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Commissioner of Internal Revenue v. Smith.

June 9, 1943


Petition for Review of the Tax Court of the United States.

Author: Hand

Before SWAN, AUGUSTUS N. HAND, and FRANK, Circuit Judges.

AUGUSTUS N. HAND, Circuit Judge.

The first question before us is whether dividends of the Chrysler Corporation to the amount of $92,667, paid in the year 1929, and dividends of the Chrysler Corporation to the amount of $82,740, and of the Hudson Motor Car Company to the amount of $6,175, paid in the year 1930, should be assessed as income of the taxpayer, John Thomas Smith, rather than as income of Innisfail Corporation, of which he was the sole stockholder.

Innisfail was a New Jersey corporation owned and controlled by the taxpayer. The Tax Court made a finding that the "purpose of the petitioner in organizing Innisfail was to have it hold securities, to avoid duplication of taxation under state inheritance tax laws in case of his death, and to gain the advantage of paying income taxes at the corporation rates." That tax avoidance was the only purpose is amply borne out by the evidence.

In 1926 Innisfail acquired from the taxpayer 5,005 shares of Chrysler preferred stock, and a conversion option, in exchange for the issue of its own stock. To facilitate the acquisition, the taxpayer, on June 14, 1926, executed a bill of sale to the corporation, covering both the preferred stock and the option. Innisfail soon afterwards exercised the option and thus became entitled to 26,477 shares of Chrysler common stock. This stock was registered in the name of the taxpayer and, because of this, all dividends on the Chrysler stock were thereafter paid directly to him, though credited on his books to Innisfail. The Tax Court found that his "object in retaining the record title in his own name was to afford greater facility in transferring the certificates, which covered a listed stock, than would be possible if the certificates were recorded in a corporate name." There was a capital gain of $516,410.13, realized through the exchange of the Chrysler preferred for the common stock in 1926. Innisfail returned and paid income taxes on this profit and the Commissioner accepted the return as correct.

As the result of cash advances and transfers of property to Innisfail by the taxpayer the former had become indebted to him at the beginning of 1929 in the amount of $312,666.51. The taxpayer credited to Innisfail, in reduction of the above indebtedness, Chrysler dividends which he had received during the year 1929, amounting to $92,667. The advantage of treating the stock as vested in Innisfail was a saving of taxes on the dividends, because dividends were then subject to substantial surtaxes if assessable against an individual taxpayer, but were exempt from tax if belonging to a corporation.Revenue Act 1928, ยง 23(p), 26 U.S.C.A. Int. Rev. Acts, page 359.

In 1928 the taxpayer subscribed for 4,412 additional shares of Chrysler common stock and paid for them from his personal funds. Though this stock, like the other Chrysler shares, was registered in Smith's own name, he charged the amount he had paid for it against Innisfail on his books. On December 6, 1929, Innisfail executed a bill of sale of these 4,412 shares to the taxpayer at a book loss of $139,571.25 as against the original purchase price. This loss was deducted by Innisfail in its 1929 income tax return.The result was a substantial tax saving, though there was never any change in the beneficial ownership of the shares. The dividends on this stock in the year 1930 were deposited in Smith's own bank account and were returned by him as income.

On September 30, 1930, Innisfail gave a bill of sale to the taxpayer for 10,000 of the 26,477 shares of Chrysler common stock at the price of $195,000. This transaction represented a book loss of $123,600, which was deducted by Innisfail on its 1930 income tax return. During that year he received dividends amounting to $82,740 on the Chrysler stock which he had sold to Innisfail, and also received dividends amounting to $6,175 on 1,900 shares of Hudson Motor Car stock standing in his name which he had also sold to Innisfail. He purported to sell these 1,900 Hudson Motor Car Company shares to Innisfail by bill of sale of December 29, 1929, at the price of $106,400, the transaction to be completed by charging Innisfail with that amount on the taxpayer's books and by similarly crediting the taxpayer on Innisfail's books. This supposed sale involved no transfer of cash but mere book entries which resulted in a book loss to the taxpayer of $48,811.

The certificates for the shares of Chrysler and Hudson Motor Car stock which the taxpayer purported to sell to Innisfail remained in his own name and within his possession and control at all times.

Because of the decision of Higgins v. Smith, 308 U.S. 473, the Tax Court refused to allow the deductions of $48,811 which the taxpayer took in 1929 for his loss resulting from his sale of Hudson Motor stock to Innisfail in 1929, and also refused to allow the deduction of $39,240 which he took in the same year for his loss that we have not heretofore mentioned resulting from his sale of 1,000 shares of Adeberan stock to Innisfail. The reason for the disallowance of each item was that the transactions were between the taxpayer and a corporation which he wholly owned and controlled. Cf. Moline Properties, Inc., v. Com'r, 319 U.S. , 63 S. Ct. 1132, 87 L. Ed. .

Notwithstanding the refusal to allow deduction of losses arising from sales by Smith to Innisfail, the Tax Court made the finding that he "intended to pass full and absolute ownership" of the Chrysler stock to Innisfail when he transferred his rights therein on June 14, 1926, and in accordance with this theory treated his contracts to sell the additional shares of Chrysler and the shares of Hudson Motor Car to Innisfail as passing title to the latter and the dividends on them as belonging to it, though the certificates stood in the name of the taxpayer. As a result of this decision the dividends which would have been subject to taxation if they had been treated as part of Smith's individual income were relieved of taxation both as against him and against Innisfail.

The Commissioner has appealed from the foregoing decision of the Tax Court on the ground that dividends paid by Chrysler in 1929, aggregating $92,667, and by Chrysler and Hudson Motor Car Company in 1930, aggregating $88,915, should be reckoned for tax purposes as income of the individual. We think that the contention of the Commissioner is well founded and that the orders of the Tax Court which adjudged tax deficiencies for the years 1929 and 1930, without including these dividends in the taxpayer's income, erroneous.

There was no substantial business advantage except saving of taxes to be derived through the organization of Innisfail in 1926, or through its subsequent operation. The taxpayer testified that he thought it to his interest to organize Innisfail and to turn over the Chrysler stock and option to it. He organized it with the immediate purpose of exercising the option to convert the Chrysler preferred stock into common. The conversion resulted in a profit to Innisfail of $516,410.13. Smith testified that in buying and selling securities he always took tax consequences into consideration, that it was desirable to have a corporation available to deal in stocks, because taxes on profits realized by an individual stockholder were likely to be heavier than those payable by a corporation. He retained as much practical control over the corporate assets of Innisfail as though they were his own. The directors, other than himself, were his friends and he was both the president of the company and its sole stockholder. He kept its securities with his ...

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