Wofac Corp. v. United States (269 F. Supp. 654, 1967)

OPINION

COHEN, District Judge:

Plaintiff, WOFAC Corporation, a Delaware corporation, engaged in the management-consultant business, seeks refund of corporate income taxes paid, which it claims were improperly assessed in the amount of $26,371.17, together with statutory interest thereon. Jurisdiction is properly invoked pursuant to 28 U.S.C. § 1346(a) (1).

The matter was tried to the Court without a jury, therefore, the stipulations of facts, as supplemented by brief oral testimony offered primarily for the introduction of documentary exhibits, shall constitute the matrices of this opinion in lieu of findings of fact and conclusions of law required under F.R.Civ.P. 52.

Application for the refund was filed by the plaintiff corporation in February of 1959, for a claimed net operating loss for 1958, in the amount of $14,523.82, which it sought to apply to its net income for 1957 of $8,593.48, leaving the sum of $5,930.34 as a carryover deduction against income of succeeding years. The claim was rejected by the Internal Revenue Service; additionally, it examined the 1957 and 1958 returns and disallowed the corporation’s accumulated net operating losses aggregating $38,595.71 and the loss of $14,228.02 on the sale of its land, factory building, machinery and equipment that was claimed in its 1957 income tax return and as well, the sum of $435.75 of its 1958 net operating loss of $14,523.82, which was attributable to the sale of its inventory and which had been claimed on its 1958 income tax returns. The reasons assigned by the Internal Revenue Service for its disallowance of the net operating loss deduction, and for the loss claimed on the sale of the business property was that these losses were incurred in a business different from the one which had produced the profits sought to be offset. The disallowance of the $435.75 portion of the 1958 net operating loss was ruled to be a loss sustained in the sale of material which represented the business activity of a corporation other than the taxpayer corporation which sought the deduction. The determination was made that the losses were incurred by Warsaw Products, Inc., a New York woodworking corporation, whereas the taxpayer which sought deduction against its income was a Delaware corporation engaged in the management-consultant business, now known as WOFAC Corporation.' Accordingly, the Internal Revenue Service made a deficiency assessment of $16,533.11 against plaintiff for the year 1957. Assessments made for this and subsequent years were paid and totaled the amount sued for.

These rulings gave rise to the present action to recover the amounts of taxes paid for 1957 and subsequent years that are attributable to the disallowance of deductions taken by the plaintiff corporation for the net operating losses sustained by it, prior to the transfer in 1957 to it of the management-consultant business.

While the parties have stipulated certain facts and events, the complexity of the legal issues involved prompts incisive treatment of the generic structure of the plaintiff corporation.

In 1951, four equal partners, James H. Duncan, William G. O’Brien, Joseph H. Quick, and George A. Goodwin owned a partnership located in New York City, New York, known as The Work-Factor Company which had engaged in a management-consultant business for a number of years. Early in 1951, the partners learned of an opportunity to purchase the assets of a woodworking corporation known as the Warsaw Button Co., a New York corporation. Instead of purchasing and conducting the woodworking business through their partnership, the four partners formed a corporation on March 13, 1951 under the laws of the State of New York, known as Warsaw Products, Inc. The four partners became its sole stockholders and its capital stock was issued to them in equal shares. Because under New York law five directors were required, George A. Goodwin transferred a-nominal part of his shares to qualify his wife.

In order to finance the purchase of the Warsaw Button Co., the assets of which totaled $50,000.00 (comprising inventory of raw materials $2,199.39; inventory of work in process $615.61; machinery and equipment $4,806.00; office equipment $279.00; land $2,600.00 and building $39,500.00), the new corporation, Warsaw Products, Inc., negotiated a loan with the Wyoming County Bank and Trust Company, of New York. On March 16, 1951, before any funds were advanced by the bank on a mortgage loan of the same date in the amount of $35,-000.00, with a 5 year amortization term, the four partners, together with their respective wives, were required and did execute an agreement to guarantee payment of the mortgage loan with interest, severally to the extent of $3,750.00, and jointly in the aggregate, $15,000.00; the guarantee agreement also provided for the application of all mortgage payments first to the portion of the loan not so guaranteed, i. e. the unpaid balance.

The purchase of the woodworking business was effected and it was operated by the new corporation, Warsaw Products, Inc., during the remainder of 1951 .and 1952. The anticipated ability of the corporation to operate the woodworking business at a profit did not materialize. Using the calendar year for its accounting base, for 1951 it showed a net operating loss of $11,418.55; for 1952 it showed another net operating loss in the amount of $10,808.03. In face of these losses, the woodworking activity, as such, was discontinued after 1952. Thereafter, the corporation sought to sell or rent its factory building, as well as its inventory, machinery and equipment. It was not able to do so at that time.

Unlike its failure in the woodworking venture, during the years of 1951 and 1952, the management-consultant partnership, the Work-Factor Company, prospered. In 1951 its gross income was $95,-263.35, with a net distributable to the partners of $27,509.50; in 1952 its gross income was $151,784.71, with a net distributable of $59,891.16. And since the corporate assets of the discontinued woodworking business exceeded its liabilities and were a source of potential capital gain, the partnership advanced various sums of money to it during 1953 aggregating $5,500.00 with which it paid it's accruing debts for interest, taxes, insurance and for the amortization of its mortgage, as the individual partners and their wives had guaranteed, as stated above, a portion of the unpaid balance of the mortgage loan. (See 26 U.S.C. § 1231, infra Capital gain and ordinary loss.)

So also in the years 1953, 1954, 1955 and 1956, the corporation continued its endeavors to rent or sell its assets, but unsuccessfully; the partnership continued to advance money to it to meet its current and accruing obligations. In 1954 the advances aggregated $6,833.55; in 1955, $4,685.00; and in 1956, $3,037.50, all by way of partners’ loans to the corporation.

In 1955, it was known to all the partners that one of them, Goodwin, would be withdrawing from the partnership at the end of that year, so that none of the advances made to the corporation by the partnership was charged to his capital account, as in prior years, and as was done in regard to the other three partners. The loans made during 1955 amounted to $4,685.00 and were charged to the accounts of the other three partners. When Goodwin withdrew during that year, his withdrawals at that time ■equated his capital contributions and nothing more was then due to him.

On January 1, 1956, the remaining three partners formed a new partnership, and the loans to the corporation still being outstanding, the capital accounts of the three remaining partners were adjusted to charge them respectively with one-third of the aggregated advances for the years 1953 to 1955 inclusive.

Warsaw Products, Inc. continued to flounder during the years 1953, 1954, 1955 and 1956, showing net operating losses for those years, respectively, of $8,156.36; $3,987.14; $6,870.01 and $6,-'774.17.

On March 1, 1957 Goodwin sold all of his capital stock in the corporation to the partnership then composed of his three former partners, including the qualifying nominal shares which he had transferred to his wife.

At, or about, the time that the Good-wins’ stock purchase was made by the partners, the latter sought legal advice and thereafter decided to incorporate the partnership’s management-consultant business. Rather than form a new corporation, as they already owned the inactive woodworking corporation, they decided to transfer the partnership assets and business to their own corporation, of which they were the sole stockholders.

The partnership balance sheet prepared as of March 31, 1957 stated the gross assets as $65,101.12, liabilities $20,-103.84, with a resulting net worth of $44,997.28 (of which $20,103.84 comprised partnership’s loans to Warsaw Products, Inc.) in unequal capital account proportions, as to each one. During this same period, they advanced an additional $2,500.00. All of the partnership business, as well as its assets and liabilities, was transferred to the corporation, but the corporation liquidated its loans from the partnership by payment to the individual partners. The factual consequence of the transfer was that Warsaw Products, Inc. obtained additional assets and liabilities, but the assets were more than sufficient to offset the liabilities. Thereafter, the corporation name was changed from Warsaw Products, Inc. to The Work-Factor Company, Inc.; the three equal partners and sole owners of the corporation ceased functioning as a partnership, and together with their former partnership employees confined their business operations to the management-consulting enterprise.

On June 30, 1957, after the mortgage loan had run its full term, the corporation finally sold its land, factory building and part of its machinery and equipment at a net loss of $14,228.02.

As of December 31, 1957 the net operating losses of the corporation for the five consecutive preceding years aggregating $38,595.71 were as follows:

Net loss for year 1952 .......$10,808.03

Net loss for year 1953 ....... 8,156.36

Net loss for year 1954 ....... 6,987.14

Net loss for year 1955 ....... 6,870.01

Net loss for year 1956 ....... 5,774.17

Total .....................$38,595.71

On December 31, 1957 the corporation had a net income of $61,417.21 before charging losses, against which it charged $14,228.02, being the net loss on the^factory property, and $38,595.17, being the five year aggregated net operating loss of the woodworking business, leaving a net taxable income, after losses, of $8,-593.48 upon which it paid an income tax of $2,578.04.

On December 30, 1957 the three stockholder-partners formed a new corporation in the State of Delaware, also known as The Work-Factor Company, Inc. On January 1, 1958 all of the assets and liabilities of the New York corporation bearing the same name were transferred to the new Delaware corporation, and the New York corporation was dissolved. The Delaware corporation filed the requisite income tax return, utilizing the loss figures set forth above and paid the taxes due.

For the calendar year 1958, the new corporation’s return showed a net op-erating loss of $14,523.82. Of that loss, $435.75 was attributable to the sale of the woodworking business inventory for $264.25, when it had cost $700.00. The remaining portion of the stated loss was attributable to the operation of the management-consultant business.

In February, 1959 the corporation filed .a claim for refund with the Internal Revenue Service regarding its 1958 net operating loss. It claimed a carryback of $14,523.82, as its net operating loss, against its 1957 net income of $8,593.48, leaving the sum of $5,930.34 as a carryover to succeeding years. It also claimed a refund of the $2,578.04 income tax which it had paid for the taxable year of 1957.

Also, in 1959, the corporation had a net income of $8,667.93 against which it charged its 1958 net operating loss carryover of $5,990.24, leaving a balance of $2,737.59 as its net taxable income on which it paid a tax of $821.28.

In 1960, the corporation reported a net operating loss of $4,190.64 and filed a claim in March 1961 for refund claiming a carryback of its net operating loss for 1960, of $4,190.64, to its net income for 1959 of $2,737.59, leaving the sum of $1,453.05 as a carryover to succeeding years. It also claimed refund of $821.28 income tax which it had paid for 1959. Of course, the claimed net operating losses also affected tax returns for subsequent years.

Not only were the claimed refunds rejected, but the charged net operating losses were disallowed and a deficiency assessment of $16,533.11 for the year 1957 entered against the corporation.

The government bases its rejection of claims for refunds, as well as its dis-allowance of net operating losses, on the ground that the losses claimed were not incurred by the same business which had produced the profits, there having been a de facto dissolution of the woodworking business in or after 1952, as well as a lack of continuity of business enterprise and, further, that the sale of inventory was a sale of capital assets not used in the trade of the taxpayer or its management-consultant business, hence not an ordinary loss deduction. Another contention is made that the purchase of the partnership assets was an “acquisition of corporate control” within the meaning of the tax laws which was calculated in effect to evade or avoid income taxes, within the prohibition of Section 269 of 26 U.S.C.

The plaintiff corporation premises its claim for refund on the fundamental proposition that it is the intention of Congress to permit a single corporation, where its stockholders remain the same, to offset its lean years against its lush years, in order to ameliorate the drastic tax consequences of a strictly annual tax accounting basis, and that the plaintiff was within the spirit of such intention as evidenced by the evolution of the legislation. It contends that mere commencement of a different corporate enterprise or activity, where corporate ownership remains the same, does not bar the application of the net operating loss deduction resulting from its prior activity or type of productivity; further, that the change from a New York to a Delaware corporation is of no tax significance; nor were the fortuitous corporate structural changes such as to bring the plaintiff within the prohibition of tax avoidance, or evasion. The additional argument is made that plaintiff’s ordinary loss treatment of the sale of its physical assets was proper, as they were acquired and used in its trade and business, even though there followed a cessation of that particular enterprise and that such cessation did not effect an abandonment or de facto dissolution of the corporation.

The issues generated for resolution by the Court are:

1. Was the plaintiff entitled to the claimed net operating losses under Section 172 of the 1954 Internal Revenue Code?

2. Does the judicial doctrine of Lib-son Shops, infra, defeat the carryover privilege?

3. Does Section 382 of the 1954 Internal Revenue Code defeat the carryover privilege?

4. Were plaintiff’s losses on sales of assets entitled to ordinary loss or capital loss treatment ?

5. Was the plaintiff’s corporate identity destroyed by de facto dissolution, or subsequent re-incorporation in another state, thus, as a tax consequence, dissipating its prior losses?

6. Assuming the carryover privilege was not defeated by any of the foregoing, was there in fact an intent to evade or avoid taxes by the plaintiff within the proscription of Section 269 (formerly Section 129 of the 1939 Code) of the 1954 Internal Revenue Code?

These issues framed in the maze of distinctions so characteristic of the tax laws are not without complexities. Changing sequence for convenience, the last issue shall be considered first. For if it is resolved against the plaintiff, the others need not be reached for disposition of the case.

Section 269 of the Internal Revenue Code of 1954 was legislatively designed to prevent acquisition of ownership of another business legal entity as a maneuver to evade or avoid income taxes. Southland Corporation v. Campbell, 358 F.2d 333, 336 (5 Cir. 1966) ; 2 Rabkin & Johnson, Fed. Income, Gift and Estate Taxation, § 11.05 (1965). The legislation has a “built-in” presumption of intent to evade or avoid tax if there has been, in fact, an acquisition of control, the principal purpose of which is to secure the benefit of a deduction, credit or allowance to which the claimant would not otherwise be entitled. Such a proscription obtains regardless of whether a “profit” corporation acquires a “loss” corporation against which to offset losses against profit, or a “loss” corporation acquires a “profit” corporation. F. C. Publication Liquidating Corp. v. Commissioner of Internal Revenue, 304 F.2d 779 (2 Cir. 1962). Julius Garfinckel & Co., Inc. v. C. I. R., 335 F.2d 744 (2 Cir. 1964). Cf: Alprosa Watch Corp., 11 T.C. 240 (1948). But acquisition of control of one corporation by another corporation cannot arise where, as in the instant case, the stockholders were the sole owners of both the surviving corporation and the absorbed partnership. At the time of the transfer of the profitable partnership business to the loss-experience corporation, the stockholder-partners owned both. So that the “acquisition of control” element of Section 269 was not met.

The only “acquisition of control” during the history of the plaintiff, within the meaning of Section 269, was the purchase of Warsaw Button Co. in 1951. Good and valuable consideration was paid for that purchase and substantial assets of $50,000.00 were acquired. This transaction of itself did not produce any tax benefit or advantage to Warsaw Products, Inc., for no attempt was made to use pre-acquisition losses. The further step, some six years later in 1957, was necessary before concepts of tax advantage or benefit, as sought here, could arise. It was during this period that Warsaw Products, Inc. incurred these post-acquisition losses for the years 1952 to 1956 inclusive. However, if it can be reasonably inferred under the facts and circumstances of this case that the acquisition of Warsaw Button Co. in 1951 was an integral component of