Warsaw Photographic Associates, Inc. v. Commissioner

*22 Respondent determined deficiencies in Federal corporate income tax against petitioner for its taxable years ended June 30, 1974, ¹ June 30, 1975, and June 30, 1976, in the amounts of $ 70,040, *140 $ 58,239, and $ 34,685, respectively.

After concessions by both sides, the issues for decision are as follows:

(1) Whether a transaction involving a transfer of assets to petitioner qualifies as a reorganization under section 368(a)(1)(D), ² thereby entitling petitioner to succeed to the transferor's net operating losses under section 381(a)(2), and giving petitioner a carryover basis (under sec. 362) in the assets acquired from the transferor. ³

*141 *23 (2) If the transfer does not qualify as a reorganization, then whether petitioner is entitled to increase its bases in the assets transferred to it, on account of the fair market value of its shares issued in connection with the transfer.

(3) Whether legal fees incurred by petitioner in acquiring Studios' assets are organizational expenses, and whether petitioner made an election under section 248 to amortize them.

(4) Whether petitioner must amortize the price of a covenant not to compete over its stated term, 6 years, or over the shorter period in which the total actual payment was made, 31 months.

FINDINGS OF FACT

Some of the facts have been stipulated; the stipulation and the stipulated exhibits are incorporated herein by this reference.

When the petition was filed in the instant case, petitioner's principal office was in New York, NY.

From 1935 or earlier, Warsaw Studios, Inc. (hereinafter sometimes referred to as Studios), ⁴ and its predecessors were engaged actively in the commercial photography business. Studios was so engaged until July 2, 1973. Studios' principal business was photography for sales catalogues; its clients included*142 Sears, Roebuck & Co., Spiegel, Montgomery Ward, J.C. Penney, and Avon.

A certificate of incorporation for Studios was filed with the New York Department of State on June 30, 1964. Amendments to this certificate of incorporation were filed on December 28, 1964, and June 30, 1965. By the amendment filed June 30, 1965, Studios increased the number of its authorized shares by*143 5,250 shares, making the aggregate number of authorized *24 shares 15,500. This amendment further provides that 15,000 of these shares are common shares with $ 1 par value. The remaining 500 shares are cumulative preferred with $ 1,000 par value. The cumulative dividends are at the rate of 3 percent, annually. Before any dividend may be declared for common shareholders for a year, Studios would have to pay a 2-percent dividend to the preferred shareholders for that year, in addition to the cumulative 3-percent dividend to the preferred shareholders.

As of July 1, 1965, Studios had 325 outstanding shares of preferred stock, which had a total par value of $ 325,000. Warsaw & Co., Inc., a corporation owned solely by J.J. Warsaw, ⁵ was the record owner of all of Studios' preferred stock.

By the end of July 1965, Studios' common stock*144 was owned as set forth in table 1.

The shares owned by Albert T. Warsaw were repurchased by Studios; his stock certificate was canceled on March 17, 1970.

The shares owned by Kyril Bromley were redeemed on or about April 19, 1973.

*25 The shares owned by Paul Diethelm and Woodbury Prentiss were transferred to William J. Zad and Stephen Neil, respectively, on or about June 1, 1973. ⁶

*145 James McFarline and Stephen Warsaw stopped being shareholders before June 27, 1973. ⁷

The following Studios shareholders were also employees of Studios: Gilbert S. Shawn; H. Donald Riley; John Basilion; James V. Oliver; Joseph C. Lewandowski; David Martin; Winfield S. Sinn, Jr.; William J. Zad; Richard Dennis; and Stephen Neil. These shareholders are hereinafter sometimes referred to individually as: "Shawn", "Riley", "Basilion", "Oliver", "Lewandowski", *146 "Martin", "Sinn", "Zad", "Dennis", and "Neil", respectively, and hereinafter sometimes referred to collectively as "the 10 shareholders".

Studios leased office space at two locations in Manhattan, NY. One of these locations was in a building known as 183 Madison Avenue and 40 East 34th Street. The lease (hereinafter sometimes referred to as the 34th Street lease) for this space was for a term of 10 years and 5 months, to begin May 1, 1970, and to continue through September 30, 1980. The 34th Street lease was a standard form of office lease requiring Studios to pay a base annual rent of $ 17,800, plus, among other things, the following:

1. Additional rent equal to 1.5 percent of the increase in real estate taxes levied or imposed by the State or local governments, over the taxes "assessed for the tax year 1970/1971."

2. Additional rent equal to 1.5 percent of the increase in the amount of the building payroll and cleaning expenses, over such expenses for the calendar year 1970.

3. Additional sums for increases in the Lessor's cost of supplying electricity. This was to take the form of an increase in the annual base rent. ⁸

*147 *26 Studios, as a lessee, had the right to sublease the office space during the term of the lease, but only with the lessor's consent. If Studios were to default, then all of the rent for the remaining term of the 34th Street lease would become due (reduced by any amounts received by the lessor if the lessor chose to relet the space).

In connection with the 34th Street lease, Studios obtained an irrevocable letter of credit issued by the Irving Trust Co. (hereinafter sometimes referred to as the bank) to Cross & Brown Co., the lessor under the 34th Street lease, in the amount of $ 100,000. J.J. Warsaw personally guaranteed this liability.

The other office space location was in a building known as 36 East 31st Street. Studios entered into three leases (hereinafter sometimes referred to as the 31st Street leases) with the 443 Fourth Avenue Corp. for various parts of the building, as reflected in table 2.

Studios employed*148 relatives and a friend of J.J. Warsaw. Also, Studios had on its payroll the captain of a yacht which J.J. Warsaw owned and used for entertaining. Studios had sustained net operating losses before July 1, 1973, due in large part to the 34th Street lease and payroll commitments beyond its means.

Sometime about May 1973, J.J. Warsaw discussed with Shawn the possible sale of Studios. He made a serious offer of $ 400,000 to Shawn. Shawn rejected the offer.

Shawn thought that Studios could be made profitable if it could get out of the 34th Street lease which Shawn considered "debilitating" and if the number of employees could be reduced. Shawn obtained legal advice on how to do this.

Acting on legal advice, the 10 shareholders decided to organize a new corporation. On June 29, 1973, a corporation was incorporated under New York law under the name of Pegasus Studio, Ltd. (See note 4 supra.) Three days later, on *27 July 2, 1973, the directors and shareholders of this corporation met and unanimously approved a resolution to amend the certificate of incorporation to change the corporation's name to Warsaw Photographic Associates, Inc. (This corporation is the petitioner*149 in the instant case.) Also, at this meeting, a plan for the issuance of common stock pursuant to section 1244 was adopted, effective June 29, 1973, and a form of subscription agreement was approved. Each of the 10 shareholders ⁹ subscribed to and paid for 100 shares of common stock (par value of $ 0.05) for $ 100 per share, or a total price of $ 10,000 for 100 shares. The total number of shares issued on petitioner's incorporation was 1,000 shares (hereinafter sometimes referred to as the 1,000 shares), for a total capital of $ 100,000. ¹⁰

*150 At this meeting, the officers of petitioner were elected as reflected in table 3.

At this meeting, petitioner adopted a plan whereby Studios was to transfer all of its operating assets ¹²*151 to petitioner. In connection with this plan, the 10 shareholders, who were also shareholders of Studios, were to each receive directly 10 *28 additional shares of petitioner's common stock. ¹³

On June 27, 1973, Studios' board of directors held a special meeting at which they adopted a plan of reorganization. Studios' directors understood the reorganization to involve a transfer of substantially all its assets to petitioner and the issuance by petitioner of 100 shares of its stock (hereinafter sometimes referred to as the 100 shares) directly to the 10 shareholders. Studios' understanding of "substantially all of its assets" is the same as petitioner's understanding of all of Studios' operating assets (see note 12 supra). As part of this plan, the 10 shareholders were to surrender their stock in Studios for cancellation.

On July 2, 1973, Studios and petitioner entered into a written agreement of "reorganization, sale and purchase" which provides in relevant part as follows:

Witnesseth:

Whereas, the Buyer [petitioner] wishes*152 to acquire (1) the right to use the Seller's [Studios'] name or similar name for certain purposes; (2) the Seller's goodwill; (3) the rights under a lease of office space at 36 East 31st Street, New York; (4) certain film and industrial supplies (the "Film and Supplies"); and (5) all of the furnishings and equipment of the Seller, including, without limitation, cameras, developing equipment and office furnishings, but excluding the Seller's telephone system and computer (such furnishings and equipment hereinafter referred to as the "Furnishings and Equipment") (the "Film and Supplies" and the "Furnishings and Equipment" hereinafter collectively referred to as the "Assets"), in exchange for the issuance of certain shares of the Buyer's stock to certain of the Seller's shareholders, the payment of certain sums of money and the assumption of certain obligations of Seller;

* * * *

3. Sale and Transfer of Property.

(a) Sale and Transfer. (A) Subject to the terms and conditions of this Agreement, the Seller is hereby selling, conveying, ceding, transferring and delivering to the Buyer, and the Buyer is hereby accepting, (a) all of the Seller's right, title and interest*153 in and to the Film and Supplies, (b) all of the Seller's right, title and interest in and to the Furnishings and Equipment, (c) the right to the use of the name "Warsaw Studios, Inc." or a similar name in the State of New York for the purpose of conducting a photography business, *29 (d) the goodwill of the Seller, and (e) all of the right, title and interest of the Seller in and to the 31st Street Lease.

(b) Consideration for Sale and Transfer. Subject to the terms and conditions of this Agreement, in full consideration for the aforesaid sale, conveyance, cession, transfer and delivery,

(1) The Buyer is hereby issuing 10 shares of Common Stock, $ .05 par value, of the Buyer to each of the shareholders of the Seller other than Warsaw & Co., Inc. who are the only shareholders of the Buyer.

(2) No later than ten days from the date hereof, the Buyer will deliver to the Seller a check in New York Clearing House Funds in the amount of $ 1,000, representing payment in full for the Film and Supplies;

(3) No later than ten days from the date hereof, the Buyer will deliver to the Seller a check in New York Clearing House Funds in the amount of $ 5,000, representing partial*154 payment for the Furnishings and Equipment and the other rights conveyed hereby;

(4) No later than 120 days from the date hereof, the Buyer will deliver to the Seller a check in New York Clearing House Funds in the amount of $ 5,000, representing partial payment for the Furnishings and Equipment and the other rights conveyed hereby;

(5) No later than 165 days from the date hereof, the Buyer will deliver to the Seller a check in New York Clearing House Funds in the amount of $ 5,000, representing partial payment for the Furnishings and Equipment and the other rights conveyed hereby;

(6) No later than 210 days from the date hereof, the Buyer will deliver to the Seller a check in New York Clearing House Funds in the amount of $ 5,000, representing payment in full for the Furnishings and Equipment and the other rights conveyed hereby;

(7) The Buyer is hereby assuming and agreeing to perform (a) all of the Seller's obligations under the 31st Street Lease; and (b) all of the Seller's liabilities and obligations to customers arising out of the ordinary course of business of the Seller through the date hereof, including, without limitation, (a) liabilities to customers in connection*155 with the completion of work in process, (b) liabilities and obligations arising with respect to warranties of products to customers, and (c) the Seller's obligation to return to its customers all property of such customers currently held by the Seller.

In addition to this written agreement, Studios and petitioner executed five more documents on July 2, 1973. In the first, entitled "CONVEYANCE AND ASSIGNMENT", Studios agreed "for and in consideration of $ 1.00 and other good and valuable consideration" to transfer the agreed-upon assets to petitioner. In the second, entitled "UNDERTAKING", petitioner agreed to "assume and * * * pay, perform and discharge" all of Studios' obligations under the 31st Street leases and all of Studios' liabilities and obligations arising out of the ordinary course of business. The third is an assignment of Studios' "right, title and interest" in the 31st Street leases to petitioner. The fourth *30 is a security agreement. The fifth is a Uniform Commercial Code Financing Statement with regard to all equipment and furnishings at 40 East 34th Street and 36 East 31st Street, excluding films and industrial supplies.

Studios transferred to *156 petitioner the assets to fully equip 10 photography studios, as well as assets used in Studios' bookkeeping office, fitting rooms, carpentry shop, storage center, and shipping room. The furnishings and equipment transferred from Studios to petitioner have a useful life of 10 years and include the following:

1. Photography studios: Cameras (including a Deardorff camera), enlargers (including a Saltzman enlarger), camera filters, stands, desks, lights (including strobe, keg, and Ascor lights), a hot press, cutting equipment, cabinets, partitions, shelving, Paz 1 converter, darkroom equipment (e.g., trays and tanks), film holders, color laboratory equipment (including a spectrograph), movable wooden folders, and light boxes.

2. Bookkeeping office: Desks and adding machines.

3. Fitting room: Stands, mirrors, and sewing machines.

4. Carpentry shop: Drill press, band saws, and table top saws.

5. Storage center and shipping room: Conveyor, shelving, wrapping paper, stands, scales, and tape machines.

6. Miscellaneous fixed assets: Photostat machine, furniture (including stools and chairs), refrigerators, and an electric range.

The value of the assets to be*157 transferred by Studios was discussed among and negotiated by the executive employees of Studios, some of whom were also shareholders of petitioner. Shawn, then president of both Studios and petitioner, wrote a letter, dated July 2, 1973, to Studios' counsel confirming that in his opinion $ 20,000 for all of Studios' equipment was fair to both parties. In this letter, Shawn stated that "we have assured you that the value ascribed to the equipment is fair -- not less than that which would have been realized had the equipment been sold to another purchaser under any conditions known to us at this time." The results of the discussion about value of the assets were brought to the attention of J.J. Warsaw at his home to ascertain his views as to whether the figures agreed on were fair and correct.

Studios could not get more than $ 20,000 for the equipment if it were sold at a forced sale to any third party and probably would get much less. A forced sale would be handled in a manner similar to an auction. Interested buyers would walk up to "auctioneers" -- i.e., representatives of the seller -- and make an offer. However, there would not be bidding. Buyers *31 would not receive*158 receipts. Usually, the assets would be sold at low prices because the auctioneers would want to clean out the premises of the seller as quickly as possible. The transaction between petitioner and Studios was not a forced sale.

Studios contracted with petitioner to also transfer its goodwill. In the negotiations leading to the transaction between petitioner and Studios, the focus was not on the goodwill or going-concern value of Studios' business. Studios' creditors could not have forced Studios' employees to continue to work for Studios. Seventy-five of Studios' 126 employees were hired by petitioner when Studios transferred the assets to petitioner.

Studios assigned all its right, title, and interest in the 31st Street leases but did not assign its right, title, and interest in the 34th Street lease.

Petitioner agreed to complete Studios' work in progress and assume Studios' liabilities to customers in connection with this work as well as with regard to warranties of products and customers. As of July 2, 1973, Studios' work in progress had cost about $ 70,000. Petitioner spent about $ 70,000 to complete this work in progress and received about $ 150,000 therefor from*159 its customers. As of July 2, 1973, this work in progress was of no value to Studios in its then-uncompleted state. Studios kept its computer and telephones, as well as cash and accounts receivable, to be used to pay its creditors.

On or about July 17, 1973, the lessor under the 34th Street lease sued on account of Studios' nonpayment of the July 1973 rent under this lease.

On July 23, 1973, Studios made a general assignment for the benefit of creditors. The assignee, Stanley S. Horvath (hereinafter sometimes referred to as Horvath), did not try to set aside Studios' transfer of assets to petitioner, because Horvath believed that petitioner had paid fair consideration for these assets. Horvath has not made any payment to Studios' creditors or to Warsaw & Co., Inc., the owner of all the outstanding preferred stock and 7,549 shares of the outstanding common stock. (See table 1 supra.)

On or about March 20, 1975, Studios filed its Federal corporate income tax return for its taxable year ending June 30, 1973. On this tax return, Studios claimed a net operating loss of $ 262,727. On or about March 20, 1975, Studios filed its tax return for the short period July 1 through*160 July 24, 1973. *32 On this tax return, Studios claimed a net operating loss of $ 101,221 which, when added to the previous year's loss, made a total of $ 363,948. On or about March 17, 1975, petitioner filed its tax return for its taxable year 1974, on which it deducted this $ 363,948.

The 100 shares did not constitute part of the consideration paid by petitioner to Studios in exchange for substantially all of Studios' assets.

During its taxable year 1974, petitioner paid and incurred certain legal expenses, including $ 942 as an organizational expense and $ 3,400 in connection with the consummation of the transaction between Studios and petitioner under the written agreement of July 2, 1973. Both the $ 942 and the $ 3,400 were deducted in full on petitioner's 1974 taxable year tax return.

Petitioner did not file a statement with its tax returns for taxable years 1974, 1975, and 1976, setting forth: (1) The description and amount of either its organizational expenses or the expenses paid or incurred in connection with the transaction with Studios; (2) the month in which petitioner began business; and (3) the number of months over which such expenses*161 were to be deducted ratably.

Petitioner entered into an agreement of purchase and sale dated December 20, 1973, with Color Masters, Inc. (hereinafter sometimes referred to as Color Masters), a New York corporation, and Michael Pelio (hereinafter sometimes referred to as Pelio), the principal executive of Color Masters.

Under this agreement, Pelio covenanted not to compete with petitioner in the business of color film processing "in any part of the City of New York or the Metropolitan New York Area" for a period of 6 years, beginning on the closing date of the agreement. Pelio and petitioner further agreed to the following remedies for Pelio's violation of the covenant:

8.2 Remedies for Violation. If any of the restrictions on competitive activities contained in section 8.1 shall for any reason be held excessively broad it shall be construed by limiting and reducing it, so as to be *33 enforceable to the extent compatible with the applicable law as it shall then appear, it being understood that at the time of execution of this agreement the parties hereto regard said restrictions as reasonable and compatible with their respective rights. *162 [Petitioner] and Pelio agree that a violation of the foregoing covenant not to compete, or of any provisions thereof, will cause irreparable injury to [petitioner] and its subsidiaries, if any, and that [petitioner] shall be entitled, in addition to any other rights and remedies it may have, at law or in equity, to an injunction enjoining and restraining Pelio from doing or continuing to do any such act and any other violations or threatened violations of this section 8.

As consideration for Pelio's covenant, petitioner agreed to pay Pelio $ 31,000, payable in 31 monthly installments of $ 1,000, each. Petitioner paid Pelio $ 3,000, $ 12,000, and $ 12,000 during its taxable years 1974, 1975, and 1976, respectively, and deducted these amounts on its tax returns for those years. Respondent partially disallowed these deductions. In the notice of deficiency in the instant case, respondent allowed deductions for these payments in the amounts of $ 2,583, $ 5,166, and $ 5,166, for the taxable years 1974, 1975, and 1976, respectively.

The life of the covenant not to compete is 6 years.

OPINION

Ordinarily, a corporation is a separate entity for Federal income*163 tax purposes; its tax attributes are not combined with those of its shareholders or other corporations. One of the major exceptions to this normal rule is part of the complex of provisions relating to corporate reorganizations, ¹⁴ in particular that part of the complex that allows a corporation to use for income tax purposes certain parts of the income tax history of another corporation.

Corporate reorganizations, as defined in one or another of the subparagraphs of section 368(a)(1), qualify for special treatment for Federal income tax purposes under certain rules. The dispute in the instant case is as to whether petitioner is entitled to the special treatment provided under *34 two of these rules. One of these rules gives *164 a transferee corporation a carryover basis (subject to certain adjustments) in the assets acquired from the transferor corporation. Sec. 362(b). ¹⁵ The other of these rules allows the transferee corporation to "succeed to and take into account" certain tax attributes of the transferor, including net operating loss carryovers (the tax attribute in issue in the instant case). Secs. 381(a), 381(c). ¹⁶

*165 Of the various definitions of corporate reorganization, the parties have apparently limited the controversy to whether the transaction qualifies as nondivisive D reorganization (sec. 368(a)(1)(D)); ¹⁷ we have chosen in the instant case to adhere to *35 the parties' view of the parameters of the controversy. See Estate of Fusz v. Commissioner, 46 T.C. 214, 215 n. 2 (1966).

*166 In order to qualify as a nondivisive D reorganization ¹⁸ (and thus, permit petitioner to (1) use Studios' bases for calculating depreciation, and (2) under sections 368(a)(1)(D) and 354, ¹⁹*167 deduct Studios' net operating losses), the transaction in the instant case must satisfy a series of statutory requirements and also a series of judicial requirements. ²⁰

Respondent contends that the transfer from Studios to petitioner does not qualify as a nondivisive D reorganization because it does not satisfy certain of the statutory and judicial requirements. Instead, respondent contends, the transfer of assets from Studios to petitioner is a sale. Respondent maintains that the transaction does not satisfy the statutory requirement that stock of the transferee corporation (i.e., petitioner) be issued and distributed in the purported reorganization. Respondent also maintains that the transaction does not satisfy the judicial requirement of continuity of interest. *36 Specifically, respondent asserts that *168 the continuity of interest requirement is not satisfied because either (1) "the preferred shareholder [Warsaw & Co., Inc.] had the proprietary interest in [Studios]" and did not continue an interest in petitioner, or (2) the minority shareholders who did continue an interest "had too small a proprietary interest in [Studios]."

Petitioner contends that the transaction between Studios and petitioner qualifies as a nondivisive D reorganization because it satisfies all the statutory and judicial requirements. In particular, petitioner contends that the 100 shares were given as consideration for Studios' assets and that the 100 shares were worth at least $ 42,727, far more than the $ 21,000 of cash and other property transferred by petitioner to Studios. Petitioner further contends that the fact that the 100 shares were issued directly to the 10 shareholders, rather than first to Studios and then distributed from Studios to the 10 shareholders, does not mean that petitioner's stock was not distributed within the meaning of section 354(b)(1)(B). Petitioner also asserts that the continuity of interest requirement is satisfied. In making this assertion, petitioner further contends*169 that the proper test for applying the continuity of interest test is whether the stock of the transferee corporation (petitioner) represents a substantial part of the consideration given in the transaction and not whether a certain percentage of historic shareholders of the transferor continue as shareholders of the transferee.

We agree with respondent that the transaction is not a D reorganization because of the failure to satisfy the statutory requirement that petitioner's stock be transferred to Studios and distributed in a transaction which qualifies under sec. 354.

In order for a transaction to be a D reorganization, the transaction must be one "which qualifies under section 354." (Sec. 368(a)(1)(D); Baan v. Commissioner, 51 T.C. 1032, 1040 (1969), affd. sub nom. Gordon v. Commissioner, 424 F.2d 378 (2d Cir. 1970), affd. 450 F.2d 198 (9th Cir. 1971).) In order for petitioner to succeed to Studios' net operating losses under a D reorganization, Studios must have received stock of petitioner, and Studios must have distributed the stock it thus received (secs. 354(a)(1) and 354(b)(1)(B)). The*170 July 2, 1973, agreement between petitioner and Studios provides (at 3(b)(1)) that, as part of the consideration flowing from petitioner to Studios, *37 "The Buyer is hereby issuing 10 shares of Common Stock, $ .05 par value, of the Buyer to each of the