Docket No. 44002.
Benjamin Alpert, Esq., for the petitioner. Arthur L. Nims, Esq., for the respondent.
Benjamin Alpert, Esq., for the petitioner. Arthur L. Nims, Esq., for the respondent.
1. On facts, issuance of petitioner's debentures held to have been supported by consideration rendering them valid corporate obligations.
2. Interest on debentures, designated as such, payable in 10 years with fixed interest rate of 3 1/2 per cent and no accompanying rights of management, issued by petitioner corporation in exchange for valuable property without excessive relation to equity investment held, further, deductible as interest on indebtedness.
Respondent determined deficiencies in petitioner's income taxes for the years 1946, 1947, and 1948 in the amounts of $2,242.10, $2,496.29, and $1,223.72, respectively. The question to be decided is whether certain securities issued by petitioner to its sole stockholder in 1946 were valid debenture bonds and represented an an indebtedness permitting the deduction of alleged interest payments thereon under section 23(b) of the Internal Revenue Code of 1939.
FINDINGS OF FACT.
Petitioner was organized on December 19, 1945, under the laws of the State of New York. Its 1946, 1947, and 1948 corporation income tax returns were filed on an accrual basis with the collector of internal revenue for the first district of New York.
John W. Walter had been engaged in the electrical and radio appliance business for many years prior to petitioner's formation. He was district and later divisional manager in the New York area for the Apex Electrical Manufacturing Company, hereinafter called Apex, from 1936 to 1942. He was well known in the appliance business and had made many contacts in that field.
On or about June 1, 1942, Walter purchased an Apex factory branch which was engaged in the distribution of parts and performed repair service for Apex washers in the metropolitan area. He operated his business as a sole proprietorship.
Sometime in 1944, when it began to appear that the electrical appliance industry would soon resume civilian production, Walter decided to go into the radio and television business for himself. He commenced negotiations with Edward Rutledge, regional manager of the Stewart-Warner Corporation, hereinafter sometimes called Stewart-Warner, in order to obtain a distributorship for the Stewart-Warner products in the New York metropolitan area. Stewart-Warner was one of the leading manufacturers and the third oldest company in the radio and television field. Rutledge was well acquainted with Walter's abilities and contacts.
After many months of negotiation, Walter was advised by Stewart-Warner, in July 1945, that he had been appointed distributor for their radio and television products for the metropolitan area and that a formal announcement had been sent to its dealers.
In granting the franchise to Walter, Stewart-Warner considered the fact that Walter was running a distributing business in Long Island City and had been in business during the war in electrical parts and appliances; that he had been an Apex regional manager for many years, and had a thorough knowledge of the marketing of electrical and radio appliances; that he had a very good dealer-following and an excellent reputation; and that at that time he was an executive officer of the Electric and Gas Association in New York City. There were many other persons and firms desirous of acquiring a Stewart-Warner distributorship.
In 1945, there was an unlimited demand for radios, television sets, and all types of electrical appliances. The market would absorb all the radio, television, and other electrical appliances that could be produced. The public had not been able to obtain such products for many years because of World War II conditions.
Based on a projection of sales made as a result of the distributorships held by Walter from Stewart-Warner and other companies, Walter expected his minimum sales volume of radio and television products to be $2,000,000 in the first year of operations. He estimated the cost of doing business at approximately 11 per cent. The markup available to distributors of radios and television sets at the time was at least 16 per cent. This would leave a net profit of 5 per cent on radios and television sets. Walter expected a minimum net profit on these items of $100,000 per annum. He anticipated that this sales volume would be substantially increased as soon as Stewart- Warner expanded its production facilities and was able to make additional merchandise available to him. Stewart-Warner had arranged to give Walter a credit line of $250,000. This was predicated on estimated shipments to him of about $3,000,000 per annum for the first year.
In addition to the radio and television sales projected, Walter anticipated that his sales of other electrical appliances would approximate a minimum of $1,000,000 per annum. On this type of merchandise, the markup was 20 per cent and the cost of doing business was about 10 per cent.
Based on his estimate of the sales volume of radios, television sets, and other appliances, Walter anticipated that he would earn a minimum of $200,000 per annum and that this would continue for many years.
All of the negotiations and all of the transactions with the various manufacturers, particularly with Stewart-Warner, were conducted by Walter as a sole proprietor. There was no corporation in existence at that time.
After Walter, individually, received notification that he had been awarded the Stewart-Warner distributorship, and prior to the end of 1945, he had several conferences with his accountants and attorneys to discuss the type of business organization best suited for his operations. Based upon the anticipated profits indicated, Walter believed that if he were to continue to operate as a sole proprietorship, his individual income tax would absorb most of the profits earned. His advisers suggested that he conduct the operations of the business in corporate form.
Prior to November 15, 1945, Stewart-Warner sent to Walter, individually, a formal Distributor Contract for his signature. This contract was returned to Stewart-Warner on November 15, 1945, with a letter which reads in part as follows:
Attached herewith please find both copies of Distributor Agreement.
You will note that we have added Inc. to the name, the reason for same being that the incorporation papers are being processed.
Walter received the following letter from Stewart-Warner, dated November 20, 1945:
We observe from your radio contract that you evidently incorporated your business recently.
Will it be possible for you to let us have a balance sheet reflecting the corporate investment and the present financial setup?
We should have this on file as a basis for whatever credit will be extended when shipments begin.
When Stewart-Warner was apprised of the fact that Walter was to take the franchise in the name of a corporation, it was interested in ascertaining whether he would continue to be associated with the new corporation in the capacity of stockholder and director. It was also interested in ascertaining the financial structure of the corporation inasmuch as it was not then dealing with an individual. If Walter had not continued to be associated with the new corporation, Stewart-Warner would not have granted it the franchise.
Shortly after petitioner's incorporation on December 10, 1945, a stockholders' meeting was held. The minutes of that meeting read in part as follows:
Upon motion duly made, seconded and carried the aforesaid proposal was order filed in the records of this meeting, said proposal being as follows:
In consideration of the issuance of $100,000 of Ten Year 3 1/2% Debenture Bonds due January 1, 1956, John W. Walter agrees to transfer all the right, title and interest in certain franchises, as more fully set forth in the attached schedule * *
And whereas, it appears after proper investigation that it is to the best interests of the corporation that such property be acquired and that the consideration is fair and reasonable:
Now, therefore, it is resolved, that the said offer be and the same is hereby approved * * *
The schedule of franchises transferred pursuant to this resolution, as set forth in petitioner's minutes, included the Stewart-Warner, Automatic Washer Company, Peerless Manufacturing Company, and Kellogg Switchboard Company franchises originally held by Walter, individually.
Walter obtained the following additional franchises for petitioner after its organization:
+-----------------------------------------------------------------------------+ ¦Presteel Car Corporation ¦Electric ranges ¦ +------------------------------+----------------------------------------------¦ ¦Empire Products Company ¦Electric ironing machines ¦ +------------------------------+----------------------------------------------¦ ¦Burtman Electric Company ¦Vacuum cleaners, mixers, and blenders ¦ +------------------------------+----------------------------------------------¦ ¦International Oil Burner ¦Heaters ¦ ¦Company ¦ ¦ +------------------------------+----------------------------------------------¦ ¦General Mills, Inc ¦Electrical irons, toasters, and iron ¦ ¦ ¦attachments ¦ +-----------------------------------------------------------------------------+
Upon the formation of petitioner, the following tangible assets were also transferred to it:
+---------------------------------+ ¦Cash ¦$10,000.00¦ +----------------------+----------¦ ¦Accounts receivable ¦3,415.91 ¦ +----------------------+----------¦ ¦Merchandise inventory ¦9,166.80 ¦ +----------------------+----------¦ ¦Furniture and fixtures¦1,417.29 ¦ +----------------------+----------¦ ¦Automobile ¦1,000.00 ¦ +----------------------+----------¦ ¦ ¦ ¦ +----------------------+----------¦ ¦ ¦$25,000.00¦ +---------------------------------+
Petitioner issued 500 shares of its capital stock with a face value of $50 per share, totaling $25,000, for these assets. This constituted all of the issued and outstanding capital stock of petitioner.
Petitioner commenced business on January 2, 1946. Prior thereto, all of the operations of the business conducted by Walter were reported by him on his individual income tax returns as a sole proprietorship.
On January 2, 1046, Walter caused petitioner to issue to him its ‘Ten Year 3 1/2 Per cent Debentures' in the total face amount of $100,000. These instruments contain the following provisions:
JOHN W. WALTER, INC., a New York corporation, hereinafter called the ‘Company’, for a value received, hereby promises to pay to the order of JOHN W. WALTER, or the registered holder hereof on the first day of January 1956.
TEN THOUSAND DOLLARS ($10,000.00)
in coin or currency of the United States of America, which at the time of payment is legal tender for public and private debts, at the principal office of the Company in the Borough of Queens, City and State of New York, and to pay at said principal office, fixed interest thereon, at the rate of 3 1/2% per annum, payable in equal quarter-annual installments on the first days of January, April, July and October of each year.
This debenture is one of a duly authorized issue of securities of the Company know as its ‘Ten Year 3 1/2 PerCent Debentures' limited to the aggregate principal amount of $100,000.00 and shall be of the authorized denomination of $10,000.00.
Interest upon this Debenture shall be payable to the order of the registered holder at the close of business on the business day next preceding the date upon which such interest shall be payable; except that, at the maturity of the Debentures, interest, as well as principal, shall be payable to the order of the registered holder thereof upon surrender of this Debenture for cancellation.
This Debenture is subject to redemption in whole or in part at the option of the Company or any interest payment date upon sixty days written notice, to be given by mail to the registered holder hereof, at 104% of the principal amount hereof if redeemed prior to January 1, 1948, or at 102% of the principal amount hereof if redeemed on and after January 1, 1948, and in either case plus accrued and unpaid fixed interest thereon to the date of redemption. In case less than all of the outstanding Debentures shall be redeemed, then the Debentures to be redeemed shall be selected by lot subject to such regulations relating thereto as may be determined by the Board of Directors of the Company.
No transfer of this Debenture shall be valid unless made on the books of the Company at its principal office by the registered holder hereof in person or by his duly authorized attorney. Upon issuance of this Debenture and upon any transfer thereof, the name of the registered holder hereof shall be noted hereon.
No recourse shall be had for the payment of the principal of or interest upon this Debenture, or for any claim based hereon, against any incorporator, or any past, present or future stockholder, officer, or director of the Company, or any successor corporation, whether by virtue of any constitution, statute, rule of law or otherwise, all such liability being by the acceptance hereof expressly waived and released.
On December 28, 1945, and again on February 14, 1946, Stewart-Warner, through A. W. Grossklags of its credit department, made further inquiries with regard to the balance sheet referred to in the first letter. On May 7, 1946, Walter wrote that he was forwarding the balance sheet requested.
On May 24, 1946, Stewart-Warner delivered to Walter the executed formal Stewart-Warner Distributor Contract referred to in the letter of November 15, 1945, as amended. The contract embodied, in written form, the franchise which had been awarded to Walter in July 1945. It provided that it could be terminated by either party with or without cause by giving 30 days' notice in writing, and expired on September 30, 1946. The contract also reads in part as follows:
8b. Upon the termination or cancellation of this agreement, Distributor covenants and agrees that it will forthwith discontinue the use of any such name or names or any combination of words or designs or trademarks which would indicate, or tend to indicate, that Distributor was or is in any way whatsoever a distributor of Stewart-Warner Radio Products.
This agreement and any rights thereunder shall not be transferable without the written consent of Stewart-Warner.
11d. This Agreement shall not be valid or become effective until and unless accepted at Chicago, Illinois, by Stewart-Warner by its proper officer or officers * * *
Neither Walter nor petitioner paid Stewart-Warner anything for the franchise.
During this entire period from December 1945, through May 1946, Stewart-Warner continued to ship merchandise to Walter, individually, as their distributor even though the written contract with petitioner was not executed by them until May 24, 1946.
Dun and Bradstreet would not give petitioner a credit rating until Walter and petitioner signed a general subordination agreement whereby these debentures would be subordinated to the claims of Dun and Bradstreet and general creditors. Such an agreement was executed not earlier than 1948. Under its terms the debentures could not be retired or sold without giving all creditors a 90-day notice.
The instruments evidencing the indebtedness of petitioner were unequivocal obligations on its part to make payment on January 1, 1956. The interest thereon was payable at fixed intervals. The maturity date was fixed. They did not create an unreasonable debt-equity ratio in petitioner's capital structure. The interest on these debentures was paid annually, in accordance with their terms.
Petitioner received valuable consideration for the issuance of these debentures by having assigned to its rights under franchises owned by Walter, including the Stewart-Warner distributorship for the New York metropolitan area.
Walter expected petitioner to gross between $2,000,000 and $5,000,000 in 1946. Petitioner grossed $598,354.51 in 1946, $1,101,746.59 in 1947, and $989,360.27 in 1948.
Regardless of whether consideration is a true prerequisite to the deductibility of interest where a distribution to stockholders of bonds valid on their face does not concededly constitute a gift, as this case is presented our finding of fact that petitioner received valuable consideration for the issuance of its debentures disposes of the issue in petitioner's favor.
See, e.g., Bazley v. Commissioner, 331 U.S. 737.
See Sand Springs Railway Co., 21 B.T.A. 1291, 1310.
Petitioner was organized in December 1945 and commenced its operations in January 1946. Prior to these dates, as early as July 1945, Walter was notified that he had been awarded the Stewart-Warner distributorship, and had received a written contract embodying his oral agreement in October or November of that year for his individual signature. Respondent does not deny, and the record corroborates, that Walter, individually, received merchandise from Stewart-Warner at least as early as December 1945, before petitioner commenced to do business. Petitioner had not yet been organized as of the date when Walter added the term ‘Inc.‘ to the written agreement and returned it to Stewart-Warner for final execution with notification of the intention to incorporate the business. And regardless of the effect of final execution of the written document by Stewart-Warner, petitioner's minutes of a stockholders' meeting shortly after its incorporation clearly establish that it issued the debentures in exchange for Walter's agreement to transfer his rights under the distributorship arrangement under which he had been receiving inventory from Stewart-Warner prior to that time. Stewart-Warner's final execution of the amended written franchise merely signified its formalization of a consent already given to petitioner's substitution under the continuing agreement.
We regard Floyd D. Akers, 6 T.C. 693, as distinguishable on its facts. The situation there arose from the dissolution of a corporation, not its creation; the asset causing the controversy was not a franchise but ‘good will’ or going-concern value; and the terms of the franchise there involved were different from those of the Stewart-Warner distributorship in several respects, notably that here the franchise was assignable with the licensor's consent, which was obtained, and the use of the trade name was not ‘specifically reserved’ as the property of the licensor. Finally, Walter agreed to and actually did transfer the franchise here while in the Akers case the corporation permitted it to expire upon its own dissolution. In these circumstances, we have found that petitioner received consideration for the issuance of the debentures by Walter's transfer of his rights under the distributorship.
Cf. Thompson v. Commissioner, (C.A. 3) 205 F.2d 73, reversing 18 T.C. 361.
We are satisfied, if such a finding is necessary, that substantial value attached to those rights. Even assuming a 1-year life for the franchise, the expectation of net profit from the distributorship in its first year, established by Walter's uncontradicted testimony as to the basis for such expectation, would equal the face amount of the debentures. While his estimate was shown by subsequent events to be overly optimistic, it appears by the same token that the value was still large. Moreover, we see no reason to disbelieve Walter's testimony that other valuable franchises held by him, individually, were transferred to petitioner in this exchange.
See Tribune Publishing Co., 17 T.C. 1228, 1235; Estate Planning Corp. v. Commissioner, (C.A. 2) 101 F.2d 15.
Nor can respondent's contention that these debentures were in fact equivalent to preferred stock be taken seriously. Unlike any of the cases in this field to which we have been referred these debentures have none of the attributes of preferred stock. They fulfilled all the formal requirements of a short-term bond; they had a maturity date fixed ‘in the reasonable future,‘ 10 years after the date of issue; they afforded no basis for participation in management; and they imposed on petitioner a fixed liability to pay interest 4 times annually irrespective of earnings or emergencies, and at a modest rate of 3 1/2 per cent. Cf. Charles L. Huisking & Co., 4 T.C. 595. No unusual unbalance in petitioner's ratio of equity capital to indebtedness resulted from their issue. Cf. Mullin Building Corporation, 9 T.C. 350, affd. (C.A. 3) 167 F.2d 1001; Swoby Corporation, 9 T.C. 887. As we have found, new property did flow to petitioner upon their issuance. Cf. 1432 Broadway Corporation, 4 T.C. 1158, affd. (C.A. 2) 160 F.2d 885. In these circumstances, that Walter and petitioner subordinated the debentures to all other creditor claims approximately 2 years after their issue date in order to obtain a favorable credit rating from Dun and Bradstreet would not be significant. See O.P.P. Holding Corporation, 30 B.T.A. 337, affd. (C.A. 2) 76 F.2d 11; Sabine Royalty Corporation, 17 T.C. 1071; Ruspyn Corporation, 18 T.C. 769.
Decision will be entered for the petitioner.