Rudolph Vs. Hardman Inc. Case Study

Citation
Rudolph A. Hardman, Frances N. Hardman and Hardman, Inc. Appellants, v. United States of America, Appellee, 827 F.2d 1409 (9th Cir. 1987)
Facts
Rudolph, Frances Hardman and Hardman, Inc. sought review of the lower court’s decision upholding tax deficiencies assessed by the Internal Revenue Service. Hardmans characterized a payment by a corporation as a part consideration for the purchase of property from Frances Hardman, treated the payment as a capital gain and the corporation added the payment to its basis in the property. IRS characterized the payment as a dividend, taxable as ordinary income and improperly added it to the corporation basis on resale. The appellate court identified eleven factors, which to varying degree influenced
the decision of whether a transfer to a corporation by a shareholder was a sale or a contribution to capital. In light of the eleven-factor test, the court reversed and remanded because the transaction was a sale rather then a contribution of capital.
Issue
Whether a transaction between Frances Hardman and Hardman Inc. constitutes a sale or a contribution to capital.
Decision
Yes. The U.S. Court of Appeals for the Ninth Circuit reversed the decision of the lower court and remanded because the lower court overemphasized one of the 11 debt-equity factors and erred in neglecting other 10 factors, which influenced the resolution that the transaction was a sale rather then a contribution of capital.
Reasoning
The IRS indicated that the transmission of Frances Hardman to Hardman Inc. was a capital contribution rather than a sale engendering capital gain. The IRS further argued that the payments made to Mrs. Hardman were in fact dividends and are taxable as ordinary income and is improperly added to the corporation’s basis on resale.
With respect to the classification of the transferal of assets to Hardman Inc., the Appellate Court studied all eleven factors, to determine the outcome of whether a shareholder’s transfer to a corporation was a sale or a contribution to capital.
Court noticed that all of the objective evidences submitted by the Hardmans and Hardman, Inc. indicate that the parties intended the transaction to be a sale. Court further states that even though the document executed by Hardman, Inc. lacks a name and contains no maturity date, the language used was typical of a promissory note and not of a stock certificate. As it contained more of the traditional sign of a debt than that of equity, the repayment is tied to a sale of the property that guaranteed payment of an amount relative to the value of the property. Court also noted that the payment received by Mrs. Hardman did not come from the general earnings and profits of the corporation but rather profits from the resale of land. As a seller, Mrs. Hardman had an absolute right to enforce the terms of the contract and also entitled to receive one-third of the profits from resale even if the company suffered a loss in its overall operations and so this transaction should not be treated as dividend distribution.
The court also detected that payment that depends on earnings or come from a constrained source indicate an equity interest, since Hardman, Inc.
was an ongoing, viable corporation with assets other than the property acquired from Mrs. Hardman. Presumably Hardman, Inc. could easily obtain financing from other sources. This factor weighs in favor of a finding that the obligation accompanying the transfer of the property to Hardman, Inc. was a bona fide indebtedness. Lastly, the court identified that the transaction between Mrs. Hardman and Hardman Inc. created a debtor-creditor correlation and should be regarded as such. Since Mrs. Hardman received money only in connection of sale of Hale Field which did not change Mrs. Hardman's percentage of ownership and control in the corporation.
Court analysis of this transaction in light of these eleven factors lead to conclusion that Mrs. Hardman's transfer of the Hale Field property to Hardman, Inc. was a sale rather than a contribution to capital. Since the trial court erred in relying on a sole factor and neglecting to consider fully the several other factors, all of which point to the opposite conclusion. Therefore, the decision of the district court was reversed and the case is remanded for a determination of the amount of excess taxes paid by the Hardmans and Hardman,
Inc.