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To assure that the substance of transactions will be determinative, courts have employed the "step transaction" doctrine. The essence of the doctrine is that an integrated transaction will not be broken down into independent steps; or, viewed from the other side, separate steps must be taken together in attaching tax consequences if that combination is the substance of the transaction.
Glacier State Electric Supply Co. (hereinafter referred to as Glacier State or petitioner) is a corporation which maintained its principal place of business in Great Falls, Mont., at the time of the filing of its petition herein. Petitioner was incorporated in 1946 by Donald P. Rearden (hereinafter Rearden) and J. Kenneth Parsons (hereinafter Parsons). One hundred ninety shares of common stock were issued by Glacier State at its incorporation: 94 each to Rearden and Parsons, and 1 each to their wives. Parsons was president of Glacier State and Rearden was vice president. Wishing to expand, Parsons and Rearden, through petitioner, joined with Arthur E. Pyle (hereinafter Pyle) to establish the Glacier State Electric Supply Co. of Billings (hereinafter GSB). GSB was organized and incorporated in 1953. Upon incorporation, GSB issued 339 shares of stock, 1 share each to Pyle, Parsons, and Rearden; with the remaining 336 shares held by petitioner. Parsons, Rearden, and Pyle were named as officers in GSB, with Pyle designated as that corporation's president. Pyle was allowed to buy into GSB (from Glacier State) as part of his business arrangement with Parsons and Rearden. In 1955, the stock of GSB was held as follows: Rearden and Parsons, 1 share; Pyle 113 shares; petitioner 224 shares.
In September 1954, Rearden and Parsons entered into an agreement with Glacier State which provided that in the event of either of their deaths, the shares of Glacier State owned by the deceased would be redeemed by that corporation. In November 1954, Pyle and petitioner entered into three agreements regarding the sale and purchase of the GSB stock. Though Parsons and Rearden were not parties to these agreements, they signed each of them to indicate their approval of the agreements' terms. The November 1954 agreements were amended by an addendum agreement on January 20, 1969 (the amendment). The amendment provided that upon the death of Pyle, his interest in GSB would be purchased by GSB. The amendment also stated that in the event of either Parsons' or Rearden's death, GSB would redeem the 1 share held in the name of the deceased along with one-half of the stock in GSB owned by petitioner. Worried that the obligations of the various buy/sell agreements might prove burdensome to the eventual obligors, life insurance was acquired on each of the officers of GSB with the proceeds payable to GSB. GSB was required to apply these proceeds to satisfy its various obligations under the amendment. Pyle never signed this amendment, however.
Parsons died on April 10, 1976. As a result of Parsons' death, life insurance in the amount of $ 52,680.09 was paid to GSB. These proceeds were deposited in a specified account in a local bank. Parsons' widow was executrix for the estate and was a party to all subsequent negotiations. In order to satisfy the obligations of the 1954 agreements and the amendment, a memorandum of agreement was entered into between petitioner and the Parsons estate in July 1976 which provided a method for the required disposition of the stock in petitioner that was held by the estate. In addition, the small number of shares owned by Parsons' widow would be redeemed. Under the terms of this agreement, the value of the Glacier State stock was to be determined by separately valuing: (1) The GSB stock held by petitioner, and (2) all of petitioner's remaining assets. The Parsons estate was to be paid 47.89 percent of the value of the remaining assets, but would receive 50 percent of the value of the GSB stock owned by petitioner.
On August 30, 1977, petitioner, GSB, and the Parsons estate entered into an agreement for the disposition of 112 shares in GSB owned by petitioner, along with the one share owned by the Parsons estate. Petitioner was required under the terms of the agreement to assign to the Parsons estate the redemption payments it received from GSB. Thereafter, two redemptions took place: (1) The stock of petitioner owned by the Parsons estate and Parsons' widow was redeemed, and (2) one-half of the stock of GSB held by petitioner along with the 1 GSB share owned by the Parsons estate was redeemed. In part payment for the value of the GSB stock, the Parsons estate was assigned a promissory note in the principal amount of $ 56,576.99 which had been issued by GSB to petitioner on August 30, 1977. Payments on the note were made by means of checks from GSB, made out to petitioner, which were then endorsed over to the Parsons estate. The balance due the estate for the value of the GSB shares was also paid by endorsing to the estate a $ 56,519.24 check issued to petitioner by GSB.
Respondent Commissioner of Internal Revenue determined deficiencies in petitioner’s Federal income taxes for the years 1976 and 1977 in the amounts of $ 7,350.71 and $ 38,943.17.
Is the “step transaction” doctrine effective to recategorize the redemption of petitioner’s stock in GSB as a nontaxable distribution to the Parsons estate?
To accept petitioner's argument that it was merely a conduit would require the court to determine that the real owners of the GSB stock were the officers. This it cannot do. Such a determination necessarily requires that the court ignored\s petitioner's existence as a taxable entity. Despite petitioner's strong urging, the facts are clear that not only was Glacier State in substance the "real" owner of the stock for over 20 years, but also that Parsons and Rearden did in fact accept it as such. Rearden testified at trial that he and Parsons had discussed holding the GSB shares in their individual capacity many times, yet did not do so for tax reasons. Such a statement necessarily implies that they believed that they were not the owners. Also, if Parsons and Rearden thought that they owned the stock, why did they observe all the technical formalities during the execution of the buy/sell agreements, the amendment to those agreements, and the later redemptions? The answer must be that Parsons and Rearden thought that petitioner was the true owner.
That the Parsons estate negotiated directly with GSB to set a value for the GSB shares does not lead to a different conclusion. Considering the close relationship between the corporations and the principals involved, such negotiations do not strike us as unusual. It is hard to fathom how the redemptions could have been structured without the presence of direct negotiations between the estate and GSB. That they were done in this manner does not influence the court to accept petitioner's claim.
The court was also not persuaded that the slightly disproportionate redemption of the GSB stock compared with the estate's ownership interest in all of the Glacier State assets should indicate Parsons and Rearden were the "true owners" of GSB. The number of GSB shares to be redeemed was set by the provisions of the buy-out agreements, not the negotiations for the redemption of the Glacier State shares. It may be assumed that the 50-percent figure was chosen to reflect the substantive ownership interests at that time, and was retained merely for mathematical convenience.
In sum, the fact that Rearden and Parsons may have deemed themselves the owners of the GSB shares because of their control over Glacier State is insufficient to establish that they were the actual or true owners of such shares. Although it is true that where appropriate, under the step transaction doctrine, separate steps must be taken together in attaching tax consequences, this is not a correct case in which to apply that doctrine. Petitioner is not asking the court to skip, collapse, or rearrange the steps he employed. He is instead asking that the court accepts an entirely new series of steps or events that did not take place. The step transaction doctrine cannot be stretched so far.