Commissioner of Internal Revenue v. Brown/Opinion of the Court

In 1950, when Congress addressed itself to the problem of the direct or indirect acquisition and operation of going businesses by charities or other taxexempt entities, it was recognized that in many of the typical sale and lease-back transactions, the exempt organization was trading on and perhaps selling part of its exemption. H.R.Rep. No. 2319, 81st Cong., 2d Sess., pp. 38-39; S.Rep. No. 2375, 81st Cong., 2d Sess., pp. 31-32, U.S.Code Congressional Service 1950, p. 3053. For this and other reasons the Internal Revenue Code was accordingly amended in several respects, of principal importance for our purposes by taxing as 'unrelated business income' the profits earned by a charity in the operation of a business, as well as the income from long-term leases of the business. The short-term lease, however, of five years or less, was not affected and this fact has moulded many of the transactions in this field since that time, including the one involved in this case.

The Commissioner, however, in 1954, announced that when an exempt organization purchased a business and leased it for five years to another corporation, not investing its own funds but paying off the purchase price with rental income, the purchasing organization was in danger of losing its exemption; that in any event the rental income would be taxable income; that the charity might be unreasonably accumulating income; and finally, and most important for this case, that the payments received by the seller would not be entitled to capital gains treatment. Rev.Rul. 54-420, 1954-2 Cum.Bull. 128.

This case is one of the many in the course of which the Commissioner has questioned the sale of a business concern to an exempt organization. The basic facts are undisputed. Clay Brown, members of his family and three other persons owned substantially all of the stock in Clay Brown & Company, with sawmills and lumber interests near Fortuna, California. Clay Brown, the president of the company and spokesman for the group, was approached by a representative of California Institute for Cancer Research in 1952, and after considerable negotiation the stockholders agreed to sell their stock to the Institute for $1,300,000, payable $5,000 down from the assets of the company and the balance within 10 years from the earnings of the company's assets. It was provided that simultaneously with the transfer of the stock, the Institute would liquidate the company and lease its assets for five years to a new corporation, Fortuna Sawmills, Inc., formed and wholly owned by the attorneys for the sellers. Fortuna would pay to the Institute 80% of its operating profit without allowance for depreciation or taxes, and 90% of such payments would be paid over by the Institute to the selling stockholders to apply on the $1,300,000 note. This note was noninterest bearing, the Institute had no obligation to pay it except from the rental income and it was secured by mortgages and assignments of the assets transferred or leased to Fortuna. If the payments on the note failed to total $250,000 over any two consecutive years, the sellers could declare the entire balance of the note due and payable. The sellers were neither stockholders nor directors of Fortuna but it was provided that Clay Brown was to have a management contract with Fortuna at an annual salary and the right to name any successor manager if he himself resigned.

The transaction was closed on February 4, 1953. Fortuna immediately took over operations of the business under its lease, on the same premises and with practically the same personnel which had been employed by Clay Brown & Company. Effective October 31, 1954, Clay Brown resigned as general manager of Fortuna and waived his right to name his successor. In 1957, because of a rapidly declining lumber market, Fortuna suffered severe reverses and its operations were terminated. Respondent sellers did not repossess the properties under their mortgages but agreed they should be sold by the Institute with the latter retaining 10% of the proceeds. Accordingly, the property was sold by the Institute for $300,000. The payments on the note from rentals and from the sale of the properties totaled $936,131.85. Respondents returned the payments received from rentals as the gain from the sale of capital assets. The Commissioner, however, asserted the payments were taxable as ordinary income and were not capital gain within the meaning of I.R.C.1939, § 117(a)(4) and I.R.C.1954, § 1222(3). These sections provide that '(t)he term 'long-term capital gain' means gain from the sale or exchange of a capital asset held for more than 6 months * *  * .'

In the Tax Court, the Commissioner asserted that the transaction was a sham and that in any event respondents retained such an economic interest in and control over the property sold that the transaction could not be treated as a sale resulting in a long-term capital gain. A divided Tax Court, 37 T.C. 461, found that there had been considerable goodfaith bargaining at arm's length between the Brown family and the Institute, that the price agreed upon was within a reasonable range in the light of the earnings history of the corporation and the adjusted net worth of its assets, that the primary motivation for the Institute was the prospect of ending up with the assets of the business free and clear after the purchase price had been fully paid, which would then permit the Institute to convert the property and the money for use in cancer research, and that there had been a real change of economic benefit in the transaction. Its conclusion was that the transfer of respondents' stock in Clay Brown & Company to the Institute was a bona fide sale arrived at in an arm's-length transaction and that the amounts received by respondents were proceeds from the sale of stock and entitled to long-term capital gains treatment under the Internal Revenue Code. The Court of Appeals affirmed, 9 Cir., 325 F.2d 313, and we granted certiorari, 377 U.S. 962, 84 S.Ct. 1647, 12 L.Ed.2d 734.

Having abandoned in the Court of Appeals the argument that this transaction was a sham, the Commissioner now admits that there was real substance in what occurred between the Institute and the Brown family. The transaction was a sale under local law. The Institute acquired title to the stock of Clay Brown & Company and, by liquidation, to all of the assets of that company, in return for its promise to pay over money from the operating profits of the company. If the stipulated price was paid, the Brown family would forever lose all rights to the income and properties of the company. Prior to the transfer, these respondents had access to all of the income of the company; after the transfer, 28% of the income remained with Fortuna and the Institute. Respondents had no interest in the Institute nor were they stockholders or directors of the operating company. Any rights to control the management were limited to the management contract between Clay Brown and Fortuna, which was relinquished in 1954.

Whatever substance the transaction might have had, however, the Commissioner claims that it did not have the substance of a sale within the meaning of § 1222(3). His argument is that since the Institute invested nothing, assumed no independent liability for the purchase price and promised only to pay over a percentage of the earnings of the company, the entire risk of the transaction remained on the sellers. Apparently, to qualify as a sale, a transfer of property for money or the promise of money must be to a financially responsible buyer who undertakes to pay the purchase price other than from the earnings or the assets themselves or there must be a substantial down payment which shifts at least part of the risk to the buyer and furnishes some cushion against loss to the seller.

To say that there is no sale because there is no risk-shifting and that there is no risk-shifting because the price to be paid is payable only from the income produced by the business sold, is very little different from saying that because business earnings are usually taxable as ordinary income, they are subject to the same tax when paid over as the purchase price of property. This argument has rationality but it places an unwarranted construction on the term 'sale,' is contrary to the policy of the capital gains provisions of the Internal Revenue Code, and has no support in the cases. We reject it.

'Capital gain' and 'capital asset' are creatures of the tax law and the Court has been inclined to give these terms a narrow, rather than a broad, construction. Corn Products Co. v. Commissioner, 350 U.S. 46, 52, 76 S.Ct. 20, 24, 100 L.Ed. 29. A 'sale,' however, is a common event in the non-tax world; and since it is used in the Code without limiting definition and without legislative history indicating a contrary result, its common and ordinary meaning should at least be persuasive of its meaning as used in the Internal Revenue Code. 'Generally speaking, the language in the Revenue Act, just as in any statute, is to be given its ordinary meaning, and the words 'sale' and 'exchange' are not to be read any differently.' Helvering v. William Flaccus Oak Leather Co., 313 U.S. 247, 249, 61 S.Ct. 878, 880, 85 L.Ed. 1310; Hanover Bank v. Commissioner, 369 U.S. 672, 687, 82 S.Ct. 1080, 1088, 8 L.Ed.2d 187; Commissioner v. Korell, 339 U.S. 619, 627-628, 70 S.Ct. 905, 909-910, 94 L.Ed. 1108; Crane v. Commissioner, 331 U.S. 1, 6, 67 S.Ct. 1047, 1050, 91 L.Ed. 1301; Lang v. Commissioner, 289 U.S. 109, 111, 53 S.Ct. 534, 535, 77 L.Ed. 1066; Old Colony R. Co. v. Commissioner, 284 U.S. 552, 560, 52 S.Ct. 211, 213, 76 L.Ed. 484.

'A sale, in the ordinary sense of the word, is a transfer of property for a fixed price in money or its equivalent,' State of Iowa v. McFarland, 110 U.S. 471, 478, 4 S.Ct. 210, 214, 28 L.Ed. 198; it is a contract 'to pass rights of property for money,-which the buyer pays or promises to pay to the seller * *  * ,' Williamson v. Berry, 8 How. 495, 544, 12 L.Ed. 1170. Compare the definition of 'sale' in § 1(2) of the Uniform Sales Act and in § 2-106(1) of the Uniform Commercial Code. The transaction which occurred in this case was obviously a transfer of property for a fixed price payable in money.

Unquestionably the courts, in interpreting a statute, have some 'scope for adopting a restricted rather than a literal or usual meaning of its words where acceptance of that meaning would lead to absurd results * *  * or would thwart the obvious purpose of the statute.' Helvering v. Hammel, 311 U.S. 504, 510-511, 61 S.Ct. 368, 371, 85 L.Ed. 303; cf. Commissioner v. Gillette Motor Transport, Inc., 364 U.S. 130, 134, 80 S.Ct. 1497, 1500, 4 L.Ed. 1617; and Commissioner v. P. G. Lake, Inc., 356 U.S. 260, 265, 78 S.Ct. 691, 694, 2 L.Ed.2d 743. But it is otherwise 'where no such consequences (would) follow and where * *  * it appears to be consonant with the purposes of the Act *  *  * .' Helvering v. Hammel, supra, 311 U.S. at 511, 61 S.Ct. at 371; Takao Ozawa v. United States, 260 U.S. 178, 194, 43 S.Ct. 65, 67, 67 L.Ed. 199. We find nothing in this case indicating that the Tax Court or the Court of Appeals construed the term 'sale' too broadly or in a manner contrary to the purpose or policy of capital gains provisions of the Code.

Congress intended to afford capital gains treatment only in situatons 'typically involving the realization of appreciation in value accrued over a substantial period of time, and thus to ameliorate the hardship of taxation of the entire gain in one year.' Commissioner v. Gillette Motor Transport, Inc., 364 U.S. 130, 134, 80 S.Ct. 1497, 1500. It was to 'relieve the taxpayer from * *  * excessive tax burdens on gains resulting from a conversion of capital investments' that capital gains were taxed differently by Congress. Burnet v. Harmel, 287 U.S. 103, 106, 53 S.Ct. 74, 75, 77 L.Ed. 199; Commissioner v. P. G. Lake, Inc., 356 U.S. 260, 265, 78 S.Ct. 691, 694, 2 L.Ed.2d 743.

As of January 31, 1953, the adjusted net worth of Clay Brown & Company as revealed by its books was $619,457.63. This figure included accumulated earnings of $448,471.63, paid in surplus, capital stock and notes payable to the Brown family. The appraised value as of that date, however, relied upon by the Institute and the sellers, was.$1,064,877, without figuring interest on deferred balances. Under a deferred payment plan with a 6% interest figure, the sale value was placed at $1,301,989. The Tax Court found the sale price agreed upon was arrived at in an arm's-length transaction, was the result of real negotiating and was 'within a reasonable range in light of the earnings history of the corporation and the adjusted net worth of the corporate assets.' 37 T.C. 461, 486.

Obviously, on these facts, there had been an appreciation in value accruing over a period of years, Commissioner v. Gillette Motor Transport, Inc., supra, and an 'increase in the value of the income-producing property.' Commissioner v. P. G. Lake, Inc., supra, at 266, 78 S.Ct. at 695. This increase taxpayers were entitled to realize at capital gains rates on a cash sale of their stock; and likewise if they sold on a deferred payment plan taking an installement note and a mortgage as security. Further, if the down payment was less than 30% (the 1954 Code requires no down payment at all) and the transaction otherwise satisfied I.R.C.1939, § 44, the gain itself could be reported on the installment basis.

In the actual transaction, the stock was transferred for a price payable on the installment basis but payable from the earnings of the company. Eventually $936,131.85 was realized by respondents. This transaction, we think, is a sale, and so treating it is wholly consistent with the purposes of the Code to allow capital gains treatment for realization upon the enhanced value of a capital asset.

The Commissioner, however, embellishes his risk-shifting argument. Purporting to probe the economic realities of the transaction, he reasons that if the seller continues to bear all the risk and the buyer none, the seller must be collecting a price for his risk-bearing in the form of an interest in future earnings over and above what would be a fair market value of the property. Since the seller bears the risk, the so-called purchase price must be excessive and must be simply a device to collect future earnings at capital gains rates.

We would hesitate to discount unduly the power of pure reason and the argument is not without force. But it does present difficulties. In the first place, it denies what the tax court expressly found-that the price paid was within reasonable limits based on the earnings and net worth of the company; and there is evidence in the record to support this finding. We do not have, therefore, a case where the price has been found excessive.

Secondly, if an excessive price is such an inevitable result of the lack of risk-shifting, it would seem that it would not be an impossible task for the Commissioner to demonstrate the fact. However, in this case he offered no evidence whatsoever to this effect; and in a good many other cases involving similar transactions, in some of which the reasonableness of the price paid by a charity was actually contested, the Tax Court has found the sale price to be within reasonable limits, as it did in this case.

Thirdly, the Commissioner ignores as well the fact that if the rents payable by Fortuna were deductible by it and not taxable to the Institute, the Institute could pay off the purchase price at a considerably faster rate than the ordinary corporate buyer subject to income taxes, a matter of considerable importance to a seller who wants the balance of his purchase price paid as rapidly as he can get it. The fact is that by April 30, 1955, a little over two years after closing this transaction, $412,595.77 had been paid on the note and within another year the sellers had collected another $238,498.80, for a total of $651,094.57.

Furthermore, risk-shifting of the kind insisted on by the Commissioner has not heretofore been considered an essential ingredient of a sale for tax purposes. In LeTulle v. Scofield, 308 U.S. 415, 60 S.Ct. 313, 84 L.Ed. 355, one corporation transferred properties to another for cash and bonds secured by the properties transferred. The Court held that there was 'a sale or exchange upon which gain or loss must be reckoned in accordance with the provisions of the revenue act dealing with the recognition of gain or loss upon a sale or exchange,' id., at 421, 60 S.Ct. at 316, since the seller retained only a creditor's interest rather than a proprietary one. '(T)hat the bonds were secured solely by the assets transferred and that upon default, the bonholder would retake only the property sold, (did not change) his status from that of a creditor to one having a proprietary stake.' Ibid. Compare Marr v. United States, 268 U.S. 536, 45 S.Ct. 575, 69 L.Ed. 1079. To require a sale for tax purposes to be to a financially responsible buyer who undertakes to pay the purchase price from sources other than the earnings of the assets sold or to make a substantial down payment seems to us at odds with commercial practice and common understanding of what constitutes a sale. The term 'sale' is used a great many times in the Internal Revenue Code and a wide variety of tax results hinge on the occurrence of a 'sale.' To accept the Commissioner's definition of sale would have wide ramifications which we are not prepared to visit upon taxpayers, absent congressional guidance in this direction.

The Commissioner relies heavily upon the cases involving a transfer of mineral interests, the transferor receiving a bonus and retaining a royalty or other interest in the mineral production. Burnet v. Harmel, 287 U.S. 103, 53 S.Ct. 74, 77 L.Ed. 199; Palmer v. Bender, 287 U.S. 551, 53 S.Ct. 225, 77 L.Ed. 489; Thomas v. Perkins, 301 U.S. 655, 57 S.Ct. 911, 81 L.Ed. 1324; Kirby Petroleum Co. v. Commissioner, 326 U.S. 599, 66 S.Ct. 409, 90 L.Ed. 343; Burton-Sutton Oil Co. v. Commissioner, 328 U.S. 25, 66 S.Ct. 861, 90 L.Ed. 1062; Commissioner v. Southwest Exploration Co., 350 U.S. 308, 76 S.Ct. 395, 100 L.Ed. 347. Thomas v. Perkins is deemed particularly pertinent. There a leasehold interest was transferred for a sum certain payable in oil as produced and it was held that the amounts paid to the transferor were not includable in the income of the transferee but were income of the transferor. We do not, however, deem either Thomas v. Perkins or the other cases controlling.

First, 'Congress * *  * has recognized the peculiar character of the business of extracting natural resources,' Burton-Sutton Oil Co. v. Commissioner, 328 U.S. 25, 33, 66 S.Ct. 861, 866; see Stratton's Independence Ltd. v. Howbert, 231 U.S. 399, 413 414, 34 S.Ct. 136, 138-139, 58 L.Ed. 285, which is viewed as an income-producing operation and not as a conversion of capital investment, Anderson v. Helvering, 310 U.S. 404, at 407, 60 S.Ct. 952, at 953, 84 L.Ed. 1277, but one which has its own built-in method of allowing through depletion 'a tax-free return of the capital consumed in the production of gross income through severance,' Anderson v. Helvering, supra, at 408, 60 S.Ct. at 954, which is independent of cost and depends solely on production, Burton-Sutton, 328 U.S. at 34, 66 S.Ct. at 866. Percentage depletion allows an arbitrary deduction to compensate for exhaustion of the asset, regardless of cost incurred or any investment which the taxpayer may have made. The Commissioner, however, would assess to respondents as ordinary income the entire amount of all rental payments made by the Institute, regardless of the accumulated values in the corporation which the payments reflected and without regard for the present policy of the tax law to allow the taxpayer to realize on appreciated values at the capital gains rates.

Second, Thomas v. Perkins does not have unlimited sweep. The Court in Anderson v. Helvering, supra, pointed out that it was still possible for the owner of a working interest to divest himself finally and completely of his mineral interest by effecting a sale. In that case the owner of royalty interest, fee interest and deferred oil payments contracted to convey them for $160,000 payable $50,000 down and the balance from one-half the proceeds which might be derived from the oil and gas produced and from the sale of the fee title to any of the lands conveyed. The Court refused to extend Thomas v. Perkins beyond the oil payment transaction involved in that case. Since the transferor in Anderson had provided for payment of the purchase price from the sale of fee interest as well as from the production of oil and gas, 'the reservation of this additional type of security for the deferred payments serve(d) to distinguish this case from Thomas v. Perkins. It is similar to the reservation in a lease of oil payment rights together with a personal guarantee by the lessee that such payments shall at all events equal the specified sum.' Anderson v. Helvering, supra, 310 U.S. at 412-413, 60 S.Ct. at 956. Hence, there was held to be an outright sale of the properties, all of the oil income therefrom being taxable to the transferee notwithstanding the fact of payment of part of it to the seller. The respondents in this case, of course, not only had rights against income, but if the income failed to amount to $250,000 in any two consecutive years, the entire amount could be declared due, which was secured by a lien on the real and personal properties of the company.

There is another reason for us not to disturb the ruling of the Tax Court and the Court of Appeals. In 1963, the Treasury Department, in the course of hearings before the Congress, noted the availability of capital gains treatment on the sale of capital assets even though the seller retained an interest in the income produced by the assets. The Department proposed a change in the law which would have taxed as ordinary income the payments on the sale of a capital asset which were deferred over more than five years and were contingent on future income. Payments, though contingent on income, required to be made within five years would not have lost capital gains status nor would payments not contingent on income even though accompanied by payments which were. Hearings before the House Committee on Ways and Means, 88th Cong., 1st Sess., Feb. 6, 7, 8 and 18, 1963, Pt. I (rev.), on the President's 1963 Tax Message, pp. 154-156.

Congress did not adopt the suggested change but it is significant for our purposes that the proposed amendment did not deny the fact or occurrence of a sale but would have taxed as ordinary income those income-contingent payments deferred for more than five years. If a purchaser could pay the purchase price out of a earnings within five years the seller would have capital gain rather than ordinary income. The approach was consistent with allowing appreciated values to be treated as capital gain but with appropriate safeguards against reserving additional rights to future income. In comparison, the Commissioner's position here is a clear case of 'overkill' if aimed at preventing the involvement of tax-exempt entities in the purchase and operation of business enterprises. There are more precise approaches to this problem as well as to the question of the possibly excessive price paid by the charity or foundation. And if the Commissioner's approach is intended as a limitation upon the tax treatment of sales generally, it represents a considerable invasion of current capital gains policy, a matter which we think is the business of Congress, not ours.

The problems involved in the purchase of a going business by a taxexempt organization have been considered and dealt with by the Congress. Likewise, it was given its attention to various kinds of transactions involving the payment of the agreed purchase price for property from the future earnings of the property itself. In both situations it has responded, if at all, with precise provisions of narrow application. We consequently deem it wise to 'leave to the Congress the fashioning of a rule which, in any event, must have wide ramifications.' American Automobile Ass'n v. United States, 367 U.S. 687, 697, 81 S.Ct. 1727, 1732, 6 L.Ed.2d 1109.

Affirmed.