts between Dec. 31, 1962, and Jan. 1, 1963, result from the creation of an account for Estimated Capital Gains Tax on Unrealized Profits and the reduction of each capital account by its allocable share thereof.
Lloyds reported taxable income (before a deduction of 85 percent of dividends received) of $345,463.62 on its 1961 tax return. This was composed of $281,769.16 of underwriting income computed as follows:
+-----------------------------------------------+ ¦Premiums earned ¦ ¦$240,672.65¦ +----------------------+------------+-----------¦ ¦Losses incurred ¦$163,051.54 ¦ ¦ +----------------------+------------+-----------¦ ¦Loss expenses incurred¦29,601.27 ¦ ¦ +----------------------+------------+-----------¦ ¦Commissions ¦(355,024.60)¦ ¦ +----------------------+------------+-----------¦ ¦Other expenses ¦121,275.28 ¦(41,096.51)¦ +----------------------+------------+-----------¦ ¦ ¦ ¦281,769.16 ¦ +-----------------------------------------------+
The balance of reported income was from the taxable portions of dividends, interest, and long-term capital gain. The total amounts of these items without reduction for the nontaxable portions were:
+------------------------------+ ¦Dividends ¦$26,072.60¦ +-------------------+----------¦ ¦Interest ¦37,570.08 ¦ +-------------------+----------¦ ¦Net long-term gain ¦99,203.02 ¦ +-------------------+----------¦ ¦Total ¦162,845.70¦ +------------------------------+
No expenses were deducted from these items.
Petitioner's active employment was in the brokerage business of Cornwall & Stevens, not with Lloyds. By letter dated June 27, 1956, he notified the partnership of Cornwall & Stevens that, in accordance with a provision of the partnership agreement, he desired to retire as of September 30, 1956, which was only 9 months in advance of the time when he would be automatically retired under the provision of the partnership agreement automatically retiring a partner upon his reaching age 67. The partnership agreement provided an option to the partners to participate in profits and losses for 5 years after retirement on the basis of the retiree's interest at the date of retirement rather than to withdraw his interest at once. Petitioner received payments from Cornwall & Stevens for 5 years under this provision. He was not active in the firm after October 1, 1956.
In 1957, petitioner informed Lloyds that he wished to withdraw his interest. Leighton H. Stevens, who in addition to owning the largest single share was one of the attorneys-in-fact of Lloyds, asked petitioner to withdraw serially, as this would make it easier to maintain the substantial capital required in the business. Petitioner agreed and Lloyds distributed $250,000 to him on June 14, 1957. Petitioner applied the basis of his interest in Lloyds of $87,266.52 to this distribution and reported $162,733.48 as long-term capital gain on his 1957 income tax return. Respondent did not challenge petitioner's method of reporting his income from this transaction.
After the June 1957 distribution, at yearend, petitioner's capital account stood at $447.380.16. It was subsequently subject to additions and distributions as follows, until 1961:
+------------------------------------------------+ ¦Year¦Additions ¦Distributions¦Capital account at¦ +----+----------+-------------+------------------¦ ¦ ¦ ¦ ¦yearend 12/31 ¦ +----+----------+-------------+------------------¦ ¦1958¦$71,498.21¦None ¦$518,878.37 ¦ +----+----------+-------------+------------------¦ ¦1959¦32,541.52 ¦$2,500.00 ¦548,919.89 ¦ +----+----------+-------------+------------------¦ ¦1960¦24,058.57 ¦5,000.00 ¦567,978.46 ¦ +------------------------------------------------+
On March 16, 1961, at the annual meeting petitioner requested permission to withdraw $200,000. Petitioner again expressed his desire to withdraw completely, but again agreed at Stevens' request that he would withdraw only part of his capital account. At a special meeting of underwriters held on April 11, 1961, at which all of the associates except Clift Cornwall were present, it was unanimously agreed that petitioner could ‘withdraw two hundred thousand dollars ($200,000.00) * * * in partial liquidation of his interest’ and that his ‘Underwriting Interest be reduced from 21% to 16% effective July 1, 1961.’ The amount of $200,000 was distributed to petitioner in April 1961. Because of the accounting problems incident to changing underwriting interests, these changes can best be made at a time when accounting statements are made and figures are more readily available. In addition to this distribution, Lloyds distributed $15,000 to Leighton H. Stevens and $5,000 to Clift Cornwall during 1961, which distributions were treated as dividends by the recipients. At all times during 1961, Lloyds had earnings and profits in excess of distributions made by it in that year.
At a special meeting of the underwriters on June 30, 1961, Serena Merck, a sister of Stevens, was accepted as a member. Knowing of petitioner's desire to withdraw, the members of Lloyds had previously been considering the capital requirements of the association and had decided that the value of Lloyds on the basis of capitalized earnings was $2 million and, therefore, that a 5-percent interest was worth $100,000. The superintendent of insurance of the State of New York approved Serena Merck as an underwriter in August 1961, at which time she paid in $100,000 for the acquisition of a 5-percent interest. The persons attending the meeting of June 30 and approving the admission of Serena Merck were Harry F. Cornwall, Dudley M. Moore, and Wayne D. Moore.
In March 1963, Lloyds distributed $206,275.22 to the petitioner. As of January 1, 1963, his underwriting interest was reduced from 16 percent to 10 percent.
The other persons who were admitted as members of Lloyds after 1961 made payments of amounts equal to $20,000 for each 1-percent interest.
Petitioner reported the $200,000 distribution which he received in 1961 as a long-term capital gain. Respondent in his notice of deficiency determined that this distribution constituted dividend income and not long-term capital gain and increased petitioner's taxable income as reported accordingly.
OPINION
Under sections 301, 317(a), and 316, I.R.C. 1954,