Waterman, Largen & Co., Inc. v. The United States

NICHOLS, Judge

(dissenting):

This is an action to recover alleged overpayments of corporate income taxes for the calendar 1961 and 1962 taxable years. Plaintiff originally showed on its returns a loss on a sale of capital stock as capital losses, but after becoming aware of certain court decisions filed claims for refund. Its position now is that the losses are deductible as ordinary and necessary business expenses (Internal Revenue Code of 1954, Sec. 162(a)) or as an uncompensated loss sustained during the taxable year (Internal Revenue Code of 1954, Sec. 165(a)). Defendants says the loss was incurred on the sale of a capital asset under §§ 165 (f), 1211(a), and 1221, with the limitations on deductibility applicable thereto. These are that such losses are allowable only .to the extent of capital gains. The returns reflected no such capital gains. I agree with defendant’s position.

The facts are set forth in the findings and are repeated here only to the extent necessary to give the setting for my conclusions of law.

Plaintiff was incorporated in May 1958, and its business was and remained to sell, on commission, various types of textile yarn produced by its mill accounts. Separation of the function of selling from production had been common in the textile industry. It was important for such a concern to be able to offer vendees all the various types of yarn, and its organization brought together three specialists in various yarns. Mr. Merrill, one of the organizers, brought into the new concern an account with Elmvale Worsted Company, a Massachusetts corporation, of Pittsfield, Massachusetts. Its product had been wool weaving yarns almost exclusively, but Mr. Merrill had induced it to stress wool knitting yarns, believed at that time to be a more promising line. He had sold for it all its production of knitting yarns amounting to one fourth to one third of its business, on the 2% commission standard in the industry. Persons not here involved effected the remainder of Elmvale’s sales.

But Elmvale Worsted was still not returning a profit and Mr. Carey R. Kinney, who owned 83% of its stock, informed Mr. Merrill that it must close. The industry at that time was in grave difficulties because of the competition of low-cost imports. The record also reflects that the textile industry was a low-wage one, by American standards, and that Massachusetts had become a high-wage area because of the impact of the prosperous electronics industry. This naturally created labor difficulties for Elmvale, as for other Massachusetts textile concerns. Besides, Elmvale’s plant was antiquated.

Mr. Merrill put forward the idea to Mr. Carey Kinney that he might organize a new company, to operate in the South, as an alternative to merely closing. To plaintiff the loss of commissions on Elmvale sales was only one aspect of the threatened disaster: the unbalancing of its line was another. It was committed to carry certain high-salary personnel and could not reduce its overhead to adjust to the threatened loss of business. Thus it had every incentive to help keep Mr. Carey Kinney in production in one way or another.

The latter was receptive to the idea, largely because he desired to secure a career in the textile industry for his son, generally referred to in the record as “Brud” Kinney. Mr. Merrill and another principal owner of plaintiff, Mr. Lar-gen, located a plant that could be purchased at the small town of Laurens, South Carolina. This plant could spin worsted yarn and, supplemented by some machinery from Pittsfield, could produce enough knitting yarn to keep plaintiff in the business. It was a going concern with an experienced labor force.

A deal was now worked out according to which a new corporation was to be formed to operate this plant. Its name was to be Elmvale Worsted Company Inc., i. e., the same as the Pittsfield con *857 cern with the addition of “Inc.” Brud Kinney would manage it and his father would be Chairman of the Board but would not move South. Every effort would be made to maintain the high reputation of the Pittsfield concern and sell the same products to the same customers.

It was agreed that plaintiff was to be the exclusive sales agent, which meant it would get its 2% commission on every pound that was sold, whether it effected the sale itself or not. As usual in the industry there was no formal or even informal agreement as to how long the agency would last or how it could be terminated.

The elder Kinney, however, insisted that he would not put plaintiff in that position unless it subscribed to stock in the new company. His purpose in taking this position was to eliminate a conflict of interest he deemed to exist as between selling agents and mills, when wholly independent financially. Mills, to earn a profit, had to work on long production runs of uniform specifications. Agents, however, to enlarge their commissions would load up the order board with variegated small orders necessitating frequent interruptions of production. The commission was earned whether or not the order was filled at a profit. Plaintiff’s officers fully understood Mr. Kinney’s position and his reasons for it, to the extent that Mr. Merrill anticipated that Mr. Kinney would make this demand even before he made it. Whether because of similar thinking or not, the complete independence of mill and agent that once had prevailed had become somewhat exceptional in that industry. There is nothing to suggest that Mr. Kinney could not have obtained the needed capital elsewhere. In fact, plaintiff was practically insolvent, had no funds available for investment, and it borrowed the $100,000 it was required to put up from a factor who would have loaned the money direct to Elmvale just as readily. For this $100,000 it received % of the stock, and nominated Mr. Lar-gen to serve on the Board of Directors. The rest of the stock went to the Kin-neys, ,to the supplier of the raw material, wool tops, who put up $50,000, and a small amount to the former owners of the Laurens plant.

According to Mr. Waterman, the president and treasurer of plaintiff (R 40):

We felt that with Mr. Kinney’s background and experience in worsted manufacturing and with Mr. Wellman, who was the largest top maker in the country, and with Mr. Merrill’s experience, broad experience in the field of selling worsted yarns that the operation should be successful. We didn’t expect any great General Motors out of it, but we felt it would be a successful operation that would remain in business for a number of years and generate commissions to us.

They did not buy .the stock for appreciation in value or dividends, but to get the commissions. They “would not have been upset” by an appreciation in value “but that was not the purpose.” Appreciation appeared unlikely, since at .that time worsted yarn organizations were “not very successful.” On the basis of full production they “hoped and expected” to get $60,000 a year in commissions, out of which allocable salaries and other overhead would have to be paid. Still, they hoped to earn enough money from the account to pay off the loan from the factor in two to three years.

This was the only stock purchase plaintiff had ever made, up to the time of trial.

It is of interest to note that the principals of the plaintiff corporation hardly hoped that their commissions from Elm-vale and all other sources would do more than pay their own salaries; for plaintiff, too, dividends or stock appreciation were a long way off at best. Such was the state of this once flourishing industry.

As it turned out, even these modest hopes were dashed. For reasons not made clear in the record, Elmvale Worsted Company Inc. was consistently unsuccessful, both as to gross volume and as to *858 profits. It became heavily in debt to the wool top supplier. What Winston Churchill called “the diseases of defeat” began to appear. Among these people, who were too gentlemanly and understood each other too well to need written agreements, there developed something like acrimony. In the spring of 1961 the gulf between Mr. Merrill and Brud Kinney became too deep for the former to continue handling the account. He was persuaded to withdraw amicably from the plaintiff corporation and others were employed to take the account over. Nevertheless, Mr. Wellman, the wool top supplier, who to all intents was in control of Elmvale Inc. owing to its unpayable debt to him, began to angle with other agents. On June 22, 1961, Brud Kinney sent plaintiff a notice in writing that the agency was terminated effective June 30.

Plaintiff’s officers were naturally irate at this. They had supposed in some vague way that their stock purchase removed their agency relationship from the category of those that were terminable at will. They consulted South Carolina counsel who gave them little encouragement. Apparently the only thing counsel could think of was some kind of minority stockholder’s suit, which he thought would be futile because of the insolvency of Elmvale Inc. If they appeared to be getting anywhere in the suit, Mr. Wellman could seize the assets in collection of his debt, leaving an empty shell for the litigants.

Plaintiff was left with its $100,000 debt to the factor, which it honored and paid in full. It endeavored to sell the stock and was able to realize but $25,000. The difference, $75,000, is the loss whose proper tax treatment is at issue here.

There can be no doubt that from the accountant’s point of view the investment was a capital investment and the loss a capital loss. Mr. Brown, a qualified CPA, so treated them on the plaintiff’s books and tax returns. He testified he would treat an inventory loss as an ordinary loss. He was asked (R 181):

Q Why did you treat this loss differently ?

A Because I had considered this as an investment in a capital asset.

Q Why?

A Because that's what it was.

It is not unusual in these cases, nor decisive, for the taxpayer to repudiate the treatment originally given the transaction on its books or tax returns. It ought to give pause when the accountant still says he was right the first time. However, there appears to be a divergence between the accounting and ,the legal point of view in the present premises. The source of this divergence, its nature, and extent, are for consideration here.

The landmark case is Corn Products Refining Co. v. Commissioner of Internal Revenue, 350 U.S. 46 , 76 S.Ct. 20 , 100 L.Ed. 29 (1955). That taxpayer, in the business of producing corn sugar and other corn products, had become accustomed to purchase corn futures at harvest time each year, at favorable prices, to guard against high prices due to droughts before the next harvest. At times it sold these futures and purchased spot corn instead. It claimed the futures were capital investments and that gains when realized were entitled to capital gains treatment. The Court held otherwise, viewing the transactions as an “integral part” of the business, “a form of insurance against increases in the price of raw corn” (p. 50, 76 S.Ct. p. 23). “Congress intended that profits and losses arising from the everyday operations of a business be considered as ordinary income or loss rather than capital gain or loss” (p. 52, 76 S.Ct. p. 24). The capital gains provision, being “an exception from the normal requirements of the Internal Revenue Code” must be construed strictly. Thus, in effect, the specific exceptions such as stock in trade or inventory to the capital asset definition in Internal Revenue Code, Sec. 1221, were held not to comprise all the exceptions .there were.

*859 In Booth Newspapers Inc. v. United States, 303 F.2d 916, 920 , 157 Ct.Cl. 886, 894 (1962); this court referred to the Corn Products rule as an “elastic concept” which in certain cases would permit transactions which would otherwise fall within the literal definition of a capital asset to be considered instead as ordinary income.

United States v. Rogers, 286 F.2d 277 (6th Cir. 1961), cert. denied, 366 U.S. 951 , 81 S.Ct. 1902 , 6 L.Ed.2d 1243 , reh. denied, 368 U.S. 870 , 82 S.Ct. 27 , 7 L.Ed. 2d 71 , illustrates the converse of Corn Products: taxpayer, a cattle dealer, bought and sold futures in other commodities with the idea that somehow he was hedging. The court held .these were capital transactions because not integral to the business.

The largest class of cases following Corn Products consists of those (commonly referred to as “source of supply cases”) where, as in Corn Products itself, a purchase of securities or other assets, normally capital, is made as an expedient to tide the buyer over a period of shortage and high prices of some material vitally needed in its business as stock in trade or inventory. Our own FS Services Inc. v. United States, 188 Ct.Cl. 874 , 413 F.2d 548 (1969), and Booth Newspapers Inc. v. United States, supra, decisions are perhaps typical. Booth Newspapers had bought stock in a paper mill during a period of acute newsprint shortage to assure a newsprint supply. FS Services bought a refinery during a period of acute shortage of petroleum products, which FS Services had to have to supply to its customers. In both cases this court assured itself (a) that the taxpayers knew they were acquiring property that would not be attractive to them to own in the long pull, after the shortage ended, and (b) that there was an intention to dispose of the acquisition when the shortage ended, which was carried out with reasonable promptness. In Booth, the acquired plant made high-quality writing and book paper and had to be converted to make newsprint which even so was of poor quality. In FS Services, the purchased refinery was outclassed in efficiency by newer plants and would become obsolete as soon as a sufficient number of the latter were in stream. Obviously, either taxpayer might have decided .to become an integrated producer, as a permanent thing, producing its own raw material or inventory. To have held the purchase not a capital transaction in such a case would be to make a dent in the legal concept of a capital transaction not warranted by anything said or done in Corn Products. We referred with approval to Missisquoi Corp., 37 T.C. 791 (1962); and Gulftex Drug Co., 29 T.C. 118 (1957), aff’d per curiam 261 F.2d 238 (5th Cir. 1958); in both of which the investment was held capital because held too long after the supply emergency ended. Defendant cited .the above two cases in FS Services, but we held them not applicable there because FS Services started trying to get rid of its refinery when no longer needed with reasonable promptness as we thought.

Other cases allowing ordinary loss or requiring ordinary gain treatment for this kind of “source of supply” transaction are: Smith & Welton v. United States, 164 F.Supp. 605 (E.D.Va.1958); Electrical Fittings Corp., 33 T.C. 1026 (1960); Tulane Hardwood Lumber Co., 24 T.C. 1146 (1955); Helen M. Livesley, 19 T.C.M. 133 (1960); Arlington Bowling Corp., 18 T.C.M. 896 (1959); Edwards v. Hogg, 214 F.2d 640 (5th Cir. 1954); Journal Company v. United States, 195 F.Supp. 434 (E.D.Wis.1961); Mansfield Journal Co. v. Commissioner of Internal Revenue, 274 F.2d 284 (6th Cir. 1960).

In arriving at our recent FS Services decision we concluded that no innovation was required of us then. On the facts found, precedents binding on us dictated the result. The main thrust of defendant’s efforts were to refute our commissioner’s fact findings which, if accepted, were practically conclusive.

Purchases of stock wholly or partly to obtain employment must be common. *860 Many stockholders of closely held corporations must expect to be employed to render the corporation services they are capable of rendering, which the corporation needs. Yet the cases applying Corn Products to stock purchases made with this motive are not very numerous. Examples are: Hagan v. United States, 221 F.Supp. 248 (W.D.Ark.1963), (plaintiff, a commission salesman, purchased stock in a business he had been selling to in order to retain it as a customer. The stock became worthless. Held, ordinary loss.) Southeastern Aviation Underwriters, 25 T.C.M. 412 (1966), (plaintiff, an aviation insurance manager, bought stock in an insurance company so as to be employed by it as its aviation insurance manager; later he sold stock at loss. Held, ordinary loss.) Charles W. Steadman, 50 T.C. 369 (1968), (plaintiff, an attorney, bought stock in a corporation of which he was secretary and general counsel in order to avert a change of control which would have cost him these jobs and the fees incidental. Stock became worthless. Held, ordinary loss. There is a dissent asserting it was no.t shown the corporation was a vital source of taxpayer’s practice. This case is on appeal in the 6th Circuit.)See also, Troxell and Noall, Judicial Erosion of the Concept of Securities as Capital Assets, 19 Tax Law Review 185, 204 (1964) and authority cited.

These cases, like .the one at bar, clearly fall outside all the statutory exceptions to the capital asset concept. For this reason, before they were decided one commentator suggested that the “source of supply” cases would not be precedents for a case:

* * * On the other hand, where the purchase is to acquire a long-term (capital) right, such as an exclusive agency * * *. Freeman, Is There A New Concept Of Business Asset?

36 Taxes 110 , 112 (1958).

This comment would be more helpful if not made by Freeman in course of an attempt to demonstrate that Com Products and other source of supply cases fall within the inventory exception, an analysis I find to be strained. Most commentators agree, reasonably in my opinion, that the Supreme Court did intend to engraft a new exception on to Sec. 1221 in addition to the inventory exception. Brown, The Growing “Common Law” of Taxation, 34 S.Cal.L.Rev. 233, 249 (1961); Chirelstein, Capital Gain And The Sale Of A Business Opportunity: The Income Tax Treatment of Contract Termination Payments, 49 Minn.L.Rev. 1, 41 (1964); Kauffman, A Second Look At The Corn Products Doctrine, 41 Taxes 605 (1963); Surrey, Definitional Problems In Capital Gains Taxation, 69 Harv.L.Rev. 985, 993 (1956); Troxell and Noall, Judicial Erosion Of The Concept Of Securities As Capital Assets, 19 Tax L.Rev. 185 (1964); Tucker, The Warren Court: Its Impact On The Capital vs. Ordinary Concept Under The Internal Revenue Code, 17 Kansas L.Rev. 53, 59 (1968); Note, Judicial Treatment Of “Capital” Assets Acquired For Business, 65 Yale L.J. 401 , 406 (1956). The Freeman comment does validly suggest the point, however, that the source of supply cases have a conceptual nexus with the express statutory exception in Sec. 1221 for inventory, which is lacking in the case of purchases of stock to secure a source of employment. It could well be that the Congress which enacted the inventory exception would have added an explicit exception for stocks purchased primarily to secure a source of inventory if it had thought of it, for otherwise the apparent statutory plan is imperfectly expressed. No such argument can be made in the case of a source of employment stock purchase.

Thus the Supreme Court’s Corn Products case had a takeoff point in the language of the statute which is lacking here. Moreover, the decided cases cited to us do not provide a body of law in the source of employment field which can be deemed stare decisis in this court. The most I can derive from the cases and comments is that the court should not flinch away from an innovative approach to accomplish the statu *861 tory scheme more perfectly, merely because some critics might call it judicial legislation.

Still, if we are to make new tax rules, we should do so in responsible fashion. The defendant points out with some justice .that in any case where possible employment came as one of the usufructs of stock ownership, a business rather than an investment motive could be asserted if the stock were sold at a loss, and forgotten if it were sold at a profit. It is not lightly to be supposed that the Congress intended to present taxpayers with so golden an opportunity to manipulate the facts to secure a tax advantage. To assuage the defendant’s concern, it is necessary to ascertain the presence of business as against investment purpose by manifestations in the external world rather than merely by subjective intent allegedly locked in the taxpayer’s breast and first disclosed years later. Then the taxpayer would have to accept tax consequences unfavorable to himself if he sold at an advance stock he had purchased with predominant business motivation. I think this is the kind of equitable balance the Supreme Court intended to bring about in Corn Products.

This kind of external evidence presumably would exist if the stock manifestly did not have the market value .the taxpayer put out for it. Then it might be inferred the purchase was really a disguised kickback or rebate to secure employment. But that is not this case. Taxpayer does not seriously contend that the stock was overpriced or that the new corporation did not have good prospects. On the other hand, taxpayer does not offer any clear extrinsic proof that the case is not the ordinary one of the investor hoping for employment as one of the usufructs of stock ownership.

If plaintiff’s officers remember their motives correctly, they did not reveal them at the time to their co-entrepreneurs. The whole point of getting $100,-000 of capital indirectly from the factor through plaintiff, rather than directly from the factor, was to secure the services of an agent who would be investor minded. Yet the officers now say their sole object was commissions, just as if they held no stock. Of course, if they had said this to Mr. Kinney, Sr., at the time, the whole deal would have been off. In effect they say they were withholding from Mr. Kinney what he had bargained to receive.

If taxpayer bought the stock only to obtain the agency it is remarkable it did no more to assure that the agency would not be terminable by the principal at its will. It is true they say that somehow, they thought .their stock ownership took the agency out of the at will category, but they do not explain how, instead of at will, they expected it to be terminable. Surely they did not imagine it to be terminable under no conditions! If they thought their stock purchase was an investment, their failure to tie in their purchase to the duration of their agency is at once explained. This point by itself cannot be deemed conclusive, however. The exhaustive analyses by Troxell and Noall, cit. supra, shows the existence of some source of supply cases where the taxpayer acquired an interest, but not control.

When the principal terminated the agency, in plaintiff’s eyes wrongly and prematurely, plaintiff took no steps to rescind the entire transaction.

Plaintiff says its need for the agency was so great as to put it under virtual duress, under all the circumstances, as recounted supra and in the findings. However, it appears Mr. Kinney was just as much in need of plaintiff, as plaintiff was of him. Only plaintiff’s Mr. Merrill had developed the market for wool knitting yarns which the new business was to exploit. Elmvale Worsted Company, Inc., was born because of the need of all its principals for one another. There is anyway, nothing to show that plaintiff was so desperate it could not bargain with Mr. Kinney on an arm’s length basis and negotiate for relief from any conditions it deemed unfair or onerous.

*862 I do not view this analysis of the facts as in conflict with Finding 29 because I read that finding as referring to a state of mind that was never disclosed to anyone until plaintiff’s officers testified in this case. Not even to their own account! I do not dispute that they had such a state of mind, but I am not willing to give it legal significance in the absence of communication. Thus I do not regard the failure of defendant to except to Finding 29 as conclusive against it. I think it is important to say that my majority colleagues, if I read their minds aright, do think that my position flouts Finding 29. An understanding of this may contribute to the proper future use of this ease as a precedent.

In Goodman v. United States, 182 C.t. Cl. 662, 390 F.2d 915 , cert. denied 393 U.S. 824 , 89 S.Ct. 87 , 21 L.Ed.2d 96 (1968), the issue was whether certain gains from sales of real estate should be regarded as from property held for sale to customers in the ordinary course of business, under the 1939 Code, or as capital gains. A majority of the court held for the former view, disregarding taxpayers’ testimony that they had an investment intent, in favor of contrary conclusions drawn from surrounding facts and circumstances. There were dissents, but they did not urge that a taxpayer’s selfserving testimony as to a previous state of mind should be decisive, and as to this point the court appeared unanimous.

It would seem the Goodman evaluation should be a fortiori when a taxpayer locks an intent in his breast, manifesting by words or deeds a contrary intent for the edification of the other parties with whom he transacts business. However genuine the secret intent may have been, it is not normally the kind of intent that can be controlling in the administration of the tax laws. If this salutary principle is remembered, the mind can remain open to applying the Corn Products doctrine to a stock purchase to secure employment in a proper case, without giving rise to the evils that concern the defendant.

Troxell and Noall, cit. supra, say “It is impossible to predict ,the outer boundaries of this rapidly expanding concept.” (p. 204). “* * * the process of the erosion of traditional concepts of capital assets has not been completed * * (pp. 207, 208). They urge further judicial refinement and say that “A clarification of the law by the Supreme Court would be appropriate.” (p. 208).

Other commentators also call attention to the onesided success of taxpayers in using Corn Products for their purposes, contrary to the Supreme Court’s apparent belief it was closing a loophole, and urge that a regulation require purchasers of securities to notify the IRS shortly after purchase if they intend to claim the purchase was not for investment. The Yale Law Journal Note, cit. supra; Kauffman, cit. supra. This has not been done, but without such a regulation the courts should achieve at least part of its purpose by recognizing the sound standard of proof of noninvestment intent here urged.

Statements are commonly made in other branches of tax law that courts cannot rectify tax inequalities by imputing to Congress an unexpressed intent to achieve uniformity and then rewriting what Congress actually put in words, e: g., Fitch Co. v. United States, 323 U.S. 582, 587 , 65 S.Ct. 409 , 89 L.Ed. 472 (1945). In Shakespeare Company v. United States, 419 F.2d 839 , 189 Ct.Cl.-(decided today) the opinion the court adopts as its own says “Courts are powerless to rewrite tax statutes, however appealing it may be.”, citing Fitch. 419 F.2d at pp. 843, 844. I joined in that opinion, .thinking the statement at least ought to be true, and no doubt generally it is. The branch we are now concerned with is, therefore, somewhat anomalous. The case before us is indeed a hard one and Congress surely should have provided for it. Before we strapped on our armor and leaped on our *863 white horse, however, it seems to me we should have considered. It is not unheard of in framing our opinions, when they are felt to be innovative in approach, ,to add, even if dictum, a warning that the innovation has limits. E. g., Sullivan v. United States, 416 F.2d 1277 , 189 Ct.Cl. - (decided October 17, 1969). If the opinion the court today adopts as its own had done this I would not find it as had to swallow as I do. Instead, it seems only to say that we have put on a good deal of speed already and therefore we should not hesitate to put on more. The innovative nature of the decision proposed is not even recognized as a reason for caution. In dealing with a doctrine commentators already seem to regard as open-ended, we should' not contribute as we do today to foster that belief. Such strictures should warn us the time has come to think again about that departure point, now long forgotten, the language used by Congress, to determine our bearings and distance with respect to it, and to plot a course having what all courses ought to have, a destination.

This view of the case makes it unnecessary to determine whether the agency, as it was or as plaintiff thought it was, constituted the kind of “long-term (capital) right” visualized in Freeman’s commentary. Also, it is unnecessary to determine whether to obtain ordinary loss treatment, plaintiff is required to show it intended to dispose of the stock at a definite or ascertainable future date, a point much debated by counsel herein, or any other ground on which it could be said that the transaction here was not entitled to be called an ordinary loss.

I would hold, therefore, that plaintiff has failed, as a matter of ultimate fact, to prove that it purchased the involved corporate stock as a business expense rather than as an investment.