Ivan Allen Co. v. United States
422 U.S. 617 (1975)

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U.S. Supreme Court

Ivan Allen Co. v. United States, 422 U.S. 617 (1975)

Ivan Allen Co. v. United States

No. 74-22

Argued April 115, 1975

Decided June 26, 1975

422 U.S. 617

CERTIORARI TO THE UNITED STATES COURT OF APPEALS

FOR THE FIFTH CIRCUIT

Syllabus

In determining the applicability of § 533(a) of the Internal Revenue Code of 1954 -- which provides a rebuttable presumption that a corporation that has accumulated earnings "beyond the reasonable needs of the business" did so with "the purpose to avoid the income tax with respect to shareholders" -- listed and readily marketable securities owned by the corporation and purchased out of its earnings and profits are to be taken into account not at their cost to the corporation, but at their net liquidation value. Pp. 422 U. S. 624-635.

493 F.2d 426, affirmed.

BLACKMUN, J., delivered the opinion of the Court, in which BURGER, C.J., and BRENNAN, WHITE, MARSHALL, and REHNQUIST, JJ., joined. POWELL, J., filed a dissenting opinion, in which DOUGLAS and STEWART, JJ., joined, post, p. 422 U. S. 635.

MR. JUSTICE BLACKMUN delivered the opinion of the Court.

Sections 531-537, inclusive, of the Internal Revenue Code of 1954, as amended, 26 U.S.C. §§ 531-537, constitute

Page 422 U. S. 618

Part I of subchapter G of the Income Tax Subtitle. These sections subject most corporations to an "accumulated earnings tax." Section 531 [Footnote 1] imposes the tax upon the "accumulated taxable income" of every corporation that, as § 532(a) states, [Footnote 2] is

"formed or availed of for the purpose of avoiding the income tax with respect to its shareholders . . . by permitting earnings and profits to accumulate instead of being divided or distributed."

And § 533(a) [Footnote 3] provides that

"the fact that the earnings and profits . . . are permitted to accumulate beyond the reasonable needs of the business shall be determinative of the purpose to avoid the income tax with respect to shareholders, unless the corporation

Page 422 U. S. 619

by the preponderance of the evidence shall prove to the contrary. [Footnote 4]"

The issue here is whether, in determining the application of § 533(a), listed and readily marketable securities owned by the corporation and purchased out of its earnings and profits are to be taken into account at their cost to the corporation or at their net liquidation value, that is, fair market value less the expenses of, and taxes resulting from, their conversion into cash.

I

The pertinent facts are admitted by the pleadings or are stipulated:

The petitioner, Ivan Allen Company (the taxpayer), is a Georgia corporation incorporated in 1902 and actively engaged in the business of selling office furniture, equipment, and supplies in the metropolitan Atlanta area. It files its federal income tax returns on the accrual basis and for the fiscal year ended June 30.

For its fiscal years 1965 and 1966, the taxpayer paid in due course the federal corporation income taxes shown on its returns as filed. Taxable income so reported was $341,045.82 for 1965 and $629,512.19 for 1966. App. 59, 84. During fiscal 1965, the taxpayer paid dividends consisting of cash in the amount of $48,945.30 and 870 shares

Page 422 U. S. 620

of Xerox Corporation common that had been carried on its books at a cost of $6,564.34. During fiscal 1966, the taxpayer paid cash dividends of $50,267.49; it also declared a 10% stock dividend. Id. at 56. The dividends paid were substantially less than taxable income less federal income taxes for those years.

Throughout fiscal 1965 and 1966, the taxpayer owned various listed and unlisted marketable securities. Prominent among these were listed shares of common stock and listed convertible debentures of Xerox Corporation that, in prior years, had been purchased out of earnings and profits. Specifically, on June 30, 1965, the corporation owned 11,140 shares of Xerox common, with a cost of $116,701 and a then fair market value of $1,573,525, and $30,600 Xerox convertible debentures, with a cost to it of $30,625 and a then fair market value of $48,424. On June 30, 1966, the corporation owned 10,090 shares of Xerox common, with a cost of $102,479 and a then fair market value of $2,479,617, and the same $30,600 convertible debentures, with their cost of $30,625 and a then fair market value of $69,768. Id. at 55.

According to its returns as filed, the taxpayer's undistributed earnings as of June 30, 1965, and June 30, 1966, were $2,200,184.77 and $2,360,146.52, respectively. Id. at 70, 91. The taxpayer points out that the marketable portfolio assets represented an investment, as measured by cost, of less than 7% of its undistributed earnings and of less than 55% of its total assets. Brief for Petitioner 4.

It is also apparent, however, that the Xerox debentures and common shares had proved to be an extraordinarily profitable investment, although, of course, because these securities continued to be retained, the gains thereon were unrealized for federal income tax purposes. The debentures had increased in fair market value more than 50% over cost by the end of June, 1965,

Page 422 U. S. 621

and more than 100% over cost one year later; the common shares had increased in fair market value more than 13 times their cost by June 30, 1965, and more than 24 times their cost by June 30, 1966.

Throughout fiscal 1965 and 1966, the taxpayer's two major shareholders, Ivan Allen Sr. . and Ivan Allen, Jr., respectively owned 31.20% and 45.46% of the taxpayer's outstanding voting stock. App. 78, 104.

Following an examination of the taxpayer's federal income tax returns for fiscal 1965 and 1966, the Commissioner of Internal Revenue determined that the taxpayer had permitted its earnings and profits for each of those years to accumulate beyond the reasonable and reasonably anticipated needs of its business, and that one of the purposes of the accumulation for each year was to avoid income tax with respect to its shareholders. Based upon this determination, the Commissioner assessed against the corporation accumulated earnings taxes of $77,383.98 and $73,131.87 for 1965 and 1966, respectively.

The taxpayer paid these taxes and thereafter timely filed claims for refund. The claims were not allowed, and the taxpayer then instituted this refund suit in the United States District Court for the Northern District of Georgia.

It is agreed that the taxpayer had reasonable business needs for operating capital amounting to $1,198,309 and $1,455,222 at the close of fiscal 1965 and fiscal 1966, respectively. Id. at 56. It is stipulated, in particular, that, if the taxpayer's marketable securities are to be taken into account at cost, its net liquid assets (current assets less current liabilities) at the end of each of those taxable years, and fully available for use in its business, were then exactly equal to its reasonable business needs for operating capital, that is the above-stated figures of $1,198,309 and $1,455,222. It would follow, accordingly,

Page 422 U. S. 622

that the earnings and profits of the two taxable years had not been permitted to accumulate beyond the taxpayer's reasonable and reasonably anticipated business needs within the meaning of § 533(a), App. 57, and no accumulated earnings taxes were incurred. It is still further stipulated, however, that, if the taxpayer's marketable securities are to be taken into account at fair market value (less the cost of converting them into cash), as of the ends of those fiscal years, [Footnote 5] the taxpayer's net liquid assets would then be $2,235,029 and $3,152,009, respectively. Id. at 56. From this, it would follow that the earnings and profits of the two taxable years had been permitted to accumulate beyond the taxpayer's reasonable and reasonably anticipated business needs. Then, if those accumulations had been for "the purpose of avoiding the income tax with respect to its shareholders," under § 532(a), accumulated earnings taxes would be incurred.

The issue, therefore, is clear and precise: whether, for purposes of applying § 533(a), the taxpayer's readily marketable securities should be taken into account at cost, as the taxpayer contends, or at net liquidation value, as the Government contends.

The District Court held that the taxpayer's readily marketable securities were to be taken into account at cost. Accordingly, it entered judgment for the petitioner taxpayer. 349 F.Supp. 1075 (1972). The court observed:

"Corporate taxpayers should not be penalized for

Page 422 U. S. 623

wise investments; they should be allowed to maximize their capital gains tax advantages in accordance with internal business policies and stock market conditions, rather than being forced to sell securities which may have a high value on an arbitrarily selected date merely because the unrealized fair market value of the securities on that date would trigger the accumulated earnings tax."

Id. at 1077. (Footnote omitted.)

The United States Court of Appeals for the Fifth Circuit reversed. 493 F.2d 426 (1974). It observed:

"[T]he securities involved in the case at bar are of such a highly liquid character as to be readily available for business needs that might arise. Thus, the appreciated value of these securities should be taken into account when determining whether the corporation has accumulated profits in excess of reasonable business needs."

"* * * *"

"This decision does not force the corporation to liquidate these securities at any time when a sale would be financially unwise, but only compels the corporation to comply with the proscriptions of the Code and refrain from accumulating excessive earnings and profits."

Id. at 428. The case was remanded, as the parties had agreed, App. 57-58,

"for the additional factual determination [under § 532(a)] of whether one purpose for the accumulation was to avoid income tax on behalf of the shareholders."

493 F.2d at 428.

Because this conclusion was claimed by the taxpayer to conflict in principle with American Trading & Production Corp. v. United States, 362 F.Supp. 801 (Md.1972), aff'd without published opinion, 474 F.2d 1341 (CA4

Page 422 U. S. 624

1973), [Footnote 6] and because of the importance of the issue in the administration of the accumulated earnings tax, we granted certiorari. 419 U.S. 1067 (1974).

II

Under our system of income taxation, corporate earnings are subject to tax at two levels. First, there is the tax imposed upon the income of the corporation. Second, when the corporation, by way of a dividend, distributes its earnings to its shareholders, the distribution is subject to the tax imposed upon the income of the shareholders. Because of the disparity between the corporate tax rates and the higher gradations of the rates on individuals, [Footnote 7] a corporation may be utilized to reduce significantly its shareholders' overall tax liability by accumulating earnings beyond the reasonable needs of the business. Without some method to force the distribution of unneeded corporate earnings, a controlling shareholder would be able to postpone the full impact of income taxes on his share of the corporation's earnings in excess of its needs. See B. Bittker & J. Eustice, Federal Income Taxation of Corporations and Shareholders

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