
    MONTE MANSFIELD AND ELEANOR MANSFIELD v. THE UNITED STATES
    [No. 319-56.
    Decided March 5, 1958]
    
    
      
      Mr. Lloyd Fletcher for the plaintiffs. Mr, Scott P. Grampton was on the briefs.
    
      Mr. George Willi, with whom was Mr. Assistant Attorney General Gharries K. Bice, for the defendant. Mr. James P. Garland was on the brief.
    
      
       Plaintiffs’ petition for writ of certiorari denied by the Supreme Court June 16, 1958.
    
   Littleton, Judge,

delivered the opinion of the court:

Plaintiffs brought this action to recover income taxes paid for the calendar year 1951 in the amount of $17,467.58 plus interest paid thereon together with interest on the total overpayment as required by law.

The facts, undisputed by the parties, are as follows: Plaintiff Monte Mansfield operated a Ford automobile agency in Tucson, Arizona, as a sole proprietorship until January 1, 1948, at which time he formed a corporation ultimately known as the Monte Mansfield Investment Company, hereafter referred to as Investment. To this corporation he transferred all of the proprietorship assets, receiving in return substantially all of the corporation’s capital stock except qualifying shares. This transaction was a tax-free exchange ímder section 112 (b) (5) of the Internal Revenue Code of 1939. During 1948, Investment accumulated earnings and profits (earned surplus available for declaration of dividends) in the amount of $31,336.92. On January 1, 1949, the corporation entered into a tax-free exchange with a newly formed subsidiary corporation, Monte Mansfield Motors, hereafter referred to as Motors. Under, this reorganization, Investment transferred a portion of its assets and a portion of its liabilities to Motors in exchange for all of the issued and outstanding capital stock of Motors amounting to 312 shares having a par value of $100 a share, and representing the excess of the value of the portion of the assets of Investment transferred to Motors over the amount of tbe liabilities of Investment assumed by Motors in the amount of $31,224.10. (The excess of $24.10 contained in the net worth of Motors on January 1,1949 was not sufficient to justify the issuance of another share of capital stock and was carried on the books of Motors as paid-in surplus.)

After the above described exchange of January 1, 1949, the assets of Investment consisted of the 312 shares of Motors capital stock, a building and fixtures therein, the land on which the building was located, and prepaid insurance on the building.

At the time of the above described exchange between Investment and Motors on January 1, 1949, the two corporations gave no thought to what disposition should be made of the $31,336.92 representing the 1948 earnings and profits of Investment, and the books and records of Investment after the exchange on January 1, 1949 reflected an earned surplus of this exact amount. The books of the two corporations show no allocation of the $31,336.92 to assets transferred to Motors and those retained by Investment.

From 1949 to the middle of 1951 Motors earned substantial net incomes but paid no dividends to its sole stockholder, Investment. During this same period, Investment received from Motors rental payments constituting its sole source of income. On July 1, 1951, Investment was liquidated in a nontaxable exchange, and plaintiff Monte Mansfield surrendered his Investment stock and received in return all of Investment’s assets consisting of the land, building, and fixtures and the 312 shares of Motors capital stock.

Plaintiffs filed a joint federal tax return in 1951, electing under section 112 (b) (7) to postpone taxation of gain on the property received in the corporate liquidation of Investment by currently reporting their ratable share of Investment’s earnings and profits as dividends taxable as ordinary income. Plaintiffs did not report as a dividend any part of Investment’s $31,336.92 earnings and profits from 1948, reporting only the $1,572.37 accumulated by Investment subsequent to the creation of Motors, i. e., from January 1,1949 to July 1,1951.

The Commissioner of Internal Revenue determined that the earnings and profits of Investment tasable to plaintiffs as a dividend under section 115 of the Internal Revenue Code of 1939 consisted not only of the $1,572.37 earned by Investment subsequent to January 1, 1949 and reported by plaintiffs as a taxable dividend, but also consisted of the $31,336.92 earned by Investment in 1948 prior to the creation of Motors, and carried on the books of Investment as of January 1, 1949. In accordance with such determination, the Commissioner of Internal Revenue assessed a deficiency against the plaintiffs. They paid the deficiency asserted against them, filed a timely claim for refund, and instituted this action more than six months thereafter as provided by 3772 of the Internal Revenue Code of 1939.

In the instant suit plaintiffs are not now claiming, as they apparently did in their tax return filed for 1951, that no part of Investment’s $31,336.92 earnings and profits from 1948 were taxable to them as a dividend. Plaintiffs do contend, however, that the Commissioner erred in determining that the entire sum was taxable to them as a dividend. It is plaintiff’s position that under applicable law they are entitled to allocate the 1948 earnings and profits of Investment between Investment and Motors for tax purposes. They do not contend that any such allocation was actually made at the time of the transfer by Investment of some of its assets and liabilities to Motors on January 1,1949, or that the earnings and profits of $31,336.92 were, in whole or in part, actually transferred to Motors at any time. The plaintiffs concede that the books and records of Investment reflect earnings and profits of $31,836.92 as of January 1,1949, but they contend that regardless, of that fact there must, in this kind of transaction, be an allocation of those earnings and profits. In other words, plaintiffs say that, in this type of tax-free exchange, the law will presume an allocation whether or not, at the time of the exchange, one was made or intended.

Plaintiffs base their argument for an allocation by operation of law on certain case law and a Treasury regulation which they claim provide for an allocation of earnings and profits in such a divisive reorganization or exchange. The plaintiffs assert that the “proper” method of making such allocation, in the instant case, is to allocate earnings to assets transferred and to those retained on the basis of their demonstrated earnings record, i. e. allocate the earnings to the asset which made the earning, which according to plaintiffs’ theory would result in an allocation of $3,398.71 to Investment and $27,938.21 to Motors.

The Government takes the position that the amount of the parent corporation’s earnings and profits available for distribution to its stockholders is unaffected by an exchange such as occurred between Investment and Motors in 1949, and that no allocation is required, because the net worth of Investment was not affected by the exchange in which Investment received back all of the capital stock of Motors. Alternatively, the Government urges that if the tax-free exchange of a portion of Investment’s tangible business assets in return for Motors’ stock does require an allocation of the transferor’s previously accumulated earnings and profits, such allocation should be in proportion to the percentage of Investment’s net book value of assets transferred compared to the net book value of those assets retained.

We are of the opinion that neither Treasury Regulation 118, section 39.115 (a)-3 (a), nor most of the cases relied upon by plaintiffs, require an allocation by operation of law of earnings and profits in a tax-free exchange where, as here, (1) only a portion of the transferor’s assets is transferred to the new corporation in exchange for all of the capital stock of the new corporation (the capital stock of the new corporation went to the old corporation and not to the shareholders of the old corporation), (2) where both corporations continue in existence after the exchange, (3) where the parties to the exchange did not, at the time of the exchange, intend or indeed make any allocation and (4) the earnings and profits of the transfei’or corporation actually remained on the books of that corporation after the exchange.

Treasury Eegulation 118, section 39.115 (a)-3 (a) is not an absolute requirement for an allocation in all kinds of tax-free exchanges. We are of the opinion that the regulation merely requires a “proper” allocation once it is established that an allocation is necessary at all. Inasmuch as the regulation is a codification of the Internal Revenue Code section dealing with the effect of tax-free exchanges upon dividends, as that section has been interpreted by the courts, we shall next consider the cases in point.

Most of the cases cited by plaintiffs can be distinguished by the fact that the transferor corporations involved therein transferred all of their assets to the transferee corporations, and the transferor corporations were simultaneously liquidated. In the instant case, as noted above, only part of the assets of the transferor corporation was transferred, and the transferor corporation was not liquidated at the time of the transfer nor as a part of the same transaction.

In Commissioner v. Sansome, 60 F. 2d 931 (2d Cir.1932), cert. denied 287 U. S. 667, the taxpayer bought stock in corporation A which had accumulated earnings and profits. Corporation A subsequently transferred all of its assets and liabilities to the newly formed B corporation, and the stockholders in A corporation received five shares of B corporation’s stock for each share of A with no change in the proportions of their holdings. At the time of the exchange corporation A was liquidated, and corporation B, making no profits while in operation, was liquidated two years later. The taxpayer did not report his liquidating distribution as a dividend but treated it as a return of capital. The court held that since no gain was recognized in the tax-free exchange two years earlier whereby B was created, the profits of A were earnings and profits of B, the successor corporation, and the distribution to the taxpayer was a distribution of dividends out of the earnings and profits of B corporation taxable as ordinary income.

As indicated above, the Sansome case can be distinguished from the instant case in several ways. In the Sansome case, all of the transferor corporation’s assets were given to the transferee without receiving anything in return, whereas in the instant case only part of Investment’s assets were transferred and all of the stock of the transferee corporation was received by Investment in exchange. The transferor corporation was completely liquidated in Sansome, but here Investment remained in operation as a going concern for two and a half years thereafter. Since all of the assets had been transferred and the transferor corporation liquidated in the Sansome case, the transferor’s earnings and profits had to go to the successor corporation or nowhere, whereas, in the instant case, there is no such necessity, because the earnings and profits can and did remain with the transferor. The type of allocation involved in the Sansome case was a choice of whether or not the earnings would go to the surviving corporation or disappear altogether, but the type of allocation urged upon us by plaintiffs is a dividing up of profits between two existing corporations by operation of law. We think this is an erroneous theory.

In the Sansome case, the stockholders in the original corporation became, as a result of the tax-free exchange, the stockholders in the successor corporation, whereas in the instant case the stockholders of Investment remained the stockholders of Investment after the tax-free exchange on January 1, 1949, and their interest in Investment was unaffected by the 1949 tax-free exchange. It was Investment that became the sole stockholder of Motors. The instant case is not a situation where the stockholder has surrendered bis stock in one corporation and received stock in another corporation. What has happened here is that Investment, as a result of the tax-free exchange of January 1, 1949, changed the composition of its assets and, in place of certain physical assets, it had after the 1949 exchange the 312 shares of Motors’ stock which had a value identical to the assets transferred to Motors. The net worth of Investment was the same after the 1949 exchange as it was immediately prior thereto.

The Sansome rule has been applied to many different situations such as liquidations of a subsidiary by its parent, Robinette v. Commissioner, 148 F. 2d 513 (9th Cir.1945), and mergers of two corporations to form a third, Commissioner v. Munter, 331 U. S. 210 (1947). In Harter v. Helvering, 79 F. 2d 12 (2d Cir.1935), the Sansome rule was applied to permit a parent corporation, in absorbing its subsidiary, to deduct its own deficit from the earnings and profits inherited from its subsidiary in computing the amount of earnings available for distribution as dividends. The Harter result was not applied in Commissioner v. Phipps, 336 U. S. 410 (1949), where the liquidated subsidiaries had deficits instead of earnings and profits.

In the Phipps case, the parent corporation had earnings and profits out of which dividends could be declared, but the five wholly-owned subsidiaries which were merged into the parent in a tax-free liquidation had an aggregate net deficit. The parent company effected the tax-free liquidation of the subsidiaries by distributing to itself all the assets and liabilities of the subsidiaries and redeeming and cancelling the stock of the subsidiaries. The taxpayers (stockholders in the parent corporation) argued that the net losses of the subsidiaries should be deducted from the earnings and profits of the parent so that the distribution made to stockholders would be a return of capital and not a dividend taxable as ordinary income. However, the court held that the tax-free liquidation did not affect the earned surplus held by the parent corporation, and the pro rata cash distribution to parent’s preferred stockholders was a dividend within the meaning of section 115 of the Internal Revenue Code of 1939.

The Phipps case would appear on first reading to be inconsistent with Sansome and Harter. But the apparently different treatment of a deficit situation in the Phipps case was explained by the Supreme Court on the ground of a different congressional policy toward losses, in that Congress had explicitly provided that the tax effects of losses should be deferred and that losses cannot be realized in the way that earnings are “realized”. The Supreme Court, in the Phipps case, also explained its decision by stating that the rule of the Bansome case was not grounded on a theory of continuity of corporate enterprise but on the necessity to prevent the escape of earnings and profits from taxation. Earnings and profits, for tax purposes, are viewed as a tangible thing which cannot escape taxation by mere changes on accounting books.

Plaintiffs relied most heavily on the case of Reed Drug Co. v. Commissioner, 130 F. 2d 288 (6th Cir.1942). The Reed, case involved a situation where the parent corporation transferred all of its assets and liabilities to a subsidiary in exchange for all the capital stock of the subsidiary. Six months thereafter, the parent corporation was liquidated and at that time it distributed the shares of the subsidiary to its stockholders. At the time of its liquidation, the parent corporation claimed a “dividends paid credit” on the ground that such a distribution to its shareholders represented a distribution of dividends out of earnings and profits. The court held that the parent corporation was not entitled to the “dividends paid credit” and that the earnings and profits of the parent corporation had gone to the surviving subsidiary corporation six months prior to the parent’s liquidation, at the time of the exchange, citing Bansome.

The Reed case can be distinguished from the instant case in that in the Reed case oil of the parent’s assets and liabilities were transferred to the subsidiary at the time of the- exchange, and, in the Reed case, the court found that, for all practical purposes, the liquidation of the parent corporation was part of the same transaction and simultaneous with the transfer of all of its assets and liabilities. Furthermore, the exchange in Reed was not a mere substitution of part of the assets of the parent for stock of the subsidiary, as in the instant case, because in Reed the shareholders of the parent became the shareholders of the subsidiary, whereas in the instant case the shareholders of the parent (Investment) continued to be the shareholders of the parent.

Although the Phipps case stated that the rationale of. the Bansome case was the necessity to prevent the escape of earnings and profits from taxation and not the continuity of corporate enterprise, cases following the Sansome rule prior to the Phipps decision had frequently spoken in terms of continuity of corporate life. See United States v. Kauffmann, 62 F. 2d 1045 (9th Cir.1933), and Reed Drug Co. v. Commissioner, supra. In the Reed case the court stated that:

It is well settled that under the Revenue Statutes upon a nontaxable reorganization the accumulated profits or earned surplus of the liquidated corporation pass to the successor corporation with the same status and are available for the payment of dividends by the successor. Such corporate transactions limited to this extent do not break the continuity of the corporate life. [Citations omitted.]

Whether the rule of the Sansome case is based on continuity of corporate enterprise, as explained in the Reed case, or on the necessity to prevent escape of earnings and profits from taxation, as the Phipps case indicates, there is no reason to apply the rule to this case. Here, there is no continuation of a single corporate venture in the Sansome sense, because both Investment and Motors continued in existence. There is no danger here of having the earnings and profits escape from taxation, as defendant fears, because taxes will be paid when the earnings and profits are ultimately distributed, and if we found that part of the earnings and profits should be allocated to Motors, those earnings would be taxed as dividends when ultimately distributed, even if Motors had not earned any profits itself, and in that event the taxation might be delayed but not escaped. Under either theory of Sansome, there is no reason to apply the rule here. The real reason for not applying the rule to the instant case, however, is that the rule does not extend to the situation now confronting this court.

In Barnes v. United States, 22 F. Supp. 282, we encounter a factual situation more closely resembling that in the instant case. In Barnes, the old corporation, in a tax-free reorganization, transferred only part of its net assets to the new corporation and the old corporation continued in existence for three years. The new corporation did not issue its capital stock to the old corporation as in the instant case, but to the shareholders of the old corporation. At the time of the exchange, the old corporation and the new corporation actually made an allocation of the earnings and profits of the old corporation between the two corporations. Three years later, the new corporation made a distribution to its stockholders part of which was from the earnings and profits which it had received from the old corporation at the time of the tax-free exchange. The stockholders of the new corporation contended that this distribution insofar as it represented earnings and profits of the old corporation was not taxable as a dividend, because it did not represent a distribution of the earnings and profits of the new corporation. The stockholders took the position that the distribution to them of the earnings and profits of the old corporation amounted to a return of capital of the new corporation. The court held that when part of the earnings and profits of the old corporation was transferred to the new corporation, they became earnings and profits of that new corporation and were available for distribution as dividends to the stockholders of the new corporation, and thus taxable to such stockholders as dividends. The court reached this result not only on the basis of the facts of the case, which involved an actual transfer of such earnings and profits to the new corporation, but by extending the Samóme rule to a situation which the court conceded was different on the facts from Samóme.

In Stella K. Mandell, 5 T. C. 684, the old corporation transferred part of its net assets to the new corporation and continued in existence. The old corporation did not transfer or allocate any of its earnings and profits to the new corporation. In exchange for the net assets transferred to the new corporation, the old corporation received stocks and bonds of the new corporation which the old corporation immediately distributed to its shareholders, thus making its shareholders the shareholders in the new corporation. This resulted in a reduction in the net worth of the old corporation and also a reduction in the interest of the shareholders of the old corporation, in such old corporation. Thereafter, the new corporation which had no earnings and profits of its own, made a distribution to its shareholders. The shareholders did not report the distribution as a dividend for tax purposes, but rather as a return of capital. The Tax Court held that under the Samóme rule it must be presumed that a proportionate amount of the earnings and profits of the old corporation followed those assets of the old corporation which were transferred to the new corporation and that the distribution to the shareholders of the new corporation was out of such earnings and profits of the old corporation which were now earnings and profits in the hands of the new corporation.

We do not think that the Samóme rule requires any such presumption and we would limit the application of the San-some rule to cases in which the facts are identical or closely analogous with those in the Samóme case, i. e., where all of the assets and liabilities of the old corporation are transferred to the new corporation and where the old corporation is liquidated simultaneously with or as a part of the same transaction. We think that where less than all of the assets are transferred, the transferor corporation continues in existence, and no actual transfer of the earnings and profits of the transferor corporation is made to the new corporation, the rationale of the Samóme case is not applicable and we can find no justification in law or under the facts of this case for presuming that a portion of such admittedly retained earnings and profits must have gone to the new corporation.

No part of the earnings and profits of Investment was actually transferred to Motors at the time of the tax-free exchange on January 1,1949, and we are of the opinion that neither the case law nor the regulations require that, under the circumstances of this case, any allocation of such retained earnings and profits be deemed to have been made as between the two corporations.

Accordingly, since Investment made no distribution between January 1, 1949 and the date of liquidation in 1951, the distribution upon liquidation included the entire amount of earnings and profits of $31,336.92 retained by Investment, and this amount is taxable to plaintiffs as a dividend within the meaning of section 115 of the Internal Revenue Code of 1939. Plaintiffs are not entitled to recover on this claim, and as to it the petition is dismissed. The depreciation deduction problem will be considered in further proceedings pursuant to Rule 38 (c).

It is so ordered.

LaRAmoke, Judge; Madden, Judge; Whitaker, Judge; and Jones, Chief Judge, concur.

FINDINGS OF FACT

The court, having considered the evidence, the stipulation of the parties, and the briefs and arguments of counsel, makes findings of fact as follows:

1. Plaintiffs are husband and wife and reside in Tucson, Arizona.

2. Prior to 1948, plaintiff Monte Mansfield, as a sole proprietor, operated an agency in Tucson, Arizona, for the sale of Ford automobiles, parts, and services.

3. On January 1, 1948, plaintiffs formed Monte Mansfield Motors, a corporation chartered under the laws of Arizona, and transferred to it the Ford Agency business and the land and building owned by plaintiffs individually and used in the conduct of the proprietorship business. In exchange for these assets, plaintiffs received substantially all of the stock of the corporation. On December 31, 1948, by an amendment to its corporate charter, the name of the corporation was changed tó Monte Mansfield Investment Co.

4. The stock of the above corporation organized on Jan- / uary 1, 1948, was held throughout 1948 as follows:

Shares
Monte Mansfield_1, 256
Eleanor Mansfield_ 1
Monte Mansfield, Jr_ 1
Heath Wright_ 1
T. K. Shoenhair_ 1

The shares held by EleanorMansfield, Monte Mansfield, Jr., Heath Wright and T. K. Shoenhair were issued to them solely for the purpose of qualifying them to act as directors of the corporation. These stockholders endorsed their respective stock certificates in blank and Monte Mansfield was the actual and beneficial owner of the shares.

5.On January 1, 1949, Monte Mansfield Investment Co. had assets in excess of liabilities (including depreciation reserves) in the sum of $157,411.67, which includes accumulated earnings and profits of $31,336.92.

6. On January 1,1949, plaintiffs organized a new corporation known as Monte Mansfield Motors as a subsidiary of Monte Mansfield Investment Company. The new corporation, hereinafter referred to as Motors, exchanged all of its issued and outstanding capital stock amounting to 312 shares, for certain assets of the parent company, Monte Mansfield Investment Co., hereinafter referred to as Investment. Motors also assumed certain liabilities of Investment. The amount of assets received by Motors in excess of the liabilities (including depreciation reserves) assumed from Investment, was $31,224.10.

7. At the time of the transfer of the assets of Investment .to Motors, noted in finding 6, no allocation of earnings and profits was made between Investment and Motors although at that time Investment had accumulated earnings and profits of $31,336.92.

8. The exchange referred to in finding 6 between Investment and Motors, was considered by plaintiffs as tax-free under the provisions of section 112 (b) (4), (g) (1) (D) and (g) (2) of the Internal Revenue Code of 1939. Defendant regarded and now regards that exchange as subject to the provisions of section 112 (b) (5) of the Internal Revenue Code of 1939 and therefore tax-free.

9. As of January 1, 1949, after the exchange referred to in finding 6, the books and records of Monte Mansfield Investment Co. reflected the following assets, liabilities and earned surplus: .

Assets ■ Booh value
Land__$55,480.81
Building and fixtures___ 211,302. 78
Prepaid insurance_ 1,605.70
312 stares of Monte Mansfield Motor Co stock.
Liabilities
Reserve for depreciation:
Building and fixtures_ 5,905. OS
Mortgages payable_•_ 136,296.64
Surplus
Earned surplus- 31, 336. 92

The following statement reflects the book value of both Monte Mansfield Investment Company and Monte Mansfield Motors after the exchange referred to in finding 6, segregated to show those transferred to Motors retained and received by Investment: with items and those

Assets Retained and re* ceived by Investment, transferor, Jan. 1, 1949 Received by Motors, tram-feree, Jan. 1, 1949
Cash_ $8, 175. 65
Notes and accounts receivable-32, 662. 01
Inventories of new and used cars, trucks, parts and materials_ 90, 362. 62
Depreciable assets:
Building_ $211, 302. 78
Less depreciation_ 5, 905. 08
$205, 397. 70
Machinery and equip-ment_ 22, 186. 56
Less depreciation_ 1, 623. 48
20, 563. 08
Office furniture and fixtures_ 19, 503. 67
Less depreciation_ 664. 28
18, 839. 39
Service cars_ 8, 378. 18
Less depreciation_ 780. 00
7, 598. 18
Land_ 55, 480. 81
Prepaid insurance_ 1, 605. 70 400. 00
Investment in Motors Co. stock, 312 shares. 31, 224. 10
Total assets_ 293, 708. 31 178, 600. 93
Liabilities
Accounts payable_ _ 12, 243. 05
Notes payable (less than 1 year):
Monte Mansfield_ _ 28, 082. 12
Other_ _ 67, 329. 23
Mortgage notes payable, secured by land ===== and building_ 136, 296. 64
Accrued taxes:
Personal property tax- - 3, 545. 44
State sales tax_ _ 2,163. 94
Unemployment and PICA- - 1, 334. 01
Federal and State income tax- - 25, 875. 90
Withholding tax payable- - 175. 80
Other accrued expense_ _ 912. 57
Customer deposits_ _ 3, 919. 80
Contingency reserves- - 1, 794. 97
Total liabilities 136, 296. 64 147, 376. 83
Capital Retained and received by Investment, transferor, Jan. 1,1949 Received by Motors, transferee, Jan. 1, 1949
Capital stock_ $126, 000. 00 $31, 200. 00
Paid-in surplus_ 74. 75 24. 10
Earned surplus (1948)-.. 31, 336. 92
157, 411. 67 31, 224. 10

The land, building and fixtures listed above were the same assets that had been transferred to Investment, pursuant to the provisions of section 112 (b) (5), Internal Eevenue Code of 1939, upon the formation of Investment on January 1, 1948. .

The 312 shares of Motors, listed above, were retained by Investment until its liquidation in 1951.

Plaintiffs do not contend that the $31,336.92 earnings and profits were actually transferred to Motors, and the books and records of Investment, above, show that Investment retained the earnings and profits. Plaintiffs admit that, at the time of the 1949 tax-free exchange, they did not put their minds to the question of the $31,336.92. Except for the above records and books, no proof has been offered as to what actually happened to the $31,336.92.

10. According to its books and records, Investment had net earnings after taxes of $1,512.37 for the period from January 1,1949 to July 1,1951, on which latter date Investment was liquidated.

During the period January 1,1949 to July 1,1951, Investment’s only source of income was the building rent paid to it by its subsidiary, Motors, at an annual rate of $21,600.

11. On March 15, 1951, plaintiffs, as directors of Motors, determined an earnings experience of the assets retained by Investment after January 1,1949. The earnings experience figure arrived at was $10,724.37 per annum before Federal income taxes, and this determination of earnings experience was made for the purpose of excess profits tax liability of Motors. The determination was never used in the calculation of the excess profits tax liability of Motors because a lesser tax liability was found to result from the use of a method of calculation not dependent upon the earnings experience of Investment.

12. Plaintiffs have determined that the profit and loss statement of Investment for the calendar year 1948 included (1) an assumed land and building rental income on assets thereafter retained by Investment in the amount of $18,345.72, based on the annual rent of $21,600 paid to Investment by its subsidiary, Motors, during the period 1949 through 1951, with appropriate adjustments for improvements, and (2) certain expenses totaling $14,043.30 assumed to be deductible from the assumed land and building rental income, as rental expense, resulting in a net income for 1948 of $4,302.42 upon which 1948 Federal income taxes of $903.51 were allocable. The balance of $3,398.71 represents the 1948 net earnings on said assets after taxes.

13. As of July 1, 1951, Investment was liquidated by plaintiffs and its assets were distributed to plaintiffs.

The unadjusted basis for Federal income tax purposes of the stock in Investment which was cancelled by plaintiffs in this liquidation, was $125,984.39.

The fair market value of the assets received by plaintiffs in this liquidation of Investment, less the liabilities assumed by plaintiffs July 1, 1951, was $413,757.96, as shown in the following statement:

Assets Fair market values July l, ÍOSt
Cash_ $1, 784. 51
Land_ $120, 000. 00
Buildings_ 200, 000. 00
320, 000. 00
Capital stock of Motors (312 shares) 210, 800. 21
Prepaid items_ 2, 004. 45
Total assets_ 534, 589. 17
Liabilities
Mortgage indebtedness on land and build-ing____— $111, 697. 84
Miscellaneous liabilities_ 9, 133. 37
- 120, 831. 21
Net worth______ 413,757.96

14.In their 1951 Federal income tax return plaintiffs elected to treat the liquidation of Investment as a nontaxable exchange within the provisions of section 112 (b) (7) of the Internal Revenue Code of 1939. A part of the assets received by plaintiffs upon that liquidation was the 312 shares of Monte Mansfield Motors stock acquired by Investment in the exchange of January 1, 1949 when Motors, the subsidiary company, was organized.

15.During the years 1948 through 1951, no dividends were paid by either Investment or its subsidiary, Motors. Motors paid dividends to stockholders in 1952 aggregating $9,360, and in 1953 aggregating $9,360, during which years Motors’ net income was $193,302.89 in 1952, and $114,129.32 in 1953. The reported net’ income and reported' salaries paid to officers for Investment and for Motors during the years 1948 through 1951, inclusive,, were as follows:

Investment: ms ms mo wbi
Net income. $60, 138. 94 $2, 276. 28 $1, 969. 21 ($190. 63)
Salaries_ 41,050.00 None None None
Motors:
Net income.. 60,831.50 175,057.20 166,348.35
Salaries — .. 42, 500. 00 43, 144. 27 44, 503. 47

16. On July 1, 1951, the buildings acquired by plaintiffs upon the liquidation of Investment had a remaining useful life of 40 years.

17. Concerning the particular land and building acquired by plaintiff Monte Mansfield from Monte Mansfield Investment Company upon the liquidation of that company in July 1951, which property was thereafter leased by plaintiff Monte Mansfield to Monte Mansfield Motors, the following schedule reflects the income and expenses for the years 1951, 1952, 1953 and 1954, as reported by plaintiffs in their joint Federal income tax returns for those years:

mi
Gross rents_ .$10,800.00
Expenses:
Depreciation_ $1,304.76
Other expenses_ 4, 200. 74 '
- 5, 505. 50
Net rental profit. 5, 294. 50
mu
Gross rents_ $21, 600. 00
Expenses:
Depreciation_ $2, 609. 53
Mortgage interest_ 4, 622. 00
Improvement bond interest_ 228. 24
Real property taxes_ 4, 940. 56
Insurance_ 313. 78
12, 714. 11
Net rental profit, 8, 885. 89
less
Gross rents_ 21, 600. 00
Expenses:
Depreciation_ 2, 609. 53
Mortgage interest_ 4, 462. 12
Improvement bond interest_ 190. 22
Real property taxes___ 4, 747. 89
Insurance_ 1, 440. 26
13, 450. 02
Net rental profit 8, 149. 98
Gross rents_ 30, 000. 00
Expenses:
Depreciation_ 2, 609. 53
Mortgage interest_ 10, 640. 14
Improvement bond interest_ 133. 16
Real property taxes_ 4, 840. 20
Insurance_ 1, 008. 84
Attorney’s fees_ 37. 50
Amortization of expense of securing new mortgage_ 178. 08
19, 447. 45
Net rental profit_ 10, 552. 55

18. Upon examination of the return of the plaintiffs for 1951 the Commissioner of Internal Eevenue determined a deficiency in the income taxes by including in the assets received on the liquidation all of the earned surplus of $31,836.92 which Investment earned in 1948.

19. Plaintiffs have exhausted their administrative remedies.

CONCLUSION OP LAW

Upon the foregoing findings of fact, which are made a part of the judgment herein, the court concludes as a matter of law that plaintiffs are not entitled to recover with respect to the allocation issue and the petition, in so far as it relates to the allocation question, is dismissed. The right of plaintiffs to recover and the amount of recovery, if any, with respect to the depreciation deduction issue will be determined pursuant to Eule 38 (c).

In accordance with the opinion of the court and on a memorandum report of the commissioner as to the amount due thereunder, it was ordered July 3,1958, that judgment for the plaintiffs be entered for $741.65, with interest as provided by law. 
      
       Eleanor Mansfield Is a plaintiff in this case merely because she and her husband filed a joint federal income tax return in 1951. These taxpayers beep their books and file their tax returns on cash receipts and disbursements basis by calendar years.
     
      
       Section 112. “Recognition of gain or loss—
      “(a) General rule, upon the sale or exchange of property the entire amount of the gain or loss, determined under section 111, shall be recognized, except as hereinafter provided in this section.
      “(b) Exchanges solely in kind—
      “(5) Transfer to corporation controlled by transferor. No gain or loss shall be recognized if property is transferred to a corporation 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 of the corporation; but in the case of an exchange by two or more persons this paragraph shall apply only if the amount of the stock and securities received by each is substantially in proportion to his interest in the property prior to the exchange. * * *”
     
      
       Both plaintiffs and- defendant regarded this transaction as tax-free, but differed as to the applicable section of the Internal Revenue Code. Plaintiffs considered this exchange as tax-free under the provisions of section 112 (b) (4), (g) (1) (D) and (g) (2) of the Internal Revenue Code of 1939. Defendant regarded and now regards that exchange as subject to the provisions of section 112 (b) (5) of the Internal Revenue Code of 1939 and therefore tax-free.
     
      
      
         Tills exchange was made pursuant to section 112 (b) (7) of the Internal Revenue Code of 1939.
     
      
       Section 115 of tie Internal Revenue Code of 1939 in pertinent part reads as follows :
      “The term ‘dividend’ * * * means any distribution made by a corporation to its shareholders, whether in money or in other property, (1) out of its earnings or profits accumulated after February .28, 1913, or (2) out of the earnings or profits of the taxable year (computed as of the elose of the taxable year without diminution by reason of any distributions made during the taxable year), without regard to the amount of the earnings and profits at the time the distribution was made. * * *” [Italics supplied.)
     
      
       This suit is based on two grounds: (1) that the Commissioner erroneously failed to make an allocation of surplus (earnings and profits) between the two corporations with the result that he overstated the available earnings and profits in Investment at the time of its liquidation in 1951 and (2) that the Commissioner understated the depreciation deduction on the improved real estate received by plaintiffs on said liquidation. The parties have agreed that the depreciation problem will be deferred and treated as a matter for consideration under Rule 38 (c), after the court has decided the allocation question.
     
      
       under the plaintiffs’ theory of the case, even if the corporate parties to the 'exchange on January 1. 1949 had intended to transfer the earnings and profits in their entirety to Motors, the applicable law, as interpreted by plaintiffs, -would require that some of those earnings and profits be allocated back to Investment.
     