Metzger Trust v. Commissioner

*42 OPINION

In these consolidated cases respondent determined the following deficiencies in the Federal income taxes of petitioners: *201 *43

Because of concessions, the remaining issues for decision are:

(1) Whether family hostility among the shareholders of Metzger Dairies, Inc., who are also beneficiaries of the David Metzger Trust, nullifies the attribution rules of section 318¹ so that a redemption by the corporation of stock owned by the trust qualifies as an exchange under section 302(b)(1) or 302(b)(3).

(2) Whether a waiver agreement filed by the trust pursuant to section 302(c)(2)(A)(iii) was effective to waive the trust-beneficiary attribution rules of section 318(a)(3) so that the trust may treat a redemption of stock as a complete termination of a shareholder's interest under section 302(b)(3).

*202 (3) Whether Metzger Dairies, Inc., may, notwithstanding section 267(a)(2), deduct accrued interest expenses owed to a cash method taxpayer but which were not actually paid until more than 2 1/2 months after the close of its fiscal year where hostility existed between the payee and her brother, who owned more than 50 percent of the corporation's stock.

These cases were submitted fully stipulated pursuant to Rule 122, Tax Court Rules of Practice and Procedure. The stipulations of fact and attached exhibits are incorporated herein by this reference. The pertinent facts are set forth below.

Jacob Metzger, Trustee of the David Metzger Trust (sometimes hereinafter referred to as the Trust) was a legal resident of Van Zandt County, Tex., when the Trust filed its petition herein. Metzger Dairies, Inc. (MDI), had its principal office in Dallas, Tex., at the time it filed its petition herein.

David Metzger formed MDI in 1946 to operate a dairy business in Dallas, Tex. He had earlier created the David Metzger Trust for his family, with his wife, Nora, as life income beneficiary, and his three children, Jacob Metzger, Catherine Staacke, and Cecelia Jane Frew, each as one-third remaindermen. *203 This trust later became a shareholder of the corporation. *44 After the death of David Metzger in 1953, Jacob assumed managerial control over MDI, installing himself as chairman of the board, and his son, David Metzger II (David II), as president, while Jacob's sisters, Catherine and Cecelia, were directors of the corporation. During the early years of Jacob's term as chief executive officer, the corporation experienced financial success and was able to distribute dividends to its shareholders: Jacob, Catherine, and Cecelia, trusts established for each of them, Nora, and the David Metzger Trust.

During the 1960's, however, corporate earnings declined and dividends were not distributed. When this happened, Catherine and Cecelia became angry and on numerous occasions accused Jacob and his son, David II, of incompetent management; raising their already high salaries at a time when the corporation was unprofitable; spending too much time golfing, hunting, and fishing; and causing MDI to sustain substantial losses by its acquisition of another corporation solely to prevent a default by the latter on a promissory note owed to a Dallas bank of which Jacob was a director. Although*204 Catherine and Cecelia were on the board of directors, they did not attempt to use their directorial voting power to change the management policy or to force a distribution of dividends because (1) Jacob as trustee of the David Metzger Trust voted and controlled its stock holdings in MDI, (2) they believed Jacob controlled the shares owned by their mother, Nora, by virtue of his ability to influence her decisions regarding the family business, (3) they were kept uninformed by Jacob regarding the business and thus lacked sufficient knowledge to suggest or demand corrective measures, and (4) Jacob threatened to use legal ploys to disinherit them from their father's trust should they attempt to overrule his managerial decisions and policies. As a result, Catherine and Cecelia found the meetings of the board of directors to be extremely unpleasant and distasteful.

Catherine also deeply resented Jacob because of his poor treatment of her son, Fred Staacke, Jr. (Fred Jr.). During the relevant years, Fred Jr. was president of Metzger Dairy of San Antonio, Inc. (MSA). This corporation was engaged in the dairy business in San Antonio, Tex., and its stock was owned, but for minor variations, *205 by the same parties and in the same percentages as MDI. Although Fred Jr. was nominally president, his uncle Jacob perceived himself to be the ultimate authority of *45 MSA and proceeded to belittle Fred Jr.'s management, reverse his business decisions, make unannounced inspections, and complain about the company's profitability while refusing to assist in soliciting new customers. Catherine believed Jacob's persistent harassment and humiliation of her son drove Fred Jr. into alcoholism.

Cecelia held an animosity toward Jacob and Catherine because she resented the fact that, although MDI and MSA discontinued paying dividends, Jacob's family (through the employment by MDI of Jacob and David II) and Catherine's family (through the employment by MSA of Fred Jr.) continued to profit from the family businesses. On several occasions, Cecelia suggested that either MDI, Jacob, or Catherine buy her stock, but they refused on the grounds that a fair market value for the shares could not be determined. Sometime thereafter, Stop & Go Food Stores, Inc., an unrelated corporation, offered to purchase the stock of MDI, and Cecelia strongly urged that the offer be accepted. When the offer*206 was rejected (or withdrawn for lack of acceptance), the enmity between Cecelia, on one side, and Jacob and Catherine, on the other side, was greatly aggravated. Cecelia became infuriated when she discovered that she had been purposely excluded from a meeting between them to make a determination as to their continued and future ownership of MDI and MSA. This was not the only occasion that pitted Cecelia against Jacob and Catherine. When the family was deciding to form the Mr. M Corp. of San Antonio, Inc. (Mr. M Corp.), to engage in the ownership and operation of retail convenience stores in San Antonio, Tex., Cecelia suggested it be formed as a wholly owned subsidiary of MDI. Instead, Jacob and his son, David II, and Catherine and her son, Fred Jr., decided the stock should be subscribed for and purchased individually. Because Cecelia was not employed by either of the existing corporations and received no dividends from them, she was financially unable to invest in the new business. Thus, when Jacob, David II, Catherine, and Fred Jr. thereafter profited from the success of Mr. M Corp., Cecelia felt she had been betrayed by her brother and sister.

In addition to matters relating*207 to the business of the three corporations, Jacob, Catherine, and Cecelia fought over other issues. Heated disputes constantly arose among them over whose family could use the family farm, a large estate containing a *46 lake, recreational area, and multiple residences, which they owned in undivided interests along with their mother. In other instances Cecelia and Catherine, each being one-third remaindermen of the David Metzger Trust, accused their brother Jacob, the sole trustee, of mismanaging the trust corpus by investing it in securities which produced only minimal income. When they demanded the trust be turned over to a professional investment adviser, Jacob refused to relinquish his position.

Jacob had felt considerable resentment toward his two sisters since the occasion when their mother, Nora, decided to make gifts to her grandchildren of her principal estate. Jacob, having only two children, believed that Nora's estate should be divided into thirds and then distributed per stirpes to Catherine, Cecelia, and himself. Catherine, having three children, and Cecelia, having four, convinced their mother to distribute her estate per capita to the grandchildren.

In another*208 incident, Cecelia, who lived in Oklahoma City, Okla., accused Jacob of failing in his responsibility of caring for their mother when she became of frail health. The feuding over this matter resulted in Catherine's moving their mother to a Houston, Tex., nursing home.

The rancor among Jacob, Catherine, and Cecelia struck a nadir in 1972 when Jacob accused Catherine and Fred Jr. of obtaining voting control of Mr. M Corp. by sharp and perfidious practices. Such passing of control occurred when Laura Metzger, upon her divorce from David II, received a portion of Mr. M Corp. stock owned by David II. David II believed that his former wife would quickly exhaust her cash resources and need more money, at which time he planned to reacquire the stock for a fraction of the value at which he conveyed it to her. However, when Fred Jr. learned that Laura owned the stock, he schemed to acquire it first. Fred Jr. arranged for a business associate to procure the stock from Laura and to hold it for, and on behalf of, Fred Jr. as a nominee. The associate soon purchased Laura's stock with funds loaned to him by Fred Jr., who had borrowed the money from his mother, Catherine.

When Jacob and David*209 II discovered the stock acquisition, they were incensed, believing they had been betrayed. Jacob immediately contacted Cecelia and Catherine and together they concluded that the business of MDI, MSA, and Mr. M Corp. could no longer be operated in the familial manner in which it had *47 been in the past. After lengthy negotiations, they agreed that Jacob and his family would own MDI, Catherine and her family would own MSA and Mr. M Corp., and Cecelia and her family would receive cash compensation for their interests in such corporations. To accomplish this, they planned to cause MDI to redeem all its stock owned by Cecelia, Catherine, and the David Metzger Trust. The trust was included in the redemption because under the terms of the trust instrument, the stock it held in MDI would, upon the death of the life income beneficiary, Nora, pass in equal shares to the remaindermen who were attempting to separate their future business and familial relations. Pursuant to the plan, MSA and Mr. M Corp. redeemed their stock from all shareholders other than Catherine and her family.

The price at which each stock issue was redeemed was based on the price previously offered by Stop & Go*210 Food Stores, Inc. Although Cecelia argued it was less than fair market value, she finally accepted such price "in order to get free of Jacob Metzger." Just when the redemption negotiations were about to be concluded, Jacob announced he would not sign the agreement unless Catherine and her children and Cecelia and her children all agreed to sell him their interests in the family farm at approximately one quarter of the then fair market value. This last minute demand initiated bitter feuding, but in the end, the affected parties acquiesced in order to sever all ties of whatever nature with and among one another.

The trust and respondent have stipulated that (1) the principal and primary reason underlying the redemption of stock by MDI was the hatred and discord existing among Jacob, Catherine, and Cecelia, (2) the redemption was not principally or primarily motivated to realize a profit on their stock or to receive undistributed earnings from prior years, and (3) both before and after the redemption, Jacob, Catherine, and Cecelia would not have acted in concert or for the benefit of one another in connection with the redemption of the stock of MDI, the business policies and operations*211 of MDI, or otherwise. On the date of the redemption, MDI had no current earnings and profits, but had accumulated earnings and profits of $ 1,815,060.77, of which 23.90889 percent was allocable to the distribution to the David Metzger Trust.

On or about January 22, 1973, the agreed-upon redemptions *48 took place. As of January 1, 1973, MDI had outstanding 3,000 shares of common stock which were owned as follows:

Subsequent to the redemption, the remaining shares of stock then outstanding were owned as follows:

On February 10, 1976, Jacob, as trustee of the David Metzger Trust, delivered to an authorized agent of the Internal Revenue Service an agreement referred to in section 302(c)(2)(A)(iii)*212 and section 1.302-4, Income Tax Regs. Subsequent to the redemption of all of its 420 shares, the trust has not acquired any MDI stock nor has it held any interest in the corporation as officer, director, or employee.

In partial payment for the 600 shares redeemed from Cecelia, MDI executed a promissory note to her in the amount of $ 627,110.53, payable in three equal annual installments, plus interest, beginning January 22, 1974. In accordance with its accrual method of accounting, the corporation claimed deductions for accrued interest expense with respect to the above-described promissory note in the amount of $ 32,167.28, $ 31,533.07, and $ 13,926.46 for its fiscal years ended September *49 30, 1973, September 30, 1974, and September 30, 1975, respectively. These interest expenses were not paid to Cecelia within 2 1/2 months after the close of MDI's fiscal years. Rather, the amounts were paid on January 21, 1974, January 7, 1975, and January 5, 1976, respectively. Cecelia reported income in accordance with the cash receipts and disbursements method of accounting for the calendar years 1974, 1975, and 1976. Accordingly, the accrued interest expense in the amount of $ *213 32,167.28, claimed as a deduction by MDI for its fiscal year ended September 30, 1973, was included in income by her for the calendar year 1974. Similarly, the accrued interest expense in the amount of $ 31,533.07, claimed as a deduction by MDI for its fiscal year ended September 30, 1974, was included in income by her for the calendar year 1975. The accrued interest expense in the amount of $ 13,926.46, claimed as a deduction by MDI for its fiscal year ended September 30, 1975, was included in income by her for the calendar year 1976.

The first issue presented is whether the trust is entitled to exchange treatment, under section 302, on a stock redemption caused by family hostility among the individual shareholders of the redeeming corporation, who were also beneficiaries of the trust. As a general rule, distribution of property by a corporation to its shareholders is treated, pursuant to sections 301 and 316, ² as a dividend out of earnings and profits to the extent of such earnings. One exception to this general rule is made for certain distributions in redemption of a corporation's stock. Section 302(a) treats such distributions as "payment in exchange for the*214 stock," taxable as capital gain, if the requirements of one of the four paragraphs of section 302(b) are met. The paragraphs *50 relevant to this case are (1) and (3). Section 302(b)(1) makes section 302(a) applicable if the redemption is not essentially equivalent to a dividend. Section 302(b)(3) makes section 302(a) applicable if there has been a complete redemption of all of that corporation's stock owned by the shareholder. Section 302(d) provides that if a corporation redeems its stock and if section 302(a) does not apply, such redemption shall be treated as a distribution of property to which section 301 applies.

*215

Section 302(c)(1) provides that, except as provided in paragraph (2), the attribution rules of section 318 shall be applied in determining the ownership of stock for purposes of applying the rules of section 302. Section 318(a)(1)(A)(ii) provides, in part, that an individual shall be considered as owning the stock owned by his children. Section 318(a)(2)(B)(i) provides that beneficiaries of a trust shall be considered as owning the stock owned by the trust in proportion to their actuarial interest. Section 318(a)(3)(B)(i) provides that a trust shall be considered to own the stock owned by its beneficiaries who have more than a remote contingent interest. However, under section 302(c)(2), the attribution rules of section 318 are not applicable where there is a complete termination of a shareholder's interest under section 302(b)(3), if certain conditions are satisfied, including the requirement that the distributee file an agreement to notify the Internal Revenue Service of any future acquisition of stock in the redeeming corporation. Sec. 302(a)(2)(A)(iii).

Respondent contends that the redemption was essentially equivalent to a dividend, and thus is taxable as a dividend under*216 sections 302(d) and 301 because the trust, after application of the attribution rules, maintained a 100-percent ownership interest both before and after the redemption. Before the redemption, the trust owned 3,000 shares, or 100 percent of the stock of MDI. It owned directly 420 shares. In addition, it constructively owned, by reason of the attribution rule of section 318(a)(B)(i), the shares owned by its beneficiaries: Nora, 420 shares; Jacob, 600 shares; Catherine, 600 shares; and Cecelia, 600 shares. ³ Moreover, the trust also constructively owned 360 shares of stock which were held in separate trusts for Jacob, Catherine, and Cecelia. Section 318(a)(2)(B)(i) attributes the 120 shares in *51 the Jacob Metzger Trust to Jacob, individually, the 120 shares in the Catherine Staacke Trust to Catherine, individually, and the 120 shares in the Cecelia Jane Frew Trust to Cecelia, individually; section 318(a)(3)(B)(i) then reattributes this stock constructively owned by the beneficiaries of the David Metzger Trust to the trust, itself.

*217 At the redemption, the stock owned by the David Metzger Trust (420 shares), Nora (420 shares), Catherine (600 shares), the Catherine Staacke Trust (120 shares), Cecelia (600 shares), and the Cecelia Jane Frew Trust (120 shares) was fully redeemed. No stock owned by Jacob or the Jacob Metzger Trust was redeemed.

After the redemption, there were 1,221 outstanding shares of MDI. Respondent argues that all the shares were attributable to the David Metzger Trust. The 600 shares owned by Jacob are attributed to the Trust by section 318(a)(3)(B)(i). The 120 shares in the Jacob Metzger Trust are attributed to Jacob by section 318(a)(2)(B)(i), and then from Jacob to the David Metzger Trust by section 318(a)(3)(B)(i). In like manner, the 501 shares held in trust for Jacob's children, David II and Nan, are attributed to them by section 318(a)(2)(B)(i), and then from them to Jacob by section 318(a)(1)(A)(ii), and then from Jacob to the trust by section 318(a)(3)(B)(i). Thus, respondent contends that the David Metzger Trust also constructively owned 100 percent of the outstanding stock after the redemption.

The trust contends that the redemption was not essentially equivalent to a dividend, *218 and thus qualifies as a distribution in exchange for the stock pursuant to sections 302(a) and 302(b)(1). This is so, the trust argues, because (1) the redemption was caused by extreme discord among the individual shareholders of MDI, (2) the stockholders had no motive to realize a profit on their stock or to receive accumulated earnings and profits at capital gains rates, and (3) the hostility among the relevant parties was so severe that they would not have acted in concert or for the benefit of each other in connection with the redemption, or with regard to the business policies and operations of MDI.

Respondent also contends that the redemption failed to qualify as a complete redemption under section 302(b)(3) because ownership of the stock of the corporation individually owned by Jacob after the redemption should be attributed to the trust under section 318(a)(3). The trust has a two-pronged rebuttal to *52 this. First, it contends that the stock should not be attributed to it because the redemption was occasioned by familial discord. Second, it argues that the exception to the attribution rules provided for in section 302(c)(2) applies to them because the trust complied*219 with the requirements of section 318(c)(2)(A)(i) and (ii), and filed the waiver agreement specified in section 318(c)(2)(A)(iii).

We are once again confronted with the difficult question of whether a distribution, coupled with a redemption, of stock is "essentially equivalent to a dividend." ⁴ This is ordinarily a question of fact. United States v. Fewell, 255 F.2d 496 (5th Cir. 1958); Wright v. United States, 482 F.2d 600 (8th Cir. 1973); sec. 1.302-2(b), Income Tax Regs. The leading case interpreting section 302(b)(1) is United States v. Davis, 397 U.S. 301 (1970). In the Davis case, Davis, his wife, son, and daughter each owned 25 percent of a corporation's common stock. In an earlier year, Davis purchased an entire issue of preferred stock for $ 25,000 to provide the corporation with sufficient capital to qualify it for a loan. Upon retirement of the loan, the corporation redeemed Davis' preferred stock for exactly his original investment, $ 25,000. Mr. Davis maintained the position that the attribution rules did not apply to a 302(b)(1) redemption, thus, the distribution was*220 not pro rata on an actual ownership basis and hence not essentially equivalent to a dividend. He also claimed the redemption was occasioned by a valid non-tax-avoidance motive and a bona fide business purpose and thus should not be treated as a dividend.

In rejecting the taxpayer's arguments, the Supreme Court held: (1) The contructive ownership rules of section 318 apply to dividend equivalency*221 determinations in section 302(b)(1); (2) redemptions of stock of a sole shareholder, including a "constructive" sole shareholder, are "always 'essentially equivalent to a dividend'" under section 302(b)(1); (3) business purpose is irrelevant in determining dividend equivalency under section 302(b)(1); and (4) in order to avoid dividend equivalency, the *53 redemption must result in a "meaningful reduction in the shareholder's proportionate interest in the corporation." ⁵

Respondent contends that (1) after application of the attribution rules, the trust was the sole shareholder of the corporation both before and after the redemption, (2) the non-tax-avoidance purpose of separating the business dealings of the feuding stockholders and members of the board of directors of MDI is irrelevant to the section 302(b)(1) determination; and (3) the redemption resulted in no meaningful reduction in*222 the trust's interests in MDI.

The trust argues that if the attribution rules are not taken into account, it is not a sole shareholder before or after the redemption, hence the distribution would not be pro rata on an actual ownership basis, therefore not essentially equivalent to a dividend within the meaning of section 302(b)(1). It relies on Haft Trust v. Commissioner, 510 F.2d 43 (1st Cir. 1975), vacating and remanding 61 T.C. 398 (1973) and 62 T.C. 145 (1974) (supplemental opinion), for the proposition that the existence of family hostility is a factor to be considered in the mitigation of the constructive ownership rules of section 318 in determining dividend equivalence under