Opinion
Docket No. 27309.
1953-07-6
DISTRIBUTORS FINANCE CORPORATION, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.
Arthur A. Armstrong, Esq., for the petitioner. Donald P. Chehock, Esq., for the respondent.
1. Petitioner purchased more than 80 per cent of the outstanding stock of X corporation and caused it to sell its operating assets to Y corporation in return for debentures of Y, the assumption of liabilities of X, and an adjustment in cash. Thereafter X was liquidate, petitioner receiving the debentures along with cash and other assets. Held, no gains was recognized on the liquidation of X under the provisions of section 112(b)(6), Internal Revenue Code. International Investment Corporation, 11 T.C. 678,affirmed175 F.2d 772 (C.A. 3); Tri-Lakes Steamship Co. v. Commissioner, 146 F.2d 970 (C.A. 6). The facts herein do not justify rendering section 112(b)(6) inapplicable on the theory that petitioner from the very outset intended to liquidate X and that therefore liquidation of X was merely one step in carrying out a preconceived plan which cannot be separated into its component parts. On this record the determination to liquidate X was independently made after petitioner entered into the basic transaction.
2. Held, the amount received by petitioner from a settlement of a disputed claim for dividends was accruable in 1946 when the compromise was made.
3. Held, petitioner failed to sustain its burden of proving that is did not become the owner of certain debentures prior to February 1946; accordingly, the interest from those debentures for a period prior to that time was properly included in petitioner's income as reported in its returns. Arthur A. Armstrong, Esq., for the petitioner. Donald P. Chehock, Esq., for the respondent.
The respondent determined the following deficiencies:
+-----------------------------------------------------------------------------+ ¦ ¦1943 ¦1945 ¦1946 ¦ +-----------------------------------------+---------+------------+------------¦ ¦Income tax ¦$198.75 ¦$59,769.85 ¦$22.152.80 ¦ +-----------------------------------------+---------+------------+------------¦ ¦Declared value excess-profits tax ¦ ¦16,821.25 ¦ ¦ +-----------------------------------------+---------+------------+------------¦ ¦Personal holding company surtax ¦ ¦ ¦530.47 ¦ +-----------------------------------------+---------+------------+------------¦ ¦ ¦ ¦ ¦ ¦ +-----------------------------------------------------------------------------¦ ¦By amended pleadings respondent claimed increased deficiencies for 1945 and ¦ ¦1946 as follows: ¦ +-----------------------------------------------------------------------------¦ ¦ ¦ ¦ ¦ ¦ +-----------------------------------------------------------------------------+
1945 1946 Income tax $59,769.85 $70,357.36 Declared value excess-profits tax 16,821.25 Personal holding company surtax 205,723.26 530.47
On brief, the respondent abandoned his claim for personal holding company surtax liability for 1945.
The petitioner does not contest the adjustment made by the respondent which resulted in the determination of a deficiency in income tax for 1943, but urges that it has made an overpayment in its income tax for that year in the amount of $397.38. The basis for the alleged overpayment is a net operating loss deduction due to a net operating loss carry-back from the year 1945, the availability of which turns on whether respondent correctly asserted a deficiency for 1945.
The issues are stated in the opinion.
FINDINGS OF FACT.
Some of the facts have been stipulated and are incorporated herein by reference.
Petitioner is a California corporation which formerly operated a Willys automobile agency in Los Angeles under the name of Willys Distributors. Early in the 1940's it relinquished that agency and changed its name to Distributors Finance Corporation. Thereafter, it financed used car dealers through the purchase of conditional sales contracts, and it also bought and sold used cars. In 1946 its principal office was moved to San Diego from Los Angeles, where it had previously been located. Its tax returns, made on the accrual method of accounting for the calendar years here involved, were filed with the collector of internal revenue for the sixth district of California at Los Angeles.
E. G. Davies was president of petitioner and dominated its affairs. During the years here involved, 88.57 per cent of the outstanding stock of petitioner was owned by Davies Motors, Inc. of San Diego, the outstanding stock of which, in turn, was owned 51 per cent by E. G. Davies, 33 per cent by F. E. Davies (adult son of E. G. Davies), 13 per cent by the wife of E. G. Davies, and 3 per cent by others. F. E. Davies also owned 11.2 per cent of petitioner's stock.
The Grand Rapids Home Furnishing Company (hereinafter also referred to as Grand Rapids) was a California corporation which had been organized in 1928 and which, until shortly prior to its dissolution in 1945, operated a department store in San Diego. Grand Rapids was about the third or fourth largest department store in San Diego, with annual gross sales in the fiscal years ended July 31, 1944, and July 31, 1945, in excess of $2,500,000. Throughout its existence in 1945 it had 3,781 shares of capital stock outstanding, all of which were of one class and had voting rights.
On February 6, 1945, and for some time prior thereto, Harry L. Kahn owned or controlled 2809.2 shares of the outstanding stock of Grand Rapids, which he was then willing to sell. Harlan B. Eldred, a resident of Los Angeles who had wide experience in the securities business, sought to obtain for himself and Edwin A. Barnes, also in the securities business, an option to purchase the stock owned or controlled by Kahn. Kahn's reluctance to dispose of the stock through the medium of an option was overcome by advice which he received from George Carlson, the resident managing partner in Los Angeles of the national accounting firm of Ernst & Ernst. Carlson and Eldred were friends, and Ernst & Ernst were the auditors and tax accountants not only for Grand Rapids but also for petitioner. Both Kahn and E. G. Davies leaned heavily on Carlson in the transactions here involved, both as to his business judgment and as to the manner and form which such transactions should take.
On February 6, 1945, Kahn executed a written option to Eldred and Barnes to purchase the Grand Rapids stock owned or controlled by him at $165 a share.
The option also contained provisions requiring the optionees to purchase at the same price any shares offered by minority stockholders within 30 days of the exercise of the option, with a further commitment to purchase at that price up to 300 additional shares offered by employee-stockholders within a year. The option was transferable at the optionees' election, and was irrevocable until noon of April 30, 1934, when it was to expire. The option was to be exercised by delivery, to the seller, of a commitment by the optionees or their transferees to purchase on or before July 31, 1945, all of the Kahn shares as well as the additional shares of the minority stockholders covered by the option. Eldred and Barnes originally considered selling the option or the shares to be purchased under it.
The option spoke of 2800 shares. However, the parties have stipulated that Kahn actually owned or controlled 2809.2 shares and that those 2809.2 shares were actually acquired under the option, as hereinafter set forth. The parties refer to the option as one for 2809.2 shares and we shall do likewise.
By the first part of April 1945, C. L. Dawson, Jr., and Charles R. Goff were taken into participation with Eldred and Barnes in the option, each with a one-fourth interest. Dawson was vice president of the Security-First National Bank of Los Angeles, one of the large banks of that city, and Goff was vice president and general manager of Walker-Scott Department Store, the second largest department store in San Diego. Goff was originally the source of the information that the Kahn shares could be purchased, and that information had been passed on successively to Dawson, Barnes, and Eldred. After Dawson and Goff joined in the option, Eldred was usually the spokesman for the four, hereinafter sometimes referred to as the Eldred group.
Grand Rapids had among its assets a large amount of cash, and the book value of its stock was substantially in excess of the option price. However, the Eldred group became interested primarily in acquiring only the operating asset of Grand Rapids and had formulated a plan to organize a new corporation to take over such assets, assume the liabilities of Grand Rapids, and give debentures of the new corporation in payment. Before this plan could be presented to Kahn, he died on April 24, 1945.
Although the Eldred group had considerable resources among themselves, and at one time had considered buying the stock of Grand Rapids under the option, they decided to seek outside financial assistance in their plan to acquire merely the operating assets of Grand Rapids. The Eldred group discussed the matter in length with Carlson.
Carlson knew that E. G. Davies has ‘gone into a number of deals‘ of this nature and that petitioner, by reason of its comparatively large capital and small income, was in a favorable tax position since it could make a profit without incurring excess profits tax liability. Carlson, therefore, arranged for a meeting between E. G. Davies and Eldred. The meeting was held in San Diego in the morning of April 26 or 27, 1945; Carlson, E. G. Davies, and Eldred were present. Eldred had never heard of E. G. Davies or petitioner prior to Carlson's suggestion that the desired financing might be obtainable from that source. At that meeting, E. G. Davies knew that Eldred was acting for himself, Barnes, Dawson, and Goff.
The plan of the Eldred group was there explained to E. G. Davies. Under the plan, as presented to and understood by E. G. Davies, the option would be assigned to petitioner which would purchase the Grand Rapids stock, the operating assets of Grand Rapids would then be sold at book value to a new corporation which the Eldred group would organize with $100,000 fresh capital, and, in addition to assumption of liabilities, the principal consideration for such assets would be 10-year debentures with a face value of $350,000 to be issued by the new corporation. In view of the fact that Grand Rapids had a large amount of cash that could readily be withdrawn by petitioner, it was represented to E. G. Davies that the net cost of the $350,000 debentures would be only about $175,000. It was also understood that Goff, whom E. G. Davies knew, would become the manager of Grand Rapids until the sale to the new corporation could be effectuated.
At the foregoing meeting Carlson had an estimated April 30, 1945, balance sheet of Grand Rapids before and after the proposed sale of operating assets to the new corporation, as well as of the new corporation after sale. Pursuant to the estimated balance sheet, as explained by Carlson, the realizable book value of the Grand Rapids stock, after sale, was $211.48 a share, or $46.48 more than the option price. The estimated balance sheet of April 30, 1945, considered by Carlson and E. G. Davies, was as follows:
+-------------------------------------------+ ¦Estimated Balance Sheet, April 30, 1945 ¦ +-------------------------------------------¦ ¦ ¦ ¦ ¦ ¦ +-------------------------------------------+
Old company Old company New company before sale after sale Cash $623,876 $532,046 $191,830 Contracts receivable 126,781 126,781 Accounts receivable 109,387 109,387 Inventory 257,847 257,847 Property and equipment 31,646 31,646 Prepaid taxes 10,322 Prepaid insurance 3,674 Other assets 542 542 Post-war refund 1,158 1,158 New company's notes 350,000 $1,165,233 $883,204 $718,033 Income taxes due $402,467 $402,467 Less tax notes owned 244,000 244,000 $158,467 $158,467 Other taxes accrued 29,121 29,121 Accounts payable 19,527 19,527 Merchandise coupons 918 918 Reserve for additional compensation 60,000 60,000 TOTAL CURRENT $268,033 $268,033 Due chief stockholder 83,585 $83,585 Ten year notes 350,000 Capital stock 378,100 378,100 50,000 Surplus 435,515 421,519 50,000 $1,165,233 $883,204 $718,033
After discussions with Carlson and his attorney, and after a visit to a San Diego bank where he learned that petitioner could obtain a loan to help finance the project, E. G. Davies, on the same afternoon, accepted the proposal on behalf of petitioner. An oral agreement was entered into between E. G. Davies, acting for petitioner, and Eldred, acting for his group.
The agreement between the petitioner and the Eldred group was in substance as follows: Petitioner agreed to purchase the stock of Grand Rapids as provided in the option and assume the optionees' obligation thereunder. The Eldred group agreed to form a new corporation, capitalized with $100,000 in cash. The new corporation was to purchase from Grand Rapids its operating assets at book value as of July 31, 1945. It was to pay for such assets by assuming the liabilities of Grand Rapids and issuing debentures in the amount of $350,000 payable in 10 years and bearing interest at 6 per cent. Any difference between the book value of the assets acquired and the debentures and liabilities assumed was to be paid in cash. Grand Rapids was to carry on business as usual prior to the transfer of the operating assets, agreeing, however, not to enter into any contracts without first obtaining consent of an authorized representative of the new corporation. Petitioner was to cause Grand Rapids to enter into this purchase and sale and to employ Goff as president of Grand Rapids at a compensation of $30,000 a year. This agreement was reduced to writing and signed on May 7, 1945. The written agreement had attached to it as an exhibit the form of agreement to be entered into between Grand Rapids and the new corporation, setting forth in detail the nature of the debentures and the rights and obligations of Grand Rapids and the new corporation.
Eldred and Barnes, on April 28, 1945, delivered to the special administrator of the estate of Harry L. Kahn a notice of exercise of the option and commitment to purchase the shares. On May 9, 1945, two days after the oral agreement of April 26 or 27 between petitioner and the Eldred group had been reduced to writing, petitioner, as assignee of the option, deposited $500,000 in escrow with the First National Trust and Savings Bank of San Diego, for the purpose of purchasing the Kahn shares. It authorized the bank to purchase in addition in accordance with the option any stock tendered by minority shareholders at $165 per share and to charge its account therefor. An additional $130,000 was deposited in the escrow account shortly thereafter. Pursuant to instructions, the 2809.2 Kahn shares were purchased and were transferred on the company books to petitioner on May 10, 1945. Between May 10, 1945, and July 31, 1945, 932.3 shares of stock were received from minority shareholders and were paid for by the bank when endorsed in blank. On August 7, 1945, the bank delivered the minority shares to the petitioner. By May 12, 1945, the bank had purchased and charged petitioner's account for more than 80 per cent of the outstanding stock of Grand Rapids.
The aggregate amount paid for the total of 3714.5 shares purchased was $617,347.50. The funds used to buy the stock were borrowed by the petitioner from the following sources, between May 9, 1945, and May 17, 1945:
+-------------------------------------------------------+ ¦First National Trust & Savings Bank, San Diego¦$350,000¦ +----------------------------------------------+--------¦ ¦Security Trust & Savings Bank, San Diego ¦75,000 ¦ +----------------------------------------------+--------¦ ¦Davies Motors, Inc. ¦140,000 ¦ +----------------------------------------------+--------¦ ¦E. G. Davies ¦65,000 ¦ +----------------------------------------------+--------¦ ¦ ¦$630,000¦ +-------------------------------------------------------+
The $350,000 loan was obtained on May 9, 1945, and was due on November 9, 1945; the note was endorsed by E. G. Davies. The $75,000 loan was obtained on May 17, 1945, and was due on November 17, 1945. Both of these loans were in fact repaid, as hereinafter set forth, in August 1945, after the sale of the operating assets of Grand Rapids to the new corporation.
Pursuant to the agreement between the Eldred group and petitioner, the new corporation, Grand Stores Company (hereinafter also referred to as Grand Stores), filed its articles of incorporation with the Secretary of State of the State of California on May 16, 1945. Thereafter, Grand Stores entered into an agreement, as of May 1, 1945, with Grand Rapids for the purchase of assets of Grand Rapids, as provided in the basic agreement between petitioner and the Eldred group. There was a contemplated transfer date of July 31, 1945, and business operations were to continue under the supervision and name of Grand Rapids until that time. September 31, 1945, was set as the latest date on which the transfer was to take place. The signatures to this agreement were acknowledged on behalf of Grand Rapids on May 25, 1945, and on behalf of Grand Stores on June 7, 1945.
A special meeting of the board of directors of Grand Rapids was held on May 10, 1945, at which Davies and Goff were elected as directors to fill the vacancies created by the resignation of Kahn's wife and one Guy A. Hoon. Goff was also elected president and general manager and Frank A. Frye, Jr., petitioner's attorney, was elected secretary. On May 25, 1945, another meeting of the board of directors was held and the agreement for the sale of assets to Grand Stores was approved.
On or about June 1, 1945, Goff terminated his employment with the Walker-Scott department store and began to devote his full time to his work as president of Grand Rapids. In the period between May 7, 1945, through July 31, 1945, Grand Rapids was actively engaged in the operation of its department store, carrying on business in all its aspects in the name of Grand Rapids. From May 1, 1945, through July 31, 1945, its net profit was approximately $63,987.54 before Federal taxes and approximately $15,965.82 after Federal taxes. These profits were part of those reported in the Grand Rapids corporation income and excess profits tax return for the fiscal year August 1, 1944, to July 31, 1945. Grand Rapids ceased its department store operations at the close of business on July 31, 1945, and thereafter kept no regular books of account. The Federal income and excess profits tax returns of Grand Rapids for its fiscal year ending July 31, 1945, reported all of its income from store operations up to the end of that day.
On August 1, 1945, an agreement and bill of sale were executed as of July 31, 1945, by Grand Rapids and Grand Stores. These were substantially in accordance with the agreement for the sale of assets which had previously been entered into by them. However, by oral arrangement between the parties, a warehouse building and land were leased to Grand Stores instead of being transferred and sold; this change was subsequently confirmed by an amendatory agreement, dated January 15, 1946, between petitioner, as successor to Grand Rapids, and Grand Stores. The purpose of this change was to reduce the amount of cash that Grand Stores would have been required to pay at the time of the sales. Another departure from the original agreement was that deferred charges for unexpired insurance premiums were sold and transferred. The following schedule, based upon book value, reflects the sale and transfer of the assets from Grand Rapids to Grand Stores:
+------------------------------------------------------------------------------+ ¦Schedule of Balance Sheets and Accounts of Grand Rapids Home Furnishing Co., ¦ +------------------------------------------------------------------------------¦ ¦Reflecting Sale to Grand Stores Co. ¦ +------------------------------------------------------------------------------¦ ¦ ¦Apr. 30, 1945 ¦July 31, 1945 ¦Sale ¦Aug. 1, 1945 ¦ +----------------------+--------------+--------------+-----------+-------------¦ ¦Assets ¦ ¦ ¦ ¦ ¦ +----------------------+--------------+--------------+-----------+-------------¦ ¦Cash ¦$560,427.77 ¦$412,131.52 ¦$1,189.84 ¦$410,941.68 ¦ +----------------------+--------------+--------------+-----------+-------------¦ ¦Trade receivables ¦191,167.19 ¦171,579.82 ¦171,579.82 ¦ ¦ +----------------------+--------------+--------------+-----------+-------------¦ ¦Inventory ¦280,159.32 ¦346,135.55 ¦346,135.55 ¦ ¦ +----------------------+--------------+--------------+-----------+-------------¦ ¦Real estate ¦22,133.31 ¦21,878.46 ¦ ¦21,878.46 ¦ +----------------------+--------------+--------------+-----------+-------------¦ ¦Fixtures & equip ¦9,613.97 ¦8,926.23 ¦8,926.23 ¦ ¦ +----------------------+--------------+--------------+-----------+-------------¦ ¦Deferred charges ¦9,691.07 ¦10,431.08 ¦10,431.08 ¦ ¦ +----------------------+--------------+--------------+-----------+-------------¦ ¦Post war refund ¦1,158.24 ¦1,147.73 ¦ ¦1,147.73 ¦ +----------------------+--------------+--------------+-----------+-------------¦ ¦Income tax refund ¦ ¦ ¦ ¦ ¦ +----------------------+--------------+--------------+-----------+-------------¦ ¦Misc ¦542.00 ¦1,937.43 ¦1,654.25 ¦283.18 ¦ +----------------------+--------------+--------------+-----------+-------------¦ ¦Tax notes ¦236,000.00 ¦235,022.10 ¦235,022.10 ¦ ¦ +----------------------+--------------+--------------+-----------+-------------¦ ¦Debentures bonds ¦ ¦ ¦ ¦350,000.00 ¦ +----------------------+--------------+--------------+-----------+-------------¦ ¦Due from vendee ¦ ¦ ¦ ¦2,264.59 ¦ +----------------------+--------------+--------------+-----------+-------------¦ ¦Accrued rent ¦ ¦ ¦ ¦ ¦ +----------------------+--------------+--------------+-----------+-------------¦ ¦Accrued interest ¦ ¦ ¦ ¦ ¦ +----------------------+--------------+--------------+-----------+-------------¦ ¦Totals ¦$1,310,892.87 ¦$1,209,189.92 ¦$774,938.87¦$786,515.64 ¦ +----------------------+--------------+--------------+-----------+-------------¦ ¦Liabilities ¦ ¦ ¦ ¦ ¦ +----------------------+--------------+--------------+-----------+-------------¦ ¦Trade accounts ¦ ¦ ¦ ¦ ¦ +----------------------+--------------+--------------+-----------+-------------¦ ¦payable ¦$42,069.33 ¦$82,009.27 ¦$73,434.78 ¦$8,574.49 ¦ +----------------------+--------------+--------------+-----------+-------------¦ ¦Mdse. coupons ¦919.89 ¦851.11 ¦851.11 ¦ ¦ +----------------------+--------------+--------------+-----------+-------------¦ ¦Accrued expenses ¦18,110.16 ¦23,202.28 ¦23,202.28 ¦ ¦ +----------------------+--------------+--------------+-----------+-------------¦ ¦Additional ¦ ¦ ¦ ¦ ¦ +----------------------+--------------+--------------+-----------+-------------¦ ¦compensation ¦74,500.00 ¦16,343.50 ¦16,343.50 ¦ ¦ +----------------------+--------------+--------------+-----------+-------------¦ ¦Due Kahn family ¦67,096.21 ¦ ¦ ¦ ¦ +----------------------+--------------+--------------+-----------+-------------¦ ¦Federal income tax ¦341,438.33 ¦304,800.94 ¦304,800.94 ¦ ¦ +----------------------+--------------+--------------+-----------+-------------¦ ¦Fed. income tax def ¦ ¦1,236.23 ¦ ¦1,236.23 ¦ +----------------------+--------------+--------------+-----------+-------------¦ ¦Proceeds of sale ¦ ¦ ¦352,264.59 ¦ ¦ +----------------------+--------------+--------------+-----------+-------------¦ ¦Net loss recognized ¦ ¦ ¦4,041.67 ¦ ¦ +----------------------+--------------+--------------+-----------+-------------¦ ¦Capital stock ¦378,100.00 ¦378,100.00 ¦ ¦378,100.00 ¦ +----------------------+--------------+--------------+-----------+-------------¦ ¦Surplus and reserves ¦388,658.95 ¦402,646.59 ¦ ¦398,604.92 ¦ +----------------------+--------------+--------------+-----------+-------------¦ ¦Totals ¦$1,310,892.87 ¦$1,209,189.92 ¦$774,938.87¦$786,515.64 ¦ +------------------------------------------------------------------------------+
On August 1, 1945, as of the close of business on July 31, 1945, Grand Stores assumed the liabilities of Grand Rapids, and possession of the store was turned over to it. As of that time, Grand Stores succeeded to the good will and all the operating assets, except the warehouse property, of Grand Rapids. Also, on August 1, 1945, Grand Stores issued and delivered to Grand Rapids its 10-year 6 per cent temporary debenture, in the principal amount of $350,000, which was registered in the name of Grand Rapids, and which had a then fair market value or $322,000.
Grand Stores operated the business beginning August 1, 1945. On that date bank accounts and payroll bank accounts were were opened in Grand Store's name. All of the normal store functions which up to the night of July 31, 1945, had been performed by and in the name of Grand Rapids, were, on and after August 1, 1945, performed by and in the name of Grand Stores. These included drawing of checks for payroll and purchases, rendering of bills, carrying of store and liquor licenses, carrying of insurance and the store lease, reporting of employment taxes, unemployment insurance taxes, and sales taxes.
Petitioner did not have any plans that contemplated any business activity on the part of Grand Rapids after the transfer of the operating assets to the new corporation. It was an integral part of the transaction, and so contemplated from the very beginning, that the large amount of cash in the hands of Grand Rapids would be promptly available to petitioner to enable it, at least in substantial part, to repay the bank loans which it expected to obtain in order to finance the transaction. However, no plan to obtain such cash through liquidation of Grand Rapids was formulated at the time that petitioner entered into its contract to purchase the Grand Rapids stock. At a time not long after the first meeting between Eldred and E. G. Davies, Carlson was giving consideration to the recommendations that he would make concerning the future of Grand Rapids; he concluded that a liquidation of Grand Rapids would be ‘tax free‘ under section 112(b)(6) of the Internal Revenue Code. That possibility was the subject of informal discussions by E. G. Davies, Carlson, and Albert H. Powers, another accountant in the Los Angeles office of Ernst & Ernst.
Immediately following the transfer of assets to Grand Stores on August 1, 1945, at a conference at which Powers, E. G. Davies, Goff, and Frye were present, Powers advised E. G. Davies that Grand Rapids should be dissolved as soon as possible in order to eliminate the necessity for payment of state franchise taxes. E. G. Davies, accepting this advice, instructed Frye to take the proper steps to achieve that end. Although the idea of liquidating Grand Rapids was not presented for the first time at the foregoing conference on August 1, 1945, and although there was a general understanding for some time prior to August 1, 1945, that Grand Rapids would be liquidated, the determination of E. G. Davies on August 1, 1945, to be forward with the liquidation constituted the adoption of a plan of liquidation.
Petitioner, on August 20, 1945, executed a written consent to the dissolution of Grand Rapids. The board of directors of Grand Rapids, on August 20, 1945, adopted a resolution to wind up and dissolve the corporation. The certificate of election to wind up and dissolve was filed along with the shareholders' consent with the Secretary of State of the State of California on August 27, 1945. The certificate of winding up and dissolution of Grand Rapids was filed with the Secretary of State on September 4, 1945.
On September 8, 1945, Goff and Frye, as president and secretary of petitioner, executed Form 966, required under section 148(d) of the Internal Revenue Code, attached copies of the resolution of dissolution of petitioner of August 20, 1945, as well as consent of stockholders to dissolution of August 20, 1945, and filed the Form 966 with the collector of internal revenue at Los Angeles on September 13, 1945. Grand Rapids' final tax return for the period August 1, 1945, to September 4, 1945, was signed by Goff and Frye, and was prepared by Ernst & Ernst, reporting net income of $6,004.28, $1,750 of which represented interest on the $350,000 debentures. The return was filed on the accrual basis and showed no assets remaining with the company; it contained the following statement:
Taxpayer corporation was inoperative from August 1, 1945, to September 4, 1945, except for activities necessary to the dissolution. Filing of certificate of dissolution was completed in the office of Secretary of State, Sacramento, California, on September 4, 1945.
Prior to the execution and filing of the necessary papers to effectuate the dissolution of Grand Rapids, Frye, on August 9, 1945, wrote a check in the amount of $270,000, on the Grand Rapids' bank account, payable to petitioner; the check was signed by Goff as president of Grand Rapids, was delivered either to Frye or E. G. Davies, and deposited in petitioner's bank account. Appended to the check was a detachable statement which read ‘Distribution on dissolution of Grand Rapids Home Furnishing Co.‘ Prior to the deposit of this check, on August 10, 1945, the bank records reflect a balance of $83,686.14 in petitioner's account. A substantial part of the proceeds of the check was used by petitioner on August 14, 1945, in repaying the balance owed on its $350,000 bank loan which it had made to finance the transaction. Repayment of the $350,000 bank loan (the First National Trust & Savings Bank loan) was made on the following dates and in the following amounts:
+-------------------------------------+ ¦Date ¦Principal ¦Interest and¦ +-------------+----------+------------¦ ¦ ¦ ¦charges ¦ +-------------+----------+------------¦ ¦June 26, 1945¦$25,000.00¦ ¦ +-------------+----------+------------¦ ¦July 6, 1945 ¦25,000.00 ¦ ¦ +-------------+----------+------------¦ ¦July 13, 1945¦25,000.00 ¦ ¦ +-------------+----------+------------¦ ¦Aug. 6, 1945 ¦ ¦$2,418.75 ¦ +-------------+----------+------------¦ ¦Aug. 10, 1945¦12,652.50 ¦ ¦ +-------------+----------+------------¦ ¦Aug. 14, 1945¦262,347.50¦153.04 ¦ +-------------------------------------+
Repayment of the $75,000 bank loan (the Security Trust & Savings Bank loan) was made as follows:
+--------------------------+ ¦Date ¦Principal ¦ +--------------+-----------¦ ¦Aug. 1, 1945 ¦$25,000 ¦ +--------------+-----------¦ ¦Aug. 14, 1945 ¦50,000 ¦ +--------------------------+
Funds from the Grand Rapids Home Furnishing Company assets were not used in making any of the payments that were made prior to August 9, 1945, on either of the two bank loans. The payment of $12,652.50 made on August 10, 1945, on the note to First National Trust & Savings Bank was the balance remaining in the escrow account after purchase of 3,741.5 shares of Grand Rapids Home Furnishing Company stock.
After the transfer of operating assets of Grand Rapids to Grand Stores on August 1, 1945, petitioner received, in the course of liquidation of Grand Rapids, the following assets (after provision for the minority stockholders), leaving Grand Rapids with no assets:
+-----------------------------------------------------------------------------+ ¦ ¦Stipulated fair market ¦ +------------------------------------------------+----------------------------¦ ¦ ¦value (as of July 31, 1945 ¦ +------------------------------------------------+----------------------------¦ ¦Assets ¦and/or Sept. 4, 1945) ¦ +------------------------------------------------+----------------------------¦ ¦$350,000 face amount of temporary debenture ¦$322,000.00 ¦ ¦bonds of Grand Stores Company ¦ ¦ +------------------------------------------------+----------------------------¦ ¦Cash ¦393,176.41 ¦ +------------------------------------------------+----------------------------¦ ¦Land ¦11,734.80 ¦ +------------------------------------------------+----------------------------¦ ¦Building ¦30,265.20 ¦ +------------------------------------------------+----------------------------¦ ¦Excess profits tax post-war refund ¦1,147.73 ¦ +------------------------------------------------+----------------------------¦ ¦Claim for refund of Federal income tax ¦1,430.75 ¦ +------------------------------------------------+----------------------------¦ ¦Accounts receivable from Grand Stores Co. ¦ ¦ +------------------------------------------------+----------------------------¦ ¦Accrued rent ¦300.00 ¦ +------------------------------------------------+----------------------------¦ ¦Accrued bond interest ¦1,750.00 ¦ +------------------------------------------------+----------------------------¦ ¦Balance of selling price ¦2,264.59 ¦ +------------------------------------------------+----------------------------¦ ¦Total ¦$764,069.48 ¦ +-----------------------------------------------------------------------------+
The distribution of the cash was made as follows: $270,000 by check dated August 9, 1945, as hereinbefore described; $100,000 by two checks in November 1945; and the remainder in December 1945. The warehouse land and building were conveyed to petitioner by a deed executed in the name of Grand Rapids, dated and acknowledged August 30, 1945. The remaining items were either received, or taken over by petitioner prior to December 31, 1945, or were subject to its unqualified control.
Although Goff was president of Grand Rapids after July 31, 1945, he had no personal or stock interest in the dissolving corporation, and signed whatever papers, wrote checks, and took whatever steps E. G. Davies or Frye requested of him. He did this because, he felt, Mr. Davies ‘owned the whole thing and it was his stock‘ and because he had confidence in Mr. Davies attorney.
On October 5, 1945, Grand Stores delivered to the trustee under the indenture definitive bearer coupon debentures in the aggregate face amount of $350,000. On January 30, 1946, the temporary debenture, together with an assignment in blank by Grand Rapids, was surrendered to the trustee to be exchanged for the definitive debentures. On February 11, 1946, the definitive debentures were delivered to Goff, who acknowledged their receipt in the name of Grand Rapids. Goff immediately turned them over to F. E. Davies as a representative of petitioner, who was also present, and they were at once placed in a safety deposit box belonging to petitioner. The February 1, 1946, interest coupons had been detached from the definitive debentures by the trustee and paid by check made payable to Grand Rapids, which check accompanied the debentures.
The $350,000 debentures were recorded on petitioner's books as its assets in December, on or before December 31, 1945. Although the entry was made in December 1945, Ernst & Ernst, petitioner's accountants, considered petitioner as the owner of the debentures from the time Grand Rapids was dissolved. The $350,000 debentures were also shown in petitioner's income tax return for the calendar year 1945 as having been received during that year. The definitive debentures represented the same rights and property interests already reflected in the temporary debenture, and petitioner acquired these rights and property interests in 1945, no later than September 4, 1945. Petitioner's returns for 1945 included interest income in the amount of $7,000, representing interest on the debentures for the period in 1945 following the dissolution of Grand Rapids. Such interest was properly included in petitioner's income for that year.
On September 30, 1946, Grand Stores called in the debentures for redemption, and in December 1946, Grand Stores paid petitioner $350,000 plus $17,500 call premium, plus accrued interest up to the date of payment.
On May 2, 1945, the board of directors of Grand Rapids declared a dividend of $5 per share to the stockholders of record on May 1, 1945. On May 22, 1945, E. G. Davies, on behalf of petitioner, wrote to Goff, who was then president of Grand Rapids, that the declaration of the dividend was a violation of the terms of the option granted by Kahn and that petitioner believed it was equitably and legally entitled to the payment of the dividend on the 2809.2 shares which Kahn sold under the option. Grand Rapids, on May 31, 1945, instituted legal proceedings against petitioner, Mrs. Kahn, and Kahn's estate for the purpose of obtaining a judicial determination of the question. On March 2, 1946, the parties filed a stipulation with the Superior Court for the County of San Diego, compromising the claim whereby petitioner received $7,023, which was one-half of the disputed amount. On or about March 29, 1946, a check for $7,023 was given to petitioner. Petitioner included this amount as dividend income in its tax return for 1945. This amount did not properly accrue as income to petitioner in 1945; it accrued in 1946 and must be included in petitioner's income for the latter year.
OPINION.
RAUM, Judge:
Petitioner urges that the liquidation of Grand Rapids, whereby it received assets having a fair market value of $764,069.48 in exchange for stock which it had purchased for $617,347.50, was tax free under section 112(b)(6) of the Internal Revenue Code.
The consequence of petitioner's contention is that realized gain in the amount of $146,721.98 would forever escape taxation. Petitioner recognizes that such result may be ‘startling,‘ but argues that it follows strictly from the unambiguous language of the statute.
SEC. 112. RECOGNITION OF GAIN OR LOSS.(b) EXCHANGES SOLELY IN KIND.—(6) PROPERTY RECEIVED BY CORPORATION ON COMPLETE LIQUIDATION OF ANOTHER.—No gain or loss shall be recognized upon the receipt by a corporation of property distributed in complete liquidation of another corporation. For the purposes of this paragraph a distribution shall be considered to be in complete liquidation only if—(A) the corporation receiving such property was, on the date of the adoption of the plan of liquidation, and has continued to be at all times until the receipt of the property, the owner of stock (in such other corporation) possessing at least 80 per centum of the total combined voting power of all classes of stock entitled to vote and the owner of at least 80 per centum of the total number of shares of all other classes of stock (except non-voting stock which is limited and preferred as to dividends), and was at no time on or after the date of the adoption of the plan of liquidation and until the receipt of the property the owner of a greater percentage of any class of stock than the percentage of such class owned at the time of the receipt of the property; and(B) no distribution under the liquidation was made before the first day of the first taxable year of the corporation beginning after December 31, 1935; and either(C) the distribution is by such other corporation in complete cancellation or redemption of all its stock, and the transfer of all the property occurs within the taxable year; in such case the adoption by the shareholders of the resolution under which it authorized the distribution of all the assets of such corporation in complete cancellation or redemption of all its stock, shall be considered an adoption of a plan of liquidation, even though no time for the completion of the transfer of the property is specified in such resolution; or(D) such distribution is one of a series of distributions by such other corporation in complete cancellation or redemption of all its stock in accordance with a plan of liquidation under which the transfer of all the property under the liquidation is to be completed within three years from the close of the taxable year during which is made the first of the series of distributions under the plan, except that * * *
Section 112(b)(6) does provide, under specified conditions, for the nonrecognition of gain or loss on the liquidation of a subsidiary, and complementary provisions in section 113(a)(15)
require that the property received in liquidation shall have the same basis that it had in the hands of the subsidiary. Thus, upon a liquidation governed by section 112(b)(6), the cost of the parent's stock in the subsidiary thereafter becomes an immaterial consideration and plays no part in the computation of the parent's income at any future time; only the basis of the assets in the hands of the subsidiary has any significance. Moreover, even where the assets received from the subsidiary consist of cash, so that there is no basis to carry over for the computation of subsequent gain or loss, section 112(b)(6) has been held applicable, thereby permanently depriving the parent of the advantage of any realized loss or relieving it forever of tax on realized gain. International Investment Corporation, 11 T.C. 678, affirmed 175 F.2d 772 (C.A. 3); Tri-Lakes Steamship Co. v. Commissioner, 146 F.2d 970 (C.A. 6). The legislative purpose in calling for such result is not readily apparent. Cf. International Investment Corporation, supra, at 683. And it may well be doubted whether Congress would have enacted section 112(b)(6) without appropriate safeguards if the full implications of these provisions, as a potential tax-avoidance device, had been effectively called to its attention. However, these provisions are part of the law and we must apply them as we find them. If they are otherwise applicable here, petitioner's position must be sustained, and it cannot be charged tax-wise with the gain which it realized on the liquidation of Grand Rapids.
Internal Revenue Code:SEC. 113. ADJUSTED BASIS FOR DETERMINING GAIN OR LOSS.(a) BASIS (UNADJUSTED) OF PROPERTY.— The basis of property shall be the cost of such property; except that—*610 * * *(15) PROPERTY RECEIVED BY A CORPORATION ON COMPLETE LIQUIDATION OF ANOTHER.— If the property was received by a corporation upon a distribution in complete liquidation of another corporation within the meaning of section 112(b)(6), then the basis shall be the same as it would be in the hands of the transferor. The basis of property with respect to which election has been made in pursuance of the last sentence of section 113(a)(15) of the Revenue Act of 1936, as amended, shall, in the hands of the corporation making such election, be the basis prescribed in the Revenue Act of 1934, as amended.
Petitioner concedes, however, that it realized gain in 1946 on the redemption of the debentures for $367,500, such gain being equal to the excess of that amount over the basis of the debentures, which it fixes at $322,000, their fair market value at the time of their issuance and the liquidation of Grand Rapids. The theory justifying the use of such fair market value as basis is apparently the assumption that assets of Grand Rapids which constituted the consideration for the debentures had a fair market value of the same amount. In any event, respondent does not appear to contest the position that the debentures had a basis of $322,000 in the hands of Grand Rapids and that such basis remained unchanged in the hands of petitioner pursuant to section 113(a)(15) if petitioner's position is otherwise correct. However, there is a dispute between the parties as to whether the conceded $45,500 gain was ordinary income or capital gain. The debentures were certainly not held for sale to customers, cf. Estate of Clarence E. Lehr, 18 T.C. 373, 379, nor do we think that they were ‘stock in trade‘ within the meaning of section 117(a)(1)(A) of the Code. Although petitioner was in a general way in the financing business and although its participation in the transaction as a whole may generally be described as providing financial assistance to the Eldred group, we think that in the circumstances of this case the debentures cannot fairly be regarded as its ‘stock in trade.‘
Respondent argues that section 112(b)(6) is inapplicable, since, in his view, the liquidation of Grand Rapids was merely one step in a single, integrated transaction, which cannot be broken up into its component parts. According to respondent, the intention to liquidate Grand Rapids existed at the very beginning; and the entire transaction, as originally planned, was to consist merely of the purchase of Grand Rapids stock at an advantageous price, to be followed by the disposition of operating assets to Grand Stores (in exchange primarily for debentures and assumption of liabilities), whereupon Grand Rapids was to be dissolved, leaving petitioner with assets substantially in excess of its original investment. This, says the Government, was the substance of the transaction, and it invokes the familiar rule that where a series of integrated steps are carried out in accordance with a preconceived plan, the tax consequences are determined by the substance of the transaction as a whole, and not by applying the statutory provisions to the separate steps. Commissioner v. Ashland Oil & R. Co., 99 F.2d 588 (C.A. 6); Kimbell-Diamond Milling Co., 14 T.C. 74, affirmed 187 F.2d 718 (C.A. t), certiorari denied 324 U.S. 827; Ruth M. Cullen, 14 T.C. 368; Koppers Coal Co., 6 T.C. 1209.
If the Government is correct as to its underlying contention that the liquidation of Grand Rapids was part of the original plan, there would be much force to its position. For, it is firmly established that a transaction carried out in accordance with a preconceived plan may not be split into its component parts, and that the substance rather than the form of the transaction is decisive. This principle has been applied in a wide variety of cases. E.g., Minnesota Tea Co. v. Helvering, 302 U.S. 609, 613; Helvering v. Alabama Asphaltic Limestone Co., 315 U.S. 179, 184-185; Helvering v. Elkhorn Coal Co., 95 F.2d 732 (C.A. 4), certiorari denied 305 U.S. 605; Electrical Securities Corp. v. Commissioner, 92 F.2d 593 (C.A. 2); Starr v. Commissioner, 82 F.2d 964 (C.A. 4), certiorari denied 298 U.S. 680; McInerney v. Commissioner, 82 F.2d 665, 668 (C.A. 6); Hazeltine Corporation v. Commissioner, 89 F2d 513 (C.A. 3); Commissioner v. Schumacher Wall Bd. Corp., 93 F.2d 79 (C.A. 9); West Texas Refining & D. Co. v Commissioner, 68 F.2d 77, 79-80 (C.A. 10). The difficulty with the Government's position is its factual contention here that ‘there was an intent and plan of liquidation of the Grand Rapids corporation by the petitioner, from the beginning * * * .‘
We cannot find, on this record, that the liquidation of Grand Rapids was part of the plan as originally formulated, when on April 26 or 27, the contractual arrangements for the transaction was orally made. Although the matter is not completely free from doubt, we are satisfied that the determination to liquidate Grand Rapids was independently made at a subsequent time and that it was not an integral part of the transaction.
It is quite true that the sale of the Grand Rapids operating assets in exchange for debentures of the new corporation was part of the original plan. And we do not give much weight to petitioner's contention that there was always the possibility that the Eldred group might not go through with the deal after petitioner had purchased the Grand Rapids stock— for, the point in this connection is that petitioner expected the transaction to be consummated as planned and it proceeded on that basis. It is difficult to see how the possibility that a contractual obligation would not be met is any more fatal to the applicability of the single transaction rule than the absence of a unifying contract itself, provided that there was in fact a unified plan. Cf. Helvering v. Elkhorn Coal Co., supra; Portland Oil Co. v. Commissioner, 109 F.2d 479, 489 (C.A. 1); Von's Investment Co., Ltd. v. Commissioner, 92 F.2d 861 (C.A. 9); Royal Marcher, 32 B.T.A. 76, 80. Accordingly, in this respect, we must accept respondent's position that there was a preconceived plan to buy stock in Grand Rapids and to cause Grand Rapids to dispose of its operating assets for debentures of the new corporation. Moreover, it was also contemplated from the beginning that within the corporate empire dominated by E. G. Davies, as augmented by Grand Rapids, a 100 per cent net profit would ultimately be realized, since the net cost of the $350,000 debentures to Davies-controlled corporations was expected to be about $175,000. But that is a far cry from saying that the plan contemplated the acquisition of the debentures by petitioner, utilizing Grand Rapids only as a conduit for that purpose. If such were the case and if the liquidation of Grand Rapids had been an integral part of the plan, we think respondent would be entitled to prevail in his contention that section 112(b)(6) is inapplicable. Cf. Kimbell-Diamond Milling Co., supra; Commissioner v. Ashland Oil & R. Co., supra.
However, so far as is disclosed by the evidence before us, there was no plan to liquidate Grand Rapids when petitioner, on April 26 or 27, 1945, entered into contractual arrangements to purchase the Grand Rapids stock. It must be remembered that Kahn had died on April 24 and the option held by the Eldred group was to expire on April 30. Time was therefore of the essence. The discussions and arrangements entered into at the hastily arranged meeting of April 26 or 27 appear to have been entirely on a trading and business level, without particular attention to tax considerations. To be sure, at some undisclosed time shortly thereafter, the thought occurred to Carlson that it would be advantageous to liquidate Grand Rapids once the transaction were completed, and it appears to have been assumed subsequently that such would be done. But the decision to liquidate Grand Rapids was one independently arrived at after the basic transaction had been formulated. Conceivably, Grand Rapids could have been kept alive indefinitely, notwithstanding that Davies had not planned any business activities for it.
Section 112(b)(6) is literally applicable here, assuming that the various other conditions have been satisfied; accordingly, unless the substance of the transaction is different from what appears, petitioner must prevail on this issue. Respondent does urge that the substance is different; he contends that the transaction from the very outset contemplated the acquisition of the debentures by petitioner, the liquidation of Grand Rapids being merely an intermediate step towards achieving that goal. We do not so conclude on the record before us, and therefore cannot hold that section 112(b)(6) is inapplicable, if its conditions are otherwise met.
Respondent contends, in the alternative, that the conditions of section 112(b)(6) have not been satisfied because petitioner was not, on the date of the adoption of the plan to liquidate Grand Rapids, the owner of at least 80 per cent of its stock. But, in accordance with our findings, petitioner's ownership of the Grand Rapids stock reached 80 per cent by May 12, 1945. We do not know exactly when Carlson concluded that the liquidation of Grand Rapids would be desirable or when he communicated his conclusion to Davies or any other authorized representative of petitioner. It seems likely that the liquidation of Grand Rapids had been contemplated for some time prior to August 1, 1945, and it is true that the ‘adoption of the plan of liquidation‘ need not be evidenced by formal action of the corporation or the stockholders. Cf. International Investment Corporation, 11 T.C. at 685. However, even an informal adoption of the plan to liquidate presupposes some kind of definitive determination to achieve dissolution, and, on the evidence before us, that determination was made on August 1, 1945. Accordingly, we must conclude that section 112(b)(6) has been satisfied in this respect.
A subsidiary issue presented for our consideration is whether the $7,023 which the petitioner received in compromise of its claim to the dividend declared by Grand Rapids on May 2, 1945, was realized in 1945 or 1946. Petitioner was on the accrual basis of accounting and the proper time for accrual of that amount was the time at which the dispute was resolved and the money became due petitioner. Cf. Foster Wheeler Corporation, 20 0t.c. 15; Cold Metal Process Co., 17 T.C. 916, affirmed C.A. 6, November 21, 1952. Boston Elevated Railway Co., 16 T.C. 1084, 1105, affirmed on another issue, 196 F.2d 923 (C.A. 1). The facts show that the stipulation of compromise was filed with the California court on March 2, 1946. Although the facts before us in this connection are meager, we think that the dispute was settled in 1946 and therefore hold that the $7,023 should have been included in petitioner's return for 1946, rather than for 1945.
The final issue presented is whether interest on the Grand Stores debentures was properly included in petitioner's income from September 1945 through January 1946. The issue turns on the question of when the ownership of the debentures passed from Grand Rapids to petitioner. The petitioner asserts that the ownership did not pass until F. E. Davies, on behalf of petitioner, accepted the permanent debentures from Goff in February 1946. However, the permanent debentures were issued merely in substitution for the temporary debentures, and respondent relies, in part, on the fact that when the temporary debenture was surrendered an assignment in blank appeared on the back thereof. No witness was able to recall when that assignment was executed Such assignment could have transferred ownership to petitioner at a considerably earlier time than February 1946. The burden of proof in this respect was on petitioner, and we think it has not been met. Moreover, we have found as a fact that all of the assets of Grand Rapids were either received, or taken over by petitioner prior to December 31, 1945, or were subject to its unqualified control. Petitioner has not shown any error in respect of this issue.
Decision will be entered under Rule 50.