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Midland-ross Corporation, Transferee of Surface Combustioncorporation, Plaintiff-appellant, v. United States of America, Defendant-appellee
United States Court of Appeals, Sixth Circuit. - 485 F.2d 110
Argued June 7, 1973.Decided Sept. 27, 1973
Henry C. Harvey, Cleveland, Ohio, for plaintiff-appellant; Bruce J. Havig-hurst, Jones, Day, Cockley & Reavis, Cleveland, Ohio, on brief.
Ernest J. Brown, Dept. of Justice, Washington, D.C., for defendant-appellee; Scott P. Crampton, Asst. Atty. Gen., Meyer Rothwacks, Attys., Tax Div. Dept., of Justice, Washington, D.C., on brief.
Before CELEBREZZE and McCREE, Circuit Judges, and MOYNAHAN,* District Judge.
CELEBREZZE, Circuit Judge.
This is an appeal from the District Court's final judgment for the Government in a suit under 28 U.S.C. Sec. 1346(a) (1) by Midland-Ross Corporation (Midland) seeking a refund of income taxes paid by Midland as transferee of Surface Combustion Corporation (including the latter's tax liabilities) for Surface's fiscal year ended March 31, 1960.
In its complaint Midland sought a refund of $113,029 plus interest paid by Midland after the Commissioner disallowed certain depreciation deductions claimed by Surface for the above tax year. The Government's answer asserted, inter alia, an affirmative defense of set off in the form of a tax liability on Surface's gross profits for work in process of $1,344,191, for which profits Midland claimed nonrecognition under 26 U.S.C. Sec. 337.1 Prior to trial, the Government conceded that the disallowance of depreciation was erroneous. Because the tax liability asserted in the Government's affirmative defense would be greater than the refund to which Midland was otherwise entitled, the sole issue before the District Court was whether the above profits fell within the nonrecognition provisions of 26 U.S.C. Sec. 337.
For several years preceding the tax year in question, Surface's principal business was the design, manufacture, and installation of heat treat equipment under contracts with various customers in the metal and glass industries. Full performance of each contract frequently required a period in excess of one year, and the contracts usually called for progress payments as Surface's work proceeded. Under the completed-contract method of accounting, 26 C.F.R. Sec. 1.451-3(b) (2), Surface consistently reported gross income from each of these contracts only in the year in which the contract was completed and accepted and similarly deducted costs and expenses allocable to each contract in said year of completion.
Having adopted a plan of complete liquidation, Surface sold substantially all of its properties and assets to Midland on November 9, 1959, with Midland assuming all the debts and liabilities of Surface, including liabilities for federal income taxes. Within 12 months after adoption of its plan of liquidation, Surface distributed the proceeds of this sale to its shareholders in cancellation and redemption of its stock.
Among the assets sold to Midland were certain uncompleted, but partially performed, long-term contracts between Surface and its customers for the design, manufacture, and installation of heat treat equipment, as described above. Prior to the date of sale, Surface had incurred accumulated costs and expenses totalling $5,357,010 in partially performing these contracts. Based on Surface's past business experiences under such contracts, it was estimated that $1,344,191 represented the portion of the total expected profits which Surface had earned through its partial performance. By adding these two amounts (costs and expenses plus estimated partial profits), the parties arrived at a fair market value of $6,701,200 for the uncompleted, long-term contracts. This fair market value-less the amount of progress payments received by Surface prior to the sale-was recorded by Midland as a portion of the total purchase price allocable to the uncompleted, long term contracts.2
Pursuant to its completed-contract method of accounting, Surface had neither taken income tax deductions for the accumulated costs and expenses incurred prior to the sale of the uncompleted, long-term contracts, nor had it reported any gross income from those contracts. Moreover, in its income tax return for its fiscal year ended March 31, 1960, which covered the November 9, 1959, sale to Midland, Surface reported no gross income from the sale of these contracts to Midland.
In its affirmative defense of set off against Midland's suit for refund, the Government asserted that Surface erroneously failed to report as ordinary income the above-described $1,344,191 in profits arising from its sale of the uncompleted, long-term contracts to Midland. Midland, on the other hand, contends that these profits were entitled to nonrecognition as gain from the sale of property in complete liquidation under 26 U.S.C. Sec. 337, the pertinent provisions of which are set forth in the margin.3
This tax liability was asserted solely by means of the Government's affirmative defense of set off in the present suit, rather than by direct assessment, in that the statute of limitations, 26 U.S.C. Sec. 6501, for further assessments had run when the complaint was filed. See generally Lewis v. Reynolds, 284 U.S. 281, 52 S.Ct. 145, 76 L. Ed. 293 (1932); Springfield Street Ry. Co. v. United States, 312 F.2d 754, 758, 160 Ct. Cl. 111 (1963)
The fair market value of the uncompleted, long-term contracts was actually added to what was apparently deemed the fair market value of certain uncompleted, short-term contracts (the gain from which has not been raised as an issue in this case), and the sum of these values was then reduced by the total amount of progress payments received by Surface on both types of uncompleted contracts prior to the sale, yielding an actual cash payment by Midland of $122,939.34 for both the long-term and the short-term uncompleted contracts, as follows:
Assets Allocated Amount
---------------------------------------------- ----------------
-------------------------------------------------------------------------------
Contracts in Process
Long Term $6,701,201.00
Short Term 816,875.00
-------------
$7,518,076.00
Less: Progress billings on contracts in 7,395,136.66 $122,939.34
process
-------------------------------------------------------------------------------
Sec. 337. Gain or loss on sales or exchanges in connection with certain liquidations
(a) General rule.-If-
(1) a corporation adopts a plan of complete liquidation on or after June 22, 1954, and
(2) within the 12-month period beginning on the date of the adoption of such plan, all of the assets of the corporation are distributed in complete liquidation, less assets retained to meet claims,
then no gain or loss shall be recognized to such corporation from the sale or exchange by it of property within such 12-month period.
(b) Property defined.-
(1) In general.-For purposes of subsection (a), the term "property" does not include-
(A) stock in trade of the corporation, or other property of a kind which would properly be included in the inventory of the corporation if on hand at the close of the taxable year, and property held by the corporation primarily for sale to customers in the ordinary course of its trade or business,
(B) installment obligations acquired in respect of the sale or exchange (without regard to whether such sale or exchange occurred before, on, or after the date of the adoption of the plan referred to in subsection (a)) of stock in trade or other property described in subparagraph (A) of this paragraph, and
(C) installment obligations acquired in respect of property (other than property described in subparagraph (A)) sold or exchanged before the date of the adoption of such plan of liquidation.
(2) Nonrecognition with respect to inventory in certain cases.-Notwithstanding paragraph (1) of this subsection, if substantially all of the property described in subparagraph (A) of such paragraph (1) which is attributable to a trade or business of the corporation is, in accordance with this section, sold or exchanged to one person in one transaction, then for purposes of subsection (a) the term "property" includes-
(A) such property so sold or exchanged, and
(B) installment obligations acquired in respect of such sale or exchange.
In this argument, which was not presented to the District Court, the Government analogizes the progress payments received and retained by Surface under the uncompleted contracts (see note 2, supra.) with the unearned premiums released to the Old Buckeye Companies as a result of the reinsurance agreement. As should be evident from subsequent portions of this opinion, the fact that Surface received substantial progress payments under the contracts at issue is irrelevant in our considerations under Section 337
But see Anders v. United States, 462 F.2d 1147, 1149 (Ct.Cl.), cert. denied, 409 U.S. 1064, 93 S.Ct. 557, 34 L.Ed.2d 517 (1972) (gain on the sale of previously expensed rental items "was not realized from the 'sale,' but rather from reconverting the previously expensed items into 'property"'); Central Building & Loan Ass'n, 34 T.C. 447, 451 (1960) (accrued interest realized on the sale of note obligations did not arise from the sale, but rather constituted "receipt and collection" of the interest; see note 6, infra)
Attempting to adhere to the express exclusions found in Section 337(b) and the Regulations thereunder [Treas.Reg. Sec. 1.337-3(a) (1955) (discussed above)], the Tax Court has averted the above results by holding that accounts receivable constitute "installment obligations" under subsection 337(b) (1), Family Record Plan, Inc., 36 T. C. 305 (1961), aff'd on other grounds, 309 F.2d 208 (9th Cir. 1962), cert. denied, 373 U.S. 910, 83 S.Ct. 1297, 10 L.Ed.2d 411 (1963); Sarah G. Wimp, 20 CCH Tax Ct. Mem., Dec. 25,187(M) (1961), and that the realization of accrued interest upon note obligations which were sold by a corporation pursuant to Section 337 are outside the nonrecognition provisions of the statute because the gain arose not from the sale or exchange of the notes, but rather from what the Tax Court termed the "receipt and collection of interest" from the purchaser. Central Building & Loan Association, 34 T. C. 447, 451 (1960). See also Coast Coil Co., 50 T.C. 528 (1968), aff'd, 422 F.2d 402 (9th Cir. 1970) (holding that the liquidating corporation could recognize a loss incurred in the sale of accounts receivable, which were deemed to be "installment obligations" as in Family Record Plan, Inc., supra)
Both types of property described in the text are excluded from the definition of a capital asset under Section 1221, and neither is afforded capital asset treatment under Section 1231
While the District Court's rule expands the scope of Section 337 beyond the strict Section 337-1221 analogy and thereby would result in a greater parity between Sections 336 and 337, we believe that the analogy itself, in which the rule has its basis, is erroneous
Presumably, had it so chosen, Congress could have incorporated under Section 337(b) (1) the full definition of a capital asset appearing in Section 1221, so as to expressly exclude from the former depreciable and real property used in the trade or business, copyrights, etc., accounts and notes receivable, and discounted government obligations, as described in subsections (2) through (5) of the latter. The rationale cited in the text, however, would suggest that Congress left this simple task of transcription to the Courts
Section 336 simply provides as follows:
"Except as provided in section 453(d) (relating to disposition of installment obligations), no gain or loss shall be recognized to a corporation on the distribution of property in partial or complete liquidation."
As noted throughout this opinion, a corporation may be required to recognize gain on the distribution of assets in kind, notwithstanding the above provision. Such recognition, however, is generally governed by the overriding assignment of income doctrine rather than by the capital or noncapital nature of the property distributed. While that doctrine is most frequently applied where ordinary-income-producing assets are distributed, it is not so restricted. See Wood Harmon Corp. v. United States, 311 F.2d 918, 921-926 (2d Cir. 1963).
Rather than borrowing the language of subsection 1221(1), the unsuccessful House version of what later became Section 337 expressly provided that its nonrecognition provisions did not apply to "a sale in the ordinary course of business". H.Rep.No.1337, 83d Cong., 2d Sess.; [1954] 3 U.S.Code Cong. & Adm.News at 4244. See also Frank W. Verito, 43 T.C. 429, 438 (1965). The Senate Report on the present version of Section 337 simply notes the following with respect to the unsuccessful House version:
"While the purpose intended to be served by section 337 is similar to that provided in section 333 of the House bill, the language and approach of section 337 differs from that of section 333." S.Rep.No.1622, 83d Cong., 2d Sess.; [1954] 3 U.S.Code Cong. & Adm.News at 4896.
See also Hollywood Baseball Ass'n v. Commissioner, 423 F.2d 494, 500 (9th Cir.), cert. denied, 400 U.S. 848, 91 S.Ct. 35, 27 L.Ed.2d 85 (1970).
It seems open to question whether the assignment of income doctrine as applied under Section 336, would require a corporation to recognize gain when inventory or property held primarily for sale is sold by its shareholders after a distribution in kind. Cf. United States v. Lynch, 192 F.2d 718 (9 Cir. 1951), cert. denied, 343 U.S. 934, 72 S.Ct. 770, 96 L.Ed. 1342 (1952). If, however, such recognition would otherwise be required, it seemingly could not be avoided by the shareholders' bulk sale of that property to a single purchaser
The nonrecognition of losses under Section 337 presents a special problem for any efforts to achieve a parity between Sections 336 and 337. See B. Bittker & J. Eustice, supra, para. 11.65, at 11-69 n. 124. It is interesting to note that the House version of what became Section 337 provided only for the nonrecognition of gains. See H.Rep.No. 1337, 83d Cong., 2d Sess.; [1954] 3 U.S. Code Cong. & Adm.News at 4244. See also Frank W. Verito, 43 T.C. 429, 438 (1965). For purposes of the present case, it is sufficient to note that the approach which we adopt creates no greater disparity in the context of sales at a loss than do the approaches based on the Section 337-1221 analogy
The decisions in Kuckenberg, Family Record Plan, Inc., and Williamson, cited in the text, rested upon the Commissioner's authority under 26 U.S.C. Sec. 446(b) to impose upon a taxpayer a method of accounting which clearly reflects income, in addition to the assignment of income doctrine. See also Jud Plumbing & Heating, Inc. v. Commissioner, 153 F.2d 681 (5th Cir. 1946) (allocating to a liquidated corporation its prorata portion of profits under uncompleted contracts, notwithstanding the corporation's completed-contract method of accounting)
While in its answer to the present suit the Government asserted that Surface's profits at issue here were "based upon the percentage of completion of work in process", it has at no time expressly invoked the Commissioner's authority under Section 446(b). We find, however, no authority suggesting that the invocation of Section 446(b) is a prerequisite to judicial application of the assignment of income doctrine.
In addition to the three completed contracts which were sold by the corporation pursuant to a Section 337 plan of liquidation, the Kuckenberg case also involved one uncompleted contract which was distributed to the shareholders and completed by them. Again relying upon the Comissioner's authority under Section 446(b) and, presumably, the assignment of income doctrine, the Court of Appeals upheld the Commissioner's imposition of a corporate tax under the percentage of completion method of accounting. See 309 F.2d at 207