Comm'r of Internal Revenue

Tax Court of the United States.Apr 17, 1946
6 T.C. 757 (U.S.T.C. 1946)
6 T.C. 757T.C.

Docket No. 8063.



Edward J. Keelan, Jr., Esq., J. N. Welch, Esq., and Anthony Brayton, Esq., for the petitioners. A. J. McDowell, Esq. for the respondent.

1. In 1931 and 1932 petitioner advanced money to X under an agreement whereby he was to obtain a certain interest in stock to be received by X through a stock purchase arrangement. X received the stock in 1932, but failed to deliver any part of it to petitioner. In 1939 petitioner brought suit in equity to compel delivery of his share of the stock, but early in 1940 the matter was settled by a compromise settlement under which X made cash payment. Held, the gain realized by petitioner was a long term capital gain.

2. In 1932 petitioner converted a residence in which he had formerly lived into rental property. In 1941 he sold the property at a loss. Fair market value at the time of conversion to rental property determined, and held that the loss attributable to the building was an ordinary loss. N. Stuart Campbell, 5 T.C. 272, followed. Edward J. Keelan, Jr., Esq., J. N. Welch, Esq., and Anthony Brayton, Esq., for the petitioners. A. J. McDowell, Esq. for the respondent.

This proceeding involves deficiencies in income tax for the years 1940 and 1941 in the amounts of $5,889.13 and $6,996.98, respectively.

Four issues are raised:

1. Was certain profit in the amount of $20,324.97, realized by petitioner in 1940, taxable as ordinary income, or, in the alternative, as short term capital gain, or did it represent long term capital gain?

2. What was the proper basis in 1940 for depreciation of petitioner's Commonwealth Avenue building?

3. What was the petitioner's basis in 1941 for determining gain or loss on the sale or exchange of the Commonwealth Avenue real estate?

4. Was the loss attributable to the building an ordinary loss or was it a long term capital loss?


Petitioners, husband and wife, are residents of Beverly, Massachusetts. They filed joint income tax returns for 1940 and 1941 with the collector of internal revenue for the district of Massachusetts. Quincy A. Shaw McKean will hereinafter be referred to as petitioner.

Petitioner and Clement M. Burnhome (herinafter sometimes referred to as the brokers) were executive officers and the sole stockholders of the Ridgeton Corporation. Both the petitioner and Burnhome were business brokers. The corporation was likewise engaged in the same business, that is, the purchasing and selling of businesses.

In 1931 the Ridgeton Corporation was employed by the trustees under the will of W. S. Quinby to negotiate a sale of the W. S. Quinby Co., hereinafter referred to as the Quinby Co., the stock of which was held by said trustees. A brokerage commission comprising a percentage of the sale price was to be paid by the sellers to the Ridgeton Corporation.

In 1931 negotiations resulted in the sale of the Quinby Co. stock to Adriel U. Bird at a price of about $2,000,000. The Ridgeton Corporation received from the trustees commissions aggregating about $100,000 for its efforts in effecting the sale.

Shortly before the sale price was to be paid Bird notified Burnhome that the financial arrangements he had made were not working out as expected and that he would have to raise additional money before the purchase could be effected. He sought to induce the brokers to invest some part of their commission from the Quinby estate in his stock purchase transaction. As a result of their talks, Bird and Burnhome entered into an agreement which was contained in two letters and a memorandum. In the first letter, dated December 10, 1931, Burnhome agreed to turn over to Bird one-half of his share of the commission, $24,851.23, in exchange for a one-half interest with Bird in the stock of the Quinby Co. which Bird would retain. (Other financial arrangements made by Bird were to be taken care of before the amount to be retained by Bird could be determined.) The brokers paid over to Bird the sum of $15,601.23 at that time. By the second letter, dated February 8, 1932, the parties agreed upon an arrangement to take care of others who had assisted Bird in raising the purchase money. It also provided that in the event Bird's creditors should foreclose on certain collateral, consisting of Quinby Co. shares, or if for any other reason Burnhome failed to get his share of the stock, Bird was to pay him $24,851.23, representing the amount Burnhome had agreed to invest, and it was further agreed that in the meanwhile Burnhome was to have the dividends on his part of the stock.

On February 9, 1932, the parties executed a memorandum of understanding as follows:

(1) Bird agrees to give Burnhome one-half of all the stock of the W. S. Quinby Co. that Bird receives after the financing and the taxes in connection with the purchase of said Quinby Co. have been completed.

(2) Burnhome agrees that Bird shall have complete authority in managing the business and in handling the above mentioned financial matters.

(3) Bird agrees that at any time previous to the above mentioned division of stock that if Burnhome is dissatisfied Bird will pay Burnhome $24,851.23 instead of giving Burnhome any of the Quinby Co. stock.

(4) The amount of $24,851.23 is the sum that Burnhome has actually paid Bird for the stock.

By check dated February 10, 1932, the sum of $9,250 was paid by Burnhome to Bird. The brokers paid Bird a total of $24,851.29.

The above agreement was only nominally between Burnhome and Bird. Actually, the negotiations leading to the arrangement were conducted by both petitioner and Burnhome and, in fact, 45 percent of the money advanced to Bird was petitioner's. In entering into the agreement in his own name, Burnhome in reality represented and acted both for himself and petitioner. The agreement between the brokers with respect to the investment was set forth in a letter dated December 16, 1931, from Burnhome to the petitioner and reads as follows:

You have advanced to me certain money which I have paid Adriel U. Bird as part consideration for one-half of the stock interest in W. S. Quinby Company which he is to assign to me. The balance of the consideration is to be paid when the Ridgeton Corporation receives the remainder of its commission on the sale of the W. S. Quinby Company stock. I am to hold the stock which I get from Bird (less the share which goes to E. B. Thomas) either in trust for the Ridgeton Corporation, or in trust for you and myself, half and half, as we may determine later.

The money so paid had been received by petitioner and Burnhome from the Ridgeton Corporation, partly as executive salaries and partly as loans. The brokers were not employed by nor did they receive any commission from Bird.

The profit here in question was derived solely from the investment by the brokers in the Quinby stock. Early in 1932 Bird acquired all of the capital stock of the Quinby Co., using as part of the purchase price the money furnished for that purpose by the petitioner and Burnhome. Thereafter, Bird entered into complete control of the Quinby Co.

Bird never delivered to petitioner or to Burnhome any of the Quinby Co. stock. On September 16, 1939, Burnhome, for himself and on behalf of petitioner, filed an equity suit asking specific performance of the contract and for delivery of the proper proportion of the stock.

Early in 1940 the suit against Bird was settled by the parties. Under the settlement agreement Bird paid Burnhome $25,000 in cash on February 1, 1940, and delivered to him 20 interest-bearing promissory notes, each in the amount of $5,000 and dated February 1, 1940, of which two were payable on or before August 1, 1940, and two more were payable at the end of each 6-month period subsequent to August 1, 1941. The total payment was $125,000.

Prior to the settlement of the suit petitioner had sold and assigned away a portion or portions of his interest in the stock. His remaining interest at the time of settlement was 22 1/2 percent of the total amount to be received from Bird. Petitioner actually received $28,170 ($28,125 being 22 1/2 percent of $125,000, and $45 being interest) from the settlement in 1940. The parties are now agreed that petitioner had a gain thereon of $20,324.97 and that the gain was realized in 1940. The 20,324.97 represents the balance of petitioner's share of the settlement after deducting $5,591.54, petitioner's remaining cost of the 22 1/2 percent interest, and $2,253.49 representing petitioner's share of the legal expenses in connection with the equity suit. Petitioner reported the profit as long term capital gain. The respondent determined the sum in question was ordinary income realized in 1940.

In 1926 petitioner purchased a residence at 205 Commonwealth Avenue, Boston, Massachusetts, at a cost of $80,000. It was a large dwelling, having over 20 rooms, and had been built about 1902. Petitioner and his family made their home in this house until about November 17, 1932, at which time they moved out and abandoned it as a home for the reason that it was too expensive to operate. On November 17, 1932, petitioner's wife leased the premises to others for a term of 3 years, beginning September 1, 1933, at an annual rental of $4,000. Petitioner made many efforts to sell the property, but received no firm offers.

At the time of its conversion to rental property the real estate was assessed at $60,000, of which $32,000 was the assessed value of the land and $28,000 was for the building. The fair market value of the property at that time was $45,000. Of that sum $25,000 was the value of the building and $20,000 was the value of the land. The applicable rate of depreciation is 3 percent.

In 1940 petitioner claimed a depreciation allowance of $1,440, computed by applying the 3 percent rate to a claimed basis of $48,000. For the years prior to 1940 the petitioner had claimed and had been allowed an annual depreciation deduction in that same amount. In 1940 the respondent determined that petitioner's basis for depreciation was $10,152, thereby reducing the depreciation allowance for that year.

In July 1941 the petitioner sold the Commonwealth Avenue property for $8,000. After paying a broker's commission of $400, he received a net of $7,600 from the sale. For the purpose of computing losses on the sale petitioner used a basis of $28,000 (unadjusted) for the building and $32,000 for the land. He reported the loss attributable to the land as long term capital loss and that attributable to the building as an ordinary loss.

In 1937, petitioner had expended the sum of $1,970.40 for electrical wiring, plumbing, and alterations. The parties have agreed that this sum is properly chargeable against and should be applied in reduction of the depreciation account.

Of the net sale price in the amount of $7,600, the sum of $3,240 is attributable to the building and $4,180 is attributable to the land.

The respondent determined that the unadjusted basis of the building was $10,152, that the basis for the land was $11,448, and that the entire loss was a long term capital loss, deductible to the extent of only 50 percent thereof.



The parties agree that the petitioner realized a net gain of $20,324.97 in 1940 as a result of the compromise settlement. Hence, the only question before us is whether that sum represents a long term capital gain, as the petitioner contends, or whether it is ordinary income, or, in the alternative, a short term capital gain, as contended by the respondent.

The money in question was capital gain unless, as is urged by the Commissioner, all or some part there of was received by petitioner as commission for services rendered by the brokers to Bird in connection with the purchase of the Quinby Co. stock. We have found as a fact that the Ridgeton Corporation was employed on a commission basis by the seller of the stock and that neither petitioner, Burnhome, nor the corporation was employed by Bird or received any commission or compensation from him in connection with the sale. The entire profit on the transaction was derived from the investment by the brokers in one-half of the stock ultimately received by Bird. Thus, the profit derived thereon was capital gain.

The memorandum agreement between the brokers and Bird, dated February 9, 1932, expressly provided that the brokers should receive one-half of all the Quinby stock received by Bird, after deducting the financing costs and the taxes in connection with the purchase. It specifically provided that $24,851.23 was the amount actually paid to Bird for the stock. The agreement further provided that if the brokers should, at any time prior to the actual division of the stock, become dissatisfied, Bird would pay them $24,851.23 instead of turning over any of the Quinby stock.

The transaction may not be regarded as the acquisition by the brokers of a mere option. It is obvious that in the circumstances here it must be regarded either as a loan or a purchase, and that it can not be both. Nor may the selection of the characterization of the transaction be said to have been at the brokers' election. It seems clear that it was not a loan, and neither party suggests that it was a loan. See Irving Fisher, 30 B.T.A. 433; Resthaven Memorial Cemetery, Inc., 43 B.T.A. 683; William H. Davey, 30 B.T.A. 837. Under the contract the broker made an investment in the stock, they acquired a present beneficial ownership therein, and, pending the clearing up of Bird's financing obligations and the taxes in connection therewith, the brokers were entitled to the dividends on their shares. The fact that the shares could not at that time, and as a matter of fact never did, come into their physical possession is entirely immaterial. I. C. Bradbury, 23 B.T.A. 1352; affd., 78 Fed.(2d) 599. They were the equitable owners of one-half of the shares that Bird had acquired. Nor does the fact that the brokers could, at any time prior to the actual division of the stock, compel Bird to return to them their investment in lieu of turning over the stock alter the situation. In contracts of this nature such an arrangement is not unusual. As we pointed out in the Resthaven Memorial Cemetery case, supra, the existence of an obligation on the part of the seller to repurchase is entirely consistent with the theory that the transaction was a sale on condition subsequent. Such a provision does not vitiate the sale. John Sherwin, 46 B.T.A. 330. It is merely a right to rescind the original completed sale. James H. Torrens, 31 B.T.A. 787.

We conclude that by the transaction the brokers acquired an economic ownership of one-half of the stock acquired by Bird. There is no evidence that the brokers ever manifested dissatisfaction with their purchase or attempted to compel Bird to repurchase their interest. Indeed, the equity proceeding instituted in 1939 was for the purpose of compelling Bird to deliver one-half of the stock.

By the compromise agreement of 1940, the brokers relinquished their right and interest in the Quinby Co. stock for a total payment of about $125,000, and that settlement constituted a sale or exchange within the meaning of the applicable statute. See I. C. Bradbury, supra. It appears from the record that Bird completed the purchase and came into possession of the Quinby Co. stock early in 1932. The brokers' right to one-half of Bird's stock attached at the time of its receipt by him and, hence, it appears that the brokers had, in fact, been the equitable owners for a period far in excess of the 18 months necessary, in 1940, to support a long term capital gain.

Turning to the question of petitioner's basis in 1940 for depreciation on the Commonwealth Avenue Building, we note that the parties are agreed that the basis is the fair market value at the time of its conversion to rental property. Heiner v. Tindle, 276 U.S. 582. Since the parties are likewise agreed that 3 percent is the proper rate for the computation, the only problem before us is its fair market value at the crucial date.

The respondent has determined that the value of the whole property was $21,600, attributable $10,152 to the building and $11,448 to the land. In his tax return for 1940, the petitioner claimed a basis of $48,000 on the building. However, for purposes of computing gain or loss on the sale thereof in 1941, he claimed that its fair market value upon conversion was $28,000.

Upon consideration of the testimony of expert witnesses, each of whom tended in his opinion to support the determination of the party by whom he was called to testify, and upon consideration of rental value, assessed valuation, and all other pertinent factors, we have found as a fact that the fair market value of the entire parcel was $45,000, and that of that sum $25,000 was attributable to the building and $20,000 to the land.

During the years prior to 1940, petitioner claimed and was allowed depreciation of $1,440 annually (3 percent on a claimed basis of $48,000). Since the amount allowed in each of those years is in excess of the amount allowable under this determination, the amount of depreciation so allowed must stand. For the year 1940 depreciation should be recomputed on the basis of a value of $25,000, the fair market value as herein redetermined.

In ascertaining petitioner's adjusted basis on the building for purposes of determining loss on the sale thereof in 1941, the depreciation reserve should be reduced by the sum of $1,970.40 representing expenditures by petitioner in 1937 for electrical wiring, plumbing, and alterations. That sum has not otherwise been accounted for and it was understood that such amount should be applied in reduction of the depreciation account.

At the time of the sale in 1941 petitioner's basis (unadjusted) for the building was $25,000 and his basis for the land was $20,000. It is agreed that the land was a capital asset. The respondent has taken the position that the loss on the building, as well as that sustained on the land, was a long term capital loss. In support of his contention he argues that the building may not be excluded from characterization as a capital asset since, while it was subject to an allowance for depreciation, it was not used in a trade or business carried on by petitioner, hence, that it fails to meet one of the requirements and must, therefore, be regarded as a capital asset. We considered the same problem in N. Stuart Campbell, 5 T.C. 272, and there held that the loss attributable to a building was an ordinary loss. We find no reason for holding contrary to that decision, nor does there appear to be any material basis upon which this case might be distinguished from it. Accordingly, we hold that the loss attributable to the building was an ordinary loss.

Of the net sale price in the amount of $7,600, the sum of $3,420 should be allocated to the building and the balance, $4,180, should be allocated to the land.

Reviewed by the Court.

Decision will be entered under Rule 50.