Rev. Rul. 60-331

Advice has been requested regarding the treatment for Federal income tax purposes of a `deficiency dividend' paid by a personal holding company under the circumstances described below.

A and his wife organized and were the sole stockholders of corporation M and corporation N . Both companies operated farm properties. In addition, corporation M received income from oil royalties and corporation N held a working interest in oil properties.

An examination was conducted, by an internal revenue agent, of the Federal income tax returns filed by corporation M for its taxable years 1956 and 1957. The examination resulted in a determination of liability for personal holding company tax under section 541 of the Internal Revenue Code of 1954, and the individual shareholders in their capacity as corporate officers were so informed on August 5, 1958. On August 13, 1958, the entire capital stock of corporation M was transferred by the individual stockholders to corporation N in exchange for stock of that company. An agreement to the proposed deficiency in tax liability was later secured from the taxpayer and an agreement on Form 2198, Determination of Liability For Personal Holding Company Tax, was executed on behalf of the taxpayer and for the Commissioner of Internal Revenue on August 20, 1958.

Section 547 of the Code provides, in part, that in the absence of fraud or willful failure to file an income tax return, a corporation may be relieved of the payment of a deficiency in personal holding company tax determined with respect to a taxable year by making a deficiency dividend distribution. Certain conditions, however, must be met. They are: (1) There must be a determination of liability for personal holding company tax under section 547(c) of the Code; (2) the deficiency dividend must be paid within 90 days after the date of determination; (3) a claim, Form 976, Credit For Deficiency Dividend Deduction, or Credit or Refund under section 547 of the Internal Revenue Code of 1954, must be filed after the deficiency dividend has been paid and within 120 days after the date of determination; and (4) the dividend must be of such a nature as would have permitted its inclusion in the computation of a dividends-paid deduction had it been distributed during the year for which the deficiency is determined. Also, see section 1.547-2 of the Income Tax Regulations.

Corporation M clearly fulfilled the conditions required by section 547 of the Code for relief of the payment of the deficiency in personal holding company tax liability. Personal holding company tax liability was established under the agreement, Form 2198, signed on behalf of the taxpayer and for the Commissioner on August 20, 1958. This constitutes the date of determination and the full amount of the deficiency dividend was distributed by corporation M to its corporate stockholder, corporation N , on September 10, 1958, within the 90-day period. A claim for the deficiency dividend deduction was filed on September 20, 1958, within the 120-day period. The dividend was of the character that would have been included in the computation of a dividends-paid deduction under section 561 of the Code had it been distributed during the years for which the deficiency was determined.

However, since the deficiency dividend was distributed to the present corporate shareholder rather than the original individual shareholders, substantially reducing the tax thereon due to the provisions of section 243(a) of the Code, which provides that a receiving corporation is allowed as a special deduction from gross income an amount equal to 85 percent of the amount received as dividends from domestic corporations, it becomes essential to carefully scrutinize the transaction between the corporation and its shareholders. In this case, the timing is significant. The controlling stockholders knew that the only way they could avoid the imposition of personal holding company tax was to declare a dividend. However, they wished to avoid the payment of individual income tax on such dividend. Therefore, before the deficiency dividends were paid, they transferred all of their stock in M to corporation N , which they also own, so that the dividend came, not directly to them but to the intervening corporate entity, N , which is entitled to a dividend received deduction under section 243 of the Code. There was no legitimate business purpose for such transfer other than the minimization of Federal income taxes.

The question in this case then is whether, under the facts as disclosed, the distribution to the corporate entity may be disregarded and the deficiency dividend, distributed by the personal holding company to avoid imposition of personal holding company tax, considered constructively received by the individual shareholders for Federal income tax purposes.

In the case of Evelyn F. Gregory v. Guy T. Helvering , 293 U.S. 465, Ct.D. 911, C.B. XIV-1, 193 (1935), it was contended on behalf of the taxpayer that since every element required by the statute involved was to be found in what was done, the tax result sought by the taxpayer had been effected, and that the motive of the taxpayer thereby to escape payment of a tax would not alter the result or make unlawful what the statute allowed. The Supreme Court of the United States pointed out that the whole undertaking, though conducted according to the terms of the statute, was in fact an elaborate and devious form of conveyance consummated solely for the purpose of tax avoidance. Accordingly, the Court ruled adversely to the taxpayer.

In a later case involving Joseph T. Higgins v. John Thomas Smith , 308 U.S. 473, Ct.D. 1434, C.B. 1940-1, 127, the Court stated that the United States Government may look at actualities in tax cases and, upon determination that the form employed for doing business or carrying out the challenged tax event is unreal or a sham, may sustain or disregard the effect of the fiction as best serves the purposes of the tax statute. To hold otherwise would permit schemes of taxpayers to supersede legislation in the determination of the time and manner of taxation.

Throughout the above-cited cases is an underlying theme that only bona fide business transactions having a legitimate business purpose in addition to the minimization of taxes will be recognized for tax purposes, and then only if the characterization the taxpayer places on the transactions is in reality what it purports to be in form. A transaction which has no purpose other than the avoidance or reduction of taxes, will be ignored for tax purposes.

In the instant case the motive for the transfer by the individual shareholders of their stock of corporation M in exchange for stock of corporation N was that of minimizing Federal income taxes. Accordingly, it is held that the deficiency dividend distributed by the personal holding company is to be treated as having been constructively received by A and his wife, rather than by corporation N , and is includible in their gross incomes under section 61 of the Code.