Braunstein v. Commissioner

PETITIONER:Braunstein
RESPONDENT:Commissioner
LOCATION:Clauson’s Inn

DOCKET NO.: 476
DECIDED BY: Warren Court (1962-1965)
LOWER COURT: United States Court of Appeals for the Second Circuit

CITATION: 374 US 65 (1963)
ARGUED: Apr 29, 1963
DECIDED: Jun 10, 1963

Facts of the case

Question

Audio Transcription for Oral Argument – April 29, 1963 in Braunstein v. Commissioner

Earl Warren:

[Inaudible]

Louis Eisenstein:

Mr. Chief Justice, may it please the Court.

This case is an income tax case, which is here on a writ of certiorari to the Court of Appeals for the Second Circuit.

There are three tax payers involved and the taxable year is 1950.

The asserted deficiencies come to about $500,000.

The resolution of the dispute before the Court turns on the meaning and application of Section 117(m) of the Internal Revenue Code of 1939.

Section 117(m) deals with tax avoidance through so called collapsible corporations.

This avoidance consists of realizing the everyday ordinary income from property as a capital gain through the device of incorporation and a disposition of stock.

In other words, the device is designed to take unfair advantage, as President Truman put it, of the difference between the ordinary income tax rates and the capital gain rate.

I will now briefly summarize the relevant facts, which I gather are not in dispute, and then I will turn to the statute.

The three tax payers are Benjamin Braunstein, Benjamin Neisloss, and Harry Neisloss.

For many years starting in 1919, the Neisloss’s and then the Neisloss’s and Braunstein were engaged in holding and managing investments in real estate.

In the 1920’s, the Neisloss’s through corporation acquired an improved commercial properties, and they also purchased parcels of land for development.

Then between 1930 and 1948, the Neisloss’s and then the Neisloss’s and Braunstein built, held, and operated multiple dwelling apartments and commercial properties all through corporations.

In every case, the stock as well as the underlying property was held as a long-term investment.

In a number of instances the holdings were retained for as long as nine, ten, and 15 years.

Five of the projects were multiple dwelling developments financed under Section 608 of the National Housing Act.

Now this case involves another FHA rental development.

In March 1948, the taxpayers organized two corporations to build and operate a development known as Oakland Gardens.

Each taxpayer owned a third of the common stock in each corporation.

Construction started in April, 1948 and the buildings were completed and ready for occupancy between September 1948 and June 1949.

In May 1950, the taxpayers were approached by brokers on behalf of certain prospective purchasers.

In June 1950, the taxpayers agreed to sell their stock and the sale was eventually consummated through a sale of stock in November 1950.

After the sale, the taxpayers remained active in the construction and operation of rental properties held as long-term investments.

They continued to own and operate four FHA developments, which had been built before Oakland Gardens.

They built a shopping center, a number of stores, and a large apartment house, and they also remodeled apartments all as a source of rental income.

They have never held rental property for sale to customers in the ordinary course of business.

It is clear, if they had owned the development as individuals their profit on its disposition would have clearly been a capital gain and it is equally clear that the corporations did not hold the development for sale.

Potter Stewart:

The Government agree with you on both of those, you mentioned?

Louis Eisenstein:

We notice that in its brief in the Supreme Court the government has suggested that if we are right on the main issues then case should be remanded and I would gather that they mean a remanding with respect to this point.

Louis Eisenstein:

But the Court of Appeals below very clearly assumed that the taxpayers would have been entitled to capital gain treatment if they had held the development as individuals.

As a matter of fact, the whole opinion otherwise is an academic exercise.

In short, the incorporation of the enterprise and the sale of stock did not enable the taxpayers to convert ordinary income into capital gain.

Each tax payer reported his profit on the sale as a long-term capital gain.

The commissioner determined that the profit was taxable as ordinary income under Section 117(m). Judge Kern, the trial judge dissented, I regret to say that the Court of Appeals affirmed the judgment of the tax court.

[Inaudible]

Louis Eisenstein:

They had only paid capital gains tax and the government has never questioned the payment.

There has been no assertion of deficiency with respect to the other developments.

[Inaudible]

Louis Eisenstein:

Well, I think there are two explanations that can be given and I’m — there is nothing in the record.

One explanation is that the government regarded them as bona fide capital gain dispositions.

Secondly, 117(m) does not apply if the sale of stock occurs more than three years after construction is completed, and it maybe that in some of the other developments that is why the government did not pursue its present tax.

This Court granted certiorari limited to the question whether Section 117(m) applies where the stockholders would have been entitled to capital gain treatment if they had conducted the enterprise as individuals instead of through a corporation and I should add that the question is so limited is the question as it was precisely phrased by the government for the consideration of this court.

The Fifth Circuit has resolved the same question in favor of the taxpayer in the Ivey case, in an opinion by Judge Wisdom concurred in by Judges Reeves and Cameron.

On the petition for certiorari, the Commissioner agreed that there is no essential difference between this case and the Ivey case that the two cases are squarely in conflict.

I now turn to the statute, Section 117(m) which the Commissioner would apply here.

This Statute is a segment of a comprehensive legislative scheme on capital gains.

It creates a special exception to the general long settled rule that a sale of stock is a conversion of a capital asset subject to the distinctive treatment of capital gains.

It provides that profit realized on a sale or exchange of stock in a collapsible corporation is taxable as ordinary income rather than capital gain.

A collapsible corporation is a very special kind of entity defined in paragraph two of the statute.

It is a corporation formed or availed off principally for the construction of property with a view to achieving two particular objectives.

The first result that must be intended is the shareholders sale or exchange of stock in the corporation before the corporation itself realizes a substantial part of the net income to be derived from the property.

The second result that must be intended is the shareholders realization now, “gain attributable to such property.”

The question in this case comes down to this.

A collapsible corporation is a corporation used principally for constructing property with a view to the shareholder’s realization of gain attributable to such property before the corporation itself realizes a substantial part of the net income to be derived from the property.

Was the profit realized by the taxpayers on the sale of their stock gain attributable to such property within the meaning of the statute?

It is our position that the profit realized here was not the gain contemplated by the statute.

We contend that gain attributable to the property within the meaning of the statute is gain which would be ordinary income from the property if the stockholders as individuals or the corporations had realized it in a normal course of business.

Here the profit would have clearly been a capital gain, not ordinary income, if the taxpayers had directly owned and sold the development or if the corporation itself had sold it.

There was no conversion of ordinary income here to incorporation and a sale of stock.

Louis Eisenstein:

Now the Court of Appeals fully agreed with us in that there was no such avoidance here.

However, it then went on to hold that the critical language, “gain attributable to such property” means any kind of profit regardless of the nature of the profit and its relation to the enterprise.

This interpretation is directly contrary to the purpose of Congress as fully illuminated and spelled out by the legislative history.

In fact, the Court of Appeals frankly indicated that its conclusion is not in accord with the stated purpose and policy of Congress.

As the legislative history plainly shows, this statute is solely concerned with profit which is a conversion of ordinary income from the property into capital gain through the deliberate use of a corporation of that purpose.

[Inaudible]

Louis Eisenstein:

The movie situation was one and as a matter of fact, the construction industry was another and I’m about to come to that.

I have indicated that the statute is solely concerned with gain which is a conversion of ordinary income.

That is why the definition of a collapsible corporation is specifically geared to whether or not the corporation itself has realized a substantial part of the net income from the property before the sale of the stock, and that is why the definition is also geared to the specific purpose or motive which prompted the stockholders to construct the property.

As the expensive legislative history shows, before 1950, various taxpayers in the movie industry and the construction industry were converting ordinary income into capital gain through the calculated abuse of the corporate forum.

For example, if motion picture producer made a movie as an individual and rented the picture under the usual arrangement, his rental income was taxable as ordinary income.

If he did the same through a corporation, the rental income was also taxable as ordinary income.

In order to avoid such unpleasant results, a producer would setup a corporation to make a film.

Upon completing the film, he would liquidate the corporation and distribute the film to himself.

He would report the difference between the cost of his stock and the value of the film as a long-term capital gain.

He would then license the film as the corporation would have done and amortize the reported value of the film against the rental income.

In this way, the usual ordinary income from the property, that is the rental income, was converted into capital gain.

The same kind of practice developed in the construction industry where houses were built for sale to customers in the ordinary course of business.

If a builder constructed and sold the houses himself, the profit on the sale was ordinary income.

If he made the sale through a corporation, the profit was also ordinary income.

Builders would convert this ordinary income into capital gain in one of two ways; they would sell the stock in the corporation or they would liquidate the corporation, report a capital gain based on the difference between the cost of their stock and the value of the houses and then sell the houses at the same price.

In either case, the content of the gain was profit normally realized as ordinary income.

Congress enacted Section 117(m) to tax all such converted income from the constructed property in terms of its true economic content as ordinary income.

The gain attributable to the property with which the statute is concerned is such converted ordinary income.

That is why the statute treats the corporation as a mere contrivance to avoid tax, and that is why it treats the stockholder’s profit as the ordinary income it essentially is.

The tax payer in this way is prevented from avoiding the tax that he should otherwise pay and rightfully pay.

Here as I have said, we do not have any such situation.

The profit was not a contrived substitute for ordinary income from the property.

The government has not been deprived of any revenue to which it would otherwise be entitled.

In short, it is our position that a statute which is directed against avoidance should be carefully confined to those against whom it was directed.

Louis Eisenstein:

It should not be applied indiscriminately as if it were a massacre.

Indeed as we pointed out in our brief, here the treasury is even better off than it would otherwise have been if the taxpayers had built and owned the property as individuals, because if they had done that then the assets would have been sold directly to the purchaser and the purchaser would have used as his basis for depreciation, his higher cost, which was not available to the purchaser here, because a corporation continued to own the development.

I should add that the Commissioner fully agrees with our understanding of Congress’ purpose and then he pays no attention to what he says.

He fully agrees that the admitted and “basic purpose of the statute is to prevent the conversion of ordinary income into capital gain,” and he emphasizes, “that statutory language should be read, indeed even strained to some degree to avoid absurd results to carry out the discovered purposes of Congress and in general in an effort to produce a rational, sensible structure.”

But having said all this, he nevertheless argues, as the Court of Appeals held that the statute applies regardless of whether the taxpayers realize the gain contemplated by Congress or regardless to put in another way of whether the result is absurd.

However, even the Commissioner is unhappy with the Court of Appeals opinion.

And so, he has tried to remedy the situation by arguing that any gain realized on a sale of constructed property as distinguished from purchased property is ordinary income.

We cannot say frankly, we have studied the Commissioners brief, we cannot say how the Commissioner came to this conclusion.

It seems to be a well kept secret.

However, even the Commissioner finally realizes that this strange argument will not do.

Therefore in the end, all he can say is that the statute taxes a gain as ordinary income whether or not it is a contrived conversion of ordinary income.

We say that what the government has done is to make a travesty of the statute.

Potter Stewart:

Commissioner makes an additional argument, does he not, that many personal services were contributed free to the construction of this apartment building, and had they been compensated that would have clearly been ordinary income and that the increment in the value reflected the fact that they were not compensated and therefore this — that in this very case ordinary income has attempted to be converted into capital gain.

That argument is made; whether it’s good or not —

Louis Eisenstein:

Well, I would like to address myself to that argument.

That argument of course was not made by the Court of Appeals, which was fully aware of all these facts, because they are set forth in the opinion.

The Commissioner’s argument in that area is this; he argues that the proceeds realized on a sale of the stock represent a conversion of ordinary income attributable to their services to the corporations.

As he puts it, by waiving the compensation for their services, the taxpayers were able to realize an amount over and above the cost of the development and a mortgage indebtedness, that’s pretty much his language.

Now this is a brand new argument, which has suddenly shown up here for the first time, it has never been made before and I should add that after he makes the argument, he dismisses it and says it is unessential and then he goes onto summarize what he considers is essential.

Now in making this new argument, the Commissioner overlooks a good many things, which are in the record, as well as things in the legislative history.

In the first place, Section 117(m) is concerned with a conversion of ordinary income from the constructed property not with the adequacy of compensation that may or may not have been paid to stockholders while the hearings indicate, that is the congressional hearings indicate that at times actors were receiving stock in collapsible corporations as compensation for their services, it is merely noted as an incidental byproduct.

In other words, they were being wrung in on what is otherwise a collapsible corporation.

That does not relate however to the nature of a collapsible corporation itself, which is the conversion of ordinary income from the property.

The statute itself, I would like to emphasize, is expressly geared to the corporation’s failure to realize the net income from the property.

At any rate, I want to add here no stock was received as compensation as is true in the actor’s case and moreover the tax avoidance of actors has been separately dealt with in Section 117(a)(1)(c) which was enacted at the very same time that the collapsible statute was enacted.

The next point I would like to make is this; in any event the Corporations did not enable the taxpayers to avoid taxes that would otherwise have been due with respect to their services.

If the taxpayers as individuals construct rental property, the profit realized on a later sale is a capital gain.

It is completely immaterial that the success of the enterprise maybe largely due to their personal efforts.

Congress has made only one exception to that rule and as a matter of fact that was the rule that came in when the collapsible statute was enacted and that one exception relates to sales of copyrights, artistic compositions and similar property and even the proceeds realized on a sale of such assets are not taxed as compensation.

They are taxed as the proceeds of a sale of property.

Louis Eisenstein:

The next point overlooked by the Commissioner is this; that the proceeds realized on a sale of property are not determined by the services that happen to be contributed to the property or the value of those services or how much has been paid.

The amount received depends on market conditions at a particular time, which fluctuate from time to time.

Potter Stewart:

But certainly, certainly, if the services had been compensated, the cost of the building would have been higher?

Louis Eisenstein:

The cost of the building would have been higher.

Potter Stewart:

And the compensation to the individuals would have been ordinary income?

Louis Eisenstein:

If there had been compensation paid to the corporation, that is correct, but I say again if they had built the houses as individuals and contributed the same services, the gain realized would have been a capital gain.

And the point I am making is that the use of the corporation did not enable them to realize a capital gain, which they would not otherwise have realized in constructing this development as individuals, but there is also something else that I would like to point out in this connection.

Potter Stewart:

But that’s not – that’s not the test though.

That’s not the test of 117(m), is it?

Louis Eisenstein:

That is the test as we understand it whether or not the use of a corporation and a sale of stock enables you to realize what you would otherwise realize as ordinary income as capital gain.

Potter Stewart:

It’s what the corporation would have realized as ordinary income?

Louis Eisenstein:

Well there is —

Potter Stewart:

It is then capitalized, the future income is capitalized, but it’s not what the individuals had they not incorporated it would have realized as ordinary income, is it or am I mistaken?

Louis Eisenstein:

I think Mr. Justice that you are mistaken.

Potter Stewart:

I might well be.

Louis Eisenstein:

That we as the examples given in the committee reports, for example, with respect to the motion picture Industry, point out that if a producer made a picture as an individual, he would get ordinary income from the property.

There is not the least concern with whether or not he has paid for his services.

Then they go on to indicate that if he did the same through a corporation, the rental income from the property would be taxed as ordinary income, and that is the tax that he is trying to avoid, but I’m willing to accept the Justice’s premise for the moment because even on that premise, even on that premise the government has overlooked something.

The Commissioner has completely misunderstood the waiver of the builder’s and architect’s fees under the rules and regulations of the FHA.

The proceeds realized on the sale would have been exactly the same even if they had not waived the fees.

They could not charge themselves or pay themselves for their services unless they paid themselves out of their own moneys.

In other words, in order for them to pay themselves the builder’s and architect’s fees, they had to contribute $600,000 to pay to themselves, and if they had done that the proceeds realized on the sale of the development would have been exactly the same.

Now what the Commissioner is complaining about is that they didn’t convert their own capital into compensation, which is a totally different thing.

[Inaudible]

Louis Eisenstein:

If they had paid him $600,000 to pay themselves, the result would have been exactly the same as it is here.

[Inaudible]

Louis Eisenstein:

That is correct.

[Inaudible]

Louis Eisenstein:

I’m not entirely clear as to who they are.

[Inaudible]

Louis Eisenstein:

Oh, they received out —

[Inaudible]

Louis Eisenstein:

We are including it because both parties have agreed that, that is part of the sale and that is the way the Court of Appeals handled the matter.

The 550 —

[Inaudible]

Louis Eisenstein:

Because they would have —

[Inaudible]

Louis Eisenstein:

And that would have been paid out to them.

[Inaudible]

Louis Eisenstein:

That is correct.

[Inaudible]

Louis Eisenstein:

No there was an intervening event.

They operated the development and the moneys that accrued within the corporation, were moneys that accrued through deprecation deductions offset against the rental income and also deductions of other costs of constructing a development which are permitted to be deducted against operating income.

They had nothing to do with the builder’s and architect’s fees.

[Inaudible]

Louis Eisenstein:

The FHA mortgage would have been exactly the same amount but they would —

[Inaudible]

Louis Eisenstein:

No, I think one has to go one step further.

They would have had to deposit, they would actually have had to raise $600,000 of their own, to put into the corporation and then pay themselves.

[Inaudible]

Louis Eisenstein:

They would still have had the same —

[Inaudible]

Louis Eisenstein:

Well actually it was more Your Honor, I don’t want to say it was 410, I want to emphasize that the —

[Inaudible]

Louis Eisenstein:

They paid to themselves 555.

[Inaudible]

Louis Eisenstein:

That is correct, yes.

I notice that my time is pretty much up and with the Court’s permission I would like to save a few minutes for rebuttal.

[Inaudible]

Louis Eisenstein:

No, I couldn’t go that far, if they kept it a year, it wouldn’t be enough.

Louis Eisenstein:

The answer to your question Your Honor would turn on whether or not the income realized before the sale was a substantial part of the net income to be realized from the property and I have no doubt the Commissioner’s position would be that realizing only one year’s income would not be a substantial amount of income and therefore assuming that your motive is otherwise present, they would treat it as a collapsible corporation.

[Inaudible]

Louis Eisenstein:

Time is an element.

If what is otherwise being converted, we say is ordinary income, but as I understood your question Mr. Justice, I assume that the property was not held for sale to customers and in that case even if they had built it as individuals and assuming they hadn’t held it for sale to customers, they could have sold it and realized the capital gain and the corporation could have done the same thing.

Earl Warren:

[Inaudible]

Wayne G. Barnett:

Chief Justice may it please the Court.

Before I turn to my main argument, I would like to clear up the confusion about the architect’s fees and how that transaction might have been conducted.

It is true Mr. Justice White that the — had they paid the — contributed money to pay the Architects & Builders fees, ultimately the proceeds and the stock sale would have been the same.

The difference is the —

Byron R. White:

[Inaudible]

Wayne G. Barnett:

That’s right.

The difference is, the gain would be different.

The proceeds are the same, but they would have a different basis.

They would have already realized $400,000 of ordinary income and that would become the basis in their stock and so, the gain on the sale of the stock would have been different.

Also, the suggestion on the same point was made that to pay themselves they would have had to contribute the money; that was not the arrangement.

What they assured the FHA was, not that they wouldn’t pay themselves for their Architects & Builders Services, they would pay themselves by means other than cash, namely they would give themselves stock in payment of the architectural and building services.

Had they done that, the stock would have been taxable compensation, that they had to pay themselves for their services of construction has nothing to do with the financial problems of raising cash.

They don’t have to pay themselves cash.

Now, I would like to start I think is always useful to start in a tax case with the statute to see what we can learn about the problem from the statute itself.

It’s at page 39 of the government’s brief.

This is the statute by the way, in the form it’s stood during the transactions in question, it’s been changed later, but I would talk about it as it then stood.

[Inaudible]

Wayne G. Barnett:

It was amended first in 1951 and in the 54 Code made substantial changes and the relative amendments, I hope to get to those, but paragraph one says that the gain from the sale or exchange or the liquidation of a collapsible corporation should be taxed as ordinary income.

Paragraph 2A defined a collapsible corporation.

It is defined as a corporation which is formed or availed of principally for the manufacture, construction or production of property with a view to the sale or exchange of the stock by the stockholders or the liquidation of the corporation prior to the realization by the corporation of a substantial part of the net income to be derived from the property and by that means the realization by the stockholders directly through the stock sale of gain attributable to such property.

Now first, I would like to note that statute applies only to a certain kind of corporations, corporations that are engaged in the manufacture, construction or production of property and that to me says a great deal of the purpose of the statute.

It is limited to corporations engaged in creative processes, production, manufacture or construction or processes by which value is created and so, its concern is with the way in which the values created by those processes is realized and taxed.

What it is concerned with is attempts by stockholders to realize upon those values directly before the corporation has realized and then taxed.

[Inaudible]

Wayne G. Barnett:

That question is now conceded, but there is no doubt there was — well, there was never any doubt that was availed principally for construction.

Wayne G. Barnett:

There was a dispute at one time whether they had the view during construction to quick sale of the stock, that is now closed, that’s the question that was foreclosed by the limitation of this grant of cert.

We are now concerned only with the question of whether a claim that the gain would have been capital gain, have they done it as individuals bears upon the application of Section 117(m).

Potter Stewart:

[Inaudible]

Wayne G. Barnett:

I might say in response to Mr. Justice Stewart’s question that we do not concede, we definitely do not concede, but have they done this as individuals it would have been capital gain.

Potter Stewart:

I should think if that second question is foreclosed and if it’s now — if we now take it as assumed that the corporation which had been formed was avail of with the view to the prompt sale, then that would have been almost necessarily as sale in the ordinary course.

Wayne G. Barnett:

Well, that would be our contention.

The exceptions from the capital gains definition is for property held primarily for sales for customers in the ordinary course of trader business.

Now, what it really comes down to this whether —

Potter Stewart:

Is a little —

Wayne G. Barnett:

The anticipation that the quality of anticipation of sale is different for purposes of 117(m) and for purposes of that definition of capital assets.

We would argue that it isn’t, and that in fact if during construction or you are building it, you’re engaged in the business of building property, you contemplate a sale, as at least one of the possible alternative ways of realizing the value of your construction profits that it is not a capital asset.

But you do not have to decide that question, we have not argued in our brief other than to note its existence in the foot note.

I think it’s on page 30.

We suggest that if that should ever become relevant, proper course would be to remand it to the tax court to consider that question.

Potter Stewart:

But didn’t they – didn’t —

Byron R. White:

[Inaudible]

Wayne G. Barnett:

It is not.

Byron R. White:

[Inaudible]

Wayne G. Barnett:

No sir, it is not, it’s not.

We do not consider —

Byron R. White:

[Inaudible]

Wayne G. Barnett:

That’s right, that’s right.

If so, I would agree and I’ll show that there might be anomaly and perhaps that difference shouldn’t exist, but that doesn’t tell us which result is the wrong one, and I would think that the individual case would be the unintended loophole and not what Congress specifically tried to foreclose in 117(m).

Byron R. White:

[Inaudible]

Wayne G. Barnett:

That’s right, that’s right.

Now —

Potter Stewart:

Didn’t our grant of certiorari are limited grant assume that this would have been capital gains.

Wayne G. Barnett:

That’s right the state — the question presented, the assumption state of question we’re now talking about is that it would be capital gain, had they done it as individuals.

I’m perfectly prepared arguendo to make that assumption orders the deal with the specific question before the Court, that’s not the same as a concession that in fact that is true.

Potter Stewart:

But the way we limited the grant of certiorari we assume so?

Wayne G. Barnett:

That’s right, for purposes of this case, no for purposes of the decision in this Court, but I’d suggest that the purpose of the statute is —

[Inaudible]

Wayne G. Barnett:

That is correct.

I think the same assumption would carry over to the corporation.

The statute directed to corporation is used to produce or create property with a view by the stockholders to realize on those values by a stock sale or liquidation of the corporation before the corporation has realized on it.

Now, the definition uses the phrase with a view of their stock sale, with a view to realizing gain attributable to the property.

Now, I’d like to first go and show whether their argument is pitched on that phrase, but the phrase appears later on the statute, I want to cover that and then come back to the phrase.

Paragraph three has limitations on the application of paragraph one and it provides — well, there are three limitations, very briefly.

The first one which isn’t important here is, you have to own more than 10% of the stock and the third one limits these application to realization of gains on property within three years after completion of the property, which likewise is not involved here, but here is explanation I would suppose why the other corporations avoided this provision.

The one we’re concerned with is B, now that provides in the case of a gain realized by a shareholder upon his stock in a collapsible corporation, this subsection should not apply to the gain recognized during taxable year, unless more than 70% of such gain is attributable to the property so manufactured constructed or produced.

Now the relationship of that reference to the gain being the attributable property and that in the definition is simply that between they’re anticipating the gain and their actual realization.

The latter provision talks about their actual realization, they in fact have to realize gain which is at least 70% attributable to the property that was constructed.

Now their argument — first of all, the phrase gain attributable to the property admittedly performs the function of confining this to gain that was caused or generated by the construction or creation of the property.

There is no dispute about that, it serves that function, distinguishes gain that was so generated from gain that was created by various other factors, purchased property or in the case of manufacturing corporation simply the enhancement of value of its fixed assets or the existence of an antitrust claim, anything at all is distinguished by that phrase.

And that phrase limits the statute to the gain, which is specifically attributable to the created property, the property constructed, manufactured or produced.

Potter Stewart:

I still don’t quite get your thought as to what that means?

Is that — the statute is confined to a corporation which produces or creates property?

Wayne G. Barnett:

Principally, principally, he may have other activities and a manufacturing incorporation would also have fixed assets.

If the gain were attributable to enhancement of the value of a manufacturing company’s fixed assets simply because of a change in the character of the neighborhood comes a better site, the gains attributable to that would not be the kind of gain that tax — that’s taxed.

Potter Stewart:

The gain of the stock in the corporation.

Wayne G. Barnett:

That’s right, the gain of the stock, which reflects that added asset value in the corporation.

Potter Stewart:

Well how about a rise in the market value, just because of market conditions.

Wayne G. Barnett:

That’s right.

Potter Stewart:

All of the property created or produced —

Wayne G. Barnett:

That is a difficult question, I think the regulations —

Potter Stewart:

[Inaudible] because I don’t —

Wayne G. Barnett:

The regulations would say that the created property, we don’t break it down into what caused the created property to be worth the increased value, whether the creation process or a subsequent change of market values and I think that’s right.

Potter Stewart:

Market value itself will be a reflection of capitalization of future earnings.

Wayne G. Barnett:

Well that’s quite right, quite right, and —

[Inaudible]

Wayne G. Barnett:

Oh that’s right, that’s right, and —

[Inaudible]

Wayne G. Barnett:

Right, right.

No I would think that it would be fruitless to even to attempt to distinguish the value of the produced property, the manufactured property attributable to changes in market values and to the process of creation.

I’m not sure that the policy would really want to make that distinction in terms of inventory items, but that isn’t our problem here nor I would like to address that.

Now, what they say is that the word gain also serves another function.

It doesn’t simply identify the source, the causal relationships, but is meant to limit the application of the statute to a certain kind of gain, one that reflects a converted ordinary income.

Now first I would like to point out, that the statutes cannot be read that way.

And starting with paragraph one, which speaks of the gain in the sale or exchange of stock clearly refers simply to the excess of the proceeds over basis, simply the quantum of profit nothing else, nothing is about its character.

And the provision, we’re just looking at page 3B starts out that in case of the gain realized by a stockholder, i.e. on the sale of exchange of a stock, again that gain is necessarily to the excess of proceeds over basis.

The subsection are applied to the gain recognized during the — unless more than 70% of such gain is attributable to the property.

Now the gain there necessarily is a reference to the gain otherwise used in the same sentence to mean simply the excess of proceeds over basis and they refer only to the fraction of that gain, which is attributable to the property.

So you cannot read into gain any qualification about the kind of gain that it represents.

Now more than that, I would like to suggest that the — and even more serious problem with their suggested method of construing the statute.

They would have you believe that it’s not you simply substituted for the word gain something like converted ordinary income that is not enough.

A great deal of baggage would have to go with that to spell out the test by which you decide whether a particular gain is a conversion of ordinary income.

Now for one thing, I think in their brief they seem to acknowledge that it wouldn’t be enough simply to ask whether the corporation would have had capital gain had it sold the property.

We’ve referred that occasionally, but generally to the emphasis on the stockholders and the reason the emphasis is on the stockholders is that at least one of the purpose is admittedly was to prevent stockholders who were themselves dealers in property from avoiding ordinary income treatment by putting each transaction into separate corporate shell.

And, so necessarily it is not enough simply to look to how the corporation would treat the gain had it sold the property.

So, you have to go back and see how the stockholders would have treated it.

Now the question as to each stockholder I take it would be, if he had held the property would he have held it as primarily for sale in the ordinary course of traded business.

Now, there is no more litigated question in the tax field when you hold property in the ordinary course of trader business hold it for sale.

Byron R. White:

[Inaudible]

Wayne G. Barnett:

That’s right, that’s right.

Byron R. White:

[Inaudible]

Wayne G. Barnett:

Well, that’s right but there, I’m assuming that you would answer that question to hold that it would be capital gain.

I’m assuming that would be the answer, but I would still like to point to the complexity of the question, that you make the application of this statute turn upon.

Now simply stating a hypothetical question that you are going to answer is enough of an undertaking, but I’d like to emphasize particularly two further specific different problems that would be faced.

First of all, all the stockholders need not to be in the same status, some of them might be dealers and others not.

Now in this case all three stockholders have always joined together in all their ventures so they all can be viewed as one, but that would not always be true.

Wayne G. Barnett:

So what would you do?

Would you have a separate treatment for the individual stockholder depending upon his status or would you say that if anyone of the stockholders was a dealer, the part would be tainted for all the stockholders?

Now when Congress granted this kind of relief in 1958 what it did is it acknowledged this problem and said that if any stockholder owning more than 20% was a dealer or trader when the corporation is collapsible as to all stockholders.

It did not grant individualized treatment, as to — if there was a 20% stockholder in that category.

For the second problem of the same kind is what do you do in making that, cited in that hypothetical question about other corporate ventures that the stockholders have engaged in of the same type.

You cannot ignore them because that would permit a dealer to avoid it simply by incorporating all of his ventures.

Now again the 1958 amendments, when they granted this relief dealt with that problem and provide very complex formula how you take into account in deciding how property would have been characterized in the hands of an individual stockholder that stockholders, other corporate ventures.

Very briefly if he is a 20% stockholder in this corporation, in the other corporation within the — during which — in which he held more than 20% of the stock during the past three years and the assets of which are the same kind you treat as though he conducted individually, but necessarily you would have to deal with that problem to articulate the test that the petitioners ask.

So I do not believe that even if there were mirror to their underlying argument on policy that it would be possible to read the statute the way they want you to read it, but I do want to deal with the questions of policies that they say are involved, specifically to show that this case does involve a conversion of ordinary income.

I’ve shown that the statute by its terms is limited to corporations engaged in construction, manufacturing or production and all you have to do is make the policy judgment that the fruits of productive activity should be taxed as ordinary income to have a full explanation of the statute as concerned only with conversions of ordinary income.

But this case in particular shows I think an extreme example of how we do covert ordinary income through construction efforts.

Byron R. White:

[Inaudible]

Wayne G. Barnett:

This is an illustrative argument that you don’t need to rewrite the statute to confine it to its proper scope and to limit it to foreclosing conversions of ordinary income.

Byron R. White:

[Inaudible]

Wayne G. Barnett:

Well, no — I use a different reference to decide whether its conversion of ordinary income, it depends upon the sense in which you define that phrase.

He would ask you to look —

Byron R. White:

[Inaudible]

Wayne G. Barnett:

That’s right, that’s right.

Byron R. White:

[Inaudible]

Wayne G. Barnett:

That’s right and I think this is illustrative of all cases that will fall within this category.

It’s simply that, he insinuates in the phrase conversion of ordinary income, a very specific reference to how stockholders would be taxed if they’ve done it individually.

And when I say conversion of ordinary income, I don’t mean that.

I mean a conversion of underlying elements of the gain that were generated by personnel services.

[Inaudible]

Wayne G. Barnett:

I’m sorry, you did that.

[Inaudible]

Wayne G. Barnett:

Well I think it would, I think all the gain here actually was really attributable to the construction efforts.

They [Inaudible] about $700,000 not simply the architect’s fees and builder’s fees, but the subcontracting services they performed.

I’d like to go through that.

[Inaudible]

Wayne G. Barnett:

Oh yes.

Actually they entered contracts.

They entered paper contracts with the corporation to perform the construction work for $700,000 more than they ultimately charged.

And all they had to do was to the charge the price that the contracts called for and every bit of their gain would have been taxed to them as construction profits.

In answer to you Mr. Justice Harlan, we go onto consider the underlying nature of the transaction, although it is never entirely satisfactory to stop simply with the words of the statute.

We would like to show that the statute does not produce absurd results.

Now in this case, the — I will use the figures related only to the Springfield Corporation, both corporations are identical really.

The Federal Housing Administration in agreeing to guarantee the Mortgage loan, estimated that the total cost of construction, I will exclude the carrying charges and the finance charges and deal with the construction costs, would be $4.5 million.

That’s the estimated reproduction cost of this project; that included $4,100,000 of cost to the builder, the direct construction cost, plus $400,000 of builder’s fees and architect’s fees.

Now the three petitioners formed a construction partnership to perform the construction work.

The partnership entered into paper contracts with the corporation calling for payment of $4,100,000 in cash, that’s the direct construction cost, plus $200,000 of builder’s fees in the form of stock, not in cash and an architectural contract called for the payment of $200,000 of architect’s fees in stock, not in cash.

In fact they were never intended to be performed.

I take it they were window dressing having something to do with the financing aspects of the case.

The work was – they waived the architect’s fees, the builder’s fees, they waived their right to $4,100,000 in cash and performed the contract at their direct out of pocket cost, which turned out to be $3,800,000, that is to say, $300,000 less than the estimated direct cost apart from the architect’s and builder’s fees.

Now those additional savings were attributable to fact that the estimates assume that they would use subcontractors to perform the work.

In fact the partnership performed itself the carpentry and plumbing and heating work without using subcontractors and thereby eliminated also the subcontractors market.

That’s the main source of the additional savings.

Well whatever the source of the savings that normally the construction company would realize and not the owner of the building.

Now by that means they ended up, the corporation ended up with a building with a estimated reproduction cost and presumably value of $4.5 million for which it had to pay only $3,800,000, that is to say $700,000 less, and it is not surprising that a year later the stockholders were able to dispose of their stock for an amount closely approximating that $683,000.

Now the way they actually disposed of the stock, the buyer insisted that they drain off from the corporation all of its cash first so that they would have to pay less.

So the corporation first wrote up the value of the buildings by $750,000 to create a capital surplus.

Out of the capital surplus they then distributed to the stockholders $410,000.

The stockholders then turned their stock over to the buyers for an additional $273,000 so they netted in the end $683,000.

Now we agree that for purposes of this case, the distribution to the corporation can basically be ignored and would be the same question, if they had simply sold it to the buyers for $683,000.

Now, I might suggest that what their gain represented, what generated their gain was simply the uncompensated services, that they contributed to the corporation in constructing the building by not charging for their services, they were able to create an equity in the corporation worth $700,000 and they cashed in on that equity by selling the stock, and I say that is precisely the kind of thing that Section 117(m), is designed to prevent.

Now they say that isn’t the purpose, they don’t really deny that, that element is involved, but they say well we could have gotten away with that had we done it as individuals and that wasn’t therefore the purpose of 117(m).

I think the history shows that 117(m) was not focused simply upon the alternative ways that they might have done it and to prevent them doing something by corporations they couldn’t have done without it, but rather was focused upon the basic nature of the transaction and how it should be taxed.

I think that’s demonstrated by the movie example that prompted the statute.

Now in the movie case Mr. Eisenstein has told you that if an individual producer produced a movie and leased it, he would have received ordinary income, well that’s quite right, an individual builder built a house and leased that he would receive ordinary income.

He doesn’t tell you what would happen if the individual producer made the movie purportedly for purposes of leasing, but then sold it and that producer would have exactly the same argument, I’m not saying that he would win, would have exactly the same argument for capital gains treatment on his sale, that these stockholders would have on their sale individually of the buildings.

Wayne G. Barnett:

So the movie case is an exact parallel, at least prior to the 1950 Act.

Now in 1950 Act as we pointed out in our brief, another change was also made at the statute, which accepted from the capital assets definition copyrights and artistic works in the hand of the person whose personal efforts created.

Maybe we acknowledge that, that might reach movies in the hands of an individual producer after 1950.

My first answer is that there is nothing to suggest that Congress when it was looking to 117(m) related its judgment there to what was going on in its amendment to the other section.

And in fact they never brought together in their development.

President’s message just talks about the movie problem, the hearing they weren’t brought together, and the capital asset definition exclusion doesn’t refer to movies, the history doesn’t refer to movies.

There are serious problems in bringing movies within that category.

This revenue ruling, in 1955 that a movie produced by a corporation is not within that exception, because it wasn’t produced by the corporation’s personal efforts, but more than that it took the combined efforts of a large number of people, and a large investment, quite different from the writings of both.

I would also say that these two provisions were responses to very different inducements.

What prompted the amendment to the capital asset definition was the Eisenhower ruling, ruling in 1958 that Eisenhower’s book then General Eisenhower, “Crusade in Europe,” his proceeds from some of that received ordinary — received capital gains treatment.

Now I myself had questioned ruling, but what Congress did in this provision was to describe all of these things as loopholes.

It doesn’t detract at all from our notion that the products of personal efforts ought to be taxed as ordinary income and something that allowed them to be taxed otherwise is a loophole, they were described as loopholes in the history of that provision.

Granted they didn’t deal with the problem of builders constructing property with the personal efforts and then selling the property, but that’s because I don’t believe there was anything to bring that to Congress’s attention, they were all done through corporations.

Over that finally that the difference between a corporation and an individual, if there is a difference in the tax treatment and I don’t agree — I don’t admit that there is, isn’t entirely a fortuitous in it’s application, because most of these things when they are done in large sizes can in fact only be done through corporations, and do a great deal more through corporation than you can in individual assets.

That doesn’t deny that there is still some anomaly, if we can’t correlate the treatment in the two cases and I would think one should strive to correlate them, but it doesn’t mean that there is nothing of substance to the distinction.

[Inaudible]

Wayne G. Barnett:

That is correct.

The petitioners I should say point out that prior to the adoption of regulations they found three rulings that they said private rulings are inconsistent.

Actually we — private rulings, I suggest simply are not authoritative of anything, and in fact those were not cleared with the Chief Counsel’s Office, when it was cleared they stopped granting them, and they didn’t grant them to other units of the same builders.

Louis Eisenstein:

With the Court’s indulgence at — time at my disposal, I would merely like to address myself to two or three questions.

The argument has been made that gain attributable to self constructed property, that is where you put your own talents and efforts into property, and constructing it is inherently ordinary income, and that is not the law.

And there are number of cases cited in our brief which have held over and over again that whether or not constructed property is rise to ordinary income or capital gain depends upon the purpose for which the property is held.

Secondly in 1950 at the very time when 117(m) was enacted, Congress enacted 117(a)(1)(c), which specifically deals with a certain kind of property to which personal efforts are devoted.

And the committee report that time very clearly indicated that if you don’t fall within that specific provision then the gain that you otherwise realize on the sale of your property gets capital gain treatment if it otherwise qualifies, regardless of how significant your services were.

They specifically give an example of a photographic studio, and it’s well settled in the light of the 1950 Act that the invention of a patent, which reflects the most unique ability that an individual can bring to property gives rise to capital gain if it is not held for sale to customers in the ordinary course of business.

There is one other point I would like to make, and that is, that an impression seems to have been left by the government that because you have some intention to sell property if a purchaser comes along, therefore you are holding it for sale to customers in the ordinary course of business, there again that is not correct.

There is a difference between selling rental property and actually actively being engaged in holding property for sale to customers.

And as a matter of fact in this particular case the evidence clearly indicates that no rental property was held for sale and it is specifically stipulated that the stock in this particular case was not held for sale to customers in the ordinary course of business.