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REPORTS

OF THE

UNITED STATES TAX COURT

HUGHES, INC., PETITIONER v. COMMISSIONER OF

INTERNAL REVENUE, RESPONDENT

Docket No. 10741-84.

Filed January 4, 1988.

Held, petitioner is not liable for the accumulated earnings tax because earnings and profits were not accumulated beyond the reasonable needs of its business.

Charles H. Egerton and Paul Mandelkern, for the petitioner.

John S. Winkler,' for the respondent.

WHITAKER, Judge: In a statutory notice of deficiency dated January 20, 1984, respondent determined the following deficiencies in petitioner's Federal income tax: TYE Dec. 31

Amount 1979...

$24,530 1980...

21,049 1981...

33,652

The issue for decision is whether petitioner is liable for the accumulated earnings tax imposed by section 531.1

All section references are to the Internal Revenue Code of 1954, as amended and in effect during the years in issue, and all Rule references are to the Tax Court Rules of Practice and Procedure.

1

FINDINGS OF FACT

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Some of the facts have been stipulated and are so found. Petitioner is a Florida corporation whose principal place of business is and has been in Orlando, Florida.

Petitioner's sole shareholders upon incorporation were
Russell S. Hughes, Harry C. Hughes, and Romania S.
Hughes. In 1959, Romania S. Hughes transferred all of her
shares in petitioner to Russell S. Hughes and Harry C.
Hughes, brothers, so that each then held 50 percent of
petitioner's stock. On December 18, 1973,2 the Hughes
brothers transferred their shares of petitioner's stock in
equal portions to their sons. Thereafter, and throughout the
years in issue, the company was owned equally by David H.
Hughes, Vincent S. Hughes, Russell V. Hughes, and Sun
First National Bank of Orlando (through its nominee FABCO
Co.) as trustee for Donald Richard Hughes.
During the years in issue the officers of petitioner were:

Russell V. Hughes, president
Vincent S. Hughes, vice president

David H. Hughes, secretary/treasurer
From its inception and throughout the years in issue,
petitioner was engaged in the trade or business of owning
and leasing improved real and tangible personal properties.
Petitioner was involved mainly in leasing warehouses and
other facilities throughout the State of Florida. Its primary
lessee of these facilities was Hughes Supply, Inc. (Hughes
Supply), a wholesale distributor of electrical, plumbing, and
industrial fixtures and supplies to the building and mechani-
cal trades.

During the years in issue, petitioner leased 16 separate parcels of improved real property to Hughes Supply. The revenue from these leases was approximately 80 percent of petitioner's revenue during those years. The leased properties included executive offices, branch facilities (warehouses, sales and administrative offices, and parking and storage areas), a utility warehouse, and a garage and trucking terminal. Petitioner also leased a facility to Southern

?The parties stipulated that the transfer took place on Dec. 18. We note however that in petitioner's statement to respondent for purposes of sec. 534(c) the date of transfer was Dec.

Lighting Mfg. Co., a wholly owned subsidiary of Hughes Supply. A typical facility was 20,000 to 30,000 square feet, with an area of 1 to 3 times that size in paved parking and outside storage.

Hughes Supply was founded as a general partnership in Orlando, Florida, in 1928. The business was incorporated in 1947, and Russell S. Hughes, Harry C. Hughes, and Romania S. Hughes, who were the sole partners, became the sole shareholders. Russell S. Hughes and Harry C. Hughes held a majority of the stock until the first public offering of 350,000 shares in 1970. Since that time, Hughes Supply has been a publicly held corporation with one class of stock actively traded in the over-the-counter market. The corporation's total net sales exceeded $100 million during each year in issue.

In June 1976, Hughes Supply was notified, pursuant to the requirements of the Securities and Exchange Commission, that 5.6 percent of its outstanding stock had been purchased by the employee retirement plan of Consolidated Electrical Distributors, Inc. (CED), a closely held Delaware corporation whose principal office was in Los Angeles, California.

A Schedule 13D had been filed, as is required to be filed when a person has acquired 5 percent or more of the voting stock of a public company. The Schedule 13D discloses information concerning the identity of the person making the acquisition of the shares, the source of funds used in the acquisition, the number of shares owned, and the purpose for which the acquisition is being made. In the Schedule 13D, the retirement plan indicated that the Hughes Supply stock was acquired for investment purposes.

In subsequent years, CED, its affiliates, and its shareholders acquired and held shares of Hughes Supply stock as follows:

Date of SEC

Number of Schedules 13D Hughes Supply shares Total shares Percentage owned and amendments owned by CEDI outstanding by CED

group 6/24/76

81,200
11,444,000

5.6
3/30/77

130,300
11,340,822

9.7
6/10/77

141,300
11,345,714

10.5

*This figure includes shares owned by CED affiliates.

Date of SEC

Number of Schedules 13D Hughes Supply shares Total shares Percentage owned and amendments owned by CED: outstanding

by CED group 10/07/77

180,000
11,343,283

13.4
11/04/77

202,300
11,339,735

15.1
12/12/77

209,300
11,341,666

15.6
3/08/78

227,800
11,342,368

16.97
11/16/78

397,600
11,351,166

29.4
11/09/792

620,700
2,032,908

30.5
3/07/80

628,200
2,032,908

30.9
5/30/80

646,750
2,032,908

31.8
12/22/82

655,750
2,032,908

32.25 Approximate number. 2As corrected by amended Schedule 13D dated 11/12/79. As the Schedules 13D were filed, some of the Hughes family members became concerned about whether the acquisitions of stock were merely for investment. CED was a competitor of Hughes Supply in the electrical materials distribution business and was known as a national company that grew primarily through the acquisition of other companies. CED had 11 branches in Florida at the time the Hughes Supply stock was acquired. A takeover by CED threatened the welfare of Hughes Supply which also, in turn, potentially threatened the viability of the leases petitioner held with Hughes Supply.

CED's chairman of the board of directors, Keith Colburn, met with David Hughes several times regarding the stock purchases. At first he told Mr. Hughes that CED bought Hughes Supply stock because it was undervalued. Later, in 1977, Mr. Colburn and his father proposed that the Hughes family join them in taking Hughes Supply private with the two families each owning one-half of the company. The Hughes family rejected this idea.

Hughes Supply's general counsel, Robert Blackford, also a director of the corporation, monitored the stock purchases. When CED's interest exceeded 10 percent of the total stock issued, he discussed responses to a hostile tender offer, such as filing litigation and alleging violations of the antitrust laws. He also advised David Hughes to contact a New York law firm specializing in mergers, acquisitions, and takeovers. In November 1977, David Hughes contacted an attorney in the New York firm. The attorney met with Mr. Hughes, as president of Hughes Supply, and two financial advisors to discuss the situation. They explained their concerns and the attorney explained to them the “state of play.” He addressed generally what things should be considered so Mr. Hughes could determine whether to retain his law firm. Hughes Supply subsequently paid the firm $40,000 as a retainer for their advice in terms of defensive measures.

The attorney reviewed documents provided by Hughes Supply, including its charter, bylaws, annual reports, other public filings, and proxy statements. He also reviewed the CED Schedule 13D filings and other background information he received on CED. Based on this information he concluded that despite reporting that it was making acquisitions for investment, CED was involved in a “creeping acquisition.” He found significant the continually increasing stock purchases at increasing price levels, a pattern seen in a creeping acquisition. He also noted that CED had made other acquisitions, they were in a related line of business, and that they were putting a lot of money into one particular situation. These factors were generally not indicative of a passive investment, and he viewed CED as a threat to the control of Hughes Supply.

In December 1977, the attorney met with David Hughes and Mr. Blackford again. He advised them with respect to the paths they could follow in reacting to CED's continuing acquisition of shares. He proposed issuing additional shares of Hughes Supply stock into “friendly hands" to increase capitalization of the company and dilute CED's position; increasing the Hughes' family interest to acquire 51 percent or as close to 51 percent as possible to assure that control would be retained by the family; litigating, i.e., challenging CED's disclosures and preventing future acquisitions; or selling the company to a third party. No action was taken by Hughes Supply that year.

David Hughes met with the attorney for the final time about a year later to discuss the status of the situation, however no further contact was made and the law firm's retainer was not renewed.

Based on the advice obtained, the strategy agreed upon in defense of a takeover was to try to purchase additional shares of Hughes Supply stock from the public sector and

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