Schweitzer & Conrad, Inc. v. Commissioner

*533 Respondent determined deficiencies in the income tax of petitioner in the amounts of $374.28 for the calendar year 1934, $2,480.03 for 1935, and $21,804.88 for 1936. The sole issue is whether or not the respondent correctly determined that petitioner's basis for depreciation and amortization of patents and other assets which it acquired from another corporation for preferred stock, cash, and the assumption of certain liabilities was the same as the basis in the hands of the transferor corporation. All of the facts are found to be as stipulated. We summarize them in the following findings of fact.

FINDINGS OF FACT.

The petitioner is a corporation, with principal office at 4435 Ravenswood Avenue, chicago, Illinois. Its income tax returns for the periods involved in this proceeding were filed with the collector of internal revenue for the district of Illinois at Chicago.

On July 1, 1930, Schweitzer & Conrad, an Illinois corporation (hereinafter called the Illinois, Edmund O. Schweitzer, and Nicholas J. Conrad, and Cutler-Hammer, Inc., a Delaware corporation having its principal place of business at Milwaukee, Wisconsin (hereinafter*1175 called Cutler-Hammer), entered into a contract which provided for *534 the acquisition of the properties of Illinois by a new company. Illinois had a capitalization of $10,000, consisting of 100 shares of common stock with a par value of $100 per share. On July 1, 1930, its stock was owned as follows: Edmund O. Schweitzer, 49 shares; Nicholas J. Conrad, 49 shares; Lillian Schweitzer, 1 share; and Irene B. Conrad, 1 share.

In the contract of July 1, 1930, Illinois and its stockholders, Edmund O. Schweitzer and Nicholas J. Conrad, represented and warranted to Cutler-Hammer that Illinois owned certain patents (under which it manufactured and sold part of its products), real estate, manufacturing plant and buildings, machinery, tools, etc., merchandise, inventory, and prepaid insurance. The contract provided that Cutler-Hammer would organize a new corporation (the petitioner) with an authorized capital stock of 12,500 shares of preferred stock of a par value $100 per share, and common stock without par value, of such number of shares as Cutler-Hammer might determine. The preferred stock was to be entitled to cumulative dividends at 6 percent per annum and was to be redeemable*1176 in whole or in part, at any time on 30 days' notice at par plus accumulated and unpaid dividends. On liquidation the preferred stock was to receive $100 per share plus accumulated and unpaid dividends. The preferred stock was to have no voting rights. Beginning with 1931 the entire net earnings of the new company, after payment of $100,000 dividends on common stock and the optional retention of 10 percent thereof for working capital, were to be applied to the redemption of the preferred stock.

The contract further provided that Cutler-Hammer for and on behalf of the new company (petitioner) was to pay to Edmund O. Schweitzer and Nicholas J. Conrad, pursuant to a resolution of the board of directors of Illinois authorizing the same, the sum of $1,000,000. Cutler-Hammer also agreed to cause the new company (petitioner) to issue and deliver (pursuant to a resolution of the board of directors of Illinois) to Edmund O. Schweitzer and Nicholas J. Conrad, in equal shares, 12,500 shares of the preferred stock of the new company, and to cause the latter to assume all the liabilities of Illinois.

In the contract of July 1, 1930, Illinois agreed to cause proceedings to be taken by its*1177 stockholders and directors to authorize the transfer to the new company (petitioner) of all of its patents, assets, business, and good will and pursuant to such authority to transfer this property to the new company (petitioner) on the closing date mentioned in the contract. Illinois warranted that the net worth of its property, exclusive of patent rights and good will, as of July 1, 1930, was not less than $480,000. Prior to the closing date, Cutler-Hammer agreed to have an appraisal made of the assets of Illinois, other than patent rights and good will, and in the event such valuation showed *535 a net worth (exclusive of patents and good will) less than $480,000 Cutler-Hammer and the new company would be entitled to withhold par for par of the preferred stock of the new company to the extent the net worth so determined was less than $480,000.

All the provisions, covenants, and agreements contained in the aforesaid contract dated July 1, 1930, were carried out and performed by the parties thereto and the petitioner was organized on July 5, 1930, under the laws of the State of Delaware, as the "new company" referred to in the contract, with a capitalization of 12,500 shares*1178 of nonvoting $100 par value preferred stock and 10,000 shares of common stock. At the first meeting of petitioner's board of directors held on July 8, 1930, petitioner approved and accepted the contract of July 1, 1930, entered into on its behalf by Cutler-Hammer; resolved that it should "purchase the assets", etc. of Illinois, pursuant to the terms of the contract; adjudged and declared that said assets had a value of at least $2,250,000 over and above the liabilities of Illinois to be assumed, and authorized and directed the officers of the corporation to do all acts, etc., necessary for the purchase of the property in accordance with the terms of the contract. At this meeting petitioner also authorized the issuance of its preferred stock to Edmund O. Schweitzer and Nicholas J. Conrad pursuant to the provisions of the contract of July 1, 1930, and accepted the offer of Cutler-Hammer to pay its subscription for 10,000 shares of petitioner's common stock by releasing petitioner from its obligation to repay to Cutler-Hammer the $1,000,000 advanced by Cutler-Hammer for and on behalf of petitioner to apply "on the purchase price of said business, assets, good will, etc."

Pursuant*1179 to a resolution of the board of directors of Illinois and in accordance with the provisions of the contract, Cutler-Hammer on or about July 8, 1930, paid to Edmund O. Schweitzer and Nicholas J. Conrad $1,000,000 and petitioner on July 15, 1930, issued its 12,500 shares of preferred stock as follows: 5,818.75 shares each to Edmund O. Schweitzer and Nicholas J. Conrad; 118.75 shares each to Lillian Schweitzer and Irene B. Conrad; and 625 shares to Cassatt & Co., brokers of Philadelphia, Pennsylvania. Under an agreement which was entered into on February 28, 1930, with Edmund ,0. Schweitzer and Nicholas J. Conrad, the brokers were to receive and did receive 5 percent of the preferred stock and cash as commission for services rendered to Schweitzer and Conrad in negotiating the disposition of the assets. Simultaneously therewith on July 15, 1930, petitioner issued, as provided in the aforesaid contract, its 10,000 shares of common voting stock. This stock was issued to and accepted by Cutler-Hammer in accordance with petitioner's aforementioned resolution of July 8, 1930.

*536 On or about July 8, 1930, all the assets of Illinois enumerated in the contract of July 1, 1930, were*1180 transferred to petitioner. The balance sheet of Illinois as of June 30, 1930, listing such assets and setting forth the cost or basis to Illinois of the assets so transferred is as follows:

In accordance with the provisions of the contract the petitioner assumed the liabilities shown on the balance sheet amounting to $90,127.69. The "closing date" *1181 referred to in the contract of July 1, 1930, was mutually agreed upon to be July 15, 1930.

Upon the acquisition of the assets by petitioner an appraisal thereof was made by petitioner and the assets were entered on its books at the appraised values as evidenced by its opening balance sheet. A copy of this balance sheet is as follows:

*1182 *537 Pursuant to a resolution of the board of directors of the petitioner at a meeting held on August 25, 1930, the petitioner on or about September 15, 1930, redeemed at the par value thereof 2,500 shares of its preferred stock theretofore issued on July 15, 1930. Petitioner's *538 records show that of the redeemed shares, 1,163.75 were owned by Edmund O. Schweitzer, 1,163.75 by Nicholas J. Conrad, 23.75 by Lillian Schweitzer, 23.75 by Irene B. Conrad, and 125 by Cassatt & Co.

Upon the transfer of its assets as aforesaid, Illinois ceased to do business and was dissolved on June 24, 1932, by reason of the lapsing of its charter under the laws of the State of Illinois. Edmund O. Schweitzer and Nicholas J. Conrad never turned in to Illinois for cancellation or otherwise any of their certificates of stock in that company.

The respondent has determined that Edmund O. Schweitzer and Nicholas J. Conrad, stockholders of Illinois, realized taxable capital net gain as a result of the receipt on July 8, 1930, of the $1,000,000 cash and of the receipt on September 15, 1930, of cash on the redemption of the preferred stock at par - $232,750 for 2,327.5 shares. The taxable*1183 capital net gain to each, so determined, was:

In computing said gain, the respondent determined that the cost or basis of the Illinois shares owned by Schweitzer was $16,723.61, and the Illinois shares owned by Conrad was $16,723.61. Upon the capital net gain so determined the respondent assessed a tax which was paid by Schweitzer and Conrad.

For the year 1930, respondent determined that the transaction by which the petitioner acquired the assets of Illinois constituted a reorganization and that any income realized by Illinois as a result of the disposition of its assets as above described was not taxable to that company under the reorganization provisions of the applicable statutes.

Of the total consideration paid by petitioner for all of the Illinois assets acquired by it, which consideration amounted to $2,340,127.69 (cash, $1,000,000; value of preferred stock, $1,250,000; and liabilities assumed, $90,127.69), it is for the purpose of this proceeding agreed that $1,000,000 thereof should be allocated to the patents acquired in July 1930. These patents were used in petitioner's trade*1184 or business during the years 1934, 1935, and 1936.

In each of petitioner's income tax returns for the years 1934, 1935, and 1936, the petitioner deducted as amortization and/or depreciation of Illinois patents acquired by it in July 1930, the sum of $196,460.88. The amount so deducted resulted from the use by the petitioner of a basis of $1,634,950.82, which was the figure set up on petitioner's books in July 1930, as the cost of the patents.

In the respondent's final determination, he determined that petitioner's basis for amortization and depreciation of the patents it *539 acquired from Illinois was the cost thereof to the latter, and that petitioner's basis for all other assets acquired from Illinois was the cost or other basis of these assets to Illinois.

The parties have stipulated the amounts petitioner would be entitled to use as its basis for amortization and depreciation on the patents it acquired from Illinois under the contract of July 1, 1930, and the amounts petitioner would be entitled to deduct for amortization and depreciation of patents during the taxable years, in the event this Board should hold that the respondent's determination is erroneous.

*1185 OPINION.

MELLOTT: The question is, What basis shall be used by petitioner in computing amortization and depreciation on the assets acquired by petitioner in 1930 from Illinois under the stipulated facts (summarized in our findings)? Petitioner contends that it is the "cost" to it of the assets; that in any event it is entitled to use Illinois' basis, increased by the gain recognized or taxed to Illinois or its stockholders; and that unless the applicable sections of the revenue acts allow it a basis equal to the predecessor's (Illinois) cost, plus the cash paid by it (petitioner) for the assets, the sections are unconstitutional. Respondent contends, and determined the deficiency upon the theory, that petitioner's basis is the cost of the assets to Illinois.

An examination of the applicable section of the Revenue Acts of 1934 and 1936 (section 114) discloses that the present question can not be determined merely by a reference to those acts. Section 114 states that the basis "upon which exhaustion, wear and tear and obsolescence are to be allowed * * * shall be the adjusted basis provided in section 113(b) * * *." Section 113(b), by its terms, refers to subsection (a) of*1186 the same section. Paragraph (12) of subsection (a) provides that if the property was acquired after February 28, 1913, in any taxable year beginning prior to January 1, 1934, and the basis thereof for the purposes of the Revenue Act of 1932 was prescribed by section 113(a)(6), (7), or (9) of such act, then for the purposes of section 113 the basis shall be the same as the basis therein prescribed in the Revenue Act of 1932. Respondent contends that section 113(a)(7) of the Revenue Act of 1932 is thus made applicable and it appears to be. It refers to the acquisition of property by a corporation after December 31, 1917, in connection with a reorganization. Inasmuch as the acquisition in question occurred during the time the Revenue Act of 1928 was in effect, it is necessary to determine first whether or not it was in connection with a reorganization and, if so, whether immediately after the transfer an interest or control in the property acquired of 50 per centum or more remained in the same persons. We *540 therefore go to the Revenue Act of 1928 for the purpose of determining whether or not there was a reorganization as defined in said section. The portion of the section*1187 relied upon by the respondent is 112(i)(1)(A). The pertinent provisions of all sections to which reference has been made are shown in the margin. ¹

*1188 Were the assets acquired in connection with a reorganization? In Nelson Co. v. Helvering,296 U.S. 374, the facts were substantially the same as in the instant proceeding. In that case the Elliott Fisher Corporation organized a new Delaware corporation with 12,500 shares of nonvoting preferred stock and 30,000 shares of common stock. The Elliott Fisher Corporation acquired all of the 30,000 shares of common stock in the new corporation for $2,000,000 in cash. The new corporation then acquired substantially all of the properties of the John A. Nelson Co., paying therefor $2,000,000 cash and the entire 12,500 shares of preferred stock issued by it. The John A. Nelson Co. used part of the cash to redeem its own preferred stock and distributed the remainder, together with the 12,500 shares of preferred stock of the new corporation, to its stockholders. The John A. Nelson Co. did *541 not dissolve. The Supreme Court held that there was a statutory reorganization, and, among other things, said:

True, the mere acquisition of the assets of one corporation by another does not amount to reorganization within the statutory definition. *1189 Pinellas Ice & Cold Storage Co. v. Commissioner,287 U.S. 462, 53 S.Ct. 257, 77 L.Ed. 428, so affirmed. But where, as here, the seller acquires a definite and substantial interest in the affairs of the purchasing corporation, a wholly different situation arises. The owner of preferred stock is not without substantial interest in the affairs of the issuing corporation, although denied voting rights. The statute does not require participation in the management of the purchaser; nor does it demand that the conveying corporation be dissolved. A controlling interest in the transferee corporation is not made a requisite by section 203(h)(1)(A) (26 U.S.C.A. § 112 note). This must not be confused with paragraph (h)(2) (26 U.S.C.A. § 112 note).

Petitioner attempts to distinguish the instant proceeding from the cited case on the ground that "the preferred stock in that case was sufficiently different from that in the present case to distinguish the two cases." The only difference, however, appears to be that in the Nelson case the preferred stockholder was expressly given the right to vote in the event of default in*1190 the payment of dividends and his stock was to be retired at stated intervals, whereas the preferred stockholders in the petitioner corporation had no voting rights and their stock could be redeemed upon 30 days' notice; but the fact that they had no voting rights does not mean that they did not have a substantial interest in its affairs. While petitioner's preferred stock was redeemable upon 30 days' notice, or sooner if the notice were waived, the agreement of July 1, 1930, contained no absolute requirement that the preferred stock need ever be redeemed in the absence of sufficient earnings. The differences between the preferred stock in the Nelson case and the preferred stock in the instant proceeding are not substantial enough to distinguish the two cases. It must be held that the acquisition of the assets was in connection with a reorganization. Cf. Helvering v. Minnesota Tea Co.,296 U.S. 378, and Helvering v. Watts,296 U.S. 387.

The next question is, Did an interest or control in the property of 50 percent or more remain in the same persons when the reorganization was consummated? If it did, petitioner must use the basis which*1191 the assets it acquired had in the hands of its transferor, Bickford's Inc. v. Helvering, 98 Fed.(2d) 568, unless it may be relieved from doing so upon some ground not heretofore discussed.

We agree with petitioner that, since the preferred stock had no voting rights of any kind, neither Illinois nor its stockholders had the 50 percent control in the transferred assets required by the statute. We do not agree with its contention, however, that neither Illinois nor its stockholders upon the completion of the transaction held a 50 percent interest in the transferred property. Petitioner's argument *542 in support of this contention is that the value of the new corporation is established by the total consideration of $2,340,127.69 paid by the petitioner for the assets of Illinois; that the 12,500 shares of preferred stock (par value of $100 per share) issued to Schweitzer and Conrad must be reduced (a) by the 625 shares issued to Cassatt & Co., brokers, and (b) by the 2,375 shares redeemed two and one-half months after the date of the execution of the reorganization agreement and approximately two months after the date on which the reorganization*1192 was consummated; and that upon completion of the transaction, therefore, Schweitzer and Conrad, as individuals, owned only 9,500 shares, which gave them an interest of $950,000 in assets having a value of $2,340,127.69, or less than 50 percent. In other words, petitioner insists that the issuance of 625 shares to Cassatt & Co. and the redemption of the 2,375 shares be treated as part of the reorganization plan and as separate steps in a single transaction.

Whether or not the 12,500 shares issued to Schweitzer and Conrad should be reduced by the 625 shares issued to the brokers need not be discussed or decided; for, as we interpret the stipulated facts, the stockholders of Illinois owned a 50 percent interest in petitioner immediately after the transfer of the assets of the former if the redemption of the 2,375 shares be determined to have been a separate and distinct transaction, as respondent contends. It will be assumed, therefore, for the purposes of this decision that the 12,500 shares should be reduced by the 625 shares, leaving Schweitzer and Conrad owning 11,875 shares and an interest in the transferred assets of $1,187,500 or more than 50 percent, unless petitioner's contention, *1193 that their ownership should be further reduced by the 2,375 shares redeemed, is sustained.

On brief petitioner urges that the redemption of 2,500 shares of the preferred stock (2,375 of which were owned by Schweitzer and Conrad) for cash, followed the acquisition of the Illinois assets so closely that, when considered with the provisions of the contract permitting redemption of all or part of the preferred stock on 30 days' notice, it is apparent the parties contemplated immediate redemption of these shares; that the slight difference in time between the transfer of Illinois assets and the redemption of the 2,500 shares of preferred stock does not control or demonstrate that the transactions were separate and distinct, citing Portland Oil Co.,38 B.T.A. 757, 775; that the temporary holding of 2,375 shares of redeemed preferred stock by the Illinois stockholders was nothing more than a transitory ownership; and that, since the ownership was transitory, a 50 percent interest in the assets did not "remain" in Illinois or its stockholders within the contemplation and meaning of section 113(a)(7) of the Revenue Act of 1932, supra. *1194 Omaha Coca-Cola Bottling Co.,26 B.T.A. 1123; *543 Paul L. Case,37 B.T.A. 365, 372; affd., 103 Fed.(2d) 283; Helvering v. Bashford,302 U.S. 454, 458.

An examination of the reorganization plan or contract of July 1, 1930, discloses that the redemption of the transferred stock over an indefinite future period was provided for; but the provisions of the contract do not justify petitioner's statement that "immediate" redemption was contemplated. In this connection the following provisions of the contract with reference to the preferred stock are significant:

(c) * * * the Preferred stock shall be entitled to receive cumulative dividends at the rate of six per cent (6%) per annum from and after July 1, 1930, payable in quarterly installments of one and one-half per cent (1 1/2%) on the fifteenth days of March, June, September and December of each year, beginning September 15, 1930, * * *: the Preferred stock shall be redeemable, in whole or in part, at any time on thirty (30) days' notice, at par, plus dividends accumulated and unpaid, and accrued to the date of redemption, and shall be entitled to be paid, *1195 on liquidation or dissolution, One hundred dollars ($100.00) per share, plus dividends accumulated and unpaid and accrued to the date of such payment, before any of the assets of the New Company shall be distributable to the holders of the Common Stock. * * * Second parties [Edmund O. Schweitzer and Nicholas J. Conrad], and each of them shall be elected members of the Board of Directors of the New Company and shall be entitled to remain as directors so long as they, or either of them, own any shares of the preferred stock. * * * The charter of the New Company shall further provide, with respect to such Preferred Stock, that, beginning with the earnings of the business for the calendar year 1931 and for each calendar year thereafter while any of said Preferred stock remains outstanding, the entire net earnings remaining after payment of taxes and Preferred dividends, but before deduction for exhaustion on patents, patent rights and other intangibles, shall be disposed of as follows: Ten per cent (10%) thereof may, at the option of its board of directors, be retained by the New Company for use as and for additional working capital; next there may be paid cash dividends of One hundred*1196 thousand dollars ($100,000.00) upon the Common stock, and all the remaining net earnings, determined as aforesaid, shall be applied to the redemption of the Preferred stock, but no fractional shares shall be redeemed. * * * The charter of the New Company shall further provide that the consent of the holders of at least two thirds (2/3) in interest of the Preferred stock then outstanding, given in person or by proxy, either in writing, or at an annual meeting or at a special meeting called for that purpose, shall be necessary for effecting the increase of the authorized amount of Preferred stock herein provided for, or the creation or issue of any stock having any preference or priority which is or would be superior to or on an equality with any preference or priority of the Preferred stock provided for herein.

The above quoted provision for the application of the 1931 earnings to the redemption of the preferred stock after making the specified deductions and payments indicates that at the time the contract of July 1, 1930, was executed it was the intention of the parties that the first redemption of preferred stock would occur either at the end of 1931 or sometime in 1932. Moreover, *1197 as of July 15, 1930, the stipulated and agreed closing date of the reorganization, there was no bligation on the part of the preferred stockholders to surrender their *544 stock for redemption, and no obligation on the part of petitioner to redeem its preferred stock within the taxable year 1930. Petitioner merely had, at the most, an option to redeem the preferred stock which it could exercise only by giving the required 30 days' notice to the preferred stockholders unless they waived their right to such notice. In other words, there was no contract requiring or entitling the petitioner, on the one hand, to redeem its preferred stock, or, on the other hand, requiring or entitling the preferred stockholders to surrender any part of the preferred stock for redemption. Cf. Helvering v. San Joaquin Fruit & Investment Co.,297 U.S. 496.

The "transitory" ownership of stock, recognized by the courts and this Board in the cases cited and relied upon by petitioner, has no application in a situation such as the one under consideration in the instant proceeding. In the cited cases the "transitory ownership" of stock was in individuals or corporations which acted*1198 merely as conduits for the passage of title to persons or corporations entitled to receive it by virtue of an arrangement or contract executed prior to, or constituting a part of, the reorganization. Most reorganization plans contemplate the retirement, sooner or later, of preferred stock of any new company provided for in the reorganization plan; but such retirement, occurring months or years later, is not, and never has been held to be, part of the reorganization plan. Cf. Nelson Co. v. Helvering, supra.If it were, the execution of the reorganization plan would be delayed indefinitely in most instances.

An examination of the contract of July 1, 1930, indicates that the parties intended that all of the steps essential to the execution of the reorganization plan should be executed on or before the "closing date." The closing date which they set and agreed upon was July 15, 1930. The situation of the parties on that date, rather than some subsequent date when part of the preferred stock was redeemed, is the important factor to be considered in determining whether or not Illinois or its stockholders owned 11,875 shares of the preferred stock of petitioner*1199 and therefore held more than the 50 percent interest in its property specified in section 113(a)(7), supra. Under the provisions of this section petitioner's basis for amortization and depreciation of the patents and other assets acquired by Illinois must be held to be the same as it would be in the hands of Illinois, the transferor, unless the stipulated facts disclose that under the law applicable to the year in which the transfer was made gain was recognized to the transferor.

Petitioner next contends that, even though it be held that the assets of Illinois were acquired in connection with a statutory reorganization and that an interest of 50 percent or more in the transferred assets remained in Illinois and its stockholders, nevertheless under section 113(a)(7) of the Revenue Act of 1932, supra, it is not limited to the *545 basis of Illinois, since that basis must be increased by the gain recognized to Illinois or its stockholders.

Illinois transferred assets to petitioner which had a cost or other basis to it of $588,012.91. In consideration for this transfer petitioner assumed liabilities amounting to $90,127.69, paid $1,000,000 in cash to the stockholders*1200 of Illinois, and issued to these stockholders 12,500 shares of its preferred stock (par value $100 per share), or a total consideration of $2,340,127.69. It is apparent, therefore, that, except for the reorganization provisions of the Revenue Act of 1928, the taxable gain to Illinois would have been $1,752,114.78. Under the provisions of