Commissioner of Internal Revenue, Petitioner, v. Walter L. and Helen Morgan, Respondents, 288 F.2d 676 (3d Cir. 1961)

This petition for review requires us to determine whether distributions made to a shareholder pursuant to a corporate liquidation are taxable as dividend income under subsection 112(c) (2) or as a long term capital gain under subsection 115(c) of the Internal Revenue Code of 1939, 26 U.S.C.A. (Int.Rev.Code 1939), which provisions control here.

For many years Wellington Fund, Inc. ("Fund"), a mutual fund, had separate contracts with Wellington Corporation ("transferor") for investment advisory services, and with W. L. Morgan & Company ("transferee") for the national promotion and distribution of the Fund's securities. These contracts constituted the principal if not exclusive business of the transferor and transferee. In 1952, the Fund terminated its contract with transferor and immediately thereafter entered into a contract with transferee for identical services.

Transferor was then liquidated, and the assets that it had utilized in performing the contract with the Fund were conveyed to the transferee. In addition, the following distributions were made to the taxpayer, transferor's sole stockholder:

 May 27, 1952 Cash ..................... $100,000.00 June 1, 1952 United States Treasury Bonds .................. 48,906.25 Sept. 18, 1952 Cash ..................... 65,244.74 ___________ $214,150.99

In his 1952 tax return, the taxpayer¹  reported $212,150.99 ($214,150.99 distribution less cost of his stock) as a long term capital gain under subsection 115 (c).²  The Commissioner, however, determined a deficiency on the ground that the distribution was taxable as dividend income under the related provisions of sub-sections 112(b) (3), (c) (1) and (2).³  The Tax Court held that even assuming all the other conditions had been met, the distribution could not qualify as dividend income because there had not been an actual exchange of stock between taxpayer and transferee.⁴  The Commissioner here maintains that in substance and effect an exchange of stock was made since the taxpayer owned all the stock in both transferor and transferee.

In order to sustain the Commissioner, it must be shown that (1) there was a distribution of property or money ("boot") in addition to an exchange of stock all made in pursuance of a plan of reorganization, and (2) that such boot has the effect of a taxable dividend, i. e., it is not in excess of the taxpayer's share of the undistributed earnings and profits of the corporation accumulated after February 28, 1913.⁵ 

We think that a chronological statement of the facts in the record, uncontradicted, largely stipulated and as found by the Tax Court, leads irresistibly to the conclusion that the distributions here were made in pursuance of a plan of reorganization.⁶ 

At all times relevant, taxpayer was president and board chairman as well as sole stockholder of both transferor and transferee, which were organized in 1929 and 1931 respectively. Another board member was Joseph E. Welch, who was also a principal executive officer in transferor, transferee, and the Fund. The taxpayer was also president of the Fund and chairman of its board. The ten other members of the board consisted of four executive officers in the transferor and transferee, the father of taxpayer's wife who died in 1941, business associates with taxpayer in other enterprises, and two others with whom he had no apparent business relationship. Four out of five and five out of seven executive officers of transferor and transferee respectively served on the Fund's board.

For the fiscal year ended May 31, 1951, transferor reported an income of $305,175.96. However, no dividends were paid that year. During late 1951 and early 1952, an internal revenue agent on several occasions met with transferor's representatives and discussed the imposition of a surtax under section 102 of the Internal Revenue Code of 1939, 26 U.S.C.A. § 102 for an allegedly improper accumulation of surplus. On February 11, 1952, a conference was held between the agent's group chief and transferor's representatives without any agreement being reached.

At the Fund's board meeting held on February 27, 1952, taxpayer raised the question of transferring the contract from transferor to transferee. It was the consensus of the board that the contract with transferor should be terminated and one calling for similar services be entered into with transferee which was to change its name to include the word "Wellington." Minutes of that meeting, signed by the Fund's secretary, who was a vice president in both transferor and transferee, contained the following:

"* * * and it was the sense of the meeting that the present contract between the Fund and Wellington Corporation should not be renewed but that the activities of Wellington Corporation and W. L. Morgan & Co. should be combined into one company for greater efficiency and the Investment Advisory Contract be made with this company."

At that meeting, taxpayer also presented a form of proposed investment services contract with transferee, apparently identical in all essential respects with the contract then in effect between the Fund and transferor.

At a special meeting of transferor's board attended by taxpayer and Welch, held on March 3, 1952, to discuss termination of its contract with the Fund, taxpayer stated that when a new contract with transferee was approved by the Fund, all of transferor's employees would be placed on transferee's payroll.

In soliciting the Fund's shareholders for approval of the change, a proxy dated March 7, 1952, prepared under order of the Fund's board and distributed over the name of its secretary, who was a vice president in both transferor and transferee, contained the following:

"Investment Advisory Agreement with The Wellington Company

"For greater efficiency and corporate simplification and economy, the Directors of Wellington Corporation, the investment advisor for Wellington Fund, Inc., and the Directors of W. L. Morgan & Co., the sponsor and national distributor for the Fund, have resolved that their activities should be combined into one company to be called The Wellington Company. Under this arrangement, the general management, investment management and research services and distribution activities will be conducted in the future by separate departments of one corporation rather than by two corporations as heretofore. This arrangement involves no changes in investment or management policies or practices. The Executive Committee, Investment Committee and the entire statistical and research staff and all employees of the investment advisor will become associated with The Wellington Company with the same duties and responsibilities as heretofore. The name of W. L. Morgan & Co. will be changed to The Wellington Company, and the present Wellington Corporation will be dissolved." (Emphasis supplied.)

The shareholders met on April 9, 1952, at 3:00 P. M. and approved the contract with transferee. At 4:00 P.M. on that same date, transferee's board at a special meeting resolved that transferee would assume the obligation transferor had toward its employees under a profit-sharing plan. The minutes of that meeting also indicate that transferee had already decided to change its name to include the word "Wellington."

On April 10, 1952, the contract with transferor was terminated and on April 12, 1952, one calling for similar services was entered into with transferee.

In the meantime, transferee took over the transferor's furniture and other equipment, research data, and all of transferor's employees together with the employees' profits sharing plan.

On May 27, 1952, after unsuccessfully attempting to secure new business, transferor's board, pursuant to taxpayer's written consent, resolved to liquidate.

Upon completion of the arrangements outlined above, the transferee had a new corporate division devoted to investment counselling. Without hiatus an intact capability to perform the contract with the Fund was transplanted from transferor to transferee. Taxpayer continued to be the sole stockholder of transferee. Also, the transferor, as taxpayer himself testified, could perform no investment advisory services without the use of transferee's personnel.

It is clear to us that these actions constituted the carrying out of a plan of reorganization under subsection 112(g) (1) (D).

The taxpayer contends there was no reorganization since the contract with the Fund, the transferor's most valuable asset, was not transferred. This, of course, is without merit. We need not articulate the obvious answer which the facts compel, for the subsection involved requires only that a part of the assets be transferred. Becher v. Commissioner, 2 Cir., 1955, 221 F.2d 252; Lewis v. Commissioner, 1 Cir., 1949, 176 F.2d 646; 3 Mertens, Law of Federal Income Taxation, ¶ 20.91 (1957).

As we noted earlier, the Tax Court held that there must be an actual physical exchange of stock before the distribution here could be taxable as dividend income. With this conclusion we cannot agree, for it is contrary to the purposes that Congress meant to serve in enacting subsections 112(b) and (c) (2).

Subsection 112(c) (2) was enacted to reach and tax as ordinary income gain realized by a stockholder from a corporate reorganization to the extent that such gain constitutes undistributed earnings. It appeared as subsection 203 (d) (2) of the Revenue Act of 1924, 26 U.S.C.A. (Rev.Act of 1924). The Senate Finance Committee Report⁷  accompanying the 1924 Act and commenting on that subsection stated:

"The committee approves certain amendments to the income tax law contained in the House bill to stop the methods of avoidance which are now being commonly availed of by taxpayers.

"(1) The provisions of the reorganization section of the present law have been rewritten to prevent the use of the section to escape proper taxation * * * by distributing as capital gain what are in effect dividends out of earnings."

If the transferor's assets had been transferred to a newly formed corporation in exchange for stock, there is no question that the boot would have been taxable as dividend income. That an existing corporation in which the taxpayer was the sole shareholder was used instead of a newly formed one cannot alter the true nature of the transaction. Here, the issuance of new stock would have been a meaningless gesture since the stock the taxpayer already held represented the total value of all the assets except for the boot.

Liddon v. Commissioner, 6 Cir., 230 F.2d 304, certiorari denied 1956, 352 U.S. 824, 77 S. Ct. 34, 1 L. Ed. 2d 48, which involved similar facts, fully supports our conclusion. There, the taxpayers, husband and wife, owned eighty per cent of the stock in a corporation engaged in selling and servicing automobiles under a franchise dealer contract with General Motors Corporation, while one Davis owned the other twenty per cent. Davis' offer to sell his stock to the taxpayers for book value was refused. Thereafter, taxpayers established a new corporation in which they owned all but one share of stock and secured a new franchise contract. The new corporation then agreed to a plan whereby it would purchase the old corporation's assets and accept an employees' retirement fund. Taxpayers invested an additional twenty thousand dollars in personal funds in the new corporation. Thereafter Davis' stock was purchased by the old corporation, which was then dissolved, and $150,000 in cash and notes distributed to the taxpayers, which the Commissioner contended, and the Tax Court agreed, should be taxed as ordinary income and not as capital gain. In affirming on this point, Judge Stewart, now Justice Stewart, approved and summarized the Tax Court's reasoning, 230 F.2d at pages 306-307:

"Moreover, since at the beginning of the series of transactions the petitioners held stock in the old corporation, and at the end they held stock in the new corporation, plus `money-to-boot,' the court reasoned that, although there was not a direct exchange of stock in the old corporation for stock in the new, plus `other property or money,' that was the net effect of what was done. Accordingly, the court concluded that the case was governed by sections 112(b) (3) and 112(c) of the 1939 Code."

Taxpayer cites Emma Cramer, 1953, 20 T.C. 679, and Trianon Hotel Co., 1958, 30 T.C. 156, which are inapplicable since in neither of these cases did the court conclude that there was a reorganization as was the case both here and in Liddon.

The decision of the Tax Court will be reversed and the cause remanded for further proceedings not inconsistent with this opinion.