Commissioner v. Brown

Clay Brown (plaintiff) was the president and a shareholder of Clay Brown & Company (CBC), a closely held corporation. The shareholders of CBC negotiated an agreement to sell CBC to the California Institute for Cancer Research (Institute) for $1.3 million on a secured promissory note to be paid over 10 years. The sales price was the result of arm’s-length negotiations and fairly represented the value of CBC. The Institute liquidated CBC and leased CBC’s assets to a newly formed corporation, Fortuna Sawmills, Inc. (Fortuna). Fortuna was formed and wholly owned by the CBC shareholders’ attorneys, and Brown served as Fortuna’s president. Fortuna paid 80 percent of its profits to the Institute as rent. The Institute paid 90 percent of this rent to the CBC shareholders as installment payments on the note. The lease payments that the Institute received from Fortuna were exempt from treatment as unrelated-business taxable income, significantly increasing the amount of business profits passed through to the shareholders. The Institute bootstrapped its purchase by using the tax-exempt income stream from Fortuna to acquire CBC’s assets over a 10-year period. During the four years that Fortuna was in business, the CBC shareholders received a total of $936,131.85 in the form of installment payments on the note. Brown reported these payments on his federal tax returns as capital gain. The federal tax commissioner (commissioner) (defendant) determined that the transaction was not a sale of a capital asset and that the Institute’s payments to Brown thus constituted ordinary income rather than capital gain. Brown petitioned the United States Tax Court for a redetermination. The tax court ruled for Brown, and the court of appeals affirmed. The United States Supreme Court granted certiorari.