Opinion
Docket No. 5426-67.
1970-03-31
JOHN H. RICKEY, AND LORRAINE C. RICKEY, PETITIONERS v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT
Paul E. Anderson, C. Henry Veit, and William E. Anderson, Jr., for the petitioners. Martin A. Schainbaum and Edward B. Simpson, for the respondent.
Paul E. Anderson, C. Henry Veit, and William E. Anderson, Jr., for the petitioners. Martin A. Schainbaum and Edward B. Simpson, for the respondent.
Held: 1. Petitioners may not report the gain realized from the sale of stock on the installment method of accounting since the payments received in the year of sale exceeded 30 percent of the selling price. Sec. 453(b)(2)(A)(ii).
2. Petitioners are not entitled to ordinary-loss treatment on the worthlessness of certain stock since the stock was not offered pursuant to a written plan within the intendment of sec. 1244.
DRENNEN, Judge:
Respondent determined deficiencies in petitioners' income tax for the taxable years 1962 and 1964 of $224,996.07 and $12,173.94, respectively.
Due to concessions by both parties, the issues remaining for our decision are: (1) Whether petitioners are entitled to report the gain from the sale in the year 1962 of stock of two corporations on the installment method of accounting as provided by section 453, I.R.C. 1954;
and (2) whether petitioners are entitled to ordinary-loss treatment under section 1244 on a portion of the loss sustained by petitioners as a result of the liquidation and dissolution of Rick's Swiss Chalet, Inc.
All statutory references are to the Internal Revenue Code of 1954, as amended.
FINDINGS OF FACT
Some of the facts have been stipulated and are so found.
Petitioners are husband and wife and resided in Palo Alto, Calif., at the time their petition in this case was filed. They filed their joint Federal income tax return for the years 1962, 1963, and 1964 with the district director, San Francisco, Calif. The returns were prepared on the calendar year cash basis method of accounting.
Petitioner John H. Rickey will hereinafter be referred to as petitioner.
Issue 1. Use of Installment Method
On September 8, 1947, petitioner incorporated a California corporation under the name of Rickey Enterprises (hereinafter referred to as Enterprises). Enterprises owned and operated a restaurant known as Rickey's at El Camino Real and West Charleston Road in Palo Alto. Sometime thereafter, but prior to the years here involved, Enterprises bought a bar and restaurant in the Southern Pacific Depot at Third and Townsend Streets in San Francisco, known as Rickey's Rendezvous Room. In addition, Enterprises acquired 90 out of 100 shares of the capital stock of Dinah's Shack, a corporation operating a restaurant located adjacent to Rickey's in Palo Alto. All of the stock of Enterprises was at all times material hereto owned by petitioner.
Rickey's Studio Inn Hotel (hereinafter referred to as Studio Inn) was incorporated as a California corporation on June 3, 1951. Petitioner was the owner of 50 percent of the stock with the other 50 percent being owed by two brothers, Alfred L. Marsten and Lewis A. Marsten, individually and as custodian for Alfred Patrick Marsten, a minor. Studio Inn constructed and operated a large motel at El Camino Real and West Charleston Road, Palo Alto, adjacent to the restaurant operated by Enterprises. Studio Inn later acquired and owned a restaurant named Rancho Rafael located in Marin County, north of San Francisco.
In 1962, negotiations commenced between petitioner and Hyatt Corporation of America (hereinafter referred to as Hyatt) for the purpose of selling the restaurant owned by Enterprises in Palo Alto and the motel owned by Studio Inn. The substance of the negotiations and the intent of the parties was set forth in a letter from petitioner to Hyatt dated March 12, 1962. The letter indicated that a purchase of assets was comtemplated, but that a purchase of stock might be necessary.
On March 31, 1962, petitioner and the Marstens, as the shareholders of Studio Inn, and petitioner as the shareholder of Enterprises, entered into a sales contract with Hyatt wherein Hyatt agreed to purchase all of petitioner's and the Marstens' stock in Studio Inn and all of petitioner's stock in Enterprise for the basic sum of $3,600,000. The $3,600,000 was deemed paid to the extent of $1,400,000 as a result of the continuation of the mortgage indebtedness of both corporations to Equitable Life Assurance Society. The balance of the basic purchase price, to wit, $2,200,000, was allocated in the following manner: $1,852,000 to the acquisition of stock of Studio Inn and $348,000 to the acquisition of the stock of Enterprises.
The provisions of the contract setting forth the term of payment of the purchase price are as follows:
(2-b) Of said sum * * * to be paid for said hotel company stock, $852,000 is to be evidenced by promissory notes * * * to be executed and delivered by Hyatt to hotel stockholders each for his respective pro-rata amount * * * . The balance of said basic price is to be paid in cash— $250,000 at the time of closing; and the difference between said sum and 29% of the sales price adjusted as provided in Paragraphs 5 and 15 hereof within thirty (30) days after completion of the audit hereinafter provided for, and the balance as so adjusted on January 2, 1963. Of said sum * * * to be paid for said restaurant company stock, $148,000 is to be evidenced by a promissory note * * * to be executed and delivered by Hyatt to Rickey, * * * and the balance of said basic price is to be paid in cash as follows: $100,000 at the time of closing; and the difference between said sum and 29% of the sales price adjusted as provided in Paragraphs 5 and 15 hereof within thirty (30) days after completion of the audit hereinafter provided for, and the balance as so adjusted on January 2, 1963.
Paragraph 5 of the sales contract set forth the basis upon which the basic purchase price was negotiated and fixed and provided for adjustments to be made in the basic purchase price, if necessary. The pertinent provisions of paragraph 5 in this respect are set forth below:
(5) Anything herein to the contrary notwithstanding, it is understood and agreed by the parties that the purchase price to be paid for said shares of stock was negotiated and fixed upon the basis that the assets of each company at the time of closing, described in Exhibit E, would equal the liabilities of each aggregate principal amount of $1,400,000. Therefore, said purchase price shall be increased by the amounts, if any, that the principal of said indebtedness owed to Equitable is less, at the time of closing, than $1,400,000, and by the amount, if any, that the assets of either or said companies as listed in Exhibit E exceed the liabilities of said companies, other than said indebtedness owed to Equitable.
(5-a) Conversely, said purchase price shall be decreased by the amounts, if any, by which at the time of closing said indebtedness to Equitable exceeds $1,400,000.00 (excluding the amount of any additional borrowings made by said companies from Equitable with the prior written consent of Hyatt) and the liabilities of said companies other than said indebtedness to Equitable exceed the same assets of said companies as listed on Exhibit E.
Exhibit E referred to in paragraph (5) and subparagraphs thereunder is set forth below:
+---------+ ¦EXHIBIT E¦ +---------¦ ¦ ¦ ¦ +---------+
OTHER ASSETS 1. Cash on hand and in banks. 2. Foods and beverages. 3. All merchandise held for sale in liquor store which Hyatt alects [sic] to purchase (at cost or market value, whichever is lower). 4. The following prepared expenses: Peninsula Manufacturer's Association California Burglar Alarm California State Auto Association Property Taxes Palo Alto Chamber of Commerce Prepaid Licenses, Alcoholic Beverages San Francisco Convention Bureau Convention Tourist Bureau Prepaid Licenses, Auto and Truck Licenses on vehicles owned by Hyatt 5. Accounts and Notes Receivable.
The terms of the contract provided that the value of the assets listed in Exhibit E and the amount of any increase or decrease in the purchase price of the stock was to be determined by an audit of the affairs of both corporations as of March 31, 1962.
The formal closing of the sale of stock in the two corporations occurred on April 2, 1962, at which time the shareholder of record of all of the stock in both corporations became Hyatt. On that date the petitioner received $125,000 in cash as the downpayment for his stock in Studio Inn and $100,000 as the downpayment for his stock in Enterprises. Also, pursuant to the terms of the contract, petitioner received promissory notes in the amount of $426,000 and $148,000 for his stock in Studio Inn and Enterprises, respectively. Simultaneous with closing, Hyatt liquidated both corporations.
Pursuant to the provisions of the contract, Harris, Kerr, Forster & Co. made an audit of Studio Inn and Enterprises for the 9-month period ended March 31, 1962. The audit was conducted under the direction of Louis Forman, head of the tax department and a partner of Harris, Kerr, Forster & Co. Audit reports of the financial condition of Studio Inn and Enterprises as of March 31, 1962, were submitted on June 26, 1962, and June 27, 1962, respectively.
Prior to the submission of the audit reports, Forman sent a letter to Hyatt and petitioner dated June 22, 1962, wherein three schedules were attached setting forth amounts involved in the sale of Studio Inn and Enterprises, including the determination of the purchase price of the capital stock and information concerning the payments required thereon. The schedules were prepared under Forman's supervision.
The schedules attached to the June 22, 1962, letter are set forth below:
+-----------+ ¦SCHEDULE I ¦ +-----------¦ ¦ ¦ ¦ ¦ ¦ +-----------+
PURCHASE PRICE OF CAPITAL STOCK OF RICKEY'S STUDIO INN HOTEL AND RICKEY ENTERPRISES AS OF MAR. 31, 1962
Rickey's Rickey Studio Inn Enterprises Total Hotel Basic purchase price $3,000,000.00 $600,000.00 $3,600.000.00 Less basic amount of equitable mortgage 1,148,000.00 252,000.00 1,400,000.00 1,852,000.00 348,000.00 2,200,000.00 Decrease or (increase) of mortgage at 3 26,868.29 (28,282.91) (1,414.62) /31/62 over basic mortgage Balance before adjustment for difference between liabilities and assets of the companies at 3/31/62 1,878,868.29 319,717.09 2,198,585.38 Amount of liabilities as of 3/31/62: Bank overdraft 33,937.79 13,649.32 Notes payable and accrued interest 280,759.17 44,000.00 Accounts payable and advance deposits 78,295.71 329,873.60 Contracts payable 36,897.91 79,475.54 Accrued taxes and expenses 108,383.65 124,384.80 Advance commission received 1,239.00 107.66 Total liabilities exclusive of mortgage 539,513.23 591,490.92 payable Deduct amount of assets included on Exhibit E of agreement: Cash 1,650.00 5,525.00 Accounts receivable 6,486.19 95,481.15 Inventories 66,942.00 Prepaid expenses and deposits 15,121.50 5,302.79 Amounts due (to) or from J.H. Rickey and affiliated companies (81,968.66) 548,367.49 Total assets (58,710.97) 721,618.43 Net excess of (liabilities) or assets (598,224.20) 130,127.51 (468,096.69) Adjusted purchase price before property 1,280,644.09 449,844.60 1,730,488.69 tax assessment deduction Deduct: 50% of unpaid property tax 17,433.09 406.62 17,839.71 assessment Purchase price of capital stock as of 3 1,263,211.00 449,437.98 1,712,648.98 /31/62 Distribution: Alfred Marsten 315,802.75 315,802.75 Lewis Marsten 315,802.75 315,802.75 John H. Rickey 631,605.50 449,437.98 1,081,043.48 1,263,211.00 449,437.98 1,712,648.98
+-----------+ ¦SCHEDULE II¦ +-----------¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ +-----------+
PAYMENT OF PURCHASE PRICE OF CAPITAL STOCK OF RICKEY'S STUDIO INN HOTEL AND RICKEY ENTERPRISES
Rickey's Studio Inn Hotel rickey Total Alfred Lewis J.H.Rickey Enterprises J.H.Rickey Marsten Marsten J.H.Rickey Payment due by $213,000.00 $213,000.00 $426,000.00 $148,000.00 $574,000.00 note Due at closing 62,500.00 62,500.00 125,000.00 100,000.00 225,000.00 Due 30 days after 29,082.00 29,082.00 58,165.00 30,337.00 88,502.00 audit (A) Due Jan. 2, 1963 11,220.75 11,220.75 22,440.50 171,100.98 193,541.48 Total amount 315,802.75 315,802.75 631,605.50 449,437.98 1,081,043.48 Deduct indebtedness of 466, 398.83 selling stockholders (B) Balance due 315,802.75 315,802.75 614,644.65 (A) 29% of 91,582.00 91,582.00 183,165.00 130,337.00 purchase price Less payment at 62,500.00 62,500.00 125,000.00 100,000.00 closing 29,082.00 29,082.00 58,165.00 30,337.00
+-------------------------------------------------------------------+ ¦(B) Net Indebtedness of Selling Stockholders and Related Companies ¦ +-------------------------------------------------------------------¦ ¦ ¦ ¦ ¦ ¦ +-------------------------------------------------------------------+
Rickey's Studio Inn Rickey Total Hotel Enterprises Amounts due from: Red Shack $5,264.87 $142,570.07 John H. Rickey 23,653.06 214,369.06 Rancho Rafael 58,041.71 North American Associates 32,219.77 Rickey's Studio Inn Hotel 162,670.28 Total 86,959.64 551,829.18 Amounts due to: Rickey Enterprises 162,670.28 Dinah's Shack 6,258.02 3,461.69 Total 168,928.30 3,461.69 Net amount due (to) or from selling (81,968.66) 548,367.49 $466,398.83 stockholders
+-----------+ ¦SCHEDULE ¦ ¦III ¦ +-----------¦ ¦ ¦ ¦ ¦ ¦ +-----------+
ADJUSTED PAYMENT OF PURCHASE PRICE
Alfred Lewis J.H.Rickey Marsten Marsten Payment by note $213,000.00 $213,000.00 $389,644.65 Due at closing 62,500.00 62,500.00 225,000.00 Due 30 days after audit 29,082.75 29,082.75 Due Jan. 2, 1963 11,220.00 11,220.00 315,802.75 315,802.75 614,644.65
The audit, as reflected in Schedule I, determined an adjusted sales price of $631,605.50 for petitioner's interest in Studio Inn and $449,437.98 for petitioner's interest in Enterprises, or a total adjusted sales price of $1,081,043.48 for petitioner's interest in both corporations. The amount of each payment due petitioner under the terms of the contract, as reflected in Schedule II, for his stock of both corporations is as follows:
+---------------------------------------------------------------------+ ¦ ¦Rickey's Studio ¦ ¦ ¦ +-----------------------+--------------------+-----------+------------¦ ¦ ¦Inn Hotel ¦ ¦Total ¦ ¦ ¦Rickey Enterprises ¦ ¦ ¦ +-----------------------+--------------------+-----------+------------¦ ¦ ¦ ¦ ¦ ¦ +-----------------------+--------------------+-----------+------------¦ ¦Due at closing ¦$125,000.00 ¦$100,000.00¦$225,000.00 ¦ +-----------------------+--------------------+-----------+------------¦ ¦Due 30 days after audit¦58,165.00 ¦30,337.00 ¦88,502.00 ¦ +-----------------------+--------------------+-----------+------------¦ ¦Due Jan. 2, 1963 ¦22,440.50 ¦171,100.98 ¦193,541.48 ¦ +-----------------------+--------------------+-----------+------------¦ ¦Payment due by note ¦426,000.00 ¦148,000.00 ¦574,000.00 ¦ +-----------------------+--------------------+-----------+------------¦ ¦ ¦ ¦ ¦ ¦ +-----------------------+--------------------+-----------+------------¦ ¦ ¦ ¦ ¦ ¦ +-----------------------+--------------------+-----------+------------¦ ¦ ¦631,605.50 ¦449,437.98 ¦1,081,043.48¦ +---------------------------------------------------------------------+
The amount due petitioner under the terms of the contract in the year of sale, namely the amounts due at closing and 30 days after audit, for his respective interest in each corporation represented 29 percent of the selling price of petitioner's stock in each corporation. Also, the total amount due petitioner in the year of sale for his stock in both corporations represented 29 percent of the total selling price of his stock in both corporations.
In order to facilitate the stock sale rather than an asset sale, as originally contemplated, petitioner agreed to purchase the assets of the restaurant known as Rickey's Rendezvous Room along with the stock of Dinah's Shack and certain other assets from Enterprises. The assets of the restaurant known as Rancho Rafael were to be purchased from Studio Inn by a new corporation organized by petitioner. The purchase of these assets by petitioner and the new corporation was accomplished by setting up accounts receivable on the books of Studio Inn and Enterprises for the purchase price of their respective assets.
Provisions were included in the sale contract for offsetting these accounts receivable against the amount due petitioner under the contract. The pertinent provisions are as follows:
(5-b) It is further expressly understood and agreed that in the audit as at the close of business on March 31, 1962, hereinafter provided for, all liabilities of said companies then owing to the selling stockholders and their related companies and all indebtedness of the selling stockholders and their related companies to said companies shall be offset and cancelled to the extent thereof; that each of the selling stockholders waives, releases and relinquishes all claims and demands against each of said companies which do not appear on or are reflected and accounted for in the respective audited balance sheets of said companies as of the close of business on March 31, 1962, and that after accomplishing such offsets any then remaining balance of indebtedness of a selling stockholder and/or his related companies to said companies shall be paid as follows: first, by the application of the balance of the 29% installment of purchase price payable to such stockholder for his stock, provided for in paragraph 2 of this agreement; second, by the application of all installments of purchase price payable to such stockholder for his stock due on or after January 1, 1963; and third, by credit against amounts becoming due on such stockholder's promissory note.
After offsetting the liabilities of both corporations to petitioner (and related companies) against the indebtedness of petitioner (and related companies) to both corporations, petitioner (and related companies) owed Enterprises $548,367.49 and Studio Inn owed petitioner (and related companies) $81,968.66. Upon the liquidation of both corporations by Hyatt (simultaneously with closing) petitioner (and related companies) became indebted to Hyatt for the net amount of $466,398.83 ($548,367.49 less $81,968.66).
When it was discovered that petitioner (and related companies) owed Hyatt $466,398.83, Hyatt threatened to rescind the sale. To keep Hyatt from rescinding the sale petitioner paid Hyatt $52,613.86 in cash obtained by surrendering policies of life insurance on his life and by returning a consulting fee of $20,000. Petitioner also made some minor payments and assumed some liabilities of Hyatt. The total amount of the payments and credits was $153,894.86, which reduced petitioner's liability to Hyatt form $446,398.83 to $313,577.59 (after a small upward adjustment of liabilities to $467,472.45).
A meeting between petitioner and Hyatt was held in August 1962. Hyatt had not anticipated that the size of petitioner's indebtedness would necessitate their being set off against its promissory notes.
Under the terms of the sale contract, the amounts owed Hyatt by petitioner (and related companies) were to be offset against amounts owed petitioner by Hyatt at the following times: 30 days after audit, January 2, 1963, and then against installment notes. The amounts due petitioner 30 days after audit and on January 2, 1963, did not bear interest in petitioner's favor, while the principal amount of the promissory notes payable to petitioner by Hyatt bear interest at the rate of 4 1/2 percent. The sales contract did not require petitioner to pay interest on the amounts he owed Hyatt.
At the meeting between petitioner and Hyatt on August 29, 1962, Louis Forman dictated a letter on behalf of Rickey and Hyatt which set forth the position of the parties with respect to the debts owed Hyatt by petitioner. The letter was addressed to petitioner and signed by Donald N. Pritzker on behalf of Hyatt. Petitioner signed the letter after the word ‘Accepted.’ Attached to the letter were schedules prepared by Louis Forman on behalf of Harris, Kerr, Forster & Co. for use by petitioner and Hyatt at the meeting. The pertinent portions of the letter are as follows:
As of this date Hyatt Corporation of America is owed $120,036.11 by you as a result of an overpayment in connection with the contract dated March 31, 1962 for the purchase of Rickeys. The sum of $120,036.11 is subject to further adjustments as determined by Harris, Kerr, Forster & Co. For and in consideration of $1.00 in hand paid, it is agreed that you will pay the above amount to HCA in the following manner:
+-----------------------------------------------------------------------------+ ¦From the recovery from the insurance company on ¦ ¦ +--------------------------------------------------------------+--------------¦ ¦account of damaged and stolen art works. To the ¦ ¦ +--------------------------------------------------------------+--------------¦ ¦extent the amount collected is less than $4900, ¦ ¦ +--------------------------------------------------------------+--------------¦ ¦the difference will be added to the amount due ¦$4,900.00 ¦ +--------------------------------------------------------------+--------------¦ ¦Payable Jan. 1, 1963 ¦18,972.01 ¦ +--------------------------------------------------------------+--------------¦ ¦Due on account of installment payments payable by ¦ ¦ +--------------------------------------------------------------+--------------¦ ¦HCA on its notes to John H. Rickey as of Apr. 2, ¦ ¦ +--------------------------------------------------------------+--------------¦ ¦1963 ¦25,830.00 ¦ +--------------------------------------------------------------+--------------¦ ¦Payable Apr. 2, 1964 ¦25,830.00 ¦ +--------------------------------------------------------------+--------------¦ ¦Payable Apr. 2, 1965 ¦31,570.00 ¦ +--------------------------------------------------------------+--------------¦ ¦Payable out of installment due Apr. 2, 1966 ¦Balance ¦ +--------------------------------------------------------------+--------------¦ ¦ ¦due ¦ +--------------------------------------------------------------+--------------¦ ¦ ¦ ¦ +-----------------------------------------------------------------------------¦ ¦Interest will be payable on an amount computed as follows: ¦ +-----------------------------------------------------------------------------¦ ¦Amount due per the schedule above ¦$120,036.11 ¦ +--------------------------------------------------------------+--------------¦ ¦Less ¦12,695.00 ¦ +--------------------------------------------------------------+--------------¦ ¦Balance ¦107,341.11 ¦ +-----------------------------------------------------------------------------¦ ¦Interest will be payable at the rate of 5 1/2% per annum on the unpaid ¦ ¦balance due commencing September 1, 1962. ¦ +-----------------------------------------------------------------------------¦ ¦Each time a payment is made, interest accrued to that date will be considered¦ ¦as the first portion of the payment made. ¦ +-----------------------------------------------------------------------------¦ ¦Sincerely yours, ¦ ¦ +-----------------------------------------------------------------------------¦ ¦HYATT CORPORATION OF AMERICA ¦ +-----------------------------------------------------------------------------¦ ¦By (S) Donald N. Pritzker ¦ +-----------------------------------------------------------------------------¦ ¦DONALD N. PRITZKER ¦ +-----------------------------------------------------------------------------¦ ¦ ¦ ¦ +--------------------------------------------------------------+--------------¦ ¦Accepted: (S) John H. Rickey ¦ ¦ +--------------------------------------------------------------+--------------¦ ¦JOHN H. RICKEY ¦ ¦ +-----------------------------------------------------------------------------+
One of the schedules attached to the letter is set forth below: SCHEDULE OF AMOUNTS DUE FROM J. H. RICKEY AND RELATED COMPANIES TO HYATT CORPORATION OF AMERICA BROUGHT FORWARD TO JAN. 2, 1963
Amounts due from (to) J. H. Rickey and related companies as of Mar. 31, 1962:
+---------------------------------------------------------------------------+ ¦Red Shack ¦ ¦$147,834.94¦ +------------------------------------------------+--------------+-----------¦ ¦John H. Rickey ¦ ¦238,022.12 ¦ +------------------------------------------------+--------------+-----------¦ ¦Rancho Rafael ¦ ¦58,041.71 ¦ +------------------------------------------------+--------------+-----------¦ ¦North American Associates ¦ ¦32,219.77 ¦ +------------------------------------------------+--------------+-----------¦ ¦Dinah's Shack ¦ ¦(9,719.71) ¦ +------------------------------------------------+--------------+-----------¦ ¦ ¦ ¦ ¦ +------------------------------------------------+--------------+-----------¦ ¦ ¦ ¦ ¦ +------------------------------------------------+--------------+-----------¦ ¦Total ¦ ¦466,398.83 ¦ +---------------------------------------------------------------+-----------¦ ¦Add: Payments made by Hyatt Corporation of America from ¦ ¦ +---------------------------------------------------------------+-----------¦ ¦Mar. 31, 1962 to Aug. 20, 1962: ¦ ¦ ¦ +---------------------------------------------------------------+-----------¦ ¦Payment to United California Bank on auto contract of Rickey ¦ ¦ +---------------------------------------------------------------+-----------¦ ¦Enterprises ¦ ¦101.57 ¦ +---------------------------------------------------------------+-----------¦ ¦Payment to Internal Revenue Service on Rickey's Studio Inn ¦ ¦ +---------------------------------------------------------------+-----------¦ ¦Hotel re late filing of depositary receipt ¦ ¦370.56 ¦ +---------------------------------------------------------------+-----------¦ ¦Payment to Internal Revenue Service on Rickey Enterprises ¦ ¦ +---------------------------------------------------------------+-----------¦ ¦re late filing of depositary receipt ¦ ¦482.64 ¦ +---------------------------------------------------------------+-----------¦ ¦Payment to tax collector San Rafael on Rancho Rafael re late ¦ ¦ +---------------------------------------------------------------+-----------¦ ¦payment of unsecured property tax ¦ ¦132.85 ¦ +------------------------------------------------+--------------+-----------¦ ¦Sundry payments on account of J.H. Rickey ¦ ¦(14.00) ¦ +------------------------------------------------+--------------+-----------¦ ¦ ¦ ¦ ¦ +------------------------------------------------+--------------+-----------¦ ¦ ¦ ¦ ¦ +------------------------------------------------+--------------+-----------¦ ¦ ¦ ¦467,472.45 ¦ +------------------------------------------------+--------------+-----------¦ ¦ ¦ ¦ ¦ +------------------------------------------------+--------------+-----------¦ ¦Deduct: ¦ ¦ ¦ +---------------------------------------------------------------+-----------¦ ¦Liability of Hyatt Corporation of America to Andrews ¦ ¦ +---------------------------------------------------------------+-----------¦ ¦Properties, transferred to Rancho Rafael ¦5,427.85 ¦ +---------------------------------------------------------------+-----------¦ ¦Liability of Hyatt Corporation of America to General Motors ¦ ¦ +---------------------------------------------------------------+-----------¦ ¦Acceptance Corporation, transferred to Dinah's Shack ¦2,772.00 ¦ +---------------------------------------------------------------+-----------¦ ¦Liability of Hyatt Corporation of America to United California ¦ ¦ +---------------------------------------------------------------+-----------¦ ¦Bank on Falcon Station Wagon transferred to Dinah's Shack ¦380.44 ¦ +---------------------------------------------------------------+-----------¦ ¦Payment by J.H. Rickey of life insurance cash surrender ¦ ¦ +---------------------------------------------------------------+-----------¦ ¦proceeds ¦ ¦30,000.00 ¦ +---------------------------------------------------------------+-----------¦ ¦Payment by J.H. Rickey of life insurance cash surrender ¦ ¦ +---------------------------------------------------------------+-----------¦ ¦proceeds ¦ ¦22,613.86 ¦ +---------------------------------------------------------------+-----------¦ ¦Payment by J.H. Rickey of consulting fees due from Hyatt ¦ ¦ +---------------------------------------------------------------+-----------¦ ¦Corporation of America ¦ ¦20,000.00 ¦ +---------------------------------------------------------------+-----------¦ ¦Payment by J.H. Rickey of proceeds of sale amount due 30 days ¦ ¦ +---------------------------------------------------------------+-----------¦ ¦after audit: ¦ ¦ ¦ +------------------------------------------------+--------------+-----------¦ ¦Total payment ¦$88,502.00 ¦ ¦ +------------------------------------------------+--------------+-----------¦ ¦Less accounts receivable transferred ¦ ¦ ¦ +------------------------------------------------+--------------+-----------¦ ¦to J.H. Rickey ¦18,972.01 (A) ¦69,529.99 ¦ +------------------------------------------------+--------------+-----------¦ ¦ ¦ ¦ ¦ +------------------------------------------------+--------------+-----------¦ ¦ ¦ ¦ ¦ +---------------------------------------------------------------+-----------¦ ¦Payment by J.H. Rickey of sale amount due Jan. 2, 1963 ¦193,541.48 ¦ +---------------------------------------------------------------+-----------¦ ¦Payment by J.H. Rickey of unsecured property taxes on art ¦ ¦ +---------------------------------------------------------------+-----------¦ ¦objects for the tax year 1962-63 ¦ ¦2,388.89 ¦ +---------------------------------------------------------------+-----------¦ ¦Payment by J.H. Rickey of insurance premium pending ¦ ¦ +---------------------------------------------------------------+-----------¦ ¦approval of loan ¦ ¦781.83 ¦ +------------------------------------------------+--------------+-----------¦ ¦ ¦ ¦ ¦ +------------------------------------------------+--------------+-----------¦ ¦ ¦ ¦ ¦ +------------------------------------------------+--------------+-----------¦ ¦Total ¦ ¦347,436.34 ¦ +------------------------------------------------+--------------+-----------¦ ¦ ¦ ¦ ¦ +------------------------------------------------+--------------+-----------¦ ¦ ¦ ¦ ¦ +------------------------------------------------+--------------+-----------¦ ¦Amount due ¦ ¦120,036.11 ¦ +---------------------------------------------------------------+-----------¦ ¦(A) Uncollected accounts receivable deduction per paragraph 5-d¦ ¦ +---------------------------------------------------------------+-----------¦ ¦of agreement. ¦ ¦ ¦ +---------------------------------------------------------------------------+
Subsequently, on December 12, 1962, petitioner wrote a letter to Hyatt for the purpose of modifying the letter agreement dated August 29, 1962. The pertinent portions of the letter are as follows:
Re: Agreement dated August 29, 1962
DEAR DON:
* * * Said agreement is hereby amended as follows:
1. The sum of $4,600 referred to in said agreement is hereby declared to have been paid to Hyatt Corporation of America as of September 1, 1962, thus reducing the balance owed by J. H. Rickey to Hyatt Corporation of America from $120,036.11 to a new balance of $115,436.11 as of September 1, 1962.
2. That the paragraph relating to the payment of interest indicating interest of 5 1/2% per annum applies on a balance of $107,341.11 commencing September 1, 1962, is amended to provide that the said interest shall be payable on the unpaid balance of $102,741.11 commencing September 1, 1962.
3. That as a result of an inventory of the art and art objects * * * , certain loss and/or damage was uncovered in the amount of $4,150.00. That said sum shall constitute a payment on the above obligation as of Sept. 1, 1962, pursuant to the term of said letter agreement of August 29, 1962, as modified.
4. That the item of $18,972.01 payable January 1, 1963, is hereby modified to provide that said amount or any portion thereof shall be payable on or before January 1, 1963.
Sincerely yours, (S) John H. Rickey JOHN H. RICKEY
Accepted:
HYATT CORPORATION OF AMERICA
By (S) Donald N. Pritzker
DONALD N. PRITZKER
On January 10, 1963, William E. Anderson, Jr., the attorney that represented petitioner in the sale, sent a letter to Hyatt setting forth agreements dated August 29, 1962, and December 12, 1962. The letter stated that as of September 1, 1962, petitioner owed Hyatt $111,286.11 and that petitioner would pay interest on the amount of $98,591.11.
Below is a summary of the changes brought about by the letter agreements dated August 29, 1962, and December 12, 1962, in the indebtedness of petitioner to Hyatt:
+------------------------------------------------------------------------+ ¦Amount due Hyatt on Mar. 31, 1962 ¦ ¦$466,398.83¦ +-------------------------------------------------+----------+-----------¦ ¦Add: ¦ ¦ ¦ +------------------------------------------------------------+-----------¦ ¦Payments made by Hyatt on account of petitioner from Mar. 31¦ ¦ +------------------------------------------------------------+-----------¦ ¦to Aug. 20, 1962 ¦ ¦1,073.62 ¦ +-------------------------------------------------+----------+-----------¦ ¦Accounts receivable transferred to petitioner ¦ ¦18,972.01 ¦ +-------------------------------------------------+----------+-----------¦ ¦ ¦ ¦ ¦ +-------------------------------------------------+----------+-----------¦ ¦ ¦ ¦ ¦ +-------------------------------------------------+----------+-----------¦ ¦ ¦ ¦486,444.46 ¦ +-------------------------------------------------+----------+-----------¦ ¦ ¦ ¦ ¦ +-------------------------------------------------+----------+-----------¦ ¦Deduct: ¦ ¦ ¦ +-------------------------------------------------+----------+-----------¦ ¦Miscellaneous payments ¦$11,751.01¦ ¦ +-------------------------------------------------+----------+-----------¦ ¦Payment due from Hyatt 30 days after audit ¦88,502.00 ¦ ¦ +-------------------------------------------------+----------+-----------¦ ¦Payment due from Hyatt Jan. 2, 1963 ¦193,541.48¦ ¦ +-------------------------------------------------+----------+-----------¦ ¦Payments from life insurance ¦76,763.86 ¦ ¦ +-------------------------------------------------+----------+-----------¦ ¦Payment from life insurance on art loss ¦4,600.00 ¦375,158.35 ¦ +-------------------------------------------------+----------+-----------¦ ¦ ¦ ¦ ¦ +-------------------------------------------------+----------+-----------¦ ¦ ¦ ¦ ¦ +-------------------------------------------------+----------+-----------¦ ¦Amount due Hyatt on Sept. 1, 1962 ¦ ¦111,286.11 ¦ +------------------------------------------------------------------------+
Petitioners in their 1962 return reported the sale of stock in Studio Inn and Enterprises as an installment sale. In the statutory notice of deficiency dated August 17, 1967, respondent determined that the installment method of reporting the sale was not proper inasmuch as the agreement of petitioner and Hyatt entered into on August 29, 1962, had the effect of accelerating the payment due January 2, 1963, and therefore petitioner had received greater than 30 percent of the selling price of the stock in the year of sale. Respondent's computation of the installment sale is as follows:
+---------------------------------------------------------------------+ ¦ ¦Enterprises ¦Studio Inn ¦Total ¦ +----------------------------+-------------+------------+-------------¦ ¦ ¦ ¦ ¦ ¦ +----------------------------+-------------+------------+-------------¦ ¦Sales price of capital stock¦$449,437.98 ¦$631,605.50 ¦$1,081,043.48¦ +----------------------------+-------------+------------+-------------¦ ¦Payments in year of sale ¦100,000.00 ¦125,000.00 ¦225,000.00 ¦ +----------------------------+-------------+------------+-------------¦ ¦ ¦30,337.00 ¦58,165.00 ¦88,502.00 ¦ +----------------------------+-------------+------------+-------------¦ ¦ ¦171,100.98 ¦22,440.50 ¦193,541.48 ¦ +----------------------------+-------------+------------+-------------¦ ¦ ¦301,437.98 ¦205,605.50 ¦507,043.48 ¦ +----------------------------+-------------+------------+-------------¦ ¦ ¦ ¦ ¦ ¦ +----------------------------+-------------+------------+-------------¦ ¦Percent of sales price ¦67 ¦32.55 ¦46.93 ¦ +---------------------------------------------------------------------+
Issue 2. Section 1244 Loss
On June 17, 1960, a corporation known as The Shack was incorporated in the State of California. The board of directors held their organizational meeting on June 27, 1960, and elected petitioner president of The Shack.
Pursuant to the articles of incorporation, The Shack was authorized to issue a total of 2,000 shares, the par value of each share to be $100. At the organizational meeting the directors adopted the following resolution:
NOW, THEREFORE, BE IT RESOLVED: That any officer of this corporation be, and he is hereby, authorized and directed to prepare, or cause to be prepared, verified and filed on behalf of this corporation an Application to the Commissioner of Corporations of the State of California for a Permit authorizing this corporation to sell and issue not to exceed 200 shares of its capital stock of a par value of $100.00 per share, for cash, at the price of $100.00 per share, to any or all of the following named individuals: J. H. Rickey.
RESOLVED FURTHER: That upon the issuance of a Permit by the Commissioner of Corporations of the State of California, pursuant to such Application, the President and/or the Vice-President and the Secretary be, and they are hereby, authorized and directed to sell and issue shares of stock of this corporation to any or all of the above named individuals in the amounts and for the considerations stated in an in compliance with all the terms and conditions of such Permit and these Resolutions.
The minutes of the organizational meeting indicate that the officers of the corporation were in the process of negotiating with the San Francisco Board of Trade for the acquisition of a restaurant for a purchase price of $75,000. After a discussion of the proposed purchase, the directors authorized the officers to complete the negotiations for the purchase of the restaurant after July 1, 1960, and after the application for stock permit had been made.
In July 1960 the application of The Shack for a permit to issue and sell its shares was filed with the Division of Corporations, Department of Investment, State of California. On July 19, 1960, the Department of Investment, Division of Corporations, of the State of California, issued a permit to The Shack authorizing it to sell and issue 200 shares of its capital stock to petitioner for $100 per share. The permit was issued upon the following condition:
That unless revoked or suspended, or renewed upon application filed on or before the date of expiration specified in this condition, all authority to sell securities under paragraph 1 of this permit shall terminate and expire on January 30, 1961. * * *
On July 22, 1960, The Shack acquired the restaurant from the San Francisco Board of Trade. The purchase price was $75,000, of which $10,000 was paid on July 22, 1960.
Sometime between the date of the granting of the permit to issue stock and the date of the acquisition of the restaurant, The Shack issued 200 shares of its stock to petitioner in return for $20,000 cash. The permit was not renewed.
In 1962 the corporate name of The Shack was changed to ‘Rick's Swiss Chalet.’ In December 1963 Rick's Swiss Chalet was liquidated and dissolved. The assets distributed to petitioner as a result of the liquidation amounted to $41,199.74. Petitioner's basis for his investment in the corporation was $355,681.27. Thus petitioner sustained a loss on his investment, $17,673.86 of which was attributable to petitioner's purchase of capital stock.
On their 1963 joint Federal income tax return petitioners claimed a $296,807.67 capital loss and a $17,673.86 ordinary section 1244 loss as a result of liquidation of Rick's Swiss Chalet. In the statutory notice of deficiency mailed to petitioners on August 17, 1967, respondent determined that a bona fide liquidation did not occur and consequently disallowed the entire loss claimed.
In the Supplemental Agreement of Partial Settlement, filed with this Court on January 24, 1969, respondent conceded that Rick's Swiss Chalet was properly liquidated and that a loss on liquidation occurred. Respondent did not, however, concede that any portion of the loss was an ordinary loss under section 1244. Thus, on January 27, 1969, respondent filed an amended answer in which he specifically denied that petitioner sustained a section 1244 loss on the liquidation of Rick's Swiss Chalet.
OPINION
Issue 1. Use of Installment Method
The first issue before us is whether the payments received by petitioner in the year of sale (1962) for his stock in Studio Inn and Enterprises exceeded 30 percent of the stocks' selling price. If we find that they did, petitioner is precluded from reporting the gain realized from the sale of his Studio Inn and Enterprises stock on the installment method.
Sec. 453(b)(2)(A)(ii) provides that the installment method is available in the case of a casual sale of personalty only if in the year of the sale ‘the payments (exclusive of evidences of indebtedness of the purchaser) do not exceed 30 percent of the selling price.’
In arriving at our determination of this issue, we must first determine whether the payment of $193,541.48 due petitioner on January 2, 1963, was actually received in 1962 (the year of sale). If we conclude that it was, petitioner received payments in the year of sale totaling $507,043.48 which exceeds 30 percent of the selling price of his stock.
This result is reached whether the contract of sale constituted one sale of stock or two sales of stock. The percentage of payments to selling price in both instances is reflected in our Findings of Fact.
Respondent contends that since this payment was to be offset against the amount petitioner owed Hyatt, this resulted in a cancellation of Hyatt's obligation for this payment, and that this constituted a payment to petitioner in the year of sale of $193,541.48. Petitioner does not dispute the fact that the payment of $193,541.48 was offset against the amount he owed Hyatt, nor that the offset was provided for in the contract. His position is that the offset occurred on January 2, 1963, and since that was the due date of the $193,541.48 payment, the offset could not have occurred prior to that date.
As originally contemplated, Hyatt was to purchase the hotel from Studio Inn and the restaurant from Enterprises. Under this arrangement, however, petitioner and the Marstens were not able to take advantage of the installment method. Therefore, so that petitioner and the Marstens could report their gain on the installment method, the sale was recast in the form of a stock sale. Because Hyatt was unwilling to purchase all of the assets underlying the stock of both corporations, some arrangement had to be made whereby the unwanted assets were pulled out of the corporations prior to the purchase of the stock by Hyatt. Consequently, petitioner agreed to purchase these unwanted assets. Evidently, petitioner did not have the necessary cash available with which to purchase these assets, so petitioner and Hyatt agreed that accounts receivable would be set up on the books of Studio Inn and Enterprises, respectively, for the amount petitioner owed for these assets. After providing in the contract of sale for offsetting these accounts receivable against any indebtedness of Studio Inn and Enterprises to petitioner, respectively, provision was made that the remaining indebtedness of petitioner would be paid as follows:
first, by the application of the balance of the 29% installment of purchase price * * * ; second, by the application of all installments of purchase price payable to such stockholder for his stock due on or after January 1, 1963; and third, by credit against amounts becoming due on * * * (petitioner's) promissory note.
Under the terms of the contract Hyatt was to pay petitioner 4 1/2 percent interest only on the promissory note, while petitioner was not obligated to pay interest on his indebtedness. However, after the audit was conducted and it was first learned that petitioner owed Hyatt $466,398.83 and that this exceeded the non-interest-bearing payments Hyatt owed petitioner, a supplemental agreement was entered into on August 29, 1962, whereby petitioner agreed to pay 5 1/2-percent interest on $107,341.11. This amount was arrived at, in part, by deducting the payment of $193,541.48 from the total indebtedness of petitioner.
We think it clear that the payment of $193,541.48 was effectively received by petitioner in 1962 (the year of sale). We reach this conclusion first by looking to the substance of the transaction rather than the form in which it was cast. As we view the transaction, petitioner deferred payment of that portion of the non-interest-bearing payments which exceeded 29 percent of the selling price, to wit, $193,541.48, solely for the purpose of altering his tax liability. While we recognize that a taxpayer may deliberately arrange the terms of a sale so he will receive less than 30 percent of the sale price in the year of sale, nevertheless to so qualify the arrangements must have substance and reflect the true situation rather than being merely the formal documentation of the terms of the sale. Here petitioner did this with the knowledge that, by virtue of the provision requiring this amount to be offset against his indebtedness to Hyatt, he would never receive this payment in the form of cash.
As far as Hyatt was concerned, its obligation to pay petitioner $193,541.48 consisted entirely of making a bookkeeping entry on January 2, 1963.
By purchasing the assets Hyatt did not want through the establishment of accounts receivable it was obvious from the beginning that Hyatt would never be called on to pay the $193,541.48. Petitioner retained possession of assets worth more than that at all times.
The formalism engaged in by petitioner and Hyatt solely for the purpose of permitting petitioner to report his gain on the installment method cannot and will not be given effect, for as the Supreme Court stated in Commissioner v. Court Holding Co., 324 U.S. 331, 334 (1945):
To permit the true nature of a transaction to be disguised by mere formalisms, which exist solely to alter tax liabilities, would seriously impair the effective administration of the tax policies of Congress.
We therefore hold that the substance and economic reality of the transaction was that a portion of petitioner's indebtedness to the corporations for assets retained, and thus to Hyatt, was effectively discharged by application of Hyatt's indebtedness to petitioner in the amount of $193,541.48 in 1962, and constituted a payment to petitioner in that year under section 453(b)(2)(A) (ii).
Our conclusion above is supported by an earlier decision of this Court. In James Hammond, 1 T.C. 198 (1942), the taxpayer sold shares of stock for a total price of $965,000, receiving in the year of sale a cash payment of $74,000 from the vendee. In addition, he received from a creditor, who was also a party to the agreement of sale, cash in the amount of $280,000 and the cancellation of a prior indebtedness in the sum of $150,000, for which petitioner gave the creditor his notes for $430,000 payable only from the payments to be made by the vendee. On those facts we held that the taxpayer had immediately received the benefit of $504,000 as a result of the sale agreement.
Our conclusion is also supported by the recent use of United States v. Ingalls, 399 F.2d 143 (C.A. 5, 1968). There Ingalls entered into an agreement in compromise of litigation and dispute whereby he sold his employment contract to his employer for $228,360 payable in equal installments of $22,836 for the next 10 years. It so happened, however, that Ingalls owed his employer the amount of $228,360. He agreed to pay off his $228,360 indebtedness also in installments of $22,836 over the same period. A provision in the agreement permitted the employer to make payments to Ingalls by crediting such against the amount he owed. The Fifth Circuit held that the substance of the agreement was the discharge of indebtedness due the employer by Ingalls at the time of the making of the agreement.
Petitioner argues that the above-cited cases are distinguishable for the following reasons: (1) Mutual debts do not automatically cancel each other; (2) the debts, here, were not made in consideration of each other; (3) under the terms of the contract he had continuing obligations, a breach of which would have defeated his claim for cancellation; and (4) if Hyatt had sued him on his indebtedness prior to January 2, 1963, he could not have pleaded a setoff under California law for the payment of $193,541.48 since it would not have matured at that time. We agree with the principle that mutual debts do not automatically cancel each other. However, it is not applicable for petitioner and Hyatt expressly provided for the cancellation. We do disagree, however, with petitioner's statement that the debts were not made in consideration of each other. We think it obvious that Hyatt agreed to the arrangement whereby accounts receivable were set up on the books of Studio Inn and Enterprises for the assets purchased by petitioner in return for requirement that petitioner's indebtedness be offset against Hyatt's payments on the purchase price.
It appears to us that the third and fourth reasons in effect constitute the argument that a breach by petitioner of any of his continuing obligations prior to January 2, 1963, would have entitled Hyatt to immediately sue petitioner on his indebtedness and that under California law he could not have pleaded a setoff with respect to Hyatt's unmatured obligations. See Estate of Lipman v. United States, 376 F.2d 455 (C.A. 6, 1967). This argument is necessarily based upon the conclusion that petitioner agreed to the continuing obligations in consideration for Hyatt's agreement to defer payment by petitioner on his indebtedness. We find nothing in the record, however, to support this conclusion. On the contrary, we think the record clearly shows that petitioner's obligations were not made in consideration of Hyatt's agreement to defer the payment of petitioner's indebtedness. We therefore reject this argument as being unsupported by the record.
Secondly, we think it clear that petitioner received the payment of $193,541.48 in 1962 since petitioner and Hyatt accelerated the offset into 1962 by the terms of the letter agreement dated August 29, 1962. In that agreement petitioner and Hyatt stated: ‘As of this date Hyatt Corporation of America is owed $120,036.11 by you (petitioner).’ The schedule attached to the letter reflected as one of the deductions in arriving at the figure of $120,036.11 the payment of $193,541.48 due petitioner on January 2, 1963.
In spite of the letter's clear and concise language, petitioner argues that neither he nor Hyatt had the intention of accelerating the $193,541.48 payment. In support of his argument, petitioner points out that the heading of the schedule used the terms, ‘Brought Forward To January 2, 1963.’ He also points to the testimony of Donald Pritzker, who signed the agreement on behalf of Hyatt, to the effect that he did not intend to accelerate the payment.
While Pritzker did say that he did not intend to accelerate the payment of $193,541.48, he also stated several times that as far as he was concerned, on August 29, 1962, Hyatt was owed $120,036.11 by petitioner. It is inescapable that if petitioner owed Hyatt only that amount on August 29, 1962, Hyatt was not obligated to pay petitioner $193,541.48 on January 2, 1963, because the $193,541.48 had already been applied against petitioner's indebtedness to Hyatt to reduce it to $120,036.11 on August 29, 1962.
Accordingly, based upon either of our views as expressed above, we hold that petitioner received the payment of $193,541.48 in the year of sale in addition to the payments of $225,000 and $88,502. Thus, petitioner received total payments in the year of sale amounting to $507,043.48.
Petitioner next contends that even if he received payments in the year of sale for his shares in Studio Inn and Enterprises totaling $507,043.48, he is still entitled to report the gain realized from his Studio Inn stock on the installment method. This contention is necessarily premised on the theory that two separate sales were integrated into one sale contract. For the purpose of entertaining this contention, we will assume, arguendo, that petitioner made separate sales of his Studio Inn stock and his Enterprises stock.
In support of his contention, petitioner first maintains that the selling price of his shares in Studio Inn should be $713,574.16 rather than the sales price of $631,605.50 as determined by the audit. It appears that he bases this conclusion upon the interpretation of the following terms of the contract:
(5-b) It is further expressly understood and agreed that in the audit * * * all liabilities of said companies then owing to the selling stockholders and their related companies and all indebtedness of the selling stockholders and their related companies to said companies shall be offset and cancelled to the extent thereof; * * *
In arriving at the figure $713,574.16, petitioner increased the original sales price of petitioner's shares in Studio Inn by $81,968.66, the net liability of Studio Inn to petitioner (and related companies) and correspondingly reduced the selling price of Enterprises by reducing the indebtedness of petitioner (and related companies) to Enterprises by $81,986.66. Petitioner argues that this adjustment is specifically required by the above-quoted terms of the contract, and furthermore that this is necessary to reflect the true value of the assets of Studio Inn. We disagree. To accept petitioner's reasoning, we would have to ignore the fact that petitioner owned only 50 percent of the stock of Studio Inn. Under petitioner's theory the selling price of petitioner's 50-percent interest in Studio Inn would be $713,574.16, while the selling price of the Marstens' 50 percent interest would be $631,605.50. We cannot perceive how this result can in any way reflect the true value of the assets of Studio Inn. Furthermore, the terms of the contract relied upon by petitioner do not provide a basis for this interpretation. As we understand those terms, they require the offset to be made in order to compute the combined sales price of the Studio Inn stock and the Enterprises stock, not the separate sales price of such stock. We therefore reject his argument as being a mere attempt on the part of petitioner to juggle figures in a manner which is to his best interest, and as being completely without merit.
Alternatively, petitioner argues that he made sufficient cash repayments of the sales price to reduce the payments he received in 1962 for his shares in Studio Inn below 30 percent of the selling price of such shares. For the purpose of this argument, petitioner agrees that the sales price for petitioner's interest in Studio Inn was $631,605.50 in the year of sale for such interest. He points out that as a result of Hyatt's concern over having paid petitioner too much cash at closing in light of the substantial indebtedness of petitioner to Hyatt, he made cash payments to Hyatt in 1962 totaling $76,763.86. He claims that these payments, of which $42,538.88 is allocable to his shares in Studio Inn, constituted a partial refund of the downpayment he received for his stock and thus reduced the payments he received in the year of sale.
This argument can be readily dismissed as being completely unsupported by the actual facts. The $76,763.86 paid by petitioner to Hyatt went to reduce the amount of petitioner's indebtedness to Hyatt and was not a partial refund of the downpayment for the stock. Even if we were to hold that this amounted to a refund of the year of sale payments, we would have to also hold that there was a simultaneous discharge of petitioner's indebtedness to Hyatt in the same amount, which would offset any reduction in the year of sale payments received by petitioner.
Issue 2. Section 1244 Loss
The second issue before us is whether petitioner are entitled to ordinary-loss treatment under section 1244 on a portion of the loss sustained by petitioners as a result of the liquidation of Rick's Swiss Chalet, Inc. In the notice of deficiency respondent disallowed the loss in toto on the ground that a bona fide liquidation had not occurred. Then, prior to trial, respondent conceded that the liquidation was valid and that petitioner had suffered a loss therefrom. Therefore, in order to place this issue properly before this Court, respondent amended his answer accordingly.
Under Rule 32 of this Court's Rules of Practice, respondent has the burden of proof ‘in respect of any new matter pleaded in his answer.’ We think that respondent in his amended answer pleaded new matter within the meaning of Rule 32, and accordingly we find that respondent has the burden of proof in respect to this issue. In reaching this conclusion, we are not unmindful of the well-settled principle that the reasons given in the notice of deficiency do not constitute the issue and the presumption of correctness which attaches to respondent's determination is not destroyed if the reason is unsoundly or badly expressed. Estate of Peter Finder, 37 T.C. 411 (1961). Here, respondent completely abandoned his determination that a loss had not occurred, and in his amended answer made a completely different determination. This, in our mind, amounts to the raising of new matter. However, this does not help petitioner because the record does not support a conclusion that the stock issued to petitioner qualifies as ‘section 1244 stock’ which is a prerequisite to petitioner's claim to the advantages of section 1244.
Petitioners seek ordinary-loss treatment on the portion of the loss attributable to the worthlessness of their stock of Rick's Swiss Chalet. Section 1244 provides an exception to the general rule that losses sustained upon the worthlessness of stock are capital losses by allowing an ordinary-loss deduction when the stock involved is ‘section 1244 stock.’
Section 1244 defines section 1244 stock, in part, as follows:
(c) SECTION 1244 STOCK DEFINED.
(1) IN GENERAL.— FOR purposes of this section, the term ‘section 1244 stock’ means common stock in a domestic corporation if
(A) such corporation adopted a plan after June 30, 1958, to offer such stock for a period (ending not later than two years after the date such plan was adopted) specified in the plan.
The regulations, promulgated under the express authority of section 1244(c), provided, in pertinent, part, as follows:
Sec. 1.1244(c)-1. Section 1244 stock defined.
(a) In general. In order that stock may qualify as section 1244 stock the requirement described in paragraphs (b) through (h) of this section must be satisfied. * * *
(c) Written plan. (1) The common stock must be issued pursuant to a written plan adopted by the corporation after June 30, 1958, to offer only such stock during a period specified in the plan ending not later than two years after the date the plan is adopted. The two-year requirement referred to in the preceding sentence will be met if the period specified in the plan is based upon the date when, under the rules or regulations of a Government agency relating to the issuance of the stock, the stock may lawfully be sold, and it is clear that such period will end, and in fact is does end, within two years after the plan is adopted. * * *
Respondent contends that neither the corporate minutes, the application for a permit to issue stock, nor the permit to issue stock, either singularly or collectively, constitutes a plan within the meaning of section 1244(c)(1)(A). We agree.
The minutes of the organizational meeting of the board of directors authorized and directed an officer of the corporation to apply for a permit to sell 200 shares of its stock to petitioner for $100 per share, and upon issuance of the permit to sell and issue the 200 shares to petitioner in compliance with all the terms and conditions of the permit and these resolutions. There is no evidence that the corporation even considered adopting a plan to issue ‘section 1244 stock.’ We do note believe this meets the requirement of a ‘plan’ within the intendment of section 1244 nor the requirement of the regulation that in order to qualify as section 1244 stock, the stock must be issued pursuant to a written plan adopted by the corporation. Bernard Spiegel, 49 T.C. 527. In this connection the Court of Appeals for the Second Circuit made the following remarks in Godart v. Commissioner, 425 F.2d 633 (C.A. 2, 1970), affirming 51 T.C. 937, a case involving facts quite similar to the facts in this case in which both this Court and the appellate court held the stock involved failed to qualify as section 1244 stock:
While one could not sustain the position that Congress meant the benefits of sec. 1244 to be given only to taxpayers who would not have invested without the promise of them, it is hard to see how its purpose would be served by according its benefits in cases where there is no indication that at the time the alleged plan was adopted the corporation had any awareness of the section or any intent to make its extraordinary tax advantages available to investors in the corporation.
It is true enough that tax consequences generally depend on what people do and not on what they say. But Congress, if it chooses, may condition tax incentives both on doing certain things and on showing in an objective way that they were done with an intention of realizing the benefits Congress had afforded.5 We do not mean either that ritualistic reference to Sec. 1244 is essential or that such a reference will save a plan that does not meet the statutory tests. We do mean that there must be some substantially contemporary objective evidence that the plan was adopted with Sec. 1244 in view. Such evidence is wholly lacking here. * * * (Fn. omitted.)
Such evidence is also wholly lacking here.
But even if the resolution constituted a plan, the plan failed to specify that the stock had to be offered within 2 years after the adoption of the plan, and, therefore, failed to comply with the specificity requirement of section 1244(c) (1)(A) as to time limitation. Bernard Spiegel, supra; Wesley H. Morgan, 46 T.C. 878.
Nowhere in the minutes of the organizational meeting was there any intention evidenced that there was a plan to offer stock only within 2 years. Petitioner maintains that this defect is cured by the statement in the permit issued to Rick's Swiss Chalet (formerly The Shack) by the State of California that the permit would terminate on January 30, 1960. Even though petitioner in his original brief argues that he should not be bound by the regulations promulgated under section 1244, since they were adopted subsequent to the adoption of the plan, he calls our attention to the following language in section 1.1244(c)-1:
(c) Written plan. (1) * * * The two-year requirement referred to in the preceding sentence will be met if the period specified in the plan is based upon the date when, under the rules or regulations of a Government agency relating to the issuance of the stock, the stock may lawfully be sold, and it is clear that such period will end, and in fact it does end, within two years after the plan is adopted. * * *
Relying on this language, petitioner argues that the permit is an integral part of the plan adopted by Rick's Swiss Chalet and that the 2-year requirement is thereby satisfied within the meaning of respondent's own regulations.
While it is true that the permit was to terminate on January 30, 1960, it must be pointed out that the permit could be renewed. It is this fact which leads us to the conclusion that even if the resolutions qualify as a plan there was no period specified in the plan for the issuance of the stock which was certain to end within 2 years of the adoption of the plan. The permit could be renewed by making application to the Division of Investments, Department of Corporations of the State of California prior to January 30, 1960, and thus it cannot be said that the requirements of the statute and the regulations promulgated thereunder were complied with in all respects. Petitioner argues that the renewal provision of the permit is of no consequence since if the permit was renewed this act would certainly constitute a new plan. Petitioner also argues that the corporation lacked authority under the resolutions to renew the permit. We cannot agree with petitioner, though, for the resolution of the board of directors directing that the stock be issued in compliance with all the terms and conditions of the permit had the effect of incorporating all of the terms and conditions of the permit into the resolution and making them a part thereof. Thus, if the termination date of the permit can be said to have been incorporated in the resolution or ‘plan,‘ so was the renewal provision of the permit. Thus, a renewal of the permit would have been within the ambit of the original plan adopted by the board of directors and would not, as petitioner argues, have constituted a new plan to issue stock.
Petitioners also point out, as extrinsic evidence, that the purpose of the formation of the corporation was to acquire a restaurant from the San Francisco Board of Trade and that in the minutes of the organizational meeting the board of directors directed that the negotiations for the purchase of the restaurant be completed after the issuance of the permit to issue shares of stock. They argue that the proceeds to be used for the purchase of the restaurant were to come from the sale of stock, and that, it necessarily follows, that the sale of stock had to occur as soon as the permit was obtained, so that the restaurant could be purchased.
The only inference, at the most, that can be drawn from these facts is that the corporation contemplated that the stock would be issued prior to the termination date of the permit. This is not sufficient, however, for the statute requires that the 2-year limitation be specified in the plan. James A. Warner, 48 T.C. 49 (1967), affd. 401 F.2d 162 (C.A. 9, 1968).
Decision will be entered under Rule 50.