Before GOODRICH, KALODNER and STALEY, Circuit Judges.
This petition for review presents for our consideration another of the countless factual situations which give rise to the question of whether a certain redemption of stock constitutes a constructive dividend under Section 115(g) of the Internal Revenue Code of 1939.
David A. Ferro (hereinafter called "petitioner") and his wife, Elizabeth N.B. Ferro, duly filed a joint income tax return for 1950.*fn1 The Commissioner of Internal Revenue determined a deficiency of $7,692.18 in their return on the basis of the following facts:
Montgomery, Inc., a Pennsylvania corporation, operated a retail clothing store in Jenkintown, Pennsylvania. On November 27, 1933, the stockholders resolved to liquidate the corporation because of its financial difficulties, and adopted their original plan of liquidation. This plan failed to produce assets sufficient to meet the corporation's outstanding indebtedness. The principal stockholders of Montgomery, Inc., were petitioner Ferro, Edward H. Thaete, and Henry C. Gibson. The petitioner proposed an alternate plan to the other stockholders in order that the corporation might continue business. Pursuant to this plan, on March 14, 1934, all of the stockholders surrendered their common and preferred stock to the corporation, and petitioner Ferro purchased all of the common stock for $15,000. Thaete owned a sizable amount of stock and agreed to surrender it to the corporation only after petitioner Ferro signed the following agreement, dated March 15, 1934, contemplating a division of future profits:
"* * * I agree that all future profits accruing to me thru my interest in Montgomery, Inc., shall be shared with you on a fifty-fifty (50-50) basis, after debt of $15,000.00, incurred as of March 17, 1934, is paid and satisfied.
"[Signed] David A. Ferro."
Montgomery, Inc., eventually prospered, and as of June 1, 1949, aggregate dividends of $15,000 were paid to petitioner. It was at that point that Thaete initiated negotiations with the petitioner in an effort to settle his rights arising from the March 15, 1934, agreement. Thaete ultimately agreed to accept $20,000 from Ferro in full settlement of the contract. The following procedure for the payment of the $20,000 was adopted at the suggestion of petitioner's accountant in an endeavor to lessen the amount of income tax petitioner would be required to pay. It was agreed that 241 shares of stock had the value of $20,000. Ferro conveyed this number of shares to Thaete who executed to Ferro a release from the 1934 agreement. Thaete immediately indorsed the certificates over to the corporation, returned them to the petitioner, and received his payment from the corporation, partly cash and the remainder by promissory note. Throughout all of the time pertinent to this petition, the accumulated earnings and profits of the corporation were in excess of $20,000.
On the basis of the above transaction the Tax Court affirmed the Commissioner's determination that Ferro constructively received a "taxable dividend" within the purview of Section 115(g) of the Internal Revenue Code of 1939, which reads as follows:
"(g) Redemption of stock.
"(1) In general. If a corporation cancels or redeems its stock (whether or not such stock was issued as a stock dividend) at such time and in such manner as to make the distribution and cancellation or redemption in whole or in part essentially equivalent to the distribution of a taxable dividend, the amount so distributed in redemption or cancellation of the stock, to the extent that it represents a distribution of earnings or profits accumulated after February 28, 1913, shall be treated as a taxable dividend." 26 U.S.C. 1952 ed., § 115(g).
The Tax Court concluded that the payment of $20,000 by the corporation to Thaete in reality discharged an obligation of petitioner to Thaete in the same amount, and consequently petitioner received a distribution "essentially equivalent" to a taxable dividend.
The petitioner urges that two separate transactions occurred. First, Ferro transferred 241 shares of stock to Thaete for the release of his rights under the 1934 agreement; and second, Thaete sold the stock to the corporation for $20,000. Viewed in this light, it is ...