Opinion
Docket No. 27096.
1951-06-29
SARAH A. YOUNG, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.
Patrick J. Ryan, Esq., for the petitioner. Thomas A. Steele, Jr., Esq., for the respondent.
Patrick J. Ryan, Esq., for the petitioner. Thomas A. Steele, Jr., Esq., for the respondent.
Petitioner, a minority stockholder in a close corporation, agreed to the sale of assets of the corporation in 1927 for purposes of liquidation. Stock was surrendered in 1939 by petitioner with reservation rights. Action in the nature of an accounting and for distribution of proportionate share of proceeds from sale of assets was brought against the majority stockholder in 1942. Judgment was obtained in 1943 awarding petitioner proportionate distribution of proceeds from sale of assets less amounts previously distributed as liquidating dividends. Held, net amount of judgment award recovered in taxable year was in the nature of distribution in partial liquidation and as such is treated as an exchange of a capital asset.
Respondent has determined a deficiency of $20,944.24 in income and victory tax of petitioner for the calendar year 1943.
The only issue for our determination is whether $36,164.15, the net amount recovered as a judgment award (including costs, less legal expenses), is taxable to petitioner in 1943 as ordinary income or capital gain.
Petitioner concedes on brief that interest recovered on the judgment is taxable in full and that the respondent properly determined and increased the amount of income from interest received during 1943 in the amount of $1,513.44.
FINDINGS OF FACT.
The case was submitted on documentary evidence and a stipulation of facts. Such facts as are material to the issue presented are incorporated herein.
Petitioner is an individual, unmarried, residing in St. Paul, Minnesota. The return for the period here involved was filed with the collector of internal revenue for the district of Minnesota.
In 1917 petitioner was the owner of 90 shares of stock of the Dispatch Printing Company, 20 shares of which she received for services to the company during the period 1914-1918, inclusive, and 70 shares of which she received as a bequest from the estate of George Thompson, who died on January 7, 1917. Some years later the capital of Dispatch Printing Company was increased and the new stock was issued at a ratio of 10 new shares for each old share held. Petitioner, accordingly, received 900 new shares in exchange for the 90 shares of the old stock then held by her. The balance of the stock was owned directly or indirectly by one Charles K. Blandin. In 1927 the Dispatch Printing Company sold its newspapers, and the name of the company was changed to St. Paul Publishers, Inc. (hereinafter called Publishers), which thereupon proceeded to liquidate.
Charles K. Blandin directly, or indirectly through his stock interest in Blandin Paper Company, controlled Publishers and he was its principal officer. In liquidating Publishers, Charles K. Blandin was actively engaged in buying and selling stocks and bonds with cash assets of Publishers during the period from October 1, 1927, through September 27, 1939, which resulted in shrinkage of the assets of Publishers.
On July 13, 1939, Charles K. Blandin, as president of Publishers, addressed a letter to petitioner, stating as follows:
After several years of intensified effort to make the investment portfolio coming out of the sale of the Dispatch Printing satisfactory, I have concluded for the best interest of all to liquidate the holdings. You will recollect that the investments have been held in the St. Paul Publishers, Incorporated.
The writer indirectly holds over 95% of the stock of St. Paul Publishers, Incorporated, and I agree to take my share by accepting the assets remaining in the Corporation after the minority stockholders have been paid in cash.
This plan will make it unnecessary to sell the securities in a thin market, which might decrease your present equity.
The assets consist of cash and marketable securities. The securities will be appraised as of July 22, 1939, and verified as being correct by n Shannon & Byers, Certified Public Accountants. The equity per share at the market will be approximately $24.00. Market fluctuations between now and July 22nd may change the estimate somewhat.
Kindly endorse your stock certificate to the St. Paul Publishers, Incorporated, and forward to this office address for payment. This will be made as soon as the appraisers have finished their work.
On September 23, 1939, the board of directors of Publishers authorized that a final liquidating dividend in the amount of $24,706.93 be paid to petitioner. Charles K. Blandin directly, or indirectly owning 96.95 per cent of the stock, waived his right to participate therein.
On September 27, 1939, petitioner answered Blandin's letter of July 13, 1939, stating as follows:
Recently St. Paul Publishers, Incorporated, advised me that some time in the past it had invested the proceeds of the sale of the property of the Dispatch Printing Company in various stocks and bonds which had greatly depreciated in value, and advised me that it proposed to liquidate and to pay over to me by way of liquidation of my 900 shares of stock approximately $24.00 a share, that being substantially the equivalent of pro rata share of the value of those securities.
This offer I have declined upon the ground that the investments so made without my knowledge or consent were illegal.
St. Paul Publishers, Incorporated, now advise me that it nevertheless proposes to go forward with liquidation upon the basis which I have rejected and in order to do so proposes to liquidate 3.05% of its capital stock, that is to say, 900 shares; that the Blandin Paper Company, the owner of 96.95% of the stock of the company, is to waive receipt of any part of said dividend and agree that all of the same shall be applied to the retirement of my stock. I have no doubt that the Blandin Paper Company will accomplish some proper business purpose in so voting its stock, and I have no desire to be obstructive. I make no objection to the payment of said 3.05% of said assets to me in cash rather than in the pro rata share of said depreciated investments. My sole objection is that I am entitled to receive a much larger amount of cash, to-wit, approximately $75.00 per share. But, in order to permit the company to carry out its objective, I agree to deliver my stock accepting said specified amount with the express reservation and upon the understanding and agreement that I will have and retain against the company, Mr. Blandin, Blandin Company, Blandin Development Company and the Blandin Paper Company any and all right which i now have to recover the amount claimed by me less the amount now to be paid in exactly the same manner and measure as if I continued to be the holder of my said shares.
Of course, I understand that neither the St. Paul Publishers, Incorporated, Mr. Blandin or any of the above described companies admit by participation in the plan of action described herein any liability to me, and I understand that they are not to be prejudiced thereby in respect of any defense to my said claim which they or any of them may now have.
Petitioner's offer contained in her letter of September 27, 1939, was accepted, and, pursuant thereto, on September 27, 1939, she was paid $24,706.93 in cash. Upon the payment of such sum to petitioner she surrendered her stock in Publishers, reserving, however, any rights she may have as a stockholder, and thereupon Charles K. Blandin took over to himself, directly or indirectly, all of the assets of Publishers.
On October 6, 1939, by action of the board of directors of Publishers all of its property and assets were transferred to Blandin Development Company in exchange for 100 shares of the full-paid and non-assessable common stock of Blandin Development Company.
On December 30, 1939, the following resolution was adopted by the shareholders of Publishers:
WHEREAS, the shares held by the said C. K. Blandin, C. K. Andrews, C. H. Schacker, Ira C. Oehler and W. H. Oppenheimer are held by them only for the purpose of qualifying them as Directors of the corporation, and said shares are equitably owned by the said Blandin Paper Company; and
WHEREAS, the assets of the corporation consist of 100 shares of the common capital stock of Blandin Development Company, a Delaware corporation, and it is deemed advisable to completely liquidate the corporation immediately on the day of the date hereof:
NOW, THEREFORE, Be it Resolved that this corporation do forthwith and on the day of the date hereof completely liquidate its assets by transferring the same and all thereof to the said Blandin Paper Company, a Minnesota corporation, the holder, legal and equitable, of all of its issued capital stock.
The charter of St. Paul Publishers, Inc., lapsed on July 12, 1942.
On December 28, 1939, petitioner filed an action in the Ramsey County District Court, Second Judicial District, State of Minnesota, against St. Paul Publishers, Inc., for breach of contract in an effort to recover the difference between $150 per share (which petitioner alleged she was promised in correspondence from Publishers— in return for her consent to a sale of the corporation's assets) and $98 per share actually received by her. The court held ‘that the correspondence upon which plaintiff (petitioner herein) relied to sustain her action for breach of contract was insufficient for that purpose. This decision was affirmed by the Supreme Court of Minnesota, Young v. St. Paul Publishers, Inc. (1941), 210 Minn. 346, 298 N.W. 251.
Prior to January 5, 1942, petitioner instituted an action in the Ramsey County District Court, Second Judicial District, State of Minnesota, against Charles K. Blandin, Blandin Development Company, and also including St. Paul Publishers, Inc., as merely a nominal defendant. In this action, in the nature of an accounting, petitioner alleged that she had agreed to the plan to sell the assets of Publishers in reliance upon the representations of Blandin that Publishers would be liquidated and the proceeds distributed forthwith to petitioner and other stockholders, reserving only so much as might be necessary to pay the income tax liability or keep them solely until such time as final distribution could properly be made; that Blandin's investment of the proceeds was unauthorized by the articles of incorporation; and that petitioner herein was entitled to her proportionate share of the net liquidating fund as of October 1927.
In that case the court found in part:
IV. BLANDIN AS LIQUIDATOR.
After the sale of the assets of the Company was consummated on or about October 3, 1927, Blandin, as president and manager, took possession of all the assets of the Company retained after and acquired through the sale. Thereafter until on or about September 27, 1939, he retained such possession for the purpose of liquidating said corporation and its corporate assets by the paying of its then obligations and by the distribution of the remainder of said assets to the stockholders, less the reasonable and necessary expenses of administration. The Company was not dissolved by court action at any time here involved. Blandin on or about September 27, 1939, paid to Miss Young what he informed her was her final liquidating dividend.
That court also found that Blandin during the period 1927 to 1939 made certain representations to petitioner in explanation for the delay in distributing the assets to the stockholders and that petitioner relied upon them. Also, that petitioner was advised by counsel that until the outstanding obligations of Publishers were fully discharged, distribution of its assets in liquidation could not be compelled. In reliance upon these representations and advice petitioner was induced to forego a demand for liquidating dividends.
From October 1927, the date of the sale of the assets, until September 1939, liquidating dividends were paid to petitioner as follows:
+------------------------------+ ¦December 31, 1927 ¦$63,000.00¦ +-------------------+----------¦ ¦December 24, 1937 ¦90.00 ¦ +-------------------+----------¦ ¦September 27, 1939 ¦24,706.93 ¦ +-------------------+----------¦ ¦ ¦$87,796.93¦ +------------------------------+
One of the reasons given by Blandin for the delay in distributing the assets of Publishers was the final determination of income tax due from the sale of the assets of Publishers. Settlement of this controversy was made February 3, 1932. Petitioner was not informed of the payment of the tax obligation until after July 1939.
It was concluded by the court in this suit that:
XXIV. THE LOSS TO MISS YOUNG.
The fair liquidating value of Miss Young's stock in the Company on October 3, 1927, was the sum of $166.62 2/3 per share, or the sum of $150,000.00. She has been paid liquidating dividends in the sum of $87,796.93. The unauthorized, wrongful and unlawful acts of Blandin as liquidator have damaged her in the sum of $62,203.07.
XXV. THE INTEREST OF THE COMPANY IN THE JUDGMENT.
At the time of the commencement of this action and at all times subsequent to July 22, the only outstanding shares of the Company were the 900 of Miss Young and the 28,600 of Blandin. On or before July 22, 1929, Blandin as liquidator purchased with funds in his hands as liquidator the other 500 shares outstanding for the sum of $13,152.20, or for $26.30 per share. This transaction was without the knowledge or consent of Miss Young. As a result, the Company has no direct pecuniary interest in the outcome of his case nor are there any other stockholders other than Miss Young, Blandin, and the Corporation interested in or involved in this action or its results.
CONCLUSIONS OF LAW.
The court determines as conclusions of law that Miss Young is entitled to judgment against Blandin and the Blandin Development Company in the sum of $62,203.07, together with her costs and disbursements herein.
Let judgment be entered accordingly.
GUSTAVUS LOEVINGER Judge of the District Court
Dated: April 29, 1942
This judgment and decision was affirmed by the Supreme Court of Minnesota, Young v. Blandin et al. (April 30, 1943), 215 Minn. 111, 9 N.W.2d 313.
As a result of the above litigation petitioner recovered in 1943 the following amounts:
+-------------------------------------------------------------+ ¦Judgment award ¦$62,203.07¦ +--------------------------------------------------+----------¦ ¦Interest at 6% from April 29, 1942, to May 8, 1943¦3,835.85 ¦ +--------------------------------------------------+----------¦ ¦Court costs ¦25.50 ¦ +--------------------------------------------------+----------¦ ¦Total recovered ¦$66,064.42¦ +-------------------------------------------------------------+
Petitioner incurred expense of litigation, including attorney's fees, in the total amount of $26,064.42.
In satisfaction of the above judgment, Blandin, by his personal check dated May 8, 1943, paid petitioner, through her attorney Patrick J. Ryan, the full amount of $66,064.42. Blandin was not and has not been reimbursed by anyone or from any source for all or any part of the said payment of $66,064.42.
In his individual income tax return filed for the calendar year 1943 Charles K. Blandin claimed and was allowed a deduction from his gross income the full amount of the $66,064.42 that he paid to petitioner.
The action brought by petitioner was in the nature of an accounting and to recover corporate funds. The recovery obtained by petitioner was, in effect, a distribution in partial liquidation.
OPINION.
JOHNSON, Judge:
The only question for our determination is whether the net amount of $36,164.15 recovered by petitioner in 1943 as a judgment award is taxable to petitioner as ordinary income or capital gain.
It is well settled that, for tax purposes, the character of an amount recovered as a result of litigation is determined by the nature of the action brought. United States v. Safety Car Heating & Lighting Co. (1936), 297 U.S. 88. And as stated in Raytheon Production Corp. v. Commissioner (C.A. 1, 1944), 144 F.2d 110, affirming 1 T.C. 952, ‘The test is not whether the action was one in tort or contract but rather the question to be asked is 'In lieu of what were the damages awarded?’,‘ citing Farmers & Merchants' Bank v. Commissioner (C.A. 6, 1932), 59 F.2d 912; Swastika Oil & Gas Co. v. Commissioner (C.A. 6, 1941), 123 F.2d 382, certiorari denied, 317 U.S. 639.
What then was the nature of the action resulting in the award of the sum here in question?
Publishers was a close corporation with 30,000 shares of stock outstanding, of which petitioner owned 900 shares and the remainder was owned by Charles K. Blandin and his solely owned corporation, the Blandin Development Company. Under these circumstances petitioner claimed it was futile to request Publishers to bring the action and that therefore she brought the action on behalf of Publishers and its stockholders. Petitioner claimed in that action that Blandin had represented that the sale of the assets of Publishers in 1927 was for the purpose of liquidation. She further claimed that as liquidator, Blandin owed a fiduciary duty to distribute the assets of Publishers as expeditiously as possible; that Blandin used the funds of Publishers, without her knowledge or consent, to make investments unauthorized by the articles of incorporation and in disregard of his duty as liquidator; that the defendants in that action (Blandin and Blandin Development Company) be required to account to Publishers for the amounts thus dissipated and that petitioner was entitled to her proportionate share of the net liquidating fund as of the time of sale of the assets in October 1927.
The trial court found that Blandin took possession of the assets of Publishers for the purpose of liquidation. He was to pay the obligations of Publishers and to distribute the remaining assets to the stockholders. That court also found that Blandin, as liquidator, made unauthorized investments with the assets of Publishers, damaging petitioner in the amount of $62,203.07. This amount was computed on the basis of the fair liquidating value of petitioner's stock at the time of the sale of the assets, October 3, 1927, less prior liquidating dividends paid to petitioner.
From the above analysis of petitioner's complaint and the trial court's findings of fact and conclusions of law, we can only conclude that the action was brought to recover an amount which she would have received had the liquidation been properly carried out. Applying the test set forth in Raytheon Production Corp. v. Commissioner, Supra, ‘In lieu of what were the damages awarded?‘, we conclude that the damages were awarded in lieu of a distribution in liquidation.
Respondent contends that the amount recovered should be taxed as ordinary income and not capital gain; that in order for the capital gain provisions of section 117 of the Code to apply, there must be a sale or exchange of a capital asset and that such a transaction did not take place.
With this contention we can not agree. Upon surrendering her shares of stock in 1939 petitioner did so with full reservation of any rights she may have had as a stockholder. The liquidation, then, as to petitioner, was not closed and completed in 1939. Cf. Charles A. Dana, 6 T.C. 177. Petitioner then brought her action praying for an accounting and recovery of a proportionate share of the net liquidating fund as of October 1927. A judgment award in this action was obtained in 1943, as pointed out above. A determination of the tax consequences of the receipt in 1943 of the judgment award, which we have found to be a distribution in liquidation, is controlled by the provisions of section 115(c)
of the Code, in effect at the time of the receipt of the award which provide that such distribution shall be treated as a payment in exchange for the stock.
SEC. 115. DISTRIBUTION BY CORPORATIONS.(c) DISTRIBUTIONS IN LIQUIDATION.— Amounts distributed in complete liquidation of a corporation shall be treated as in full payment in exchange for the stock, and amounts distributed in partial liquidation of a corporation shall be treated as in part of full payment in exchange for the stock. * * *
It was determined by this Court (Sarah A. Young, Docket No. 5557, Memorandum Opinion entered October 30, 1945), that the surrender of petitioner's stock in 1939 constituted a partial liquidation. We therefore find it unnecessary in this proceeding to consider that question.
Section 115(c) provides that a distribution in partial liquidation shall be treated as a payment in exchange for the stock. That being the case, it then comes within the capital gain provisions of section 117 of the Code and, having been held for more than six months, the gain realized constitutes long term capital gain. Petitioner concedes that for the computation of the long term capital gain the amount recovered has a zero basis.
Respondent argues that after petitioner surrendered her stock in 1939 she no longer had any contractual rights against Publishers and that this fact was established by the Supreme Court of Minnesota in petitioner's first action. Young v. St. Paul Publishers, Inc. (1941) 210 Minn., 346, 298 N.W. 251. That action, as we read the case, had nothing whatever to do with petitioner's surrender of stock in 1939. It was based upon the theory that an express contract resulted from the exchange of correspondence in 1927 concerning the sale of the assets of Publishers and the court held that petitioner had failed to establish a contract. It therefore has no effect upon the issue before us.
Respondent further argues that the action brought by petitioner was brought on her own behalf, not that of Publishers; that the judgment was against Blandin and Blandin Development Company; that Blandin paid the judgment personally; that Publishers had no assets at the time of judgment; that Publishers received no award as a result of the action and that therefore it was not a payment by Blandin on behalf of Publishers, but an action to recover damages from Blandin personally for his wrong doing. In considering this contention we must keep in mind the broad powers of the trial court in its determination of matters of an equitable nature, the situation of a close corporation, and the particular circumstances giving rise to the action brought. Blandin, as liquidator, was charged with the proper distribution or safekeeping of the corporate funds. It is not uncommon that a court will trace funds of a corporation, and where, as here, it finds them to have been diverted, it will direct repayment to the corporation. So here, it was a direction to Blandin, in his status as liquidator, to return funds rightfully belonging to the corporation. The fact that the court directed that the funds be paid directly to the minority stockholder and not to the corporation appears to us, under the circumstances present, to be merely an exercise of equity powers in accord with the well established principle that a fiduciary may not profit from his own wrong doing and that also the distribution was made in this manner to avoid circuity. The final result, then, is that the trial court awarded to petitioner corporate funds in proportion to the number of shares of stock surrendered for liquidation.
Respondent relies upon Harwick v. Commissioner (C.A. 8, 1943), 133 F.2d 732, and Dobson v. Commissioner (1943), 320 U.S. 489, which affirmed the Harwick case. In those cases it was determined that the sales of stock in 1930 and 1931 were closed and completed transactions and that the subsequent settlements of the fraud actions in 1939 were separate and unrelated transactions; that there was not casual relation between the sales of the stock and the settlements of the fraud claims and that the settlements were not exchanges within the meaning of the statute. In the instant case, however, the recovery realized in 1943 was a recovery of corporate funds held for the purpose of liquidation, to which petitioner was entitled by reason of her stock ownership. In effect, then, it was a distribution in partial liquidation which by statute is to be treated as an ‘exchange.‘ We believe, upon this analysis, that the Dobson and Harwick cases are distinguishable from the instant case on their facts. It should further be pointed out that the Supreme Court in the Dobson case affirmed the Harwick case on the basis that the taxpayer there had received an economic benefit, having taken deductions in an earlier year. Consideration of whether there had been a sale of a capital asset was therefore unnecessary. Margery K. Megargel, 3 T.C. 238.
We conclude and hold that the sum recovered in 1943 is taxable as proceeds from an exchange of a capital asset.
Decision will be entered under Rule 50.