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Commissioner v. Brown :: 380 U.S. 563 (1965) :: Justia U.S. Supreme Court Center Log In
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Commissioner v. Brown 380 U.S. 563 (1965)
U.S. Supreme CourtCommissioner v. Brown, 380 U.S. 563 (1965)Commissioner of Internal Revenue v. BrownNo. 63Argued March 3, 1965Decided April 27, 1965380 U.S. 563CERTIORARI TO THE UNITED STATES COURT OF APPEALS
1. The transaction constituted a bona fide sale under local law, the Institute having acquired title to the company stock, and, by Page 380 U. S. 564 liquidation, to all the assets in return for its promise to pay over money from the operating profits. P. 380 U. S. 569.
4. The Treasury Department itself has noted the availability of capital gains treatment on the sale of capital assets where the seller Page 380 U. S. 565 retained an interest in the income produced by the assets. Pp. 380 U. S. 578-579.
In 1950, when Congress addressed itself to the problem of the direct or indirect acquisition and operation of going businesses by charities or other tax-exempt entities, it was recognized that, in many of the typical sale and lease-back transactions, the exempt organization was trading on, and perhaps selling part of, its exemption. H.R.Rep. No. 2319, 81st Cong., 2d Sess., pp. 38-39; S.Rep. No. 2375, 81st Cong., 2d Sess., pp. 31-32. For this and other reasons, the Internal Revenue Code was accordingly amended in several respects, of principal importance for our purposes by taxing as "unrelated business income" the profits earned by a charity in the operation of a business, as well as the income from long-term leases of the business. [Footnote 1] The short-term lease, however, of five years or Page 380 U. S. 566 less, was not affected, and this fact has moulded many of the transactions in this field since that time, including the one involved in this case. [Footnote 2]
This case is one of the many in the course of which the Commissioner has questioned the sale of a business concern to an exempt organization. [Footnote 3] The basic facts are undisputed. Page 380 U. S. 567 Clay Brown, members of his family and three other persons owned substantially all of the stock in Clay Brown & Company, with sawmills and lumber interests near Fortuna, California. Clay Brown, the president of the company and spokesman for the group, was approached by a representative of California Institute for Cancer Research in 1952, and, after considerable negotiation, the stockholders agreed to sell their stock to the Institute for $1,300,000, payable $5,000 down from the assets of the company and the balance within 10 years from the earnings of the company's assets. It was provided that, simultaneously with the transfer of the stock, the Institute would liquidate the company and lease its assets for five years to a new corporation, Fortuna Sawmills, Inc., formed and wholly owned by the attorneys for the sellers. [Footnote 4] Fortuna would pay to the Institute 80% of its operating profit without allowance for depreciation or taxes, and 90% of such payments would be paid over by the Institute to the selling stockholders to apply on the $1,300,000 note. This note was noninterest bearing, the Institute had no obligation to pay it except from the rental income, and it was secured by mortgages and assignments of the assets transferred or leased to Fortuna. If the payments on the note failed to total $250,000 over any two consecutive years, the sellers could declare the entire balance of the note due and payable. The sellers were neither stockholders nor directors of Fortuna, but it was provided that Clay Brown was to have a management contract Page 380 U. S. 568 with Fortuna at an annual salary and the right to name any successor manager if he himself resigned. [Footnote 5]
In the Tax Court, the Commissioner asserted that the transaction was a sham, and that, in any event, respondents retained such an economic interest in and control over the property sold that the transaction could not be treated as a sale resulting in a long-term capital gain. A divided Tax Court, 37 T.C. 461, found that there had Page 380 U. S. 569 been considerable good faith bargaining at arm's length between the Brown family and the Institute, that the price agreed upon was within a reasonable range in the light of the earnings history of the corporation and the adjusted net worth of its assets, that the primary motivation for the Institute was the prospect of ending up with the assets of the business free and clear after the purchase price had been fully paid, which would then permit the Institute to convert the property and the money for use in cancer research, and that there had been a real change of economic benefit in the transaction. [Footnote 6] Its conclusion was that the transfer of respondents' stock in Clay Brown & Company to the Institute was a bona fide sale arrived at in an arm's length transaction, and that the amounts received by respondents were proceeds from the sale of stock, and entitled to long-term capital gains treatment under the Internal Revenue Code. The Court of Appeals affirmed, 325 F.2d 313, and we granted certiorari, 377 U.S. 962.
Having abandoned in the Court of Appeals the argument that this transaction was a sham, the Commissioner now admits that there was real substance in what occurred between the Institute and the Brown family. The transaction was a sale under local law. The Institute acquired title to the stock of Clay Brown & Company and, by liquidation, to all of the assets of that company, in return for its promise to pay over money from the operating profits of the company. If the stipulated price was paid, the Brown family would forever lose all rights to the income and properties of the company. Prior to the transfer, these respondents had access to all of the income of the company; after the transfer, 28% of the income remained with Fortuna and the Institute. Respondents Page 380 U. S. 570 had no interest in the Institute, nor were they stockholders or directors of the operating company. Any rights to control the management were limited to the management contract between Clay Brown and Fortuna, which was relinquished in 1954.
"Capital gain" and "capital asset" are creatures of the tax law, and the Court has been inclined to give these terms a narrow, rather than a broad, construction. Corn Products Co. v. Commissioner, 350 U. S. 46, 350 U. S. 52. A "sale," however, is a common event in the non-tax world, and Page 380 U. S. 571 since it is used in the Code without limiting definition and without legislative history indicating a contrary result, its common and ordinary meaning should at least be persuasive of its meaning as used in the Internal Revenue Code.
Helvering v. Hammel, 311 U. S. 504, 311 U. S. 510-511; cf. Commissioner v. Gillette Motor Transport, Inc., 364 U. S. 130, 364 U. S. 134; and Commissioner v. P. G. Lake, Inc., 356 U. S. 260, 356 U. S. 265. But it is otherwise "where no such consequences [would] follow and where . . . it appears to be consonant with the purposes of the Act. . . ." Helvering v. Hammel, supra, at 311 U. S. 511; Takao Ozawa v. United States, 260 U. S. 178, 260 U. S. 194. We find nothing in this case indicating that the Tax Court or the Page 380 U. S. 572 Court of Appeals construed the term "sale" too broadly or in a manner contrary to the purpose or policy of capital gains provisions of the Code.
Obviously, on these facts, there had been an appreciation in value accruing over a period of years, Commissioner v. Gillette Motor Transport, Inc., supra, and an "increase in the value of the income-producing property." Commissioner v. P. G. Lake, Inc., supra, at 356 U. S. 266. This increase taxpayers were entitled to realize at capital gains rates on a cash sale of their stock; and likewise if they sold on a deferred payment Page 380 U. S. 573 plan taking an installment note and a mortgage as security. Further, if the down payment was less than 30% (the 1954 Code requires no down payment at all) and the transaction otherwise satisfied I.R.C.1939, § 44, the gain itself could be reported on the installment basis.
Secondly, if an excessive price is such an inevitable result of the lack of risk-shifting, it would seem that it would not be an impossible task for the Commissioner to demonstrate the fact. However, in this case, he offered no evidence whatsoever to this effect; and in a good many other cases involving similar transactions, in some of which Page 380 U. S. 574 the reasonableness of the price paid by a charity was actually contested, the Tax Court has found the sale price to be within reasonable limits, as it did in this case. [Footnote 7]
id. at 308 U. S. 421, since the seller retained only Page 380 U. S. 575 a creditor's interest, rather than a proprietary one.
First, "Congress . . . has recognized the peculiar character of the business of extracting natural resources," Burton-Sutton Oil Co. v. Commissioner, 328 U. S. 25, 328 U. S. 33; Page 380 U. S. 576 see Stratton's Independence Ltd. v. Howbert, 231 U. S. 399, 231 U. S. 413-414, which is viewed as an income-producing operation, and not as a conversion of capital investment, Anderson v. Helvering, 310 U. S. 404 at 301 U. S. 407, but one which has its own built-in method of allowing through depletion "a tax-free return of the capital consumed in the production of gross income through severance," Anderson v. Helvering, supra, at 310 U. S. 408, which is independent of cost and depends solely on production, Burton-Sutton, at 328 U. S. 34. Percentage depletion allows an arbitrary deduction to compensate for exhaustion of the asset, regardless of cost incurred or any investment which the taxpayer may have made. The Commissioner, however, would assess to respondents as ordinary income the entire amount of all rental payments made by the Institute, regardless of the accumulated values in the corporation which the payments reflected and without regard for the present policy of the tax law to allow the taxpayer to realize on appreciated values at the capital gains rates.
"the reservation of this additional type of security for the deferred payments serve[d] to distinguish this case from Page 380 U. S. 577 Thomas v. Perkins. It is similar to the reservation in a lease of oil payment rights together with a personal guarantee by the lessee that such payments shall at all events equal the specified sum."
Anderson v. Helvering, supra, at 310 U. S. 412-413. Hence, there was held to be an outright sale of the properties, all of the oil income therefrom being taxable to the transferee notwithstanding the fact of payment of part of it to the seller. The respondents in this case, of course, not only had rights against income, but, if the income failed to amount to $250,000 in any two consecutive years, the entire amount could be declared due, which was secured by a lien on the real and personal properties of the company. [Footnote 8] Page 380 U. S. 578
Congress did not adopt the suggested change, [Footnote 9] but it is significant for our purposes that the proposed amendment did not deny the fact or occurrence of a sale, but would have taxed as ordinary income those income-contingent Page 380 U. S. 579 payments deferred for more than five years. If a purchaser could pay the purchase price out of a earnings within five years the seller would have capital gain, rather than ordinary income. The approach was consistent with allowing appreciated values to be treated as capital gain but with appropriate safeguards against reserving additional rights to future income. In comparison, the Commissioner's position here is a clear case of "overkill" if aimed at preventing the involvement of tax-exempt entities in the purchase and operation of business enterprises. There are more precise approaches to this problem as well as to the question of the possibly excessive price paid by the charity or foundation. And if the Commissioner's approach is intended as a limitation upon the tax treatment of sales generally, it represents a considerable invasion of current capital gains policy, a matter which we think is the business of Congress, not ours.
Were it not for the tax laws, the respondents' transaction with the Institute would make no sense, except as one arising from a charitable impulse. However, the tax laws exist as an economic reality in the businessman's world, much like the existence of a competitor. Businessmen Page 380 U. S. 580 plan their affairs around both, and a tax dollar is just as real as one derived from any other source. The Code gives the Institute a tax exemption which makes it capable of taking a greater after-tax return from a business than could a non-tax-exempt individual or corporation. Respondents traded a residual interest in their business for a faster payout apparently made possible by the Institute's exemption. The respondents gave something up; they received something substantially different in return. If words are to have meaning, there was a "sale or exchange."
The force underlying the Government's position is that the respondents did clearly retain some risk-bearing interest in the business. Instead of leaping from this premise to the conclusion that there was no sale or exchange, the Government might more profitably have Page 380 U. S. 581 broken the transaction into components and attempted to distinguish between the interest which respondents retained and the interest which they exchanged. The worth of a business depends upon its ability to produce income over time. What respondents gave up was not the entire business, but only their interest in the business' ability to produce income in excess of that which was necessary to pay them off under the terms of the transaction. The value of such a residual interest is a function of the risk element of the business and the amount of income it is capable of producing per year, and will necessarily be substantially less than the value of the total business. Had the Government argued that it was that interest which respondents exchanged, and only to that extent should they have received capital gains treatment, we would perhaps have had a different case.
The essential facts of this case, which are undisputed, illuminate the basic nature of the transaction at issue. Page 380 U. S. 582 Respondents conveyed their stock in Clay Brown & Co., a corporation owned almost entirely by Clay Brown and the members of his immediate family, to the California Institute for Cancer Research, a tax-exempt foundation. The Institute liquidated the corporation and transferred its assets under a five-year lease to a new corporation, Fortuna, which was managed by respondent Clay Brown, and the shares of which were in the name of Clay Brown's attorneys, who also served as Fortuna's directors. The business thus continued under a new name with no essential change in control of its operations. Fortuna agreed to pay 80% of its pretax profits to the Institute as rent under the lease, and the Institute agreed to pay 90% of this amount to respondents in payment for their shares until the respondents received $1,300,000 at which time their interest would terminate and the Institute would own the complete beneficial interest, as well as all legal interest, in the business. If remittances to respondents were less than $250,000 in any two consecutive years or any other provision in the agreements was violated, they could recover the property. The Institute had no personal liability. In essence, respondents conveyed their interest in the business to the Institute in return for 72% of the profits of the business and the right to recover the business assets if payments fell behind schedule.
At first glance, it might appear odd that the sellers would enter into this transaction, for, prior to the sale, they had a right to 100% of the corporation's income, but, after the sale, they had a right to only 72% of that income and would lose the business after 10 years, to boot. This transaction, however, afforded the sellers several advantages. The principal advantage sought by the sellers was capital gain, rather than ordinary income, treatment for that share of the business profits which they received. Further, because of the Tax Code's charitable exemption [Footnote 2/1] Page 380 U. S. 583 and the lease arrangement with Fortuna, [Footnote 2/2] the Institute believed that neither it nor Fortuna would have to pay income tax on the earnings of the business. Thus, the sellers would receive free of corporate taxation, and subject only to personal taxation at capital gains rates, 72% of the business earnings until they were paid $1,300,000. Without the sale, they would receive only 48% of the business earnings, the rest going to the Government in corporate taxes, and this 48% would be subject to personal taxation at ordinary rates. In effect, the Institute sold the respondents the use of its tax exemption, enabling the respondents to collect $1,300,000 from the business more quickly than they otherwise could, and to pay taxes on this amount at capital gains rates. In return, the Institute received a nominal amount of the profits while the $1,300,000 was being paid, and it was to receive the whole business after this debt had been paid off. In any realistic sense, the Government's grant of a tax exemption was used by the Institute as part of an arrangement that allowed it to buy a business that, in fact, cost it nothing. I cannot believe that Congress intended such a result.
The Court today legitimates this bootstrap transaction and permits respondents the tax advantage which the parties sought. The fact that respondent Brown, as a Page 380 U. S. 584 result of the Court's holding, escapes payment of about $60,000 in taxes may not seem intrinsically important -- although every failure to pay the proper amount of taxes under a progressive income tax system impairs the integrity of that system. But this case in fact has very broad implications. We are told by the parties and by interested amici that this is a test case. The outcome of this case will determine whether this bootstrap scheme for the conversion of ordinary income into capital gain, which has already been employed on a number of occasions, will become even more widespread. [Footnote 2/3] It is quite clear that the Court's decision approving this tax device will give additional momentum to its speedy proliferation. In my view, Congress did not sanction the use of this scheme under the present revenue laws to obtain the tax advantages which the Court authorizes. Moreover, I believe that the Court's holding not only deviates from the intent of Congress, but also departs from this Court's prior decisions.
The purpose of the capital gains provisions of the Internal Revenue Code of 1954, § 1201 et seq., is to prevent gains which accrue over a long period of time from being taxed in the year of their realization through a sale at high rates resulting from their inclusion in the higher tax brackets. Burnet v. Harmel, 287 U. S. 103, 287 U. S. 106. These provisions are not designed, however, to allow capital gains treatment for the recurrent receipt of commercial or business income. In light of these purposes, this Court has held that a "sale" for capital gains purposes is not produced by the mere transfer of legal title. Burnet v. Harmel, supra; Palmer v. Bender, 287 U. S. 551. Rather at the very least, there must be a meaningful economic transfer in addition to a change in legal title. See Corliss v. Bowers, 281 U. S. 376. Thus, the question posed here is not whether this transaction constitutes a sale within the Page 380 U. S. 585 terms of the Uniform Commercial Code or the Uniform Sales Act -- we may assume it does -- but, rather, the question is whether at the time legal title was transferred, there was also an economic transfer sufficient to convert ordinary income into capital gain by treating this transaction as a "sale" within the terms of I.R.C. § 1222(3).
In Thomas v. Perkins, 301 U. S. 655, an owner of oil interests transferred them in return for an "oil production payment," an amount which is payable only out of the proceeds of later commercial sales of the oil transferred. The Court held that this transfer, which constituted a sale under state law, did not constitute a sale for tax purposes because there was not a sufficient shift of economic risk. The transferor would be paid only if oil was later produced and sold; if it was not produced, he would not be paid. The risks run by the transferor of making or losing money from the oil were shifted so slightly by the transfer that no § 1222(3) sale existed, notwithstanding the fact that the transaction conveyed title as a matter of state law, and, once the payout was complete, full ownership of the minerals was to vest in the purchaser. Page 380 U. S. 586
I would conclude that, on these facts, there was not a sufficient shift of economic risk or control of the business Page 380 U. S. 587 to warrant treating this transaction as a "sale" for tax purposes. Brown retained full control over the operations of the business; the risk of loss and the opportunity to profit from gain during the normal operation of the business shifted but slightly. If the operation lost money, Brown stood to lose; if it gained money, Brown stood to gain, for he would be paid off faster. Moreover, the entire purchase price was to be paid out of the ordinary income of the corporation, which was to be received by Brown on a recurrent basis as he had received it during the period he owned the corporation. I do not believe that Congress intended this recurrent receipt of ordinary business income to be taxed at capital gains rates merely because the business was to be transferred to a tax-exempt entity at some future date. For this reason, I would apply here the established rule that, despite formal legal arrangements, a sale does not take place until there has been a significant economic change such as a shift in risk or in control of the business. [Footnote 2/4]
To hold, as the Court does, that this transaction constitutes a "sale" within the terms of I.R.C. § 1222(3), thereby giving rise to capital gain for the income received, legitimates considerable tax evasion. Even if the Court restricts its holding, allowing only those transactions to be § 1222(3) sales in which the price is not excessive, its decision allows considerable latitude for the unwarranted conversion of ordinary income into capital gain. Valuation of a closed corporation is notoriously difficult. The Tax Court in the present case did not determine that the price for which the corporation was sold represented its true value; it simply stated that the price "was the result Page 380 U. S. 588 of real negotiating" and "within a reasonable range in light of the earnings history of the corporation and the adjusted net worth of the corporate assets." 37 T.C. at 486. The Tax Court, however, also said that
Although the Court implies that it will hold to be "sales" only those transactions in which the price is reasonable, I do not believe that the logic of the Court's opinion will justify so restricting its holding. If this transaction is a sale under the Internal Revenue Code, entitling its proceeds to capital gains treatment because it was arrived at after hard negotiating, title in a conveyancing Page 380 U. S. 589 sense passed, and the beneficial ownership was expected to pass at a later date, then the question recurs, which the Court does not answer, why a similar transaction would cease to be a sale if hard negotiating produced a purchase price much greater than actual value. The Court relies upon Kolkey v. Commissioner, 254 F.2d 51 (C.A.7th Cir.), as authority holding that a bootstrap transaction will be struck down where the price is excessive. In Kolkey, however, the price to be paid was so much greater than the worth of the corporation in terms of its anticipated income that it was highly unlikely that the price would in fact ever be paid; consequently it was improbable that the sellers' interest in the business would ever be extinguished. Therefore, in Kolkey, the court, viewing the case as one involving "thin capitalization," treated the notes held by the sellers as equity in the new corporation and payments on them as dividends. Those who fashion "bootstrap" purchases have become considerably more sophisticated since Kolkey; vastly excessive prices are unlikely to be found, and transactions are fashioned so that the "thin capitalization" argument is conceptually inapplicable. Thus, I do not see what rationale the Court might use to strike down price transactions which, though excessive, do not reach Kolkey's dimensions, when it upholds the one here under consideration. Such transactions would have the same degree of risk-shifting, there would be no less a transfer of ownership, and consideration supplied by the buyer need be no less than here.
Further, a bootstrap tax avoidance scheme can easily be structured under which the holder of any income-earning asset "sells" his asset to a tax-exempt buyer for a promise to pay him the income produced for a period of years. The buyer in such a transaction would do nothing whatsoever; the seller would be delighted to lose his asset at the end of, say, 30 years in return for capital gains treatment Page 380 U. S. 590 of all income earned during that period. It is difficult to see, on the Court's rationale, why such a scheme is not a sale. And, if I am wrong in my reading of the Court's opinion, and if the Court would strike down such a scheme on the ground that there is no economic shifting of risk or control, it is difficult to see why the Court upholds the sale presently before it, in which control does not change and any shifting of risk is nominal.
I believe that the Court's overly conceptual approach has led to a holding which will produce serious erosion of our progressive taxing system, resulting in greater tax burdens upon all taxpayers. The tax avoidance routes opened by the Court's opinion will surely be used to advantage by the owners of closed corporations and other income-producing assets in order to evade ordinary income taxes and pay at capital gains rates, with a resultant large-scale ownership of private businesses by tax-exempt organizations. [Footnote 2/5] While the Court justifies its result in the name of conceptual purity, [Footnote 2/6] it simultaneously violates longstanding congressional tax policies that capital gains treatment is to be given to significant economic transfers of investment-type assets, but not to ordinary commercial or business income, and that transactions are to be judged on their entire substance, rather than their naked form. Though turning tax consequences on form alone might produce greater certainty of the tax results of any transaction, this stability exacts as its price the certainty that tax evasion will be produced. In Commissioner v. P.G. Page 380 U. S. 591 Lake, Inc., 356 U. S. 260, 356 U. S. 265, this Court recognized that the purpose of the capital gains provisions of the Internal Revenue Code is