Comm'r of Internal Revenue

Tax Court of the United States.Feb 28, 1944
3 T.C. 363 (U.S.T.C. 1944)
3 T.C. 363T.C.

Docket Nos. 112004 112005.



Max F. Goldstein, Esq., for the petitioners. J. Marvin Kelley, Esq., for the respondent.

Petitioners, sole holders of the common stock of a corporation, caused preferred to be authorized, exchanged some of their common stock for some preferred, and paid off indebtedness with such preferred. No change was made in surplus. Held, on the fact that there was no reorganization with business purpose sufficient to cause nonrecognition of gain or loss. Held, further, that there was no dividend in either cash or stock, and that there was no distribution essentially equivalent to distribution of a taxable dividend. Held, further, that no gain was realized by petitioners in the payment of their obligation with a part of the preferred stock. Max F. Goldstein, Esq., for the petitioners. J. Marvin Kelley, Esq., for the respondent.

These cases, duly consolidated, involve income taxes for the calendar year 1939. In Docket No. 112004, Louis Wellhouse, Jr., the deficiency determined was $7,640.88; in Docket No. 112005, Ely Meyer, it was $8,043.35.

The questions presented are (a) whether a transaction by which the petitioners each exchanged 200 shares of common stock, which were then cancelled, for 200 shares of preferred stock in the same corporation, resulted in realization by the petitioners of taxable gain or income within the meaning of the Sixteenth Amendment to the Constitution; or (b) whether income was realized upon the subsequent disposition of part of the preferred stock received in the exchange.

From evidence adduced, we make the following findings of fact.


The petitioners are residents of Florida, and filed their Federal income tax returns for the taxable year with the collector at Jacksonville in the district of Florida. On May 5, 1939, they were the sole stockholders (except as appears below) of United Paper Co. (hereinafter referred to as United), a corporation duly organized and existing under the laws of the State of Delaware. At this time, United had an authorized capital of 7,000 shares of common stock, each with a par value of $100, and 200 shares of special common stock, the par value of which was $100 per share, all of which shares were issued and outstanding.

Each of the petitioners owned 3,500 shares of the common stock, more than 200 shares of which had been purchased in 1926 by each petitioner at a cost of $123.37 per share. The common shares were the only shares of United which carried voting privileges. The holders of the common shares were restricted by the terms of the charter of incorporation from selling them to third persons without offering them for sale first to existing stockholders.

The 200 shares of special common stock were fully paid and nonassessable. They were owned by four of United's employees (other than the petitioners). These shares of special common stock were preferred as to assets on dissolution. They had no voting power and could be sold only to existing stockholders of United (or to United itself). They also had the following rights which appear on the face of each certificate: ‘The dividends on the SPECIAL COMMON STOCK are to be equal in amount to any dividend that is now and may hereafter be paid on the Common Stock and is (sic) to be payable under like conditions and at the same time.‘

Petitioner Louis Wellhouse, Jr., was United's president; petitioner Ely Meyer was its vice president and treasurer. Together, they were and have continued to be United's only managing officers.

On May 5, 1939, United had a surplus of $344,833.39. The book value of each share of common stock (not including the special common) was $149.26.

On May 5, 1939, at a meeting of all the directors of United, a resolution was unanimously adopted recommending the recapitalization of United by amending its charter of incorporation to authorize the issuance of 2,800 shares of preferred stock, having a par value of $100 per share and entitled to cumulative dividends at the rate of 6 percent per annum. This resolution further provided that the preferred stock was to be issued only in exchange for common stock, share for share, as and when the same was tendered to the corporation by stockholders of record; that the common shares received in exchange were to be canceled; and that the capitalization of the corporation was not to be changed. On May 5, 1939, the stockholders of United, by resolution unanimously passed, adopted the recommendation of the board of directors. An appropriate certificate of amendment was duly filed with the Secretary of State of Delaware on June 9, 1939.

After the amendment of United's charter, each petitioner exchanged 200 shares of common stock, which had been purchased for $123.37 a share, for 200 shares of preferred stock, having a par value and fair market value of $100 a share. The 400 shares of old common were then canceled. The shares of preferred stock contained all the restrictions set forth in the amendment to United's charter. They were issuable only in exchange for common stock and not for special common, had no voting rights except upon default in payment of dividends, and dividends on the preferred were to be paid in full before any could be paid on common. The preferred was subject to retirement at $100 per share plus accrued dividends, and in case of liquidation or dissolution of United the holders of preferred stock were entitled to be paid in full both the par value of their shares and the accumulated unpaid dividends thereon before any amount could be paid to the holders of the common stock. The common stock alone was entitled to the net assets of United upon dissolution after the payment of the preferred stock and of the special common stock.

The petitioners did not report any income from the foregoing transactions in their Federal income tax returns for 1939.

The exchange effected no change in the total amount of United's capital, although after the exchange it consisted of 6,600 shares of common, 200 shares of special common, and 400 shares of preferred stock. No entries were made in the surplus account as a result of these transactions; the earned surplus remained, as shown in the books, unchanged at $344,833.39. No cash or property other than the stocks was passed in these exchanges. The corporation did not in form declare or pay a stock dividend in preferred stock. The holders of the special common stock received nothing as a result of these transactions in the form of a dividend or otherwise. The book value of each share of the remaining 6,600 shares of common stock rose to $152.25 per share after the exchange.

Within a reasonable time after the exchange, during 1939, each petitioner transferred 150 shares of preferred stock, the fair market value of which was $100 per share, to the Trust Co. of Georgia in satisfaction of the personal indebtedness of each petitioner to the estate of Louis Wellhouse, Sr. This indebtedness arose out of the purchase by each petitioner of common stock in United, in an amount exceeding $15,000. The balance of the indebtedness of each was paid with the proceeds of dividends declared and paid by United on its common stock. No additional shares of preferred stock have ever been exchanged for common, and no disposition or use has been made by either petitioner of the remaining 50 shares of preferred stock of which each is the owner.

United and its predecessors have been engaged in the specialized business of selling paper wrappers which are used in packing citrus fruits. It is a family business and has been in existence since 1900. At the time of the transactions in question, the nature of its business was such that the interests of the corporations would be served best if petitioners were in a position to manage its affairs and to determine its policies without outside interference. The continued success of the business was dependent upon the sound exercise of discretion by petitioners in extending credit to United's customers, and this, in turn, was based upon petitioners' long experience and personal familiarity with the growers and jobbers to whom they sold their product.

Prior to 1934 United's source of supply for the paper it required in the conduct of its business was Dells Pulp & Paper Co. (Hereinafter referred to as Dells), which manufactured this paper exclusively for United. Dells was operating at a loss and proposed to liquidate. Ely Meyer, with $50,000 in personal funds, purchased the assets of that part of Dells which manufactured paper for United. Thereupon, in 1934, he caused Sterling Pulp & Paper Co. (hereinafter referred to as Sterling), to be incorporated and he became a stockholder therein. Sterling then manufactured paper exclusively for United, which later became the owner of preferred and common stock in Sterling and also advanced money to the latter, accepting debentures therefor. Petitioner Louis Wellhouse, Jr., never directly owned stock in Sterling.

Between 1935 and 1937 United's business fell off sharply, due to a drastic decline in the demand for paper wrappings caused by the development of a new method of packing citrus fruits unwrapped. Petitioners deemed it advisable for United to seek other lines of business. Together with a third person, the petitioners organized a new corporation, which proved unsuccessful. However, United has since gone into the field in which the unsuccessful corporation operated. By 1939, when the transactions here in question took place, the fruit-Wrapping business had improved.

The exchange of common stock for preferred was pursuant to a plan the principal purpose of which was to enable the petitioners to discharge their personal obligations. From the point of view of United, the exchange was without any business purpose, as the plan was not intended to benefit United.


DISNEY, Judge:

The deficiency notice in each case determines that the 200 shares of preferred stock received by the petitioner constitutes income within the Sixteenth Amendment of the Constitution, and $20,000 is added to income as ‘dividends.‘

The petitioners seek, first of all, to demonstrate error in the assertion of realization of income by showing receipt of the stock in the course of a nontaxable reorganization, i.e., a recapitalization, under section 112(b)(3) and (g)(1) of the Internal Revenue Code. In our opinion, they have not so shown, for, assuming without deciding that there was, in form, such reorganization through recapitalization, within the definition furnished in section 112(g)(1), that alone does not apply the nonrecognition provisions of section 112(b)(3). Ernst Kern Co., 1 T.C. 249, 263; Gutbro Holding Co., 47 B.T.A. 374, 378, 379. Under the well crystallized doctrine of Gregory v. Helvering, 293 U.S. 465, there must be corporate business purpose in the transaction. We find none in the facts, and since Bass v. Commissioner, 129 Fed.(2) 300, and Jacob Fischer, 46 B.T.A. 999, principally relied upon by the petitioners, did, as plainly shown in the facts, involve such business purpose in the reorganization involved, we fail to find authority in them for our present purposes.

SEC. 112. RECOGNITION OF GAIN OR LOSS.(b) EXCHANGE SOLELY IN KIND.—(3) STOCK FOR STOCK ON REORGANIZATION.— No gain or loss shall be recognized if stock or securities in a corporation a party to a reorganization are, in pursuance of the plan of reorganization, exchanged solely for stock or securities in such corporation or in another corporation a party to the reorganization.(g) DEFINITION OF REORGANIZATION.— As used in this section and section 113—(1) The term ‘reorganization‘ means * * * (E) a recapitalization, * * *

Here, under the evidence, the purpose was to permit the petitioners, stockholders in the corporation, to pay off their debt. That in so doing it was desired to retain the control of the corporation in the petitioners, because of some peculiarity in the business done, and to keep others from acquiring familiarity with the business methods of United, is, in our opinion, immaterial. The recapitalization was not necessary, either for keeping control or keeping the public unaware of the corporation's affairs, for the petitioners already enjoyed control, and had nothing been done the public would have continued to be uninformed as to the business of United. Sale of the stock necessary to pay the indebtedness would not have divested petitioners of control, nor would declaration of a dividend from the considerable corporate surplus on hand.

The record fails to establish any need in the corporation itself, as distinguished from the petitioners-stockholders, for funds at the time of the change in corporate structure. By 1939, when the transaction in question took place, United's business had begun to improve. Furthermore, the petitioners did organize a new corporation, together with a third person, for the manufacture of a new product. It was unsuccessful. United later went into this new business. It is not clear whether the organization of the new corporation occurred before or after the exchange of common stock for preferred. It is clear that petitioners did not use the preferred stock, which they acquired in the exchange, for the corporation or in connection with United's participation in this new line of business. There is no evidence that either United or the petitioners required any capital, other than that already a part of United, to finance any new venture. The petitioners have never, in fact, made any use of these shares of preferred stock for any business purpose related to United. It is to be noted further that although the issuance of 2,800 shares of preferred stock was authorized, only 400 were ever issued and 300 of these were used almost immediately to satisfy petitioners' personal obligations to the estate of Louis Wellhouse, Sr. The evidence clearly establishes that the petitioners had in mind the payment of these obligations when they caused United's charter to be amended and then exchanged their common stock for preferred. The readjustment of capital in these cases was not ‘undertaken for reasons germane to the conduct of the venture in hand,‘ but was ‘an ephemeral incident, egregious to its prosecution. ‘ To pay the shareholders' personal obligations is not one of the transactions contemplated as the purpose of corporate reorganization. We conclude that there was no such reorganization as to confer nontaxability upon any gain realized.

Helvering v. Gregory, 69 Fed.(2d) 809, 811.

We therefore next inquire whether such gain was realized. We have found as fact that there was exchange of stock for stock, for the old common stock was actually turned in and canceled, and the new preferred was issued to petitioners. We so held under similar facts in Jacob Fischer, supra. See H. E. Muchnic, Administrator, 29 B.T.A. 163. We therefore examine such facts in the light of the further contentions of the parties.

The respondent having determined that the full $20,000 par value of the preferred stock received by each petitioner was income, it is of course incumbent upon the petitioners to demonstrate error in such determination, regardless of the reasons suggested therefor. Edgar M. Carnrick, 21 B.T.A. 12. However, upon brief, the respondent takes the view that the $20,000 constitutes taxable dividend, cash or in stock, or that it was essentially equivalent to distribution of a taxable dividend. The applicable statutes, section 22(a) and section 115 (a), (f), and (g), are set forth in the margin. The petitioner therefore argues (in addition to the above discussed contention as to nontaxable reorganization) that the facts negative each of respondent's views.

SEC. 22. GROSS INCOME.(a) GENERAL DEFINITION.— ‘Gross income‘ includes gains, profits, and income derived from * * * ; also from interest, rent, dividends, securities, or the transaction of any business carried on for gain or profit, or gains or profits and income derived from any source whatever. * * *SEC. 115. DISTRIBUTION BY CORPORATIONS.(a) DEFINITION OF DIVIDENDS.— The term ‘dividend‘ when used in this chapter * * * means any distribution by a corporation to its shareholders, whether in money or in other property, (1) out of its earnings or profits accumulated after February 28, 1913, or (2) out of the earnings or profits of the taxable year * * * without regard to the amount of the earnings and profits at the time the distribution was made. * * *(f) STOCK DIVIDENDS.—(1) GENERAL RULE.— A distribution made by a corporation to its shareholders in its stock or in rights to acquire its stock shall not be treated as a dividend to the extent that it does not constitute income to the shareholder within the meaning of the Sixteenth Amendment to the Constitution.(g) REDEMPTION OF STOCK.— If a corporation cancels or redeems its stock (whether or not such stock was issued as a stock dividend) at such time and in such manner as to make the distribution and cancellation or redemption in whole or in part essentially equivalent to the distribution of a taxable dividend, the amount so distributed in redemption or cancellation of the stock, to the extent that it represents a distribution of earnings or profits accumulated after February 28, 1913, shall be treated as a taxable dividend.

We dispose at once of the idea that there may have been cash dividend. No cash passed. We find no cash dividend.

Was there stock dividend? In our opinion there was not. No dividend was declared, and we have indicated the necessity of declaration as requisite to finding of stock dividend. J. Weingarten, Inc., 44 B.T.A. 798; Humphryes Manufacturing Co., 45 B.T.A. 114. Nor was there any capitalization of surplus. Surplus remained the same before and after the change in corporate structure. Webster's New International Dictionary defines ‘stock dividend‘ as:

Stock dividend. Finance. The distribution by a corporation to its shareholders of additional stock created by capitalizing its surplus or from the stock of subsidiary corporations. Also, the stock so distributed.

The case of Bass v. Commissioner, supra, at pages 304 and 305, contains the following discussion on this point:

‘A stock dividend always involves a transfer of surplus (or profit) to capital stock.‘ Graham and Katz, Accounting in Law Practice, 2d ed. 1938, Sec. 80. As the court said in United States v. Siegel, 8 Cir., 1931, 52 F.2d 63, 65, 78 A.L.R. 672: ‘A stock dividend is a conversion of surplus or undivided profits into capital stock, which is distributed to stockholders in lieu of a cash dividend.‘ Congress itself has defined the term ‘dividend‘ in Sec. 115(a) of the Act as meaning any distribution made by a corporation to its shareholders, whether in money or in other property, out of its earnings or profits. In Eisner v. Macomber, 1920, 252 U.S. 189, 40 S.Ct. 189, 64 L.Ed. 521, 9 A.L.R. 1570, both the prevailing and the dissenting opinions recognized that within the meaning of the revenue acts the essence of a stock dividend was the segregation out of surplus account of a definite portion of the corporate earnings or profits theretofore available for dividends, the freezing of such segregated earnings as part of the permanent capital resources of the corporation by the device of capitalizing the same, and the issuance to the stockholders of additional shares of stock representing the profits so capitalized. * * *

This result is not changed by section 115(b) of the Internal Revenue Code, which provides that ‘ * * * every distribution is made out of earnings or profits to the extent thereof, and from the most recently accumulated earnings or profits * * * ,‘ because that section neither ‘prescribes the criteria for determining when a distribution has taken place, as distinguished from an exchange which is governed by section 112,‘ nor ‘converts what is not income into income.‘

Bass v. Commissioner, supra, at page 308.

Leland v. Commissioner, 50 Fed.(2) 523, 525.

We conclude that no stock dividends are here involved, and that section 22(a), in so far as it relates to dividends, and section 115(a) and (f) of the Internal Revenue Code are not applicable.

(b) Respondent next contends in the alternative that the transactions in the instant cases fall within the purview of section 115(g) of the Internal Revenue Code, i.e., that the distribution by United of 400 shares of preferred stock and the cancellation of the 400 shares of common stock took place at such time and in such manner as to make the distribution and cancellation essentially equivalent to the distribution of a taxable dividend. A similar argument was rejected in the case of H. Y. McCord, 31 B.T.A. 342, in which this Court stated at page 343: ‘No question arises under section 115(g) because, as we have seen, the cancellation of outstanding shares was not for cash, but only in exchange for new common and preferred shares.‘ Section 115(g) provides that ‘the amount so distributed in redemption or cancellation of the stock, to the extent that it represents a distribution of earnings or profits accumulated after February 28, 1913, shall be treated as a taxable dividend.‘ As has already been stated, there was no distribution out of earnings and profits in the instant cases; the surplus and capital stock accounts both remained unchanged in amount. To come within the scope of section 115(g), the distribution must result in a pro tanto reduction of the corporation's capital; in other words, section 115(g) is limited to a distribution out of earnings and surplus. South Atlantic Steamship Line, 42 B.T.A. 705, 714. We conclude that section 115(g) of the Internal Revenue Code is not applicable.

The gravamen of respondent's position in these cases is stated in his brief as follows: ‘What actually transpired in the instant case is that there was a partial liquidation of the common stock resulting in a paid-in surplus followed by either (1) a cash dividend, the profits of which were used to acquire preferred stock, /or (2) a taxable dividend in preferred stock on common to the extent of the preferred stock issued.‘ To agree with that theory would require the breaking up of a single transaction, which is an exchange, into a series of transactions. ‘Whether an apparently integrated transaction shall be broken up into several separate steps and whether what apparently are several steps shall be synthesized into one whole transaction is frequently a necessary determination in deciding tax consequences.‘ Dobson v. Commissioner, 320 U.S. 489. See also, Helvering v. New Haven & S.L.R. Co., 121 Fed.(2d) 985, 988. It is the duty of this Court to make that determination from the evidence. The facts show that United did not declare a stock dividend in form and that the petitioners never had any thought at the time of these transactions of effecting a partial liquidation of United. We, therefore, can find no basis in the evidence in these cases which justifies regarding the transactions here in question in any other light than that of an exchange. To support respondent's contention would require a finding of fact contrary to the evidence.

The respondent further contends upon brief that the petitioners realized a taxable gain upon the disposition by each of 150 shares of preferred stock for $15,000 in partial satisfaction of their respective indebtedness to the estate of Louis Wellhouse, Sr. The gain or loss from that transaction is not properly before this Court, as that issue was not raised by the pleadings. H. Elkan & Co., 2 T.C. 597, 606, 607; William H. Joseph, 43 B.T.A. 273; Warner G. Baird, 42 B.T.A. 970, 975; Citizens Nat. Trust & Sav. Bank of Los Angeles, 34 B.T.A. 140, 145. Even if the respondent were permitted to assert this issue at this time, he could not prevail because, looking at these transactions as a whole, it is obvious that there was no gain realized by the petitioners on the disposition of these shares of preferred stock. This is true whether we regard their basis as the cost of the common shares for which they were exchanged, to wit, $123.37, or the fair market value of each share of preferred stock, to wit, $100. The increase in the book value of the remaining shares of common stock is not taxable until some disposition is made thereof. Eisner v. Macomber, 252 U.S. 189; Malone v. Commissioner, 128 Fed.(2d) 967; Clark v. Commissioner, 77 Fed.(2d) 89.

Petitioners do not assign as error denial of any loss as a result of these transactions under section 112(a) of the Internal Revenue Code, and respondent does not claim they realized a taxable gain under that section. It follows that the Commissioner's determination of deficiencies in the income tax liability of the petitioners was in error.

SEC. 112. RECOGNITION OF GAIN OR LOSS.(a) GENERAL RULE.— Upon the sale or exchange of property the entire amount of the gain or loss, determined under section 111, shall be recognized, except as hereinafter provided in this section.

Decisions will be entered under Rule 50.