Cary v. Commissioner

*215 Respondent determined a deficiency in petitioner's income tax for the year 1957 in the amount of $ 167,048.29.

The principal issues presented are whether the provisions of section 302(c)(2)(A)(iii), I.R.C. 1954, and the regulations thereunder, providing for the nonapplicability of section 318(a)(1) to stock redemptions which would otherwise qualify as in complete termination of a stockholder's interest in the redeeming corporation, are mandatory, requiring strict compliance, or merely directory, requiring substantial compliance; and, if merely directory, whether petitioner substantially complied with such provisions.

FINDINGS OF FACT

Most of the facts necessary for a resolution of the above issues have been stipulated by the parties and are found accordingly.

Georgie S. Cary (hereinafter referred to as petitioner) is an individual presently residing in Dallas, Tex. Her individual income tax return for the taxable year 1957 was filed with the district director*25 of internal revenue, Dallas, Tex.

Petitioner is the widow of Dr. E. H. Cary. Dr. Cary died testate on December 11, 1953, appointing the Republic National Bank of Dallas and his son, E. H. Cary, Jr., independent coexecutors and trustees of his estate. Under the terms of Dr. Cary's will, the residue of his estate was left in equal shares to four separate trusts, one for each of his four children, with petitioner, the surviving widow, having a life interest in each of these trusts.

Dr. Cary's estate at the time of his death consisted only of community property in which petitioner, as his surviving wife, had a one-half interest. The principal assets of his estate consisted of 145 shares of common capital stock in the Medical Arts Hospital of Dallas (hereinafter sometimes referred to as Medical), a Texas corporation, and other miscellaneous stocks, bonds, and real estate. From the time of its incorporation to the time of Dr. Cary's death, all of the outstanding stock in the Medical Arts Hospital was owned as follows:

*26 *216 In closing the administration of Dr. Cary's estate petitioner received, as part of her community property share, the 145 shares of Medical Arts stock. For Federal estate tax purposes these shares were reported by the E. H. Cary estate at a total fair market value of $ 206,625, or $ 1,425 per share, and this valuation was accepted by the Commissioner of Internal Revenue as correct. Pursuant to the provisions of section 1014(b)(6), petitioner's basis for the 145 shares thus received was $ 206,625. After the settlement of Dr. Cary's estate, all of the outstanding stock in the Medical Arts Hospital was owned 5 shares by E. H. Cary, Jr., and 145 shares by petitioner.

On December 12, 1957, petitioner resigned the positions which she had held as an officer and director of Medical Arts Hospital. On December 13, 1957, Medical redeemed the 145 shares of its stock held by petitioner, distributing to her in exchange the sum of $ 206,625 which was both petitioner's basis for such stock and the fair market value thereof on the date of the redemption. Immediately after the redemption all of the outstanding 5 shares of Medical's stock were owned by E. H. Cary, Jr., petitioner's son, *27 and none were owned directly by petitioner.

On her Federal income tax return for the taxable year 1957, petitioner reported the December 13, 1957, transaction as a sale of stock resulting in no gain or loss, on the theory that the distribution by Medical was in complete redemption of all of the Medical stock owned by her and that the amount received was equal to her basis in the stock redeemed. Petitioner's income tax return for the taxable year 1957 was prepared and filed by a reputable firm of certified public accountants in Dallas, Tex., specializing in the auditing and preparation of Federal income tax returns. This firm had prepared petitioner's Federal income tax returns for many years, was fully conversant with her financial affairs, and was advised of petitioner's resignation on December 12, 1957, from the board of Medical, as well as the stockholder resolution authorizing the December 13, 1957, stock redemption.

In 1959, during an audit of petitioner's 1957 return by the Internal Revenue Service, it was discovered that petitioner had failed to file with that return an agreement, as provided by section 302(c)(2)(A)(iii) and the regulations thereunder, to notify the district*28 director of internal revenue in the event she reacquired any stock in Medical within 10 years following the December 13, 1957, redemption. Thereafter, from records maintained by petitioner, an amended return for 1957 was filed with the agreement attached in accordance with section 1.302-4(a), Income Tax Regs. This amended return, with agreement attached, was received by the district director at Dallas on August 3, 1959.

*217 Since her resignation from the board on December 12, 1957, petitioner has not served either as an employee, officer, or director of Medical; nor, since the redemption of her stock on December 13, 1957, has she reacquired any interest in that corporation as a stockholder. In his notice of deficiency respondent determined that the distribution made by Medical to petitioner in redemption of her stock on December 13, 1957, was the essential equivalent of a taxable dividend in the amount of $ 206,625.

OPINION

The tax treatment to be accorded distributions in redemption of stock made after December 31, 1954, is controlled by section 302 of the Internal Revenue Code of 1954. That section provides that such distributions are to be treated as in part or full payment*29 in exchange for the stock redeemed where the redemption, pursuant to which the distribution was made, qualifies as an exchange under paragraphs (1), (2), (3), or (4) of section 302(b). It is petitioner's position that the redemption of December 13, 1957, does so qualify under the provisions of paragraph (3) of section 302(b).

Section 302(b)(3) permits exchange treatment of a redemption which is made "in complete redemption of all of the stock of a corporation owned by the shareholder." Moreover, while the constructive ownership provisions of section 318(a) are made expressly applicable to determinations of stock ownership for the purposes of section 302, an exception to this rule is provided in cases of section 302(b)(3) redemptions by section 302(c)(2)(A). That section states that:

(A) In the case of a distribution described in * * * [sec. 302(b)(3)], section 318(a)(1) [which for purposes pertinent to the instant case would attribute the ownership of stock, owned by taxpayer's children, to the taxpayer] shall not apply if --

(i) immediately after the distribution the distributee has no interest in the corporation (including an interest as officer, director, or employee), other *30 than an interest as a creditor,

(ii) the distributee does not acquire any such interest (other than stock acquired by bequest or inheritance) within 10 years from the date of such distribution, and

(iii) the distributee, at such time and in such manner as the Secretary or his delegate by regulations prescribes, files an agreement to notify the Secretary or his delegate of any acquisition described in clause (ii) and to retain such records as may be necessary for the application of this paragraph.

If the distributee acquires such an interest in the corporation (other than by bequest or inheritance) within 10 years from the date of the distribution, then the periods of limitation provided in sections 6501 and 6502 on the making of an assessment and the collection by levy or a proceeding in court shall, with respect to any deficiency (including interest and additions to the tax) resulting from such acquisition, include one year immediately following the date on which the distributee (in accordance with regulations prescribed by the Secretary or his delegate) notifies the Secretary or his delegate of such acquisition; *218 and such assessment and collection may be made notwithstanding*31 any provision of law or rule of law which otherwise would prevent such assessment and collection.

The regulation referred to in section 302(c)(2)(A)(iii) is section 1.302-4(a):

The agreement specified in section 302(c)(2)(A)(iii) shall be in the form of a separate statement in duplicate signed by the distributee and attached to his return timely filed for the year in which the distribution described in section 302(b)(3) occurs. The agreement shall recite that the distributee has not acquired any interest in the corporation * * * since such distribution, and that he agrees to notify the district director of internal revenue * * * of any acquisition of such an interest in the corporation within 30 days after such acquisition if such acquisition occurs within 10 years from the date of such distribution.

Immediately after the December 13, 1957, redemption by which the 145 shares of Medical stock owned by petitioner were redeemed, her son, E. H. Cary, Jr., continued to own the remaining 5 outstanding shares of stock in that corporation. Unless the application of the constructive ownership rules of section 318(a)(1) is barred by section 302(c)(2)(A), supra, it is clear that the *32 redemption of December 13 does not qualify as a complete termination of petitioner's interest in the redeeming corporation within the meaning of section 302(b)(3).

Petitioner did not file the agreement contemplated by section 302(c)(2)(A)(iii) with her return for 1957. She did, however, report on that return the redemption of her stock by Medical as a sale which resulted in no gain or loss since her basis for the stock sold was equal to the amount received by her from the sale. When in 1959, during an audit of her 1957 return, petitioner's failure to file the agreement was brought to her attention, she promptly filed an amended return for 1957 attaching that agreement. It is respondent's position that petitioner's failure to file the section 302(c)(2)(A)(iii) agreement in the manner prescribed by section 1.302-4(a), Income Tax Regs., precludes her use of the exemption provided by section 302(c)(2). Petitioner contends that the statute requires only substantial, rather than strict, compliance, and that substantial compliance was effected.

We agree with petitioner. The essence of section 302(c)(2) taken in conjunction with section 302(b)(3) is to allow exchange*33 treatment to redemptions which result in the complete cessation of a shareholder's interest in a corporation for a period of 10 years. In this connection, we observe that section 302, as originally enacted by the House, provided that the rules of family attribution (now section 318(a)(1)) would not be applicable to redemptions in complete termination of a shareholder's interest if only two conditions were met, viz, that "immedately [after the redemption] * * * the distributee *219 has no interest in the corporation * * * and * * * such distributee does not acquire any such interest in [the] corporation within 10 years from the date of the distribution in redemption." ¹ We further note that the House version of the statute exacted no requirement that an agreement be filed with the Secretary or his delegate before "complete termination" redemptions would qualify for exemption from the family attribution rules.

The Senate version of section*34 302 retained the two essential requirements for the exemption of redemptions in complete termination from the family attribution rules, and added a third provision, relating to the filing of an agreement, with this explanation:

Moreover, in order to qualify for nonattribution between members of a family, sub-paragraph (A)(iii) [of section 302(c)(2)] requires that the distributee, under regulations prescribed by the Secretary or his delegate, file an agreement to notify the Secretary or his delegate of any acquisition of any interest (other than by bequest or inheritance) within the 10 year period and to retain such records as the Secretary or his delegate may prescribe as necessary for the application of paragraph (2) [of section 302(c)]. Thus, your committee anticipates that the Secretary or his delegate may require that the distributee retain personal income tax returns and other records indicating fully the amount of tax which would have been payable had the redemption not been treated as a distribution in full payment for his stock. ² [Emphasis supplied.]

It would thus appear that a primary purpose for the addition of section 302(c)(2)(A)(iii) to the House version*35 of section 302 was so that records, "indicating fully the amount of tax which would have been payable had the redemption not been treated as a distribution in full payment for his stock," could be required of distributees by the Commissioner of Internal Revenue.

As we have hereinbefore noted, what is essential with respect to sections 302(b)(3) and (c)(2) is that the redemption result in the complete cessation of the shareholder's interest in the corporation, and, that such cessation extend for a period of 10 years. The requirement that the distributee agree to retain records of the redemption does not relate to the substance of the transaction, but, on the contrary, relates merely to procedural detail. Such a requirement can, in our view, be satisfied by substantial compliance with its provisions. Respondent, however, contends that such a view would be prejudicial to him.

Relying on the case of Archbold v. United States, 201 F. Supp. 329 (D.N.J. 1962),*36 affirmed per curiam 311 F. 2d 228 (C.A. 3, 1963), respondent argues that section 302(c)(2)(A)(iii) was designed principally to protect the Government from any attempt on the part of a *220 taxpayer to terminate his interest in a corporation for the 3-year period of limitations provided by section 6501 and then reacquire this interest after having taken advantage of the favored capital gains treatment afforded by section 302(b)(3). Archbold, in denying a taxpayer-distributee's request to file a section 302(c)(2)(A)(iii) agreement 2 years after the return was filed, reasoned that if the agreement was not required to be timely filed (i.e., with the original return), a situation would be created where a distributee could reacquire the stock after the running of the 3-year statute of limitations with impunity, while should his return be audited within 3 years of the year of distribution, he need only file the agreement to retain his section 302(b)(3) treatment. With this reasoning we respectfully disagree.

Looking once again to the legislative history of section 302, we find that, as originally enacted by the House, that section provided:

*37 that in any case in which the [section 302(b)(3)] distributee acquires an interest in [the redeeming] corporation in less than 10 years from the date of such distribution [in complete redemption], the amount of tax attributable to the inclusion in income pursuant to section 301 of the amount of such distribution shall be assessed and collected notwithstanding any statutes of limitation or other rule of law. ³ [Emphasis supplied.]

However, consistent with the theory that some statute of repose is necessary in order to insure the taxpayer, who has made an honest return, that after such period his tax liability will not be reopened, see Mabel Elevator Co., 2 B.T.A. 517, 519 (1925), the Senate amended section 302 to provide that:

In the event that the [section 302(b)(3)] distributee acquires an interest in the corporation * * * within the 10 years from the date of distribution, then the period of limitation provided in sections 6501 and 6502 * * * shall, with respect to any deficiency * * * resulting from such acquisition, include 1 year following the date the distributee, in accordance with regulations, notifies the Secretary or his delegate*38 [of such acquisition]. ⁴ [Emphasis supplied.]

Thus, as originally written, section 302 contained no statute of limitations on the assessment and collection of deficiencies which resulted from reacquisitions within the 10-year period. The Senate amendment modified the House version by providing that, in the case of reacquisitions, the Government would have, in addition to the periods already provided by sections 6501 and 6502, "1 year following the date the distributee * * * notifies the Secretary or his delegate" of such acquisition to make assessment or collection of any deficiencies in tax arising as a result of said acquisition. Since the additional 1-year statute does not begin to run until after notification by the distributee *221 of reacquisition, the Government is fully protected even where the section 302(c)(2)(A)(iii) agreement is not filed.

This same result *39 was reached by the District Court in the recent case of Van Keppel v. United States, 206 F. Supp. 42 (D. Kan. 1962), affd. 321 F. 2d 717 (C.A. 10, 1963). The facts of the Van Keppel case are, for all practical purposes, indistinguishable from those in the instant case. ⁵ There, as here, the Government contended for the application of the Archbold rationale. This approach was rejected by the District Court, which stated:

I disagree with * * * [Archbold] because in my opinion the three year statute does not bar recovery of additional taxes upon reacquisition of stock within ten years. * * * Section 302(c)(2) provides for the assessment of tax deficiencies within one year after notice of reacquisition is given. The statute does not say the one-year statute of limitation is applicable only if an agreement is filed. It says the one-year statute of limitation applies if the taxpayer reaquires an interest within ten years.

* * * *

If the statute of limitation extends to one year after notice, regardless of a filed agreement, both the taxpayer and the Government are fully protected. Obviously, a filed agreement*40 would make it easier for the Director to detect reacquisitions; but detection is not the essence of section 302(c)(2), since the taxpayer must notify the Director in order to set the one year statute of limitations in motion.

*41 In affirming Van Keppel we note that the Tenth Circuit chose to distinguish, rather than disagree with, the Third Circuit's affirmance of Archbold. ⁶ The Tenth Circuit found that:

Nothing in the statutes or regulations precludes the Director from accepting an agreement filed after the prescribed period. Established administrative practice has long recognized and accepted amended returns filed after the due date "for the purpose of correcting clear errors or plain mistakes inhering in original returns." [Citing authorities.]

* * * *

The Director did not reject the agreement or the amended return. Unless the assessment of the deficiency may be considered a rejection, the Government has never disclaimed the agreement and the taxpayers are bound by it. The situation *222 is different from that presented in Archbold v.United States [citation]. That case did not consider a claim of mistake. [In Archbold,] after the Director had made a deficiency assessment on the basis that a redemption was ordinary income, the taxpayers offered to file an amended return appending the required agreement. Here the failure of the taxpayers to file the agreement was a *42 mistake, the submission of the agreement preceded the assessment, and the record does not disclose any rejection of the agreement other than the deficiency assessment. * * * Acceptance of the late filing was discretionary. Fairness to the taxpayers requires that the discretion be exercised for their benefit and failure to do so was an abuse of discretion. [Emphasis supplied.]

While, as stated earlier, we disagree with the substantive rationale of the Archbold case, it is to be noted that all of the factors used by the Tenth Circuit to distinguish Van Keppel from Archbold are present here. Petitioner is a widow, who was 73 years of age at the time of the December 13, 1957, redemption of her Medical stock. Her return for the year 1957 was prepared by competent certified public accountants, familiar with her financial affairs, in consultation with her attorneys. On her 1957 return the *43 redemption was reported as a sale of stock. Through the inadvertence of someone, no section 302(c)(2)(A)(iii) agreement was attached to the return. When petitioner's 1957 return was audited in 1959 and the absence of the agreement was made known to her, she promptly filed an amended 1957 return attaching the agreement. The district director duly acknowledged receipt of this amended return and agreement on August 3, 1959. Since that time he has neither rejected the return nor, quite obviously, has there ever been an assessment of the alleged deficiency. These being the relevant facts, if Archbold is distinguishable from Van Keppel, then it is also distinguishable for the same reasons from the instant case.

It is our decision that the provisions of section 302(c)(2)(A)(iii), requiring the filing of an agreement to notify the Secretary or his delegate of reacquisitions of stock within a 10-year period of a section 302(b)(3) redemption in the manner prescribed by regulation, are directory rather than mandatory. It appearing that petitioner's failure to file the agreement was through inadvertence, that she forthwith filed it upon learning of the defect, that in the interim*44 she acquired no interest in Medical Arts Hospital, and that she maintained appropriate records relating to the transaction, we hold that she substantially complied with the statute.

This disposition of the case makes it unnecessary for us to consider other issues raised by the parties.

Decision will be entered for the petitioner.