Tbe respondent has determined deficiencies in tbe Federal income tax returns of tbe petitioners as follows:
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The above-entitled proceedings were consolidated for purposes of trial and opinion. Concessions and agreements having been made by tbe parties, tbe sole issue for decision in this case is whether tbe transaction pursuant to which petitioners purported to sell tbe stock of Kitro Casuals Co. and Marilyn Togs, Inc., to tbe Temple Beth Ami constituted tbe sale or exchange of a capital asset within tbe meaning of section 1222 (3).2
FINDINGS OF FACT
Some of tbe facts have been stipulated. The stipulation of facts and exhibits attached thereto are incorporated herein by this reference.
Petitioners Louis Berenson and Sue A. Berenson are husband and wife who filed their joint Federal income tax returns for the calendar years 1966 and 1967 with the district director of internal revenue in Newark, N.J. At the time of the filing of the petition herein, they legally resided in Passaic, N.J.
Petitioners Sam and Sarah Cohen were husband and wife who filed their joint Federal income tax returns for the calendar years 1966, 1967, and 1968 with the district director of internal revenue in Brooklyn, New York. At the time of the filing of the petition herein, Sam Cohen legally resided in Laurelton, New York, and Isidore Feldman, the executor of the Estate of Sarah Cohen, deceased, had his office in New York, N.Y.
Petitioners Isidore Cohen and Pauline Cohen are husband and wife who filed their joint Federal income tax returns for the calendar years 1966, 1967, and 1968 with the district director of internal revenue in Brooklyn, New York. At the time of the filing of the petition herein, they legally resided in Brooklyn, New York.
Petitioners David and Marilyn Cohen are husband and wife who filed their joint Federal income tax returns for the calendar year 1966 with the district director of internal revenue in Brooklyn, New York. At the time of the filing of the petition herein, they legally resided in Kings Point, New York.
Sue A. Berenson, Pauline Cohen, Sarah Cohen, and Marilyn Cohen are petitioners solely by reason of having filed joint returns, and Isidore Feldman is a petitioner solely by virtue of being the executor of the Estate of Sarah Cohen, deceased. Consequently, hereinafter the term “petitioners” will refer collectively to Louis Berenson, Sam Cohen, Isidore Cohen, and David Cohen.
Kitro Casuals, Inc. (hereinafter referred to as Elitro), was a corporation incorporated in the State of New York on August 14, 1959. It engaged in the manufacturing of women’s sportswear. Its main office was located in New York, N.Y. In 1961 through 1965, Kitro filed timely income tax returns for its taxable year, which ended July 31 in each of said years. A short period return was filed for its final operations for the period August 1 to December 31, 1965.
Marilyn Togs, Inc. (hereinafter referred to as Marilyn), was a corporation incorporated in the State of New York on February 28, 1955. It was a selling organization, and its main office was located in New York, N.Y. In 1961 through 1965, Marilyn filed timely income tax returns for its taxable year, which ended July 31 in each of said years. A short period return was filed for its final operations for the period August 1 to December 31, 1965.
For the taxable years ended July 31, 1961 to 1964, inclusive, the U.S. Corporation Income Tax Returns filed by Kitro and Marilyn disclosed the following:
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For the taxable year ended July 31, 1965, the U.S. Corporation Income Tax Returns filed by Kitro and Marilyn disclosed the following:
Kitro Marilyn
Gross receipt or sales_ $6, 514, 980. 82 8419, 764. 84
Cost of sales_ 5, 338, 731. 85 _
Gross profit.... 1,176, 248. 97 419, 764. 84
Other income_ 10, 473. 79 _
Total income___ 1, 186, 722. 76 419, 764. 84
Total deductions_ 864, 470. 90 371, 959.11
Taxable income___ 322,251.86 47,805.73
Total income tax_ 149, 446. 37 16, 637. 94
Net income after tax. 172, 805. 49 31, 167. 79
The balance sheets as of July 31, 1965, attached to said returns, disclosed the following:
Assets Kitro Marilyn
Cash_ $275, 892. 02 $62, 451. 78
Accounts receivable (less reserve)_ 791, 358. 50 _
Inventories_ 848,174. 25 _
Other current assets [3]_ 48, 943. 49 39, 639. 14
Fixed assets [4] (net of depreciation)_ 88, 526. 79 _
Other assets_ 168, 104. 79
Total assets_ 2, 052, 895. 05 270, 195. 71
Liabilities and capital
Accounts payable_ $1, 353, 624. 36 $3, 383. 77
Notes payable_ 125, 000. 00 _
Other current liabilities_ 355, 994. 51 191, 268. 61
Common stock_ 22, 000. 00 19, 000. 00
Surplus_ 196, 276. 18 56, 543. 33
Total liabilities and capital_ 2, 052, 895. 05 270, 195. 71
As of December 31, 1965, the total shares of common stock outstanding of Kitro and Marilyn and the number of said shares owned by each of the respective petitioners were as follows:
Shares
Stockholders
Kitro Marilyn
David Cohen_ 17. 6 35.2
Louis Berenson. 7. 04 14. 08
Samuel Cohen._ 13. 2 26. 4
Isidore Cohen. _ 6. 16 12. 32
44. 00 88. 00
The petitioners-stockholders constituted the management of Kitro and Marilyn. Their respective duties, as described by them, were as follows:
David Cohen-Chief executive or general manager
Louis Berenson_Sales manager
Samuel Cohen-Production manager
Isidore Cohen_Production and shipping coordinator
Temple Beth Ami (hereinafter referred to as the temple) is and was, during each of the years at issue herein, a nonprofit corporation located in Philadelphia, Pa., a religious organization exempt from tax under sections 501(a) and 511(a)(2)(A).
During the period involved herein, and prior thereto, the firm of Isidore Feldman & Co., New York, certified public accountants, were the accountants for both Kitro and Marilyn. Harvey Feldman was the employee of that firm to whom these accounts were assigned. In September 1965, a meeting was arranged between Harvey Feldman and one Robert M. Bernstein (hereinafter referred to as Bernstein) through a mutual acquaintance to discuss the possible sale of the stock of Kitro and Marilyn to the temple in Philadelphia, Pa. In a series of meetings, Bernstein explained the mechanics of a proposed sale of the stock to the temple. Following these meetings, Harvey Feldman consulted with David Cohen, one of the petitioners herein. David Cohen became very interested because it “was at least twice what anybody else offered.” David Cohen instructed Feldman to go back to Bernstein and try to get the best price that he could.
Feldman and Bernstein thereupon set about to negotiate an agreement whereby the petitioners would sell their stock to the temple. They agreed upon a projection of estimated earnings before tax. They then allocated 80 percent of the estimated earnings to the petitioners and 20 percent of the estimated earnings to the partnership. In this manner, they arrived at a price of $6 million payable with interest at the minimum statutory rate, over a period of 13 years, making a total of $7,840,000.
The fair market value of the stock of Kitro and Marilyn, as measured by the price at which it could be sold as between the hypothetical willing seller and willing buyer for cash or its equivalent, independently of the services of petitioners, was not substantially in excess of its book value. The stated price of $6 million was more than double the price that would be paid for the stock, on substantially the same terms, by a prospective purchaser who was not exempt from the income tax.
As of December 31, 1965, petitioners David Cohen, Samuel C. Cohen, Louis Berenson, and Isidore Cohen, therein referred to as the sellers, and the temple, therein referred to as the buyer, entered into a “Sales Agreement,” pursuant to which the sellers agreed to sell and the buyer agreed to purchase the outstanding shares of stock of Kitro and Marilyn for a stated purchase price of $6 million, payable in quarterly installments, witb interest at 4 percent, in accordance with the following schedule:
Year Annual amount to be paid Quarterly amount to be paid Allocation between Interest and principal
1960. $300,000 $76,000 Principal.
1967. 300,000 76,000 Principal.
1968. — __ 400,000 100,000 Principal.
1969. 400,000 100,000 Principal.
1970. 400,000 100,000 Principal.
1971.-. 600,000 126,000 Principal.
1972. 600,000 160,000 Principal.
1973. 700,000 176,000 Principal.
1974. 700,000 175,000 Principal.
1976. 700,000 175,000 Principal.
1976. 1,000,000 250,000 Principal.
1977. 920,000 230,000 Interest.
1978. 920,000 230,000 Interest.
As of December 31, 1965, the temple and Bernstein entered into an agreement for the formation of a limited partnership, under the Uniform Limited Partnership Act of the Commonwealth of Pennsylvania, for the purpose of conducting business under the name of Kitro. Pursuant to said agreement, all rights, obligations, and liabilities of the buyer under the aforesaid sales agreement were transferred to and assumed by the partnership. The partnership agreement further provided that Bernstein would be a general partner and that the temple would be a limited partner.
From January 3, 1966, through January 1, 1981, the partnership agreement provided that the general partner’s share in the profits and losses of the partnership was 4% percent and the limited partner’s share in the profits and losses of the partnership was 95% percent. From and after January 1, 1981, the partnership agreement provided that the general partner and the limited partner were to share equally in all profits and losses of the partnership. The partnership agreement further provided that as of that date the capital accounts of the partners as then constituted would be totaled and each partner would receive an interest equal to one-half of the total capital of the partnership.
As of January 3, 1966, Bernstein, on behalf of the partnership, entered into an agreement with David Cohen, pursuant to which the latter was constituted general manager to supervise all operations of the business and to confer with the partners on the problems, growth, and development of such partnership. Said employment agreement provided for an initial term of 5 years, ending December 31, 1970, and gave to the manager the right to renew said agreement for an additional term of 5 years. In his capacity as general manager, David Cohen thereupon entered into an agreement with Samuel C. Cohen, Louis Berenson, and Isidore Cohen, to be employed by the partnership as assistant general managers.
Finally, as of January 3, 1966, the petitioners, as sellers, and the temple, as buyer, together with Bernstein, entered into a modification agreement. Said agreement provided, in part, as follows:
4. The parties agree that in the event Buyer or Bernstein shall be in default under any of the provisions of the Sales Agreement, Management and Consultant Agreement, Limited Partnership Agreement and/or this Modification Agreement, that Sellers’ sole remedy shall be the right to have returned to them the Buyer’s capital account in the business formerly conducted by the Corporations. The parties agree that the Buyer’s capital account shall consist of such assets, subject to liabilities and withdrawals, of the business formerly conducted by the Corporations, as sue h may exist at the time of the default. The parties agree that only the aforesaid items shall be subject to any claim of the Sellers by virtue of any default hereunder by Buyer or Bernstein. The parties further agree that none of the assets of the Buyer or Bernstein, except the Buyer’s capital account in the business formerly conducted by the Corporations as aforesaid, shall be subject to the obligation of Buyer and/or Bernstein to Sellers under the agreements. The parties agree that, upon default, Buyer and Bernstein shall execute such assignments as are necessary to transfer to Sellers the Buyer’s capital account in the business formerly conducted by the partnership, and the parties shall further execute mutual releases and any other required or desirable documents to effectuate the intent and purpose of this agreement. The provisions of this paragraph shall apply to any employment agreement which David Cohen enters into with any of the other Sellers.
As of December 31, 1965, Kitro and Marilyn were liquidated and the assets transferred to the partnership. Thereafter, the business was conducted under the name of Kitro Casuals Co., the partnership. The petitioners managed that business, performing the same duties that they had performed when employed by Entro and Marilyn, the only change being the consultation with Bernstein in financial matters.
During the years involved in these proceedings, the results of the operation of the business under the name of Kitro Casuals Co., the partnership, were as follows:
Year ending Dee. Si— Pretax earnings
1966______$751,086.27
1967___ 354,402.09
1968_ 535, 205. 79
The petitioners duly received the amounts due under, the sales agreement except that the petitioners permitted certain amounts due to be withheld to be used in the business. The amounts received were reported by petitioners as a gain from the sale of their respective shares of Kitro and Marilyn, taxable as a long-term capital gain pursuant to sections 1221 and 1222. In each of the years 1968 and 1969, the sum of $75,000 of the amount due petitioners was withheld, making a total of $150,000 due and unpaid as of December 31, 1969.
OPINION
The petitioners owned all of the stock of Kitro and Marilyn and were engaged in the business of designing, manufacturing, and selling ladies’ sportswear. The petitioners managed this business, each having specific areas of responsibility under the direction of David Cohen. The petitioners constituted a closely knit management group. One petitioner described it as a “family business,” referring to conditions both before and after the purported sale. From modest beginnings, the petitioners had developed the business to the extent that its products were well received by the large chain buyers.
During the year 1965, the petitioners foresaw a substantial growth in sales and earnings. At the same time, David Cohen was looking into the possible sale of the business. He had discussions with various interested parties without success. At this time, their accountant, Harvey Feldman, was introduced to Bernstein, who had negotiated for the acquisition of other businesses for the Temple Beth Ami of Philadelphia, which sought to take advantage of the recent decision of the Supreme Court in Commissioner v. Brown, 380 U.S. 563 (1965). From that point on, the negotiations were entrusted to Feldman.
As a result of these negotiations, a plan was evolved pursuant to which the petitioners might ultimately, receive $6 million plus interest from the purported sale of the stock of Kitro and Marilyn to the temple. Under this plan, the assets of the business would be transferred to a partnership in which the temple would constitute a limited partner entitled to 95K percent of the profits. Projecting the earnings into the future, a schedule of payments was set up, pursuant to which specified amounts would be paid to the petitioners out of profits until such time as the sum of $6 million was paid in full, followed by the payment of interest at 4 percent, making a total of $7,840,000, to be paid to the petitioners by December 31, 1978.
During the period of the payout, the agreement provided that petitioners would continue to operate the business as salaried employees of the partnership. Neither the temple nor Bernstein paid anything for their interest in the business and neither stood to gain anything until such time as the petitioners were paid in full. At this time, what remained would be divided equally between the temple and Bernstein, notwithstanding that up until then the temple purported to have a 95%-percent interest in the earnings.
Except for amounts withheld for purposes of expanding the business during the years involved in this proceeding, the scheduled payments were made to petitioners as due. The petitioners elected to report the resulting gain from the transactions with the temple as a capital gain from the sale or exchange of a capital asset within the meaning of section 1222(3). In bis notice of deficiency, tbe respondent treated the gain as ordinary income on the grounds that the transaction did not constitute such a sale.
The petitioners’ position in this case rests primarily on the decision of the Supreme Court in Commissioner v. Brown, supra.5 In that case, the taxpayer owned substantially all of the stock of a lumber company. In 1953, an agreement was entered into to sell this stock to an exempt organization for $1.3 million, payable $5,000 down from the assets of the company and the balance without interest out of earnings over a period of 10 years. Pursuant to the agreement of sale, the assets of the business were taken over by an exempt organization and leased to a new corporation which would operate the business. As rental, the operating corporation was required to pay 80 percent of its operating profit without allowance for depreciation or taxes, 90 percent of which would in turn be paid to the former stockholders to apply on the $1.3 million note. Provision was made that if payments on the note failed to total $250,000 in any two consecutive years the seller could declare the entire balance due and payable. Clay B. Brown, principal stockholder and manager of the business, entered into a management contract with the operating corporation with the right to name his successor. Later, due to a decline in the lumber market, operations proved to be unprofitable. By agreement of the parties, the properties were sold for $300,000 with the exempt organization retaining 10 percent of the proceeds. In accordance with the terms of the contract, the exempt organization was relieved of any further liability. Total payments on the note from rentals and from the sale of the properties aggregated $936,131.85. The taxpayer treated the payments received from rentals as gain from the sale of capital assets. The Commissioner determined that the transaction did not constitute a completed sale, relying on the fact that since the exempt organization invested nothing, assumed no liability for the purchase price, and promised only to pay over a percentage of the earnings, the entire risk of the business remained with the sellers. A majority of the Supreme Court rejected that argument. In effect, the Supreme Court held that there is no less a sale even though the purchaser’s obligation is limited to the earnings from the assets which were sold. Since the Supreme Court concluded that there had been a sale of the lumber business, it necessarily followed that the taxpayers were entitled to report amounts received from the sale as a capital gain.
As a result of Commissioner v. Brown, supra, the Congress enacted section 514.6 The petitioners argue that the prior legislative history of congressional action in this type of transaction, coupled with the enactment of section 514, constitutes an affirmation by the Congress of the petitioners’ position in this case. The difficulty with that argument is that it assumes that there was in the first instance a sale of an income-producing asset, albeit debt-financed. That is the question to be decided in this case.
The decision of the Supreme Court in Commissioner v. Brown, supra, stressed the fact that the price to he paid for the assets, although payable solely out of earnings, was not disproportionate to the fair market value of the property sold. As a result, the respondent promulgated Rev. Rul. 66-153, 1966-1 C.B. 187, which held that the decision in Brown would not be deemed controlling where the consideration for the property sold was in excess of its fair market value. In conformity with this ruling, the position of the respondent in the notice of deficiency, and the evidence of the petitioners before this Court, were directed largely to the question of value.
In looking to the question of value, we are faced at the outset with the necessity of determining what was meant by the majority of the Supreme Court in Commissioner v. Brown, supra, in placing emphasis on the value of the property sold. If we consider what a private investor or commercial corporation would have paid for the business of Kitro and Marilyn, we must inevitably come to the conclusion that the stated price of the transaction between the petitioners and the temple was grossly excessive. Petitioners’ counsel freely admitted as much.
On the other hand, as petitioners’ counsel also stated, the formula whereby 80 percent of future earnings was paid back to the owners of the business and 20 percent of the future earnings was withheld by the exempt organization was one upon which businesses were being “bought and sold” between private owners and exempt organizations at the time in question. We would assume that the Supreme Court in Commissioner v. Brown, supra, was not referring to this type of transaction as a criteria for fair market value, but rather the more appropriate test is whether the agreed-upon price is disproportionate to the fair market value of the asset as the term “fair market value” is commonly understood.
While we would regard the question of value as evidentiary and certainly to be considered in determining whether there has been a sale, it is not controlling as a matter of law. Where the price is excessive, if measured by the norm of the conventional willing buyer and willing seller, such excess would only serve to indicate that there was not in substance a bona fide sale of the property. Petitioners’ counsel succinctly stated the issue, as follows:
Was there a bonafide [sic] sale based on the statutes in existence at the time? That is our position, your Honor, no getting awajr from that. We concede the Temple was selling us their tax exemption. We concede that we were buying it, that we wind up more selling to them than selling to an outsider, and we’ll prove that with another witness.
The real question presented for decision in this case is whether, looking to the substance of the transaction, it can be said that the petitioners sold the dress business, or whether what really happened was that the petitioners agreed to pay to the temple any earnings in excess of the specified payments in exchange for the enjoyment of the exemption.
When we look to the record as a whole, it becomes apparent that there is no real dispute between the parties with respect to the fair market value of the property sold. As between a willing buyer and a willing seller, using the hypothetical yardstick of the marketplace, it is clear that the petitioners’ stock was not worth $6 million. In fact, it is doubtful whether anyone would have paid as much as $3 million for the stock on an unconditional basis.
On the other hand, it must be assumed that from the standpoint of the tax-exempt purchaser, the opportunity to acquire either the business or its assets at the end of the payout period for the use of its exemption resulted from an “arm’s-length” negotiation. The determination of the amount to be paid under this type of transaction was dependent, not on the fair market value of the property, but on projecting a schedule of earnings into the future which would be adequate to meet the payments as due and leave something “in the pot” for the exempt organization.7
At the outset, as distinguished from Brown, we are dealing with a business which was dependent largely on the managerial skill of the petitioners. We are not dealing with “bricks and mortar.” The earnings of the business in the years prior to the sale were insignificant in relation to the sales price. Net worth was less than one-twelfth the sales price. All the petitioners really were selling was the expectation of future earnings. When viewed in this light, the question of fair market value, as conventionally determined, may become a significant factor. If the amount set forth as the purchase price is grossly disproportionate to present value of the business, there is a strong inference that the schedule of payments was intended, not as the purchase price, but as a means of returning the earnings to the former owners of the business at a tax saving.
In Commissioner v. Brown, supra, tbe discounted sales price payable over a period of 10 years was found not to exceed significantly tbe underlying value of tbe business. In tbe case before us, tbe amount payable was grossly disproportionate to tbe present worth of tbe business. It was predicated solely on an assumed-earnings base, tbe realization of wbicb was not only subject to tbe risks of a bigbly competitive business, but was dependent on tbe continued managerial skills and services of tbe sellers. All tbe petitioners really bad to sell was “themselves.”
In Commissioner v. Brown, supra, upon payment of tbe note, tbe exempt organization would acquire ownership of tbe assets wbicb were sold. In tbe case before us, once petitioners received payment in full, tbe temple was obligated to turn over approximately one-balf of a supposed $6 million business to its 4%-pereent partner, who bad invested nothing.
With these facts in mind, can it be said that the temple really purchased tbe stock of petitioners? Or, if we look to tbe substance of tbe transaction, was tbe temple merely attempting to extend its exemption to tbe earnings, which would be generated by tbe petitioners as managers of this business, for a fee?
While tbe transaction was in form a sale of stock by the petitioners, whether or not tbe temple would ever receive what it purported to buy was wholly Avitbin tbe petitioners’ control. It was incumbent upon tbe selling stockholders, as managers of tbe business, to produce tbe income required to pay tbe notes as due. In tbe event that petitioners did not do so, there would be a default. Tbe only remedy in such case was tbe return of tbe business to tbe petitioners “including tbe Buyer’s capital account in tbe business.” The petitioners would get back everything.
Tbe failure of tbe price to bear any relationship to tbe value of assets sold, tbe dependency of earnings on tbe managerial skills of tbe sellers, tbe postponement of any realization by tbe temple of tbe benefits of tbe sale during a 13-year payout period, coupled with tbe fact that when that period expired tbe temple would receive only one-balf of what remained, lead inescapably to tbe conclusion that tbe transaction was in substance an agreement by the temple to lend its tax exemption to tbe petitioners for a period of years in exchange for a share in tbe tax savings resulting therefrom. These facts make this case distinguishable from Commissioner v. Brown, supra.
While we recognize the right of taxpayers to cast their plans in such manner as to minimize their tax liabilities, it is equally axiomatic that such plans must have substance in order to achieve tbe intended result. To treat the transaction presented in this case as a sale of a capital asset would be wholly inconsistent with the realities of tbe situation. While it is true, as petitioners argue, that the Congress did not enact legislation which would prevent a religious organization from going into the dress business without losing its exemption, on the record before us it is our conclusion that the temple never really acquired the dress business. The incidence of taxation must depend on the substance of the transaction and not its form. Commissioner v. Court Holding Co., 324 U.S. 331 (1945); Higgins v. Smith, 308 U.S. 473 (1940); and Gregory v. Helvering, 293 U.S. 465 (1935). When looked upon in that light, it is our conclusion that the transaction did not result in the sale or exchange by petitioners of a capital asset within the meaning of section 1222(3).
Reviewed by the Court.
Decisions will be entered under Rule 50.
All statutory references are to the Internal Revenue Code of 1954, as amended, unless otherwise indicated;
Loans to stockholders.
The fixed assets of Kitro consisted of sewing machines and office furniture at a cost amount of about $130,000. No real property was owned.
Our decision in Royal Farms Dairy Co., 40 T.C. 172 (1963), also cited by petitioner, preceded the decision of the Supreme Court in Commissioner v. Brown, 380 U.S. 563 (1965), and presented facts which were indistinguishable from that case.
Tax Reform Act of 1969, sec. 121(d);
Petitioners' attorney stated that the temple's workpapers show i t anticipated an ultimate profit oí $1,260,-000 for which it paid nothing.