Opinion
No. 335.
Argued February 5, 1974. —
Decided March 18, 1974.
APPEAL from a judgment of the circuit court for Dane county: W. L. JACKMAN, Circuit Judge. Reversed and remanded.
For the appellants there were briefs by Marvin E. Klitsner, John S. Skilton and Foley Lardner, all of Milwaukee, and oral argument by Mr. Skilton.
For the respondent the cause was argued by Allan P. Hubbard, assistant attorney general, with whom on the brief was Robert W. Warren, attorney general.
In the years 1964 to 1967, Master Lock Company deducted from its gross income for tax purposes the amount of interest it paid in those years on money borrowed purchase and retire some of its stock. In 1964, Master Lock Company also deducted the legal fees involved in the stock purchase. The Wisconsin Department of Revenue disallowed the deductions and denied Master Lock's application for partial abatement of the department's assessment of taxes. On Master Lock's petition for review, the Wisconsin tax appeals commission affirmed the department's partial denial of the application for abatement. On Master Lock's petition for review of the decision and order of the tax appeals commission, judgment was entered in the circuit court for Dane county affirming the commission. Master Lock has appealed from that judgment.
The Master Lock Company was organized in the early 1920's and was engaged in the manufacture and sale of locks and other security devices. From the time of the incorporation until 1964, Master Lock's common stock, with the exception of a few shares that are not material to this case, were owned by the families of the original incorporators. By 1964, these families had resolved themselves into two separate factions — the Yolles-Stahl families and the Soref family. The Yolles-Stahl interests owned the majority of the stock. Samuel Stahl had been the president of the company for more than forty years, and in 1964 he was in his middle seventies.
In the three or four years that preceded Master Lock's purchase of the corporate stock owned by the Yolles-Stahl families, there was evidence of conflicts and disputes between them and the Soref family.
Bernard Soref, prior to the stock sale in 1964, was the assistant vice-president of the company, but the record indicated that all executive decisions were made, if at all, by Samuel Stahl.
Bernard Soref testified before the Wisconsin tax appeals commission that, in the years just before 1964, although the company remained profitable, it was losing its competitive position in the security-device market. The Soref group felt that the company was on a downhill trend and wished to undertake new marketing and advertising techniques. Samuel Stahl, however, refused to approve of any alteration in the company's basic system of operations.
Bernard Soref testified that when the new marketing programs were proposed and placed before Samuel Stahl, he delayed and sometimes completely avoided any decision making. Sorer who was nominally in charge of sales, advertising, service, labor relations, and patent work, testified that he was unable to carry out necessary executive decisions because Samuel Stahl and Nathan Berkowitz, Samuel Stahl's son-in-law, interfered with and countermanded orders that had been given. As a consequence of these management problems, Bernard Soref testified that there was confusion and dissension among the entire staff and a lack of any resolution of the responsibility for executive decision making. Samuel Stahl's indecision and the refusal to accept what the Sorefs at least believed were accepted modern techniques resulted in indecisions at all levels of operations.
On the other hand, there was testimony by Nathan Berkowitz that the company was highly profitable, that the business was not stagnating, and that in general there was unanimity on basic company problems and that differences of opinion were "[j]ust the normal . . . strong feelings between individuals."
In the fall of 1963, however, Samuel Ettinger, the secretary of the corporation and a member of the board of directors, died. This left the directors with four surviving members evenly split between the factions. Special meetings were held for the stockholders and the board of directors on November 1, 1963. At that meeting, the stockholders approved the increase in the number of directors from five to seven, and immediately thereafter the board of directors met and elected three additional directors.
Bernard Soref testified that, immediately after the death of Samuel Ettinger, he had been induced by Samuel Stahl to take a vacation. It was while he was on a vacation that the stockholders' meeting and the board of directors' action of November 1, 1963, occurred.
Samuel Soref, who, as a result of these meetings, was left without an office, and Milton Soref attacked the action of the stockholders and the board of directors. Milton and Samuel Soref claimed that the action was illegal and had been taken at meetings held without proper notice. As a result of Stahl's action in calling the meetings and the election by the board of directors of Nathan Berkowitz to the position of vice-president, the Sorefs consulted their attorneys, who challenged the stockholders' and directors' action and apparently threatened legal proceedings because of the alleged acts of mismanagement and malfeasance.
There was testimony that during the first half of 1964 there was considerable intracorporate strife and that it was difficult for the company to operate properly because of the differing views of management that were espoused by the two family groups.
A series of negotiations took place during 1964 between the groups and their attorneys. At one point the parties considered the possibility of selling the corporation to a third party. This idea was discarded, and eventually the parties reached the conclusion that the circumstances in which they were attempting to operate would have to be corrected by either one group or another disposing of its stock. An agreement was entered into on July 3, 1964, whereby the Yolles-Stahl group agreed to sell their shares of common and preferred stock to the company. In consideration of this agreement, the Sorefs released the other family group from any claims that might have arisen out of the alleged acts of mismanagement and malfeasance. The closing of the stock sale was set for September 14, 1964. All the officers and directors submitted their resignations, to be held in escrow until the closing date. The effect of this agreement was that, if the sale of the Yolles-Stahl shares could not be financed, the Sorefs would be out of any management or directorial positions with the company because of the Yolles-Stahl control of the majority of the shares. Financing was, however, obtained, and Master Lock borrowed $8,500,000 from the Prudential Insurance Company of America and $4,000,000 from the First Wisconsin National Bank of Milwaukee. The company purchased the stock for the sum of $14,537,000. This transaction left the Soref group in complete control of the corporation.
In the years 1964-67 Master Lock deducted for tax purposes the interest paid on the sums borrowed to buy the shares. Deductions were claimed in the sum of $205,000 (1964), $645,000 (1965), $545,000 (1966), and $499,000 (1967). For the year 1964 the company also deducted $27,000 for legal expenses that had been incurred in negotiating, purchasing, and arranging the financing of the stock purchase. These deductions were disallowed by the Wisconsin Department of Taxation in January of 1969. Master Lock's application for the abatement of the additional taxes which had been assessed was denied by the Department of Revenue. The Department of Revenue's decision was reviewed by the Wisconsin tax appeals commission, which upheld the Department of Revenue's action. Following hearings, the commission on September 1, 1972, issued its findings of fact and conclusions of law. The commission held that, under the provisions of sec. 71.04(2), Stats., and 8 Wisconsin Administrative Code, Rule TAX 3.20, the interest and legal expenses were not deductible. Master Lock brought an action in the circuit court for Dane county to review the order of the Wisconsin tax appeals commission. The circuit court affirmed the tax appeals commission's order. Master Lock has taken its appeal from the circuit court judgment of January 19, 1973.
Sec. 71.04(2), Stats., provides:
" 71.04 Deductions from gross income of corporations. Every corporation, joint stock company or association shall be allowed to make from its gross income the following deductions:
". . . (2) Other ordinary and necessary expenses actually paid within the year out of the income in the maintenance and operation of its business and property, including with respect to the calendar year 1963 and corresponding fiscal years and prior calendar and fiscal years, but not thereafter a reasonable allowance for depreciation by use, wear and tear of property from which the income is derived; and in the cases of mines and quarries an allowance for depletion of ores and other natural deposits on the basis of their actual original cost in cash or the equivalent of cash; and including also interest and rent paid during the year in the operation of the business from which its income is derived; provided, the payor reports the amount so paid, together with the names and addresses of the parties to whom interest or rent was paid as provided in s. 71.10(1)."
8 Wis. Adm. Code, Rule TAX 3.20, provides:
" Interest paid by corporations. (Section 71.04(2), Wis. Stats.) Interest paid on money borrowed by a corporation to purchase its own capital stock is not deductible."
This court has previously considered the deductibility of interest paid by a corporation and incurred by financing of the purchase of its own stock. The cases demonstrate that, if the purchase amounts to no more than a readjustment of internal affairs, i.e., a realignment of the interests of the individual stockholders, the interest on the debt created by the purchase is not paid in the operation of the business from which the corporate income is derived and, therefore, the interest is not deductible. Basic Products Corp. v. Department of Taxation (1963), 19 Wis.2d 183, 186, 120 N.W.2d 161; Pelton Steel Casting Co. v. Department of Taxation (1954), 268 Wis. 271, 276, 67 N.W.2d 294; and Wisconsin Ornamental Iron Bronze Co. v. Wisconsin Tax Comm. (1930), 202 Wis. 355, 363, 229 N.W. 646, 233 N.W. 72. On the other hand, if the stock purchase is related to the income production of a corporation, the interest on a debt is deductible as being paid in the operation of the business from which income is derived. Hoffman Co. v. Department of Revenue (1971), 51 Wis.2d 220, 229, 186 N.W.2d 228; Basic Products, supra, page 187; Pelton Steel, supra, page 277; and Wisconsin Ornamental, supra, page 363. The Basic Products Case pointed out that the rule can be literally and properly applied to situations like those in Wisconsin Ornamental and in Pelton, where the purpose of the repurchase was merely to adjust or realign the interests of individual stockholders. It held, however, in Basic Products that the rule was inapplicable and beyond the mandate of the statute where there was no suggestion that the purchase of the entire outstanding preferred stock was for the purpose of merely realigning the shareholders' interest or to favor any individual stockholders. Basic Products held that, where there is a repurchase of corporate stock and the motivation of the transaction was the improvement of the corporate structure and the realignment of its finances, such a transaction could play a role in the operation of the business from which the corporation's income is derived. Basic Products held that the realignment of the corporate stock interest in those circumstances was in pursuit of a valid and regular business purpose and that, where there was no showing that the repurchase was accomplished for the benefit of the few, in contrast to the benefit of the corporation, the interest was deductible.
Basic Products was, however, a publicly owned corporation, and the court recognized that in such cases it is easier to justify the corporate purpose when stock is repurchased than in circumstances where the corporation is a closely held family business.
In the Hoffman Case, supra, the company purchased the shares of a minority stockholder and a payment was made over a period of years at a rate of seven percent interest. The supreme court upheld the commission's finding that the interest paid was not ordinary and necessary expense actually paid within the year out of the income for maintenance and operation of its business. The court pointed out that the only evidence before the commission merely indicated that the seller of the stock was dissatisfied with the failure of the corporation to pay dividends, which he needed to supplement his income. The evidence before the commission tended to show that Hoffman was a dissatisfied stockholder and he sold his shares for that purpose. In Hoffman, this court said:
"Petitioner argues it had many good business reasons for the purchase of the stock, including prevention of the sale of the stock to outsiders and the preservation of working capital. However, the commission made a determination to the contrary." (P. 230)
The court emphasized that there was no showing that the maintenance of control by the remaining shareholders, rather than a sale to a third party, was necessary to preserve or strengthen the corporation's financial status.
In the instant case, the tax appeals commission made 23 findings of fact. These findings of fact are undisputed, since they recite nothing more than the chronology of the circumstances and the transactions that led to the financing of the purchasing of the stock. The last of the findings of fact, No. 23, recites:
"The interest expense and legal fees involved herein were not ordinary and necessary expenses of the petitioner within the scope and meaning of Section 71.04(2) of the Wisconsin Statutes."
While this conclusion may or may not be correct, it is the crucial conclusion of the commission, but it is rendered almost completely meaningless because of its failure to recite the purpose of the stock purchase transaction either therein or in another finding. As we pointed out in Basic Products, a realignment of corporate stock interests may well be in the pursuit of a valid and regular business purpose. Basic Products held that, in the absence of a showing that the realignment was for the benefit of a few rather than for the benefit of the corporation, the interest should be considered deductible. Hoffman, supra, page 230, relying on earlier cases, emphasized that the question is not to be determined merely on the fact that one group of stockholders might incidentally have been benefited. Obviously, in any sale of corporate securities, both parties presumably would at the time think that they had received a benefit. The basic question is whether the transaction was designed to protect and benefit the corporation in its income-producing capacity. A corporation must be considered as an entity separate and apart from the interests of individual groups of stockholders.
Finding of fact No. 4 recites, and it is undisputed in the evidence:
"For some years prior to 1964, a condition of strife developed and existed between the Soref and Yolles-Stahl groups, which came to a climax in 1964, allegedly threatening the continued income producing capacity, prosperity and growth of the business."
Finding No. 6 indicates that the hiring of the attorneys and the eventual negotiation and execution of the stock purchase agreement was for the purpose of attempting to resolve the dispute between the stockholders.
There was evidence produced at the commission hearings which could lead a reasonable trier of the fact to find that the condition of strife threatened the continued income-producing capacity of the corporation. There was also testimony, principally that of Nathan Berkowitz, which could lead to the conclusion that the dissension, although concededly existing, did not affect the basic well-being of the corporation and that the conflict was not one that affected the continued viability of the corporation, but merely involved a realignment of stock to get rid of one dissident group or the other.
In view of the state of this ambivalent evidence, it was incumbent upon the commission to make a finding of fact either that the stock transaction was beneficial for the continued income-producing capacity, prosperity, and growth of the business, or that it was merely a realignment of stockholder interests that was not related to the corporate interest. No such finding was made.
Finding No. 23, in the context of the commission's record, is meaningless as a finding of fact. It is, in effect, a conclusion of law, since there is no finding that would lead to the determination made in Finding No. 23. Nor do the other 22 findings of fact support what is included as a finding of fact in No. 23. While the first 22 findings demonstrate that there was a realignment of shareholder interest, the mere fact of that realignment is irrelevant if a corporate purpose is served.
The cases cited above point out that the true interest of the state of Wisconsin is served by permitting deductions from gross income when those deductions serve the purpose of preserving the corporate entity in such a manner that it may in the future continue to produce income that will be taxable by the state of Wisconsin. On the basis of the rationale of earlier cases, a deduction should be allowed in those instances where a stock realignment is effected by a corporate purchase of its own stock when it is for the purpose of preserving the income-producing capacity of the corporation. It is then an expenditure in the maintenance and operation of the corporate business.
The rationale set forth in Mountain State Steel Foundries, Inc. v. Commissioner of Internal Revenue (4th Cir. 1960), 284 F.2d 737, is persuasive in our interpretation of the Wisconsin statute. Concededly, as the respondent argues, Wisconsin tax law is not "federalized" in respect to the type of deduction under consideration herein, but the rationale of the case is convincing. The court in Mountain State said:
"When the stockholders have such conflicting interests, the corporation and its future are necessarily affected. When the situation results in demands that the business be sold or liquidated, as it did here, the impact of the conflict upon the corporation is direct and immediate. . . . The resolution of such a conflict, so that the need of the corporation may govern managerial decision, is plainly a corporate purpose." (P. 745)
There was strong evidence in this case to support a finding that the long-standing conflict in respect to basic management policies affected the continued well-being of the corporation. An intracorporate dispute was approaching the litigation stage. The threat was so substantial that its withdrawal was part of the consideration for the stock transfer agreement. There was substantial evidence on which the commission could, had it wished to, find that the internal strife was thus resolved to protect the corporate entity. We believe that the weight of the evidence would support that finding. That fact-finding function is, however, not ours, but the commission's.
We have pointed out that there was also testimony to the contrary. The respondent asked for a specific finding that "The money was borrowed . . . for the direct benefit of the Soref stockholders."
The attorneys for the Department of Revenue recognized that, where the evidence revealed a corporate purpose connected with income production, the commission was required, if it were to uphold the tax, to specifically find that the motive for the transaction was the benefit of the Soref stockholders. Inexplicably, despite the request, no finding in that respect was made. Such finding was essential to support the conclusion of law that the commission reached.
No reliance can be placed upon Administrative Code, Rule TAX 3.20 to bolster the commission's conclusion unless it is first determined that the stock purchase was in furtherance only of a private interest and not of the corporate interest. Under the interpretations heretofore rendered by the court, no question relevant to the taxability of the corporation's gross income is resolved merely by concluding that the interest expense and legal fees involved were not "ordinary and necessary expenses."
A similar tax provision using the phrase, "ordinary and necessary expenses," appeared in sec. 71.03(2), Stats., and was discussed in Wisconsin Electric Power Co. v. Department of Taxation (1947), 251 Wis. 346, 29 N.W.2d 711. Mr. Justice J. WARD RECTOR, speaking for the court, pointed out that whether expenses were ordinary and necessary were to be measured by their purpose, and that if a proper corporate purpose is served, the expense is deductible even though that expense be "quite extraordinary." He said, "The only permissible inquiry is whether interest is paid in the operation of the business." (Pp. 358, 359) No findings in respect to this inquiry were made in the instant case. Accordingly, the cause must be remanded to the commission for further findings of fact consistent with this opinion.
The same rationale is appropriate in respect to the deductibility of the legal expenses. 8 Wis. Adm. Code, Rule TAX 3.47, provides: "Legal expenses incurred in connection with the operation of a taxpayer's business are proper deductions . . . ." This administrative rule is in interpretation of sec. 71.04(2), Stats. It clearly indicates that the test for the deductibility for legal expenses is the same as that which we have set forth in respect to the deductibility of interest: Were they incurred in the operation of the business. No finding was made to support the denial of the deduction for legal expenses. Since the criterion in respect to each is the same, the entry of proper findings in respect to the purpose of the entire transaction will resolve the questions in respect to both the interest and the legal expenses. Because of the inadequacy of the findings, the order of the commission and the judgment of the circuit court which affirmed that order cannot be sustained. By the Court. — Judgment reversed, and cause remanded for further proceedings consistent with this opinion.
ROBERT W. HANSEN, J., took no part.