Stanley H. Brams, Petitioner-appellant, v. Commissioner of Internal Revenue, Respondent-appellee, 734 F.2d 290 (6th Cir. 1984)

The petitioner-taxpayer appeals from a decision of the Tax Court denying a capital gain allowance with respect to certain income. The issues presented on this appeal are, (1) whether the Tax Court correctly held that income received by the taxpayer in exchange for certain stock came within the purview of I.R.C. Sec. 304(a) (1) and was therefore taxable by virtue of Secs. 301, 302, and 316 as a dividend,¹  and (2) whether the Tax Court was correct in holding that the income received by the taxpayer could not be reported on an installment basis. We conclude that the Tax Court properly resolved both issues.

The facts of this case are undisputed. Prior to December 1, 1973, the taxpayer, Stanley H. Brams, owned all of the stock of Labor Trends, Inc. (Labor) and Trends Publishing Company (Trends), and 31.6 percent of the outstanding stock of Brams Communication Services Company (Communication). The taxpayer's two sons owned 52.6 percent of the stock of Communication. The Stanley H. Brams Trust, the income beneficiaries of which were taxpayer's two sons, owned 14.7 percent of the stock of Communication.

All three corporations occupied the same office space, shared many of the same employees and used the same telephones and office equipment. The three corporations each had identical profit sharing plans, which recognized employment time for each corporation as time credited to vesting under all plans.

On December 1, 1973, taxpayer exchanged all of the stock of Trends for 700 shares of stock of Communication. Following this exchange, taxpayer owned directly 34 percent of the stock of Communication as opposed to the 31.6 percent which he had previously owned. Furthermore, after the transaction the taxpayer's sons and the Stanley H. Brams Trust owned 50.8 and 14.2 percent of the stock of Communication respectively.

On December 1, 1973, the same date as the above transaction, taxpayer transferred all of the stock of Labor for cash and cash equivalents, including an interest bearing promissory note payable in installments. Both transactions were part of a plan to combine the operations of the three corporations into Communication. Communication acquired all of taxpayers stock in Labor and was to pay taxpayer $121,977.11, in five installments, in return. In 1973, Communication paid the first installment of 20 percent and gave taxpayer an interest bearing promissory note for the remaining amount. The issues in this case relate to the transfer of the Labor stock to Communication.

At the time Communication acquired the Labor stock, it had earnings and profits in excess of $121,977.11, the price paid for the stock. In each of the years 1974 through 1976, Communication had earnings and profits in excess of the amount paid on the installment obligation.

Taxpayer reported long-term capital gain on the transfer of his Labor stock to Communication. The transaction was reported as an installment sale on the taxpayer's federal income tax returns for 1973, 1974, 1975, and 1976. The Commissioner determined that the transfer of taxpayer's Labor stock to Communication was a distribution in redemption of stock and was taxable as ordinary income. In an amended answer, the Commissioner further determined that the dividend income could not be reported in installments and was entirely includable as income in 1973. The Commissioner, therefore, assessed tax deficiencies against the taxpayer for the years 1973 through 1976. The Tax Court agreed with the Commissioner and entered its decision accordingly on March 31, 1983. The taxpayer thereafter filed a notice of appeal with this Court.

The first issue presented by the taxpayer requires that we determine whether the transfer of the Labor stock to Communication is governed by Sec. 304²  of the Code, and is therefore taxed as a dividend, as the Commissioner contends, or whether the transaction comes within Sec. 351³  of the Code, and is therefore taxed as a capital gain, as the taxpayer contends. The taxpayer's precise argument is that this transaction comes within the literal terms of both Secs. 351 and 304(a) (1) but that Sec. 351 controls. See Commissioner v. Stickney, 399 F.2d 828 (6th Cir. 1968).

Section 351, however, does not apply to this case. In order to apply Sec. 351, the taxpayer would have to show that he owned at least 80 percent of the voting stock of Communication following the transaction. See Sec. 368(c).⁴  The taxpayer, however, owned only 34 percent of the Communication stock directly. He could not be attributed with owning additional stock indirectly because the attribution rules of Sec. 318⁵  do not apply to Sec. 351. By its terms, section 318(a) applies only to "those provisions of this subchapter to which the rules contained in this section are expressly made applicable." (Emphasis added). See also Kern's Bakery of Va. v. Commissioner, 68 T.C. 517, 527 (1977); Berghash v. Commissioner, 43 T.C. 743 (1965) aff'd, 361 F.2d 257 (2d Cir. 1966). Neither section 351 nor 368(c) expressly makes applicable the attribution rules of section 318. Since the taxpayer only owned 34 percent of the stock of Communication he cannot invoke the benefits of Sec. 351. We must therefore determine whether section 304(a) (1) of the Code applies, as the Commissioner contends.

Section 304(a) (1) of the Code was designed to prevent the bailout of corporate earnings at capital gain rates where a shareholder transferred stock of one corporation to another corporation under common control. Section 304(a) (1) treats such a sale as a redemption under Sec. 302 rather than as a sale to an independent party.

In order for Sec. 304(a) (1) to apply to this case, the taxpayer must have been in control of both Labor and Communication prior to the transaction. For purposes of Sec. 304(a), control is defined as "50 percent of the total combined voting power of all classes of stock." Sec. 304(c) (1). Furthermore Sec. 304(a) (1), unlike Sec. 351, takes into consideration the attribution rules of Sec. 318. Sec. 304(c) (2). Accordingly, in addition to the 31.6 percent of the voting stock of Communication which the taxpayer owned directly, he can be attributed with owning certain shares indirectly.

It is undisputed that the taxpayer was in control of Labor prior to the transaction because he owned 100 percent of its stock. Using the attribution rules of Sec. 318, the taxpayer was also in control of Communication. Under Sec. 318 the shares of stock owned by his sons and the shares owned by the trust are attributable to the taxpayer. Sec. 318(a) (1) (B) states that " [a]n individual shall be considered as owning the stock owned, directly or indirectly by ... his children ..." Accordingly, the taxpayer was the constructive owner of the 52.6 percent of Communication's shares owned by his sons.

Section 318 further provides that the stock owned by a trust shall be considered as owned by its beneficiaries, in this case, the taxpayer's sons. Sec. 318(a) (2) (B). Based upon these principles, the taxpayer's sons owned not only the 52.6 percent of the stock of Communication which they owned directly, but also the 14.7 percent owned by the Trust. In total the sons owned 67.3 percent of the stock of Communication prior to the transaction. The taxpayer is attributed with owning the entire 67.3 percent since these shares were owned by his children. Furthermore, he owned 31.6 percent of the stock of Communication directly. The taxpayer, therefore, owned approximately 99 percent of the stock of Communication before the transaction and 100 percent of the stock of Labor. Accordingly, he was in control of both corporations.

After the transaction, the taxpayer owned 34 percent of Communication directly and is attributed under Sec. 318 with owning the 50.8 percent of the stock owned by his sons directly and the 14.2 percent owned by his sons indirectly by virtue of the Trust. Thus the taxpayer owned 99 percent of the stock of Communication after the transaction and was still in "control" under Sec. 304. The net effect of the December 1, 1973 transaction was a distribution of Communication's assets to its shareholder, while the taxpayer retained control of the same corporate resources (now under the single control of Communication). This seems to be the precise situation at which Sec. 304(a) (1) was aimed. In Radnitz v. United States, 294 F.2d 577 (2d Cir. 1961), for example, the Court stated that " [t]he clear intent of this provision [Sec. 304(a) (1) ] is to make all sales of stock to related corporations subject to the rules of section 302." 294 F.2d at 578. (Footnote omitted).

The fact that a transaction is treated as a redemption under Sec. 304(a) (1) is not determinative of whether the amount received by the taxpayer for his Labor stock is to be taxed as ordinary income or capital gain. The character of the income received by the taxpayer must be determined pursuant to Sec. 302.

Section 302(a) provides that if a redemption of stock meets any of the tests provided in Sec. 302(b) the redemption shall be treated as a distribution in exchange for stock and taxed as a capital gain. If, however, Sec. 302(b) does not apply, the transaction will be treated as a distribution under Sec. 301. See Sec. 302(d). The taxpayer contends that Secs. 302(b) (1) and (2) are applicable and that the income received should therefore be taxed at capital gain rates.

Sec. 302(b) (1) provides that a redemption will be treated as a distribution in exchange for stock if it is "not substantially equivalent to a dividend." In determining whether a redemption is "not essentially equivalent to a dividend" the Supreme Court has set forth the following test:

If a corporation distributes property as a simple dividend, the effect is to transfer the property from the company to its shareholders without a change in the relative economic interests or rights of the stockholders. Where a redemption has that same effect, it cannot be said to have satisfied the "not essentially equivalent to a dividend" requirement of Sec. 302(b) (1). Rather, to qualify for preferred treatment under that section, a redemption must result in a meaningful reduction of the shareholder's proportionate interest in the corporation.

United States v. Davis, 397 U.S. 301, 313, 90 S. Ct. 1041, 1048, 25 L. Ed. 2d 323 (1970). In determining whether there has been a meaningful reduction in the shareholder's proportionate interest under section 302(b), reference is made to the stock of the issuing corporation, in this case Labor. See Section 304(b). Furthermore, the attribution rules of Sec. 318 apply. See Sec. 302(c) (1); United States v. Davis, 397 U.S. at 307, 90 S. Ct. at 1045. In the case at bar, the taxpayer owned 100 percent of Labor before the transaction. He owned 99 percent after the transaction because he constructively owned the Labor shares which were transferred to Communication. See 318(a) (2) (C). Accordingly there was no "change in the relative economic interests or rights of the stockholders," 397 U.S. at 313, and 302(b) (1) does not apply. See Brown v. United States, 345 F. Supp. 241 (S.D. Ohio 1972), aff'd, 477 F.2d 599 (6th Cir.) cert. denied, 414 U.S. 1011, 94 S. Ct. 377, 38 L. Ed. 2d 250 (1973).

The taxpayer also contends that Sec. 302(b) (2) applies to this case. Section 302(b) (2) states that a redemption will be treated as a distribution in exchange for stock if "the distribution is substantially disproportionate with respect to the shareholder." Section 302(b) (2) (B) specifically provides that a redemption cannot be substantially disproportionate unless "immediately after the redemption the shareholder owns less than 50 percent of the total combined voting power of all classes of stock entitled to vote." As pointed out above, the application of the attribution rules of Sec. 318 results in the taxpayer owning approximately 99 percent of the Labor voting stock after the transaction. Thus, the transaction was not "substantially disproportionate with respect to the shareholder."

Since the taxpayer fails to qualify under Sec. 302(b), Sec. 301 applies and the income received is taxable as ordinary income. Section 301(c) (1) provides that, "that portion of the distribution which is a dividend (as defined in section 316) shall be included in gross income." Section 316 defines a dividend as any distribution of property made by a corporation to its shareholders from current or accumulated earnings and profits. Section 304(b) (2) (A) provides that the determination of the amount which is a dividend is made by reference to the earnings and profits of the acquiring corporation, which in this case is Communication. The parties have stipulated that at the time of the transaction the earnings and profits of Communication were in excess of $121,977.11, the total purchase price of the stock, and that in each of the years 1973 through 1976 Communication had earnings and profits in excess of the amount of each installment. Thus, the combined operation of Secs. 301, 302, 304, 316 and 318 calls for dividend treatment of the $121,977.11. The Tax Court, therefore, correctly determined that the taxpayer was not entitled to capital gain treatment.

The remaining issue on this appeal is whether the taxpayer was entitled to report the money received for the stock under the installment basis of Sec. 453 of the Code. Section 453(b) provides in pertinent part that "a casual sale or other casual disposition of personal property ... for a price exceeding $1,000, may (under regulations prescribed by the Secretary or his delegate) be returned" on an installment basis provided that in the taxable year of the sale or other disposition the seller received no payments or the payments did not exceed 30 percent of the selling price. Although the taxpayer did not receive more than 30 percent of the price of the stock in 1973, Sec. 453 is inapplicable here. The tax court has held that the installment method treatment is not available where section 304 applies so as to treat the purported sale as a distribution to which section 301 applies. Cox v. Commissioner, 78 T.C. 1021 (1982). The rationale behind Cox is that such a distribution is not a "casual sale or other casual disposition of personal property" within the meaning of Sec. 453. Because Sec. 453 does not apply to this type of transaction, the taxpayer was not entitled to report the income under the installment method.

For the foregoing reasons we AFFIRM the judgment of the Tax Court.