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HEMPT BROS. v. UNITED STATES

UNITED STATES DISTRICT COURT FOR THE MIDDLE DISTRICT OF PENNSYLVANIA


February 15, 1973

Hempt Bros., Inc., Plaintiff
v.
United States of America, Defendant

Sheridan, District Judge.

The opinion of the court was delivered by: SHERIDAN

Memorandum

SHERIDAN, District Judge:

 Plaintiff, Hempt Bros., Inc., seeks to recover income taxes alleged to have been improperly assessed and collected. Jurisdiction is asserted pursuant to 28 U.S.C.A. Section 1346(a) (1). The parties have filed a joint stipulation of facts, and plaintiff has moved for summary judgment. Briefs have been submitted and oral argument made with respect to plaintiff's motion. *fn1"

 From 1942 until February 28, 1957, a partnership comprised of plaintiff's shareholders was engaged in the business of quarrying and selling stone, sand, gravel and slag; manufacturing and selling ready-mix concrete and bituminous materials; constructing roads, highways and streets, principally for the Pennsylvania Department of Highways and various political subdivisions of Pennsylvania; and constructing driveways, parking lots, street and water lines, and related accessories. The partnership maintained its books and filed its partnership income tax return on a calendar-year basis pursuant to the cash method of accounting. Accordingly, it included neither uncollected receivables nor inventories in its calculation of taxable income, although both items existed to a substantial extent at the end of each year. *fn2"

 On March 1, 1957, the partnership's business and most of its assets were transferred to plaintiff solely in exchange for plaintiff's capital stock; neither gain nor loss was recognized upon the exchange. Int. Rev. Code of 1954, Section 351(a). Among the assets transferred were accounts receivable of $662,824.40 and inventories of $351,266.05.

 Subsequent to the transfer, Hempt Bros., Inc. continued the business formerly conducted by the partnership. It reported its income on a fiscal-year basis commencing the first day of March. For all relevant years, plaintiff maintained its books and reported its income in accordance with the cash method of accounting. Amounts due on accounts receivable transferred from its predecessor were collected by the corporation and reported as corporate income in the year of collection. Plaintiff performed no other services with respect to the receivables.

 As a result of an examination extending over a period of years, the Commissioner of Internal Revenue *fn3" determined that plaintiff's accounting method did not clearly reflect income. The corporation therefore was required to use the accrual method commencing with its first taxable year, *fn4" and adjustments were made to accrue unreported sales and to account for inventories in computing the cost of goods sold. Plaintiff's opening inventory for its first taxable year was valued at zero, and the result was an increase in taxable income for that year.

 Hempt Bros., Inc. filed timely refund claims with respect to each of its first three taxable years in which it contended, inter alia, that amounts collected on transferred accounts receivable should be excluded from its income because the partnership performed all the services upon which the right to collection depended, and that its initial opening inventory should be valued at not less than $351,266.05 in order to consistently account for beginning and ending inventory during its first taxable year. Each claim was disallowed in full, and plaintiff then instituted this action to recover alleged overpayments.

 With respect to the transferred accounts receivable, plaintiff argues that they are not " property" within the meaning of Section 351(a) and that the partnership therefore realized recognizable income at the time it exchanged them for plaintiff's stock; that the rule enunciated in Commissioner v. P.G. Lake, Inc. *fn5" requires attribution of ordinary income to the partnership at the time of the exchange; that the assignment-of-income doctrine requires its predecessor to recognize income as amounts are collected by plaintiff; that attribution of collections to plaintiff is improper because inconsistent with its accrual method of accounting; and that the individual partners should be responsible for the accounts receivable because the amount of plaintiff's stock which each partner received was allocated pursuant to proportional interests in the partnership's capital account rather than with reference to individual shares in transferred income items. These points will be discussed seriatim.

 The meaning of "property" is not defined by Section 351; however, known inclusions and exclusions suggest that the term encompasses whatever may be transferred, *fn6" including accounts receivable. Burke, Section 351: The Beginning of Life in Subchapter C, 1970, 24 Sw. L.J. 742, 747-48; see Bongiovanni v. Commissioner, 470 F.2d 921 (2 Cir., 1972); P. A. Birren & Son, Inc. v. Commissioner, 7 Cir. 1940, 116 F.2d 718; Peter Raich, 1966, 46 T.C. 604; Pittsfield Coal & Oil Company, Incorporated, 1966, T.C. Memo 4, 25 CCH Tax Ct. Mem. 11; Arthur L. Kniffen, 1962, 39 T.C. 553; Ezo Products Company, 1961, 37 T.C. 385; Thomas W. Briggs, 1956, T.C. Memo 86, 15 CCH Tax Ct. Mem. 440; Wobbers, Incorporated, 1932, 26 B.T.A. 322; Charles F. Meagher, 1930, 20 B.T.A. 68; cf. Halliburton v. Commissioner, 9 Cir. 1935, 78 F.2d 265, 268-70; American Bantam Car Company, 11 T.C. 397, 403, aff'd per curiam, 3 Cir. 1949, 177 F.2d 513, cert. denied, 1950, 339 U.S. 920, 70 S. Ct. 622, 94 L. Ed. 1344. But see Merchants Bank Bldg. Co. v. Helvering, 8 Cir. 1936, 84 F.2d 478, 481; Note, Section 351 of the Internal Revenue Code and "Mid-Stream" Incorporations, 1969, 38 U. Cin. L. Rev. 96, 106-07. There is a compelling reason to construe "property" to include potential income items: a new corporation needs working capital, and accounts receivable can be an important source of liquidity. Cf. Halliburton v. Commissioner, 9 Cir. 1935, 78 F.2d 265, 269-70; Bittker, The Corporation and the Federal Income Tax: Transfers to a Controlled Corporation, 1959 Wash. U.L.Q. 1, 7.

 Lake is not on point because it does not involve the issue of income recognition upon the exchange of an item of potential income for stock in a controlled corporation. H. B. Zachry Company, 1967, 49 T.C. 73, 79-80. As the legislative history of a predecessor to Section 351 *fn7" makes clear, *fn8" the purpose of the provision is to facilitate movement into the corporate form by preventing immediate recognition of gain or loss when there has been a mere change in the form of ownership. Helvering v. Cement Investors, Inc., 1942, 316 U.S. 527, 533, 86 L. Ed. 1649, 62 S. Ct. 1125; Bongiovanni v. Commissioner, 470 F.2d 921 (2 Cir. 1972); Estate of Walling v. Commissioner, 3 Cir. 1967, 373 F.2d 190, 194; Mather & Co. v. Commissioner, 3 Cir., 171 F.2d 864, cert. denied, 1949, 337 U.S. 907, 69 S. Ct. 1049, 93 L. Ed. 1719; Portland Oil Co. v. Commissioner, 1 Cir., 109 F.2d 479, 488, cert. denied, 1940, 310 U.S. 650, 60 S. Ct. 1100, 84 L. Ed. 1416. Therefore, when a cash-method taxpayer transfers accounts receivable to a controlled corporation solely in exchange for securities therein, the recognition of any gain realized upon the exchange is deferred. Arthur L. Kniffen, 1962, 39 T.C. 553; Charles F. Meagher, 1930, 20 B.T.A. 68. This best comports with the policy of Section 351. Dauber, Accounts Receivable in Section 351 Transactions, 1966, 52 A.B.A.J. 92; Hickman, Incorporation and Capitalization, 1962, 40 Taxes 974, 979; Riebesehl, Tax-Free Incorporations Under Section 351, 1968, 46 Taxes 360.

 However, the question of non-recognition upon the exchange itself is distinct from the issue whether the partnership or the corporation is taxable when collections upon transferred receivables are made. H. B. Zachry Company, 1967, 49 T.C. 73, 80 n. 5. Plaintiff contends that such amounts are properly attributable to its predecessor at the time of collection because the partnership performed all the services upon which the right to payment depends. *fn9"

  There is a tension which inheres in Section 351: although its animating concept is that of a mere change in form of ownership, the act of incorporation yields an entity distinct from its predecessor which may independently select many of its characteristics, e.g., its accounting period and its methods of accounting, depreciation and inventory valuation. White, Sleepers That Travel With Section 351 Transfers, 1970, 56 Va. L. Rev. 37. Therefore, it would be erroneous to assume that the assignment-of-income doctrine is necessarily inapplicable. Biblin, Assignments of Income in Connection with Incorporating and Liquidating Corporations, 1969, 21 U. So. Cal. Tax Inst. 383, 385-87. However, for reasons to be enumerated, the court holds that Hempt Bros., Inc. is properly taxable upon collections made with respect to accounts receivable which have been transferred to it in conjunction with the Section 351 incorporation of a going business by a cash-method partnership for a legitimate business purpose.

 The market value of the receivables notwithstanding, they had a basis of zero to the partnership because no collections were made prior to the transfer. Bongiovanni v. Commissioner, 470 F.2d 921 (2 Cir. 1972); P. A. Birren & Son, Inc. v. Commissioner, 7 Cir. 1940, 116 F.2d 718, 720; Peter Raich, 1966, 46 T.C. 604, 610; Note, Section 357(c) and the Cash Basis Taxpayer, 1967, 115 U. Pa. L. Rev. 1154, 1165. Since the exchange was solely for stock, plaintiff's carry-over basis was also zero. Int. Rev. Code of 1954, Section 362(a), as construed in, e.g., Ezo Products Company, 1961, 37 T.C. 385, 392-93. Upon collection, plaintiff realized income which it must recognize to the extent that the amounts received exceed basis. P. A. Birren & Son, Inc. v. Commissioner, 7 Cir. 1940, 116 F.2d 718, 720; Thomas W. Briggs, 1956, T.C. Memo 86, 15 CCH Tax Ct. Mem. 440; accord, Divine v. United States, W. D. Tenn. 1962, 62-2 U.S. Tax Cas. (CCH) P9632; Sohmer & Co., Inc. v. United States, S.D.N.Y. 1949, 86 F. Supp. 670, 671; Wobbers, Incorporated, 1932, 26 B.T.A. 322; see Pittsfield Coal & Oil Company, Incorporated, 1966, T.C. Memo 4, 25 CCH Tax Ct. Mem. 11.

 This result facilitates the basic policy of Section 351. *fn10" Arent, Reallocation of Income and Expenses in Connection with Formation and Liquidation of Corporations, 1962, 40 Taxes 995, 996; Biblin, supra, at 407; Burke, supra, at 795; Hickman, supra, at 977-83; White, supra, at 46; Worthy, IRS Chief Counsel Outlines What Lies Ahead for Professional Corporations, 1970, 32 J. Tax. 88, 90. But see Note, 38 U. Cin. L. Rev., supra, at 112-13. Moreover, it is especially apposite because the partnership operated a business in which expenses were paid and income was earned in the accounting period prior to that in which collections were made and income was realized. Under these circumstances, taxation to the partnership would deter incorporation by generating a significant amount of taxable income for which there might be no off-setting deductions: matching expenses of post-incorporation collections would already have been deducted, and expenses subsequent to incorporation would be deductible by the transferee. Weiss, Problems in the Tax-free Incorporation of a Business, 1966, 41 Indiana L. J. 666, 681 & n.65. In addition, it seems anomalous to require the partnership to account for income which it never received and to which it cannot gain access without the declaration of a taxable dividend. Biblin, supra, at 408; Burke, supra, at 795; Tritt and Spencer, Current Tax Problems in Incorporation of a Going Business, 1958, 10 U. So. Cal. Tax Inst. 71, 95.

 In support of its contention, plaintiff relies upon the persuasive force of the application of the assignment-of-income doctrine to transactions the tax consequences of which are regulated by Section 311, *fn11" Section 336 *fn12" and Section 337. *fn13" However, other analogies are more instructive, *fn14" especially those involving corporate reorganization. *fn15"

 It is also argued that taxation to the transferor will have no deleterious effect on incorporation because a rational taxpayer is unlikely to transfer items of potential income and expense to a controlled corporation in any event due to alleged uncertainty whether the Commissioner will seek to apply the assignment-of-income doctrine; whether transferred accounts payable will be deductible by the transferee upon payment; *fn16" and whether gain will be recognized upon the exchange itself to the extent that transferred liabilities exceed the adjusted basis of transferred assets. *fn17"

 This is without merit. In many cases, the withholding of accounts receivable would substantially impair corporate operations by making it difficult to meet working capital requirements. See Tritt and Spencer, supra, at 95; cf. Bittker, supra, at 7. Additionally, the policy of Section 351 reflects a realistic awareness that the incorporating entity is itself likely to perceive the transaction as a formal change which has little impact upon continuity of operation: the more natural inference is to simply assume the transfer of payables and receivables. However, a more basic problem is that plaintiff's predecessor did precisely that which is now asserted to be irrational. Assuming arguendo that there exist circumstances in which it makes sense to withhold income items from a controlled corporation, this hardly mandates reversing the tax consequences which naturally arise when they are in fact transferred. The partnership could have retained its receivables; having chosen to transfer them, Hempt Bros., Inc. may properly be required to accept the consequences of the exchange. Pittsfield Coal & Oil Company, Incorporated, 1966, T.C. Memo 4, 25 CCH Tax Ct. Mem. 11.

 The court does not suggest that the Commissioner is powerless to make adjustments when necessary to prevent income distortion or tax avoidance. Indeed, the assignment-of-income doctrine might itself apply to transactions motivated primarily by tax advantage. Arent, supra, at 1002. However, the role of the doctrine seems relatively modest in this context, primarily because other means are available to reach the same result, *fn18" e.g., the business-purpose doctrine *fn19" and the Commissioner's discretionary power to allocate items of income and expense among related taxpayers. Int. Rev. Code of 1954, Section 482, as construed in Estate of Walling v. Commissioner, 3 Cir. 1967, 373 F.2d 190; Rooney v. United States, 9 Cir. 1962, 305 F.2d 681; National Securities Corporation v. Commissioner, 3 Cir., 137 F.2d 600, cert. denied, 1943, 320 U.S. 794, 64 S. Ct. 262, 88 L. Ed. 479.

 Plaintiff's remaining arguments require only brief discussion. The decision of the Tax Court in E. Morris Cox20 is relied upon for the proposition that amounts collected on transferred receivables cannot be attributed to the corporation because to do so would be inconsistent with its accrual method of accounting, pursuant to which income is realized when earned rather than when collected. To the contrary, Cox involved an accrual-method transferor who realized income as billings were made; the court held that the corporation was not taxable upon items billed by its predecessor prior to the transfer. This is merely an application of the principle that the amount of gain realized by a Section 351 transferee is to be assessed with reference to the basis of its transferor. Since plaintiff's carry-over basis in the receivables was zero, it realized income to the full extent collections were made. See, e.g., P. A. Birren & Son, Inc. v. Commissioner, 7 Cir. 1940, 116 F.2d 718.

 Furthermore, the parties agree that the Commissioner properly required the corporation to change its method of accounting in order to clearly reflect income. Int. Rev. Code of 1954, Section 446(b). Permissible alternatives include a hybrid method which contains cash and accrual elements. Int. Rev. Code of 1954, Section 446(c) (4); H. Rep. No. 1337, 83rd Cong., 2d Sess. A158 (1954); S. Rep. No. 1622, 83rd Cong., 2d Sess. 300 (1954). The only requirements are that the method be used consistently and that it properly match items of income and expense. See Treas. Reg. Sections 1.446-1(c) (1) (iv) (a) (1957) and 1.446-1(c) (2) (ii) (1957). In effect, Hempt Bros., Inc. has been placed on the accrual method with respect to income earned subsequent to March 1, 1957, and on the cash method for items transferred from the partnership. The Commissioner's decision will be set aside only when it constitutes an abuse of discretion, *fn21" and there is no abuse when a Section 351 transferee is required to accrue post-transfer items of income and expense while reporting as income amounts collected on accounts receivable acquired from its cash-method predecessor. See Ezo Products Company, 1961, 37 T.C. 385; cf. Pittsfield Coal & Oil Company, Incorporated, 1966, T.C. Memo 4, 25 CCH Tax Ct. Mem. 11.

 Finally, it is asserted that the receivables are taxable to the individual partners because the stock which each received upon the exchange was allocated in proportion to respective interests in the partnership capital account rather than with reference to shares in transferred income items. Specifically, each partner was taxable upon twenty-five percent of partnership income, whereas individual interests in the partnership capital account and in plaintiff's stock were apportioned differently. The only authority cited in support of this position is Turnbull, Inc. v. Commissioner, *fn22" in which it was held that the transfer of accounts receivable among related corporations for inadequate consideration in order to utilize the transferee's large net operating loss carry-overs was a transparent tax-avoidance scheme which required attribution of income to the nominal seller. Even assuming that adequacy of consideration were to be evaluated relative to proportional shares in partnership income, the facts before the court do not resemble those in Turnbull, and plaintiff's argument is rejected.

 The corporation's second major contention is that it is entitled to an opening inventory of not less than $351,266.05 for its first taxable year because the value of the stock issued in exchange for partnership property reflected the cost of transferred inventory, constituting to its predecessor the recovery of a previously-expensed item the basis of which must be restored to cost. *fn23" However, since this ground for recovery was not presented in the corporation's claim for refund, the court lacks jurisdiction to entertain it.

 Filing of a timely refund claim is a prerequisite to the maintenance of an action to recover taxes alleged to have been improperly assessed or collected. Int. Rev. Code of 1954, Section 7422(a). It must set forth in detail each ground upon which a credit or refund is claimed and facts sufficient to apprise the Commissioner of the exact basis thereof. Treas. Reg. Section 301.6402-2(b) (1) (1954). A corollary of the enumerated principles is that a court lacks jurisdiction of an action to recover taxes except upon grounds reasonably encompassed by the claim for refund as originally filed or properly amended; *fn24" the purpose of this rule is to facilitate administrative determination of claims and to limit litigation to issues which the Commissioner has considered and is prepared to defend. Austin v. United States, 10 Cir. 1972, 461 F.2d 733; Herrington v. United States, 10 Cir. 1969, 416 F.2d 1029; Thompson v. United States, 5 Cir. 1964, 332 F.2d 657; Carmack v. Scofield, 5 Cir. 1953, 201 F.2d 360; Tompkins v. United States, Ct. Cl. 1972, 198 Ct. Cl. 814, 461 F.2d 1304; Union Pacific Railroad Company v. United States, 1968, 389 F.2d 437, 182 Ct. Cl. 103.

 Plaintiff does not argue that its tax-benefit theory of recovery was presented to the Commissioner. *fn25" Instead, this is asserted to be irrelevant since the Commissioner is alleged to have been apprised of all the operative facts upon which the new theory depends and since, in any event, the refund claim is not intended to be a legal brief in which the taxpayer is required to elaborate all theories upon which the claim is based.

 To the contrary, the Commissioner is required to examine only those points to which his attention is necessarily directed, *fn26" and this is especially apposite here because the corporation's amended claim sets forth specific reasons in support of its inventory argument the natural effect of which is to induce the Commissioner to pursue quite a different line of inquiry than is relevant to the theory upon which plaintiff presently seeks to rely. Tompkins v. United States, Ct. Cl. 1972, 198 Ct. Cl. 814, 461 F.2d 1304, 1314-15 (Dissenting Opinion). Similarly, it is immaterial that facts which might support recovery pursuant to the tax-benefit theory were before the Commissioner when he reviewed the corporation's claim. The mere availability of information is not equivalent to notice that a specific claim based thereon is being made because the Internal Revenue Service cannot be expected to discover every claim which a taxpayer might conceivably assert. Herrington v. United States, 10 Cir. 1969, 416 F.2d 1029; Nemours Corp. v. United States, 3 Cir. 1951, 188 F.2d 745; Pelham Hall Co. v. Carney, 1 Cir. 1940, 111 F.2d 944; Commercial Solvents Corporation v. United States, Ct. Cl., 192 Ct. Cl. 339, 427 F.2d 749, cert. denied, 1970, 400 U.S. 943, 91 S. Ct. 242, 27 L. Ed. 2d 247; Union Pacific Railroad Company v. United States, Ct. Cl. 1968, 182 Ct. Cl. 103, 389 F.2d 437.

 For the reasons given, plaintiff's motion will be denied, and summary judgment will be entered for defendant.


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