Bryant, Victor S., Jr.

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Federal Income Taxation -- Sale of Corporate Assets -- Capital Gains Tax

University of North Carolina School of Law

NORTH CAROLINA LAW REVIEWVolume 28 | Number 4 Article 116-1-1950Federal Income Taxation -- Sale of CorporateAssets -- Capital Gains TaxVictor S. Bryant Jr.Follow this and additional works at: http://scholarship.law.unc.edu/nclrPart of the Law CommonsThis Note is brought to you for free and open access by Carolina Law Scholarship Repository. It has been accepted for inclusion in North Carolina LawReview by an authorized editor of Carolina Law Scholarship Repository. For more information, please contact law_repository@unc.edu.Recommended CitationVictor S. Bryant Jr., Federal Income Taxation -- Sale of Corporate Assets -- Capital Gains Tax, 28 N.C. L. Rev. 409 (1950).Available at: http://scholarship.law.unc.edu/nclr/vol28/iss4/11NOTES AND COMMENTSEven if the exemption of dwellings, gardens, etc., were considereda way, means, method, or procedure, the same are to be applicable tothe SH&PWC only insofar as "suitable for the purposes of this sec-tion." If the SH&PWC were forced to so locate its routes as to avoidevery dwelling-house, garden, yard, kitchen, and burial ground en-countered, the development of a state highway system would be seri-ously impeded. Such a result would hardly be compatible with thepurposes of N. C. GEN. STAT. §136-19 (1943).N. C. Sess. Laws 1947, c. 806, added a new subsection to N. C. GEN.STAT. §40-2 (1943) which, in effect, gives the SH&PWC the power tocondemn land for facilities, a power not theretofore conferred upon it.39Inasmuch as the corporations listed in N. C. GEN. STAT. §40-2 (1943)are subject to the provisions of N. C. GEN. STAT. §40-10 (1943),40 itwould seem that in granting this additional power by amending N. C.GEN. STAT. §40-2 (1943), instead of by amending N. C. GEN. STAT.§136-19 (1943), the legislature intended to subject the power of con-demnation for facilities purposes to the "dwelling house" limitation im-posed in N. C. GEN. STAT. §40-10 (1943). But inasmuch as N. C. GEN.STAT. §136-19 (1943) grants the SH&PWC the power of eminent do-main for highway purposes, and N. C. GEN. STAT. §40-2 (1943) grantsonly the additional power of eminent domain for facilities purposes, onlythat latter power should be limited by the provisions of N. C. GEN STAT.§40-10 (1943). It is hardly probable that the legislature intended, bythe 1947 amendment, to limit indirectly the broad powers of condemna-tion for highway purposes elsewhere conferred upon the SH&PWC.LLOYD S. ELKINS, JR.Federal Income Taxation-Sale of Corporate Assets-Capital Gains TaxWhen a corporation wishes to sell its assets the problem of capitalgains taxable to the corporation arises. If there has been an apprecia-tion in the value of the assets, as usually there has been, the sellingcorporation will be subject to a heavy capital gains tax on this appre-ciation, and, in addition, its stockholders will be subject to a capital gainstax on the proceeds of the sale when they are distributed, if the distribu-" "The right of eminent domain may, under the provisions of this chapter, beexercised . . .by the bodies politic, corporation, or persons following..."9. The state highway and public works commission, for the purpose of acquir-ing such land or property as may be necessary for the erection of or addi-tion to any building or buildings for the purpose of housing its offices, shops,garages, for storage of supplies, -material or equipment, for housing, caringor providing for prisoners, or for any other purpose necessary in its work,including the administration of the state prison system"40 Clifton v. Duplin Highway Comm'n, 183 N. C. 211, 111 S. E. 176 (1922)Raleigh, C. & S. R. R. v. Mecklenburg Mfg. Co., 166 N. C. 168, 180, 82 S. E. 5, 10(1914).1950]NORTH CAROLINA LAW REVIEWtion is in retirement of the outstanding stock under a plan of completeor partial liquidation.' Thus, a heavy double taxation may result froma sale of corporate assets. To avoid this, and so reduce taxes, severalmethods for the transfer of the selling corporation's assets have beendevised.One such possible method is to have the corporation liquidate and,upon liquidation, distribute its assets in kind to its stockholders in re-tirement of the outstanding stock. The stockholders may then sell theassets to the buyer. By the terms of U. S. Treas. Reg. 111, §29.22(a)-20 (1943), distribution in kind of assets on liquidation of a corporationis not subject to a capital gains tax. Thus, here, the only tax on theentire transaction is that levied upon the proceeds of the sale of theassets by the stockholders. By using this method the buyer gets onlythe desired assets of the corporation, free of its unwanted liabilities. Itwould seem desirable then to use this method of transfering the assets.However, in Court Holding Co. v. Commissioner,2 perhaps the mostwidely recognized case interpreting U. S. Treas. Reg. 111, §29.22(a)-20 (1943), the United States Supreme Court held that mere formalsteps of liquidation and sale by the stockholders would not be permittedto -disguise what was in substance a sale by the corporation. In thatcase, the petitioner, Court Holding Co., was a corporation formed tohold an apartment house as its only asset. The apartment house wasleased and the lessees, after approximately one year's occupancy, statedtheir desire to purchase the property. Thereupon the two stockholdersof petitioner, who were also two of the three directors, began negotiationsand terms were eventually agreed upon, satisfactory both to the lesseesand to the stockholders and directors of petitioner. The directors ofpetitioner, however, refused to execute the contract of sale because aheavy capital gains tax would result. On the same day, the directorsvoted to liquidate and distribute the assets in kind to the stockholdersin return for all the outstanding stock. This being done, the stock-holders, three days later, sold the apartment to the lessees, using thesame terms previously agreed upon between the lessees and the direc-tors. Though all the steps required by the regulation were carriedout, the Court held that petitioner corporation was subject to a capitalgains tax on the sale, with the result that the double tax was imposed.The Court reasoned that since the corporation had done all the nego-tiating and had agreed upon terms which the stockholders only carriedout, the stockholders were mere conduits for a sale which in substancewas one by the corporation.From this decision it appeared that U. S. Treas. Reg. 111, §29.22'INT. REv. CODE §115(c); Adams, Some Tax Aspects of the Complete andPartial Liquidation of Corporations, 28 N. C. L. REv. 36 (1949).2324 U. S. 331 (1945).[Vol. 28NOTES AND COMMENTS(a)-20 (1943) would not exempt a liquidation from the capital gainstax if such liquidation were made for the sole purpose of consummatinga sale of the corporation's assets and avoiding a tax to the corporation.This principle is in line with the Court's policy of looking through atransaction to discover the substance and taxing it accordingly.3Recently, however, United States v. Cumberlaizd Public ServiceCo.,4 a case involving the same regulation, was before the Court and itwas there held that the corporation was not subject to the capital gainstax. There a closely held corporation was engaged in generating anddistributing electric power, but the stockholders and directors, realizingthe inability to compete with companies supplied with T.V.A. power,had offered to sell all-the outstanding stock to an electric power coopera-tive using T.V.A. power. The cooperative refused to purchase the stockbut offered to purchase certain of petitioner's assets. Petitioner rejectedthis offer due to the heavy capital gains tax involved in such a sale.Petitioner then called in an accountant to discuss a possible transfer ofthe assets which would avoid the double taxation. It was then decidedthat the petitioner should liquidate and distribute the assets to the stock-holders who in turn would sell them to the cooperative.These steps were carried out and the commissioner, relying uponthe Court Holding Co. case, imposed a capital gains tax upon the peti-tioner. The Court of Claims, however, rejected the commissioner'sclaim,5 reasoning that since the negotiations were started by the stock-holders as such, rather than by the corporation, the Court Holding Co.rule should not apply. This was affirmed by the Supreme Court.Though it refused to overrule the Court Holding Co. case, how effectiveis the distinction made? Does not the Cumberland case rob the CourtHolding Co. decision of its desired effect and underlying principle?It is true that in the Cumberland case the stockholders acted as such,and not as the directors of the corporation, in carrying on the negotia-tions. But this distinction leads to the conclusion that the future deci-sions will be made to rest, in part at least, upon whether the directors,being cognizant of the tax problems involved, preface their negotiationsfor sale by an indication that they are acting as stockholders, or whether,being unaware of the tax problems, they act as directors and officersof the corporation. In a closely held corporation having only two orthree stockholders, it is often difficult to determine whether it is thecorporation or the stockholders who are negotiating. That the corpora-'Weiss v. Steam, 265 U. S. 242 (1924) ; United States v. Phellis, 257 U. S.156 (1921) ; Muerer Steel Barrel Co. v. Commissioner, 144 F. 2d 282 (3d Cir.),cert. denied, 324 U. S. 860 rehearing denied, 325 U. S. 892 (1944) (Court con-strued the same regulation section as did the Court in Court Holding Co. v. Com-missioner) ; Commissioner v. Ashland Oil & Refining Co., 99 F. 2d 588 (6th Cir.),cert. denied, 306 U. S. 661 (1938).'338 U. S. 451 (1950). '83 F. Supp. 843 (Ct. Cl. 1949).19501NORTH CAROLINA LAW REVIEWtion owns the property during the negotiations is not decisive, since ithas been held that a stockholder may negotiate and contract to sell prop-erty which he expects to receive by liquidation, though title to it is stillin the corporation. 6 Thus, it cannot be said that the stockholder ispresumed to be negotiating for the corporation simply because the titleremains in the corporation and the stockholder who is negotiating isalso a director of the corporation. This is true though no liquidationplan has yet been formulated.7 On the other hand, the fact that theliquidation plan has been enacted by the directors prior to the negotia-tions for sale is not sufficient to enable courts to hold that the negotia-tions are being carried on by the stockholders, even though it might besaid that the stockholders obtained equitable title to the assets by theenactment of the liquidation plan.sIn the Court Holding Co. case there was no binding contract enteredinto by the corporation before the liquidation. For this reason it seemsthat the Court might have held that adoption of the previous terms andexecution of a written contract by the stockholders was sufficient to holdthat the sale was one by the stockholders. They had the power to rejectthe previous terms and negotiate anew. They chose, however, not toexercise such power but rather to accept the terms already agreed upon.In the field of taxation a power is frequently decisive, even though notexercised, 9 and so it might have been here. Rather, the Court held thepoint immaterial and of no effect.In the Cuinberland case the Court said: "but congress has imposedno tax on liquidating distributions in kind or on dissolution, whatevermay be the motive for such liquidation. Consequently, a corporationmay liquidate or dissolve without subjecting itself to the corporate gainstax, even through a primary motive is to avoid the burden of corporatetaxation."'1 There is nothing unusual about this statement. It is a long"Howell Turpentine Co. v. Commissioner, 162 F. 2d 319 (5th Cir. 1947);United States v. Cumberland Public Service Co., 83 F. Supp. 843 (Ct. Cl. 1949).But cf. Kaufman v. Commissioner, 175 F. 2d 28 (3d Cir. 1949) (court held thatsince stockholders were also directors, they were under a legal duty to act asdirectors when dealing with corporate property; hence, they cannot, as stock-holders, negotiate regarding corporate property before liquidation) ; Trippett v.Commissioner, 118 F. 2d 764 (5th Cir.), cert. denied, 314 U. S. 644 (1941).Howell Turpentine Co. v. Commissioner, 162 F. 2d 319, 324 (5th Cir. 1947).1 Borall Corp. v. Commissioner, 167 F. 2d 865 (2d Cir. 1948) (Directors re-solved: (1) that the corporation distribute its assets to the stockholders, (2) thatthe assets be actually delivered to the stockholders or sold by an agent selectedfor them. Part of the assets, at the stockholder's election, the corporation turnedover to a bank to sell for the stockholders and distribute the proceeds to them.Held: since the bank was selected by the corporation, the bank was a liquidationtrustee of the corporation and sale was one by the corporation and not by thestockholders.).Helvering v. Clifford, 309 U. S. 331 (1940) (setting up the so-called Clifforddoctrine, holding that certain powers, when retained in a trust by the settlor, makethe income taxable to the settlor even though the powers are not exercised)Fulham v. Commissioner, 110 F. 2d 916 (1st Cir. 1940).3070 Sup. Ct. 280, 282 (1950).[Vol. 28NOTES AND COMMENTSestablished principle. 1 ' But, how can it be reconciled with the CourtHolding Co. decision? A distinction is sometimes made between atransaction which serves a legitimate business purpose and one whichis merely a cover for what is, in substance, an entirely different type oftransaction. 12 Since in both the Court Holding Co. and Cumberlandcases the business purpose behind the transactions was the sale of theassets to the buyer, it hardly seems that the liquidation in the one in-stance was more bona fide than in the other.It seems that the mere form of the negotiations, and not the sub-stance behind the transactions, is to be the deciding factor in cases ofthis type. We are left with a rigid set of facts on the one hand underwhich the tax may be reduced successfully, while on the other hand wehave another set of facts which fails to accomplish this result. This isnot surprising in view of the importance of minute procedural steps inthe field of taxation.This presents the problem of where, relative to the two sets of facts,the Court will draw the line between corporate and stockholder action.In the Court Holding Co. case the Court relied heavily upon the factthat the terms of the sale were exactly those reached in the negotiationsbetween the directors and the lessees. Perhaps the result would havebeen different had the corporate negotiations left unsettled a materialpoint which the stockholders later settled. On the other hand, the Courtmight have held that the sale was in effect one by the corporation, sincea majority of the negotiations had been completed before the liquidation.In a more recent lower court case, 13 the negotiations were begun bythe president but were shortly assumed and completed by the stock-holders, who made it plain from the beginning that an individual saleby the stockholders and. not a corporate sale was contemplated. Thecourt of appeals there held that since title was in the corporation duringnegotiations and since no liquidation steps were taken prior to startingnegotiations, the stockholders were acting for the corporation. Theresult was that the sale by the stockholders following liquidation washeld to be a corporate sale. Under the Cumberland rule it seems thatthis holding would be reversed by the Supreme Court, if brought before"' Motive of avoidance is immaterial if the means is legal. Commissioner v.Tower, 327 U. S. 280 (1945) ; Gregory v. Helvering, 293 U. S. 465 (1935). Butcf. Commissioner v. Phipps, 336 U. S. 410 (1948) (In interpreting and approvingthe theory behind Commissioner v. Sansome, 60 F. 2d 937 (1932), the Court heresays that a tax may be upheld solely on grounds of preventing tax avoidance. Thislooks like a statement of what has been the actual practice, though a contrary rulehas been stated.)."2 Gregory v. Helvering, 293 U. S. 465 (1935) ; Chisholm v. Commissioner, 79F. 2d 14 (2d Cir.) cert. denied, 296 U. S. 641 (1935) (the purpose which countsis the one which defeats or contradicts the apparent transaction, not the purposeto escape taxation which the apparent, but not the whole, transaction wouldrealize).13 Kaufman v. Commissioner, 175 F. 2d 28 (3d Cir. 1949).1950]NORTH CAROLINA LAW REVIEWit, but we must wait for the ruling on each set of facts as it is presented.It is suggested, on the basis of present decisions, that in carryingout the liquidation and sale by the stockholders, the liquidation shouldbe effected, if at all possible, before any definitive negotiating takes place.It should be done as soon as the idea to sell is conceived in order toprevent a holding that any part of the negotiations was corporate action.If the negotiations do take place before liquidation, they should be car-ried on in behalf of the stockholders by someone who is not an officerof the corporation.14 When the assets are transferred to an agent forthe stockholders, care should be taken that the corporation or the boardof directors, as a body, has no hand in the appointment of such agent,but rather that a stockholder's petition or consent should be obtainedappointing him.' 5There should be a complete vesting of title to the assets in the stock-holders before the sale takes place. It has been held that payment of acorporate debt out of the proceeds of the sale by the stockholders doesnot make the sale one by the corporation.' 0 It is best, however, to avoidthis since it is possible that courts may say that the sale was for thecorporation's benefit and hence was corporate action. The rule whichpermits escape from double taxation in this situation is a just one butgreat care must be exercised to reap its benefits.VICTOR S. BRYANT, JR.Federal Jurisdiction-Amount in Controversy-Effect of CounterclaimUnder Rule 13 of the Federal Rules of Civil Procedure counter-claims are divided into two classes, compulsory and permissive. A com-pulsory counterclaim is one which must be pleaded if it arises out ofthe transaction or occurrence that is the subject matter of the opposingparty's claim, does not require the presence of parties over whom thecourt cannot acquire jurisdiction, and is not the subject matter of apending action.' A permissive counterclaim is any other claim againstan opposing party.2"Louisville Trust Co. v. Glenn, 65 F. Supp. 193 (W. D. Ky. 1946) (threeman committee appointed by stockholders; only one member of committee wasofficer of corporation; liquidation resolution but no actual liquidation occurredbefore negotiations began)." Borall Corp. v. Commissioner, 167 F. 2d 865 (2d Cir. 1948); LouisvilleTrust Co. v. Glenn, 65 F. Supp. 193 (W. D. Ky. 1946); Burnet v. Lexington Ice& Coal Co., 62 F. 2d 906 (4th Cir. 1933) (North Carolina federal case using whatis now N. C. GEN. STAT. §55-132 (1943) which provides that corporation is stillentity for winding up purposes for three years after dissolution, and holding thateven after dissolution, agent appointed by corporation for stockholders actuallycorporation's trustee in liquidation and sale by him corporate sale)." Louisville Trust Co. v. Glenn, 65 F. Supp. 193 (W. D. Ky. 1946).1 Fed. R. Civ. P. 13(a). 'Fed. R. Civ. P. 13 (b).[Vol. 28

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Federal Income Taxation -- Sale of Corporate Assets -- Capital Gains Tax

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