Cerone v. Commissioner

*2 In these consolidated cases, *91 respondent determined deficiencies in petitioners' Federal income taxes as follows:

After concessions, ¹ the issues for decision are as follows:*93

*3 (1) Whether distributions received by petitioner Michael N. Cerone from petitioner Stockade Cafe, Inc., in redemption of his stock in the corporation should be treated as being received in exchange for such stock under section 302(a)² or as dividends under sections 302(d), 301, and 316. Resolution of this issue depends on whether the redemption qualifies as being not essentially equivalent to a dividend under section 302(b)(1) or, alternatively, as a complete redemption of all of his stock under section 302(b)(3). These determinations in turn involve the family attribution rules*92 of section 318(a)(1) in a context of family hostility.

(2) Whether petitioner Stockade Cafe, Inc., can deduct the portion of such distributions it designated as interest as such under section 163. The parties agree that resolution of the first issue is determinative of this issue.

FINDINGS OF FACT

Some of the facts have been stipulated and are so found. The stipulation of facts and exhibits attached thereto are incorporated herein by this reference.

Petitioners Michael N. Cerone and Helen E. Cerone (collectively, the individual petitioners) resided in Omaha, Nebraska, at the time they filed their petitions in this case, except that petitioner Michael N. Cerone resided in Gretna, Nebraska, at the time they filed the petition in docket No. 27979-82. Petitioner Stockade Cafe, Inc. (the corporation), a Nebraska corporation, had its principal office at 13325 Millard Avenue, Omaha, Nebraska, at the time it filed its petition in this case. The individual petitioners filed joint Federal individual income tax returns (Forms 1040) for the years 1974 through 1979 with the Internal Revenue Service Center in Ogden, Utah. The corporation filed Federal*94 corporation income tax returns (Forms 1120) for its taxable years ending September 30, 1975 and 1976, with the Internal Revenue Service Center in Ogden, Utah.

In the years prior to 1963, petitioner Michael N. Cerone (petitioner or "Mike") and his son (Michael L. Cerone or "Mick") worked together as painting and decorating contractors. ³*95 *4 In March of 1963, petitioner, his son, and their acquaintance, Dan Malone, purchased the assets (including appurtenant real estate and liquor license) ⁴ of a restaurant and bar (individually, the restaurant or the bar; collectively, the business) known as the Stockade Cafe. The business was located at 13325 Millard Avenue, in what was then Millard and is now part of Omaha, Nebraska. The three men operated the business as equal partners for approximately 1 year until Dan Malone withdrew from the partnership. Thereafter, petitioner and his son operated the business as equal partners.

On or about October 1, 1964, petitioner and his son organized petitioner Stockade Cafe, Inc. (the corporation), and transferred thereto the assets of the business (including appurtenant real estate and liquor license). They each purchased 50 shares of the corporation's common stock for $ 5,000. These shares were the only outstanding shares of stock in the corporation. Petitioner and his son also became the directors and the president and secretary/treasurer, respectively, of the corporation. They maintained their respective ownership interests in and positions with the corporation until at least November 7, 1974.

Throughout the period of joint ownership, petitioner and his son were both very actively involved in managing the business. Petitioner ran the cash register and supervised the waitresses in the restaurant. He had authority to sign the corporation's checks. For awhile, petitioner also ordered supplies for the business, but his son soon assumed that responsibility. Petitioner's son ran the restaurant's kitchen*96 and the bar. He also kept the corporation's books. Petitioner and his son shared responsibility for major management decisions and for hiring and firing personnel.

During the years 1971 through 1974, the corporation paid petitioner an annual salary and bonus as follows:

*5 The corporation paid petitioner's son an annual salary and bonus during those years in amounts equal to those it paid petitioner.

Under the joint management of petitioner and his son, the business steadily grew. They expanded the facilities to accommodate this growth. Petitioner and his son completely remodeled the restaurant and the bar and also put in a new kitchen. By 1974, the corporation employed between 50 and 60 employees. Approximately 175 patrons could be seated in the restaurant. Between 60 and 70 patrons could be seated in the bar. The restaurant and the bar were usually open from 10 in the morning until 1 a.m.

Despite their success, petitioner and his son disagreed about the management and operation of the business. As the years went by, the conflicts between the two*97 increased in frequency and intensity. They disagreed about a number of matters. Petitioner refused to follow operating rules for employees that his son had established and that the son and the other managers were trying to enforce. Petitioner frequently reinstated employees that Mick or another manager had dismissed or reprimanded. Since a large number of the corporation's employees worked only part time, Mick and the other managers thought it extremely important to establish well-defined rules for the employees and to rigidly adhere to those rules. Petitioner's failure to follow the rules in such circumstances increased the growing hostility between him and his son.

Petitioner and his son also argued over expanding the business' facilities. Mike wanted to go slow on expansion. Mick favored expansion on a much larger scale than did his father. In particular, they disagreed about the new kitchen they put in. After petitioner's son became the sole shareholder of the corporation, he had this kitchen completely remodeled to his satisfaction.

The greatest source of discord between Mike and Mick resulted from the father's gambling activities. For many *6 years, Mike held *98 big gambling games in a relatively large apartment ⁵ located on the second floor of the building ⁶ that housed the restaurant and the bar. Over the years the gambling games got larger to the point that nothing smaller than a $ 20 bill was on the table during the games. Twice, the Omaha vice squad raided the building in search of betting slips or other evidence of petitioner's gambling activities. During one such raid, members of the vice squad ransacked the upstairs apartment. They searched for betting slips in the office that was also located on the second floor of the building. They also asked petitioner's son to open the safe in the office, which he did, but they failed to find any evidence of gambling. As they left the premises, the frustrated vice squad members walked through the restaurant and the bar and pulled out the telephones. ⁷ Shortly after this raid, a representative of the Nebraska Liquor Control Commission visited petitioner's son and said to him, "Mick, you're going to have to get your father out of here or you ain't going to have no liquor license." Without a liquor license, both the restaurant and the bar business would have been ruined. After this, petitioner*99 and his son "could not get along at all." Petitioner's son was deeply concerned about losing the liquor license. ⁸

*100 Sometime after the second vice squad raid and the informal liquor commission warning, in late 1973 or early 1974, Mick told his father that one of them should buy out the other's ownership interest in the corporation. Petitioner did not think he could run the business without his son. Therefore, petitioner tentatively agreed to allow the corporation to redeem his stock therein, but he and his son haggled about the price for several months.

*7 Petitioner and his son hotly negotiated the terms of the redemption, especially the price petitioner would receive for his stock in the corporation. They met together with their attorney, Tom Kelley (Kelley), in Kelley's office between 6 and 8 times to negotiate the redemption. A number of these meetings ended with either Mike or Mick "blowing up" and walking out of the meeting. Sometimes, petitioner or his son would meet separately with Kelley to discuss the redemption. Although they both continued to work at the restaurant and the bar, petitioner and his son sometimes were not speaking to one another, and their relationship was volatile. Finally, after almost a year of negotiations, on November 7, 1974, petitioner and the corporation*101 entered into an agreement (the redemption agreement) ⁹ whereby petitioner and *8 the corporation agreed that the corporation would redeem petitioner's 50 shares of stock therein for $ 125,000. The $ 125,000 was to be paid $ 25,000 down; the balance of $ 100,000 was payable over 7 years in equal, semiannual installments due on the first day of May and December of each year, commencing on May 1, 1975, with interest at an annual rate of 6 1/2 percent.

*102 Petitioner and his son intended that the execution of the redemption agreement finalize their arrangement regarding the ownership of the corporation. It did not. Petitioner did not receive the $ 25,000 downpayment required ¹⁰ by the redemption agreement on the date it was signed. Petitioner's son did not bring to the November 7th meeting at Kelley's office a corporate check or any other means by which the corporation could pay petitioner the downpayment. Nevertheless, petitioner and his son (on the corporation's behalf) signed the redemption agreement on November 7, 1974. They agreed to handle the downpayment at the corporation's office.

*103 Even after signing the redemption agreement, petitioner and his son continued to argue over its terms. ¹¹*104 Thereafter, they had several meetings in which they tried to resolve their differences. At one such meeting on December 27, 1974, petitioner's son brought a corporate check in the amount of $ 25,000, which was dated that date, in hopes of completing the redemption. However, petitioner and his son started arguing again and did not consummate the redemption. *9 Finally, on January 16, 1975, the redemption was finalized. Mick gave petitioner the corporation's $ 25,000 check dated December 27, 1974, and a promissory note ¹² in the amount of $ 100,000, which represented the balance of the purchase price. In return, petitioner delivered the stock certificate representing his stock in the corporation to Kelley. He also executed a document directing Kelley to deliver the stock certificate to the corporation on May 1, 1975, upon payment of the first installment due under the promissory note on that date. ¹³

*105 Although the record does not show exactly when, on or about January 16, 1975, petitioner resigned from his positions as president and director of the corporation. He also relinquished his managerial and check-signing authority. Petitioner's son became the corporation's president. Nancy J. Cerone (Nancy Cerone), then Mick's wife, ¹⁴ became the corporation's secretary and treasurer. She also became a director of the corporation.

Petitioner's managerial responsibilities were assumed by Nancy Cerone and Eunice Marty Postma (Eunice Postma). Nancy Cerone had been employed by the corporation since her marriage to petitioner's son in 1967. She had worked full time for the corporation during the 2- or 3-year period before the redemption. Eunice Postma had been employed by the corporation, and its predecessor restaurants at that location, for more than 20 years. After the redemption, *10 Nancy Cerone assumed responsibility*106 for hiring and firing waitresses and other restaurant personnel, as well as some kitchen personnel. She prepared work schedules and the payroll. She also arranged substitutes for absent employees. Eunice Postma helped prepare work schedules and supervised other employees. Petitioner's son continued to handle the responsibilities he had before the redemption. Petitioner's son, Nancy Cerone, and Eunice Postma arranged their schedules so that one of them was always at the restaurant and bar.

The redemption agreement did not provide that petitioner would continue as an employee of the corporation after the redemption. At no time during the negotiations or consummation of the redemption did petitioner and his son enter into any other oral or written agreement that petitioner would continue as an employee of the corporation. Petitioner may have remained away from the restaurant for about a month after January 16, 1975. If so, then approximately 1 month after the redemption, Mick asked petitioner to come back and run the cash register in the restaurant. ¹⁵*107 Petitioner did so. ¹⁶

Petitioner worked full time (between 30 and 40 hours each week) for the corporation in 1975, 1976, and 1977, and at least until sometime during 1978. Thereafter, he worked only part time, usually on Friday and Saturday nights. Petitioner continued to work part time for the corporation at least through 1979 and probably until 1980 or 1981. ¹⁷ He *11 stopped working for the corporation after suffering*108 a heart attack while on vacation in Texas.

During 1975 through 1979, the corporation paid petitioner the following annual salaries:

The corporation did not pay petitioner any bonuses during these years. The record does not indicate whether petitioner received*109 any salary from the corporation in 1980 and 1981. See note 17 supra.

Throughout his employment after the redemption, petitioner's responsibilities primarily involved handling the cash register in the restaurant. ¹⁸*110 During that time period, petitioner's son suffered from a number of physical ailments. He had continuing back problems, ¹⁹ sometimes suffered severe migraine headaches, and also had high blood pressure. At some point, he became addicted to prescribed drugs. ²⁰ These physical ailments sometimes caused petitioner's son to be absent from the business. ²¹ Nonetheless, at *12 no time after the redemption did petitioner exercise any managerial authority in the restaurant or in the bar. Petitioner had no authority to hire and fire personnel nor did his son consult with him regarding any management decisions. When petitioner's son was absent, Nancy Cerone usually took over his responsibilities. Additionally, a number of kitchen employees became experienced enough that they could help with ordering food and other of his duties when petitioner's son was absent from work.

In early 1982, petitioner's son sold the business for over $ 1 million. ²² The operating assets of the business have been sold. *111 However, the corporation has not yet been dissolved pursuant to Nebraska State law. It is retaining some of its assets until this case is concluded.

During the taxable years in issue, the corporation paid petitioner the following amounts pursuant to the redemption agreement and promissory note:

*112 On the Schedule D (Capital Gains and Losses) attached to their return for each year in issue, the individual petitioners reported as long-term capital gain, under the installment method, a portion of the total payments designated as principal that petitioner received from the corporation *13 during such year. The amounts ²³ so reported are as follows:

On the Schedule D attached to their 1975 return, the individual petitioners also included the following statement: "Taxpayer elects to report gain by using the installment method, and agrees to notify IRS if any stock is reacquired within 10 years." On the Schedule B (Dividend and Interest Income) attached to their return for each year in issue, the individual petitioners reported as interest income the total payments designated as interest that petitioner received during that year.

*113 On its return for its taxable year ending September 30, 1975, the corporation claimed an interest deduction in the amount of $ 5,662. This amount includes the $ 3,250 payment designated as interest made to petitioner on June 30, 1975. On its return for its taxable year ending September 30, 1976, the corporation claimed an interest deduction in the amount of $ 7,722. This amount includes the $ 3,062.99 and $ 2,869.90 payments designated as interest made to petitioner in October of 1975 and May of 1976, respectively. On its returns for its taxable years ending September 30, 1975 through 1979, the corporation reported gross receipts, deductions for the salary of petitioner's son, and taxable income as follows:

*14 In statutory notices of deficiency dated November 5, 1979 (for 1974 ²⁴ and 1976), August 21, 1981 (for 1975), and August 26, 1982 (for 1977, 1978, and 1979), respondent determined that all of the payments designated as principal*114 that petitioner received during the taxable years in issue were essentially equivalent to dividends and therefore constituted ordinary income rather than long-term capital gain. In a statutory notice of deficiency dated November 5, 1979, respondent determined that the corporation's redemption of petitioner's stock was not a sale but a distribution essentially equivalent to a dividend. He therefore disallowed the interest expense deductions claimed by the corporation for the payments designated as interest made during the corporation's taxable years ending September 30, 1975 and 1976.

OPINION

Petitioner Michael N. Cerone (petitioner or "Mike") and his son (Michael L. Cerone -- the son or "Mick") owned and operated the Stockade Cafe (the corporate taxpayer herein), each owning 50 percent of the stock of the corporation. The father and son had a volatile relationship and frequently disagreed over management decisions. Over the years their disagreements became more serious, and finally they*115 decided one of them should buy the other's interest in the business. Petitioner did not think he could run the business alone, so it was decided that the corporation would redeem all of his stock. After the redemption, petitioner worked at the Stockade Cafe for several years, but he did not exercise any control over the corporation. This case involves the tax treatment of the payments or distributions petitioner received for his stock. Specifically, the issue is whether the distributions are dividends under section 301(a)²⁵ taxable as ordinary income or payments in exchange for stock under section 302(a)²⁶ taxable as capital gain. The family attribution *15 rules of section 318 play a prominent role in this determination.

*116 To have the distributions treated as payments in exchange for stock under section 302(a), petitioner must bring himself within either section 302(b)(1) or section 302(b)(3). Section 302(b)(1) provides that "Subsection (a) shall apply if the redemption is not essentially equivalent to a dividend." Section 302(b)(3) provides that "Subsection (a) shall apply if the redemption is in complete redemption of all of the stock of the corporation owned by the shareholder." These determinations involve the family attribution rules. According to section 302(c)(1), "Except as provided in paragraph (2) of this subsection, section 318(a) shall apply in determining the ownership of stock for purposes of this section." Under section 318(a), certain individuals and entities are treated as owning stock actually owned by certain related individuals and entities. Specifically, under section 318(a)(1)(A) --

An individual shall be considered as owning the stock owned, directly or indirectly, by or for --

* * * *

(ii) his children, grandchildren, and parents. [Emphasis added.]