1952 U.S. Tax Ct. LEXIS 261">*261 Decisions will be entered under Rule 50.
1. Redemption of Stock -- Distributions in Liquidation -- Payment for Stock or Dividend. -- A distribution in kind in cancelation of stock was not essentially equivalent to the distribution of a taxable dividend within the meaning of section 115 (g) but was taxable as provided in section 115 (c).
2. Section 117 (j) (2) -- Interpretation -- Capital Asset Sales. -- Not all long term gains from sales of capital assets are to be added in the formula of section 117 (j) (2) but only the recognized gains from the compulsory or involuntary conversion of capital assets held for more than 6 months into other property or money.
17 T.C. 1420">*1420 The Commissioner determined1952 U.S. Tax Ct. LEXIS 261">*262 the following deficiencies in income taxes for 1943:
| John L. Sullivan | $ 146,110.73 |
| Georgia E. Sullivan | 146,110.73 |
| B. C. Garnett | 126,621.79 |
| Betty K. S. Garnett | 162,463.79 |
The issue which is common to all four proceedings is whether a distribution in kind, made on April 1, 1943, by Texon Royalty Company (Delaware) to two stockholders in cancelation of two-fifths of its stock gave rise to a taxable gain on the stock surrendered by each distributee or was essentially equivalent to the distribution of a taxable dividend to the extent of the accumulated earnings of the corporation. The Sullivans claim, in addition, that casualty losses and losses from the sale of race horses sustained by them in 1943 are allowable as ordinary deductions rather than short term capital losses.
FINDINGS OF FACT.
John L. Sullivan and Georgia E. Sullivan are husband and wife. B. C. Garnett and Betty K. S. Garnett are husband and wife. Betty is the daughter of the Sullivans. Each petitioner filed an individual income tax return for 1943 on the community property basis with the collector of internal revenue for the first district of Texas.
17 T.C. 1420">*1421 Texon Royalty Company, hereafter sometimes called1952 U.S. Tax Ct. LEXIS 261">*263 Texon, was incorporated under the laws of Delaware in 1937. Georgia E. Sullivan and Betty K. S. Garnett each owned one-half of its stock at all times material hereto.
The Board of Directors of Texon, at a meeting on March 23, 1943, adopted the following resolutions:
WHEREAS, this corporation presently is the owner of sundry producing and undeveloped oil and gas leases, drilling equipment, oil payments, and miscellaneous properties, and
WHEREAS, the Board of Directors deem it good business and advisable to make a partial liquidation of the corporation and to pay out certain properties of the company as a dividend in kind ratably to the stockholders of record on the 1st day of April, 1943, and
WHEREAS, the payment of a partial liquidating dividend will impair the capital stock of the corporation,
NOW, THEREFORE, BE IT RESOLVED, that a partial liquidating dividend be declared and paid as of April 1, 1943, said dividend to be paid in properties in kind and consisting of the following described properties:
(1) Austin Lease with producing wells and equipment.
(2) Clara Driscoll Lease with producing wells and equipment.
(3) C. J. Horne Lease with producing wells and equipment.
(4) 1952 U.S. Tax Ct. LEXIS 261">*264 Irene Walton Lease with producing wells and equipment.
All of the foregoing leases are located in what is known as the Agua Dulce oil and gas field.
(5) Notes Receivable due to the Company by John L. Sullivan, of the principal amount of $ 250,000.00.
(6) The Gulf Plains Corporation gas payment of $ 1,275,000.00 on which a balance of approximately $ 1,050,000.00 remains unpaid.
(7) Drilling Equipment.
BE IT FURTHER RESOLVED, That since the properties listed as items (1) to (4) above, inclusive, are pledged with other properties to the First National Bank of Chicago, Chicago, Ill., as security to indebtedness due by this Company to said Bank in the approximate amount of $ 475,000.00, said stockholders agree to assume $ 225,000.00 of this indebtedness, or whatever amount is deemed to be reasonable and fair by the officers of this Company.
BE IT FURTHER RESOLVED, That the Certificate of Incorporation of this Company be amended, reducing the capital stock of the corporation from 5,000 shares of the par value of $ 100.00 per share to 3,000 shares of the par value of $ 100.00 per share; and that of the net book value of the assets paid out as a liquidating dividend $ 200,000.00 of such 1952 U.S. Tax Ct. LEXIS 261">*265 amount be charged against the capital stock account and the remainder be charged against the Paid-in Surplus account.
The action of the Board was approved by the stockholders at a meeting on March 23, 1943, and the authorized distribution was made on April 1, 1943, to the two stockholders who assumed $ 225,000 of the corporation's indebtedness to the First National Bank of Chicago. The two stockholders at that time each surrendered 1,000 shares of their stock in exchange for the assets distributed to them and the capital stock of the corporation was reduced from 5,000 to 3,000 shares.
17 T.C. 1420">*1422 Texon held a great many producing oil leases outside of the Agua Dulce oil field. The latter field was a high pressure field. A suit for damages from a blow-out which occurred in prior operations in that field was pending against Texon at the time of the distribution. The leases transferred needed to be developed. The leases were transferred because Texon did not want to take the risks of developing them and because it did not have authority under its charter to drill wells. The same reasons prompted the distribution of the drilling equipment. Another reason was that that equipment could1952 U.S. Tax Ct. LEXIS 261">*266 be used in the development of the oil properties transferred. The gas payment and the notes were included in the distribution in order to furnish the distributees with additional capital or credit to aid them in the development of the properties. Development of the properties transferred was undertaken soon after the distribution. The drilling equipment was transferred by the stockholders to a corporation in connection with that development. The tax counsel, upon whom Texon relied for advice, believed on April 1, 1943, that Texon had little surplus, if any, from which a taxable dividend could be distributed.
The avoidance of tax was not one of the reasons for the distribution.
The distribution of April 1, 1943, in cancelation of two-fifths of the stock of the corporation, was a distribution in partial liquidation of the corporation and the cancelation of the stock was not at such time and in such manner as to make the distribution and cancelation, in whole or in part, essentially equivalent to the distribution of a taxable dividend.
The total fair market value of the properties distributed on April 1, 1943, minus the amount of the notes payable assumed by the distributees, was1952 U.S. Tax Ct. LEXIS 261">*267 $ 1,259,036.27 and the net amount received by each stockholder was $ 629,518.13.
The interest of Georgia E. Sullivan in Texon was community property. The interest of Betty K. S. Garnett in Texon was her separate property.
The petitioners reported on their returns for 1943 the receipt on April 1, 1943, of a liquidating dividend in the amount of $ 554,518.14 from which they subtracted $ 50,000 as purchase price of the stock, resulting in a long term capital gain of $ 504,518.14 of which 50 per cent, or $ 252,259.07, was reported as community income.
The Commissioner, in determining the deficiencies for 1943, explained that the distribution of April 1, 1943, was an ordinary dividend under section 115 (g) to the extent of the corporation's earnings and profits, and the excess of the distribution over that amount was a capital gain to the extent that it exceeded the basis of the stock. He held that the total accumulated earnings of the corporation amounted to $ 905,217.94, the value of the assets distributed amounted to $ 1,259,036.27, 17 T.C. 1420">*1423 and the cost to each stockholder of the stock surrendered was $ 36,053.27, with the result that each stockholder received an ordinary dividend1952 U.S. Tax Ct. LEXIS 261">*268 of $ 452,608.97 and a long term capital gain of $ 140,855.90. He held that both the dividend and the capital gain were community income of the Sullivans, the ordinary dividend was community income of the Garnetts, and the long term capital gain was separate income of Betty.
The Sullivans for 1943 reported a net loss of $ 39,675.76 from the business of "Horse Racing." One of the "Expenses" which they deducted in arriving at the net loss was $ 2,829.16 "Loss on Dead Horse (Cost 3,500.00 -- Depr. $ 670.84)." They also reported on that return a net loss of $ 2,277.04 from the sales of two race horses. The basis for each horse was determined after subtracting depreciation allowed in prior years. The Commissioner, in determining the deficiencies for 1943, added $ 2,277.04 to income on account of "Horse Sales" and $ 2,827.16 (sic) on account of "Casualty loss disallowed" with the explanation:
These losses are deemed unallowable as ordinary deductions. They are allowable, to the extent of 50%, as partial offset against long-term capital gains. See adjusting item (d) herein below, and section 117 (j) (2) of the Internal Revenue Code.
He allowed 50 per cent of each of the items mentioned1952 U.S. Tax Ct. LEXIS 261">*269 as an offset against long term capital gains under item (d). The petitioners had no gains from the compulsory or involuntary conversion of property into other property or money during 1943.
The stipulations of the parties and all exhibits made a part thereof are incorporated herein by this reference.
OPINION.
The Commissioner maintains that the distribution made by Texon on April 1, 1943, was "at such time and in such manner as to make the distribution and cancellation * * * in part essentially equivalent to the distribution of a taxable dividend" within the meaning of section 115 (g), so that the distribution is taxable as a dividend to the extent that accumulated earnings of Texon were available. The petitioners contend that the distribution does not come within that section and the entire amount must be treated as in payment for the stock under section 115 (c). The Court, after considering the entire record, has come to the conclusion that section 115 (g) does not apply since the corporation did not cancel or redeem its stock at such time and in such manner as to make the distribution and cancelation or redemption in whole or in part essentially equivalent to the distribution1952 U.S. Tax Ct. LEXIS 261">*270 of a taxable dividend. This result follows 17 T.C. 1420">*1424 whether regard is had to the net effect of the transaction, to the motives and purposes of the corporation and its stockholders, or to a combination of the two.
Business purposes and motives dictated by the reasonable needs of the business occasioned the distribution. It was not made to avoid taxes or merely to benefit the stockholders by giving them a share of the earnings of the corporation. The corporation did not regard itself as being in position to declare a taxable dividend. These properties needed to be developed through drilling. They were in a high pressure field. A suit for damages from a blow-out which occurred in prior operations in that field was pending against Texon at the time of the distribution. Texon had no authority under its charter to drill and did not want to subject its other properties to possible liability in the development of these leases. The partial distribution was to protect its remaining leases. Cf. L. M. Lockhart, 8 T.C. 436. The stock redeemed in 1943 was originally issued in 1937 for a legitimate business purpose, although the subsequent distribution 1952 U.S. Tax Ct. LEXIS 261">*271 somewhat undid the result accomplished at that time. There is no relationship between the issuance of the stock and its redemption which would tend to make the latter resemble an ordinary dividend. The stockholders assumed a part of the indebtedness of the company secured by the leases. Cf. L. M. Lockhart, supra.The principal business of Texon had been that of producing oil. The distribution relieved it of properties which it did not need in that business and some of which it did not use. Cf. Pullman, Inc., 8 T.C. 292; James F. Boyle, 14 T.C. 1382, affd. 187 F.2d 557, certiorari denied 342 U.S. 814">342 U.S. 814; Elwood W. McGuire, 32 B. T. A. 1075, affd. 84 F.2d 431, certiorari denied 299 U.S. 591">299 U.S. 591.
The gas payments and the notes were included in the distribution to furnish the distributees with capital and credit which they would need for the development of the properties. The notes represented money withdrawn by John L. Sullivan from Texon. He, through the1952 U.S. Tax Ct. LEXIS 261">*272 community, was a part owner of some of the stock redeemed. Thus, the cancelation of the stock reduced the indebtedness of a stock owner to the corporation. Cf. Bona Allen, Jr., 41 B. T. A. 206. The Sullivans and Garnetts proceeded with the development of the leases soon after the distribution. The drilling equipment was transferred by them to a new corporation, the stock of which was held equally by Georgia and Betty and the remaining assets were transferred to a new partnership composed of the two. The drilling equipment, being all of such equipment owned by Texon, was transferred because Texon had no further use for it and because it would be needed by the distributees in order to develop the high pressure leases. There were business reasons for the distribution of the drilling equipment.
17 T.C. 1420">*1425 There is no particular significance in the fact that the distribution was pro rata or that the corporation had never declared any regular dividends. There is ample evidence that the corporation did not intend this particular distribution as an ordinary dividend from accumulated earnings. The Commissioner has not called the attention of the Court 1952 U.S. Tax Ct. LEXIS 261">*273 to any circumstances or authorities which really support his determination that section 115 (g) applies.
The holding that section 115 (g) does not apply to the distribution of April 1, 1943, disposes of the main issue in the case since the parties are agreed upon the fair market value of the properties which were the subject of the distribution and the briefs indicate that they are also in agreement upon the amount of cost of the stock to be offset against the distribution in computing the capital gains. The respondent, on page 40 of his brief, says that the applicable cost in each case is $ 41,410.44 and the petitioners, at page 84 of their brief, contend that that same amount is the proper amount in each case. The parties disagree as to the accumulated earnings of Texon, but the question thus raised as an alternative issue need not be decided unless it is first determined that the transaction comes within section 115 (g).
The petitioners contend that the Commissioner has misread and likewise misapplied section 117 (j) (2). The portion of that provision under consideration is as follows:
General rule. -- If, during the taxable year, the recognized gains upon sales or exchanges1952 U.S. Tax Ct. LEXIS 261">*274 of property used in the trade or business, plus the recognized gains from the compulsory or involuntary conversion * * * of property used in the trade or business and capital assets held for more than 6 months into other property or money, exceed the recognized losses from such sales, exchanges, and conversions, such gains and losses shall be considered as gains and losses from sales or exchanges of capital assets held for more than 6 months.
The effect of the returns filed by the petitioners was to deduct in full losses of $ 2,277.04 (from sales of two horses) and $ 2,829.16 (from the death of a horse). The Commissioner, in determining the deficiencies, regarded the loss from the death of the horse as a loss from an involuntary conversion. He also considered the horses to be property used in the racing business of the petitioners. The petitioners agree with the Commissioner that the race horses were property used in the business of the petitioners within the meaning of section 117 (j) (1). The petitioners reported long term gains for 1943 on sales of capital assets held for more than 6 months. Those gains, giving effect to the holding on the main issue, were substantially in1952 U.S. Tax Ct. LEXIS 261">*275 excess of losses of the type mentioned in section 117 (j) (2). The Commissioner, in order to "consider" the losses on the horses losses from sales "of capital assets held for more than 6 months" within the meaning of section 117 (j) (2), offset against those losses all of the gains from sales of capital 17 T.C. 1420">*1426 assets held for more than 6 months. The petitioners contend that he had no authority to do that since the only gains from capital assets to be added in the formula of section 117 (j) (2) are those resulting from the compulsory or involuntary conversion of such assets, not those from free sales. All of the capital gains of the petitioners were from free sales and none were from the compulsory or involuntary conversion of capital assets. The Commissioner has read and applied that provision as if it were in the following form:
If, during the taxable year, the recognized gains upon sales or exchanges of property used in the trade or business, plus the recognized gains from the compulsory or involuntary conversion * * * of property used in the trade or business into other property or money and the recognized gains upon sales or exchanges of capital assets held for1952 U.S. Tax Ct. LEXIS 261">*276 more than 6 months, exceed the recognized losses from such sales, exchanges, and conversions, such gains and losses shall be considered as gains and losses from sales or exchanges of capital assets held for more than 6 months.
The words "into other property or money" appear after, not before, the mention of capital assets and refer to all of that part of the sentence after the word "plus." The other underlined words do not appear at all. The Commissioner's interpretation of section 117 (j) (2) is untenable and is contrary to his Regulations 111, section 29.117-7. A proper interpretation is that not all gains on capital assets held for more than 6 months are to be considered for the purpose of section 117 (j) (2) but only the recognized gains from the compulsory or involuntary conversion of capital assets held for more than 6 months into other property or money. The petitioners had no such gains in 1943. The section does not apply. The petitioners correctly reported their losses on the race horses.
Decisions will be entered under Rule 50.
Footnotes
1. Proceedings of the following petitioners are consolidated herewith: Georgia E. Sullivan, Docket No. 23027; B. C. Garnett, Docket No. 23028; and Betty K. S. Garnett, Docket No. 23029.↩