SCOTUS Reports

Tag: Section 117(m)

  • Gerber v. Commissioner, 32 T.C. 1199 (1959): Collapsible Corporations and Gain Attributable to Land Value

    32 T.C. 1199 (1959)

    Under Internal Revenue Code of 1939 §117(m)(3)(B), the collapsible corporation provisions apply unless more than 70% of the gain realized is attributable to the property manufactured or constructed, and any increase in land value due to the building project is included in the gain attributable to the property constructed.

    Summary

    The case involved a tax dispute over whether gains from the sale of stock in real estate corporations should be taxed as ordinary income or capital gains. The Commissioner determined that the corporations were “collapsible” under the Internal Revenue Code of 1939, leading to ordinary income tax treatment. The taxpayers argued that a significant portion of the gain was attributable to increases in land value independent of the apartment houses constructed, thus qualifying for capital gains treatment under an exception in the code. The Tax Court sided with the Commissioner, ruling that the taxpayers failed to prove that more than 30% of the gain was attributable to land value and that any increase in land value due to the building projects must be included in the gain “attributable to” the property constructed.

    Facts

    Erwin and Ruth Gerber, husband and wife, organized three corporations in 1948 to construct apartment houses in East Orange, New Jersey. The corporations acquired land and built apartment buildings. The Gerbers sold their stock in these corporations in 1950, realizing gains. The Commissioner determined that the corporations were “collapsible” corporations, and that the gain realized from the sale of the stock was to be taxed as ordinary income under section 117(m) of the Internal Revenue Code of 1939.

    Procedural History

    The Gerbers filed a joint income tax return for 1950, reporting the gain as long-term capital gain. The Commissioner determined a deficiency, treating the gain as ordinary income. The Gerbers challenged the determination in the United States Tax Court. The trial was delayed multiple times pending decisions in other cases involving similar issues. The Tax Court ruled in favor of the Commissioner, which led to this case brief.

    Issue(s)

    1. Whether the corporations were “collapsible” within the meaning of section 117(m)(2)(A) of the Internal Revenue Code of 1939.

    2. Whether more than 70% of the gain realized was attributable to the property so manufactured, constructed, produced, or purchased under section 117(m)(3)(B) of the Internal Revenue Code of 1939.

    3. Whether the increase in land value due to the building projects should be included in the gain attributable to the property constructed under section 117(m)(3)(B).

    Holding

    1. Yes, because the taxpayers did not deny that each of the three corporations were collapsible.

    2. No, because the Tax Court found that the Gerbers failed to bring themselves within the exception in section 117(m)(3)(B).

    3. Yes, because any increase in the land’s value brought about by an apartment house development on such land must be included in the gain attributable to the property constructed.

    Court’s Reasoning

    The court primarily focused on the application of section 117(m) of the 1939 Internal Revenue Code, dealing with “collapsible corporations.” The taxpayers conceded that the corporations met the definition of collapsible corporations. However, they argued that an exception under section 117(m)(3)(B) applied because more than 30% of their gain was attributable to the increase in value of the underlying land, separate from the apartment houses constructed on it. The court found that the taxpayers failed to meet their burden of proving this, primarily due to the weakness of their expert’s valuation of the land and the fact that any value increase in land due to construction must be included in the total gain. The court noted that under §117(m)(3)(B) the collapsible corporation provisions “shall not apply to the gain * * * unless more than 70 per cent of such gain is attributable to the property so manufactured, constructed, produced, or purchased.”

    Practical Implications

    This case underscores the importance of precise valuation in tax disputes related to real estate development. It emphasizes that taxpayers seeking to invoke the exception under section 117(m)(3)(B) bear the burden of proving that a sufficient portion of the gain is attributable to the property constructed and not to the appreciation in value of the land itself. Furthermore, this case provides a practical understanding of the meaning of “attributable to” in cases where there are improvements to land and how the increase in land value directly related to the project cannot be excluded. This case is important for attorneys and real estate developers as it informs tax planning and litigation concerning collapsible corporations. Taxpayers should ensure that expert testimony and supporting evidence clearly delineate the sources of gain to meet the requirements to properly file and defend their taxes.

  • Spangler v. Commissioner, 32 T.C. 782 (1959): Defining “Collapsible Corporations” for Tax Purposes

    32 T.C. 782 (1959)

    A corporation is considered “collapsible” under Section 117(m) of the Internal Revenue Code of 1939 if it is formed or availed of principally for the construction of property with a view to shareholder gain before the corporation realizes substantial income from the property.

    Summary

    The case involves a tax dispute where the Commissioner of Internal Revenue determined that gains from stock redemptions by C.D. Spangler were taxable as ordinary income, rather than capital gains. The court addressed whether two corporations, Double Oaks and Newland Road, were “collapsible corporations” under Section 117(m) of the Internal Revenue Code of 1939. This determination hinged on whether the corporations were formed primarily to construct properties with a view to shareholder gain through stock redemptions before the corporation realized substantial net income from the projects. The Tax Court held for the Commissioner, concluding the corporations were collapsible because the redemptions occurred before substantial income realization, thereby classifying the gains as ordinary income.

    Facts

    C.D. Spangler was the principal shareholder of Construction Company, which built rental housing projects. Spangler sponsored two housing projects, Double Oaks and Newland Road, each structured with two classes of common stock. Class B stock was issued to architects and others involved in the construction. Spangler later purchased this class B stock. Double Oaks and Newland Road obtained FHA-insured loans for construction. Prior to substantial income generation, Spangler redeemed portions of his class B stock in both corporations. The corporations had significant net operating losses during the relevant periods, and the redemptions occurred soon after the construction was completed. Spangler reported gains from the redemptions as long-term capital gains. The Commissioner determined these gains were ordinary income under Section 117(m) of the Internal Revenue Code of 1939.

    Procedural History

    The Commissioner issued a notice of deficiency, asserting that the gains from the stock redemptions should be taxed as ordinary income under section 22(a). The Commissioner later amended his answer, specifically citing Section 117(m) as the basis for this determination. The petitioners challenged this assessment in the United States Tax Court. The Tax Court upheld the Commissioner’s determination, concluding that the corporations were “collapsible” under Section 117(m), thereby classifying the gains as ordinary income.

    Issue(s)

    1. Whether the corporations, Double Oaks Apartments, Inc., and Newland Road Apartments, Inc., were “collapsible corporations” under Section 117(m) of the Internal Revenue Code of 1939?

    2. Whether the Commissioner’s reliance on Section 117(m) shifted the burden of proof to the petitioners?

    Holding

    1. Yes, because the corporations were formed primarily to construct properties with a view to shareholder gain before realizing substantial income.

    2. No, because the Commissioner’s reliance on Section 117(m) was permissible under his initial deficiency notice.

    Court’s Reasoning

    The court first addressed the procedural issue of the burden of proof. The court clarified that the Commissioner’s amended answer, invoking Section 117(m), did not introduce new matter, thereby avoiding the burden of proof shifting to him. The court overruled a prior decision, Thomas Wilson, to maintain that the Commissioner could assert Section 117(m) as a reason for his deficiency determination, even if not explicitly stated in the initial notice. The court then focused on whether the corporations met the definition of a “collapsible corporation.” The court found that they were formed “principally for the construction of properties with a view to the sale or exchange of the class B stock…prior to the realization by the corporations of substantial parts of the net income to be derived from the properties.” The court noted that the redemptions occurred shortly after construction, before the corporations generated significant rental income, and that the amount of the FHA-insured loans far exceeded the construction costs. Thus, the court concluded the redemptions were a means for Spangler to realize gain, triggering Section 117(m). The court also rejected Spangler’s argument that more than 70% of the gain was attributable to rentals, noting that the distributions could have been made from the excess of the loans over construction costs.

    Practical Implications

    This case highlights the importance of carefully structuring real estate projects to avoid the “collapsible corporation” provisions. Tax advisors and attorneys should scrutinize the timing of stock redemptions relative to income generation. If distributions to shareholders occur before the corporation has realized a significant portion of its net income, the IRS is more likely to classify the corporation as collapsible. The decision clarifies that the government can change its legal basis for asserting a tax deficiency as long as it’s within the scope of the original notice, which affects the burden of proof. Finally, this case illustrates that funding redemptions from the proceeds of a loan does not prevent the IRS from asserting Section 117(m), particularly when the loans exceed the construction costs.

  • Braunstein v. Commissioner, 30 T.C. 1131 (1958): Collapsible Corporations and Taxation of Gains

    Braunstein v. Commissioner, 30 T.C. 1131 (1958)

    Gains from distributions and sales of stock in a corporation formed to construct and own an apartment complex are taxable as ordinary income, not capital gains, if the corporation is deemed “collapsible” under the Internal Revenue Code.

    Summary

    The case concerns whether gains from cash distributions and the sale of stock in Kingsway Developments, Inc., a corporation formed to build an apartment complex, should be taxed as ordinary income or capital gains. The IRS determined that Kingsway was a “collapsible corporation,” thus triggering ordinary income tax treatment for the taxpayers. The Tax Court agreed with the IRS, finding that the taxpayers’ gains were attributable to the construction of the apartment project and that the corporation was formed with the requisite view to collapse before realizing substantial income. The court rejected several arguments by the taxpayers regarding the timing of the distributions, the definition of construction, and the calculation of income derived from the property.

    Facts

    Petitioners (Braunstein et al.) formed Kingsway to construct and own an apartment house development. The project received financing under the National Housing Act. Cash distributions were made to shareholders before the project was fully completed. The taxpayers later sold their stock in Kingsway, realizing substantial gains. The IRS contended that Kingsway was a “collapsible corporation,” and therefore the gains were taxable as ordinary income under Section 117(m) of the Internal Revenue Code of 1939.

    Procedural History

    The Commissioner of Internal Revenue determined that the gains from the distributions and stock sales were taxable as ordinary income. The taxpayers contested this decision in the U.S. Tax Court. The Tax Court ruled in favor of the Commissioner.

    Issue(s)

    1. Whether the taxpayers’ gains were subject to ordinary income tax under Section 117(m) of the Internal Revenue Code of 1939, due to Kingsway being a “collapsible corporation.”
    2. Whether the distributions and sales took place before the realization of a substantial portion of the net income to be derived from the property.
    3. Whether more than 70 percent of the gain was attributable to the property constructed.

    Holding

    1. Yes, because Kingsway was a collapsible corporation, the gains were subject to ordinary income tax.
    2. No, the distributions and sales did not occur after the realization of a substantial part of the net income.
    3. No, more than 70% of the gain was attributable to the property constructed.

    Court’s Reasoning

    The court found that Kingsway met the definition of a collapsible corporation under the statute because the distributions and stock sales occurred before Kingsway realized substantial income from the apartment project. The court rejected the taxpayers’ arguments based on a “post-construction motive” because the “view” to collapse existed before the project was completed. The court also determined that the project was not fully completed before the events that triggered the tax liability.

    The court reasoned that the distribution of excess mortgage proceeds was a key factor. The court stated that the regulations defined the required “view” as existing if the sale of stock or the distribution to shareholders is contemplated “unconditionally, conditionally, or as a recognized possibility” and, further, that the view exists during construction if the sale or distribution is attributable to “circumstances which reasonably could be anticipated at the time of such * * * construction.”

    The court further held that net income should not include the mortgage premium and that early years of apartment operation should not be used to determine the substantiality of income. Regarding the allocation of gain to the property constructed, the court found that the increase in land value attributable to its use in the apartment project was part of the profit relating to the property. The court emphasized that the distribution of funds closely matched the excess mortgage proceeds, strongly indicating the source of the gain. The court cited previous cases to support its conclusions.

    Practical Implications

    This case reinforces the importance of understanding the “collapsible corporation” rules and the implications for real estate development ventures. It clarifies that a “view” to collapse can exist even if the specific timing is not entirely fixed and emphasizes the importance of the construction phase. The case serves as a warning to taxpayers and their advisors to carefully plan the timing of distributions and sales in relation to the completion of a project and the realization of income. It highlights that the source of gains is scrutinized to determine the proper tax treatment, especially when excess mortgage proceeds are involved.

    The decision has practical implications for: (1) Tax planning: Developers must understand how distributions and sales affect tax liability; (2) Business structuring: The form of entity (corporation, LLC, etc.) is important. (3) Legal analysis: Attorneys must evaluate the timing and source of gains in their cases, and analyze the net income expectation. The court cited multiple other cases which should also be evaluated.

  • August v. Commissioner, 30 T.C. 969 (1958): Collapsible Corporations and the Tax Treatment of Surplus Funds

    30 T.C. 969 (1958)

    A corporation can be considered a “collapsible corporation” if it’s formed or used to construct property with the intent to distribute funds to shareholders before realizing substantial income from the property, thus converting what would be capital gains into ordinary income for tax purposes.

    Summary

    The August case involved shareholders who owned all the stock in a corporation that built apartment houses. The corporation received construction loans exceeding construction costs, creating surplus funds. After construction was complete, the corporation distributed these surplus funds to the shareholders by redeeming a portion of their stock. The IRS argued that the corporation was a “collapsible corporation” under Section 117(m) of the Internal Revenue Code of 1939, meaning the shareholders’ gain from the stock redemption should be taxed as ordinary income, not capital gains. The Tax Court agreed, holding that the corporation was formed and availed of for construction with the intent to distribute the surplus funds, triggering the “collapsible corporation” rules, and that more than 70% of the gain realized by the petitioners was attributable to the constructed property, negating the application of the 70% rule exemption.

    Facts

    The petitioners were siblings who owned all the stock of the Camden Housing Corporation. Camden constructed apartment houses (Washington Park Apartments) financed by loans insured by the Federal Housing Administration (FHA). The construction loans exceeded construction costs, resulting in surplus funds. After construction was complete, the corporation distributed $205,000 to the shareholders in redemption of half their stock. The petitioners then used these funds to finance another project. The IRS determined that the corporation was a collapsible corporation.

    Procedural History

    The Commissioner of Internal Revenue determined deficiencies in the petitioners’ income tax for the taxable year 1950, arguing that the gains realized from the redemption of their stock in Camden were taxable as ordinary income. The petitioners challenged the deficiencies in the United States Tax Court. The Tax Court ruled in favor of the Commissioner.

    Issue(s)

    1. Whether Camden Housing Corporation was a “collapsible corporation” under Section 117(m)(2)(A) of the 1939 Internal Revenue Code?

    2. If so, whether more than 70% of the petitioners’ gain from the stock redemption was attributable to the constructed property, as per Section 117(m)(3)(B)?

    Holding

    1. Yes, because Camden was availed of for the construction of property with a view to the distribution of funds to its shareholders before realizing substantial income from that property.

    2. Yes, because more than 70% of the petitioners’ gain was attributable to the construction of the apartment houses.

    Court’s Reasoning

    The Court focused on whether the corporation was formed or availed of with the intent to distribute funds to shareholders before earning substantial income from the constructed property, as defined in Section 117(m)(2)(A). The Court found that the shareholders’ plan from the outset was to utilize any surplus mortgage funds as working capital for other enterprises, which was a key factor. The Court referenced the regulations, specifically that “if the distribution is attributable solely to circumstances which arose after the construction” the corporation will not be considered a collapsible corporation, unless those circumstances could have been anticipated at the time of construction. The court determined that the intent and circumstances surrounding the distribution of surplus funds, while not determinable until after the completion of construction, were anticipated as a recognized possibility from the outset. The Court also addressed the 70% limitation in Section 117(m)(3)(B), stating that all of the gain realized by the petitioners on the partial liquidation was attributable to the constructed property. The Court referenced the Burge case, where the gain realized by the shareholders was “gain attributable to the property constructed” and held in line with the logic from Glickman v. Commissioner.

    Practical Implications

    This case highlights the importance of considering the tax implications of construction projects, especially those involving government-insured loans. It emphasizes that the IRS will scrutinize distributions of surplus funds from construction projects to determine if they are attempts to convert ordinary income into capital gains through the use of a “collapsible corporation.” The case also indicates that a corporation can be considered “collapsible” even if the shareholders didn’t have a specific plan for distribution at the construction’s start, as long as the possibility of such a distribution was reasonably anticipated. This case is still relevant today, and serves as precedent for other similar cases. Corporate and tax attorneys need to carefully structure transactions and maintain documentation to avoid unintended tax consequences.