Zenz v. Quinlivan - 213 F.2d 914 (6th Cir. 1954)

Rule:

Under the applicable statutes and Treasury regulations a corporation's distribution of its earned surplus out of its accumulated earnings or profits or out of the earnings or profits for the taxable year is subject to tax as an ordinary dividend, but an amount distributed by a corporation in partial liquidation shall be treated as in complete cancellation or redemption of a part of its stock and as in full payment in exchange for the stock. However, if a corporation cancels or redeems its stock at such time and in such manner as to make the distribution and cancellation or redemption in whole or in part essentially equivalent to the distribution of a taxable dividend, the amount so distributed in redemption or cancellation of the stock, to the extent that it represents a distribution of accumulated earnings or profits, shall be treated as a taxable dividend. Whether a distribution in connection with a cancellation or redemption of stock is essentially equivalent to the distribution of a taxable dividend depends upon the facts and circumstances of each case.

Facts:

The taxpayer's husband died leaving her all shares of stock issued by his closely held corporation. She sought to dispose of the corporation. The buyer did not want to assume the tax liabilities that were inherent in the accumulated earnings of the corporation. The buyer bought part of the stock for cash. After corporate action, the corporation redeemed the balance of the taxpayer's stock as treasury stock, which absorbed most of the accumulated earnings and surplus of the corporation. The District Court sustained the deficiency assessment of the  Commissioner of Internal Revenue that the amount received from accumulated earnings and profits was ordinary income since the stock redeemed by the corporation was 'at such time and in such manner as to make the redemption thereof essentially equivalent to the distribution of a taxable dividend' under Section 115(g) of the Code. The District Court's findings were premised upon the view that taxpayer employed a circuitous approach in an attempt to avoid the tax consequences which would have attended the outright distribution of the surplus to the taxpayer by the declaration of a taxable dividend. The rationale of the District Court is dedicated to piercing the external manifestations of the taxpayer's transactions in order to establish a subterfuge or sham.

Issue:

Is a distribution of substantially all of the accumulated earnings and surplus of a corporation, which are not necessary to the conduct of the business of the corporation, in redemption of all outstanding shares of stock of said corporation owned by one person essentially equivalent to the distribution of a taxable dividend under the Internal Revenue Code?

Answer:

No

Conclusion:

The court stated that a taxpayer had the right to reduce the amount of his taxes or altogether avoid them, by lawful means. The court noted the question was not whether the transaction, carried out for the purpose of avoiding taxes, actually avoided taxes which would have been incurred if the transaction had taken a different form, but whether the sale constituted a taxable dividend or the sale of a capital asset. Since the intent of the taxpayer was to completely liquidate her holdings, the distribution of the earnings and profits by the corporation in payment for the stock was not made as to make the transaction essentially equivalent to the distribution of a taxable dividend.