*109 Decisions will be entered for the respondent.
A closely held corporation, possessing cash in excess of its business requirements and equaling at least half its total assets, canceled one-half its shares of stock and made a cash distribution in the amount of $ 67,250 on a pro rata basis. It had earnings and profits in the amount of $ 58,027.91. Held, the pro rata cash distribution in redemption of stock, to the extent of earnings and profits, was made at such a time and in such a manner as to be essentially equivalent to the distribution of a taxable dividend within the purview of section 115 (g), Internal Revenue Code of 1939.
*1159 Respondent determined deficiencies in the income taxes of the petitioners for the calendar year 1946, as follows:
| Charles D. Chandler (deceased) | $ 11,667.70 |
| Helen Ott | 1,205.79 |
| John W. Bush | 1,233.54 |
| Margaret C. Bush | 4,801.44 |
Substantially all of said amounts are in dispute. The proceedings were consolidated for hearing. The issue for decision is whether respondent correctly determined that a pro rata cash distribution in cancellation of half the stock of a corporation was made at such a time and in such a manner as to be essentially equivalent to the distribution of a taxable dividend to the extent of accumulated earnings and profits within the purview of section 115 (g), Internal Revenue Code of 1939.
FINDINGS OF FACT.
Charles D. Chandler (hereinafter referred to as Chandler or as one of the petitioners) was a resident of Maryville, Tennessee. He died on May 29, 1950, and his estate was substituted as the petitioner. Helen Ott resides in Maryville, Tennessee, and John W. Bush and Margaret C. Bush are husband and wife residing in Knoxville, Tennessee. *111 Margaret Bush is Chandler's daughter and Helen Ott is his niece. Petitioners filed their individual income tax returns for the taxable year 1946 with the collector of internal revenue for the district of Tennessee.
All of the petitioners were stockholders of Chandler-Singleton Company (hereinafter referred to as the Company), a Tennessee corporation organized on May 9, 1923. The capital stock of the Company consisted of 500 shares of common stock of $ 100 par value, all of which were outstanding until November 7, 1946. From its organization until February 28, 1946, the Company was engaged in the operation of a general department store in Maryville, Tennessee. It had a ladies' ready-to-wear department, men's department, children's department, piece goods department, and a bargain basement.
Chandler was the president and manager of the Company. At the beginning of 1944 he was in very poor health. John W. Bush was the secretary of the Company, but until 1944 he had not been particularly active in its affairs. On January 1, 1944, he became assistant manager of the Company. By profession he was a civil enginer, but at that time he was unemployed due to a change in the administration*112 of the City of Knoxville, Tennessee. During 1944 and 1945 Chandler was sick most of the time. In his absence John W. Bush managed the department store.
John W. Bush did not like being a merchant and decided to return to engineering. In November 1945 he informed Chandler that he *1160 was resigning as manager at the end of the year. Chandler, feeling unable to manage the department store himself, decided to sell.
At a stockholders' meeting held on February 20, 1946, it was unanimously agreed that the Company should accept an offer to purchase its merchandise, furniture and fixtures, and lease. Chandler was instructed to consummate the deal. The sale was consummated and a bill of sale was executed which reads as follows:
BILL OF SALE.
KNOW ALL MEN BY THESE PRESENTS that Chandler-Singleton Company, a corporation existing under the laws of the State of Tennessee, with its principal office in Blount County, Maryville, Tennessee, for and in consideration of the payments hereinafter set out, does hereby sell, transfer and convey to McArthur's Incorporated, a corporation existing under the laws of the State of Tennessee, with its principal office in Maryville, Blount County, Tennessee, *113 all the stock of goods, furniture and fixtures, accounts, office supplies, including also the lease of the building formerly occupied by the said Chandler-Singleton Company in Maryville, Tennessee.
The consideration paid for said assets is the sum of Seventy-two thousand, two hundred four and .01/100 ($ 72,204.01) Dollars, the receipt of which is hereby acknowledged by the said Chandler-Singleton Company. The proration of which consideration is as follows:
| Furniture and fixtures | $ 10,000.00 |
| Stock of goods | 46,592.33 |
| Office supplies | 478.07 |
| Accounts receivable | 10,133.61 |
| Lease | 5,000.00 |
| Total | $ 72,204.01 |
To have and to hold said property to the said McArthur's Inc., it's [sic] successors and assigns forever and the said Chandler-Singleton Company hereby covenants with the said McArthur's Inc. that said property is free from all encumbrances and that it has the legal right to transfer and sell the same and that it will forever defend the title thereto against all persons whomsoever. It is further a part of the consideration of this transfer that the name of Chandler-Singleton Company or any portion thereof shall not be used by the said McArthur's Inc. in the operation*114 of the business subsequent to this transfer nor will said name be sold or transferred by the said Chandler-Singleton Company to any other person or persons provided, however, this restriction shall not be construed to prohibit the designation by McArthur's Inc. that it is the successor to Chandler-Singleton Company.
In witness whereof the said Chandler-Singleton Company and McArthur's Inc. have caused this instrument to be duly signed by the proper person thereto duly authorized on this 1st day of March, 1946.
Attest:
(sgd.) John W. Bush
Sec.
Chandler-Singleton Company
By (sgd.) C. D. Chandler
PresidentAttest:
(sgd.) J. W. King
Sec.
McArthur's Incorporated
By (sgd.) David L. McArthur
President*1161 The Company ceased operating the department store on February 28, 1946. McArthur's Incorporated moved in that night and began operating the store the following day.
Chandler had worked hard in the department store and had no outside interest. He wanted something to do and did not want to get out of business entirely. It was planned that a ladies' ready-to-wear store would be opened by the Company to be managed by Clara T. McConnell (now Clara M. *115 Register) who had managed the ladies' ready-to-wear department of the department store. Thirty shares of stock in the Company owned by Chandler's wife were canceled on April 5, 1946. Ten of these shares were issued to Clara McConnell on April 13, 1946, in order that she might have an interest in the Company whose store she was going to manage. A men's store, to be eventually taken over by the eldest son of John and Margaret Bush, was also contemplated. It was thought that approximately half of the assets of the Company would be needed for each of the two stores.
The charter of the Company was amended on May 18, 1946, changing the name of the Company to "Chandler's" pursuant to a resolution passed at a stockholders' meeting held on May 15, 1946.
About the first of June 1946, the Company obtained space for the ladies' ready-to-wear store about one-half block from the old department store now occupied by McArthur's Incorporated. Merchandise was purchased beginning in June; improvements were made; furniture and supplies were acquired; and the store was opened on September 23, 1946. No sales had been made by the Company between February 28, 1946, and September 23, 1946.
The ladies' *116 ready-to-wear store was about the same size as that department in the former department store. The department store had occupied 8,000 to 9,000 square feet of floor space, had employed 10 to 20 persons, and had carried fire insurance in the amount of $ 65,000 on its stock and fixtures. The new store had approximately 1,800 square feet of floor space, employed 4 to 6 persons, and carried fire insurance in the amount of $ 10,000.
A meeting of the board of directors of the Company was held on September 28, 1946, and the minutes of said meeting read in part as follows:
The Chairman stated that the purpose of the meeting was to consider the advisability of proposing to the stockholders an Amendment to the Charter of Incorporation so as to provide for a reduction of the number of shares of stock heretofore authorized from 500 shares of $ 100.00 par value to 250 shares of $ 100.00 par value to the end that this corporation may redeem from each share holder one-half (1/2) of the stock issued to said respective share holder paying therefor the book value of said respective shares of stock to be thus redeemed.
*1162 WHEREUPON, Margaret Chandler Bush, introduced the following Resolution: *117
"BE IT RESOLVED, that application be made to the State of Tennessee for an Amendment to the Charter of Incorporation of the Company so as to provide for a reduction in the capital stock of the corporation from 500 shares of $ 100.00 par value to 250 shares of $ 100.00 par value.
"BE IT FURTHER RESOLVED that the President call a meeting of all the stockholders of the corporation to the end that said proposed amendment to the Charter be submitted to the stockholders for approval."
A special meeting of the stockholders was held on September 28, 1946, the minutes of which read in part as follows:
The Chairman explained that the purpose of the meeting was to authorize partial liquidation for the following reasons:
The old business was sold and plans were developed to go back into business, operating two stores, a ladies ready-to-wear business and a men's store. The ladies ready-to-wear store has been opened and is now operating. Up to now, we have been unable to negotiate a lease for a suitable location, and, after considerable thought, it has been decided to abandon the idea of operating an exclusive men's shop and operate only the one store at the present time. It appears that requirements*118 of the one store will be approximately one-half the capital now invested in Chandler's, Inc.
Upon motion of Margaret Chandler Bush, seconded by J. W. Bush, and unanimously carried, the officials were authorized and instructed to redeem from each shareholder one-half of his stock, paying therefor the book value, which is approximately $ 269.00 per share. Therefore they are authorized to retire one-half of each shareholder's stock at $ 269.00 per share and are authorized to apply to the Secretary of State for reduction of the outstanding stock from 500 shares to 250 shares of $ 100.00 each.
On October 29, 1946, the charter of the Company was amended and its capital stock was reduced from 500 shares of $ 100 par value common stock, to 250 shares of $ 100 par value common stock. On November 7, 1946, the 500 shares of outstanding capital stock designated "Chandler-Singleton Company" were called in and canceled. Each stockholder received 1 share of stock designated "Chandler's" and $ 269 in cash for each 2 shares turned in. The $ 269 represented the approximate book value of 1 share of Chandler-Singleton Company stock on February 28, 1946. The stockholders, on November 7, 1946, the*119 number of shares each turned in, and the number of shares and cash each received therefor are as follows:
| Turned in | Received | ||
| Stockholder | |||
| Number | Number | Cash | |
| shares | shares | ||
| Charles D. Chandler | 240 | 120 | $ 32,280 |
| Helen Ott | 50 | 25 | 6,725 |
| John W. Bush | 50 | 25 | 6,725 |
| Margaret C. Bush | 150 | 75 | 20,175 |
| Clara McConnell Register | 10 | 5 | 1,345 |
| Totals | 500 | 250 | $ 67,250 |
*1163 Thirty of the 50 shares held by Helen Ott prior to November 7, 1946, were acquired from A. J. Stansberry on December 15, 1945, and 20 shares were acquired from Chandler's wife on April 13, 1946. Chandler acquired 45 of the 240 shares held by him from Frank Coleman on December 12, 1945.
The five stockholders named above were the directors of the Company. Chandler was the Company's president, Margaret C. Bush was its vice president, and John W. Bush was its secretary. After Clara McConnell acquired stock in the Company, she became its treasurer.
The comparative balance sheets on December 31, 1945, on February 28, 1946, after the sale to McArthur's Incorporated, and on December 31, 1946, were as follows:
| Dec. 31, 1945 | Feb. 28, 1946 | Dec. 31, 1946 | ||
| Assets | ||||
| Current assets: | ||||
| Cash | $ 74,486.67 | $ 111,095.14 | $ 16,372.69 | |
| U. S. bonds and accrued interest | 34,089.20 | 34,089.20 | ||
| Accounts receivable | 16,195.87 | 6,028.49 | ||
| Notes receivable | 1,531.67 | 1,531.67 | ||
| Savings and Loan Association | 5,000.00 | |||
| Credit balance in accounts | ||||
| payable | 132.52 | |||
| Postwar refund excess profits tax | ||||
| and refund bonds | 9,610.85 | 4,124.34 | ||
| Inventories | 30,412.83 | 16,409.23 | ||
| Total current assets | $ 166,327.09 | $ 150,972.87 | $ 43,810.41 | |
| Fixed assets: | ||||
| Furniture and fixtures | $ 15,465.61 | $ 7,829.35 | ||
| Bookkeeping machine | 875.67 | |||
| Automobile | 692.40 | 692.40 | ||
| Carpet, leasehold improvements, | ||||
| neon signs | 7,716.29 | |||
| $ 17,033.68 | $ 16,238.04 | |||
| Less: | ||||
| Reserve for depreciation | 14,709.98 | 1,142.60 | ||
| Fixed assets -- net | $ 2,323.70 | $ 15,095.44 | ||
| Prepaid insurance | 85.00 | 184.80 | ||
| Total assets | $ 168,735.79 | $ 150,972.87 | $ 59,090.65 | |
| Liabilities and Net Worth | ||||
| Current liabilities: | ||||
| Accounts payable | $ 21,558.42 | $ 5,369.34 | ||
| Accrued taxes | 39,570.58 | $ 16,405.64 | 6,943.40 | |
| Total current liabilities | $ 61,129.00 | $ 16,405.64 | $ 12,312.74 | |
| Net worth: | ||||
| Capital stock -- common | $ 50,000.00 | $ 50,000.00 | $ 25,000.00 | |
| Paid in surplus | 6,000.00 | 6,000.00 | 3,000.00 | |
| Earned surplus | 51,606.79 | 78,567.23 | 18,777.91 | |
| Total net worth | $ 107,606.79 | $ 134,567.23 | $ 46,777.91 | |
| Total liabilities and net worth | $ 168,735.79 | $ 150,972.87 | $ 59,090.65 |
*120 A 10 per cent dividend totaling $ 5,000 was declared on September 24, 1943. The amount of cash and United States bonds possessed by the Company at the beginning of 1946 exceeded the amount required for the current operation of the business by approximately $ 45,000. Between January 1 and February 28, 1946, the Company's earned surplus increased by $ 39,460.44, out of which the Company paid *1164 dividends in the amount of $ 12,500. To the extent of at least $ 58,027.91, the excess cash possessed by the Company prior to the November 7 distribution was not created by a reduction in the amount of capital needed to operate the Company's business.
Petitioners reported the excess of the payments received over the cost of the stock in their individual income tax returns as capital gain. Respondent treated the payments, to the extent of the earned surplus of $ 58,027.91, as dividends and taxed them to the petitioners as ordinary income.
The acquisition and cancellation of one-half the Company's stock in 1946 was done at such a time in such a manner as to make the distribution and cancellation essentially equivalent to the distribution of a taxable dividend to the extent of $ 58,027.91.
*121 OPINION.
Respondent contends that the Company's pro rata distribution in redemption of half its capital stock at book value was made at such a time and in such a manner as to make the distribution essentially equivalent to the distribution of a taxable dividend to the extent of earnings and profits. If respondent's contention is correct the distribution to the extent of earnings and profits loses its capital gain status acquired under section 115 (c) and (i) and is treated as a taxable dividend under section 115 (g) 1 of the Internal Revenue Code of 1939 as it applied in 1946. 2
*123 A cancellation or redemption by a corporation of all of the stock of a particular shareholder has been held not to be essentially equivalent to the distribution of a taxable dividend. Cf. Carter Tiffany, 16 T. C. 1443; Zenz v. Quinlivan, (C. A. 6) 213 F. 2d 914; Regs. 111, sec. 29.115-9. However, "A cancellation or redemption by a corporation of its stock pro rata among all the shareholders will *1165 generally be considered as effecting a distribution essentially equivalent to a dividend distribution to the extent of the earnings and profits accumulated after February 28, 1913." Regs. 111, sec. 29.115-9. Such a redemption of stock is generally considered equivalent to a dividend because it does not, as a practical matter, change the essential relationship between the shareholders and the corporation. Cf. Commissioner v. Roberts, (C. A. 4) 203 F.2d 304">203 F. 2d 304, reversing 17 T.C. 1415">17 T. C. 1415. But, as pointed out by the regulations, a pro rata distribution is not always "essentially equivalent to the distribution of a taxable dividend" and each case depends upon*124 its own particular circumstances. Commissioner v. Sullivan, (C. A. 5) 210 F. 2d 607, affirming John L. Sullivan, 1420">17 T. C. 1420. The circumstances in the instant case, however, do not warrant a finding that to the extent of earnings and profits the pro rata distribution was not essentially equivalent to a taxable dividend.
Being a question of fact, the decided cases are not controlling. However, in Joseph W. Imler, 11 T. C. 836, 840, we listed some of the factors which have been considered important, viz, "the presence or absence of a real business purpose, the motives of the corporation at the time of the distribution, the size of the corporate surplus, the past dividend policy, and the presence of any special circumstances relating to the distribution." See also Commissioner v. Roberts, supra, at p. 306; Rheinstrom v. Conner, (C. A. 6) 125 F.2d 790">125 F. 2d 790.
An examination of the facts reveals that the Company had a large earned surplus and an unnecessary accumulation of cash from the standpoint of business requirement, both*125 of which could have been reduced to the extent of earnings and profits by the declaration of a true dividend. The only suggested benefit accruing to the business by the distribution in cancellation of half the stock was the elimination of a substantial amount of this excess cash. Ordinarily such cash would be disposed of by the payment of a dividend. Coupled with the fact that the stockholders' proportionate interests in the enterprise remained unchanged, these factors indicate that section 115 (g) is applicable. Cf. James F. Boyle, 14 T. C. 1382, affd. (C. A. 3) 187 F. 2d 557, certiorari denied 342 U.S. 817">342 U.S. 817; Hyman v. Helvering, (C. A., D. C.) 71 F.2d 342">71 F. 2d 342, affirming 28 B. T. A. 1231, certiorari denied 293 U.S. 570">293 U.S. 570.
Petitioners seek to avoid the application of section 115 (g) by contending that the cash distribution and redemption of stock did not represent an artifice to disguise the payment of a dividend but was occasioned by a bona fide contraction of business with a resulting decrease in the need for capital. *126 While important, the absence of a plan to avoid taxation is not controlling. A distribution in redemption of stock may be essentially equivalent to a taxable dividend although it *1166 does not represent an attempt to camouflage such a dividend. McGuire v. Commissioner, (C. A. 7) 84 F. 2d 431, affirming 32 B. T. A. 1075, certiorari denied 299 U.S. 591">299 U.S. 591; Fred B. Snite, 10 T. C. 523, affd. (C. A. 7) 177 F. 2d 819. Commissioner v. Cordingly, (C. A. 1) 78 F.2d 118">78 F. 2d 118, and Commissioner v. Quackenbos, (C. A. 2) 78 F. 2d 156, both of which adopted a "bad faith" test as controlling, have either been overruled or rejected by later opinions. Kirschenbaum v. Commissioner, (C. A. 2) 155 F. 2d 23, certiorari denied 329 U.S. 726">329 U.S. 726; Long v. Commissioner, (C. A. 6) 155 F.2d 847">155 F. 2d 847, 850, affirming 5 T. C. 327; Flanagan v. Helvering, (C. A., D. C.) 116 F. 2d 937;*127 Hirsch v. Commissioner, (C. A. 9) 124 F. 2d 24, affirming 42 B. T. A. 566; cf. Fred B. Snite, supra.Whether a cancellation or redemption of stock is "essentially equivalent" to a taxable dividend depends primarily upon the net effect of the distribution rather than the motives and plans of the shareholders or the corporation. Flanagan v. Helvering, supra, at p. 939; James F. Boyle, supra;Smith v. United States, (C. A. 3) 121 F. 2d 692, 696; cf. Commissioner v. Sullivan, supra;Rheinstrom v. Conner, supra.Moreover, we cannot find from the present record that the reduction of taxes was not the motivating factor causing the stockholders to make a distribution in redemption of stock rather than to declare a dividend to the extent of earnings and profits.
Petitioners' primary contention is that the sale of the department store and the opening of the smaller ladies' ready-to-wear store resulted in a contraction of corporate business. *128 This is a vital factor to be considered, but a contraction of business per se does not render section 115 (g) inapplicable. L. M. Lockhart, 8 T. C. 436. Furthermore, even though it is clear that there was a diminution in the size of the Company's business, there was no contraction such as was present in Commissioner v. Sullivan, Joseph W. Imler, and L. M. Lockhart, all supra. In those cases there was a contraction of business with a corresponding reduction in the amount of capital used. Here, although the business was smaller, the amount of capital actually committed to the corporate business was not reduced accordingly. On December 31, 1945, before the sale of the department store to McArthur's Incorporated, the Company had $ 32,736.53 tied up in fixed assets and inventories. On December 31, 1946, after the ladies' ready-to-wear store was opened, it had $ 31,504.67 invested in those items. Undoubtedly the department store required larger reserves than the ladies' ready-to-wear store for purchasing inventories and carrying accounts receivable. But to the extent of earnings and profits the excess cash *129 distributed was not created by a reduction in the amount of capital required for the operation of the business. Most of the excess cash had existed since prior to the sale of the department store and did not arise from fortuitous circumstances, as petitioners contend, *1167 but from an accumulation of earnings beyond the needs of the business. This excess could have been eliminated by the payment of a taxable dividend, and its distribution in redemption of stock was essentially equivalent to a taxable dividend.
It is true that the entire $ 67,250 distribution could not have been made in the form of an ordinary dividend and to some extent a redemption of stock was required. But section 115 (g) applies if the distribution is only "in part" essentially equivalent to a taxable dividend, and here the distribution was essentially equivalent to a taxable dividend to the extent of earnings and profits.
Decisions will be entered for the respondent.
Footnotes
1. SEC. 115. DISTRIBUTIONS BY CORPORATIONS.
(g) Redemption of Stock. -- If a corporation cancels or redeems its stock (whether or not such stock was issued as a stock dividend) at such time and in such manner as to make the distribution and cancellation or redemption in whole or in part essentially equivalent to the distribution of a taxable dividend, the amount so distributed in redemption or cancellation of the stock, to the extent that it represents a distribution of earnings or profits accumulated after February 28, 1913, shall be treated as a taxable dividend.↩
2. Senate Report No. 1631, 77th Cong., 2d Sess., 1942-2 C. B. 504, 591, in proposing that the Revenue Act of 1942 amend section 115 (c) as described below, made the following statement regarding section 115 (g):
"Under existing law the gain realized from a distribution in partial liquidation is treated, despite the provisions of section 117, as a short-term capital gain: This treatment was occasioned by the facility with which ordinary dividends may be distributed under the guise of distributions in partial liquidation, although section 115 (g) makes explicit provision for the treatment of such distributions as ordinary dividends. Inequality results, however, under the existing law in the case of unquestionable bona fide redemptions of stock not equivalent in any way to the distribution of a taxable dividend. It is believed that the proper application of section 115 (g)↩ will prove adequate to prevent taxable dividends disguised as liquidations from receiving capital gain treatment. Accordingly, this section of the bill eliminates the provision requiring the gain from a partal liquidation to be treated as a short-term capital gain."