COATES TRUST v. C. I. R

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Docket Number

Nos. 71-1968 to 71-1973.

Attorney(S)

Gerald R. Hergert (argued), Joseph H. Trethewey, Trethewey Brink, Seattle, Wash., for appellants-petitioners. Charles E. Anderson (argued), Scott P. Crampton, Asst. Atty. Gen., Tax Div., Dept. of Justice, K. Martin Worthy, Chief Counsel, IRS, Meyer Rothwacks, Ernest J. Brown, Tax Div., Dept. of Justice, Washington, D.C., for appellee-respondent.

Judges

Eugene Allen Wright

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Smart Summary

Factual and Procedural Background

Sydney and Rose Ann Coates, along with their family members, owned all shares of two corporations: CAM Industries, Inc. (CAM) and Washington Industrial Products, Inc. (WIP). After Sydney Coates' death, the family agreed to combine the corporations by having CAM purchase WIP's shares. On May 20, 1965, CAM and WIP shareholders executed agreements whereby CAM purchased WIP shares at $1,000 per share, with payment installments and interest over a ten-year period. Subsequently, the Superior Court of Washington allocated interests in the purchase contract between trusts established under the wills of Sydney and Rose Ann Coates. The taxpayers reported the transaction as a sale of stock entitling them to capital gains treatment on their 1965 income tax returns. However, the Commissioner of Internal Revenue recharacterized the transaction as a redemption under § 304(a)(1) of the Internal Revenue Code, taxable as a dividend. The Tax Court upheld the Commissioner's treatment but found the fair market value of the agreements to be 60% of face value rather than 100%. The taxpayers appealed this decision.

Legal Issues Presented

Whether the trusts established after Sydney Coates' death were proper taxpayers for the transaction under § 7701(a)(14).
Whether the agreements entered into on May 20, 1965, constituted "securities" under § 351, potentially qualifying the transaction for capital gains treatment.
Whether § 304(a)(1) applies to the transaction as a redemption by a related corporation, including the interpretation of "one or more persons" and aggregate control under Reg. § 1.304-2(b).
Whether the redemption qualified as an exchange under § 302(b)(1) or must be treated as a dividend under § 301.
Whether the Tax Court erred in determining the fair market value of the agreements at 60% of face value.

Arguments of the Parties

Appellants-Petitioners' Arguments

The trusts were not taxpayers at the time of the transfer; therefore, deficiencies were assessed against incorrect parties. The proper taxpayers should be the Estate of Sydney Coates and Rose Ann Coates as community property owners.
The agreements are "securities" under § 351, and since WIP shareholders controlled over 80% of CAM stock post-transaction, § 351 should apply, resulting in no tax liability or capital gain treatment.
The Tax Court erred in applying § 304(a)(1) redemption treatment, arguing that "one or more persons" in § 304(a)(1)(A) should be interpreted narrowly and that aggregate control under Reg. § 1.304-2(b) improperly expands the statute's scope.
The Tax Court incorrectly concluded the redemption was not essentially equivalent to a dividend under § 302(b)(1), and the taxpayers’ interests were not meaningfully reduced.
The Tax Court erred in valuing the agreements at 60% of face value instead of full face value.

Appellee-Respondent's Arguments

The Trust Under Will of Sydney Coates and the Rose Ann Coates Trust were proper parties for taxation because the trusts held beneficial and equitable ownership interests under Washington law.
The agreements are not "securities" under § 351, as supported by precedent (Warren H. Brown) and the Tax Court's determination.
§ 304 applies to the transaction because the same group controlled both corporations, and the statute's language and legislative intent support a broad application beyond family relationships.
The redemption did not qualify as an exchange under § 302(b)(1) because there was no meaningful reduction in the shareholders' proportionate interests in WIP, consistent with United States v. Davis.
The Tax Court's valuation of the agreements at 60% of face value was supported by evidence and not clearly erroneous.

Table of Precedents Cited

Precedent	Rule or Principle Cited For	Application by the Court
Healy v. Commissioner, 345 U.S. 278 (1953)	Recognition of constructive trust and beneficial ownership for tax purposes.	Used to support that the Rose Ann Coates Trust was the equitable owner of the WIP shares and thus subject to tax.
Warren H. Brown, 27 T.C. 27 (1956)	Definition of "securities" under § 351 and distinction from installment sales contracts.	Tax Court's conclusion that the agreements were not securities was affirmed based on this precedent.
Commissioner v. Stickney, 399 F.2d 828 (6th Cir. 1968)	Interpretation of § 304 and § 351 conflict regarding stock redemptions and transfers to controlled corporations.	The court declined to follow this precedent, favoring a different interpretation that § 304 overrides § 351.
Radnitz v. United States, 187 F. Supp. 952 (S.D.N.Y. 1960), aff'd per curiam, 294 F.2d 577 (2d Cir. 1961)	Application of § 304(a)(1) to persons acting in concert beyond family relationships.	Supported the court's broad interpretation of "one or more persons" in § 304(a)(1).
United States v. Davis, 397 U.S. 301 (1970)	Standard for "not essentially equivalent to a dividend" under § 302(b)(1) requiring meaningful reduction in shareholder's interest.	Applied to reject taxpayers’ argument that redemption qualified for exchange treatment under § 302(b)(1).
In re Young's Estate, 40 Wn.2d 582, 244 P.2d 1165 (1952)	Enforceability of agreements transferring community property interests into trust under Washington law.	Supported the conclusion that Rose Ann Coates’ interest was subject to a constructive trust enforceable by beneficiaries.

Court's Reasoning and Analysis

The court first addressed the issue of proper taxpayers, holding that the trusts created under the mutual wills were the equitable owners of the WIP shares at the time of the transaction and thus were proper parties for taxation. This conclusion was grounded in Washington law and supported by precedent recognizing constructive trusts for tax purposes.

Next, the court examined whether the May 20 agreements were "securities" under § 351. Citing the Tax Court and Warren H. Brown, the court found they were not securities, and even assuming arguendo that they were, § 304's provisions override § 351. The court declined to follow the Sixth Circuit's contrary interpretation in Commissioner v. Stickney, reasoning that such an approach would produce inconsistent and unintended tax outcomes contrary to legislative intent.

Regarding the application of § 304(a)(1), the court rejected petitioners' narrow interpretation of "one or more persons," affirming that the statute applies broadly to any persons acting in concert controlling both corporations. The related corporation redemption treatment was thus appropriate.

The court then analyzed whether the redemption qualified as an exchange under § 302(b)(1). Applying United States v. Davis, the court found no meaningful reduction in shareholders' proportionate interests in WIP, so the transaction did not qualify for exchange treatment and must be taxed as a dividend under § 301.

Finally, the court reviewed the Tax Court's valuation of the agreements at 60% of face value, finding ample evidentiary support and no clear error in that determination.

Holding and Implications

The decision of the Tax Court is affirmed.

The court upheld the Commissioner's treatment of the transaction as a redemption under § 304(a)(1), taxable as a dividend, and confirmed the Tax Court's valuation of the agreements at 60% of face value. The trusts established under the mutual wills were proper taxpayers for the transaction. The court rejected petitioners' arguments regarding the applicability of § 351 and the interpretation of § 304. This decision directly affects the parties by affirming their tax liabilities as determined by the Tax Court but does not establish new precedent beyond the interpretation and application of existing statutory provisions and precedent.

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ROSE ANN COATES TRUST ET AL., APPELLANTS-PETITIONERS, v. COMMISSIONER OF INTERNAL REVENUE, APPELLEE-RESPONDENT.

EUGENE A. WRIGHT, Circuit Judge:

Sydney and Rose Ann Coates, together with their children, children's spouses, and grandchildren, owned all of the shares of two corporations, CAM Industries, Inc. (hereinafter called CAM) and Washington Industrial Products, Inc. (hereinafter called WIP). After the death of Sydney Coates, the family group agreed to combine the two corporations by having CAM "purchase" the shares of WIP.

When the transaction was complete, CAM and WIP shares were held by members of the family as follows: CAM Class A Class B WIP Voting Nonvoting Estate of Sydney Coates 75 664 Robert N. Coates 51 1,640 2,250 Peter Coates 6 205 Cathy Coates 6 205 Pamela Coates 6 205 Charles N. Coates 6 205 Marjorie Coates (Mrs. Robt.) 290 R. Morgan Boyd 63 10 422 Robert M. Boyd, Jr. 6 391 James Boyd 6 391 Ruby Boyd (Mrs. R. M.) 390 372 A. C. Heinen 57 10 375 Barbara Heinen 6 340 Gary Heinen 6 340 Richard Heinen 6 340 Molly Heinen (Mrs. A. C.) 390 325 ___ _____ _____ Totals 300 2,440 7,320 The "purchase" was effected on May 20, 1965 when CAM and the shareholders of WIP entered into agreements in this form:

AGREEMENT FOR SALE OF STOCK

Agreement made this 20th day of May, 1965, by and between the undersigned "Seller" and CAM INDUSTRIES, INC., a corporation, hereinafter called the "Buyer".

Seller hereby sells to Buyer, and Buyer hereby purchases from Seller, . . . . . . . shares of the common stock of Washington Industrial Products, Inc., a Washington corporation, at the price and on the terms and conditions herein set forth.

1. Purchase Price. The price to be paid by Buyer to Seller for said shares of common stock shall be $1,000.00 per share or an aggregate purchase price of . . . . . .

2. Delivery of Stock and Payment of Purchase Price.

(a) The certificate or certificates for the shares of common stock sold hereunder by Seller are herewith delivered to Buyer, duly endorsed for transfer to Buyer, and Buyer hereby acknowledges receipt of said certificate or certificates.

(b) The purchase price shall be paid . . . . ., or more at Buyer's option, on or before May 31, 1966, and a like sum, or more at Buyer's option, on the 31st day of May of each year thereafter until the 31st day of May, 1975, at which time the entire unpaid balance of the purchase price shall be due and payable. Buyer shall pay interest on the diminishing balance of said purchase price at the rate of four percent per annum from the 1st day of June, 1965, which interest shall be deducted from each installment payment and the balance of each payment applied in reduction of principal.

3. Successors and Assigns. The provisions of this agreement shall inure to the benefit of and bind the successors and assigns of Buyer and the executors, administrators, heirs, successors and assigns of Seller.

Subsequently, by order of the Superior Court of Washington for King County on September 23, 1965, Robert N. Coates as Trustee of the Trust Under Will of Sydney Coates received an undivided one-third interest in the May 20 contract for the sale of 75 shares of WIP held by the Sydney Coates Estate. By the same order Robert N. Coates as Trustee for the Rose Ann Coates Trust received an undivided two-thirds interest in the May 20 contract for the sale of the 75 shares held by the Estate.

Sydney and Rose Ann Coates had executed mutual wills. His will gave the house, auto, bank accounts and personal effects to Rose Ann Coates, with the residue of his estate going to the Trust Under Will of Sydney Coates. Her will provided that, in the event Sydney Coates predeceased her, she would convey by separate instrument her interest in any community property "to the Trustee or Trustees as named under the terms of the Trust created by the Will of Sydney N. Coates." Pursuant to this agreement, the Rose Ann Coates Trust was created by instrument dated August 21, 1965, executed by Rose Ann Coates, trustor, and Robert N. Coates, trustee.

The court below determined that the WIP stock was held by Sydney and Rose Ann Coates as community property. 37 1/2 shares belonging to each spouse. The odd apportionment is explained by the Order Approving Final Account, Report and Decree of Distribution of the Superior Court, which provided that in dividing the community property "any disproportionate allocation necessary shall be made in the respective ownership of the contract receivable for the sale of the Washington Industrial Products stock."

In their 1965 income tax returns, all parties reported the 1965 transaction as a sale of their WIP stock entitling them to capital gain treatment. In his notice of deficiencies the Commissioner treated the "sale" as a redemption by a related corporation under § 304(a)(1) of the Internal Revenue Code of 1954, taxable as a dividend at the face value ($1,000) of the agreements. The Tax Court upheld the Commissioner's § 304(a)(1) and dividend treatment, but found the fair market value of the agreements to be 60% of their face value rather than 100% as determined by the Commissioner. It is from this decision that the taxpayers appeal.

All section references hereafter are to the Internal Revenue Code of 1954, as amended.

On October 24, 1969, the Tax Court entered decisions of no deficiency in the following listed cases on the basis that the redemption of their stock in WIP by CAM was substantially disproportionate pursuant to § 302(b)(2): Arthur C. Heinen and Molly M. Heinen; Estate of Ruby M. Boyd, deceased, R. Morgan Boyd, executor; R. Morgan Boyd; Robert W. Boyd and Judith K. Boyd; Gary A. Heinen; Richard G. Heinen; Barbara Gaye Heinen; James E. Boyd. Robert and Marjorie are not parties in this case because of other matters with respect to their 1965 return which had not been resolved by the Service at the time this suit was instituted.

The decision of the Tax Court is reported at 55 T.C. 501 (1970).

Initially, petitioners contend that since the two trusts were not in existence at the time of the transfer of the WIP shares to CAM they are not taxpayers within the meaning of § 7701(a)(14), and that, accordingly, the Commissioner determined deficiencies against the wrong parties. They would have us hold that since the WIP shares were community property, the proper parties for taxation are the Estate of Sydney Coates and Rose Ann Coates. We decline to do so and affirm the Tax Court.

The Trust Under Will of Sydney Coates, under §§ 661 and 662, was a proper party to the proceedings below. While the question raised as to the Rose Ann Coates Trust is more difficult, we have concluded it also was a proper party below. Upon the death of her husband, Mrs. Coates held her community property interest in the WIP shares subject to a restriction on their use, by virtue of the mutual wills (see footnote 1 supra). Under Washington law, her agreement to transfer her half of the community property into trust was specifically enforceable by the beneficiaries thereof. In re Young's Estate, 40 Wn.2d 582, 244 P.2d 1165 (1952).

Thus on May 20, 1965 when the WIP shares held by the Estate were "sold," Mrs. Coates held her half of the community property in constructive trust for the beneficiaries of her agreement. Cf. Healy v. Commissioner, 345 U.S. 278, 73 S.Ct. 671, 97 L.Ed. 1007 (1953). We conclude, therefore, that the beneficial and equitable owner of the 50 WIP shares on May 20 was the Rose Ann Coates Trust, and as such it was subject to the tax on the transfer thereof. 2 Mertens, Law of Federal Income Taxation, § 17.08 (1967 Revision).

It is noteworthy that at no time after the death of her husband did Mrs. Coates obtain control over the WIP shares or the purchase agreements. Also, the agreements did not pass through Mrs. Coates, but rather were transferred directly from the Estate of Sydney Coates to the Rose Ann Coates Trust.

II.

Petitioners next contend that the agreements entered into on May 20 between CAM and the WIP shareholders are "securities" as that term is used in § 351 and that, since after the May 20 transaction the WIP shareholders controlled over 80% of the stock of CAM, § 351 operates to grant them either no tax liability or capital gain treatment. The Tax Court concluded that the agreements were not securities, citing Warren H. Brown, 27 T.C. 27 (1956).

Section 351(a) provides that:

No gain or loss shall be recognized if property is transferred to a corporation . . . by one or more persons in exchange for stock or securities in such corporation and immediately after the exchange such person or persons are in control . . . of the corporation.

The taxpayers argue two alternative positions: (1) that all of the agreements are securities, that § 351 is applicable and, no "other property" having been received, that the taxpayers did not incur any tax liability on the transfer; or (2) that certain of these agreements are "securities" but that some of them could be treated as "other property" under § 351, thus making the transaction taxable at capital gains rates to the extent of the value of this other property.

Petitioners argue that the Brown decision creates an invalid distinction between an installment sales contract and other long term corporate obligations. See Bittker Eustice, Federal Income Taxation of Corporations and Shareholders 3-55 (3d Ed. 1971); Comment, Section 351 Transfers to Controlled Corporations: The Forgotten Term — "Securities," 114 U.Pa.L.Rev. 314 (1965). We do not reach that issue, however, for even assuming arguendo that these agreements are "securities" under § 351, we are convinced that the provisions of § 351 are overridden by those of § 304 and that, accordingly, § 304 and not § 351 applies to this transaction. See Henry McK. Haserot, 46 T.C. 864, 872 (1966) (Tannenwald, J.) (separate opinion).

In Commissioner v. Stickney, 399 F.2d 828 (6th Cir. 1968), aff'g, Henry McK. Haserot, supra, the Sixth Circuit reached a contrary result. While the statutory language and legislative history reveal that Congress did not provide for or contemplate the possible conflict between the permissive policy of § 351 and the preventive policy of § 304, we are convinced that our decision "best achieves the underlying legislative intent and policy and . . . more nearly reflects the manner in which Congress would have `straightened this ruck out if they had come across it.'" Haserot, supra, 46 T.C. at 878 (Tannenwald, J.). Accordingly, we decline to follow the Sixth Circuit for the reasons so cogently set forth by Judge Tannenwald.

Our case reveals the ultimate inconsistency that would result if we followed Stickney and held that the "except as otherwise provided" provisos of §§ 302(d) and 301(a) precluded § 304 applicability to these taxpayers. Other parties to this transaction were taxed at the capital gains rate by virtue of §§ 304(a) and 302(b)(2). (See footnote 4, supra). That result would not be altered were we to follow Stickney's interpretation of the provisos. Thus Stickney's rationale would lead us to hold that those specifically excluded by Congress from dividend treatment (by virtue of § 302(b)(2)) would be taxed at the capital gains rate, while those Congress intended to be taxed at ordinary income rates (by virtue of §§ 304(a), 302(d), and 301(a) would escape taxation altogether by § 351. Such a result does not comport with our reading of the legislative intent behind §§ 304 and 351.

III.

Petitioners next argue that the Tax Court erred in holding that the transaction was a redemption through the use of a related corporation under § 304(a)(1). They would have us hold that the "one or more persons" of § 304(a)(1)(A) refers to one person plus those persons whose shares are attributed to him under § 318, and that the concept of aggregate control as prescribed by Reg. § 1.304-2(b) and applied by the Tax Court departs from the specific language and intent of the statute.

Reg. § 1.304-2(b): In any case in which two or more persons, in the aggregate, control two corporations, section 304(a)(1) will apply to sale by such persons of stock in either corporation to the other (whether or not made simultaneously) provided the sales by each of such persons are related to each other. The determination of whether the sales are related to each other shall be dependent upon the facts and circumstances surrounding all of the sales. For this purpose, the fact that the sales may occur during a period of one or more years (such as in the case of a series of sales by persons who together control each of such corporations immediately prior to the first of such sales and immediately subsequent to the last of such sales) shall be disregarded, provided the other facts and circumstances indicate related transactions.

Petitioners misconceive the operation and effect of § 304. That section was not designed to be so narrowly confined as to relate only to "family" transactions. To the contrary, it was designed to apply to any closely held corporations whether or not the parties were related by blood. The phrase "or more persons" is not superfluous, as petitioners ultimately must contend, but rather indicates an attempt to expand the scope of § 304(a)(1) beyond the family relationship to include unrelated persons who act in concert. See Radnitz v. United States, 187 F. Supp. 952 (S.D.N.Y. 1960), aff'd per curiam, 294 F.2d 577 (2d Cir. 1961).

Since in the instant case the same group of persons controlled both WIP and CAM, § 304(a)(1) applies to this transaction, and the property received by the WIP shareholders must be treated as a distribution in redemption of the stock of CAM.

Section 304(a)(1)(B).

IV.

To determine the tax consequences of a § 304(a)(1) redemption, it is necessary to refer to § 302. Unless the redemption qualifies as an exchange under one of the categories of § 302(b), it is to be treated under § 301. The only portion of § 302(b) relevant here is § 302(b)(1), which provides that a redemption shall be treated as an exchange if it is "not essentially equivalent to a dividend." To so qualify, the redemption "must result in a meaningful reduction of the shareholder's proportionate interest." United States v. Davis, 397 U.S. 301, 313, 90 S.Ct. 1041, 1046, 25 L.Ed.2d 323 (1970).

It is undisputed that § 301 treatment results in the distribution being taxed to each of the taxpayers as a dividend under §§ 316 and 301(c)(1).

The instant transaction resulted in no reduction in any of the taxpayers' proportionate interests in WIP. That being the case, the Tax Court correctly concluded that the distribution did not qualify for the preferred treatment under § 302(b)(1).

The relevant inquiry concerns the taxpayers' respective interests in WIP. Section 304(b)(1).

Taxpayers attempt to distinguish Davis on the grounds that that opinion applies only to 100% shareholders. The rationale of Davis does not support such a distinction, and we reject it without further discussion.

Petitioners finally contend that the Tax Court erred in determining the fair market value of the agreements to be $600 per $1,000 face value. We have carefully examined the record and conclude that there was ample support for the court's finding. It certainly was not clearly erroneous.

The amount of the distribution is the fair market value of the property received. Section 301(b)(1).

The decision of the Tax Court is affirmed.