Commissioner v. Brown

380 U.S. 563 (1965)

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Nature of the Case

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Facts

In 1950, Congress passed laws to prohibit sales to charities involving long term lease transactions. The short-term lease of five years or less was not affected by this prohibition. The Commissioner in 1954 moved to close this loophole and stated that when an exempt organization purchased a business and leased it for five years to another corporation and would pay off the purchase price with rental income from the leaseback, the purchasing organization was in danger of losing its exemption. The rental income in effect would become taxable, and the charity would be unreasonably accumulating income, and the payments received would not be entitled to capital gains treatment. Clay Brown (P), members of his family and three others owned substantially all of the stock of Clay Brown & Company. They were approached by the California Institute for Cancer Research, and after considerable negotiations, they sold 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. With the transfer of the stock, the Institute would liquidate the company and lease its assets for five years to a new corporation wholly owned by the attorneys of the seller. That corporation would pay the Institute 80% of its operating profit without allowance for depreciation or taxes and 90% of those payments would be paid over to the sellers. The note was a noninterest-bearing and the only recourse was against the rental payments. If payments failed to total $250,000 over any two consecutive years, the sellers could declare the entire balance due and payable. The sellers were neither stockholders nor directors of the new corporation, but it was provided that P was to have a management contract with an annual salary and the right to name a successor manager if he resigned. The transaction closed in 1953 and P eventually resigned in 1954. In 1957, because of declining lumber prices, the corporation suffered severe reverses, and its operations were terminated. The sellers did not repossess the properties but agreed that they should be sold with the Institute retaining 10%. They were sold for $300,000. The total payments to the sellers totaled $936,131.85. Sellers (P) claimed the payments as the gain from the sale of assets. The Commissioner asserted that they were ordinary income. In Tax Court, the Commissioner claimed that the transaction was a sham and P retained such control and interest that the transaction could not be treated as a sale resulting in a long-term capital gain. The Tax Court found arm’s length and good faith bargaining. In the Appeals court, the Commissioner argued that the transaction did not have the substance of a sale within 1223(3). The Commissioner argued that the Institute invested nothing, assumed no liabilities and the entire risk of the transaction remained in P.