Petition — Tilford v. Commissioner

eme Court, U.S,

83-299 Bays ary

AUG 23 1983

tn

No. —

IN THE

Supreme Court of the United States

OCTOBER TERM, 1983

HENRY C. TILFORD, JR. and BARBARA N. TILFORD,

« Petitioners

NTERNA™ REVENUE,

COMMISSIONER OF IN

Respondent

PETITION FOR WRIT OF CERTIORARI TO THE

UNITED STATES COURT OF APPEALS

FOR THE SIXTH CIRCUIT

H. WAYNE GRANT

(Counsel of Record)

JOHN P. KONVALINKA

GRANT, KONVALINKA &

GRUBBS, P.C

}

a )

r =@36 999

15/756-8232

WILSON - EPES PRINTING CO

QUESTIONS PRESENTED

1. Whether Treasury Regulation § 1.83-6(d) (1978),

which defines the tax consequences to shareholders of

transfers of their property to corporate employees in con-

nection with restricted stock plans, reasonably promotes

the purpose of section 83 of the Interna] Revenue Code,

which does not mention such shareholders and which deals

solely with the tax consequences of such transfers to the

recipient-employees and their employers; whether lan-

guage in the Senate Finance Committee Report on which

the Regulation is based goes beyond section 83, rendering

it infirm as support for the Regulation.

2. Whether Treasury Regulation § 1.83-6(d) (1978) is

inconsistent with section 1001(c) [formerly section 1002]

of the Internal Revenue Code to the extent that the Regu-

lation purports to treat such property transfers by share-

holders as contributions to the capital of the corporation

rather than as sales or exchanges of property on which

gain or loss is recognized.

(i)

TABLE OF CONTENTS

Page

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TABLE OF AUTHORITIES

CASES Page

Chock Full O’Nuts Corp. v. United States, 453 F.2d

BOO CBA CaP, TOT) nncnoseccececcnsecsesenssnsssecsocassatteinines 7

Commissioner v. Brown, 380 U.S. 563 (1965) ..... 7

Downer v. Commissioner, 48 T.C. 86 (1967) .......... 8

Estate of Foster v, Commissioner, 9 T.C. 930

CITY ac caecassscsstndyevicisesvesennecsonbatcegninnenenancopnsseinnanss 8

Ex Parte Collett, 8387 U.S. 55 (1949) .........2...ccceeeees 9

Gregory v. Helvering, 293 U.S. 465 (1935) ............. 7

Hart v. United States, 585 F.2d 1025 (Ct.Cl. 1978).. 10

Helvering v. City Bank Farmers Trust Co., 296

is © 2. | | pee 9

Howe v. Smith, 452 U.S. 473 (1981) ........ccceceeeees i)

Immigration and Naturalization Service v. Chadha,

51 U.S.L. Week 4907 (June 21, 1983) ............05 10

Miller v. Commissioner, 45 B.T.A. 292 (1941)........ 8

Peabody Coal Co, v. United States, 8 F. Supp. 845

COTE, SIE vcsecseiceccvestccrenrevccessiccehesesierestomnencsccete x

Sack v. Commissioner, 33 T.C. 805 (1960) ............ 8

Tennessee Valley Authority v. Hill, 4837 U.S. 153

DID essence eevee soreneesessnccincnnbtiainnebansannnesnesbeest 9

United States v. Cartwright, 411 U.S, 546 (1973).. 6,8

United States v. Missouri Pacific Railroad Co., 278

THB, GO CRIN accesses ieccersontirescreinenines 9

United States v. Shreveport Grain & Elevator Co.,

OE TT FE CID cavceacexccerre cesses nrsrcententrnncicnivapeenmens

Wright v. Commissioner, 18 B.T.A. 471 (1929) .......

STATUTES

GB U.S.C. § 8B .....s.ccscccescessorsesscseccecsssrsscescseosnonsess 1-3, 9

26 U.S.C. § 1001 (C) .........eeccccseereessenenneenenseseeneennes 1, 3, 8

2B U.S.C. § 6218 (a) .........cesseesseeeeeeeeneneseresensnnsennnnenes 5

5

1

aowo

2B U.S.C. § 7460 (1) .........ceccsssssessesesessersecssenssensnreees

OB VG.C. & 12B4( 1) ..............c.c.crsececsrssessserassonesscssosse

REGULATION

Treasury Regulation § 1.83-6(d) (1978) ...........0. 1, 4-9

LEGISLATIVE HISTORY

Tax Reform Act of 1969, S. Rep. No, 552, 91st

Cong., 1st Sess, 123-24, 1969 U.S. Code Cong.

Be Ad. NewS 2087 ....0c.-ccccsccssessseossoccccsvcessscseseensnsseese 3, 4,9

IN THE

Supreme Court of the United States

OCTOBER TERM, 1983

No, ——

HENRY C. TILFORD, JR. and BARBARA N, TILFORD,

m Petitioners

COMMISSIONER OF INTERNAL REVENUE,

Respondent

PETITION FOR WRIT OF CERTIORARI TO THE

UNITED STATES COURT OF APPEALS

FOR THE SIXTH CIRCUIT

OPINIONS BELOW

The opinion of the Tax Court is reported at 75 T.C.

134. The opinion of the United States Court of Appeals

for the Sixth Circuit is reported at 705 F.2d 828.

STATEMENT OF JURISDICTION

The judgment of the United States Court of Appeals

for the Sixth Circuit was made and entered on April 20,

1983, Petitioners’ motion for rehearing and rehearing en

bane was denied in an order entered on May 27, 1983.

The jurisdiction of this Court is invoked under 28 U.S.C.

§ 1254(1).

STATUTES AND REGULATIONS

26 U.S.C. § 88

26 U.S.C. § 1001(c)

Treasury Regulation § 1.83-6(d) (1978)

The full text of the cited statutes and regulation is

found at Appendix C,

2

STATEMENT OF THE CASE

A restricted stock plan is an arrangement in which

stock, either of the employer corporation or other com-

panies, is transferred to employees at bargain prices, sub-

ject to restrictions which affect its value. Such restric-

tions commonly require the return or resale of the stock

if the employee leaves the employer before expiration of

a stated employment term. Restricted stock plans are

forms of deferred compensation that have become increas-

ingly widespread in recent years.

Until 1969, the Internal Revenue Service imposed no

tax on the recipient-employee at the time he received the

restricted stock. Tax was deferred until] the restrictions

lapsed, and then imposed only on the value of the stock as

of its date of transfer, without regard to any increase

in value in the interim; moreover, if the stock value had

declined at the time the restrictions lapsed, the lower

value was regarded as the amount of compensation. This

treatment gave restricted stock plans important advan-

tages over other deferred compensation arrangements.

By 1969, the increasing popularity of restricted stock

plans caused Congress to tighten this favorable tax treat-

ment. In section 321 of the Tax Reform Act of 1969, now

codified as section 83 of the Interna] Revenue Code, Con-

gress dealt with the tax consequences of transfers of

property made in connection with the performance of

services, particularly including restricted stock plans.

The primary aim of section 83 was to accelerate and

enhance the taxability of such transfers by defining those

amounts includable in gross income of the recipient-

employee and by determining the timing of such income

inclusion. “In general, section 83 provides that property

received for the performance of services is to be included

in the income of the recipient (at its fair market value) ;

3

however, if the property is not freely transferable by the

recipient, or is subject to forfeiture, the value of the

property is determined and taken into income only upon

the termination of such restrictions.” Tilford v. Com-

missioner, 75 T.C. 134, 143 (1980).

Although section 83 was an income-defining measure in

primary purpose and effect, section 83(h) dealt with

deductions, continuing the former practice of granting a

business expense deduction to the employer to correspond

with the income required to be reported by the recipient-

employee.

Stock used in restricted stock plans may be provided by

the employer, or the stock may be transferred to the em-

ployees by shareholders of a corporate employer. Nowhere

does section 83 address the tax consequences of such

transfers to such third-party shareholders who may pro-

vide the stock used in a restricted stock plan. Such trans-

fers have long been governed by section 1001(c) [for-

merly section 1002] of the Internal Revenue Code, which

recognizes gains or losses to the shareholder in connec-

tion with any such sale or exchenge of property.

But although Congress did not seek to address in sec-

tion 83 the tax consequences of such stock transfers by

shareholders, or undertake to affect the longstanding ap-

plicability to them in section 1001(c), the Senate Finance

Committee included the following language in its Com-

mittee Report on the Tax Reform Act of 1969:

In general, where a parent company’s or a share-

holder’s stock is used to compensate employees under

a restricted stock plan, the transfer of the stock by

the parent company or shareholder is to be treated

as a capital contribution to the company which is to

be entitled to a deduction in accordance with the re-

stricted property rules. The parent company or the

shareholder merely is to reflect the contribution as

an increase of the equity in the company which is

entitled to the compensation deduction.

4

Tax Reform Act of 1969, S. Rep. No. 552, 91st Cong., 1st

Sess. 123-24, 1969 U.S. Code Cong. & Ad. News 2027,

2155.

Nine years later, the Internal Revenue Service adopted

26 C.F.R. § 1.838-6(d) (1978), which, based on the lan-

guage of the Senate Committee Report, undertook to

preclude the established application of section 1001(c) to

shareholder stock transfers by characterizing the transfers

as contributions to capital of the employer corporation:

(d) Special rules for transfers by shareholders—(1)

Transfers. If a shareholder of a corporation trans-

fers property to an employee of such corporation or

to an independent contractor (or to a beneficiary

thereof), in consideration of services performed for

the corporation, the transaction shall be considered

to be a contribution of such property to the capital

of such corporation by the shareholder, and immedi-

ately thereafter a transfer of such property by the

corporation to the employee or independent con-

tractor under paragraphs (a) and (b) of this sec-

tion. For purposes of this (1), such a transfer will

be considered to be in consideration for services per-

formed for the corporation if either the property

transferred is substantially nonvested at the time of

transfer or an amount is includable in the gross in-

come of the employee or independent contractor at

the time of transfer under § 1.83-1(a) (1) or § 1.83-

2(a). In the case of such a transfer, any money or

other property paid to the shareholder for such stock

shall be considered to be paid to the corporation and

transferred immediately thereafter by the corpora-

tion to the shareholder as a distribution to which

section 302 applies.

Treasury Regulation § 1.83-6(d) (1978).

This taxpayer’s suit arises out of the Commissioner of

Internal Revenue’s disallowance of a deduction claimed by

petitioner Henry C. Tilford, Jr. pursuant to section

1001(c) on losses on transfers of stock in a closely held

5

corporation in the years 1971 through 1973. The basis for

the disallowance was Treasury Regulation § 1.83-6(d).

Tilford has a sign business, incorporated in 1969 as

Watco, Inc., a Tennessee corporation. As of December 31,

1970, Tilford had invested $350,000.00 in Watco stock,

owning all of the company’s shares, and had loaned the

company an additional $79,500.00. Wateo consistently

lost money, and Tilford, without significant experience in

the sign industry, solicited experienced personnel in an

effort to turn the company around.

To give key employees a stake in the future outcome

of the business, Tilford sold them substantial blecks of

his Watco stock at nominal prices which accurately re

flected the company’s lack of market value at the time.

By contract, Tilford retained the first right of refusal

to repurchase the stock so transferred, if the recipient-

employee ever wished to sell or for any reason left Watco’s

employment. In 1971-73, Tilford claimed losses that re

flected the difference between his basis in the transferred

Watco stock and the nominal amounts he received from

the recipient-employees.

The Commissioner disallowed the deductions, conclud-

ing that the stock transfers were contributions to the

capital of Watco by Tilford. The basis for the disallow-

ance is Treasury Regulation § 1.83-6(d), which became

finally effective in 1978, years after Tilford’s claimed

deductions, and subsequent to the commencement of this

litigation. The Tax Court’ allowed the claimed deduc-

tions, holding that Treasury Regulation § 1.83-6(d) was

invalid because it lay “outside the scope of the statutory

provisions of section 83[,]” 75 T.C. at 145, a section the

Tax Court found to be “an income-defining section, en-

1The Tax Court’s jurisdiction was properly invoked under 26

U.S.C. §6213(a). This case was heard before the Honorable Leo

H. Irwin and was considered significant enough to be reviewed

by the Tax Court pursuant to 26 U.S.C. § 7460(b).

6

acted primarily to deal with the recognition of income

under certain restricted stock compensation plans.” 75

T.C. at 144. The Tax Court found nothing in the plain

language of section 83 to support a conclusion that Con-

gress had intended to remove bona fide sales or exchanges

of stock from the treatment provided by section 1001(c).

The Tax Court was unimpressed by the Senate Commit-

tee Report, noting that “the committee report is not the

statute, and to the extent that its language goes beyond

the legislation then being enacted or theretwfore existing

statutory provisions (7.e., section 1002), it certainly can-

not serve as support for a regulation suffering the same

infirmity.” 75 T.C. at 146.

On appeal, a divided Court of Appeals for the Sixth

Circuit reversed, upholding Treasury Regulation § 1.83-

6(d) as consistent with the legislative history of section

83 expressed in the above-quoted portion of the Senate

Committee Report. A timely petition for rehearing and

rehearing en bane was denied, and this petition for

certiorari followed.

REASONS FOR GRANTING THE WRIT

This case draws into serious question the validity of an

important Treasury Regulation not previously considered

by this Court. Moreover, the judgment below raises sig-

nificant issues concerning the use of congressional com-

mittee reports to legislate matters neither addressed nor

suggested by the statutes to which they pertain.

1. The Commissioner’s disallowance of Tilford’s

claimed deduction is based solely on Treasury Regulation

§ 1.83-6(d), which must be reasonably related to the

purpose of section 83, the statute from which the Regula-

tion derives. United States v. Cartwright, 411 U.S. 546,

550 (1973).? But section 83 has nothing to do with the

2Interestingly, Treasury Regulation §1.83-6(d) was finally

adopted only after this case had been tried and briefed in the Tax

Court. Although the Secretary of the Treasury has power to adopt

7

tax consequences to third-party shareholders who sell or

exchange property in connection with restricted stock

compensation plans; that section undertakes to define

such consequences only for the recipients of the trans-

ferred stock and for persons for whom the recipient-

employees performed services. Section 83 nowhere pur-

ports to deny a deduction to third-party shareholders who

provide the stock for restricted stock plans. Because it

goes far beyond the plain language of section 83(h) and

legislates with respect to matters not included in the

statute’s scope, Treasury Regulation § 1.83-6/d) is in-

valid.

The Regulation further contradicts section 1001(c), in

which Congress specifically provided for recognition of a

gain or loss upun the sale or exchange of property such as

the Watco stock here involved.* By forcing such transfers

to be treated as contributions to capital, Treasury Regu-

lation § 1.83-6(d) defeats the congressional purpose ex-

pressed in section 1001(c). The inconsistency of the

regulations with retroactive effect, that power is subject to an abuse

of-discretion review. The Secretary’s exercise of his discretion is

properly regarded with some skepticism when the regulation with

which the Commissioner seeks to support his disallowance of a de

duction was adopted both after the disallowance decision was made

and after litigation challenging that decision was commenced. See

Chock Full O’Nuts Corp. v. United States, 453 F.2d 300, 203 (2d

Cir. 1971) (“the Commissioner may not take advantage of his power

to promulgate retroactive regulations during the course of a litiga-

tion for the purpose of providing himself with a defense based on

the presumption of validity accorded to such regulations.” )

* The Commissioner has not seriously contended that the trans-

actions between Tilford and Watco employees were not sales or

exchanges of property otherwise within the scope of section 1001(c).

See Commissioner v. Brown, 380 U.S. 563, 570-71 (1965). The claim

is rather that section 83(h) and Treasury Regulation § 1.83-6/d)

preclude the application of section 100l(c) to such transactions.

Even if Tilford’s actions were motivated in part by a desire to

reduce his taxes, rather than solely by concern for Watco, that is of

course no reason why section 1001(c) could not apply. See Gregory

v. Helvering, 293 U.S. 465 (1935).

8

Regulation with section 1001(c) is ample reason to in-

validate the Regulation. United States v. Cartwright, 411

U.S. 546, 557 (1973).

The Regulation also obliterates the necessary distinc-

tion between a shareholder’s contribution to a corporation

which does not affect his ownership interest in the cor-

poration, and a stock transfer which reduces that owner-

ship interest. In the former situation, the transfer in-

creases the shareholder’s basis in his stock, and is there-

fore properly regarded as a contribution to capital; in the

latter circumstance, the transfer, as a non pro rata sur-

render of stock, reduces the shareholder’s interest in the

corporation and may give rise to a deductible loss rather

than a contribution to capital. This view has been gen-

erally accepted, Downer v. Commissioner, 48 T.C. 86

(1967); Sack v. Commissioner, 33 T.C. 805 (1960),

Estate of Foster v. Commissioner, 9 T.C. 930 (1947);

Peabody Coal Co. v. United States, 8 F. Supp. 845 (Ct.Cl.

1934); Miller v. Commissioner, 45 B.T.A. 292 (1941),

acquiesced 1941-2 C.B. 9, acquiescence withdrawn and

nonacquiescence substituted 1977-1 C.B. 2; Wright v.

Commissioner, 18 B.T.A. 471 (1929), and its disregard

by the Regulation constitutes an independent reason

warranting this Court’s attention.

Treasury Regulation § 1.83-6(d) and the result below

have important consequences. Restricted stock plans con-

stitute an increasingly prevalent and useful means of

granting deferred compensation to corporate employees.

The ability to make the full benefits of such stock trans-

fers contingent upon the recipient-employee’s continued

tenure in the corporation makes the plans attractive to

employers. Restricted stock plans can be important con-

tributors to business stability and employee incentive.

Transfers of stock from existing shareholders to corporate

employees are a common method of executing restricted

stock plans, particularly in the case of professional and

closely held corporations. In these cases, application of

Treasury Regulation § 1.83-6(d) may impede restricted

stock plans and produce anomalous tax consequences.

Clearly, shareholders will be reluctant to convey stock

under circumstances which will cause an economic loss

to them if they are deprived of the benefits of a deduc-

tion. Moreover, stock transfers may be made by share-

holders to employees for reduced consideration, but under

circumstances in which a capital gain would be realized

by the shareholder, whose basis in the stock may be low.

Application of Treasury Regulation § 1.83-6(d) would

permit the shareholder to avoid or defer taxation of this

gain. Congress cannot have intended, in section 83, to

create a tax shelter for private investors.

2. Without support in the language of section 83,

Treasury Regulation § 1.83-6(d) is derived exclusively

from the previously-quoted language in the Senate Fi-

nance Committee Report. 1969 U.S. Code Cong. & Ad.

News 2027, 2155; supra at 3. That the Regulation is

faithful to this language cannot be doubted. But it also

cannot be doubted that nothing in section 83 provides any

basis for the Senate Committee Report.

There is no ambiguity in the treatment section 83 af-

fords third-party shareholders who provide the stock used

in restricted stock plans. The statute does not purport to

affect them. Because no ambiguity exists in the scope of

section 83, the Court of Appeals was wrong to consult

legislative history indicating a contrary congressional in-

tent, Tennessee Valley Authority v. Hill, 437 U.S. 153,

184 n.29 (1978); Ex parte Collett, 387 U.S. 55, 61

(1949) ; Helvering v. City Bank Farmers Trust Co., 296

U.S. 85, 89 (1935), which in any event cannot contradict

the statute’s conclusive effect. See Howe v. Smith, 452

U.S. 473 (1981); United States v. Shreveport Grain &

Elevator Co., 287 U.S. 77, 83-84 (1932); United States

v. Missouri Pacific Railroad Co., 278 U.S. 269, 277-78

(1929).

10

The inclusion of language in congressional committee

reports that is at odds with the plain language of the

statute is not a phenomenon unique to this case. In

Hart v. United States, 585 F.2d 1025 (Ct. Cl. 1978), the

Court of Claims was confronted with such language in

both the House and Senate Committee Reports to a 1960

tax bill. The Court’s reaction was correct:

The first and most obvious comment is that these

statements contradict the plain language of the stat-

ute they purport to relate to. It seems obvious that,

under the Constitution, Congress must legislate in

bills enacted in proper form and presented to the

President for signature. To legislate by committee

report would raise a constitutional problem at least

as serious as the current one about the one-house

veto. For such a contradictory report to have weight,

therefore, we believe that even though contradictory,

it must afford persuasive indication on its face that

its authors believed they were fairly construing the

statute as enacted, not amplifying, amending, or

correcting it.

585 F.2d at 1030.

To be sure, not all statutes offer plenary solutions to

the problems they address. In those instances where stat-

utes are ambiguous, resort to legislative history is some-

times needed to determine congressional intent. Admin-

istrative regulations, when necessary and authorized by

the Congress, fill in the spaces that statutes do nev reach.

But as this Court has often recognized, a committee re-

port is not the statute, and an administrative agency is

not the Congress. Just as the Presentment Clauses and

the bicameral requirement, as aspects of our separation

of powers, limited the power of Congress to act through

the one-house veto, Immigration and Naturalization Serv-

ice v. Chadha, 51 U.S.L. Week 4907 (June 21, 1983), the

constitutional system requires the tax laws to be passed

by the Congress, not its committees, and to be presented

to the President for approval. When a committee report

11

undertakes to speak on a subject on which the statute is

wholly silent, and when courts give effect to that language

without regard to the plain terms of the statute, the con-

stitutional scheme is subverted.

It is impossible to review this case without being left

with the view expressed by Judge Nichols in dissent

below:

[T]he Finance Committee wanted very much for

the stockholder to be required for tax purposes to

treat as a capital contribution to the corporation the

stock he distributed to employees to retain them in

corporate employ. The only trouble is the Committee

failed to embody its wishes in an enacted bill. If this

failure is not decisive of the case before us, the

Committee is potent indeed.

705 F.2d at 832.

CONCLUSION

The Petition for Writ of Certiorari should be granted.

Respectfully submitted,

H. WAYNE GRANT

(Counsel of Record)

JOHN P. KONVALINKA

GRANT, KONVALINKA &

GRUBBS, P.C.

600 Tallan Building

Chattanooga, Tennessee 37402-2502

615/756-8232

W. WAYNE DRINKWATER, JR.

LAKE, TINDALL, HUNGER

& THACKSTON

127 South Poplar Street

P, O. Box 918

Greenville, Mississippi 38701

601/378-2121

APPENDICES

la

APPENDIX A

UNITED STATES COURT OF APPEALS

FOR THE SIXTH CIRCUIT

No, 81-1447

HENRY C. TILFORD, JR. and BARBARA N. TILFORD,

Petitioners-A ppellees,

Vv.

COMMISSIONER OF INTERNAL REVENUE,

Respondent-A ppellant.

Appeal from the Decision of the

United States Tax Court

Decided and Filed April 20, 1983

Before: EDWARDS, Chief Circuit Judge, JoNEs, Circuit

Judge and NICHOLs,® Circuit Judge.

EpWarps, Chief Circuit Judge, delivered the opinion

of the court and was joined by JoNEs, Circuit Judge.

NICHOLS, Circuit Judge, (pp. 7-10) delivered a separate

dissenting opinion.

Epwarpbs, Chief Circuit Judge. This is an appeal by

the Commissioner of the Internal Revenue Service from

*Judge Nichols was an Associate Judge of the United States

Court of Claims when this case was argued. He was sitting by

designation. On October 1, 1982, he became a member of the newly

created United States Court of Appeals for the Federal Circuit,

with the title of Circuit Judge, by various provisions of Pub. L

No. 97-164.

2a

a Tax Court decision that held an IRS regulation invalid

and by so doing, permitted the taxpayer to take substan-

tial capital loss deductions.

The facts indicate that taxpayer Henry Tilford was the

principal officer and shareholder of a company called

Watco. He had invested $350,000 in the company stock,

thereby owning all of Watco’s 170,000 issued shares, and

had advanced an additional $79,500 in loans by the end

of 1970. Seeking to motivate a number of employees, he

“sold” approximately 133,000 of these shares to said em-

ployees, each block of stock being priced at $1.00 but with

an agreement by which he reserved the right of first re

fusal to himself to repurchase the stock at book value in

the event the employee concerned left Watco employment.

The company failed and plaintiff, as employees left,

repurchased the stock which had been issued to them.

In his personal tax returns for the years 1971, 1972

and 1973, Tilford claimed losses from the original sales

of stock. He took deductions in amounts of $370,992,

$150,497 and $159,246, respectively for those years.

The Revenue Service disallowed these deductions claim-

ing they were transfers of property in connection with

the performance of services and hence contributions to

Watco’s capital under section 83 of the Interna] Revenue

Code. The Tax Court reversed and found for the tax-

payer. It reasoned that the treasury regulation on which

IRS relied is outside the scope of section 83 and held that

Tilford was entitled to his claimed capital loss deductions.

Six Tax Court judges dissented. The Revenue Service

appeals to this court.

The case involves consideration of a Tax Court case

upon which the majority of the Tax Court relied, Downer

v. Commissioner, 48 T.C. 86 (1967), and another Tax Court

decision Smith v. Commissioner, 66 T.C. 622 (1976). The

Smith case was subsequently reversed by the Fifth Cir-

cuit under the name Schleppy v. Commissioner, 601 F.2d

196 (1979), with Judge Tuttle writing for the court. See

8a

also Deputy v. Dupont, 308 U.S. 488 (1940), and /nter-

state Transit Lines v. Commissioner, 319 U.S. 590

(1943).

The applicable subsection of the IRS Code is section

83(h):

(h) Deduction by employer.—In the case of a

transfer of property to which this section applies or

a cancellation of a restriction described in subsection

(d), there shall be allowed as a deduction under

section 162, to the person for whom were performed

the services in connection with which such property

was transferred, an amount equal to the amount in-

cluded under subsection (a), (b), or (d) (2) in the

gross income of the person who performed such serv-

vices. Such deduction shall be allowed for the tax-

able year of such person in which or with which

ends the taxable year in which such amount is in-

cluded in the gross income of the person who per-

formed such services.

We note at the outset that section 83(h) was adopted

by Congress in 1969 after the decision of the Downer case

and with apparent intention on the part of the Congress

to embrace a theory contrary to the one underlying the

Downer case.

The Internal Revenue Service, after Congress adopted

section 83(h), interpreted it and the congressional intent

in enacting it by adopting 26 C.F.R. § 1.83-6(d). This

regulation reads:

(d) Special rules for transfers by shareholders.—

(1) Transfers. If a shareholder of a corporation

transfers property to an employee of such corpora-

tion or to an independent contractor (or to a bene-

ficiary thereof), in consideration of services per-

formed for the corporation, the transaction shall be

considered to be a contribution of such property to

the capital of such corporation by the shareholder,

and immediately thereafter a transfer of such prop-

4a

erty by the corporation to the employee or inde

pendent contractor under paragraphs (a) and (b)

of this section. For purposes of this (1), such a

transfer will be considered to be in consideration for

services performed for the corporation if either the

property transferred is substantially nonvested at

the time of transfer or an amount is includible in

the gross income of the employee or independent con-

tractor at the time of transfer under § 1.83-l/(a) (1)

or § 1.83-2/a). In the case of such a transfer, any

money or other property paid to the shareholder for

such stock shall be considered to be paid to the cor-

poration and transferred immediately thereafter by

the corporation to the shareholder as a distribution

to which section 302 applies.

Treas. Reg. § 1.83-6(d) (1978).

This regulation appears to us to be consistent with both

the legislative history and statutory intent of section

83th).

The report of the Senate Finance Committee which

added section 83(h) to the bill which had already passed

the House explained:

In general, where a parent company’s or a share

holder’s stock is used to compensate employees under

a restricted stock plan, the transfer of the stock by

the parent company or shareholder is to be treated

as a capital contribution to the company which is to

be entitled to a deduction in accordance with the

restricted property rules. The parent company or the

shareholder merely is to reflect the contribution as an

increase of the equity in the company which is

entitled to the compensation deduction.

Tax Reform Act of 1969, S. Rep. No. 91-552, 91st Cong.,

Ist Sess. at 123-24, 1969-3 Cum. Bull. 500, 502.

This language is entirely consistent with much earlier

tax law interpretation written by the Supreme Court of

5a

the United States in Deputy v. Dupont, 308 U.S. 488

(1940) and Interstate Transit Lines v. Commissioner,

319 U.S. 590 (1943). Both cases held that payments

made by a stockholder for the benefit of his corporation

are not deductible by the stockholder.

Judge Simpson’s interpretation of the statute and the

regulation in his dissent (joined by three other judges)

is, we think, illustrative of the legislative purpose:

Usually, when we have a vexing question of statu-

tory interpretation, we are faced with a problem not

anticipated during the development of the legisla-

tion, and we are unable to ascertain the treatment

which Congress would have intended if it had con-

sidered the matter. Not so in this case. Here, the

legislative purpose is indisputable, and the regula-

tions undertake to carry out that purpose. The

majority quibbles with the way Congress undertook

to express its purpose, and because it did not set

forth all the intended rules in the statute itself, the

majority proposes to disregard the clearly manifested

legislative purpose.

When Congress decided to legislate with respect to

the tax treatment of bargain sales of property to

persons rendering services, it recognized that in ad-

dition to sales by an employer to an employee, it

needed to provide rules broad enough to cover other

compensatory sales of property. Thus, section 83(a),

which governs the taxability of the recipient of the

property, applies “If, in connection with the perform-

ance of services, property is transferred to any per-

son other than the person for whom such services

are performed.” Thus, the rule applies to any com-

pensatory transfer, not merely to a transfer to an

employee. It includes a sale made by a parent or

shareholder of the employer corporation to an em-

ployee of such corporation.

6a

By describing the recipient of the deduction as

“the person for whom were performed the services,”

it is clear that Congress had in mind situations

where the transferor would be a person other than

the employer; there would have been no need to use

such convoluted language if Congress had meant

merely to cover a bargain sale by an employer to an

employee. The committee report reinforces that view.

S.Rept. 91-552 (1969), 1969-3 C.B. 423, 500-502.

In deciding whether a deduction is to be allowable

in such situation, and to whom, the draftsmen no

doubt had in mind the various views of the trans-

action that could be taken: when a shareholder sells

his stock to an employee of the corporation, it could

be viewed as a simple sale (Downer v. Commissioner,

48 T.C. 86 (1967)); under that view, there would

be a capital transaction giving rise to gain or loss,

but there would be no transfer of compensation tax-

able to the employee and deductible by either the

transferor or the employer. Deputy v. du Pont,

supra. In the alternative, the transaction could be

viewed as a transfer of stock to the corporation and

a transfer of such stock by the corporation to the

employee. Since the statute allows a deduction for

compensation, the statute makes clear that Congress

rejected the view that the transaction was merely

a sale by a shareholder to an employee.

Having decided to tax the employee on the re-

ceipt of compensation and to allow the corporation a

deduction for that payment thereof, the draftsmen

went on to explain in the committee report the

theory on which such treatment was based; that is,

the parent or shareholder is considered to have made

a contribution to the capital of the corporation.

Tilford v. Commissioner, 75 T.C. 134, 154-56 (1980)

(Simpson, J., dissenting).

For the reasons set forth above and further explicated

by Judge Tuttle in Schleppy v. Commissioner, supra, we

7a

hold that the majority opinion of the Tax Court in this

case is erroneous as a matter of law and hence must

be reversed.

NICHOLS, Circuit Judge, dissenting:

Respectfully, I dissent. I appreciate we have a difficult

question. A treasury regulation is entitled to judicial

deference unless it clearly misconstrues the statute it

ostensibly interprets. I have respect for the Tax Court

dissenters as well as the majority there and here, but I

think the dissenters and our panel overlook a vital con-

sideration which was obviously much in the mind of the

Tax Court majority, namely, how far Congress can

effectively go in enacting legislation by means other than

bills passed by both Houses and placed before the Presi-

dent for his signature or veto?

The author of the Tax Court majority opinion, Honor-

able Leo Irwin, was a chief counsel of the House Ways

and Means Committee for 14 years (see Congressional

Directory, 1981 ed. at 741), and is entitled to special

deference when he touches in an opinion, as he does here,

upon transactions in the Congress.

I am sure the court will agree there would have been

no regulation but for the so-called legislative history. The

regulation was issued only in 1978, as Judge Irwin points

out, and so is not contemporary with the legislation to be

construed: actually it was finalized after the trial and

briefing in this case. This reduces the deference to which

the regulation would otherwise be entitled. The legisla-

tive history is the key to the case. The IRS Commissioner

hardly can ignore the kind of pronouncement made in the

Report of the Senate Finance Committee on the Tax Re

form Act of 1969, S. Rep. No. 91-522 (1969) 1969-3 C.B.

500, 502, as quoted by the court, supra. But for that

statement I do not think it would ever have occurred to

anyone that legislation dealing with income and deduc-

tions of other taxpayers, § 83, implicity denies a deduction

8a

to a taxpayer that statute never mentions, to which he

would otherwise be entitled. The suggestion is made that

the convoluted language of § 83(h) indirectly indicates

such an intention. The Tax Court is in a better position

than we are to appreciate whether the Congress normally

grants or withdraws deductions in such an arcane and

cryptic manner.

The Committee Report is in my view ambiguous

whether the legislative command there unambiguously

stated derives its authority from—

(1) The requirements of prior law, as construed

by the Committee,

(2) The requirements of the reported bill, as con-

strued by the Committee, or

(3) The command of the Senate Finance Commit-

tee itself,

My experience on the Hill is much inferior to Judge

Irwin’s. However, such as it is, it leads me to adopt

explanation (3) as the correct one. The objections to (1)

and (2) are compelling. If the Committee had intended

(1), surely it would have explained how existing law so

required. But in any case, the Committee’s interpretation

of prior law, though worthy of respectful consideration,

is nowhere near as compelling on courts as its interpreta-

tion of the bill reported. If the Committee is in error

about prior laws, courts are free to say so.

On the other hand, explanation (2) founders on the utter

absence of congruity between the language of the bill and

the language of the report. The latter deals with a sub-

ject the former never touches. It would seem any report

draftsman, aware of the Committee’s wishes, would not

state them in the report without a glance at the bill.

Making such a glance, he would perceive the absence of

anything in the bill to match his statements about it, and

he would leap to correct the deficiency in the bill. Or

9a

would he? The legislative situation could make it difficult

to amend the bill without endangering other purposes

deemed more important, perhaps its passage in that ses-

sion. There might be a temptation to try to put across a

Committee command.

At any event, in support of the probability of (3) that

the statement in question is a Committee command, every-

one who has dealt with congressional committees knows

that their reports, when made, ure replete with Commit-

tee commands. They expect this, they require that, they

disapprove of the other, and it must not be done. I

suppose members and staff are all aware, when they

think about it, that such Committee commands are of

dubious legal authority. As a practical matter they are

usually effective because addressed to persons who can-

not afford to incur Committee wrath. The “legislative

history” here involved is of course really addressed to the

IRS Commissioner, who is commanded to try to put it

across, and if he fails, that will occur many years hence,

and besides, the wench will be dead. It will also be,

though, the same country. (Cf. Christopher Marlowe.)

This may seem like an improbable scenario, and doubt-

less it is, but Conan Doyle’s writings about Sherlock

Holmes teach that, when all explanations of an occur-

rence are improbable, the more improbable ones must be

rejected, and the least improbable accepted as true.

Judge Irwin expresses his appreciation of the situation

in a more diplomatic manner, but as I read him, he per-

ceives it as I do. He cannot see how the “legislative

history” has any credibility or plausibility, other than as

a Committee command. It follows that one must and I

do conclude that the Finance Committee wanted very

much for the stockholder to be required for tax purposes

to treat as a capital contribution to the corporation the

stock he distributed to employees to retain them in

corporate employ. The only trouble is the Committee

failed to embody its wishes in an enacted bill. If this

lda

failure is not decisive of the case before us, the Com-

mittee is potent indeed.

I have not attempted to collect all the decisions deal-

ing with this problem of statutory construction, which

has become acute so recently, and of which even the

capable counsel in the case before us may not be wholly

aware. They did not cite one case which I deem to be a

striking parallel. It is an en bane decision of the old

Court of Claims, now defunct. Hart v. United States,

218 Ct. Cl. 212, 585 F.2d 1025 (1978), dealing with an

earlier Revenue Act, that raised issues so complex I will

not attempt to explain them. There were committee re-

ports embodying a legislative command not stated in the

bill reported, clearly or ambiguously. There was an

obedient IRS Regulation. Reference is made to the dis-

cussion in that case and to the cases there cited. I will

quote a few sentences, 218 Ct. Cl. at 231, 585 F.2d at

1035:

We could hope for beneficial results, too, if this

case should lead congressional committees to write

corrective legislation when they perceive errors in

statutes, rather than make bold [bald?] assertions

in committee reports, in the hope they will be ac-

cepted as valid legislative history. People are entitled

to find in the statute books the laws that govern

them. ee.

lla

UNITED STATES COURT OF APPEALS

FOR THE SIXTH CIRCUIT

No, 81-1447

HENRY C. TILFORD, JR., and BARBARA N. TILFORD,

Plaintiffs-A ppellees,

vs.

COMMISSIONER OF INTERNAL REVENUE,

Defendant-A ppellant.

[Filed May 27, 1983]

ORDER

Before: EDWARDS, Chief Judge, JONES and NICHOLS,*

Circuit Judges.

On receipt and consideration of a petition for rehear-

ing and suggestion for rehearing en banc in the above

styled case; and

No judge in active service in this court having moved

for rehearing en banc and the motion therefore having

been referred to the panel which heard the case; and

The panel having noted nothing of substance in said

motion for rehearing which had not been carefully con-

sidered before issuance of the court’s opinion,

Now, therefore, the motion for rehearing is hereby

denied.

Entered by order of the Court

/s/ John P. Hehman,

Clerk

* Honorable Philips Nichols, Jr., Circuit Judge for the United

States Court of Appeals for the Federal Circuit, sitting by desig-

nation.

12a

UNITED STATES COURT OF APPEALS

FOR THE SIXTH CIRCUIT

No, 81-1447

HENRY C. TILFORD, JR., and BARBARA N. TILFORD,

Petitioners-A ppellees,

vs.

COMMISSIONER OF INTERNAL REVENUE,

Respondent-A ppellant.

(Filed Apr. 20, 1983]

Before: EDWARDS, Chief Circuit Judge, JONES, Circuit

Judge and NICHOLS, Circuit Judge.

JUDGMENT

ON APPEAL from a decision of the Tax Court of the

United States.

THIS CAUSE came on to be heard on the transcript

of record from the said Tax Court and was argued by

counsel.

ON CONSIDERATION WHEREOF, It is now here

ordered and adjudged by the court that the decision of

the said Tax Court in this cause be and the same is

hereby reversed.

Each party to bear its own costs on this appeal.

ENTERED BY ORDER OF

THE COURT

/s/ John P. Hehman

JOHN P. HEHMAN

Clerk

13a

Issued as Mandate: June 6, 1983

COSTS: None.

A True Copy.

Attest:

s Linda L. Brinson

Deputy Clerk

l4a

APPENDIX B

75 UNITED STATES TAX COURT REPORTS

Docket No. 1334-77

HENRY C. TILFORD, JR., and BARBARA N, TILFORD,

Petitioners

Vv.

COMMISSIONER OF INTERNAL REVENUE,

Respondent

Filed October 20, 1980

Petitioner sold stock, subject to restrictions, in a cor-

poration of which he was a majority shareholder, to em-

ployees in order to induce them to work for the corpora-

tion. Held: Capital loss deduction claimed by petitioner

sustained, Downer v. Commissioner, 48 T.C. 86 (1967),

followed. Sec. 1.83-6(d), Income Tax Regs., treating such

transaction as capital contribution to the corporation,

held invalid. Held, further, respondent’s determination

of ordinary income from sale of farm recapture property

under sec. 1251, as a result of adjustments to the excess

deductions account, sustained.

H. Wayne Grant, Howell G. Clements, John T. Hen-

niss, and James L. Bomar, for the petitioners.

John B. Harper, for the respondent.

IRWIN, Judge: Respondent determined deficiencies in

petitioners’ income tax as follows:

Year Deficiency

1966 $ 4,467.67

1967 1,235.71

1969 58,372.10

1970 8,644.06

1972 68,650.84

1973 46,897.37

lida

Due to concessions by petitioners, the only issues remain-

ing for our consideration are:

(1) Whether section 83' denies petitioner a loss on

the sale of stock of a corporation, in which he was the

majority shareholder, made to employees of the corpora-

tion in order to induce them to work for it.

(2) Whether respondent correctly determined the ex-

cess deductions account for purposes of section 1251.

FINDINGS OF FACT

Some of the facts have been stipulated. The stipula-

tion of facts together with the exhibits attached thereto

are incorporated herein by this reference.

Petitioners Henry C. and Barbara N. Tilford filed joint

income tax returns for the years 1966, 19C7, 1969, and

1970 with the Southeast Service Center, Chamblee, Ga.

They filed their joint income tax returns for 1972 and

1973 ‘as amended) with the Memphis Service Center,

Memphis, Tenn. At the time they filed their petition

herein, petitioners resided in Shelbyville, Tenn. Barbara

N. Tilford is a petitioner herein only because joint re-

turns were filed for the years in issue. Therefore, ref-

erences to “petitioner” will be to Henry C. Tilford, Jr.

Issve 1. Capital Loss Deductions

Watco, Inc., is a Tennessee corporation, chartered in

November 1968. Its principal offices are located in Shel-

byville, Tenn. Watco is primarily engaged in the man-

ufacture and sale of commercial! signs.

Petitioner H&s been a principal officer and either the

sole or majority shareholder of Watco since its incor-

poration. In most years, petitioner was Watco’s presi-

' Unless otherwise indicated, al] statutory references are to the

Internal Revenue Code of 1954 as in effect during the years at

issue.

l6a

dent, and during the years in issue was chairman of the

board of directors. By December 31, 1970, petitioner had

invested $350,000 in Watco stock, owning 100 percent of

its 170,000 issued shares, and had loaned it an additional

$79,500.

Watco was started by petitioner and a friend, Eddie

Watson. Petitioner was to put up the money, and Watson

was to manage the company. When the company began

operations, it manufactured a “vacuum form magnetic”

sign which is affixed to the sides of trucks and cars to

identify a business. It rented a small building and hired

two employees. During 1969, the company grew to three

or four employees but was losing money because of in-

adequate sales. By 1970, Watson had talked to petitioner

into enlarging the business to manufacture electric trailer

signs in hopes of generating greater sales and earning

a profit. This expansion necessitated the hiring of more

employees and a move to a larger building.

Neither Watson nor petitioner had any knowledge or

experience in manufacturing signs, and petitioner had

to hire experienced personnel to manage both the manu-

facturing and marketing aspects of the company, as well

as for administrative functions. As an inducement in

hiring these key personnel—Pat Driscoll, Dorothy Haith-

cote, and Ronnie Besaw—they were told that they would

eventually particiapate as owners in the business.

On March 29, 1971, petitioner sold portions of his

Watco stock for $1 per share to Driscoll (4,500 shares),

to Besaw (3,500 shares), to Haithcote (500 shares), to

Mays Montgomery, a commercial salesman (750 shares),

and to Ben Kingree, petitioner’s attorney, who was also a

director of Watco (750 shares}. Each purchaser paid a

total of $1 per share for all of the shares acquired. The

amount of shares sold to each individual was based upon

what petitioner considered to be his relative importance

to the company. An additional 100 shares were sold in

lia

1971 tc Bayard Tarpley, a retired attorney who had

previously done some work for both petitioner and Watco.

Petitioner considered it to be advantageous for these

employees to be shareholders, and he sold the stock for $1

because he believed it had no market value. Petitioner

reserved a right of first refusal to repurchase the stock

at book value within 5 years in the event that a purchas-

ing employee desired to sell his stock or in the event his

employment with Watco was terminated (voluntarily or

otherwise). The stock sold was deposited in escrow with

the Peoples National Bank of Shelbyville in order to

assure petitioner his rights under the contract.* Addi-

tional stock was sold to Driscoll and Haithcote on De-

cember 22, 1972, on similar terms, although the contract

with Haithcote had the additional provision that after

5 years, in the event Haithcote desired to sell the stock

to a third party, petitioner had a right of first refusal

to buy the stock at the price Haithcote was offered by

the third party.

Watco continued to lose money after these employees

were hired, and it had to borrow funds for current

2 These contracts typically stated, in pertinent part, as follows:

“H. C, TILFORD, JR., has this day sold to ——, ——, ——, ——

shares of the common capital stock of Watco, Inc. for the considera-

tion of $1.00 and for further consideration of affording —— an

opportunity to acquire a financial interest in Watco, Inc., by which

he is being employed.

“This stock is sold with the express understanding and agreement

that in the event the purchaser should at any time within five (5)

years from date either (1) desire to sell said stock, or (2) terminate

his employment with Watco, Inc. either voluntarily or otherwise,

the said H. C. Tilford, Jr., shall be accorded the first right of

refusal to purchase said stock at a price equivalent to its then

existing book value as determined by Watco, Inc. accounting firm.

Upon the transfer of this stock to purchaser, the purchaser shall

thereupon endorse the stock certificate in blank and deposit same in

escrow for a period of five (5) years with the Peoples National

Bank of Shelbyville, Tennessee, to assure the performance on the

part of the purchaser of the convenant relating to the first right of

refusal to purchase same.”

18a

operations. Petitioner was required to guarantee these

borrowings, as well at Watco’s accounts payable, because

of its poor financial condition, and by the end of 1971,

the total amount guaranteed was over $300,000. Even-

tually, petitioner guaranteed over $900,000 of Watco’s

loans and accounts payable.

Due to large losses, petitioner considered selling, merg-

ing, or liquidating the business in late 1971, and hired a

consultant, Barry Winston, for advice. After reviewing

Watco’s balance sheet, personnel, and facilities, Winston

told petitioner he had to find a knowledgeable person to

manage the company; otherwise, if he could not sell it,

he should liquidate. Petitioner did not desire to liquidate

the company, and Winston was then asked to find a

qualified manager.

Winston also explored possibilities of merging with

Winkler Sig Corp. but that transaction, as well as a

possible sale to United Advertising Co., never material-

ized. There was one other company which looked seri-

ously at the prospect of purchasing Watco, but it even-

tually rejected the idea because it determined that Watco

was not a good investment.

After several months, in September 1971, Watco hired

Nelson Early under a 2-year employment contract tu help

manage the company. At the time, petitioner told Early

he thought Early should also become a shareholder in

Watco, and in November 1971, petitioner sold Early

5,000 shares for $1 on the same terms as the previous

sales. Petitioner also told Early that he would provide

the additional capital that Watco needed in order to

continue operations and expand.

After he hired Early, petitioner received an applica-

tion for the job from Tom Watson. Watson cume highly

recomended and, after negotiations, was hired in late

1971. As part of his employment terms, Watson de

manded stock in the company and in November 1971

19a

purchased 22,000 shares from petitioner for $1 on the

same terms as the previous sales. Petitioner assured

Watson, moreover, that he would continue to put up

money for the corporation. Watson then hired Leo Pitt;

4,000 shares were also sold to him at $1 in order to

induce him to come to work for Watco. Pitt’s contract

concerning the Watco shares was similar to the previous

contracts except that one of petitioner’s rights was de-

scribed as a “right at his sole option to repurchase

stock” rather than a “right of first refusal.” It also

contained a provision that if the stock was transferred

without petitioner’s being accorded the right to repur-

chase the stock, Watco had the right to refuse to transfer

any stock certificate on its stock ledger. When Pitt left

Watco in late 1972 or early 1973, petitioner repurchased

the stock for $1. Pitt believed it had no value at that

time.

Sales increased in 1972, and Watco expanded to about

40 employees. In order t» obtain the sales, however,

Watco was required to sell its signs below cost, and

substantial losses were incurred. Watson then brought

in an expert in manufacturing to reduce costs. Early

then became disenchanted because of Watson’s control

and left Watco, pursuant to a mutually agreed upon

recision of his contract. Early sold his shares back to

petitioner for $1.

Watson also left Jater, due to personal problems, and

sold back his shares to petitioner for $1. Petitioner, in

turn, in October 1972, sold 18,000 of these shares to

Robert Price (one of the original employees of the com-

pany) for $1. Petitioner later sold an additional 9,000

shares to Price for $1.

Watco hired Tom Cannon in 1973 to manage its na-

tional sales. Petitioner sold Cannon 24,500 shares of

Watco for $1. In acdition to the terms set forth in the

original agreements, the stock was to be escrowed for

6 years instead of 5, and petitioner had the right to

20a

repurchase the stock at $1 if Cannon left Watco within

1 year. After 5 years, petitioner had the right of first

refusal to repurchase at any price Cannon could other-

wise obtain. Cannon then hired two salesmen, Jim

3 The contract read, in pertinent part:

“This stock is sold subject to the following terms and conditions:

“A. That the parties hereto agree that in the event the Purchaser

shall at any time within one (1) year from the date of the execu-

tion of this agreement either (1) desire to sell the subject stock

or (2) terminate his employment with WATCO, INC., either

voluntarily or otherwise, the said H. C. TILFORD, JR. shall be

accorded the right to repurchase said stock for the price of One

($1.00) Dollar.

“B, That the parties hereto agree that in the event the Purchaser

should at any time within the next five (5) years thereafter from

the date of termination of the one (1) year period set forth in (A)

above, either (1) desire to sell the subject stock or (2) terminate

his employment with WATCO, INC., either voluntarily or other-

wise, the said H. C. TILFORD, JR. shall be accorded the right at

his sole option to repurchase the subject stock at a price equivalent

to the then existing book value of the subject stock, as determined

by accountants of or selected by WATCO, INC.

“C, That upon the transfer of the stock to the Purchaser the

Purchaser shal] endorse the stock certificate in blank and deposit

the same in escrow for a period of six (6) years with the Peoples

National Bank of Shelbyville, Tennessee, as Escrow Agent. The

parties hereto agree that this provision assures the performance

on the part of the Purchaser of the covenants stated in paragraphs

“A” and “B” above relating to Tilford’s sole option to repurchase

the subject stock.

“D, That after six (6) years from the date of this contract,

the Purchaser shal] be permitted to sell said stock to third parties.

However, he shall first offer said stock to the Seller at a price

equivalent to that which he proposes to receive from said third

parties, and the Seller shall have ten (10) days to purchase said

stock at said price. If the Seller does not exercise this option to

purchase, then, the Purchaser shall be free to sell said stock to third

parties at said price, but he shall not sell said stock to third parties

at a lesser price than originally offered unless he first gives to the

Seller a ten (10) day option to buy same at said lesser price.

“B, That in the event the subject stock should be transferred to

a third party without Tilford’s being accorded the option to pur-

2la

McMullen and Jim Marren, who were also offered, and

purchased from petitioner, 24,500 and 14,700 shares in

Watco, respectively, for $1 and on the same terms Can-

non purchased his stock. Petitioner assured these two

salesmen that he would continue to commit his personal

resources to keep Watco going. Without this commit-

ment, they would not have agreed to come to work for

Watco. After these three individuals were hired, sales

increased, but expenses also increased, and Watco con-

tinued to lose money.

Price eventually decided to retire and, pursuant to pe

titioner’s right of first refusal, sold back his 27,000 shares

to Watco to petitioner for their book value, a total of

$9,318.55. McMullen, Cannon, and Marren also even-

tually decided to leave Watco, and each sold his stock

back to petitioner for $1.

Petitioner claimed losses from the sales of Watco stock

to Tarpley, Kingree, and the key employees, except for

the stock sold to Price ‘since he had repurchased these

shares from Watson for $1 and, therefore, had a basis

of only $1). Respondent disallowed the deductions for

the losses and determined the sales to be transfers of

property in connection with the performance of services

that must be treated as contributions to capital of Watco

under section 83.

Issue 2. Income From Farm Recapture Property

Bedford Farms, Inc., is a Tennessee corporation char-

tered on Apri] 26, 1960. It owns and operates a farm of

approximately 1,000 acres near Shelbyville, Tenn. On

January 5, 1966, Bedford Farms elected tax options

status under section 1372. The corporation’s business

activities during the years in question included selling

chase stated in paragraphs “A”, “B”, “C”, and “D” above, WATCO,

INC, shall have the right to refuse to transfer any stock certificates,

so transferred on the stock ledger of the corporation.”

22a

farm products, renting farm property and equipment,

and raising and selling cattle and other livestock.

During the years in question, Bedford Farms had out-

standing 750 shares of common stock, owned as follows:

Shareholder Shares

Henry C. Tilford, Jr. 739

Barbara N. Tilford 10

Henry C. Tilford III 1

On its 1973 income tax return, Bedford Farms re

ported taxable income of $119,150.27. It reported a sale

of breeding stock at a gain of $269,905.02. Of this

amount, $40,829.03 was reported as ordinary gain, and

$229,075.99 * was reported as capital gain, both of which

were used to arrive at taxable income. On Schedule K

(Computation of Undistributed Taxable Income and Sum-

mary of Distributions) of Bedford Farms’ Form 1120S,

the corporation’s undistributed taxable income is listed

as $119,150.27. All of this amount is listed as undis-

tributed taxable income taxable as long-term capital gain.

In the notice of deficiency to petitioner, respondent de-

termined that $51,436.70 of a long-term capital gain re

ported as petitioner’s distributive share of the capital

gains of Bedford Farms, Inc., should have been reported

as ordinary income under the farm loss recapture of sec-

tion 1251. Accordingly, petitioner’s capital gains were

reduced, and his share of the undistributed taxable in-

come of Bedford Farms was increased. The parties agree

that the figures used by respondent in making this de

termination are correct but do not agree that respond-

ent’s method of computation and, therefore, the results

of the computation, are correct. The following is re-

spondent’s computation of the 1973 increase in Bedford

Farms’ ordinary income for i973, as set forth in the

notice of deficiency:

4 The return shows $229,175.99, which is $100 in error.

23a

COMPUTATION OF ORDINARY INCOME UNDER THE

RECAPTURE OF SECTION 1251, IRC OF

BEDFORD FARMS, INC.

Since the nonfarm adjusted gross income of the major

shareholder, Henry C. Tilford, Jr., plus the nonfarm ad-

justed gross income of Bedford Farms, Inc. (none ex-

ceeded $50,000.00) in each of the taxable years 1972 and

1973, and Bedford Farms net loss for each of those years

exceeded $25,000.00, the recapture of farm loss provisions

of section 1251 applies and gain from farm recapture

property of $161,439.05 is reclassified as ordinary in-

come for the taxable year 1973, as detailed below.

1972 1978

Farm net loss:

Total income shown in return,

Form 11208 $128,434.33 $372,157.96

Less gain in disposition of farm

recapture property referred to in

sec. 1231(a)—excluded from

computation under sec. 1251 ‘e) (2 __ 20,169.14 229,075.99

Gross farm income as adjusted 108,265.19 148,081.97

Less deductions:

Total deductions

shown in schedule $212,693.60 $253,007.69

Less insurance expense

disallowed; This report __ 1,450.36 1,462.72

Farm deductions as determined (211,243.24) (251,542.97)

Farm net loss as determined (102,978.05 ) (108,461.00)

Less exclusion provided by sec.

1251(b) (2) (B) (ii) 25,000.00 25,000.00

Addition to excess deduction id

account for each year (77,978.05 )) (83,461.00)

Balance in excess deduction account at the end of 1973 to be recap-

tured as ordinary income from the sale of farm recapture property

during that year:

Balance in EDA account at 1/1/73 as determined above $77,978.05

Addition to the account for 1973, as shown above 83,461.00

Balance in EDA account at 12/31/73 and gain recognized

as ordinary income under sec. 1251(c) (1) 161,439.06

24a

Respondent decreased Bedford Farm’s net long-term

capital gain from $229,075.99 by this $161,439.05 to

$67,636.94 and increased ordinary income of $40,829.03

by the same $161,439.05. The effect was to change

$52,978.05 of the $120,614.99 taxable income of Bedford

Farms from long-term capital gain to undistributed tax-

able income.* Petitioner’s share of the undistributed tax-

able income was determined to be $52,907.41.

Respondent then reduced the $119,150.27 reported on

petitioner’s 1973 return as net long-term capital gain

from Bedford Farms by $51,436.70. This was done by

first subtracting the portion of Bedford Farms’ capital

gain respondent attributed to petitioner’s son, $166.81,

and then by subtracting petitioner’s share of the net

long-term capital gain derived from the sale after applica-

tion of section 1251.

OPINION

Issue 1. Capital Loss Deductions

Petitioner transferred stock in his corporation, subject

to certain restrictions, to certain key employees to induce

them to remain with, or to come to work for, the corpora-

tion. Many of these employees were promised, at the

time of receipt of the stock, that petitioner would con-

tinue to apply his personal resources to Watco in order

to keep it operating in the face of large operating deficits.

The number of shares transferred to each employee was

based upon the importance of the employee’ to the com-

pany, and petitioner considered it important for the key

employees to have a proprietary interest in Watco. Peti-

tioner claimed loss deductions on his income tax return

with respect to these transfers of shares.*

5 $119,150.27, as reported, plus $1,464.72, representing a deduc-

tion claimed for insurance premiums disallowed by respondent, not

in dispute here.

* Petitioner's primary contention is that the transfer amounted

to sales of the stock, giving rise t> deductions under sec. 1002.

Alternatively, petitioner claims ordinary loss deductions on the

25a

The instant case is similar in its facts to Downer v.

Commissioner, 48 T.C. 86 (1967). There, the taxpayer,

the majority shareholder of a corporation, transferred

100,000 shares of stock in the corporation to an employee

of the corporation to induce the employee to continue

work. The taxpayer’s basis in the 100,000 shares was

$100,000, and the shares had a fair market value of

$15,000. We held that the taxpayer did not make a capi-

tal contribution to his corporation of the 100,000 shares,

as the Commissioner contended, but rather, the transac-

tion constituted a “sale or exchange,” and the taxpayer

suffered an $85,000 capital loss. In the instant case, the

facts are similar except that petitioner transferred the

stock subject to certain restrictions imposed on the trans-

ferees, while in Downer, there apparently were no such

restrictions. Respondent, however, does not attempt to

distinguish Downer on that basis, but rather, maintains

that regardless of the Downer facts and the Downer re-

sult, the transactions in the instant case fall under the

rules of section 83, which was not in effect at the time

of the Downer case.

Section 83 was added to the Internal Revenue Code by

the Tax Reform Act of 1969, Pub. L. 91-172, 83 Stat.

588, and it applies (with certain transitional exceptions)

to transfers after June 30, 1969. This section deals with

the tax consequences of transfers of property in connec-

tion with the performance of services, and it was en-

acted primarily to deal with certain so-called “restricted

stock” compensation plans. In general, section 83 pro

vides that property received for the performance of serv-

ices is to be included in the income of the recipient (at

its fair market value); however, if the property is not

freely transferable by the recipient, or is subject to for-

theory that, in substance, the stock was surrendered to the corpora-

tion for use as employee compensation, and such a transaction is

net a sale or exchange. See Smith v. Commissioner, 66 T.C. 622

(1976), revd. sub nom. Schleppy v. Commissioner, 601 F.2d 196

(5th Cir. 1979); Estate of Foster v. Commissioner, 9 T.C. 930

(1947).

26a

feiture, the value of the property is determined and taken

into income only upon the termination of such restric-

tions. In addition to prescribing rules for the taxability

of the recipient, section 83 provides a corresponding de

duction “under section 162” to the party for whom the

services were performed, keyed to match the timing of

the reporting of the income by the recipient. Sec. 83(h).

The Treasury regulations under section 83 were final-

ized subsequent to the trial and briefing in this case

(T.D. 7554, filed July 21, 1978), although they were pub-

lished in proposed form prior thereto. The heart of the

issue in this case involves section 1.83-6/d), Income Tax

Regs., upon which respondent relies in disallowing the

losses claimed. This regulation provides as follows:

(d) Special rules for transfers by shareholders—

(1) Transfers. If a shareholder of a corporation trans-

fers property to an employee of such corporation

or to an independent contractor ‘or to a beneficiary

thereof), in consideration of services performed for

the corporation, the transaction shall be considered

to be 2 contribution of such property to the capital

of such corporation by the shareholder, and immedi-

ately thereafter a transfer of such property by the

corporation to the employee or independent contrac-

tor under paragraphs (a) and (b) of this section.

For purposes of this (1), such a transfer will be

considered to be in consideration for services per-

formed for the corporation if either the property

transferred is substantially nonvested at the time of

transfer or an amount is includible in the gross in-

come of the employee or independent contractor at

the time of transfer under § 1.83-1(a) (1) or § 1.83-

2(a). In the case of such a transfer, any money or

other property paid to the shareholder for such stock

shall be considered to be paid to the corporation and

transferred immediately thereafter by the corpora-

tion to the shareholder as a distribution to which

section 302 applies.

27a

This regulation is based upon the following language in

the report of the Senate Finance Committee on the Tax

Reform Act of 1969:

In general, where a parent company’s or a share

holder’s stock is used to compensate employees under

a restricted stock plan, the transfer of the stock by

the parent company or shareholder is to be treated as

a capital contribution to the company which is to be

entitled to a deduction in accordance with the re

stricted property rules. The parent company or the

shareholder merely is to reflect the contribution as

an increase of the equity in the company which is

entitled to the compensation deduction. [Tax Reform

Act of 1969, S. Rept. 91-522 (1969), 1969-3 C.B.

500, 502]

Of course, it is well established that Treasury regula-

tions, when not inconsistent with express statutory pro

visions, have the force of law. Maryland Casualty Co.

v. United States, 251 U.S. 342 (1920). See sec. 7805.

As such, they should not be overruled except for weighty

reasons. Commissioner v. South Texas Lumber Co., 333

U.S. 496 (1948), revg. 162 F.2d 866 (Sth Cir. 1947),

revg. 7 T.C. 669 (1946). Ordinarily, regulations must

be sustained unless they are unreasonable and plainly

inconsistent with the revenue statute. Topps of Canada,

Ltd. v. Commissioner, 36 T.C. 326 (1961). Petitioner

herein contends that the regulation in question is unrea-

sonable and is not supported by the statute.

Section 83 is basically an income-defining section, en-

acted primarily to deal with the recognition of income

under certain restricted stock compensation plans. The

matter at issue here is a claimed deduction. But for sub-

section (h), section 83 really has nothing to do with

deductions. Section 83(h) provides a deduction “under

section 162” for the employer, to correspond in time with

the income required to be reported by the employee. This

subsection does not address itself to the tax consequences

28a

to a stockholder who provides the shares used in the

restricted stock plan. Thus, it would appear that section

1.83-6(d), Income Tax Regs., is clearly outside the scope

of the statutory provisions of section 83.

Petitioner’s claim for a loss deduction in this case

is based upon section 1002, which provides for recogni-

tion of gain or loss upon the sale or exchange of prop-

erty.” The facts are quite clear in this regard: peti-

tioner sold shares of Watco stock to various employees

for nominal consideration.* The fact that these sales were

in connection with the rendering of services by the pur-

chasers, while it may bring into play certain tax con-

sequences to the employees and Watco under section 83,

does not render the transaction any less a sale under

section 1002, as far as petitioner is concerned. Thus,

we believe that section 1.83-6(d), Income Tax Regs., is

contrary to the express terms of the Code (i.e., sec. 1002)

insofar as it would preclude the recognition of a loss

on a sale of securities by characterizing the sale as a

contribution to capital.

Moreover, the regulation in question flies in the face

of numerous decisions of this and other courts holding

that non-pro-rata surrenders of stock to the issuing cor-

poration do not represent capital contributions but give

rise to deductible losses. See, e.g., Downer v. Commis-

sioner, supra; Sack v. Commissioner, 33 T.C. 805 (1960) ;

Estate of Foster v. Commissioner, 9 T.C. 930 (1947);

Miller v. Commissioner, 45 B.T.A. 292 (1941), acquiesced

1941-2 C.B. 9, acquiescence withdrawn and nonacquies-

cence substituted 1977-1 C.B. 2; Budd International

Corp. v. Commissioner, 45 B.T.A. 737 (1941), acquiesced

1942-2 C.B. 3, acquiescence withdrawn and nonacquies-

7 Since 1976, the provisions of sec. 1002 have been embodied in

sec. 1001(c).

§ Despite the restrictions on resale and the contingent right of

petitioner to repurchase the stock sold, all of the sales in question

appear to be closed transactions for tax purposes.

29a

cence substituted 1977-1 C.B. 2, revd. on other grounds

143 F.2d 784 ‘3rd Cir. 1944), cert. denied 323 U.S. 802

(1945); Peabody Coal Co. v. United States, 80 Ct. Cl.

202, 8 F. Supp. 845 (1984); Burdick Executriz v. Com-

missioner, 20 B.T.A. 742 (1930), nonacquiesced X-2 C.B.

82 (1931), affd. on other grounds 59 F.2d 395 (8rd Cir.

1932); Wright v. Commissioner, 18 B.T.A. 471 (1929).

But see Schleppy v. Commissioner, 601 F.2d 196 (5th Cir.

1979), revg. Smith v. Commissioner, 66 T.C, 622 (1976),

in which a surrender of stock not involving a transfer

to a third party, was treated as a capital contribution.

In support of section 1.83-6(d), Income Tax Regs., re

spondent relies heavily upon the language of the Senate

commitee report quoted above. There can be no doubt

that the regulation specifically follows the dictates of the

committee report. However, the committee report is not

the statute, and to the extent that its language goes

beyond the legislation then being enacted or theretofore

existing statutory provisions (i.e., sec. 1002), it certainly

cannot serve as support for a regulation suffering the

same infirmity. Fler-O-Glass, Inc. v. United States, an

unreported case (N.D. Ill. 1959, 3 AFTR 2d 1034, 59-1

USTC par. 9828). This is particularly so in light of

the long history of litigation, cited above, in which the

Government had consistently failed to establish that non-

pro-rata stock surrenders amounted to capital contribu-

tions, rather than recognizable losses. Certainly, if the

Congress had intended to change the result of these cases,

it could and should have done so by specific codification.

Legislative history is strictly a tool of statutory inter-

pretation (cf. Gilbert v. Commissioner, 241 F.2d 491 (9th

Cir. 1957), revg. 25 T.C. 81 (1955)); it cannot be in-

fused with an authority of its own.

Another argument which might be advanced in sup-

port of the regulation in question is that because section

83{h) allows a deduction which might not have been

allowable under the prior case law (i.e, the deduction to

80a

the corporation, even though the compensation for serv-

ices is effectively being paid by the stockholder), it is

necessary to eliminate the stockholder’s loss deduction

previously allowed in the cases; otherwise section 83(h)

would have, in effect, created a double deduction.* Al-

though this argument at first blush has a persuasive

ring, it does not withstand careful scrutiny. We do not

view the loss resulting from the disposition of shares by

a stockholder as the same economic loss or expenditure as

that associated with the payment for services rendered.

In other words, the deduction provided by section 83(h)

merely recognizes that whenever income is required to

be reported under section 83, there should be a matching

business expense deduction under section 162; this has

no inherent relationship with the realization of a gain

or loss by a stockholder upon disposition of shares in

return for services. Regardless of the fact that the dis-

position of shares is in a transaction which brings sec-

tion 83 into play with respect to other parties, the rele

vant question for the stockholder is simply whether or

not there has been a realization of a gain or loss in a

transaction which warrants recognition of gain or loss

for tax purposes.

Another reason that we are not persuaded by the

“double deduction” argument is that it seems clear that

such a “double deduction” would be appropriate in a case

where stock is used in payment for services rendered

directly to and for the benefit of the business of the

stockholder, and not for the corporation. Thus, if serv-

ices are paid for by the recipient thereof with securities

*This argument can be stated another way as follows: If a

stockholder pays the expense of his corporation, the corporation

might claim the deduction on the theory that, in substance, the

stockholder made a capital contribution and the corporation paid the

expense. After the enactment of sec. 83(h) codifying the corpora-

tion’s deduction, consistency of the theoretical construction requires

that the paying stockholder be deemed to have made a capital

contribution.

Sla

which have increased or decreased in value, the transac-

tion would result in a capital gain or loss to such recipient

(relating to the economic gain or loss during the holding

period of the securities), as well as a business expense

deduction for the cost (measured by the value of the

services rendered. United States v. General Shoe Corp.,

282 F.2d 9 (6th Cir. 1960); International Freighting

Corp. v. Commissioner, 185 F.2d 310 (2d Cir. 1943),

aitg. 45 B.T.A. 716 (1941). In the factual situation

where the services are performed for the corporation,

and not for the stockholder himself, as in Downer and

its predecessors, prior to the enactment of section 83(h),

the business expense deduction might have been lost be

cause the expense was paid by another party. See Zoby

v, United States, 364 F.2d 216 (4th Cir. 1966). Eco

nomically, the business expense was still incurred, There

fore, as we view it, the enactment of section 83(h),

rather than allowing a double deduction, merely has the

effect of allowing the business expense deduction which

may have been previously disallowed solely for technical

reasons. Again, the realization of a capital gain or loss

to the stockholder should be viewed as a separate trans-

action,"®

Moreover, if one is to accept the double deduction argu-

ment, and to treat the stockholder as having made a

capital contribution to the corporation, the result would

be merely a deferral of the gain or loss with respect to

the shares transferred, with their basis added to the basis

of the shares retained. However, such a “unitary view”

of a stockholder’s investment in his corporation was ana-

lyzed and specifically rejected in Downer (48 T.C, at 91).

Under the Downer “fragmented view” of stock owner-

1© To the extent that the allowance of a deduction by sec, 83(h)

requires that the amount deducted be deemed to have been first

contributed to capital by the stockholder who actually paid the

deductible amount, such stockholder’s capital gain or loss would still

be recognized on the theory that, in substance, his stock was sold

for cash, which cash was in turn contributed to the corporation.

32a

ship, the disposition of a portion of one’s stockholdings

would ordinarily call for a recognition of gain or loss

with respect to that portion, rather than an adjustment

to the basis of the remaining shares.“ Again, the fact

that section 83(h) now allows a business expense deduc-

tion to the corporation does not seem to produce any

inherent inequity or loophole which would require the

deferral of a gain or loss that would otherwise be recog-

nized under the application of normal tax principles.

Finally, it should be noted that throughout the fore

going discussion, we have referred to “gain or loss” rec-

ognition upon the transfer of shares for services. Al-

though the instant case and its predecessors involve the

question of a loss deduction with respect to shares that

have decreased in value, section 1.83-6'd), Income Tax

Regs., if upheld, would apply equally to transfers of ap

preciated stock. This would result in a deferral of capi-

tal gain upon the transfer of appreciated stock for serv-

ices rendered to the corporation, which deferral in our

view would have no justification; in a capital gain situa-

tion the “double deduction” argument is, of course, ob-

literated.

In light of all of the foregoing, we hold that petitioner

is entitled to capital loss deductions with respect to the

sales of stock in question. Downer v. Commissioner,

supra,

Issue 2. Income From Farm Recapture Property

Section 1251, in general, provides that if farm recap-

ture property is disposed of, the gain realized is treated

11 “There is no persuasive reason why the shareholder's recogni-

tion of loss with respect to the surrendered stock should be sus-

pended simply because he holds additional stock of the same cor-

poration.” See G. Bolding, ‘Non-Pro Rata Stock Surrenders, Capital

Contribution, Capital Loss or Ordinary Loss?” 32 Tax Law, 275,

278 (1979).

33a

as ordinary income to the extent of the amount contained

in the taxpayer’s “excess deductions account” (EDA).

Subject to certain dollar limitations, in general, a tax-

payer’s EDA increases by the amount of his farm net

loss each year (sec. 1251(b)(2)) and decreases by the

amount of his farm net income (section 1251(b) (3)).

Farm net loss is defined in section 1251(e) (2) as:

(2) FARM NET Loss.—The term “farm net loss”

means the amount by which—

(A) the deductions allowed or allowable by

this chapter which are directly connected with

the carrying on of the trade or business of

farming, exceed

(B) the gross income derived from such trade

or business.

Gains and losses on the disposition of farm recap-

ture property referred to in section 1231(a) (deter-

mined without regard to this section or section

1245(a)) shall not be taken into account.

Total gross income shown on Bedford Farms’ return

was $128,434.33 in 1972 and $372,157.96 in 1973. From

these amounts, respondent subtracted $20,169.14 in 1972

and $229,075.99 in 1973 in arriving at a revised gross

income of $108,265.19 in 1972 and $143,081.97 in 1973.

It is this reduction in gross income, leading to a corre

sponding increase in Bedford Farms’ farm net loss and,

in turn, a larger addition to the EDA in each of the

years, that is in issue here.

In making his adjustment, respondent relies on the

flush language in section 1251(e)(2) which provides

that “Gains and losses on the disposition of farm recap-

ture property referred to in section 1231(a) * * * shall

not be taken into account.” Bedford Farms reported

capital gains of $20,169.14 in 1972 and $229,075.99 in

1973 from the sale of breeding cattle, and it is these

84a

gains which respondent has eliminated in computing

“farm net loss” and the additions to the EDA. There is

no dispute that this breeding cattle is livestock within

the meaning of sections 1231(a) and 1231(b) (8) and,

thus, farm recapture property. Under a literal reading

of the statute, therefore, respondent is correct in his

determination. Petitioner contends, however, that be-

cause the $20,169.14 in 1972 and $109,925.72 of the

$229,075.99 in 1973 were not passed through by Bedford

Farms as capital gains to petitioner on his personal re-

turns, due to certain statutory limitations applicable to

subchapter S corporations,’? such amounts do not con-

stitute farm recapture property.

Petitioner maintains that because these amounts were

not passed through as capital gains to the shareholders,

they were effectively treated as ordinary income by Bed-

ford Farms and thus did not constitute the proceeds from

section 1231 property. Although petitioner’s argument is

ingenious, we must reject it. Section 1.1375-1(d), In-

come Tax Regs., provides, with exceptions not here rele

vant, that “for purposes of determining whether gain on

the sale or exchange of an asset by an electing small

business corporation is capital gain, the character of the

asset is determined at the corporate level.” Bedford

Farms sold section 1231 property and, therefore, regard-

less of the character of the pass through of the gain to

petitioner, it follows that such amounts are capital gains

properly reported as such by Bedford Farms. Although

petitioner may not have benefited from the capital gain

treatment, this situation, in our view, does not warrant

a result at variance with the literal language of section

1251(e) (2).

Petitioner next argues that respondent failed to prop-

erly reduce Bedford Farms’ EDA by $56,860.89 in 1972.

2 The limitation is not disputed by respondent. Sec. 1375 and

sec. 1.1375-1(a), Income Tax Regs., provide that capital gains of a

subch. S corporation can be passed through to its shareholders only

to the extent of current earnings and profits.

85a

On his 1972 return, petitioner reported adjusted gross

income of negative $7,674.92 (‘including a loss of

$84,141.50 attributable to his share of Bedford Farms’

loss ($84,259.27) ) and itemized deductions of $46,185.97.

After deducting an additional $3,000 for exemptions, pe-

titioner showed taxable income of negative $56,860.89.

Relying upon section 1251/b) (3) (A), petitioner main-

tains that $56,860.89 of the $84,141.30 loss should reduce

Bedford Farms’ EDA.

Section 1251(b) (3) provides:

(3) SUBTRACTIONS FROM ACCOUNT.—If there is any

amount in the excess deductions account at the close

of any taxable year (determined before any amount

is subtracted under this paragraph for such year)

there shall be subtracted from the account—

(A) an amount equal to the farm net income

for such year, plus the amount (determined as

provided in regulations prescribed by the Sec-

retary or his delegate) necessary to adjust the

account for deductions which did not result in

a reduction of the taxpayer’s tax under this

subtitle for the taxable year or any preceding

taxable year, and

(B) after applying paragraph (2) or sub

paragraph (A) of this paragraph (as the case

may be), an amount equal to the sum of the

amounts treated, solely by reason of the appli-

cation of subsection (c), as gain from the sale

or exchange of property which is neither a capi-

tal asset nor property described in section 1231.

Petitioner argues that the amount of the negative taxable

income in his 1972 return, $56,860.89, constitutes “the

amount * * * necessary to adjust the [EDA] account for

deductions which did not result in a reduction of the tax-

payer’s tax * * * for the taxable year or any preceding

taxable year,” within the meaning of subparagraph (A)

quoted above.

86a

The reduction provided in subparagraph 1251(b) (3)

(A) is specifically to be determined as provided in regu-

lations prescribed by the Secretary of the Treasury. The

governing regulations are found in section 1.1251-2(c)

(3), Income Tax Regs. These regulations provide com-

plex mechanics for the computation of both a “tempo

rary subtraction” from the EDA (sec. 1.1251-li(c) (3)

(ii), Income Tax Regs.) and a “permanent subtraction”

from the EDA (sec. 1.1251-2/c) (3) (iii), Income Tax

Regs.). The temporary subtraction is applicable for any

given taxable year only in the determination of farm

property recapture income for that year, if any; it does

not affect the EDA which gets carried forward to suc-

ceeding taxable years. Thus, the “temporary subtrac-

tion” rules are not applicable with respect to petitioner’s

1972 EDA balance (which is carried forward into 1973

for purposes of determining ordinary income from Bed-

ford Farms’ sale of farm recapture property in that

year).

With regard to the permanent subtraction from the

EDA for deductions not giving rise to tax benefits, sub-

division (iii) of section 1.1251-2(c)(8), Income Tax

Regs., limits this as follows:

(iii) Permanent subtraction. The amount perma-

nently subtracted from the excess deductions account

for a taxable year is the excess of the farm portion

of any net operating loss which may be carried to the

preceding year (reducing by the portion of such loss

which reduced taxable income (computed without

regard to the deduction under section 172(a)) for

such preceding year) over the amount of such loss

which may be carried to the taxable year, but the

subtraction shall not be made earlier than the tax-

able year in which the excess deductions account is

increased by reason of such loss.

Thus, the permanent adjustment to petitioner’s EDA for

1972 would be applicable only with respect to certain

87a

prior years’ net operating losses. The foregoing regula-

tion does not contemplate a reduction in the EDA with

respect to negative taxable income (or even operating

losses) of the current tax year, and thus. section 1251

(b) (3) (A) cannot be interpreted to permit the reduc-

tion urged by petitioner.

However, from our review of petitioner’s income tax

returns included in the record, it appears that the per-

manent EDA reduction provided in section 1.1251-2(c)

(3) (iii), Income Tax Regs., might be applicable in 1972

or 1973 with respect to net operating loss carryovers

from prior years. Thus, a net operating loss carryover

from a year prior to 1971 might result in the carryover

to 1971 exceeding the carryover to 1972 or the carryover

to 1972 exceeding the carryover to 1973. In either event,

the amount of such excess would require a permanent

adjustment in the taxpayer’s EDA, which in turn would

affect the amount of farm recapture income in 1973.

The amount of such adjustment, if any, May be deter-

mined in the computation under Rule 155.

Decision will be entered under Rule 155

Reviewed by the Court.

ScoTT, J., dissenting: I respectfully dissent from the

holding of the majority on the capital loss issue in this

case. I agree that our cases cited by the majority for

the proposition that “non-prorata surrenders of stock

to the issuing corporation do not represent capital con-

tributions, but give rise to deductible losses” so hold.

8 Unlike the regulation held invalid in our opinion on the first

issue in this case, sec. 1.1251-1(c) (3), Income Tax Regs., has not

been challenged by petitioner, and it appears to be a reasonable

and well thought out (although well nigh unreadable) attempt to

apply the policy contemplated in the statute. Moreover, this regu-

lation was promulgated under specific statutory mandate and, thus,

must be accorded nearly statutory weight. See Rudd Mfg. Co. v.

Commissioner, 10 T.C. 14 (1948), affd. 173 F.2d 222 (34 Cir. 1949).

38a

However, I do not agree that any other court has so held.

The Court of Appeals for the Fifth Circuit in Schleppy

v. Commissioner, 601 F.2d 196 (5th Cir. 1979), in re

versing Smith v. Commissioner, 66 T.C. 622 (1976), held

to the contrary. After referring to the holdings of this

Court allowing a loss for the non-pro-rata surrender of

stock by a stockholder to the issuing corporation, the

Circuit Court stated: ‘We find no Court of Appeals de

cision that determines the correctness of these decisions.

We therefore write on a clean sheet.”

In my view, we have been incorrect in our holding that

an individual who transfers stock either to the corpora-

tion or to a third party for the benefit of the corporation

sustains a loss. The Supreme Court and numerous lower

courts, including this Court, have uniformly held that a

payment by a stockholder for the benefit of his corpora-

tion constitutes a contribution to capital and not an ex-

pense of carrying on the business of the individual. Jn-

terstate Transit Lines v. Commissioner, 319 U.S. 590

(1943),

If the transfer for the benefit of the corporation made

by a stockholder was of some property other than cash

or stock of the corporation for whose benefit the transfer

was made, we would undoubtedly hold that such transfer

was a contribution to the capital of the corporation. I can

see no reason why a different result should be reached

because the property used by a stockholder for the bene-

fit of the corporation is the stock of the corporation for

whose benefit the transfer was made. I therefore agree

with the conclusion of the Circuit Court in Schleppy v.

Commissioner, supra, although I respectfully disagree

with the interpretation placed by that court on our opin-

ion in Foster v. Commissioner, 9 T.C. 930 (1947).

Since, clearly, the transfer of the stock by petitioner in

this case was for the benefit of the corporation, I would

hold for respondent. Even though I consider our holdings

39a

in the cases relied on by the majority to be incorrect,

I would be hesitant to depart from holdings extending

over a period of 50 years, except for the fact that re

spondent’s regulation, which the majority has declared

invalid, fairly puts taxpayers on notice that transfers of

stock for the benefit of the issuing corporation might now

be considered contributio.s to capital.

I would accept respondent’s regulation, not because of

any specific statement in section 83 of the Code which

supports it, but because it is now and has been, despite

our decisions to the contrary, a proper interpretation of

the result of a transaction such as is here involved.

I have no problem with the situation of a stockholder

transferring stock to a third party for the benefit of the

issuing corporation where the transfer is for a sum that

results in a gain to the transferor. To the extent the trans-

ferring stockholder receives consideration other than a

benefit to the corporation from his transfer of stock, he

has received a gain in the amount of the difference in

the monetary consideration received and his basis in the

stock transferred. This is true even though the transfer

may be at less than the fair market value of the stock.

This situation can be equated with a bargain sale of stock

to a relative. We have held that a taxpayer in such a

situation has made a gift of the value of the stock in

excess of the bargain price at which it is transferred

even though that bargain price was greater than his basis

in the stock. In such a situation, we have held that there

is both a taxable gain and a gift. If stock is transferred

at less than its value but more than its basis for the

benefit of the issuing corporation, instead of a gift, a tax-

payer would have made a contribution to the capital of

the corporation of the excess of the value of the stock

over the price received for it. He would have a taxable

gain and also would have made a contribution to the capi-

tal of the corporation. This is not to be interpreted as

determining whether a contribution to capital under these

40a

circumstances would increase the taxpayer’s basis in his

remaining stock. This is a separate issue that is not

involved in the instant case.

DAWSON and CHABOT, JJ., agree with this dissenting

opinion.

Stimpson, J., dissenting: Usually, when we have a vex-

ing question of statutory interpretation, we are faced

with a problem not anticipated during the development of

the legislation, and we are unable to ascertain the treat-

ment which Congress would have intended if it had con-

sidered the matter. Not so in this case. Here, the legisla-

tive purpose is indisputable, and the regulations under-

take to carry out that purpose. The majority quibbles

with the way Congress undertook to express its purpose,

and because it did not set forth all the intended rules in

the statute itself, the majority proposes to disregard the

clearly manifested legislative purpose.

When Congress decided to legislate with respect to the

tax treatment of bargain sales of property to persons

rendering services, it recognized that in addition to sales

by an employer to an employee, it needed to provide rules

broad enough to cover other compensatory sales of prop-

erty. Thus, section 83(a), which governs the taxability

of the recipient of the property, applies “If, in connection

with the performance of services, property is transferred

to any person other than the person for whom such serv-

ices are performed.” Thus, the rule applies to any com-

pensatory transfer, not merely to a transfer to an em-

ployee. It includes a sale made by a parent or share-

holder of the employer corporation to an employee of

such corporation. For example, in the case of a group of

affiliated corporations, the parent corporation may wish

to retain all of the stock of the subsidiaries so that

employees of the subsidiaries are offered an opportunity

to purchase, at a bargain, the stock of the parent.

4la

Though the primary purpose of section 83 wes to pro-

vide rules for determining when the recipient of the bar-

gain realized compensation and was taxable thereon,

Congress recognized that questions would arise as to

whether and when a deduction for compensation is to be

allowed. See Deputy v. du Pont, 308 U.S. 488 (1940) ;

Hewett v. Commissioner, 47 T.C. 483 (1967); Rand v.

Commissioner, 35 T.C. 956 (1961). As a result, it enacted

section 83(h), which accomplishes two objectives: it al-

lows a deduction under section 162 to the person for

whom the services are performed, and it allows such a

deduction when the compensation is includable in income.

By describing the recipient of the deduction as “the per-

son for whom were performed the services,” it is clear

that Congress had in mind situations where the transferor

would be a person other than the employer; there would

have been no need to use such convoluted language if Con-

gress had meant merely to cover a bargain sale by an

employer to an employee. The committee report reinforces

that view. S. Rept. 91-552 (1969), 1969-3 C.B. 423, 500-

502.

In deciding whether a deduction is to be allowable in

such situation, and to whom, the draftsmen no doubt had

in mind the various views of the transaction that could

be taken: when a shareholder sells his stock to an em-

ployee of the corporation, it could be viewed as a simple

sale (Downer v. Commissioner, 48 T.C. 86 (1967) );

under that view, there would be a capital transaction giv-

ing rise to gain or loss, but there would be no transfer

of compensation taxable to the employee and deductible by

either the transferor or the employer. Deputy v. du Pont,

supra. In the alternative, the transaction could be viewed

as a transfer of stock to the corporation and a transfer

of such stock by the corporation to the employee. Since

the statute allows a deduction for compensation, the

statute makes clear that Congress rejected the view that

the transaction was merely a sale by a shareholder to

an employee.

42a

Having decided to tax the employee on the receipt of

compensation and to allow the corporation a deduction for

the payment thereof, the draftsmen went on to explain

in the committee report the theory on which such treat-

ment was based; that is, the parent or shareholder is

considered to have made a contribution to the capital of

the corporation. The draftsmen could have expanded the

provisions of section 83(h) and included in the statute

rules reflecting the treatment of the transaction described

in the committee report.' Surely, we cannot have any

doubt that Congress would have passed the legislation

had the statutory provisions been expanded in that man-

ner, and surely, we can have no doubt that the statements

of the committee reported accurately reflect the legisla-

tive purpose. See, for example, United States v. Davis,

397 U.S. 308-312 (1970), in which the Supreme Court

relied on legislative history to decide the scope of the “not

essentially equivalent to a dividend” provision of section

802(b) (1), and Walt Disney Productions v. United

States, 480 F.2d 66, 68-69 (9th Cir. 1973), cert. denied

415 U.S. 934 (1974), in which the court relied on legisla-

tive history to decide what was “tangible personal prop-

erty” for purposes of the investment credit.

In Downer v. Commissioner, supra, we adopted a dif-

ferent view of the transaction, but since the decision in

that case, Congress has reviewed the subject and adopted

section 83(h) reflecting its view of the transaction. In

taxing the employee on the compensation and in allow-

ing the corporation a deduction for compensation, Con-

1 Sec. 83 was enacted as a part of the Tax Reform Act of 1969,

Pub. L. 91-172, 83 Stat. 588. Although such legislation was a major

Ways and Means Committee on Jan. 29, 1969, and the legislation

was ‘inally approved by the Congress on Dec. 22, 1969. In hind-

sight, it is easy for us to say that the draftsmen should have

expanded the statutory provisions, but their failure to do so may

be understandable in the light of the time pressures upon them.

48a

gress rejected the view that there was simply a sale by

the shareholder to the employee. Under such circum-

stances, we are no longer bound by our decision in

Downer, and we should accept and apply the clearly

expressed legislative purpose.’

Fay, WILBER, and CHABOT, JJ., agree with this dis-

senting opinion,

44a

APPENDIX C

Section 83(a) GENERAL RULE.—If, in connection with

the performance of services, property is transferred to

any person other than the person for whom such services

are performed, the excess of —

(1) the fair market value of such property (de-

termined without regard to any restriction other

than a restriction which by its terms will never

lapse) at the first time the rights of the person hav-

ing the beneficial interest in such property are trans-

ferable or are not subject to a substantial risk of

forfeiture, whichever occurs earlier, over

(2) the amount (if any) paid for such property,

shall be included in the gross income of the person who

performed such services in the first taxable year in which

the rights of the person having the beneficial interest in

such property are transferable or are not subject to a

substantial risk of forfeiture, whichever is applicable.

The preceding sentence shall not apply if such person

sells or otherwise disposes of such property in an arm’s

length transaction before his rights in such property be-

come transferable or not subject to a substantial risk of

forfeiture.

(b) ELECTION To INCLUDE IN Gross INCOME IN YEAR

OF TRANSFER. —

(1) IN GENERAL.—Any person who performs serv-

ices in connection with which property is transferred

to any person may elect to include in his gross in-

come, for the taxable year in which such property is

transferred, the excess of —

(A) the fair market value of such property

at the time of transfer (determined without re-

gard to any restriction other than a restriction

which by its terms will never lapse), over

45a

(B) the amount (if any) paid for such prop-

erty.

If such election is made, subsection (a) shall not

apply with respect to the transfer of such property,

and if such property is subsequently forfeited, no

deduction shall be allowed in respect of such forfei-

ture.

(2) ELECTION.—An election under paragraph (1)

with respect to any transfer of property shall be

made in such manner as the Secretary prescribes and

shall be made not later than 30 days after the date

of such transfer. Such election may not be revoked

except with the consent of the Secretary.

(c) SPECIAL RULES.—For purposes of this section—

(1) SUBSTANTIAL RISK OF FORFEITURE.—The rights

of a person in property are subject to a substantial

risk of forfeiture if such person’s rights to full en-

joyment of such property are conditioned upon the

future performance of substantial services by any

individual.

(2) TRANSFERABILITY OF PROPERTY.—The rights

of a person in property are transferable only if the

rights in such property of any transferee are not

subject to a substantial risk of forfeiture.

(3) SALES WHICH MAY GIVE RISE TO SUIT UNDER

SECTION 16(b) OF THE SECURITIES EXCHANGE ACT OF

1934.—So long as the sale of property at a profit

could subject a person to suit under section 16(b) of

the Securities Exchange Act of 1934, such person’s

rights in such property are—

(A) subject to a substantial risk of forfei-

ture, and

(B) not transferable.

(d) CERTAIN RESTRICTIONS WHICH WILL NEVER

LAPSE.—

46a

(1) VALUATION.—In the case of property subject

to a restriction which by its terms will never lapse,

and which allows the transferee to sell such prop-

erty only at a price determined under a formula, the

price so determined shal! be deemed to be the fair

market value of the property unless established to

the contrary by the Secretary, and the burden of

proof shal] be on the Secretary with respect to such

value.

(2) CANCELLATION.—If, in the case of property

subject to a restriction which by its terms will never

lapse, the restriction is cancelled, then, unless the

taxpayer establishes—

(A) that such cancellation was not compen-

satory, and

(B) that the person, if any, who would be al-

lowed a deduction if the cancellation were

treated as compensatory, will treat the transac-

tion as not compensatory, as evidenced in such

manner as the Secretary shall prescribe by regu-

lations,

the excess of the fair market value of the property

(computed without regard to the restrictions) at the

time of cancellation over the sum of- -

(C) the fair market value of such property

(computed by taking the restriction into ac-

count) immediately before the cancellation, and

(D) the amount, if any, paid for the cancella-

tion,

shall be treated as compensation for the taxable year

in which such cancellation occurs.

(e) APPLICABILITY OF SECTION.—This section shal] not

apply to—

47a

(1) a transaction to which section 421 applies,

(2) a transfer to or from a trust described in sec-

tion 40l‘a) or a transfer under an annuity plan

which meets the requirements of section 404(a) (2),

(3) the transfer of an option without a readily

ascertainable fair market value, or

(4) the transfer of property pursuant to the exer-

cise of an option with a readily ascertainable fair

market value at the date of grant.

(f) HoLpING PERIop.—In determining the period for

which the taxpayer has held property to which subsection

(a) applies, there sha!l be included only the period be-

ginning at the first time his rights in such property are

transferable or are not subject to a substantial risk of

forfeiture, which ever occurs earlier.

(g) CERTAIN EXCHANGES.—If property to which sub-

section (a) applies is exchanged for property subject to

restrictions and conditions substantially similar to those

to which the property given in such exchange was sub-

ject, and if section 354, 355, 356, or 1036 (or so much of

section 1031 as relates to section 1036) applied to such

exchange, or if such exchange was pursuant to the exer-

cise of a conversion privilege—

(1) such exchange shall be disregarded for pur-

poses of subsection (a), and

(2) the property received shall be treated as prop-

erty to which subsection (a) applies.

(h) DEDUCTION BY EMPLOYER.—In the case of a trans-

fer of property to which this section applies or a can-

cellation of a restriction described in subsection (d),

there shall be allowed as a deduction under section 162,

to the person for whom were performed the services in

connection with which such property was transferred, an

amount equal to the amount included under subsection

48a

(a), (b), or (d)(2) in the gross income of the person

who performed such services. Such deduction shall be

allowed for the taxable year of such person in which or

with which ends the taxable year in which such amount

is included in the gross income of the person who per-

formed such services.

(i) TRANSITION RULES.—This section shall apply to

property transferred after June 30, 1969, except that this

section shal] not apply to property transferred—

(1) pursuant to a binding written contract entered

into before April 22, 1969,

(2) upon the exercise of an option granted before

April 22, 1969,

(3) before May 1, 1970, pursaunt to a written

plan adopted and approved before July 1, 1969,

(4) before January 1, 1973, upon the exercise of

an option granted pursuant to a binding written con-

tract entered into before Apri! 22, 1969, between a

corporation and the transferor requiring the trans-

feror to grant options to employees of such corpora-

tion (or a subsidiary of such corporation) to purchase

a determinable number of shares of stock of such

corporation, but only if the transferee was an em-

ployee of such corporation (or a subsidiary of such

corporation) on or before April 22, 1969, or

(5) in exchange for (or pursuant to the exercise

of a conversion privilege contained in) property

transferred before July 1, 1969, or for property to

which this section does not apply (by reason of para-

graphs (}', (2), (3), or (4)), if section 354, 355,

356, or 1036 (or so much of section 1031 as relates

to section 1036) applies, or if gain or loss is not

otherwise required to be recognized upon the exercise

of such conversion privilege, and if the property re-

ceived in such exchange is subject to restrictions and

49a

conditions substantially similar to those to which the

property given in such exchange was subject.

Section 1001\c) RECOGNITION OF GAIN OR LOss.—Ex-

cept as otherwise provided in this subtitle, the entire

amount of the gain or loss, determined under this section,

on the sale or exchange of property shall be recognized.

Treasury Regulation § 1.83-6/d) Special rules for trans-

fers by shareholders—i1) Transfers. If a shareholder

of a corporation transfers property to an employee of

such corporation or to an independent contractor (or to

a beneficiary thereof), in consideration of services per-

formed for the corporation, the transaction shall be con-

sidered to be a contribution of such property to the capi-

tal of such corporation by the shareholder, and immedi-

ately thereafter a transfer of such property by the cor-

poration to the employee or independent contractor under

paragraphs (a) and (b) of this section. For purposes of

this (1), such a transfer will be considered to be in con-

sideration for services performed for the corporation if

either the property transferred is substantially nonvested

at the time of transfer or an amount is includible in the

gross income of the employee or independent contractor

at the time of transfer under § 1.88-1(a)(1) or § 1.83-2

(a). In the case of such a transfer, any money or other

property paid to the shareholder for such stock shall be

considered to be paid to the corporation and transferred

immediately thereafter by the corporation to the share-

holder as a distribution to which section 302 applies.

(2) Forfeiture. If, following a transaction described

in paragraph (d)(1l) of this section, the transferred

property is forfeited to the shareholder, paragraph (c) of

this section shall apply both with respect to the share-

holder and with respect to the corporation. In addition,

the corporation shall, in the taxable year of forfeiture be

allowed a loss (or realize a gain) to offset any gain (or

loss) realized under paragraph (b) of this section. For

example, if a shareholder transfers property to an em-

50a

ployee of the corporation as compensation, and as a result

the shareholder’s basis of $200z in such property is al-

located to his stock in such corporation and such corpora-

tion recognizes a short-term capital gain of $800zx, and

is allowed a deduction of $1,000z on such transfer, upon

a subsequent forfeiture of the property to the shareholder,

the shareholder shall take $2007 into gross income, and

the corporation shall take $1,000z into gross income and

be allowed a short-term capital loss of $800z.