Opinion
Docket Nos. 25751 25554 25555 25556 25557 25558 25559 25560.
1951-09-28
THE WOLF ENVELOPE COMPANY, ET AL., PETITIONERS,* v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.
Irvin N. Loeser, Esq., and Daniel W. Loeser, Esq., for the petitioners. Clarence E. Price, Esq., for the respondent.
A corporation had outstanding 5 per cent debenture shares, class A and class B common stock. Class A shares were principally held by inactive and absentee stockholders and class B by the active managing stockholders. Class A shares carried a fixed cumulative dividend and a liquidating value of $100 each. Class B shares carried the right to any further earnings and to the remaining assets on dissolution. Both classes carried voting rights. Pursuant to agreement, the stockholders adopted a plan of reorganization under which new 5 per cent 20-year debenture bonds were issued to retire the class A stock at $175 per share and the debenture shares dollar for dollar. New common stock was issued to the holders of class G stock who thereafter held the voting power. Held, the exchanges of debenture shares and class A stock for debenture bonds were exchanges of stock and securities for securities pursuant to a plan of reorganization and, in accordance with section 112(b)(3), Internal Revenue Code, no gain or loss is to be recognized. Irvin N. Loeser, Esq., and Daniel W. Loeser, Esq., for the petitioners. Clarence E. Price, Esq., for the respondent.
Respondent determined deficiencies against the Wolf Envelope Company (Docket No. 25751) in income tax for 1944 in the amount of $7,526.64 and in excess profits tax for 1945 in the amount of $10,629.51. Respondent determined deficiencies in income tax for 1945 against the other petitioners as follows:
+-----------------------------------------------------+ ¦Docket No. ¦Petitioner ¦Deficiency ¦ +------------+---------------------------+------------¦ ¦25554 ¦Jennie Littman ¦$81,499.74 ¦ +------------+---------------------------+------------¦ ¦25555 ¦Alan L. Littman ¦4,546.59 ¦ +------------+---------------------------+------------¦ ¦25556 ¦Elsa L. Selden ¦9,661.68 ¦ +------------+---------------------------+------------¦ ¦25557 ¦Rhoda L. Affelder ¦8,977.83 ¦ +------------+---------------------------+------------¦ ¦25558 ¦Harry F. Affelder ¦6,710.30 ¦ +------------+---------------------------+------------¦ ¦25559 ¦Doris L. Lux ¦6,514.08 ¦ +------------+---------------------------+------------¦ ¦25560 ¦Estate of Nathan I. Dryfoos¦82,353.10 ¦ +-----------------------------------------------------+
The principal issue relates to the tax effect of an exchange of stock and securities of the Wolf Envelope Company in 1945 upon the corporation and its security holders. Other issues relating to deductions for medical expenses and income of the beneficiary of a trust are dependent upon the conclusion reached on the principal issue. Nathan L. Dryfoos filed his income tax return for the calendar year 1945 with the collector of internal revenue at Jacksonville, Florida. The individual petitioners filed income tax returns for the calendar year 1945 with the collector of internal revenue at Cleveland, Ohio. The Wolf Envelope Company filed income and excess profits tax returns for the calendar years 1944 and 1945 with the collector at Cleveland.
A partial stipulation of facts was filed.
FINDINGS OF FACT.
The stipulated facts are so found. They are here stated to the extent deemed necessary for the purposes of this opinion, together with other facts found from the evidence introduced.
The Wolf Envelope Company, hereinafter sometimes referred to as the Company, was incorporated in 1899 under the laws of the State of Ohio for the purpose of ‘manufacturing, printing and dealing in envelopes, stationery and novelties for advertising and other purposes, and to do all things incident thereto for profit.‘ The Company has since done business in the city of Cleveland, Ohio. On completion of the organization the issued stock, 120 shares, was held by Alfred Wolf, Nathan I. Dryfoos, and Louis Littman in equal amounts of 40 shares each.
Alfred Wolf was born in 1854 and died in 1928. He lived in New York, New York. He took no active part in the management of the business. His widow died in 1935. Some of his stockholdings were transferred to other stockholders and the remainder descended to his son, Alan L. Wolfe, and his daughter, Margaret Namm. These stockholders lived in New York and took no part in the management of the business.
Nathan I. Dryfoos was born in 1860. He was a brother-in-law to Alfred Wolf. He served the Company as director and officer in an advisory capacity. He died a resident of Florida in 1949. The First National Bank of Miami is the duly qualified executor of his estate.
Louis Littman was born in 1855. He was the general manager of the Company from 1899 until July 1929. He died in 1937. Under his will a trust was created whereby the entire net income from the trust estate was to be paid to his widow Jennie Littman, the principal, within limits, to be distributed to her by the trustees to the extent that they might determine ‘in their complete discretion.‘ Jennie Littman held securities of the Company by transfer from Louis Littman. She took no part in the management of the business of the Company.
Alan L. Littman is the son of Louis Littman. He entered the employ of the Company about 1913 and later became sales manager and a director.
Harry F. Affelder had married Rhoda, daughter of Louis Littman, and entered the employ of the Company as superintendent in 1913. He devised methods and processes for improving the manufacturing operations of the Company and designed and patented new machinery and equipment which contributed materially to the success of the business. In 1929 he succeeded Louis Littman as general manager.
Elsa L. Selden and Doris L. Lux are daughters of Louis Littman. They received securities of the Company as a result of gifts of Jennie Littman. They took no part in the management of the business.
The Company from and after 1902 paid substantial cash dividends in every year of its existence. The dividends from 1913 through 1947 aggregated $1,641,506.25, the equivalent of 69.7 per cent of its net profits through those years.
The original capital investment in the Company was $12,000. The Company declared dividends in common stock of $6,000 in 1903, $6,000 in 1904, and $6,000 in 1905, and further dividends of $45,000 in first preferred stock in 1908 and $75,000 in second preferred stock in 1914.
In 1916 or 1917 the stockholders of the Company formed a new corporation, the Wald Realty Company, hereinafter referred to as Wald, to acquire title to a factory site in Cleveland. Wald then leased the site to the Company for a term of 20 years beginning January 1, 1918. The lease contained a purchase option under which the lessee might purchase the land at an arbitrated price but not less than $67,500. A new factory building was constructed on the site at the expense of the lessee.
In 1918 Affelder entered into a new employment agreement with the Company under which he was to receive, in addition to a fixed salary, 25 per cent of any net profits of the Company in excess of its largest earnings for any previous year. In 1919 Alan Littman entered into a similar contract with the Company to receive a salary and 25 per cent of any increased net profits similarly computed, after the deduction of Affelder's percentage.
In 1922 the stockholders of the Company entered into an agreement whereby the common stock was increased from 300 to 1,500 shares and the additional shares were distributed as a stock dividend and, in addition, ‘participating certificates‘ were issued providing for the division of the remaining surplus earnings after payment of annual cumulative dividends of $13.20 per share on the 1,500 shares of common stock. ‘Participating certificates‘ were issued in shares.
The following table shows the stockholdings and the shares of participating certificates issued at the time of the stockholder's agreement of 1922:
+---------------------------------------------+ ¦Stockholder ¦Common stock¦Participating¦ +------------------+------------+-------------¦ ¦ ¦ ¦certificates ¦ +------------------+------------+-------------¦ ¦Nathan I. Dryfoos ¦93.5 ¦240 ¦ +------------------+------------+-------------¦ ¦Louis Littman ¦103.5 ¦240 ¦ +------------------+------------+-------------¦ ¦Flora M. Wolf ¦73 ¦170 ¦ +------------------+------------+-------------¦ ¦Alan L. Littman ¦5 ¦280 ¦ +------------------+------------+-------------¦ ¦Harry F. Affelder ¦10 ¦280 ¦ +------------------+------------+-------------¦ ¦Grover C. Halliday¦5 ¦20 ¦ +------------------+------------+-------------¦ ¦Rhoda Affelder ¦10 ¦ ¦ +------------------+------------+-------------¦ ¦Olive Lins ¦ ¦5 ¦ +---------------------------------------------+
Halliday was office manager and Olive Lins was a bookkeeper in the employ of the Company.
In 1923 the stockholder and holders of ‘participating certificates‘ entered into a written agreement providing that when the certificates should have acquired a book value of $100 each, the Company should be reorganized, class A common stock to be issued for common shares of the 1922 issue and class B stock to be issued for the ‘participating certificates.‘ It was further provided that all dividends declared on class A and class B shares should be paid to trustees who should distribute from the fund to class A stockholder $13.20 per share annually and cumulatively, and distribute the residue to holders of class B shares.
The reorganization contemplated by the agreement of 1923 was carried out in January 1925. As a result of such reorganization the Company had outstanding 450 shares of first preferred stock, par value $45,000, 750 shares of second preferred stock, par value $75,000, 1,500 shares of class A stock, no par value, and 1,500 shares authorized of class B stock, no par value, of which 1,260 shares were issued. By virtue of the 1923 agreement the class A common shares were assigned a liquidating value limited to $100 per share and annual cumulative dividends of $13.20 per share, the residue of surplus being assigned to the class B shares. Voting rights rested equally share for share in class A and class B stock, with the exception that should the book value of the class B shares fall below $100 per share voting rights were to be solely in the class A shares.
Between 1927 and 1935 the Company's first preferred stock was completely retired and its second preferred stock was reduced to $35,000.
One of the stockholder, Grover C. Halliday, died in 1936. The Company purchased from his estate the 25 shares of class A and 20 shares of class B common stock he had owned.
Prior to 1940 the Company's stockholders negotiated with reference to the possible elimination of class A stock from the capital structure. Dryfoos, Jennie Littman, Alan Wolfe, and Margaret Namm, who were holders of substantial amounts of class A stock, were reluctant to surrender it with its voting rights and preferential dividend. On the other hand, Affelder and Alan Littman, who with their wives owned substantial amounts of class B stock and were actively conducting the business of the Company, considered that the class A stockholders were receiving a disproportionate share of the profits and that the progress of the Company might be retarded as a consequence of the ownership of a large proportion of its voting stock by inactive and absentee holders. By 1940 no agreement had been reached among the stockholders upon a basis for retiring the class A stock, but agreement had been reached upon a merger between the Company and Wald.
On June 15, 1940, an agreement of merger between Wolf Envelope Company and the Wald Realty Company was filed with the Secretary of State of Ohio. As a consequence of the merger Wald ceased to exist and Wolf Envelope Company continued as the consolidated corporation. After that date, the Company's capital structure consisted of 3,000 authorized shares of common stock of no par value, of which 1,500 were class A and 1,500 class b. The holders of class A shares were entitled to a fixed annual cumulative dividend of $13.20 per share before dividends could be paid on the class B shares. In the event of liquidation class A share owners were to receive $100 per share plus any accrued and unpaid dividends before any distribution in liquidation to the class B shareholders. The merger agreement also authorized the issue of 1,095 debentures of $100 each bearing interest at 5 per cent per annum and payable on or before June 15, 1960. Voting rights were vested in the class A and class B shareholders equally share for share. Debentures in the face amount of $67,500 were issued in exchange for the 300 shares of Wald; $42,000 in debentures were exchanged for the outstanding $35,000 of second preferred stock which was redeemable at $120 per share. The new class A and class B common shares were exchanged equally for corresponding shares of the 1925 issue. After consummation of the merger the Company had issued and outstanding $109,500 in debentures, 1,475 shares of class A common stock, and 1,240 shares of class B common stock.
Between 1940 and 1945 certain principal payments were made on the 1940 debentures and certain gifts of class B stock and 1940 debentures were made by Jennie Littman.
Also between 1940 and 1945 negotiations were continued concerning the retirement of the class A stock. Agreement was reached in 1945 for the retirement of the class A stock upon the basis of an exchange of $175 in new debenture bonds for each share. Following this agreement a ‘Plan of Reorganization and Recapitalization‘ was adopted by corporate action in June 1945 and was duly carried out. Under this plan there was one class of common stock amounting to 30,000 shares of the par value of $10 each. 24,800 of these shares were issued to the holders of the class B stock at the rate of 10 shares for one. Debenture bonds in the total amount of $400,000 were authorized of which bonds in the amount of $104,500 were issued in exchange for the corresponding amount of 1940 debentures outstanding and in the amount of $258,125 were issued in exchange for the outstanding 1,475 shares of class A stock at the rate of $175 per share.
The corporate resolution authorizing the recapitalization provided for the creation of a bookkeeping account designated ‘Capital Surplus Arising from 1945 reappraisal of fair value of shares of The Wolf Detroit Envelope Company owned by the Company.‘ To this account was charged $124,000, representing the increase in capital liability on the common stock over the class B stock, as well as $110,625, representing the excess of the face amount of new debenture bonds issued to replace the class A common shares over the liquidating value formerly assigned to such shares. To this account was credited the sum of $234,625, representing an increase determined by the board of directors in the valuation of shares of stock in the Wolf Detroit Envelope Company, a subsidiary, which shares were owned by the Company.
The Company had undivided earned surplus as of June 30, 1945, in excess of $362,000. For several years prior to 1945 the class B stockholders received dividends of $14.50 annually.
The recapitalization was effected as of July 1, 1945. Prior thereto the holders of the class A stock and debentures of the 1940 issue had been paid in cash all the dividends and interest called for by the debentures and by the stockholders' agreement.
The following schedule shows the security holdings in the Company and Wald as of June 14, 1940, prior to the merger of the two corporations, also the amounts of debentures distributed in the merger during that year, and the amounts of such debentures held on June 30, 1945, prior to recapitalization, together with the amounts of Class A and Class B common stock held as of June 30, 1945. The last two columns of the schedule show the number of shares of new common stock and the amounts of debentures distributed as of July 1, 1945, in the recapitalization.
+-------------------------------------------------------------------------------------------+ ¦Corporate Security Holdings in the Wolf Envelope Company and the Wald Realty ¦ ¦Company ¦ +-------------------------------------------------------------------------------------------¦ ¦ ¦June 14, 1940 ¦Dec. 31, ¦June 30, 1945 ¦July 1, 1945 ¦ ¦ ¦ ¦1940 ¦ ¦ ¦ +-----------+-----------------------+-----------+-------------------------+-----------------¦ ¦ ¦Common ¦ ¦ ¦Common ¦ ¦ ¦ ¦ ¦ ¦ +-----------+------------+-----+----+-----------+------+------+-----------+------+----------¦ ¦Stockholder¦“A” ¦“B” ¦2d ¦Wald¦Debentures ¦“A” ¦“B” ¦Debentures ¦Common¦Debentures¦ ¦ ¦ ¦ ¦Prfd.¦ ¦a ¦ ¦ ¦b ¦c ¦a ¦ +-----------+------+-----+-----+----+-----------+------+------+-----------+------+----------¦ ¦Nathan I. ¦467.5 ¦240 ¦50 ¦82.5¦$24,562.50 ¦467.5 ¦240 ¦$23,440.93 ¦4,800 ¦$150,000 ¦ ¦Dryfoos ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ +-----------+------+-----+-----+----+-----------+------+------+-----------+------+----------¦ ¦Alan L. ¦182.5 ¦85 ¦ ¦37.5¦8,437.50 ¦182.5 ¦85 ¦8,052.23 ¦1,700 ¦40,000 ¦ ¦Wolfe ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ +-----------+------+-----+-----+----+-----------+------+------+-----------+------+----------¦ ¦Margaret W.¦182.5 ¦85 ¦ ¦37.5¦8,437.50 ¦182.5 ¦85 ¦8,052.23 ¦1,700 ¦40,000 ¦ ¦Namm ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ +-----------+------+-----+-----+----+-----------+------+------+-----------+------+----------¦ ¦Louis ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦Littman ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ +-----------+------+-----+-----+----+-----------+------+------+-----------+------+----------¦ ¦Trust ¦258.75¦132.5¦ ¦ ¦ ¦258.75¦132.5 ¦ ¦2,650 ¦45,000 ¦ +-----------+------+-----+-----+----+-----------+------+------+-----------+------+----------¦ ¦Jennie ¦258.75¦132.5¦275 ¦92.5¦17,812.50 ¦258.75¦ ¦16,999.14 ¦ ¦62,000 ¦ ¦Littman ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ +-----------+------+-----+-----+----+-----------+------+------+-----------+------+----------¦ ¦Doris L. ¦ ¦ ¦ ¦ ¦e 18,000 ¦ ¦ ¦17,178.08 ¦ ¦17,000 ¦ ¦Lux ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ +-----------+------+-----+-----+----+-----------+------+------+-----------+------+----------¦ ¦Elsa L. ¦ ¦ ¦ ¦ ¦e 18,000 ¦ ¦ ¦17,178.08 ¦ ¦17,000 ¦ ¦Selden ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ +-----------+------+-----+-----+----+-----------+------+------+-----------+------+----------¦ ¦Alan L. ¦25 ¦50 ¦ ¦10 ¦2,250 ¦25 ¦e ¦2,147.26 ¦2,325 ¦7,000 ¦ ¦Littman ¦ ¦ ¦ ¦ ¦ ¦ ¦116.25¦ ¦ ¦ ¦ +-----------+------+-----+-----+----+-----------+------+------+-----------+------+----------¦ ¦Gladys G. ¦ ¦230 ¦ ¦ ¦ ¦ ¦230 ¦ ¦4,600 ¦ ¦ ¦Littman ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ +-----------+------+-----+-----+----+-----------+------+------+-----------+------+----------¦ ¦Rhoda L. ¦50 ¦200 ¦25 ¦35 ¦10,875 ¦50 ¦e ¦10,378.42 ¦4,725 ¦19,000 ¦ ¦Affelder ¦ ¦ ¦ ¦ ¦ ¦ ¦236.25¦ ¦ ¦ ¦ +-----------+------+-----+-----+----+-----------+------+------+-----------+------+----------¦ ¦Harry F. ¦50 ¦40 ¦ ¦5 ¦1,125 ¦50 ¦e 50¦1,073.63 ¦1,000 ¦10,000 ¦ ¦Affelder ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ +-----------+------+-----+-----+----+-----------+------+------+-----------+------+----------¦ ¦Lewis J. ¦ ¦20 ¦ ¦ ¦ ¦ ¦e 30¦ ¦600 ¦ ¦ ¦Affelder ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ +-----------+------+-----+-----+----+-----------+------+------+-----------+------+----------¦ ¦Ruth A. ¦ ¦20 ¦ ¦ ¦ ¦ ¦e 30¦ ¦600 ¦ ¦ ¦Hexter ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ +-----------+------+-----+-----+----+-----------+------+------+-----------+------+----------¦ ¦Olive A. ¦ ¦5 ¦ ¦ ¦ ¦ ¦5 ¦ ¦100 ¦ ¦ ¦Lins ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ ¦ +-----------+------+-----+-----+----+-----------+------+------+-----------+------+----------¦ ¦Total ¦1,475 ¦1,240¦350 ¦300 ¦$109,500.00¦1,475 ¦1,240 ¦$104,500.00¦24,800¦$362,000 ¦ +-------------------------------------------------------------------------------------------+
FNa Holdings of common “A” and “B” stock same as on June 30, 1945.FNb After reduction of $5,000 from the original amount issued, by proportionate payments to all holders on June 16, 1941.FNc Exchanged 20 for each share of “B” stock.FNd Exchanged evenly for old debentures; and $175 of debenture bonds for each share of “A” stock. Odd amounts adjusted by cash payments.FNe Gift November 16, 1940, from Jennie M. Littman.FNf Increase of 10 shares each through gift of Rhonda L. Affelder, December 12, 1940.
The shares of class A and class B common stock issued in 1925 and in 1940, the debenture shares issued in 1940, and the common stock issued in 1945 were subject to certain restrictions upon their transferability. Shares could be transferred by gift or sale to another stockholder or a member of the family of a stockholder or could pass to an heir under the Statutes of Descent and Distribution, or to a guardian, executor, or trustee. Shares could not be pledged or sold otherwise unless they were first offered for sale to the Company and the price fixed by arbitration if not otherwise agreed upon. The debenture bonds issued in 1945 were not subject to this restriction.
The debenture shares issued in 1940 were of the par value of $100 each, bore interest at 5 per cent per annum payable quarterly, and matured June 15, 1960, unless sooner called for redemption. The Company retained the right to redeem $5,000 in par value each year substantially in proportion to the amounts held. The debenture shares were convertible at the option of the holder into class B common stock at the rate of one share of stock for each $400 face value of debentures, provided the holders of two-thirds of the outstanding debentures consented thereto and there was unissued class B stock available.
The debenture bonds issued in 1945 were coupon books in denominations of $1,000, bore 5 per cent interest payable semiannually, and matured July 1, 1965. The Company at its option might after 1 year call for retirement each year from two to five per cent of the issue, the bonds to be selected by lot. After 10 years the Company might retire any or all of the bonds upon the payment of a stipulated premium.
Edward D. Green, employed by the Company as city sales manager, was elected to the Company's board of directors in October 1945. In November of that year he purchased 400 of the Company's new common shares. Lewis J. Affelder, son of Harry F. Affelder, has been a director since March 1942.
As a consequence of the recapitalization in 1945 the trustees of the Louis Littman Trust received approximately $45,000 of the newly authorized debenture bonds in exchange for class A common stock. The trustees held such bonds as capital assets of the trust and did not distribute them to Jennie Littman, the beneficiary.
Condensed balance sheets of the Company as of June 30, 1945, and July 1, 1945, show the following:
+-------------------------------------------------------------------+ ¦Assets: ¦June 30 ¦July 1 ¦ +------------------------------------------+-----------+------------¦ ¦Cash, Accounts Receivable, and Inventories¦$338,837.79¦$338,212.79 ¦ +------------------------------------------+-----------+------------¦ ¦Investments- ¦ ¦ ¦ +------------------------------------------+-----------+------------¦ ¦Bonds ¦231,061.26 ¦231,061.26 ¦ +------------------------------------------+-----------+------------¦ ¦Wolf Detroit Stock ¦38,700.00 ¦273,325.00 ¦ +------------------------------------------+-----------+------------¦ ¦Total Current ¦608,599.05 ¦842,599.05 ¦ +------------------------------------------+-----------+------------¦ ¦Fixed Assets-less depreciation ¦179,252.29 ¦179,252.29 ¦ +------------------------------------------+-----------+------------¦ ¦Other Assets ¦71,236.27 ¦71,236.27 ¦ +------------------------------------------+-----------+------------¦ ¦Total Assets ¦859,087.61 ¦1,093,087.61¦ +------------------------------------------+-----------+------------¦ ¦Liabilities: ¦ ¦ ¦ +------------------------------------------+-----------+------------¦ ¦Current ¦190,086.31 ¦190,086.31 ¦ +------------------------------------------+-----------+------------¦ ¦Capital Stock ¦271,500.00 ¦248,000.00 ¦ +------------------------------------------+-----------+------------¦ ¦Debentures ¦104,500.00 ¦362,000.00 ¦ +------------------------------------------+-----------+------------¦ ¦Surplus ¦293,001.30 ¦293,001.30 ¦ +------------------------------------------+-----------+------------¦ ¦Total Liabilities, Capital, and Surplus ¦859,087.61 ¦1,093,087.61¦ +-------------------------------------------------------------------+
The exchanges in 1945 of debenture shares for debenture bonds and of class A stock for debenture bonds pursuant to the plan adopted by the board of directors of the Company did have have the effect of the distribution of a dividend, nor did they occur at such time and in such manner as to make them in any part the essential equivalent of the distribution of a dividend. The recipients of the debenture bonds did not realize income taxable in 1945 as a consequence of these exchanges.
OPINION.
TIETJENS, Judge:
The principal issue concerns the tax effect of an exchange of securities of the Wolf Envelope Company carried out July 1, 1945. There were three types of exchanges, two of which are in controversy. The exchange of class B no par value common stock for new $10 par value common at 20 shares for one is not in question. The challenged exchanges were those in which 5 per cent debenture bonds of the 1945 issue were received. The holders of debentures shares of the 1940 issue exchanged them for debenture bonds of the 1945 issue of the same face amount, but containing terms and conditions substantially different. Also, the holders of class A common shares exchanged such shares for debenture bonds, receiving $175 in face amount of debenture bonds for each share of stock. Respondent contends that the exchanges in which security holders received debentures effected a distribution of earnings and profits accumulated by the Company. The deficiency notices stated that the exchanges resulted in a distribution by the corporation to its stockholders of property, taxable as a dividend, in amounts equal to the fair market of the debenture bonds, in accordance with the provisions of section 115(g)(1), Internal Revenue Code.
SEC. 115. DISTRIBUTION BY CORPORATIONS.(g) REDEMPTION OF STOCK.—(1) IN GENERAL.— If a corporation cancels or redeems its stock (whether or not such stock was issued as a stock dividend) at such time and in such manner as to make the distribution and cancellation or redemption in whole or in part essentially equivalent to the distribution of a taxable dividend, the amount so distributed in redemption or cancellation of the stock, to the extent that it represents a distribution of earnings or profits accumulated after February 28, 1913, shall be treated as a taxable dividend.
Section 115(g)(1) provides that where a corporation cancels or redeems its stock in such a manner as to make the distribution and cancellation or redemption in whole or in part essentially equivalent to the distribution of a taxable dividend, the amount so distributed shall be treated as a taxable dividend to the extent that it represents a distribution of accumulated earnings or profits. The respondent says that the Company accumulated profits from many years of successful operation until the major part of its financial structure consisted of undistributed earnings that had been capitalized and that the 1945 exchange effected a distribution reducing the Company's assets by $234,625 and increasing by this amount the assets in the hands of the stockholders.
The petitioners contend that section 112(b)(3) of the Code is controlling here. Such section provides:
No gain or loss shall be recognized if stock or securities in a corporation a party to a reorganization are, in pursuance of the plan of reorganization, exchanged solely for stock or securities in such corporation * * *
Under section 112(g)(2)(E) a ‘reorganization‘ is defined as including a ‘recapitalization.‘ The petitioners contend that the changes effected in 1945 in the capital structure of the Company constitute a recapitalization within the scope of this provision.
It is plain that stock and debenture shares of the corporation were exchanged for debenture bonds of the same corporation and that the exchange was pursuant to a plan adopted by the board of directors. There appears to be no reason to doubt that the debenture bonds were ‘securities‘ within the meaning of section 112(b)(3). They were 20-year 5 per cent bonds. While the Company reserved the right after 1 year to redeem them in amounts of from two to five per cent annually of the total issued and to redeem all after 10 years on payment of a stipulated premium, long term bonds frequently contain similar provisions. Such provisions do not require treatment of the bonds as short term obligations and therefore not ‘securities.‘ Cf. L. & E. Stirn, Inc. v. Commissioner, 107 F.2d 390, reversing 39 B.T.A. 143.
The term ‘recapitalization‘ is not defined in the statute. It has a broad meaning, and has been held to apply to exchanges involving debentures. Commissioner v. Neustadt's Trust, 131 F.2d 528, affirming 43 B.T.A. 848. See also Mutual Fire, Marine & Inland Insurance Co., 12 T.C. 1057; Globe-News Publishing Co., 3 T.C. 1199. It has been said to refer to a ‘reshuffling of a capital structure within the framework of an existing corporation, ‘ Helvering v. Southwest Consol. Corporation, 315 U.S. 829. The exchanges here involved accomplished such a rearrangement of the capital structure. This was a ‘recapitalization‘ and hence a ‘reorganization,‘ within the intent of section 112. See Edgar M. Docherty, 47 B.T.A. 462, Clarence J. Schoo, 47 B.T.A. 459.
Respondent contends that the exchanges of debentures were without a genuine business purpose of the corporation, and relies on Bazley v. Commissioner, 331 U.S. 737, and Adams v. Commissioner, (same citation). In the Bazley case, the taxpayer and his wife owned 999 of a corporation's 1,000 shares of stock. Under a plan of reorganization they exchanged each share for five shares of new no-par-value stock and new debenture bonds, payable in 10 years but callable at any time. In the Adams case the taxpayer owned all but a few shares of a corporation's stock, and, pursuant to a purported plan of reorganization exchanged each for one share of new no-par-value stock and one 6 per cent 20-year debenture bond. The capital amount was reduced and the book surplus left intact. The Tax Court (4 T.C. 897 and 5 T.C. 351), the Court of Appeals for the Third Circuit (155 F.2d 237 and 246), and the Supreme Court concluded in both cases that the exchanges were not within the reorganization provisions of section 112, but represented a distribution of profits. The Supreme Court pointed out that a distribution of accumulated earnings obtains no immunity by being cast in the form of a reorganization, that nothing was accomplished by the exchanges that could not have been accomplished by an outright dividend of debentures, and that the provisions of section 112 do not apply unless the new arrangement has the characteristics of a reorganization which underlie the purpose of the Congress in postponing tax upon the securities distributed.
The instant case, unlike the Bazley and Adams cases, does not involve a corporation which was the alter ego of the taxpayer. No one stockholder here held a majority of the voting shares at any time.
There was a purpose accomplished by these exchanges. It was one which would not have been carried out by an outright dividend of debentures. The sequence of events and trends of interests which led to this transaction are shown in detail in the stipulated facts and are summarized in our stated findings.
The founders of the Company had developed an unusually profitable business. The stock was always closely held and, with only minor exceptions, remained in the possession of the families of the founders. When Affelder and Alan Littman entered the employ of the Company, the founders were enjoying the fruit of their investment and good business fortune. Affelder contributed some inventions and developments and served as superintendent of the Company. Alan Littman became sales manager. These two men succeeded in effecting an increase in the Company's earnings. As a consequence they received employment contracts providing for a fixed salary and additional compensation to be measured by a percentage of the increases they were able to bring about in the profits. The ‘participation certificates‘ and the ‘B‘ stock issued later, in 1925, carried out this scheme of additional compensation. The ‘A‘ stock, replacing the former common, carried a fixed dividend representing the earnings level of the business prior to 1918. The ‘B‘ stock was to receive all further dividends. Affelder and Alan Littman received each about 22.5 per cent of this class of stock which gave them a share in the increased earnings and carried voting rights. The remainder of the ‘B‘ stock was issued to other holders of ‘A‘ stock.
During the years 1935 to 1940 Affelder and Alan Littman were in active charge of the business. The principal holders of ‘A‘ stock were generally not participating in the management. Dryfoos, who held nearly 32 per cent of the ‘A‘ stock, served as a director and in an advisory capacity. Alan Wolfe and Margaret Namm had inherited the interest of Alfred Wolf and together held about 25 per cent of the ‘A‘ stock. Louis Littman's interest was held by his widow Jennie Littman and by the Louis Littman Trust, of which Jennie was life beneficiary, each holding some 17.5 per cent of the ‘A‘ stock.
Affelder and Littman sought to improve their own positions with respect to sharing in the earnings and to reduce the burden the business had carried of paying the preferential dividend of $13.20 annually on the class A stock, principally benefiting inactive stockholders. The business had to pay $17,280 each year in dividends on the 1,350 ‘A‘ shares held by Dryfoos, Alan Wolfe, Margaret Namm, Jennie Littman, and the Louis Littman Trust, before dividends could be distributed to the active managers upon their ‘B‘ shares. This was a cumulative dividend and in adversity might deprive the active managers of dividends except on their comparatively small ‘A‘ holdings. At the time of the merger with Wald in 1940 no agreement had been reached on this question. Affelder and Littman negotiated with the ‘A‘ stockholders for the surrender of their voting rights and preferential dividends and for retirement the debenture shares, principally held by ‘A‘ stockholders, which were convertible into ‘B‘ stock and might thereby dilute the voting power of the ‘B‘ stockholders, but did not reach agreement as to the basis until 1945. The recapitalization here involved carried out that agreement.
This exchange of ‘A‘ stock for debenture bonds served the purposes of Affelder and Littman by eliminating the ‘A‘ stock, with its voting rights and preferential dividend. For each former ‘A‘ share with its $13.20 dividend requirement before ‘B‘ stock could receive dividends, there was issued $175 in principal amount of debentures, on which $8.75 in interest was to be paid. Also, Affelder and Littman could thereafter engage executive talent with the promise of stock available for the purchase of an interest not subject to the former burden of the preferential dividend. The arrangement served the purposes of the ‘A‘ stockholders who were not contributing to the Company's management by giving them a long term interest bearing security in a sound going business in which the management would be more satisfied with the capital structure. The exchange of debenture shares for debenture bonds eliminated the possibility of conversion of shares into ‘B‘ stock, thus securing the voting power of the new common stockholders and gave the debenture holders a security free of restrictions upon transferability. The plan accomplished what all the stockholders agreed upon. It is a sufficient and valid purpose if the exchange effects a shift in voting rights as between one group of stockholders and another. Marjorie N. Dean, 10 T.C. 19, and Elmer W. Hartzell, 40 B.T.A. 492. These purposes could not have been carried out by a direct pro rata distribution of debentures such as could have been done in Bazley, supra, and Adams, supra. While each ‘A‘ stockholder had some ‘B‘ stock and nearly every ‘B‘ stockholder held ‘A‘ stock, the holdings were in different proportions and a rearrangement was accomplished among the stockholders effecting alterations in their relationships to each other and to the Company as in the Dean and Hartzell cases, supra. Although the stockholders who received new debentures for ‘A‘ stock received securities having a face value in excess of the liquidating value previously assigned to the stock they surrendered, this was still an ‘exchange‘ governed by section 112, not a taxable ‘distribution‘ within the province of section 115, and the resulting gain, if any, was not ‘cashed in‘ at that time. Under the statute its liability is postponed to a later disposition whereby gain or loss is realized.
Respondent argues that the professed purpose of shifting voting control to the ‘younger group‘ was not accomplished, saying that Harry Affelder and Alan Littman are by now elderly men and soon will be ‘absentee owners‘ and that Lewis Affelder and E. D. Green, who now are the ‘younger group‘ acquired only some three per cent of the voting stock and have little chance of getting more, and argues further that the ‘B‘ stockholders, receiving a dividend of $14.50 a year per share, had no reason to complain about the $13.20 per share dividend on the ‘A‘ shares. These arguments are beside the point. Harry Affelder and Alan Littman were actively in management since about 1925 and, as the record shows, were still the managers in 1950. Their ages do not appear in the record and there is no evidence to support the respondent's assumption that they are now elderly men or ‘absentees.‘ They were doing the work and carried a burden in earning a large dividend for the inactive stockholders. Their dividends could be larger if this burden was reduced. The point is that all the stockholders, by agreement, accomplished a change in the corporation's capital structure affecting voting control and the carrying charges ranking prior to the new common stock.
Respondent contends, in the alternative, that section 112(c)
applies. Section 112 deals with recognition of gain or loss and subsection (b) thereof applies to exchanges solely in kind. This was an exchange of stock or securities for stock or securities, and, since the exchange was pursuant to a reorganization, section 112(b)(3) provides that no gain is to be recognized. Section 112(c) deals with exchanges not solely in kind; that is, where other property or money is received in the exchange. There was no money received here and no property other than the debentures, which fall within subsection (b)(3); hence 112(c) is not applicable. Respondent points out that in the Bazley case, supra, the Court observed that even if the transaction were deemed a reorganization, ‘the facts would equally sustain the imposition of the tax on the debenture under Sec. 112(c)(1) and (2).‘ The Court had earlier commented that the debentures ‘were virtually cash because they were callable at the will of the corporation which in this case was the will of the taxpayer.‘ No such circumstances exist here. The debentures were not callable within 10 years except in small amounts and by lot.
SEC. 112. RECOGNITION OF GAIN OR LOSS.(c) GAIN FROM EXCHANGES NOT SOLELY IN KIND.—(1) If an exchange would be within the provisions of subsection (b)(1), (2), (3), or (5), or within the provisions of subsection (1), of this section if it were not for the fact that the property received in exchange consists not only of property permitted by such paragraph or by subsection (1) to be received without the recognition of gain, but also of other property or money, then the gain, if any, to the recipient shall be recognized, but in an amount not in excess of the sum of such money and the fair market value of such other property.(2) If a distribution made in pursuance of a plan of reorganization is within the provisions of paragraph (1) of this subsection but has the effect of the distribution of a taxable dividend, then there shall be taxed as a dividend to each distributee such an amount of the gain recognized under paragraph (1) as is not in excess of his ratable share of the undistributed earnings and profits of the corporation accumulated after February 28, 1913. The remainder, if any, of the gain recognized under paragraph (1) shall be taxed as a gain from the exchange of property.
Respondent further argues that, aside from other evidence, the reduction occurring in the Company's surplus as a consequence of this exchange demonstrates that a dividend was distributed. This contention might be pertinent if the transaction were removed from the scope of section 112. We think, however, it falls within the operation of that section and we hold that the exchanges of 1940 debenture shares and ‘A‘ stock for 1945 debenture bonds were exchanges of stock or securities for securities pursuant to a plan or reorganization in which, pursuant to section 112(b)(3) of the Code, no gain or loss is to be recognized.
In view of this conclusion it is not necessary to decide the issue raised in the case of Jennie Littman, Docket No. 25554, with reference to taxing to her the income of the Louis Littman Trust arising from receipt of debenture bonds by the Trust. Also, contested adjustments for medical expense deductions resulting from the increased income determined will now be resolved in favor of the taxpayers in Alan L. Littman, Docket No. 25555, Rhoda L. Affelder, Docket No. 25557, and Estate of Nathan I. Dryfoos, Docket No. 25560.
It appears that issues arising in the case of the Company, Docket No. 25751, which depended upon our conclusion upon the principal issue may be resolved in a computation under Rule 50.
Reviewed by the Court.
Decision in Docket No. 25751 will be entered under Rule 50. Decision in the other Docket Nos. will be entered for the petitioners.