Appeal from a decision of the United States Tax Court, Arnold Raum, J., finding petitioners liable for income tax deficiencies arising out of the sale of stock to a tax-exempt organization.
Lumbard, Friendly and Mulligan, Circuit Judges.
These appeals by taxpayers raise once again the question of the tax consequences under § 1222(3)*fn1 of the Internal Revenue Code of 1954 of a sale of stock by an ordinary seller to a tax-exempt purchaser, when the sale is financed by the profits of the sold business. See CIR v. Brown, 380 U.S. 563, 14 L. Ed. 2d 75, 85 S. Ct. 1162 (1965) (Clay Brown). The transactions involved here preceded the Tax Reform Act of 1969*fn2 and the decision below was rendered before the opinion of this court in Berenson v. CIR, 507 F.2d 262 (2d Cir. 1974). The question posed is to what extent, if any, are the proceeds of such sale to be considered ordinary income to the seller.
The taxpayers, Aaron and Iris Kraut, and Harry and Marian Kraut, appeal from decisions of the United States Tax Court which, in an opinion and findings of fact by Hon. Arnold Raum, filed on June 27, 1974 and reported at 62 T.C. 420 (1974), determined that Aaron and Iris Kraut owed a deficiency of $240,787.08 in income taxes for the year 1967 and that Harry and Marian Kraut owed a deficiency of $246,847.44 in income taxes for the same year.
Aaron and Harry Kraut had been for some twenty years in the business of manufacturing electric wire. The Krauts' business was operated through a variety of corporations, Trio Wire and Cable Corporation (Trio), Christmas Wire Manufacturing Corporation (Christmas), and eventually in 1965 Nassau Plastic and Wire Corporation (Nassau). Iris Kraut and Marian Kraut each contributed $100 to Nassau in exchange for 100 shares of stock in the corporation. Their husbands were not stockholders but effectively operated the business. Nassau occupied a leased building, previously occupied by Christmas, on Meserole Avenue in Brooklyn, where it kept its only equipment, an extruder owned by Trio. The extruder was utilized to manufacture Christmas wire which is light gauged and protected by a plastic insulation. Christmas decoration manufacturers purchased the wire and attached to it light bulb sockets which puncture the plastic jacket and make contact with the wires. Nassau had developed a new insulating material which was easily penetrable and was likely to minimize manufacturer rejection which had plagued the Christmas-light business in the past.
In 1966, an investment counseling firm brought a proposal to Rev. Rex T. Humbard, pastor of the Cathedral of Tomorrow (Cathedral), a tax-exempt religious corporation in Akron, Ohio, that it purchase Nassau. Before any deal was consummated, however, the Krauts entered into a contract of sale on May 31, 1966 with Wilson Mold & Die Corporation (Wilson) which purported to sell all the stock of Nassau to Wilson. Shortly thereafter, on June 15, 1966 the Krauts entered into a three-cornered deal with Wilson and Cathedral whereby Wilson was relieved of its obligation to buy the Nassau stock and Wilson assigned all of its rights and obligations to Cathedral. The significant terms of the agreement are set forth in the margin.*fn3 We note that the sales price was dependent upon Nassau's future profits and was to range from a minimum of $500,000 to a maximum of $3,500,000, entirely paid from the sold business's income, for the following ten years. The Krauts, husbands of the Nassau stockholders, were retained as employees of Cathedral at $5,200 each per annum and so remained in effective day-to-day control of the business. Cathedral qualified under § 501(c)(3) of the Internal Revenue Code as a tax-exempt religious organization and so was exempt from paying either normal income tax or taxes on unrelated business income.*fn4 Cathedral paid off its debt to the Krauts with tax-free income from Nassau.
The agreement further provided that the taxpayers were to retain a security interest in all of the assets of Nassau subordinate to prior liens and the right of present and future creditors. In the event of default by Cathedral, enforcement of the security agreement constituted the taxpayer-sellers' exclusive remedy with no right to secure any deficiency judgment or other judgment for damages against Cathedral.
The business was initially very successful. Cathedral paid Iris and Marian Kraut $147,500 in 1966 (including a required $50,000 down payment) and $1,332,500 in 1967. Thereafter the business became unprofitable and ceased operation in 1969. The taxpayers, after deductions, each reported $606,416.67 as long-term capital gains for 1967. The Commissioner determined that $595,776.09 of each couple's receipts was taxable as ordinary income. He deducted the value of Nassau's stock from the taxpayers' receipts under the sales contracts, assigning a value of $168,445.60 to the stock, an amount equal to ten times Nassau's taxable income for the year ended June 30, 1966, the year prior to the sale. Taxpayers then filed petitions contesting the determination, taking the position that the property sold was a capital asset so that the gain was taxable only as a long-term capital gain. The Tax Court rejected this contention and this appeal followed.
In Clay Brown the Supreme Court held that the somewhat similar transaction there involved constituted a sale within the meaning of § 1222(3) (and thus was taxable as long-term capital gain) even though the exempt organization incurred no downside risk. The absence of a shift in risk did not preclude the "sale" of the stock and underlying assets under applicable law. The Court further noted the Tax Court's finding that the purchase price was "within a reasonable range in light of the earnings history of the corporation and the adjusted net worth of the corporate assets." 380 U.S. at 572. In Clay Brown the appraised net worth of the assets of the business was $1,064,877 and the sales price was approximately $1,300,000.
This court faced a related problem in Berenson, which involved a bootstrap sale of closely held corporate stock. There a tax-exempt entity agreed to pay $6,000,000 over a twelve-year period for stock, a price which the Tax Court held was more than double the price that would be paid for the same stock by a prospective purchaser who was not exempt from income tax. We held that Clay Brown did not wholly govern in view of the disparity in Berenson between the prices that exempt and non-exempt purchasers would pay, a disparity that did not exist in Clay Brown. Rather than holding that none of the proceeds were entitled to capital gains treatment, since a sale had in fact occurred in Berenson within the Clay Brown rationale, we determined:
In sum, we conclude that the portion of the purchase price agreed to by Temple [the tax-exempt entity] and Taxpayers that is in excess of the price a non-exempt purchaser would have paid under identical terms is not part of the proceeds of a § 1222(3) ...