*1412 Pro rata redemption by a corporation at book value of a portion of its preferred stock, with the stipulation that the proceeds would first be applied to discharge indebtedness of the stockholders to the corporation, held, on the facts essentially equivalent to the distribution of a taxable dividend to the extent of earnings available therefor. Revenue Act of 1936, sec. 115(g).
*1078 These proceedings were brought for a redetermination of deficiencies in income tax for the year 1936 in the following amounts:
| A. E. Levit | $389.28 |
| Estate of Leo J. Clayburgh, Deceased, Virginia A. Clayburgh, Executrix | 8,487.99 |
| Virginia A. Clayburgh | 2,034.21 |
The single issue is whether a portion of the consideration received by petitioners in 1936 in redemption of shares of Clayburgh Brothers, a Nevada corporation, should be treated as essentially equivalent to the distribution of an ordinary dividend under section 115(g) of the Revenue Act of 1936, or the entire consideration regarded as a distribution in partial*1413 liquidation under section 115(c).
FINDINGS OF FACT.
The facts have been stipulated in part and as so stipulated are hereby found accordingly. The material parts are set out hereinafter, together with other findings which we have made from the record presented at the hearing.
Prior to 1914 Leo J. Clayburgh, referred to hereinafter for convenience as the decedent and as one of the petitioners, his brother Herbert Clayburgh, and Arthur P. Epstein, were copartners engaged in the business of silk merchants at San Francisco and Los Angeles, California, a business that was built up primarily by decedent. On January 27, 1914, a California corporation, hereinafter referred to as the old corporation, was organized and took over the business of the partnership. From March 1922 until its dissolution in April 1928, the old corporation had issued and outstanding 6,000 shares of $100 par value stock, all of one class. Prior to 1928 decedent had purchased the holdings of his brother Herbert, and in March 1928 he and his wife Virginia together owned 3,550 shares, or approximately 60 percent of the total. Epstein's holdings were approximately 20 percent of the total.
In 1920 decedent*1414 was afflicted with a disease, encephalitis, which gradually incapacitated him, and the responsibility of the business fell more and more on Epstein's shoulders, who as time went on felt that he was not receiving adequate compensation for the work he was doing. In order to secure more compensation to Epstein, and for the purpose of capitalizing the accumulated surplus that had been actively employed in the business for some time, an agreement was entered into on March 5, 1928, between decedent and Epstein whereby a new corporation was to be organized and the old one dissolved. On March 16, 1928, pursuant to this agreement, Clayburgh Brothers, Inc., hereinafter referred to as the new corporation, was organized under the laws of the State of Nevada, with its principal place of business at San *1079 Francisco and with an authorized capital stock of 10,000 no par value common shares and 10,000 preferred shares of $100 par value entitled to cumulative dividends of 7 percent per annum. On the same date, pursuant to the plan of reorganization, the old corporation transferred to the new corporation as of the preceding December 1 all its assets, subject to its liabilities, in consideration*1415 for 8,500 preferred and 8,500 common shares of the new corporation, which shares were distributed by the old corporation to its shareholders upon liquidation in April 1928, in proportion to their holdings of old corporation stock. This transaction constituted a reorganization in which no gain or loss was recognized. Immediately thereafter decedent for $1,500 sold to Epstein 2,550 of the common shares he received in the reorganization, as a result of which Epstein owned approximately 50 percent of the outstanding common shares. The salaries of decedent and Epstein were fixed in the agreement at $18,000 per annum.
For at least six years prior to the reorganization the old corporation had been successful financially. An accumulated earned surplus of about $250,000 was maintained by the corporation for some time prior to 1928, which together with its capital was actively employed in the business. Excluding this surplus, the average net profits for each of the six years preceding 1928 were $104,000, and it was the policy of the corporation to distribute all its current earnings as cash dividends to the shareholders and in the form of a bonus to those actively engaged in the business. *1416 The corporation was engaged in the business of converting raw silk cloth and purchasing finished silk cloth from mills, and selling both classes of merchandise to the trade on the Pacific Coast. Its capital and surplus being insufficient to carry the required large inventories and accounts receivable, particularly during peak seasons, the corporation borrowed substantial sums from the Bank of California. It was the custom of the board of directors of the corporation by resolution to authorize certain officers to borrow amounts in behalf of the corporation and to fix the maximum amounts that might be borrowed at any one time. The maximum during 1924 was $450,000 and from 1925 to 1928, $550,000. During February of 1927 and 1928 the borrowings reached the authorized limit, and except for two months during 1927 and 1928 the corporation owed in excess of $100,000 to the bank. The inventory from November 1925 to March 1928 fell below $527,000 in only four months, and at one time was as high as $933,000. During the same period the cash on hand averaged from $20,000 to $40,000.
On the date of reorganization the undistributed surplus of the old corporation, as recorded on its books, *1417 was $255,000 and its capital issued and outstanding $600,000. In setting up its books as of December *1080 1, 1927, the new corporation assigned the sum of $850,000 as capital to the 8,500 shares of preferred stock, $500 to its 8,500 shares of common stock, and the balance of $4,500 as paid-in surplus. The capital of the new corporation remained unchanged until April 29, 1931, when 250 shares of preferred at $100 each and 250 shares of common for a total of $97.50 were issued and sold on credit to one Biehl, an officer or employee of the corporation, a total addition to capital of $25,097.50.
The combined sales of both corporations for the fiscal year 1928 and the annual sales of the new corporation to and including the fiscal year 1936 are set forth in the following table, together with the profit or loss, dividends paid, and surplus or deficit for each fiscal year:
| Year ended Nov. 30 | Sales | Profit or loss | Dividends paid | Surplus or deficit |
| 1928 | $3,634,838 | $115,398 | $44,625 | $75,273 |
| 1929 | 3,370,327 | 96,734 | 89,250 | 82,758 |
| 1930 | 3,097,238 | (1,838) | 61,625 | 19,295 |
| 1931 | 3,091,194 | (20,126) | 30,187 | (31,019) |
| 1932 | 2,869,772 | (110,481) | (141,500) | |
| 1933 | 1,856,733 | 46,749 | 80,248 | |
| 1934 | 2,101,903 | 10,389 | 49,000 | 41,638 |
| 1935 | 2,208,806 | 36,480 | 61,250 | 16,868 |
| 1936 | 2,418,380 | 59,260 | 49,000 | 27,129 |
*1418 All such dividends were paid on preferred shares, except that of the dividends paid in 1929, $39,750 was paid on common shares and of the dividends paid in 1930, $17,000 was paid on common shares.
By reason of the deficit of $141,500 which existed at the close of the 1932 fiscal year, the capital of the corporation was reduced on February 11, 1933, pursuant to resolutions of the board of directors and the stockholders, from $875,597.50 to $700,597.50. This reduction was effected by the surrender by each preferred shareholder without consideration of 20 percent of his preferred stock, a total surrender of 1,750 shares, upon which at that date dividends of $14 per share had accrued, were unpaid, and were forfeited. The amount of the reduction, $175,000, was debited to capital and credited to surplus on the corporation's books.
The losses and the decline in the volume of sales beginning with the year 1930 were due primarily to the general drop in prices caused by the depression and to the advent in that year of rayons. The wholesale price of rayons was approximately 50 percent that of silks, with a consequent reduction in the margin of profits, and of the amount of capital*1419 required by the corporation to handle them. At the same time a change in the nature of the merchandise dealt in resulted in a large part of the corporation's business being transferred to a consignment basis. In addition the corporation increased the cash discounts which it allowed customers and the volume of accounts *1081 receivable was substantially reduced. As a consequence of these circumstances, from about 1930 the corporation required less capital than was needed in former years. In 1931 the corporation entered the commission weaving business, which proved unprofitable, and in 1933 that was discontinued. Thereafter the corporation engeged only as jobbers and as agents for manufacturers.
During the existence of the old and new corporations, accounts were maintained on the corporate books in the names of the three petitioners and Epstein, as well as in the names of other shareholders, wherein were entered various personal charges and credits. The credits consisted in part of salary and dividends, although not all of the salaries and dividends were credited to the accounts. The debits represented withdrawals from the corporation, and the debit balances carried*1420 interest at rates varying from 4 to 5 1/2 percent. The debit balances, except where credit balances are noted, in petitioners' accounts on the dates listed were as follows:
| Debit balances | |||
| Date | Leo J. Clayburgh | Virginia Clayburgh | Levit |
| Nov. 30, 1924 | (Cr.) $12,673.47 | ||
| Nov. 30, 1925 | 14,286.57 | (Cr.) $1,109.95 | |
| Nov. 30, 1926 | 8,798.86 | (Cr.) 1,558.27 | $4,160.19 |
| Nov. 30, 1927 | 45,332.31 | 6,420.14 | 4,739.73 |
| Jan. 31, 1928 | (Cr.) 471.00 | ||
| Mar. 12, 1928 | 7,575.13 | ||
| Apr. 30, 1928 | (Cr.) 1,033.40 | ||
| Nov. 30, 1928 | 32,597.28 | 3,628.44 | 2,689.23 |
| Nov. 30, 1929 | 59,119.74 | 2,801.21 | |
| Nov. 30, 1930 | 68,262.97 | 3,339.86 | |
| Nov. 30, 1931 | 93,025.22 | 49.55 | 4,964.93 |
| Nov. 30, 1932 | 102,936.29 | 5,990.21 | |
| Nov. 30, 1933 | 112,027.85 | 8,742.46 | |
| Nov. 30, 1934 | 110,983.17 | 7,308.02 | |
| Nov. 30, 1935 | 91,646.54 | 1,930.24 | 4,566.90 |
| Nov. 30, 1936 | 93,233.29 | 1,937.40 | 3,427.36 |
| Dec. 14, 1936 | 93,233.29 | 2,126.32 | 3,446.46 |
By reason of the accumulation of unpaid dividends on the preferred stock, amounting to $17.50 per share in 1936, and of the fact that no common stock dividends had been paid since 1930, one of the principal purposes of the 1928 reoganization, namely, *1421 the receipt of additional compensation by Epstein by way of common stock dividends, was not realized. He therefore consulted Herbert Clayburgh early in 1936 and requested a further adjustment. Epstein was considering an offer for his services from the Celanese Co. and the Clayburghs were contemplating the investment of their capital in preferred stocks of other corporations. Discussions extended over some weeks, and inquiry was made into the advisability of continuing the business. This question was decided in the affirmative upon the recommendation of a disinterested survey.
*1082 In July of 1936 Epstein, through his attorney, proposed to the attorney representing the Clayburgh interests that the following changes be made:
(1) Retransfer of the 2,550 common shares from Epstein to decedent.
(2) Cancellation of the unpaid dividends on the preferred stock.
(3) Elimination of decedent's salary, then amounting to $16,200 a year, but at the same time assuring decedent a return of at least $29,000 per year, the amount he would receive if the 7 percent dividend on the preferred stock he owned was paid in full; and further, that decedent's salary be paid to Epstein as*1422 a bonus.
The Clayburghs being apprehensive about decedent's large indebtedness to the corporation, the attorney representing decedent pointed out that he would be unable to liquidate this debt if he received only $29,000 annually. The attorney considered the indebtedness a constant threat to decedent's investment. In the latter part of October, therefore, he proposed that all indebtedness to the corporation be liquidated by the payment of cash or the surrender of preferred stock, and that accumulated dividends be canceled. Epstein was indifferent to these proposals, being primarily interested in the reduction or elimination of decedent's salary in view of the fact that decedent performed no services for the corporation and had not done so for many years.
As a result of negotiations it was finally agreed at the end of November that on December 3, 1936, the preferred stock outstanding would be reduced from 7,000 shares to 5,100 shares; that the 5,100 new shares to be issued and exchanged for the old would pay 8 percent dividends only if earned; that the reduction would be accomplished through the surrender by each stockholder of 25 percent of his preferred stock, with the exception*1423 of Biehl, who would surrender 205 of his 220 preferred and in addition his 250 common shares; that the preferred shares would be retired at the book value of $103.50 per share, $100 being charged to capital account and $3.50 to surplus; that the accumulated dividends would be canceled; that the stockholders owing money to the corporation would have the purchase price credited to their accounts and the balance paid in cash; that stockholders thereafter would not be permitted to borrow from the corporation; that Epstein's salary would be increased from $16,200 to $20,000 per year; and that decedent's salary would be reduced to $6,000, but that if the dividends of the Clayburgh family in any year were less than $10,200 the corporation would pay them the difference between the dividends actually paid and $10,200.
The aggregate price paid by the corporation for the preferred stock was $196,650. Pursuant to this agreement, decedent surrendered 724 1/2 shares of preferred stock and on December 14, 1936, his account *1083 was credited with $74,985.75, leaving a debit balance of $18,273.42 Petitioner Virginia Clayburgh surrendered 256 1/2 shares and her account was credited with*1424 $26,547.75, leaving a credit balance of $24,421.43, $18,273.42 of which was transferred to decedent's account to balance it; and the balance of $6,148.01 was paid her in cash. Petitioner Levit surrendered 90 shares and his account was credited with $9,315, leaving a credit balance of $5,868.54, which was paid in cash. The total indebtedness of all stockholders to the corporation amounted to approximately $150,000 and the difference between that amount and the $196,650 required to redeem the preferred stock was paid in cash.
On their Federal income tax returns for 1936 petitioners reported the gain upon this transaction as the difference between the price received and the adjusted basis, treating the redemption as a distribution in partial liquidation. Respondent in determining the deficiencies eliminated from taxable income any profit from the retirement of the stock reported on the returns, and included as dividends approximately 52 percent of the amount received by each petitioner on the redemption of his preferred stock, on the following basis:
| Surplus of old corporation | $255,000.00 |
| Net earnings 1928-1936 | 232,566.68 |
| 487,566.68 | |
| Dividends paid 1928-1936 | 384,937.50 |
| Earnings available for distribution | 102,629.18 |
*1425 Virginia Clayburgh in her return computed her gain upon an adjusted basis of $22,500.16, whereas the correct adjusted basis is stipulated to be $28,407.38; and decedent computed his gain upon an adjusted basis of $70,689.46, which, according to the stipulation, should be $63,533.14.
The redemption and distribution by Clayburgh Bros., Inc., in 1936 was made at such time and in such manner as to be essentially equivalent to the distribution of a taxable dividend to the extent of $102,629.18.
OPINION.
OPPER: It has been frequently asserted that solution of the question presented here - whether a distribution in partial liquidation is such in time and manner as in substance to approximate a dividend - must rest upon the particular facts of each individual case. . It is thus of less than the usual value to attempt an extended discussion of the precedents. Even the general *1084 rules established are no more dispositive than the language of the statute 1 itself.
*1426 All that may be done is to examine with care the circumstances surrounding the transaction for the purpose of determining the extent of essential equivalence, which is the only test the statute describes. It is sometimes urged, as petitioners do here, that our attention should be focused on the original issuance of the stock and not on its redemption, so that if we can find no scheme or plan relating the two, the equivalence must be absent without further investigation. See . Even this helpful simplification of the problem, however, is unacceptable, since the rule of the Patty case had been found to be too broad for adoption by other courts or by this Board. See e.g. ; affd. (C.C.A., 4th Cir.), ; ; ; ;
One of the tests which is more favored is whether the redemption was apparently dictated by the reasonable needs of the business or*1427 whether, on the other hand, it originated with or was designed for the benefit of the stockholders who received its fruits. W. & K. Holding corporation,; Cf. ; affd. (C.C.A. 7th Cir.), ; certiorari denied, ; . It is true that most, if not all, of the cases applying that test have found other circumstances as well to support the result. But essentially we think the test applicable by its own weight and that if applied it will be decisive of the present controversy.
Without reiterating in detail the circumstances surrounding the redemption, which appear fully in the findings of fact, it is we think sufficient to quote here a portion of petitioners' proposed findings which seem to us to summarize fairly the immediate background of the transaction:
* * * there was considerable apprehension on the part of the Clayburghs [petitioners] with respect to the large indebtedness of Mr. Clayburgh to the corporation representing monies loaned to him over a period*1428 of years, only a part of which had been repaid. (Stip. par. XVI) This presented a constant threat to Mr. Clayburgh's investment which Mr. Ackerman [the Clayburghs' lawyer] felt should be eliminated and resulted in his proposal that Leo J. Clayburgh surrender sufficient preferred stock to satisfy this indebtedness.
*1085 After further negotiations a plan was evolved which * * * provided first for the redemption of 25% of the outstanding preferred stock, the redemption price to be applied first in each case to the satisfaction of the stockholder's indebtedness to the company, * * * It thus appears that the initiative for the redemption in question originated with the stockholders who were to receive the distribution; and that its purpose was primarily to benefit them by furnishing a means of paying off their debts to the corporation.
Petitioners' proposed findings also assert that "in determining the amounts of the reduction to be made in the preferred stock there was taken into consideration the amount of capital required by the business as well as the amounts necessary to discharge the indebtedness of stockholders to the corporation." This may be so as far as it goes, *1429 but an examination of the record demonstrates that the consideration given to the needs of the business was a negative and not an affirmative factor. There is nothing to indicate that those actively interested in the corporation's management were proponents of the redemption plan. 2 Their concern was merely to safeguard the venture by assuring that the plan, if agreed to, would not unduly weaken the corporation's capital structure. This supplies the distinction from such cases as
If the indebtedness, which struck the stockholders as so precarious that a means should be found to pay it, had been merely forgiven by the corporation, it is clear a taxable dividend to the stockholders would have been the result. . And cf. *1430 . That course was impossible here for two reasons. The first was that the debtor stockholders were not the only interested parties. Any plan designed to cancel the indebtedness had at the same time to preserve the interests in the corporation of all of the stockholders in their proper proportions. This result the pro rata redemption of the preferred stock accomplished. The second difficulty was that there was at the time no surplus available for distribution. This, however, was due in part to an earlier capitalization of earnings, which took the form of a reorganization of a predecessor company, "the effect" of which, as petitioners observe in their brief "is recognized to be the same" as a stock dividend. And see ; certiorari denied, . This absence of available surplus could be overcome, as it was, by reversing the process of capitalization and freeing the captured earnings for distribution to the stockholders *1086 by means of redeeming the stock which had originally capitalized them.
*1431 Both of the factors, therefore, which characterized the plan in its final form were those which are familiar in situations of this kind, and which emphasize rather than dim the aspect of a dividend. That the distribution was pro rata to the stockholders is one of the characteristics acteristics of cases found to fall within the section. See . And that a taxable distribution may involve a reversal of the process of capitalization of earnings is a possibility which the parenthetical phrase at the opening of the section itself recognizes. Giving full weight to the origin, purpose, and development of this redemption, we think the circumstances as a whole bring it within the terms of section 115(g) and that it was, considering its time and manner, essentially equvalent to the distribution of a taxable dividend. ;;;
It is true there were other phases of corporate action taken at the same time which were quite clearly dictated by the necessities of the corporation's position. Elimination*1432 of the cumulative provision of the preferred stock, renunciation by the stockholders of the accumulated preferred dividends, and reduction of a nonessential salary item fall into that category. But none of these steps was connected, except indirectly, with the stock redemption. They could have been accomplished without it and by themselves they would not have achieved the purpose sought by redeeming the stock. It is that phase of the entire transaction with which we are concerned and as to that the other aspects mentioned are insufficient to overturn the considerations already discussed.
Decision will be entered under Rule 50.
Footnotes
1. SEC. 115. [Act 1936.] 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. The witness Epstein, manager and moving spirit of the corporation, testified on cross examination:
"The part of the plan was to - the consideration was that by doing this we would accomplish the liquidation of the monies that were owed by the parties mentioned." ↩