Docket No. 43504.
David Livingston, Esq., and Louis F. DiResta, C.P.A., for the petitioner. Charles W. Nyquist, Esq., for the respondent.
David Livingston, Esq., and Louis F. DiResta, C.P.A., for the petitioner. Charles W. Nyquist, Esq., for the respondent.
Petitioner owned a tract of land with valuable mineral rights. The mineral rights had a zero basis. Petitioner transferred the entire property to a wholly owned subsidiary, and, after having arranged to sell a portion of these rights, petitioner reacquired the mineral rights from the subsidiary as a dividend in kind. It then consummated the sale. Held, in the circumstances of this case, that petitioner intended from the outset to reacquire the mineral rights from the subsidiary for purposes of sale, that the transfer of the mineral rights to the subsidiary was without business purpose and was lacking in bona fides, and that the reacquisition of the mineral rights by petitioner from the subsidiary did not result in a stepped-up basis.
Respondent determined a deficiency in the income tax of petitioner for the year 1947 in the amount of $66,082.54.
The sole question is whether, in determining petitioner's basis for gain or loss of gas rights in a tract of land known as the Henning Tract, transactions involving a transfer of these rights by petitioner to a wholly owned subsidiary in June of 1946 and a reconveyance back to petitioner in December of 1946 should be disregarded as being without substance or business purpose.
FINDINGS OF FACT.
Petitioner, a California corporation (hereinafter referred to as Weyl), was organized in 1907. Its principal office was located in Stockton, California. It's income tax return for the year 1947 was filed with the collector of internal revenues for the first district of California.
McDonald Island is located in the Delta Region of the San Joaquin River in San Joaquin County, California, approximately 10 miles northwest of the city of Stockton. The island comprises, and at all times involved in this controversy has comprised, two tracts. A slough which forms a natural dividing line runs between the tracts. One tract contains approximately 2,700 acres and is known as the Henning Tract; the other contains approximately 3,400 acres and is known as the McDonald Tract. Substantially all of this island is farming land and has been farmed year after year. In 1935 presence of gas under the surface of the island was indicated and wells were brought into production in 1937.
The Henning Tract was acquired by Weyl in 1912 at a cost of $338,375. For many years prior to 1943 the McDonald Tract was owned by McDonald Island Farms, Ltd., a California corporation, hereinafter referred to as McDonald Ltd.
Prior to the year 1931 neither Weyl nor any of its shareholders had any interest in McDonald Ltd. In 1931 three members of the Zuckerman family purchased one-half of the outstanding shares of McDonald Ltd. and Holly Sugar Corporation, hereinafter referred to as Holly, purchased the remaining one-half interest. Later, in 1934, the Zuckermans transferred their shares to Weyl in consideration for shares of Weyl.
On November 18, 1935, Weyl leased the mineral rights in the Henning Tract to Standard Oil Company of California, and McDonald Ltd. similarly leased to Standard Oil Company of California the mineral rights in McDonald Tract.
Weyl and Holly disagreed both as to the farming activities on McDonald Tract and also as to fiscal matters. Upon the insistence of Holly, a dividend in kind was declared on August 11, 1943, by McDonald Ltd. The subject of this dividend was a two-thirds interest in the surface rights of Mcdonald Tract. Holly received a one-third interest, and Weyl received a one-third interest. McDonald Ltd. retained the remaining one-third undivided interest. McDonald Ltd. also continued to own the mineral rights in the McDonald Tract.
Weyl's consent to the dividend was given on condition that Holly give Weyl an option to purchase for $120,280.30 the one-third interest to be acquired by Holly as the result of the dividend. Holly executed an option agreement.
The option was transferred by Weyl to the Zuckerman Potato Company, a partnership. The members of this partnership were stockholders and employees of Weyl. It was formed in 1942 for the purpose of farming leased lands in Oregon. On December 27, 1944, the partnership exercised the option and received from Holly its one-third interest in the surface rights of the McDonald Tract.
Petitioner had been having disagreements with Standard Oil Company in connection with apportionment of royalties and drilling of offset wells, as more fully hereinafter set forth. There appeared to be two possible solutions: the purchase of the gas rights by Standard or the institution of litigation to resolve the differences. In November of 1945, Standard Oil Company made an offer to Maurice Zuckerman, president of Weyl, of $500,000 for gas rights underlying both the Henning and McDonald Tracts. This offer was regarded as too low; it was not accepted.
In January 1946, Holly urged that McDonald Ltd. declare a dividend in kind to its shareholders of the mineral rights in the McDonald Tract. The board of directors of McDonald Ltd. at a meeting on January 22, 1946, concluded that ‘a dividend in kind at this time of the mineral rights * * * might not be for the best interests of the corporation and its shareholders,‘ and adopted a resolution that the mineral rights ‘be retained by the corporation until such time in the future when this Board of Directors may deem it advantageous and for the best interest of the corporation and its shareholders that such dividend be declared.’ Holly renewed its request at a meeting of the directors on March 8, 1946. Weyl consented to the declaration of the dividend on the condition that Holly give it an option to buy its share of the dividend. On March 11, 1946, the Commissioner of Corporations of the State of California approved an application filed for permission to make the dividend. On March 13, 1946, McDonald Ltd. declared the dividend and Weyl and Holly each received a 50 per cent interest in the mineral rights on the McDonald Tract. At the same time Holly gave Weyl an option to purchase Holly's 50 per cent interest in the McDonald Tract mineral rights. On the same day Holly also sold to Weyl its 50 per cent of the capital stock of McDonald Ltd., and Weyl thereby became owner of all of the outstanding stock of McDonald Ltd.
On June 5, 1946, Weyl exercised the option to purchase Holly's one-half interest in the mineral rights in the McDonald Tract. Upon the exercise of this option Weyl became the owner of all the mineral rights in this tract and had a cost basis for them of $238,666.28.
At the regular meeting of the board of directors of Weyl on May 1, 1946, a resolution was adopted authorizing its president or vice president to endorse a promissory note of McDonald Ltd. payable to the Bank of America in the amount of $720,000 and guarantee payment of this note.
A promissory note, dated May 20, 1946, was executed by McDonald Ltd. It provided for the payment of $720,000 in installments prior to May 20, 1956. McDonald Ltd. also executed a deed of trust, dated May 20, 1946, ‘on the property of the corporation commonly known as the Henning Tract and McDonald Tract located on McDonald Island * * *‘ to secure payment of the note. The deed, which was acknowledged on June 27, 1946, specifically excepted from its provisions ‘All minerals, mineral substances, mineral interests, ores, oil, gas, asphaltum and other hydrocarbons lying in or under the Henning and McDonald Tracts.’
In a letter dated June 15, 1946, to the Bank of America National Trust and Savings Association, McDonald Ltd. applied for a loan of $720,000 ‘to be evidenced by a promissory note dated May 20, 1946.’ This letter stated when payments would be made; that payment of the note was to be secured by deed of trust, and that
The undersigned hereby agrees that on or before the 1st day of April 1947, and annually thereafter, additional payments on account of principal of said loan will be made to said Bank in a sum equivalent to the difference between the minimum payment of Twenty-Eight Thousand Eight Hundred and 00/100 ($28,800.00) Dollars as provided for in said note and 35% of the net profits of the corporation for the prior fiscal year; net profits as here used shall mean profits before depreciation, but after provision for Income Taxes.
The lower left-hand corner of the letter contains the notation in writing ‘Accepted Julius Blum, Vice Pres. Bank of America N.T.&S.A. Stockton, Calif.’
On or about June 15, 1946, Weyl purchased from the partnership, Zuckerman Potato Company, its one-third interest in the surface rights of the McDonald Tract for which Weyl paid cash at the time. No deed was ever executed for this transfer. On June 27, 1946, Weyl sold a two-thirds interest in the surface rights in the McDonald Tract to McDonald Ltd., and it so entered the sale on its books. The conveyance with respect to one-third of the surface rights was made directly from the partnership to McDonald Ltd. by deed executed on June 27, 1946.
The Henning Tract had a cost to petitioner of $338,375, but its value had been written up on petitioner's books, so that in June of 1946 it was carried on these books at a value of $811,750. The mineral rights in this tract had no cost basis to petitioner. On June 27, 1946, Weyl conveyed to McDonald Ltd. the entire fee of the Henning Tract, including surface and mineral rights. This was entered on petitioner's books as a sale for $338,375 and a book loss of $473,375 was written off to surplus. The amounts entered on petitioner's books as sales price of Henning Tract ($338,375) and as sales price for two-thirds of the McDonald Tract surface rights ($226,843.22) were less than their fair market value on June 27, 1946.
In July of 1946, Maurice Zuckerman, the then president of Weyl, went to the offices of the Standard Oil Company and offered to sell the gas rights in both tracts for $875,000; on the same day he later indicated that he would be willing to reduce the figure to $820,000. Standard Oil rejected this offer in August of 1946.
Henning Tract and McDonald Tract were portions of a single gas field which also included two other properties in the vicinity, one of which was owned by Mayberry and the other by Tilden. As gas was withdrawn from the field the Standard Oil Company determined the percentage to be allocated to each of the four properties and paid royalties on that basis. A dispute arose between Standard Oil and Weyl as to its allotment and also as to whether Standard Oil Company was obligated to drill an offset well on the McDonald Tract after it had drilled a well on the Mayberry property. Differences between petitioner and Standard had existed for several years. Standard's offer to purchase the gas rights for $500,000 in November of 1945 was an effort to solve the problem in that manner. At the time of Standard's rejection of the $820,000 offer in 1946, John Zuckerman informed Standard's representative that Weyl was making preparations to institute suit.
On December 12, 1946, John Zuckerman, then manager of Weyl and president and manager of McDonald Ltd., conferred with the Standard Oil representative. He told the representative that they did not like to sue and would like to sell their interests in the gas rights. At that meeting a basis for determining a sales price for the mineral rights in both tracts was discussed.
On December 16, 1946, a price for the sale of gas rights underlying both the Henning and McDonald Tracts was agreed upon between representatives of Standard Oil Company and the petitioner, subject to ratification by their superiors. However, prior to the consummation of the sale, the board of directors of McDonald Ltd., on December 21, 1946, adopted a resolution declaring a dividend in kind of the mineral rights in the Henning Tract. By deed dated December 21, 1946 (recorded January 10, 1947), McDonald Ltd. conveyed these mineral rights to Weyl. It was of no importance to Standard whether title to the gas rights underlying the Henning Tract was conveyed directly by McDonald Ltd., or in some other manner, and Standard had prepared papers which were intended to consummate the sale. However, petitioner's counsel desired that the conveyance take a different route, and the route adopted— involving a transfer of mineral rights underlying the Henning Tract from McDonald Ltd. to Weyl, followed by a conveyance of gas rights underlying both tracts from Weyl to the buyer— was in accordance with the plan proposed by petitioner and the papers subsequently submitted by petitioner's counsel.
Standard elected to take title in the name of a subsidiary, Pacific Oil Company, and, on January 20, 1947, a deed to Pacific Oil Company of gas rights in McDonald Tract and Henning Tract, reserving oil, asphaltum, minerals, and hydrocarbons other than gas, and also reserving fas rights below a specified depth, was executed and acknowledged by Weyl.
On Weyl's 1946 Federal income tax return it reported the receipt of a dividend of the mineral rights underlying Henning Tract at a fair market value of $230,000, and claimed a dividend received credit.
The gross sales price of the gas rights which petitioner sold to Pacific Oil Company in January of 1947 was $609,514.46. Of this amount $230,000 was allocable to the Henning Tract gas rights, and $379,514.46 was allocable to the McDonald Tract gas rights.
In its income tax return for 1947, the petitioner claimed that its basis for gain or loss on the Henning Tract gas rights was $230,000, and that the amount received therefor was $230,000, and reported no profit on their sale. The respondent disallowed all of the claimed basis of $230,000 and determined a deficiency of $66,082.54 in petitioner's income tax for 1947.
McDonald Island consisted of two tracts of land, Henning Tract and McDonald Tract, both used for farming. In addition, gas had been discovered under the island in 1935, and thereafter the gas rights were leased to Standard Oil Company of California. Petitioner had owned the Henning Tract for a long period of years. The mineral rights under that land had a zero basis to petitioner. On June 27, 1946, petitioner transferred the Henning Tract, including the mineral rights, to its wholly owned subsidiary at its original cost, which was substantially less than its then fair market value as well as less than its book value. In December 1946, when a sale of the gas rights under the entire island to Standard Oil had already been arranged, the mineral rights, including gas rights, under the Henning Tract, were declared as a dividend by the subsidiary and reconveyed to the petitioner. The value of the gas rights at that time was $230,000. Shortly thereafter the sale was consummated, and the portion of the sale price allocable to the gas rights under the Henning Tract was $230,000. Although these gas rights had a zero basis in the hands of petitioner for a number of years, its contention is that by reason of the conveyance to the subsidiary and reconveyance some 6 months later as a dividend, these rights acquired a stepped-up basis equal to $230,000, with the result that it realized no gain upon the sale.
The Commissioner argues that the transfer of the mineral rights to the subsidiary was not bona fide, that no business purpose was served or intended by such transfer, that the possible sale to Standard Oil was contemplated from the beginning, and that the round-trip of these rights from parent to subsidiary and back to parent again was engineered for the purpose of attempting to obtain a stepped-up basis.
Of course, on petitioner's theory, the retransfer of the rights to it by the subsidiary would result in petitioner receiving a taxable dividend in the amount of $230,000. However, by reason of section 26(b), I.R.C. of 1939, 85 per cent of that dividend is received tax free. In substance, therefore, the tax advantage to petitioner would be that it would be chargeable with dividend income in the amount of only 15 per cent of $230,000, while the entire gain of $230,000 upon sale of the gas rights to Standard Oil would be tax free.
The question is largely one of fact, for, if it be true that the round-trip of the mineral rights was in fact a sham and lacking in bona fides, petitioner's basis for the rights, namely zero, will be unaffected, and its gain on sale must be measured from that basis.
In cases of this character the absence of any direct evidence of sham is not surprising. If petitioner intended from the beginning, through those who controlled its affairs, to transfer the entire Henning Tract to the subsidiary with the expectation of a retransfer of the mineral rights, it is hardly likely that such intention would be admitted. The intention, if it did exist, would ordinarily have to be established by circumstantial evidence. And in this connection it is important at the outset to bear in mind the matter of burden of proof. Petitioner's counsel completely misconceives the burden of proof when he says in his reply brief ‘In order successfully to attack the conveyance of Henning Tract as to mineral rights, the Commissioner must show that they were included with the intent to pull them back again into the petitioner for purposes of ultimate disposition.’ The burden is not upon the Commissioner. The burden is upon the petitioner to overcome the correctness of the Commissioner's determination. Moreover, the requisite business purpose or intention must be established by evidence; it is not enough for counsel to theorize as to what the intention might have been. It must be shown by satisfying evidence that the alleged business purpose was in fact entertained as a motivating factor by petitioner or its responsible representatives; a possible business purpose conceived after the event in order to give color to the transaction cannot retroactively supply the required bona fides which might otherwise be lacking. We have concluded, after hearing the witnesses and studying the entire record, that the alleged business purposes relied upon by petitioner to explain the manner in which the transaction was carried out were colorable only, and that the round-trip of the mineral rights was contemplated from the start and was lacking in bona fides.
Prior to the issuance of the deficiency notice in this case, petitioner filed a written protest against the proposed deficiency. The protest stated two reasons for the transfer of the mineral rights to petitioner's subsidiary, as follows:
The transfer was made so that all the McDonald Island property would be owned by one company and thereby lend itself to a more efficient conduct of farming operations. Also, all the land could then be pledged as collateral to a trust deed note with a bank. * * *
Each of these reasons is spurious. While it may be true that the farming operations on McDonald Island could be more efficiently conducted if all the surface rights were in a single ownership, the ownership of the mineral rights is completely immaterial in this connection. Indeed, when petitioner on June 27, 1946, transferred to its subsidiary the Henning Tract and its interest in the surface rights in the McDonald Tract, it at the same time retained and did not transfer to the subsidiary the mineral rights in the McDonald Tract. Moreover, the December 31, 1946, resolution of the board of directors of the subsidiary, providing for the retransfer of the mineral rights to petitioner, explicitly recited that ‘none of the rights * * * are necessary for the operation of the business of this corporation and may be distributed to the stockholder thereof by way of a dividend in kind.’ It is quite plain that they were no more necessary to the business of the subsidiary on June 27, 1946, when they were first transferred by petitioner as part of the entire Henning Tract.
The second reason suggested by the protest, i.e., that the land could be pledged as collateral to secure a bank loan, equally spurious. The evidence shows that the loan in question had already been negotiated, and that it was to be secured by a deed of trust with respect to the entire island, excluding, however, all mineral rights. It was therefore misleading to suggest that the proposed bank loan was a motivating factor in the transfer of the mineral rights to the subsidiary.
In the testimony before us, the reasons set forth in the protest were repeated and embellished. However, we are firmly convinced on this record that these reasons did not in fact play any part whatever in the transfer of the mineral rights. And other reasons advanced, some of them merely variations of the foregoing, appear to us to be afterthoughts. We are satisfied that the transfer of the mineral rights had in fact no business purpose whatever, other than to set the stage for an attempt to establish a stepped-up basis for these rights.
It should be remembered that petitioner was encountering difficulty with Standard Oil in connection with Standard's leases of these gas rights. One way of settling the dispute was to have Standard purchase the rights. Standard had made an offer of $500,000 for the gas rights under the entire island in November 1945. The offer was considered too low and was not accepted. The conflict between Standard and the petitioner persisted. The transfer of the Henning Tract to the subsidiary took place on June 27, 1946, and shortly thereafter, in July 1946, petitioner's president offered to sell the gas rights under the entire island to Standard for some $800,000. Here then was a situation where petitioner knew that a sale to Standard was a distinct possibility, provided that a satisfactory price could be agreed upon, and where its president reactivated the negotiations with Standard after transferring the rights to the subsidiary. To be sure, the evidence is circumstantial, but it is strong and convincing that when petitioner transferred the Henning Tract to the subsidiary it intended to recapture the mineral rights. True, it was not able to come to terms with Standard in July or August of 1946, but negotiations were opened again in December of the same year, and an agreement was finally reached at that time.
The protest falsely stated that after the transfer, ‘the petitioner was approached by a third party desiring to purchase all the known mineral rights located on the McDonald Island,‘ identifying the third party as Pacific Oil Company. The fact is, as plainly shown by the evidence, that it was petitioner's president who approached Standard. The initiative at this time did not come from Standard or its subsidiary, Pacific Oil Company. This is a difference of great importance in the context of this case, for it shows that petitioner sought to bring about a sale of the mineral rights shortly after transferring them to the subsidiary. The affirmative step thus taken by petitioner within so short a period is highly persuasive that the transfer was made with a view towards attempting to bring about a sale thereafter.
It is no answer to say, as does petitioner's counsel, that petitioner merely employed a standard form of deed on June 27, 1946, when it transferred Henning Tract in its entirety to the subsidiary. Petitioner at that time was fully aware of a separate interest in the mineral rights, for, on the same day, its deed of its interest in the McDonald Tract to the same subsidiary expressly excluded the mineral rights. And later, on the same day, the deed of trust to secure the bank loan expressly excluded the mineral rights under the very tract here involved. We are satisfied on the evidence that the course of action taken by petitioner was deliberate and calculated, without business purpose other than to establish an artificially stepped-up basis. The gas rights in the Henning Tract had a zero basis in petitioner's hands, and we hold that the planned excursion of these rights form petitioner to its subsidiary and back again to petitioner could not result in any stepped-up basis. The intermediate steps were lacking in bona fides, and must be ignored.
Decision will be entered for the respondent.