decided as amended january 31 1980.: January 28, 1980.
ON APPEAL FROM THE UNITED STATES TAX COURT
Before Gibbons and Higginbotham, Circuit Judges and Weiner, District Judge.*fn*
This case presents cross-appeals from decisions of the United States Tax Court upholding, in consolidated cases, a deficiency in federal income tax asserted for the taxable year 1970 against Stephan and Mildred Schaffan, a deficiency in accumulated earnings tax against Atlas Tool Co., Inc. (Atlas) for the fiscal years ending June 30, 1969 and 1970, and transferee liability of Atlas for conceded deficiencies in accumulated earnings taxes of Fletcher Plastics, Inc. (Fletcher) for the fiscal years ending November 30, 1968, 1969 and 1970.*fn1 Stephan Schaffan is the sole stockholder of Atlas, a New Jersey corporation still in existence, and of Fletcher, also a New Jersey corporation, which was dissolved in 1970. The deficiency assessed against the Schaffans involves the tax treatment of over $400,000 in cash distributed to Schaffan upon the dissolution of Fletcher. The Schaffans reported this distribution as a long-term capital gain but the Commissioner of Internal Revenue and the Tax Court treated it as a dividend, taxable as ordinary income. The individual taxpayers contend that the distribution from Fletcher qualified for capital gains treatment, while the Commissioner urges that the Tax Court erred in calculating the amount of the dividend, and that a higher tax is due. Atlas contends that the Tax Court erred in upholding the accumulated earnings tax assessed against it, and in imposing transferee liability on it for Fletcher's tax obligations. We affirm the Tax Court in all respects.
I. The Schaffan's Individual Tax Liability
In October 1970, Schaffan owned all the stock of Atlas and of Fletcher. Atlas was then engaged in the business of designing and selling products for the hobby industry, principally model railroads. Prior to 1960, Atlas also manufactured such products. In 1960, Fletcher was incorporated, acquired Atlas' plastic molding machines, and thereafter, conducted the manufacturing operations previously conducted by Atlas. Fletcher occupied one floor of a building, the balance of which was occupied by Atlas. Atlas was virtually the only customer of Fletcher.
During the 1960's, Atlas continually increased its purchase of foreign manufactured components, which were cheaper than those domestically manufactured. Eventually, Schaffan decided that the manufacturing operations being performed by Fletcher were no longer essential since the same quality components could be acquired at a lower cost from foreign sources. Accordingly, in October 1970, at the directors' and stockholders' meetings, it was voted that Fletcher liquidate in the manner permitted by section 337, 26 U.S.C. § 337 (1976).
On November 5, 1970, Fletcher transferred to Atlas all its machinery and equipment for an appraised price of $100,250, and all its inventory for its $14,600 cost. Fletcher's only accounts receivable were from Atlas, and these were paid in full. On November 19, 1970, Schaffan received from Fletcher a cash distribution of $482,246.82 which represented all of its remaining assets. Fletcher filed an appropriate Form 966 with the District Director of its intended section 337 liquidation, and filed final federal and state tax returns for the fiscal year ending November 30, 1970. Fletcher was formally dissolved in June 1971.
The machinery and equipment transferred to Atlas remained in place in the building otherwise occupied by Atlas. Fletcher's former employees were employed by Atlas, initially in its packing and shipping departments. The machinery and equipment, left in place, was idle for a time. However, by December 1970, Atlas began experiencing delivery and quality difficulties with its foreign suppliers, and to keep its inventory adequate, it soon started operating some of the Fletcher machines. By the end of 1971, all the machinery and equipment acquired from Fletcher were in operation.
On the Schaffan's 1970 federal income tax return they reported $400,000 as a distribution from Fletcher in complete liquidation under section 331, which provides that "(a)mounts distributed in complete liquidation of a corporation shall be treated as in full payment in exchange for stock." 26 U.S.C. § 331 (1976). They claimed an adjusted basis of $10,000 for the Fletcher stock, and paid tax on a long-term capital gain of.$390,000. In the notice of deficiency, the Commissioner asserted that the amount distributed to Schaffan was actually $482,246.82 (an amount not contested by the taxpayer) and that the transaction was not a section 331-337 liquidation, but a reorganization within the meaning of 26 U.S.C. § 368(a)(1)(D). Section 368(a)(1)(D) provides that:
a transfer by a corporation of all or a part of its assets to another corporation (is a reorganization) if immediately after the transfer the transferor, or one or more of its shareholders (including persons who were shareholders immediately before the transfer), or any combination thereof, is in control of the corporation to which the assets are transferred; but only if, in pursuance of the plan, stock or securities of the corporation to which the assets are transferred are distributed in a transaction which qualifies under section 354, 355, or 356; . . . .
26 U.S.C. § 368(a)(1)(D) (1976). Whether the transaction is characterized as a section 368(a)(1)(D) reorganization or a section 337 liquidation, there is still no gain or loss recognized to Fletcher on the transfer of its machinery and equipment to Atlas. But if the transaction was a reorganization, the distribution by Fletcher to Schaffan would be covered by the "boot" provision of section 356, 26 U.S.C. § 356 (1976), and thus be treated as ordinary income rather than as a capital gain pursuant to section 331, 26 U.S.C. § 331(a) (1976).
Section 356(a)(2) provides that money distributed to stockholders in a reorganization shall, to the extent of the stockholders' gain, be treated as a dividend out of earnings and profits of "the corporation." 26 U.S.C. § 356(a)(2) (1976). The Commissioner contends that when, as here, there is complete identity of shareholders in the two corporate parties to a D reorganization, the earnings and profits of both corporations should be taken into account to determine how much of the cash distributed by either is the equivalent of a dividend. The combined earnings and profits of Fletcher and Atlas exceeded $5 million, and thus the Commissioner proposes to treat the entire $482,246.82, less Schaffan's $10,000 basis for his Fletcher stock, as a section 356(a)(2) dividend.*fn2
The Tax Court held that the transaction was a D reorganization, and therefore section 356(a)(2) applied, but that the dividend treatment was authorized only to the extent of earnings and profits of Fletcher. It computed those earnings and profits as $440,342.56, and determined that the difference between that sum and $472,246.82 was taxable as a long-term capital gain. The Schaffans contend that the entire $472,262.82 was a long-term capital gain. The Commissioner contends it was all a section 356(a)(2) dividend.
We turn first to the Schaffan's contention. They point to the adoption by appropriate corporate resolution of a plan of complete liquidation of Fletcher within twelve months, to the accomplishment of both the disposition and distribution of Fletcher's assets within that time, and to Fletcher's dissolution. These events, they urge, were in full compliance with section 337, which provides for the nonrecognition of gain or loss on the sale of Fletcher's machinery and equipment to Atlas. Moreover, they argue that the distribution is "in complete liquidation" of Fletcher and should, therefore, "be treated as in full payment in exchange for (Fletcher) stock" pursuant to section 331, 26 U.S.C. § 331(a)(1) (1976). Taxpayers ...