Opinion
Docket Nos. 55517 55556 59154 59155.
1958-07-11
ESTATE OF ERNEST G. HOWES, DECEASED, EARL JOHNSON, HAROLD T. DAVIS, AND JOHN D. MERRIAM, EXECUTORS, ET AL.,1 PETITIONERS v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.
Robert W. Meserve, Esq., and William Shelmerdine, Jr., Esq., for the petitioners in Docket Nos. 55517, 59154, and 59155; Harry J. Rudick, Esq., and Mason G. Kassel, Esq., for the petitioner in Docket No. 55556. John M. Doukas, Esq., Manning K. Leiter, Esq., and Geoffrey Lanning, Esq., for the respondent.
Robert W. Meserve, Esq., and William Shelmerdine, Jr., Esq., for the petitioners in Docket Nos. 55517, 59154, and 59155; Harry J. Rudick, Esq., and Mason G. Kassel, Esq., for the petitioner in Docket No. 55556. John M. Doukas, Esq., Manning K. Leiter, Esq., and Geoffrey Lanning, Esq., for the respondent.
The shareholders of a group of affiliated corporations wished to sell their stock therein. The representative of an alumni group of New York University expressed interest in purchasing the stock of the affiliated group if all stock could be acquired. A corporation was organized with authorized capital of $1,000, whose charter provided it was organized exclusively for the benefit of the University, and that no part of its income or property could inure to the private benefit of any stockholder, director, or officer. The stockholders of the affiliated group transferred their stock to that corporation in exchange for cash of $6,042,497.52, a note in the amount of $4,531,873.14, and 20-year first mortgage bonds in the amount of $19,638,116.94 bearing 3 1/2 per cent interest giving their holders the right to elect one class of directors and one-third of another. The affiliated group thereafter was merged into the new corporation and the management of the group signed long-term management contracts. Held, the exchange by the old shareholders of their stock for cash, a note and bonds of the new corporation constituted the sale of a capital asset. Held, further, the new corporation was exempt from income tax under section 101(6) of the 1939 Code and section 302(d) of the Revenue Act of 1950 as amended for its taxable periods ended June 30, 1948 through 1951.
TIETJENS, Judge:
These consolidated proceedings involve deficiencies and claimed overpayments of income tax for the taxable periods set forth below:
+-----------------------------------------------------------------------------+ ¦Docket¦Calendar¦Petitioner ¦Deficiency ¦Claimed ¦ +------+--------+---------------------------------+-------------+-------------¦ ¦No. ¦year ¦ ¦ ¦overpayment ¦ +------+--------+---------------------------------+-------------+-------------¦ ¦55517 ¦1947 ¦Estate of Ernest G. Howes, ¦$1,845,936.20¦ ¦ ¦ ¦ ¦Deceased, et al ¦ ¦ ¦ +------+--------+---------------------------------+-------------+-------------¦ ¦59154 ¦1947 ¦Edith E. Boyer ¦143,580.48 ¦ ¦ +------+--------+---------------------------------+-------------+-------------¦ ¦59155 ¦1947 ¦Everett W. Pervere ¦263,977.94 ¦ ¦ +------+--------+---------------------------------+-------------+-------------¦ ¦ ¦( 1948 ¦Howes Leather Company, Inc ¦261,163.51 ¦$1,777,427.23¦ ¦ ¦1 ¦ ¦ ¦ ¦ +------+--------+---------------------------------+-------------+-------------¦ ¦ ¦( 1949 ¦Howes Leather Company, Inc ¦285,866.13 ¦410,270.18 ¦ ¦ ¦1 ¦ ¦ ¦ ¦ +------+--------+---------------------------------+-------------+-------------¦ ¦55556 ¦( 1950 ¦Howes Leather Company, Inc ¦289,509.40 ¦276,520.45 ¦ ¦ ¦1 ¦ ¦ ¦ ¦ +------+--------+---------------------------------+-------------+-------------¦ ¦ ¦( 1951 ¦Howes Leather Company, Inc ¦1,081,812.36 ¦ ¦ ¦ ¦1 ¦ ¦ ¦ ¦ +-----------------------------------------------------------------------------+
The issues are: (1) Whether the exchange by petitioners of their stock in an affiliated group of corporations for cash, a note and bonds of the corporate petitioner, into which the affiliated group was merged, constituted the sale of a capital asset, or was it lacking in substance so as to subject the cash received to taxation either as ordinary business income, or as a dividend, or as a distribution in the course of a section 112(g)(1)(A) reorganization; (2) in the event the transaction is held not to constitute a sale, what were the earnings and profits of the affiliated group as of the date of the exchange; (3) whether the statute of limitations bars assessment and collection of the deficiency in Docket No. 55517; (4) whether the Howes Leather Company, Inc., was exempt from income tax during the taxable periods in issue under section 101(6) of the 1939 Code as amended; and (5) whether the amounts claimed as deductions for interest on bonds issued by the corporate petitioner were deductible under section 23(b) of the 1939 Code.
Other issues raised by the pleadings have been conceded.
Some of the facts were stipulated.
FINDINGS OF FACT.
The stipulated facts are so found and are incorporated herein by this reference.
Ernest G. Howes (hereinafter referred to as the decedent) died October 7, 1951. The executors were duly qualified and appointed for his estate. During 1947, the decedent resided in Cohasset, Massachusetts, and filed his Federal income tax return for that year on January 15, 1948, on the cash basis with the former collector of internal revenue for the district of Massachusetts.
Edith E. Boyer (hereinafter referred to as Boyer) resided in Braintree, Massachusetts, during 1947, and filed her Federal income tax return for that year on the cash basis with the former collector of internal revenue for the district of Massachusetts.
Everett W. Pervere (hereinafter referred to as Pervere) resided in North Andover, Massachusetts, during 1947, and filed his Federal income tax return for that year on the cash basis with the former collector of internal revenue for the district of Massachusetts.
Howes Leather Company, Inc. (hereinafter referred to as the new company), was organized July 15, 1947, under the laws of the State of Delaware. Since August 12, 1947, it maintained its principal place of business at Boston, Massachusetts. It filed its Federal income tax returns for the taxable periods ended June 30, 1948, 1949, 1950, and 1951, with the former collector of internal revenue for the district of Massachusetts.
In 1895, decedent went into business as a leather broker. By 1905, he had been joined in the business by his four brothers. In 1914, the assets of the business were transferred to Howes Brothers Company (hereinafter referred to as Brothers), a Massachusetts corporation. In 1917, Howes Brothers Hide Company (hereinafter referred to as Hide) was incorporated under the laws of Maine. Long prior to August 12, 1947, Hide had become a personal holding company. From its inception, the business expanded from brokerage and jobbing operations to include the tanning and cutting of leather. The tanning and cutting operations were conducted by a group of corporations affiliated with, or subsidiary to, Brothers and Hide. Operating control was centered in Brothers, which functioned as a commission merchant in buying hides and selling the leather of the group. As of July 16, 1947, the group was composed of 11 corporations of which 6 were engaged in the tanning of leather, 3 in the cutting of leather, 1 in the manufacture of tanning extract, and 1 in research relating to tanning processes. These corporations and their places of business were as set forth below.
+----------------------------------------------------------------------+ ¦Operation ¦Corporation ¦Place of Business¦ +-------------------+--------------------------------+-----------------¦ ¦ ¦(Michigan Tanning and Extract Co¦Michigan. ¦ +-------------------+--------------------------------+-----------------¦ ¦ ¦(W. W. Mooney and Sons Corp ¦Indiana. ¦ +-------------------+--------------------------------+-----------------¦ ¦Tanneries ¦(Franklin Tanning Co ¦Massachusetts. ¦ +-------------------+--------------------------------+-----------------¦ ¦ ¦(Mount Jewett Tanning Co ¦Pennsylvania. ¦ +-------------------+--------------------------------+-----------------¦ ¦ ¦(West Hickory Tanning Co ¦Pennsylvania. ¦ +-------------------+--------------------------------+-----------------¦ ¦ ¦(Pocahontas Tanning Co ¦West Virginia. ¦ +-------------------+--------------------------------+-----------------¦ ¦ ¦ ¦ ¦ +-------------------+--------------------------------+-----------------¦ ¦ ¦(Tanners Cut Sole Co ¦Maine. ¦ +-------------------+--------------------------------+-----------------¦ ¦Cutting Companies ¦(J. D. Neilson Co ¦Illinois. ¦ +-------------------+--------------------------------+-----------------¦ ¦ ¦(Stephenson & Osborne, Inc ¦Massachusetts. ¦ +-------------------+--------------------------------+-----------------¦ ¦Extract Manufacture¦Gardner Extract Co ¦Virginia. ¦ +-------------------+--------------------------------+-----------------¦ ¦Research Company ¦Leather Institute, Inc ¦Pennsylvania. ¦ +----------------------------------------------------------------------+
On July 16, 1947, decedent, his two surviving brothers, Henry S. and Samuel C. Howes, and their relatives owned a controlling interest in Brothers and Hide. Those corporations owned in excess of 50 per cent of the common stock of Michigan Tanning and Extract, W. W. Mooney and Sons, and Franklin Tanning. The stock of those three companies not owned by Hide or Brothers was owned by employees, retired employees or beneficiaries of deceased employees of one or more of the affiliated group. W. W. Mooney and Sons owned 98 per cent of Mount Jewett's common stock. Brothers owned a minority interest in the common stock of West Hickory Tanning and Pocahontas Tanning. The majority interests in those two corporations were owned by stockholders unrelated to the Howeses. Pocahontas Tanning owned all the outstanding common stock of Gardner Extract. The tanneries owned, in varying percentages, all of the common stock of Tanners Cut Sole, which owned all of the common stock of J. D. Neilson, Stephenson & Osborne, and Leather Institute.
For a number of years prior to July 16, 1947, the management of the group of decedent, Samuel C. and Henry S. Howes, John Schanzle, Pervere, and Leo F. Ready. Schanzle and Ready had spent their entire careers with the group, and were not related to the Howeses. Pervere was decedent's stepson.
In 1945, decedent and his brothers, Henry S. and Samuel C. Howes, were elderly men. Most of their wealth was invested in the affiliated group, leaving them with insufficient resources with which to meet anticipated estate taxes. Numerous conferences were held with their attorney, accountant, and representatives of the First Boston Corporation to devise way and means of diversifying the family investment. In 1946, as a result of those conferences, the Howeses decided to sell all of their stock in the affiliated group. First Boston was instructed to find a purchaser for that stock.
In April 1947, Howard P. Richardson of First Boston contacted John Gerdes, an alumnus and General Counsel of New York University, informing him of the Howeses' wish to sell their interest in the affiliated group. Richardson suggested the sale might proceed on a basis which would enable Gerdes to acquire that stock for the benefit of the University. On April 25, Gerdes, Richardson, and counsel for the Howeses met in New York to discuss the matter further. Thereafter, during May, June, and July of 1947, further conferences were held. Gerdes explained that he represented an alumni group of New York University; that his purpose in purchasing the affiliated group would be to benefit the University; that should the acquisition be made, it was hoped the University would have the benefit of the earnings of the enterprise exempt from Federal taxation. Gerdes stated the ultimate purchase price would have to be reasonable without regard to any such exemption; that payment thereof would have to extend over a number of years; that all the stock of the affiliated group would have to be available for purchase; and that, since the purchaser was in no position to supply the required technical management, the management would have to agree to sign long-term contracts to remain as employees. He further acquainted the Howeses with the tax-exempt status of the Ramsey Corporation of St. Louis, Missouri, which had been similarly organized for the benefit of the University.
In the latter part of May, negotiations temporarily halted due to differences as to price, terms of payment, and inability to deliver all the stock of the affiliated group. First, it developed that all of the stock of the Pocahontas Tanning Company could not be acquired due to the illness of its president and substantial stockholder. Secondly, Gerdes insisted on a price based upon the market value of the group's assets or upon its earnings record plus its asset value, whichever was lower, while the Howeses insisted that the price be measured solely by the market value of the assets. Moreover, since a substantial portion of the purchase price would be payable over a number of years, the Howeses were concerned over the protection to be afforded their position as creditors. On June 4, negotiations were reopened, and suggestions made for a resolution of the differences. Thereafter, Henry S. Howes, Pervere, and others visited the Ramsey plant in St. Louis to observe its operations.
By late June of 1947, certain understandings, subject to final agreement, had been reached. Gerdes and his associates were to form a corporation under Delaware law for the benefit of the University. To give additional security to the bondholders, its charter was to provide for three classes of directors; one to be elected by stockholders; one to be elected by bondholders; and one, consisting of three members, to be elected one-third by the stockholders, one-third by the bondholders, and one-third by joint action. Any stockholders of the affiliated group who desired were to agree to sell all of their stock in the affiliated group to the new corporation. That corporation, however, was not to be obliged to purchase unless the individual holders of all of the stock of the group, except Pocahontas, agreed to sell. The price of the stock was to equal the market value of the assets of the affiliated group attributable to such stock, less liabilities, but not to exceed $30,300,000. Market value of the assets was to be based upon an appraisal of plants and equipment; goodwill of $500,000; inventory valued at market as of June 30, 1947; and the value agreed upon by Gerdes and Schanzle for the remaining assets. The purchase price was to be paid: 20 per cent by closing, 15 per cent during 1948, and the balance to be evidenced by first mortgage bonds, payable over a term of years, bearing interest at the rate of 3 1/2 per cent. The purchaser was to be protected from unknown liabilities by a deposit in escrow of a portion of those bonds. Thereafter the parties concerned themselves with the drafting of an agreement to embody those understandings. Matters relating to the organization of the new company were left to the purchaser, except that the sellers concerned themselves with those portions of its charter and bylaws affecting their position as security holders. These latter provisions, which granted certain voting rights to the bondholders, were inserted in the agreement at the insistence of the Howeses for the purpose of securing the purchase price.
During late June and early July 1947, conferences were held with the First National Bank of Boston, to negotiate a loan for the new corporation, to enable the latter to meet the obligations which were to be incurred upon the purchase of the stock of the affiliated group. As a result, a loan of $6,200,000 was approved, repayable within a few months. It was understood that two-thirds of the loan would remain on deposit with the bank.
On July 15, 1947 Howes Leather Company, Inc., was organized by Gerdes and his associates. Its authorized capital stock was $1,000, divided into 10 shares. It was authorized to issue $30,000,000 of first mortgage 20-year bonds bearing interest at the rate of 3 1/2 per cent per annum. Its charter provided that it was organized exclusively for charitable or educational purposes; that it was incorporated solely for the benefit of New York University; that no part of its income or property could inure to the private benefit of any stockholder, director, or officer; that it was not to engage in propaganda or otherwise attempt to influence legislation; that it was to distribute to New York University such part of its property and net income as its directors should determine; that, in the event of liquidation, its assets, after satisfaction of creditors, were to be distributed to New York University; and that its certificate of incorporation could be amended by a majority of its stock and bond holders, provided such amendment should not divert any of its income or property, after satisfaction of creditors, to any other than New York University. It had broad powers to engage in business and to acquire and hold property. It had three classes of directors. The class A and one-third of the class C directors were to be elected by the stockholders; the class B and one-third of the class C directors were to be elected by the bondholders; the remaining one-third of the class C directors were to be elected by a majority of the stockholders together with a majority of the bondholders. A majority of the class A and class B directors was necessary to constitute a quorum. Shareholders were to elect the corporate officers.
Excluding Pocahontas Tanning, there were 24 individual stockholders of the affiliated group. On July 16, 1947, 17 of those shareholders, including decedent, Boyer, and Pervere, met in Boston with Gerdes, counsel for the Howeses, and a representative of First Boston. Terms of the agreement were explained. The stockholders present then signed it as sellers, and Gerdes signed on behalf of the new company as the purchaser. The agreement embodied the understandings theretofore reached. By July 23, all the shareholders of the affiliated group, excluding Pocahontas, other than the corporation themselves, had signed that agreement.
From the outset, Gerdes hoped to accomplish the transfer of assets from the affiliated group to the new company through the means of statutory merger. However, it was not until after July 23, 1947, that he was satisfied such a transaction could be effected under the laws of the various jurisdictions within which the new company would operate.
On August 12, 1947, pursuant to the agreement the following occurred. The new company received a $6,200,000 loan from the First National Bank of Boston. The sellers delivered to the new company their stock certificate together with the resignations of the officers and directors of the affiliated group except Pocahontas. New share certificates for the stock of the affiliated group were issued to the new company. The new company caused its nominees to be elected officers and directors of the corporations of the affiliated group. An indenture of trust and mortgage was executed by the new company to Old Colony Trust Company, Boston, to secure its authorized $30,000,000 principal amount of first mortgage 20-year bonds, the property covered being the stock and property of the affiliated group then or thereafter acquired by the new company, with certain exceptions. The new company paid $6,042,497.52 in cash to Old Colony for the benefit of the sellers, and delivered to Old Colony its promissory note payable in the amount of $4,531,873.14, due January 15, 1948, to be collected and paid over to the sellers as provided in the agreement, and further delivered to Old Colony a single first mortgage 20-year bond in the amount of $19,638,116.94 representing the balance of the tentative purchase price of $30,212,487.60. Old Colony then issued checks to the sellers for the amount due each of them. Pursuant to the agreement, the respective interests of the sellers in the bond and note were to be determined after an audit of the assets and liabilities of the various corporations in the affiliated group. Thereafter, Brothers, Hide, and the tanneries, except Pocahontas, were merged into the new company. No change was effected in the capital structure of the new company as a result of that merger. Decedent, Henry S. and Samuel C. Howes, Pervere, Schanzle, and Ready signed 20-year employment contracts with the new company at salaries which are stipulated to be reasonable. They were then elected class B directors of the new company. The six class A directors ultimately selected were all business and professional men interested in New York University. Gerdes was selected as one of the three class C directors, representing New York University, Arthur E. Whittemore was selected as the class C representative of the bondholders, and Joseph P. Spang, Jr., who had no prior connection with any of the parties involved, was selected as the third class C director.
Following their election as class B directors, decedent, Henry S. and Samuel C. Howes, Pervere, and Ready were elected vice presidents of the new company. The other officers selected were Dudley L. Miller, president; Gerdes, treasurer; and Winthrop A. Short, secretary.
On July 10, 1947, the president of Pocahontas died. During the latter part of August and early part of September 1947, negotiations took place between the new company and a majority of the Pocahontas shareholders looking toward the acquisition of the latter's stock. The Pocahontas shareholders agreed to a sale of their stock for bonds and short-term notes, and on September 19, 1947, Pocahontas was merged into the new company.
On October 31, 1947, the cutting companies were formally merged into the new company. The new company continued to hold the stock of Gardner Extract Co., acquired on the Pocahontas merger, and the stock of Leather Institute, Inc., acquired on the merger of the cutting companies.
On October 15, 1947, the shareholders of the new company entered into a voting trust agreement for the benefit of New York University. The purpose of that trust was to provide against possible inconvenience in the event of a stockholder's death.
The final authority with respect to the conduct of the new company's business rested in its board of directors, scheduled to meet four times a year and specially when needed. A committee on operations was provided for to act in the interim. That committee was scheduled to meet monthly, and specially when required. As first organized it consisted of decedent, Henry S. and Samuel C. Howes, Pervere, Schanzle, Ready, and Gerdes. Among other things, it was authorized to manage the manufacturing and selling operations of the new company. The first meeting of that committee was held on October 23, 1947, at which time it was resolved that any action approved by any four members of the committee should constitute action by the committee.
The bonds issued pursuant to the July 16 agreement and pursuant to the Pocahontas merger, were identical in form and substance. They matured on August 12, 1967, bore interest at 3 1/2 per cent per annum, and were secured by a mortgage of the new company's fixed assets, the stocks of the affiliated group transferred to the new company on August 12, 1947, and by its trade-marks and trade names. In the event of default in principal or interest, payment was to be accelerated, and the property subject to the mortgage seized. The bonds were prior to all other claims against the mortgaged property, and with respect to other property, were on a parity with all other creditor claims. It was provided that 40 per cent of consolidated net profits was to be annually applied to a sinking fund for their retirement. Sinking fund payments in the following amounts were made on the dates indicated:
+---------------------------------------------------+ ¦Year ending June 30 ¦Date of payment ¦Amount ¦ +---------------------+-----------------+-----------¦ ¦1948 ¦Aug. 12, 1949 ¦$987,364.50¦ +---------------------+-----------------+-----------¦ ¦1949 ¦Aug. 12, 1950 ¦172,485.92 ¦ +---------------------+-----------------+-----------¦ ¦1950 ¦Aug. 12, 1951 ¦60,063.36 ¦ +---------------------+-----------------+-----------¦ ¦1951 ¦Aug. 12, 1952 ¦233,069.46 ¦ +---------------------------------------------------+
The balance of bonds outstanding as of August 12, 1952, was $21,207,077.01. No principal payments for years subsequent to 1951 have been made. All payments of interest have been made when due.
On August 12, 1952, Henry S. Howes sold approximately $1,500,000 in face amount of those bonds at 30 per cent of their face value. Since the new company had determined not to purchase any of its bonds on the open market, it did not participate in that transaction.
The new company has made distributions to New York University or its affiliates in the following amounts:
+-----------------------+ ¦Date ¦Amount ¦ +--------------+--------¦ ¦June 28, 1948 ¦$200,000¦ +--------------+--------¦ ¦June 27, 1949 ¦100,000 ¦ +--------------+--------¦ ¦June 26, 1950 ¦50,000 ¦ +--------------+--------¦ ¦June 28, 1951 ¦50,000 ¦ +--------------+--------¦ ¦Total ¦400,000 ¦ +-----------------------+
No distributions have been made since 1951. On June 17, 1948, the directors of the new company voted to pay a further amount of $700,000 to the University should the new company be held exempt from tax for its taxable year ended June 30, 1948.
In 1947, the affiliated group was a substantial factor in the production of sole leather in the United States. For the 10-year period immediately preceding July 16, 1947, it had produced on the average of 15 to 20 per cent of all the sole leather produced in this country. It had built up a fine reputation for its product. Its organization was recognized throughout the industry as energetic and resourceful. In addition to its top management, it had a large group of younger executives with recognized ability to carry on the management of the enterprise. Its consolidated sales, after exclusion of intercompany sales, and its consolidated profits, before and after renegotiation and Federal taxes, for the years 1937 through 1946, were as follows:
+------------------------------------------------+ ¦ ¦ ¦Profits before¦Profits after¦ +----+--------------+--------------+-------------¦ ¦Year¦Sales ¦renegotiation ¦renegotiation¦ +----+--------------+--------------+-------------¦ ¦ ¦ ¦and taxes ¦and taxes ¦ +----+--------------+--------------+-------------¦ ¦1937¦$15,281,448.95¦$1,024,310.45 ¦$774,252.57 ¦ +----+--------------+--------------+-------------¦ ¦1938¦12,402,937.09 ¦920,927.76 ¦756,298.94 ¦ +----+--------------+--------------+-------------¦ ¦1939¦13,012,364.13 ¦1,054,876.82 ¦848,455.94 ¦ +----+--------------+--------------+-------------¦ ¦1940¦13,972,852.34 ¦876,699.73 ¦648,168.16 ¦ +----+--------------+--------------+-------------¦ ¦1941¦26,382,360.97 ¦3,747,019.35 ¦1,793,693.13 ¦ +----+--------------+--------------+-------------¦ ¦1942¦28,396,846.72 ¦6,275,249.47 ¦1,665,744.79 ¦ +----+--------------+--------------+-------------¦ ¦1943¦23,724,002.45 ¦3,829,848.57 ¦1,285,436.02 ¦ +----+--------------+--------------+-------------¦ ¦1944¦25,458,606.58 ¦3,559,055.88 ¦1,188,297.64 ¦ +----+--------------+--------------+-------------¦ ¦1945¦24,160,759.85 ¦2,418,897.43 ¦1,006,217.88 ¦ +----+--------------+--------------+-------------¦ ¦1946¦41,243,572.80 ¦11,584,457.91 ¦7,161,797.29 ¦ +------------------------------------------------+
Set forth below are the undistributed earnings of each of the corporations in the affiliated group accumulated since February 28, 1913, as of August 12, 1947.
+------------------------------------------------------+ ¦ ¦Undistributed ¦ +-------------------------------+----------------------¦ ¦Corporation ¦earnings and profits ¦ +-------------------------------+----------------------¦ ¦ ¦ ¦ +-------------------------------+----------------------¦ ¦Howes Brothers Co ¦$3,013,708.58 ¦ +-------------------------------+----------------------¦ ¦Howes Brothers Hide Co ¦(171,988.29) ¦ +-------------------------------+----------------------¦ ¦West Hickory Tanning Co ¦1,005,439.62 ¦ +-------------------------------+----------------------¦ ¦Pocahontas Tanning Co ¦1,310,346.94 ¦ +-------------------------------+----------------------¦ ¦W. W. Mooney and Sons Corp ¦1,565,523.73 ¦ +-------------------------------+----------------------¦ ¦Mount Jewett Tanning Co ¦1,326,372.85 ¦ +-------------------------------+----------------------¦ ¦Franklin Tanning Co ¦2,336,655.18 ¦ +-------------------------------+----------------------¦ ¦Michigan Tanning and Extract Co¦2,989,331.99 ¦ +-------------------------------+----------------------¦ ¦Tanner's Cut Sole Co ¦1,868,517.60 ¦ +-------------------------------+----------------------¦ ¦J. D. Neilson Co ¦240,153.36 ¦ +-------------------------------+----------------------¦ ¦Stephenson & Osborne, Inc ¦278,976.88 ¦ +-------------------------------+----------------------¦ ¦Gardner Extract Co ¦23,606.42 ¦ +-------------------------------+----------------------¦ ¦Leather Institute, Inc ¦(1) ¦ +-------------------------------+----------------------¦ ¦ ¦ ¦ +------------------------------------------------------+
Fiscal period ended June 30
1None.
In accordance with the agreement, an audit report was prepared based on the balance sheets of the affiliated group as of June 30, 1947. Set forth below is a summary of the net worth of the group disclosed in that report.
+----------------------------------------+ ¦Assets ¦ +----------------------------------------¦ ¦ ¦ ¦ +-------------------------+--------------¦ ¦Cash 1 ¦$13,484,332.47¦ +-------------------------+--------------¦ ¦Receivables ¦3,221,210.92 ¦ +-------------------------+--------------¦ ¦Inventories ¦15,407,348.36 ¦ +-------------------------+--------------¦ ¦Investments ¦3,920,590.61 ¦ +-------------------------+--------------¦ ¦Real estate and equipment¦8,106,249.93 ¦ +-------------------------+--------------¦ ¦Goodwill ¦500,000 ¦ +-------------------------+--------------¦ ¦Deferred charges ¦194,074.43 ¦ +-------------------------+--------------¦ ¦Other assets ¦1,500.00 ¦ +-------------------------+--------------¦ ¦ ¦ ¦ +-------------------------+--------------¦ ¦Total assets ¦44,835,306.72 ¦ +-------------------------+--------------¦ ¦ ¦ ¦ +----------------------------------------+
Liabilities and Net Worth Payables $2,819,165,81 Taxes 4,965,486.49 Accrued liabilities 322,084.58 Reserved for retirement of preferred stock 411,800.00 Total liabilities 8,518,536.88 Net worth 1 36,316,769.84 1Cash and net worth adjusted to reflect $87,512.40 expended on August 6, 1947, to retire 120 shares of common stock of Hide.
That report was not submitted until November 24, 1947. Prior to audit, all trade accounts receivable, representing some $2,428,585.46, had been collected. Inventory was valued at market as of June 30, 1947, based on a physical count. The real estate and equipment values were principally based upon reports of the American Appraisal Company which had physically inspected the properties of the group in 1942 and 1943. Those appraisals had been adjusted for additions and replacements occurring in later years, which, except for Pocahontas and West Hickory, were determined from company records. Additions and replacements of those two companies were verified by inspection.
For each of the years 1931 through 1941, the percentage of shoes made with leather soles to the total shoe production in this country exceeded 73 per cent. During the period 1942 through 1945, wartime needs brought about a shortage of leather for civilian use. That shortage was partially alleviated through the use of substitutes, which proved unsatisfactory. In 1946, when leather once more became plentiful, it displaced substitutes and temporarily regained its prewar prominence in the civilian market.
Neolite, a substitute, was first marketed in November 1944. By 1946 its production had substantially increased. Subsequent to 1948, advances in the field of substitutes had had a serious effect on the sole leather industry. Set forth below are the annual percentages of shoes made with leather soles to the total shoes produced in this country for the years 1949 through 1956:
+--------------------+ ¦Year ¦Percentage ¦ +------+-------------¦ ¦1949 ¦56.5 ¦ +------+-------------¦ ¦1950 ¦51.3 ¦ +------+-------------¦ ¦1951 ¦44.5 ¦ +------+-------------¦ ¦1952 ¦41.2 ¦ +------+-------------¦ ¦1953 ¦40.3 ¦ +------+-------------¦ ¦1954 ¦38.0 ¦ +------+-------------¦ ¦1955 ¦37.4 ¦ +------+-------------¦ ¦1956 ¦35.6 ¦ +--------------------+
During that period, a number of sole leather firms went out of business. The influence of substitutes on upper leather, which is used in the sides and tops of shoes was negligible. In order to counteract the inroads suffered by virtue of the increased use of substitutes, the new company, during 1949 and later years, broadened its scope of activities to include the production of upper leather, acquiring two upper leather plants at a cost of between two and three million dollars.
The aggregate purchase price contained in the agreement was $30,212,487.60, exclusive of the stock of Pocahontas. If that stock had been included the price would have been $34,866,872.24. In arriving at those amounts Gerdes analyzed the consolidated balance sheets of the affiliated group for a 10-year period prior to 1947 in the light of the history, the prospective earning capacity of the group, and the estimated value of its assets. He estimated that cash and inventory to the extent of some $12,250,000 could be withdrawn from the enterprise without affecting its earning capacity.
On schedules attached to his 1947 return, decedent set forth that he had sold his stock for a contract price of $7,435,506.24, that his basis for that stock was $892,763.78, that costs of sale were $74,647.77, and that he realized a net gain of $6,468,094.69. Electing to report the sale on the installment basis he returned $1,289,444.69 of the $1,482,249.98 received in that year as an installment payment, applying the alternative tax rate.
On their 1947 returns Boyer and Pervere reported the exchange of their stock in the affiliated group as a sale, and the gain attributable thereto as a long-term capital gain. They reported the cash actually received during 1947 on the installment basis.
Respondent determined that the individual petitioners had exchanged their stock in the affiliated group in a partially nontaxable reorganization, and that the cash and notes which they received represented a taxable dividend under section 112(c)(2). B y amended answer he contends that the cash and notes received constituted gross income taxable at ordinary income rates or, in the alternative, taxable dividends under section 115(a).
The new company filed a claim for exemption under section 101(6) of the Internal Revenue Code of 1939 for the taxable periods ending June 30, 1948, 1949, and 1951. On its returns for those periods it claimed deductions for interest accrued on its bonds.
Respondent determined the new company was not exempt from Federal income tax during the years here in issue, and further determined that the amounts deducted as interest constituted dividends on capital stock and hence were nondeductible.
The decedent's return for 1947 was timely filed. The deficiency notice with respect thereto was mailed to his executors on September 20, 1954. His executors executed waivers extending the time for assessment and collection of that deficiency to June 30, 1955, only if there had been an omission by decedent from gross income of an amount properly includible therein in excess of 25 per cent of the amount of gross income which was stated on his return.
OPINION.
Simply stated the issue is whether the exchange of the stock of the affiliated group for cash, a note and bonds of the new company constituted a sale. Respondent maintains that it did not. In support of his position he argues three alternatives.
First, respondent contends the amounts received during 1947 by the individual petitioners represented gain from the operation of the new company taxable under section 22(a), and not as proceeds of a sale. That is so he maintains because the alleged sellers retained such control of the business that the existence of a sale was totally negated. He argues that the bonds were in fact the equivalent of preferred stock issued solely to enable the withdrawal of surplus and earnings as capital gains, and further argues that the tax-exempt status of the new company was claimed merely to increase those earnings and profits.
Respondent's second argument is that the entire transactions should be disregarded as lacking in bona fides, in the light of the control retained by the sellers, the payment of what he maintains was an inflated sales price, the tax avoidance motives giving rise to the entire transaction, and what he terms was the diversion of charitable funds to private interests.