Adams, Max Rosenn and Hunter, Circuit Judges.
This appeal calls into question the application of section 306 of the Internal Revenue Code of 1954*fn1 and the "first in-first out rule"*fn2 to a redemption of preferred stock in a corporation by plaintiff,*fn3 one of its principal shareholders. In particular we are asked to decide whether the transaction here had "as one of its principal purposes the avoidance of Federal income tax,"*fn4 whether a prior sale of a portion of the underlying common stock immunized a like proportion of the section 306 stock from treatment as a noncapital asset*fn5 and whether another block of the redeemed stock should be considered to represent stock not subject to section 306.
On November 24, 1948, Fireoved and Company, Inc. was incorporated for the purpose of printing and selling business forms. At their first meeting, the incorporators elected Eugene Fireoved, his wife, Marie, the plaintiffs, and a newphew, Robert L. Fireoved, as directors of the corporation. Subsequently, the directors elected Eugene Fireoved as President and Treasurer and Marie Fireoved as Secretary. The corporation had authorized capital stock of 500 shares of $100 par value non-voting, non-cumulative preferred stock and 100 shares of $1 par value voting common stock. On December 31, 1948, in consideration for $100 cash, the corporation issued Eugene Fireoved 100 shares of common stock; for $500 cash, it issued him five shares of preferred stock; and in payment for automotive equipment and furniture and fixtures, valued at $6,000, it issued him an additional 60 shares of preferred stock.
In 1954, when Mr. Fireoved learned that his nephew, Robert, was planning to leave the business, he began discussions with Karl Edelmayer and Kenneth Craver concerning the possibility of combining his business with their partnership, Girard Business Forms, that had been printing and selling business forms for some time prior to 1954. Messrs. Fireoved, Edelmayer and Craver agreed that voting control of the new enterprise should be divided equally among the three of them. Because Mr. Fireoved's contribution to capital would be approximately $60,000 whereas the partnership could contribute only $30,000, it was decided that preferred stock should be issued to Mr. Fireoved to compensate for the disparity. In furtherance of this plan, the directors and shareholders of Fireoved and Company, in late 1954 and early 1955, held several meetings at which the following corporate changes were accomplished: The name of the company was changed to Girard Business Forms; the authorized common stock was increased from 100 to 300 shares and the authorized preferred stock was increased to 1000 shares; Mr. Fireoved exchanged his 100 shares of common and 65 shares of preferred stock for equal amounts of the new stock; an agreement of purchase was authorized by which the company would buy all the assets of the Edelmayer-Craver partnership in return for 200 shares of common and 298 shares of preferred stock; and Mr. Fireoved was issued 535 shares of the new preferred stock as a dividend*fn6 on his 100 shares of common stock, thereby bringing his total holding of preferred stock to 600 shares to indicate his $60,000 capital contribution compared to the $29,800 contributed by the former partnership.
As the business progressed, Mr. Edelmayer demanded more control of the company. In response, Mr. Fireoved and Mr. Craver each sold 24 shares of common stock in the corporation to him on February 28, 1958.
On April 30, 1959, the company redeemed 451 of Mr. Fireoved's 600 shares of preferred stock at $105 per share, resulting in net proceeds to him of $47,355.*fn7 The gain from this transaction was reported by Mr. and Mrs. Fireoved on their joint return for the year 1959 as a long term capital gain. Subsequently, the Commissioner of Internal Revenue (Commissioner) assessed a deficiency against the Fireoveds of $15,337.13 based on the Commissioner's view that the proceeds from the redemption of the 451 shares of preferred stock should have been reported as ordinary income and the tax paid at that rate based on section 306. Mr. and Mrs. Fireoved paid the assessment on March 14, 1963, but on March 10, 1965, filed a claim for a refund with the Commissioner.
After the Commissioner disallowed the refund claim on March 8, 1966, the Fireoveds instituted the present action against the United States on August 4, 1967 seeking a refund of the $15,337.13 plus interest on the ground that the transaction came within an exception to section 306, and that they were therefore entitled to report the income as a long term capital gain. The case was tried to the court without a jury on stipulated facts. It is from the district court's determination, 318 F. Supp. 133, on October 29, 1970, that $8,885.50 should be refunded to the taxpayers that both parties appeal.
II. Background of Section 306
Because we are the first court of appeals asked to decide questions of law pursuant to section 306, it is appropriate that we first examine the circumstances that led to the inclusion in 1954 of this section in the Code.
Generally, a taxpayer will benefit monetarily if he is able to report income as a long term capital gain rather than as ordinary income. Under normal circumstances a cash dividend from a corporation constitutes ordinary income to the shareholder receiving such money. Therefore, it would be to the advantage of a shareholder if a method could be devised by which the money could be distributed to him, that would otherwise be paid out as cash dividends, in a form that would permit the shareholder to report such income as a long term capital gain.
A temporarily successful plan for converting ordinary income to long term capital gain is described by the facts of Chamberlin v. C. I. R., 207 F.2d 462 (6th Cir. 1953). There a close corporation had assets of $2.5 million, approximately half of which were in the form of cash and government securities. To have distributed the cash not required in the operation of the business to the shareholders as a dividend would have subjected them to taxation at ordinary income rates. The corporation therefore amended its charter to authorize 8,020 shares of preferred stock to be issued to the shareholders as a dividend on their common stock. The accounts of the corporation were adjusted by transferring $802,000 from earned surplus to the capital account. While these corporate changes were taking place, negotiations occurred between the shareholders and two insurance companies for the purchase of the newly issued preferred stock. In addition, the corporation constructed a timetable for retirement of the preferred stock, which proved satisfactory to the purchasing companies. When the transaction was completed, the selling shareholders reported the gain they realized from the sale of the preferred stock to the insurance companies as a long-term gain from the disposition of a capital asset. The Commissioner contended ...