Petition — Kraut v. Commissioner

Supreme Court brief1976

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——

‘Supreme Court, U. S

FEB 26 1916

— -_ -_— zm

ut the Buide Orton CLERK

Supreme Court i

October Term, 1975

No. ........ rd 52-1222

AARON KRAUT and IRIS KRAUT,

HARRY KRAUT and MARIAN KRAODT,

Petitioners,

agaust

COMMISSIONER OF INTERNAL REVENUE,

Respondent.

PETITION (WITH APPENDICES) FOR A WRIT

OF CERTIORARI TO THE UNITED STATES

COURT OF APPEALS FOR THE

SECOND CIRCUIT

O. Joun Roacz

Attorney for Petitioners

777 Third Avenue

New York, New York 10017

Of Counsel:

O. Joun Roces

Hermann Rocce

TABLE OF CONTENTS

PAGE

Opinions Below..................... | al . 2

Jurisdiction . | 2

Questions Presented 2

Statutory Provision Involved Nene 3

Section 1222 (3) of the Internal Revenue Code

of 1954 ® 3

Statement of the Case

Reasons for Granting Writ 9

I—The transaction between the shareholders of

Nassau Corp and the Cathedral was a bona fide

sale for a fair price that falls squarely within

Commissioner v. Clay Brown, 380 U.S. 563

(1965), but the Second Circuit held exactly to

the contrary le 9

II—Where a question of valuation is involved and

the Commissioner’s determination of a defi-

ciency is arbitrary, unreasonable and unsup-

ported by any evidence, the taxpayers, at the

very least, are entitled to an evidentiary hear-

ing on the question of value 18

I1J—The Commissioner cannot, consistent with due

process, arbitrarily fix the amount of a valua-

tion by a presumption without putting in any

proof | 23

Conclusion | 24

Appendices :

Appendix I Opinion of Judge Raum Al-A26

Appendix II Opinion of Second Cireuit A26—-A40

Appendix III Order Denying Rehearing _ A4il

| ' |

TABLE OF AUTHORITIES

PAGE

Cases:

Andrews v. Commissioner, 135 F. 2d 314 (2d Cir.),

cert. dented, 320 U.S. 748 (1943) 0000... 20-21

Berenson v. Commissioner, 507 F.2d (2d Cir. 1974),

aff’g in part, rev’g in part, and remanding, 59

T.C. 412 (1972) | ...4, 8, 14, 18, 20, 21, 22

Commissioner v. Clay Brown, 380 U.S. 563 (1965) __ 2, 3, 9,

11, 15, 17

Commissioner v. Riss, 374 F. 2d 161 (8th Cir. 1967) 20

Garner v. Louisiana, 368 U.S. 107 (1961) . a

Helvering v. Taylor, 293 U.S. 507 (1935) 2, 19-20, 22, 23

Stout v. Commissioner, 273 F. 2d 345 (4th Cir. 1959) 20

Thompson v. City of Louisville, 362 U.S. 199 (1960) . 3, 23

Other Authorities Cited:

Hearings before House Committee on Ways and

Means, 88th Cong., Ist Sess. : ——

Hearings before House Committee on Ways and

Means, 91st Cong., 1st Sess. ) | 14

Internal Revenue Code of 1954, §482 ae 5

Internal Revenue Code of 1954, §1222(3) 3

President’s 1963 Tax Message 11

Rev. Ruling 66-153, 1966-1 C.B. 187 3,11

Senate Finance Committee Hearings 16

Tax Reform Act of 1969 2

26 U.S.C. §7442 3

§7482(a) 4

§$7482(b) (1) (A) 4

§7483 4

28 U.S.C. §1254(1) 2

I Weinstein’s Evidence 300-1 to 300-16 (1975) 19

a en nal

IN THE

Supreme Court of the United States

October Term, 1975

Aaron Kraut and Iris Kravt,

Harry Kraut and Marian Kravt,

Petitioners,

against

COMMISSIONER OF INTERNAL REVENUE,

Respondent.

PETITION FOR A WRIT OF CERTIORARI TO

THE UNITED STATES COURT OF APPEALS

FOR THE SECOND CIRCUIT

The petitioners, Aaron and Iris Kraut, and Harry and

Marian Kraut, pray that a writ of certiorari be issued to

review the final judgment of the United States Court of

Appeals for the Second Circuit entered in the office of the

clerk on December 31, 1975, as well as the order of that court

denying a petition for a rehearing entered in the office of the

clerk of that court on January 15, 1976.

Opinions Below

The opinion of the United States Tax Court is reported,

62 T.C. 420 (1974). It is reproduced as Appendix I, infra,

pp. Al-A26. The opinion of the United States Court of

Appeals for the Second Circuit is not yet reported. It is

reproduced as Appendix II, infra, pp. A27-A40.

Jurisdiction

The Second Circuit rendered its judgment affirming the

decisions of the United States Tax Court and entered its

order of affirmance on December 31, 1975, and thereafter

entered its order denying the petitioners’ petition for a

rehearing on January 15, 1976 (Appendix III, infra, p.

A41). The jurisdiction of this Court is invoked under 28

U.S.C. §1254 (1).

Questions Presented

1. In the even‘ of a bona fide sale of stock to a charity,

is the excess which the charity pays above that which a non-

tax-exempt entity would have paid, entitled to capital gains

treatment under Commissioner v. Clay Brown, 380 U.S. 563

(1965), particularly in the light of the Tax Reform Act of

19691

2. In the event such excess is taxable as ordinary in-

come, is the Commissioner’s arbitrary and unreasonable

determination of such excess in a deficiency notice conclu-

sive without more under Helvering v. Taylor, 293 U.S. 507

(1935) ?

oe wee

A ny OE saat be Tale ete ly A A Se as EP Ee DE, ie

3. In the event such excess is taxable as ordinary in-

come, can the Commissioner, consistent with due process,

arbitrarily fix the amount of such excess by a presumption

without putting in any proof? Cf. Thompson v. City of

Louisville, 362 U.S. 199 (1960); Garner v. Louisiana, 368

U.S. 157 (1961).

Statutory Provision Involved

Section 1222 (3) of the Internal Revenue Code of 1954

(3) Long-term capital gain. The term ‘‘long-term cap-

ital gain’’ means gain from the sale or exchange of a capital

asset held for more than 6 months, if and to the extent that

such gain is taken into account in computing gross income.

Statement of the Case

The Commissioner in one of the first applications of his

new Rev. Ruling 66-153, 1966-1 C.B. 187, by which he sought

to avoid Commissioner v. Clay Brown, 380 U.S. 563 (1965),

in his statutory notices of deficiencies in this case dated

October 9, 1970 (9, 14)* acknowledged the validity of the

sale by the shareholders of Nassau Corp to the Cathedral

of Tomorrow, Inc. (Cathedral), but sought arbitrarily and

erroneously to value the stock of Nassau Plastic and Wire

Corp (Nassau Corp) at $168,445.60 (31).

On December 16, 1970 the taxpayers Aaron and Iris

Kraut and Harry and Marian Kraut, pursuant to 26 U.S.C.

§7442, filed their petitions in the Tax Court of the United

States for redeterminations of the Commissioner’s asserted

* References are to pages of the Joint Appendix.

deficiencies (9, 14). The Tax Court, Judge Arnold Raum

presiding, let stand on procedural grounds the Commis-

sioner’s arbitrary and erroneous figure of $168,445.60

(286), and on February 21, 1975 entered his decisions of

deficiencies for the taxable year 1967 in the amounts of

$240,787.08 against Aaron and Iris Kraut (304) and $246,-

847.44 against Harry and Marian Kraut (306).

On May 19, 1975 Aaron and Iris Kraut (308) and on

May 21, 1975 Harry and Marian Kraut (309), pursuant to

26 U.S.C. §§7482 (a) and (b) (1) (A) and 7483, filed their

notices of appeal to the United States Court of Appeals

for the Second Circuit.

The taxpayers Iris and Marian Kraut, who owned all

of the stock of Nassau Corp, had first contracted to sell

their stock to Wilson Mold and Die Corp (Wilson Corp).

Nassau Corp and Wilson Corp did not go through with the

sale. Subsequently, in a separate three-cornered agree-

ment under date of June 15, 1966, Wilson Corp assigned

all of its rights and delegated all of its duties to the Cathe-

dral (195, 280). The Cathedral was an exempt organiza-

tion; Wilson Corp was not.

The purchase price was not less than $500,000 nor more

than $3,500,000 payable out of 75% of Nassau Corp’s net

income before federal income taxes (280, 166, Ex. 4-D; 195,

Ex. 5-E). The assignment from Wilson Corp to the Cathe-

dral resulted from . detailed presentation that Eugene O.

Cobert of Management Methods, Inc. made to the Cathedral

(121, 199). Management Methods, Inc. was an independent

entity that represented the Cathedral. The Cathedral,

after a thorough investigation of Nassau Corp, bought the

stock for the same price that Wilson Corp had originally

agreed to pay.

Nassau Corp was a new corporation, organized in July,

1965 to develop and manufacture a new product, namely,

copper wiring coated with a unique softer plastic insulation

to be used in the Christmas tree lighting business (56, 58,

69, 161, Ex. 3-C).

The operations of Nassau Corp were experimental in

1965 but based on the trade’s acceptance of its experimental

product as evidenced by its year-end order backlog, in 1966

the sales of the new product skyrocketed, for the new prod-

uct was a dramatically exciting type of Christmas tree

lighting wire (69-70). The new softer coated wire had a

spectacular market acceptance because it enabled Christ-

mas tree lighting manufacturers to assemble their product

with great accuracy and tremendous speed with a minimal

rejection rate, as Judge Raum found (277).

In 1967, pursuant to the agreement between the Cathe-

dral and the shareholders of Nassau Corp, the Cathedral

paid to the shareholders the amount of $1,268,275. Each

of the shareholders after deducting expenses, reported on

her 1967 United States income tax return the receipt of the

net amount of $606,416.47 as a long-term capital gain pur-

suant to section 1222 (3) of the Internal Revenue Code of

1954, less those amounts reported as interest income in

accordance with section 482 of the Internal Revenue Code

of 1954 (138).

Because of the tremendous amount of orders that Nas-

sau Corp had for its Christmas wire in 1966, it projected

earnings over a ten-year period of at least $10-million and

regarded this projection as a conservative one (85). Aaron

Kraut testified:

‘‘A. I projected earnings in the area—and this is

conservative, over a ten-year period of at least $10,-

000,000.00.

““Q. If it could produce $10,000,000.00 in earnings

over a ten-year period, well, how come you sold it for

500,000.00?

™ A, Because those were projections, and no one

knows what is going to happen six months from now—

““Q. The Cathedral offered you $3,500,000.00 for

this business and you sold it immediately?

‘A, No.

‘‘Q, Tell me what happened?

‘¢A. We wanted $5,000,000.00 for it.

‘*Q. Based on what?

‘¢A. On my projected earnings.

‘*Q. And, why did you accept $3,500,000.00 1 we

‘<A. Well, it was a matter of bargaining, they didn’t

want to pay $5,000,000.00, and I didn t want $2,500,-

000.00 or whatever they come in, I think it was $2,500,-

000.00’ (85-86).

Nassau Corp’s earnings over a 3-year period from J uly

1, 1965 through June 30, 1968 were more than $2-million

(Exs. 1-A, 2-B). Thus, Nassau Corp’s average yearly net

profit was $666,000.

In 1966 and 1967 the Cathedral paid the shareholders

of Nassau Corp the sum of $1,480,750 (137-39, 149, Exs.

1-A, 2-B). This represented but 75% of the net income

before Federal income taxes. At this rate the Cathedral

Ch A te RE ee

Seen ee ee ere Ses

ee ee eT

abet

Ble hoe

would have paid out the shareholders of Nassau Corp in

another two years in accordance with the terms of the

agreement of sale (195, Ex. 5-E).

The sale of Nassau Corp’s stock to the Cathedral for

$31-million was the result of hard bargaining at arm’s

length. Although the Cathedral was a charity, the record

indicates that it exercised careful and considered business

judgment in negotiating this purchase.

Nevertheless, the Commissioner in his statutory notice

arbitrarily picked the figure of $168,445.30, out of a hat as

it were, a figure which is less than 5% of the actual price

the parties themselves arrived at, and hardly more than

10% of the amount that the Cathedral actually paid to the

shareholders of Nassau Corp in 1967. Yet the Commis-

sioner, throughout these proceedings, conceded the bona

fides of the sale to the Cathedral. It is as if the Com-

missioner’s left hand did not know what his right hand

was doing. One thing is clear and that is that his picking

of the figure of $168,445.30 is arbitrary governmental action

at its worst.

At trial, Judge Raum did not follow the apportionment

rule which the Second Circuit announced in 1974, reversing

on this point the Tax Court, in Berenson v. Commissioner,

507 F.2d 262 (2d Cir. 1974), af'’g impart, rev *9 in part, and

remanding 59 T.C. 412 (1972). The instant case was tried

in 1973 in between these two rulings. Judge Raum, follow-

ing Berenson in the Tax Court, felt that the purchase price

in Kraut so substantially exceeded the statement net worth

of Nassau Corp that the transaction did not constitute a

sale. In the Second Circuit the petitioners argued that

Judge Raum failed to take into aecount the inherent value

of Nassau Corp’s business, which had a potential for mak-

ing millions in profits and did make more than $2,000,000.00

in a short period of time. The parties to the transaction,

namely, the petitioners and the Cathedral did take into

account the inherent value of Nassau Corp’s business.

On the point of valuation, the Second Circuit reversed

the Tax Court in Berenson and established an apportion-

ment rule which required a determination of the excess

that a charity paid over what a non-tax-exempt entity would

have paid. Judge Raum deciding Kraut before the Second

Circuit reversed in Berenson did not get into the question

of the excess a charity pays over what a non-tax-exempt en-

tity would have paid. Neither did the petitioners. Judge

Raum thus reached the result of holding on the one hand

that there was no sale and on the other hand that the Com-

missioner was procedurally bound by his statutory notice.

In this way, Judge Raum let stand the Commissioner’s arbi-

trary and unsupported figure of $168,445.30.

The Second Circuit rejected Judge Raum’s view that

there was no sale, but nevertheless let his decision stand

on the ground that since the Commissioner’s statutory no-

tice had contained some apportionment, the petitioners in

their turn were now procedurally barred on appeal from

attacking it because they failed to overcome the presump-

tion of correctness in the Commissioner’s determination.

Thus, the petitioners were effectively denied a meaning-

ful evidentiary hearing on the value of the stock of Nassau

Corp; for neither the petitioners nor Judge Raum knew

about the Second Circuit’s apportionment test in Berenson,

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ae te te me ee ee

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which came in November 1974, nearly a year after the trial

of the instant case before Judge Raum. As a result, the

petitioners made no effort in the Tax Court to show what a

non-tax-exempt entity would have paid for the stock of

Nassau Corp, the critical element in the Second Circuit’s

apportionment test. Indeed, if the petitioners had sought

to introduce such evidence, Judge Raum might well have

excluded it on the ground that he did not consider it

relevant.

Reasons for Granting the Writ

The transaction between the shareholders of Nassau

Corp and the Cathedral was a bona fide sale for a fair

price that falls squarely within Commissioner v. Clay

Brown, 380 U.S. 563 (1965), but the Second Circuit

held exactly to the contrary.

The Second Circuit was ‘‘constrained to find that the

sale was bona fide under Clay Brown’’ (App. II at p. A34);

yet reached just the opposite result. Indeed, the Conimis-

sioner treated the transaction between the Cathedral and

the shareholders of Nassau Corp as a valid sale of stock

in his statutory notice; and further acknowledged its bona

fides in his brief and argument in the Second Circuit.

In doing so, the Commissioner paid lip service to United

States v. Clay Brown, 380 U.S. 563 (1965), where he had

earlier contended that since the charity assumed no inde-

pendent liability for the purchase price, there was no sale.

To this contention the Supreme Court responded:

‘*to say there is no sale because there is no risk-

shifting and that there is no risk-shifting because the

price to be paid is payable only from the income pro-

duced by the business sold, is very little different from

saying that because business earnings are usually tax-

able as ordinary income, they are subject to the same

tax when paid over as the purchase price of property.

This argument has rationality but it places an unwar-

ranted construction on the term ‘sale’, is contrary to

the policy of the capital gains provisions of the Inter-

nal Revenue Code, and has no support in the cases.

We reject it.’’ At 570.

Justice Harlan in his concurring opinion added:

‘*Obviously the Institute traded on its tax exemp-

tion. The Government would deny that there was an

exchange essentially on the theory that the Institute

did not put anything at risk; since its exemption is un-

limited, like the magic purse that always contains an-

other penny, the Institute gave up nothing by trading

on it.

‘*Qne may observe preliminarily that the Govern-

ment’s remedy for the so-called ‘bootstrap’ sale—defin-

ing sale or exchange so as to require the shifiing of

some business risks—would accomplish little by way

of closing off such sales in the future. It would be

neither difficult nor burdensome for future users of the

bootstrap technique to arrange for some shift of risks.

If such sales are considered a serious abuse, ineffective

judicial correctives will only postpone the day when

Congress is moved to deal with the problem compre-

hensively. Furthermore, one may ask why, if the Gov-

ernment does not like the tax conseguences of such

sales, the proper course is not to attack the exemption

rather than to deny the existence of a ‘real’ sale or

exchange.’’ At 580.

The Commissioner tried to get the law changed legisla-

tively but the Congress did not respond favorably until

1969. When the Congress did respond, it did not deprive

the seller of capital gains treatment.

The Commissioner tried to get the law changed in 1963

to deprive seller of capital gains treatment. The Congress

did not act. From this failure to act in 1963, the Court in

Clay Brown inferred that sellers were to continue to get

capital gains treatment. Today this is no longer a matter

of inference; for when Congress did act in 1969 it still did

not deprive sellers of capital gains treatment.

In short, the Second Circuit’s apportionment rule is

wrong, the Commissioner’s Rev. Ruling 66-153, 1966-1 C.B.

187 is wrong, and the Second Circuit’s decision in Beren-

son is wrong.

In the President’s 1963 Tax Message we find:

‘‘Pursuant to the President’s recommendation that

changes be effected in the definitional aspect of capital

gains taxation, it is proposed that payments on the sale

of a capital asset (or payments so treated under pres-

ent law) which are deferred over more than 5 years

and are contingent on future income be treated as

ordinary income.”’

Hearings before the House Committee on Ways and

Means, 88th Cong., Ist Sess., Feb. 6, 7, 8 and 18, 1963, Pt. 1

(rev.), on the President’s 1963 Tax Message, p. 154.

With reference to the Commissioner’s 1963 attempt, the

Court in Clay Brown wrote:

‘‘There is another reason for us not to disturb the

ruling of the Tax Court and the Court of Appeals.

In 1963, the Treasury Department, in the course of

hearings before the Congress, noted the availability

of capital gains treatment on the sale of capital assets

even though the seller retained an interest in the in-

come produced by the assets. The Department pro-

posed a change in the law which would have taxed as

ordinary income the payments on the sale of a capital

asset which were deferred over more than five years

and were contingent on future income. Payments,

though contingent on income, required to be made

within five years would not have lost capital gains

status nor would payments not contingent on income

even though accompanied by payments which were.

Hearings before the House Committee on Ways and

Means, 88th Cong., Ist Sess., Feb. 6, 7, 8 and 18, 1963,

Pt. 1 (rev.), on the President’s 1963 Tax Message,

pp. 154-156.

‘‘Congress did not adopt the suggested change but

it is significant for our purposes that the proposed

amendment did not deny the fact or occurrence of a

sale but would have taxed as ordinary income those

income-contingent payments deferred for more than

five years. If a purchaser could pay the purchase

price out of earnings within five years, the seller would

have capital gain rather than ordinary income. The

approach was consistent with allowing appreciated

values to be treated as capital gain but with appro-

priate safeguards against reserving additional rights

to future income. In comparison, the Commissioner’s

position here is a clear case of ‘overkill’ if aimed at

preventing the involvement of tax-exempt entities in

the purchase and operation of business enterprises.

There are more precise approaches to this problem as

well as to the question of the possibly excessive price

paid by the charity or foundation. And if the Com-

missioner’s approach is intended as a limitation upon

the tax treatment of sales generally, it represents a

considerable invasion of current capital gains policy,

a matter which we think is the business of Congress,

not ours.

‘‘The problems involved in the purchase of a going

business by a tax-exempt organization have been con-

sidered and dealt with by the Congress. Likewise, it

has given its attention to various kinds of transactions

involving the payment of the agreed purchase price

for property from the future earnings of the property

itself. In both situations it has responded, if at all,

with precise provisions of narrow application. We

consequently deem it wise to ‘leave to the Congress

the fashioning of a rule which, in any event, must have

wide ramifications.’ American Automobile Assn. Vv.

United States, 367 U.S. 687, 697.’’ At 578-79.

In 1969 the Commissioner was more successful in ob-

taining new legislation. But the instant case involved the

year 1967.

One will further note that in all of the Treasury Depart-

ment position papers from 1963 to 1969 for new tax legis-

lation it never challenged the validity of such a sale as that

involved in the instant ase. Rather, it sought in one way

or another to have earnings taxed as ordinary income

rather than as capital gains.

The Treasury Department in its study of 428 pages in

1969 for the House Ways and Means Committee began its

treatment of sales such as the one in the instant case with

these paragraphs:

‘*H. H. 12663 and H. R. 12664 were introduced in

the 90th Congress. They are designated to deal with

the problems raised when tax exempt organizations

borrow money for purposes unrelated to their func-

tions. These problems were emphasized by the 1965

decision of the Supreme Court in Commissioner v. Clay

B. Brown, 380 U.S. 563. In the Clay Brown case, the

Supreme Court approved capital gains treatment for

persons who sold a sawmill and lumber business to a

tax-exempt organization in an arrangement elaborately

structured both to avoid payment of Federal income

tax upon the earnings of the business and to immunize

the exempt organization from any liability or risk of

loss. By means of the arrangement, the exempt orga-

nization undertook to acquire ownership of the busi-

ness—valued at $1,300,000—entirely without invest-

ment of its own funds.

‘‘The availability of the tax exemption for uses in

transactions following this pattern creates several se-

rious problems. First, when the purchase price of a

business or other income-producing property is to be

financed from the future earnings of the property, tax-

exempt organizations are uniquely suited to pay a con-

siderably higher price than other purchasers can af-

ford; their exemption makes it possible for them, in

effect, to pay to the former owners of the business the

money which a taxable purchaser would have to pay

to the Government in taxes. This advantage of exempt

organizations creates a strong incentive for the sale

of businesses to them. Secondly, the price inflation

characteristic of transactions of this type diverts to

the personal advantage of private parties a substantial

measure of the benefit which Congress intended tax

exemption to produce for the organizations on which

it conferred the exemption. Dealing with a closely

related problem some years ago, both the House Ways

and Means Committee and the Senate Finance Com-

mittee referred to this result as a ‘sale of the exemp-

tion.’ ’’

Hearings before the House Committee on Ways and Means,

Jist Cong., Ist Sess., Apr. 22, 1969, Pt. 14, pp. 5050, 5358-

59. However, nowhere did the Treasury challenge the

validity of sales to exempt organizations.

The legislative solution to Clay Brown was to deprive

tax-exempt organizations of the commercial advantage flow-

ing from their tax-exempt status to the extent they acquire

businesses on credit (with the obligation typically limited

to the assets acquired or earnings therefrom). The general

nature of the new provisions was briefly described in the

Senate Report (at pp. 63-64) as follows:

‘*Explanation of provision. Both the House bill

and the committee amendments provide that all exempt

organizations’ income from ‘debt-financed’ property,

which is unrelated to their exempt function, is to be

subject to tax in the proportion in which the property

is financed by the debt. Thus, for example, if a busi-

ness or investment property is acquired subject to an

80 per cent mortgage, 80 per cent of the income and

80 per cent of the deductions are to be taken into ac-

count for tax purposes. As the mortgage is paid off,

the percentage taken into account diminishes.’’

The significant lesson to be learned from the congres-

sional action taken as a result of Clay Brown and its impact

on the decisions now sought to be reviewed, is that Congress

did not deprive the seller of its right to receive capital gain

treatment of the proceeds of the sale of an unrelated busi-

ness to a tax-exempt organization. Instead, it deprived the

tax-exempt entity of some of its tax exemption where the

acquisition was debt-financed. There can be no doubt that

this amendment to the Internal Revenue Code was per-

ceived and intended as the proper response to the Clay

Brown problem. Indeed it was referred to as the ‘‘Clay

Brown provision’’ (Senate Report, pp. 62-63; Senate Hear-

ings, p. 37).

The principal spokesman for the Treasury at the 1969

hearings was the Honorable Edwin S. Cohen, Assistant

Secretary of the Treasury for Tax Policy. In his testimony

before the Ways and Means Committee (at p. 5491), Mr.

Cohen referred to the Treasury recommendation as follows:

‘We also recommend extending the »rovisions for

taxation of unrelated business income to churches and

other exempt organizations not now subject to these

provisions. We recommend enacting legislation to

overcome the effect of the Supreme Court decision in

the Clay Brown case, a bill which has previously been

introduced and is pending before the committee.’’

This was amplified in his written statement (at p. 5509) :

‘*8. Enact pending legislation to overcome the ef-

fect of the Supreme Court decision in the Clay Brown

case to prevent a charitable organization from bor-

rowing to purchase investment assets. The effect of

such borrowing is often to pass the benefit of the tax

exemption on to the seller, a non-exempt party, in the

form of an artificially high price. There is no warrant

in any event for a tax-exempt organization borrowing

money to purchase income producing assets unrelated

to its charitable function.’’

In the hearings before the Senate Finance Committee

(at page 567) Mr. Cohen presented a statement which ex-

plained the proposed amendment as one which ‘‘ prevents

a tax-exempt organization from extending its tax shelter

to a non-exempt seller through inflation of the price.’’ It

is clear that the legislation ultimately adopted by the Con-

gress showed an election to solve Clay Brown by acting

upon the tax exemption rather than disturbing the capital

gain treatment which Clay Brown mandated. Indeed the

Second Circuit so held in Berenson v. Commissioner, 507

¥’, 2d 262, 267 (2d Cir. 1974), when it wrote:

‘*To recount the Commissioner’s victory in Con-

gress, the Tax Reform Act of 1969 stripped transac-

tions, such as that recognized to be a ‘sale’ in Clay

Brown, of their tax avoidance potential by ensuring

that the income from the business in the hands of the

exempt organization was taxable as unrelated business

income. Section 511 (a) (2) (A) was amended to sub-

ject churches and related organizations to the tax im-

posed by §511 (a) (1) upon ‘unrelated business tax-

able income’; §514 was also revamped to ensure that

rental income from all leases of business assets ac-

quired through debt financing would be included with-

in the exempt organizations’ ‘unrelated business tax-

able income.’ No effort was made to alter the 41222

(3) capital gains provision at issue both here and in

Clay Brown. Consequently, congressional disapproval

of the Supreme Court’s resolution of the ‘sale’ issue

in Clay Brown cannot be inferred.’’

The Second Circuit has taken a curiously myopic ap-

proach to Clay Brown cases. It has acknowledged, as it

must, the binding authority of Clay Brown, but then has

proceeded to a result which is just to the contrary. It has

found the sale involved to be bona fide, but then has refused

to give the proceeds of the sale capital gains treatment.

Judge Raum, following Berenson v. Commissioner, 59

T.C. 412 (1972), aff’d in part, rev’d in part, and remanded,

507 F. 2d (2d Cir. 1974), in the Taxt Court on the point

on which the Second Circuit reversed and remanded for

an evidentiary hearing, in effect held that because the

Cathedral, in his mind, agreed to pay more than a non-tax-

exempt entity would have paid, there was no sale. The

Second Circuit affirmed, but contrary to what it did in

Berenson did not reverse in part and remand for an evi-

dentiary hearing on value. Thus, the taxpayers never had

a meaningful day in court on the value of the stock of

Nassau Corp.

Where a question of valuation is involved and the

Commissioner’s determination of a deficiency is arbi-

trary, unreasonable and unsupported by any evidence,

the taxpayers, at the very least, are entitled to an evi-

dentiary hearing on the question of value.

The taxpayers introduced evidence to show that the fair

market value of the stock of Nassau Corp in 1967 was

$3,500,000. The Commissioner introduced no evidence at

all on fair market value, not even a scintilla.

Revenue Agent Meyer Shapiro, who had béen an In-

ternal Revenue agent for more than 25 years (34), treated

the transaction between the Cathedral and the shareholders

of Nassau Corp as a valid sale and valued the stock at

$500,000 (39; Ex. 7; Sched. 4-A2; Ex. 8, Sched. 4-A2). In

Schedule 4-A2 of Exhibit 7, Mr. Shapiro wrote:

1966 1967 Total

Deemed Suaie Price

of Capital Asset $69,331.25 $180,668.75 $250,000.00

Basis of Cost 100. 100.

Capital gain realized

at 100% 69,231.25 180,668.75 249,900.00

In Schedule 4-A2 of Exhibit 8, he wrote:

1966 1967 Total

Deemed Proceeds of Sale

of Capital Asset $69,331.25 $180,668.75 $250,000.00

Cost Basis allowed 100. 100.

Capital gain realized

—100% 69,231.25 180,668.75 249,900.00

The Commissioner himself assigned to the stock the

value of $168,445.60 (31), but there is no sure way of deter-

mining just how he arrived at this figure. Here we have

two members of the same agency, one of whom values the

stock at $500,000, and the other, the Commissioner, at one-

third of that amount, $168,445.60; dramatic proof, the peti-

tioners submit, that the $168,445.60 figure is arbitrary and

unreasonable.

The taxpayers concede that the Commissioner’s deter-

mination of a deficiency is presumptively correct. This is

as it should be, for the facts with reference to income and

deductions are peculiarly within the knowledge of the tax-

payer. See the discussion in 1 Weinstein’s Evidence 300-1

to 300-16 (1975).

However, if the facts are not peculiarly within the

knowledge of the taxpayer, where, for instance, as here, a

question of valuation is involved and the facts are as much

within the knowledge of the Commissioner as of the tax-

payer, the taxpayer’s burden should be no greater than that

of showing that the Commissioner’s determination is arbi-

trary and unreasonable. This Court so held in Helvering v.

Taylor, 293 U.S. 507 (1935). That case involved an ap-

portionment of costs between preferred and common stock.

The Court held:

‘*Unquestionably the burden of proof is on the tax-

payer to show that the commissioner’s determination

is invalid. Lucas v. Structural Steel Co., 281 U.S. 264,

271. Wickwire v. Reinecke, 275 U.S. 101, 105. Welch v.

’ Helvering, 290 U.S. 111, 115. Frequently, if not quite

generally, evidence adequate to overthrow the commis-

sioner’s finding is also sufficient to show the correct

amount, if any, that is due. See, e.g., Darcy v. Com-

missioner, 66 F. (2d) 581, 185. But, where as in this

case the taxpayer’s evidence shows the commissioner’s

determination to be arbitrary and excessive it may not

reasonably be held that he is bound to pay a tax that

confessedly he does not owe, unless his evidcnce was

sufficient also to establish the correct amount that law-

fully might be charged against him.’’ At 515.

In Clay Brown itself, the Court indicated that if the

Commissioner contends that the price which a charity pays

is excessive because of the lack of risk-shifting, he has to

come forward with proof; for in that case the Court said:

‘*Secondly, if an excessive price is such an inevitable result

of the lack of risk-shifting, it would seem that it would not

be an impossible task for the Commissioner to demonstrate

the fact.’’ 380 U.S. at 573. In the instant case, as we have

said, the Commissioner introduced no evidence at all of fair

market value.

Reference may also be made to Commissioner v. Riss,

374 F. 2d 161 (8th Cir. 167) ; Stout v. Commissioner, 273 F.

2d 345 (4th Cir. 1959); Andrews v. Commissioner, 135 F.

2d 314 (2d Cir.), cert. denied, 320 U.S. 748 (1943). In

Stout v. Commissioner, supra, the Fourth Circuit wrote:

‘‘The presumption of correctness is procedural. It

transfers to the taxpayer the burden of going forward

with evidence, but it disappears in a proceeding to

review the assessment when substantial evidence con-

trary to the Commissioner’s finding is introduced.

Thereafter, the Tax Court, in such a proceeding, must

make its own findings based upon the evidence before

it, and we may affirm only if the findings of the Tax

Court are supported by substantial evidence in the

record of that proceeding.’’ At 390.

In their brief and reply brief the petitioners asked the

Second Circuit to reverse the decisions of the United States

Tax Court and annul the deficiency. In their petition for

rehearing the petitioners beseeched the Second Circuit to

reverse in part and remand for an evidentiary hearing as

to the value of the stock of Nassau Corp to a non-tax-

exempt entity for the purpose of applying the Second Cir-

cuit’s apportionment rule. The taxpayers at the time of

their trial in the Tax Court in November 1973 of course did

not know about the Second Circuit’s apportionment rule

announced in Berenson in 1974, almost a year later.

Nevertheless, the Second Cireuit gave the taxpayers

no chance to have such an evidentiary hearing. Instead,

the court simply stated: ‘‘The burden of establishing

what was a fair market value therefore remained with the

taxpayer.’’ App. II at p. A35. The result is that the tax-

payers were deprived of any meaningful evidentiary hear-

ing on the fair market value of the stock of Nassau Corp.

The Commissioner’s figure of $168,445.30 is not only

arbitrary, but also manifestly incorrect under the Second

es Se

Circuit’s apportionment rule in Berenson. The Second Cir-

cuit said:

‘** * * The same tax exemption which gives an unfair

competitive advantage to an exempt organization in the

operation of a business also permits it an unfair degree

of purchasing power in the acquisition of such a busi-

ness. We think it would be inappropriate to include an

increase in value, attributable solely to the presence of

such unfair purchasing power, within the past accrued

appreciation that the capital gains provisions seek to

shield from taxation at ordinary rates. * * *

* . *

‘** * * Tt will be necessary for the Tax Court, as a be-

ginning computation, to separate the purchase price

into the portion that is attributable to the accumulated

value of the corporations at the time of the purchase

and the portion attributable solely to the extra pur-

chasing power possessed by Temple by virtue of its

tax-exempt status.’’ At p. 266.

In no case can ‘‘the portion attributable solely to the extra

purchasing power’’ possessed by the charity because it was

tax-exempt exceed the amount of the taxes that it did not

have to pay, in the instant case, 48%. Therefore the Com-

missioner’s figure of $168,445.30, which is but 5% of the

purchase price that the parties arrived at themselves by

hard bargaining in an unchallenged arm’s length transac-

tion (and hardly more than 10% of the money that the Ca-

thedral actually paid to the petitioners) is clearly erroneous.

Even if the petitioners failed in the burden of proof to

show what a non-tax-exempt entity would have paid they

are at least entitled to a new hearing under Helverig v.

Taylor, 293 U.S. 507 (1935), because the Commissioner’s

statutory notice is not only arbitrary but also clearly

erroneous.

In reducing the Commissioner’s position to its logical

absurdity. the petitioners observe that had they sold to a

non-tax-exempt entity under the same no-risk terms except

that the purchase price was payable out of after-tax instead

of pre-tax profits, they would have received in excess of

$700,000.00, unchallenged by the Commissioner as being

entitled to capital gains treatment, for «n asset the Com-

missioner would have us believe is not worth more than

$168,445.30.

The sources for the Commissioner’s valuation, in the

absence of any evidence, can only be a matter for specula-

tion; but the petitioners respectfully submit that the conse-

quence of his error is categorically mandated by the Court’s

decision in HHelvering v. Taylor, 293 U.S. 507 (1935): at

the very least the petitioners are entitled to a meaningful

evidentiary hearing.

The Commissioner cannot, consistent with due

process, arbitrarily fix the amount of a valuation by a

presumption without putting in any proof.

It is contrary to due process in a contested case for the

government to prevail without putting in a single particle

of proof. Cf. Thompson y. City of Louisville, 362 U.S. 199

(1960); Garner v. Louisiana, 368 U.S. 157 (1961). It is

also relevant to add that such a course is unbecoming a

free people.

Presumptions of correctness are intended, as a matter

of public policy, to put the burden of proof on the party

who has superior means of proof. As to most items in a

taxable transaction, such as income and expenses, we con-

cede that this is the taxpayer. But where the Commis-

sioner challenges the consequences of a transaction as

proved, and valuation is an issue, then, as in the case of

an affirmative defense, the Commissioner should have the

burden of proof; or, minimally at least, the duty to sub-

stantiate by evidentiary offering equal to that necessary

to establish a prima facie case, his contended for evalua-

tion. In this circumstance, due process forbids a presump-

tion of correctness in such an item as valuation in the

Commissioner’s statutory notice.

Conclusion

The Court should grant this petition for a writ of

certiorari and rule once again as it did in Clay Brown

that a sale to a tax-exempt charity remains a sale even

though the charity assumes no independent liability for

the purchase price.

Respectfully submitted,

O. Jonn Rocce

Attorney for Petitioners

777 Third Avenue

New York, New York 10017

Of Counsel:

O. Joun Rocce

HerRMANN Rocce

ke © Fee

APPENDIX I

Opinion of Judge Raum

Appendiaz I, Opinion of Judge Raum

62 T. C. 420 (1974)

UNITED STATES TAX COURT

Aaron Kract anv Ints Kraut, Petitioners v. ComMIssIONER

or InreRNAL REveNvE, Respondent

| Harry Kraut anp Marian Kravt, Petitioners v,

CoM MISSIONER OF INTERNAL REVENUE, Respondent

Docket Nos. 7663-70, 7664-70. Filed June 27, 1974.

In 1965 petitioners organized and became the sole

stockholders of Nassau Plastic & Wire Corp. (‘‘Nas-

sau’’) to manufacture wire to be used in Christmas

decorations. Less than one year later, petitioners en-

tered into an agreement to sell their Nassau stock to

Cathedral of Tomorrow, a Federally tax-exempt re-

ligious organization, which simultaneously agreed to

liquidate Nassau. Nassau’s assets consisted almost

entirely of a second hand automobile, $50,000 of re-

ceivables, and a five-year lease of its single piece of

machinery—all subject to liabilities in excess of

$36,000. The stated sales price was a flexible amount

ranging from a minimum of $500,000 to a maximum

of $3,500,000, and was payable primarily out of 75 per-

cent of the business’ net income for the ensuing ten

years. As employees, petitioners remained in control

of the operation of the business. In the event of de-

fault, petitioners’ sole recourse was the enforcement

of a lien upon the business’ assets. The lease agree-

ment for the machine entitled the lessor, a corporation

wholly-owned by petitioners, to terminate the lease

unilaterally after the expiration of its initial term.

Held, this transaction amounted merely to the payment

| of a fee to Cathedral in return for lending its tax

exemption to Nassau’s earnings rather than the actual

transfer of the business to Cathedral, and it therefore

did not constitute a bona fide sale of a capital asset

within the meaning of section 1222(3).

lle es -- lm

Appendix I, Opinion of Judge Raum

Sidney N. Solomon, Fredric Scheinfeld, and O. John

Rogge, for the petitioners.

Stanley J. Goldberg and Walter C. Welsh, for the re-

spondent.

The Commissioner determined deficiencies in petition-

ers’ 1967 income tax as follows:

Docket No. Petitioners Amount

7663-70 Aaron and Iris Kraut $254,437.12

7664-70 Harry and Marian Kraut 258,544.82

The cases were consolidated for trial. At issue is whether

an agreement by which two of petitioners purported to

transfer the stock of their wholly-owned corporation to a

tax-exempt charitable organization in exchange primarily

for a portion of the business’ profits for a period of ten

years constituted a bona fide sale within the meaning of

section 1222(3), I.R.C. 1954, thereby entitling petitioners to

capital gains treatment in respect of the proceeds. In the

event such a sale did occur, there is the further question

whether those proceeds in excess of approximately $168,000

were capital gains.

Finpine or Fact

The parties have filed a stipulation of facts, which,

together with its accompanying exhibits, is incorporated

herein by this reference.

Petitioners Iris Kraut and her husband Aaron Kraut

resided in Oceanside, New York, at the time they filed

their petition herein; petitioners Marian Kraut and her

husband Harry Kraut resided in Flushing, New York, at

Appendix I, Opinion of Judge Raum

the time they filed their petition herein. Both pairs of

petitioners timely filed joint Federal income tax returns

for the year 1967 with the district director of internal

revenue at Brooklyn, New York.

Aaron Kraut and his brother Harry together were in

the business of developing and manufacturing electric wire

of various types. For at least 20 years they had owned

and acted as president and vice president, respectively, of

Trio Wire & Cable Corporation (‘‘Trio’’), which was pri-

marily concerned with the production of assorted types

of wires and cables encased in plastic insulation. In addi-

tion to and as an offshoot of that business the Kraut

brothers in or around 1960 formed a separate corporation,

Christmas Wire Manufacturing Corporation (‘‘Christmas

Wire’ ), through which they hoped to penetrate the more

specialized and very competitive market for wiring used

in the manufacture of Christmas decorations. Although

Trio itself did not produce such wire, it owned the neces-

sary machine, an extruder, which Christmas Wire made

use of. The extruder was housed in a leased building, one

of three separate but interconnected buildings on Meserole

Avenue in Brooklyn in which Trio carried on its business.

That machine appears to have been the only item of equip-

ment used in the production of the Christmas wire, and

the record fails to show that any appreciable number of

employees was engaged in its operation.

The heart of the manufacturing process for Christmas

wire consisted of extruding a coat of plastic insulation

around light gage wire. The Curistmas decoration manu-

facturers who purchased the wire then attached light bulb

Appendia I, Opinion of Judge Rawm

sockets to it by means of small brass spurs on the sockets

which punctured the plastic jacket and made contact with

the electric wire inside. A major problem for manufactur-

ers of such wire was the normally tough consistency of the

plastic used which created difficulty in attaching the sockets

and thus led to a high ‘‘rejection rate’’ in the decoration

assembly process. As a result of various problems, pri-

marily the rejection rate, the Kraut brothers brought pro-

duction under Christmas Wire’s name to an end sometime

in the spring of 1965. Although the Krauts ‘‘sold” the

Christmas Wire corporation at that time at a price not

satisfactorily shown in the record, the purchaser never

conducted operations at the Meserole Avenue location. The

Krauts retained the use of Christmas Wire’s premises as

well as Trio’s extruder which remained there. Within a

very short time thereafter, possibly as little as several

weeks and certainly no more than a few months, Harry

and Aaron Kraut formed another corporation, Nassau

Plastic & Wire Corporation (‘‘Nassau’’), which they in-

tended would operate as an adjunct to Trio similar in

fashion to Christmas Wire. As a matter of convenience,

Nassau issued all of its stock, 200 shares, in equal amounts

to Iris and Marian Kraut in return for their contributions

to its capital of $100 apiece. Although neither Aaron nor

Harry contributed to Nassau’s capital, they nonetheless

were the dominant figures in its activities, while their wives

provided no services at all to it. Nassau occupied the same

premises which Christmas Wire had previously used, and

its only equipment was the extruder belonging to Trio

which Trio had in the past supplied to Christmas Wire.

Appendia I, Opinion of Judge Raum

Nassau required the extruder to manufacture Christmas

wire with a new insulating material which, due to its easily

penetrable consistency, promised to minimize the rejection

problem associated with conventional plastic insulation.

This new material was, however, ‘‘an unknown quantity”’,

and its resistance to wear and decay over a period of

several years was as yet unproven. Despite the new ma-

terial’s alleged superiority to the insulating material com-

monly in use at the time, the Krauts did not obtain, nor

apparently did they apply for, a patent on it.

On its Federal income tax return for the fiscal year

ended June 30, 1966, Nassau reported gross income of

$26,189.84, which represented the difference between its

sales of $492,305.16 and its cost of goods sold, $466,115.32.

The cost of goods sold consisted entirely of merchandise

bought for manufacture or sale; Nassau reported no ex-

pense for salaries and wages other than $2,600 paid to the

Krauts, no expense for use of the extruder, nor any ex-

pense for the building in which it was kept. As of June

30, 1966, Nassau maintained no inventory whatsoever.

After deducting tue Krauts’ salaries, taxes, depreciation

on a car, and $5,913.40 of operating expenses, Nassau re-

ported a taxable income of $15,831.56 and a resultant tax

liability of $3,482.94.

At some time in the early part of 1966, Management

Methods, an investment counseling and legal firm located

in New York City, brought to Reverend Rex T. Humbard,

its client, a proposal for the purchase of Nassau. Reverend

Humbard was the pastor of the Cathedral of Tomorrow

(‘‘Cathedral’’), a Federally tax-exempt religious organiza-

Appendix I, Opinion of Judge Raum

tion in Akron, Ohio. Its activities included conducting

Sunday services, a Sunday school, and youth groups as

well as sponsoring the worldwide telecast of its church

services and supporting an extensive missionary program.

Among its assets, Cathedral owned two businesses, at least

one of which it had acquired in an entirely debt-financed

transaction. After expressing his preliminary interest in

the proposal concerning Nassau, Reverend iiumbard with

his associates undertook to examine Nassau’s business

more closely.

Before the parties had entered a binding agreement,

however, Iris and Marian Kraut executed an agreement

with a party identified only as Wilson Mold & Die Corpora-

tion (‘‘Wilson’’) on May 31, 1966, purporting to sell to it

their entire interest in Nassau, payments to commence on

September 1, 1966. Beyond its participation in this con-

tract, the record contains no evidence as to any and all

particulars in respect of Wilson and its principals.

On the foliowing day, June 1, 1966, Trio and Nassau

executed an agreement whereby Trio leased to Nassau the

extruder which Nassau had theretofore been using along

with its accompanying apparatus. The lease was to run

for a term of five years, to continue indefinitely thereafter

but subject to termination by either party upon 60 days’

written notice. Nassau agreed to pay Trio $500 per month.

The lease further provided that:

The Lessor [Trio] shall at all times have free access

to the machines for the purpose of inspection or obser-

vation, or to make alterations, repairs, improvements,

—s

Shetbie >. Oeihe

No en Ld tle eR ok

Detrite Bib ee te

iY Wiis BATA AAA AS SRI MD Ske NA Seiten etki AR PS a Ci ea iT tee Bi A Lace SE EA Se ee DP

Appendia I, Opinion of Judge Raum

or additions, or to determine the nature or extent of use

of the machines.

Furthermore:

The machines shall be used only by operators in the

direct employ of the Lessee [Nassau], and only in the

factory now occupied by it at its principal place of

business, and shall be used only for the purpose of insu-

lating and spooling copper wire, made by or for the

Lessee.

Iris and Marian Kraut signed on behalf of Nassau.

Shortly thereafter, before the time of its performance

had arrived, Nassau and Wilson abandoned their purported

contract of sale. In a separate three-cornered agreement

dated June 15, 1966, only 15 days after the initial contract,

Wilson assigned all of its rights and delegated all of its

duties arising under the May 31, 1966, agreement to Cathe-

dral; Iris and Marian Kraut agreed to release Wilson from

the prior contract; and Cathedral covenanted to purchase

Nassau’s stock according to the following terms:

The Buyer [Cathedral] shall take all such action as

may be required so that on or as of June 25, 1966 Nas-

sau Plastic shall be liquidated and all of its assets dis-

tributed to the Buyer. Simultaneously with the execu-

tion of this Agreement, the Buyer, with the consent of

the stockholders and directors of the Sellers [Iris and

Marian Kraut], shall take steps forthwith to accom-

plish the following:

(a) Create a separate operating-manufacturing

unit, owned by the Buyer, to be denominated and

known as Nassau Plastic (hereinafter sometimes in-

Appendix I, Opinion of Judge Raum

terchangeably referred to as ‘‘ Nassau Plastic & Wire

Co.’’ * * *); the Buyer to file such documents with

the proper goverrmental authorities as may be neces-

sary to effectuate the same.

(b) The name of Nassau Plastic & Wire Corp.

shall be changed forthwith, to such name as the

Buyer may designate.

The purchase price for all of the stock sold under

this Agreement shall be not less than $500,000 (herein-

after called the ‘‘ Minimum Price’’) nor more than $314

million (hereinafter called the ‘‘Maximum Price’’).

The purchase price shall be paid by the Purchaser to

the Sellers at the following time in the following man-

ner and to the extent set forth below:

(a) For the period from June 25, 1966 to July 1,

1966, 100% of the net income of the Corporation shall

belong to the Sellers; the Purchasers shall receive

credit for said amount toward the purchase price.

(b) $50,000 on or before August 1, 1966.

of the years 1967 through 1976 terminating however

on June 30, 1976 inclusive, unless the Maximum Price

be paid in full prior thereto; commencing with the

15th day of October 1966 and on the 15th day of each

January, April, July and October thereafter in re-

spect to each preceding quarterly period from July 1,

1966 through June 30, 1976, an amount equal to 75%

of the Corporations [sic] net income before Federal

income taxes for each of such next preceding fiscal

periods. In the event a loss occurs in any quarterly

period, said loss shall be utilized as an offset in each

of the sneceeding quarterly periods (until said loss

Appendix I, Opinion of Judge Raum

has been recouped) before payments to the Sellers

are resumed.

(d) In any event and notwithstanding any pro-

vision in this Agreement with respect to the contin-

gent deferral of installment payments of the Pur-

chase Price, the full Minimum Price referred to above

and any portion of the Maximum Price referred to

above which Sellers may become entitled to receive

shall be paid in full on or before July 15, 1976.

(e) The Purchaser may prepay at any time all or

any part of the unpaid amount of the Maximum Price.

The terms of payment agreed to by Cathedral largely re-

flected the substance of Wilson’s antecedent commitment,

the one notable difference being that Wilson had agreed to

pay 75 percent of its pre-tax earnings only through June 30,

1971, thereafter applying the same percentage to its after-

tax income for the duration of the ten-year period.

The ultimate transaction did not contemplate any cash

outlay by Cathedral, either at the outset or in the event of

default. Although the terms of the contract provided for an

initial $50,000 payment on August 1 irrespective of Nas-

sau’s profits, Nassau’s assets at the time of the purported

sale included $50,089.75 of notes and accounts receivable

plus $2,323.36 in cash. In point of fact, petitioners permit-

ted Cathedral to postpone that payment until mid-October,

1966, by which time Nassau had generated sufficient cash

flow from which Cathedral could pay petitioners. Even

though Iris and Marian Kraut retained a security interest

in all of the assets, business, and good will of Nassau, their

interest was subject not only to prior liens, but to ‘‘the

rights of present and future general creditors for obliga-

A10

Appendix I, Opinion of Judge Raum

tions arising in the regular course of business, and liens,

collateral or security for the loan or loans advanced or to

be advanced by any bank.’’ Moreover, it was stipulated

that, in the event of Cathedral’s default in payments or

otherwise, enforcement of the security agreement would

constitute the seiler’s exclusive remedy ‘‘and in no event

shall the Sellers seek any deficiency judgment or other

judgment for damages against the Buyer.’’ In addition

thereto, Cathedral agreed to employ both Harry and Aaron

Kraut as its chief executive officers, Aaron in the capacity

of production manager and internal office manager and

Harry as sales manager. As such, Cathedral granted them

full authority and responsibility to direct the business of

Nassau in every respect. For such services, Cathedral

agreed to pay them each $5,200 yearly, their employment to

terminate on the day following the date »f Cathedral’s final

payment to Iris and Marian.

At the time of this agreement, Nassau owned neither

the building in which it operated nor the single piece of

machinery with which it produced wire. Its interest in the

machine consisted of the five year lease from Trio described

above. On its tax returns for the year ending June 30, 1966,

it listed total assets in the amount of $53,867.56, of which

notes and accounts receivable amounted to $50,089.75; the

remaining assets consisted of cash and an automobile. In

the same return, it reported $36,575.99 in accounts payable

while its capital account showed $200 in respect of its

common stock.

Following the disposition of the stock, Nassau’s opera-

tions continued at the same location with the same person-

All

Appendix I, Opinion of Judge Raum

nel using the same equipment, and apparently under the

same or a very similar name. Harry and Aaron Kraut, as

‘*Cathedral’s employees’’, still managed the business. Un-

der this arrangement the business met with early and quite

remarkable success. Although on August 1 the business’

cash flow apparently had been insufficient to provide Cathe-

dral with the funds necessary to make the down payment

then due, on October 12 Harry Kraut drew two checks of

$25,000 each on Nassau’s account in favor of Cathedral

which Reverend Humbard then endorsed as payable to Iris

and Marian Kraut individually. During the remainder of

1966 Cathedral paid Iris and Marian an additional $97,500;

in 1967 Cathedral paid them a total of $1,332,500,’ which

raised the overall level of payments to $1,480,000. After

1967, though, the business rapidly became unprofitable, and

in 1969 it ceased operating altogether. The sudden turn-

about in the business’ fortunes was attributable, at least in

part, to its competitors’ ability to reduce the rejection rate

of their Christmas wire through improved techniques and

production quality. Ownership of Nassau’s then remaining

assets, which were of negligible vaiue, reverted to the orig-

inal owners.

In each of their respective joint income tax returns for

1967, petitioners reported the receipt of $66,250 from Cathe-

dral, of which they treated $27,720.83 as interest and from

which they deducted collection expenses of $32,112.50,

primarily brokers’ commissions. They then listed the net

amount of $606,416.67 in each return as long-term capital

1. This is a gross amount against which there should be charged

$64,225, the related expenses of collection, leaving a net amount of

$1,268,275.

A12

Appendix I, Opinion of Judge Raum

gains and computed their tax liability according to the

alternative tax provided in section 1201(b). In each of his

deficiency notices, the Commissioner determined

that $595,766.09 of the amount collected in 1967 pur-

suant to the sale of your shares of stock in Nassau

Plastics & Wire Corp. to the Cathedral of Tomorrow,

Ine. in 1966, payments to be made out of the profits of

the company sold, constitutes ordinary income to you

in 1967. * * *

In arriving at this amount, the Commissioner assigned to

the stock of Nassau a selling price of $168,445.60, a value

equal to ten times the taxable income of Nassau for the

taxable year ended June 30, 1966. He then made the fol-

lowing computation :

Amount received in 1966 and 1967 $1,480,000.00

Less interest as reported | 56,904.16

$1,423,095.84

Amount deemed applicable to sell-

ing price of shares : ae 168,445.60

Balance | wee $1,254,650.24

Less expenses incurred in 1967 63,098.07

Increase in ordinary income for

1967 7 Ss $1,191,552.17

50% applicable to each shareholder $ 595,776.09

2. Nassau’s Federal income tax return for the year ended June

30, 1966, indicated taxable income of $15,831.56, which, multiplied by

10, equals only $158,315.60. The Commissioner, on brief, noted the

discrepancy between this amount and the figure used in computing the

deficiencies, but he does not now contend that the value of Nassau’s

stock should be limited to the lower figure.

A13

Appendix I, Opinion of Judge Raum

OPINION

Raum, Judge: This case presents a factual variation

of a common transaction, the heart of which is the debt-

financed acquisition of a going business by a tax-exempt

organization. Prior to the Tax Reform Act of 1969,

churches described in section 501(c) (3), I.R.C. 1954, which

were exempt from ordinary taxation were also singled out

in section 511(a)(2)(A) for relief from taxation on so-

called unrelated business taxable income.’ This provision

enabled a qualified church to receive the income from the

3. Pai. III of Subchapter F of Chapter 1 of the Income Tax

Subtitle of the Internal Revenue Code, consisting of sections 511

through 515, extends taxation to the business income of certain ex-

empt organizations. The critical language therein is “unrelated busi-

ness taxable income”, a defined term denoting income from a trade or

business carried on by the exempt organization but which trade or

business is not substantially related to the organization’s exempt pur-

pose. Section 511(a) (1) contains the operative language of Part III,

imposing a tax on the unrelated business taxable income “of every

organization described in paragraph (2)”. Section 511(a)(2), as

effective in 1967, provided in reievant part:

(2) Organizations subject to tax.—

“(A) Organizations described in section 501(c)(2), (3),

(5), (6), (14)(B) or (C), and (17), and section 401 (a).—

The taxes imposed by paragraph (1) shall apply in the case of

any organization (other than a church, a convention or associ-

ation of churches, or a trust described in subsection (b))

which is exempt, except as provided in this part, from taxation

under this subtitle by reason of section 401 (a) or of paragraph

(3), (5), (6), (14)(B) or (C), or (17) of section 501(c).

Such taxes shall also apply in the case of a corporation de-

scribed in section 501(c)(2) if the income is payable to an

organization which, itself is subject to the taxes imposed by

paragraph (1) or to a church or to a convention or association

of churches.”” [Emphasis supplied. ]

The Tax Reform Act of 1969, section 121(a)(1), repealed the

referred status of churches in respect of unrelated business income

y deleting the parenthetical exception in section 511(a)(2) (A).

Al4

Appendix I, Opinion of Judge Raum

operation of a trade or business, itself unrelated to the

church’s exempt purpose, without incurring tax liability

on the proceeds, provided the business was not conducted

as a separate corporate entity.‘ Arrangements of this type

held out to businessmen the prospect of relieving the tax

burden on otherwise tixable business prefits by ‘‘selling”’

the business to a church, which could then pass on a sub-

stantial portion of those untaxed profits to the seller as

deferred payment of the purchase price, ultimately result-

ing in tax liability of the seller only for long-term capital

gains.

In the case before us, the events of which transpired

prior in time to the amendment of section 511(a)(2)(A),

the Commissioner has challenged petitioners’ decision to

treat the payments received from Cathedral as long-term

capital gains. He proposes two bases for this conclusion:

first, that the totality of the dealings between the parties

did not amount to a bona fide sale, without which long-term

capital gain does not arise ;* second, that in the event we find

this transaction to exhibit the substance of a sale, the value

of Nassau’s stock was nevertheless limited to $168,445.60,

and the payments which petitioners received in excess

4. Treas. Regs. section 1.511-2(a) (3) (i1).

5. Sec. 1222. Orner TERMS RELATING TO CAPITAL GAINS AND

LOSSES.

For purposes of this subtitle—

* * *

(3) Long-term capital gain—-The term “long-term capital

gain” means gain from the sale or exchange of a capital asset

heid for more than 6 months, if and to the extent such gain is

taken into account in computing gross income.

« * -

Al5

Appendix I, Opinion of Judge Raum

thereof were thus not ‘‘from the sale or exchange of a

capital asset’’, To these contentions petitioners respond

simply that there was a bona fide common law sale, that

the agreed-upon price for Nassau’s stock resulted from

urm’s-length negotiations between the parties and fell well

within a reasonable range of values in light of Nassau’s

alleged potential sales volume. We, however, are not per-

suaded by the evidence before us that the Commissioner

has erred.

It is a cardinal rule that, in characterizing a transaction

for purposes of taxation, we are obliged to look beyond

the form in which the parties have chosen to cast it and to

draw our conclusions from that which we perceive to be

the substance of the matter. Griffiths v. Commissioner,

308 U.S. 355, 357-358; Higgins v. Smith, 308 U.S. 473, 476;

Jack E. Golsen, 54 T.C. 742, 754, affirmed 445 F. 2d 985

(C.A. 10). In particular here we must determine whether

the parties effected a true sale of Nassau’s stock. In its

benchmark decision in this area, Commissioner v. Brown,

380 U.S. 563, the Supreme Court addressed itself to the

relevant characteristics of a sale, stating (380 U.S. at 571):

‘*A sale, in the ordinary sense of the word, is a

transfer of property for a fixed price in money or its

equivalent,’’ Iowa v. McFarland, 110 U.S. 471, 478;

it is a contract ‘‘to pass rights of property for money,

—which the buyer pays or promises to pay to the

seller * * *,’’ Williamson v. Berry, 8 How. 495, 544.

Inherent in the Court’s understanding of a sale is the

notion of movement through exchange, the idea that, at

the conclusion of the sale, the buyer possess that which

A16

Appendix I, Opinion of Judge Raum

was the object of the sale. And, indeed, this comports well

with the ‘‘common and ordinary meaning”’ of a sale. Com-

missioner v. Brown, supra, at 571. On the strength of this

definition, the Supreme Court characterized the transaction

before it as a sale, and in so doing it underscored a variety

of detail which irupresses us as highly significant in an-

alyzing the facts before us.

At the outset, the Court recognized the necessity of

construing the term ‘‘sale’’ in a manner consistent with

the purpose of the capital gains provisions of the Code.

That purpose is (380 U.S. at 572)—

to afford capital gains treatment only in situations

‘*typically involving the realization of appreciation

in value accrued over a substantial period of time, and

thus to ameliorate the hardship of taxation of the en-

tire gain in one year.’’ Commissioner v. Gillette Motor

Co., 364 U.S. 130, 134.

Unlike the facts in Brown, in which the transferred

business had an adjusted net worth of $619,457.63 which

included $448,471.63 of accumulated earnings, at the time

of the present transaction Nassau’s balance sheet showed

total assets of $53,867.56, accumulated earnings of $12,-

348.62, and a net worth of only $12,548.62. Yet the pur-

ported sales price was a flexible figure between $500,000

and $3,500,000 as opposed to the correspondingly more

realistic price of $1,300,000 in Brown. While the absence

of accrued value is not conclusive with regard to the

existence of a sale, it quite clearly demonstrates that the

consideration here reflected whatever future income Nassau

might produce rather than the typical capital gains situa-

Al7

Appendix I, Opinion of Judge Raum

tion ‘‘involving the realization of appreciation in value

accrued over a substantial period of time’’ as was the case

in Brown. We think that such a transaction may most

accurately be described as a retained proprietary interest

by the shareholders in the business’ future earnings rather

than the creation of a creditor’s interest in future earnings

born of past accrued value of a capital asset. To treat such

as a sale is at odds with the very purposes of the Code in

allowing capital gains treatment for realization of the

enhanced value of a capital asset.

The Court in Brown further stressed the express find-

ing of the Tax Court that the price paid was within

reasonable limits based on the earnings and net worth of

the company. 380 U.S. at 572-574. In the context of a

purchase to be financed entirely and exclusively from the

earnings of the business acquired, this factor properly

focuses attention upon what Justice Harlan referred to as

the purchaser’s ‘‘residual interest’. Commissioner v.

Brown, supra, at 581 (concurring opinion). While Justice

Harlan agreed with the majority’s conclusion that a sale

had occurred, he offered the following analysis which we

deem to be especially helpful in the case before us:

[T]he Government might more profitably have broken

the transaction into components and attempted to dis-

tinguish between the interest which [the taxpayers]

retained and the interest which they exchanged. The

worth of a business depends upon its ability to produce

6. In this respect, we regard the $3,000,000 range within which

the purchase price was allowed to vary as incompatible with a sale of

Nassau’s past accrued value and goodwill. Rather, it is highly sug-

gestive of an arrangement by which the Krauts retained a most sub-

stantial interest in Nassau’s future profits.

A18

Appendix I, Opinion of Judge Raum

income over time. What [the taxpayers] gave up was

not the entire business, but only their interest in the

business’ ability to produce income in excess of that

which was necessary to pay them off under the terms

of the transaction. The value of such a residual inter-

est is a function of the risk element of the business and

the amount of income it is capable of producing per

year, and will necessarily be substantially less than the

value of the total business. Had the Government ar-

gued that it was that interest which [the taxpayers]

exchanged, and only to that extent should they have

received capital gains treatment, we would perhaps

have had a different case.

It follows therefrom that to the extent the so-called sales

price is excessive, albeit agreed upon, the purchaser’s re-

sidual interest is correspondingly diminished. Despite

inadequacies in the record before us, there is sufficient evi-

dence to create serious doubt in our minds that Nassau’s

expected earnings even approximated, no less exceeded,

the level necessary to render payments to the Krauts of

$3,500,000. And to the extent the clouded record precludes

us from making any specific finding with reasonable con-

fidence in this respect, we find that petitioners have failed

to sustain their burden of proving that the facts were other-

wise.

In urging upon us the reasonableness of the contract

price, petitioners have relied heavily upon Aaron Kraut’s

projection of Nassau’s earnings from its new Christmas

wire, which valuation is supported, they argue, by the fact

that Wilson Mold & Die Corporation, an allegedly non-

exempt corporation subject to the constraints of taxation,

agreed to substantially the same terms as did Cathedral

A1g

Appendix I, Opinion of Judge Raum

in a contract to purchase Nassau. At trial, Aaron Kraut

testified that, based upon the customer acceptance of Nas-

_ Sau’s new wire and the growing backlog of unfilled orders

in the first half of 1966, he expected Nassau to yield gross

profits of $10,000,000 during the ensuing ten years. We,

however, simply do not believe this evidence. Petitioners

introduced neither documentary nor other specific evidence

of Nassau’s allegedly skyrocketing business of early 1966.

And Aaron Kraut’s narrowly selective and seemingly self-

serving memory rendered his testimony wholly unsatisfac-

tory. On the one hand, he repeatedly professed his com-

plete ignorance even of Trio’s and Nassau’s most general

financial concerns, such as the information in tax returns

which he himself had signed, explaining that his brother

Harry handled all financial matters while he was engaged

exclusively in the production end of the business.’ Yet,

with respect to the central question of the case, Nassau’s

7. Another instance of Aaron Kraut’s remarkably inconsistent

memory arose in respect of the sale of Christmas Wire, an event no

more than eight years past at the time of trial. He at first professed

to have no recollection whatever of the purchase price, but after per-

sistent questioning by the Court, prompted by the witness’ startling

total lapse of recall, he finally testified that the price was somewhere

between $100,000 and $1,000,000. We did not find him a credibl

witness and are unwilling to ground our findings on what is so obvi-

ously contrived testimony.

We also mention that, although the Government had subpoenaed

Harry Kraut to appear at trial, the Government's attorney explained

that he had not sought to enforce the subpoena. Inasmuch as it was

represented that Harry was scheduled to appear at a trial elsewhere

at the same time, the Government attorney relied upon petitioners’

counsel’s assurance that Aaron was every bit as knowledgeable as

Harry with respect to the details of Nassau’s business. At trial, peti-

tioners’ counsel did not contest the accuracy of such representation,

and we simply note that petitioners must bear the consequences of

their failure to adduce credible evidence of Nassau’s value.

A20

Appendix I, Opinion of Judge Raum

earning capacity over a period of ten years, he presumed

to ask the Court to rest content entirely on the strength

of his knowledge of that matter. The valuation of a busi-

ness is a delicate and sophisticated calculation, the more

so with only one year’s operation from which to extrapo-

late, and we are hardly inclined to credit Aaron Kraut with

the necessary knowledge or ability to lend the slightest

probative value to his testimony.

Insofar as Wilson is concerned, we are faced with unex-

plained silence. The record is barren of evidence with re-

spect to Wilson. We do not know what business, if any, it

conducted, who its principals were and what relationship,

if any, existed between them and Cathedral or other persons

involved in these transactions, and what negotiations, if

any, preceded the signing of the contract. Ail we do know

is that a party referred to as Wilson Mold & Die Corpora-

tion signed a contract to purchase Nassau’s stock and 15

days later assigned the entirety of its interest in the con-

tract to Cathedral. In the absence of any explanatory evi-

dence (which was peculiarly within the control of petition-

ers) and in view of the two contracts’ all too convenient

timing, it is strongly suggestive the initial Wilson contract

was merely a bootstrap effort to bolster petitioners’ conten-

tion as to Nassau’s fair market value, and we consequently

must discount its evidentiary value.

In addition to petitioners’ failure to produce credible

evidence supporting the value they have tried to attach to

Nassau, what evidence the record does provide in respect of

this issue compels us to conclude that petitioners have failed

to show that the contract price of as much as $3,500,000 was

A21

Appendix I, Opinion of Judge Raum

not grossly excessive. Nassau was a company which, in its

one year of existence, had managed to generate profits of

less than $16,000 before taxes, with total assets amounting

to slightly more than $50,000 and a net worth of $12,548.62.

Its only fixed asset was an automobile. Its sole product

was still experimental in June of 1966, untested in actual

use over a period of time. Most significantly, though, was

the fact that the Krauts neither obtained, nor apparently

did they apply for, a patent on the new wire of such alleg-

edly explosive sales potential, nor was it shown that produc-

tion depended on a trade secret. Petitioners offered no

explanation for such omission. Even assuming, arguendo,

that this wire possessed the marketing potential urged by

petitioners, without the protection afforded by a patent

(and without any convincing evidence showing that produc-

tion of the wire was based on a secret process) Nassau’s

competitors could have appropriated such a valuable proc-

ess and a corresponding share of the market for such wire.

The decision in Brown rested as well upon a finding that

the transaction had effected a real change of economic

benefit, that the tax-exempt organization involved there was

motivated by the genuine prospect of owning outright the

substantial assets of a business after paying the purchase

price in full. The record does not support a similar conclu-

sion in the instant case.

Cathedral had no prospect of ending up with the sub-

stantial assets of an active business simply because Nassau

owned no manufacturing assets at the time of the purported

sale. Nassau’s only fixed asset was an automobile; it

owned no manufacturing equipment, no building, no in-

ventory. The single piece of machinery employed in pro-

A22

Appendix I, Opinion of Judge Raum

duction was the extruder which it leased from Trio. By the

terms of that lease, Trio had the right to determine the

nature or extent of use of the machine and Nassau could

make no additions or alterations to the extruder without

the permission of Trio. After the initial five year period

ending on May 31, 1971, either party could unilaterally

cancel the lease. In effect, the Kraut brothers, through

their wholly-owned corporation, Trio, had reserved the

power to terminate the lease and to repossess Nassau’s

sole source of income at any time after May 31, 1971. In

that event, there would have been small likelihood that Nas-

sau’s two key employees, Aaron and Harry Kraut, would

have remained with Nassau and applied their skills to re-

building the business around a new extruder, even if one

were available.* Reduced to its essentials, this arrangement

in substance would have permitted petitioners, after five

years, to deprive Cathedral of its newly acquired business,

the value of which would have been obvious had the enter-

prise been sufficiently profitable to permit Cathedral to pay

the Krauts in full.

On the other hand, although in Brown the Supreme

Court rejected the argument that risk-shifting was an essen-

tial element of a bona fide sale, the transaction there never-

theless contemplated the payment by the exempt organiza-

tion of a fixed price that we deemed to have a reasonable

relationship to the subject matter of the sale. In the present

ease, however, the wholly unrealistic sales price coupled

8. The extruder here under discussion had been specially tooled

for the production of this wire, and the record leaves in doubt whether

an extruder adapted as such might be readily available for purchase or

rental.

A23

Appendix I, Opinion of Judge Raum

with the so-called sellers’ remedy in the event of Cathe-

dral’s default makes it obvious that what we have here is a

transaction designed, on the one hand, to insure Cathedral

against any expense in the event Nassau failed to generate

sufficient sales and, on the other hand, to provide the Krauts

with the practical opportunity of recapturing the substance

of Nassau’s business in the event it proved profitable be-

yond the unrealistic level fixed in the contract. Our diffi-

culty in discerning a sale in this arrangement is not that

risk-shifting is absent; it is that nothing of substance has

shifted other than a portion of the business’ profits to

Cathedral for a limited period of time. And the latter was

merely the price that the Krauts paid for the opportunity

of claiming capital gains treatment in respect of future

speculative profits that might be realized by the enterprise.

Petitioners have thus failed entirely to demonstrate that

their arrangement with Cathedral contemplated the pros-

pect of Cathedral retaining any residual interest in Nassau.

It follows therefrom that the transaction lacked the essen-

tials of an exchange upon the basis of which a sale might be

founded.

In a recent decision of this Court, Louis Berenson, 59

T.C. 412, appeal pending (C.A. 2), the majority refused to

recognize the bona fides of a purported sale of a business to

a tax-exempt organization. In distinguishing the holding in

Brown, the Court found that the agreed upon price was

‘“‘grossly excessive’’, bearing no relationship to the value

of the assets sold or to the earnings history of the business.

The Court concluded therefrom that the sale was merely a

sham. In the present case the facts are even stronger than

those relied upon in Berenson. Not only have petitioners

A24

Appendix I, Opinion of Judge Raum

here failed to demonstrate that the agreed upon price was

not grossly excessive, but moreover they have not shown by

satisfying evidence that Cathedral entertained even a re-

mote prospect of actually acquiring anything of value.

Cathedral’s residual interest in Nassau was purely nominal,

and we think the facts therefore fall within the rule of

Kolkey v. Commissioner, 254 F. 2d 51 (C.A. 7), affirming

27 T.C. 37. The Seventh Circuit there decided that when,

in a debt-financed acquisition by an exempt organization, the

sales price is so grossly inflated that the purchaser’s pros-

pect of finally owning the business outright is at best re-

mote, the transaction does not amount to a sale. Likewise

in the instant case, we are not persuaded that petitioners

formulated the terms of payment for any purpose other

than to secure this right to receive 75 percent of Nassau’s

profits throughout the specified period. It is our opinion

that the transaction never contemplated the actual transfer

to Cathedral of a going business in fact. Far from compris-

ing a sale, this was quite plainly an agreement to pay Cathe-

dral a fee in return for lending its exemption to Nassau’s

earnings. This is not to say that every debt-financed acqui-

sition of a business by a charitable organization which is

payable exclusively from its future earnings is a tainted

sale. But the sweep of Commissioner v. Brown, 380 U.S.

563, is not unlimited, and we do not believe that either the

logic or the intent of the Court’s decision there compels a

finding for the petitioners before us. The Supreme Court

itself in Brown recognized the appropriateness of a con-

trary result in cases like Kolkey, 380 U.S. at 574, n. 7, and,

in our view, there was here similarly lacking a bona fide sale.

A25

Appendix I, Opinion of Judge Raum

Although our finding that petitioners have failed to

prove the existence of a bona fide sale to Cathedral is con-

ceptuaily sufficient to render the entire net proceeds of the

transaction taxable as ordinary income to Iris and Marian

Kraut, the decisions to be entered herein will necessarily be

limited by the Commissioner’s computation in the deficiency

notices. The Commissioner there determined an amount,

$168,445.60, applicable to the selling price of the stock of

Nassau (on the theory that there was a bona fide sale only

to the extent of that amount), and only the proceeds in

excess thereof, after deducting collection expenses of $63,-

098.07, and interest of $56,904.16, were deemed to be ordi-

nary income to each of the shareholders. In the proceedings

in this Court, the Commissioner contended alternatively

that the entire transaction was lacking in bona fides—a

conclusion which we have found to be valid and which

would justify charging petitioners with the entire net pro-

ceeds undiminished by any so-called true selling price of

$168,445.60.° However, the Commissioner has not sought to

9. As noted above, pp. 426-427, the Commissioner attempted to

fix a selling price in terms of 10 times indicated taxable income. But,

as pointed out in fn. 2, supra, such taxable income was $15,831.56,

and 10 times that amount would be $158,315.60. Moreover, the

usual method of computing value in terms of a multiple of earnings

is to use an after-tax earnings figure, and if Nassau’s $3,482.94 tax

liabilit is subtracted from $15,831.56, there would remain net earn-

ings of only $12,348.62. Accordingly, the 10 times earnings formula

would yield a value of $123,486.20. It seems hardly likely that any

greater multiple than 10 would be justified in the light of the fact that

the stock was closely held, that the company’s net assets were very

modest in amount, that its only physical asset of any consequence was

a second hand automobile, that its successful operation obviously de-

—_ upon the continued management of the enterprise by the

rauts, that it had such a brief history, and that its sole product was

untested over a sufficiently lengthy period.

A26

Appendia I, Opinion of Judge Raum

amend the pleadings to ask for increased deficiencies, and

in the circumstances the redetermination of deficiencies

herein will be limited accordingly. Section 6214(a); Tax

Court Rule 41(a) and (b). Cf. Commissioner v. Long’s

Estate, 304 F. 2d 136, 141-142 (C.A. 9), affirming an unre-

ported Tax Court Opinion. We wish to add that in neither

Commissioner v. Brown, 380 U.S. 563, nor in Louis Beren-

son, 59 T.C. 412, did the respective courts have before them

an allocation by the Commissioner to the purchase prices

therein, and our conclusion in these proceedings that the

entire transaction lacked bona fides should not be inter-

preted as being inconsistent with the propriety of making

an allocation if the facts in a particular case are thought to

justify such action.

Due to concessions in another respect made prior to trial,

Decisions will be entered

under Rule 155.

APPENDIX II

Opinion of Second Circuit

A27

Appendia II, Opinion of Second Circuit

UNITED STATES COURT OF APPEALS

For THE Seconp Circuit

Nos. 359-360—September Term, 1975.

(Argued December 1, 1975 Decided December 31, 1975.)

Docket Nos. 75-4124, 75-4125

Aaron Kraut and Iris Kraut,

Harry Kraut and Marian Kraut,

Petitioners-A ppellants,

agaimst

CoMMISSIONER OF INTERNAL REVENUE,

Respondent-A ppellee.

= + il: <i

Before:

Lumsarp, Frrenpty and MuLuican,

Circuit Judges.

Appeal from a decision of the United States Tax Court,

Arnold Raum, J., finding petitioners liable for income tax

deficiencies arising out of the sale of stock to a tax-exempt

organization.

Affirmed.

HerManw Rocces, New York, New York (O. John Rogge,

New York, New York; Sidney N. Solomon, Lake

Success, New York), for Petitioners-Appellants.

A28

Appendix Il, Opinion of Second Circuit

Micuae.t L. Paup, Attorney, Tax Division, Department

of Justice, Washington, D.C. (Scott P. Crampton,

Assistant Attorney General, Gilbert E. Andrews,

Jeffrey S. Blum, Attorneys, Tax Division, Depart-

ment of Justice, Washington, D.C.), for Respond-

ent-A ppellee.

Mveuuiean, Circuit Judge:

These appeals by taxpayers raise once again the ques-

tion of the tax consequences under (1222 (3)' of the In-

ternal Revenue Code of 1954 of a sale of stock by an

ordinary seller to a tax-exempt purchaser, when the sale

is financed by the profits of the sold business. See C/R v.

Brown, 380 U.S. 563 (1965) (Clay Brown). The transac-

tions involved here preceded the Tax Reform Act of 1969°

and the decision below was rendered before the opinion of

this court in Berenson v. CIR, 507 F.2d 262 (1974). The

question posed is to what extent, if any, are the proceeds of

such sale to be considered ordinary income to the seller.

The taxpayers, Aaron and Iris Kraut, and Harry and

Marian Kraut, appeal from decisions of the United States

Tax Court which, in an opinion and findings of fact by

Hon. Arnold Raum, filed on June 27, 1974 and reported at

62 °T.C. 420 (1974), determined that Aaron and Iris Kraut

1. “For purposes of this subtitle—...

(3) Long-term capital gain—The term ‘long-term capital gain’

means gain from the sale or exchange of a capital asset held for more

than 6 months, if and to the extent such gain is taken into account

in computing gross income.”

2. That act, Pub. L. 91-172, 83 Stat. 536, repealed the pre-

ferred status of churches with respect to unrelated business income by

deleting the former exception for churches in Int. Rev. Code

§511(a)(2) (A).

A29

Appendix II, Opinion of Second Circuit

owed a deficiency of $240,787.08 in income taxes for the

year 1967 and that Harry and Marian Kraut owed a defi-

ciency of $246,847.44 in income taxes for the same year.

Aaron and Harry Kraut had been for some twenty years

in the business of manufacturing electric wire. The Krauts’

business was operated through a variety of corporations,

Trio Wire and Cable Corporation (Trio), Christmas Wire

Manufacturing Corporation (Christmas), and eventually

in 1965 Nassau Plastic and Wire Corporation (Nassau).

Iris Kraut and Marian Kraut each contributed $100 to

Nassau in exchange for 100 shares of stock in the cor-

poration. Their husbands were not stockholders but effec-

tively operated the business. Nassau occupied a leased

building, previously occupied by Christmas, on Meserole

Avenue in Brooklyn, where ‘i kept its only equipment, an

extruder owned by Trio. The extruder was utilized to

manufacture Christmas wire which is light gauged and pro-

tected by a plastic insulation. Christmas decoration manu-

facturers purchased the wire and attached to it light bulb

sockets which puncture the plastic jacket and make contact

with the wires. Nassau had developed a new insulating

material which was easily penetrable and was likely to

minimize manufacturer rejection which had plagued the

Christmas-light business in the past.

In 1966, an investment counseling firm brought a pro-

posal to Rev. Rex T. Humbard, pastor of the Cathedral

of Tomorrow (Cathedral), a tax-exempt religious corpora-

tion in Akron, Ohio, that it purchase Nassau. Before any

A30

Appendix II, Opinion of Second Circuit

deal was consummated, however, the Krauts entered into

a contract of sale on May 31, 1966 with Wilson Mold & Die

Corporation (Wilson) which purported to sell all the stock

of Nassau to Wilson. Shortly thereafter, on June 15, 1966

the Krauts entered into a three-cornered deal with Wilson

and Cathedrai whereby Wilson was relieved of its obliga-

tion to buy the Nassau stock and Wilson assigned all of

its rights and obligations to Cathedral. The significant

terms of the agreement are set forth in the margin.’ We

3. “The Buyer [Cathedral] shall take all such action as may be

required so that on or as of June 25, 1966 Nassau Plastic shall be

liquidated and all of its assets distributed to the Buyer. Simultane-

ously with the execution of this Agreement, the Buyer, with the con-

sent of the stockholders and directors of the Sellers [Iris and Marian

Kraut], shall take steps forthwith to accomplish the following :

(a) Create a separate operating-manufacturing unit, owned

by the Buyer, to be denominated and known as Nassau Plastic

(hereinafter sometimes interchangeably referred to as ‘Nassau

Plastic & Wire Co.’ * * *); the Buyer to file such documents

with the proper governmental authorities as may be necessary to

effectuate the same.

(b) The name of Nassau Plastic & Wire Corp. shall be

changed forthwith, to such name as the Buyer may designate.

* * *

The purchase price for all of the stock sold under this Agreement

shall be not less than $500,000 (hereinafter called the ‘Minimum

Price’) nor more than $3% million (hereinafter called the ‘Maximum

Price’). The purchase price shall be paid by the Purchaser to the

Sellers at the following time in the following manner and to the extent

set forth below: ;

(a) For the period from June 25, 1966 to July 1, 1966, 100%

of the net income of the Corporation shall belong to the Sellers;

the Purchasers shall receive credit for said amount toward the

purchase price.

(b) $50,000 on or before August 1, 1960.

1967 through 1976 terminating however on june 30, 1976 inclu-

(footnote continued on next page)

A31

Appendix II, Opinion of Second Circuit

note that the sales price was dependent upon Nassau’s

future profits and was to range from a minimum of $500,000

to a maximum of $3,500,000, entirely paid from the sold

business’s income, for the following ten years. The Krauts,

husbands of the Nassau stockholders, were retained as em-

ployees of Cathedral at $5,200 each per annum and so re-

mained in effective day-to-day control of the business.

Cathedral qualified under §501(¢)(3) of the Internal Rev-

enue Code as a tax-exempt religious organization and so

was exempt from paying ecither normal income taxes or

taxes on unrelated business income.* Cathedral paid off its

debt to the Krauts with tax-free income from Nassau.

The agreement further provided that the taxpayers

were to retain a security interest in all of the assets of

Nassau subordinate to prior liens and the right of present

sive, unless the Maximum Price be paid in full prior thereto;

commencing with the 15th day of October 1966 and on the 15th

day of each January, April, July and October thereafter in respect

to each preceding quarterly period from July 1, 1966 through

June 30, 1976, an amount equal to 75% of the Corporations [sic]

net income before Federal income taxes for eagh of such next

preceding fiscal periods. In the event a loss occurs in any quar-

terly period, said loss shall be utilized as an offset in each of the

succeeding quarterly periods (until said loss has been recouped)

before payments to the Sellers are resumed.

(d) In any event and notwithstanding any provision in this

Agreement with respect to the contingent deferral of installment

payments of the Purchase Price, the full Minimum Price referred

to above and any portion of the Maximum Price referred to above

which Sellers may become entitled to receive shall be paid in full

on or before July 15, 1976.

(e) The Purchaser may prepay at any time all or any part of

the unpaid amount of the Maximum Price.”

4. However, the Tax Reform Act of 1969 later changed the status

of churches as regards unrelated business income. See note 2 supra

and accompanying text.

A32

Appendix II, Opinion of Second Circuit

and future creditors. In the event of default by Cathedral,

enforcement of the security agreement constituted the tax-

payer-sellers’ exclusive remedy with no right to secure any

deficiency judgment or other judgment for damages against

Cathedral.

The business was initially very successful. Cathedral

paid Iris and Marian Kraut $147,500 in 1966 (including a

required $50,000 down payment) and $1,332,500 in 1967.

Thereafter the business became unprofitable and ceased

operation in 1969. The taxpayers, after deductions, each

reported $606,416.67 as long-term capital gains for 1967.

The Commissioner determined that $595,776.09 of each

couple’s receipts was taxable as ordinary income. He de-

ducted the value of Nassau’s stock from the taxpayers’

receipts under the sales contracts, assigning a value of

$168,445.60 to the stock, an amount equal to ten times

Nassau’s taxable income for the year ended June 30, 1966,

the year prior to the sale. Taxpayers then filed petitions

contesting the determination, taking the position that the

property sold was a capital asset so that the gain was

taxable only as a long-term capital gain. The Tax Court

rejected this contention and this appeal followed.

In Clay Brown the Supreme Court held that the some-

what similar transaction there involved constituted a sale

within the meaning of §1222(3) (and thus was taxable as

long-term capital gain) even though the exempt organiza-

tion incurred no downside risk. The absence of a shift

in risk did not preclude the ‘‘sale’’ of the stock and under-

A33

Appendix II, Opinion of Second Circuit

lying assets under applicable law. The Court further noted

the Tax Court’s finding that the purchase price was ‘‘ within

a reasonable range in light of the earnings history of the

corporation and the adjusted net worth of the corporate

assets.’’ 380 U.S. at 572. In Clay Brown the appraised

net worth of the assets of the business was $1,064,877 and

the sales price was approximately $1,300,000.

This court faced a related problem in Berenson, which

involved a bootstrap sale of closely held corporate stock.

There a tax-exempt entity agreed to pay $6,000,000 over a

twelve-year period for stock, a price which the Tax Court

held was more than double the price that would be paid for

the same stock by a prospective purchaser who was not

exempt from income tax. We held that Clay Brown did not

wholly govern in view of the disparity in Berenson between

the prices that exempt and non-exempt purehasers would

pay, a disparity that did not exist in Clay Brown. Rather

than holding that none of the proceeds were entitled to

capital gains treatment, since a sale had in fact occurred in

Berenson within the Clay Brown rationale, we determined:

In sum, we conclude that the portion of the purchase

price agreed tv by Temple [the tax-exempt entity]

and Taxpayers that is in excess of the price a non-

exempt purchaser would have paid under identical

terms is not part of the proceeds of a §1222(3) ‘‘sale,’’

and is, therefore, taxable as ordinary income to the

recipients.

507 F.2d at 269.

Both parties to this appeal agree that Clay Brown and

Berenson are applicable. The appellants maintain however

that the fair market value of the stock of Nassau should

A34

Appendix II, Opinion of Second Circuit

be held to be $3,500,000, which was the maximum price that

the non-exempt purchaser Wilson as well as Cathedral

agreed to pay. The appellee argues that the allocation

made below should be affirmed or the basis of our holding in

Berenson.

In light of Berenson we feel constrained to find that the

sale was bona fide under Clay Brown and the Commissioner

on this appeal does not argue to the contrary. The Tax

Court below, which rendered its decision before Berenson

was decided, concluded that the sale was not bona fide

within Clay Brown and would have charged the taxpayers

with the entire net proceeds undiminished by any so-called

‘‘true selling price.’’ However, the Commissioner had pre-

viously determined an amount of $168,445.60 to be a bona

fide sales price and had limited the taxpayers’ ordinary

income tax liability to the excess over that true value.

Since the Commissioner had not successfully sought to

amend the pleadings below to ask for increased deficien-

cies, the Tax Court felt compelled to make the allocation

set by the Commissioner. Thus, although Judge Raum

found that no bona fide sale took place, he applied in effect

the Berenson allocation rule yet to be articulated by this

court.

Ill

The sole issue before us is whether or not the Tax

Court’s refusal to disturb the Commissioner’s determina-

tion that the true value of Nassau’s stock was $168,445.60

5. After the opinion below was filed, the Commissioner, no doubt

prompted by the opinion’s finding that no bona fide sale existed, moved

to amend its answers to so allege. The motions were summarily de-

nied by Judge Raum on July 26, 1974.

A35

Appendia II, Opinion of Second Circuit

was erroneous. We commence with the proposition that

the deficiency asserted by Commissioner is presumptively

correct and the burden of disproving it rests upon the

taxpayer. Rule 142(a), Rules of Practice and Procedure

of the United States Tax Court (see 26 U.S.C.A. §7453

(1975 Supp.)); Helvering v. Taylor, 293 U.S. 507, 515

(1935) (‘‘Unquestionably the burden of proof is on the

taxpayer to show that the commissioner’s determination is

invalid’’ (citations omitted)); Rockwell v. CIR, 512 F.2d

882, 885 (9th Cir. 1975) ; Valetti v. CIR, 260 F.2d 185, 187

(3d Cir. 1958) (‘‘It is the burden of a taxpayer who insti-

tutes such a suit as this to overcome the presumption that

the Commissioner’s deficiency finding was correct by show-

ing by a preponderance of evidence that the Commissioner

erred.’’); 10 J. Mertens, Federal Income Taxation §55.18,

at 113-14 and cases cited (1970).

The taxpayers rely upon McSpadden v. CIR, 50 T.C.

478, 491-94 (1968) and Wilson v. CIR, 25 T.C. 1058, 1066

(1956) for the proposition that when the Commissioner

departs from the grounds relied on in his deficiency notice

to sustain a theory later raised, he has the burden of

proving any. new matter. While the Commissioner here

did contend below that the entire transaction lacked bona

fides and the Tax Court agreed, which would have resulted

in the application of ordinary income tax liability for the

entire proceeds of the sale, Judge Raum expressly limited

the Commissioner to its previous deficiency notice. Hence

we have no occasion to decide whether the Commissioner

carried any burden of establishing that no bona fide sale

at all took place. The burden of establishing what was a

fair market value therefore remained with the taxpayer.

A36

Appendix II, Opinion of Second Circuit

As we indicated in Berenson, the test to be applied in

determining the extent of capital gains treatment is the

establishment of the fair price which a non-exempt entity

would pay for the stock in an arm’s length negotiation.

Here the taxpayers had the unique advantage of being

able to show that Wilson, just 15 days before Cathedral

received its assignment, was willing to pay the same price

on practically identical terms.® But not only was there no

evidence of the Wilson-Kraut negotiations, the record is

also barren of any proof that Wilson even exists or if it

does, that it is a non-tax-exempt entity. The agreement

assigning Wilson’s contract of sale to Cathedral not only

fails to provide any financial consideration for the assign-

ment by Wilson but it is not even signed by any Wilson

representative. (The original contract between Nassau and

Wilson is signed by one Leon Lautin on the latter’s behalf

but no corporate title is indicated.) Judge Raum noted

below: ‘‘In the absence of any explanatory evidence (which

was peculiarly within the control of petitioners) and in

view of the two contracts’ all too convenient timing, it is

strongly suggestive [sic] the initial Wilson contract was

merely a bootstrap effort to bolster petitioners’ contention

as to Nassau’s fair market value, and we consequently

must discount its evidentiary value.’’ 62 T.C. at 431.

The only evidence presented by the petitioners below as

to Nassau’s fair market value was the testimony of Aaron

Kraut, who testified that, on the basis of consumer ac-

6. The only difference was that Wilson had agreed to pay the tax-

payers 75% of its pre-tax earnings for five yars and thereafter 75%

of its after-tax earnings, while Cathedral had agreed to pay 75% of

its pre-tax income for the entire ten-year period.

A37

Appendia II, Opinion of Second Circuit

ceptance of Nassau’s new wire and unfilled orders for the

first half of 1966, he anticipated gross profits of more

than $10,000,000 during the next ten years. No documen-

tary evidence of any sort was submitted in support of

this estimate. Moreover, Judge Raum held ‘‘we . . . simply

do not believe this evidence.’’ He characterized Kraut’s

memory of the transaction as ‘‘narrowly selective and

seemingly self-serving . .. we are hardly inclined to eredit

Aaron Kraut with the necessary knowledge or ability to

lend the slightest probative value to his testimony.’’ 62

T.C. at 430-31." In view of Judge Raum’s opportunity to

observe the demeanor of the witness we obviously cannot

characterize this finding of fact as clearly erroneous. CIR

v. Duberstein, 363 U.S. 278, 291 (1960); Adler v. CIR, 422

F.2d 63, 68 (6th Cir. 1970) (credibility of witnesses is

particularly for the Tax Court); Casey v. CIR, 267 F.2d

26, 31 (2d Cir. 1959) (same) (dictum). Finally, the fact

that a tax-exempt organization was willing to pay a maxi-

mum price of $3,500,000 for the stock was obviously not

probative of its value to a non-tax-exempt entity.

On appeal, the taxpayers urge that Judge Raum did

not sufficiently recognize that Nassau had a ‘‘valuable trade

7. In addition, Judge Raum noted that another Kraut, Aaron’s

brother Harry, was actually the witness the government had sub-

poenaed to appear at the trial. The government did not attempt to

enforce its fo < coal in part because petitioners represented that Aaron

was as knowledgeable as Harry as regards the details of Nassau’s

business. However, on the stand Aaron at times professed ignorance

of Nassau’s financial concerns, explaining that Harry and not he him-

self handled all financial matters for the company. 62 T.C. at 430.

Judge Raum concluded this point by saying, “. . . we simply note that

tioners must bear the consequences of their failure to adduce cred-

ible evidence of Nassau’s value.” Id. at 431 n.7.

A38

Appendix II, Opinion of Second Circuit

secret for the production of a dramatically new type of

Christmas tree lighting wire.’’ On the contrary, Judge

Raum found that there was no convincing evidence that the

production of the wire was based on a secret process and

further noted that Nassau had no patent protection for

its ‘‘secret’’. Nassau’s competitors were free to appro-

priate the process and Nassau’s short-lived success would

tend to support the argument that this eventually hap-

pened by 1968. It is also significant that Kraut testified

that the new plastic material was an ‘‘unknown quantity’’

and that after discussions with his accountant and at-

torney decided ‘‘we would be complete idiots to take a

chance on putting—producing this material in Trio Wire

and jeopardizing the corporation.”’

The other evidence of value is supportive of the view

that the Commissioner’s valuation of $168,445.60 for the

Nassau stock is not clearly erroneous.* In the one-year

period of its existence prior to sale, it had a taxable in-

come of less than $16,000; its total assets were slightly in

excess of $50,000, most of which consisted of accounts

receivable. Its only owned asset was a used automobile.

It leased the building in which it operated and the only

equipment utilized in manufacturing the Christmas dec-

oration wiring, the extruder, was leased from Trio at $500

8. We note that, in general, a trial court’s evaluation of stock or

other property is subject to reversal only if it is clearly erroneous.

E.g., Bormes v. CIR, 512 F.2d 442 (8th Cir. 1975) (per curiam)

(affirming valuation of real estate donated to charity, where Tax Court

sustained the Commissioner’s valuation) ; Rubber Research, Inc. v.

CIR, 422 F.2d 1402, 1405 (8th Cir. 1970) (per Blackmun, J.) (valu-

ation of stock for tax purposes is a question of fact, and hence is sub-

ject to the “clearly erroneous” standard of review) ; Seas Shipping Co.

v. CIR, 371 F.2d 528, 532 (2d Cir.), cert. denied, 387 U.S. 943

(1967) (same).

A39

Appendia II, Opinion of Second Circuit

a month. Although Nassau’s earnings rose rapidly after

the sale to Cathedral, and the Krauts received $1.48 million

under the contract, the company suffered a precipitous drop

in income that could not have been wholly unexpected given

the failure to attempt to patent the ‘‘unique’’ process. By

1969, Nassau had ceased all operations.

It is true that the Tax Court made no specific finding

that the true value of Nassau was $168,445.60 since it found

that the sale was not bona fide. However, it did accept the

deficiency assessment of the Commissioner and the taxpayer

failed miserably to shoulder the burden of establishing that

this was erroneous. A casual reading of its opinion indi-

cates that the Tax Court, had it anticipated Berenson’s

requirement of an apportionment, would have found Nas-

sau’s value to be, if anything, less than that determined by

the Commissioner. The Commissioner’s evaluation was

based upon a formula of ten times Nassau’s taxable income

for the fiscal year ending on June 30, 1966. Judge Raum

pointed out, however, that this would result in a price of

$158,315.60 since Nassau’s taxable income for 1966 was only

$15,831.56. He further noted that the usual method of

computing value in terms of a multiple is to employ an after

tax earnings figure which would yield a value of $123,486.20.

He explicitly noted that a greater multiple than ten would

not be justified since the stock was closely held, the com-

pany’s net assets were modest, its history brief and its sole

product was untested over a sufficiently lengthy period.

While the Commissioner’s findings on valuation were far

less specific than those presented in Berenson, where an

expert witness testified as to a detailed formula for estimat-

A40

Appendix II, Opinion of Second Circuit

ing the price that would be paid by a non-exempt purchaser,

those findings must stand in light of appellant’s failure to

present any countervailing evidence. We see no advantage

in remanding for a specific finding of value by the Tax

Court since it could not be any greater than that found; if

less, both the Tax Court and this court would be bound by

the Commissioner’s initial determination. In any event,

neither party has sought such a remand.

Finally, taxpayers argue that the fair market value of

the Nassau stock could not be less than forty-eight percent

of the price which Cathedral agreed to pay since in 1967

the corporate tax rate was forty-eight percent on profits in

excess of $25,000. We fail to see any nexus between a non-

exempt entity’s tax bracket and the price a tax-exempt

entity might be willing to pay. There is no such limitation

in Berenson and no authority is cited for the proposition.

We affirm.

APPENDIX III

Order Denying Rehearing

A41

Order Denying Rehearing

UNITED STATES COURT OF APPEALS

Seconp Circuit

At a Stated Term of the United States Court of

Appeals, in and for the Second Circuit, held at

the United States Court House, in the City of

New York, on the 15th day of January, one

thousand nine hundred and seventy-six.

Present:

Hon. J. Epwarp LuMmsarp,

Hon. Henry J. Frrienpvy,

Hon. Wiiuiam H. Muuuiean,

Circuit Judges.

Docket Nos. 75-4124-5

TT A i

Aaron Kravt and Iris Kraut,

Harry Kraut and Marian Kravt,

Petitioners-Appellants,

Vv.

CoMMISSIONER OF INTERNAL REVENUE,

Respondent-A ppellee.

A petition for a rehearing having been filed herein by

counsel for the appellants,

Upon consideration thereof, it is

Ordered that said petition be and hereby is denied.

/:/ A. Dante. Fusaro

A. DanreL F'usaro

Clerk

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