Was a dissolving art corporation's transfer of $187,292.97 in paintings to a shareholder-creditor an exempt capital distribution?

Plain-English summary

Two people formed a corporation to buy and sell art, each contributing $500 for an equal stated shareholding interest. During its three or four years of operation, one of them advanced $224,681 to the corporation. When the corporation dissolved, that person received paintings carried at $187,292.97, wrote the remaining $37,388.03 off as a bad debt, and credited the full $224,681 accounts receivable balance.

The recipient argued that the paintings were an exempt return of capital rather than a purchase. The memorandum disagreed. The parties' books treated the advances as loans and recorded the paintings as property accepted by a creditor in partial satisfaction of that debt. The recipient also claimed the remaining amount as a nonbusiness bad debt on the 1951 federal income-tax return.

Counsel therefore viewed the transfer as a purchase with a sales price of $187,292.97, not a shareholder distribution. The corporation had an operating deficit, and the creditor claim had to be satisfied before any assets could be distributed to shareholders. The memorandum concluded that use tax should apply, but expressly stated that the corporation first had to qualify as a retailer under section 6015(b).

Common questions

Why was the transfer treated as debt repayment rather than a capital distribution?

The corporation and recipient recorded the advances as a loan, the paintings as partial satisfaction of the receivable, and the remaining balance as a bad debt. The memorandum also found no shareholder distribution.

What value did the memorandum use as the sales price?

$187,292.97, the corporation's stated value for the paintings transferred to the creditor.

Was the tax conclusion unconditional?

No. The memorandum said the corporation had to be a retailer as defined in section 6015(b) for the use tax to apply.

Citations and references

• California Sales and Use Tax Law § 6015(b), retailer definition
• Internal Revenue Code § 23(K)(4), historical nonbusiness bad-debt provision cited for the 1951 federal return

Source

• Annotated Legal Opinions collection: https://cdtfa.ca.gov/taxes-and-fees/annotations-menu.htm
• Annotation page: https://cdtfa.ca.gov/lawguides/vol2/suta/495-0000-all.html
• Original supporting opinion: https://cdtfa.ca.gov/lawguides/annotations/495-0736-720.pdf

Original ruling text

State of California

Board of Equalization

Memorandum

495.0736.720

To:

Mr. Fred T. Larsen

From:

W. W. Mangels

Subject:

X-------------------------------

Date:

September 16, 1953

As I understand the facts, X--------------- formed the X Corporation in 1947, each contributing
$500.00 to the corporation and each receiving a $500.00 shareholding interest. The corporation was created to engage in the business of buying and selling objects of art. X---------------, during the three or four years of operation, loaned $224, 681.00 to the X Corporation. In the fourth quarter of 1951, when dissolution of the corporation was effected, X--------------- received all the paintings on hand from the X Corporation valued at $187,292.97 by the X Corporation. In his books he debited the asset “Paintings” in this amount, and deibted “Bad Debts” for $37,388.03, and, of course, credited “Accounts Receivable” for $224,681.00. Below the entry was the following statement in X--------------- books: “to record receipt of paintings accepted by X-------------- at cost as creditor of X Corporation which dissolved 7-25-51.” I understand that X--------------- claimed the $37,388.03 as a short-term capital loss deduction on his 1951 calendar year Federal Income Tax return as a non-business bad debt under Section 23(K)(4) of the Federal Internal Revenue Code. I further understand that no assets were distributed to X--------------- at this time. I understand that the balance sheet at the end of 1950 was as follows: Assets

Liabilities

Cash
Paintings
Organization
Expense

13.25
187,292.97

Loans Payable
Capital Stock

449.76

Less Operating
Deficit

Total

$187,755.98

$223,819.74
1,000.00
224,819.74
37,063.76
$187,755.98

X-------------- claims that he did not purchase the paintings, that there merely was an exempt distribution to him of his capital investment. In my opinion the use tax should apply, there being a purchase and the sales price being
$187,292.97. Clearly the moneys transferrred to the X Corporation were handled by the parties as a loan. When the paintings were transferred to X-------------- the transaction was handled as a transfer of title to satisfy a loan on X-------------- books. X-------------- took a deduction for a loan on his 1951 Federal Income Tax return. X-------------- contends that he never loaned money to the corporation, that he only invested capital and that it would be so regarded by the Federal Income Tax authorities. However, X-------------- did not so handle this matter on his 1951 Income Tax return. Furthermore, the entire transaction took the form of a loan followed by partial satisfaction of that loan. There was no distribution to the shareholders. In fact, there was an operating deficit. In other words, it appears that X Corporation has transferred title to the paintings to satisfy a creditor of the corporation. this claim had to be satisfied before assets could be distributed to the two shareholders. For the tax to apply X Corporation, of course, must be a retailer, as that term is defined in Section 6015(b) of the California Sales and Use Tax Law.

W. W. Mangels
WWM:ja