Commissioner of Internal Revenue v. Brown/Dissent Goldberg

by Arthur Goldberg

United States Supreme Court

380 U.S. 563

Commissioner of Internal Revenue  v.  Brown

 Argued: March 3, 1965. --- Decided: April 27, 1965

Mr. Justice GOLDBERG, with whom THE CHIEF JUSTICE and Mr. Justice BLACK join, dissenting.

The essential facts of this case which are undisputed illuminate the basic nature of the transaction at issue. Respondents conveyed their stock in Clay Brown & Co., a corporation owned almost entirely by Clay Brown and the members of his immediate family, to the California Institute for Cancer Research, a tax-exempt foundation. The Institute liquidated the corporation and transferred its assets under a five-year lease to a new corporation, Fortuna, which was managed by respondent Clay Brown, and the shares of which were in the name of Clay Brown's attorneys, who also served as Fortuna's directors. The business thus continued under a new name with no essential change in control of its operations. Fortuna agreed to pay 80% of its pretax profits to the Institute as rent under the lease, and the Institute agreed to pay 90% of this amount to respondents in payment for their shares until the respondents received $1,300,000, at which time their interest would terminate and the Institute would own the complete beneficial interest as well as all legal interest in the business. If remittances to respondents were less than $250,000 in any two consecutive years or any other provision in the agreements was violated, they could recover the property. The Institute had no personal liability. In essence respondents conveyed their interest in the business to the Institute in return for 72% of the profits of the business and the right to recover the business assets if payments fell behind schedule.

At first glance it might appear odd that the sellers would enter into this transaction, for prior to the sale they had a right to 100% of the corporation's income, but after the sale they had a right to only 72% of that income and would lose the business after 10 years to boot. This transaction, however, afforded the sellers several advantages. The principal advantage sought by the sellers was capital gain, rather than ordinary income, treatment for that share of the business profits which they received. Further, because of the Tax Code's charitable exemption ^[1] and the lease arrangement with Fortuna, ^[2] the Institute believed that neither it nor Fortuna would have to pay income tax on the earnings of the business. Thus the sellers would receive free of corporate taxation, and subject only to personal taxation at capital gains rates, 72% of the business earnings until they were paid $1,300,000. Without the sale they would receive only 48% of the business earnings, the rest going to the Government in corporate taxes, and this 48% would be subject to personal taxation at ordinary rates. In effect the Institute sold the respondents the use of its tax exemption, enabling the respondents to collect $1,300,000 from the business more quickly than they otherwise could and to pay taxes on this amount at capital gains rates. In return, the Institute received a nominal amount of the profits while the $1,300,000 was being paid, and it was to receive the whole business after this debt had been paid off. In any realistic sense the Government's grant of a tax exemption was used by the Institute as part of an arrangement that allowed it to buy a business that in fact cost it nothing. I cannot believe that Congress intended such a result.

The Court today legitimates this bootstrap transaction and permits respondents the tax advantage which the parties sought. The fact that respondent Brown, as a result of the Court's holding, escapes payment of about $60,000 in taxes may not seem intrinsically important-although every failure to pay the proper amount of taxes under a progressive income tax system impairs the integrity of that system. But this case in fact has very broad implications. We are told by the parties and by interested amici that this is a test case. The outcome of this case will determine whether this bootstrap scheme for the conversion of ordinary income into capital gain, which has already been employed on a number of occasions, will become even more widespread. ^[3] It is quite clear that the Court's decision approving this tax device will give additional momentum to its speedy proliferation. In my view Congress did not sanction the use of this scheme under the present revenue laws to obtain the tax advantages which the Court authorizes. Moreover, I believe that the Court's holding not only deviates from the intent of Congress but also departs from this Court's prior decisions.

The purpose of the capital gains provisions of the Internal Revenue Code of 1954, § 1201 et seq., is to prevent gains which accrue over a long period of time from being taxed in the year of their realization through a sale at high rates resulting from their inclusion in the higher tax brackets. Burnet v. Harmel, 287 U.S. 103, 106, 53 S.Ct. 74, 75, 77 L.Ed. 199. These provisions are not designed, however, to allow capital gains treatment for the recurrent receipt of commercial or business income. In light of these purposes this Court has held that a 'sale' for capital gains purposes is not produced by the mere transfer of legal title. Burnet v. Harmel, supra; Palmer v. Bender, 287 U.S. 551, 53 S.Ct. 225, 77 L.Ed. 489. Rather, at the very least, there must be a meaningful economic transfer in addition to a change in legal title. See Corliss v. Bowers, 281 U.S. 376, 50 S.Ct. 336, 74 L.Ed. 916. Thus the question posed here is not whether this transaction constitutes a sale within the terms of the Uniform Commercial Code or the Uniform Sales Act-we may assume it does-but, rather, the question is whether, at the time legal title was transferred, there was also an economic transfer sufficient to convert ordinary income into capital gain by treating this transaction as a 'sale' within the terms of I.R.C. § 1222(3).

In dealing with what constitutes a sale for capital gains purposes, this Court has been careful to look through formal legal arrangements to the underlying economic realities. Income produced in the mineral extraction business, which 'resemble(s) a manufacturing business carried on by the use of the soil,' Burnet v. Harmel, supra, 287 U.S. at 107, 53 S.Ct. at 76, is taxed to the person who retains an economic interest in the oil. Thus, while an outright sale of mineral interests qualifies for capital gains treatment, a purported sale of mineral interests in exchange for a royalty from the minerals produced is treated only as a transfer with a retained economic interest, and the royalty payments are fully taxable as ordinary income. Burnet v. Harmel, supra. See Palmer v. Bender, supra.

In Thomas v. Perkins, 301 U.S. 655, 57 S.Ct. 911, 81 L.Ed. 1324, an owner of oil interests transferred them in return for an 'oil production payment,' an amount which is payable only out of the proceeds of later commercial sales of the oil transferred. The Court held that this transfer, which constituted a sale under state law, did not constitute a sale for tax purposes because there was not a sufficient shift of economic risk. The transferor would be paid only if oil was later produced and sold; if it was not produced, he would not be paid. The risks run by the transferor of making or losing money from the oil were shifted so slightly by the transfer that no § 1222(3) sale existed, notwithstanding the fact that the transaction conveyed title as a matter of state law, and once the payout was complete, full ownership of the minerals was to vest in the purchaser.

I believe that the sellers here retained an economic interest in the business fully as great as that retained by the seller of oil interests in Thomas v. Perkins. The sellers were to be paid only out of the proceeds of the business. If the business made money they would be paid; if it did not, they would not be paid. In the latter event, of course, they could recover the business, but a secured interest in a business which was losing money would be of dubious value. There was no other security. The Institute was not bound to pay any sum whatsoever. The Institute, in fact, promised only to channel to the sellers a portion of the income it received from Fortuna.

Moreover, in numerous cases this Court has refused to transfer the incidents of taxation along with a transfer of legal title when the transferor retains considerable control over the income-producing asset transferred. See, e.g., Commissioner v. Sunnen, 333 U.S. 591, 68 S.Ct. 715, 92 L.Ed. 898; Helvering v. Clifford, 309 U.S. 331, 60 S.Ct. 554, 84 L.Ed. 788; Corliss v. Bowers, supra. Control of the business did not, in fact, shift in the transaction here considered. Clay Brown, by the terms of the purchase agreement and the lease was to manage Fortuna. Clay Brown was given power to hire and arrange for the terms of employment of all other employees of the corporation. The lease provided that 'if for any reason Clay Brown is unable or unwilling to so act, the person or persons holding a majority interest in the principal note described in the Purchase Agreement shall have the right to approve his successor to act as general manager of Lessee company.' Thus the shareholders of Clay Brown & Co. assured themselves of effective control over the management of Fortuna. Furthermore, Brown's attorneys were the named shareholders of Fortuna and its Board of Directors. The Institute had no control over the business.

I would conclude that on these facts there was not a sufficient shift of economic risk or control of the business to warrant treating this transaction as a 'sale' for tax purposes. Brown retained full control over the operations of the business; the risk of loss and the opportunity to profit from gain during the normal operation of the business shifted but slightly. If the operation lost money, Brown stood to lose; if it gained money Brown stood to gain, for he would be paid off faster. Moreover, the entire purchase price was to be paid out of the ordinary income of the corporation, which was to be received by Brown on a recurrent basis as he had received it during the period he owned the corporation. I do not believe that Congress intended this recurrent receipt of ordinary business income to be taxed at capital gains rates merely because the business was to be transferred to a tax-exempt entity at some future date. For this reason I would apply here the established rule that, despite formal legal arrangements, a sale does not take place until there has been a significant economic change such as a shift in risk or in control of the business. ^[4]

To hold as the Court does that this transaction constitutes a 'sale' within the terms of I.R.C. § 1222(3), thereby giving rise to capital gain for the income received, legitimates considerable tax evasion. Even if the Court restricts its holding, allowing only those transactions to be § 1222(3) sales in which the price is not excessive, its decision allows considerable latitude for the unwarranted conversion of ordinary income into capital gain. Valuation of a closed corporation is notoriously difficult. The Tax Court in the present case did not determine that the price for which the corporation was sold represented its true value; it simply stated that the price 'was the result of real negotiating' and 'within a reasonable range in light of the earnings history of the corporation and the adjusted net worth of the corporate assets.' 37 T.C., at 486. The Tax Court, however, also said that '(i)t may be * * * that petitioner (Clay Brown) would have been unable to sell the stock at as favorable a price to anyone other than a tax-exempt organization.' 37 T.C., at 485. Indeed, this latter supposition is highly likely, for the Institute was selling its tax exemption, and this is not the sort of asset which is limited in quantity. Though the Institute might have negotiated in order to receive beneficial ownership of the corporation as soon as possible, the Institute, at no cost to itself, could increase the price to produce an offer too attractive for the seller to decline. Thus it is natural to anticipate sales such as this taking place at prices on the upper boundary of what courts will hold to be a reasonable price-at prices which will often be considerably greater than what the owners of a closed corporation could have received in a sale to buyers who were not selling their tax exemptions. Unless Congress repairs the damage done by the Court's holding, I should think that charities will soon own a considerable number of closed corporations, the owners of which will see no good reason to continue paying taxes at ordinary income rates. It should not be necessary, however, for Congress to address itself to this loophole, for I believe that under the rpesent laws it is clear that Congress did not intend to accord capital gains treatment to the proceeds of the type of sale present here.

Although the Court implies that it will hold to be 'sales' only those transactions in which the price is reasonable, I do not believe that the logic of the Court's opinion will justify so restricting its holding. If this transaction is a sale under the Internal Revenue Code, entitling its proceeds to capital gains treatment because it was arrived at after hard negotiating, title in a conveyancing sense passed, and the beneficial ownership was expected to pass at a later date, then the question recurs, which the Court does not answer, why a similar transaction would cease to be a sale if hard negotiating produced a purchase price much greater than actual value. The Court relies upon Kolkey v. Commissioner, 254 F.2d 51 (C.A.7th Cir.), as authority holding that a bootstrap transaction will be struck down where the price is excessive. In Kolkey, however, the price to be paid was so much greater than the worth of the corporation in terms of its anticipated income that it was highly unlikely that the price would in fact ever be paid; consequently it was improbable that the sellers' interest in the business would ever be extinguished. Therefore, in Kolkey the court, viewing the case as one involving 'thin capitalization,' treated the notes held by the sellers as equity in the new corporation and payments on them as dividends. Those who fashion 'bootstrap' purchases have become considerably more sophisticated since Kolkey; vastly excessive prices are unlikely to be found and transactions are fashioned so that the 'thin capitalization' argument is conceptually inapplicable. Thus I do not see what rationale the Court might use to strike down price transactions which, though excessive, do not reach Kolkey's dimensions, when it upholds the one here under consideration. Such transactions would have the same degree of risk-shifting, there would be no less a transfer of ownership, and consideration supplied by the buyer need be no less than here.

Further, a bootstrap tax avoidance scheme can easily be structured under which the holder of any income-earning asset 'sells' his asset to a tax-exempt buyer for a promise to pay him the income produced for a period of years. The buyer in such a transaction would do nothing whatsoever; the seller would be delighted to lose his asset at the end of, say, 30 years in return for capital gains treatment of all income earned during that period. It is difficult to see, on the Court's rationale, why such a scheme is not a sale. And, if I am wrong in my reading of the Court's opinion, and if the Court would strike down such a scheme on the ground that there is no economic shifting of risk or control, it is difficult to see why the Court upholds the sale presently before it in which control does not change and any shifting of risk is nominal.

I believe that the Court's overly conceptual approach has led to a holding which will produce serious erosion of our progressive taxing system, resulting in greater tax burdens upon all taxpayers. The tax avoidance routes opened by the Court's opinion will surely be used to advantage by the owners of closed corporations and other income-producing assets in order to evade ordinary income taxes and pay at capital gains rates, with a resultant large-scale ownership of private businesses by tax-exempt organizations. ^[5] While the Court justifies its result in the name of conceptual purity, ^[6] it simultaneously violates long-standing congressional tax policies that capital gains treatment is to be given to significant economic transfers of investment-type assets but not to ordinary commercial or business income and that transactions are to be judged on their entire substance rather than their naked form. Though turning tax consequences on form alone might produce greater certainty of the tax results of any transaction, this stability exacts as its price the certainty that tax evasion will be produced. In Commissioner v. P.G. Lake, Inc., 356 U.S. 260, 265, 78 S.Ct. 691, 694, 2 L.Ed.2d 743, this Court recognized that the purpose of the capital gains provisions of the Internal Revenue Code is "to relieve the taxpayer from * * excessive tax burdens on gains resulting from a conversion of capital investments, and to remove the deterrent effect of those burdens on such conversions.' * * * And this exception has always been narrowly construed so as to protect the revenue against artful devices.' I would hold in keeping with this purpose and in order to prevent serious erosion of the ordinary income tax provisions of the Code, that the bootstrap transaction revealed by the facts here considered is not a 'sale' within the meaning of the capital gains provisions of the Code, but that it obviously is an 'artful device,' which this Court ought not to legitimate. The Court justifies the untoward result of this case as permitted tax avoidance; I believe it to be a plain and simple case of unwarranted tax evasion.

Notes

1. See I.R.C.1954, § 501(c)(3).
2. This lease arrangement was designed to permit the Institute to take advantage of its charitable exemption to avoid taxes on payment of Fortuna's profits to it, with Fortuna receiving a deduction for the rental payments as an ordinary and necessary business expense, thus avoiding taxes to both. Though unrelated business income is usually taxable when received by charities, an exception is made for income received from the elase of real and personal property of less than five years. See I.R.C. § 514; Lanning, Tax Erosion and the 'Bootstrap Sale' of a Business I, 108 Pa.L.Rev. 623, 684-689. Though denial of the charity's tax exemption on rent received from Fortuna would also remove the economic incentive underlying this bootstrap transaction, there is no indication in the Court's opinion that such income is not tax exempt. See the Court's opinion, ante, at 565-566.
3. See the articles cited in the majority opinion, ante, at 566, n. 2.
4. The fact that respondents were to lose complete control of the business after the payments were complete was taken into account by the Commissioner, for he treated the business in respondents' hands as a wasting asset, see I.R.C.1954, § 167, and allowed them to offset their basis in the stock against the payments received.
5. Attorneys for amici have pointed out that tax-exempt charities which they represent have bought numerous closed corporations.
6. It should be noted, however, that the Court's holding produces some rather unusual conceptual results. For example, after the payout is complete the Institute presumably would have a basis of $1,300,000 in a business that in reality cost it nothing. If anyone deserves such a basis, it is the Government, whose grant of tax exemption is being used by the Institute to acquire the business.