Decision will be entered under Rule 50.
Held, on the facts disclosed by the record a profit-sharing plan which had at one time been approved was no longer entitled to be treated as qualified where drastic changes had occurred in the operation of the plan requiring its disqualification.
*137 The Commissioner determined deficiencies in income tax against petitioners for their taxable years 1958, 1959, and 1960 in the amounts of $ 1,653.71, $ 79,730.97, and $ 2,176.41, respectively, and an addition to tax under section 6653(a) of $ 3,986.55 for 1959. All issues have been settled except the question whether the distribution of $ 168,922.55 from the Madison Trust to petitioner Harold D. Greenwald in 1959 should be taxable as ordinary income or as long-term capital gain.
FINDINGS OF FACT
The petitioners, Harold D. Greenwald and Nana Greenwald, husband and wife, reside in New York City. They filed joint income tax returns on the cash basis for the calendar years 1958, 1959, and 1960, with the district director of internal revenue, New York, N.Y.
Interstate *94 Hosiery Mills, Inc. (Interstate), was the successor to International Hosiery Mills, Inc., a corporation organized under the laws of Delaware on February 11, 1929. Interstate was engaged in the manufacture and sale of women's hosiery until December 30, 1953. Although its stock was publicly held and traded, its principal officers -- petitioner Harold D. Greenwald, Ivan Selig, and Lawrence H. Greenwald -- together with members of their families owned a substantial minority interest in the stock of the corporation, and appear to have dominated its affairs.
On December 29, 1943, Interstate entered into an agreement with Ivan Selig and Theresa Schilling, trustees, providing for a pension plan and trust for Interstate's "salaried" employees. At that time Interstate employed approximately 445 persons of whom 47, including *138 petitioner Harold D. Greenwald, were considered salaried employees under the plan. The plan was contingent upon approval by the Commissioner of Internal Revenue.
On September 5, 1944, the attorneys for Interstate requested a ruling from the Commissioner that the pension trust was exempt from tax pursuant to section 165(a) of the 1939 Code. On December 7, 1944, an unfavorable *95 ruling letter was issued partly because of the failure of Interstate to amend the plan to provide that in the aggregate not more than 30 percent of each annual contribution could be allocated to the benefit of employees owning 10 percent or more of the stock of the company. Following the receipt of the disapproval letter, attorneys for Interstate made further but unsuccessful attempts to have the plan approved.
On April 6, 1945, the pension plan was converted by amendment to a profit-sharing plan. Included was a provision that "those Participating Employees owning directly or indirectly 10% or more of the voting stock of the Corporation shall not have allocated to them in any one year in the aggregate more than 30% of the Corporation's contribution to the Trust for such year or amounts forfeited under the provisions of this plan in such year."
As in the pension plan, only "salaried" employees were included as participants. In general, the contribution formula required Interstate to contribute 30 percent of its annual profits (before taxes) in excess of $ 100,000 to the trust. An advisory committee consisting of three individuals, one designated by Interstate from its board of directors, *96 another designated by the board of directors from the participating employees who were not directors, and a third designated by the board of directors who was not an employee of Interstate, was established to supervise the management and operation of the trust and trust funds. Subject to the approval of the advisory committee, the trustees were authorized to invest the trust funds. Investment in Interstate's stock, bonds, or obligations was expressly excluded. The corporate contributions to the trust were to be allocated among the participants in the ratio that the "admissible compensation" of the individual bore to the aggregate "admissible compensation" as defined in the instrument. There was provision for payment of amounts standing to the credit of each participant upon termination of service, and there was also provision for forfeiture as well as vesting of rights of the employee in specified circumstances to a specified extent. The profit-sharing plan was approved by the Commissioner on May 23, 1945, after minor changes suggested by the examiner were incorporated therein. Additional amendments were required by the Salary Stabilization Unit and were executed on June 20, *97 1945. On June 27, 1945, a ruling was issued stating that the trust was still qualified after the amendments.
*139 On December 3, 1945, the trust was amended to change its name from "Interstate Hosiery Mills, Inc. Employees' Profit-Sharing Trust" to "The Madison Trust." A copy of the amendment was sent to the Commissioner on January 2, 1946, for approval. On February 13, 1946, the Commissioner issued a ruling letter stating that the plan still qualified after the change in name.
On April 19, 1946, the plan was further amended to limit the term "Annual Admissible Compensation" to 52 weeks' basic salary, and to provide for a 5-year payout instead of a 10-year payout in the event of voluntary discontinuance of service, involuntary discontinuance of service, or retirement, except that at the option of the advisory committee in all three instances the entire amount due the terminated employee could be paid to him at one time. Upon request by Interstate, the Commissioner issued a ruling on July 18, 1946, stating that the plan still qualified after this amendment.
In 1948, the Madison Trust was the subject of an examination by a revenue agent for the year ended December 31, 1945. The revenue *98 agent raised some questions concerning the ownership of certain machinery by the trust (over one-third of its assets) which was leased to Interstate. On January 19, 1949, the trustees of the Madison Trust sent a letter of intent to the internal revenue agent in charge in New York stating that no further investments would be made by the Madison Trust in plant, machinery, equipment, or any other assets in which Interstate had a direct or indirect ownership.
By letter dated July 5, 1949, the Madison Trust requested a ruling from the Commissioner that would permit it to invest $ 50,000 of its funds in the common stock of Interstate. Incorporated in that request were exhibits showing the profit and loss of Interstate for the years 1944 through 1948 and its balance sheets as of December 31, 1948, and May 31, 1949, as well as the balance sheet of the Madison Trust as of June 20, 1949. The latter disclosed that the trust then had assets in the aggregate of $ 315,736.01, in cash, bonds, mortgages, and real estate. Based upon the provisions of the trust agreement, and on the information submitted with the aforesaid letter, a ruling was issued on July 21, 1949, that the investment would not *99 defeat the purpose of the trust as part of a plan for the exclusive benefit of the employees.
On June 20, 1950, the trust was amended to allow the trustees to invest in the stock, bonds, or mortgages of Interstate, since there appeared to be no authority for them to do so under the original trust instrument. Interstate requested approval of the trust with this amendment, but was informed by letter dated October 19, 1950, that certain additional information would be required before a ruling could be made. The additional information was not supplied, and on January 21, 1952, Interstate withdrew its request for a ruling on the June *140 20, 1950, amendment. In May 1952, the Madison Trust purchased 1,350 shares of Interstate common stock for $ 48,600.
A further amendment, dated June 4, 1952, was adopted whereby an employee could elect to receive 10 percent of his credits annually from and after March 1, 1953, but in the absence of such election, credits would be held by the trust and payable as provided by its terms. The amendment was sent to the Commissioner for approval.
On October 6, 1952, the trust was again amended, identical in substantive form and effect to the proposed but withdrawn *100 amendment of June 20, 1950, except that a provision for collection of rents, etc., which was contained in the amendment of June 20, 1950, was eliminated from the amendment of October 6, 1952. On November 25, 1952, Interstate sent to the Commissioner some of the information requested by him on October 19, 1950, in connection with the June 20, 1950, amendment. By letter dated December 1, 1952, to the Commissioner, Interstate submitted the amendment of October 6, 1952, for approval along with information in support thereof. Interstate further corresponded with the Commissioner regarding this amendment on December 16, 1952, and January 16, 1953. On the latter date Interstate requested that the amendments of June 4, 1952, and October 6, 1952, be considered in the "near future." Negotiations between Interstate and Burlington Mills Corp. for the purchase of Interstate's assets had commenced by this time, but no mention thereof was made in these communications. Such negotiations in fact subsequently culminated in a contract on December 9, 1953, as hereinafter more fully set forth, whereby Interstate sold substantially all of its assets to a subsidiary of Burlington Mills Corp.
Pursuant *101 to a suggestion by the Commissioner, a further amendment, dated March 26, 1953, was made to the Madison Trust. Prior to this amendment negotiations between Interstate and Burlington Mills Corp. had broken off, but were later resumed. The amendment provided that termination of contributions by Interstate would not terminate the trust and amounts held to the credit of individual employees upon termination of contributions would be fully vested to their individual credits regardless of the number of years of service. It also provided that the board of directors of Interstate could terminate the Madison Trust at any time provided such termination would be without prejudice to rights of individual employees, who, in such event, would be fully vested in their credits regardless of number of years of service. This amendment of March 26, 1953, was forwarded to the Commissioner by letter dated March 31, 1953, by Interstate.
Following receipt of the amendment of March 26, 1953, the Commissioner approved that amendment and those dated June 4, 1952, and October 6, 1952. However, the trust's investment in the stock of Interstate was limited to $ 50,000, as previously allowed.
*141 On May 22, 1953, *102 Interstate requested permission allowing the trustees of the Madison Trust to invest an additional $ 100,000 in the common stock of Interstate. The purpose of the investment, according to the request, was "to secure a greater rate of return for the Trust than can be obtained from most other investments. This would redound to the benefit of the employees covered by the Trust. In addition, such an investment will give the employees a double in the profits of Interstate, and would, it is believed, give an added incentive to them in their work for the Company." Comparative income statements and balance sheets of Interstate and a list of the assets held by the Madison Trust were submitted with the request. The assets of the trust were shown to be in the amount of $ 505,597.83 as of April 30, 1953. Such assets included stock of Interstate in the amount of $ 43,875. On or about July 23, 1953, the Madison Trust purchased 993 additional shares of Interstate stock for $ 39,720 plus commissions of $ 297.90.
On September 24, 1953, Interstate sent additional information to the Commissioner in support of its request. This letter pointed out the fine dividend record which Interstate had and *103 the per share value of the stock. Negotiations with Burlington Mills Corp. for the purchase of Interstate's assets had resumed in August 1953, but no mention was made thereof. On October 7, 1953, the additional investment of $ 100,000 by the Madison Trust in the common stock of Interstate was approved "on the basis of all the facts submitted."
On November 4, 1953, Green Cove Hosiery Corp., a subsidiary of Burlington Mills Corp., was formed as a Delaware corporation for the specific purpose of acquiring the assets of Interstate. On December 9, 1953, Interstate entered into a contract of sale with Green Cove Hosiery Corp. whereby Interstate agreed to sell and Green Cove agreed to buy all of Interstate's operating assets, real property, inventories, accounts receivable, leases, name, customers lists, goodwill, and covenant not to compete. This contract was consummated on December 30, 1953. The contract was subject to the condition, among others, that Ivan Selig and Lawrence H. Greenwald be relieved of their employment contracts with Interstate, and upon consummation of the sale Ivan Selig and Lawrence H. Greenwald in fact left the employ of Interstate and were employed by the purchaser *104 of the hoisery business.
For each of the years ended December 31, 1949, 1951, and 1952, Interstate had net profits (before Federal income taxes) in excess of $ 500,000, and for the years ended December 31, 1948 and 1950, such profits exceeded $ 1 million. For the period January 1, 1953, to March 31, 1953, Interstate had earnings of $ 68,986. According to petitioner's letter of May 22, 1953, there had been no material changes in surplus *142 since March 31, 1953, and by letter of September 24, 1953, petitioner stated that the book value per share was in excess of the amount determined as of March 31, 1953. However, its 1954 return in evidence recites that the corporation sustained a net loss for the year 1953 in the amount of $ 172,147.72. After the foregoing sale of its assets, the corporation engaged solely in an investment business, as hereinafter set forth. For the years 1954-58 its highest earnings figure for any one year was reached in 1955 when it had a taxable income of $ 41,495.38.
Prior to the sale of its operating assets, Interstate had paid the following dividends per share to its shareholders: 1946 -- $ 3.00; 1947 -- $ 5.00; 1948 -- $ 4.00; 1949 -- $ 3.00; 1950 -- $ 3.00; *105 1951 -- $ 2.00; 1952 -- $ 2.50. For the years 1954-58 the per share dividend was substantially less. In 1954 it was $ 1.25; 1955 -- $ 1.50; 1956 -- $ 1.50; 1957 -- $ .40; 1957 -- $ 1.10; and 1958 -- $ 1.00.
For the years ended December 31, 1948, 1949, 1950, 1951, and 1952, and as of March 31, 1953, Interstate had a capitalization of 125,000 no-par common shares of stock with a stated value of $ 20 per share. Of the 125,000 shares authorized during these years, 98,291 shares were issued (stated value, $ 1,965,820); of such issued shares, 48,832 shares were held in the treasury (stated value, $ 976,640), and 49,459 shares (stated value, $ 989,180) were outstanding. Between March 31, 1953, and December 31, 1953, Interstate redeemed 4,468 shares (stated value $ 89,360) so that, on December 31, 1953, 44,991 shares were outstanding (stated value, $ 899,820), and 53,300 shares were held in the treasury (stated value, $ 1,066,000). This was the situation at the time of the sale of the assets to Green Cove Hosiery Corp. on December 30, 1953.
As of January 1, 1954, Interstate changed its name to I.H.L. Corp. and was thereafter engaged in the investment business. Petitioner Harold D. Greenwald *106 was in charge of running the affairs of I.H.L. from this time until October 1959. The number of outstanding shares, the number of shares acquired and the stated value of each, as well as the total cost of shares acquired, the portion of the cost in excess of the stated value of such shares charged, respectively, to capital surplus and earned surplus, and the per share cost of the acquired shares for the years 1954 through 1958 are as follows:
| Shares | Treasury | Shares | |||
| Year | outstanding as | Stated | shares | acquired | Stated |
| of Jan. 1 | value | outstanding as | during | value | |
| of Jan. 1 | the year | ||||
| 1954 | 44,991 | $ 899,820 | 53,300 | 11,625 | $ 232,500 |
| 1955 | 33,366 | 667,320 | 64,925 | 2,424 | 48,480 |
| 1956 | 30,942 | 618,840 | 67,349 | 230 | 4,600 |
| 1957 | 30,712 | 614,240 | 67,579 | 11,072 | 221,440 |
| 1958 | 19,640 | 392,800 | 78,651 | 9,700 | 194,000 |
| 1959 | 9,940 | 198,800 | 88,351 | None | None |
| Per share | Balance of | ||||
| Charge to | Charge to | Total cost | cost of | earned | |
| Year | capital | earned | of acquired | acquired | surplus |
| surplus | surplus | shares | shares | account as | |
| of Jan. 1 | |||||
| 1954 | $ 77,500.00 | $ 775,877.04 | $ 1,085,877.04 | 1*107 $ 93.40 | $ 3,393,617.10 |
| 1955 | 16,160.00 | 165,596.00 | 230,236.00 | 2 94.98 | 2,667,544.89 |
| 1956 | 1,533.36 | 15,444.64 | 21,578.00 | 93.86 | 2,497,915.51 |
| 1957 | 73,812.51 | 899,192.55 | 1,194,445.06 | 107.88 | 2,396,916.38 |
| 1958 | 64,666.17 | 856,833.83 | 1,115,500.00 | 115.00 | 1,479,999.98 |
| 1959 | None | None | None | None | 707,211.49 |
Of the 9,940 shares of I.H.L. outstanding on January 1, 1959, 9,670 shares were owned or controlled by petitioner Harold D. Greenwald or members of his immediate family, as follows:
| Owner | Number of shares |
| Harold D. Greenwald | 330 |
| Nana Greenwald (wife) | 6,605 |
| John H. Greenwald (son) | 1,420 |
| Harold D. Greenwald, Jr. (son) | 1,315 |
| Total | 9,670 |
During the period from January 1, 1954, to March 31, 1954, the Madison Trust liquidated its assets except $ 25,523.50 face value U.S. G-bonds in order to raise cash with which to make distributions to the employees of Interstate whose employment was terminated on or about December 30, 1953, and whose participation in the Madison Trust ceased as of March 31, 1954.
The Madison Trust sold five mortgages to I.H.L. for their unamortized cost of $ 95,375.01. It also sold two pieces of rental real estate to I.H.L. at cost, one for $ 60,000 and one for $ 185,000. Each of these rental properties was then subject to a lease which provided the lessee with an option to repurchase the property, during the term of the lease, at its cost to the trust. *108 In addition, all the stock of I.H.L. then owned by the Madison Trust (2,343 shares) was redeemed at a total cost of $ 222,585. The redemption was pursuant to an offer made by the trustee of the Madison Trust, with the concurrence of its advisory committee, to sell their shares to the corporation at $ 95 per share. In conjunction with the redemption of the shares held by the Madison Trust, I.H.L. tendered an offer to its shareholders to purchase their shares at $ 95 per share. An additional 7,292 shares of stock were redeemed by I.H.L. in 1954 pursuant to this tender.
The total liquidating value of the Madison Trust as of March 31, 1954, was $ 709,597.84 of which $ 619,445.97 was then distributed to or in behalf of 59 of the 60 persons who had been participating employees of Interstate. There remained in the trust undistributed the sum of $ 90,281.08 consisting of $ 64,757.58 cash in bank and $ 25,523.50 in Government G-bonds constituting the entire amount allocated to petitioner Harold D. Greenwald on the books of the trust. No amount *144 was forfeited by any employee so as to increase the amount credited to the account of Harold D. Greenwald. Petitioner Harold D. Greenwald remained *109 as an employee of I.H.L. and was the only employee of Interstate whose interest in the Madison Trust was not distributed on March 31, 1954. He was paid an annual salary by I.H.L. in the amount of $ 36,000 for each of the years 1954-57 and $ 18,000 for 1958. Two secretaries, neither of whom was ever a participant in the trust, were also employed by I.H.L.
Following the acquisition of the assets of Interstate by Green Cove Hosiery on December 30, 1953, I.H.L. never earned net profits of $ 100,000 or more in any of the years 1954 through 1959, and made no contributions to the Madison Trust with respect to 1954 or later years.
Following the distribution to the employees (other than petitioner Harold D. Greenwald) on March 31, 1954, the funds remaining in the Madison Trust were invested exclusively in corporate stocks and bonds. A brokerage account was opened in the name of the Madison Trust and common stocks and corporate bonds were purchased and sold on the New York stock exchange and over the counter. Trading was active and the sales were frequently short term, i.e., made within 6 months of the date of purchase.
The Commissioner was never informed as to the changes which took place *110 in Interstate, nor was he informed as to the reduction in participants and funds of the Madison Trust. With the exception of Forms 990-P for 1957, 1958, and 1959 which were filed with the district director in 1958, 1959, and 1960, respectively, and not directed to the attention of the pension trust group by the Madison Trust, there was no written communication between the Madison Trust and the Internal Revenue Service, or between the Internal Revenue Service and the Madison Trust, from October 7, 1953, to the issuance of the notice of deficiency on March 30, 1962.
Neither of the petitioners was ever a trustee of the Madison Trust. The minute book of I.H.L. does not show that Ivan Selig was ever replaced or discharged from his duties as trustee. The minute book of I.H.L. does show that Robert M. Gluck (who was an attorney for Ivan Selig) replaced Francis Greenwood as successor trustee on April 5, 1954, and the minute book does not show that Robert M. Gluck was ever replaced or discharged. Ivan Selig died in February 1963.
In 1959, the Madison Trust purchased I.H.L. common stock for $ 100 per share in the total amount of $ 122,330 as follows:
| Date of purchase | Number of | Seller |
| shares | ||
| Jan. 9, 1959 | 320 | John H. Greenwald. |
| Jan. 16, 1959 | 370 | Harold D. Greenwald, Jr. |
| Jan. 23, 1959 | 450 | Nana Greenwald. |
| Apr. 20, 1959 | 80 | Harold D. Greenwald. |
*145 *111 John H. Greenwald and Harold D. Greenwald, Jr., the petitioners' two sons, used the money paid them to pay off loans from the Chase Manhattan Bank for which they had pledged I.H.L. stock as security. At the time of the first of these purchases the Madison Trust owned no shares of I.H.L. stock.
On July 31, 1959, I.H.L. entered into a reorganization agreement with Fundamental Investers, Inc. (an unrelated, regulated, open-end investment company), whereby Fundamental agreed to acquire substantially all the assets of I.H.L. in exchange for stock of Fundamental. I.H.L. agreed to liquidate and distribute the stock of Fundamental to its stockholders on a prorata basis. Petitioner Harold D. Greenwald has never been a director, officer, or employee of Fundamental.
On August 12, 1959, I.H.L. applied to the Commissioner of Internal Revenue for a ruling as to the tax-free nature of the exchange and distribution. A favorable reply was received on or about September 15, 1959.
Between July 31, 1959, and September 30, 1959, I.H.L. converted its assets into cash except for certain selected securities and purchased additional securities as approved or directed by Fundamental, and on October 1, 1959, *112 I.H.L. transferred securities valued at $ 759,551.11 and $ 389,182 in cash to Fundamental in exchange for 119,280 shares of Fundamental stock. I.H.L. then distributed to its shareholders the 119,280 shares of Fundamental stock on a 12-for-1 basis. I.H.L. retained $ 58,115.64 in cash in order to wind up its affairs. After payment of all expenses there was a balance remaining of $ 15,783.61. By check dated December 10, 1959, I.H.L. distributed $ 15,250 to petitioners which they did not report on their 1959 return. The remaining balance of $ 533.61 was distributed to petitioners in 1960 which they did not report on their 1960 return. I.H.L. was dissolved under the laws of New York on December 28, 1959.
On October 6, 1959, I.H.L. distributed 14,640 shares of Fundamental stock to the Madison Trust. On November 2, 1959, the Madison Trust transferred the cash held by it, $ 31,266.83, to Harold D. Greenwald, and on November 12, 1959, the 14,640 shares of Fundamental stock were placed in Harold D. Greenwald's name.
On his 1959 income tax return, Harold D. Greenwald stated that his 1959 distribution (Fundamental stock and cash) from the Madison Trust had an aggregate value of $ 168,922.55, *113 and he reported it as a long-term capital gain.
OPINION
In November 1959 petitioner Harold D. Greenwald received distributions from the Madison Trust in the aggregate amount of $ 168,922.55. The Commissioner determined that such distributions constituted ordinary income rather than capital gain as reported by petitioner, who relied upon section 402(a)(2) of the 1954 Code. By *146 its terms, section 402(a)(2) applies only in the case of "an employees' trust described in section 401(a), which is exempt from tax under section 501(a)." 1*114 The principal question for decision therefore is whether the Madison Trust qualified under section 401(a) for exemption under section 501(a) at the time of the 1959 distributions. Pertinent provisions of these sections are set forth in the margin. 2*115 *116
The Commissioner had ruled in 1945 that the trust, established under Interstate's profit-sharing plan, qualified for exemption under the predecessor provisions of the 1939 Code then in effect. Subsequent proposed changes in the plan or its operation were scrupulously called to the attention of the Commissioner from time to time during the *147 period 1945-53, and a ruling was sought and obtained from him on each occasion (with specified limitations in some instances) that the plan still qualified under the statute after the proposed amendments or changes. *117 Thus, there is no controversy between the parties that the trust was part of a qualified profit-sharing plan and was accordingly tax exempt up to the end of 1953. The essence of the Government's position is that certain events occurred toward the end of 1953 which resulted in a radically different situation thereafter, and that certainly by the time of the 1959 distributions the plan no longer qualified under the statute and the trust was no longer tax exempt. 3*118 The Government also charges that, in sharp contrast to the numerous detailed communications with the Commissioner in connection with proposed changes during the period 1945-53, the drastically altered situation commencing toward the end of 1953 was never called to his attention and that he thus was never presented with the opportunity of reexamining his ruling in the light of the new facts. It argues that for this latter reason alone, the tax-exempt status of the trust must be deemed forfeited. We do not pass upon this contention because we agree that on the facts developed in this record the trust was not tax exempt in 1959.
At the time of the Commissioner's approval of the plan in 1945 and until December 30, 1953, Interstate was engaged in the manufacture and sale of women's hosiery. Although its stock was publicly traded, the Ivan Selig family, the Lawrence H. Greenwald family, and the Harold D. Greenwald family owned substantial stock interests therein, and these three men, who were its principal officers, appear to have been in control of the enterprise. On December 30, 1953, a drastic change occurred in the affairs of the corporation. On that day it sold its entire business to a subsidiary of Burlington Mills Corp. The assets thus transferred included all of its operating assets, inventories, accounts receivable, leases, goodwill, customers lists, and even its name "Interstate Hosiery Mills," together with a covenant not to compete. The employment contracts of Ivan Selig and Lawrence H. Greenwald were terminated and they were employed by the purchaser of the business. Of the 60 employees covered by the profit-sharing plan at that time, petitioner Harold *119 D. Greenwald alone remained in the employ of Interstate, which changed its name to I.H.L. Corp. as of January 1, 1954. The Madison Trust thereupon liquidated its assets and made payment as of March 31, 1954, to or in behalf of the 59 participating employees whose employment had been terminated *148 by the end of 1953. The total amount in the trust was then $ 709,597.84, of which $ 619,445.97 was paid out in respect of those 59 employees. The $ 90,281.08 undistributed balance was allocable solely to petitioner Harold D. Greenwald. He was in charge of running I.H.L.'s affairs, which consisted merely of investment of its funds. Also, following the distributions to the participating employees (other than Harold D. Greenwald), a brokerage account was opened in the name of the Madison Trust, and its funds, allocable solely to Harold D. Greenwald, were used to purchase corporate securities. There was active trading in that account.
As of January 1, 1954, there were 44,991 shares of I.H.L. outstanding, but, as a consequence of what plainly appears to have been a program of having the corporation purchase the shares of stockholders other than those of the Harold D. Greenwald family, the number *120 of outstanding shares was progressively reduced to 9,940 as of 1959. Over 97 percent of such 9,940 outstanding shares were owned by the Harold D. Greenwald family as of January 1, 1959, a portion of which (1,220 shares) was transferred to the Madison Trust later in January and in April of that year. I.H.L.'s corporate existence was finally terminated in 1959, following the acquisition of its assets by Fundamental Investors, Inc., an unrelated, regulated, open-end investment company, in exchange for stock. At about the same time the Madison Trust made distributions of its total assets, then aggregating $ 168,922.55, to petitioner.
We find it impossible to conclude on the facts before us that the Madison Trust was a tax-exempt entity in 1959. The question is not whether it was part of a qualified profit-sharing plan when first approved in 1945 or whether it continued to enjoy such status up to the sale of the hosiery business toward the close of 1953. The question is whether it was tax exempt in 1959. And the answer depends not merely upon the form of the plan but upon "its effects in operation." See Income Tax Regs., sec. 1.401-1(b)(3).
Following the sale of the hosiery business, *121 the employer corporation became transformed from a widely held operating company to an investment company and ultimately to a family-owned investment company. All of its participating employees, except petitioner, left its employ as a result of the 1953 sale of the business. Petitioner remained with a substantial salary as the chief executive officer of I.H.L. The corporation also had several other employees who received far more modest compensation and who in no way participated in any of the benefits of the plan. It is inconceivable that the Commissioner would ever have approved the plan and sanctioned the tax-exempt status of the Madison Trust upon the facts as they existed after 1953. *149 The Government correctly characterizes the Madison Trust during this period as "nothing more than a tax-exempt fund utilized on behalf of its sole participant, Harold D. Greenwald, for tax-free trading in stocks and bonds." To hold that the trust was tax free in the circumstances disclosed herein would be to disregard the plainly expressed legislative declaration that benefits provided under the plan may not discriminate in favor of employees who are officers, shareholders, supervisory employees, *122 or highly compensated employees. See sec. 401(a)(4), supra fn. 2. Petitioner's relationship to I.H.L. was such that the plan would be disqualified on each of these four grounds.
Of course, we do not suggest that a plan becomes disqualified merely because, in the normal course of the employer's business, the number of participating employees is reduced to one. Cf. Marjorie F. Birnie, 12 T.C.M. 867, where the pivotal issue was whether the remaining beneficiary of the trust was a "supervisory employee." But a one-employee plan where the beneficiary falls within one of the four categories in whose favor the plan may not discriminate may be a wholly different matter, particularly in circumstances such as those disclosed by this record. Cf. Rev. Rul. 55-81, 1955-1 C.B. 392; Rev. Rul. 63-108, 1963-1 C.B. 87. This is not a case where the sole remaining employee was retained merely for the purpose of winding up the affairs of the employer. Here, the corporation continued to operate in an entirely new activity, namely, the investment business; and the maintenance of the so-called profit-sharing fund for petitioner's sole benefit for a prolonged period as a means of tax-free trading in securities *123 is wholly outside the purpose of the statutory provisions.
However, even assuming that Harold D. Greenwald were not a member of any of the four classes, the plan would be disqualified after 1953 for an entirely different reason. Section 1.401-1(b)(2) of the regulations makes clear that the plan must provide for "recurring and substantial contributions out of profits for the employees." To be sure, where failure to contribute is the result of decreased earnings due to business reverses and where there is no reason to assume that previously attained profit levels will not be reached again, a plan may well continue to remain qualified. Cf. Sherwood Swan & Co., 42 T.C. 299. But the situation here is entirely different. The formula for the employer's contributions was based upon Interstate's operation as a hosiery manufacturer. Upon the sale of that business and the progressive reduction of the corporation's assets through repurchase of some 77 percent of its outstanding stock, it became a virtual certainty that the corporation's earnings would never reach the level required by the formula for any contribution to the trust. In effect the corporation abandoned the plan. For this reason *124 as well, the plan failed to qualify during its later years.
*150 The Government has presented other arguments calling for the disqualification of the plan, but we need not consider them. Nor is it necessary to pass upon its contention that petitioner is not entitled to capital gains treatment with respect to the Madison Trust distribution because it was not made on account of his "separation from the service" as required by section 402(a) (2).
Decision will be entered under Rule 50.
Footnotes
1. 9,635 shares redeemed at $ 95, 1,990 shares purchased on open market.
2. 2,414 shares redeemed at $ 95, 10 shares purchased on open market.↩
1. SEC. 402. TAXABILITY OF BENEFICIARY OF EMPLOYEES' TRUST.
(a) Taxability of Beneficiary of Exempt Trust. --
* * * *
(2) Capital gains treatment for certain distributions. -- In the case of an employees' trust described in section 401(a), which is exempt from tax under section 501(a), if the total distributions payable with respect to any employee are paid to the distributee within 1 taxable year of the distributee on account of the employee's death or other separation from the service, or on account of the death of the employee after his separation from the service, the amount of such distribution * * * shall be considered a gain from the sale or exchange of a capital asset held for more than 6 months. * * *
2. SEC. 401. QUALIFIED PENSION, PROFIT-SHARING, AND STOCK BONUS PLANS.
(a) Requirements for Qualification. -- A trust created or organized in the United States and forming part of a stock bonus, pension, or profit-sharing plan of an employer for the exclusive benefit of his employees or their beneficiaries shall constitute a qualified trust under this section --
(1) if contributions are made to the trust by such employer, or employees, or both, or by another employer who is entitled to deduct his contributions under section 404 (a)(3)(B) (relating to deduction for contributions to profit-sharing and stock bonus plans), for the purpose of distributing to such employees or their beneficiaries the corpus and income of the fund accumulated by the trust in accordance with such plan;
(2) if under the trust instrument it is impossible, at any time prior to the satisfaction of all liabilities with respect to employees and their beneficiaries under the trust, for any part of the corpus or income to be (within the taxable year or thereafter) used for, or diverted to, purposes other than for the exclusive benefit of his employees or their beneficiaries;
(3) if the trust, or two or more trusts, or the trust or trusts and annuity plan or plans are designated by the employer as constituting parts of a plan intended to qualify under this subsection which benefits either --
(A) 70 percent or more of all the employees, or 80 percent or more of all the employees who are eligible to benefit under the plan if 70 percent or more of all the employees are eligible to benefit under the plan, excluding in each case employees who have been employed not more than a minimum period prescribed by the plan, not exceeding 5 years, employees whose customary employment is for not more than 20 hours in any one week, and employees whose customary employment is for not more than 5 months in any calendar year, or
(B) such employees as qualify under a classification set up by the employer and found by the Secretary or his delegate not to be discriminatory in favor of employees who are officers, shareholders, persons whose principal duties consist in supervising the work of other employees, or highly compensated employees;
and
(4) if the contributions or benefits provided under the plan do not discriminate in favor of employees who are officers, shareholders, persons whose principal duties consist in supervising the work of other employees, or highly compensated employees.
SEC. 501. EXEMPTION FROM TAX ON CORPORATIONS, CERTAIN TRUSTS, ETC.(a) Exemption From Taxation. -- An organization described in subsection (c) or (d) or section 401(a)↩ shall be exempt from taxation under this subtitle unless such exemption is denied under section 502, 503, 504.
3. There is no dispute that if the plan in fact fails to qualify under the statute by reason of the changed factual situation the Commissioner is not bound by his prior rulings approving the plan on the basis of the facts then presented to him.