Coffee v. Commissioner

United States Tax Court · 1950 · Corporations

CorporationsDividendsStock salesEarnings and profitsValuationdividend distributionstock salereserved corporate asset

Facts

Petitioners agreed to sell their stock in Smith Brothers Refinery Co., Inc. for $190,000, but the purchasers did not want the corporation's contingent right to the Cabot payment and negotiated to acquire the stock only after that asset was removed from the corporation. Before the stock transfer, the board adopted a resolution assuring petitioners that they would receive the Cabot payment, and petitioners did not transfer their stock until that resolution passed. The corporation had earnings and profits in excess of the amount the Commissioner determined to be the Cabot payment's value at distribution. Although the payment was uncertain during negotiations, gas-price increases after April 10, 1941 improved its prospects, and petitioners ultimately received the full $200,000 by March 31, 1944.

Issue

Whether the Cabot payment received by petitioners in connection with the stock sale was part of the consideration for the sale of their stock and thus capital gain, or instead a dividend distribution taxable to them as shareholders. If it was a dividend, the court also had to determine its fair market value at the time of distribution and whether it was taxable to petitioners rather than the purchasers.

Rule

When shareholders sell stock but expressly reserve a corporate asset to themselves, and the corporation's directors authorize the asset's distribution to them before or in connection with the transfer, the shareholders receive that asset as stockholders rather than as part of the stock sale price. If the corporation has sufficient earnings and profits and the distribution is not in cancellation or redemption of stock, the distribution is a dividend taxable as ordinary income to the shareholders who were entitled to receive it, to the extent of its fair market value. In valuing property with no ready market, the court may consider subsequent facts and circumstances bearing on intrinsic worth.

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In Tulsa, Nora Benton and Eli Cruz agreed to sell all their shares of Red Mesa Solvents, Inc. to Prairie Lantern Holdings for $600,000. During negotiations, Prairie Lantern said it did not want the corporation's contingent royalty claim, and the sellers refused to close unless Red Mesa's board first adopted a resolution assigning that claim to the current shareholders.

How should the royalty claim most likely be characterized for federal tax purposes if Red Mesa had ample earnings and profits and the claim was not distributed in redemption of stock?

Explanation. The majority rule is that when a corporate asset is expressly reserved to the selling shareholders, the buyers do not want that asset, and the board authorizes its distribution before or in connection with the stock transfer, the sellers receive the asset as stockholders rather than as part of the stock sale price. If the corporation has sufficient earnings and profits and the distribution is not a redemption or partial liquidation, the distribution is a dividend taxable as ordinary income to the shareholders who were entitled to receive it.