# Petition — Kraut v. Commissioner > Briefs, arguments, decisions, and more. URL: https://www.frixlaw.com/law-library/documents/brief%3Amicro_IA40385003_1780%3A1 ## Record - **Collection:** Supreme Court brief - **Document type:** Petition - **Published:** January 1, 1976 - **Citation:** 425 U.S. 973 ## Text —— ‘Supreme Court, U. S LD 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 | ' | II 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. 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. 4 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 5 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 6 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 ‘. 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 A7 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- A8 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. (c) For the balance of the year 1966 and in each 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 A9 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 eR Aaron Kraut and Iris Kraut, Harry Kraut and Marian Kraut, Petitioners-A ppellants, agaimst CoMMISSIONER OF INTERNAL REVENUE, Respondent-A ppellee. = + il: