Commissioner of Internal Revenue v. Brown

PETITIONER:Commissioner of Internal Revenue
RESPONDENT:Brown
LOCATION:Point of picking up hitchhiker

DOCKET NO.: 63
DECIDED BY: Warren Court (1962-1965)
LOWER COURT: United States Court of Appeals for the Ninth Circuit

CITATION: 380 US 563 (1965)
ARGUED: Mar 03, 1965
DECIDED: Apr 27, 1965

Facts of the case

Question

Audio Transcription for Oral Argument – March 03, 1965 in Commissioner of Internal Revenue v. Brown

Earl Warren:

Number 63, Commissioner of Internal Revenue, Petitioner, versus Clay B. Brown, et al.

Mr. Barnett.

Wayne G. Barnett:

Mr. Chief Justice, may it please the Court.

This case is an income tax case and it is I think one of very special importance.

It involves a form of transaction.

It has become standardized, has been widely exploited and widely publicized.

Under which the stockholders are closely held corporation, transfer the stock to a tax exempt charity.

On the charity’s promise to remit to them all the earnings of the business until they have received a — some prescribed amount.

The question is whether the earnings remitted to the stockholders are taxable then as ordinary income or as capital gain that is as gain from sale or exchange of the capital assets.

The respondent’s contend that such transaction is a sale and that the earnings remitted to them — to the stockholders are simply payments of a purchased price and thus, amounts realized from a sale taxable as capital gain.

We contend that what the stockholders have is simply a right to the future income which when received must be taxed to them as income.

Basically in our view, the transaction is simply a gift of a remainder in busi — in a business.

Arthur J. Goldberg:

In other words, you said a kind of sale.

Wayne G. Barnett:

It is not a sale.

It may — it may be a tax within another character, I would deal with that later.

It is not an installment sale.

Not — the question also is whether these receipts in the later years are proceeds of the sale and these receipts are not proceeds of the sale.

Arthur J. Goldberg:

So this means (Inaudible)?

Wayne G. Barnett:

Not at all, not at all.

I think a taxpayer can do anything in the world he wants to, motivated solely for tax purposes and the transaction stands or falls for what it is regardless of why he did it.

If in this case they had not done it for tax purposes, you would have no doubt at all that it was gift.

If they’d done this transaction because they were charitably motivated and simply wanted to give something for cancer research, there would be no question if this would be a gift with retained interest.

Now just as a transaction is no worse because it was done for tax purposes likewise it is no better because it is done for tax purposes.

Arthur J. Goldberg:

How about (Inaudible)?

Wayne G. Barnett:

Well, let me —

Potter Stewart:

And they had a right to recapture the property if it —

Wayne G. Barnett:

That is correct.

Potter Stewart:

(Voice Overlap)

Wayne G. Barnett:

That is quite correct.

I wanted (Voice Overlap) —

Potter Stewart:

(Voice Overlap)

Wayne G. Barnett:

— the case and take you on at a later point.

I haven’t really given the facts at all and I think it may be helpful at some (Voice Overlap) —

Potter Stewart:

Just before you do —

Wayne G. Barnett:

Yes.

Potter Stewart:

— launch under the facts, I want to be sure I understand what your point is?

What is the crucial word?

Is it that this is not a sale or that —

Wayne G. Barnett:

Well —

Potter Stewart:

— it’s not an exchange or that that was a transfer.

It was not a capital asset?

It has —

Wayne G. Barnett:

No.

Potter Stewart:

You only have to say something is not?

Wayne G. Barnett:

The transfer is capital asset.

The asset is capital asset.

Potter Stewart:

Right.

Wayne G. Barnett:

The transfer may have been a sale or exchange without at the moment the same of which —

Potter Stewart:

It was held for six months.

Wayne G. Barnett:

It was held for six months.

Potter Stewart:

Well —

Wayne G. Barnett:

Actually, the more universal question and the question which I think I would emphasize in argument is whether the amounts realized.

The gain is the amount realized from the sale.

Potter Stewart:

Well —

Wayne G. Barnett:

And our basic argument is that these amounts were not amounts realized from the transaction even if the transaction was a sale or exchange of some sort.

Potter Stewart:

Now, you mean there was no gain?

Wayne G. Barnett:

Well, let me say, if I exchange my house for a share of General Motor stock that’s a taxable exchange.

Potter Stewart:

Yes.

Wayne G. Barnett:

It doesn’t mean that the dividends I thereafter receive on the General Motor’s stock are taxable as capital gain.

They are taxed as ordinary income.

Wayne G. Barnett:

The only thing that is taxed is capital gain is the value at the time of the exchange of the thing received.

If there was a taxable exchange in this case as a result of liquidation, what was re — the gain is measured by the value then of what they received, not the later proceeds, not the income distributed to them in later years from the interest they acquired in the exchange.

Now I’m getting very far ahead of what are —

Potter Stewart:

I know but I — but I think — your brief, as I understood your brief, I mean —

Wayne G. Barnett:

Well, the brief —

Potter Stewart:

— your brief said this was not a sale and now —

Wayne G. Barnett:

The (Voice Overlap) —

Potter Stewart:

— I think you’re rather (Voice Overlap) —

Wayne G. Barnett:

The opening brief frames the question in terms of what are the requirements of an installment sale.

An installment sale is a particular kind of sale.

It is a transfer of property exchange for debt.

And that is the one case, the one exception in which the later payments of the debt, the later receipts are treated as an amount realized.

Potter Stewart:

Part of the purchase price?

Wayne G. Barnett:

That is correct, only if it is a debt.

Now, there are other kinds of sales or exchanges.

The reason — our reply brief is basic — directed in the argument of amici that say, “Well, perhaps it was an installment sale but surely there was some kind of taxable event because it was a liquidation”, and I agree with them.

I think there was a taxable event and I think the respondent should have been taxed in 1953 in the year of the transaction on the full value of the asset as capital gain.

But that would not affect the treatment of their subsequent receipt of the future earnings that were remitted to them.

As I say, I am getting very far ahead of my argument.

Potter Stewart:

Well, I just want to be sure what — upon what’s your theory is based, I —

Wayne G. Barnett:

Ultimately the question to my mind is, even in payment terms of the word “sale”, the word not realized, it doesn’t really make a difference.

Ultimately, the question is, is what they had after the transaction, a debt or a right to income?

Earl Warren:

Or what?

Wayne G. Barnett:

A right to income, an income interest.

That’s the ultimate question.

If what they had would was a debt they would agree that the later payment can be related back and treated as amounts realized from the original transaction.

Potter Stewart:

Well, I suppose a — you owe me $100,000 payable over — $10,000 a year over 10 years, I’d suppose that had a right to income (Voice Overlap) —

Wayne G. Barnett:

Well —

Potter Stewart:

— follow either one.

Wayne G. Barnett:

I think not.

Wayne G. Barnett:

But I hope so, it is the essence of a debt but just — let me for the moment take the Poller case.

Look it down to draw and define the lines later.

The right to income is a right to payments if and when — and only if and when there is income.

A debt in the Poller case is a right to be paid an amount in all events regardless of whether there’s income, regardless of any future event.

Now, those are the Poller cases.

And I agree that — a thing may still be a debt even though they’ve got absolute certainty of payment, even though there is a very substantial risk of nonpayment.

But — when I come to draw in the line, my answer is, there must be a cushion of some sort, something that shifts the primary risks to the transferee and gives the transferor at least some insulation from the future risk of the business.

Potter Stewart:

In order for there to be a sale?

Wayne G. Barnett:

In order for there be — to be a debt.

Now, we used “sale” in our opening brief as an exchange for a debt.

That’s what — that is an installment sale and the only kind of sale in which you can treat it at later receipts as an amount realized from the original transaction.

Using sale in that sense, this is no sale.

Now, I don’t care where you play on the word “sale”.

I don’t want to get into a fight with the amici about whether this should be focused on the word sale and the word “amount realized” or the word “from”.

Ultimately the distinction is the same and that is the question.

Potter Stewart:

Well, I’ve made you get way ahead of yourself and I’m sorry but I want to understand it much better after you go into preliminary hearing?

Wayne G. Barnett:

Oh, I hope so.

The actual transaction is quite complicated and I would like — I will omit some minor details that neither party considers significant.

Respondent Clay Brown was the President and the Managing Officer of a corporation engaged in lumber milling.

He, his wife and his children owned 94% of the stock of the corporation, estate acquired on organization at a total subscription of $30,000.

The remaining few shares were owned by two other officers of the company who also participated.

The – in November 1952, Clay Brown, who was the spokesman for all of the stockholders and transaction was approached by a representative of the California Institute for cancer research, the tax exempt charitable organization.

The Institute was interested in acquiring ownership of closely held businesses pursuant to a plan that had been developed and widely utilized by another charity in Los Angeles, the University Hill Foundation which is one of the amici.

And they furnished Clay Brown with a brochure, outlined in the details of the plan and the advantages to the owners of the business which is primarily tax exempt.

Brown expressed interest and on February 4th, 1953, after some months of negotiation, the transaction was consummated.

Now, I can best describe the transaction by following through the transferors and then tracing back what was received in exchange from them.

Now, the respondents, the stockholders of the corporation, first transferred all of their stock to the Institute.

The Institute immediately liquidated the corporation and took over the assets.

The Institute then leased the assets to new operating company called Fortuna Sawmills Inc.

Fortuna was a new corporation that has just been formed for the purpose by Clay Brown’s attorneys and they owned all its stock.

Wayne G. Barnett:

The attorney is dead.

They — Fortuna then hired Clay Brown as the general manager at the same salary that he’d previously been paid by the old corporation, took over all of the other operating personnel and continued the operation of the business ithout interruption.

Let me repeat that very briefly.

The respondent, the stockholders transferred their stock to the Institute.

The Institute liquidated the corporation, leased its asset to Fortuna and Fortuna then took over the operating personnel and continued the business.

Potter Stewart:

And the — amount of the lease was 90% of the profit.

Wayne G. Barnett:

Well, I’m going to go back to trace what was received in exchange.

I’m just following through the assets to see what happened to them first and then I’ll trace back what goes back.

Potter Stewart:

If you could but the — you’re satisfied to call that a lease?

Wayne G. Barnett:

For present purposes, I am.

I think it would become important primarily in whether Fortuna owes a —

Potter Stewart:

Yes.

Wayne G. Barnett:

— further tax.

Potter Stewart:

But that’s not the (Voice Overlap) —

Wayne G. Barnett:

For purposes of this case —

Potter Stewart:

Right.

Wayne G. Barnett:

— you can assume that that is a lease.

Now, all of those steps happened in a single day and all they were, were signing a series of documents.

From the point of view of the operation of the business, nothing had happened.

I — you — it went on as though nothing had happened.

Now, to trace back what was given in exchange.

Fortuna agreed to pay to the Institute as rent, and I will assume that it is simply rent, for the use of the assets 80 % of the net profits from the conduct of the business before income taxes or depreciation, 80% of the net profits were to be paid as rent.

The Institute in turn agreed to repay over to the respondents 90% of whatever amount were paid to it by Fortuna.

And to continue paying those amounts to the respondents until they had received $1,300,000.

Arthur J. Goldberg:

(Inaudible)

Wayne G. Barnett:

Actually, I don’t question the Institute’s taxes — exemption.

Arthur J. Goldberg:

I thought the government remand–

Wayne G. Barnett:

The Government — finding the shell under which the peanut is in this kind of transaction is not easy and the Commissioner does what you’d expect him to do.

He challenges everything.

Now, I think we have —

(Inaudible)

Wayne G. Barnett:

Well — and — it’s a fair thing to do.

It takes a time before you find out — before you really have figured out what — the — I would — I would just say, what the rat hole is.

And it took me a long time before I was satisfied about this case.

I thought for a time that it was really the devious of the exemption.

I don’t think it is devious of the exemption.

I think it is the question here.

That’s real — the real question the transaction raises.

Arthur J. Goldberg:

(Inaudible) in this case — (Inaudible)

Wayne G. Barnett:

If I own a stock worth $10,000 and I offer to give it to Harvard University on condition that the Harvard remit to me the first $20,000 of dividends.

Harvard doesn’t do a thing wrong.

I’m giving the Harvard a gift of a remote remainder interest.

Arthur J. Goldberg:

This is quite different.

Wayne G. Barnett:

This is not — this is that case.

Hugo L. Black:

(Inaudible)

Wayne G. Barnett:

What they did —

Hugo L. Black:

(Inaudible)

Wayne G. Barnett:

What they did —

Hugo L. Black:

(Inaudible)

Wayne G. Barnett:

No.

What they’d — what they did was to convey the property to the Institute on condition that the Institute remit the first one million three of income.

That’s all they did.

They called it a lot of things.

They called the obligation to remit one million three of — to remit 90% of the earnings up to one million three.

They called that obligation a promissory note.

They didn’t call the document a deed of gift.

They called it an agreement of sale.

But the only thing that differentiates this case from my gift to Harvard of the remainder interest in stock after I received so much of the income is to label the parties used, that is the only thing that differentiates this case.

Arthur J. Goldberg:

That’s a (Inaudible) —

Wayne G. Barnett:

But —

Arthur J. Goldberg:

(Inaudible)

Wayne G. Barnett:

No.

Arthur J. Goldberg:

(Inaudible)

Wayne G. Barnett:

Let me —

Arthur J. Goldberg:

(Inaudible)

Wayne G. Barnett:

Let me —

Arthur J. Goldberg:

(Inaudible)

Wayne G. Barnett:

Let me give you an example that doesn’t involve a charity.

It doesn’t involve a lease.

You don’t need to have a charity to work this kind of transaction.

I can do it to my son and at least I will manage to shift the income into the lower tax bracket.

But more than that, if I have fully depreciable property, I don’t need to have a charity at all and realize the full tax benefit that respondent sought in this case.

Let’s suppose that I own a leasehold from — which I’d build a building.

Now, I’ve leased the building for the four remaining term of the ground lease and an annual net rent in excess to the ground rent of $21,000.

When the lease has 20 years to go, I purport to sell my leasehold interest to be my son or a stranger for $400,000, he gives me a note, it’s called a promissory note.

We called an agreement of sale.

He’s to pay me $20,000 a year for 20 years as the purchase price.

However we add, his liability is limited to remitting that out of the rents received from the property and if I don’t get it, all I can do is give back the leasehold.

Now, let me just point out what happens if you say that transaction is a sale.

Not only are the $400,000 that I received over the 20 years tax as capital gain but be — now has a cost basis for the lease of $400,000.

So the lease is entirely a wasting asset.

He is entitled to amortize it.

In principle, he would have income of $21,000 a year from the lease.

But he has a $20,000 offsetting amortization deduction and in fact, his taxed only under $1000, I let him keep as his fee.

This case doesn’t have a thing to do with abuse of charitable exemptions.

You can work this transaction out with — sometimes as equal benefits, if you have fully depreciable property, with lesser benefits if it’s an interfamily shift of income to different brackets.

Without using charities, without using the lease device, that is not what the case is about and I’m perfectly — had this lease been a real lease in which I’m pursuing that it is to a wholly separate party.

Clay Brown had nothing to do with the management for a fixed rent.

The case to my mind would be exactly the same as this case.

I don’t rely at all and I don’t think it is important to the issue in this case.

Wayne G. Barnett:

It would be important as to whether Fortuna can deduct the amount.

It’s not important that this case that this lease was a rather strange document.

I would assume it’s a straight lease under this rent.

Well, then even after the — I guess I’m still on the facts.

After the transaction, the business did go on and the amounts paid by Fortuna as rent for the Institute were remitted to respondents.

During the years 1953 to 1956, they received amounts totaling $651,000 and the question here is the treatment of those amounts, if the amounts received in the later years.

Now in economic term, but first I like to analyze the transaction in economic terms without any — necessarily implying any tax consequences.

The crucial thing about the transaction is that the Institutes neither pay nor risk a single dollar of its own.

It made no down payment out of its own funds.

It assumed no personal liability ever to make a payment out of its funds.

All it agreed to do and this is all it agreed to do was to remit to the respondent 90% of the income earned by the lease of the assets to Fortuna.

Arthur J. Goldberg:

(Inaudible)

Wayne G. Barnett:

No, sir.

Arthur J. Goldberg:

(Inaudible)

Wayne G. Barnett:

If I give it to my —

Arthur J. Goldberg:

Our position is (Inaudible) —

Wayne G. Barnett:

Let me be —

Arthur J. Goldberg:

(Inaudible)

Wayne G. Barnett:

Let —

Arthur J. Goldberg:

(Inaudible)

Wayne G. Barnett:

Alright.

If he isn’t — if we loss this case, if this transaction works, a corollary of it is that the Institute would have — will have — the income would be (Inaudible).

Let me say that I wouldn’t — I — I’m not tax exempt.

I would’ve entered this transaction with Clay Brown and gave him a note of $2 million.

I’m not worried about someone trying to tax me on the income.

It isn’t my income.

It’s their income.

All I’ve agreed to do is remit it to them.

The problem — the tax probably institute arises only after you characterize the transaction as a sale.

Arthur J. Goldberg:

(Inaudible)

Wayne G. Barnett:

Yes.

Arthur J. Goldberg:

If I receive (Inaudible) —

Wayne G. Barnett:

That I don’t believe that is the normal rule.

A lot of people receive money from the lease and who were simply agents.

It’s not their income and my argument is that it was not their income.

Arthur J. Goldberg:

What’s their income?

Assuming it was a sale?

Wayne G. Barnett:

If assuming that it was a sale, it was their income.

That’s the question you’re answering when you say it’s a sale.

If they — you didn’t have taxes and parties at all and you have these transaction between A and B, the question would be, “Whose income is it, A or B?”

And that is this case, that’s the question in this case, whose income is it?

Arthur J. Goldberg:

(Inaudible)

Wayne G. Barnett:

They took some tax risks.

Arthur J. Goldberg:

What is (Inaudible)

Wayne G. Barnett:

No.

This Court says it’s not a sale.

It doesn’t hurt the answer at all.

It’s only if this Court says it is a sale, that the Institute has any taxes.

It’s only if this Court says that it is a sale that the Institute have any tax risks.

If it is not a sale, the Institute has simply accepted a gift of a right to 10 per —

Hugo L. Black:

But it wasn’t the (Inaudible)?

Wayne G. Barnett:

It’s only their effort to make this look like a sale that any tax risks are created by the Institute.

They call this a gift?

No one in the world would have any doubt that the Institute didn’t own the income and none of its earnings were being nearing to the benefit of a private person.

It’s only because they tried to make it look like a sale that the Institute ever has any tax problem.

Now, but economic — let me go back.

Economically, is to — did not risk a thing.

Economically, as this — the tax result out of the picture of the moment, they didn’t —

And they asked this Court?

Wayne G. Barnett:

Well, but taxes follow economic.

Wayne G. Barnett:

Economics don’t follow taxes.

You don’t decide what a transaction is by asking what is tax consequences will be and then say, “Is therefore, it has those tax consequences.”

You start with the economics and then decide what the tax consequences are.

And economically, the Institute did not put out — did not risk a single dollar of its own.

It agreed to do nothing more than to remit 90% of the income from the lease of the assets to respondents into there — received $1,300,000.

Its role was entirely passive.

It didn’t agree to manage the business or even contribute in any way to produce any income.

Now since the Institute put up nothing.

The respondents got nothing.

They got nothing at all from the Institute.

The — now, all they did economically, was to keep a lesser part of what they already have.

Before the transaction they owned the business outright.

They were entitled not to 90% to 100% of whatever it earned.

Not up to a limit of $1,300,000 but without limit and not just to a possibility of recovering the assets, to keep the assets.

They had everything before the transaction.

Potter Stewart:

Now, who is “they”?

Wayne G. Barnett:

The respondents.

Potter Stewart:

Yeah.

Wayne G. Barnett:

Now to be sure in the transaction, the corporation was liquidated and the elimination of the corporation eliminates the corporation income tax and therefore increases the amount flowing to the respondents.

But the respondents didn’t need the Institute to liquidate the corporation.

They could have liquidated the corporation themselves and themselves lease the assets to Fortuna on the same terms.

Potter Stewart:

They would have paid the capital gains tax on liquidation.

Wayne G. Barnett:

That’s what the transaction is about.

If they’ve done that, if they’ve done that, they would’ve gotten much more economically.

They would have a 100% percent without limit.

But there would have – there are two serious tax consequences.

They would be tax on the liquidation and immediate capital gains tax in the year of the liquidation, measured by the full value of the assets.

And in addition, not besides, in addition, all the rents they thereafter receive would admittedly be taxable as ordinary income less only depreciation deduction.

Now, the purpose of this transaction and the only purpose of this transaction of respondent’s point of view was to avoid both of those tax consequences by first transferring the stock to the Institute and having the Institute do the liquidation.

They hoped not to be taxed themselves on the liquidation and in that they have succeeded.

Wayne G. Barnett:

The Commissioner did not assert a tax on the liquidation.

I happen to think Commission was wrong.

I think it would be quite plainly were taxable in the liquidation and should have paid the capital gains tax in 1953.

But that isn’t in this case.

We didn’t assert it and the respondents, I guess, they are not going to assert it.

The other object is to convert the later earnings remitted to them into capital gain instead of ordinary income as they would otherwise have been.

And that’s the issue of this case is about.

Now, if they are successful on that by making a gift and economically, all that it is a gift to the Institute of a remainder interest in the property they will come out ahead after taxes to be sure they get nothing in the world from the Institute.

They will get something from the United States Treasurer which more than pays them for what they give the Institute.

Now, I don’t think —

Potter Stewart:

The big difference though is that they have paid — kept the corporation.

They would have spent title to its earnings and profits as stockholders in perpetuity.

Wayne G. Barnett:

That’s correct.

Potter Stewart:

Here, they — they’re entitled to $1,300,000 and that’s the end of it.

Wayne G. Barnett:

That’s right.

They did give something away.

I don’t deny that they gave something away.

They have less after the transaction than they had before it.

If that’s what a gift, the remainder interest is.

If I give my son or harbor anyone else a remainder interest in stock, I do have less after the transaction I had before.

But I’m not getting anything from harbor to my son.

Potter Stewart:

But at the outset, I thought you said it couldn’t have.

It’s really just the income.

It is —

Wayne G. Barnett:

It is —

Potter Stewart:

— not installment payment —

Wayne G. Barnett:

It is in —

Potter Stewart:

— and the —

Wayne G. Barnett:

Well, I think —

Potter Stewart:

— reason I have been —

Wayne G. Barnett:

I think —

Potter Stewart:

— probably getting that is that I conceive of income as the income —

Wayne G. Barnett:

Yeah.

Potter Stewart:

— on capital in perpetuity or at least —

Wayne G. Barnett:

Alright.

Potter Stewart:

— from an indefinite period not —

Wayne G. Barnett:

If —

Potter Stewart:

— up until (Voice Overlap) —

Wayne G. Barnett:

If I give a remainder interest in stock or real estate or anything else and retain for my life the right to the income, the dividends in case of stock.

I think the respondents will agree that the dividends I receive during my lifetime are fully taxable as ordinary income to me.

None of it is capital gain.

I’ve given away something and I don’t — won’t receive in perpetuity but only because if — I’d given it away.

Actually, I think — well, if I do it for term of years, the same result follows.

If I do it for right to the dividends until I receive some specified amount how large it may be.

What I receive is simply, I retrained the right to the income for a time and given away the remainder.

So, this isn’t a noble kind of transaction.

It happens all the time.

And the fact that I’ve given up ultimate ownership in no way determines the question of whether what I received in the interim is income or not.

Now, the — if — economically, as I say, that is — just to get to the remainder, retention of the interest.

I haven’t really meant to talk about tax law on the process.

Let me turn to tax law.

The statute is very simple, the relevant provisions of the statute.

They’re very general.

Gain is gain from — capital gain is gained from the sale or exchange of a capital asset.

Gain is measured by the amount realized from the sale or exchange.

The amount realized is this amount of money received plus the fair market value of property other than money.

Now to illustrate the application of those provisions in very simple terms, I’d like several — a few simple examples of — let’s take — the gift of — the transfer of — A transfers stock to B on B’s agreement to remit income for his life.

Now what — I told you, everyone who agrees that isn’t, that’s still income.

Why isn’t it capital gain?

My transactions — a transfer of stock on the transferee’s agreement to remit the dividends either for life, for a term or up to stated amount.

Wayne G. Barnett:

And I think it is agreed that is not — the dividends remitted will be taxable as ordinary inome and not as capital gain.

Now, there are basically two reasons why that isn’t capital gain.

The first is that since my right to income is a right in the very same property I transferred, it’s only a retained right.

I may have disposed the remainder but what I have is just a carved out interest on the very thing I had before and it’s not even a taxable exchange.

I didn’t receive it in exchange for something else.

I just kept it and so there’s no sale or exchange in that case.

But the second reason is much more fundamental and that is what I have is a right to income.

And even if there were a sale or exchange, what you received under a right to income remains income.

Now, let me take a case which there is a taxable event to demonstrate that.

Suppose that I own some General Motors stock permit which I bought for $20,000 and it’s now worth $30,000 and I want to dispose it.

If I sold it for $30,000, I would have $10,000 capital gain admitted.

Instead of selling it, I transfer it to Mr. Cox and I’d tell him I don’t want the money.

Just create a trust for me of some Ford stock that he owns and give me life interest in the Ford stock.

Now, the life insurance in Ford stock is worth $30,000, so it’s an equal exchange.

However, during my life, Ford does very well and I receive total distributions of a $100,000 or $200,000 from that trust (Inaudible) — interest.

Now, the fact — there is a taxable exchange.

The exchange of my General Motor stock for a life and estate in Ford stock is a taxable exchange.

But the amount realized is the value of the interest I received, the value of the life estate and that value is $30,000.

It is only the excess of that over my basis of 20 that is capital gain.

So, I have a capital gain to be sure but only of $10,000.

Thereafter, my — I have a basis, my life estate now is $30,000 and I can amortize that against my later receipts of a $100,000 of dividends and I would be taxed on $70,000 net of dividends as I received them.

As I — later, during my lifetime, I’m — suppose I receive a $100,000 of dividends just distributed from the trust, dividends from the Ford stock.

Potter Stewart:

Extraordinary income, I don’t see (Voice Overlap) —

Wayne G. Barnett:

Of course, yes.

Potter Stewart:

— and you pay annually on that as ordinary income.

Wayne G. Barnett:

That’s correct.

Except that I can amortize my basis.

So, if you buy a life estate, you can amortize your basis against the income.

Alright, so — but my — the point is a very simple one, that if you trade — if you exchange a capital asset for a right to income even from other property.

The only amount realized — the only thing taxed as capital gain is the value of the right at the time of the exchange not the later yield.

Wayne G. Barnett:

Now, the only ex — well, let me say that that — that I think illustrates the fundamental principle of capital gains taxation, that you hit capital gains only on the values accrued up to the time of the disposition.

Not on the future income yielded by the interest received or retained.

Potter Stewart:

But now Mr. Barnett, you’re speaking in terms of simple cases.

Let me give you a simple case, tell me what the tax consequences would be?

We’re talking about General Motors stock and let’s say I have some which I haven’t — and I transferred — and this stock, pays a thousand dollars a year in —

Wayne G. Barnett:

At the moment.

Potter Stewart:

— dividends in that —

Wayne G. Barnett:

At the moment.

Potter Stewart:

At the moment in —

Wayne G. Barnett:

(Voice Overlap)

Potter Stewart:

— in dividends and its market value is a $100,000 and I —

Wayne G. Barnett:

It’s not much of a yield.

Potter Stewart:

Alright, let’s make it a $150,000 and I transfer it to you and you sale — well, you buy it for a $150,000, and you give me a promissory note and you’d — the agreement is that you’d pay me of the sales price at $10,000 a year for 15 years.

And I forgot about interest and (Inaudible) — forget about it.

Wayne G. Barnett:

Yes sir.

Potter Stewart:

But the — now who — what happens then?

Wayne G. Barnett:

I agree to pay it.

Potter Stewart:

(Voice Overlap)

Wayne G. Barnett:

I’m personally liable to pay it?

Potter Stewart:

Yes.

Wayne G. Barnett:

Oh!

Of course, that’s a sale, but a debt.

Arthur J. Goldberg:

Could we change the —

Potter Stewart:

And this is payable right out of assuming the —

Wayne G. Barnett:

It doesn’t make any difference where I get the money to pay it.

Potter Stewart:

That’s a self-liquidating pay —

Wayne G. Barnett:

If I’m liable to pay it — if I’m liable to pay it, what you have is my obligation.

Now, what money I use to pay it with —

Potter Stewart:

That’s right.

Wayne G. Barnett:

— is my concern, not yours.

Potter Stewart:

Well, let us assume it’s — that can be shown that the money you used to pay it is —

Wayne G. Barnett:

(Voice Overlap)

Potter Stewart:

— the dividends from that very stock.

Wayne G. Barnett:

It makes no difference at all.

Potter Stewart:

That’s a sale, isn’t it?

Wayne G. Barnett:

That is a sale.

Potter Stewart:

On a (Inaudible)?

Wayne G. Barnett:

That is correct.

But add that you get paid only if there is income and I have no personal liability to pay you and tell me the difference between that and the retained interest right to income.

Arthur J. Goldberg:

Let me change this example a bit.

Potter Stewart:

I’m glad you did so I don’t have to —

Arthur J. Goldberg:

(Inaudible)

Wayne G. Barnett:

I can stop with the hearing.

Arthur J. Goldberg:

(Inaudible)

Wayne G. Barnett:

No down payment.

Arthur J. Goldberg:

No down payments in a future (Inaudible) —

Wayne G. Barnett:

The value is a hundred —

Arthur J. Goldberg:

How much would it be?

Wayne G. Barnett:

The value is a 100,000.

Arthur J. Goldberg:

(Inaudible)

Wayne G. Barnett:

The value is a 100,000.

Certainly, I would agree that the extra 5,000 which is paid — that’s rather like the sale of the home with no down payment in which there’s no personal liability.

To start out with, no one pays anything but the home buyer monthly begins to pay for it out of his own pocket and I think that’s probably enough to make it a sale.

In your case —

Arthur J. Goldberg:

(Inaudible)

Wayne G. Barnett:

In your case, I’m not sure —

Arthur J. Goldberg:

(Inaudible)

Wayne G. Barnett:

No.

The problem we have arises really on only when the thing transferred its income-producing property and the right to be paid is limited.

The right is limited.

Wayne G. Barnett:

I don’t care what — where in fact it come from to be paid out of the income.

Once you add the element that the buyer is putting up something of his own, out of his own pocket, we have a very different case.

Arthur J. Goldberg:

(Inaudible)

Wayne G. Barnett:

That’s right.

You — you’re case, I find it a very tough one.

Whether — whether the — I could ask there’s no sale initially when he makes the first $5000 payment.

He’s now got something in it and that is a sale.

Arthur J. Goldberg:

(Inaudible)

Wayne G. Barnett:

I don’t think —

Arthur J. Goldberg:

— that there is (Inaudible) —

Wayne G. Barnett:

For the ultimate liability, is not greater?

Arthur J. Goldberg:

(Inaudible)

Wayne G. Barnett:

Well, the only basis I’m taking is that if you get nothing at all from the transferee, if everything you’re ever entitled to get is depended on what income that property produces without any contribution being made by the transferee, all you have is a right to the future income.

Arthur J. Goldberg:

(Inaudible)

Wayne G. Barnett:

I don’t think anybody — I don’t think anybody in the law of sales would call this a sale if it were labeled a deed of gift and the tax law doesn’t care what labels the parties use.

I do that — the same transaction occur — occurs all the time and its called a gift and the law of sale doesn’t come a long and say it’s a sale.

And —

Arthur J. Goldberg:

(Inaudible)

Wayne G. Barnett:

With no down payment, with the buyer furnishing no management, no contribution to make the asset more productive —

Arthur J. Goldberg:

(Inaudible)

Wayne G. Barnett:

But usually the payments would come out of the buyer’s pocket.

Arthur J. Goldberg:

(Inaudible)

Wayne G. Barnett:

It — come only out of income —

Arthur J. Goldberg:

(Inaudible)

Wayne G. Barnett:

And the buyer is not — is not —

Hugo L. Black:

And no personal contribution?

Wayne G. Barnett:

And no personal contribution to produce in the income and nothing is to come out of the buyer’s pocket.

If — there are lot of cases, there a lot of gifts.

The — I don’t believe there are a lot of those cases.

It can’t occur.

Wayne G. Barnett:

Why should I give you my — unless I’m undoubtedly motivated, or I have some tax advantage for my making a gift.

Why should I give you my property for nothing from you except an agreement to give me back some of the income it produces?

I was entitled to all of the income to begin with.

The transaction makes no sense except as a gift and that is what it is.

Arthur J. Goldberg:

And that was (Inaudible) — now if you take that up (Inaudible)?

Wayne G. Barnett:

Oh, but these are my payments coming out of their pockets.

But then in the case —

Hugo L. Black:

(Inaudible)

Wayne G. Barnett:

No, no, obliga — alright.

I agree with you.

I agree with you that — let’s just take the typical home, a sale of a home with no down payment.

Actually, I don’t think those are very typical, I’ll use it as guarantee or something, but assume that’s a sale of a house with no down payment at all.

I think that ought to be accounted for is a sale.

Now granted, there was no immediate down payment but the buyer makes one heck of a commitment.

In fact, the buyer — first off all, he moves in and he didn’t plan to move out next month and he’s going to start paying monthly.

And once he starts paying, he’s got a stake, a stake out of his pocket, out of his own pocket.

Now, that is not in the case I thought you were posing.

If that’s the case you’re talking about, I withdraw what I said.

But the case I thought you were posing is one in which you transfer income-producing property and the obligation is limited to remitting the income.

And that transaction just doesn’t make any sense except as a gift and it is a gift.

The essence — the essential difference between a right to income and a right in a debt and this is a distinction that arises all the time in the tax laws is whether there is a cushion for there’s somebody else that’s assuming the primary risk and the transferor has some (Inaudible) from the future risk, something that gives him at least some additional assurance of payment.

If he gets — if the transferor puts up nothing of his own, assumes no risk, has nothing to loss, the transferee.

The transferor has received nothing.

He continues to bear all the risks and it’s — he’s the only loser.

He is the only loser if the income falls off or the value goes down.

Yes, he couldn’t lose anything in this transaction.

Only the respondents could.

They’re entirely dependent on income and that I say is better right to income.

Now, I don’t know how you would ever draw the line otherwise.

This transaction, the price is one million three.

Wayne G. Barnett:

Why not two million, four million, ten million?

There is no — nothing in the economics to prevent ths price from being $10 million.

I can transfer stock and retain the right to the dividends in perpetuity and in effect simply by making the note big enough and living in the liability to remit in the dividends.

Well, if anyone of you has a share of General Motor stock, I will buy it for a million dollars on these terms.

There’s nothing in the economics for the gift of the remainder and I would — I at least who accept the gift, however, remote it is.

(Inaudible)

Wayne G. Barnett:

If I may, I’d like to reserve my time for rebuttal.

Earl Warren:

You may.

Mr. Kinsey.

William H. Kinsey:

Chief Justice, if it please the Court.

Back in 1953 in behalf of our firm, I wrote an opinion that told Mr. Brown that he was entitled to capital gain if he went into this transaction.

Today, I would not write an opinion saying that the tax consequences flowed in the manner that Mr. Barnett has stated in some of the illustrations he used.

But I won’t show the flaws in them because I’m not sure that the — particularly pertinent, I’d rather proceed with the case.

It is true that a transaction of this type is subject to abuse.

It is also true that the standard of the plan for a corporate buyout that I outlined in my brief, where a person forms a thinly capitalized corporation and buys the stock of another corporation liquidates it in that that too is subject to abuse.

In either case, the purchaser could assume the role of a complete patsy and say, “Since I’m risking nothing.

Since there’s no skin off my nose, I don’t care what the purchase price is.

The agreements I have here have the price left blank, you fill it in.

You just see that I get something as we go along such as 10% or a little salary and I won’t care”.

Such a situation, such a sale would be bad and it would not be entitled to capital gain.

Now, the factors that make it subject to abuse are the lack of down payment, the lack of personal liability or the lack a commitment of independent assets but whatever the fact that it may be subject to abuse does not mean that every case where you have these lacks is abused.

Also, this transaction does not fit in with may be which we would call the traditional or standard mold of commercial transaction.

However, the capital gain provision does not say sale or exchange.

In ordinary commercial transactions, it says, “Sales or exchanges”.

In the definition of a capital asset, it excludes from the definition property held for sale to customers in the ordinary course of business.

But that’s an exclusion in defining sale.

There’s nothing that says that it has to be a sale in an ordinary commercial transaction.

Potter Stewart:

Why wouldn’t your first case you’re abused — be a capital gain and why — and what would the difference?

If you look at the — well, that’s a sales price, is that it?

William H. Kinsey:

Yes, because if you wrote in a sales price where it was necessary run the asset to extinction to pay the price you have converted future income into capital gain.

William H. Kinsey:

Our whole thesis is based that to distinguish the good from the bad there has to be a reasonable relationship between the values of the property at the time a conversion at the time of a sale and the amount that you have received for it.

Potter Stewart:

And that in your opinion is a crucial issue?

William H. Kinsey:

That is the crucial issue.

That’s and another one what I refer to is no strings.

A what?

William H. Kinsey:

No strings.

In other words, you don’t have the right to get the property back.

The only strings is a security device that’s reasonable under the circumstances and where you’re dependent upon the future income from the property and management.

A management contract is part of the reasonable security device.

But it can extend beyond payment of the full purchase price.

In other words as I paraphrase it shortly, if the price is right and no strings, all possible questions are answered so far as capital gain prerequisites are concerned despite the fact that there’s no down payment, no personal liability or no injection or commitment of independent assets.

That was the position that we took in the Tax Court.

That was our theme.

Byron R. White:

— you may rely on the tax advantages of the buyers to enhance your purchase price.

I mean, they’re reasonable as to the purchase price includes — I mean it is reasonable to take advantage of the buyer tax position in order to get a higher price to you by using the standard transaction.

William H. Kinsey:

I don’t think that the use of –-

Byron R. White:

Isn’t that the only — the only reason you got a higher price here than you would’ve had under the standard deal is because of the Institute position?

William H. Kinsey:

I don’t think we did get this higher price than we would under the standard deal because I think the standard deal would have given just as much as the Institute deal did.

That was the point I was making in the brief in comparing the results of how this would have work if you handled that under the standard deal.

And maybe I should get to show how the standard deal works in —

Byron R. White:

Well, I thought you at least said that if you — you had more money to work with through this deal than what the —

William H. Kinsey:

We had a little bit —

Byron R. White:

You have $00.72 in price.

William H. Kinsey:

We had $00.72 as contrast to the $00.70, the first or $00.65 composite — but that was over the short period of time.

At the end, you still had depreciation left.

In other words, that was over the five-year period.

You hadn’t used up all your depreciation.

It just gave you the cash flow quicker.

It didn’t give you anymore cash flow.

In other words, under the basic tax axiom that every purchaser receives a tax basis in the amount that he pays for the property that he is entitled to recoup at some time in some way tax free.

William H. Kinsey:

All he has to do is coordinate that recoupment with this payment upon the purchase price and he is entitled to receive tax fee everything he pays on the purchase price but as a matter of timing.

The difference was only one of timing as I see it between the standard transaction and the Institute transaction.

Under the standard transaction, the purchaser would receive a basis that would entitle him to recoup tax free the full $1,300,000 that he paid.

And even in this particular transaction that’s particularly conducive of that because most of the assets were depreciable or depletable assets.

You didn’t have much value in land where you have a considerable value in land or an undepreciable asset.

It’s a little more difficult to get the same results under the standard transaction.

Byron R. White:

So, why did you choose the Institute group rather than the tax with the foundation group rather than the — than your group?

William H. Kinsey:

Because the Institute came to Clay Brown and by the time we were submitted with the transaction, it was pretty well gelled.

I actually explained to Mr. Brown how you could get this about the same results under the (Inaudible) — standard transaction but I just pointed it out.

We didn’t go out and shop it.

If that’s — happen to us when we have represented people, I don’t like to steal a deal when somebody else has it all gelled.

But that was pointed out that he could do it through the standard transaction.

That’s why we felt fairly confident in telling him that he could get capital gain if — because gut wise nothing more was happening here than you could do under a standard transaction there would have been through several times that had been passed with no questions asked.

(Inaudible)

William H. Kinsey:

Now of course, nothing in the law requires a down payment.

As a matter of fact, the Installment Section, Section 453 was amended to expressly exclude the necessity for a down payment in the year of the sale.

You are entitled to report under the installment method if you receive nothing in the year of sale.

Also, under most state laws deficiency judgments are forbidden.

So, certainly there’s nothing in the law that prevents a combining of the two no down payment and no personal liability so as not repugnant to the law.

I think that all that we can say where we have a lack of these elements that is the down payment and commitment of assets that the transaction is subject to additional scrutiny because you don’t have the interplay of economic forces that you would have if you did have a down payment or a commitment of other assets.

But if it survives that scrutiny, then the mere fact that it might have been abused but wasn’t abused doesn’t disvalue — disqualify it for capital gain.

Now, what scrutiny did this transaction obtained?

I’d like to say a few words about the Tax Court trial.

This wasn’t a case that got through the local office in Portland without the Government being aware of its significance.

They were aware that this was the first case, the forerunner case.

We purposely wanted to be the first case because I didn’t know when I wrote the opinion back in 1953 that this was a widely publicized tax avoidance scheme.

So, law review articles hadn’t been written in, that revenue ruling hadn’t been issued at that time.

So, we had taken a couple of features out that were present in it, one being, the Institute’s invitation that Mr. Brown own 49% of the lessee company.

We couldn’t see how that had any relationship to just a security device.

Also, that you — they said you can have a management contract, an employment contract until you’re ready to retire.

William H. Kinsey:

We couldn’t see how that had anything to do with the security device.

So Mr. Brown did not own anything in the lessee corporation and his management contract is extended only until the purchase price was paid.

Now, I’m not sure that those two will make it bad if it’s otherwise good.

It’s just, we didn’t want to come through (Inaudible) — mudded waters.

And also, our price was right and we got the inference, maybe it was the wrong inference because all of the cases decided since then have been favorable to the taxpayers that perhaps there is a backlog of cases where they have unrealistic purchase prices.

Well, ours wasn’t and we were willing to subject it to the scrutiny of the Tax Court and we did and as I say, our tom tom there was the price is right and no strings.

So maybe it is a little bit of an offbeat transaction but still we’re entitled to capital gain because there’s nothing that says that the purchaser has to contribute something to a deal for capital gain.

It’s what the seller gives up.

And if the price is right and you give up all ownership and the assets when that price has been paid, you have converted your capital investment pure and simple.

And you should be entitled to capital gain for what you received despite the fact that the source of the payment are the income earned, is the income earned by the assets transferred and any proceeds from the sale are up by virtue of the mortgage that you have —

Potter Stewart:

Mr. Kinsey, I should know the answer to your question but I don’t.

Are there explicit findings here as to the fairness of the price or the economic reality of the price?

William H. Kinsey:

Absolutely.

In fact my — there are very explicit findings.

I have summarized them somewhat in the brief and I’m quoting now from what the Tax Court said.

Potter Stewart:

You refer in the record, do you?

William H. Kinsey:

Yes.

I’ll give the record page, it jumps around.

Potter Stewart:

Alright.

William H. Kinsey:

It’s on page 12 of my brief where the extracts are —

Potter Stewart:

Alright.

William H. Kinsey:

— where it says, “The price was the result of real (Inaudible) — real negotiating.

The final agreed price was arrived at in an arms length transaction.

The price was within a reasonable range in the light of the earnings history of the corporation and the adjusted net worth of the corporate assets”.

Petitioners by the transaction here involved parted with their equitable ownership of the assets when they transferred their stock to the Institute and became the creditors of the Institute with the mortgages and the management contract to security for payment of the purchase price in the stock.

Now, then this next one I think is important because it goes to the validity and the impact of the negotiation.

The primary motivation of the Institute was the prospect of earning up the assets free and clear after the purchase price had been fully paid which would permit the Institute to convert the property into money for use in cancer research.

Now, it could have been content with just 10%.

It could have taken the patsy approach but it didn’t.

It’s (Inaudible) as I believe it was expressed in the testimony.

William H. Kinsey:

It’s (Inaudible) was ending up with the assets free and clear.

Therefore, every dollar it knocked down in the purchase price, 90 cents of those dollars were extra dollars that it would get that it otherwise wouldn’t get if it didn’t knock the price down and there was real negotiation.

Arthur J. Goldberg:

(Inaudible)

William H. Kinsey:

Well, Clay Brown, weren’t happy with the price and I’m sure the Institute didn’t seem happy so I guess that’s the way it should be with neither side as happy with the price, you finally got a good one.

Arthur J. Goldberg:

(Inaudible)

William H. Kinsey:

Pardon?

Arthur J. Goldberg:

You would cut off (Inaudible) —

William H. Kinsey:

Well, not in the traditional mode.

I would — I would not say — I’d say yes, it’s a commercial transaction because they had a motivation for negotiating a lower price.

Arthur J. Goldberg:

The motivation being if they wanted to get more money for the charity.

William H. Kinsey:

That’s correct.

Arthur J. Goldberg:

Just as any charity would like to get from any — give her more money than they were originally offered.

That’s the same motivation, are they?

William H. Kinsey:

In a sense, yes.

There was another reason why the purchase price — another governor on the reasonableness of the purchase price and that’s the — in order to have this not beyond related income, the lease cannot extend for more than five years so as stated in the brochure that Mr. Barnett referred to.

It says, “We only want companies where we can show that the purchase price can be paid in five years”.

Well, if you can pay the purchase price in five years, you can’t pay a very exorbitant price for that business.

That’s anything they can pay off in five years, that’s an automated governor on the amount of the purchase price.

You can’t go sky high in a situation like that.

Now —

Arthur J. Goldberg:

Is this any different in substance and I’m not talking about the tax constitution, and is this not really as it appears from the amicus brief and others, an arrangement by this charities can accumulate the property.

And the donor, the giver, the seller, whatever you may call it they give benefits by reason on the operation of the tax.

William H. Kinsey:

Well, with our thesis of the price, it was right and there were no strings, the sellers got no benefit that they could have gotten by selling it to a non-charitable institution.

Yes, the Institution does benefit and but the true benefit has not yet happened yet.

I mean, the true beauty of this from the charity hasn’t — didn’t come into play.

Ordinarily, a person who bought a business and used cash flow to pay the purchase price, used up all its depreciation then when he sell it, he’s going to have a big capital gain, the charity wouldn’t.

In other words, that that the true beauty of the charitable exemption isn’t even involved here.

That would come into play when it subsequently sold the assets.

It didn’t have to pay anything on the gain and would have a hundred cents out of every dollar for which it sold.

Now at the trial, and the reason I think this is important is because Mr. Barnett asked a lot of questions and raises a lot of inferences, many in which could well be — well, been asked at the trial.

William H. Kinsey:

We presented all of the principal parties as our witnesses although there was a big — a stipulation.

It would have been sufficient in themselves and our purpose of doing it was to tender them for cross-examination.

So if they had any questions they could ask them.

Earl Warren:

Continue your argument.

William H. Kinsey:

Chief Justice, may it please the Court.

I was relating something about the Tax Court trial with the thought in the mind that this would be of interest to negate some of the inferences that may have been raised by Mr. Barnett’s brief in his oral argument that our approach there is the same here that if the price is right and there are no strings, we’re entitled to capital gain treatment.

The Commissioner’s main contention at — in the Tax Court was that there was a secret understanding, a tacit agreement that the Institute was never really to end up with the assets but that Clay Brown could get them back anytime he wanted so he could generate this capital gain and also not have to give up the assets and the Institute would get its 10% so it would be happy with that.

Of course, we recognize that they were correct in that statement, that we were entitled to capital gain.

That was quite a potent accusation they made which meant that we put everything on the record.

That’s why the record was so complete.

Now on appeal, I get a little bit of the inference that because the record is so voluminous, therefore, it must have been kind of an offbeat transaction.

And the reason the record was so voluminous is because of that contention made by the Commissioner at the Tax Court trial.

The Tax Court held against that contention and the Commissioner abandoned it on appeal.

The Commissioner also contended that Clay Brown retained too much control over the assets.

There wasn’t much contention that the purchase was too high.

That was an attack.

There wasn’t any statement saying, “Well, no one on the right mind would make this sale.

You must have had an unusually high purchase price because the witnesses were there”.

They could have asked them that question.

We put on Clay Brown and we put on Bill Booth who was his treasurer who took care of that compiling the figures and showing the earning at the record and so forth.

Mr. (Inaudible) who formed — Fortuna, was there.

We tendered them all on cross-examination so they could have the omplete leeway of cross-examination to ask any questions they wanted.

Also, the Institute, I mean the Commissioner subpoenaed and brought up for Los Angeles the President of the Institute, Mr. (Inaudible) and Mr. Seagrave who negotiated the transaction.

However, the Commissioner did not call them and would not have called them.

I had to call them as our witness so they had them on cross-examination to ask whatever questions they want.

The Commissioner in the Tax Court called only one witness and that one witness was me and they asked me just a couple of questions, my name, whether I specialize in tax planning, and that was about all.

John M. Harlan:

How about (Inaudible)?

William H. Kinsey:

What — the way they arrived at the price was they took the earnings record.

They based some on the earnings record.

The average earnings were about 350,000 a year.

William H. Kinsey:

Another thing, they reconstructed the balance sheet.

(Inaudible)

William H. Kinsey:

They took the book balance sheet and substituted — appraised the values for the book values and came out to a figure that was about a million one then they justified the difference between the million one and the million three by the earnings record of the company.

It was a combination of the two.

The original asking price was I think about a million six.

It’s a little confusing because there are a $125,000 of promissory notes in there and in some of the negotiations they were talking about the purchase price exclusive of the notes.

In another negotiation they were talking about the purchase price including the notes.

But the $1,300,000 included the notes so the purchase price of the stock exclusive of the notes would be a $1,175,000.

Whenever I say the purchase price for the stock, I mean the stock in the notes.

I’m just using the short term “stock” in this argument.

Byron R. White:

Well, Mr. Kinsey, what in your mind would be the reason for getting a different result in this case than you contend for now.

If the purchase price would — had been specified here at say $10 million?

William H. Kinsey:

Then I think you get into the Koki situation.

That was where there was a high purchase price and at the time of the trial, the seller was back in possession of the assets.

If you have the purchase price very high plus some mortgage, and it’s a foregone conclusion, you’re going to default, you’re really have the strength if you really given up the asset.The way the Circuit Court expressed it you have a closed circuit.

If the purchase price is high coupled with the security device, there’s little likelihood that the purchaser will end up for the assets.

Byron R. White:

Yes, but the purchase price playing only out of — paid only out of income.

William H. Kinsey:

Yes, but —

Byron R. White:

And there might be just a little income but it might be payable or you might be able to pay it out over a 100 years or —

William H. Kinsey:

Well —

Byron R. White:

— 10 years or 20 years or 30 years?

Where would the default be?

William H. Kinsey:

Well, in ours and I think in the once that follow this pattern.

There are — the default if a specified amount and not have been paid over a two year period and a note became payable in all events in 10 years.

In other words, it just didn’t go on forever.

And also, I think we’re being may be somewhat liberal.

At least, we’re not taking an extreme position when we say that a reasonable price is necessary to get the capital gain.

Maybe we should better express it by saying if the price is right.

Then there’s no question about qualification for capital gain.

But it kind it goes with the concept of conversion of capital investment which is the phrase used by this Court that your capital investment is the value of the assets at the time of the conversion.

William H. Kinsey:

So, if the purchase price way exceeds the value at the time of conversion.

Don’t you have proceeds from something other than the conversion of capital investment?

Byron R. White:

And you say that the advantage refers to the advantage to your client here was in the — is the timing advantage only that the rate of payout is faster than in the normal circumstance where the — where it depend on the appreciation appraised?

William H. Kinsey:

That is correct.

That’s correct.

Byron R. White:

So that is risk against the — against risk in the marketplace as the — what’s left here.

It’s something that — maybe just — this risk doesn’t last for so long.

William H. Kinsey:

That’s correct.

The quicker you can get paid out, the last risk there is.

Now —

Byron R. White:

And the — and for the Institute, they guaranteed to pay a certain amount — certain percentage before taxes.

William H. Kinsey:

Well, taxes weren’t mentioned because they just agreed to pay a certain percentage because they’re not subject to tax.

Byron R. White:

Oh, I know, but what if it turned out that they were?

William H. Kinsey:

That’s a good question.

On the amici brief, uses that as a reason for — may be there’s some consideration there that if that they would have to pay the taxes out of their own funds.

Byron R. White:

And that — and if — that would be on the basis of this lease — had rent this — the rental income really is a rental income but it’s from the operation of business.

William H. Kinsey:

Well, yes.

I think —

Byron R. White:

Or unless there a whole exemption is cancelled.

William H. Kinsey:

Yes.

But even then, I think in this case, there wouldn’t be a much taxable income because —

Byron R. White:

(Voice Overlap)

William H. Kinsey:

— they’d be entitled to the depreciation.

Byron R. White:

But except that basis.

William H. Kinsey:

Correct.

And here, the property was condemned and it was all gone over a seven year period and they get to recoup their whole basis over that seven-year period so they get to deduct the million three.

The only question it would be whether they carry back and carry forward provisions would even it all out or whether some operating loss might go down the drain but even if their not tax exempt.

There would be very little tax is payable by the Institute.

So whether they are tax exempt or not, I don’t think it’s much concern to anybody.

And also, just because there’s a sale, it doesn’t follow that the Institute is taxed on the rental.

William H. Kinsey:

True that Mr. Barnett says that if we lose the case, they aren’t even going to press the issue with the Institute.

But it doesn’t mean that if we win the case and they press it that the Government will win.

I don’t think they will.

And even if they did it doesn’t mean that they’re — that they are entitled to their depreciation because of course, they would be.

But now, may be to pursue that point a little further, to understand why someone might want to sell on one of these bootstrap situations, it’s necessary to understand the position of the owner of a closely held corporation.

He can’t take his earnings out in the form of dividends because the tax cost is rather prohibited.

His tax of 52% in the corporation and say, if he’s in the 50% bracket, that’s 50 cents coming out.

And what he looks that is the dollar earned by the underlying assets.

What do I have left over for a dollar for the underlying assets?

It’s not the situation like that Mr. Barnett’s suppositions where you’re owning stock in a publicly held corporation where your only source of income were dividends.

I mean, that’s a completely different world.

That’s the main difference between Mr. Barnett and myself that we’re talking in different economic worlds.

He puts the transaction against one native habitat and I do against another and the transaction is (Inaudible) — completely different.

And I think he might illustrate the difference in our world but Mr. Barnett would ask with rising inflection in his voice, “Do you mean to tell me that a purchaser will pay for a business out of the very earnings of the business that you’re buying?”

And my reaction to that is, how else?

How else do you buy a business?

In our world that’s the norm.

That’s the way businesses are bought.

Now —

Byron R. White:

But in the real — in your real world, of course, the standard transaction, the buyer runs his business.

William H. Kinsey:

Correct.

Byron R. White:

And the fellow who sits there are being paid for his stock out of the earnings of the business he just sold, sits there and gets his money at capital gains rate but he can’t determine whether or not that company is going to be able to pay or not.

William H. Kinsey:

That is correct.

Byron R. White:

In this transaction, this fellow retains control — this fellow contains control, he runs the business.

At any time he wanted to, I suppose you could say, he could cause it to fail.

William H. Kinsey:

He could.

He would do that.

Byron R. White:

He’d get enough money on — that’s the — if he wants it back, he can get it back.

That isn’t true in your (Inaudible) — in the transaction you weighed us from against.

William H. Kinsey:

That’s correct.

Byron R. White:

(Voice Overlap) transaction.

William H. Kinsey:

And in that aspect of the case was the main one they gave me pause when I rendered the opinion that he is entitled to capital gain.

And that one has not been raised by the Government either in the Tax Court, in the Circuit Court or here up till now.

And the way I answered that was — well, that they did in the Circuit Court.

They said that the control was so great that they could’ve forced the default by maybe mismanagement or doing this and that.

But as we pointed out, it would be a breach of the agreement.

And also, I think they couldn’t purposely throw the ball game.

I think they had a fiduciary duty to run the business so that there’d be a payoff.

But the main way I answered that which I recognized as being the most difficult point in the whole thing was to analogize it to other situations where capital gain is realized, particularly in a Section 1239 situation, where a person owns depreciable property and he sells it to a corporation in which he owns 80% of the stock.

There, capital gain is expressly condoned by the statute.

I can sell to may own corporation.

I own 80% of the stock.

I can take capital gain, the corporation gets the depreciation.

I control the Board of Directors, I’m President and capital gain is allowed.

So at that background, I couldn’t see why the fact that Clay Brown also managed the assets, the profits of which were used to pay as purchase price was the thing that would disqualify this for a capital gain.

Byron R. White:

Of course, his failure to produce income, his own failure to produce income triggers the default on the part of the other party.

William H. Kinsey:

That is correct.

But, they certainly could cancel the lease if they figured that he was guilty of mismanagement or there was anything peculiar going on.

And also, I think it was to his self-interest.

He wouldn’t have gone into the deal in the first place.

It’s one of those situations where it’s got to be good for all parties.

And I think it was his self-interest to get paid out.

And as you’ll note from the record that the Institute did do checking on him through the bankers and they got a good reference on his character and integrity.

So I think that possibility was contemplated.

But the mere fact that he might breach the agreement and do something that I think we would even say unethical that you don’t take that into consideration in determining the tax consequences particularly when you say, “Well, I can sell them my own corporation; 80% owned”.

And there, I even have the assets.

I mean, it isn’t a — here, they’re all gone when the purchase price is paid.

There, I still have them in my corporation, at least 80% of the —

Byron R. White:

Did the Government contend in the Tax Court or any place else that your client could not have sold its business for this price in a normal transaction?

William H. Kinsey:

No.

Byron R. White:

When the — what — in Tax Court, I gather you say found the price reasonable.

William H. Kinsey:

We said their price was reasonable, yes.

Byron R. White:

But the — did they mean to say that you should’ve gotten this price from anybody else?

William H. Kinsey:

No, that the Tax Court said that, the Institute might have paid more than the ordinary purchaser in a different transaction.

But I don’t know what the Tax Court — but they said the price was within a reasonable range and as —

Byron R. White:

The Government never contended this was an unreason — that you could have gotten this in a normal transaction?

William H. Kinsey:

They never did, no.

Or at least never were they said there was this much more and if I don’t even think they said anymore.

Of course, they’re lot of inference that they didn’t agree with anything.

But they never came right out and say we think this price is too high or that the evil in this thing is an exorbitant price.

But we just knew it was important so we put in all of that.

It wasn’t to counter an argument of theirs.

It was to make our record because we had the burden of proof.

Byron R. White:

I take it the Institute have the right at any time to pay the balance of the purchase price.

William H. Kinsey:

Absolutely.

They can refinance anytime they wanted.

And if they gotten near the end and they make it carry default and I imagine there’s an equity or redemption.

And so that they could protect themselves there was nothing that prohibited them from using other funds if they wanted.

Now —

Byron R. White:

So, if this business is really worth something when it went — when it got into trouble, it is — if the Institute had thought that the — is really worth more than what was left going on and that it could’ve salvaged the business.

William H. Kinsey:

Yes.

And that’s exactly what it would have done of course because if it had a — been commercially feasible for — to do it.

It wouldn’t let a default, just a technical default go by if the business were worth something and it could salvage it by getting outside funds.

While it might not be able to use funds it could get for cancer research still it had quite a potent management committee that passed upon this transaction.

I think between and they could have seen that it was refinanced.

Their funds were procured in order to preclude any default.

Now, I think maybe a good test to see whether anyone in their right mind would enter into a (Inaudible) — transaction like this would be — to look an example of a transaction given by the Secretary of the Treasury before the House Ways and Means Committee, when he was attempting to have the law changed to adopt just about the thesis that Mr. Barnett is expounding before this Court.

That example is on page 44 and 45 of my brief.

Byron R. White:

When was that?

William H. Kinsey:

That was in 1963.

Byron R. White:

(Inaudible)

William H. Kinsey:

And this example is captures.

If you’re going to capture in a law school type essay question, you couldn’t better capture our situation and the standard plan too say across breeding of it too.

You couldn’t better capture it than you do in Example 1 right here.

There isn’t any down payment of — from independent funds.

It seems obvious they’re using funds from the company purchased.

The purchase price is payable only out of 75% of the corporation’s net profits.

And I’m sure that the Secretary of the Treasury here wasn’t just giving to Congress an example of an idiotic situation no in their right mind would enter into.

I think he was giving a very real situation and you’ll notice that the Secretary of the Treasury said that under present law, capital gain treatment would be accorded.

He didn’t say capital gain treatment might be accorded.

He said it would be accorded.

His only qualification was whether you get your basis recovery right of or whether you have to take your basis recovery pro rata.

And that is an important part they made in the brief that I won’t to elaborate on too much in argument that that plus, Section 4 of the Interest Imputation Section, Section 483 that the Commissioner went out to Capitol Hill and try to get Congress to adopt this view point.

Congress knowingly said, “No, we don’t want it.”

But they didn’t leave at all tax as ordinary income.

They said we’re going to impute interest because we didn’t have interest in our — the $1,300,000 was payable without interest and one of the alternative contentions made by the Commissioner was that you have an interest factor in there.

The Tax Court held against them on that and the commissioner abandoned that upon appeal.

And as we have stated in our brief, if it takes an act of Congress to reverse an alternative contention of the Commissioner, why should they take an act of Congress to do as main contention, particularly when its main contention is set forth in a question in an example presented to Congress where he says unequivocally, you get capital gain in a situation like that.

Also, I cite that example for the proposition that situations like this are normal that people do enter into them.

Otherwise, the Secretary of the Treasurer wouldn’t have given this example and I’m certainly sure that you don’t presuppose in this example that the purchase price was adjust purchased price from $350,000 was an exorbitant price.

I think it’s a reasonable price.

But I think we can see from this example why a purchaser adds something and contribute something to the deal even though there’s no injection on new capital, no down payment or no personal liability and that’s because of the increased cash flow.

Because all we have to do in this example is superimpose a few facts and I think it comes out fairly clear.

It says that M — that S had a basis of 75,000 for a stock.

That means, they only paid 75,000 into the corporation.

So, the corporation made profits and bought machinery but let’s say that it’s also depreciated its machinery.

Let’s say its machinery has depreciated down to $50,000.

Now, the purchaser who comes along and pays $350,000 for that business gets added depreciation of $300,000, added depreciation of $300,000 at a 50% rate is a $150,000.

A $150,000 of additional cash flow, of additional available dollars that a purchasing company gets irrespective and independent from any initial injection of capital or any personal liability.

Actually, a person who is selling a small corporation has to sell on the deferred payment basis because there aren’t too many people around with that much cash and if they have that much cash, they don’t want to put it on one deal so selling on the deferred payment basis is the norm.

William H. Kinsey:

So the question is, how much beefing up can you get.

In every purchaser likes to get away with this little as possible, he likes to commit as little of its assets as possible.

And usually the reason that you want some beefing up is not so much that that is going to give you a cushion because how much — cause if things go bad even if $50,000 cushion isn’t really going to be adequate.

The main reason for the cushion is to make the purchaser hurdle a little so that he’s sure that he gives it a college try.

But here, we didn’t have to have that because Clay Brown was managing it and he knew it would be given a college try because he was the one expending the effort.

But that’s what makes these things go under the standard plan that you get this additional cash flow by virtue of this depreciation.

But may be that’s a bygone era and that’s another thing and I think the Commissioner is already won the day but not in this Court but by statute.

Because under Section 1245 that adds back your depreciation.

Any depreciation taken since January 1, 1962 is taxed as ordinary income.

So, if you got to step up to $300,000 from depreciation I mention and all that depreciation were taken since January 1, 1962 it would be taxed as ordinary income.

All the beauty is gone from the transaction and you probably wouldn’t do it that way.

So, this maybe is a passing era, this of the standard plan.

But it wasn’t a bygone era at the time this transaction was entered into it.

And all that this formula with the Institute was simply a different means of generating cash flow.

Byron R. White:

What has happened in — (Inaudible)?

William H. Kinsey:

The 1245?

Byron R. White:

Yes.

William H. Kinsey:

Well, that’s only prospective.

That that’s of — that’s the trouble here you see.

We don’t mind stuff that’s prospective.

It’s when you go in the deal and then it’s done.

Anything that’s prospective is alright.

I recognize as taken some of the beauty out of this deals but in other words he changed the ground rules.

When you know the ground rules —

Byron R. White:

What statute was (Inaudible)?

William H. Kinsey:

It was both.

And it only implied to deals made after a specified date and only applies to depreciation taken subsequent to January 1, 1962.

In other words, you work hard in it unknowingly.

There was plenty of advanced notice.

(Inaudible)

William H. Kinsey:

Pardon?

(Inaudible)

I don’t think there’s any exemption (Inaudible)?

William H. Kinsey:

No, that was —

Isn’t that the (Inaudible) — something about the (Inaudible)?

William H. Kinsey:

Well, 1245 is that the appreciation recapture.

The interest imputation one is 483, that’s prospective too and the prospective ones are alright.

It’s this retroactive —

(Inaudible)

William H. Kinsey:

— that hurts.

— the prospective that the (Inaudible)?

William H. Kinsey:

Is prospective as to new deals and also as to depreciation.

(Inaudible)

William H. Kinsey:

Yes, on new deals.

(Inaudible)

William H. Kinsey:

Yes, correct.

So, that is part of our thesis that Congress is aware of this bootstrap sale situation.

They know what’s going on and they’re aware of all its facets and they’ve taken care of it.

They’ve changed the ground rule.

Byron R. White:

But you would — I thought you had the same (Inaudible)?

William H. Kinsey:

That — well, no, this also stops deals with the Institute because the 1245 pick up — applies upon the liquidation of the corporation, the tax exemption that the Institute were not affected.

It’s a bygone era for Institute deals as well as the stamp —

Byron R. White:

I know that.

William H. Kinsey:

Well, because of Section 1245 picks up the depreciation on — not just to sale but any disposition with certain exceptions that don’t apply the liquidating distributions to any disposition of depreciable equipment.

Its tax to the distributing corporation like when Clay Brown was liquidated into the Institute, Clay Brown is the distributing corporation.

Its not tax exempt, you see.

So the Institute’s exemption does not immunize the 1245 pick up.

So I — as I say, the danger in any — well, actually I thinking it was good.

It gives (Inaudible).

It helps deals be made my philosophy of taxation.

William H. Kinsey:

But Congress has spoken so we have to play with the ground rules as they are but they apply.

If the standard plan approach is dead, the Institute — formula approach is just as dead because this hit just as hard as is this standard plan.

So, whenever they do that Section 1245 in the impute interest and not only that but Commissioner goes to Capitol Hill and gives a hypothetical like this which adopts — practically what Mr. Barnett was saying and Congress says, “No”.

I think you have a pretty good expression of congressional intent.

And now under law and Mr. Barnett’s argument, actually I go along with them a surprisingly long way in the law and it might be some help if I indicated how far along I go with him, and then see where we part.

And then maybe where we part maybe some indication of who’s right.

When you’re dealing with taxation, I like to start with the Code provisions.

And there is one spot in Mr. Barnett’s brief where he mentions the Code provisions, both in the same paragraph which is the only place that he mentions on both on the same paragraph.

And that’s on page 15 and 16 at his brief where he says, “If in a realizing event, a transferor receives a right to income in exchange for a couple assets the only amount realized from the exchange itself and hence the amount taxed as well as capital gain is the value of the right to the income.

The income may after produced by that right remains fully taxable.

Capital gain is from the sale or exchange of a capital asset”.

What page is that?

William H. Kinsey:

That’s on page 15 and 16 of into reply brief.

Hugo L. Black:

Oh, his reply brief.

William H. Kinsey:

And then it says, since the right to future income is property it is only the fair market value of the right received the enters into the computation of capital gain.

I can go along with that.

I don’t have to quarrel with that statement.

And it isn’t just taken out of contents because he ends up his brief with the same thing.

His reply brief, where he says the only thing entitled to capital gain treatment is the appreciation in value of the capital asset prior to the disposition.

Where is that?

William H. Kinsey:

That’s on page 37, right down near the bottom.

We agree with that.

We’re not ascribing any other attributes to the capital gain provisions.

When what is received may exchange for a capital asset is its self right to income.

The only possible way in which the gain can be separated from the future income is by valuing the right to the future payment and treating its value as the amount realized.

Well, applying that to the facts of our situation, the realizing event was the transfer of the Clay Brown and company stock to the Institute in return for the right to receive a million three.

Now that million three was represented by a note, but the note was non-negotiable and incorporated the agreement by reference.

So I don’t have ascribe any particular significance, the factors, I know it.

I’m willing to say, it was just a contractual right to receive a million three.

So, alright, we’ll let our capital gain be determined by the value of that right on February 4, 1953.

William H. Kinsey:

What was the value of that right?

We think it was a million three or it was the same as the value of the stock.

And all he has done is taking the reverse side or back door approach to point one of our initial thesis that your only entitled to capital gain in the extent that the stock was worth a million three on February 4, 1953.

It’s the same criteria go into determining what’s the value of the right to receive the million three as go into the determining what’s the value of the stock.

It’s the earning record of the company.

It’s the underlying assets, because there was a mortgage on it.

So I think we have a merge plot if the stock was worth a million three, the right to receive a million three was worth a million three.

Potter Stewart:

But suppose it’s a matter of economics it wouldn’t be exactly a million three.

It’s a million three discounted by the facts (Voice Overlap) —

William H. Kinsey:

Yes, but the —

Potter Stewart:

— installment faction.

William H. Kinsey:

The fact that you don’t discount the reason — alternative contention and they lost that and they abandoned that and that’s what Section 483 remedies.

So, I think that is kind of a side.

Potter Stewart:

Walks out of this (Voice Overlap) —

William H. Kinsey:

Yes, that’s correct.

But I think actually you can find a value easier in the right to receive the million three than you can in valuing the stock because here, there is a finding that the Commissioner agreed to because its I meant to mention in discussing what the Tax Court said that the Commissioner excepts in the Circuit Court all of the basic findings of the Tax Court.

One of those findings was that the Institute expect it.

And I think the Institute would include Clay Brown because he furnished the figures expected that the purchase price would be paid in five years.

The note wasn’t due till — for 10 years.

So, he had a 100% leeway there reduced between 5 years and 10 years to expect to be in — paid in 5 years be pretty hard to say that a note secured by this underlying assets and so forth was worth anything less than a million three.

So, let our capital gain be determined by the million three.

But then where we part company is — I’m not sure we part the company, it’s how then he gets the receipts on a tax as ordinary income because under the installment method, you’re entitled to report on the installment method.

And the installment provision does not apply just to sales even if these weren’t a sale it applies to sales in any other dispositions.

The installment method does not require any indebtedness.

All it requires is the right to receive income.

The only mention of indebtedness is it says, “You can’t receive more than 30% of the purchase price during the year sale and in determining the 30% you exclude evidences of indebtedness of the purchaser.”

But evidence of indebtedness of the purchaser are only something you exclude to keep from getting knocked out of the coverage of the provision, it’s not that we requisite for coming under it.

So if we have a — the right to receive the million three, is worth a million three in February 4, 1953 we don’t have to take it into income and figure out some way to get it back through amortization or depreciation.

We rely on the installment provision or even if you didn’t have to get it back, you could amortize it.

Because if I paid a million three for a non-negotiable promissory note for a million three, I certainly would get to set off my purchase price for it as I received it.

William H. Kinsey:

Now, he tries to relate it back got, you got to get it related to the underlying assets some weight but that isn’t necessary at all.

In other words, you can go right down with them on the approach.

I think our approach is better.

I think in the front door, a conversion of capital investment, what was the stock worth at the time is a little more better approach than taking the other end of it that the –what was the right to income that you receive, what was that worth?

But either way, you end up on the same spot and the only place he goes astray — and I think what he says is, “You not only got to take the million three in as capital gain but also you should receive payments on the million three.

You got to take that in as ordinary income where there’s just no foundation for that in the tax flow whatsoever”.

Then say, “Even if it wasn’t for the installment sale provision, you have the equivalent of cash doctrine for a cash basis taxpayer which these were and while the right to receive the million three maybe worth a million three for determining capital gain purposes it’s not for the purpose of reporting income because it’s been established that if you have the obligation to General Motors to receive a million three, a cash basis taxpayer doesn’t have to take all of that in.

He just takes it as he receives it.

He only has to take it all in if he receives the equivalent of cash such as a promissory note.

But as I say we don’t have to rely on that doctrine because we did elect the installment method.

The Tax Court found we elected the installment method and that was one of the basic findings that the Commissioner accepted.

So we can even go right down with them in the law.

And also, on some of the illustrations that the he used at the end of the brief where he supposes of the — some tax abused — going on and this are the ones he use in oral argument about the General Motor stock or the Ford stock.

(Inaudible) the General Motor’s —

William H. Kinsey:

Well —

He doesn’t want to (Inaudible)?

William H. Kinsey:

I really don’t understand it.

In the first place, I don’t see there’s any evil because if you’re only going to — you could sell the General Motor stock right now.

And — well, let’s say I don’t know what their yield in General Motors is but the Dow Jones yield say is 3%.

At 3% it take you 3 and 1/2 years to get back which you — he gets tomorrow by going out and selling it on the market.

So, were —

(Inaudible)

William H. Kinsey:

— where you get capital gains.

So were — where’s there any big tax bonanza for that, you see.

In other words, he raises the boogieman and I don’t think it has any scaring quality.

I don’t see how you gain anything by it.

The second example about the lease were —

(Inaudible)

William H. Kinsey:

No, I don’t contend.

No I —

(Inaudible)

William H. Kinsey:

No.

You don’t have to meet that.

All you do is to depend on this life expectancy.

You get into a private annuity situation.

In other words, it’d be the value of the General Motor stock and the right to receive income for specified years.

You’d project what that greater return ones against the life — its expectancy and if that equal the then value of the stock, you’d be entitled to your capital gain to the extent that it exceeded at it something else from capital gain.

But the — there is any tax, the evil or tax danger there.

And also if you sell stock they answer one question, it was brought up.

And your obligation to pay for this stock is payable only out of the dividends from the stock or the proceeds from the stock with no personal liability, with no down payment.

I say that’s capital gain, provided the price was the value of the stock at the time of the transfer and I think anybody agree, but you see, he gazes it up a little with the suppositions that the price is way higher.

You’re going to get this — all this extra stuff coming in.

I don’t say that.

But now one thing I’d like it — to differentiate because the impact of this case go beyond this.

Everything I’ve been saying applies to a fixed price.

We have a situation where you have an open enterprise such as — the patents cases, where your purchase price isn’t a fixed amount.

It’s a percentage.

But it’s not a hundred percentage.

With the fixed price, you devote a 100% of the income towards payment or as much as you can and still not keep — maintain the assets.

But where you have an open price, you don’t take 100%.

You take a smaller percent such as 5%.

But there, the principle still applies, the value — the consideration is equal of the value at the time.

The problem is that you can’t value the time.

How do you value a patent like — as this Court has said of, “A patent is a flash of genius.”

How do you value a flash of genius?

You can’t.

So what you have to do is use an (Inaudible), get formula approach and say its worth 5% of the gross sales, price sale, whatever it manufacturer and under it.

Arthur J. Goldberg:

Mr. Kinsey, can I —

William H. Kinsey:

I don’t think (Voice Overlap) —

Arthur J. Goldberg:

I don’t read the Tax Court finding of value exactly the way you do.

Arthur J. Goldberg:

I don’t read it — I’m looking at page 64.

I don’t read the Tax Court to say that the value of these assets was one million three.

I read it to meant that the value — after you — as to one million three was the result of real negotiating —

William H. Kinsey:

Yes.

Arthur J. Goldberg:

— which is a different thing?

The result of real negotiating might be negotiating this type of transaction in light of its tax consequences and would you apply the same test in General Motors that you would sustain this transaction if as a result was real negotiating, I gave a higher price than the market to General Motors because the tax consequently worked out more favorably?

William H. Kinsey:

No.

In another part of the opinion it says that the price was within a reasonable —

Potter Stewart:

(Voice Overlap)

Arthur J. Goldberg:

A reasonable range.

(Voice Overlap)

Arthur J. Goldberg:

A reasonable range.

Potter Stewart:

The very next (Inaudible).

William H. Kinsey:

That’s correct.

Hugo L. Black:

A reasonable range is different from saying it’s the same as the value.

William H. Kinsey:

Well — yes.

And I think what they meant by reasonable range is something along the line what Mr. Barnett meant when you’re valuing a closely held corporation who’s to say what the value is?

It applies what percentage of return you (Inaudible) — you apply.

It’s a very difficult thing.

So, I’m not saying its worth exactly a million three.

It isn’t any exact science, no one can value that.

But what I’m saying is if he were valuing it that is the Commissioner for a state tax purpose because you’re going to rest assure it would come out a lot more than a million three.

And as long — if that’s the case I don’t think that theirs any undue tax benefit here that the taxpayer is getting when the price was right.

When I say right, I mean when in a reasonable range and there were no strings when that price is paid off his all through irrespective of the fact that it was only payable out of the income in the assets sold.

Byron R. White:

Well, what if the —

Earl Warren:

Mister —

Byron R. White:

(Inaudible)

William H. Kinsey:

It had to – been a percentage of profits?

Then I wouldn’t have been that higher percentage.

It had to be a lower percent because you have to leave something over for the purchaser too.

William H. Kinsey:

Now — then it would be a question of what percentage like 50% of the profit and that’s a good question.

I’m not sure of the answer like that and I’ve never had a client that wanted to find out bad enough to try that.

But I think it would be good, I think it could be good.

Like you say, “We don’t know what the asset is worth”.

Byron R. White:

You must be looking not from this (Inaudible)?

William H. Kinsey:

Well, the useful life of the asset would have something to do with the time.

It couldn’t be forever.

You’d have to have some time limit and it have to be something other than a 100%.

In other words, you only have a 100% when you got a top limit then you devote everything towards it that you can.

If it were not the top limit then it would be less than that.

(Inaudible)

William H. Kinsey:

With your life expectancy in the projective profits, if there were some reason and rationale for it, in other words, you could say this is not subject to a — determining a fixed price because it’s dependent on a lot of contingencies, so we can analyze now.

Or if you can analyze them, and you say there’s some relationship to what you expect the ultimate take to be with your life expectancy, I would say that’s good, that’s alright.

But just automatically just because you say — for the rest of my life 25% you don’t have any rationale for it.

I would say, I couldn’t underwrite it but if there’s a good rational for it, I think you should be entitled to capital gain, you should have converted an investment.

Before that you are entitled to all the profit.

(Inaudible)

William H. Kinsey:

That’s another thing that I meant to cover that the penalty is too severe for the infraction and I think they’re practically backing off a little.

Another —

Byron R. White:

They don’t allow the (Inaudible)?

William H. Kinsey:

They don’t allow — they tax all of the income that the whole million three is — they allow basis recovery.

The small basis for the stock but you got to remember that the book value of the company is worth $600,000 but — and they’d had accumulated earnings and profits upon which corporate tax have been paid to $400,000 and more.

They would tax all that as ordinary income.

And I think if there weren’t a sale, the proper thing is to tax as ordinary income the extent to which the price was excessive not the whole thing.

In other words, fit the penalty to the rule infraction.

Earl Warren:

Mr. Barnett.

Wayne G. Barnett:

Mr. Chief Justice.

I’d like to start by dealing with the question about the findings of value of which much has been made.

I don’t think they’re relevant but I would like to answer what is said about them.

Justice Goldberg, I think is quite right in pointing out that the finding — quoted didn’t say that the property was worth one million three.

Wayne G. Barnett:

That was the result of real negotiating and within reasonable range in the light of the earnings as in the net worth corporation.

But what was not quoted was the —

What exactly was the (Inaudible)?

Wayne G. Barnett:

Well, let me first say what else they found then I would suggest how you reconcile what they did find.

The Government in the Tax Court makes two arguments.

The first was since in the argument we make here that there’s no shift to risk and it was not a sale at all.

The second argument — well, let me give the Tax Court’s answer to that argument.

In entering that argument, the Tax Court opinion at page 62 of the record, they’re answering that — at this point, they’re answering argument that I make in here basically.

They say, “It may be as respondent contends that petitioner would have been unable to sell the stock at as favorable a price to anyone other than a tax exempt organization.”

Well, it’s on top of the page and they –skipping down on several sentences, they say that however that the right of a taxpayer by legal means to increase the amount received by — from a different transaction rather than some other transaction is fundamental and that a substantive sale in substance is not to be ignored solely because the exempt organization is willing to pay a somewhat higher price than someone else might pay.

I may say that the Court of Appeals likewise especially acknowledged that the price was probably higher than it would have been in any other kind of transaction.

Byron R. White:

(Inaudible)

Wayne G. Barnett:

Well, they —

Byron R. White:

(Inaudible)

Wayne G. Barnett:

They do not find — they — this rejects any finding I think that the price was or — I’m — (Inaudible) he’s having calling the price.

The limit of one million three on the amount that they were to receive happened to be just equal to the amount they could have sold the property for — anybody else on secured terms.

The Tax Court —

Arthur J. Goldberg:

(Inaudible)

Wayne G. Barnett:

Well, wait — at this point, the tax — we — when we argued, it was more than they could have gotten.

We contend that there’s more than they could’ve gotten in any other kind of sale, (Inaudible) of that maybe so.

What value —

Wayne G. Barnett:

Alright.

(Inaudible)

Wayne G. Barnett:

Alright.

Suppose Mr. Barnett (Inaudible) — an assumption.

Wayne G. Barnett:

Alright.

And —

(Inaudible)

Wayne G. Barnett:

— they never —

(Inaudible)

Wayne G. Barnett:

They never —

Hugo L. Black:

Is that the (Inaudible) —

Wayne G. Barnett:

Yes.

(Inaudible)

Wayne G. Barnett:

I’m sorry.

I’m so sorry.

— whatever under the — in fact the court found (Inaudible).

Wayne G. Barnett:

Well, they never retracted that assumption.

The Government also made a second argument.

The second argument that the – the second argument the Government made was in fact the transaction was a sham.

It was never expected that the property could pay itself out and it was known all along that it would collapse as it all ultimately did.

It was a sham in that sense.

In answering that argument, they finished the first argument.

In answering that argument, the Tax Court said, “No, it was a bona fide deal.”

The Institute really expected to end up owning the properties.

And then it said, “Supporting that finding, the findings — they hadn’t reasonable expectations that it would pay out as a supporting fact to that.”

They say, “The price of one million three was the result of real negotiating, it was within a reasonable range in the light of the earnings history and the net worth.”

And to me all that says is that there was a very good likelihood that it would pay out.

There was no — this — and this is why they said it, to support their finding that it was not a sham.

There was a bona fide expectation of a pay out.

Potter Stewart:

Mr. Barnett, I might understand by your eagerness to dispute this fair and — fact finding that you think it’s crucial, do you think —

Wayne G. Barnett:

No, I do not think it is crucial.

Let me address myself to that.

Let’s suppose that I — a father conveys stock to his son.

The stock is selling in the market at a thousand dollars.

He conveys it to his son on a condition that the son remits the first thousand dollars dividends to him.

Is that a sale?

The amount to be remitted happens to coincide with the value of the property.

I say it is not a sale.

It is all it is —

Potter Stewart:

So, if the —

Wayne G. Barnett:

— a retention of the right income —

Potter Stewart:

Let’s forget the father-son because that’s not involved here really.

Wayne G. Barnett:

Well —

Potter Stewart:

Mr. Smith and Mr. Jones and if the value is a thousand dollars, what’s – why isn’t that a sale?

Wayne G. Barnett:

Mr. Smith and Mr. Jones wouldn’t do it.

Potter Stewart:

Why wouldn’t they?

Wayne G. Barnett:

I can keep it (Voice Overlap) —

Potter Stewart:

If the value is a thousand dollars, why wouldn’t —

Wayne G. Barnett:

I can keep it as a stock.

Potter Stewart:

— somebody sell it for a thousand dollars and somebody else buy it —

Wayne G. Barnett:

I would —

Potter Stewart:

— for a thousand dollars (Voice Overlap) —

Wayne G. Barnett:

Alright.

Potter Stewart:

— value.

Wayne G. Barnett:

That is correct.

If you take the risk, you give me the money and you gamble on what dividends it produces.

If you want me to take the gamble to see whether it does produce that much income, I want all of it.

I don’t want just a thousand dollars.

I want everything it ever produces.

Why should I give you anything?

The only reason I transfer the stock to you for a thousand dollars in a normal transaction is you take over the burdens of ownership.

The risk that maybe the company will go bankrupt.

I’m sorry I used General Motors as an example.

Not all stock is General Motors’ stock.

A lot of stocks is very speculative stock.

Potter Stewart:

You’re all giving it away pretty freely before lunch.

Wayne G. Barnett:

The — well, I didn’t offer to give it.

I offer to accept any.

So, it doesn’t depend on how much I’m ultimately going to receive.

Wayne G. Barnett:

It depends upon the nature of my right to it.

If I gotten out and shifted to you the burdens of ownership, the economic incidents of ownership, the risk that it won’t produced a thousand dollars of income, if I get all the risk, all of them as in this case, I’m entitled to everything and all I’ve done is give away is to make a gift of a remainder interest.

And whether the amount of income I retain is if the stock is worth a hundred dollars, if I reach a thousand dollars, if all — whether I retain the right of the first 500, the first thousand, the first 2000 or the first million, the transaction is the same.

The only time you have a sale is when the purchaser puts up something.

The purchaser makes a commitment and relieves of total dependence on what the asset will produce by itself (Voice Overlap) —

Potter Stewart:

If — you told us that the — whether or not this was sold on its real value, it’s not crucial to your case (Voice Overlap) —

Wayne G. Barnett:

I —

Potter Stewart:

Then is it crucial to your case if there was no down payment?

Wayne G. Barnett:

It is absolutely crucial that there was no down payment.

No undertaking to do anything else.

No undertaking ever to pay anything.

No contribution to the management of the business, nothing.

That is what’s crucial to my case that the Institute furnished nothing at all.

Now, Justice White mentioned the case which the buyer is going to operate the business.

The sale to — the key employee, they say.

The manager dies, his widow is left with the business and she wants to sell it to the key employees, only guy who knows run it and for years, didn’t have any money.

So, the key employee creates a corporation and gives notes and he runs the business and tries to make a go of it.

(Inaudible)

Wayne G. Barnett:

No.

No, no, no, no.

Not at the Ins — the Institute isn’t doing anything.

No, the Institute does (Inaudible) —

Wayne G. Barnett:

The important thing —

(Inaudible)

Wayne G. Barnett:

Right.

(Inaudible)

Wayne G. Barnett:

No.

(Inaudible)

Wayne G. Barnett:

No.

I don’t say that would be the result.

(Inaudible)

Wayne G. Barnett:

That’s — in that case, the purported buyer, the ones who is purportedly making a —

(Inaudible)

Wayne G. Barnett:

— a note.

(Inaudible)

Wayne G. Barnett:

The Institute —

(Inaudible)

Wayne G. Barnett:

Well, the Institute isn’t.

(Inaudible)

Wayne G. Barnett:

Well —

(Inaudible)

Wayne G. Barnett:

We made a —

(Inaudible)

Wayne G. Barnett:

We made the prior arrangement that the transferor and he should agree on who — to whom it would be leased.

(Inaudible)

Wayne G. Barnett:

Well, that’s a question, who this — contract it is?

(Inaudible)

Wayne G. Barnett:

This is — signed the paper but it was part of the original transaction, I take it.

The transferor could have at least to the same outfit could run the business.

(Inaudible)

Wayne G. Barnett:

No.

It —

(Inaudible)

Wayne G. Barnett:

If — look — if I’m the key employee and you sell business to me, the widow of the owner or something.

When I agree to take over the business and give you notes for it and subordinate my rights to the payment of your notes, I invest a very great deal in running that business in the hope of making it pay out and ending up with something.

That is a very significant change in the relationship of the parties.

Now, whether that change is enough to make it a sale, it’s not something that I need to answer.

(Inaudible)

Wayne G. Barnett:

I have —

(Inaudible)

Wayne G. Barnett:

The greater the risk the less likely it is to be debt and if there is absolutely no shifting of risks and the transferee furnishes nothing, it is not a sale.

All it is, is a gift —

(Inaudible)

Wayne G. Barnett:

Well, let me see.

I have difficulty with that case.

I don’t want to argue that it is a sale.

All I want to do is acknowledge the difference of the transactions.

That in that case would — that key employee could leave and go some place else.

He decides to commit himself to running this business in trying to make it pay out for the widow and then he’ll end up owning it.

He does have a stake.

He puts something into it and if it fall — if it collapses after a year or so, he’s out a great deal.

Arthur J. Goldberg:

(Inaudible)

Wayne G. Barnett:

Yes.

Arthur J. Goldberg:

(Inaudible)

Wayne G. Barnett:

That depends what this Court decides.

The — most of the — what Mr. Kinsey refers to as a standard plan, if it is indeed the way he describes it, it’s exactly the same thing that happens without a charity.

And you can accomplish the same result by — through depreciation.

So that kind of transaction could very well occur and he said it does occur.

My answer to him is that the plan he describes of the — is exactly — produces exactly the same results as this one.

I don’t think anything turns in the fact that the Institute was tax exempt.

With depreciable property, you can accomplish is ultimately the same results without a tax exempt into it.

However, you can use a lost corporation.

You can use a nonresident alien.

They’re all kinds of ways to provide tax shelters for income.

The important thing is the tax law, tax income to the persons who economically benefits from it.

And once you separate the tax from the benefit of the income, any good lawyer can find a way to exploit it.

It is essential that tax consequences follow economics.

Byron R. White:

But if the (Inaudible)?

Wayne G. Barnett:

Well — let me say first of all that if a transferee furnishes something, there’s always a question whether what it furnishes is enough to make a real cushion — make a real change in the nature of the position.

Byron R. White:

(Inaudible)

Wayne G. Barnett:

In which the — well, in his brief, he doesn’t really tie it down to a case in which the buyers do operate the business.

He just — their case he talks about in the brief to create the very — the case he talks about in the brief is the case we talk about in our petition for certiorari.

You create a corporation with no money at all and then somebody else owns than you.

Byron R. White:

Well, why wouldn’t we —

Wayne G. Barnett:

Then you transfer your stock for —

Byron R. White:

(Inaudible)

How about this case?

Wayne G. Barnett:

That case is nothing more — it is nothing more than a gift with a retain right to income.

Byron R. White:

(Voice Overlap)

Wayne G. Barnett:

The things that are called notes are not notes.

Byron R. White:

What he calls the transfer (Inaudible)?

Wayne G. Barnett:

Exactly, exactly.

Arthur J. Goldberg:

Now, whether you (Inaudible).

Wayne G. Barnett:

Well, I — first factually, I would like to clarify something.

The Interest Imputation Provision, it was adopted, this is a 1964 Act.

The Interest Imputation Provision, it were adopted.

It was a much broader problem.

Even though you have two debts given in exchange for installment the court somehow has been reluctant to impute interest.

I never quite understood why not.

We never really thought of this as far as I can tell.

That’s — and it’s a problem that cuts across the board.

It has nothing to do with particularly with this kind of transaction.

It was not an alternative solution to this problem.

That problem is up around all the time and every installment sale interest ought to be imputed even those through sale and to through debt.

Congress did that.

The other proposal was to deal with this problem.

Now, an awful lot of proposals were made in the 1964 Act that weren’t enacted.

We kept cutting down the program.

The committee approved only a very limited member of proposals.

I think the failure to ever — to even get this out of committee doesn’t — it proves very little about tax legislations.

Wayne G. Barnett:

If we lose this case, we’ll be — go back and we’ll try again.

To get into legislation isn’t just a matter of saying this is right therefore you must give it to us.

Potter Stewart:

You’re suggesting that the —

Wayne G. Barnett:

That —

Potter Stewart:

— that the Congress may well change the law for you.

Wayne G. Barnett:

Well, that would — that we would certainly have to try, I suppose.

It’s a very hard problem to solve by the legislation by the way.

They tried to solve it the 1950 Act but they picked on the wrong things.

They thought it was abuse of the charity exemption.

They taxed unrelated business income, the — and various other provisions.

And of course, taxpayers found a way around it.

That’s what happens when you try to deal with a basic fundamental question of principle by particularized legislation.

It generally doesn’t work, if — they may take you years of it, amending the statute again and again, really to cover the problem.

And as to the Secretary’s reference to the existing law is quite right that under the existing decision, people were getting away with it, there are a bit — about a dozen of cases involving exactly this transaction and the patent cases in isolated areas.

It’s quite right when he says under existing law in that sense, this is happening and at the same time he said that by — we were litigating this case.

I — the Government didn’t take his position was wrong when the Secretary (Inaudible) was trying to get a legislative solution.

That happens all the time.

And they say, the problem is a — when the — a very broad importance and I do think it is of crucial importance that the decisions have tax consequences follow the true economics of the case.

Thank you sirs.

Earl Warren:

Very well.