Petition for Writ of Certiorari — Hempt Bros. v. United States

Supreme Court brief1974

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Supreme Court of the United staia¢:*

——

October Term, 1973

No 73- 1523

HEMPT BROS., INC.., Petitioner

vz.

UNITED STATES OF AMERICA, Respondent

PETITION OF HEMPT BROS., INC.

FOR A WRIT OF CERTIORARI

TO THE UNITED STATES COURT OF

APPEALS FOR THE THIRD CIRCUIT

Sheldon M. Bonovitz

John F. Fansmith, Jr.

DUANE, MORRIS & HECKSCHER

Attorneys for Petitioner

1600 Land Title Building

100 South Broad Street

Philadelphia, Pa. 19110

TWE LEG/1 IN7ZLLIGENCER, OS NORTH JUNIPER STREET, PHILA, PA. 19167

ja erga

Bete oO

TABLE OF CONTENTS

Page

Opinions I aside Geos Wc am Oe oo eek 1

SN cei occ cir eet tase sate dh bess oie s 2

Statutes Involved in the Case .................---- 2

ND ae RS cea s Cie nev aw es 3

oo eee kes eaetsenedeu sd 4

IN a im re rei claws e man enees 4

I IN ig ec evi had ote ew ke

ere ere 7

Court of Appeais Decision ...............-.-- 7

Reasons for Granting the Writ ................ 8

Assignment of income doctrine—Under the

assignment of income doctrine one

cannot dispose of his right to receive

ordinary income and thus avoid being

OR INTE 5. n.5 5s hns ganas Reet ere 8

Section 351—Neither the provisions of Sec-

tion 351 nor its legislative history pre-

clude an application of the assignment

of income doctrine ................. 10

The assignment of income doctrine applies

to Section 351 transferors ............ 14

Conia 5... 5. o4ccua eee cee ae er eee 18

Appendix

Memorandum Decision of the United States Dis-

trict Court fer the Middle istrict vf Pennsyl-

OE Tao cecxe os eases v ns esa peneseeeres 19

Clic Tine: TE BEE oon eos ch es por ecseee 37

pe err rapes peed Pe" 38

TABLE OF CONTENTS—(Continued)

Page

Opinion of the United States Court of Appeals

for the Third Circuit ».. 2.2.0.0... cece cceeees 39

DE 0064 day Wain Rew Bodh nee hee an ees 59

TABLE OF CITATIONS

Cases Cited:

Alderman, Velma W., 55 T.C. 662 (1971) ......... a

Bongiovanni v. Commissioner, 470 F.2d 921 (2d Cir.

ME in hodinattint «ates Ri aes reek kar ones 12

Bongiovanni, John P., 30 T.C. Memo. 1124(1971).... 12

Briggs, Thomas W., 15 T.C. Memo. 440 (1956) ....... 17

Burnet v. Leininger, 285 U.S. 136 (1932) ............ 8

Burnet v. Wells, 289 U.S. 670 (1933) ............... 8

Commissioner v. Culbertson, 337 U.S. 733 (1949) .... 4,8

Commissioner v. P. G. Lake, Inc., 356 U.S. 260

SN gh ons cab 24 a Kee a eR 4,8, 9, 10,17, 18

Commissioner v. Sunnen, 333 U.S. 591 (1948) ....... 8

Commissioner v. Tower, 327 U.S. 280 (1946) ........ S

Corliss v. Bowers, 281 U.S. 376 (1930) .............. S

Dearborn Gage Co., 48 T.C. 190 (1967) ............. 12

Divine v. U.S., 622 U.S.T.C. $9632 (W.D. Tenn.

DE oon BUaek ave Mew itke o's Faatha 15, 17

Douglas v. Willcuts, 296 U.S. 1(1935) .............. s

Ezo Products Co., 37 T.C. 385 (1961) ............... 12

Foster, T. J., 25 T.C. Memo. 1390 (1966) ............ 12

Harrison v. Schaffner, 312 U.S. 579 (1941) .......... 8

RR CRRA, <

ant ee, :

eS PO a ae

TABLE OF CITATIONS— Continued)

Cases Cited: x Page

H. B. Zachry Co., 49 T.C. 73 (1967) .......... 15, 17, 18

Helvering v. Clifford, 309 U.S. 331 (1940) ........... 8

Helvering v. Eubank, 311 U.S. 12241940) ........... 8

Helvering v. Horst, 311 U.S. 112(1940)............. 8

Holdcroft Transportation Co. v. Commissioner, 153

ee | eee 12

Hort v. Commissioner, 313 U.S. 28 (1941) ........... 9

Jack Ammann Photogrammetric Engineers, Inc. v.

Commiissioner, 341 F.2d 466 (5th Cir. 1965) ... .15, 16

Kniffen, Arthur, 39 T.C. 553 (1962) ................ 17

Leavitt, Mark O., 31 T.C. Memo 453 (1972) .......... 12

Lucas v. Earl, 281 U.S. 111 (1990) .......5.......... 8,9

Lusthaus v. Commissioner, 327 U.S. 293 (1946) ...... 8

M. Buten & Sons, Inc., 31 T.C. Memo. 178 (1972) ..... 12

Meeks Motor Freight, Inc., 8 T.C. Memo. 838 (1949)... 12

McCoy, Robert L., 30 T.C. Memo. 146 (1971) ........ 12

Palmer v. Commissioner, 267 F.2d 434 (9th Cir. 1959) 11

Pittsfield Coal & Oil Co., Inc., 25 T.C. Memo. 11(1966) 12

Portland Gasoline Co. v. Commissioner, 181 F.2d 538

CE os Gas ba ee oo eh oe ee Scie 12

Raich, Peter, 46 T.C. 604 (1966) ............. 12,14, 15

Rooney v. U.S., 305 F.2d 681 (9th Cir. 1962) ......... 11

Sol C. Siegel Productions, Inc., 46 T.C. 15 (1966) ..... 18

Textile Apron Co., Inc., 21 T.C. 147 (1953) .......... 12

Thatcher, Wilford E., 61 T.C. No. 4 (1973) .......... 12

US. Astetie Co., SOT. 1357S CGGB) .. co. cc i ccc 12

lii

TABLE OF CITATIONS— Continued)

Cases Cited: Page

U.S. v. Basye, 410 U.S. 441 (1973) ...............-. 8

Watson v. Commissioner, 345 U.S. 544 (1953) ....... 9

Weinberg, Adolph, 44 T.C. 233 (1965) .............. 15

Statutes Cited:

Section 202(c\(3) of the Revenue Act of 1921, 42 Stat.

lta par sk ln ae Macea Seles hace ak eo a 13

| REPRESS RoE ree Moe ee rear 2,4, 10, 14

Fi) i | ree bed tacdhaake paeren 10, 11, 12, 13

Eo ve soe eb eens be VNC ENE EE OE TET TEES 14

IE 8 oa ks Woy NG Gan ooyes Vusenetieees 13

ED fia en WS hah os he oe asa ee cee ows 2

Regulations and Revenue Ruling Cited:

Te a on 5 oes oii op ose encores 10, 11

pe ee 10

po er ee 10

Treas. Reg. §1.381(c)(2)}-1(a) .......... el aan cig Bact 11

Treas. Reg. §1.441-1(bX(3) ...............2 2. ee eee 11

po) eee ee rere rrr rer ee 11

ps rr 11

Rev. Rul. 73-423, 1973-42 I.R.B.9.................. 16

ain

TABLE OF CITATIONS— Continued)

Miscellaneous:

Bittker and Eustice, Federal Income Taxation of Cor-

porations and Shareholders (3d Ed. 1971) ......

Burke, Section 351: The Beginning of Life in Sub-

chapter C, 24 Southwestern L.J. 742 (1970) .....

Paul and Kalish, Transition from a Partnership to

Corporation, 18 N.Y.U. Inst. of Fed. Tax 639

CRE a ca Sco nb hoe Leak b Ae stexet Pare as

Worthy, I.R.S. Chief Counsel Outlines: What Lies

Ahead for Professional Corporations, 22 J. Taxa-

tion 88(1970)..... ke Gia ae en Seah a

S. Rep. No. 275, 67th Cong. Ist Sess. 11 (1921) .......

IN THE

Supreme Court of the United States

October Term, 1973

No.

HEMPT BROS., INC., Petitioner

UNITED STATES OF AMERICA, Respondent

PETITION FOR A WRIT OF CERTIORARI

TO THE UNITED STATES COURT OF

APPEALS FOR THE THIRD CIRCUIT

The petitioner, Hempt Bros., Inc., respectfully prays

that a Writ of Certiorari issue to review the judgment and

opinion of the United States Court of Appeals for the Third

Circuit entered in this proceeding on January 14, 1974.

. OPINIONS BELOW

The opinion of the Court of Appeals for the Third

Circuit appears in the Appendix hereto at pages 39-58. The

order, judgment and memorandum opinion of the United

States District Court for the Eastern District of Pennsyl-

vania appear in the Appendix hereto at pages 19-38.

JURISDICTION

The judgment of the Court of Appeals for the Third

Circuit was entered on January 14, 1974. This petition

for certiorari was filed within 90 days of that date. This

Court's jurisdiction is invoked under 28 U.S.C. §1254(1).

STATUTES INVOLVED IN THE CASE

The Statute involved in this case is 26 U.S.C. §351

which provides in relevant part:

No gain or loss shall be recognized if property is

transferred to a corporation (including, in the case of

transfers made on or before June 30, 1967, an invest-

ment company) by one or more persons solely in

exchange for stock or securities in such corporation

and immediately after the exchange such person or

persons are in control (as defined in section 368(c)) of

the corporation. For purposes of this section, stock

or securities issued for services shall not be consid-

ered as issued in return for property.

If subsection (a) would apply to an exchange

but for the fact that there is received, in addition to

the stock or securities permitted to be received under

subsection (a), other property or money, then—

(1) gain (if any) to such recipient shall be

recognized, but not in excess of —

(A) the amount of money received, plus

(B) the fair market value of such other

property received; and

(2) no loss to such recipient shall be recog-

nized.

In determining control, for purposes of this sec-

tion, the fact that any corporate transferor distributes

part or all of the stock which it receives in the ex-

’ change to its shareholders shall be not taken into

account.

QUESTION PRESENTED

Whether accounts receivable earned by a partnership

and transferred to a corporation, along with the other

business assets of the partnership solely in exchange for

the corporation's stock, are excludable from the taxable

income of the transferee corporation.

ee — — -

ai eee Re SE a er ons eRe

STATEMENT OF THE CASE

INTRODUCTION

At issue is whether accounts receivable transferred by

a partnership to Hempt Bros., Inc. (hereinafter referred to

as “Hempt Bros.”) solely in exchange for Hempt Bros.

stock, were taxable to Hempt Bros.

It is Hempt Bros.’ position that because all of the

events fixing the partnership's rights to receive the ac-

counts receivable had occurred prior to the transfer, the

assignment of income doctrine prevented the partnership

from shifting the incidence of taxation to Hempt Bros., a

separate taxpayer.

The Court of Appeals for the Third Circuit held that

on balance the teachings of this Court’s decision in Com-

missioner v. P. G. Lake, Inc., 356 U.S. 260 (1958), and other

cases of this Court, which have uniformly applied the

assignment of income doctrine to prevent the shifting of

income from the person who earned the income to another,

give way to the broad congressional purpose of facilitating

the incorporation of “going” businesses under 26 U.S.C.

351. (Unless otherwise indicated, all section references are

to Title 26 of the United States Code).

It is submitted that the Court of Appeals erroneously

carved out an exception to this Court’s unbroken line of

decisions which have refused to permit the shifting of the

incidence of taxation from the person who earned it to

another. That a transaction would otherwise qualify under

Section 351 is no answer to the “first principle of income

taxation” that “income must be taxed to him who earns

it.” Commissioner v. Culbertson, 337 U.S. 733, 739-40

(1949). The Court of Appeals also misconceived the role

of Section 351 in facilitating the incorporation of “going”

businesses, which Section permits only a limited continuity

of interest and does not extend to the shifting of earned in-

come, expense items or accounting methods between the

transferor and transferee. The Section 351 corporate

transferee and its transferor(s) are separate taxpayers.

This separateness has been carefully preserved in other

related areas of the law involving Section 351 and the

transfer of earned income items is no exception to such

separateness.

STATEMENT OF FACTS

he facts were fully stipulated by the parties.

From 1942 until February 28, 1957, a partnership,

consisting of four partners, was engaged in the business

of quarrying and selling stone, sand, gravel and slag; the

manufacture and sale of ready-mix concrete and bitumi-

nous materials and the construction of roads, highways and

streets (this partnership will hereinafter be referred to as

“Partnership’ ).

Partnership maintained its books and records and

filed its partnership tax returns on the basis of a calendar

year and on the cash method of accounting so that no

income was reported by Partnership until actually received

in cash. Accordingly, in computing its income for federal

income tax purposes, Partnership did not take uncollected

receivables into income and inventories were not used in

the calculation of its taxable income, although both

accounts receivable reflecting sales already made and

physical inventories existed to a substantial extent at the

end of each of Partnership's taxable years.

The Internal Revenue Service audited Partnership's

federal income tax returns during the period 1953-1956.

On March 1, 1957, the business and assets of Partner-

ship were transferred to Hempt Bros. solely in exchange

for Hempt Bros. capital stock.

Among the assets transferred to Hempt Bros. on

March 1, 1957, were accounts receivable of $662,824.40.

Of said accounts receivable of $662,824.40, the amount of

$282,409.57 represented amounts owing for sales and

rentals and $390,414.83 represented amounts owing for

services with respect to the construction of streets, high-

ways, driveways and similar projects.

TORN eT Sy

From March 1, 1957, Hempt Bros. conducted the busi-

ness formerly conducted by Partnership.

All the events fixing Partnership’s rights to receive

the accounts receivable of $662,824.40 had occurred prior

to March 1, 1957. Hempt Bros. did not perform any ser-

vices or furnish any materials in respect of the accounts

receivable transferred to it.

Commencing with its fiscal year ending February

28, 1958, and for subsequent fiscal years, Hempt Bros.

continued the method of accounting of Partnership. It

maintained its books and filed its corporate income tax

returns on the cash method and, accordingly, did not

take uncollected receivables into income and inventories

were not used in the calculation of its taxable income.

In its taxable year ended February 28, 1958, Hempt

Bros. coliected $533,247.87 of the aforesaid $662,824.40

amount of accounts receivable and inciuded said amount

of $533,247.87 in income.

In its taxable years ending February 28, 1959. and

February 29, 1960, Hempt Bros. collected the balance of

the accounts receivable of $129,576.43 and included said

amount in income in computing its federal income tax

liability for these taxable years.

As a result of an examination extending over a period

of years, the Internal Revenue Ser ice converted tax-

payer's method of reporting income from the cash to the

accrual basis. It was determined by the Commissioner of

Internal Revenue by notice dated September 15, 1964,

that the use of the cash receipts and disbursements method

of accounting with regard to purchases and sales, without

taking into account merchandise on hand at the beginning

and end of the year, did not clearly reflect Hempt Bros.’

income. Hempt Bros. did not contest such conversion

from the cash to the accrual method and agreed that it

was proper.

Corporation’s income was accordingly adjusted to

accrue unreported sales made during the taxable years

and to take into account inventories in computing its

cost of goods sold.

In converting the corporation’s method of reporting

income from the cash to the accrual method with respect

to purchases and sales, the Commissioner did not adjust

Hempt Bros. reporting of the accounts receivable trans-

ferred to it by Partnership.

DISTRICT COURT DECISION

The District Court held that Hempt Bros. was taxable

upon its collection of accounts receivable transferred to

it by Partnership. It also held it had no jurisdiction to

consider whether Hempt Bros. was entitled to an opening

inventory equal in amount to the inventory transferred to

it by Partnership. This latter holding is nct involved in

this petition.

COURT OF APPEALS DECISION

The Court of Appeals affirmed the District Court's

holding on the accounts receivable issue and found that

Hempt Bros. was taxable on the accounts receivable trans-

ferred to it by Partnership. The Court of Appeals also dealt

with the substance of Hempt Bros.’ claim on the inventory

issue. The Court of Appeals’ holding on the inventory issue

which was adverse to Hempt Bros. is not involved in this

petition.

SSOP REL NI MLL TOE ROTI, LAOH IT OTE SLE BERIT

REASONS FOR GRANTING THE WRIT

Fhe question before the Court of Appeals, namely,

whether the assignment of income doctrine precluded the

taxing of Hempt Bros. on the accounts receivable trans-

ferred to it by Partnership, was essentially one of first

impression. Indeed, the Court of Appeals cited no au-

thority in support of its holding that this Court's decision

in Commissioner v. P.G. Lake, Inc., supra, should give

way to the legislative purpose of Section 351.

Assignment of income doctrine—Under the assignment

of income doctrine one cannot dispose of his right

to receive ordinary income and thus avoid being

taxed on it.

Under the assignment of income doctrine, one can-

not dispose of his right to receive ordinary income and

thus avoid being taxed on it. This rule was first enunciat-

ed by this Court in Lucas v. Earl, 281 U.S. 111 (1930) and

has been applied by this Court in numerous subsequent

cases, the most recent one being United States v. Basye,

410 U.S. 441 (1973). Where the right to receive income is

transferred to another person in a transaction not giving

rise to tax at the time of transfer, the transferor is taxed

on the income when it is collected by the transferree.

Lucas v. Earl, supra; Helvering v. Horst, 311 U.S. 112

(1940); Helvering v. Eubank, 311 U.S. 122 (1940); Com-

missioner v. Culbertson, supra, Corliss v. Bowers, 281

U.S. 376 (1930); Burnet v. Leininger, 285 U.S. 136 (1932);

Burnet v. Wells, 289 U.S. 670 (1933); Helvering v. Clif-

ford, 309 U.S. 331 (1940); Harrison v. Schaffner, 312 U.S.

579 (1941); Douglas v. Willcuts, 296 U.S. 1 (1935); Com-

missioner v. Tower, 327 U.S. 280 (1946); Lusthaus v. Com-

missioner, 327 U.S. 293 (1946); and Commissioner v.

Sunnen, 333 U.S. 591 (1948). A variation of the doctrine

has been applied when the transferor receives considera-

tion for his right to receive ordinary income. Such con-

Ser he EL cal aa eee Se ee

sideration is taxable to the transferor at the time of

transfer at ordinary income rates on a “substitution for

ordinary income” principle. Hort v. Commissioner, 313

U.S. 28 (1941); Watson v. Commissioner, 345 U.S. 544

(1953) and Commissioner v. P. G. Lake, Inc., supra.

The only requisite for the application of the assign-

ment of income doctrine is a transfer of a right to receive

ordinary income. There is no requirement of a tax avoid-

ance motive or other type of “sinister purpose” in order

to invoke the doctrine. Lucas v. Earl, supra. Moreover,

the doctrine may be invoked by either the taxpayer or

the government. It is not solely available to the govern-

ment to police anticipatory assignments when it wants

to; the doctrine either applies or it doesn’t, and its ap-

plication does not revert to the invoking party.

In Commissioner v. P. G. Lake, Inc., supra, this

Court applied the assignment of income doctrine to deny

capital gain treatment to money received on the sale of

carved out mineral payments and to deny the application

of the tax-free exchange provisions of the predecessor

section to Section 1031, involving “like kind” exchanges

(Section 112(b) (1) of the Internal Revenue Code of

1939), to the exchange of an oil payment for a fee interest

in real estate. Although the oi] payment was an interest

in land, the tax-free exchange provisions of Section 1031

were held not to apply “where the effect under the tax

laws is a transfer of future income from oil leases for

real estate.” Commissioner v. P.G. Lake, Inc., supra at

268.

Under Commissioner v. P.G. Lake, Inc., supra, an ex-

change of property will not be given effect to shift the in-

cidence of taxation from the transferor to the transferee

where it amounts to a mere anticipation of that which,

absent the exchange, would be received as ordinary in-

come by the transferor.

The accounts receivable at issue in the instant case

are the classic type of ordinary income items to which the

assignment of income doctrine app!<es.

a a rd ee ee

Indeed, a sale by Partnership of the accounts receiv-

able for cash, or a gift by it of the accounts receivable would

not have shifted ordinary income recognition to the trans-

feree. Nor should the exchange of the accounts receivable

for stock as part of an incorporation under Section 351

alter the result. Commissioner v. P. G. Lake, Inc., supra.

Section 351 provides no exception to the long standing

assignment of income rule that has been enunciated by.this

Court on so many occasions.

Section 351—Neither the provisions of Section 351 nor

its legislative history preclude an application of the

assignment of income doctrine.

Under Section 351, no gain or loss is recognized if

property is transferred to a corporation by one or more

persons solely in exchange for stock in such corporation

where the transferors are in control of the corporation

immediately after the exchange.

Section 351 may apply to such varying types of incor-

porations as: Incorporations of going businesses with the

corporate transferee conducting the same business, or not

conducting the same business, as that conducted by the

transferor; incorporations involving the transfers of one

or more going businesses plus the transfers by investors

of non-business property such as cash, real estate or securi-

ties; incorporations involving the transfer of solely non-

business assets. See, Bittker & Eustace, Federal Income

Taxation of Corporations and Shareholders (3d Ed. 1971)

43.01 and cases cited therein.

Under the Internal Revenue Code, the transferor and

corporate transferee in ali Section 351 transactions are

regarded as separate taxpayers with each having a separate

identity and separate attributes. For example:

1. net operating losses of the transferor do not

carry over to the transferee. See 26 U.S.C. §381;

Treas. Reg. §1.381(a)-1(b); Treas. Reg. §1.381(a}

1(b)(3); Treas. Reg. §1.381(c\1}-1(a);

PSY RO MRO OIA” LENSING hp LE IE EL ORI OEY LOO NEEL LENGE LE ESERIES ELE DEDE EBS EDEN

2. earnings and profits of the transferor do not

carry over to the transferee. See 26 U.S.C. §381; Treas.

Reg. §1.381(a}-1(b); Treas. Reg. §1.381(c)\(2}-1(a);

3. the taxable year of the transferor continues

uninterrupted ;

4. the corporate transferee has the right to

choose its own accounting period (calendar or fiscal

year) regardless of the accounting period of the

transferor. Treas. Reg. §1.6012-2(a\2);

5. the corporate transferee has the right to elect

its own method of accounting (cash or accrual), ir-

respective of the method of accounting of the trans-

feror, and its own method of accounting for such

items as inventory (LIFO, FIFO, or lower of cost or

market) bad debts (specific charge-off method or

reserve method) and depreciation (straight line or

accelerated). Treas. Reg. §1.441-1(b)(3); Treas. Reg.

§1.446-1(e)(1);

6. the Commigsioner’s statutory authority under

Sections 446 and 482 to require a change in ac-

counting method or a reallocation of income and

deductions in order to “clearly reflect income,”

overrides and takes precedence over Section 351,

Palmer v. Commissioner, 267 F.2d 434 (9th Cir. 1959);

Rooney v. United States, 305 F.2d 681 (9th Cir. 1942);

7. a transfer of property that is being depreciated

on an accelerated method by the transferor does not

qualify the transferee to continue such accelerated

method; it is limited to only the method of deprecia-

tion afforded taxpayers initially acquiring used depre-

ciable property.

The government, in recent litigation involving issues

related to the issue in the instant case, has successfully

established and reaffirmed the separateness of the Section

351

transferor and transferee, and the limited continuity

of interest afforded by such Section.

isn enero: ;

1. The corporate transferee in a Section 351

transaction is a separate taxpayer from that of the

+ Ne < “5H

transferor and where a change in the accounting

practices of the transferee is made in the first year of

the corporation’s existence (as in the instant case

involving Hempt Bros.), the corporation cannot treat

as a preceding taxable year the tax year of its prede-

cessor partnership or proprietorship. Ezo Products

Co., 37 T. C. 385, 394 (1961); Dearborn Gage Co., 48

T. C. 190, 200 (1967); Pittsfieid Coal & Oil Co., Inc., 25

T. C. Memo 11, 13 (1966); Textile Apron Co., Inc., 21

T. C. 147, 151 (1953).

2. The assumption of accounts payable by a

Section 351 corporate transferee (the other side of

the transfer of income coin) represents a cost of

acquisition of the acquired assets and hence the

payables are not deductible by the transferee when

it pays them irrespective of whether the transferee is

on the cash or accrual method of accounting and

irrespective of whether the transferor was on the cash

method and had not previously deducted them. Robert

L. McCoy, 30 T. C. Memo 146, 153 (1971); Holdcroft

Transportation Co. v. Commissioner, 153 F.2d 323,

324 (8th Cir. 1946); U.S. Asiatic Co., 30 T. C. 1373,

1380 (1958); Portland Gasolin ‘o. v. Commissioner,

181 F.2d 538, 540 (1950); Meen; Motor Freight, Inc.,

8 T. C. Memo 838, 840-41 (1949); T. J. Foster, 25 T. C.

Memo 1390, 1402 (1966); Mark O. Leavitt, 31 T. C.

Memo 453, 456-57 (1972); M. Buten & Sons, Inc., 31

T. C. Memo 178, 180 (1972).

3. To the extent accounts payable of a Section

351 transferor exceed the basis of the assets trans-

ferred, gain is recognized to the transferor. Peter

Raich, 46 T.C. 604, 611 (1966); Velma W. Alderman,

55 T.C. 662, 666 (1971); Wilford E. Thatcher, 61 T.C.

No. 4 (1973); but see Bongiovanni v. Commissioner,

470 F. 2d 921 (2d Cir. 1972), revg., John P. Bongio-

vanni, 30 T.C.Memo. 1124 (1971).

In contrast to the strict preservation of the separate-

ness of the Section 351 transferor and transferee, as

RSS Ewe 0 ’

13 \

discussed above, Section 381, which applies to certain

corporate reorganizations, sets forth a highly detailed

statutory mechanism providing for the carryover of tax

attributes relating to income, expense and accounting

items from the transferor to the transferee, with the trans-

feror stepping into the “tax shoes” of the transferee.

Each of the items or attributes discussed above that

does not carry over to a Section 351 transferee does

carry over to the Section 381 transferee by statute (and the

Regulations thereunder). Congress could have made

Section 381 applicable to Section 351 exchanges, but it

chose not to do so. Accordingly, one can hardly quarrel

with the proposition that Congress intended the continu-

ity of interest in Section 351 to be far more limited in

scope than the continuity of interest applying to corporate

reorganizations.

The Court of Appeals in reaching its decision relied

‘upon the legislative history of Section 351 and its prede-

cessor. Section 202(c) (3) of the Revenue Act of 1921, 42

Stat. 230, the original predecessor of Section 351, applied

to three types of transactions:

1. Like kind exchanges (Section 1031);

2. Corporate reorganizations (Section 368); and

3. Transfers to controlled corporations (Section 351).

In discussing all three of these exchanges, the drafts-

man stated that no gain or loss is to be recognized in

certain classes of exchanges “which will permit business

to go forward with the readjustments required by existing

conditions.” S. Rep. No. 275, 67th Cong. Ist Sess. 11

(1921).

The evolution of Section 351, as shaped by Congress

and the courts, shows that income, expense and account-

ing methods cannot be shifted to another taxpayer in a

Section 351 transaction, which in this respect is similar

to a Section 1031 like kind exchange. Both Sections 351

and 1031 provide for a much more limited continuity of

interest than corporate reorganizations. They do not

SAC Maen

extend to the shifting of earned income items between

separate taxpayers.

The assignment of income doctrine applies to Section 351

transferors.

It is Hempt Bros.’ position that under the assignment

of income doctrine, it is not taxable on the accounts

receivable of Partnership transferred to it. Such was the

income of Partnership, not Hempt Bros., and accordingly

should have been taxed. to Partnership, which it is noted

was open to the government to do.

The Section 351 transferee and its transferor(s) are

separate taxpayers and there is no justification for deviat-

ing from this treatment in respect of the transfer of earned

income items.

The cases relied on by Hempt Bros., at pages 11 and

12 herein, in support of its position, are those in which the

government was successful in establishing the separate-

ness of the taxpayers and the limited continuity that

Hempt Bros. contends should apply in this case.

In the instant case, moreover, the government

properly invoked a rule of taxpayer separateness to

prevent a tacking by Hempt Bros. of Partnership’s taxable

years to make the accounting adjustments afforded by

Section 481. The Court of Appeals, in its opinion, adopted

this rule of taxpayer separateness but failed to perceive

that the separate-taxpayer accounting treatment under

Section 481 also pointed toward respecting the separate-

ness of the taxpayers in the case of a transfer of earned

income items. It is precisely this separateness that under-

lies the assignment of income doctrine and prevents the

shifting of earned income items between the transferor

and transferee.

‘Nor would .a decision of this Court, favorable to

Hempt Bros., create a hardship to taxpayers. All a

taxpayer-transferor need do is withhold the earned

income items and collect them, transferring the net pro-

ceeds to the corporation. Indeed, in cases such as Peter

Raich, supra (which represented another government

victory in sustaining the separateness of the Section 35]

transferor and transferee and a taxpayer hardship), the

transferor could retain both accounts receivable and ac-

counts payable to avoid income recognition at the time of

transfer and to have sufficient funds with which to pay

accounts payable. Where, as in the instant case, the tax-

payer is on the cash method of accounting, the deduction

of the accounts payable would be applied against the

income generated by the accounts receivable. Thus, in-

come and expense items would be accounted for when the

taxpayer ceases its activities and transfers all or a portion

of its business to a separate taxpayer.

It is also noted that the transfer of the net proceeds

from the collected accounts receivable (after payment of

accounts payable and any resultant income taxes) for

stock or as a capital contribution would result in an

upward basis adjustment in the transferor’s stock. The

transfer of the accounts receivable by a cash basis tax-

payer, under the Court of Appeals’ decision, would not

result in an upward basis adjustment in the transferor’s

stock.

The few cases which have discussed the assignment

of income doctrine have indicated it should be applicable

to the corporate transferee in a Section 351 exchange.

See Jack Ammann Photogrammetric Engineers, Inc. v.

Commissioner, 341 F.2d 466 (Sth Cir. 1965); Divine v.

United States, 62-2 U.S.T.C. 99632 (W.D. Tenn. 1962);

Adolph Weinberg, 44 T.C. 233, 245 (1965) aff'd per curiam,

368 F.2d 836 (9th Cir. 1968) and H.B. Zachry Co., 49 T.C.

73 (1967).

“Petitioner makes another strong argument that

the tax liability should be fixed on Ammann rather

than the corporation. It says that the realization by

Ammann of the value of the future installments when

he received stock of value equal to the future install-

ments brought the transaction within the principles

announced by the Supreme Court in Commissioner

of Internal Revenue v. P. G. Lake, Inc. Supra. The

Supreme Court, in Lake, held that if an otherwise

non-recognition exchange under Section 112(b) (1)

of the 1939 Code also amounts to the ‘anticipatory

assignment of income’, such income is taxable

notwithstanding it arises from a non-recognition type

of transfer. The Government seems to come just up

to the point of conceding this contention. In his brief,

the Commissioner says: “While the rationale of the

judicially-formed assignment of income principles

would, concededly, seem broad enough to generally

encompass a non-recognition type of transfer, . . .

the transfer, pursuant to Section 351, of installment

obligations with the inherent deferred gain has

probably become so engrained in the law as to be

subject to change only by Congress. This seems to

downgrade rather severely the conceded effect of a

Supreme Court decision because of assertedly con-

trary decisions by inferior courts and a rather vague

legislative history to the contrary.”

Jack Ammann Photogrammetric Engineers, Inc. v. Com-

missioner, supra, at 468-69.

The Government has, over the years, vacillated on the

question this Court is being asked to decide with respect

to both its litigating position and its private ruling position.

For example, the Internal Revenue Service has only

recently published a ruling which taxes the transferor of

installment receivables owed to the Section 351 transferee

at the time of transfer to it. Rev. Rul. 73-423, 1973-42 I.R.B.

9. The ruling cites Jack Ammann Photogrammetric Engi-

neers, Inc. v. Commissioner, supra, at pages 468-469, in

support of its holding. For a discussion of the Govern-

ment’s ruling position see Burke, Section 351: The Begin-

ning of Life in Subchapter C, 24 Southwestern L.J. 742,

797 (1970); and, Worthy, I.R.S. Chief Counsel Outlines

What Lies Ahead for Professional Corporations, 22 J.

Taxation 88, 90-91 (1970).

The very cases in support of the Government's posi-

tion in the instant case are ones it previously lost. See

Arthur Kniffen, 39 T.C. 553 (1962); Thomas W. Briggs, 15

T.C. Memo. 440 (1956) and Divine v. United States, supra.

Indeed, the known litigating position of the Government,

as evidenced by the span of years in which it litigated the

very question before this Court, but on grounds other than

assignment of income principles, has indicated to com-

mentators that the corporate transferee is not taxable on

transferred income items.

“Logically the previously accrued items of in-

come or deduction should be picked up by the Part-

nership, either at the time of transition or when the

item is finally received or paid. In the case of income,

ample authority exists to support this conclusion in

the form of the doctrine of anticipatory assignment

of income.”

Paul and Kalish, Transition from a Partnership to Corpora-

tion, 18 N.Y. U. Inst. of Fed. Tax 639, 657 (1966).

All of this vacillation has created extreme taxpayer

uncertainty in transactions of this kind, and it is precisely

this uncertainty which Hempt Bros. is asking this Court

to reselve by granting a writ of certiorari in this case.

The Court of Appeals found that accounts receivable

are “property” within the meaning of Section 351. But

irrespective of whether the accounts receivable are

property or not, the rationale of Commissioner v. P.G. Lake,

Inc., supra, is controlling. If the receivables are not

property within the meaning of Section 351, their transfer

would be the taxable event for the transferor; if they are

property; then their collection by the transferee would be

the taxable event for the transferor. For example, in H.B.

Zachry Co., supra, the Tax Court held that a carved out oil

payment was property within the meaning of Section 351,

and that the transferor was not taxable in the year of

transfer under Section 351, but the Court expressly left

open the question of taxation to the transferor in the later

years at the time the oil payments were collected. H.B.

Zachry Co., supra, n.5. See also Sol C. Siegel Productions,

Inc., 46 T.C. 15 (1966).

In summary, Section 351 involves varying types of

incurporations between separate taxpayers. Unlike cor-

porate reorganizations which, under Section 381, merge

and carry over the attributes of the transferor and

transferee, the separateness of the transferor and the

Section 351 transferee has been carefully preserved by

statute, regulations and the vast body of decisional law.

The carefui preservation of the separateness of the

taxpayers in a Section 351 transaction by Congress and

the courts conclusively shows that no exception to the

application of the assignment of income doctrine should

be carved out from any Section 351 transfers.

This Court's decision in Commissioner v. P.G. Lake,

Inc., supra, is clearly applicable to Hempt Bros. position,

and the decision of the Court of Appeals directly conflicts

with its teachings.

CONCLUSION

For all the foregoing reasons, petitioners respectfully

request this Honorable Court to grant a Writ of Certiorari

upon the United States Court of Appeals for the Third

Circuit.

Respectfully submitted,

Spee ™

Sheldon M. Bonovitz

John F. Fansmith, Jr.

DUANE, MORRIS & HECKSCHER

Attorneys for Petitioner

Hempt Bros., Inc.

MEMORANDUM DECISION OF THE

UNITED STATES DISTRICT COURT FOR THE

MIDDLE DISTRICT of PENNSYLVANIA

173-631

Hempt Brothers, Inc., Plaintiff v. U.S., Defendant. U.S.

District Court, M. Dist. of Pa., No. 68-484 Civil, Feb. 15.

1973.

aa * =

James H. King, McNees, Wallace & Nurick, 100 Pine

St., Harrisburg, Pa.. Sheldon M. Bonovitz, John F. Fan-

smith, Jr.. Duane, Morris & Heckscher, 1617 Land Title

Bidg., Broad & Chestnut Sts., Phiiadeiphia, Pa., Attys. for

Plaintiff.

S. jonn Cottone, U.S. Atty., Scranton, Pa., Scott P.

Crampton, Asst. Atty. Gen., Tax Div., David A. Wilson, Jr.,

Chief, Refund Trial Section No. 1, Thomas R. Wechter,

Donald R. Anderson, Daniel J. Dinan, Attys., Dept. of

Justice, Wash., D.C., for Defendant.

SHERIDAN, Chief Judge:

Plaintiff, Hempt Bros., Inc., seeks to recover income

taxes alleged to have been improperly assessed and col-

lected. Jurisdiction is asserted pursuant to 28 U.S.C.A. Sec-

tion 1346(a\ 1). The parties have filed a joint stipulation of

facts, and plaintiff has moved for summary judgment.

Briefs have been submitted and oral argument made with

respect to plaintiff ’s motion.!

: _ 1. Beth parties have referred to a crossmotion for summary judg-

ment made by defendant. No such motion appears in the record.

However, resolution of the legal issues presented is clearly contem-

plated to the extent permitted by the stipulated facts; and, if appro-

priate, the court will enter summary judgment for defendant on its

own motion. Missouri Pacific Railroad Company v. National Milling

Company, Inc., 3 Cir. 1969, 409 F.2d 882, 885; Jackson v.

Hammock, E.D.Pa. 1971, 330 F. Supp. 1124; Peoples Trust Company

of Bergen County v. United States, D.N.J. 1970, 311 F. Supp. 1197,

From 1942 until February 28, 1957, a partnership

comprised of plaintiff ‘s shareholders was engaged in the

business of quarrying and selling stone, sand, gravel and

slag; manufacturing and selling ready-mix concrete and

bituminous materials; constructing roads, highways and

streets, principally for the Pennsylvania Department of

Highways and various political subdivisions of Pennsy]-

vania; and constructing driveways, parking lots, street and

water lines, and related accessories. The partnership main-

tained its books and filed its partnership income tax re-

turns on a calendar-year basis pursuant to the cash method

of accounting. Accordingly, it included neither uncol-

lected receivables nor inventories in its calculation of

taxable income, although both items existed to a substantial

extent at the end of each year.?

On March 1, 1957, the partnership's business and

most of its assets were transferred to plaintiff solely in ex-

change for plaintiff's capital stock; neither gain nor loss

was recognized upon the exchange. Int. Rev. Code of 1954,

Section 35l(a). Among the assets transferred were ac-

counts receivable of $662,824.40 and inventories of

$351,266.05.

Subsequent to the transfer, Hempt Bros., Inc. con-

tinued the business formerly conducted by the partnership.

It reported its income on a fiscal-year basis commencing

the first day of March. For all relevant years, plaintiff

maintained its books and reported its income in accord-

ance with the cash method of accounting. Amounts due on

accounts receivable transferred from its predecessor were

collected by the corporation and reported as corporate in-

come in the year of collection. Plaintiff performed no other

services with respect to the receivables.

Note 1—Continued

1201 aff ‘d. 3 Cir. 1971, 444 F.2d 193; DeFelice v. Philadelphia

Board of Education, E.D.Pa. 1969, 306 F. Supp. 1345, 1348, aff ‘d

per curiam, 3 Cir. 1970, 432 F.2d 1358; United States v. Cless,

M.D.Pa. 1957, 150 F. Supp. 687, aff ‘d, 3 Cir. 1958, 254 F.2d 590.

2. The propriety of the partnership's method of accounting is

not in issue.

As a result of an examination extending over a period of

years the Commissioner of Internal Revenue* determined

that plaintiff's accountirg method did not clearly reflect

income. The corporation therefore was required to use the

accrual method commencing with its first taxable year,*

and adjustments were made to accrue unreported sales and

to account for inventories in computing the cost of goods

sold. Plaintiff's opening inventory for its first taxable year

was valued at zero, and the result was an increase in taxable

income for that year.

Hempt Bros., Inc. filed timely refund claims with re-

spect to each of its first three taxable years in which it con-

tended, inter alia, that amounts collected on transferred

accounts receivable should be excluded from its income be-

cause the partnership performed all the services upon

which the right to collection depended, and that its initial

opening inventory should be valued at not less than $35i,-

266.05 in order to consistently account for beginning and

ending inventory during its first taxable year. Each claim

was disallowed in full, and plaintiff then instituted this

action to recover alleged overpayments.

With respect to the transferred accounts receivable,

plaintiff argues that they are not “property” within the

meaning of Section 351(a) and that the partnership there-

fore realized recognizable income at the time it exchanged

them for plaintiff ’s stock; that the rule enunciated in Com-

missioner v. P. G. Lake, Inc.> requires attribution of ordi-

nary income to the partnership at the time of the exchange;

that the assignment-of-income doctrine requires its prede-

3. Hereinafter “Commissioner.”

4. The parties agree that the Commissioner's determinaiion

was proper.

5. 1958, 356 U.S. 260 78 S.Ct. 691, 2 L.Ed. 2d 743. In Lake,

it was held that the transfer of an income interest in !and, ¢.g., a

carved-out oil payment, in exchange for consideration equivalent to

the present value of future payments derivable therefrom constituted

ordinary income to the transferor and not capital gain. It was also

decided that a similar assignment in return for an interest in real

estate was not a like-kind exchange.

bedatr

cessor to recognize income as amounts are collected by

plaintiff; that attribution of collections to plaintiff is im-

proper because inconsistent with its accrual method of ac-

counting; and that the individual partners should be re-

sponsible for the accounts receivable because the amount

of plaintiffs stock which each partner received was allo-

cated pursuant to proportional interests in the partner-

ship's capital account rather than with reference to indi-

vidual shares in transferred income items. These points

will be discussed seriatim.

The meaning of “property” is not defined by Section

351; however, known inclusions and exclusions suggest

that the term encompasses whatever may be transferred,®

including accounts receivable. Burke, Section 351: The

Beginning of Life in Subchapter C, 1970, 24 Sw.L.J. 742.

747-48; see Bongiovanni v. Commissioner, 470 F.2d 921

(2 Cir., filed Dec. 11, 1972); P. A. Birren & Son, Inc. v.

Commissioner, 7 Cir. 1940, 116 F.2d 718; Peter Raich,

1966, 46 T.C. 604; Pittsfield Coal & Oil Company, Incor-

porated, 1966, 25 CCH Tax Ct. Mem. 11; Arthur L. Kniffen,

1962, 39 T.C. 553; Ezo Products Company, 1961, 37 T.C.

385; Thomas W. Briggs, 1956, 15 CCH Tax Ct. Mem. 440;

Wobbers, Incorporated, 1932, 26 B.T.A. 322; Charles F.

Meagher, 1930, 20 B.T.A. 68; cf. Halliburton v. Commis-

sioner, 9 Cir. 1935, 78 F.2d 265, 268-270; American Ban-

tam Car Company, 11 T.C. 397, 403, aff'd per curiam, 3

Cir. 1949, 177 F.2d 513, cert. denied, 1950, 329 U.S. 920,

70 S.Ct. 622, 94 L.Ed. 1344. But see Merchants Bank Bldg.

Co. v. Helvering, 8 Cir. 1936, 84 F.2d 478, 481; Note, Sec-

tion 351 of the Internal Revenue Code and “Mid-Stream”

Incorporations, 1969, 38 U.-Cin.L.Rev. 96, 106-07. There is

a compelling reason to construe “property” to include

potential income items: a new corporation needs working

capital, and accounts receivable can be an important

source of liquidity. Cf. Halliburton v. Commissioner, 9 Cir.

1935, 78 F.2d 265, 269-70; Bittker, The Corporation and

the Federal Income Tax: Transfers to a Controlled Corpo-

ration, 1959 Wash. U.L.Q. 1,7.

6. H. B. Zachry Company, 1967, 49 T.C. 73, 80 n. 6.

Lake is not on point because it does not involve the

issue of income recognition upon the exchange of an item of

potential income for stock in a controlled corporation. H. B.

Zachry Company, 1967, 49 T.C. 73, 79-80. As the legisla-

tive history of a predecessor to Section 3517 makes clear,*

the purpose of the provision is to facilitate movement into

the corporate form by preventing immediate recognition

of gain or loss when there has been a mere change in the

form of ownership. Helvering v. Cement Investors, Inc.,

1942, 316 U.S. 527, 533, 62 S.Ct. 1125, 86 L.Ed. 1649;

Bongiovanni v. Commissioner, 470 F.2d 921 (2 Cir., filed

Dec. 11, 1972); Estate of Walling v. Commissioner, 3 Cir.

1967, 373 F.2d 190, 194; Mather & Co. v. Commissioner,

3 Cir., 171 F.2d 864, cert. denied, 1949, 337 U.S. 907, 69

S.Ct. 1049, 93 L.Ed. 1719; Portland Oil Co. v. Commis-

sioner, 1 Cir., 109 F.2d 479, 488, cert. denied, 1940, 310

U.S. 650, 60 S.Ct. 1100, 84 L.Ed. 1416. Therefore, when a

cash-method taxpayer transfers accounts receivable to a

controlled corporation solely in exchange for securities

therein, the recognition of any gain realized upon the ex-

change is deferred. Arthur L. Kniffen, 1962, 39 T.C. 553;

Charles F. Meagher, 1930, 20 B.T.A. 68. This best com- ©

ports with the policy of Section 351. Dauber, Accounts

7. Int. Rev. Code of 1921, ch. 136, Section 202(c)(3), 42 Stat.

230.

8. S.Rep. No. 275, 67th Cong., Ist Sess. 11 (1921):

“Section 202 (subdivision c) provides new rules for these ex-

changes or ‘trades’ in which, although a technical ‘gain’ may be real-

ized under the present law, the taxpayer actually realizes no cash

profit. . . . The existing law makes a presumption in favor of

taxation. The proposed act modifies that presumption by providing

. . . certain classes of exchanges on which no gain or loss is recog-

nized even if the property received in exchange has a readily realiz-

able market value. These classes comprise the cases . . . where an

individual or individuals transfer property to a corporation and after

such transfer are in control of such corporation.

“The preceding amendments, if adopted, will, by removing a

source of grave uncertainty and by eliminating many technical

constructions which are economically unsound, . . . permit busi-

ness to go forward with the readjustments required by existing

conditions. .. .”

Receivable in Section 351 Transactions, 1966, 52 A.B.A.J.

92; Hickman, Incorporation and Capitalization, 1962, 40

Taxes 974, 979; Riebesehl, Tax-Free Incorporations Under

Section 351, 1968, 46 Taxes 360.

However, the question of non-recognition upon the ex-

change itself is distinct from the issue whether the partner-

ship or the corporation is taxable when collections upon

transferred receivables are made. H. B. Zachry Company,

1967, 49 T.C. 73, 80n. 5. Plaintiff contends that such

amounts are properly attribuiabie to its predecessor at the

time cf cuiiection because the partnership performed all

the services upon which the right to paying depends.®

There is a tension which inheres in Section 351: al-

though its animating concept is that of a mere change in

form of ownership, the act of incorporation yields an

entity distinct from its predecessor which may inde-

pendently select many of its characteristics, e.g., its ac-

counting period and its methods of accounting, depreci-

ation and inventory valuation. White, Sleepers That Travel

With Section 351 Transfers, 1970, 56 Va.L.Rev. 37. There-

fore, it would be erroneous to assume that the assignment-

of-income doctrine is necessarily inapplicable. Biblin, As-

signments of Income in Connection with Incorporating

and Liquidating Corporations, 1969, 21 U.So.Cal.Tax Inst.

383, 385-87. However, for reasons to be enumerated, the

court holds that Hempt Bros., Inc. is properly taxable upon

collections made with respect to accounts receivable which

have been transferred to it in conjunction with the Section

351 incorporation of a going business by a cash-method

partnership for a legitimate business purpose.

9. See, e.g., Lucas v. Earl, 1930, 281 U.S. 111, 50 S.Ct. 241, 74

L.Ed. 731. The assignment-of-income doctrine is a common-law

acknowledgment that the dominant purpose of the revenue laws is

the taxation of income to those who earn it or who otherwise create

the right to receive and to enjoy the benefit of it when paid, rather

than to tax a mere collector or conduit through whom income passes.

Helvering v. Horst, 1940, 311 U.S. 112, 119, 61 S.Ct. 144, 85 L.Ed.

75.

The market value of the receivables notwithstanding,

they had a basis of zero to the partnership because no

collections were made prior to the transfer. Bongiovanni v.

Commissioner, 470 F.2d 921 (2 Cir., fiied Dec. 11, 1972);

P. A. Birren & Son, Inc. v. Commissioner, 7 Cir. 1940, 116

F.2d 718, 720 [26 AFTR 197]; Peter Raich, 1966, 46 T.C.

604, 610; Note, Section 357(c) and the Cash Basis Taxpayer,

1967, 115 U.Pa.L.Rev. 1154, 1165. Since the exchange was

solely for stock, plaintiff ’s carryover basis was also zero.

Int.Rev.Code of 1954, Section 362(a), as construed in, e.g.,

Ezo Products Company, 1961, 37 T.C. 385, 392-93. Upon

collection, plaintiff realized income which it must recog-

nize to the extent that the amounts received exceed basis.

P. A. Birren & Son, Inc. v. Commissioner, 7 Cir. 1940, 116

F.2d 718, 720; Thomas W. Briggs, [956,086 P-H Memo

TC] 1956, 15 CCH Tax Ct. Mem. 440; accord, Divine v.

United States, W.D. Tenn. 1962, 62-2 U.S. Tax Cas. 85,589;

Sohmer & Co., Inc. v. United States, S.D.N.Y. 1949, 86 F.

Supp. 670, 671; Wobbers, Incorporated, 1932, 26 B.T.A.

322; see Pittsfield Coal & Oil Company Incorporated, 1966,

25 CCH Tax Ct. Mem. 11.

This result facilitates the basic policy of Section 351.'°

Arent, Reallocation of Income and Expenses in Connection

10. In general, cases which have attributed income to the trans-

feror involve circumstances not present in the record before the

» court:

Commissioner v. Griffiths, 7 Cir., 103 F.2d 110, aff'd, 1939,

308 U.S. 355, 60 S.Ct. 277, 84 L.Ed. 319, is a case in which the tax-

payer devised an intricate tax-avoidance scheme to use a controlled

corporation as a conduit to defer immediate recognition of amounts

paid in settlement of a claim.

In Brown v. Commissioner, 2 Cir. 1940, 115 F.2d 337, the

taxpayer personally received payment which he then endorsed to the

corporation. In addition, the court found the corporation to be a sham

the sole purpose of which was tax avoidance.

Clinton Davidson, 1941, 43 B.T.A. 576, held that a life insur-

ance broker who transferred his going business to a controlled

corporation whose agent he then became for the purpose of procur-

ing insurance contracts was personally taxable on commissions

generated by such contracts because he had earned them; the con-

with Formation and Liquidation of Corporations, 1962, 40

Taxes 995, 996; Biblin, supra, at 407; Burke, supra, at 795;

Hickman, supra, at 977-83; White, supra, at 46; Worthy,

IRS Chief Counsel Outlines What Lies Ahead for Profes-

sional Corporations, 1970, 32 J. Tax. 88, 90. But see Note,

38 U.Cin.L. Rev., supra, at 112-13. Moreover, it is es-

pecially apposite because the partnership operated a busi-

Note 10—Continued

tracts were treated as his business; he and not the corporation was

licensed as an insurance broker; insurance companies, as a general

rule, decline to appoint corporations as agents; and Davidson per-

sonally received payment which he then endorsed to the corpora-

tion

Adolph Weinberg, 1965, 44 T.C. 233, aff 'd per curiam sub nom.

Commissioner v. Sugar Daddy, Inc., 9 Cir. 1967, 386 F.2d 836, cert.

denied, 1968, 392 U.S. 929, 88 S.Ct. 2282, 20 L.Ed.2d 1388,

involves a cash-method transferor who directed his obligors to deposit

proceeds due him from the sale of crops into the accounts of a number

of controlled corporations. The court found the transferor taxable with

respect to such proceeds because he had performed all services upon

which the right to collection depended and because no plausible

business purpose was shown for the existence of the corporations

except as shells or conduits for sales proceeds. The foregoing cases

illustrate, inter alia, the principle that income will not be shifted to

the transferee if it appears that the exchange was motivated primarily

by tax avoidance rather than being made for a legitimate business

purpose. This requirement will not be found in the language of

Section 351, but it appears to be fundamental to the provision. 3

Mertens, Law of Federal Income Taxation Section 20.46 at 127-33;

see Blanc, The Tax Treatment of Reserves Upon a Change in the

Form of Doing Business, 1967, 19 U.So.Cal. Tax Inst. 433, 474 n.

108; Lyon and Eustice, Assignment of Income: Fruit and Tree as

Irrigated by the P. G. Lake Case, 1962, 17 Tax L.Rev. 293, 425-26.

Weinberg is troublesome because its language implies that the

assignment-of-income doctrine might apply regardless of whether

the primary purpose of the transfer is tax avoidance. Nevertheless,

this court believes that Weinberg is properly limited to its facts. See

Biblin, supra, at 391-94. Since both parties agree that Hempt Bros.,

Inc. received the assets of its predecessor in an exchange made for

a legitimate business purpose in which tax avoidance played no

part, attribution pursuant to the assignment-of-income doctrine is

improper.

PASI SRG LE Be, GI LP LL ETE PEL TOO WE ig OF RINE ony YK PEND TSA CET PORTLET DOD CR LEDS LLY OLIN TE AO IRS ae NTA INE TN yey PLT

ness in which expenses were paid and income was earned

in the accounting period prior to that in which collections

were made and income was realized. Under these circum-

stances, taxation to the partnership would deter incorpora-

tion by generating a significant amount of taxable income

for which there might be no off-setting deductions: Match-

ing expenses of post-incorporation collections would already

have been deducted, and expenses subsequent to incorpo-

ration would be deductible by the transferee. Weiss, Prob-

lems in the Tax-free Incorporation of a Business, 1966, 41

Indiana L.J. 666, 681 & n.65. In addition, it seems anoma-

lous to require the partnership to account for income which

it never received and to which it cannot gain access with-

out the declaration of a taxable dividend. Biblin, supra, at

408; Burke, supra, at 795; Tritt and Spencer, Current Tax

Problems in Incorporation of a Going Business, 1958, 10

U.So.Cal.Tax Inst. 71, 95.

In support of its contention, plaintiff relies upon the

persuasive force of the application of the assignment-of-

income doctrine to transactions the tax consequences of

which are regulated by Section 311,'! Section 336'* and

11. Int. Rev. Code of 1954, Section 311. The legislative history

of the provision makes explicit that it is not intended to alter the

principle enunciated in Commissioner v. First State Bank of Stratford,

5 Cir. 1948, 168 F.2d 1004, viz., that the assignment-of-income doc-

trine applies to a corporation which declares a dividend the sub-

stance of which is the right to receive ordinary income. S.Rep. No.

1622, 83rd Cong., 2d Sess. 247 (1954). No similar endorsement ap-

pears in either the legislative history or the cases regarding Section

351.

12. Int. Rev. Code of 1954, Section 336. This section and

Section 311 are intended to be parallel provisions; to properly imple-

ment the legislative intent, the Bank of Stratford rule should be con-

sistently applied to both of them. Williamson v. United States, Ct.Cl.

1961, 292 F.2d 524, 155 Ct.Cl. 279; Lyon and Eustice, supra, at

396-97. Furthermore, a failure to attribute ordinary income to the

distributing corporation might yield complete tax avoidance in many

cases: The corporation could not be taxed on amounts collected

because its existence would have terminated and its property would

have passed to the shareholders; the shareholders might acquire a

Section 337.'5 However, other analogies are more instruc-

tive,'* especially those involving corporate reorganization. '®

Note 1 2—Continued

. Stepped-up basis in the distributed income items which would allow

them to amortize market value against income as collections were

made. Blanc, supra, at 451-52. This result does not obtain with

respect to Section 351 because the transferee's basis is assessed with

reference to that of its predecessor pursuant to Section 362.

13. Int. Rev. Code of 1954, Section 337. The purpose of Section

337 is to eliminate the problem exemplified in Commissioner v. Court

Holding Co., 1945, 324 U.S. 331, 65 S.Ct. 707, 89 L.Ed. 981, and

United States v. Cumberland Public Service Co., 1950, 338 U.S. 451,

70 S.Ct. 280, 94 L.Ed. 251, in order to permit the same tax.conse-

quences to a liquidating corporation whether it sells its assets or

distributes them to its shareholders for sale. S.Rep. No. 1622, 83rd

_ Cong., 2d Sess. 258 (1954). Since the provision was enacted to

eliminate a formalistic inequity rather than to create one, the assign-

ment-of-income doctrine is properly applied to Section 337 in the

same manner as it applies to Section 336. Commissioner v. Kucken-

berg, 9 Cir. 1962, 309 F.2d 202. In addition, its legislative history

indicates unambiguously that Congress did not intend to exempt

from corporate taxation income from sales in the ordinary course of

business. S.Rep. No. 1622, 83rd Cong., 2d Sess. 259 (1954). Since the

underlying operations which generate ordinary income are not

exempt, accounts receivable arising therefrom are properly taxable

to the corporation. Note, Tax-free Sales in Liquidation Under Sec-

tion 337, 1963, 76 Harv.L.Rev. 780, 795.

14. For example, Sections 1245(b)(3) and 1250(d)(3) express-

ly exclude the Section 351 exchange from recapture of excess

depreciation because the transferee receives a carryover basis in

which recapture potential is preserved. This is in contradistinction

to other transactions, e.g., pursuant to Sections 311, 336 and 337,

in which the recapture exemption is denied when the transferee’s

basis and holding period are assessed independently of those of its

transferor. Blanc, supra, at.443-46; O'Hara, Statutory Nonrecogni-

tion of Income and the Overriding Principle of the Tax Benefit Rule

in the Taxation of Corporations and Shareholders, 1972, 27 Tax

L.Rev. 215, 217-18 & n. 13.

Consider, too, the treatment of installment obligations, a type

of account receivable. When the Section 351 transferor has per-

formed all the services upon which the right to payment depends,

a shift of attribution with respect to future installments would

seem unlikely; yet, that is the result. Lyon and Eustice, supra, at

SELIM I IML SO CT a NYPD ANE TT FAL OSE OTN . BRIBE TERME ITN Ei ASIN AI pe hen PIL TENE

» 29

It is also argued that taxation to the transferor will

have no deleterious effect on incorporation because a ra-

tional taxpayer is unlikely to transfer items of potential in-

come and expense to a controlled corporation in any event

due to alleged uncertainty whether the Commissioner will

seek to apply the assignment-of-income doctrine; whether

transferred accounts payable will be deductible by the

transferee upon payment,'* and whether gain will be recog-

-—

—_~

427. Not only is the exchange not deemed a “disposition,” but any

post-transfer amounts received in payment have the same character

to the transferee which they would have had in the hands of the

transferor. Treas. Reg. Sections 1.453-9(c)(2) (1958) and 1.453-9

_(c)(3) (1958). In particular, amounts collected in excess of basis

are taxable as profit to the transferee. Divine v. United States,

W.D.Tenn. 1962, 62-2 U.S. Tax Cas. 85,589; Wobbers, Incor-

porated, 1932, 26 B.T.A. 322; H.Rep. No. 1860, 75th Cong., 3d

Sess. 29 (1938).

15. Int. Rev. Code of 1954, Section 381. Both cases and com-

mentators recognize the close relationship between Section 351 and

the reorganization provisions. Heivering v. Cement Investors, inc.,

1942, 316 U.S. 527, 533-34, 62 S.Ct. 1125, 86 L.Ed. 1649; Blanc,

supra, at 473-74 & n. 108; Bonovitz, Restoration to Income of Bad

Debt Reserves, 1966, 44 Taxes 300, 307-08. The exclusion of

Section 351 from those transfers to which Section 381(c) applies

creates no negative pregnant with respect to the incidence of taxa-

tion under the former section. H.Rep. No. 1337, 83rd Cong., 2d

Sess. Al35 (1954); S.Rep. No. 1622, 83rd Cong., 2d Sess. 276-77

(1954); White, supra, at 38 n. 8. To the contrary, the philosophy

of reorganization is that the propriety of carryover attribution

should depend upon economic reality and substance rather than

Y upon the form of a transaction. H.Rep.No. 1337, 83rd Cong., 2d

Sess. 41 (1954); S.Rep.No. 1622, 83rd Cong., 2d Sess. 52 (1954).

Presumably, a similar concern should animate analysis of conse-

quences pursuant to Section 351.

16. See, e.g., Merchants Bank Bldg. Co. v. Helvering, § Cir.

1936, 84 F.2d 478.

On March 1, 1957, the Board of Directors of Hempt Bros., Inc.

resolved to acquire the partnership's receivables, payables and

inventory in exchange for stock. The corporation does not contend

that it was disallowed deductions as payments on transferred

accounts payable were made. Rather, it argues that it has been the

policy of the Internal Revenue Service to challenge deductions

Vitek (ot aa >

SEN ae at enero nena OMe emma. = _

ae we ERT RI Te ME ROL TEE RIN FL LI AMEN LEP OE EERNTAS: CRE NSYT TTONE RIRMNLE SEENON

nized upon the exchange itself to the extent that transferred

liabilities exceed the adjusted basis of transferred assets.'?

This is without merit. In many cases, the withholding

of accounts receivable would substantially impair corporate

operations by making it difficult to meet working capital

requirements. See Tritt and Spencer, supra, at 95; cf. Bitt-

ker, supra, at 7. Additionally, the policy of Section 351 re-

flects a realistic awareness that the incorporating entity is

itself likely to perceive the transaction as a formal change

which has little impact upon continuity of operation: the

more natural inference is to simply assume the transfer of

payables and receivables. However, a more basic problem

is that plaintiff's predecessor did precisely that which is

now asserted to be irrational. Assuming arguendo that

there exist circumstances in which it makes sense to with-

hold income items from a controlled corporation, this

hardly mandates reversing the tax consequences which

naturally arise when they are in fact transferred. The

parinership could have retained its receivables; having cho-

Note 16—Conftinued

unless closing agreements are entered into in which the transferee

agrees to report collections made on accounts receivable as income,

“and that this policy represents a fatal inconsistency with respect

to defendant's argument that there exists a continuity of interest

and operation between parties to a Section 351 exchange.

The court disagrees. It is true that the non-deductibility of

transferred payables would deter the incorporation of a going

business. However, the purpose of the closing agreement is merely

to facilitate a proper matching of revenue and expense to preclude

duplication or omission of items of income and deduction. Burke,

supra, at 797; Hennessey, Accounting for a Transfer of Assets:

Taxable vs. Nontaxable Acquisitions, 1972, 30 N.Y.U. Inst. on Fed.

Tax. 1677, 1680-81; see Benjamin, Problems in Transition From

Sole Proprietorship or Partnership to Corporation, 1968, 26 N.Y.U.

Inst. on Fed. Tax. 791, 805-06; Worthy, supra, at 90-91.

17. Int. Rev. Code of 1954, Section 357(c), as construed in

Peter Raich, 1966, 46 T.C. 604. Contra, Bongiovanni v. Commis-

sioner, 470 F.2d 921 (2 Cir., filed Dec. 11, 1972). In this case, both

parties agree that the exchange qualified for non-recognition, and

no issue has been raised regarding Section 357(c).

sen to transfer them. Hempt Bros., Inc. may properly be re-

quired to accept the consequences of the exchange. Pitts-

field Coal & Oil Company, Incorporated, 1966, 25 CCH Tax

Ct. Mem. 11.

The court does not suggest that the Commissioner is

powerless to make adjustments when necessary to prevent

income distortion or tax avoidance. Indeed, the assignment-

of-income doctrine might itself apply to transactions moti-

vated primarily by tax advantage. Arent, supra, at 1002.

However, the role of the doctrine seems relatively modest

in this context, primarily because other means are available

to reach the same result,'* e.g., the business-purpose

doctrine'® and the Commissioner's discretionary power

to allocate items of income and expense among related tax-

payers. Int.Rev.Code of 1954, Section 482, as construed in

Estaie of Walling v. Commissioner, 3 Cir. 1967, 373 F.2d

190; Rooney v. United States, 9 Cir. 1962, 305 F.2d 681; Na-

tional Securities Corporation v. Commissioner, 3 Cir. 137

F.2d 600, cert. denied, 1943, 320 U.S. 794, 64 S.Ct. 262, 88

L.Ed. 479.

Plaintiff 's remaining arguments require only brief dis-

cussion. The decision of the Tax Court in E. Morris Cox?®

is relied upon for the proposition that amounts collected

on transf.vea receivables cannot be attributed to the

corporation because to do so would be inconsistent with its

accrual method of accounting, pursuant to which income

is realized when earned rather than when collected. To the

contrary, Cox involved an accrual-method transferor who

realized income as billings were made; the court held that

the corporation was not taxable upon items billed by its

predecessor prior to the transfer. This is merely an appli-

cation of the principle that the amount of gain realized by

a Section 351 transferee is to be assessed with reference

18. Lyon and Eustice, supra, at 424-26. See generally Rubin

v. Commissioner, 2 Cir. 1970, 429 F.2d 650 (26 AFTR 2d 70-

5051;.

19. See note 10, supra.

20. 1555, 43 T.C. 448.

OO AAR QT Rt 4 oe Rae pe rerTees

to the basis of its transferor. Since plaintiff's carryover

basis in the receivables was zero, it realized income to the

full extent collections were made. See, e.g., P. A. Birren &

Son, Inc. v. Commissioner, 7 Cir. 1940, 116 F.2d 718.

Furthermore, the parties agree that the Commissioner

properly required the corporation to change its method of

accounting in order to clearly reflect income. Int. Rev.Code

of 1954, Section 446(b). Permissible alternatives include a

hybrid method which contains cash and accrual elements.

Int.Rev.Code of 1954, Section 446(c)(4); H.Rep. No. 1337,

83rd Cong., 2d Sess. A158 (1954); S.Rep. No. 1622, 83rd

Cong., 2d Sess. 300 (1945). The only requirements are that

the method be used consistently and that it properly match

items of income and expense. See Treas.Reg. Sections 1.446-

l(c 1ivXa) (1957) and 1.446-1(c)(2)ii) 61957). In effect,

Hempt Bros., Inc. has been placed on the accrual method

with respect to income earned subsequent to March 1, 1957,

and on the cash method for items transferred from the part-

nership. The Commissioner's decision will be set aside only

when it constitutes an abuse of discretion,?' and there

is no abuse when a Section 351 transferee is required to ac-

crue post-transfer items of income and expense while re-

porting as income amounts collected on accounts re-

ceivable acquired from its cash-method predecessor. See

Ezo Products Company, 1961, 37 T.C. 385; cf. Pittsfield

Coal & Oil Company, Incorporated, 1966, 25 CCH Tax Ct.

Mem. 11.

[2] Finally, it is asserted that the receivables are tax-

able to the individual partners because the stock which each

received upon the exchange was allocated in proportion to

respective interests in the partnership capital account

rather than with reference to shares in transferred income

items. Specifically, each partner was taxable upon twenty-

five percent of partnership income, whereas individual in-

terests in the partnership capital account and in plaintiff's

21. See, e.g., Commissioner v. Joseph E. Seagram & Sons,

Inc., 2 Cir. 1968, 394 F.2d 738, 743.

RE ETRE ho,

stock were apportioned differently. The only authority cited

in support of this position is Turnbull, Inc. v. Commis-

sioner,?? in which it was held that the transfer of ac-

counts receivabie among related corporations for inade-

quate consideration in order to utilize the transferee’s large

net operating loss carryovers was a transparent tax-avoid-

ance scheme which required attribution of income to the

nominal seller. Even assuming that adequacy of considera-

tion were to be evaluated relative to proportional shares in

partnership income, the facts before the court do not resem-

ble those in Turnbull, and plaintiff ‘s argument is rejected.

The corporation’s second major contention is that it

is entitled to an opening inventory of not less than $351,-

266.05 for its first taxable year because the value of the

stock issued in exchange for partnership property reflected

the cost of transferred inventory, constituting to its prede-

cessor the recovery of a previously-expensed item the basis

of which must be restored to cost.2* However, since this

ground for recovery was not presented in the corporation's

claim for refund, the court lacks jurisdiction to entertain

it.

22. 5 Cir., 373 F.2d 91 [19 AFTR 2d 609}, cert. denied, 1967,

389 U.S. 842, 88 S.Ct. 72, 19 L.Ed. 2d 105.

23. Cf. Nash v. United States, 1970, 398 U.S. 1, 90 S.Ct.

1550, 26 L.Ed.2d 1.

An alternative argument originally propounded was based

upon the theory that a change of accounting method initiated by the

Commissioner requires that opening and closing inventory for the

year of change be valued consistently. Int. Rev. Code of 1954,

Section 481, as construed in Fruehauf Trailer Company, 1964,

42 T.C. 83. However, in its reply brief, plaintiff indicates that the

only issue with respect to inventory valuation is the applicability

of the tax-benefit rule. The corporation’s change of position rests

upon express acquiescence in the principle that Section 481 adjust-

ments are not made to the initial opening inventory of a Section

351 transferee because it has no “preceding taxable year” within

the meaning of that section. See, e.g., Dearborn Gage Company,

1967, 48 T.C. 190, 196-201. Therefore, the court does not reach

naam. DNs Aw a

Filing of a timely refund claim is a prerequisite to the

maintenance of an action to recover taxes alleged to have

been improperly assessed cr collected. Int.Rev.Code of

1954, Section 7422(a). It must set forth in detail each

ground upon which a credit or refund is claimed and facts

sufficient to apprise the Commissioner of the exact basis

thereof. Treas.Reg. Section 301.6402-2(b\1) (1954). A

corollary of the enumerated principles is that a court lacks

jurisdiction of an action to recover taxes except upon

ground reasonably encompassed by the claim for refund as

originally filed or properly amended,24 the purpose of

this rule is to facilitate administrative determination of

claims and to limit litigation to issues which the Commis-

sioner has considered and is prepared to defend. Austin v.

United States. 10 Cir. 1972, 461 F.2d 733; Herrington v.

United States, 10 Cir. 1969, 416 F.2d 1029; Thompson v.

United States, 5 Cir. 1964, 332 F.2d 657; Carmack v. Sco-

field, 5 Cir. 1953, 201 F.2d 360 [43 AFTR 154]; Tompkins

v. United States, Ct.Cl. 1972, 461 F.2d 1304; Union Pacific

24. See Real Estate-Land Title & Trust Co. v. United States,

1940, 309 U.S. 13, 60 S.Ct. 371, 84 L.Ed. 542; Austin v. United

States, 10 Cir. 1972, 461 F.2d 733; Sid W. Richardson Foundation

v. United States, 5 Cir. 1970, 430 F.2d 710, cert. denied, 1971, 401

U.S. 1009, 91 S.Ct. 1251, 28 L.Ed.2d 544; Herrington v. United

States, 10 Cir. 1969, 416 F.2d 1029; Thompson v. United Siates,

5 Cir. 1964, 332 F.2d 657; Goelet v. United States, 2 Cir. 1959,

266 F.2d 881; Fidelity-Philadelphia Trust Company v. United

States, 3 Cir. 1955, 222 F.2d 379; Scovill Manufacturing Company:

v. Fitzpatrick, 2 Cir. 1954, 215 F.2d 567; Carmack v. Scofield, 5

Cir. 1953, 201 F.2d 360; Nemours Corp. v. United States, 3 Cir.

1951, 188 F.2d 745; Pelham Hall Co. v. Carney, 1 Cir. 1940, 111

F.2d 944; Paul v. United States, $.D. Ill. 1971, 334 F. Supp. 1138

First National Bank & Trust Company of Chickasha v. United

States, W.D. Okla. 1971, 329 F. Supp. 1147; Egan v. United States

D.Del. 1971, 325 F. Supp. 1227, 1229 n.3; Lehigh Inc. v. United

States, E.D. Pa. 1968, 290 F. Supp. 584; Miniature Vehicle Leasing

Corp. v. United States, D. N.J. 1967, 266 F. Supp. 697; Schuylkill

Haven Trust Company v. United States, E.D. Pa. 1966, 252 F. Supp.

557; Tompkins v. United States, Ct.Cl. 1972, 461 F.2d 1304; Union

Pacific Railroad Company v. United States, Ct.Cl. 1968, 389 F.2d

437, 182 Ct.Cl. 103.

EEE MEN AER OE ET Wey Dee . —

FSG BOGE NI

TL FAO SSR BE IK

Railroad Company v. United States, Ct.Cl. 1968, 389 F.2d

437, 182 Ct.Cl. 103.

Plaintiff does not argue that its tax-benefit theory of

recovery was presented to the Commissioner.** Instead,

this is asserted to be irrelevant since the Commissioner is

alleged to have been apprised of all the operative facts upon

which the new theory depends and since, in any event, the

refund claim is not intended to be a legal brief in which the

taxpayer is required to elaborate all theories upon which

the claim is based.

To the contrary, the Commissioner is required to

examine only those points to which his attention is neces-

sarily directed,2® and this is especially apposite here be-

25. On June 24, 1965, plaintiff filed a claim for refund which,

in pertinent part, is as follows:

“The taxable income of Hempt Bros., Inc. (the taxpayer-

claimant herein) for its fiscal year ended February 28, 1958 has

been accordingly overstated as follows:

(a) By reason of Internal Revenue Service's failure to elimi-

nate March 1, 1957 inventories of stone, sand and gravel from tax-

able income $351,266.05. . . .”

The corporation amended its claim on July 9, 1965:

“Reference is made to claim for refund filed June 24, 1965

with respect to the above period. This ‘Amendment to Claim’ is filed

in further explanation and amplification of one of the issues set

forth in said claim.

“In respect of ‘(a)’ on page 3 of the rider attached to tax-

payer's claim for refund (failure to eliminate March 1, 1957 in-

ventories of stone, sand and gravel from taxable income) filed on

June 24, 1965, the Internal Revenue Service was in error because

for purposes of accounting, it was inconsistent in its treatment of

taxpayer's inventory for said period.

“The Internal Revenue Service changed taxpayer's method of

accounting from a cash basis method to an accrual basis for the

period March 1, 1957 to February 28, 1958 and for all taxable years

subsequent thereto. The Internal Revenue Service, pursuant to this

change, made an ‘Inventory Adjustment for the period of March 1,

1957 to February 28, 1958 whereby it set off against taxpayer's

cost of sales the amount of $258,201.35, which amount constituted

‘the value of stone, sand and gravel produced during and on hand

at the end of the taxable year. However, the Internal’ Revenue

Service erroneously failed to include taxpayer's beginning inventory

cause the corporation’s amended claim sets forth specific

reasons in support of its inventory argument the natural

effect of which is to induce the Commissioner to pursue

quite a different line of inquiry than is relevant to the

theory upon which plaintiff presently seeks to rely. Tomp-

kins v. United States, Ct.Cl. 1972, 461 F.2d 1304, 1314-15

(Dissenting Opinion). Similarly, it is immaterial that facts

which might support recovery pursuant to the tax-benefit

theory were before the Commissioner when he reviewed the

corporation's claim: the mere availability of information

is not equivalent to notice that a specific claim based there-

on is being made because the Internal Revenue Service can-

not be expected to discover every claim which a taxpayer

might conceivably assert. Herrington v. United States, 10

Cir. 1969, 416 F.2d 1029; Nemours Corp. v. United States,

3 Cir. 1951, 188 F.2d 745; Pelham Hall Co. v. Carney, 1 Cir.

1940, 111 F.2d 994; Commercial Solvents Corporation v.

United States, Ct. Cl., 427 F.2d 749, 192 Ct. Cl. 339, cert.

denied, 1970; 400 U.S. 943, 91 S. Ct. 242, 27 L. Ed. 2d 247;

Union Pacific Railroad Company v. United States, Ct. Cl.

1968, 389 F. 2d 437, 182 Ct. Cl. 103.

For the reasons given, plaintiff ’s motion will be denied,

and summary judgment will be entered for defendant.

Note 25—Continued es

of $351,266.05 in its cost of sales. Because the Internal Revenue

Service included the taxpayer’s ending inventory in income, it

should have eliminated beginning inventory from income in order

to put taxpayer on a consistent accounting method for such period

(March 1, 1957 to February 28, 1958). It was in error in failing to

put taxpayer on the same method of accounting with respect to both

beginning and ending inventory.”

In substance, this is the alternative argument which the cor-

poration originally made and then abandoned in this action. See

note 23, supra.

26. Stoller v. United States, 5 Cir. 1971, 444 F.2d 1391; Sid

W. Richardson Foundation v. United States, 5 Cir. 1970, 430 F.2d

710, cert. denied, 1971, 401 U.S. 1009, 91 S.Ct. 1251, 28 L.Ed.2d

544; Schuylkill Haven Trust Company v. United States, E.D. Pa.

1966, 252 F. Supp. 557; see Nemours Corp. v. United States, 3 Cir.

1951, 188 F.2d 745.

UNITED STATES DISTRICT COURT .

FOR THE MIDDLE DISTRICT OF PENNSYLVANIA

HEMPT BROS., INC.,

Plaintiff,

v. No. 68-484 Civil

UNITED STATES OF AMERICA,

Defendant.

ORDER

Plaintiff, Hempt Bros., Inc., having moved for sum-

mary judgment in the above captioned matter, and the

court having heard oral argument and having considered

the briefs and supporting documents of the parties,

It is ORDERED that summary judgment for the plain-

tiff, Hempt Bros., Inc., is denied.

It is FURTHER ORDERED that summary judgment

for the defendant, United States of America, is granted.

Ctl bakd GlurcLe

Chief Judge a

Middle District of Pennsylvania

Dated: December 30, 1972.

UNITED STATES DISTRICT COURT,

FOR THE S

MIDDLE DISTRICT OF PENNSYLVANIA

Civit Action Fite No. 68-484

HEMPT BROS., INC., Plaintiff

vs. JUDGMENT

UNITED STATES OF AMERICA, Defendant

This action came on for (hearing) before the Court,

Honorable Michael H. Sheridan, United States District

Judge, presiding, and the issues having been duly (heard)

and a decision having been duly rendered,

It is Ordered and Adjudged that pursuant to the

Court’s Order granting Summary Judgment for the defen--

dant, United States of America,

It is ordered and adjudged that the plaintiff take noth-

ing and the case be, and hereby is, dismissed with prejudice.

Dated at Scranton, Pa., this 30th day of December, 1972.

T. Harold Campion

Clerk of Court

oF iviale ats as (

Frank Kurdziei, Deputy Clerk

UNITED STATES COURT OF APPEALS

For THE THIRD CIRCUIT

No. 73-1296

HEMPT BROS., INC.,

Appellant,

UNITED STATES OF AMERICA

APPEAL FROM THE UNITED STATES DistRICT COURT

FOR THE MippLe District OF PENNSYLVANIA.

(D.C. Civil No. 68-484)

Argued November 2, 1973

Before: ALpisERT and Wels, Circuit Judges, and

LatcuuM, District Judge.

OPINION OF THE COURT

(Filed January 14, 1974)

Sheldon M. Bonovitz, Esg. Scott P. Crampton,

John F. Fansmith, Jr., Esq. Assistant Attorney General

Duane, Morris & Heckscher Meyer Rothwacks,

Philadelphia, Pennsylvania Ernest J. Brown,

Attorneys for Appellant ‘Attorneys, Tax Division

Department of Justice

Washington, D.C.

Attorneys for Appellee

POEL RE Le TE IE IESE OEE TE AO T

ALpIsEeRT, Circuit Judge.

In this appeal by a corporate taxpayer from a grant of

summary judgment in favor of the government in a claim

for refund, we are called upon to decide the proper treat-

ment of accounts receivable and of inventory transferred

from a cash basis partnership to a corporation organized

to continue the business under 26 U.S.C. §351(a).! This

appeal illustrates the conflict between the statutory pur-

pose of Section 351, postponement of recognition of gain

or loss, and the assignment of income and tax benefit

doctrines.

The facts were wholly stipulated; therefore, they may

be summarized as set forth by this government in its brief:

The taxpayer is a Pennsylvania corporation with

its principal place of business in Camp Hill, Pennsyl-

vania. It files its federal income tax returns for a fiscal

year beginning March 1.

From 1942 until February 28, 1957, a partnership

comprised of Loy T. Hempt, J. F. Hempt, Max C.

Hempt, and the George L. Hempt Estate was engaged

in the business of quarrying and selling stone, sand,

gravel, and slag; 1.:anufacturing and selling ready-mix

concrete and bituminous material; constructing roads,

highways, and streets, primarily for the Pennsylvania

Department of Highways and various political subdivi-

sions of Pennsylvania, and constructing driveways,

parking lots, street and water lines, and related ac-

cessories.

1. Sec. 351. Transfer to Corporation Controlled by Transferor.

(a) General Rule.—No gain or loss shall be recognized

if property is transferred to a corporation (including, in the

case of transfers made on or before June 30, 1967, an invest-

ment company) by one or more persons solely in exchange for

stock or securities in such corporation and immediately after

the exchange such person or persons are in control (as defined

in section 368(c)) of the corporation. For purposes of this

section, stock or securities issued for services shall not be

considered as issued in return for property.

PEDO EPID RECS SPL NEGO STA ETO Doty be RE ap + Phy RLY DOP SANS LEON TERE tm

The partnership maintained its books and

records, and filed its partnership income tax returns,

on the basis of a calendar year and on the cash method

of accounting, so that no income was reported until

actually received in cash. Accordingly, in computing

its income for federal income tax purposes, the partner-

ship did not take uncollected receivables into income,

and inventories were not used in the calculation of its

taxable income, although both accounts receivable re-

flecting sales already made and physical inventories

existed to a substantial extent at the end of each of the

partnership's taxable years. Rather than using the in-

ventory method of accounting, the partnership de-

ducted the costs of its physical inventories of sand,

gravel, and stone as incurred.

On March 1, 1957, the partnership business and

most of its assets were transferred to the taxpayer

solely in exchange for taxpayer's capital stock, the

12,000 shares of which were issued to the four mem-

bers of the partnership. These shares constituted

100% of the issued and outstanding shares of the tax-

payer. This transfer was made pursuant to Section 351

(a) of the Internal Revenue Code of 1954; ...

Thereafter, the taxpayer conducted the business form-

erly conducted by the partnership.

Among the assets transferred by the partnership

to the taxpayer for taxpayer's shares of stock were ac-

counts receivable in the amount of $662,824.40 arising

from performance of construction projects, sales of

stone, sand, gravel, etc., and rental of equipment prior

to March 1, 1957. Also among the assets transferred

were physical inventories of sand, gravel, and stone,

with respect to which the partnership had deducted

costs of $351,266.05 and the value of which was no less

than $351 266.05.

Commencing with its initial fiscal year [which]

ended February 28, 1958, taxpayer maintained its

books and filed its corporation income tax returns on

SALE OLIV TOLER TM MELE YSN BRED Eo ree a ew Ae a ge re

the cash method of accounting and, accordingly, did

not take uncollected receivables into income and did

not use inventories in the calculation of its taxable in-

come. In its taxable years ending in 1958, 1959, and

1960, taxpayer collected the respective amounts of

$533,247.87, $125,326.71 and $4,249.72 of the ac-

counts receivable in the aggregate amount of $662,-

824.40 (sic) that had been transferred to it, and in-

cluded those amounts in income in computing its in-

come for its federal income tax returns for those years,

respectively,

‘As a result of an examination extending over a

period of years, it was determined by the Commis-

sioner of Internal Revenue, and agreed to by the tax-

payer, that the use of the cash receipts and disburse-

ments method of accounting with regard to purchases

and sales, without taking into account merchandise

on hand at the beginning and end of the taxable year,

did not clearly reflect taxpayer’s income. Accordingly,

taxpayer's income was adjusted as set forth in an

examination report of August 24, 1964 . . . to accrue

_ unreported sales [accounts receivable] made during

the taxable years in question and to take into account

inventories in computing its cost of goods sold. In com-

puting taxpayer's cost of goods sold under the inven-

tory method, for the fiscal year ended February 28,

1958, the Commissioner of Internal Revenue, in con-

junction with his accrual method treatment, fixed the

beginning inventory of stone, sand, and gravel, which

had been transferred to the taxpayer by the partner-

ship, at zero, and the ending inventory at $258,201.35.

The result was an increase in taxpayer's taxable in-

come for the fiscal year ended February 28, 1958, in

the amount of $258,201.35.

The Commissioner of Internal Revenue assessed de-

ficiencies in taxpayer’s federal income taxes for its fiscal

years ending February 28, 1958, and 1959. The taxpayer

ORAL ES 3 PEO RAE ER NT! GAIN RRND te es

paid the amounts in 1964, and in 1965 filed claims for re-

fund of $621,218.09 plus assessed interest.2 The claims

were disallowed in full on September 24, 1968, and the dis-

trict court action was timely instituted on December 5,

1968.

The district court held: (1) ‘taxpayer was properly tax-

able upon collections made with respect to accounts re-

ceivable which were transferred to it in conjunction with

the Section 351 incorporation, and (2) the court lacked

jurisdiction to entertain taxpayer's contention that the

tax-benefit theory of recovery entitled it to an opening in-

ventory of not less than $351,266.05, since that theory of

recovery was not presented in taxpayer’s claim for refund.

Hempt Bros., Inc. v. United States, 354 F. Supp. 1172 (M.D.

Pa. 1973).

Taxpayer argues here, as it did in the district court,

that because the term “property” as used in Section 351

does not embrace accounts receivable, the Commissioner

lacked statutory authority to apply principles associated

with Section 351. The district court properly rejected the

legal interpretation urged by the taxpayer.

The definition of Section 351 “property” has been ex-

tensively treated by the Court of Claims in E. I. DuPont de

Nemours and Co. v. United States, 471 F.2d 1211, 1218-19

(Ct. Cl. 1973), describing the transfer of a non-exclusive

license to make, use and sell area herbicides under French

patents:

Unless there is some special reason intrinsic to. . .

[Section 351] . . . the general word “property” has

2. The Commissioner of Internal Revenue assessed deficiencies

in the amounts of $364,154.20 plus interest of $125,740.42, and

$75,995.46 plus interest of $24,343.53 for fiscal years ending in

1958 and 1959 respectively. Taxpayer filed claims for refund of

$456,218.76 plus assessed interest for fiscal 1958, $113,163.03 plus

assessed interest for fiscal 1959 and $51,836.30 for fiscal 1960.

estetews

’ S Be ce wp yr ne ee ate

PETER BEES RAEI BORE SLL TTS rae Pie pe SELLER ICED AY ORSON IE gts sR —

a broad reach in tax law. . . . For section 351, in par-

ticular, courts have advocated a generous definition

of “property,” . . . and it has been suggested in one

capital gains case that nonexclusive licenses can be

viewed as property though not as capital assets. . . .

We see no adequate reason for refusing to follow

these leads.

We fail to perceive any special reason why a restrictive

meaning should be applied to accounts receivables so as to

exclude them from the general meaning of “property.” Re-

ceivables possess the usual capabilities and attributes as-

sociated with jurisprudential concepts of property law.

They may be identified, valued, and transferred. Moreover,

their role in an ongoing business must be viewed in the con-

text of Section 351 application. The presence of accounts

receivable is a normal, rather than an exceptional accou-

trement of the type of business included by Congress in the

transfer to a corporate form. They are “commonly thought

of in the commercial world as a positive business asset.”

DuPont v. United States, supra, at 1218. As aptly put by the

district court: “There is a compelling reason to construe

‘property’ to include . . . [accounts receivable]: a new

corporation needs working capital, and accounts receivable

can be an important source of liquidity.” Hempt Bros. Inc.

v. United States, supra, at 1176.5 In any event, this court

had no difficulty in characterizing a sale of receivables as

“property” within the purview of the “no gain or loss” pro-

3. Du Pont v. United States, supra, at 1214, citing P. A. Birren

& Son, Inc. v. Commissioner, 116 F.2d 718 (7th Cir. 1940), ob

served that nonrecognition under Section 351 has been granted for

accounts receivable. In the recent case of Thatcher v. Commis-

sioner, — T.C. — (42 U.S.L.W. 2228, October 30, 1973), the Tax

Court reaffirmed its decision in Raich v. Commissioner, 46 T.C.

604 (1966), holding that accounts receivable transferred by a cash

basis taxpayer to a corporation under Section 351 had a zero basis.

By placing a tax basis in that which was transferred, the Tax Court

by implication assumed that accounts receivable are “property”

within the meaning of Section 351.

; ae . STI OS Pee etter rere —

vision of Section 337 as a “qualified sale of property within

a 12-month period.” Citizens Acceptance Corp. v. United

States, 462 F.2d 751, 756 (3d Cir. 1972).

The taxpayer next makes a strenuous argument that

“[t}he government is seeking to tax the wrong person.”4

It contends that the assignment of income doctrine as de-

veloped by the Supreme Court applies to a Section 351 trans-

fer of accounts receivable so that the transferor, not the

transferee-corporation, bears the corresponding tax liabil-

ity. It argues that the assignment of income doctrine dic-

tates that where the right to receive income is transferred

to another person in a transaction not giving rise to tax at

the time of transfer, the transferor is taxed on the income

when it is collected by the transferee; that the only require-

ment for its application is a transfer of a right to receive

ordinary income; and that since the transferred accounts

receivable are a present right to future income, the sole re-

quirement for the application of the doctrine is squarely

met. In essence, this is a contention that the nonrecogni-

tion provision of Section 351 is in conflict with the assign-

ment of income doctrine and that Section 351 should be

subordinated thereto. Taxpayer relies on the seminal case

of Lucas v. Earl, 281 U.S. 111 (1930), and its progeny® for

support of its proposition that the application of the doc-

trine is mandated whenever one transfers a right to receive

ordinary income.

On its part, the government concedes that a taxpayer

may sell for value a claim to income otherwise his own and

4. We put aside the pragmatic consideration that the trans-

feree-corporate taxpayer raises the argument that the partnership

should be taxed at a time when the statute of limitations has pre-

sumably run against the transferor partners, who ostensibly are

the stockholders of the new corporation.

5. United States v. Basye, 410 U.S. 441 (1973); Commissioner

v. First Security Bank of Utah, 405 U.S. 394 (1972); Commissioner

v. Culbertson, 337 U.S. 733 (1949); Commissioner v. Sunnen, 333

U.S. 591 (1948); Helvering v. Eubank, 311 U.S. 122 (1940); Hel-

vering v. Horst, 311 U.S. 112 (1940).

adie ae POE RP GA OT A EI ne en

he will be taxable upon the proceeds of the sale. Such was

the case in Commissioner v. P. G. Lake, Inc., 356 U.S. 260

(1958), in which the taxpayer-corporation assigned its oil

payment right to its president in consideration for his can-

cellation of a $600,000 loan. Viewing the oil payment

right as a right to receive future income, the Court applied

the reasoning of the assignment of income doctrine, nor-

mally applicable to a gratuitous assignment, and held that

the consideration received by the taxpayer-corporation

was taxable as ordinary income since it essentially was a

substitute for that which would otherwise be received at a

future time as ordinary income.

Turning to the facts of this case, we note that here

there was the transfer of accounts receivable from the

partnership to the corporation pursuant to Section 351. We

view these accounts receivable as a present right to receive

future income. In consideration of the transfer of this right,

the members of the partnership received stock—a valid

consideration. The consideration, therefore, was essentially

a substitute for that which would otherwise be received at

a future time as ordinary income to the cash basis partner-

ship. Consequently, the holding in Lake would normally

apply, and income would ordinarily be realized, and thereby

taxable, by the cash basis partnership-transferor at the time

of receipt of the stock. ;

But the terms and purpose of Section 351 have to be

reckoned with. By its explicit terms Section 351 expresses

the Congressional intent that transfers of property for stock

or securities will not result in recognition. It therefore be-

comes apparent that this case vividly illustrates how Sec-

tion 351 sometimes comes into conflict with another pro-

vision of the Internal Revenue Code or a judicial doctrine,®

and requires a determination of which of two conflicting

doctrines will control.

6. Weiss, Problems in the Tax-Free Incorporation of a Busi-

ness, 41 tnd. L.J. 666, 676 (1966). See, e.g., Henry McK. Haserot,

41 T.C. 562 (1964), rev'd and rem’d 355 F.2d 200 (6th Cir. 1965).

aa “at V@ ean a

PREETI OIE

Pttrerne neces ee on

As we must, when we try to reconcile conflicting

doctrines in the revenue law, we endeavor to ascertain a

controlling Congressional mandate. Section 351 has been

described as a deliberate attempt by Congress to facilitate

the incorporation of ongoing businesses and to eliminate

any technical constructions which are economicaliy un-

sound.’

Appellant-taxpayer seems to recognize this and argues

that application of the Lake rationale when accounts re-

ceivable are transferred would not create any undue hard-

ship to an incorporating taxpayer. “All a taxpayer [trans-

feror] need do is withhold the earned income items and

collect them, transferring the net proceeds to the Corpora-

tion. Indeed . . . the transferor should retain both accounts

receivable and accounts payable to avoid income recogni-

tion at the time of transfer and to have sufficient funds with

which to pay accounts payable. Where the taxpayer [trans-

feror] is on the cash method of accounting [as here], the

deduction of the accounts payable would be applied against

the income generated by the accounts receivable.” (Appel-

lant’s Brief at 32.)

7. “One of the purposes of this section [Section 202(c\3) of

the Revenue Act of 1921] was to permit changes in form [of

business} involving no change in substance to be made without

undue restriction from the tax laws.” Note, Section 351 of the In-

ternal Revenue Code and “Mid-Stream” Incorporations, 38 U. Cin.

L. Rev. 96 (1969). See, S Rep. No. 275,.67th Cong. Ist Sess. 11

(1921). This intention is also reflected in the report of the House of

Representatives accompanying §351 of the Internal Revenue Code

of 1954. H.R. Rep. No. 1337, 83rd Cong. 2d Sess. 34 (1954).

The House Ways and Means Committee recommended that

non-recognition treatment be granted for incorporation, reorganiza-

Sess. 10 (1921). The Senate Finance Committee added that such

treatment would eliminate “many technical constructions which

are economically unsound.” See S. Rep. 275, 67th Cong., Ist Sess.

12 (1921).

Weiss, supra, 41 Ind. L.J. 666 n.4 (1966).

While we cannot fault the general principle “that in-

come be taxed to him who earns it,” to adopt taxpayer's

argument would be to hamper the incorporation of ongoing

businesses; additionally it would impose technical construc-

tions which are economically and practically unsound.

None of the cases cited by taxpayer, including Lake itself,

persuades us otherwise. In Lake the Court was required to

decide whether the proceeds from the assignment of the oil

payment right were taxable as ordinary income or as long

term capital gains. Observing that the provision for long

term capital gains treatment “has always been narrowly

construed so as to protect the revenue against artful de-

vices,” 356 U.S. at 265, the Court predicated its holding

upon an emphatic distinction between a conversion of a

capital investment—“income-producing property”—and an

assignment of income per se. “The substance of what was

assigned was the right to receive future income. The sub-

stance of what was received was the present value of in-

come which the recipient would otherwise obtain in the

future.” Ibid., at 266. A Section 351 issue was not presented

in Lake. Therefore the case does not control in weighing the

conflict between the general rule of assignment of income

and the Congressional purpose of nonrecognition upon the

incorporation of an ongoing business.*

We are persuaded that, on balance, the teachings of

Lake must give way in this case to the broad Congressional

interest in facilitating the incorporation of ongoing busi-

nesses. As desirable as it is to afford symmetry in revenue

law, we do not intend to promulgate a hard and fast rule.®

8. A second issue in Fleming, a companion case to Lake,

“like kind” exchange under §112(b) (1) of the Internal Revenue

Code of 1939. The Court held that the exchange was not “like

kind” since its effect is a transfer of future income from oil leases

in exchange for real estate. There is no “like kind” requirement

under Section 351. See note 1, ante.

9. The Commissioner has apparently taken the position that

We believe that the problems posed by the clash of con-

flicting internal revenue doctrines are more properly deter-

mined by the circumstances of each case. Here we are in-

fluenced by the fact that the subject of the assignment was

accounts receivable for partnership's goods and services

sold in the regular course of business, that the change of

business form from partnership to corporation had a basic

business purpose and was not designed for the purpose of

deliberate tax avoidance, and by the conviction that the

totality of circumstances here presented fit the mold of the

Congressional intent to give nonrecognition to a transfer

of a total business from a non-corporate to a corporate

form.

But this too must be said. Even though Section 351(a)

immunizes the transferor from immediate tax conse-

quences, Section 358" retains for the transferors a poten-

tial income tax liability to be realized and recognized upon

351 transfers. “However, the Service's ruling policy apparently is

subject to the proviso that the taxpayer enter into a closing agree-

ment assuring that the corporation will report the income reflected

in the receivables upon their collection or other disposition. It

would also appear that favorable rulings will not be issued where

the timing of the transfer will be such as to result in a distortion

of income. For example, such a ruling presumably could not be

obtained if a seasonable business were to be incorporated during the

portion of the year occurring after sizeable operating expenses

had been incurred but before the income attributable thereto was

collected.” Weiss, supra, 41 Ind. L.J. at 681 (footnote omitted). '

10. Sec. 358. Basis to Distributees.

(a) General Rule.—Iin the case of an exchange to which

section 351, 354, 355, 356, 361, or 371 (b) applies—

(1) Nonrecognition property.—The basis of the property

permitted to be received under such section without the

recognition of gain or loss shall be the same as that of the

property exchanged—

(A) decreased by—

(i) the fair market value of any other property (ex-

cept money) received by the taxpayer,

(ii) the amount of any money received by the tax-

payer, and

EEE A LIE LPL OL CET EE TETRIS ESE NITION I PRS

a Di aE laa i ee

a subsequent sale or exchange of the stock certificates re-

ceived. As to the transferee-corporation, the tax basis of the

receivables will be governed by Section 362."!

The taxpayer contends that the court erred in ruling

that its inventory argument was not reasonably encom-

passed within its claim for refund, and that had the court

considered this contention for the fiscal year commencing

March 1, 1957, the taxpayer-corporation would have been

entitled to a beginning inventory of $351,266.05 instead of

zero by application of the tax benefit rule.

The government restates the reason for the district

court’s refusal to consider taxpayer’s argument but by its

brief advises: “We believe it unnecessary for this Court to

explore the often obscure distinction hetween the facts to

support a claim and the theory of a ciaim” and that

Note i@—Continued

(iii) the amount of loss to the taxpayer which was

recognized on such exchange, and

(B) increased by—

(i) the amount which was treated as a dividend, and

(ii) the amount of gain to the taxpayer which was

recognized on such exchange (not including any portion of

such gain which was treated as a dividend).

(2) Other property.—The basis of any other property

(except money) received by the taxpayer shall be its fair

market value.

11. Sec. 362. Basis to Corporations

(a) Property acquired by issuance of stock or as paid-in sur-

plus.—if property was acquired on or after Jume 22, 1954, by a

corporation—

(1) in connection with a transaction to which section

351 (relating to transfer of property to corporation controlled

by transferor) applies, or

(2) as paid-in surplus or as a contribution to capital, then

the basis shall be the same as it would be in the hands of the

transferor, increased in the amount of gain recognized to the

transferor on such transfer.

“[w]ithout joining in the debate over facts versus theory,

examination of the substance of taxpayer's claim for inven-

tory adjustment makes it clear that the facts asserted in its

claim for refund do not support it and the agreed facts

negative it.” (Appellee’s brief at 19.) Regardless of the

procedural question, we are persuaded that appellant's tax

benefit argument does not apply to this factual complex,

and “[w]Je pass at once to a consideration of . . . [the

merits].” B.F. Goodrich Co. v. United States, 321 U.S. 126

(1944).

The tax benefit rule can be simply stated: If a taxpayer

makes an expenditure or suffers a loss for which it takes

a deduction giving rise to a reduction in its income tax and

later recovers the funds or property that it has spent or lost,

it must take the amount recovered as income. Connery v.

United States, 460 F.2d 1130, 1132 (3d Cir. 1972); Alice

Phelan Sullivan Corp. v. United States, 381 F.2d 399, 401-

02 (Ct. Cl. 1967).

Applying this rule to the facts of this case taxpayer

contends that partnership’s receipt of stock in exchange for

inventory previously expensed but presently valued at

$351,266.05 constituted a “recovery” which stepped up the

basis of the inventory from zero to $351,266.05 and that

this stepped-up basis became the basis to the pened

and the corporation under Sections 358 and 362.

Relying on Nash v. United States, 398 U.S. 1 (1970),

and the various courts of appeals decisions in Commis-

sioner v. Anders, 414 F.2d 1283 (10th Cir. 1969); Spitalny

v. United States, 430 F.2d 195 (9th Cir. 1970); Connery v.

United States, supra, and Citizens’ Acceptance Corp. v.

United States, supra, taxpayer proceeds to equate “value”

of the inventory with tax “basis” as conceptualized in Sec-

tions 358 and 362. This keystone in the taxpayer's arch of

reasoning proves to be most fragile upon close inspection.

Although Justice Douglas in Nash addressed a transfer

of receivables under Section 351(a), the Court did not have

before it the critical question posed here—whether a part-

nership’s “basis,” and ultimately the corporation’s

“basis,” in a previously expensed inventory is equal to the

“value” of the inventory when transferred.

“In Nash the Court held that when eight partnerships

transferred their assets to eight newly formed corporations

in exchange for shares in the corporations—transfers that

produced no gain or loss under §351 of the Internal Reve-

nue Code—there was no ‘recovery’ of the bad debt reserves

under the tax benefit rule ‘[s]ince the reserve for purposes

of this case was deemed to be reasonable and the value of

the stock received upon the transfer was equal to the net

value of the receivables. . . .. 398 U.S., at 4, 90 S. Ct., at

1552 (emphasis in original).” Citizens’ Acceptance Corp.

v. United States, supra, at 754. While it is true that Justice

Douglas stated that “[a]ll that petitioners received from

the corporations were securities equal in value to the net

worth of the accounts transferred, that is the face value less

the amount in reserve for bad debts”, 398 U.S. at 4, the sole

issue before the Court was whether such receipt constituted

a “recovery” within the meaning of the tax benefit rule.

It was not necessary for the Nash Court ever to reach the

question of the tax “basis” in the hands of either the trans-

feror or transferee. Thus, the taxpayer would have us read

into Nash a holding which did not appear therein, which

was not posed by the facts, and which does not inexorably

nor logically follow therefrom.

Nor may the taxpayer find suiace in ine decisions of ine

various courts of appeals upon which it relies. At issue in .

Anders and Spitalny were inventories which had been com-

pletely expensed and therefore had a zero basis. After the

inventories were sold, the liquidated corporations attempt-

ed to assert a no-gain immunity from tax liability by virtue

of the operation of §337.!? In each case the court held the

12. §337. Gain or loss on sales or exchanges in connection

with certain liquidations

(a) General Rule.—If—

(1) a corporation adopts a plan of complete liquidation

on or after June 22, 1954, and

OLN IER IRIE AOE EI BRENT ENT SORE TEN OP AE ROR RR prea eu coomerm a nan 7

sale proceeds would not be considered as non-recognizable

gain.

We find nothing in the teachings of the Ninth and

Tenth Circuits supporting taxpayer's contention that in a

Section 351(a) transfer the accounting basis for property

must equal the actual or market value thereof. At the time

taxpayer's inventory was totally expensed on the cash basis

books of the partnership that property had mercantile value

in the sense as described by Justice Douglas in Nash, but

for accounting purposes and as a tax basis it still had a zero

value. The mere fact that an asset has been transferred

under Section 351(a) from a partnership ownership to a

corporate ownership does not in itself alter its tax basis.

We now turn to our decisions in Connery and Citizens.

The Connery issue was whether tax benefit principles ap-

plied following recovery of previously expensed prepaid

advertising. We agreed with the Commissioner in the ap-

plication of the tax benefit rule because the taxpayer real-

ized income equivalent to the value of the previously ex-

pensed advertising costs. We said that the taxpayer incurred

a tax liability based on the difference between a zero basis

and the amount previously expensed.

The difficulty presented in both Section 337 and Sec-

tion 351 cases is that the statute expressly provides for no-

gain and no-loss tax consequences by virtue of the actual

liquidation or transfer. Nothing in the statutory schema

permits an immunization of normal tax consequences aris-

ing out of those separate activities which may accompany a

liquidation under Section 337 or a transfer under Section

351 but which are not inherently a necessary aspect of the

liquidating or transferring process. The tax imposed in

(2) within the 12-month period beginning on the date of

the adoption of such plan, all of the assets of the corporation

are distributed in complete liquidation, less assets retained to

meet claims, then no gain or loss shall be recognized to such

corporation from the sale or exchange by it of property within

such 12-month period.

26 U.S.C. §337(a).

EDGES SEIT OP ES BARRE A RST RI PEA a, eS OT ET SA a

SS PE RP RPT SE

Connery was not the result of the liquidation process per se;

it was imposed because of the recovery of an item previously

expensed. The happenstance that the recovery took place as

an additional feature of the liquidating process does not

immunize that recovery from normal tax consequences. The

prepaid advertising expenses had a zero basis before the

liquidation process began; it had the same basis during the

liquidation process.

The Citizens issue was the extent to which the taxpayer

had recovered its previously deducted bad debt reserve.

Our holding in Citizens was simply a reiteration of the hold-

ing in Nash, that the receivables had to be valued on the

basis of face value less bad debt reserve. Citizens did not

involve an adjustment of the tax basis.

In the case before us, whatever may have been the

actual value of the inventory at the time of the transfer, the

“basis of . . . the property exchanged,” Section 358(a)(1),

remained the same as it appeared in the partnership's

books—zero. As to the distributees, the “basis of the . . .

[stock] permitted to be received under . . . {Section 351]

shall be the same as that of the property exchanged”—zero.

Section 358(a)(1).

As to the corporation, according to Section 362(a)

“the basis shall be the same as it would be in the hands of

the transferor [partnership]. . . .” This must be zero as

well. Accordingly, the taxpayer cannot prevail in his con-

tention that he is entitled to a basis for the inventory in the

amount of $351,266.05.

Ill.

Appellant raised at oral argument a question which,

on first blush, is extremely attractive and appealing. It ques-

tions the fundamental fairness of the Commissioner's

action in requiring a corporation to change from a cash to

an accrual basis without permitting adjustments to the

predecessor partnership. We note, however, that appellant

does not dispute the Commissioner's determination that its

use of the cash receipts and disbursements method of

accounting with respect to purchases and sales, without

taking into account merchandise on hand at the beginning

and end of the year did not clearly reflect income. (Appendix

at 18a).

The argument is premised on the history of IRS audits

of the previous partnership books, and the failure of the

Commissioner to direct that the partnership change from

a cash to an accrual basis. To this is added the reality that

the identical partnership business was continued by the

corporation with present stock ownership reflecting past

partnership interests. The argument continues: requiring

the corporate taxpayer to make a sudden change in account-

ing methods, generating huge new tax liabilities, is basical-

ly unfair to the taxpayer; that at the very least, there should

now be permitted a reopening of the partnership books to

allow for adjustments under 26 U.S.C. §481 so that a new

basis for an opening inventory may be permitted and a dis-

tribution of increased tax liabilities shared by the previous

partnership.

Where a method of accounting differs from that under

13. Where the Commissioner has accepted over a long period

of years or approved a method of accounting by a taxpayer, this

fact will be given weight in determining whether the Commissioner

is justified in changing the method used by such taxpayer. Ezo

Products Co., 37 T.C. 385, 391 (1961); Geometric Stamping Co.,

26 T.C. 301 (1956). The Commissioner's authority to order a change

in accounting methods when the taxpayer has regularly employed

a consistent method depends upon the validity of his finding that

the taxpayer's method does not clearly reflect income. Glenn v.

Kentucky Color & Chemical Co., 186 F.2d 975 (6th Cir. 1951). The

Commissioner is not estopped from computing a taxpayer’s income

on an accrual method of accounting because he has not objected to

the method used by the taxpayer in his examination of prior re-

turns. Caldwell v. Commissioner, 202 F.2d 112 (2d Cir. 1953). The

Commissioner's regulation requiring that purchases and sales be

reported on an accrual basis where it is necessary to use an inven-

tory is one of long standing and has received the approval of the.

courts. Iverson’s Estate v. Commissioner, 255 F.2d 1 (8th Cir. 1958),

cert. denied, 358 U.S. 893 (1958).

STE HA LET ELI SEEL IA: ELLE MIE MELT PAS POE PENIS \ TI SSIS BE NE EI ee Tle I EE

which the taxpayer's income for a preceding calendar year

was computed, Section 481(a) provides for adjustments in

previous years which are détermined to be necessary solely

by reason of the change, in order to prevent an amount from

being duplicated or omitted. Notwithstanding the adjust-

ment provisions of Section 481(a), a corporation formed for

a business purpose is a separate entity 2nd a separate tax-

payer from the stockholders who are responsible for its

creation. Moline Properties v. Commissioner, 319 U.S. 436

(1943). And because of the separate taxable corporate

entity, it has been held that where the change in the ac-

counting practices is ordered for the first year of the cor-

poration’s existence, the corporation had no preceding tax-

able year, and therefore, Section 481 is inapplicable. Ezo

Products Co., supra, at 394. “Equally clearly, section 481

may be applied only to the petitioner [corporation] and not

to make adjustments with respect to its predecessor [part-

nership].” Dearborn Gage Co., 48 T.C. 190, 198, (1967)

citing E. Morris Cox, 43 T.C. 448 (1965); Ezo Products Co.,

supra.'4

Judge Tannewald’s observations in Dearborn seem

pertinent to our facts: “We recognize that, if petitioner

[corporation] had never been formed, and the predecessor

partnership had continued in business, and the issue before

us involved a comparable change in the latter’s method of

14. “The critical question which we must resolve is whether

. [there can be adjustments] in opening inventory for 1957.

In so doing, we must decide which of two general principles ap-

plies. The first principle requires that opening inventory must be

computed on the same basis as closing inventory . . . The second

principle requires that, . . . in a tax free exchange such as oc-

curred herein when the predecessor partnership transferred its

assets to petitioner, the basis of the transferred assets in the hands

of the latter is the same as it was in the hands of the former. In

implementing this second principle, it has been held that the basis

‘ of initial opening inventory in the hands of the transferee corpora-

tion should not be adjusted in order to correct for an erroneous

method of accounting for that inventory by the predecessor trans-

feror.”

Dearborn Gage v. Commissioner, supra, at 198.

AES RA AN RS ae EONS EM ETRE EME NILES LOLI He EB IRC TIEN, WE

accounting for overhead costs, respondent . . . would,

under the applicable decisions, have been required, in

making the necessary computations, to . . . [make ad-

justments] both in the opening inventory and closing in-

ventory for the . . . [previous years permitted by Section

481]. Thus, petitioner—a taxpayer separate and distinct

from its predecessor—appears to fare worse than its pred-

ecessor would have. We also recognize . . . the tax benefit

of the deductions . . . taken by petitioner’s predecessor

may not have been as great as the tax burden which our

rationale now requires petitioner to bear, e.g., because the

partners may have been in lower tax brackets or the partner-

ship may have operated at a loss in some of the prior years.

Moreover,- if the ownership of—petitioner’s stock had

changed prior to the taxable years herein involved, the

economic effect of the tax benefit would not inure to, nor

would the tax burden fall upon, the same persons. But these

are nothing more than some of the myriad of different con-

sequences which may result from a change to the corporate

form of doing business or from the acquisition of stock of a

corporation rather than corporate assets.” 48 T.C. at 199

200 (footnote omitted).

Applied to this case, these principles preclude a judicial

command that the Commissioner make adjustments in the

predecessor business entity to supplement the direction that

the new corporate taxpayer convert to an accrual basis.'®

15. Had these applicable principles permitted a:1 adjustment

to the predecessor partnership accounting principles. any attempt

by the Commissioner to increase the tax liabilities of the partners

would probably be barred by the statute of limitations. In Purseil

v. Commissioner, 38 T.C. 263, 276, (1962) aff’d per curiam, 315

F.2d 629 (3d Cir. 1963), we considered and rejected the approach

i similar to that urged by the taxpayer here: “Petitioners’ argument,

: if sustained, would logically require an examination of every tax-

; able year that . . . [taxpayer] has been in business, since it

{ appears that the sale of merchandise has always been an income

i producing factor. Section 481 would have to be interpreted as per-

mitting the correction of errors long since ordinarily barred by the

statute of limitations. We do not believe that Section 481 sanctions

such corrections, even if they could be accurately determined.”

OB tterercemmmnan POOP A LLP AR LOND CE

ve CEASA

We have carefully considered each of appellant's con-

tentions and have concluded that the judgment of the dis-

trict court will be affirmed.

A True Copy:

Teste:

Mok, z ont Do ut2< Loom __

Chief Deputy

Clerk of the United States Court of Appeals

for the Third Circuit.

UNITED STATES COURT OF APPEALS

For THE THIRD CIRCUIT

No. 73-1296

HEMPT BROS., INC., Appellant

vs.

UNITED STATES OF AMERICA

(D. C. Civil Action No. 68-484)

On AppeaL From Tue Unitep States District Court

For THe Mippie District OF PENNSYLVANIA

Present: ALDISERT and WEIS, Circuit Judges and

LATCHUM, District Judge

JUDGMENT

This cause came on to be heard on the record from

the United States District Court for the Middle District

of Pennsylvania and was argued by counsel.

On consideration whereof, it is now here ordered

and adjudged by this Court that the judgment of the said

District Court, filed December 30, 1972, be, and the same

is hereby affirmed. Costs taxed against appellants.

January 14, 1974 _Clerk

A true copy: THOMAS F. QUINN, Clerk

oe >, : Re

/1/ El wheck aa, Ce

M. Elizabeth Ferguson {

Chief Deputy Clerk «

This is a copy of a public record, reproduced as it was published. It is not legal advice, and it may not be the version a court would rely on. Check the official source before you cite it.