                        T.C. Memo. 2001-19



                      UNITED STATES TAX COURT



            KNIGHT FURNITURE CO., INC., Petitioner v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 15369-99.           Filed January 29, 2001.



     Samuel W. Graber and Jason W. Richardson, for petitioner.

     James F. Prothro, for respondent.



             MEMORANDUM FINDINGS OF FACT AND OPINION

     COHEN, Judge:   Respondent determined deficiencies of

$94,876, $75,398, and $62,569 in petitioner’s Federal income tax

for 1995, 1996, and 1997, respectively.   The sole issue for

decision is whether, for each of the years in issue, petitioner

was a corporation described in section 532, i.e., a corporation

availed of for the purpose of avoiding income tax with respect to
                                 - 2 -

its shareholders, by permitting its earnings and profits to

accumulate rather than to be divided and distributed, and was

thus liable for the accumulated earnings tax imposed by section

531.

       Unless otherwise indicated, all section references are to

the Internal Revenue Code in effect for the years in issue, and

all Rule references are to the Tax Court Rules of Practice and

Procedure.

                          FINDINGS OF FACT

       Some of the facts have been stipulated, and the stipulated

facts are incorporated in our findings by this reference.

       Knight Furniture Co., Inc., is a corporation with its

principal place of business in Sherman, Texas.    Petitioner

operates two furniture stores.    Petitioner’s main store is

located in Sherman, Texas, and its other store is located in

Gainesville, Texas.

       During the years in issue, petitioner’s officers were Jim

Hughes as chairman, Sam Knight as president, Henry Griffin as

vice president, and David Gunn as treasurer.    David Pedigo served

as secretary in 1995 but was removed and replaced by David Gunn,

who served as both secretary and treasurer in 1996 and 1997.

       David Pedigo remained an employee of petitioner even though

he was removed from the board in January 1996.    He received the

same annual salary of $50,000 but was no longer eligible for

management bonuses.    The board also removed David Pedigo from
                                - 3 -

several job responsibilities.   David Pedigo was shocked by his

removal from the board and by the major changes to his employment

responsibilities and income, but he did not retaliate and did not

threaten to quit.

Liquid Assets

     Petitioner sustained increases in the amount of its retained

earnings and profits, during the years in issue, as follows:

                            Retained             Increase
              Year     Earnings & Profits       in Amount

              1995         $6,450,910             $243,273
              1996          6,644,238              193,328
              1997          6,804,671              160,433

     Petitioner’s short-term investments were primarily

certificates of deposit and money market funds.    Petitioner’s

cash on hand and short-term investments were $1,976,779,

$1,599,756, and $2,038,430 at yearend 1995, 1996, and 1997,

respectively.

     Petitioner historically and as a matter of corporate policy

maintained high levels of liquidity.    Petitioner also had a

policy of not incurring substantial amounts of debt.

Petitioner’s liquid assets available for 1995 through 1997 were

as follows:
                                  - 4 -

                                  1995          1996           1997
Current Assets:

  Cash                        $  818,960    $  381,039     $  945,413
  Accounts receivable          2,569,616     2,565,656      2,334,468
  Inventories                    651,151       692,309        659,987
  U.S. Govt. obligations       1,157,819     1,218,717        905,017
  Certificates of deposit          –-            –-           188,000

Less Current Liabilities:

  Accounts payable             (172,506)     (125,570)      (123,562)
  Federal tax payable           (55,014)         --             --

  Net liquid assets           $4,970,026    $4,732,151     $4,909,323

Stock Ownership and Redemption

     At the time that petitioner incorporated in 1927, two

brothers owned all of petitioner’s stock.       All of petitioner’s

stock has since been owned by the descendants of the two brothers

or spouses of the descendants.     The Knight family, consisting of

Sam and Jan Knight, David and Gina Gunn, and Jeremy Knight, were

the controlling stockholders of petitioner during the years in

issue.   During 1995, the Knight family held 51 percent of the

total outstanding stock.    The Pedigo family, consisting of Paul

Pedigo, David and Sharon Pedigo, and Steve and Susan Pedigo, held

47 percent of the total outstanding stock.

     During 1996, the Knight family owned 56 percent and the

Pedigo family owned 42 percent of the outstanding stock.        After

David Pedigo’s demotion and removal from the board in January

1996, the stockholders met on March 26, 1996, to elect a new

board.   David Pedigo nominated himself, and his wife, Sharon
                               - 5 -

Pedigo, seconded his nomination, but David Pedigo was not elected

to the board.

     During 1997, the Knight family owned 56 percent and the

Pedigo family owned 42 percent of the total outstanding stock.

At the March 25, 1997, annual stockholders meeting to elect a new

board, David Pedigo did not nominate himself but had the minutes

reflect that both he and his wife opposed the nominated list.

David Pedigo requested clarification of his standing with the

company, and Sam Knight explained that David Pedigo’s performance

would be the determining factor and that, as of that time, there

was no action pending that would change his status with the

company.   David Pedigo had not requested redemption of his stock

as of the time of trial in June 2000.

     Stockholders were forbidden, by corporate bylaws, from

selling their stock to unrelated third parties, without the

unanimous consent of all of the stockholders.   Petitioner’s

corporate bylaws, as amended May 25, 1989, provide the following

guidelines for the sale of stock by stockholders:

          Stock is first offered to stockholders - then to
     the Corporation. The Corporation can redeem the stock
     only to the extent it has funds available.

          If no funds [are] available, the Corporation will
     pay the seller 10 percent of the sales price and give a
     ten year note, secured by the stock, for the balance
     upon which he will be paid interest. The interest will
     be figured annually on the anniversary date of the sale
     and will be based on the latest six month T-Bill
     interest quotes.
                                 - 6 -

          The funds available for redemption of stock will
     be determined by the Board of Directors. The notes can
     be paid off early without penalty at the discretion of
     the Board of Directors.

Petitioner amended its bylaws on May 25, 1989, to include the

option to pay 10 percent of the sales price and give a 10-year

note for stock redemptions, because its sales volume dropped in

the previous 2 years and the board was concerned about whether

the company could survive a stock redemption.      Petitioner’s

policy has been to pay cash for stock redemptions.

     Petitioner adopted a formula by which it would value its

stock.   The formula price per share was determined as 10 times

the average earnings per share for the previous 5 years, plus the

book value, then divided by 2.    The redemption price per share,

based on the formula, was $2,682.62, $2,798.07, and $2,836.52 in

1995, 1996, and 1997, respectively.      Petitioner used this formula

consistently for every redemption.       If all of the Pedigo family

members had sought redemption of their stock, the redemption

would have required $1,975,750, $2,044,847, and $1,697,657 in

liquid assets in 1995, 1996, and 1997, respectively.

     The only shares redeemed during the years in issue were 138

shares that Paul Pedigo inherited in 1993 and sold in 1996 for

$370,201.56.   Paul Pedigo was not an officer or employee and was

not involved in petitioner’s business.      He had been a music

educator for 30 years and retired shortly after the redemption of

his shares.    Paul Pedigo wanted to invest the money to provide
                               - 7 -

for his retirement income, and the redemption of his shares was

not motivated by David Pedigo’s reduced responsibilities at the

store.

     Other redemptions of stock occurred before and after the

years in issue.   On December 22, 1988, Paul Pedigo redeemed 13.5

shares that he had inherited from his mother.   Jan Knight

redeemed 140 shares on January 16, 1998, for $352,556.82.    Sharon

Pedigo, wife of David Pedigo, redeemed 80 shares in May 1998 for

$226,921.60 to obtain funds to buy a new home and to pay for the

college tuition of her two daughters.

     On January 29, 1996, Steve Pedigo wrote a letter to Sam

Knight and to petitioner discussing the then recent demotion and

removal of David Pedigo from the board.   His letter, in part,

stated:

     The manner in which the board of Knight Furniture
     Company has redefined David Pedigo’s responsibilities
     and disseminated the announcement appears to be
     designed to undermine David’s credibility with his
     peers and co-workers. Restricting David from physical
     locations within the store was mean-spirited and petty
     and designed to reduce David’s credibility and
     compromise his dignity.

     As I understand the bylaws of Knight Furniture Company,
     a change in the board of directors requires a vote of
     all shareholders including David, * * * [Paul] and
     myself. It appears that the board is attempting to
     make a change without the appropriate vote.

     In looking at the stock ownership, except for token
     amounts owned by Jimmy H. Hughes and Henry Griffin, the
     remainder of the stock is owned by either the Ed Pedigo
     family or the Sam Knight family. I would hope the
     recent events have not been orchestrated to force the
     Pedigo family to sell.
                                - 8 -


     Ron Bostwick (Bostwick), petitioner’s certified public

accountant, met with the board of directors annually to explain

the yearend financial statements, and he routinely advised

petitioner in determining its working capital needs.    Bostwick

stressed to the board the need to hold sufficient capital

reserves to fund the contingent stock repurchases from

nonparticipating stockholders when the board met on February 2,

1993; February 24, 1995; March 8, 1996; March 4, 1997; and

February 28, 1998.    Bostwick also advised petitioner that it

should provide funding for the redemption of stock from its

working capital and that it should not look to current earnings.

At the December 8, 1995, board meeting, the board decided that

adequate funds were necessary to its future stability.

Class Action Lawsuit

     In January 1994, petitioner was sued as part of a class

action lawsuit concerning credit life insurance purchased by some

of its customers.    Petitioner carried a commercial insurance

policy and an umbrella insurance policy, but neither provided

coverage for the conduct alleged in the lawsuit.

     The potential liability exposure of the class action lawsuit

was unknown to petitioner for several reasons.    First,

petitioner’s insurance company refused to defend and indemnify

petitioner.   Second, damages were not quantified by plaintiffs.

Third, petitioner could be liable for actual damages, treble
                                - 9 -

damages for deceptive trade practices, punitive damages, and

plaintiffs’ attorney’s fees.    Fourth, class action cases are more

expensive to defend than routine insurance cases, because there

are many parties involved, a great deal of discovery, a lengthy

certification process, and a lengthened time frame for final

resolution of the case.

     The cost of legal fees was a substantial concern to

petitioner.   Petitioner’s defense counsel provided an estimate of

attorney’s fees in excess of $100,000.     The actual legal fees

that were paid for petitioner’s defense were $9,982, $6,816, and

$5,294 in 1995, 1996, and 1997, respectively.

     While petitioner’s defense counsel was concerned about the

credit life insurance scenario in which petitioner participated,

counsel was of the opinion that petitioner had not participated

in deceptive trade practices.   Petitioner’s officers maintained

that they did not participate in deceptive trade practices and

were comfortable with what they had done.

     The class action lawsuit was removed to bankruptcy court,

because the primary defendants filed bankruptcy.     Petitioner’s

defense counsel advised petitioner, in a letter dated June 19,

1995, that plaintiffs filed a Motion to Dismiss and that

“plaintiffs may be considering dismissal of the adversary

proceeding in the bankruptcy case so that they can refile in

another court” or a “less restrictive forum”.     Petitioner was

dismissed from the lawsuit in 1995.     In a letter dated
                               - 10 -

February 21, 1996, petitioner’s defense counsel again advised

petitioner that “there is some possibility that the Plaintiff

will somehow structure a case with other individuals or with

other issues which could possibly be filed against * * *

[petitioner] and the other defendants”.

     Bostwick advised petitioner not to plan to pay for

contingencies out of current earnings and profits and to set

aside funds in the amount that petitioner’s defense attorneys

advised.    At the February 18, 1994, and February 24, 1995, board

meetings to review petitioner’s capital reserves, Bostwick

advised petitioner to hold sufficient capital reserves to serve

as a contingency fund for situations that required legal counsel.

Business Expansion Plans

     Petitioner was interested in expanding into McKinney, Texas,

because it was a rapidly growing market.   McKinney is about

30 miles south of Sherman on a major thoroughfare.    Petitioner

has a centralized warehouse that could service the store in

McKinney and the surrounding area.

     On May 7, 1993, petitioner’s board met to discuss the

possibility of opening a store to sell furniture in the area of

McKinney.    Sam Knight and David Gunn were appointed to

investigate the possibilities further by viewing sites for the

new store.    Thereafter, Sam Knight and David Gunn contacted Kelly

Davis (Davis), a real estate agent, to inquire about available

properties in McKinney.
                               - 11 -

     Petitioner was generally interested in properties along

highways and was looking for a building to either lease or buy

for a furniture store.   Davis notified petitioner of properties

available in the McKinney area, and approximately six of these

properties were viewed by Sam Knight and David Gunn.     Davis also

notified petitioner of about a dozen parcels of vacant land.

     At the July 9, 1993, board meeting, Sam Knight and David

Gunn reported that there were no suitable existing buildings

available in McKinney at the time.      The board reiterated the need

to hold sufficient capital reserves to accommodate the possible

addition of the McKinney store and estimated the McKinney store

could cost $300,000 to $400,000 for the land and in excess of

$500,000 for building costs.   At this meeting, the board also

discussed a possible store opening in the Bonham/Fannin County

area.   After a full discussion, no specific action was taken, and

both store site considerations were tabled for further

discussion.

     At the May 20, 1994, board meeting, the board discussed the

possibility of a future store location in the Bonham area.

Recent reports indicated that new businesses, new housing, and

new jobs meant an increased customer potential for the store.

There was no decision as to the future store location, other than

to continue to monitor the growth in Bonham.

     In 1996, Davis showed to Sam Knight and David Gunn an old

grocery store that was of interest to them, but it was leased
                                - 12 -

within a day to someone else.    In 1996, an old Wal-Mart building

in Bonham that was bigger than what petitioner needed became

available, but the lessor did not want to lease only a portion of

the building.   Properties were last reviewed in McKinney in 1996.

     In 1997, the board again considered the possibility of a

store in Bonham, but most options would have involved the

purchase of land and construction of a building, which the board

felt was cost prohibitive.   The board decided that consideration

would still be given for the right opportunity.

     At the February 24, 1995, and March 4, 1997, board meetings,

Bostwick advised the board that a safe level of cash reserves was

necessary to finance possible future store locations and that the

Board should set aside adequate retained earnings to fund such

projects.

     Despite efforts to locate suitable property, petitioner did

not purchase or lease another store location during the years in

issue.   Petitioner had concerns regarding its expansion, because

it feared a possible rift in the family in 1995 when it removed

David Pedigo from the board and reduced his job responsibilities.

Also, Lay-Z-Boy, which was petitioner’s number one vendor and a

nationally recognized quality furniture manufacturer, would not

allow petitioner to put its products into the McKinney market

because Lay-Z-Boy already covered the McKinney market.
                               - 13 -

Repairs and Renovations

     Petitioner’s board minutes document several discussions and

decisions by the board to make major repairs and renovations to

its assets.   At the August 5, 1994, board meeting, the board

addressed the need to reroof the Jones Street warehouse and the

main warehouse, to repair the firewalls in the main building, and

to purchase a new delivery truck.   In the December 2, 1994, and

December 8, 1995, board minutes, the board listed several items

that would require a considerable expenditure of its reserves:

(1) General maintenance, such as reroofing, repainting, and

improving parking; (2) replacement of the delivery fleet; and

(3) remodeling.   On January 20, 1995, David Gunn updated the

board on the computer situation, and the board moved to proceed

with a new computer system that would cost in excess of $50,000.

     Petitioner also decided to expand the Lay-Z-Boy line and to

devote more square footage to the product.   The Lay-Z-Boy gallery

was discussed and approved by the board of directors in 1995, and

construction began in early 1996.   Construction entailed the

closing off and gutting of a significant amount of square footage

in the store.    Merchandise was relocated, and other renovations

were done to house those goods.   The costs incurred by

petitioner, other than building improvements and renovations,

included the purchase of a large exterior sign and the

acquisition of inventory.   The renovation project was completed

in March 1996.
                                - 14 -

Dividend History

     At the suggestion of Bostwick, the board unanimously

approved an increase in cash dividends at the February 18, 1994,

board meeting.     Petitioner’s taxable income, net book income, and

dividends paid for years 1995 through 1997 were as follows:

                                              Total
                      Taxable    Net Book   Dividends    Dividend
          Year         Income     Income       Paid     Per Share

          1995       $390,935    $258,938    $15,665        $10
          1996        298,772     208,993     15,665         10
          1997        248,978     174,718     14,285         10

     Petitioner has a history of making regular, annual dividend

payments to its stockholders.    Petitioner’s payments of

dividends, over the years in issue, averaged 5 percent and

7 percent of petitioner’s taxable and net book incomes,

respectively.

                                OPINION

     As a result of the examination of the years in issue,

respondent determined that petitioner’s earnings and profits

exceeded the reasonable needs of its business.    Respondent

determined that the accumulated earnings tax applied to

petitioner’s accumulated taxable income of $243,273, $193,328,

and $160,433 for 1995, 1996, and 1997, respectively, and

determined deficiencies of $94,876, $75,398, and $62,569 for

1995, 1996, and 1997, respectively.

     Respondent, in accordance with section 534(b), sent to

petitioner a notification informing petitioner that a proposed
                               - 15 -

statutory notice of deficiency included an amount with respect to

the accumulated earnings tax imposed by section 531 for 1995,

1996, and 1997.   Petitioner, in accordance with section 534(c),

timely submitted a statement setting forth the grounds upon which

it relied to establish that all or part of its retained earnings

for the years in issue have not been permitted to accumulate

beyond the reasonable needs of its business.

     The grounds relied upon by petitioner in its statement were

as follows:

     1.   Liquidity.   The company was not as highly liquid as

other companies that have been found to have unreasonably

accumulated earnings.

     2.   Investment in Assets Unrelated to Business.     The company

held low earning, highly liquid investments unrelated to its

business in order to pay for its future business needs and

contingent liabilities.

     3.   Redemption of Stock of Dissenting Stockholders.     The

company faced the contingent need to redeem the stock of the

dissenting Pedigo family stockholders.

     4.   Class Action Lawsuit.   The company faced the contingent

liability for damages as a defendant in a class action lawsuit.

     5.   Business Expansion Plans.     The company had definite,

substantial business plans to expand its business.
                                - 16 -

     6.   Repairs and Renovations.   The company had both

anticipated needs and made significant repairs and renovations to

its assets.

     7.   Dividend History.   The company had a history of paying

regular dividends.

     Petitioner’s statement provided varying degrees of detail as

to the different grounds.     Petitioner filed a Motion to Shift

Burden of Proof to respondent.     See Rule 142(e).   We granted

petitioner’s Motion to Shift Burden of Proof as to grounds 3 and

5 set forth above.

     The sole issue for decision is whether, for each of the

years in issue, petitioner was availed of for the purpose of

avoiding income tax with respect to its shareholders, within the

meaning of section 532, and was thus liable for the accumulated

earnings tax imposed by section 531.

     The accumulated earnings tax is imposed on the accumulated

taxable income of every corporation formed or availed of for the

purpose of avoiding the income tax with respect to its

shareholders, by permitting earnings and profits to accumulate

instead of being divided or distributed.     See secs. 531 and 532.

The purpose of the accumulated earnings tax is to compel the

company to distribute any profits not needed for the conduct of

its business so that individual stockholders will become liable

for taxes on the dividends received.     See Ivan Allen Co. v.

United States, 422 U.S. 617, 626 (1975); United States v. Donruss
                              - 17 -

Co., 393 U.S. 297, 303 (1969); Helvering v. Chicago Stock Yards

Co., 318 U.S. 693, 699 (1943).   The tax is considered to be a

penalty and, therefore, has been strictly construed.   See Ivan

Allen Co. v. United States, supra at 626.

      Earnings and profits of a corporation permitted to

accumulate beyond the reasonable needs of the business are

determinative of the purpose to avoid the income tax with respect

to shareholders, unless the corporation proves otherwise by a

preponderance of the evidence to the contrary.   See sec. 533(a);

Technalysis Corp. v. Commissioner, 101 T.C. 397, 403 (1993);

Hughes, Inc. v. Commissioner, 90 T.C. 1, 16 (1988); Snow

Manufacturing Co. v. Commissioner, 86 T.C. 260, 269 (1986).

      Pursuant to section 534, the burden of proof was shifted to

respondent to demonstrate that petitioner’s accumulation of

earnings and profits for stockholder redemptions of stock and

business expansion plans was beyond petitioner’s reasonable

needs.   The burden of proof remains on petitioner as to the other

grounds asserted.   The ultimate burden of proving that petitioner

was not availed of for the prohibited statutory purpose is and

remains upon petitioner.   See American Metal Prods. Corp. v.

Commissioner, 34 T.C. 89, 99 (1960), affd. 287 F.2d 860 (8th Cir.

1961); Pelton Steel Casting Co. v. Commissioner, 28 T.C. 153

(1957), affd. 251 F.2d 278 (7th Cir. 1958).

A.   Net Liquid Assets
                                - 18 -

     The accumulated earnings and profits of prior years are

taken into consideration in determining whether any amount of the

earnings and profits of the taxable year has been retained for

the reasonable needs of the business.    See sec. 1.535-

3(b)(1)(ii), Income Tax Regs.    The critical factor is not the

monetary size of the accumulated earnings and profits, but the

corporation’s liquid position and the relation of that position

to the corporation’s current and anticipated needs.    See Ivan

Allen Co. v. United States, supra at 628; Faber Cement Block Co.

v. Commissioner, 50 T.C. 317, 329 (1968).    Thus, the first step

is to determine petitioner’s net liquid assets for the purpose of

determining the funds available to petitioner to meet its

business needs.   See Wilcox Manufacturing Co. v. Commissioner,

T.C. Memo. 1979-92 (citing Faber Cement Block Co. v.

Commissioner, supra at 330).    Petitioner’s liquid assets

available are calculated as current assets less current

liabilities for each tax year in issue.    The parties have

stipulated that the amounts of petitioner’s net liquid assets

were $4,970,026, $4,732,151, and $4,909,323 in 1995, 1996, and

1997, respectively.

     Investments in properties or securities that are unrelated

to the activities of the business of the taxpayer corporation may

also indicate that earnings and profits of a corporation are

being accumulated beyond the reasonable needs of the business.

See sec. 1.537-2(c), Income Tax Regs.    We have considered
                              - 19 -

petitioner’s liquidity ratio and investments unrelated to its

business and are satisfied that these factors are included in the

above calculation of petitioner’s net liquid assets.

B.   Reasonable Needs of the Business

      The second step is to decide whether the grounds asserted by

petitioner justify the accumulation of earnings and profits for

its reasonable business needs.   The term “reasonable needs of the

business” includes “the reasonably anticipated needs of the

business.”   Sec. 537(a).

      The need to retain earnings and profits must be directly

connected with the needs of the corporation, itself, and must be

for bona fide business purposes.   See sec. 1.537-1, Income Tax

Regs.   The regulations adopt a “prudent businessman” standard for

determining whether earnings have been accumulated beyond the

present and reasonably anticipated future needs of the business.

Section 1.537-1, Income Tax Regs., states, in part:

      An accumulation of the earnings and profits * * * is in
      excess of the reasonable needs of the business if it
      exceeds the amount that a prudent businessman would
      consider appropriate for the present business purposes
      and for the reasonably anticipated future needs of the
      business.

Thus, determining the reasonable needs of a business is, in first

instance, a question for the officers and directors of the

corporation.   See Snow Manufacturing Co. v. Commissioner, 86 T.C.

260, 269 (1986); John P. Scripps Newspapers v. Commissioner, 44

T.C. 453, 468 (1965); Crawford County Printing & Publishing Co.,
                              - 20 -

17 T.C. 1404, 1414 (1952).   Courts should be hesitant to

substitute their judgment and attribute a tax-avoidance motive

unless the facts and circumstances clearly warrant the conclusion

that the accumulation of earnings and profits was unreasonable

and for the proscribed purpose.   See Snow Manufacturing Co. v.

Commissioner, supra at 269; Atlantic Properties, Inc. v.

Commissioner, 62 T.C. 644, 656 (1974), affd. 519 F.2d 1233 (1st

Cir. 1975); Faber Cement Block Co. v. Commissioner, supra at 329;

John P. Scripps Newspapers v. Commissioner, supra at 468.

     Whether a particular ground or grounds for the accumulation

of earnings and profits indicate that the earnings and profits

have been accumulated for the reasonable needs of the business or

beyond such needs is dependent upon the particular circumstances

of the case.   Sec. 1.537-2(a), Income Tax Regs.   Taking into

consideration the applicable burden of proof, we address each of

the grounds asserted by petitioner in justifying its accumulation

of earnings and profits for its reasonable business needs.

     1.   Working Capital Needs for Operating Cycle

     Earnings retained to provide for working capital

requirements are accumulated for the reasonable needs of the

business.   See sec. 1.537-2(b)(4), Income Tax Regs.   The working

capital needs of a business are commonly evaluated by means of

the “Bardahl formula”.   See Technalysis Corp. v. Commissioner,

101 T.C. 397, 407 (1993); Bardahl Manufacturing Corp. v.

Commissioner, T.C. Memo. 1965-200.     The parties have separately
                               - 21 -

determined for the close of each of the years in question the

amount of working capital that is reasonably needed to cover a

single operating cycle of petitioner.    Petitioner determined the

working capital for one operating cycle to be $3,877,503,

$4,090,630, $3,885,163 in 1995, 1996, and 1997, respectively.

Respondent determined the working capital for one operating cycle

to be $3,735,858, $3,863,008, $3,737,073 in 1995, 1996, and 1997,

respectively.    Petitioner used monthly balances to compute the

annual average balances of its inventory and accounts receivable,

whereas respondent used yearend balances to determine the annual

average balances.    We adopt respondent’s calculation because the

yearend balances respondent uses have been stipulated by the

parties.    The difference in the calculations, however, does not

affect the result in this case for the reasons appearing below.

     2.    Redemption of Stock of Dissenting Minority Stockholders

     Petitioner contends that there was an actual redemption of

stock during the years in issue and a manifest dissent among the

Pedigo stockholders.    Petitioner’s officers believed that the

action to remove David Pedigo, a large stockholder, as a

corporate officer and reduce his employment responsibilities

would strain the relations between the Knight and Pedigo families

and could result in the redemption of stock by the Pedigo family.

     Respondent argues that it was not a reasonably anticipated

need of the business to accumulate earnings and profits for the

redemption of stock of minority stockholders.    Respondent
                              - 22 -

contends that the three Pedigo brothers were not dissenting

stockholders and that the Pedigo redemption of stock would not

hurt management, because the Knight family already had 51 percent

of the voting power of the stock and control over the board and

management of petitioner.   Respondent views petitioner’s policy

of redeeming stock fully in cash as a retirement vehicle that

allowed stockholders to obtain favorable tax treatment when they

reached retirement age.   Respondent also claims that the

redemption of stock does not threaten the survival of the

business or impair the corporation’s ability to continue as a

profitable concern.

     The redemption of the stock of dissenting, minority

stockholders is a reasonable need of the business where the

ability to redeem the stock of dissenting, minority stockholders

appears necessary to preserve the existence of the corporation,

or, at least necessary to promote the harmony in the conduct of a

business.   See Wilcox Manufacturing Co. v. Commissioner, T.C.

Memo. 1979-92; Farmers & Merchants Inv. Co. v. Commissioner, T.C.

Memo. 1970-161.

     The Pedigo family owned less than 50 percent of the stock in

petitioner.   Based on the evidence, it was reasonable for

petitioner’s officers to believe that there was dissent and

discord between management and the minority stockholders.    The

facts and circumstances that were known to petitioner’s officers

include the demotion of David Pedigo in January 1996; the removal
                              - 23 -

of David Pedigo from the board of directors in January 1996; the

actual redemption of the stock of David Pedigo’s brother, Paul

Pedigo, in April 1996; and the correspondence from Steve Pedigo

in January 1996 to the board stating:    “I would hope that recent

events have not been orchestrated to force the Pedigo family to

sell.”   Additionally, the Pedigo family was unable to elect David

Pedigo to the board of directors at the March 1996 annual

stockholders meeting, and the 1997 minutes reflect the opposition

of David and Sharon Pedigo to the election of the board of

directors.

     Based on the facts and circumstances, we believe that

petitioner’s officers were exercising their prudent business

judgment in preparing for the redemption of stock by the Pedigo

family stockholders.   We are convinced that petitioner did not

want the redemption of the stock by its stockholders to affect

the stability of its business or to threaten the management of

the business.

     Petitioner’s stockholders were limited by the corporate

bylaws from selling their stock to unrelated third parties

without the unanimous consent of all of the stockholders.

Stockholders could either sell to existing stockholders or have

their stock redeemed by petitioner.    The restriction on the

transfer of stock in petitioner’s bylaws served the purpose of

maintaining control over management and keeping ownership in the

hands of the stockholders who managed the company.
                              - 24 -

     Petitioner also had a policy of not incurring debt and a

history of redeeming the stock of stockholders in full, upon

request, even though the bylaws provided for the option of paying

10 percent of the sales price and giving a 10-year note.

Petitioner added the option of paying 10 percent of the sales

price and giving a 10-year note as a precautionary measure to

ensure the survival of its business after several poor fiscal

years.   Petitioner was also continually advised by its certified

public accountant to hold sufficient capital reserves to fund the

contingent stock repurchases from its nonparticipating

stockholders.

     Respondent has not met his burden of proving that the

accumulation of earnings to redeem the stock of minority

stockholders was not a reasonable accumulation of earnings and

profits.   Respondent provided evidence in an attempt to

demonstrate that the actual redemptions of stock were for reasons

unrelated to dissent.   Such reasons, however, were not known to

petitioner’s officers at the time of the accumulations and,

therefore, are unpersuasive in analyzing the business judgment of

petitioner’s officers at the time they decided to accumulate

earnings and profits for the redemption of stock of stockholders.

     Respondent argues, in the alternative, that it was

reasonable for petitioner to accumulate 10 percent of the total

amount needed to redeem the stock of stockholders as provided for

in petitioner’s bylaws, because petitioner could finance the
                              - 25 -

remaining 90 percent by giving a 10-year note.   We have

previously held that the Commissioner cannot effectively compel

taxpayers to incur debt rather than to utilize accumulated

earnings and profits and that the reasonableness of accumulations

should be judged without regard to the borrowing capacities of a

corporate taxpayer.   See General Smelting Co. v. Commissioner, 4

T.C. 313, 323 (1944); C.E. Estes, Inc. v. Commissioner, T.C.

Memo. 1980-504.   Once an expenditure is deemed to be a reasonable

need of the business, that a corporation chooses to finance the

expenditure from earnings and profits rather than from debt

should not place the corporation in a position of being subjected

to the accumulated earnings tax.   See John P. Scripps Newspapers

v. Commissioner, 44 T.C. 453, 468 (1965).   Based on petitioner’s

historical aversion to debt, conservative financial management

philosophy, and policy of redeeming the stock of stockholders

fully in cash, respondent cannot require petitioner to exercise

its safety net provision in its bylaws that allowed it to pay

10 percent down and incur debt for the remaining portion.    In

this case, the working capital accumulation would not have

covered a full redemption of the stock of the Pedigo

stockholders, and petitioner might still have needed to exercise

the option of financing a portion of the redemption of stock to

ensure the survival of the business.

     The events that were known to petitioner’s officers that

compelled them to retain earnings and profits for the redemption
                                 - 26 -

of the stock of minority, dissenting stockholders began in

January 1996; thus, it was reasonable for petitioner to

accumulate its 1995 earnings and profits for the purpose of

redeeming the stock of stockholders.      The events continued into

1996 with the redemption of Paul Pedigo’s stock and the

continuing opposition to the board of directors election at the

1996 and 1997 annual stockholders meetings.     Thus, petitioner’s

accumulation of earnings was also reasonable at the end of both

1996 and 1997.

     A complete redemption of all of the stock held by the Pedigo

family members would have required $1,975,750, $2,044,847, and

$1,697,657 in 1995, 1996, and 1997, respectively.     We conclude

that the amounts needed to redeem the stock of minority

stockholders were a reasonable business need that justified the

accumulation of earnings and profits.

     3.   Class Action Lawsuit

     Petitioner contends that the accumulation of its earnings

and profits was a direct result of being named as a defendant in

a class action lawsuit and was a provision for attorney’s fees in

the defense of the lawsuit and a reserve for the potential

liability of an unspecified amount of damages.     Petitioner argues

that these circumstances justify the accumulation of reserves to

meet a contingency, which is a reasonable need of the business.

     Respondent contends that the accumulation of earnings and

profits was not necessary to defend against the lawsuit or to
                                 - 27 -

provide for possible damages, because the lawsuit was dropped in

June 1995 and the lawsuit was never refiled against petitioner.

     In Steelmasters, Inc. v. Commissioner, T.C. Memo. 1976-324,

the taxpayer was a defendant in a major civil suit during the 2

tax years in issue.    During the first year in issue, the taxpayer

was faced with the possible entry of an adverse judgment, and the

taxpayer was advised by counsel of its potential exposure and its

division of the liability.   By the second year in question, the

judgment was entered, causing the liability to become fixed.    The

Court reasoned that uncertainties regarding outcome are inherent

in any litigation and held that it was entirely reasonable for

the taxpayer’s officers to permit earnings to accumulate as a

means of insulation.   See id.

     Similar to Steelmasters, Inc., the class action lawsuit that

petitioner faced was also a present and pending contingency in

1995.   At the close of 1995, petitioner’s officers knew that

petitioner had been dismissed as a defendant in the adversary

proceeding in the bankruptcy case, but petitioner was also

advised by its attorneys that the plaintiff could refile the case

in another forum.   Petitioner also knew that its insurance

company refused to defend it in the lawsuit and that its

attorneys provided an estimate of attorney’s fees in excess of

$100,000.   Petitioner also maintained that it had not

participated in deceptive trade practices and that its officers

were comfortable with what they had done.   Based on the facts and
                                - 28 -

circumstances known to petitioner’s officers, a prudent

businessman would consider it appropriate to accumulate at least

$100,000 for the purpose of defending the lawsuit in the event

that the lawsuit was refiled.    However, the lawsuit was not

refiled in 1996.   The lawsuit then ceased to be a contingency for

petitioner, and the accumulation of earnings and profits for this

business purpose was no longer necessary.

     4.   Business Expansion Plans

     Petitioner maintains that, even though not every contact

regarding its efforts to expand its business was reflected in the

board of directors minutes, it had a business plan to expand and

took active steps toward expanding its business.

     Respondent contends that petitioner had no specific,

definite, and feasible business expansion plan during the years

in issue, but rather that petitioner’s expansion plan was vague,

undefined, and uncertain.   Respondent contends that no plan of

expansion had been committed to and that no substantial steps had

been taken to achieve implementation.

     A business may accumulate earnings and profits to provide

for the bona fide expansion of its business.    See sec. 1.537-

2(b)(1), Income Tax Regs.   Section 1.537-1(b), Income Tax Regs.,

explains, in part, how a corporation must justify the

accumulation of earnings and profits for reasonably anticipated

future needs:
                                - 29 -

          In order for a corporation to justify an
     accumulation of earnings and profits for reasonably
     anticipated future needs, there must be an indication
     that the future needs of the business require such
     accumulation, and the corporation must have specific,
     definite, and feasible plans for the use of such
     accumulation. Such an accumulation need not be used
     immediately, nor must the plans for its use be
     consummated within a short period after the close of
     the taxable year, provided that such accumulation will
     be used within a reasonable time depending upon all the
     facts and circumstances relating to the future needs of
     the business. Where the future needs of the business
     are uncertain or vague, where the plans for the future
     use of an accumulation are not specific, definite, and
     feasible, or where the execution of such a plan is
     postponed indefinitely, an accumulation cannot be
     justified, on the grounds of reasonably anticipated
     needs of the business.

     The requirement of a “specific, definite, and feasible” plan

does not demand that a taxpayer produce meticulously drawn,

formal blueprints for action.    See Faber Cement Block Co. v.

Commissioner, 50 T.C. 317, 332 (1968); John P. Scripps Newspapers

v. Commissioner, 44 T.C. 453, 469 (1965).   A corporation,

however, cannot immunize itself from the accumulated earnings tax

merely by referring to expansion in its corporate minutes.     See

Faber Cement Block Co. v. Commissioner, supra at 332.

Definiteness of a plan coupled with action taken towards its

consummation are essential to justify an accumulation as

reasonable.   See Snow Manufacturing Co. v. Commissioner, 86 T.C.

260, 274 (1986) (citing Dixie, Inc. v. Commissioner, 277 F.2d

526, 528 (2d Cir. 1960), affg. 31 T.C. 415 (1958)).

     The record indicates that during the years in issue

petitioner considered a number of different properties.    However,
                                - 30 -

a plan is not created simply by adding together the number of

sites considered.   See id. at 277.

     Petitioner’s corporate minutes document discussions of the

possibility of opening stores in McKinney or Bonham, but no

specific action was taken by the board because the available

properties were not suitable.    We realize that not all of the

actions and decisions of the board of directors are documented in

the corporate minutes, and we have considered the testimony of

the corporate officers and petitioner’s realtor.

     Based on the facts and circumstances, we agree with

respondent.   Petitioner had an intent to expand its business and

seriously investigated the possible expansion into McKinney or

Bonham by considering specific properties.    However, no specific,

definite, and feasible business expansion plan materialized from

the research.   We conclude that petitioner had neither developed

a business expansion plan that was definite, specific, and

feasible nor taken a substantial step to implement a business

expansion plan.

     Respondent has met his burden of proof in demonstrating that

petitioner did not have a specific, definite, and feasible

business expansion plan during the years in issue and that it was

not reasonable for petitioner to accumulate its earnings and

profits for this purpose.
                              - 31 -

     5.   Repairs and Renovations

     Petitioner argues that its accumulated earnings and profits

were justified to meet repair and renovation expenses.

Respondent, appropriately, reduced the amount of excess

accumulated earnings and profits for each year in issue, by the

actual cost of petitioner’s capital purchases.   These reductions

include $74,669 primarily for the computer system purchased in

1995, $70,445 for renovations in 1996, and $34,024 for carpet and

computer equipment in 1997.   No further accumulation for this

purpose has been justified by petitioner.

     6.   Dividend History

     Petitioner argues that it has a history of consistently

distributing regular, annual dividend payments to its

stockholders.   Petitioner believes that the payment of additional

dividends might have been a breach of its fiduciary duties to its

stockholders by threatening the existence of the corporation and

not providing for the reasonable needs of its business.

     Respondent contends that dividends that were paid by

petitioner have been nominal in amount.   Petitioner paid

dividends that amounted to $10 per share and totaled $15,665,

$15,665, and $14,285 in 1995, 1996, and 1997, respectively.

Dividends that were paid averaged 5 percent to 7 percent of

petitioner’s taxable and net book incomes, respectively.

     The extent to which earnings and profits have been

distributed by the corporation may be taken into account when
                               - 32 -

determining whether or not retained earnings and profits exceeded

the reasonable needs of the business.    See sec. 1.537-1(a),

Income Tax Regs.   Respondent, accordingly, reduced petitioner’s

current taxable income by the amount of dividends that were

actually paid when respondent determined petitioner’s tax

deficiency.   No further accumulation for this purpose has been

justified by petitioner.

C.   Conclusion

      Based upon the record before us, we conclude that

petitioner’s accumulated earnings and profits that were available

during the years in question did not exceed the reasonable needs

of its business.   Petitioner’s reasonable needs are summarized in

the chart below:

                                  1995         1996         1997

Net liquid assets              $ 4,970,026 $ 4,732,151 $ 4,909,323
Less reasonable needs:
  1. Operating cycle           (3,735,858)   (3,863,010) (3,737,075)
  2. Stock redemption          (1,975,750)   (2,044,847) (1,697,657)
  3. Class action lawsuit        (100,000)        -0-         -0-
  4. Business expansion             -0-           -0-         -0-
  5. Repairs & renovations        (74,669)      (70,445)    (34,024)
Excess accumulated earnings
  & profits                    $ (916,251) $(1,246,151) $ (559,433)

      We are satisfied that the reasonably anticipated needs of

petitioner’s business substantially exceeded petitioner’s

available net liquid assets.    We conclude that petitioner was not

availed of for the purpose of avoiding income tax with respect to

its shareholders and, thus, not subject to the accumulated

earnings tax imposed by section 531.
                             - 33 -

     We have carefully considered all remaining arguments made by

both parties for a result contrary to those expressed herein,

and, to the extent not discussed above, they are irrelevant or

without merit.

     To reflect the foregoing,

                                        Decision will be entered

                                   for petitioner.
