*264 Decisions will be entered under Rule 50.
1. In 1948 petitioners formed a corporation for the purpose of constructing a mulitple-unit housing project. Construction was financed by an F. H. A.-insured mortgage loan, and the amount of such loan substantially exceeded costs of construction. More than 6 months after the formation of the corporation, petitioners caused the corporation to redeem and retire part of their stock in proportion to their holdings, a part of the cash used for the redemption being out of borrowed funds. Held, the gain to petitioners is taxable at capital gains rates pursuant to the provisions of section 115 (d), 1939 Code.
2. Held, deficiency for the year 1948 in Docket No. 49003 is barred by the statute of limitations.
3. Respondent determined in his deficiency notice that the proceeds of certain sales and redemptions of stock were ordinary income to petitioners under section 22 (a), 1939 Code. At the hearing, for the first time, he indicated that he was relying on section 117 (m) to support his determination. Held, respondent's reliance on section 117 (m) requires proof of new matter, and as to such new matter respondent has the burden of *265 proof. Sheldon Tauber, 24 T. C. 179, followed. Held, further, respondent has failed to prove that more than 70 per cent of the gain to petitioners was attributable to the property constructed by the corporations herein.
*1059 The respondent determined deficiencies in the income taxes of petitioners and additions thereto under section 294 (d), 1939 Code, for the years and in amounts as follows:
| Thomas and Mary W. Wilson, Docket No. 49001 | ||
| Year | Deficiency | Sec. 294 (d) |
| 1948 | $ 23,370.10 | |
| 1949 | 26,238.18 | |
| 1950 | 31,365.98 | $ 3,238.29 |
| 1951 | 14,711.00 | 2,260.06 |
| Edward N. and Helene H. Richards, Docket No. 49003 | |
| Year | Deficiency |
| 1948 | $ 24,270.24 |
| 1949 | 32,196.02 |
| 1950 | 69,862.71 |
| 1951 | 29,654.92 |
The parties have made certain stipulations and concessions to which effect will be given on the Rule 50 computation. The issues remaining for our decision are:
1. Whether certain corporate distributions to petitioners in 1948 in pro rata redemption of part of their stock were taxable to them as capital gains, as reported by petitioners, or as ordinary income, as determined by respondent;
2. Whether the deficiency of petitioners Edward N. and Helene H. Richards for the year 1948 is barred by the statute of limitations; and
3. Whether gains realized by petitioners in 1950 from sales of stock and from distributions in redemption of stock are taxable to them as capital gains, as reported by petitioners, or ordinary income, as determined by respondent.
FINDINGS OF FACT.
Most of the facts have been stipulated and are found as stipulated.
Petitioners Thomas Wilson and Mary W. Wilson, husband and wife, and petitioners Edward N. Richards and Helene H. Richards, husband and wife, reside in Raleigh, North Carolina. For the taxable years 1948-1951*267 the Wilsons and the Richards filed their respective joint returns with the collector of internal revenue for the district of North Carolina.
*1060 During the taxable years involved Richards and Wilson were engaged in the contracting business involving primarily the building of houses and apartment units as members of several joint ventures. They were also officers and stockholders in various corporations, some of which were engaged in the construction business.
Edward N. Richards, at the time of the hearing, was 44 years of age and had been engaged in the construction business for 22 years. He specialized in construction engineering in college and is highly skilled in the construction business. Thomas Wilson was 55 years of age at the time of the hearing. After leaving college he was in the business of developing and selling real estate until 1934. In 1935 he became a valuator for the Federal Housing Administration (sometimes hereinafter referred to as F. H. A.), and in 1937 he became chief valuator for the F. H. A. in North Carolina, which position he retained until 1943, when he returned to the private real estate and building business.
Brookwood, Inc. (sometimes hereinafter*268 referred to as Brookwood), is a North Carolina corporation organized January 5, 1948, to build for rent single and duplex houses in the vicinity of Winston-Salem, North Carolina. On January 8, 1948, the outstanding capital stock of the corporation was held as follows:
| Common | Preferred | |
| J. W. York | 3 | 62 1/2 |
| E. N. Richards | 6 | 125 |
| Thomas Wilson | 3 | 62 1/2 |
The common stock, having no par value, was issued to the above persons for cash at $ 25 per share. The preferred stock, having a par value of $ 100, was acquired as follows: J. W. York, E. N. Richards, and Thomas Wilson held a one-fourth, one-half, and one-fourth interest, respectively, in the title to certain land which they acquired for a total cost of $ 50,000, and which was subject to indebtedness of $ 50,000. This land was transferred to Brookwood, subject to the $ 50,000 indebtedness, which Brookwood assumed, in exchange for the issuance of the aforesaid preferred stock to J. W. York, E. N. Richards, and Thomas Wilson in proportion to their respective interests in the land. The basis of the common stock in the hands of the shareholders was $ 25 per share, and the basis of the preferred stock, being a substituted*269 basis, was zero.
Construction of the Brookwood project progressed rapidly due in large measure to the availability of an efficient labor force and to favorable weather conditions. The demand for housing was such at the time that as each unit was completed it was rented immediately. The net effect was to cut expected construction and overhead costs substantially.
*1061 Pursuant to a resolution of the board of directors of Brookwood, at a meeting held October 27, 1948, the following plan was put into effect: The outstanding preferred stock was retired at par, Wilson receiving $ 6,250 for his stock and Richards $ 12,500 for his; the 12 shares of no-par-value common stock were exchanged for 175,000 shares of $ 1-par-value common stock, whereby Wilson received 43,750 shares and Richards 87,500; and 75,000 of the new shares of common stock were immediately redeemed for cash at par and retired, Wilson receiving $ 18,750 and Richards $ 37,500. On October 27, 1948, when the foregoing transactions occurred, the corporation had no accumulated or current earnings and profits. Wilson and Richards were officers and directors of Brookwood at that time, and participated in the meeting.
Thomas*270 and Mary W. Wilson jointly and Edward N. and Helene H. Richards jointly reported the proceeds from the redemption of the holdings of the respective husbands as long-term capital gains in their 1948 returns. The respondent in his deficiency notices has determined that the entire redemption price of $ 25,000 in the case of the Wilsons and $ 50,000 in the case of the Richards was ordinary income.
Edward N. and Helene H. Richards reported gross income of $ 43,331.01 in their joint return for 1948. The deficiency notice in Docket No. 49003 was mailed to the Richards more than 3 but less than 5 years after the 1948 return was filed.
Immediately prior to March 1, 1949, Richards owned 50,000 shares of Brookwood common stock. On March 1, 1949, he transferred 12,500 of these shares to his wife, Helene, and he sold 12,500 shares to Mary W. Wilson for a consideration of $ 5,000.
By letter dated February 9, 1950, Richards offered to sell his 25,000 remaining shares of stock in Brookwood, Inc., and the 12,500 shares held by his wife to the board of directors of the corporation for a total consideration of $ 12,162. He simultaneously tendered his resignation as president and director of Brookwood, *271 Inc., to be effective upon the acceptance of the offer to sell. At a special meeting of the board of directors, held February 9, 1950, the terms of Richards' letter were accepted, and the 37,500 shares were purchased and retired by the corporation on February 13. In their joint return for 1950, Edward N. and Helene H. Richards reported the proceeds of the above sale, $ 12,162, as long-term capital gain. Respondent, in determining the deficiency for 1950, held that the entire amount of $ 12,162 was ordinary income of Richards, taxable under the provisions of section 22 (a).
After the above transactions, the capital stock of Brookwood, Inc., was held, 25,000 shares by Wilson and 12,500 shares by Mary *1062 W. Wilson. Immediately prior to May 1, 1950, Wilson sold 11,000 shares of common stock of Brookwood to F. B. Smitherman and 9,500 shares to Bert L. Bennett, Jr., for a total consideration of $ 13,757.24. Wilson offered to sell his remaining 4,500 shares in Brookwood to the corporation for $ 2,728.29, and at a meeting of the board of directors held May 1, 1950, the offer was accepted, and the stock was purchased by the corporation and retired. As at April 30, 1950, Brookwood, *272 Inc., had accumulated and current earnings and profits totaling $ 6,512.70.
Immediately prior to May 1, 1950, Mary W. Wilson sold to Bert L. Bennett, Jr., the 12,500 shares of Brookwood which she had acquired from Richards for $ 5,000 in 1949.
In their return for 1950 the Wilsons reported the proceeds of the sales of stock to Smitherman and Bennett and the transfer of Wilson's remaining shares to Brookwood, less $ 887.69 for expenses of sale, as long-term capital gain and included one-half thereof in net income. The respondent, in determining the deficiency, made no adjustment of the gain realized by Mary W. Wilson, but determined that the total amount of $ 16,485.53 received by Wilson was ordinary income under section 22 (a).
Greenway Apartments, Inc. (hereinafter sometimes referred to as Greenway), is a corporation organized under the laws of the State of North Carolina on May 4, 1949, for the purpose of building and renting an apartment project in Winston-Salem, North Carolina. The capital stock issued by the corporation was held as follows:
| $ 1-par-value | ||
| Class B | Class A | |
| E. N. Richards | 33,871 1/2 | 148 |
| Helene Richards | 2 | |
| Thomas Wilson | 33,871 1/2 | 148 |
| Mary W. Wilson | 2 |
*273 The class A stock was issued for cash at par value. Of the class B stock, 55,000 shares were issued at par for land (owned in equal shares by the transferors Edward N. Richards and Thomas Wilson), which cost the transferors $ 10,962.84, and 12,743 shares were issued, one-half to each, for $ 12,743 cash. The basis of the class A stock to petitioners was $ 1 per share; the basis of all the class B stock was $ 23,705.84, one-half of which ($ 11,852.92) was allocable to Wilson and the other half to Richards.
At a special meeting held May 1, 1950, the board of directors of Greenway authorized the redemption and retirement of all the outstanding class B stock of the corporation for a total consideration of $ 115,000. This was done on May 31, 1950. Richards and Wilson each received $ 57,500, and on their respective joint returns for the year *1063 1950, they reported the excess of the redemption price over their respective bases, $ 45,647.08, as long-term capital gain. Respondent in his deficiency notices has included the entire redemption price as ordinary income of each petitioner. As at May 31, 1950, Greenway had no accumulated or current earnings and profits.
Washington Terrace*274 Apartments, Inc. (sometimes hereinafter referred to as Washington Terrace), was organized under the laws of the State of North Carolina on December 30, 1949, for the purpose of building and renting an apartment project for colored people in Raleigh, North Carolina.
The outstanding capital stock of Washington Terrace immediately prior to December 30, 1950, consisted of 300 shares of class A stock of $ 1 par value, and 839.64 shares of class B stock of $ 100 par value. Richards owned one-half of the outstanding shares in each class and was an officer and director of the corporation; Wilson was not concerned with the Washington Terrace enterprise. Richards had acquired the class A stock from the corporation for $ 1 per share, or for a total consideration of $ 150. On June 21, 1950, he acquired the class B stock for $ 3,750 cash from Leif Valand, who had acquired it for architectural services. Richards' basis in the class A stock was $ 150, and in the class B stock, $ 3,750.
On December 30, 1950, at a special meeting, the board of directors of Washington Terrace accepted Richards' tendered resignation as an officer and director of the corporation and concurrently accepted his offer*275 to sell all of his class A and class B stock for $ 90,000. On the same day the stock was redeemed and retired. The corporation had no earnings and profits immediately prior to the redemption.
Richards, in his joint return for 1950, reported the excess of the redemption price of the stock over his basis, $ 86,100, as long-term capital gain. Respondent has included the entire selling price of $ 90,000 in the Richards' gross income for 1950.
In his determination of the deficiency against the Richards for 1950, respondent gave the following explanation for his adjustment of the taxable income Richards realized in connection with the redemption of stock of the three corporations:
It has been determined that Mr. Richards realized during the taxable year ordinary income in the amount of $ 159,662.00 of which $ 12,162.00 was received with respect to 37,500 shares of Brookwood, Incorporated stock, $ 57,500.00 received with respect to 33,871.5 shares of Class B stock of Greenway Apartments, and $ 90,000.00 received with respect to Washington Terrace Apartments stock.
It is held this amount is taxable under the provisions of section 22 (a) of the Internal Revenue Code. Since you reported*276 in your return for this year a long-term capital gain of $ 71,954.54 (50% of $ 45,647.08, $ 86,100.00, $ 8,109.00 *1064 and. $ 4,053.00) in respect to these transactions, your net income has been increased by the amount of $ 87,707.46.
A like explanation was made in connection with the adjustments made for income realized by Wilson in the redemption of his stock of Brookwood and Greenway, except that as to Brookwood the amounts differed. No statement appears in the deficiency notices to petitioners that the gain was taxable to them pursuant to the provisions of section 117 (m) of the Internal Revenue Code of 1939.
The housing projects constructed by Brookwood, Greenway, and Washington Terrace, respectively, were financed by F. H. A.-insured mortgage loans. In each instance, the amount of the mortgage loans exceeded construction costs. The funds used by the corporations to effect the above-described purchases and redemptions of stock were traceable to the following sources: Gross rentals, build-up of depreciation reserves, and the excess of amounts borrowed under the mortgage loans over costs of construction.
OPINION.
The deficiencies herein for the year 1948 result in part*277 from respondent's determination that the amounts realized by petitioners from the distributions in partial redemption of stock made by Brookwood, Inc., on October 27, 1948, resulted in ordinary income to them, and not long-term capital gain, as reported by petitioners on their respective joint returns for that year. Respondent bases his position on sections 22 (a) and 115 (a) of the Internal Revenue Code of 1939.
At the time of these distributions, Brookwood, Inc., had no accumulated earnings and profits. Therefore, the provisions of sections 115 (a) and 115 (b) have no applicability. Respondent advances the theory that for a corporate distribution to be "out of capital," within the meaning of section 115 (d), it must leave the capital of the corporation "impaired," and he argues on brief:
The earnings or profits account of the distributing corporation is not the critical factor in determining whether a distribution has impaired capital. The fact that a distribution is not out of earnings or profits does not compel a conclusion that it is out of capital. * * *
This Court has recently rejected a similar contention of respondent in the case of George M. Gross, 23 T. C. 756*278 (on appeal, C. A. 2). In that case, various corporations had been organized to construct apartment projects in the vicinity of New York City. These apartments were covered by F. H. A.-insured mortgage loans, and the amount of the loans exceeded the costs of construction in each instance. At various times prior to 1950, the corporations made cash distributions *1065 to their shareholders. The sources of such distributions, where there were no earnings and profits, were current gross rentals, build-up of depreciation reserves, excess of funds borrowed over costs of construction, and in some instances premiums on bonds issued by the corporations to certain insurance companies. Respondent argued that these distributions were taxable as ordinary income in accordance with the principles set forth in Commissioner v. Fannie Hirshon Trust, (C. A. 2, 1954) 213 F. 2d 523, certiorari denied 348 U.S. 861">348 U.S. 861, and Commissioner v. Estate of Ida S. Godley, (C. A. 3, 1954) 213 F. 2d 529, certiorari denied 348 U.S. 862">348 U.S. 862. In our opinion in George M. Gross, supra,*279 we set forth in considerable detail the reasons why the distributions there involved were not governed by the Hirshon and Godley decisions in the Courts of Appeals. Nevertheless, respondent argues on brief:
Respondent's position with respect to the distributions of cash in the instant cases is essentially the same as the position taken by him in George M. and Anna Gross, et al. (1955) 23 T. C. No. 97. While recognizing that the Tax Court rejected his position in the Gross cases, supra, respondent respectfully submits that the decision therein was incorrect and continues to maintain his position that the principles enunciated in Commissioner v. Fannie Hirshon Trust, supra, and Commissioner v. Estate of Ida S. Godley, supra, are controlling in the Gross cases and, accordingly, are controlling in the instant cases.
We adhere to our recent decision in George M. Gross, supra, and for the reasons set forth therein, we must reject respondent's position. Accordingly, we hold that, as the corporation had no earnings and profits, the distributions*280 must be applied against and reduce petitioners' bases in the stock, and to the extent that the distributions exceed those bases, such excess is taxable as long-term capital gain. Sec. 115 (d), 1939 Code.
The deficiency in Docket No. 49003 for the year 1948 was determined by the respondent more than 3 years but within 5 years after the petitioners therein filed their joint return. Respondent asserts that the failure of Richards to report the gain realized from redemption of his stock of Brookwood as ordinary income constituted an omission from gross income of an amount in excess of 25 per centum of the gross income reported in the return under section 275 (c), which permits assessment at any time within 5 years after the return was filed. Under the conclusion reached by us the gain was properly reported. It follows that the omission relied upon to extend the period of limitations did not occur and assessment of any deficiency for 1948 is barred.
No issues arise as to the taxable year 1949.
In their respective returns for the year 1950, petitioners reported the gain to them on the sales and redemptions of stock of the various corporations (described fully in our Findings of Fact) *281 as long-term *1066 capital gain. Respondent determined, in his statutory notices of deficiency, that the entire amounts received by petitioners were ordinary income to them under section 22 (a). At the hearing, for the first time, he indicated that to support his determination he was relying on section 117 (m) of the Internal Revenue Code 1939. 1 Petitioners' position is that, on this state of the pleadings, as to any issue relating to section 117 (m), the respondent has assumed the burden of proof. While a statutory notice of deficiency is presumed correct, and a petitioner has the burden of disproving its correctness, when the Commissioner departs from the grounds relied on in his deficiency notice to sustain a theory later raised, he has the burden of proving any new matter raised. Sheldon Tauber, 24 T.C. 179">24 T. C. 179. We think that in the light of the deficiency notices herein, respondent's reliance on section 117 (m) to sustain the deficiencies necessarily requires proof of new matter. Therefore, on the authority of the Tauber case, we hold that, as to issues relating to section 117 (m) respondent has the burden of proof.
*282 Subsection 117 (m) (3) (B) provides that the section shall not apply to the "gain recognized during a taxable year unless more than 70 per centum of such gain is attributable to the property so * * * constructed * * *." It is part of the respondent's burden of proof to establish that more than 70 per cent of the gain to petitioners in each instance is attributable to the property constructed. So far as appears from the record, more than 30 per cent of the gain may have been attributable to factors totally unrelated to the construction by the various corporations in each case. We therefore hold that respondent has failed to meet his burden of proof on the 117 (m) question. W. H. Weaver, 25 T.C. 1067">25 T. C. 1067.
Petitioners correctly reported their gain on the sales and redemptions of stock in Brookwood, Greenway, and Washington Terrace in the year 1950.
Decisions will be entered under Rule 50.
Footnotes
1. Section 117 (m) was added to the Internal Revenue Code of 1939 by section 212 of the Revenue Act of 1950. Its purpose generally is to foreclose the use of certain types of corporations as a means of converting ordinary income into capital gain. To this end, it provides in effect that gain from the sale or exchange of stock in a "collapsible" corporation will be taxed at ordinary income rates. The section defines a collapsible corporation, insofar as is applicable to the facts in the instant case, as a corporation, formed or availed of principally for the construction of property, with a view to the sale or exchange of stock or a distribution to the shareholders, prior to the realization by the corporation of a substantial amount of the income to be derived from the property constructed. Section 117 (m) (3) provides certain limitations on the application of the section, the pertinent one of which, subparagraph (B), provides that:
(B) this subsection shall not apply to the gain recognized during a taxable year unless more than 70 per centum of such gain is attributable to the property so manufactured, constructed, produced, or purchased; * * *
By section 212 (b) of the Revenue Act of 1950, the provisions of 117 (m) are made applicable only to transactions taking place after December 31, 1949. Pat O'Brien, 25 T. C. 376↩.