Petition — David Metzger Trust v. Commissioner

APR 25 1985

82-1798 |

‘

No. 83-

In The

Supreme Court of the United States

October Term, 1982

Davin METZGER TRUST,

JACOB METZGER, TRUSTEE,

Petitioner,

U.

COMMISSIONER OF INTERNAL REVENUE,

Respondent.

PETITION FOR A WRIT OF CERTIORARI

TO THE UNITED STATES COURT OF APPEALS

FOR THE FIFTH CIRCUIT

Hersert S. KENDRICK

Rosert E, GOODFRIEND

AKIN, GuMP, STRAUSS,

Hauer & FELD

2800 RepublicBank Building

Dallas, Texas 75201

(214) 655-2800

Counsel of Record for

Petitioner

Of Counsel:

Don C. STEPHENSON

DonaLp L. STUART

JENKINS & GILCHRIST

2200 InterFirst One

Dallas, Texas 75202

(214) 653-4500

April 25, 1983

nel

i

QUESTION PRESENTED

Whether evidence of family discord properly should be

considered in mitigation of the attribution rules of section

318’ in determining whether a redemption of stock is

essentially equivalent to a dividend pursuant to section

302 (b) (1)?

PARTIES BELOW

Appellants in the Court of Appeals were the David

Metzger Trust, Jacob Metzger, Trustee, and Metzger

Dairies, Inc. Metzger Dairies, Inc. has not joined in this

Petition for a Writ of Certiorari. Appellee in the Court of

Appeals was the Commissioner of Internal Revenue.

Unless otherwise indicated, all section references herein are to the

Internal Revenue Code of 1954, as amended.

ii

TABLE OF CONTENTS

Question Presented

Parties Below ._. Be

eee cue

7 2 eee

CR eS eta

Jarmmcntion .................. DOLCE) CU ea pele Set

Reasons for Granting the Writ... ...... iL

I. The Decision of the Fifth Circuit Created

a Conflict Between the Fifth Circuit and

First Circuit as to the Proper

Application of Section 302(b) (1) .. ‘

II. There is a Pressing Need for Clarification

of this Court’s Decision in Davis so as

to Permit Proper and Consistent

Administration of the Tax Laws... ss—itw

III. The Instant Case Provides an Ideal Vehicle

for the Clarification by this Court of the

Proper Application of Section 302 (b) ( 1)

ee

dass 5

ene: 12

ili

APPENDICES

Page

A-1

B-1

. Cl

. D-l

iv

TABLE OF AUTHORITIES

Cases:

Page

Davis, United Sictes v.,

397 U.S. 301 (1970) 4, 5, 6, 7, 8, 9, 10

Haft Trust, Robin v. Commissioner,

510 F.2d 43, (1st Cir. 1975) 3, 4, 5, 6, 7, 8

Rickey v. United States,

592 F.2d 1251 (5th Cir. 1979) ' 7

Title Insurance and Trust Co. v. United States,

484 F.2d 462 (9th Cir. 1973) 9

Wright v. United States,

482 F.2d 600 (8th Cir. 1973) 9

Statutes:

Internal Revenue Code of 1954, as amended:

Sec. 302 . 2, 3, 5, 6, 7, 8, 10, 11

Sec. 318 3 : 2, 3, 4, 5, 8, 9

Treasury Regulations:

Reg. § 1.302-2(b) ee ee

Miscellaneous:

Bacon, Corporate Stock Redemptions — Definitions;

Basic Categories, 343 Tax Mgt. A-75 (1978) ........ 9

Bittker and Eustice, Federal Income Taxation of

Corporations and Shareholders (4th ed. 1979) .......... 3

Vv

TABLE OF AUTHORITIES — (Continued)

Page

Boyd and Boyd, “Faraily Discord May Negate

Attribution Rules and Allow Capital Gain Treat-

ment of a Redemption”, 15 Tax. for

Accts. 362 (1975) ............... iui 9

Comment, “Section 318 — Family Hostility May

Negate Application of Stock Attribution Rules to

Section 302(b) (1) Stock Redemption. Haft Trust

v. Commissioner, 510 F.2d 43 (1st Cir. 1975)”,

7 Rutgers — Camden L. J. 609, 613 (1976) «0.0.0.0... 10

Englebrecht and DeCelles, “Family Discord and

Section 302 Stock Redemptions: A Review and

Analysis”, 58 Taxes 43 (January 1980) ©0000... 9

Note, “Family Hostility as a Factor in Determining

Constructive Stock Ownership in Corporate

Redemptions”, 29 Tax. Law. 386 (1976) .............0.000... 9

O’Dell and Boyd, “Family Hostility and Stock

Redemptions: Revenue Ruling 80-26 Revives the

Controversy”, 59 Taxes 153 (March 1981) .................... 9

Randall and Benson, “Family Dissension and the

Attribution Rules of Sections 267, 318 and 544”,

aor ce a. 9

Swennes, “ ‘Not Essentially Equivalent to a Dividend’

Exception Still Viable Despite Davis”,

ee 9

No. 83-

In The

Supreme Court of the United States

October Term, 1982

Davip METZGER TRUST,

JACOB METZGER, TRUSTEE,

Petitioner,

v.

COMMISSIONER OF INTERNAL REVENUE,

Respondent.

PETITION FOR A WRIT OF CERTIORARI

TO THE UNITED STATES COURT OF APPEALS

FOR THE FIFTH CIRCUIT

David Metzger Trust, Jacob Metzger, Trustee, petitions

for Writ of Certiorari to review the judgment of the United

States Court of Appeals for the Fifth Circuit in this case.

OPINIONS BELOW

The opinion of the United States Tax Court, dated

January 12, 1981, is reported at 76 T.C. 42 (1981) and is

set forth in Appendix A. The opinion of the Court of

Appeals, dated December 13, 1982, is reported at 693 F.2d

459 (5th Cir. 1982) and is set forth in Appendix B. The

opinion of the Court of Appeals, dated January 26, 1983,

on Petition for Rehearing and Suggestion for Rehearing

En Banc is reported at €98 F.2d 1216 and is set forth in

Appendix C.

2

JURISDICTION

The judgment of the Court of Appeals was entered on

December 13, 1982, and its order denying the Petition for

Rehearing and the Suggestion for Rehearing En Banc was

entered on January 26, 1983. This petition is filed within

ninety days of that denial. The jurisdiction of this Court

is invoked under 28 U.S.C. § 1254(1) (1976).

STATUTORY PROVISIONS

The pertinent provisions of sections 301, 302 and 318 of

the Internal Revenue Code of 1954, as amended, are set

forth in Appendix D below.

STATEMENT OF THE CASE

This suit was brought on behalf of the Petitioner, David

Metzger Trust, Jacob Metzger, Trustee (the “Trust”), a

testamentary trust created by David Metzger for the benefit

of his wife, Nora, and his three children, Jacob Metzger

(“Jake”), Catherine Staacke (“Catherine”) and Cecelia

Jane Frew (“Cecelia”). Prior to the stock redemption

hereinafter described, the Trust and the above-named bene-

ficiaries held all of the outstanding stock of Metzger Dairies,

Inc. (“Dairies”).

Subsequent to the death of David Metzger in 1953, severe

acrimony developed between Jake, Catherine and Cecelia

which lead to the conclusion that Dairies could no longer

be operated as a family business. In order to terminate the

business and familial relations of these parties, Dairies

redeemed, on or about January 22, 1973, all of its stock held

by Catherine and Cecelia. In addition, Dairies likewise

redeemed all of its stock held by the Trust because such

stock would, under the terms of the Trust, pass to Jake,

Catherine and Cecelia upon the death of their mother,

Nora Metzger.

The Trust treated the proceeds from the redemption of

its Dairies stock as payment in exchange for such stock

and reported the resulting gain as capital gain on its federal

income tax return for the calendar year 1973. The Com-

missioner of Internal Revenue (the “Commissioner”) , how-

ever, disputed such capital gain treatment and instead

determined that the proceeds received by the Trust pursuant

to the redemption should be taxed as ordinary (dividend)

income to the extent of the earnings and profits of Dairies.

The Trust petitioned the United States Tax Court for

a redetermination of the federal income tax deficiency pro-

posed by the Commissioner for the calendar year 1973. In

its petition, the Trust contended that the redemption of

the stock of Dairies was not essentially equivalent to a

dividend under section 302(b) (1).

Section 302(b) (1) provides that a redemption of stock

will be considered as full payment in exchange for such

stock, and thus subject to capital gain treatment, if such

redemption is not essentially equivalent to a dividend. In

determining whether a redemption is not essentially equiva-

lent to a dividend, section 302(c) (1) provides that the

constructive ownership rules contained in section 318, which

attribute ownership of stock among certain related parties

or entities, shall be applied. However, the application of

the constructive ownership rules is not the only factor to

be considered. Treas.Reg. § 1.302-2(b). Instead, in cir-

cumstances where extreme discord exists between the

parties among whom stock ownership would otherwise be

attributed, the courts, including the United States Court

of Appeals for the First Circuit in Robin Haft Trust v.

4

Commissioner, 510 F.2d 43 (1st Cir. 1975), have recognized

that the underpinnings of the section 318 attribution rules

are not present, and thus family discord may be a mitigating

factor in testing the dividend equivalence of a redemption.

In connection with the submission of the case to the Tax

Court, the Trust and the Commissioner stipulated three

critical facts: (i) the principal and primary reason under-

lying the redemption of stock of Dairies was the determina-

tion by Jake, Catherine and Cecelia that the hatred and

discord existing between them necessitated the discontinu-

ance of the operation of the corporation’s business by these

named individuals, (ii) the redemption was not principally

or primarily motivated by an attempt to realize a profit on

their stock in the corporation or to receive dividends undis-

tributed from prior years, and (iii) both before and after

the redemption in question, the discord and complete dis-

harmony between Jake, Catherine and Cecelia was so

extreme that they would not have acted in concert or for

the benefit of each other in connection with the redemption

of the stock of Dairies, its business policies and operations,

or otherwise.

Notwithstanding the holding in Haft and other relevant

authorities, the Tax Court upheld a deficiency in federal

income tax in the amount of $187,037.80 for the calendar

year 1973. The court determined that since, as a result of

attribution from Jake, the Trust constructively owned 100

percent of the stock of Dairies after the redemption, the

redemption was essentially equivalent to a dividend. Relying

on this Court’s decision in United States v. Davis, 397 U.S.

301 (1970), the court held that evidence of family discord

should not be considered in determining whether a redemp-

tion was essentially equivalent to a dividend where the

redeemed shareholder owned, actually or constructively,

100 percent of the stock of the redeeming corporation both

before and after the redemption in question.

The Court of Appeals affirmed the decision of the Tax

Court, specifically recognizing that its refusal to consider

evidence of family discord in mitigation of the attribution

rules in the context of section 302(b) (1) was in conflict

with the decision of the First Circuit in Robin Haft Trust,

supra. The Trust thereupon filed a Petition for Rehearing

and a Suggestion for Rehearing En Banc, each of which was

denied by the Court of Appeals.

REASONS FOR GRANTING THE WRIT

I. The Decision of the Fifth Circuit Created a Conflict

Between the Fifth Circuit and First Circuit as to the

Proper Application of Section 302(b) (1).

The instant case presents an opportunity for the Court

to resolve a clear conflict between the circuit courts involving

a question of substantial practical importance. The con-

troversy concerns section 302 (b) (1) of the Internal Revenue

Code, which provides that a stock redemption will be treated

as a sale of stock (and thus subject to capital gain treat-

ment) if it is not “essentially equivalent te a dividend.”

As stated above, in determining the dividend equivalence

of a redemption, the general rule of section 302 (c) (1)

requires that the constructive ownership rules of section 318

shall be applied.

The principal judicial decision regarding the application

of section 302(b) (1) is this Court’s decision in Davis, supra,

wherein a corporation redeemed all of its outstanding pre-

ferred stock from a shareholder who, together with his

immediate family, continued to own all of the corporation’s

outstanding common stock. This Court held that in order

to qualify for preferred treatment under section 302(b) (1),

“a redemption must result in a meaningful reduction of the

shareholder’s proportionate interest in the corporation.”

397 U.S. 301, 313. Since, under the facts presented (which

did not entail the existence of family discord), the taxpayer

constructively owned 100 percent of the common stock of

the corporation both before and after the redemption, this

Court concluded that the preferred stock redemption was

essentially equivalent to a dividend. In this connection, the

Court made the now often-quoted statement that the

redemption of stock of a sole shareholder, including a “con-

structive” sole shareholder, is “always ‘essentially equivalent

to a dividend’ ” under section 302(b) (1).

Subsequent to Davis, the First Circuit was asked in Robin

Haft Trust, supra, to apply section 302(b) (1) in a situation

factually analogous to Davis, except that evidence of family

discord was presented. There, in connection with a bitter

divorce action, a corporation redeemed its stock owned by

four trusts, the beneficiaries of which were the children of

the hostile parties. As in the case of the David Metzger

Trust, the four trusts in Haft did not actually own any stock

of the redeeming corporation after the redemption; however,

the application of the attribution rules resulted in an increase

in the trusts’ respective interests in the corporation after

the redemption. The First Circuit concluded that such post-

redemption constructive ownership was not determinative of

the dividend equivalence issue, and that “family discord

could belie the community-of-interest rationale of the attri-

bution rules and was thus a relevant circumstance in

determining dividend equivalency under [section 302]

(b) (1).” 510 F.2d at 46.

The First Circuit in Haft rejected the Tax Court’s holding

that Davis precluded consideration of family discord, particu-

?

larly since this Court was not presented with evidence of

family hostility in Davis. Instead, the First Circuit inter-

preted the holding in Davis that the redemption must result

in & “meaningful reduction of the shareholder’s proportionate

interest in the corporation” as permitting, if not mandating,

“an examination of the facts and circumstances to determine

the effect of the transaction transcending a mere mechanical

application of the attribution rules.” Id. at 48.”

The Court of Appeals in the instant case interpreted

Davis differently. It held that, since the Trust constructively

owned 100 percent of the stock of Dairies both before and

after the redemption, such redemption of the Trust’s shares

must be treated as essentially equivalent to a dividend

without consideration of family discord or other mitigating

factors. Specifically, although recognizing that its decision

would create a clear conflict among the circuit courts, the

Fifth Circuit ruled that, pursuant to Davis, evidence of

family discord cannot be considered in mitigation of the

attribution rules in the course of a determination under

section 302 (b) (1).°

Accordingly, as evidenced by the conflicting decisions of

the Courts of Appeals in the instant case and Haft, the

confusion regarding the proper application of section

802 (b) (1), which this Court sought to eliminate in Davis,

*The First Circuit remanded the case to the Tax Court for a recon-

sideration of the facts and circumstances, “including the existence of

family discord tending to negate the presumption that the taxpayers

would exert continuing control over the corporation despite the

redemption.” Id. at 48. The case was subsequently settled, and thus

no further opinion was issued.

*The Court of Appeals dismissed as dictum its statement in Rickey

v. United States, 592 F.2d 1251, 1257 (5th Cir. 1979), that Davis had

not precluded a consideration of family discord with respect to a

determination under section 302(b) (1). 693 F.2d at 466.

8

has again reappeared. The Court should grant the writ in

order to resolve this disarray among the various circuit

courts.

II. There is a Pressing Need for Clarification of this

Court’s Decision in Davis so as to Permit Proper and

Consistent Administration of the Tax Laws.

The decision ot the Fifth Circuit in the instant case not

only conflicts with the First Circuit’s decision in Haft,

it stems from a disagreement among the circuit courts as

to the proper interpretation of this Court’s opinion in Davis.

Thus, while the very existence of a conflict among the

circuit courts, which subjects litigants in different juris-

dictions to differing legal principles, might in itself be a

sufficient basis for review of this case on certiorari, only

this Court can resolve a dispute that involves the proper

interpretation of one of its own decisions.

The long-standing prevailing view of the proper inter-

pretation of the Davis decision, and specifically, this Court’s

statement that a redemption of stock from a sole share-

holder, including a constructive sole shareholder, would

always be essentially equivalent to a dividend, has been

that Davis does not preclude consideration of mitigating

factors such as family discord in the application of section

302(b) (1).* This view as to the proper interpretation and

application of section 302(b) (1) is in accord with views

expressed by the Eighth Circuit and Ninth Circuit subse-

‘This view is supported by Treas. Reg. § 1.302-2(b) which pro-

vides, in pertinent part, as follows:

(b) The question whether a distribution in redemption of

stock of a shareholder is not essentially equivalent to a dividend

under section 302(b)(1) depends upon the facts and circum-

stances of each case. One of the facts to be considered in making

this determination is the constructive stock ownership of such

shareholder under section 318(a). (Emphasis added).

9

quent to the Davis decision.’ In addition, a substantial

majority of such commentators, including Bittker and

Eustice (described by this Court in Davis as the “leading

commentators” in this area, and twice cited in that opin-

ion), have advocated that this Court’s decision in Davis

did not eliminate the consideration of family discord in

mitigation of stock attribution under section 318.°

5See, Wright v. United States, 482 F.2d 600, 612 (8th Cir. 1973),

where Judge Bright, in his dissenting opinion, stated:

If the record in the present case revealed the exceptional sit-

uation where the interest of family-member shareholders (whose

shares were attributable to the taxpayer) were in fact adverse to

the taxpayer, I would be inclined to agree that the Squier case

would be applicable here, and under its holding the taxpayer

would have made a meaningful change in his interest through

the redemption. However, the record before us provides no basis

for assuming that the shares attributable to the taxpayer are held

by shareholders with interests adverse to the taxpayer.

In addition, see Title Insurance and Trust Co. v. United States, 484

F.2d 462, 465 (9th Cir. 1973), where, after stating that the effect of

the constructive ownership rules of section 318 is to attribute unity

and entity to a family, the court stated:

Such assumptions may, indeed, prove awkward or unfair in

cases where families do not believe as the rules assume they will,

and intra-family disputes exist as to who should control and

how. However, we do not have such problems here.

*See, B. Bittker and J. Eustice, Federal Income Taxation of

Corporations and Shareholders, § 9.24 at n. 73 (4th ed. 1979); O’Dell

and Boyd, Family Hostility and Stock Redemptions: Revenue Ruling

80-26 Revives the Controversy, 59 Taxes 153 (March 1981); Engle-

brecht and DeCelles, Family Discord and Section 302 Stock Redemp-

tions: A Review and Analysis, 58 Taxes 43 (January 1980); Bacon,

Corporate Stock Redemptions — Definitions; Basic Categories, 343

Tax Mgt. A-75 (1978); Note, Family Hostility as a Factor in

Determining Constructive Stock Ownership in Corporate Redemp-

tions, 29 Tax. Law. 386 (1976); Randall and Benson, Family Dis-

sension and the Attribution Rules of Sections 267, 318 and 544, 53

Taxes 534 (1975); Boyd and Boyd, Family Discord May Negate

Attribution Rules and Allow Capital Gain Treatment of a Redemp-

tion, 15 Tax. for Accts. 362 (1975); Swennes, “Not Essentially

Equivalent to a Dividend” Exception Still Viable Despite Davis, 41

10

In view of this long-standing interpretation of Davis,

the conflict caused by the Fifth Circuit’s decision in the

instant case will result in confusion and uncertainty with

respect to a continually recurring issue in the administra-

tion of the revenue laws affecting, among others, closely

held corporations, Moreover, in the absence of a resolution

of the conflict which now exists, the common occurrence of

the events giving rise to the instant case will cause duplica-

tive, expensive and needless litigation in the lower courts.

Certainly, the cause of improved judicial administration will

not be served by permitting the separate development of

case law within each circuit, especially where, as here, a

narrow issue of law is presented. Finally, resolution of the

present conflict by this Court is necessary to establish a

uniform, predictable and national standard as to the proper

application of section 302(b) (1) which will guide both the

Internal Revenue Service and interested taxpayers.

Ill. The Instant Case Provides an Ideal Vehicle for the

Clarification by this Court of the Proper Application

of Section 302(b) (1).

The instant case was submitted fully stipulated to the

Tax Court with no factual issues remaining for determina-

tion. In particular, the Trust and the Commissioner have

stipulated that the redemption in question was motivated

by the extreme discord existing between Jake, Catherine

and Cecelia and that, both before and after the redemption

in question, such discord was so extreme that the parties

would not have acted in concert or for the benefit of each

J. Tax 78 (1974); Contra, Comment, Section 318 — Family Hostility

May Negate Application of Stock Attribution Rules to Section

302(b)(1) Stock Redemption. Haft Trust v. Commissioner, 510 F.2d

43 (Ist Cir. 1975), 7 Rutgers — Camden L. J. 609, 613 (1976).

11

other. Accordingly, this case presents a simple, clear legal

issue uncluttered by factual disputes. As such, it is an ideal

case in which to determine whether family discord may be

considered in mitigation of the attribution rules under

section 302 (b) (1).

Accordingly, Petitioner submits that this Court should

grant the writ in order to clarify whether evidence of family

discord can be considered in mitigation of the section 318

attribution rules with respect to a determination of dividend

equivalence under section 302(b) (1), and thus resolve the

conflict which currently exists between the Fifth Circuit and

the First Circuit.

12

CONCLUSION

For the reasons stated, Petitioner prays that its Petition

for a Writ of Certiorari be granted.

OF COUNSEL:

Don C. STEPHENSON

Donatp L. Sruart

JENKENS & GILCHRIST

2200 InterFirst One

Dallas, Texas 75202

(214) 653-4500

April 25, 1983

Respectfully submitted,

HERBERT S. “ENDRICK

Rosert E. GoopFRiEND

Akin, Gump, STRAUss,

Haver & Ferp

2800 RepublicBank Building

Dallas, Texas 75201

(214) 655-2800

COUNSEL OF RECORD

FOR PETITIONER

Daviy Metzcer Trust, JACOB METZGER, TRUSTEE,

PETITIONER v. COMMISSIONER OF INTERNAL REVENUE,

RESPONDENT

Metzcer Darrtss, INc., PETITIONER v. COMMISSIONER OF

INTERNAL REVENUE, RESPONDENT

Docket Nos. 8824-77, 8856-77, 6990-79.

Filed January 12, 1981.

A brother and two sisters were shareholders in MDI

and remaindermen in a trust which also held stock in

MDI. Family hostility among the siblings caused MDI to

redeem the stock owned by the trust and the two sisters.

The trust was included in the redemption because under

its terms, the stock it held in MDI would have passed

to the remaindermen who were attempting to separate

their business and family relations.

The trust complied with the prerequisites of sec. 302 (c) -

(2) (A), I.R.C. 1954, and filed an agreement purporting

to waive the trust-beneficiary attribution rules of sec.

318 (a) (3).

In partial payment of the redemption price, MDI exe-

cuted a promissory note to one of the sisters. MDI claimed

deductions for accrued interest expenses with regard to

the note but did not actually make payment to the sister

within 2% months after the close of its fiscal years.

Family hostility existed between the brother who owned

more than 50 percent of the stock in MDI and the payee-

sister. Held:

1. Family hostility does not nullify the attribution rules

of sec. 318. The redemption was essentially equivalent to

a dividend under sec. 302(b) (1). There was no complete

termination of the trust’s interest in MDI under sec.

302(b) (3). Thus, under sec. 302(d), the distribution is

governed by sec. 301.

A-1

2. The agreement filed by the trust under sec. 302(c)-

(2) (A) (iii) was ineffective to waive the trust-beneficiary

attribution rules of sec. 318(a) (3). The trust may not

treat the redemption of stock as a complete termination

of a shareholder’s interest under sec. 302 (b) (3).

3. Family hostility does not nullify the attribution rules

of sec. 267. MDI may not deduct accrued interest ex-

penses paid over 2% months after the close of its fiscal

years.

Herbert S. Kendrick and Don C. Stephenson, for the

petitioners.

Thomas G. Potts, for the respondent.

OPINION

Dawson, Judge: In these consolidated cases respondent

determined the following deficiencies in the Federal income

taxes of petitioners:

Petitioner Docket No. Year Amount

David Metzger Trust 8824-77 1973 $292,977.47

Metzger Dairies, Inc. 8856-77 1973 2,106.86

1974 24,856.38

Metzger Dairies, Inc. 6990-79 1975 6,684.68

Because of concessions, the remaining issues for decision

are:

(1) Whether family hostility among the shareholders of

Metzger Dairies, Inc., who are also beneficiaries of the David

Metzger Trust, nullifies the attribution rules of section 318'

so that a redemption by the corporation of stock owned by

the trust qualifies as an exchange under section 302 (b) (1)

or 302(b) (3).

1AIl section references are to the Internal Revenue Code of 1954

as amended and in effect in the years at issue unless otherwise

indicated.

A-2

(2) Whether a waiver agreement filed by the trust pur-

suant to section 302(c) (2) (A) (iii) was effective to waive

the trust-beneficiary attribution rules of section 318 (a) (3)

so that the trust may treat a redemption of stock as a com-

plete termination of a shareholder’s interest under section

302 (b) (3).

(3) Whether Metzger Dairies, Inc., may, notwithstanding

section 267(a) (2), deduct accrued interest expenses owed

to a cash method taxpayer but which were not actually

paid until more than 2% months after the close of its fiscal

year where hostility existed between the payee and her

brother, who owned more than 50 percent of the corpora-

tion’s stock.

These cases were submitted fully stipulated pursuant to

Rule 122, Tax Court Rules of Practice and Procedure. The

stipulations of fact and attached exhibits are incorporated

herein by this reference. The pertinent facts are set forth

below.

Jacob Metzger, Trustee of the David Metzger Trust (some

times hereinafter referred to as the Trust) was a legal resi-

dent of Van Zandt County, Tex., when the Trust filed its

petition herein. Metzger Dairies, Inc. (MDI), had its prin-

cipal office in Dallas, Tex., at the time it filed its petition

herein.

David Metzger formed MDI in 1946 to operate a dairy

business in Dallas, Tex. He had earlier created the David

Metzger Trust for his family, with his wife, Nora, as life

income beneficiary, and his three children, Jacob Metzger,

Catherine Staacke, and Cecelia Jane Frew, each as one-

third remaindermen. This trust later became a shareholder

of the corporation. After the death of .David Metzger in

1953, Jacob assumed managerial control over MDI, install-

ing himself as chairman of the board, and his son, David

Metzger II (David II), as president, while Jacob’s sisters,

Catherine and Cecelia, were directors of the corporation.

During the early years of Jacob’s term as chief executive

A-3

officer, the corporation experienced financial success and was

able to distribute dividends to its shareholders: Jacob,

Catherine, and Cecelia, trusts established for each of them,

Nora, and the David Metzger Trust.

During the 1960’s, however, corporate earnings declined

and dividends were not distributed. When this happened,

Catherine and Cecelia became angry and on numerous occa-

sions accused Jacob and his son, David II, of incompetent

management; raising their already high salaries at a time

when the corporation was unprofitable; spending too much

time golfing, hunting, and fishing; and causing MDI to sus-

tain substantial losses by its acquisition of another corpora-

tion solely to prevent a default by the latter on a promissory

note owed to a Dallas bank of which Jacob was a director.

Although Catherine and Cecelia were on the board of direc-

tors, they did not attempt to use their directorial voting

power to change the management policy or to force a dis-

tribution of dividends because (1) Jacob as trustee of the

David Metzger Trust voted and conirolled its stock holdings

in MDI, (2) they believed Jacob controlled the shares

owned by their mother, Nora, by virtue of his ability to

influence her decisions regarding the family business, (3)

they were kept uninformed by Jacob regarding the business

and thus lacked sufficient knowledge to suggest or demand

corrective measures, and (4) Jacob threatened to use legal

ploys to disinherit them from their father’s trust shouid

they attempt to overrule his managerial decisions and poli-

cies. As a result, Catherine and Cecelia found the meetings

of the board of directors to be extremely unpleasant and

distasteful.

Catherine also deeply resented Jacob because of his poor

treatment of her son, Fred Staacke, Jr. (Fred Jr.). During

the relevant years, Fred Jr. was president of Metzger Dairy

of San Antonio, Inc. (MSA). This corporation was engaged

in the dairy business in San Antonio, Tex., and its stock

was owned, but for minor variations, by the same parties

and in the same percentages as MDI. Although Fred Jr.

was nominally president, his uncle Jacob perceived himself

A-4

to be the ultimate authority of MSA and proceeded to be-

little Fred Jr.’s management, reverse his business decisions,

make unannounced inspections, and complain about the

company’s profitability while refusing to assist in soliciting

new customers. Catherine believed Jacob’s persistent harass-

ment and humiliation of her son drove Fred Jr. into

alcoholism.

Cecelia held an animosity toward Jacob and Catherine

because she resented the fact that, although MDI and MSA

discontinued paying dividends, Jacob’s family (through the

employment by MDI of Jacob and David II) and Cather-

ine’s family (through the employment by MSA of Fred Jr.)

continued to profit from the family businesses. On several

occasions, Cecelia suggested that either MDI, Jacob, or

Catherine buy her stock, but they refused on the grounds

that a fair market value for the shares could not be deter-

mined. Sometime thereafter, Stop & Go Food Stores, Inc.,

an unrelated corporation, offered to purchase the stock of

MDI, and Cecelia strongly urged that the offer be accepted.

When the offer was rejected (or withdrawn for lack of accep-

tance), the enmity between Cecelia, on one side, and Jacob

and Catherine, on the other side, was greatly aggravated.

Cecelia became infuriated when she discovered that she had

been purposely excluded from a meeting between them to

make a determination as to their continued and future own-

ership of MDI and MSA. This was not the only occasion

that pitted Cecelia against Jacob and Catherine. When the

family was deciding to form the Mr. M Corp. of San Antonio,

Inc. (Mr. M Corp.), to engage in the ownership and opera-

tion of retail convenience stores in San Antonio, Tex.,

Cecelia suggested it be formed as a wholly owned subsidiary

of MDI. Instead, Jacob and his son, David II, and Catherine

and her son, Fred Jr., decided the stock should be sub-

scribed for and purchased individually. Because Cecelia was

not employed by either of the existing corporations and

received no dividends from them, she was financially unable

to invest in the new business. Thus, when Jacob, David II,

Catherine, and Fred Jr. thereafter profited from the success

A-5

of Mr. M Corp., Cecelia felt she had been betrayed by her

brother and sister.

In addition to matters relating to the business of the three

corporations, Jacob, Catherine, and Cecelia fought over other

issues. Heated disputes constantly arose among them over

whose family could use the family farm, a large estate

containing a lake, recreational area, and multiple residences,

which they owned in undivided interests along with their

mother. In other instances Cecelia and Catherine, each

being one-third remaindermen of the David Metzger Trust,

accused their brother Jacob, the sole trustee, of mismanag-

ing the trust corpus by investing it in securities which pro-

duced only minimal income. When they demanded the trust

be turned over to a professional investment adviser, Jacob

refused to relinquish his position.

Jacob had felt considerable resentment toward his two

sisters since the occasion when their mother, Nora, decided

to make gifts to her grandchildren of her principal estate.

Jacob, having only two children, believed that Nora’s estate

should be divided into thirds and then distributed per stirpes

to Catherine, Cecelia, and himself. Catherine, having three

children, and Cecelia, having four, convinced their mother

to distribute her estate per capita to the grandchildren.

In another incident, Cecelia, who lived in Oklahoma City,

Okla., accused Jacob of failing in his responsibility of caring

for their mother when she became of frail health. The feud-

ing over this matter resulted in Catherine’s moving their

mother to a Houston, Tex., nursing home.

The rancor among Jacob, Catherine, and Cecelia struck a

nadir in 1972 when Jacob accused Catherine and Fred Jr.

of obtaining voting control of Mr. M Corp. by sharp and

perfidious practices. Such passing of control occurred when

Laura Metzger, upon her divorce from David II, received a

portion of Mr. M Corp. stock owned by David II. David II

believed that his former wife would quickly exhaust her

cash resources and need more money, at which time he

planned to reacquire the stock for a fraction of the value

A-6

at which he conveyed it to her. However, when Fred Jr.

learned that Laura owned the stock, he schemed to acquire

it first. Fred Jr. arranged for a business associate to procure

the stock from Laura and to hold it for, and on behalf of,

Fred Jr. as a nominee. The associate soon purchased Laura’s

stock with funds loaned te him by Fred Jr., who had bor-

rowed the money from his mother, Catherine.

When Jacob and David II discovered the stock acquisi-

tion, they were incensed, believing they had been betrayed.

Jacob immediately contacted Cecelia and Catherine and

together they concluded that the business of MDI, MSA,

and Mr. M Corp. could no longer be operated in the familial

manner in which it had been in the past. After lengthy

negotiations, they agreed that Jacob and his family would

own MDI, Catherine and her family would own MSA and

Mr. M Corp., and Cecelia and her family would receive cash

compensation for their interests in such corporations. To

accomplish this, they planned to cause MDI to redeem all

its stock owned by Cecelia, Catherine, and the David Metz-

ger Trust. The trust was included in the redemption be-

cause under the terms of the trust instrument, the stock it

held in MDI would, upon the death of the life income bene-

ficiary, Nora, pass in equal shares to the remaindermen who

were attempting to separate their future business and

familial relations. Pursuant to the plan, MSA and Mr. M

Corp. redeemed their stock from all shareholders other than

Catherine and her family.

The price at which each stock issue was redeemed was

based on the price previously offered by Stop & Go Food

Stores, Inc. Although Cecelia argued it was less than fair

market value, she finally accepted such price “in order to

get free of Jacob Metzger.” Just when the redemption nego-

tiations were about to be concluded, Jacob announced he

would not sign the agreement unless Catherine and her

children and Cecelia and her children all agreed to sell him

their interests in the family farm at approximately one

quarter of the then fair market value. This last minute de-

A-7

mand initiated bitter feuding, but in the end, the affected

parties acquiesced in order to sever all ties of whatever na-

ture with and among one another.

The trust and respondent have stipulated that (1) the

principal and primary reason underlying the redemption of

stock by MDI was the hatred and discord existing among

Jacob, Catherine, and Cecelia, (2) the redemption was not

principally or primarily motivated to realize a profit on their

stock or to receive undistributed earnings from prior years,

and (3) both before and after the redemption, Jacob, Cath-

erine, and Cecelia would not have acted in concert or for

the benefit of one another in connection with the redemp-

tion of the stock of MDI, the business policies and opera-

tions of MDI, or otherwise. On the date of the redemption,

MDI had no current earnings and profits, but had accumu-

lated earnings and profits of $1,815,060.77, of which 23.90889

percent was allocable to the distribution to the David Metz-

ger Trust.

On or about January 22, 1973, the agreed-upon redemp-

tions took place. As of January 1, 1973, MDI had outstand-

ing 3,000 shares of common stock which were owned as

follows:

Number of

Shareholder shares

David Metzger Trust Bs . 420

Nora Metzger ered a ae 420

Jacob Metzger a, , 600

Trust for Jacob Metzger ee 120

Catherine Staacke i 600

Trust for Catherine Staacke a : 120

Cecelia Jane Frew i. 600

Trust for Cecelia Jane Frew : 120

Total , 2 .... 8,000

Subsequent to the redemption, the remaining shares of

stock then outstanding were owned as follows:

A-8

Number of

Shareholder shares

Jacob Metzger . ans : 600

Trust for Jacob Metzger a 120

Trust for David Metzger II

(son of Jacob Metzger) Lise ins

Trust for Nan Metzger

(daughter of Jacob Metzger) ...................... 207

On February 10, 1976, Jacob, as trustee of the David

Metzger Trust, delivered to an authorized agent of the

Internal Revenue Service an agreement referred to in section

302 (c) (2) (A) (iii) and section 1.302-4, Income Tax Regs.

Subsequent to the redemption of all of its 420 shares, the

trust has not acquired any MDI stock nor has it held any

interest in the corporation as officer, director, or employee.

In partial payment for the 600 shares redeemed from

Cecelia, MDI executed a promissory note to her in the

amount of $627,110.53, payable in three equal annual install-

ments, plus interest, beginning January 22, 1974. In accord-

ance with its accrual method of accounting, the corporation

claimed deductions for accrued interest expense with respect

to the above-described promissory note in the amount of

$32,167.28, $31,533.07, and $13,926.46 for its fiscal years

ended September 30, 1973, September 30, 1974, and Sep-

tember 30, 1975, respectively. These interest expenses were

not paid to Cecelia within 24% months after the close of

MDI’s fiscal years. Rather, the amounts were paid on

January 21, 1974, January 7, 1975, and January 5, 1976,

respectively. Cecelia reported income in accordance with

the cash receipts and disbursements method of accounting

for the calendar years 1974, 1975, and 1976. Accordingly, the

accrued interest expense in the amount of $32,167.28,

claimed as a deduction by MDI for its fiscal year ended

September 30, 1973, was included in income by her for the

calendar year 1974. Similarly, the accrued interest expense

in the amount of $31,533.07, claimed as a deduction by MDI

A-9

for its fiscal year ended September 30, 1974, was included

in income by her for the calendar year 1975. The accrued

interest expense in the amount of $13,926.46, claimed as a

deduction by MDI for its fiscal year ended September 30,

1975, was included in income by her for the calendar year

1976.

Issue 1

The first issue presented is whether the trust is entitled

to exchange treatment, under section 302, on a stock redemp-

tion caused by family hostility among the individual share-

holders of the redeeming corporation, who were also bene-

ficiaries of the trust. As a general rule, distribution of

property by a corporation to its shareholders is treated,

pursuant to sections 301 and 316,’ as a dividend out of

earnings and profits to the extent of such earnings. One

exception to this general rule is made for certain distri-

butions in redemption of a corporation’s stock. Section

302(a) treats such distributions as “payment in exchange

for the stock,” taxable as capital gain, if the require-

ments of one of the four paragraphs of section 302(b)

are met. The paragraphs relevant to this case are (1) and

(3). Section 302(b) (1) makes section 302(a) applicable

if the redemption is not essentially equivalent to a divi-

dend. Section 302(b) (3) makes section 302(a) applicable

if there has been a complete redemption of all of that cor-

poration’s stock owned by the shareholder. Section 302 (d)

*Under sec. 301, that portion of a distribution which is considered

a dividend under sec. 316 is ordinary income; that portion which is

not a dividend is treated as return of capital to the extent of the

shareholder’s basis in the stock; and any excess over basis is treated

as gain from the sale or exchange of property.

On Jan. 22, 1973, MDI distributed $585,303.25 to the David

Metzger Trust in redemption of 420 shares of MDI. On that date,

MDI had no current earnings and profits under sec. 31€, but it did

have $1,815,060.77 of accumulated earnings and profits. The parties

have stipulated that if the redemption were deemed, pursuant to

sec. 302(d), to be a distribution to which sec. 301 applied, then

$433,960.88 should be treated as dividend under sec. 301(c)(1), and

$151,342.37 should be applied to reduce the basis of the stock held

by the trust ($231,000) under sec. 301(c) (2).

A-10

provides that if a corporation redeems its stock and if

section 302(a) does not apply, such redemption shall be

treated as a distribution of property to which section 301

applies.

Section 302(c) (1) provides that, except as provided in

paragraph (2), the attribution rules of section 318 shall be

applied in determining the ownership of stock for purposes

of applying the rules of section 302. Section 318 (a) (1)-

(A) (ii) provides, in part, that an individual shall be con-

sidered as owning the stock owned by his children. Section

318 (a) (2) (B) (i) provides that beneficiaries of a trust shall

be considered as owning the stock owned by the trust in

proportion to their actuarial interest. Section 318 (a) (3)-

(B) (i) provides that a trust shall be considered to own

the stock owned by its beneficiaries who have more than a

remote contingent interest. However, under section

302(c) (2), the attribution rules of section 318 are not

applicable where there is a complete termination of a

shareholder’s interest under section 302(b) (3), if certain

conditions are satisfied, including the requirement that the

distributee file an agreement to notify the Internal Revenue

Service of any future acquisition of stock in the redeeming

corporation. Sec. 302 (a) (2) (A) (ili).

Respondent contends that the redemption was essentially

equivalent to a dividend, and thus is taxable as a dividend

under sections 302(d) and 301 because the trust, after

application of the attribution rules, maintained a 100-percent

ownership interest both before and after the redemption.

Before the redemption, the trust owned 3,000 shares, or

100 percent of the stock of MDI. It owned directly 420

shares. In addition, it constructively owned, by reason of

the attribution rule of section 318(a) (B) (i), the shares

owned by its beneficiaries: Nora, 420 shares; Jacob, 600

shares; Catherine, 600 shares; and Cecelia, 600 shares.’

’'There have been no claims made that any beneficiary’s interest in

the David Metzger Trust is a remote contingent interest under

sec. 318(a) (3) (B) (i).

A-11

Moreover, the trust also constructively owned 360 shares

of stock which were held in separate trusts for Jacob,

Catherine, and Cecelia. Section 318 (a) (2) (B) (i) attributes

the 120 shares in the Jacob Metzger Trust to Jacob, in-

dividually, the 120 shares in the Catherine Staacke Trust

to Catherine, individually, and the 120 shares in the

Cecelia Jane Frew Trust to Cecelia, individually; section

318 (a) (3) (B) (i) then reattributes this stock constructively

owned by the beneficiaries of the David Metzger Trust to

the trust, itself.

At the redemption, the stock owned by the David Metz-

ger Trust (420 shares), Nora (420 shares), Catherine (600

shares), the Catherine Staacke Trust (120 shares), Cecelia

(600 shares), and the Cecelia Jane Frew Trust (120 shares)

was fully redeemed. No stock owned by Jacob or the Jacob

Metzger Trust was redeemed.

After the redemption, there were 1,221 outstanding shares

of MDI. Respondent argues that all the shares were attribu-

table to the David Metzger Trust. The 600 shares owned

by Jacob are attributed to the Trust by section 318 (a) (3)-

(B) (i). The 120 shares in the Jacob Metzger Trust are

attributed to Jacob by section 318 (a) (2) (B) (i), and then

from Jacob to the David Metzger Trust by section 318(a)-

(3) (B) (i). In like manner, the 501 shares held in trust

for Jacob’s children, David II and Nan, are attributed to

them by section 318(a) (2) (B) (i), and then from them to

Jacob by section 318(a) (1) (A) (ii), and then from Jacob

to the trust by section 318 (a) (3) (B) (i). Thus, respondent

contends that the David Metzger Trust also constructively

owned 100 percent of the outstanding stock after the

redemption.

The trust contends that the redemption was not essen-

tially equivalent to a dividend, and thus qualifies as a dis-

tribution in exchange for the stock pursuant to sections

302(a) and 302(b) (1). This is so, the trust argues, because

(1) the redemption was caused by extreme discord among

the individual shareholders of MDI, (2) the stockholders

A-12

had no motive to realize a profit on their stock or to receive

accumulated earnings and profits at capital gains rates, and

(3) the hostility among the relevant parties was so severe

that they would not have acted in concert or for the benefit

of each other in connection with the redemption, or with

regard to the business policies and operations of MDI.

Respondent also contends that the redemption failed to

qualify as a complete redemption under section 302(b) (3)

because ownership of the stock of the corporation individu-

ally owned by Jacob after the redemption should be attrib-

uted to the trust under section 318(a) (3). The trust has

a two-pronged rebuttal to this. First, it contends that the

stock should not be attributed to it because the redemption

was occasioned by familial discord. Second, it argues that

the exception to the attribution rules provided for in section

302(c) (2) applies to them because the trust complied with

the requirements of section 318(c) (2) (A) (i) and (ii),

and filed the waiver agreement specified in section

318 (c) (2) (A) (iii).

We are once again confronted with the difficult question

of whether a distribution, coupled with a redemption, of

stock is “essentially equivalent to a dividend.’* This is

ordinarily a question of fact. United States v. Fewell, 255

F.2d 496 (5th Cir. 1958); Wright v. United States, 482 F.2d

600 (8th Cir. 1973) ; sec. 1.302-2(b), Income Tax Regs. The

leading case interpreting section 302(b) (1) is United States

v. Davis, 397 U.S. 301 (1970). In the Davis case, Davis,

his wife, son, and daughter each owned 25 percent of a

corporation’s common stock. In an earlier year, Davis pur-

chased an entire issue of preferred stock for $25,000 to

provide the corporation with sufficient capital to qualify

‘This problem has been called “exasperating,” Lewis v. Com-

missioner, 35 T.C. 71, 76 (1960), “vexing,” Bradbury v. Commis-

sioner, 298 F.2d 111, 114 (1st Cir. 1962), “the morass created by

decisions,” Ballenger v. United States, 301 F.2d 192, 196 (4th Cir.

1962), and “nigttmarish,” United States v. Fewell, 255 F.2d 496,

499 (5th Cir. 1958); see also Wilson v. United States, 154 F. Supp.

341, 342-343 (N.D. N.Y. 1957), affd. 257 F.2d 534 (2d Cir. 1958).

A-13

it for a loan. Upon retirement of the loan, the corporation

redeemed Davis’ preferred stock for exactly his original

investment, $25,000. Mr. Davis maintained the position that

the attribution rules did not apply to a 302(b) (1) redemp-

tion, thus, the distribution was not pro rata on an actual

ownership basis and hence not essentially equivalent to a

dividend. He also claimed the redemption was occasioned

by a valid non-tax-avoidance motive and a bona fide business

purpose and thus should not be treated as a dividend.

In rejecting the taxpayer’s arguments, the Supreme Court

held: (1) The constructive ownership rules of section 318

apply to dividend equivalency determinations in section

302(b) (1); (2) redemptions of stock of a sole shareholder,

including a “constructive” sole shareholder, are “always

‘essentially equivalent to a dividend’” under section

302(b) (1); (3) business purpose is irrelevant in determin-

ing dividend equivalency under section 302(b) (1); and (4)

in order to avoid dividend equivalency, the redemption must

result in a “meaningful reduction in the shareholder’s pro-

portionate interest in the corporation.”®

Respondent contends that (1) after application of the

attribution rules, the trust was the sole shareholder of the

corporation both before and after the redemption, (2) the

non-tax-avoidance purpose of separating the business deal-

ings of the feuding stockholders and members of the board

of directors of MDI is irrelevant to the section 302(b) (1)

determination; and (3) the redemption resulted in no mean-

ingful reduction in the trust’s interests in MDI.

The trust argues that if the attribution rules are not

taken into account, it is not a sole shareholder before or

after the redemption, hence the distribution would not be

pro rata on an actual ownership basis, therefore not essen-

tially equivalent to a dividend within the meaning of section

302(b) (1). It relies on Haft Trust v. Commissioner, 510

F.2d 43 (1st Cir. 1975), vacating and remanding 61 T.C.

398 (1973) and 62 T.C. 145 (1974) (supplemental opinion),

‘See generally B. Bittker & J. Eustice, Federal Income Taxation

of Corporations and Shareholders, par. 9.24 (4th ed. 1979).

A-14

for the proposition that the existence of family hostility is

a factor to be considered in the mitigation of the construc-

tive ownership rules of section 318 in determining dividend

equivalence under section 302(b) (1). The Haft Trust case

concerned four trusts established by the maternal grand-

father, one trust for each of the children of Burt and Marcia

Haft. The sole asset of each trust was 25,000 shares of stock

of Haft-Gaines Corp. Before the redemption, there were

500,000 shares of Haft-Gaines Corp. stock outstanding. Burt

Haft owned 100,000 shares directly, 33,33344 shares con-

structively through a trust of which he was a beneficiary,

and 100,000 shares constructively through four trusts set

up for his children (the 25,000 shares of stock of each trust

being attributed to each child, then reattributed from each

child to Burt), for a total of 233,333% shares, or approxi-

mately 47 percent of the outstanding shares. Each trust

owned 25,000 shares directly, and 133,333% shares con-

structively (by attribution from Burt of his directiy and

constructively owned stock to each child, and then from

each child to his or her respective trust), for a total of

158,3334%4 shares or approximately 3134 percent of the

500,000 shares of outstanding stock.

As a result of bitter acrimony between Burt and Marcia

Haft, divorce proceedings were begun. During the course

of the divorce, it was decided to separate the direct financial

interests of Burt’s corporation from the trusts established

by Marcia’s father. Accordingly, the corporation redeemed

all of the shares owned by each of the four trusts.

After the redemption, there were 400,000 shares outstand-

ing. Each trust owned no shares directly, but owned

133,333% shares constructively (again, by attribution of

133,33344 shares, owned directly and constructively by Burt,

to each child, and then from each child to his or her respec-

tive trust), for a total of 133,33314 shares or 33% percent of

the 400,000 shares of outstanding stock. Because of the

attribution rules, each of the four trusts owned more shares

after the redemption of its directly owned shares than

before the redemption.

A-15

The Commissioner determined the proceeds of the re-

demption to be essentially equivalent to a dividend because

there had not been a meaningful reduction of each trust’s

proportionate interest in the corporation according to the

rule of United States v. Davis, 397 U.S. 301 (1970). The

trusts petitioned this Court arguing that attribution should

not be applied when there has been a “family fight” and

hostility exists among the members of the family. In hold-

ing against the taxpayers, we stated:

A careful review of the opinion of the Supreme Court

in Davis convinces us that the petitioners’ argument is

inconsistent with the statements and rationale of that

opinion. Before the enactment of the 1954 Code, the

attribution rules were sometimes applied, and sometimes

not applied; to avoid that uncertainty, section 302

expressly made the attribution rules applicable for pur-

poses of determining whether a distribution in redemp-

tion should be treated as a dividend. H. Rept. No. 1337,

83d Cong., 2d Sess., p. A96 (1954). The Court relied

upon “the plain language of the statute” in concluding

that the attribution rules were applicable. 397 U.S. at

306. The Court was obviously convinced that in enact-

ing the rules of section 302, Congress sought to provide

definite and specific rules and to avoid the uncertainties

which had arisen under the earlier law.* * *

If the applicability of the attribution rules depended

upon the feelings or attitudes among the members of a

family, it would then be necessary to inquire into

whether there was hostility or animosity among them,

whether such discord was serious, and whether it would

actually or likely imps the ability of one member of

the family to influence the conduct of other members.

By the terms of the statute, the attribution rules are

applicable irrespective of the personal relationships

which exist among the members of a family, and an

interpretation of the statute which made their applica-

bility depend upon whether there was discord among

the members of the family — or the extent of any such

A-16

discord — would frustrate the legislative objective and

would be clearly inconsistent with the language and

the rationale of Davis. * * * [61 T.C. at 403].

The trusts appealed our decision to the First Circuit which

analyzed the law differently. Haft Trust v. Commissioner,

supra. The Court of Appeals interpreted our opinion in

Estate of Squier v. Commissioner, 35 T.C. 950 (1961), as

embracing the principle that family discord could belie the

community-of-interest rationale of the attribution rules, and

their earlier opinion in Bradbury v. Commissioner, 298 F.2d

111 (1st Cir. 1962), as approving it:

While these attribution rules are generally applicable

to §302(b) (1), see, Thomas G. Lewis, 35 T.C. 71

(1960), their imposition is not inflexible and if it can

be demonstrated that discord exists in a family relation-

ship which would make attribution unwarranted, they

will not be applied. Compare, Estate of Arthur H.

Squier, 35 T.C. 950 (1961) with Herbert C. Parker,

T.C. Memo. 1961-176 * * * [298 F.2d 111, 116-117 n. 7.]

It construed the Davis opinion as not requiring that the

factual inquiry end after taking into account the attribution

rules. The Court also relied on section 1.302-2 (b), Income

Tax Regs., for the rule that “one of the facts to

be considered” in making the determination of dividend

equivalency is the constructive stock ownership caused by

section 318. It further interpreted the Davis requirement

for dividend nonequivalency of a “meaningful reduction of

the shareholder’s proportionate interest in the corporation”

(397 U.S. at 313; emphasis added), as permitting, if not

mandating, an examination of the facts and circumstances

to determine the effect of the transaction transcending a

mere mechanical application of the attribution rules. 510

F.2d at 48. Finally, the appellate court thought that Con-

gress in retaining the “essentially equivalent to a dividend”

exception of section 302(b) (1) in the Internal Revenue

Code, showed itself willing to tolerate some administrative

and judicial inconvenience brought about by inquiries into

A-17

“the uncertain shifting quagmires of family relationships”

for the sake of taxpayer equity. 510 F.2d at 48. On the

basis of its analysis, the First Circuit reversed our decision

and remanded it for reconsideration of the trusts’ claims

in light of the facts and circumstances of the case, including

the existence of family discord tending to negate the pre-

sumption that taxpayers would exert continuing control over

the corporation despite the redemption.

The attribution rules of section 318 came into the tax law

with the enactment of the Internal Revenue Code of 1954.

Their legislative history provides an illuminating back-

ground for our examination. In the report of the House

Ways and Means Committee to accompany H.R. 8300

(March 9, 1954), the committee stated:

SECTION 311. ATTRIBUTION OF OWNERSHIP

[Now section 318.]

Section 311 articulates the circumstances under which

ownership of stcck by one person shall for the purpose

of the sections to which section 311 is specifically made

applicable be attributed to such other person. The sec-

tions to which section 311 are applicable are the follow-

a.”

no specific statutory guidance is at present provided for

stock ownership in the area of corporate distributions

and adjustments. As a result the administration of

provision such as section 115(g)(1) [now section

302(b) (1)] of existing law has become clouded with

uncertainty by reason of executive application of rules

of attribution of ownership. Your committee intends,

through section 311, to remove these uncertainties by

providing in the bill precise rules for attribution where

this is appropriate."*! * * * [Emphasis added. ]

Regarding what is now section 302(b) (3), the committee

further stated:

*H. Rept. 1337, 83d Cong., 2d Sess. A96 (1954), U.S. Code Cong.

& Adm. News 4234 (1954).

A-18

A distribution in complete redemption of a share-

holder’s stock will also result in capital gain. To prevent

evasion of the complete redemption test a shareholder

is considered as owning stock held by members of his

immediate family, or by partnerships, corporations and

trusts which he controls. At the present time a possible

opportunity for tax avoidance results where redemp-

tions are effected in the case of family-owned corpora-

tions. To prevent tax avoidance, but at the same time

to provide definitive rules for the guidance of tax-

payers, your committee has provided precise standards

whereby under specific circumstances, a shareholder

may be considered as owning stock held by members of

his immediate family (or by partnerships, corporations,

or trusts which he controls). * * * [Emphasis added.]"!

Before the Senate Finance Committee issued its report,

it held hearings on the proposed House bill. The Section on

Taxation of the American Bar Association filed a statement

with the committee in connection with H.R. 8300 which

advised:

[Section 318] assumes a unity of action and of inter-

est within the family which is frequently lacking, at

least where dependency does not exist. It has been sug-

gested, therefore, that the family should be limited to

one’s minor children, spouse and other dependants. It is

the experience of practicing lawyers that one is con-

sulted far more often with respect to family and partner-

ship squabbles over property than on family plans to

avoid income taxes, "*!

The Senate Finance Committee, in its report to accom-

pany H.R. 8300, refused to amend the House bill to accord

with the A.B.A. suggestion, stating:

"H. Rept. 1337, supra at 36, U.S. Code Cong. & Adm. News

4061 (1954).

*Hearings on F1.R. 8300 Before the Senate Comm. on Finance,

83d Cong., 2d Sess. (Part 1), 366 (Apr. 7 and 8, 1954).

A-19

Your committee retained, with modifications noted in

(2) below, the following provisions of the House bill

which revise existing law with respect to corporate dis-

tributions:

* ¥ ba * * * *

(h) Provide rules to indicate specific instances when,

for purposes of preventing tax avoidance, a person shall

be considered to own stock owned by a related person.

(2) CHANGES MADE BY COMMITTEE

* * * * * * *

A distribution in complete redemption of a share-

holder’s stock will also result in capital gain. However,

in order to prevent tax avoidance, your committee fol-

lows the rules of the House bill whereby, under specific

circumstances, a shareholder may be considered as own-

ing stock held by members of his family (or by partner-

ships, corporations, or estates, trusts in which he has

an interest). * * *

The Senate committee further explained:

SECTION 318. CONSTRUCTIVE OWNERSHIP OF

STOCK

This section describes the area in which although in

fact transactions related to stock ownership are in con-

nection with a specific individual, ownership of stock is

deemed to be in the hands of persons other than the

person directly involved. * * *

The area of constructive ownership includes members

of the family, persons having interests in partnerships,

estates, trusts, and corporations, such partnerships, es-

tates, trusts, and corporations and stock held under an

option.

* * e a 8 * *

*S. Rept. 1622, 83d Cong., 2d Sess. (1954), 43-45, U.S. Code Cong.

& Adm. News 4674-4675 (1954).

A-20

In the case of trusts, a similar rule applies, i.e., the

beneficiary or grantor is deemed to own his propor-

tionate interest in the stock owned by the trust or

estate and the trust or estate is deemed to own all of

* * ® [10]

the stock owned by its beneficiaries or grantors.

The American Law Institute Tax Project, which had made

suggestions in February 1954 relating to corporate distribu-

tions for the then-prospective Internal Revenue Code of

1954, wrote a summary of its follow-up work for the period

1956-58 wherein it stated:

The stock redemption rules of Code section 302 refer

to the redemption of all of the stock “owned” by a

shareholder and to distributions disproportionate to the

stock “owned” by shareholders. It has long been recog-

nized that the substance of these sections could be

defeated where the particular shareholder permitted

some of the stock involved to be held by members of

his close family or by corporations, partnerships, or

trusts in which he had an interest. To meet this diffi-

culty, the tax law has devised rules regarding the

attribution of stock ownership. Under these rules stock

so distributed among the family or placed in controlled

entities is collected and reallocated to the basic share-

holder. These rules of attribution rest on certain

assumptions, as, for example, that one member of a

family can control the stock owned by other members

of the family, or rather that whenever the extent of

the stock ownership of one member of the family is in

issue, it is proper to regard that member as holding all

of the shares possessed by the family. Similarly, a

partner or a shareholder can be regarded as owning a

pro rata portion of the stock held by the entity. These

assumptions obviously have a considerable factual basis

in most situations. Further, the burden on tax adminis-

tration and tax planning would be almost intolerable if

10S. Rept. 1622, supra at 252-253, U.S. Code Cong. & Adm. News

4890 (1954).

A-21

these assumptions were treated only as presumptions,

with the final issue depending on the particular factual

situation. [Emphasis added.]"

Finally, the end product of the legislative process, the

statute itself makes the application of the attribution rules

mandatory:

SEC. 318 (a). GeNgRAL Rute. —For purposes of those

provisions of this subchapter to which the rules con-

tained in this section are expressly made applicable—

(1) MEMBERS OF FAMILY. —

(A) IN GENERAL. —An individual shall be con-

sidered as owning the stock owned, directly or in-

directly, by or for—

(i) his spouse (other than a spouse who is

legally separated from the individual under a de-

cree of divorce or separate maintenance), and

(ii) his children, grandchildren, and parents.

* * * * e * ©

(2) ATTRIBUTION FROM PARTNERSHIPS, ESTATES,

TRUSTS, AND CORPORATIONS.

* e es 2 a e e

118. Surrey, “Income Tax Problems of Corporations and Share-

holders: American Law Institute Tax Project— American Bar

Association Committee Study on Legislative Revision,” 14 Tax L.

Rev. 1, 50-51 (1958). See also F. Ringel, S. Surrey & W. Warren,

“Attribution of Stock Ownership in the Internal Revenue Code,” 72

Harv. L. Rev. 209-210 (1958):

“These rules of constructive ownership rest on vertain assumptions

which are readily supported in the everyday conduct of affairs * * *

Tax administration would be severely handicapped if the rules

applied only as presumptions; tax planning, moreover, would be

hazardous if it depended on an analysis of the actual relationship in

each case. Therefore these assumptions have evolved as statutory

rules, [Emphasis added. ]”

A-22

(B) From TRUSTS. —

(i) Stock owned, directly or indirectly, by and

for a trust * * * shall be considered as owned by

its beneficiaries in proportion to the actuarial

interest of such beneficiaries in such trust.

* * * * * ” am

(3) ATTRIBUTION TO PARTNERSHIP, ESTATES, TRUSTS,

AND CORPORATIONS. -——

. ~ a . . * *

(B) To Trusts.—

(i) Stock owned, directly or indirectly, by or

for a beneficiary of a trust * * * shall be con-

sidered as owned by the trust, unless such bene-

ficiary’s interest in the trust is a remote

contingent interest.

[Emphasis added. ]

The language of the statute is clear.’* Courts do not have

the power to repeal or amend the enactments of the legis-

lature even though they may disagree with the result; rather,

it is their function to give the natural and plain meaning to

the statutes as passed by Congress. National Life & Accident

Insurance Co. v United States, 524 F.2d 559, 560 (6th Cir.

1975) ; International Trading Co. v. Commissioner, 484 F.2d

707, 713 (7th Cir. 1973); Busse v. Commissioner, 479 F.2d

1147, 1152 (7th Cir. 1973). Some commentators have sug-

gested that it would be better to ignore the attributions rules

where family discord is present.’* But courts should not

1220ther cases have consistently applied the attribution rules of

sec. 318. Title Ins. & Trust Co. v. United States, 484 F.2d 462 (9th

Cir. 1973), affg. 326 F. Supp. 617 (C.D. Cal. 1971); Fehrs Finance

Co. v. Commissioner, 487 F.2d 184 (8th Cir. 1973), affd. 58 T.C. 174

(1972); Grabowski Trust v. Commissioner, 58 T.C. 650 (1972);

Estate of Runnels v. Commissioner, 54 T.C. 762 (1970).

188, Bittker, “The Taxation of Stock Redemptions and Partial

Liquidations,” 44 Cornell L. Q. 299, 324 (1959); T. Moore, “Divi-

dend Equivalency-Taxation of Distributions in Redemption of

A-23

aiiempt to rewrite statutes because they feel that the

scheme Congress created could be improved upon. United

States v. Calamaro, 354 U.S. 351, 357 (1957).

It is not the function of a Court to rewrite or amend a

statute in the guise of construing it. It is the Court’s duty

to construe and apply the statute as it is written; and if

this results in inequity to certain taxpayers, the fault lies

in the statute itself and is beyond the power of the Court

to correct. Farmers Tractor & Equipment Co. v. United

States, 224 F. Supp. 391 (E.D. Ark. 1963), appeal dismissed

326 F.2d 971 (8th Cir. 1964). Congress might have added a

greater family-fight exception to the attribution rules than

it did when it eliminated, under section 318 (a) (1) (A) (i),

attribution from a spouse who is legally separated from the

individual under a decree of divorce or separate mainten-

ance, but it did not. Our judicial function is limited to

applying statutes on the basis of what Congress has written,

not what Congress might have written. Youakim v. Miler,

562 F.2d 483, 487 (7th Cir. 1977).

Although section 318 assumes, as the A.B.A. Section on

Taxation pointed out to the Senate Finance Committee,

a “unity of action and of interest within the family which

is frequently lacking,” a Court should not make an exception

to a statutory rule on the basis of that Court’s determina-

tion that Congress established the rule on the basis of a

faulty set of assumptions. Jn re Continental Investment

Corp., 586 F.2d 241 (1st Cir. 1978).

The legislative history (supra p. 56) clearly shows the

intention of Congress to provide “definitive rules for the

guidance of taxpayers, [and] * * * precise standards

Stock,” 19 Tax L. Rev. 249, 254-255 (1964); J. Boyd & M. Boyd,

“Family discord may negate attribution rules and allow capital gain

treatment of a redemption,” 15 Taxation for Accountants 362 (1975);

Note, “Family Hostility as a Factor in Determining Constructive

Stock Ownership in Corporate Redemptions,” 29 Tax Law. 386

(1976); Note, “Stock Redemptions From Close Family Corporations

Under Section 302,” 47 Minn. L. Rev. 853 (1963); A. Cohen,

“Receipts Related to Corporate Equity: Return on Investment or

Exchange?” 53 Taxes 824 (1975).

A-24

whereby under certain circumstances a shareholder may be

considered as owning stock held by members of his immed-

iate family (or by * * * trusts which he controls) .” Congress

sought to remedy the then-existing law which had “become

clouded with uncertainty by reason of executive application

of rules of attribution of ownership, * * * by providing in

the bill precise rules for attribution where this is appro-

priate.” (Emphasis added.) Only the most compelling

demonstration of a contrary legislative intent could persuade

this Court to ignore the plain words of the statute. United

States v. Le Beouf Bros. Towing Co., 537 F.2d 149, 152

(5th Cir. 1976). The legislative history of the attribution

rules can hardly be called contrary to the plain words of

section 318.

This does not mean that evidence of family discord is

irrelevant to the question of dividend equivalency under

section 302(b) (1). It does have a role, albeit limited. In the

Davis case the Supreme Court analyzed Mr. Davis’s stock-

holdings to determine if there had been a “meaningful reduc-

tion” of his proportionate interest in the corporation “after

application of the attribution rules.” United States v. Davis,

397 U.S. 301, 313. (Emphasis added.) Thus, the Court sets

forth the order of analysis. First, the attribution rules are

plainly and straightforwardly applied. Second, one looks

to see if there has been a reduction in the stockholder’s

proportionate interest in the corporation. If not, as in the

situation of Mr. Davis (who owned only 25 percent directly,

owning the other 75 percent constructively through attribu-

tion from his wife, son, and daughter), then a Court need

not proceed any further because there being no change in

the stockholder’s interest, dividend equivalency must

follow.** If there has been a reduction, then a Court should

proceed to examine all the facts and circumstances to see if

144As the Supreme Court stated:

“After application of the stock ownership attribution rules, this

case viewed most simply involves a sole shareholder who causes part

of his shares to be redeemed by the corporation. We conclude that

such a redemption is always ‘essentially equivalent to a dividend’

within the meaning of that phrase in § 302(b)(1) * * * [United

States v. Davis, 397 U.S. 301, 307 (1970). Emphasis added.]”

A-25

the reduction was meaningful for the purposes of section

302. At this point, family hostility becomes an appropriate

factor for consideration.

Two arguments have been used to raise the family

hostility factor prematurely in the process of determining

dividend equivalency. The first involves a Treasury regu-

lation; the second concerns the issue of corporate control.

Section 1.302-2(b), Income Tax Regs., states:

The question whether a distribution in redemption of

stock of a shareholder is not essentially equivalent to

a dividend under section 302(b) (1) depends upon the

facts and circumstances of each case. One of the facts

to be considered in making this determination is the

constructive stock ownership of such shareholder under

section 318 (a).

The regulation has been misinterpreted as meaning construc-

tively owned stock could be disregarded under certain cir-

cumstances, such as family discord, in determining whether

a meaningful reduction in the stockholder’s proportionate

interest in the corporation has resulted from the redemption.

The calculation under this thesis must therefore relate only

to the change in actual stock ownership. To treat construc-

tively owned stock different from actually owned stock for

section 302(b) (1) purposes would be the same as ignoring

the attribution rules in the first place. This is clearly con-

trary to the plain meaning of the statute and its legislative

history.

Some cases** and commentators’* suggest that where

family hostility exists, the concept of “interest” in a corpora-

tion can be broken down into two components, ownership

1*Estate of Squier v. Commissioner, 35 T.C. 950 (1961); Parker

v. Commissioner, T.C. Memo. 1961-176.

1*J. Boyd & M. Boyd, “Family discord may negate attribution

rules and allow capital gain treatment of a redemption,” 15 Taxation

for Accountants 362 (1975); Note, “Family Hostility as a Factor in

Determining Constructive Stock Ownership in Corporation Redemp-

tions,” 29 Tax Law. 386 (1976).

A-26

and control, for purposes of applying or not applying the

attribution rules in determining dividend equivalency. Under

such a theory a stockholder, who before the redemption

owned 100 percent of a corporation, actually, and who after

the redemption owned no stock, actually, but 100 percent,

constructively, could be deemed to have no control over the

corporation where the remaining shareholders were unfriend-

ly section 318 relatives or entities. Because his “control” of

the corporation went from 100 percent to nothing, the snare-

holder, according to the theory, had a meaningful reduction

in his “interest” in the corporation. This, in effect, ignores

the constructively owned stock for the purposes of deter-

mining dividend equivalency contrary to the statute, the

regulations, the legislative history, and the rule of Davis.

Niedermeyer v. Commissioner, 62 T.C. 280, 285-86 (1974),

affd. 535 F.2d 500 (9th Cir. 1976), cert. denied 429 U.S. 1000

(1976). Although the degree of control of a corporation is a

factor to be considered in testing dividend equivalency

(Benjamin v. Commissioner, 66 T.C. 1084 (1976), affd. 592

F.2d 1259 (5th Cir. 1979)), the final determination must

take into account constructively owned stock as well as

actually owned stock. Such a position is consistent with the

effect of attribution in situations where there is no family

discord and where the taxpayer, after the redemption, owned

no stock, actually, but 100 percent, constructively. In such

cases, courts have held the distribution to he essentially

equivalent to a dividend. Lewis v. Commissioner, 35 T.C. 71

(1960) ; Levin v. Commissioner, 385 F.2d 521 (2d Cir. 1967),

affg. 47 T.C. 258 (1966) .?”

Family discord can be a relevant fact to be considered in

determining whether the reduction in the shareholder’s inter-

est is meaningful so as to qualify the distribution as not

essentially equivalent to a dividend under section 302 (b) (1).

The Commissioner’s revenue rulings pertaining to that sec-

tion provide a convenient vehicle for illustrating the proper

"See also Title Insurance & Trust Co. v. United States, 484 F.2d

462 (9th Cir. 1973).

A-27

role of such a fact. In Rev. Rul. 75-502, 1975-2 C.B. 111, the

Commissioner determined that a redemption of an estate’s

250 shares of common stock by a corporation, whose remain-

ing 1,500 shares were equally divided between the estate’s

sole beneficiary and an unrelated individual, constituted a

meaningful reduction of the estate’s interest and was not

essentially equivalent to a dividend under section 302 (b) (1).

The Commissioner explained that it was significant that the

redemption reduced the estate’s voting rights in the redeem-

ing corporation from 57 percent to 50 percent, and also

reduced the estate’s rights to share in net assets on liquida-

tion. Furthermore, the reduction of the estate’s voting rights

from 57 percent to 50 percent produced a situation in which

the other 50 percent of the voting rights were held by a single

unrelated shareholder. Had the stock been owned by a

brother and sister of the beneficiary, who were not them-

selves beneficiaries of the estate, and whose stockholdings

could not be attributed to the estate or to the beneficiary, the

Internal Revenue Service could have argued that the siblings

would act in concert, one for the benefit of the other. Thus,

the fact that the estate’s drop of 7 percent from majority

interest to an equal interest might not be meaningful. Here,

family discord would tend to show the “hostile relative”

should be treated as an unrelated shareholder.

In Rev. Rul. 76-364, 1976-2 C.B. 91, the Commissioner

determined that a redemption by a corporation of its out-

standing common stock, which resulted in a 4.73-percent

reduction of ownership of stock of a taxpayer who previously

owned 27 percent of the stock, with the remaining 73 percent

being held in equal portions (of 24% percent each) by three

unrelated persons, was a meaningful reduction of the tax-

payer’s interest in the corporation and was not essentially

equivalent to a dividend. It was explained that the redemp-

tion not only reduced the taxpayer’s interest from 27 percent

to 22.27 percent (with a corresponding reduction in rights

to vote, to earnings, and to share in net assets on liquida-

tion), but also was meaningful in itself because it caused

the redeemed shareholder to go from a position that afforded

A-28

hizu control of the corporation if he acted in concert with

only one other stockholder, to a position where such action

was not possible. If all four stockholders had been brothers

and sisters, whose stock was not attributed one to another

by section 318, the Internal Revenue Service could challenge

the redemption on the grounds that the siblings acted in

concert, one for the other, thus, although the taxpayer

dropped from 27-percent ownership to 22.27 percent, there

was no real change. Here, again, family hostility would tend

to show that the redeemed shareholder once could have

gained control of the corporation by acting in concert with

only one sibling, but now was in a position where that was

not possible.

In Fehrs Finance Co. v. Commissioner, 58 T.C. 174, 185

(1972), affd. 487 F.2d 184 (8th Cir. 1973), cert. denied 416

U.S. 938 (1974), we stated that, in dicta, there might be

unusual circumstances where a 10-percent reduction in stock

ownership, after attribution, would be material in determin-

ing whether there had been a meaningful reduction of the

shareholder’s proportionate interest. Here, again, family hos-

tility would be a factor to be weighed in the facts and cir-

cumstances.**

We realize that the application of the law can produce

harsh results in certain circumstances. Mr. Davis bought

$25,000 of preferred stock so his corporation could qualify for

a loan. After the loan was repaid, he sold the preferred stock

back to the corporation at its original purchase price. Mr.

Davis argued he had a capital gain of zero. Instead, the

Supreme Court held he received $25,000 of ordinary income.

While we can sympathize with the plight of such taxpayers,

as Justice Douglas did in his dissent (United States v. Davis,

397 U.S. 301, 314), we observe the Supreme Court has been

unwilling to reconsider the harsh effects of the Davis decision

18For a discussion of other facts and circumstances, see R.

Swennes, “ ‘Not essentially equivalent to a dividend’ exception still

viable despite Davis,” 41 J. Tax. 78 (1974). See also A. Cathcart,

“Section 302 Redemptions: Family Fights and Attribution,” 61

A.B.A.J. 1272 (1975).

A-29

(Albers v. Commissioner, 414 U.S. 982 (1973) (denying cer-

tiorari) ), thus, we must follow the law.*®

Accordingly, we conclude here that the redemption did

not result in a meaningful reduction in the trust’s propor-

tionate interest in MDI for the purposes of section

301(b) (1). The trust’s section 318(b) (3) argument rested

on not applying section 318 to attribute the stock owned by

Jacob to the trust after the redemption because of hostility

among Jacob, Catherine, and Cecelia. Because family discord

does not nullify the attribution rules, we hold that, except

for the applicability of section 302 (c) (2), the trust did not

completely terminate its interest in MDI for the purposes of

section 302 (b) (3).

Issue 2

Next, we must decide whether the statutory exception to

the attribution rules applies in this case. Section 302 (b) (3)

provides that a complete redemption of all the stock of the

corporation owned by the shareholder will be treated as an

exchange entitled to capital gains tax rates. Section

302 (c) (2) provides:

(A) In the case of a distribution described in sub-

section (b) (3), section 318(a) (1) shall not apply if —

(i) immediately after the distribution the distrib-

utee has no interest in the corporation (including an

interest as officer, director, or employee), other than

an interest as a creditor,

(ii) the distributee does not acquire any such

interest (other than stock acquired by bequest or

°Tennessee Valley Authority v. Hill, 437 U.S. 153, 195 (1978),

the Supreme Court, in another statutory construction case, found

that the following lines ascribed to Sir Thomas More by Robert

Bolt were worthy of reflection.

“The law, Roper, the law. I know what’s legal, not what’s right. And

I'll stick to what’s legal. * * * I’m not God. The currents and eddies

of right and wrong, which you find such plainsailing, I can’t navigate,

I’m no voyager. But in the thickets of the law, oh there I’m a forester

A-30

inheritance) within 10 years from the date of such

distribution, and

(iii) the distributee, at such time and in such

manner as the Secretary by regulations prescribes,

files an agreement to notify the Secretary of any

acquisition described in clause (ii) and to retain such

records as may be necessary for the application of this

paragraph.

Respondent contends that the attribution rules contained

in section 318 (a) (3) apply to attribute to the trust all stock

owned directly and beneficially by Jacob as well as the stock

owned beneficially by Jacob’s children, David II and Nan,

which would be attributed to the trust through Jacob.

Section 302(c) (2), respondent contends, does not apply

because it allows only an exception to the family attribution

rules specified in section 318(a) (1) and not the trust

attribution rules specified in section 318(a) (3). In this

contention, respondent relies on the language of the statute

and our decision in Johnson Trust v. Commissioner, 71 T.C.

941 (1979), wherein we stated;

Therefore, even though [the trust] waives the family

attribution rules of section 318(a) (1) so that stock

owned by [the beneficiary’s] mother is not considered

attributable to [the beneficiary], it has not waived, and

cannot, under section 302(c), waive the provisions of

section 318 (a) (3) (B) (i) attributing to it stock owned

by its beneficiary * * * [71 T.C. at 952.]

Because only the trust attribution rules of section 318 (a) (3)

have any application to this issue, it is those rules and not

* * * What would you do? Cut a great road through the law to get

after the Devil? * * * And when the last law was down, and the

Devil turned round on you—where would you hide, Roper, the

laws all being flat? * * * This country’s planted thick with laws

from coast to coast — Man’s laws, not God’s — and if you cut them

down * * * d’you really think you could stand upright in the

winds that would blow them? * * * Yes, I’d give the Devil benefit

of law, for my own safety’s sake. [R. Bolt, ‘A Man For All Seasons’,

1967} Pp. 147 (Three Plays, Heinemann Educational Books, Inc.

A-31

the family attribution rules of section 318(a) (1), which

operate to treat the trust as owner of the stock still owned

after the redemption by Jacob.*’ Thus, respondent argues

that the trust could report the redemption as a complete

termination of its interest in MDI only if it could avoid the

trust attribution rules of section 318(a) (3). Respondent

contends that the trust has failed in this because, although

it may have performed the prerequisites of the exception by

having no other interest in the corporation other than a

creditor (sec. 302(c) (2) (A) (i)), by not acquiring any such

interest within 10 years from the redemption (sec.

302 (c) (2) (A) (ii) ), and filing an agreement to notify the

Internal Revenue Service of any acquisition within the

10-year period and to keep necessary records (sec. 302(c)

(2) (A) (ili)), the exception applies only to section 318

(a) (1) and not section 318 (a) (3).

To the contrary, the trust contends that the issue of

whether the filing of a waiver is effective to waive the

attribution rules of section 318(a)(3)(B) was resolved in

its favor by the Court of Appeals for the Fifth Circuit in

Rickey v. United States, 592 F.2d 1251 (5th Cir. 1979),

which held that an estate had validly waived the estate-

beneficiary attribution rule of section 318(a) (3) (A), so

that a redemption of all the shares actually owned by the

estate qualified as a complete redemption under section

302 (b) (3).

In the Rickey case, the corporation had 2,255 shares of

common stock outstanding before the redemption. The

decedent had been president and principal stockholder of

the corporation and his 1,292 shares (approximately 57

percent) passed to his estate. Another 788 shares (approxi-

mately 35 percent) were owned by the decedent’s children.

The balance, 175 shares (approximately 8 percent), were

owned by unrelated shareholders. The company’s articles

of incorporation required that upon the death of a deceased

2°No arguments were made that there was any hostility between

Jacob and his children, David II and Nan, such that their stock

should not be attributed to him under sec. 318(a) (1) (A) (ii).

A-32

shareholder, the corporation be offered the option to pur-

chase his shares at book value. All of the shareholders

viewed the provision as requiring the company to purchase

the stock. This policy was designed to insure that corporate

control was maintained by those who were active in the

business. The decedent’s will, moreover, directed his execu-

trix to tender his stock to the company for redemption

pursuant to the articles of incorporation. The will further

named as residuary universal legatees the decedent’s three

children. In accordance with the will, the executrix offered

all 1,292 shares to the company, which redeemed them a few

months later.

After the redemption, the decedent’s children still owned

788 shares which were now approximately 82 percent of

the outstanding stock (963 shares). The remaining 175

shares, now approximately 18 percent of the outstanding

stock, were held by unrelated stockholders. The estate

treated the distribution as full payment in exchange for the

stock, with no capital gain recognized because the basis in

the stock had been stepped up, pursuant to section 1014,

to the fair market value of the stock on the decedent’s date

of death. In the year following the redemption the estate

was closed, and all of the assets, including the redemption

proceeds, were distributed to the decedent’s children, one-

third to each of the estate’s beneficiaries.

Upon audit of the beneficiaries, the Internal Revenue

Service determined a deficiency on the grounds that the

distribution was essentially equivalent to a dividend. The

deficiency was paid. Thereafter, the estate was reopened and

the executrix filed the agreement required by section 302 (c)

(2) (A) (iii) to notify the Internal Revenue Service of any

acquisition by the estate of a prohibited interest in the

company within 10 years after the redemption. After the

Internal Revenue Service denied their claims for refunds,

the beneficiaries filed a refund suit in the United States

District Court. Following a decision for the taxpayers (427

F. Supp. 484 (W.D. La. 1976) ), the Government appealed.

A-33

On appeal to the Fifth Circuit, the Government argued

that, because of the attribution rules, the redemption of all

of the stock actually held by the estate did not qualify as

a complete termination of a stockholder’s interest under

302 (b) (3). This was so because the 788 shares (82 percent

of the outstanding stock) owned by the decedent’s three

children who were residuary beneficiaries of the estate at

the time of the redemption were still constructively owned

by the estate under section 318 (a) (3) (A) which provides

in part, “Stock owned, directly or indirectly, by or for * * *

a beneficiary of an estate shall be considered as owned by

the * * * estate.” The Government further maintained that

the application of all of the constructive ownership rules of

section 318 were required by section 302 (c) (1), and that

the exception in section 302(c) (2) applied only to the

family attribution rules of section 318 (a) (1) and not the

estate-beneficiary attribution rules of section 318 (a) (3).

The Fifth Circuit held the estate effectively waived the

attribution rules of section 318 (a) (3) in order to qualify

for a section 302(b) (3) redemption. The Court of Appeals

rested its holding on three grounds: (1) It believed appli-

cation of the literal language of the statute would not bring

about a result more in consonance with the intent of Con-

gress in enacting the attribution and waiver sections; (2)

it was convinced Congress intended and desired enforcement

proceedings to be accompanied by commonsense and basic

principles of fairness; (3) it rejected a “crabbed reading”

of the Code where the rationale for applying the law was

absent and where application of the rule leads to inap-

propriately harsh results. Thus, where the estate was merely

carrying out the provisions of the decedent’s will, the Court

of Appeals concluded that the decedent’s death was not

“a device to bleed out corporate profits at capital gains

rates.” 592 F.2d at 1258.

With due respect for the views of the Court of Appeals,

we nevertheless disagree with its reasoning. As discussed

earlier, the intent of Congress in enacting the attribution

rules was twofold, (1) to prevent tax avoidance, and (2)

A-34

to provide definitive rules and precise standards whereby

attributions may be applied.” The Senate report gives an

example of entity-beneficiary attribution which is analogous

to the facts of both the Rickey case and this case.** That

21“A distribution in complete redemption of a shareholder’s stock

will also result in capital gain. To prevent evasion of the complete

redemption test a shareholder is considered as owning stock held by

members of his immediate family, or by partnerships, corporations

and trusts which he controls. At the present time a possible oppor-

tunity for tax avoidance results where redemptions are effected

in the case of family-owned corporations. To prevent tax avoidance,

but at the same time to provide definitive rules for the guidance of

taxpayers, your committee has provided precise standards whereby

under specific circumstances, a shareholder may be considered as

owning stock held by members of his immediate family (or by

partnerships, corporations, or trusts which he controls).”

[H. Rept. 1337, 83d Cong., 2d Sess. 36 (1954), U.S. Code Cong.

& Adm. News 4061 (1954). Emphasis added. ]

*2Paragraph (3) (relating to termination of a shareholder’s inter-

est) corresponds to section 302(a) (3) of the House bill by providing

that a distribution which is in complete redemption of all of the

stock of a corporation owned by a shareholder shall be treated as

a distribution in full payment for the stock of such shareholder. This

paragraph must be read in connection with the provisions of sub-

section (c) of section 302 relating to constructive ownership of

* * * * * * & © * ae

“Subsection (c) of section 302, which corresponds in general to

section 302(c) of the House bill, provides rules for determination of

the constructive ownership of stock for the purpose of section 302.

“Paragraph (1) provides that the rules for constructive ownership

of stock of section 318(a) shall apply for purposes of this section

generally. For example, if an individual owns half of the stock of a

corporation, and a trust of which such individual is the sole bene-

ficiary, owns the other half of such stock, a redemption of all of the

stock of the corporation owned individually would not qualify under

paragraph (2) or (3) of subsection (b). Under these circumstances,

by reason of the application of section 318(a)(2)(B), such individual

would be considered as owning all of the stock of the corporation,

both before and after the redemption.

“Paragraph (2) of subsection (c) provides special rules for appli-

cation of section 318(a)(1) (relating to constructive ownership of

stock between members of a family) in the case of a distribution

in redemption under paragraph (3) of subsection (b) (relating to

A-35

example, set out in the footnote below, shows Congress con-

templated applying the entity-attribution rules to preclude

eligibility for section 302(b) (3) treatment; and the para-

graphs following the example show that Congress was refer-

ring to “members of a family” when discussing the waiver

exception under 302(c) (2). The other references which we

have found in the legislative history discussing the 302(c) -

(2) exception to the attribution refer only to family attribu-

tion, never entity-beneficiary attribution.** As we read the

termination of a shareholder’s interest). Under subparagraph (A)

of paragraph (2), it is provided that section 318(a)(1) shall not

apply, i.e., stock owned by members of the family of the distributee

would not be attributed to him immediately after the distribution in

redemption, if the distributee himself has no interest in the corpora-

tion, including but not limited to an interest as officer, director or

employee other than an interest as a creditor, and such distributee

does not acquire such interest (other than stock acquired by

bequest of inheritance) within 10 years from the date of distribution

in redemption.

“Moreover, in order to qualify for nonattribution between members

of a family, subparagraph (A) (iii) requires that the distributee,

under regulations prescribed by the Secretary or his delegate, file

an agreement to notify the Secretary or his delegate of any acquisi-

tion of any interest (other than by bequest or inheritance) within

the 10-year period and to retain such records as the Secretary or

his delegate may prescribe as necessary for the application of

paragraph (2).”

[S. Rept. 1622, 83d Cong., 2d Sess. 235-236 (1954), U.S. Code

Cong. & Adm. News 4872-4873 (1954). Emphasis added. ]

**The rules of family ownership will not apply if the shareholder

completely terminates his interest in the corporation and does not

reacquire, other than by bequest or inheritance, an interest (other

than an interest as a creditor), for a period of 10 years thereafter.

s* ese”

[H. Rept. 1337, 83d Cong., 2d Sess. 36 ( 1954), U.S. Code Cong.

& Adm. News 4061 (1954). Emphasis added. ]

“Subsection (c) makes clear that the rules of attribution of

ownership provided in section 311 will be applicable in determining

ownership of stock for the purpose of section 302. * * *

“Paragraph (2) of subsection (c) provides special rules for applica-

tion of section 311(a) [now section 318] applicable solely to a

distribution in redemption in termination of a shareholder’s interest

otherwise qualifying under paragraph (3) of subsection (a). It is

intended by paragraph (2) and (3) to clarify the consequences of

a complete redemption of a shareholder’s interest where family

A-36

legislative history, we think the application of the language

of section 302(c) (2) which provides an exception to the

family attribution rules of section 318(a) (1) and provides

no exception for the entity-beneficiary attribution rules of

section 318(a) (3), would be consistent with the intent of

Congress in enacting those sections.

While we agree with the Fifth Circuit that “Congress

intended and desired enforcement proceedings to be accom-

panied by commonsense and basic principles of fairness,” we

are also mindful of the Supreme Court’s warning on judicial

restraint:

Here we are urged to view the * * * Act “reasonably,”

and hence shape a remedy “that accords with some

modicum of common sense and the public weal.” * * *

But is that our function? * * * Congress has spoken in

the plainest of words, * * *

ownership obtains so that the administration of this problem pres-

ently uncertain under section 115(g)(1) of existing law may be

definitive.

“Subparagraph (A) of paragraph (2) provides that the rules of

family attribution under section 311(a) shall not be applicable if

immediately thereafter the distributee has no interest in the corpora-

tion (including an interest as an officer, director, or employee but

not including an interest as a creditor) and under subparagraph (B)

of paragraph (2) such distributee does not acquire any such interest

in a corporation within 10 years from the date of the distribution

in redemption. * * *”

[H. Rept. 1377, supra at A75, U.S. Code Cong. & Adm. News

4212 (1954). Emphasis added. ]

“If a shareholder desires to sever completely his interest in a corpora-

tion which he and his family control, the rules of family ownership

are waived, as under the House bill, if the shareholder does not

reacquire, other than by bequest or inheritance, an interest (other

than an interest as a creditor), for a period of 10 years thereafter.

However, such a shareholder may not have made or received a gift

of stock of the corporation, to or from his wife, for example, within

10 years prior to the distribution. If any interest is reacquired by

a shareholder within the prohibited period, an additional tax

may be recovered as if the original distribution had been a dividend.

Thus modified the family attribution rules will be applied to insure

a bona fide severance of a particular shareholder's interest in an

enterprise and will not apply where there is no purpose of tax

avoidance.”

[S. Rept. 1622, 83d Cong., 2d Sess. 45 (1954), U.S. Code Cong.

& Adm. News 4676 (1954). Emphasis added. ]

A-37

Our individual appraisal of the wisdom or unwisdom

of a particular course consciously selected by the Con-

gress is to be put aside in the process of interpreting a

statute. Once the meaning of an enactment is discerned

and its constitutionality determined, the judicial process

comes to an end. We do not sit as a committee of review,

nor are we vested with the power of veto. [Tennessee

Valley Authority v. Hill, 437 U.S. 153, 194-195 (1978).]

The Rickey opinion has, in effect, added a new provision

to the Internal Revenue Code.** Section 302(c) (2) (A)

states, in part, “In the case of a distribution described in

subsection (b) (3), section 318(a) (1) shall not apply if

* * * ” The Fifth Circuit has rewritten that provision to

read “section 318(a) (1) and section 318(a)(3) shall not

apply if * * *.” The Supreme Court has held, “There is a

basic difference between filling a gap left by Congress’ silence

and rewriting rules that Congress has affirmatively and

specifically enacted. * * * Perhaps the wisdom we possess

today would enable us to do a better job * * * than Congress

did [years ago] * * * but even if that be true, we have

no authority to substitute our views for those expressed by

Congress in a duly enacted statute.” Mobil Oil Corp. v.

Higginbotham, Administratrix, 436 U.S. 618, 625-626 (1978).

Where Congress has specifically excluded a term or phrase,

it is not for the courts to read that term or phrase into the

statute. United States v. Moreno, 561 F.2d 1321, 1322 (9th

Cir. 1977). Such a rewriting of a statute, plain on its face,

is an example of lawmaking as distinguished from statutory

interpretation that is beyond the power of the courts.

Gaddis v. Calgon Corp., 449 F.2d 1318, 1319 (5th Cir. 1971).

Accord, Allen v. David, 334 F.2d 592, 601 (5th Cir. 1964),

cert. denied 379 U.S. 967 (1965).

For a general analysis of the Rickey opinion, see A. Andrews,

“Estate Waiver of the Estate-Beneficiary Attribution Rule in Non-

liquidating Redemptions Under Section 302 and Related Matters:

The Rickey Case in the Fifth Circuit,” 35 Tax L. Rev. 147 (1979);

Comment, “Stock Redemptions and the Estate-Attribution Rules,”

128 U. Pa. L. Rev. 650 (1980); C. Fassler, “Waiver of Entity Attri-

bution — The Rickey, Jr. Case,” 57 Taxes 658 (1979).

A-38

Treating the redemption in the Rickey case as a distribu-

tion under section 301, rather than an exchange under section

802(a), may have seemed to the Fifth Circuit so inappro-

priately harsh as to violate basic principles of fairness. How-

ever, so long as the results do not violate the constitutional

protections of due process and equal protection, “Whether

a transaction or result is taxable and what the tax is is not

a matter to be determined in law upon considerations of

general justice or equity. It is a matter of statutes and valid

regulations, and what they mean.” Jeffries v. Commissioner,

158 F.2d 225, 226 (5th Cir. 1946), cert. denied 330 U.S.

843 (1947).

The Fifth Circuit’s third ground is stated as follows:

It cannot be argued that the estate’s motivation in

allowing this redemption was one of benefitting the

beneficiaries. Rather the estate was merely carrying

out the provisions of decedent’s will — selling the shares

back to the Corporation and distributing the proceeds

to the beneficiaries, thereby terminating its control over

the corporation. We will not find that decedent’s death

was a device to bleed out corporate profits at capital

gains rates. [592 F.2d at 1258.]

Again, we respectfully disagree that the estate’s motivation

is relevant to the section 302 question. As the Supreme

Court stated in Davis:

It was clearly proper for Congress to treat distributions

generally as taxable dividends when made out of earn-

ings and profits and then to prevent avoidance of that

result without regard to motivation where the distribu-

tion is in exchange for redeemed stock.

We conclude that that is what Congress did when

enacting § 302(b) (1) * * * [897 U.S. at 313.]

We think the irrelevance is equally applicable to section

302 (b) (3).

The trust urges that the holding in the Rickey case should

control our decision under the doctrine of Golsen v. Com-

A-39

missioner, 54 T.C. 742 (1970), affd. 445 F.2d 985 (10th Cir.),

cert. denied 404 U.S. 940 (1971). In Golsen we said that

“better judicial administration requires us to follow a Court

of Appeals decision which is squarely in point where appeal

from our decision lies to that Court of Appeals and to that

court alone.” (54 T.C. at 757.)

Respondent argues that the Golsen rule applies only

where the Court of Appeals has decided a case that is

“squarely in point,” citing Cottrell v. Commissioner, 72 T.C.

489, 492-493 (1979), and Lerner v. Commissioner, 71 T.C.

290, 297 (1978), as examples in which this Court did not

apply the rule where the cases were distinguishable from

the appellate precedents in the circuits to which an appeal

would lie. He contends that Rickey can be distinguished on

the basis of the redemption option in the articles of incor-

poration and the corresponding direction in the decedent’s

will. The trust in the present case has no such similar

provision requiring it to offer the shares to MDI prior to

any alternative disposition, nor do we have any evidence that

the articles of incorporation of MDI required redemption.”

25Respondent suggests on brief that the trust (not being required

to offer the shares to MDI, itself) and the beneficiaries could have

achieved favorable tax treatment by dissolving the David Metzger

Trust, making in-kind distributions of the MDI stock to the respec-

tive beneficiaries and then have MDI redeem Catherine’s, Cecelia’s

and Nora’s stock. (As it later turned out, Cecelia disclaimed her

interest in the David Metzger Trust on Aug. 10, 1976, and Catherine

did the same on Oct. 12, 1976.) The individuals could then have

followed the procedures of sec. 302(c)(2) so that Nora’s stock would

not be attributed to her daughters, Catherine and Cecelia, or vice

versa, thus permitting Nora, Catherine, and Cecelia to qualify for

capital gains treatment under sec. 302(b)(3). See Rev. Rul. 79-67,

1979-1 C.B. 128. On brief, the trust agreed with this suggestion but

contended that because the beneficiaries did not obtain proper advice

as to the potentially differing tax consequences of the alternative

courses of action, they fell into a “trap for the unwary.” Regarding

the actual facts of the present case, however, “Taxation deals not

with what was attempted to be done but with what was done.”

Jeffries v. Commissioner, 158 F.2d 225, 226 (5th Cir. 1946), cert.

denied 330 U.S. 843 (1947).

A-40

We agree with respondent. The important distinguishing

factor between the facts before the Fifth Circuit in Rickey

and those in the present case is that the redemption in

Rickey was required by the decedent’s will ** and the articles

of incorporation of the redeeming corporation.

The Fifth Circuit pointed out that the estate’s motivation

in proceeding with the redemption was not te benefit the

beneficiaries, but to carry out the provisions of the

decedent’s will. By contrast, the redemption in the present

case was effectuated solely to accomplish the objectives of

the beneficiaries, which were to split up the separate family

businesses so that there would not be any further family

discord during board of directors and stockholders meetings

over the proper operation of the businesses.

In Rickey, the Court relied on the fact that the corporate

policy of purchasing a deceased shareholder’s interest in the

corporation through redemption was designed to insure that

control of the company was maintained in the hands of

those who were active in the business. In the present case,

the David Metzger Trust had been a passive stockholder for

at least 20 years, from David Metzger’s death in 1953 until

the redemption in 1973.

For these reasons, we think the Rickey case is not

“squarely in point” concerning the present case, and thus,

the Golsen rule need not be applied. Accordingly, we hold

that the agreement filed by the trust was ineffective to waive

the attribution rules of section 318(a) (3). Johnson Trust

v. Commissioner, 71 T.C. 941 (1979).

**It would appear that a minor amount of pre-death planning

would enable all estates under the Rickey rule to avoid the attribu-

tion rules. One commentator has suggested the waiver of entity

sanctioned by Rickey may even apply to redemptions required in

employment agreements and_ buy-sell agreements. C. Fassler,

“Waiver of Entity Attribution—The Rickey Jr. Case,” 57 Taxes 658,

662 (1979).

A-41

Issue 3

The final issue is whether MDI may properly deduct for

the fiscal years ended September 30, 1973, September 30,

1974, and September 30, 1975, despite section 267, accrued

interest paid to Cecelia, a cash method taxpayer, more than

2% months after the close of MDI’s fiscal years.

MDI redeemed Cecelia’s stock with a promissory note

dated January 22, 1973, in the original principal amount of

$627,110.53. The terms of the note provided for payment in

three equal annual installments, together with interest,

beginning January 22, 1974. MDI performed in accordance

to the terms of the note, making payments in January 1974,

1975, and 1976. MDI, an accrual method taxpayer, claimed

deductions for accrued interest expense, with respect to the

note, for its taxable years ended September 30, 1973, 1974,

and 1975. Because such interest was not actually paid

within 24% months after the end of the taxable years in

question, and, because Cecelia was a cash method taxpayer,

respondent determined that the deductions claimed by MDI

for the taxable years in issue should be disallowed pursuant

to section 267(a) (2). Since Cecelia owned no MDI stock

after the redemption, respondent’s contention is premised on

the attribution to Cecelia, under section 267(c), of the MDI

stock owned by her brother, Jacob.

MDI, however, asserts that family discord is a relevant

factor to be considered in the application of the family

attribution rules of section 267(c). It contends that the

section 267(c) attribution rules should be ignored in situa-

tions where the discord is so severe as to establish that the

pertinent family members would not act in concert or for

the benefit of each other.

Section 163(a) allows a deduction for interest which is

either paid or accrued during the taxable year on indebted-

ness owed by the taxpayer. Thus, the proper accrual of

interest expense on indebtedness of the taxpayer will result

in the allowance of a deduction under section 163, notwith-

standing the absence of an actual payment of such interest

A-42

during the taxable year. However, certain exceptions to the

general rule of section 163 have been enacted to prevent

the use of this provision as a tax avoidance device. One such

exception is set forth in section 267, which provides, in

pertinent part, as follows:

(a) Depuctions DisALLowep. — No deduction shall

be allowed —

* * * cd * * *

(2) UNPAID EXPENSES AND INTEREST. — In respect

of expenses, otherwise deductible under section 162

or 212, or of interest, otherwise deductible under

section 163,—

(A) If within the period consisting of the taxable

year of the taxpayer and 2% months after the close

thereof (i) such expenses or interest are not paid,

and (ii) the amount thereof is not includible in the

gross income of the person to whom the payment is

to be made; and

(B) If, by reason of the method of accounting of

the person to whom the payment is to be made, the

amount thereof is not, unless paid, includible in the

gross income of such person for the taxable year in

which or with which the taxable year of the tax-

payer ends; and

(C) If, at the close of the taxable year of the

taxpayer or at any time within 24% months there-

after, both the taxpayer and the person to whom

the payment ‘is to be made are persons specified

within any one of the paragraphs of subsection (b).

The congressional purpose underlying the enactment of

the predecessor of section 267 was to prevent the use of the

differing methods of reporting income for Federal income

tax purposes in order to obtain artificial deductions for

interest and business expenses. It was recognized that there

were instances where an individual on the accrual method

A-43

became indebted to a creditor with whom he enjoyed a

special relationship, such as a member of his family, or to

a corporation he controlled, and his creditor reported income

on the cash method. Thereafter, as interest became due on

the debt, the debtor on the accrual method reported the

interest as a deduction for income tax purposes, but he did

not make any actual payment to his creditor. Since the

creditor was on the cash method, he reported no income.

The debtor would consequently gain the benefit of a current

deduction, whereas the related creditor would defer income

recognition until the year of receipt of actual payment.

Sometimes the sum involved would escape income taxation

altogether because the payment was timed to a year when

the creditor had offsetting losses.*’

As provided in section 267 (a) (2) (C), the limitations on

the deductibility of interest and other expenses imposed by

section 267(a) are applicable only in situations involving a

taxpayer and another person or entity having a specified

relationship, set forth in section 267(b) (2), as “an indi-

vidual and a corporation more than 50 percent in value

of the outstanding stock of which is owned, directly or

indirectly, by or for such individual.” For purposes of deter-

mining the existence of such relationship, section 267 (c) sets

forth the following rules of constructive ownership of stock:

(c) CONSTRUCTIVE OWNERSHIP OF Stock. — For pur-

poses of determining, in applying subsection (b), the

ownership of stock —

® os a * % * *

(2) An individual shall be considered as owning

the stock owned, directly or indirectly, by or for his

family;

* * * # * * *

*"H. Rept. 1546, 75th Cong., Ist Sess. (1937), 1939-1 C.B. (Part 2)

704, 724-725. See also Young Door Co. v. Commissioner, 40 T.C.

890, 893 (1963); Geiger & Peters, Inc. v. Commissioner, 27 T.C. 911,

poo “pa Platt Trailer Co. v. Commissioner, 23 T.C. 1065, 1068

A-44

(4) The family of an individual shall include only

his brothers and sisters (whether by the whole or

half blood), spouse, ancestors, and lineal descen-

dents: * * *

Since the Supreme Court’s decision in McWilliams v.

Commissioner, 331 U.S. 694 (1947), courts have adopted a

literal approach with regard to section 267, whereby a

deduction encompassed within the scope of the statute has

been disallowed without consideration of other mitigating

circumstances. Section 267 and its predecessor, section

24(b), I.R.C. 1939, prohibited not only unpaid expenses and

interest but also losses from sales or exchanges between

certain related parties. The McWilliams case concerned the

latter provision and held that section 24(b), I.R.C. 1939,

provided an absolute prohibition against the allowance of

losses on any sales between members of certain designated

groups.

MDI maintains that the cases in which McWilliams has

been cited or followed have focused principally on the strict

application of section 267(a) to the specific interest or

expense deduction in question and never on the relationship

between the attribution rules of section 267(c) and the

operative provisions of section 267(a) and (b). In view of

the similarity of section 267(c) to section 318,** MDI con-

tends that, where hatred and disharmony exist between the

related parties, the initial focus in applying section 267

should be on whether to apply the attribution rules at all.

Petitioners contend that not only were the attribution rules

of sections 267 and 318 intended to be similarly applied, but

also that section 267 was not enacted by Congress in order

to prevent the avoidance of Federal income taxes in sit-

uations involving extreme discord and hatred between

siblings. MDI does not argue that mere lack of a tax-

28For a general discussion of the attribution rules in secs. 267, 318,

and 544, see F. Ringel, S. Surrey & W. Warren, “Attribution of

Stock Ownership in the Internal Revenue Code,” 72 Harv. L. Rev.

209 (1958); B. Randall & K. Benson, “Family Dissension and the

Attribution Rules of Sections 267, 318, and 544” 53 Taxes 534

(1975).

A-45

avoidance motive in executing the promissory note to

Cecelia and in paying the principal and interest more than

2% months after the end of its fiscal year should preclude

the disallowance of the interest deduction. Rather, it con-

tends that the extreme discord and hatred existing between

Jacob and Cecelia prevented such parties from enjoying

the requisite “special relationship” intended by Congress

as a condition precedent to the application of the disallow-

ance provisions of section 267 (a). In other words, it argues

that the family discord nullified the attribution of stock

ownership from Jacob to Cecelia and thus Cecelia lacked

the relationship with MDI required by sections 267(a)

(2) (c) and 267(b) as a predicate to the disallowance provi-

sions of section 267 (a).

We disagree. When the Supreme. Court was interpreting

section 24(b) of the 1939 Code, then in effect, in

McWilliams, that section included both the operational

sections now found in section 267(a) (1) and (b) and the

attribution sections now found in section 267 (c).*°

20H. Rept. 1546, 75th Cong., Ist Sess. (1937), 1939-1 C.B. (Part 2)

704, 724-725.

80SEC. 24. ITEMS NOT DEDUCTIBLE.

(b) Losses From Sales or Exchanges of Property. —

(1) Losses disallowed.—In computing net income no deduction

shall in any case be allowed in respect of losses from sales or

exchanges of property, directly or indirectly—

(A) Between members of a family, as defined in paragraph

(2)(D);

(B) Except in the case of distributions in liquidation, between

an individual and a corporation more than 50 per centum in

value of the outstanding stock of which is owned, directly or

indirectly, by or for such individual;

(C) Except in the case of distributions in liquidation, between

two corporations more than 50 per centum in value of the

outstanding stock of each of which is owned, directly or

indirectly, by or for the same individual, if either one of such

corporations, with respect to the taxable year of the corporation

preceding the date of the sale or exchange was, under the law

applicable to such taxable year, a personal holding company or

a foreign personal holding company;

A-46

In the McWilliams case, the taxpayer managed the

independent estate of his wife and on a number of occasions

ordered his broker to sell certain stock for the account of

one of the two, and to buy the same number of shares of the

same stock for the other, at as nearly the same price as

possible. On each occasion, the sale and purchase were

negotiated through a stock exchange, and the identity of the

persons buying from the selling spouse and the persons

selling to the buying spouse was never known. The tax-

payers contended that Congress never intended to disallow

(D) Between a grantor and a fiduciary of any trust;

(E) Between the fiduciary of a trust and the fiduciary of

another trust, if the same person is a grantor with respect to

each trust; or

(F) Between a fiduciary of a trust and a beneficiary of such

trust.

(2) Stock ownership, family, and partnership rule. — For the

per of determining, in applying paragraph (1), the ownership

of stock —

(A) Stock owned, directly or indirectly, by or for a corpora-

tion, partnership, estate, or trust, shall be considered as being

owned proportionately by or for its shareholders, partners, or

beneficiaries;

(B) An individual shall be considered as owning the stock

owned, directly or indirectly, by or for his family;

(C) An individual owning (otherwise than by the application

of subparagraph (B)) any stock in a corporation shall be con-

sidered as owning the stock owned, directly or indirectly, by or

for his partner;

(D) The family of an individual shall include only his broth-

ers and sisters (whether by the whole or half blood), spouse,

ancestors, and lineal descendants; and

(E) Constructive Ownership as Actual Ownership. — Stock

constructively owned by a person by reason of the application

of subparagraph (A) shall, for the purpose of applying sub-

paragraph (A), (B), or (C), be treated as actually owned by

such person, but stock constructively owned by an individual

by reason of the application of subparagraph (B) or (C) shall

not be treated as owned by him for the purpose of again apply-

ing either of such subparagraphs in order to make another the

constructive owner of such stock.

[Emphasis added. ]

A-47

losses on such transactions which, having been made through

a public market, were undoubtedly bona fide sales, and that

disallowance of such losses would be tantamount to treating

a husband and wife as a single individual for tax purposes.

The Supreme Court answered this objection to the attribu-

tion rules by saying:

We are not persuaded that Congress had so limited an

appreciation of this type of tax avoidance problem. Even

assuming that the problem was thought to arise solely

out of the taxpayer’s inherent advantage in a contest

concerning the good or bad faith of an intra-family sale,

deception could obviously be practiced by a buying

spouse’s agreement or tacit readiness to hold the

property sold at the disposal of a selling spouse, rather

more easily than by a pretense of a sale where none

actually occurred, or by an unfair price. The difficulty

of determining the finality of an intra-family transfer

was one with which the courts wrestled under the

pre-1934 law, and which Congress undoubtedly meant

to overcome by enacting the provisions of § 24 (b). [331

U.S. at 698. Fn. ref. omitted.]

The Court specifically discussed the attributions rules and

their strict application:

Section 24(b) states an absolute prohibition — not a

presumption — against the allowance of losses on any

sales between the members of certain designated groups.

The one common characteristic of these groups is that

their members, although distinct legal entities, generally

have a near-identity of economic interests. It is a fair

inference that even legally genuine intra-group transfers

were not thought to result, usually, in economically

genuine realizations of loss, and accordingly that Con-

gress did not deem them to be appropriate occasions for

the allowance of deductions. [331 U.S. at 699. Fn. ref.

omitted. ]

Thus, the Supreme Court realized that some legally genuine

intra-group transfers which resulted in economically genuine

A-48

realizations of loss would be caught in this absolute prohibi-

tion. Because such intra-group transfers did not “usually”

result in genuine economic realizations of loss, it held that

Congress did not deem any of them deductible. W. A.

Drake, Inc. v. Commissioner, 3 T.C. 33, 39 (1944), affd. 145

F.2d 365 (10th Cir. 1944).

In our opinion, the attribution rules should not be applied

differently to the unpaid expenses and interest than as

applied to losses from sales even where there is evidence of

family discord. In Radom & Neidorff, Inc. v. United States,

150 Ct. Cl. 826, 281 F.2d 461 (1960), cert. denied 365 U.S.

815 (1961), a brother and sister each owned 50 percent of

the outstanding stock of the taxpayer corporation. As a

result of personal controversy, the sister refused to counter-

sign the brother’s payroll checks, and thus his salary was

not paid within 24% months after the close of the corpora-

tion’s taxable year. The Court of Claims found that no

actual or constructive payment had been received by the

brother within the prescribed period, and thus held that

section 267(a) was applicable irrespective of the absence

of a tax avoidance motive.

Section 267, as interpreted by the Supreme Court in

McWilliams, states an absolute prohibition. There is no

mitigation of its attribution rules. Miller v. Commissioner,

75 T.C. 182 (1980). It is true that a hardship may result in

particular cases. Congress could have provided some excep-

tion for certain intra-family transactions. But it did not do

so. It may be that such a qualification would have defeated

the purpose of the measure, or it may be that consideration

of administrative convenience in collecting revenue out-

weighed the occasional hardship which would result in par-

ticular cases. But, whatever the reason, we cannot, without

indulging in judicial legislation, grant an exception to the

road provisions adopted by Congress. Blum v. Commis-

sioner, 5 T.C. 702 (1945); Miller v. Commissioner, supra.

_ To reflect the concessions of the parties and our conclu-

sions with respect to the disputed issues,

A-49

Decisions will be entered in all dockets

under Rule 155.

Reviewed by the Court.

CHasor, J., concurs.

TANNENWALD, J., concurring: While I agree that the stock

owned by the beneficiary of the petitioner trust must be

attributed to it, I reach this conclusion by a path other than

that taken by the majority. I therefore concur in the Court’s

opinion only as to Issues 2 and 3.

As a result of a bitter family feud, the MDI stock held by

the Metzger Trust (the trust) was completely redeemed.

There is no question that this redemption would be “not

essentially equivalent to a dividend” within the meaning of

section 302(b) (1) were it not for the attribution rules of

section 318. Those rules cause the trust to be the owner —

albeit only constructively — of 100 percent of the MDI stock

outstanding after the redemption and accordingly repel the

trust from the gates of section 302(b) (1). The trust argues

that the presence of the family feud should protect it from

the clutches of section 318 and allow it access via section

302 (b) (1) to the basis recovery and capital gains treatment

of section 301(c) (2) and (3).

Whether a corporate distribution is essentially equivalent

to a dividend is a question of fact, although which factors

may contribute to a court’s finding is, of course, a question

of law.* In United States v. Davis, 397 U.S. 301 ( 1970), the

Supreme Court held that the corporate purpose behind a

redemption should play no role in determining dividend

equivalency under section 302(b(1). To the extent, then,

that the trust herein argues that the family feud demon-

*Sec. 1.302-2(b), Income Tax Regs.; Wright v. United States,

482 F.2d 600, 606 (8th Cir. 1973).

A-50

strates the bona fide business purpose of the corporate dis-

tribution, its argument is irrelevant under Davis.

The trust, however, seeks to benefit from the family dis-

harmony in a different way. The attribution rules of section

318 provide that one individual or entity should be treated

as the owner of stock in fact owned by another individual

or entity because of the close relationship between the two.

For example, parent/child, husband/wife, and trust/benefi-

ciary relationships trigger constructive ownership by virtue

of section 318. The underlying premise of these attribution

rules is that, because of a sharing of interest and advantage,

a nominal redemption might have the effect, not of a sale

of shares to the corporation, but of a corporate dividend, and

that the release of shares by the “redeemed” taxpayer might

possess little substance because of shares retained by a

related taxpayer. S. Rept. 1240, 88th Cong., 2d Sess. 7

(1964), 1964—2 C.B. 701, 705—706. The trust simply argues

that family discord undermines the premises of the attribu-

tion rules and that they should not be applied when they

belie reality.’

The Supreme Court held in Davis that the attribution

rules of section 318 should be applied by a court when

making a section 302(b) (1) determination, but it did not

decide whether family discord may soften their application

because that issue was not presented; the attribution in that

case was between two happily married spouses and their

children. The respondent would have us hold, however, that

the broad language used in the Davis opinion should be read

to foreclose any mitigation of the application of the attribu-

tion rules; admittedly, there is judicial support for this

position."

In Robin Haft Trust v. Commissioner, 510 F.2d 43 (ist

Cir. 1975), the First Circuit held that Davis did not preclude

*See Title Insurance & Trust Co. v. United States, 484 F

465 n. 4 (9th Cir. 1973). oe

*Robin Haft Trust v. Commissioner, 61 T.C. 398 (1973), and 62

T.C. 145 (1974) (supplemental opinion), revd. and remanded 510

F.2d 43 (1st Cir. 1975). Cf. Niedermeyer v. Commissioner, 62 T.C.

280, 286 (1974), affd. per curiam 535 F.2d 500 (9th Cir. 1976).

A-51

the use of a family feud. In that case, as in the case at bar,

the taxpayer/trust undoubtedly would have been entitled

to the protection of section 302(b) (1) but for the section 318

attribution. However, the taxpayer in Robin Haft Trust

could only be treated as a constructive owner of the redeem-

ing corporation’s stock if ownership could be attributed

under section 318 (a) (1) (A) (ii) from a father to his child,

and the taxpayer there argued that the parent/child

relationship was so strained that attribution was unreason-

able. Accepting that the existence of family disharmony can

outweigh the attribution rules, the Court of Appeals

remanded for additional fact-finding as to the breakdown

of the father/child relationship. See J. Boyd & M. Boyd,

“Family discord may negate attribution rules and allow

capital gain treatment of a redemption,” 15 Taxation for

Accountants 362, 364-365 (1975).

The respondent herein argues, despite the clear implication

to the contrary of the language of section 1.302-2(b) , Income

Tax Regs.,‘ that Robin Haft Trust is inconsistent with

United States v. Davis, supra, or that if it is not, it is none-

theless ill advised and should not be followed. Although

the majority of this Court feels compelled to respond to these

challenges, I would decline the opportunity to take so

precipitous a step until required to do so, and the facts of

‘Sec. 1.302—2(b), Income Tax Regs., states—

“The question of whether a distribution in redemption of the stock

of a shareholder is not essentially equivalent to a dividend under

section 302(b)(1) depends upon the facts and circumstances of

each case. One of the facts to be considered in making this deter-

mination is the constructive stock ownership of such shareholder

under section 318(a). [Emphasis added.]”

The Supreme Court in United States v. Davis, 397 U.S. 301 (1970),

ignored this regulation except for a general reference to the regula-

tion according with the view that section 318 “applies to all of sec-

tion 302” — a reference which does not answer the question we

have before us, namely, the extent to which it applies. See Comment,

55 B.U. L. Rev. 667, 674 (1975); Comment, 28 Maine L. Rev. 222,

237-239 (1976). In this connection, we note that, at one point in

its opinion, the Supreme Court merely states that “Congress

intended that they [the attribution rules] be taken into account

wherever ownership of stock was relevant.” See 397 U.S. at 307;

emphasis added.

A-52

this case make no such demand. Indeed, respondent on brief

makes clear that the instant case can be disposed of on

a narrower ground.

The trust herein is the constructive owner of 100 percent

of the shares because its beneficiary, one Jacob Metzger

(Jacob), is deemed to own them all. See sec. 318 (a) (3) -

(B) (i). He is the actual owner of some, and is the con-

structive owner of the rest of the shares, which are actually

owned by a trust, of which he is the beneficiary, and trusts

for each of his children. See sec. 318(a) (2) (B) (i) and

(a) (1) (A) (ii). There is no link in the chain from child’s

trust to child to father (Jacob) to the trust where dishar-

mony exists; to the contrary, the only fight was between

Jacob and his sisters, and no one is seeking to attribute

stock ownership across those unfriendly lines.’ To be sure,

were the trust controlled by a trustee who was given sub-

stantial discretion and who thought ill of Jacob, this case

might be fitted within the Robin Haft Trust mold. But here,

Jacob was both the trustee of the taxpayer/trust and a

beneficiary, and it seems obvious that Jacob could not be

hostile to himself. Thus, all of the attribution rules relevant

to the instant case accord with reality, and so their appli-

cation herein is consistent with the rationale behind section

318. We need not decide whether we may or should

ameliorate the application of the section 318 rules if justice

would be served thereby, and I believe that a proper respect

for the judicial function and its inherent limitations requires

that we do not decide these questions before they are

properly presented.

The majority apparently does not entirely reject the use

of family discord. However, it limits such use to cases in

‘which the taxpayer’s actual and constructive ownership

after the redemption is less than his actual and constructive

ownership before the redemption, and only at that point is

it used to determine whether such reduction was “meaning-

SSomewhat ironically, attribution between siblings is not even

authorized by the statute. See sec. 318(a)(1) and (a)(5)(B).

Compare secs. 267(c) (4), 544(a) (2), and 554 (a)(2).

A-53

ful.” Yet, if a taxpayer’s only ownership of stock after the

redemption is purely constructive, and if the premise upon

which that legal fiction was built is refuted by family

discord, of what possible relevance can the amount of owner-

ship fictionally attributed be? The Court today raises to the

level of an essential prerequisite to rational factfinding @

factor which, under the circumstances of this case, seems

wholly irrelevant, and thereby paves a road for objection-

ably arbitrary results.

Suppose a father and son jointly own a corporation until

they have a bitter dispute, at which time the son is com-

pletely redeemed. If, before the redemption, they owned in

the aggregate 100 percent of the corporation’s outstanding

stock, they each will be deemed to own 100 percent of the

corporation after the redemption. Thus, the rule which the

majority feels compelled to adopt would treat the

redemption as essentially equivalent to a dividend under

section 302(b) (1).° However, if a third party (say, an

employee) owned as little as 1 share, the redemption would

reduce percentage-wise the son’s constructive ownersitip

ever so slightly below that of his previous actual and con-

structive ownership, and thus he would now be free under

the majority’s rule to argue that the attribution rules should

be overlooked because of the family feud.’ Yet, it seems

clear to me that whether or not a third party owns a minimal

amount of stock has nothing whatsoever to do with the

issue. How one should dovetail United States v. Davis,

supra, with the views of the Court of Appeals in Robin Haft

Trust v. Commissioner, supra, can be left for another day.®

I would refrain from doing more than deciding this case

solely upon the basis that the family hostility in this case

does not preclude the application of section 318.

Fay, Irwin, SrerreTt, and HALL, JJ., agree with this

concurring opinion.

In order to keep the hypothetical simple, I have ignored the

waiver provisions of sec. 302(c) (2) which might be available to

the son as I have posed the case. However, by simply modifying

the facts in Robin Haft Trust, one can create a perfectly valid if

somewhat complex situation involving a trust which would be

analogous to the situation presented above.

1Cf£. Parker v. Commissioner, T.C. Memo. 1961-176.

8See, e.g., A. Cathcart, “Section 302 Redemptions: Family Fights

and Attribution,” 61 A.B.A.J. 1272 (1975).

A-54

UNITED STATES COURT OF APPEALS

FOR THE FIFTH CIRCUIT

a

eal

No. 81-4324

tin

Your Nos. TC 8824-77, 8856-77 & 6990-79

Davp Merzcer Trust, JAcoB METzcer, TRUSTEE, and

METzcER Darrtes, INc.,

Petitioners-Appellants,

versus

COMMISSIONER OF INTERNAL REVENUE,

Respondent-Appellee.

Appeal from the Decision of the United States Tax Court

Before THORNBERRY, JOHNSON and HIGGINBOT-

HAM, Circuit Judges.

JUDGMENT

This cause came on to be heard on the transcript of the

record of the Tax Court of the United States, and was

argued by counsel;

ON CONSIDERATION WHEREOF, It is now here ordered and

adjudged by this Court that the decisions of the said Tax

Court in the cause be, and the same are hereby affirmed;

IT IS FURTHER ORDERED that petitioners-appellants pay to

respondent-appellee the costs on appeal to be taxed by the

Clerk of this Court.

DECEMBER 13, 1982

ISSUED AS MANDATE:

B-1

David METZGER TRUST, et al.,

Petitioners-Appellants,

Vv.

COMMISSIONER OF INTERNAL REVENUE,

Respondent-Appellee.

No. 81-4324.

United States Court of Appeals,

Fifth Circuit.

December 13, 1982.

Taxpayers petitioned for a redetermination of deficiencies.

The Tax Court, 76 T.C. 42, upheld the deficiencies, and

taxpayers appealed. The Court of Appeals, Patrick E. Hig-

ginbotham, Circuit Judge, held that: (1) the attribution

rules of the Internal Revenue Code were applicable despite

family discord, and (2) a trust could not waive the

attribution rules by filing a waiver agreement.

Affirmed.

1. Internal Revenue — 3815

Family hostility did not mitigate application of attribution

rules in determining dividend equivalency of redemption of

stock. 26 U.S.C.A. § 302 (b) (1).

2. Internal Revenue — 3815

Trust could not waive attribution rules by filing waiver

agreement. 26 U.S.C.A. §§ 302(c) (2) (A) (iii), 318 (a).

3. Internal Revenue — 3815

Attribution rules of statute disallowing deductions for

certain transactions between related taxpayers were appli-

cable to interest payments between family members, even

though family members were in discord. 26 U.S.C.A. §

267 (c).

Appeal from the Decision of the United States Tax Court.

B-2

Before THORNBERRY, JOHNSON and HIGGIN-

BOTHAM, Circuit Judges.

PATRICK E. HIGGINBOTHAM, Circuit Judge:

We decide today a story driven by tensions as old as

Genesis but told in the modern lexicon of the tax law. It is

the story of David who built a business and left it in the

charge of his eldest son Jacob to be shared with Jacob’s

two sisters Catherine and Cecelia, of their alienation and

resulting quarrel with the tax collectors. In reviewing this

decision of the Tax Court we are asked to determine the

tax consequences of a reallocation of ownership of this

family-owned business operated as a closely held corpora-

tion. In doing so we face three questions: (1) whether the

attribution rules of I.R.C. § 318(a) must be applied despite

family discord in determining whether a redemption meets

the “not essentially equivalent to a dividend test” of §

302(b) (1); (2) whether a trust may waive the attribution

rules of § 318(a) by filing a waiver agreement pursuant to

§ 302(c) (2) (A) (iii); (3) whether the attribution rules of

§ 267(c) must be applied to interest payments between

family members in discord. Governed by the plain language

of the Code, a goal of a coherent tax policy, and the relevant

Supreme Court precedents, 76 Tax Court 42, we affirm the

decision of the Tax Court.

FACTS

The relevant facts are not in dispute and have been agreed

to in a stipulation of record. Appellant David Metzger Trust

was created by David Metzger in 1942 to benefit his wife

as life income beneficiary and his three children, Jacob,

Catherine, and Cecelia, as one-third remaindermen each.

Jacob, the eldest son, was named trustee of the Trust.

Four years later, David incorporated the family business

as Metzger Dairies, Inc., the other appellant. The Trust

became a shareholder of Metzger Dairies.

On David’s death in 1953 Jacob Metzger assumed control

of Metzger Dairies. Catherine and Cecelia were directors.

In the years following the father’s death the sibling quarrel

B-3

grew in intensity. By the 1960’s, open animosity developed

among Jacob, Catherine, and Cecelia. Whatever the source

of their alienation, a downturn in the success of the dairy

only exacerbated the problem. Catherine and Cecelia

became angry when the corporation stopped paying divi-

dends. Catherine resented what she considered to be Jacob’s

interference in the management of Metzger Dairy of San

Antonio, a corporation of which her son was president but

whose stock was owned for the most part by the same

parties who owned the stock of Metzger Dairies. Cecelia

was annoyed at both Jacob and Catherine because both

corporations failed to pay dividends. The argument among

Jacob, Catherine, and Cecelia over these and other issues

unrelated to the business of the corporations continued until

1972, when the acrimony reached the point that Jacob,

Catherine, and Cecelia concluded it was necessary to termi-

nate their joint ownership of the corporations.

After lengthy negotiations all agreed that Jacob and his

family would own Metzger Dairies, Catherine and her

family would own Metzger Dairy of San Antonio, and

Cecelia and her family would be cashed out. The plan was

for Metzger Dairies to redeem all shares owned by

Catherine, Cecelia, the trusts for Catherine and Cecelia,

and the David Metzger Trust. It was necessary to include

the David Metzger Trust in the redemption because Cath-

erine and Cecelia were due to receive one-third of the Trust

corpus on the death of David Metzger’s widow.

Immediately before the redemption, the stock of Metzger

Dairies was held as follows:

Stockholder

David Metzger Trust

Nora Metzger (David Metzger’s widow)

Jacob Metzger

Trust for Jacob Metzger

Catherine

Trust for Catherine

Cecelia

Trust for Cecelia

esuguges|e

The redemption occurred on January 22, 1973, leaving

Metzger Dairies’ stock as follows:

Stockholder Shares

Jacob Metzger 600

Trust for Jacob Metzger 120

Trust for David Metzger, II (son of Jacob) 294

Trusts for Nan Metzger (daughter of Jacob) 207

The Commissioner concedes that the principal motivation

for the redemption was not to receive undistributed earn-

ings,’ but to end a business relationship that was charac-

terized by hatred and discord among Jacob, Catherine, and

Cecelia. On February 10, 1976, Jacob, as trustee of the

David Metzger Trust, delivered to the IRS a waiver agree-

ment, executed pursuant to 26 C.F.R. § 1.302-4 and pur-

porting to waive any future interest the trust might have in

the corporation.

The deferred obligation of Metzger Dairies to pay for

Cecelia’s 600 shares was evidenced by a promissory note

executed by the corporation and payable to Cecelia in three

annual installments of principal, plus interest, beginning

January 22, 1974. Interest payments were actually made on

January 21, 1974, January 7, 1975, and January 5, 1976.

As a cash basis taxpayer, Cecelia reported interest income

in 1974, 1975 and 1976, the respective years of receipt.

Metzger Dairies was an accrual basis taxpayer and claimed

deductions in the fiscal years ending September 30, 1973,

September 30, 1974, and September 30, 1975, for the liability

for interest as it accrued.

In May 1977 the Commissioner of Internal Revenue

assessed deficiencies against the David Metzger Trust for

the calendar year 1973 and against Metzger Dairies for the

fiscal years ending September 30, 1973, and September 30,

1As of the time of redemption, Metzger Dairies had accumulated

earnings of $1,815,060.77.

B-5

1974.2 On August 17, 1977, Metzger Dairies and the Trust

petitioned the Tax Court for a redetermination of these

deficiencies. Later the Commissioner assessed deficiencies

against Metzger Dairies for fiscal year 1975 as well.’ Metz-

ger Dairies filed a second petition for redetermination with

the Tax Court. All of the cases were consolidated for trial.

The Tax Court upheld the deficiencies. After an agreed

computation had been filed, it entered the judgment* here

appealed from.

THE TRUST’S APPEAL

(a) The Statutory Framework

While ordinary income treatment for dividends and

capital gains treatment for sales of stock are primer cate-

gories of the Internal Revenue Code, their line of separation

with stock redemptions is less than bright. Stock redemp-

tions may resemble both sales of stock and dividends, since

they involve corporate payment to a shareholder for stock

but may also distribute corporate earnings. The desire for

tax advantage insures recurring disputes over when a stock

redemption is a dividend and when it is a purchase of stock.

Given the inherent economic incentives of stock redemptions

in myriad form mirroring the variety of their commercial

2The Commissioner assessed a deficiency of $292,977.47 against

the Trust on the grounds that the $585,303.25 it received in redemp-

tion of the Metzger Dairies stock should have been reported as

dividend income. The Commissioner assessed deficiencies against

Metzger Dairies of $2,106.86 (FY 1973) and $24,856.38 (FY 1974)

mainly after disallowing interest deductions of $32,167.28 (FY 1973)

and $31,533.07 (FY 1974) for interest accrued but not paid to

Cecelia until more than 244 months after the close of the fiscal year.

*The Commissioner disallowed $13,926.46 of the interest deduction

claimed by Metzger Dairies for FY 1975 that represented interest

accrued but not actually paid to Cecelia until more than 244 months

after the close of the fiscal year. On this basis a deficiency of

$6,684.68 was assessed.

‘The Tax Court found deficiencies of $187,037.80 on the part of

the Trust for taxable year 1973, $21,677.55 on the part of Metzger

Dairies for taxable (i.e., fiscal) year 1974, and $6,684.68 on the

part of Metzger Dairies for taxable (i.e., fiscal) year 1975.

B46

objectives and often constructed by lawyers trained in an

adversarial tradition, a workable decision mechanism must

be capable of looking through innovative form te the eco-

nomic reality beneath. It is not surprising then that the

categorization process is heavily indexed by actual changes

in corporate ownership. That is, when a redemption sig-

nificantly reduces a stockholder’s voting interest in a cor-

poration, it resembles a sale of stock more than a dividend

and is to be accorded capital gains treatment. On the other

hand, if the redemption is basically a pro rata distribution,

it is treated as a dividend.* This principle, whose application

may also be termed a wary search for reality, is overlaid by

the circumstance that here the tax code presents in an acute

fashion the constant judicial tension of the competing

demands of predictability and case specific equity. Despite

their generality these principles form the regression line for

case reconciliation, and as we will see they provide an aid

to the identification of the judicial outliers.

Our specific analysis is channelled by the Code’s struc-

ture: payments to shareholders from accumulated earnings

will be treated as dividends unless the payment can be

brought under an exception. That is, the controlling premise

is that distributions by corporations to stockholders out of

the taxable year’s earnings or out of accumulated earnings

are to be treated as dividends. I.R.C. § 316(a). Section 302

provides the exceptions. If the redemption is “not essentially

equivalent to a dividend,” § 302(b) (1), a “substantially

disproportionate redemption of stock,” § 302(b) (2), or a

“termination of [the] shareholder’s interest,” § 302(b) (3),

5So, for example, if Stockholder A owns 60 of a corporation’s 100

shares of common stock, Stockholder B owns the other 40 shares,

and the corporation redeems 50 of A’s shares, capital gains treat-

ment is appropriate. On the other hand, if the corporation redeems

only 30 of A’s shares and 20 of B’s, the redemption is treated as a

dividend to the extent there are earnings to distribute. For some

practical examples illustrating the effects of §§ 302 and 318, see

Rickey v. United States, 592 F.2d 1251, 1256 (5th Cir. 1979). See

also Treas. Reg. § 1.302-2(b). There is a gray area — distributions

that do not significantly reduce a stockholder’s voting interest but

are not pro rata, either.

B-7

it will be treated as a distribution in exchange for the stock.

At first glance, all three of these provisions are applicable

to the Metzger transaction since the corporation purchased

all the stock of Catherine, Cecelia, their trusts, and the

David Metzger Trust, while at the same time made no pay-

ments to the other stockholders, namely Jacob Metzger and

his trust. Yet the attribution rules of the Code pose imme-

diate problems.

Attribution

If a father sells some of his shares back to a corporation,

yet after the transaction he and his ten year old son end

up owning the same combined percentage of voting shares,

the transaction cast as a stock purchase might be an extrac-

tion of corporate earnings in nondividend form. The Code

responds to this risk, with fixed attribution rules. An individ-

ual is considered to own the stock owned by his spouse,

children, grandchildren, and parents. § 318(a) (1). An estate

or trust is considered to own the stock owned by a bene-

ficiary of the estate or trust. § 318(a) (3). A beneficiary is

considered to own proportionately the stock owned by the

estate or trust of which he is a beneficiary. § 318(a) (2).

By these rules the Trust is the owner of the entire stock of

Metzger Dairies both before and after the redemption.

The Code provides that, with one exception, these attribu-

tion rules “shall apply in determining the ownership of stock

for purposes of” § 302. § 302(c) (1). The one exception is

that § 318(a) (1), the rules governing attribution of owner-

ship from individuals to individuals, shall not apply in the

*Before redemption the Trust was the constructive owner of Nora,

Jacob, Catherine, and Cecelia’s shares, because they were its bene-

ficiaries. § 318(a)(3)(B). Jacob, Catherine, and Cecelia were the

constructive owners of the shares held by their individual trusts.

§ 318(a)(2)(B). Thus, the Trust constructively owned all of Metz-

ger Dairies’ stock.

After redemption the Trust remained constructive owner of all

the stock because the shares held by the trusts for Jacob’s children

were attributable to the children, § 318(a)(2)(B), thence to Jacob,

§ 318(a)(1)(A), and finally to the Trust, § 318(a)(3)(B).

B-8

case of a distribution described in § 302(b) (3), that is, a

complete termination of a shareholder’s interest, if:

1. “immediately after the distribution the distributee has

no interest in the corporation (including an interest as

officer, director, or employee), other than an interest

as a creditor” (§ 302(c) (2) (A) (i));

2. “the distributee does not acquire any such interest

(other than stock acquired by bequest or inheritance)

within 10 years. . .” (§ 302(c) (2) (A) (ii));

3. the distributee files an agreement (a “waiver agree-

ment”) as prescribed by Treasury regulations (§ 302

(c) (2) (A) (iii) ).”

In other words, § 302(c) (2) (A) by its terms permits an

individual to avoid attribution of ownership if he gets out

of the corporation and agrees to stay out.

The commands of §§ 302 and 318 are unambiguous. By

their literal language, as an “entity” rather than an indivi-

dual, the David Metzger Trust does not qualify for the sole

statutory exception to the attribution rules. The Trust

argues however (1) that family discord should “mitigate”

against the applicability of the attribution rules, and (2)

that the Trust’s filing of a waiver agreement and complete

termination of its actual interest in the corporation (even

though the Trust is not an “individual”) effectively waived

the attribution rules. We turn to the first contention.

(b) A Family Discord Exception to Attribution?

"Even if these three conditions are met, the attribution rules will

not be waived if the distributee acquired any of the redeemed stock

within the past ten years from a person whose stock ownership is

otherwise attributable to him and tax avoidance was a primary pur-

pose of the transaction. § 302(c)(2)(B)(i). Nor will they be waived

if within the past ten years a person whose stock ownership is other-

wise attributable to the distributee acquired stock from the distribu-

tee and tax avoidance was a primary purpose of that transaction,

unless the stock is included in the redemption. § 302(c) (2) (B) (ii).

These are known as the “look back” provisions; § 302(c) (2) (A) (ii)

is known as the “look forward” provision.

B-9

[1] The Trust argues that family discord may “mitigate”

the application of the Attribution rules in determining divi-

dend equivalency, especially given the undisputed fact that

the purpose of the redemption was not to distribute cor-

porate earnings. From the stipulated fact that the purpose

of redemption was to bring peace to a family quarrel, the

Trust launches two attacks upon the attribution rules. First,

it argues that because it is undisputed here that the family

cannot function as an economic unit, the attribution rules,

built as they are upon that premise, are inapplicable.

Second, the Trust argues that even if the Trust by virtue

of attribution is virtually the sole shareholder before and

after, the redemption was nonetheless not essentially

equivalent to a dividend. The argument continues that this

follows from the undisputed purpose of the redemption.

That is, the purpose not being to bail out corporate earn-

ings, the central base for application of nonequivalency has

been touched.

As will be seen the first argument fails because it is built

upon the erroneous assumption that attribution is treated

by the Code as a rebuttable presumption rather than a

mandated view of familial relationships. The second argu-

ment fails because it denies full sway to the decision of the

Supreme Court in United States v. Davis, 397 U.S. 301, 90

S.Ct. 1041, 25 L.Ed.2d 323 (1970). Indeed, Davis provides

much of the answer to the first argument as well. For this

reason we will address the arguments together, separating

them only when necessary to context.

Davis

In Davis the Court held that the attribution rules of

§ 318(a) must be applied before determining dividend

equivalency. The Court held that regardless of a purpose

other than to distribute corporate earnings the after-attribu-

tion structure was such that the redemption was in the

nature of a dividend. In Davis, the taxpayer had purchased

the preferred stock of a corporation in 1945 in order to in-

B-10

crease the corporation’s working capital so that it might

qualify for an RFC loan. As originally planned, the loan was

fully repaid and the corporation redeemed the taxpayer's

preferred stock. By this time, however, the corporation’s

common stock was held entirely by the taxpayer, his wife,

his son, and his daughter. The Commissioner viewed the

redemption as essentially equivalent to a dividend because

after application of the attribution rules the taxpayer

“owned” 100% of the corporation’s common stock. Any

distribution to him, therefore, was a pro rata distribution to

all the corporation’s stockholders, or the essential equivalent

of a dividend.

The Supreme Court agreed with the Commissioner’s

analysis. In its first step it held that the attribution rules

had to be applied in determining dividend equivalency under

§ 302(b) (1). “[T]he attribution rules continued to be made

specifically applicable to the entire section, and we believe

that Congress intended that they be taken into account

wherever ownership of stock was relevant.” 397 U.S. at

306-307, 90 S.Ct. at 1044-1045. The taxpayer was deemed

the owner of all 1000 shares of the company’s common stock.

Second, the Court held that the presence or absence of

a tax-avoidance motive could not be considered in deter-

mining dividend equivalency under § 302(b) (1). Jd. 397

U.S. at 311, 90 S.Ct. at 1047. “‘[T]he business purpose of a

transaction is irrelevant in determining dividend equival-

ence.’” Id. 397 U.S. at 312, 90 S.Ct. at 1047 (quoting Has-

brook v. United States, 343 F.2d 811, 814 (2d Cir.1965) ).

The Court therefore concluded that the IRS had properly

characterized the redemption of the preferred stock as

essentially equivalent to a dividend, regardless of the tax-

= (and the corporation’s) business purpose back in

*It is not totally clear that the attribution rules Aad to be applied

in Davis to reach the Commissioner's result. Even if the taxpayer

were not considered the owner of all the corporation's common stock,

redemption of his preferred did not reduce his voting interest in the

corporation.

B-11

In Davis the Court reasoned:

After the application of the stock ownership attribu-

tion rules, this case viewed most simply involves a sole

stockholder who causes part of his shares to be re-

deemed by the corporation. We conclude that such a

redemption is always ‘essentially equivalent to a divi-

dend’ within the meaning of that phrase in § 302 (b) (1)

Id. 397 U.S. at 307, 90 S.Ct. at 1045. Davis teaches that in

applying the “essentially equivalent to a dividend” test after

the attribution rules are applied, if the resulting structure

has virtually the same incidents of ownership the corporate

payments distribute earnings despite an indisputable con-

trary business purpose.

Treas.Reg. § 1.302-2(b)

Confronted by the Supreme Court’s holding in Davis, the

Trust argues that its position nevertheless is supported by

Treas.Reg. § 1.302-2(b), language in Davis interpreting

§ 302(b) (1) as applying whenever there is a “meaningful

reduction in the shareholder’s proportionate interest,” and

the legislative history of § 302(b) (1).

Treas.Reg. § 1.302-2(b) provides:

The question of whether a distribution in redemption

of stock of a shareholder is not essentially equivalent

to a dividend under section 302(b) (1) depends upon

the facts and circumstances of each case. One of the

facts to be considered in making this determination is

the constructive stock ownership of such shareholder

under section 318 (a).

Pointing to this language the Trust argues that before and

after structure is only one factor in the dividend equivalency

inquiry. The argument continues that despite the circum-

stance that after attribution there was

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