Edwards Industries, Inc. v. Tracy - Ohio Supreme Court Opinion - Ohio Supreme Court Decision

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1 Edwards Industries, Inc., Appellant, v. Tracy, Tax Commr., Appellee.
2 [Cite as Edwards Industries, Inc. v. Tracy (1996), _____ Ohio St.3d _____.]
3 Taxation -- Franchise tax -- Calculating net worth of corporation --
4
R.C. 5733.05, applied.
5
(No. 94-1568--Submitted January 9, 1996--Decided March 1, 1996.)
6 Appeal from the Board of Tax Appeals, No. 91-J-528.
7
On March 16, 1978, Edwards Industries , Inc., appellant, was
8 incorporated. On March 17, 1978, the Edwards family, the sole
9 shareholders of the J. T. Edwards Company ("JTE"), exchanged all their
10 shares of JTE stock for an identical number of shares of stock of appellant.
11 On the March 17, 1978 exchange date, JTE had retained earnings of
12 $3,711,010.
13
By following certain federal income tax guidelines, the Edwards
14 family was able to exchange its shares of JTE for those of appellant with no
15 federal tax liability and no increase in their tax basis. No money or other
16 property was exchanged.
17
Appellant adopted the equity method of accounting for its ownership
18 of JTE stock. Appellant calculated and paid its 1987 franchise taxes based

1 on its calculation of the net worth of its issued and outstanding shares of
2 stock. In calculating its net worth for its 1987 franchise tax, appellant
3 reduced the value of its issued and outstanding shares of stock by
4 $3,711,010, claiming that that amount was excludable as appreciation
5 under R.C. 5733.05(A)(4).
6
For tax year 1987 the Tax Commissioner denied appellant's exclusion
7 of the $3,711,070 as appreciation. Appellant appealed to the Board of Tax
8 Appeals ("BTA"), which affirmed the Tax Commissioner. Appellant filed a
9 notice of appeal with this court.
10
This cause is now before this court upon an appeal as of right.
11
12
Squires, Sanders & Dempsey and Ted B. Clevenger, for appellant.
13
Betty D. Montgomery, Attorney General, and Steven L. Zisser,
14 Assistant Attorney General, for appellee.
15
16
Per Curiam. The sole issue presented by this case is whether or not
17 appellant can deduct as appreciation the $3,711,010 in retained earnings that

2

1 the equity method of accounting permitted it to include on its balance sheet
2 as of the date of the transfer of the JTE stock.
3
Accounting Principles Board Opinion No. 18, entitled "The Equity
4 Method of Accounting for Investments in Common Stocks," summarizes the
5 equity method of accounting in part as follows:
6
"An investor initially records an investment in the stock of an
7 investee at cost, and adjusts the carrying amount of the investment to
8 recognize the investor's share of earnings or losses of the investee after the
9 date of the acquisition. *** The investment of an investor is also adjusted
10 to reflect the investor's share of changes in the investee's capital ***."
11
By adopting the equity method of accounting, appellant was able to
12 include JTE's $3,711,010 of retained earnings as retained earnings on its
13 consolidated balance sheet. Both before and after the exchange, the retained
14 earnings of JTE continued to be carried on JTE's books
15
R.C. 5733.05(A), which sets forth the method for calculating the net
16 worth of a corporation, states that the following is one measure of the value
17 of the issued and outstanding shares of stock:

3

1
"(A) The total value, as shown by the books of the company, of its
2 capital, surplus, whether earned or unearned, undivided profits, and
3 reserves, but exclusive of:
4 "***
5
"(4) Goodwill, appreciation, and abandoned property as set up in the
6 annual report of the corporation ***." (Emphasis added.)
7
There is no statutory definition of "appreciation." Webster's Third
8 New International Dictionary (1986) 105-106 defines "appreciation" as an
9 "increase in exchangeable value." Black's Law Dictionary (6 Ed. 1990)
10 101, has no definition of "appreciation," but defines "appreciation in value"
11 as an "[i]ncrease in the market value of an asset (e.g., real estate) over its
12 value at some earlier time." Robert Birzer, a CPA from the accounting firm
13 of Deloitte and Touche testifying on behalf of appellant, agreed that
14 appreciation was "the increase in value over the cost or historical book
15 value of an asset."
16
Appellant's witnesses explained that appellant had two choices to
17 account for the JTE stock transaction: the cost method or the equity method.
18 By choosing the equity method of accounting, appellant was permitted to

4

1 carry the full amount of JTE's retained earnings on its consolidated balance
2 sheet at the time of the exchange. Under the cost method of accounting,
3 which appellant elected not to use, it would not have been permitted to carry
4 JTE's retained earnings on its consolidated balance sheet.
5
Appellant's position is that when it traded its stock for that of JTE,
6 the appreciation shown on JTE books became appreciation on its books, and
7 excludable under R.C. 5733.05(A)(4).
8
R.C. 1.42 requires that "[w]ords and phrases shall be read in context
9 and construed according to the rules of grammar and common usage." Our
10 review of R.C. 5733.05 and the definitions of appreciation set forth above
11 leads us to the conclusion that "appreciation" as used in R.C. 5733.05 is an
12 increase in value over some period of time. Thus the initial amount of
13 $3,711,010 shown on appellant's books did not represent excludable
14 appreciation under R.C. 5733.05. The fact that under proper accounting and
15 federal tax procedures appellant is allowed to carry the retained earnings of
16 JTE on its books does not in any way turn JTE's retained earnings into
17 excludable appreciation for Ohio franchise tax purposes.

5

1
In this case, appellant started business with reported retained earnings
2 of $3,711,010 as of March 17, 1978. Appreciation could be recognized by
3 appellant if the retained earnings of JTE increased above $3,711,010. The
4 Tax Commissioner recognized this in his certificate of final determination
5 when he stated, "Since JTE's use of the equity method has resulted in both
6 upward and downward deviations from costs, the amount to properly reflect
7 on its books for franchise tax purposes must be adjusted to reflect the net
8 amount. This then is the amount excludable as appreciation."
9
While the retained earnings of JTE may have been properly handled
10 from an accounting point of view, those procedures cannot create
11 appreciation when there has been none. The concept of creation of
12 instantaneous appreciation goes against the concept of appreciation as
13 increase in value over time. For there to be an increase in value there must
14 be a starting value against which the increase is measured. Appreciation is
15 the difference between two values, and when, as in this case, there was only
16 one value for retained earnings on March 17,1978, there could be no
17 appreciation in retained earnings on that date.

6

1
Appellant's argument, although not directly stated, appears to be that
2 while JTE's stock was in the hands of the Edwards family it appreciated in
3 the amount of $3,711,010; therefore, when the Edwards family transferred
4 its stock to appellant, the appreciation went along with the stock ownership.
5 While permissible accounting procedures allowed appellant to carry the
6 retained earnings of JTE on its balance sheet, there could be no appreciation
7 in the hands of appellant until after the stock became the property of
8 appellant. Only if the retained earnings of JTE increased in value after
9 appellant owned the stock would there be appreciation that could be
10 excluded by appellant for franchise tax purposes.
11
Appellant chose not to adopt the cost method of accounting, which
12 would have excluded the retained earnings of JTE. No witness could say
13 why appellant chose the equity method of accounting rather than the cost
14 method, but once it did, it was subject to all the ramifications resulting
15 therefrom. In Natl. Tube Co. v. Peck (1953), 159 Ohio St. 98, 50 O.O. 74,
16 111 N.E.2d 11, this court held that the commissioner must take taxpayer's
17 properly prepared books as he finds them. In this case the commissioner
18 took appellant's books as he found them, and he found no appreciation on

7

1 the initial financial statement. No appreciation occurred in the value of the
2 JTE retained earnings until some time after the exchange date; therefore, the
3 amount of $3,711,070 does not represent excludable appreciation for
4 purposes of R.C. 5733.05.
5
Accordingly, the decision of the BTA, being neither unreasonable nor
6 unlawful, is affirmed.
7
Decision affirmed.
8
MOYER, C.J., DOUGLAS, WRIGHT, RESNICK, F.E. SWEENEY and
9 COOK, JJ., concur.
10
PFEIFER, J., dissents.
11
PFEIFER, J., dissenting. The BTA's decision is unreasonable and
12 unlawful because it results in double taxation. I accordingly dissent.
13

8