
    EDWARD C. SMITH v. THE UNITED STATES
    [No. 50017.
    Decided May 3, 1955.]
    
      
      Mr. N. Barr Miller for plaintiff. Messrs. J. Marvin Haynes, F. Eberhart Haynes, and Oscar L. Tyree, were on the briefs.
    
      Mr. H. S. Fessenden, with whom was Mr. Assistant Attorney General H. Brian Holland, for defendant. Messrs. Andrew D. Sharpe and Ellis N. Slack were on the brief.
   LittuetoN, Judge,

delivered the opinion of the court:

The plaintiff sues to recover individual income taxes and deficiency interest paid for the calendar year 1944 in the amount of $11,070.57, with interest thereon. The plaintiff duly filed his income tax return for 1944 and paid the tax shown thereon.

In July 1944, the Bay City Electric Steel Casting Company (sometimes hereinafter referred to as the company), in which the plaintiff was a stockholder, acquired from the plaintiff and other stockholders certain shares of its own outstanding stock. The plaintiff received $12,698.27, which was his cost basis, for 460% shares transferred by him to the company. These shares were held by the company as treasury shares and a majority of them were immediately optioned to the company’s general manager in order to make it possible for him to acquire a one-third equity interest in the company in accordance with a prior agreement at the time he was employed.

The Commissioner of Internal Eevenue considered the transaction a cancellation or redemption of the company’s stock at such time and in such manner as to make the distribution of the $12,698.27 and the cancellation or redemption essentially equivalent to the distribution of a taxable dividend to the plaintiff in 1944 under the terms of section 115 (g) of the Internal Eevenue Code of 1939, as amended. The Commissioner included the $12,698.27 in the plaintiff’s income for 1944, and assessed a deficiency in the amount of $8,669.39, with interest thereon in the amount of $2,401.18. The plaintiff paid the deficiency and interest totaling $11,070.57 on November 16, 1949. The plaintiff’s claim fox refund was rejected and suit was timely instituted in this court.

The undisputed facts as found by the commissioner of this court may be summarized as follows: The authorized capital stock of the Bay City Electric Steel Casting Company was 15,000 shares of common stock of a stated par value of $10 per share. On January 11, 1944, its outstanding capital stock consisted of 6,350 shares of common stock, of which none had been issued as a stock dividend. Prior to January 11,1944, all the outstanding stock had been owned by Edward M. Mills and Lillian M. Mills. The plaintiff, who was president of another corporation, learned that Mr. Mills, who managed the company, desired to retire and sell the outstanding stock.

The plaintiff and his associates wanted to purchase the stock of the company but did not desire to undertake full-time management. They were not interested in purchasing the stock without first making arrangements for the employment of a capable general manager by the company. Consequently the plaintiff contacted Charles C. Keegan, who had an established reputation as a competent general manager in that line of business, to obtain his services as the general manager of the company. Keegan refused to take the position unless he could become the owner of one-third of the stock of the company. At that time Keegan was financially unable to raise one-third of the proposed purchase price of the stock.

On January 11, 1944, the plaintiff and his wife, Vera G. Smith, and William L. Mueller, and Laura L. Mueller, his wife, entered into an agreement to purchase the 6,350 outstanding shares of the company for $175,000, which was equivalent to approximately $27.56 per share. Upon execution of the agreement the plaintiff and his wife became joint owners of one-half of the stock and Mr. and Mrs. Mueller the joint owners of the other half.

On January 12, 1944, Keegan acquired 907 shares of the stock, which was approximately one-seventh of the 6,350 shares, purchasing 453% from the plaintiff and his wife and 453% from Mr. and Mrs. Mueller at the price of approximately $27.56 per share. It was orally agreed at that time that Keegan would be afforded an opportunity to acquire a one-third interest in the company if his services were satisfactory. Keegan became general manager of the company on that day and was also elected to the board of directors and to the office of the secretary-treasurer of the company. His compensation was 10 percent of the gross profit of the company before Federal income taxes, with certain other adjustments, but not less than $7,500 a year. On the same date the plaintiff, Mueller and Keegan, each borrowed $25,000 from the company on demand notes with interest at two percent. The $75,000 was used to pay Mr. and Mrs. Mills pursuant to the terms of the agreement of January 11, 1944. It was necessary for the plaintiff to borrow from some source to purchase the stock. Although he had substantial credit and might have borrowed funds elsewhere, he borrowed the $25,000 from the company because the rate of interest was lower and the company would benefit by the receipt of interest on its temporarily idle funds. On November 30, 1944, the plaintiff and Mueller paid off the balance due on their respective notes, and interest, and neither was substantially indebted to the company in 1945 or 1946. Keegan paid off the balance of his note of $25,000, and interest, on December 27,1945.

Keegan’s services proved highly satisfactory and in July 1944, he insisted on a definite arrangement to allow him to gradually, over a. period of time, acquire one-third of the outstanding stock, inasmuch as he was still financially unable to purchase the additional shares at that time.

At a board of directors meeting on July 18, 1944, it was resolved that the company would purchase 921% shares from the plaintiff and his wife, 921% shares from Mr. and Mrs. Mueller, and 307 shares from Keegan, at the price of $27.56 per share. It was further resolved that a 5-year option agreement be entered into between the company and Keegan offering Keegan the right to purchase up to 1,200 shares of the common stock of the company so that his total holdings would total, but not exceed, 1,800 shares, at a price of $27.56 per share plus two percent per annum from July 1, 1944. The directors also determined that since the plaintiff, Mueller and Keegan were indebted to the company in the respective amounts of $30,796.63, $30,664.67 and $25,231.53, the payments by the company for the shares of these stockholders should be applied to reduce their indebtedness to the company.

On July 19, 1944, the company pursuant to the resolution received the 2,150 shares and credited against the indebtedness of the plaintiff and his wife, $25,396.54, Mr. and Mrs. Mueller, $25,396.54, and Keegan, $8,460.92. On that date the 2,150 shares were issued to the company and it held these shares as treasury stock. On August 8, 1944, the company entered into a contract with Keegan wherein Keegan was given the option to purchase at any time within five years 1,200 shares of the treasury stock at $27.56 per share plus two percent per annum from July 1,1944.

The operating machinery and equipment of the company were badly worn and in need of replacement. However, it was not possible during 1944 and 1945 to replace this worn machinery and equipment since it was not available because of the war conditions. It was therefore possible for the company to employ these temporarily idle funds in the stock transaction of January and July 1944, without interfering with its replacement operation.

Before the transaction the plaintiff and his wife jointly owned three-seventh of the outstanding stock, Mr. and Mrs. Mueller three-sevenths, and Keegan one-seventh. The reason for the transaction was to temporarily reduce the number of shares owned by the plaintiff and his wife and the Muellers to 3,600 so that it would be possible for Keegan to obtain a one-third ownership interest by purchasing 1,800 shares instead of 2,116% shares, that is, one-third of 6,350. It was not the intention of the company or its stockholders at the time of the acquisition of the 2,150 shares to reduce the capitalization of the company by cancellation of any of the acquired shares, but it was the company’s intention to hold these shares as treasury stock pending the resale of 1,200 shares to Keegan, pursuant to his option, and the other 950 shares to the stockholders for the purpose of securing funds to acquire new machinery and equipment when it became available.

After the transaction the plaintiff and his wife jointly owned approximately two-sevenths of the outstanding stock, and the Muellers approximately two-sevenths. The company owned approximately two-sevenths, of which 1,200 shares were optioned to Keegan. Keegan owned approximately one-seventh and had an option to purchase 1,200 shares.

The net profits of the company after Federal taxes which were carried to its surplus for the years 1943 to 1948, inclusive, were as follows:

The earned surplus of the company at December 31, of the years 1943 through 1948, before the treasury stock, which was recorded at cost, was deducted from surplus, and after payment of dividends during the years 1946 and 1947, was as follows:

During the year 1946, cash dividends totaling $35,700 were declared and paid to the five stockholders, the plaintiff and his wife, Mr. and Mrs. Mueller, and Mr. Keegan. In 1947, cash dividends totaling $33,600 were declared and paid to these five stockholders. The record indicates that the plaintiff was not in need of funds. He had a taxable income of over $20,000 for the taxable year 1944.

About the end of 1945, Keegan discussed with the plaintiff the fact that he had not yet been financially able to acquire any of the optioned stock and expressed a wish that it could be made financially easier for him to acquire a one-third interest in the company. Up to that time it had been Keegan’s intention to exercise the option when he became financially able to do so. The company’s attorney was consulted and he suggested that if funds represented by the treasury stock were not immediately needed in the business, the sale of those shares could be postponed and Keegan might instead purchase enough additional shares from the other stockholders to make him the owner of one-third of the shares outstanding, exclusive of the treasury shares. Accordingly, in January 1946, Keegan purchased from the plaintiff and his wife 400 shares of stock of the company and a like number of shares from Mueller and his wife at $27.56 a share. Keegan borrowed $23,000 from the company on .a two percent demand note to enable him to make the purchase. This transfer increased Keegan’s stockholdings in the company to 1,400 shares' and reduced the stockholdings of the plaintiff and his wife to 1,400 and of Mueller and his wife to 1,400. At the time of the above transaction, January 1946, the company did not have immediate need for cash in the amount at which the treasury stock was carried on its books, $59,254, since it had not been able to acquire the needed new machinery and equipment, nor did it appear that it would need such funds for some time to come. However, it was still expected that it would be necessary to resell the treasury stock when the new machinery and equipment were obtained. No such transfer as occurred in January .1946, was under consideration by the stockholders at any time during 1944 as a substitute for the option plan of July and August 1944. At all times material to this proceeding, the plaintiff and his wife, and Mueller and his wife, were financially able to repurchase the treasury shares whenever the company had need for cash.

The company acquired new machinery and equipment of approximately $27,000 during 1946, $23,000 during 1947, and $115,000 during 1948. These acquisitions were financed by the company without the resale of the treasury stock and without the issuance of any additional stocks or bonds.

The plaintiff contends that the facts in this case demonstrate that the company purchased the shares and held them throughout 1944 for the legitimate business purpose of resale to Keegan and the other stockholders in order to satisfy Keegan’s demands. The plaintiff contends that since the shares were purchased and held for resale there was no cancellation or redemption of the shares within the meaning of section 115 (g), and further that there was no distribution in 1944 of earnings or profits essentially equivalent to a dividend.

The defendant contends that the facts show there was a pro rata redemption of the capital stock of the company which constituted a distribution essentially equivalent to a taxable dividend.

Section 115 (g) provides:

Redemption of stools. — If a corporation cancels or redeems its stock (whether or not such stock was issued as a stock dividend), at such time and in such manner as to make the distribution and cancellation or redemption in whole or in part essentially equivalent to the distribution of a taxable dividend, the amount so distributed in redemption or cancellation of the stock, to the extent that it represents a distribution of earnings or profits accumulated after February 28, 1913, shall be treated as a taxable dividend.

The pertinent regulation is set forth below.

The provision that the cancellation or redemption by a corporation of its stock in such a manner as to make the distribution essentially equivalent to a taxable dividend first made its appearance as section 201 (d) of the Revenue Act of 1921 (42 Stat. 227). The legislative history of this provision and its amendments, and section 115 (c) and its amendments (which section deals with partial liquidations), and section 802 of the 1954 Code, displays a design to impose a tax at the ordinary income tax rates on dividend distributions from earnings or profits regardless of whether or not the dividend distribution is disguised as a sale or partial liquidation. It was not intended to cover bona fide sales or bona fide partial liquidations which may have the same effect on the profits but not the same effect on the corporation and its stockholders.

This court stated in Stein v. United States, 104 C. Cls. 446, that the terms of the statute make the question under section 115 (g) one of equivalence. If the distribution is essentially equivalent to the distribution of a taxable dividend section 115 (g) is applicable. Commissioner v. Sullivan et al., 210 F. 2d 607. The question then is whether the transaction has in substance the same characteristics, attributes, and effect as a dividend distribution.

As provided in the applicable regulation, and as the many courts that have considered this problem have held, each case turns on its own peculiar facts and surrounding circumstances, guided by the terms of the statute and the general principles which have been established through the years by the courts in construing this section.

We agree with the plaintiff’s contention that the facts in this case clearly show that the company purchased the shares and held them throughout 1944 for the purpose of resale to Keegan and the other stockholders in order to satisfy Keegan’s demands. The plaintiff points out that the purpose of the transaction was not to distribute the earnings and profits of the company but rather to acquire the stock which the company could use in meeting the demands of Keegan for a one-third stock interest in the company. The distribution of an ordinary dividend would not have accomplished the purpose of acquiring stock which could be optioned and resold to Keegan who was a key, and, from a business standpoint, a necessary employee. It has been recognized by the courts that a legitimate business purpose, separate from tax savings, is an important although not conclusive factor to consider in determining the applicability of section 115 (g). Keefe v. Cote, 213 F. 2d 651; Commissioner v. Sullivan et al., supra; Commissioner v. Snite, 177 F. 2d 819; Smith v. United States, 121 F. 2d 692, and the cases there cited.

The company was not in a particularly good financial condition to warrant the payment of a $59,254 dividend because of the need of funds in the near future for the replacement of its worn equipment and machinery. The company had a definite plan by which it was to recover the $59,254 that it paid for the stock by reselling 1,200 shares to Keegan pursuant to his option and the other 950 shares to the stockholders when the company replaced its worn machinery and equipment. The recovery of the distribution by the corporation is not a characteristic, attribute or effect of a taxable dividend. The Tax Court in Snite v. Commissioner, 10 T. C. 523, and the Seventh Circuit Court in affirming that decision held that where the taxpayer transferred part of his stock in a close corporation to the corporation to be held temporarily as treasury stock and be optioned to certain key employees when the restrictions of the Stabilization Act of 1942 (50 U. S. C. App. sec. 961 et seq.), were removed, the distribution was not essentially equivalent to a taxable dividend.

The other significant factor that persuades us that this transaction was not a distribution essentially equivalent to a taxable dividend is that the proportionate interest of the stockholders was substantially altered by the transaction. The genesis and purpose of the transaction was to change the proportionate interest of the stockholders in the company. The commissioner of this court has very ably and properly found all of the relevant facts relating to this transaction, including its purpose, intent and effect. The defendant does not object to his findings but argues that the fact that the plaintiff and his associates borrowed money from the company to purchase part of the stock of the company and “redeemed” the stock pro rata is sufficient to make section 115 (g) applicable.

The Tax Court held in Sullivan et al. v. Commissioner, 17 T. C. 1420, and the Fifth Circuit Court affirmed that decision, with one judge dissenting, where the stock in a close corporation was redeemed pro rata in exchange for oil leases, equipment and cash, that section 115 (g) was inapplicable because the distribution was dictated by the reasonable needs of the corporate business and not for tax avoidance. In the instant case, although the “redemption” was pro rata, the transaction as a whole was designed to effect a change in the proportionate interest of the stockholders in the corporation. After the transfer of the stock to the corporation the plaintiff owned a two-sevenths rather than three-sevenths stock interest, and more important Keegan owned not just his previous one-seventh but also an option to purchase up to a one-third stock interest in the company. In 1944, Keegan fully intended to exercise this option. The plaintiff parted with his title to the shares and a majority of them were immediately optioned to another stockholder whose interests may well have been adverse to those of the plaintiff as a stockholder. Suite v. Commissioner, supra. The stockholders’ relationship with the company had been substantially changed by the transaction.

The defendant’s argument based on the fact that the plaintiff borrowed money from the company to purchase part of his stock is not deemed too significant under the facts of this case. It was just a prudent and convenient business arrangement and the funds were repaid or credited with interest. The cases cited by the defendant on this point, Wall v. United States, 164 F. 2d 462; Lowenthal et al. v. Commissioner, 169 F. 2d 694; Woodworth et al. v. Commissioner, 218 F. 2d 719, involve factual situations distinguishable from the instant case. A sufficient distinction is that in all three of these cases the stock in close corporations was redeemed pro rata in satisfaction of personal notes held by the corporation and the stockholders’ proportionate interest remained the same before and after the transactions, and there was no intention on the part of the corporation to recover the distributions.

It is not necessary to answer the plaintiff’s first contention that there was no redemption of the stock here in question since it was held as treasury stock for the purpose of resale, because of the view we take on the primary question of equivalence. It may be noted however, that if all of the other essentials of this section were met, the mere fact that the corporation carried the stock as treasury stock would not in and of itself prevent the application of section 115 (g). If the mere carrying of the stock as treasury stock would preclude the application of section 115 (g), the section could easily be circumvented and the intent of Congress completely frustrated by a close corporation through the simple expedient of distributing earnings for stock and indefinitely carrying the stock on the corporation’s books as treasury stock. See Keefe v. Cote, supra; Boyle v. Commissioner, 187 F. 2d 557, cert. denied, 342 U. S. 817; Wall v. United States, supra; and cf. Commissioner v. Snite, supra; Kirschenbaum v. Commissioner, 155 F. 2d 23; Alpers v. Commissioner, 126 F. 2d 58. Also we do not consider treasury stock to be an asset of the corporation unless the corporation deals in its own shares as it might in the shares of another corporation. Anderson, Clayton & Co. v. United States, 129 C. Cls. 295, cert. granted, 348 U. S. 936.

After a consideration of the purpose of section 115 (g) and the many cases that have been decided under this section, we are of the opinion that the transaction in this case was a sale and not a distribution essentially equivalent to a taxable dividend.

The plaintiff is entitled to recover and judgment will be entered for plaintiff in the sum of $11,070.57, with interest as provided by law.

It is so ordered.

Laramore, Judge; MaddeN, Judge; Whitaker, Judge; and JoNes, Chief Judge, concur.

FINDINGS OF FACT

The court, having considered the evidence, the briefs and argument of counsel, and the report of Commissioner Richard H. Akers, makes the following findings of fact:

1. The plaintiff is an individual residing in Bay City, Michigan, at all times relevant to this proceeding. On Jan-nary 15, 1945, the plaintiff filed with the Collector of Internal Revenue at Detroit, Michigan, an individual income tax return for the calendar year 1944, reporting thereon taxable income as follows:

Compensation (Salary, Wages) :
National Electric Welding Machines Co-$13,200.00
Bay City Electric Steel Casting Co_ 10, 000. 00
Bay City Bank_ 240.00
Less: Business Expense- (600.00)
Total compensation_ 22,840.00
Dividends and interest- 3, 971.26
Net gain from sales of assets_ 1,521.26
Total income_ 28,332.52
Less: Deductions for contributions, interest, taxes and losses_ 2,203. 67
Net taxable income_ 26,128.85

The tax liability reported on this amount of taxable income was $10,740.79, which was paid by the plaintiff as follows:

Date: Amount
April 20, 1944_ $791.83
June 24, 1944_ 791. 83
September 14, 1944_ 1,899.69
January 15, 1945_ 2,913.48
Withheld from wages_ 4,343.96
Total_ 10, 740. 79

2. The plaintiff, by timely filed consents, mutually agreed with the Commissioner of Internal Revenue to extend the period for assessment of any additional tax for the year 1944 to any time on or before June 30,1950.

3. Under date of August 5,1949, the Commissioner issued a ninety-day letter disclosing the determination of a deficiency against the plaintiff for the year 1944 in the amount of $8,669.39. Among the adjustments to taxable income for such year the Commissioner included as income the sum of $12,698.27, and as reason therefor stated:

It is held that the amount of $12,698.27 is includible as a dividend in your income for the taxable year ended December 31, 1944, under the provisions .of Section 22 (a) of the Internal Revenue Code because the redemption of 460% shares of Bay City Electric Steel Casting Company common capital stock owned by you and the crediting of the amount $12,698.27 against your indebtedness to said corporation was in effect a distribution essentially equivalent to a taxable dividend distribution within the meaning of Section 115 (g) of the Internal Revenue Code.

By letter dated October 25,1949, the plaintiff waived the restrictions provided in Section 272 (b) of the Internal Revenue Code and/or the corresponding provisions of prior internal revenue laws and consented to an immediate assessment and collection of the deficiency in income tax of $8,669.39 for the year 1944. The deficiency, together with interest thereon of $2,401.18, was thereupon assessed on the October 27,1949, Assessment List for the District of Michigan. The deficiency and interest totaling $11,070.57 were paid by the plaintiff to the Collector on November 16, 1949.

4. On February 27, 1950, the plaintiff filed with the Collector at Detroit, Michigan, a claim for the refund of $11,-070.57 of the income tax paid for the year 1944. The claim was grounded upon the contention that the payment ($12,698.27) received by the plaintiff from the Bay City Electric Steel Casting Company for 460% shares of its stock represented the recovery of his cost basis of $27.56 per share and was not a distribution of any part of the earned surplus of the corporation; and that there was no cancellation or redemption of the stock at such time and in such manner as to make the payment substantially equivalent to the distribution of a taxable dividend.

5. The Commissioner, by registered letter dated December 6, 1950, advised the plaintiff, in accordance with the provisions of Section 3772(a) (2) of the Internal Revenue Code, of the disallowance in full of his claim for refund.

6. Bay City Electric Steel Casting Company (hereinafter sometimes referred to as the Casting Company) is a corporation organized under the laws of the State of Michigan on January 1, 1928. That corporation at all times relevant to this proceeding was engaged in the operation of a foundry for the manufacture of all kinds of steel castings in job lots.

7. The Casting Company filed a corporation income and declared value excess profits tax return for 1944. In schedule M of that return there was shown a distribution of other property to stockholders in the amount of $4:,003.66. That distribution was made on January 11, 1944, to the former stockholder, Edward M. Mills, and consisted of Houghton Lake real estate ($3,591.16) and a Buick coupe ($412.50) which had been carried on the books as corporate assets.

8. In a report dated October 30,1946, an internal revenue agent made the following adjustments to the foregoing return of the Casting Company for 1944, all of which were agreed to by the Casting Company when it filed a waiver of restrictions on assessment and collection of a deficiency and acceptance of an overassessment:

Net income as disclosed by return_$56,421. 08
As corrected_ 69,446. 67
Net adjustment as computed below_ 13,025. 59
Unallowable deductions and additional income:
(a) Compensation of officers_$9,520.00
(5) Depreciation — acceleration_ 1,019.04
(c) Repairs_ 3, 762. 54
- 14,301.58
Nontaxable income and additional deductions:
(d) Capital stock tax- $62.50
(e) Depreciation — normal_ 823.98
(†) Compensation of officers_ 389.51
- 1,275.99
Net adjustment as above_ 13, 025.59

As a result of those adjustments, the Casting Company paid an additional assessment of excess profits tax for the year 1944 in the amount of $13,413.40 and received a credit for overpayment of income tax for the same year of $1,321.05.

9.In its return for 1944, referred to above, the Casting Company claimed as a deduction for “Repairs” the amount of $12,145.50. In the examination, likewise referred to above, the revenue agent disallowed $3,762.54 of the claimed deduction and, in explanation of the adjustment, stated:

In the deduction for repairs are the following items:

Bay City Roofing and Insulating Co.— application of felt and asphalt to roof of foundry building---$2, 600. 00
Chas. C. Engelhardt Construction Co.— building toilet room and additional footing in foundry---- — -- 627. 00
A. W. Eurich — install plumbing, liquid soap dispenser, and 50 gallon Gilco heater in toilet room in foundry-1,225.24
Total_ 4,452. 24
These amounts represent an amount for repairs, the cost of restoring the property in making good the exhaustion thereof, and in replacing the toilet room and facilities. The amount for repairs and the adjusted basis of facilities discarded (on which a loss would be deductible) are not known. As a means of disposing of the item it was agreed that 40 percent of the total or $1,780.90 would be allowed as a deduction and the balance or $2,671.34 would be capitalized and charged against the depreciation reserve.
Also in repairs is the amount of $430.56 to C. H. Eaton for repairs and for an asphalt floor put in the office building over the wood floor. To dispose of this item it was agreed that 40 percent thereof or $172.22 would be allowed as repairs and the balance or $258.34 would be charged against the depreciation reserve.
Also in repairs is the amount of $1,388.10 to Chas. C. Engelhardt Construction Co. billed to taxpayer as “Repairing garage, oil shed, and lumber sheds and covering same, with brick siding.” Such amount covers repairs and betterments. To dispose of this item it was agreed that 40% thereof or $555.24 be allowed as repairs and the balance or $832.86 be capitalized. It is not known in which asset account these sheds are originally included.

10. The authorized capital stock of the Casting Company was 15,000 shares of common stock of a stated par value of $10 per share, that is, a total authorized par value of $150,000. On January 11, 1944, its outstanding capital stock consisted of 6,350 shares of common stock. None of the outstanding shares had been issued by the Casting Company to any shareholder as a stock dividend. Prior to January 11, 1944, all the outstanding stock had been owned by Edward M. Mills and Lillian M. Mills. Edward M. Mills was actively engaged in managing the corporate business and as superintendent of the plant.

11. Sometime in 1943, the plaintiff was advised that Mr. Mills wanted to retire from the business of the Casting Company and that Mr. and Mrs. Mills desired to sell the outstanding capital stock of the Company. In November 1943, the plaintiff undertook negotiations with the Mills for the purchase of the capital stock of the Casting Company.

12. On January 11, 1944, the plaintiff and his wife, Vera G. Smith, and William L. Mueller and Laura L. Mueller, his wife (sometimes jointly referred to as the plaintiff and his associates), entered into an agreement for the purchase of the 6,350 outstanding shares of stock of the Casting Company from Edward M. and Lillian M. Mills for a consideration of $175,000, which is equivalent to approximately $27.56 per share. The agreement provided for the payment of $25,000 in cash at once, $75,000 in cash on or before ten days from the date of the agreement, and the promissory note of the plaintiff and his associates in the amount of $75,000 payable on or before sixty days from the date of the agreement and secured by 50,000 shares of the common capital stock of National Electric Welding Machines Company.

13. Upon execution of the foregoing agreement, the plaintiff and his wife became owners of one-half the outstanding capital stock of the Casting Company and Mr. and Mrs. Mueller the owners of the other one-half. The plaintiff became an officer and director of the Casting Company on January 11, 1944. The terms of the agreement of January 11,1944, were carried out by the parties.

14. On January 12,1944, the plaintiff, William L. Mueller, and Charles C. Keegan each borrowed $25,000 from the Casting Company on demand notes with interest at 2 percent. The $75,000 so obtained from the Casting Company was used to make payments to Mr. and Mrs. Mills pursuant to the terms of the agreement of January 11, 1944. It was necessary for the plaintiff to borrow from some source to purchase the Casting Company stock from Mr. and Mrs. Mills. While the plaintiff had substantial credit and might have borrowed funds elsewhere for the cash payments required for the purchase of the Casting Company stock, he borrowed tbe $25,000 from tbe Casting Company because tbe rate of interest was lower than on bank loans and at tbe same time tbe Casting Company would benefit by tbe receipt of interest on its temporarily idle funds. On March 1,1944, tbe plaintiff and Mueller each borrowed an additional $5,000 from the Casting Company on their individual demand notes providing for interest at 2 percent, and subsequently each borrowed an additional amount of $1,198.06 on an open account. Tbe plaintiff, William L. Mueller, and Charles C. Keegan each paid interest to the Casting Company on these demand notes and made payments on the principal from time to time. On November 30, 1944, the plaintiff and Mueller each paid off the balance due on their respective notes and neither was substantially indebted to the Casting Company in 1945 or 1946. Keegan paid off the balance on his demand note of $25,000 on December 27,1945.

15. At the time of the negotiation and purchase of the capital stock of the Casting Company by the plaintiff and his associates, the plaintiff was actively engaged as president in the business of the National Electric Welding Machines Company of Bay City, Michigan, and Mueller was also actively engaged in that enterprise. Neither the plaintiff nor Mueller intended to undertake full-time management of the Casting Company. The plaintiff and his associates would not have purchased the stock without first making arrangements for the employment of a capable general manager by the Casting Company.

16. Some two months prior to the execution of the agreement of January 11, 1944, for the purchase of the stock, the plaintiff approached Charles C. Keegan of Bay City, Michigan (referred to in finding 14), about becoming general manager of the Casting Company in the event the plaintiff and his associates should purchase the outstanding capital stock of that Company. At that time Keegan was general manager of Alert Pipe and Supply Company of Bay City, Michigan, a plumbing, heating and industrial supply company whose sole owner was C. H. Bissell. Bissell had first employed Keegan in 1941 as a personal representative to straighten out Bissell’s business affairs, and subsequently had given Keegan full responsibility for operating the business of the supply company. The plaintiff, as a director of the Bay City Bank, had observed the results of Keegan’s work as general manager of the supply company and knew that Keegan was the type of business man the plaintiff and his associates wanted as manager of the Casting Company enterprise.

17. The first discussion between the plaintiff and Keegan took place in the fall of 1943, probably in November. The plaintiff proposed that Keegan become general manager of the Casting Company at a fixed annual salary plus a bonus arrangement. Keegan refused the offer, stating that he was getting what he thought was a fair salary as general manager of the Alert Pipe and Supply Company and was not interested in another similar proposition. Keegan stated, however, that he would be interested if he could make arrangements with the plaintiff and his associates to become the owner of one-third of the capital stock of the Casting Company. Keegan explained that he was not financially able at that time to raise one-third of the $175,000 proposed purchase price of the Casting Company stock. The plaintiff replied that arrangements might be made to permit Keegan some stock ownership but that the matter would have to be discussed by the plaintiff with his associates.

18. Subsequent to the first discussion and prior to January 11, 1944, the plaintiff offered to arrange for the immediate purchase by Keegan of approximately one-seventh of the 6,350 shares of capital stock, with the understanding that if Keegan proved to be a satisfactory general manager the plaintiff and his associates would make an arrangement for acquisition by Keegan of a one-third interest in the capital stock of the Casting Company. The plaintiff also proposed that Keegan be elected to the board of directors and to the office of secretary and treasurer of the Casting Company, and that his compensation should be 10 percent of the gross profit of the company before federal income taxes, with certain other adjustments, but not less than $7,500 a year. Kee-gan agreed to accept such offer.

19. On January 12, 1944, Keegan acquired 907 shares of the capital stock of the Casting Company, which was approximately one-seventh of the 6,350 shores, purchasing 453% shares from the plaintiff and the plaintiff’s wife and 453% shares from Mr. and Mrs. William L. Mueller. The purchase price of the 907 shares was approximately $27.56 per share. To obtain cash to pay for the stock, Keegan borrowed $25,000 from the Casting Company, giving the company his demand note in that amount with interest at 2 percent. (See finding 14.) On the same day, Keegan was employed by the Casting Company as its general manager, and was elected a member of the board of directors and to the office of secretary-treasurer of the company.

20. Keegan’s management of the Casting Company was satisfactory to the plaintiff and his associates. Relations between the old management and employees of the Casting Company had been unsatisfactory. Keegan, as general manager, “sold himself” to the employees and the Casting Company has had no serious labor difficulties of any kind since he became general manager. The quality of the work produced by the employees improved under his supervision. Keegan also secured a number of new customers for the company. These results were accomplished despite the fact that the plant and the machinery and equipment were badly rundown when Keegan took charge. Essential repairs were made to the plant buildings during the first year of Keegan’s management. Because of wartime shortages, it was not possible to replace worn machinery and equipment either in 1944 or for some time thereafter.

21. The financial results of operation of the Casting Company for the taxable year prior to that in which Keegan became general manager and for the first five taxable years of Keegan’s management are as follows:

22.About July 1944 Keegan began to insist to the plaintiff and Mueller that a definite arrangement be made for his acquisition of enough additional capital stock of the Casting Company to give him a one-third interest in the enterprise, in accordance with the oral agreement made at the time of his employment in January 1944. The matter was brought up and discussed at a meeting of the board of directors of the Casting Company attended by the plaintiff, the plaintiff’s wife, Mr. and Mrs. Mueller, and Keegan. Keegan stated to- the other directors that he was still not financially able to purchase the additional shares necessary to make up one-third of the outstanding stock of the Casting Company, but he desired a long-term agreement which would permit him gradually to acquire up to a one-third interest in the company. Up to that time Keegan had not paid off any of the indebtedness to the Casting Company incurred in January 1944 in the acquisition of 907 shares of stock.

23. At a meeting of the board of directors of the Casting Company on July 18, 1944, a proposal was made by Keegan that 2,150 shares of the outstanding capital stock be purchased by the Casting Company from its stockholders at a price of $27.56 per share and be owned and held by the company as treasury stock. It was also proposed that the company enter into an agreement with Keegan granting him a five-year option to purchase up to 1,200 shares of the treasury stock at a price of $27.56 per share. After discussion of the two proposals, the following resolutions were adopted:

* * * that the company purchase from E. C. Smith and Vera G. Smith, Joint Owners, 921% shares of the common stock of the company at a price of $27.56 per share and that the company purchase from William L. Mueller and Laura Mueller, Joint Owners, 921% shares of the common stock of the company at a price of $27.56 per share and that the company purchase from C. C. Keegan 307 shares of the common stock of the company at a price of $27.56 per share, this stock to be owned by the company and to be known as Treasury stock.

and

* * * that a five-year optional agreement be entered into between the Company and its Secretary-Treasurer-General Manager, C. C. Keegan, offering to Charles C. Keegan the right to purchase up to 1,200 shares of the common stock of the company so that his total holdings shall total but not exceed 1,800 shares, at a price of $27.56 per share plus 2% per annum interest from July 1,1944, such option to be properly approved by the company attorney and become a part of the minutes of this meeting.

The directors also determined that since the plaintiff, Mueller, and Keegan were indebted to the Casting Company in the respective amounts of $30,796.63, $30,664.67, and $25,-231.53, the payments by the Casting Company to these three officers for shares of stock should be applied to reduce their indebtedness to the Casting Company.

24.On July 19, 1944, pursuant to the resolution of the board of directors, the Casting Company made the following credits to its stockholders and received from them the following number of shares of its stock:

Before the transfer, Keegan owned approximately one-seventh of the outstanding stock of the Casting Company and after the transfer he continued to hold one-seventh of the outstanding stock.

25. On July 19, 1944, a stock certificate for 2,150 shares of capital stock of the Casting Company was issued to the Casting Company, representing the shares acquired from its stockholders. That stock certificate was placed by the secretary-treasurer of the company in its safety deposit box in in the Bay City Bank. On the balance sheet of the Casting Company for the year ended December 31,1944, the amount of $59,254 is shown as “Treasury stock, at cost”, and “Capital stock issued” is shown in the amount of $63,500, the same amount as for the year ended December 31, 1943. On the annual balance sheets for the years 1945-48, inclusive, the same entries appear.

26. Ownership of the outstanding capital stock of the Casting Company before and after the transaction of July 19, 1944, between the Casting Company and its stockholders was as follows:

27. On August 8,1944, pursuant to the resolution of July 18,1944 (see finding 23), the Casting Company, by its president and vice president, entered into the following option agreement with Keegan:

This Agreement made this 8th day of August 1944, by and between Bay City Electric Steel Casting Company, a Michigan corporation, with its principal office and place of business located in the City of Bay City, Bay County, Michigan, hereinafter referred to as First Party, and C. C. Keegan, likewise of the City of Bay City, Bay County, Michigan, hereinafter referred to as Second Party, Witnesseth :
Whereas, Second Party is Secretary-Treasurer and General Manager of First Party and it is desired by both that Second Party shall have the opportunity and right to acquire and own a larger portion of the capital stock of First Party than presently owned by Second Party:
And Whereas, a number of shares of such capital stock are at present unissued and constitute Treasury stock of said First Party;
Now, therefore, for and in consideration of the mutual covenants herein expressed and the sum of One Dollar paid by Second Party to First Party upon the execution of these presents, the receipt whereof is hereby acknowledged, the parties hereto agree as follows, to-wit:
1. First Party grants, and Second Party shall have, option or the right to purchase up to an aggregate of Twelve Hundred (1,200) shares of said unissued or Treasury stock at any time or times during the period of five (5) years from the date hereof upon payment therefor of the sum of Twenty-seven and 56/100 ($27.56) plus 2% per annum from July 1, 1944, per share in cash to First Party, provided, however, that at the time or times when said right or option shall be exercised by Second Party, he shall be then actively associated with and employed by said First Party in the capacity here-inbefore described or some successive capacity approximately the equivalent thereof.

As shown above, the acquisition of the stock by the Casting Company temporarily reduced to 3,600 the number of shares owned by the plaintiff and his wife and the Muellers, thus making it possible for Keegan to obtain a one-third ownership interest by purchasing 1,800 shares instead of 2,116%, that is, one-third of 6,350.

28. Both at the time Keegan came with the Casting Company in January 1944 and continuing throughout that year, substantial items of the operating machinery and equipment were badly worn and in need of replacement. On its books by the end of 1944 the Casting Company had set up a depreciation reserve of over three-fourths of the cost of its assets, as shown by the following schedule:

Fixed assets:
Land _ $2,124.65
Buildings — foundry and storage_$54,790. 58
Equipment- 136, 735.26
Pattern and pattern equipment_ 3,257. 92
Office furniture and fixtures_ 2, 881.20
Trucks and automobiles- 1,250.00
Flasks- 4,166.44
203, 081.40
Less: Reserve for depreciation_ 156, 690.49
- 46,390.91
Total fixed assets after depreciation_ 48,515.56

However, during 1944 and 1945 it was not possible, because of war conditions, to replace the worn machinery and equipment since the desired items were not available.

29. Since it was not possible to proceed with the replacement of machinery and equipment, funds of the Casting Company to the extent available for that purpose were not used in that way and it was possible for the Casting Company to participate in the stock transaction of January and July 1944, heretofore referred to, without interfering with any replacement operation. Of the 2,150 shares of stock acquired by the Casting Company on July 19,1944, and thereafter carried as treasury stock, 1,200 shares were potentially obligated under the option agreement of August 8, 1944, with Keegan. It was the intention of the Casting Company to resell the remaining 950 shares of treasury stock to its stockholders if and when it became necessary to do so in order to secure funds for its replacement program. However, Keegan never exercised his option to acquire any of the treasury stock and none of that stock was ever sold to Keegan, the other stockholders, or anyone else, or reissued.

30. About the end of 1945, Keegan discussed with the plaintiff the fact that he had not yet been financially able to acquire any of the optioned stock and expressed a wish that it could be made financially easier for him to acquire a one-third interest in the Casting Company. Up to that time it had been Keegan’s intention to exercise the option when he became financially able to do so. The Casting Company’s attorney was consulted and he suggested that if funds represented by the treasury stock were not immediately needed in the business, the sale of those shares could be postponed and Keegan might instead purchase enough additional shares from the other stockholders to make him the owner of one-third of the shares outstanding, exclusive of the treasury shares. Accordingly, in January 1946, Keegan purchased from the plaintiff and the plaintiff’s wife 400 shares of stock of the Casting Company and a like number of shares from Mueller and his wife at $27.56 per share. Keegan borrowed $23,000 from the Casting Company on a 2 percent demand note to enable him to make the purchase. This transfer increased Keegan’s stockholdings in the Casting Company to 1,400 shares and reduced the stockholdings of the plaintiff and his wife to 1,400 and of Mueller and his wife to 1,400. At the time of the above transaction, January 1946, the Casting Company did not have immediate need for cash in the amount at which the treasury stock was carried on its books, $59,254, since it had not been able to acquire the needed new machinery and equipment, nor did it appear that it would need such funds for some time to come. However, it was still expected that it would be necessary to resell the treasury stock when the new machinery and equipment were obtained. No such transfer as occurred in January 1946 was under consideration by the stockholders at any time during 1944 as a substitute for the option plan of July and August 1944. At all times material to this proceeding, the plaintiff and his wife and Mueller and his wife were financially able to repurchase the treasury shares whenever the Casting Company had need for cash. It was not the intention of the Casting Company or its stockholders at the time of the acquisition of the 2,150 shares to reduce the capitalization of the Casting Company by cancellation of any of the acquired shares; but it was the Casting Company’s intention to hold those shares as treasury stock, pending their resale to the stockholders for the purpose of securing funds to acquire new machinery and equipment when such machinery and equipment became available.

31. The net profits of the Casting Company after federal taxes which were carried to its surplus account for the years 1943 to 1948, inclusive, were as follows:

Years: Amounts Tears: Amounts
1943_$22,555.03 1940_$56, 843.87
1944_ 23,536.26 1947_ 54,740.04
1945_ 25,108.12 1948_ 82,719.14

In determining the above net profits, the Casting Company deducted depreciation on its plant and equipment for the years 1943 to 1948, inclusive, as follows:

Tears: Amounts Tears: Amounts
1943_$13,711.06 1946_ $6,125.48
1944_ 10,926.45 1947_ 7,406.23
1945_ 5,970.16 1948_ 9,552.58

32. The earned surplus of the Casting Company at December 31 of the years 1943 through 1948, exclusive of the treasury stock recorded by the Company at cost and after payment of dividends during the years 1946 and 1947, as shown below, was as follows:

Tears: Amounts Tears: Amounts
1943_$80,032.49 1946_$127,472. 76
1944_ 97,714.57 1947_ 140,045.56
1945_ 121,361.15 1948_ 222, 764.70

During the year 1946, cash dividends totaling $35,700 were declared and paid to the five stockholders, the plaintiff and his wife, Mr. and Mrs. Mueller, and Mr. Keegan. In 1947, cash dividends totaling $33,600 were declared and paid to these five stockholders. Except for the dividend of $4,003.66 paid in property to Mr. and Mrs. Mills in January 1944, as shown in finding 7, no dividends were paid by the Casting Company during the years 1944 and 1945.

33. During the years 1943 through 1948, the land and de-preciable assets and reserves for depreciation of the Casting Company on its books were as follows, land being included each year at a cost of $2,124.65:

The Casting Company acquired new machinery and equipment of approximately $27,000 during 1946, $23,000 during 1947, and $115,000 during 1948. These acquisitions were financed by the Casting Company without the resale of the treasury stock heretofore referred to and without the issuance of any additional stocks or bonds.

34. Prior to the purchase in January 1944 of the stock of the Casting Company by the plaintiff and his associates, the plaintiff had an appraisal of the physical property of the Casting Company made by The Manufacturers’ Appraisal Company. Under date of December 16, 1943, the Appraisal Company addressed the following letter to the plaintiff:

Herewith, I am enclosing a duplicate summary of our valuation analysis of the Bay City Electric Steel Casting Company in accordance with your requirements.
The sound valuation established represents the fair market value of the property as a going concern and incorporates the basic depreciation generally used for insurance purposes. However, in determining a liquidating or quick-sale-value this figure might be subject to an additional 50% reduction.
We estimate the expense of rehabilitating the plant for more efficient and. desirable operations would be $7,500.00. This expense represents the cost of building a wash room and toilet in the foundry, repairing and rebuilding ovens, painting all steel work and pointing-up and repairing building walls, windows and heating system. Better working conditions would be created throughout the plant resulting in more efficient labor practices.

Enclosed with the letter was a document designated “Appraisal Certificate”, reading as follows:

Appraisal Certificate
The Manufacturers’ Appraisal CompaNY, a Corporation duly incorporated under the laws of Pennsylvania, hereby
CERTIFIES
that it has made a cursory survey of the land, buildings, machinery and equipment of the plant of the Bay City Electric Steel Casting Company located at Bay City, Michigan, as of December 15,1943. This appraisal does not include patterns, merchandise or supplies on hand. The valuations are as follows:
Land and land improvements_ $8,250.00
Buildings and building fixtures_ 78,856.00
Machinery and equipment_ 128,186.00
Total- 215,242.00
These valuations are the result of a personal inspection of the. property based upon the cost of reproduction according to present average market prices, less deductions for depreciation for considerations of mechanical deterioration and obsolescence, and are in accordance with the actual physical condition of the property as a going concern at the date of the appraisal.

CONCLUSION OF LAW

Upon the foregoing findings of fact, which are made a part of the judgment herein, the court concludes that as a matter of law the plaintiff is entitled to recover, and it is therefore adjudged and ordered that he recover of and from the United States ten thousand six hundred and thirty-nine dollars and eighty-six cents ($10,639.86), with interest as provided by law. 
      
       Treasury Regulations 111.
      “Sec. 29.115-9. Distribution in redemption or cancellation of stock taxable as a dividend. — If a corporation cancels or redeems its stock (whether or not such stock was issued as a stock dividend) at such time and in such manner as to make the distribution and cancellation or redemption in whole or in part essentially equivalent to the distribution of a taxable dividend, the amount so distributed in redemption or cancellation of the stock, to the extent that it represents a distribution of earnings or profits accumulated after February 28, 1913, shall be treated as a taxable dividend.
      “The question whether a distribution in connection with a cancellation or redemption of stock is essentially equivalent to the distribution of a taxable dividend depends upon the circumstances of each case. A cancellation or redemption by a corporation of a portion of its stock pro rata among all the shareholders will generally be considered as effecting a distribution essentially equivalent to a dividend distribution to the extent of the earnings and profits accumulated after February 28, 1913. On the other hand, a cancellation or redemption by a corporation of all of the stock of a particular shareholder, so that the shareholder ceases to be interested in the affairs of the corporation, does not effect a distribution of a taxable dividend. A bona fide distribution in complete cancellation or redemption of all of the stock of a corporation, or one of a series of bona fide distributions in complete cancellation or redemption of all of the stock of a corporation, is not essentially equivalent to the distribution of a taxable dividend. If a distribution is made pursuant to a corporate resolution reciting that the distribution is made in liquidation of the corporation, and the corporation is completely liquidated and dissolved within one year after the distribution, the distribution will not be considered essentially equivalent to the distribution of a taxable dividend; in all other cases the facts and circumstances should be reported to the Commissioner for his determination whether the distribution, or any part thereof, is essentially equivalent to the distribution of a taxable dividend.”
     
      
       H. Rep. No. 179, 68th Cong., 1st sess., pp. 11-12; S. Rep. No. 62, 69th Cong., 1st sess., p. 15 ; S. Rep. No. 558, 73d Cong., 2d sess., p. 37; S. Rep. 1631, 77th Cong., 2d sess., p. 116; S. Rep. No. 2375, 81st Cong., 2d sess., pp. 42-43; S. Rep. No. 1622, 83d Cong., 2d sess., pp. 233-237.
     
      
       Amended July 8, 1955.
     