## Facts

- A Georgia corporation wholly owned by Erwin G. Baumer (Father) bought Atlanta real estate for $175,000 after Father advised his son (Son), a real-estate attorney, not to purchase it personally.
- Father caused the corporation to grant Son an option to buy a one-half interest in the property for nominal consideration ($10) at a fixed price plus interest.
- The corporation later purchased an adjacent parcel, increasing development potential; Son performed development-related efforts that contributed to increased value.
- Son’s option was amended to cover both parcels, extend the term, and set a revised exercise price, again for nominal consideration.
- The corporation separately granted a third party (Pope) an option to buy the combined properties for $500,000; Pope paid monthly amounts to extend its option.
- Son exercised his option in late 1968, buying a one-half interest for roughly $115,000; about a week later, Pope (through an assignee) exercised its option to buy the properties for $500,000.
- At closing, Son received roughly $252,700 for his one-half interest; Father reported no income from the option grant or Son’s gain.
- The IRS asserted (1) the overall sequence should be treated as a corporate sale of the entire property with a constructive dividend to Father, and (2) the option grant to Son constituted a constructive dividend; it also disputed valuation.

## Issues

1. Whether the transactions should be collapsed so the corporation is treated as selling the entire property to the ultimate purchaser, with Son’s role disregarded, thereby taxing the full gain at the corporate level.
2. Whether the corporation’s grant of the option to Son for nominal consideration was an arm’s-length transaction or a constructive dividend to Father.
3. If a constructive dividend arose, whether the district court used an improper valuation method by using the third party’s option-extension payments as a proxy for the option’s value.

## Decision

- The Fifth Circuit affirmed rejection of the Government’s attempt to treat the transaction as a corporate sale of 100% of the property under a substance-over-form/Court Holding theory.
- The Fifth Circuit affirmed that the option grant to Son was not arm’s-length and conferred a substantial economic benefit, constituting a constructive dividend to Father.
- The Fifth Circuit reversed in part and remanded for redetermination of the constructive dividend’s value, holding the district court’s valuation method was erroneous.

## Legal Principles

- A constructive dividend arises when a closely held corporation confers a substantial economic benefit on a shareholder (or the shareholder’s family member) without adequate consideration and outside an arm’s-length context; the benefit is treated as a distribution to the shareholder.
- Transactions will not be collapsed to impose corporate-level gain where intermediate steps have real economic effect; a non-arm’s-length transaction can still be “real” for tax purposes rather than a sham.
- Valuation of a constructive dividend must reflect the economic reality of the benefit transferred (commonly tied to fair market value versus amounts paid), and may not rest mechanically on unrelated third-party benchmarks that do not measure the transferee’s benefit.

## Conclusion

The court held that the corporation’s option to the shareholder’s son had substantive effect and could not be ignored to tax the entire gain to the corporation, but because the option was granted for nominal consideration in a non-arm’s-length setting it produced a constructive dividend to the shareholder; the case was remanded to revalue that dividend using an economically grounded measure.


Baumer v. United States, 580 F.2d 863 (5th Cir. 1978)