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(1) Whether distributions received by petitioner Michael N. Cerone from petitioner Stockade Cafe, Inc., in redemption of his stock in the corporation should be treated as being received in exchange for such stock under section 302(a)2 or as dividends under sections 302(d), 301, and 316. Resolution of this issue depends on whether the redemption qualifies as being not essentially equivalent to a dividend under section 302(b)(l) or, alternatively, as a complete redemption of all of his stock under section 302(b)(3). These determinations in turn involve the family attribution rules of section 318(a)(1) in a context of family hostility.
(2) Whether petitioner Stockade Cafe, Inc., can deduct the portion of such distributions it designated as interest as such under section 163. The parties agree that resolution of the first issue is determinative of this issue.
FINDINGS OF FACT
Some of the facts have been stipulated and are so found. The stipulation of facts and exhibits attached thereto are incorporated herein by this reference.
Petitioners Michael N. Cerone and Helen E. Cerone (collectively, the individual petitioners) resided in Omaha, Nebraska, at the time they filed their petitions in this case, except that petitioner Michael N. Cerone resided in Gretna, Nebraska, at the time they filed the petition in docket No. 27979-82. Petitioner Stockade Cafe, Inc. (the corporation), a Nebraska corporation, had its principal office at 13325 Millard Avenue, Omaha, Nebraska, at the time it filed its petition in this case. The individual petitioners filed joint Federal individual income tax returns (Forms 1040) for the years 1974 through 1979 with the Internal Revenue Service Center in Ogden, Utah. The corporation filed Federal corporation income tax returns (Forms 1120) for its taxable years ending September 30, 1975 and 1976, with the Internal Revenue Service Center in Ogden, Utah.
In the years prior to 1963, petitioner Michael N. Cerone (petitioner or "Mike") and his son (Michael L. Cerone or "Mick") worked together as painting and decorating con
2 Unless otherwise indicated, all section references are to the Internal Revenue Code of 1954, as amended and in effect during the taxable years in question, and all "Rule" references are to the Tax Court Rules of Practice and Procedure.
tractors. In March of 1963, petitioner, his son, and their acquaintance, Dan Malone, purchased the assets (including appurtenant real estate and liquor license) of a restaurant and bar (individually, the restaurant or the bar; collectively, the business) known as the Stockade Cafe. The business was located at 13325 Millard Avenue, in what was then Millard and is now part of Omaha, Nebraska. The three men operated the business as equal partners for approximately 1 year until Dan Malone withdrew from the partnership. Thereafter, petitioner and his son operated the business as equal partners.
On or about October 1, 1964, petitioner and his son organized petitioner Stockade Cafe, Inc. (the corporation), and transferred thereto the assets of the business (including appurtenant real estate and liquor license). They each purchased 50 shares of the corporation's common stock for $5,000. These shares were the only outstanding shares of stock in the corporation. Petitioner and his son also became the directors and the president and secretary/treasurer, respectively, of the corporation. They maintained their respective ownership interests in and positions with the corporation until at least November 7, 1974.
Throughout the period of joint ownership, petitioner and his son were both very actively involved in managing the business. Petitioner ran the cash register and supervised the waitresses in the restaurant. He had authority to sign the corporation's checks. For awhile, petitioner also ordered supplies for the business, but his son soon assumed that responsibility. Petitioner's son ran the restaurant's kitchen and the bar. He also kept the corporation's books. Petitioner and his son shared responsibility for major management decisions and for hiring and firing personnel.
During the years 1971 through 1974, the corporation paid petitioner an annual salary and bonus as follows:
3 However, for a few months during 1958, petitioner operated "a little hamburger joint" on South 24th Street, in what was then Millard and which in 1970 or 1971 became part of Omaha, Nebraska. He disposed of the business because he was losing money.
The license is a class "C" liquor license, subject to annual renewal.
The corporation paid petitioner's son an annual salary and bonus during those years in amounts equal to those it paid petitioner.
Under the joint management of petitioner and his son, the business steadily grew. They expanded the facilities to accommodate this growth. Petitioner and his son completely remodeled the restaurant and the bar and also put in a new kitchen. By 1974, the corporation employed between 50 and 60 employees. Approximately 175 patrons could be seated in the restaurant. Between 60 and 70 patrons could be seated in the bar. The restaurant and the bar were usually open from 10 in the morning until 1 a.m.
Despite their success, petitioner and his son disagreed about the management and operation of the business. As the years went by, the conflicts between the two increased in frequency and intensity. They disagreed about a number of matters. Petitioner refused to follow operating rules for employees that his son had established and that the son and the other managers were trying to enforce. Petitioner frequently reinstated employees that Mick or another manager had dismissed or reprimanded. Since a large number of the corporation's employees worked only part time, Mick and the other managers thought it extremely important to establish well-defined rules for the employees and to rigidly adhere to those rules. Petitioner's failure to follow the rules in such circumstances increased the growing hostility between him and his son.
Petitioner and his son also argued over expanding the business' facilities. Mike wanted to go slow on expansion. Mick favored expansion on a much larger scale than did his father. In particular, they disagreed about the new kitchen they put in. After petitioner's son became the sole shareholder of the corporation, he had this kitchen completely remodeled to his satisfaction.
The greatest source of discord between Mike and Mick resulted from the father's gambling activities. For many
years, Mike held big gambling games in a relatively large apartments located on the second floor of the building that housed the restaurant and the bar. Over the years the gambling games got larger to the point that nothing smaller than a $20 bill was on the table during the games. Twice, the Omaha vice squad raided the building in search of betting slips or other evidence of petitioner's gambling activities. During one such raid, members of the vice squad ransacked the upstairs apartment. They searched for betting slips in the office that was also located on the second floor of the building. They also asked petitioner's son to open the safe in the office, which he did, but they failed to find any evidence of gambling. As they left the premises, the frustrated vice squad members walked through the restaurant and the bar and pulled out the telephones.7 Shortly after this raid, a representative of the Nebraska Liquor Control Commission visited petitioner's son and said to him, "Mick, you're going to have to get your father out of here or you ain't going to have no liquor license." Without a liquor license, both the restaurant and the bar business would have been ruined. After this, petitioner and his son "could not get along at all." Petitioner's son was deeply concerned about losing the liquor license.8
Sometime after the second vice squad raid and the informal liquor commission warning, in late 1973 or early 1974, Mick told his father that one of them should buy out the other's ownership interest in the corporation. Petitioner did not think he could run the business without his son. Therefore, petitioner tentatively agreed to allow the corporation to redeem his stock therein, but he and his son haggled about the price for several months.
Although petitioner may have lived in the apartment at some point, one of the corporation's managers, Eunice Marty Postma, (Eunice Postma) and her husband lived there during the time period in which the gambling games occurred.
6 The building was approximately 70 years old. It had two floors. The restaurant and the bar were located on the first floor. An office used by petitioner's son in connection with the business and an apartment were located on the second floor. The entrance to the second floor was just inside the front door of the building, so that a person walking into the restaurant or the bar would walk past the upstairs door before reaching the restaurant or the bar.
7 Twenty to twenty-five percent of the restaurant's business consisted of carryout orders that were phoned in by customers, and this business was briefly interrupted by this incident.
8 This concern was reflected in the terms of the redemption agreement by which the corporation agreed to redeem petitioner's stock, subject to the granting of a renewed liquor license for the license year commencing May 1, 1975. As noted above, note 4 supra, the liquor license was subject to annual renewal.
Petitioner and his son hotly negotiated the terms of the redemption, especially the price petitioner would receive for his stock in the corporation. They met together with their attorney, Tom Kelley (Kelley), in Kelley's office between 6 and 8 times to negotiate the redemption. A number of these meetings ended with either Mike or Mick "blowing up" and walking out of the meeting. Sometimes, petitioner or his son would meet separately with Kelley to discuss the redemption. Although they both continued to work at the restaurant and the bar, petitioner and his son sometimes were not speaking to one another, and their relationship was volatile. Finally, after almost a year of negotiations, on November 7, 1974, petitioner and the corporation entered into an agreement (the redemption agreement) whereby petitioner and
* The redemption agreement provides as follows:
THIS AGREEMENT is entered into this 7 day of November, 1974, between MICHAEL N. CERONE, hereinafter called Seller, and STOCKADE CAFE, INC., a Nebraska corporation, hereinafter called Buyer, of the corporate stock of STOCKADE CAFE, INC.
The Stockade Cafe, Inc. owns and operates a bar and restaurant at 13325 Millard Avenue, Omaha, Nebraska, formerly known as Millard, Nebraska.
The parties to this agreement state that the total of the outstanding shares of stock in the corporation as of this date are: Michael N. Cerone, 50 Shares, and Michael L. Cerone, 50 shares.
The Seller agrees to sell to the Buyer, 10 shares of the stock of the corporation as of October 1, 1974, and the balance of 40 shares of the stock of the corporation as of May 1, 1975, under the following terms and conditions:
The total sum of $125,000.00, payable as follows: $25,000.00 down, receipt of which is hereby acknowledged, and the balance of $100,000.00 payable over a period of seven years in equal semi-annual payments due on May 1st and December 1st of each year, commencing on May 1, 1975, with interest at the rate of 6 1/2% per annum on the unpaid balance.
The Seller agrees not to compete in the liquor business within a five mile radius, and seller further agrees not to enter into the restaurant business in any manner within a ten mile radius of the Millard location set forth above for a period of five years. The five year period does not apply to the liquor business.
The Seller shall further be entitled to one half of the cash kept in savings accounts in the corporate name as of October 1, 1974, plus the amount of the yearly bonus for the year ending September 30, 1974, as directed to be paid in whatever manner by the advice of Hess & Boyle, accountants, in accordance with payments as received by the two stockholders in previous years as bonus and director fees.
The stock certificate shall be signed in blank on this date by the Seller and left in the office of Tom Kelley, attorney, in trust, to be delivered to the corporation on May 1, 1975.
This contract is subject to the granting of the Class C Liquor License to the corporation for the license year commencing May 1, 1975.
The Buyer shall further, on May 1, 1975, give a note to the Seller for the unpaid amount of the total of $100,000.00, and that as a part of the consideration of this sale, Michael L. Cerone shall personally guarantee said note.
The chicken recipe used by the corporation at its restaurant is its sole property, and the Seller agrees not to use this recipe without written permission of the corporation, nor will he disclose it to any other persons.