Waterman, Moore and Anderson, Circuit Judges.
This is a petition for review of a decision of the Tax Court, Raum, J., 44 T.C. 137 (1965), holding that a profit-sharing trust for salaried employees of a company, although originally tax-exempt, had lost its tax-exempt status by reason of radical changes in the nature of the company, so that lump-sum distributions from the trust should have been taxed as ordinary income, rather than as capital gains, as reported by petitioners.
Petitioners, Harold D. Greenwald and Nana Greenwald, husband and wife, filed joint income tax returns for the years 1958, 1959 and 1960 with the District Director of Internal Revenue in New York City, where petitioners reside. Since Mrs. Greenwald is involved in this case only by virtue of having filed joint returns with her husband, we shall hereafter refer to Harold Greenwald as the taxpayer.
The taxpayer was a principal officer of Interstate Hosiery Mills, Inc., a Delaware corporation engaged in the manufacture and sale of women's hosiery. Stock of Interstate was publicly held and traded. A substantial minority interest was owned by its principal officers, taxpayer, Ivan Selig, and Lawrence Greenwald, and their families.
In 1945, Interstate set up a profit-sharing trust, which eventually changed its name to "The Madison Trust." The trust included only salaried employees as participants, and provided that "those Participating Employees owning directly or indirectly 10% or more of the voting stock of the Corporation shall not have allocated to them in any year in the aggregate more than 30% of the Corporation's contribution to the Trust for such year or amounts forfeited under the provisions of this plan in such year." In general, the contribution formula required Interstate to contribute 30 percent of its annual profits (before taxes) in excess of $100,000 to the trust.
The Commissioner approved the plan on May 23, 1945. Several amendments were made in the plan during the next several years. Each was submitted to the Commissioner, who ruled in each case that the plan still qualified as a taxexempt employees' profit-sharing trust after the amendment.
Towards the end of 1952, negotiations began between Interstate and Burlington Mills Corp. about the possibility of a sale of Interstate to Burlington Mills. These negotiations broken off at the start of 1953, were resumed in August 1953 and led finally to an agreement dated December 9, 1953, under which Green Cove Hosiery Corp., a subsidiary of Burlington Mills formed for the express purpose of acquiring the assets of Interstate, agreed to buy all of the assets of Interstate, including its name, customer list, and good will. This agreement was consummated on December 30, 1953.
59 of the 60 persons who had been participating employees in the Interstate profit-sharing trust left Interstate at the time of the sale, at least some of them to work for Green Cove. Only the taxpayer remained as a participant in the profit-sharing trust of the company, which on January 1, 1954, changed its name from Interstate to "I.H.L. Corporation."
After distributions to the departing employees on March 31, 1954, $90,281.08 in cash and Government "G" bonds remained in the Madison Trust, all of it credited to the account of the taxpayer.
I.H.L. was engaged in the investment business until 1959. During the period 1954-1959, I.H.L. gradually purchased a considerable amount of its own shares. On January 1, 1954, I.H.L. had 44,991 shares outstanding and 53,300 shares in its treasury; on January 1, 1959, I.H.L. had only 9,940 shares outstanding and 88,351 in its treasury. 97% of the shares outstanding on January 1, 1959 were controlled by Harold Greenwald or members of his immediate family.
I.H.L. never made $100,000 a year in pre-tax profits,*fn1 and as a result no contributions by I.H.L. were made to the profit-sharing trust from 1954 to 1959. During those years, taxpayer was the only participating employee in the trust. I.H.L. employed two secretaries who were not participating employees, and in 1958 and 1959 taxpayer's two sons received salaries, but did not qualify for participation in the trust.
On July 31, 1959, I.H.L. entered into a reorganization agreement with Fundamental Investors, Inc., an unrelated regulated open-end investment company, under which agreement Fundamental agreed to acquire substantially all of the assets held by I.H.L. in exchange for stock of Fundamental. The transaction was consummated on October 1, 1959. I.H.L. then distributed its assets to its shareholders and was dissolved. In the process, the Madison Trust received 14,640 shares of Fundamental stock which, together with $31,266.83 in cash, the trust transferred to Harold Greenwald in November 1959. Petitioners reported the value of the distribution from the trust in their 1959 tax return as $168,922.55, and reported this amount as a long-term capital gain, namely, as a distribution to an employee from a taxexempt profit-sharing trust.
The Commissioner contends, and the Tax Court held, that the fundamental changes in the nature of the employer's business as a result of the sale of assets in 1953 meant that what had hitherto been a ...