Opinion
Docket Nos. 64133 64134.
1959-04-17
JAMES B. KELLEY AND LENA S. KELLEY, HUSBAND AND WIFE, PETITIONERS, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.JOHN WALTMAN AND DORIS WALTMAN, HUSBAND AND WIFE, PETITIONERS, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.
William R. Frazier, Esq., for the petitioners. Henry C. Stockell, Jr., Esq., for the respondent.
William R. Frazier, Esq., for the petitioners. Henry C. Stockell, Jr., Esq., for the respondent.
A corporation bought and subdivided certain Florida real estate. After a little over a year's activity in selling these lots, the two remaining stockholders sold their shares in the corporation to a syndicate at a profit. The corporation was then dissolved and the purchasers sold the remaining lots over the next 3 years. Assuming the same basis and accounting method used by the corporation at the time of the sale of its stock, the amount of the net income which might be reasonably anticipated, as of the time of the sale of the stock, to be realized from the property plus the amount of net income realized prior thereto was a sum of which the amount of net income realized prior to the sale of the stock constituted approximately one-third. Held, such one-third is a substantial part of the net income to be derived from such property and, accordingly, the corporation is not a collapsible corporation under section 117(m)(2)(A) of the Internal Revenue Code of 1939.
In Docket No. 64133 the respondent has determined a deficiency in Federal income tax for the year 1952 in the sum of $6,911.70.
In Docket No. 64134 the respondent has determined a deficiency in Federal income tax for the year 1952 in the sum of $63,212.60.
In both cases, which have been consolidated for trial and opinion, those parts of the deficiencies are at issue which result from respondent's determinations that the profits realized by the taxpayers on the sale of stock of Island Shores, Inc., and reported by them as capital gains constituted ‘gain from the sale of property which was not a capital asset as provided by Section 117(m) of the Internal Revenue Code of 1939.’
In each case the allegations of error contained in the petition are as follows:
(a) The Commissioner of Internal Revenue is in error in disallowing capital gains treatment upon the disposition of the stock of Island Shores, Inc., sold during the calendar year ended December 31, 1952, as claimed on the original return filed.
(b) The Commissioner of Internal Revenue is in error in classifying the stock of Island Shores, Inc., sold and disposed of during the calendar year ended December 31, 1952, as stock in a collapsible corporation.
FINDINGS OF FACT.
Those facts stipulated and the exhibits attached thereto are made a part of our findings of fact by this reference.
Petitioners were residents of Fort Myers, Florida, during the taxable year 1952.
Kelley and his wife, and Waltman and his wife, filed joint returns for that year with the director of internal revenue for the district of Florida at Jacksonville.
Waltman had been a resident of Fort Myers since 1925 and had been active in real estate and construction operations in that city since the late 1930's. He had no permanent place of business, however, during the years 1950-1952, but used facilities in the office of an attorney and accountant, George E. Allen, who was counsel and business adviser to Waltman in the activities relevant to these proceedings. This office was in Fort Myers. Kelley, a resident of that city since 1925, was in the real estate business.
Jewell Van Slyde Ursoleo, hereinafter sometimes referred to as Van Slyke, at all times relevant to these proceedings was a real estate agent in the Fort Myers area. She had lived in Fort Myers since 1946 and had been an agent since 1948. In 1950 she was employed by Douglass-Chambers, Inc., a local real estate brokerage firm. She had knowledge that T. H. Phillips, the owner of a tract of land on Estero Island off of Fort Myers, was willing to sell it, and early in 1950 she obtained an option from him to purchase the tract for $150,000. Van Slyke approached Waltman with the idea that he buy part of the tract, but he expressed a desire to purchase the entire tract. She declined to make a sale of the entire parcel of land, but reached an agreement with Waltman whereby they would organize a corporation to develop the tract and sell lots. Waltman was to own two-thirds of the stock and Van Slyke, one-third.
Island Shores, Inc., hereinafter sometimes referred to as the corporation, was organized on April 1, 1950, and a corporate charter was filed with the secretary of state for the State of Florida on April 5, 1950.
The organizers of the corporation were Waltman and Van Slyke, with Allen holding a qualifying share. Waltman held a two-thirds interest and Van Slyke a one-third interest without regard for Allen's single share which he held only temporarily. Waltman and Van Slyke paid into the corporation $25,000, $1,000 of which was allocated as payment for stock and $24,000 was allocated to notes of the corporation.
At a meeting of the incorporators of the corporation on April 6, 1950, each of the incorporators present was elected a director. At a directors meeting held the same day the following officers of the corporation were elected:
Waltman: President and treasurer
Van Slyke: Vice president and secretary
Allen: Assistant secretary and treasurer
Salaries per annum were fixed as follows:
+-----------------------------------------+ ¦President and treasurer ¦$12,000¦ +---------------------------------+-------¦ ¦Vice president and secretary ¦4,000 ¦ +---------------------------------+-------¦ ¦Assistant secretary and treasurer¦1,200 ¦ +-----------------------------------------+
These amounts were to be paid at such time as the corporation was able to do so.
On April 10, 1950, the corporation purchased the tract of land on Estero Island from T. H. Phillips for $150,000, payable $25,000 in cash at closing with the execution of a purchase money mortgage in the amount of $125,000, which latter amount was to be paid in 5 annual installments of $25,000 each plus interest at the rate of 6 per cent per annum. The mortgage also provided for the release of certain sections of the tract upon the payment of specified sums.
Van Slyke arranged partial payment of her one-third interest in the transaction by taking credit from the seller, T. H. Phillips, for her real estate commission, which amounted to approximately $7,500. The balance of the ‘cash’ payment of $25,000 was paid by Waltman. Van Slyke did not complete her payment of one-third of $25,000 although she was financially able so to do. Waltman furnished all of the cash which changed hands on the closing date.
The purchase of the tract by the corporation was publicized in the Fort Myers News-Press on March 27, 1950. The article was, in part, as follows:
Waltman, announcing the purchase yesterday, disclosed plans for a restricted subdivision, home and resort development on the property, including a beach club and a $300,000 hotel.
Waltman said he hopes to obtain FHA approval of the property for home and apartment building. The FHA previously has refused to approve any Beach projects because of the lack of zoning restrictions and of a public beach which would be available for property-owners away from the waterfront. The beach requirement now is met at the Island Shores location.
Waltman said he planned to impose rigid building and zoning restrictions on the property which he hoped would meet FHA requirements. * * *
Waltman said he was unable to make public any details yet of his plans for the Cabana Club and resort hotel.
Even before the purchase of the tract by the corporation, Waltman had shown interest in the construction of a hotel on another parcel of land on Estero Island. He had obtained an option on the land and had preliminary drawings and a sketch made of a hotel edifice to be built on that island. The option on the other parcel was never exercised.
At sometime after the incorporation of Island Shores, Inc., and before October 16, 1950, Van Slyke assigned part of her equity interest in the corporation to Sara C. Douglass, a stockholder in Douglass-Chambers, Inc. On October 16, 1950, Waltman arranged to acquire the one-third interest which Van Slyke had held in the corporation, her stock, and notes. Upon learning of the assignment to Douglass, which he believed violated an oral agreement between the stockholders restricting sale of stock to outsiders, Waltman went about acquiring what interest was held by both Van Slyke and Douglass. He paid $1,300 in cash to Douglass and caused the corporation to convey a lot in the tract free and clear of encumbrances to Van Slyke in payment for their interests. Waltman for personal domestic reasons desired that either Van Slyke or himself be disassociated from the corporation. He did not want a real estate broker, such as Douglass, to be his costockholder. Waltman paid $4,000 to the corporation for the lot which he had the corporation convey to Van Slyke upon termination of her interest. This was the cost of that lot to the corporation; the corporation valued it at $7,000; Van Slyke later sold it for $10,000.
On or about October 18, 1950, Waltman sold a one-half interest in the corporation, in the form of stock and notes, to Sidney Davis, the owner of a men's store, C. J. Zimmerman, a doctor, petitioner Kelley, and S. W. Johnson and L. C. Curtright, who were in the insurance and mortgage loan business. Each of the 5 men obtained a 10 per cent debt and equity interest; each paid $5,000— allocated $2,400 to a 10 per cent debt interest represented by corporate notes, and $2,600 to a 10 per cent equity interest represented by corporate stock.
At a meeting of the shareholders on October 18, 1950, Waltman, Davis, Zimmerman, Kelley, Johnson, and Curtright were elected directors of the corporation. At a meeting of the directors held the same day the following officer were elected:
Waltman: President and treasurer
Davis: Vice president
Zimmerman: Vice president
Johnson: Vice president
Curtright: Vice president
Kelley: Secretary
Allen: Assistant secretary-treasurer
Salaries of the officers were fixed by a vote of directors as reported in the corporate minutes:
Upon motion duly made and seconded the salary of John Waltman was established at an amount equal to a 10% over-ride upon all sales of lands made by the corporation or a maximum of $24,000.00. Said salary to be payable in monthly installments of $2,000.00 each with the provision that should the 10% over-ride on all sales not be equal to such sum of $24,000.00 that the sum so paid would be accepted as compensation for the year.
The salaries of the Vice-Presidents was established at $2,500.00 and the salary of the Secretary, James B. Kelley, likewise established at $2,500.00, George E. Allen, Assistant Secretary and Treasurer to be paid upon the basis of services rendered at the discretion of the Board of Directors.
The corporation operated its sales activities through the use of a trailer stationed on the tract and the individual sales efforts of the director-shareholders, principally on weekends. Waltman devoted full time to the operations; the other directors were occupied with affairs of the corporation only part time, primarily at frequent directors meetings and on weekends selling lots.
The only land owned by the corporation at any time relevant to these proceedings was the tract on Estero Island purchased from T. H. Phillips on April 10, 1950. The total cost to the corporation of this tract was $184,474.89, consisting of the purchase price of $150,000 plus improvements in the amount of $30,474.89. The tract was subdivided into 4 units. The plat for unit No. 1 was prepared and executed on August 14, 1950, and was recorded on November 8, 1950, in the office of the Clerk of the Circuit Court for Lee County, Florida. The plat for unit No. 2 was executed on December 19, 1950, and recorded on January 24, 1951. The plat for unit No. 3 was executed on April 2, 1951, and was recorded on April 16, 1951. The plat for unit No. 4 was executed on October 9, 1951, and recorded on October 22, 1951.
No sales of lots in the tract were made until December 1950. Between that time and the middle of 1951 Van Slyke made 30 to 35 sales of lots acting as an agent on commission.
Prior to closing the purchase of the tract on April 4, 1950, Waltman had submitted FHA Form 2084 to the Federal Hosing Administration office in Miami for the purpose of having it analyzed by the FHA and approved as a subdivision for one-family residences. In submitting information for the approval of the subdivision Waltman also submitted a map of the tract showing a tentative plat. In presenting this tentative plat Waltman indicated theron by penciled notation his desire to have a hotel site, first in the center of the tract and then, after discussion with an FHA representative, at one end of the tract. The FHA planner to whom the plat was submitted superimposed the FHA plan on the map, and this plan included lettering indicating a hotel at the end of the plat, at the same place where Waltman's tentative plat had been marked ‘Hotel.’ The application for approval did not include a request for FHA approval of the hotel since the FHA does not guarantee loans for hotel construction. An FHA representative so advised Waltman.
The application was forwarded to the land-planning section of the FHA in Atlanta, Georgia, on April 7, 1950. By letter of April 14, 1950, that section returned the map and plan with suggested changes including the moving of the hotel area to the end of the tract.
Waltman discussed with the FHA the possibility of constructing and financing a hotel on the tract. Though Waltman was advised that FHA did not help finance such a venture, he received some informal advice from an FHA representative as to how to proceed to acquire financing privately.
In connection with the FHA application, the Miami office of FHA made a request to the Washington, D.C., office that a land-planning engineer be sent from Washington to inspect the tract for the purpose of determining whether the tract qualified for loan guarantees. On October 27, 1950, the engineer from the Washington office gave a written report to the Miami office setting forth the fact that he had inspected the tract on that date. The report in substance indicated that it would be necessary to raise the ground level of the island to a minimum elevation of between 4 and 5 feet. It also indicated that it would be necessary to build a seawall along one side of the island tract with an average elevation of 5 feet above mean low sea level. Finally, it stated that Estero Island where the tract was located was inundated to a depth of approximately 4 feet during the 1944 hurricane which struck the area and that similar ravages of nature had occurred several times in the prior 10 years. Waltman and the corporation were officially advised of the contents of the engineer's report at sometime during early November 1950. He had informal notice as early as the spring of 1950 that FHA guarantees would be conditioned on raising the sea level of the tract. The FHA had consistently refused to guarantee loans between 1949 and 1952 in the Fort Myers beach area where the tract was located. Banks would not lend money for construction there with the exception of short-term 90-day loans. There had been no FHA guarantees of loans on property on Estero Island at the time the corporation was organized.
The construction of a hotel on the tract would have enhanced the value of the lots in the tract. At all times relevant to these proceedings, Waltman personally had no funds with which to finance the construction of a hotel on the tract, and Van Slyke at no time made funds available for such purpose, even though she was aware that such construction would have appreciated the value of the other lots in the tract.
At meetings of the board of directors held in October and November 1950 and attended by Waltman, Davis, Zimmerman, Johnson, and Curtright, the matter of building a hotel on the tract was discussed and also the matter of procuring FHA guarantees on the tract. At the meeting of November 7, 1950, the lack of success in obtaining FHA approval of the tract in its condition was reported and discussed. At the meeting of November 12, 1950, a sketch of a hotel was presented and Johnson and Davis ‘were instructed to make all necessary contacts to ascertain what loan facilities were available for such construction,‘ and it was agreed that the corporation should construct such a hotel if it could arrange for the borrowing of the necessary funds.
On November 16, 1950, the directors consulted with representatives of an insurance company with regard to ‘feasibility of such hotel construction and mortgage possibilities.’
At the directors meeting held on November 20, 1950, a hotel was again the subject of discussion and it was decided to gather more information relative to ‘type of construction and foundation of footings * * * required.’
At a special meeting of the directors of the corporation December 5, 1950, the subject of a hotel and the financing of such construction were again discussed. The minutes of that meeting are, in part, as follows:
A report was made, relative to the hotel project and it was agreed at that particular point that it would probably be best to defer any further steps in this direction (sic) since financing would be unavailable. Mr. Johnson stated that he would continue his efforts to obtain approval through the various insurance agencies but he did not feel that it would meet with much success as he had discussed it with representatives of insurance companies in Orlando, Jacksonville, Atlanta and New York. Having made one special trip to Atlanta and Mr. Davis having made contacts in New York while there in connection with other affairs in an effort to obtain proper financing.
On January 5, 1951, the subject of a hotel was again discussed, and it was pointed out that the proposed construction of some motels on property purchased from the corporation might improve the possibility of obtaining loans and make it feasible ‘to revive the hotel project.’
On January 18, 1951, the directors authorized the sale of land in the tract at a discount to a purchaser ‘providing construction of a motel unit commenced immediately.’ Other directors meetings during January discussed building restrictions to be imposed on purchasers of lots and possible advertising campaigns in northern States to increase sales. However, this advertising campaign was not undertaken. Sales were good and expressions of satisfaction at the rate of sales appeared in the minutes. Local advertising was continued.
On March 6, 1951, the directors met and discussed the low cash position of the corporation and the possibility of renegotiating the mortgage running to T. H. Phillips, and the directors agreed that the officers would accept corporate notes in payment of the corporate obligations to them. At later meetings in March the weak cash position of the corporation was again referred to and the questions of interesting other motel owners in purchasing lots and of constructing a hotel were discussed. At the directors meeting held on March 30, 1951, Allen discussed the finances of the corporation. The minutes for that date are, in part, as follows:
Mr. Allen presented a brief resume of the transactions of the corporation during the preceding twelve month period of time, and stated that predicated upon the accrual of the salary and expense items it appeared that the corporation would operate at a loss of better than Ten Thousand ($10,000.00) Dollars, possibly as high as fourteen, unless some additional sales were made * * *
At the directors meeting of April 9, 1951, there was a report of a decreasing number of prospective purchasers appearing at the tract during the weekends—the principal sales periods. The directors reduced the number of sales personnel (i.e., themselves) who would be available on the tract on the weekends.
On April 18, 1951, at a directors meeting a financial report was made which showed a profit for the preceding year in lieu of a loss as previously and erroneously forecast by Allen.
During the taxable year April 1, 1950, to March 31, 1951, the corporation made sales of land in the tract with cost attributed thereto as follows:
+------------------+ ¦Sales¦$113,807.44 ¦ +-----+------------¦ ¦Cost ¦51,921.49 ¦ +------------------+
On April 26, 1951, at a directors meeting it was agreed that it was no longer ‘necessary or desirable to continue to man the sales office on Sundays at the Beach.’ Kelley and Waltman were to continue their sales operations during the summer and in the fall of that year ‘consideration would be given to re-establishing the same sales procedure as previously used so successfully.’
Fewer directors meetings of the corporation were held during the late spring and summer of 1951. At a meeting on May 18, 1951, it was voted that salaries of officers should continue for another year. Waltman announced that his wife had experienced a worsening of a skin irritation condition and that this would necessitate his leaving the Fort Myers area ‘for a considerable period of time, in order that she might have the benefits of another climate.’
Waltman, prior to the summer of 1951, advised his fellow directors that he contemplated a possible change of his permanent residence from the Fort Myers area because of his wife's health and suggested that an attempt be made to find a single purchaser for the remaining lots on the tract. At a meeting of the directors on June 20, 1951, Waltman reported that interest had been shown by a ‘syndicate to purchase the entire remaining assets of the corporation.’ Waltman was instructed to proceed with negotiations in connection with this matter. Bob Nash, who was in the real estate business, managing the Fort Myers beach office of Douglass-Chambers, Inc., represented the ‘syndicate’ and made inquiries relative to the purchase of the land assets of the corporation in the spring and summer of 1951.
During the summer of 1951, Waltman journeyed to Colorado with his wife for reasons of her health. They did not return until September. During his absence the sales of lots in the tract by the corporation dropped significantly.
No formal meeting of the directors was held between June 20 and September 26, 1951. On that latter date Waltman, after hearing a favorable report on the operations of the corporation was reflected in a financial report, reported that negotiations with the ‘syndicate’ had probably failed and stated he would be willing to buy the stock of any shareholder desirous of selling out his equity interest at that time. Curtright and Johnson expressed such a desire at that meeting but no action was taken.
Curtright was concerned about the fact that sales of lots had decreased during the summer and about the ever-present possibility that a fall hurricane or other storm would do damage to the tract. As a result of his influence and the other directors' doubts and fears along similar lines Davis, Zimmerman, Johnson, and Curtright decided to withdraw from the corporation. At a directors meeting on October 15, 1951, the corporation accepted the resignations of Davis, Zimmerman, Johnson, and Curtright as officers and directors.
The transactions whereby the withdrawal of the shareholders on or about October 15, 1951, was accomplished were stipulated to be as follows: Davis, Zimmerman, Johnson, and Curtright sold their stock to the corporation and the corporation paid to each 10 per cent of the $24,000 in outstanding notes payable. Each of the withdrawing shareholders selected one beach-front lot plus two other lots, paying for them the following amounts, representing the cost to the corporation of the three lots selected by each individual:
+-------------------+ ¦Davis ¦$2,600.00¦ +---------+---------¦ ¦Zimmerman¦2,585.74 ¦ +---------+---------¦ ¦Johnson ¦2,562.31 ¦ +---------+---------¦ ¦Curtright¦2,562.31 ¦ +-------------------+
Following the withdrawal of these shareholders, the outstanding stock of the corporation was held by Waltman and Kelley in the proportions of five-sixths by Waltman and one-sixth by Kelley. A shareholders meeting followed and Waltman, Kelley, and Allen were elected directors. Another directors meeting followed and the following officers were elected:
Waltman: President
Allen: Vice president and assistant secretary
Kelley: Secretary
At a subsequent meeting on November 19, 1951, Waltman's salary as president was continued, Kelley's was raised so that it equaled one-fifth of Waltman's salary, and Allen's remuneration was to continue on the basis of time and services rendered. After the withdrawal of the shareholders in October Bob Nash made several further inquiries to Waltman regarding sale of the remaining land.
At a meeting of the directors on November 19, 1951, Waltman stated that a proposal had been received from F. A. DeWitt for the purchase of remaining lands of the corporation for $175,000. The minutes of that meeting show that Allen recommended and the directors agreed that the land itself should not be sold, but that the total outstanding stock of the corporation should be sold and that this stock be quoted at a price of $225,000. A purpose of the recommendation of the sale of the stock rather than a sale of the land was to minimize the tax to be incurred on the transaction. Waltman acquiesced in this recommendation by Allen.
On or about January 5, 1952, Waltman and Kelley undertook to sell their stock in the corporation to a syndicate composed of Sara C. Douglass, Katherine Hyatt, Jack Conzelman, Albert Woas, Sr., and Albert Woas, Jr. (who was known as Bob Nash), hereinafter sometimes referred to as the syndicate. The purchase price was$192,666.29 of which $15,000 was to be paid in cash with the balance represented by a note for $177,666.29 payable to Waltman and Kelley and signed by M. L. Harvey, F. A. DeWitt, and E. M. Matson, acting as nominees for the syndicate. Waltman and Kelley then transferred the outstanding capital stock to the nominees.
On January 7, 1952, the promissory note in the amount of $177,666.29 was marked ‘Paid’ by Walton, and on the same day a new note was executed by Harvey payable only to the order of Waltman in the amount of $93,326. The difference between this figure and the amount of the note marked ‘Paid’ was satisfied by the transfer of a section of the tract known as the Point (where the hotel location had appeared on the map as ultimately submitted as aforementioned to the FHA in 1950) to Waltman and Kelley for an agreed price of $60,000 and the transfer to them of mortgages receivable by the corporation in the amount of $17,960 plus cash in the amount of $6,380.29. The mortgage held by T. H. Phillips on the tract, originally in the amount of $125,000, had been reduced to the amount of $20,000. As amounts had been applied to that mortgage by the corporation and paid over to T. H. Phillips, releases of lots in the tract had been obtained from T. H. Phillips. The following is a summary of the computation of the final sales price determined for the stock:
+-----------------------------------+ ¦Value of unsold land ¦$188,326.00¦ +-----------------------+-----------¦ ¦Less Phillips' mortgage¦20,000.00 ¦ +-----------------------+-----------¦ ¦ ¦168,326.00 ¦ +-----------------------+-----------¦ ¦Mortgages receivable ¦17,960.00 ¦ +-----------------------+-----------¦ ¦Cash ¦6,380.29 ¦ +-----------------------+-----------¦ ¦Total ¦192,666.29 ¦ +-----------------------------------+
As indicated above, the sellers, Waltman and Kelley, ultimately retained the cash and mortgages receivable.
Under date of January 7, 1952, a resolution was entered on the books of Island Shores, Inc., to dissolve that corporation. In this dissolution all corporate assets were distributed by Harvey as trustee for the syndicate.
After grading, improving, and platting the section known as the Point Waltman sold it for approximately $82,000 less than 1 week following its purchase on January 7, 1952. He made a profit of approximately $10,000 on the transaction.
The corporation, prior to the time sale of the land or stock was considered, constructed streets on the tract, graded several small areas, and negotiated with the local water company to furnish water to lots in the tract. The tract when purchased in 1950 had a road running through it and was interlaced with canals. These canals were straightened and improved by the corporation prior to consideration of sale to the syndicate. Aside from the grading, improving, and platting of the Point by Waltman and the contemplated construction of the hotel, nothing in the way of improvements was contemplated or planned by the corporation, its directors, or shareholders prior to the consideration of sale to the syndicate. At the time of the sale of the stock no further improvement was required to sell the lots on the tract to the public.
The net income of Island Shores, Inc., for the years of its existence was as follows:
+----------------------------------------------+ ¦ ¦Fiscal year ¦Fiscal period¦ +-----------------+--------------+-------------¦ ¦ ¦ended Mar. 31,¦ended Jan. 7,¦ +-----------------+--------------+-------------¦ ¦ ¦1951 ¦1952 ¦ +-----------------+--------------+-------------¦ ¦Sales ¦$113,807.44 ¦$154,206.75 ¦ +-----------------+--------------+-------------¦ ¦Cost of lots sold¦51,921.49 ¦83,562.23 ¦ +-----------------+--------------+-------------¦ ¦Gross profit ¦61,885.95 ¦70,644.52 ¦ +-----------------+--------------+-------------¦ ¦Other income ¦131.34 ¦633.86 ¦ +-----------------+--------------+-------------¦ ¦Adjusted gross ¦62,017.29 ¦71,278.38 ¦ +-----------------+--------------+-------------¦ ¦Expenses ¦1 46,679.82 ¦2 38,503.38¦ +-----------------+--------------+-------------¦ ¦Net income ¦15,337.47 ¦32,775.00 ¦ +----------------------------------------------+
Total net income of Island Shores, Inc., from April 1, 1950 to January 7, 1952: $48,112.47.
The total net income of the trust carrying on the business for the purchasing syndicate for the years 1952, 1953, and 1954 was as follows:
+---------------------------------------------------------------+ ¦ ¦1952 ¦1953 ¦1954 ¦ +--------------------+--------------+-------------+-------------¦ ¦Sales ¦$194,738.00 ¦$55,487.50 ¦$10,025.00 ¦ +--------------------+--------------+-------------+-------------¦ ¦Cost of lots sold ¦1 183,880.70¦1 28,874.00¦1 10,253.10¦ +--------------------+--------------+-------------+-------------¦ ¦Gross profit ¦10,857.30 ¦26,613.50 ¦(228.10) ¦ +--------------------+--------------+-------------+-------------¦ ¦ ¦23.10 ¦ ¦ ¦ +--------------------+--------------+-------------+-------------¦ ¦Other income ¦17,731.92 ¦924.38 ¦1,158.91 ¦ +--------------------+--------------+-------------+-------------¦ ¦Adjusted gross ¦28,612.32 ¦27,537.88 ¦930.81 ¦ +--------------------+--------------+-------------+-------------¦ ¦Expenses ¦15,754.81 ¦5,212.97 ¦3,376.24 ¦ +--------------------+--------------+-------------+-------------¦ ¦Net income (or loss)¦12,857.51 ¦22,324.91 ¦(2,445.43) ¦ +---------------------------------------------------------------+
Although recognizing that in the ‘requirement that the sale of stock be prior to the realization by the corporation of a substantial part of the net income to be derived from the property,’ ‘the statute merely says ‘substantial’ and it does not state any arbitrary percentage, making it obvious that substantial realization is a relative term which is to be judged in each case on its own facts,‘ and that ‘what constitutes substantial realization of net income to be derived from the property requires both statutory interpretation and a factual determination,’ ‘it is respondent's contention that a taxpayer has not realized a substantial part of the net income to be derived from the property if at the time of the stock sale there remains a substantial part of the net income yet to be derived from the property,‘ and that the corporation in these cases ‘did not realize a substantial part of the net income from the property, if at the time of the stock sale there remained a substantial part of the net income yet to be derived from the property.’ Respondent also makes the observation that ‘(i)n providing the ‘substantial realization test’ in the statute, Congress was obviously (?) trying to except from its effect only those corporations which had realized substantially all of their net income and had paid the tax due on it.'
With regard to this observation by respondent (which is really the keystone in his argument), we can only make our own observation that if Congress had intended to exclude from its definition of ‘collapsible corporation’ only a corporation which had realized substantially all of the net income to be derived from its property, it could and would have said so instead of saying as it did ‘the realization by the corporation * * * of a substantial part of the net income to be derived from such property.’ We are unaware of any principle of statutory construction which would warrant the conclusion that the words ‘substantial part’ are equivalent to the words ‘substantially all.’
The implications of respondent's argument on this point are somewhat startling. On the assumption that 50 per cent of ‘the net income to be derived from such property’ constitutes ‘a substantial part’ of such income and that 50 per cent of such income remained ‘yet to be derived from the property,‘ the corporation owning the property producing the income must be considered a ‘collapsible corporation’ even though 50 per cent of the income from the property had been realized prior to the sale. In other words, since 50 per cent of the income from the property was unrealized at the time of the sale of the stock and this constituted a considerable part of such income, it would follow from this argument that the 50 per cent of the income from the property realized prior to the sale could not be a substantial part of the income to be derived from such property. Even more startling would be the implication from this argument on the assumption that 40 per cent of such income was ‘a substantial part.’ It would follow that if 40 per cent of the net income to be derived from the property of the corporation was unrealized at the time of the sale of its stock, the realization of 60 per cent of such income prior to the sale of the stock would not be the realization of a substantial part of such net income.
Obviously the fallacy in this argument is the assumption that there can only be one ‘substantial part’ of a whole.
In these cases it is our opinion that the ‘whole’ to which the term ‘substantial part’ applies is the net income to be derived from the property from the time of its purchase to the time of its sale by the purchasers of the corporation's stock.
Respondent's argument on this point is foreshadowed by a paragraph in his regulations.
In Regulations 118, section 39.117(m)-1(d)(2), it is correctly stated that one of the facts which will ordinarily be considered sufficient to establish that a corporation is a collapsible corporation is the fact that ‘(v) at the time of the sale, exchange, or distribution described in subdivision (i) of this subparagraph, the corporation which manufactured, constructed, produced, or purchased such property has not realized a substantial part of the net income to be derived from such property.’ However, in section 39.117(m)-1(d)(3) of the same regulations, a different phraseology is used in stating the facts which will ordinarily be sufficient to establish that a corporation is not a collapsible corporation. That portion of the regulations reads as follows:
(ii) In the case of a corporation subject to the rules of subparagraph (2) of this paragraph with respect to the manufacture, construction, or production (either by the corporation or by another corporation the stock of which is held by the corporation) of property, the amount of the unrealized net income from such property is not substantial in relation to the amount of the net income realized (after the completion of a material part of such manufacture, construction, or production, and prior to the sale, exchange, or distribution referred to in subparagraph (2)(i) of this paragraph) from such property and from other property manufactured, constructed, or produced by the corporation.
Respondent points to the language of one case as judicial authority for his argument on this question. In J. D. Abbott, 28 T.C. 795, we were concerned with the question of whether ‘only the property actually sold by the corporation can be regarded as giving rise to the income from the transaction’ or whether the enhancements in value to the property arising from commitments made by the corporation but carried out by the stockholders after its dissolution could also be considered. Having resolved this question, we found as a conclusion of fact that ‘(w)hen Leland (the corporation) distributed the land to petitioners (the stockholders), it had not realized a substantial part of the net income to be derived from the property.’ In that case the ‘part of the net income to be derived from the property’ which had been realized by Leland at the time of its dissolution was approximately 10 per cent of such income. Therefore, we inferentially held in that case that 10 per cent of the net income to be derived from the property was not a substantial part thereof. However, on appeal, the Court of Appeals in affirming us (258 F.2d 537) considered that our finding that the corporation ‘had not realized a substantial part of the net income to be derived from the property’ was equivalent to a finding that ‘the dissolution from the property’ was equivalent to a finding that ‘the dissolution (of the corporation) took place before a substantial part (nearly 90%) of the total profit was realized.’ In the course of its opinion, the court used the following language:
The real question posed by the statute, however, is not whether a substantial part of the total profit was realized prior to dissolution, but rather whether that part of the total profit realized after dissolution was substantial. This was the test correctly applied by the Tax Court in making its finding that the dissolution took place before a substantial part (nearly 90%) of the total profit was realized.
With all due deference to the Court of Appeals for the Third Circuit, we were not aware that we made the finding and applied the test referred to in the above quotation. The matter being now squarely before us, it is our opinion that the question posed by the statute is, to quote the statute itself, whether there was ‘a view to (i) the sale * * * of stock by * * * shareholders * * * prior to the realization by the corporation * * * constructing * * * or purchasing the property of a substantial part of the net income to be derived from such property.’ Put more succinctly, it is our opinion that the question to be decided is whether the realized income is a substantial part of the net income to be derived from the property and not whether the unrealized income is a substantial part of such net income. See Rose Sidney, supra at 1163. It is our further opinion that there may be two (or more) substantial parts of a whole, and therefore a finding that the unrealized part of such net income is substantial does not preclude a finding that the realized part of such net income is substantial.
This conclusion is in harmony with the legislative history of the statute here involved. In S. Rept. No. 2375, 81st Cong., 2d Sess., the Finance Committee stated with regard to the proposed section 117(m): ‘The corporation (i.e., the ‘collapsible corporation’), furthermore, has been so defined as to describe corporations different in kind from those which ordinarily liquidate following normal business operations. This objective has been specifically strengthened by the statement made in subparagraph (i) above (sec. 117(2)(A)(i)), to the effect that the sale or exchange or the distribution be made prior to the realization by the corporation of a substantial part of the net income to be derived from the property.' See also Report No. 2319, House of Representatives, 81st Cong., 2d Sess., where the report of the Ways and Means Committee contains the same language. This would indicate to us the legislative intent that when a corporation has itself realized by reason of its own normal business operations a substantial part of the net income to be derived from its property, and a sale or exchange of its stock takes place after its realization of a substantial part of such net income, the corporation is not to be considered a ‘collapsible corporation.’
Accordingly, we come to the question of whether under the facts of the instant cases the sale of the stock by petitioners was ‘prior to the realization by the corporation * * * constructing * * * or purchasing the property of a substantial part of the net income to be derived from such property.’ This involves a determination by us of what constitutes ‘a substantial part.’ In this connection the views of Judge Lynne in Evenson v. United States, 157 F.Supp. 244, are worthy of quotation. In that case he said:
No definition of ‘substantial’ appears in the collapsible section or elsewhere in the Revenue Act of 1939. Nor does the legislative history of Section 117(m) shed any light on its intended scope. Cases dealing with the meaning of this adjective in the context of the National Labor Relations Act, the Fair Labor Standards Act, and the Bankruptcy Act afford little or no guidance.
It ill becomes this court to criticize the language employed by the Congress in drafting a Revenue Act. It is quite easy to observe after the event has occurred that in lieu of ‘substantial’ the Congress might have employed a percentage to express its true meaning. However, this court has been impressed time and again more often with the excellence of legislative draftsmanship than with its deficiencies.
It is to be expected that the word ‘substantial’ as used in the phrase ‘substantial part of the net income’ will continue to be a cause of interpretative difficulty. Its counterpart is found in the Revenue Act of 1954 (26 U.S.C.A. 341(b)(1)(A)) in the phrase ‘a substantial part of the taxable income.’ The regulations promulgated by the Treasury Department both under the 1939 Act as amended and under the 1954 Act go so far in one place as to suggest that until the yet unrealized income from property is insubstantial in relation to the income that has been realized, the realization may not be regarded as having been a substantial part of the net (taxable) income.
It would appear that the problem is one for the Congress to resolve by amendment to provide a clear and adequate definition of its concept of ‘substantial.’ The disagreeable alternative is to leave the matter for definition by the courts and local tax officials on an ad hoc basis in each case.
Under the facts presented by that case and giving to the word ‘substantial’ its ordinary meaning as ‘(c)onsiderable in amount, value, or the like; large; as, a substantial gain,‘ it was decided that the realization of slightly more than 50 per cent (51.37 per cent) of the net income from the property was substantial.
As we said in Rose Sidney, supra at 1163, ‘In determining what is ‘a substantial part of the net income to be derived from such property’ we must consider the relationship between the net income realized by the corporations prior to the distributions and the whole of the net income which may be reasonably anticipated to be derived from such property.' It is obvious that in many cases (as in the cited case) the amount of ‘the whole of the net income which may be reasonably anticipated to be derived from such property’ must be an approximation. In the instant cases the approximation can be close to the absolute amount since the property was liquidated within 3 years subsequent to the sale of the stock. However, there must still be some approximation since we are concerned not with gross receipts but with net profits. It would not, in our opinion, be within the legislative intent of the statute for ‘the whole of the net income which may be reasonably anticipated to be derived from such property’ to be measured by two different bases or two different accounting systems. Stated another way, it is our opinion that ‘the whole of the net income which may be reasonably anticipated’ must be approximated as of the date of the sale or exchange of the corporation's stock on the assumption that the cost basis and accounting method used by the corporation in measuring its net income from the property at that time will remain static.
Turning to the facts of the instant cases, it appears that the total net income reported by the corporation for the periods prior to the sale of its stock was $48,112.47 while the total net income reported by the purchasers for the periods subsequent to the sale of the stock was $32,756.99. If we accepted these figures as representing in their aggregate the total ‘net income to be derived from’ the property constructed or purchased by the corporation, it is obvious that considerably more than 50 per cent of such income had been realized prior to the sale of the stock. However, these figures are misleading in at least two respects. In the first place, on account of the purchase price paid to petitioners for this stock, the purchasers had a greater cost basis with regard to the property than did the corporation and consequently realized a smaller amount of net income from their sales of the property than the corporation would have realized. To some extent the purchase price for the stock received by petitioners represented a discount of net income which might reasonably be anticipated from the property. In the second place, the deductions taken by the corporation from gross income in determining net income included deductions in considerable amounts for ‘Compensation of officers' and ‘Salaries and wages.’ No such deductions were taken by the purchasers after the sale of the stock. Thus the ‘Cost of lots sold’ by the purchasers in the years 1952, 1953, and 1954 was greater than it would have been had the corporation retained the ownership of the property and the expenses deducted by them from gross income were less than the expenses deducted by the corporation. These circumstances indicate the practical necessity of approximating ‘the whole of the net income which may be reasonably anticipated’ as of the time of the sale or exchange of the stock of the corporation using the basis and accounting methods actually used at that time.
Proceeding on this reasoning, we have determined that the corporation had realized prior to the sales of its stock here in question one-third of the net income to be derived from the property constructed or purchased by it.
Thus we reach the crucial question of whether one-third of such income is a substantial part thereof. In J. D. Abbott, supra, we held that one-tenth was not a substantial part. In Levenson v. United States, supra, it was held that approximately one-half was a substantial part. Approaching the problem in the same manner as that in which the court approached it in the Levenson case, by giving to the word ‘substantial’ its ordinary ‘dictionary’ meaning as '(c) onsiderable in amount, value, or the like; large; as, a substantial gain,‘ we are of the opinion that one-third is a substantial part.
Accordingly, we conclude that the corporation here involved was not a collapsible corporation in that it was not formed or availed of with a view to the sale or exchange of its stock by its shareholders prior to the realization by the corporation of a substantial part of the net income to be realized from its property.
This conclusion based upon petitioners' third argument requires a decision of the issue presented by the pleadings in favor of the petitioners, and therefore it is unnecessary for us to consider their other contentions.
Reviewed by the Court.
Decisions will be entered under Rule 50.
DRENNEN, J., concurs in the result.
OPPER, J. dissenting:
I.
The primary question is the meaning to be attributed to ‘prior to’ realization as applied to sales or liquidations in order to determine whether a corporation is ‘collapsible.’ It is by no means clear to me that the interpretation now being employed is so ‘obvious.’
In the phrase ‘prior to the realization by the corporation * * * of a substantial part of the net income to be derived,‘ the liquidation or sale represents a point of time as of which we are required to inspect the entire income-producing history of the corporation. The words ‘to be derived’ mean ‘which has been, and remains to be,‘ derived. So much the present opinion accepts.
Dealing with the bare language of the statute, that point of time could hence as readily be intended to mean ‘while a substantial part remains unrealized,’ or to be realized, as to carry the construction now being given it which is ‘until after a substantial part has been realized’ regardless of the fact that a substantial— indeed a much greater— part still remains to be realized.
Granting then that the language of the statute is wholly ambiguous, what guides do we have for construing it? First, the legislative purpose which was to prevent transformation of ‘substantial’ amounts of ordinary income into capital gain
could be frustrated by the present construction. Second, the Commissioner's regulations, which are certainly not unreasonable, forbid it. And third, the only appellate court which has spoken, clearly views the critical words as meaning the opposite of what is now being accepted. Abbott v. Commissioner, (C.A. 3) 258 F.2d 537, affirming 28 T.C. 795. And this was not a reversal of a Tax Court opinion but its affirmance. Cf. Arthur L. Lawrence 27 T.C. 713, revd. (C.A. 9) 258 F.2d 562.
This figure includes “Compensation of Officers” in the amount of $20,000.
This figure represents the new cost basis of the purchasing syndicate.
At the time of the sale of petitioners' stock in Island Shores, Inc., it had realized approximately one-third of the total net income which might be reasonably anticipated to be realized from its property. Such one-third of such income was a substantial part thereof.
SEC. 117. CAPITAL GAINS AND LOSSES.(m) COLLAPSIBLE CORPORATIONS.—(2) DEFINITIONS.—(A) For the purposes of this subsection, the term ‘collapsible corporation’ means a corporation formed or availed of principally for the manufacture, construction, or production of property, for the purchase of property which (in the hands of the corporation) is property described in subsection (a)(1)(A), or for the holding of stock in a corporation so formed or availed of, with a view to—(i) the sale or exchange of stock by its shareholders (whether in liquidation or otherwise), or a distribution to its shareholders, prior to the realization by the corporation manufacturing, constructing, producing, or purchasing the property of a substantial part of the net income to be derived from such property, and(ii) the realization by such shareholders of gain attributable to such property. 2. (1) TREATMENT OF GAIN TO SHAREHOLDERS.— Gain from the sale or exchange (whether in liquidation or otherwise) of stock of a collapsible corporation, to the extent that it would be considered (but for the provisions of this subsection) as gain from the sale or exchange of a capital asset held for more than 6 months, shall, except as provided in paragraph (3), be considered as gain from the sale or exchange of property which is not a capital asset.
Petitioners' argument may be summarized as follows: (1) They did not have any intention of causing the corporation to be formed or availed of with a view to the sale of their stock prior to the realization by the corporation of a substantial part of the net income to be derived from its property; (2) the sale of their stock in 1952 was caused by circumstances arising after the purchase and development of the corporation's property and therefore, under the provisions of Regulations 111, section 29.117-11(b), section 117(m) is inapplicable; and (3) their sale of the corporation's stock occurred not prior to but after ‘the realization by the corporation * * * purchasing the property of a substantial part of the net income to be derived from such property,‘ and therefore the corporation is not to be considered a collapsible corporation as defined in section 117(m)(2)(A).
With regard to the first contention of petitioners, respondent argues that it is not supported by the facts and that under the interpretation of the statute made in Burge v. Commissioner, 253 F.2d 765, affirming 28 T.C. 246, the contention is without merit. See also Glickman v. Commissioner, 256 F.2d 108; Rose Sidney, 30 T.C. 1155.
With regard to the second contention of petitioners, respondent argues that it is not supported by the facts.
With regard to the third contention of petitioners, respondent makes the following argument:
‘The collapsible corporation is a device whereby one or more individuals attempt to convert the profits from their participation in a project from income taxable at ordinary rates to long-term capital gain taxable only at a rate of 25 percent.’ H. Rept. No. 2319, 81st Cong., 2d Sess. (1950), p. 96; 1950-2 C.B. 449.
It is necessary to emphasize that the present assumption is that the corporation was ‘formed or availed of’ ‘with a view to’ the results which were achieved. In other words, we are now saying that even though the purpose with which petitioners were acting was to terminate their relationship with the corporation at a time when a substantial amount of the prospective income was yet unrealized, the statue was not intended to apply to them. This is an open invitation to calculated schemes of avoidance, which it is difficult to believe Congress intentionally and purposely proffered.
II.
But even if that interpretation of the language is correct, it is still necessary to consider whether in the context of the legislative purpose anything less than half of the total net income should be considered as ‘substantial.’ In the only cited case dealing with the subject, more than 50 per cent of the amount to be realized had been received as ordinary income. Levenson v. United States, (N.D. Ala.) 157 F.Supp. 244. This might well be the smallest proportion of the total which should be treated as a sufficient ‘view’ to avoid the application of the section. But we are now holding that as little as one-third is sufficient, with two-thirds successfully converted into capital gain.
MURDOCK, HARRON, RAUM, and FORRESTER, JJ. agree with this dissent.
OPINION.
KERN, Judge:
The question to be resolved in these cases is whether the corporation, Island Shores, Inc., was a collapsible corporation in 1952 as that term is defined in section 117(m)(2)(A) of the Internal Revenue Code of 1939
1 and therefore the gain realized by petitioners from the sale of its stock in that year is to be considered as gain from the sale of property which is not a capital asset pursuant to the provisions of section 117(m)(1).