MONTELEPRE SYSTEMED, INC. v. C.I.R.

REAVLEY, Circuit Judge:

Taxpayer Montelepre Systemed, Inc. (Systemed) gave up one of its rights under a management contract in exchange for money. The Tax Court characterized the payment that Systemed received as compensation taxable under 26 U.S.C. § 83 in the first year that Systemed's right ceased being subject to a substantial risk of forfeiture. We hold that Systemed's right was subject to a substantial risk of forfeiture until Systemed disposed of that right, and that the assignment-of-income doctrine precludes application of 26 U.S.C. § 337 to the payment that Systemed received. We affirm the Tax Court's judgment in favor of the Commissioner of Internal Revenue (CIR).

I. BACKGROUND

Thian and Company (Thian), a Louisiana limited partnership, developed Chalmette General Hospital (Chalmette General). Just before Chalmette General opened in 1975, Thian entered into a hospital management contract (the Contract) with Systemed. At this time, Paul Montelepre held both a controlling interest in Systemed and a general partnership interest in Thian.

The Contract provided that Thian would not sell Chalmette General without first affording Systemed the right of first refusal (the Right).1 The Contract precluded Systemed from assigning the Right. The Contract did not specify whether Systemed's Right terminated with the Contract.

In December 1982, while Thian and Systemed were conducting business under the Contract, Qualicare of Chalmette, Inc. (Qualicare) offered Systemed $1.5 million to forfeit the Right. Qualicare made its offer contingent on its purchase of Chalmette General. Systemed accepted. On March 15, 1983, Systemed's shareholders formally adopted a plan of liquidation. Two days later, Qualicare acquired Chalmette General and paid Systemed $1.5 million.

Systemed did not include the $1.5 million payment from Qualicare in its taxable income for the year ending March 31, 1983, and instead explained that this "capital gain [was] not recognized per [26 U.S.C. §] 337 liquidation." In 1988, CIR sent Systemed the following notice of deficiency:

Systemed contested CIR's proposed income increase by filing a petition in the Tax Court. The Tax Court issued an opinion in which it considered the parties' arguments under section 83 and ruled in CIR's favor.

II. DISCUSSION

Systemed contends on appeal that section 83 does not support CIR's notice of deficiency and section 337 precludes it.

A. SECTION 83

Section 83(a) explains how property received in exchange for services is taxed:

26 U.S.C. § 83(a) (emphasis added). The Tax Court held that Systemed received the Right as part of its compensation for its hospital management services under the Contract, and therefore section 83 governs the valuation and taxation of the Right. To hold Systemed liable for tax on the $1.5 million payment in 1983, the Tax Court also held that, until Qualicare bought Chalmette General, Systemed held the Right subject to a substantial risk of forfeiture. The Tax Court understood the Right to be "substantially nonvested" in 1983, meaning that the Right was both subject to a substantial risk of forfeiture and nontransferable. See Treas.Reg. § 1.83-3(b). And if

Treas.Reg. § 1.83-1(b).

On appeal, Systemed does not dispute the Tax Court's characterization of the Right as section 83 property or the Tax Court's holding that the Right was never transferable. Systemed only argues that the Right was not subject to a substantial risk of forfeiture in the tax year ending March 31, 1983, so section 83 applied in a previous tax year for which CIR has not sought tax adjustment. We reject the two theories that Systemed offers in support of this argument.

1. Right Survival of Contract

Systemed contends that a right of first refusal relating to immovable property is a sui generis real right that is not extinguished upon termination of the Contract, citing Crawford v. Deshotels, 359 So.2d 118, 122 (La.1978) and Terrell v. Messenger, 428 So.2d 1241, 1247 (La.Ct.App.1983) in support. While these cases suggest that a recorded right of first refusal can be a real right under Louisiana law, neither purports to establish a universal rule for the duration of that right.

The parties' intent governs our construction of the Right's duration. Price v. Town of Ruston, 132 So. 653, 655-56 (La. 1931); see also Ebrecht v. Ponchatoula Farm Bureau Ass'n, 498 So.2d 55, 57 (La. Ct.App.1986) ("[L]essor's inclusion of the `first right to purchase' in a lease agreement without an option to renew the lease and the plaintiff's failure to show that the lessee ever attempted to negotiate a new lease are evidence that the term of the `first right to purchase' was intended to be limited by the length of the lease;" "When the lease terminated by its own terms, the `right of first refusal' also terminated."); 1A CORBIN ON CONTRACTS § 261 at 476 (1963) ("In all cases, interpretation [of a right of first refusal] requires knowledge of the entire context, context of facts as well as context of words.").

While the Contract specifies no time for the Right's termination, the Contract's provisions and the circumstances surrounding the Contract's execution indicate that the parties intended the Right to be coterminous with the Contract. The way that Systemed and Thian phrased the Right indicates that they understood that, to exercise the Right, Systemed must still be Chalmette General's operator. The Contract language establishing the Right only refers to Systemed as "Operator." Moreover, in the Contract's section 10, immediately after establishing Systemed's Right, the Contract states:

Nothing in the Contract indicates that Thian granted Systemed the Right indefinitely and unconditionally. Had this been the case, the parties would likely have recorded Systemed's Right because without recordation or actual notice, Systemed could not enforce its Right against third parties. See E.P. Dobson, Inc. v. Perritt, 566 So.2d 657, 660 (La.Ct.App.1990). While Systemed was managing Chalmette General under the Contract, it would necessarily be aware of any prospective purchasers and could notify them of its Right, so it is understandable that Systemed saw no need to record the Right.

We thus agree with the Tax Court that Systemed had to continue performing substantial services under the Contract to retain the Right.

2. Actual Risk of Contract Termination

Systemed states that if the Right was coterminous with the Contract, this fact only establishes that the Right was subject to a risk of forfeiture. Systemed argues that the Tax Court erred by not considering all of this case's facts and circumstances to assess the substantiality of the risk to which the Right was subject. See Treas.Reg. § 1.83-3(c)(1) ("whether a risk of forfeiture is substantial or not depends upon the facts and circumstances").

We agree with CIR that a facts and circumstances test is unnecessary in this case. Congress prescribes that "[t]he rights of a person in property are subject to a substantial risk of forfeiture if such person's rights to full enjoyment of such property are conditioned upon the future performance of substantial services by any individual." 26 U.S.C. § 83(c)(1). And the House Report on section 83(c)(1) explains that a

H.R.REP. No. 413, 91st Cong., 1st Sess., pt. 1, at 88 (1969), reprinted in, 1969 U.S.C.C.A.N. 1645, 1735 (emphasis added); see also Robinson v. Commissioner, 805 F.2d 38, 40 (1st Cir.1986) (facts and circumstances test only applicable when section 83(c)(1) does not apply).

Systemed recognizes that the Contract required it to perform substantial services, but simply argues that section 83(c)(1) only applies to natural persons and not corporations such as itself. In support of its argument, Systemed points to the House Report's use of the word "his" and to the fact that the performance of substantial services is a greater burden to individuals than to corporations, which can simply hire more agents. We find nothing in the language or history of section 83 to suggest that Congress intended to limit its application to natural persons. See 26 U.S.C. § 7701(a) (in Title 26, "where not otherwise distinctly expressed or manifestly incompatible with the intent thereof — [t]he term `person' shall be construed to mean and include ... a ... corporation"). Moreover, we do not agree that individuals are necessarily more burdened by performing substantial services than corporations. And even if individuals are always more burdened, nothing suggests that Congress considered the relative burden of performing substantial services a significant consideration in enacting section 83(c)(1). Systemed's retention of the Right was conditioned on its continued performance of substantial services under the Contract until a third party offered to purchase Chalmette General. So, under section 83(c)(1), Systemed held the Right subject to a substantial risk of forfeiture until it relinquished the Right in exchange for $1.5 million from Qualicare.

Thus, we conclude that the Tax Court properly held that, in 1983, the $1.5 million that Systemed received from Qualicare "is compensation under section 83."

B. SECTION 337

The Tax Court did not consider Systemed's contention that, even if the payment that Systemed received from Qualicare is taxable under section 83, section 337, as it existed in 1983, allowed Systemed to refrain from recognizing the payment on its 1983 corporate tax return. We consider and reject Systemed's contention.

In 1983, section 337(a) provided that:

26 U.S.C. § 337(a). Systemed claims that this language governs its disposal of the Right. But the Supreme Court recognizes that section 337 does not absolutely free a corporation "from tax on gains whenever it decides to liquidate." Central Tablet Mfg. Co. v. United States, 417 U.S. 673, 691, 94 S.Ct. 2516, 2526, 41 L.Ed.2d 398 (1974).

In Hillsboro Nat'l Bank v. Commissioner, 460 U.S. 370, 397-402, 103 S.Ct. 1134, 1150-53, 75 L.Ed.2d 130 (1983), the Court traces the development of the rationale supporting section 337. The statute has its origin in General Util. & Operating Co. v. Helvering, 296 U.S. 200, 206, 56 S.Ct. 185, 187, 80 L.Ed. 154 (1935), where the Court established the doctrine that a corporation need not recognize gain on the distribution of appreciated corporate property to its shareholders. Congress codified this doctrine as section 336 of the 1954 Internal Revenue Code.2 After considering the legislative history of section 336, the Court concluded that

Hillsboro, 460 U.S. at 398, 103 S.Ct. at 1151. The Court then considered how other courts have interpreted section 336 in conformity with its "market appreciation" purpose:3

Id. at 398-99, 103 S.Ct. at 1151 (citations and footnotes omitted).

The Court then explained how section 337 evolved from the Helvering doctrine that became section 336. In Commissioner v. Court Holding Co., 324 U.S. 331, 65 S.Ct. 707, 89 L.Ed. 981 (1945), the Court held that, if a corporation plans the sale of its assets and distributes the assets to its shareholders as part of its liquidation, then, when the shareholders sell the assets according to the corporation's plan, the proceeds are taxable to both the corporation and the shareholders. Id. at 334, 65 S.Ct. at 708. But in United States v. Cumberland Pub. Serv. Co., 338 U.S. 451, 70 S.Ct. 280, 94 L.Ed. 251 (1950), the Court held that if the shareholders negotiate the sale of corporate assets upon the corporation's liquidation, the corporation may escape tax on gains from those sales. The Court stated that, "[w]hile the distinction between sales by a corporation as compared with distribution in kind followed by shareholder sales may be particularly shadowy and artificial when the corporation is closely held, Congress has chosen to recognize such a distinction for tax purposes." Id. at 454-55, 70 S.Ct. at 282. Congress enacted section 337 to eliminate the confusion wrought by the distinction that evolved from Court Holding and Cumberland. "The very purpose of § 337 was to create the same consequences as § 336" if the corporation, rather than the shareholders, sold its assets while executing a plan of liquidation instead of distributing them directly to the shareholders, so "the two provisions ... should be construed in tandem." Hillsboro, 460 U.S. at 400-401, 103 S.Ct. at 1152.

The Court's endorsement of the assignment-of-income doctrine as an exception to section 336 and the Court's conclusion that sections 336 and 337 must be construed in tandem require us to reject Systemed's section 337 argument. Under section 83(b), Systemed could have elected to value the Right in 1975 and pay taxes then on this aspect of its compensation under the Contract. Then section 337 would have protected Systemed from tax on any market appreciation of the Right. Instead, Systemed waited to dispose of the Right for value until after it declared a plan of liquidation under section 337. This is exactly the conduct that the Court in Hillsboro understood to fall within the assignment-of-income doctrine. Systemed attempts to shift income that Systemed earned to its shareholders to avoid one level of tax. Like the courts in Midland-Ross Corp. v. United States, 485 F.2d 110, 119 (6th Cir. 1973)4 and Commissioner v. Kuckenberg, 309 F.2d 202, 205 (9th Cir.1962), cert. denied, 373 U.S. 909, 83 S.Ct. 1296, 10 L.Ed.2d 411 (1963) which refused to permit section 337 nonrecognition of proceeds that are attributable to corporate efforts but collected during liquidation, we think that Systemed

Because the Right was compensation to Systemed under section 83 and Systemed did not pay tax on that corporate-earned income before declaring its liquidation, Systemed's attempt to avoid the tax now under section 337 is thwarted by the assignment-of-income doctrine.

The Tax Court's judgment is AFFIRMED.