Opinion
Docket No. 10018 10019 10020.
1948-01-8
MARJORIE N. DEAN, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.VIRGINIA DEAN GRANT-LAWSON, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.ETHEL X. NORTHUP, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.
F. N. Furber, Esq., for the petitioners. E. C. Adams, Esq., for the respondent.
Stockholders of a corporation in 1941 adopted a plan of recapitalization whereby stockholders were permitted to exchange one share of existing stock having $50 par value for 1 1/4 shares of nonvoting preferred stock of no par value carrying a $5 cumulative dividend and redeemable at $100. The purpose of the plan was to induce inactive women stockholders to surrender voting stock, to make remaining stock more salable, and to induce new executive talent to accept employment. Held, recapitalization had a corporate business purpose and constituted a nontaxable reorganization. Elmer W. Hartzell, 40 B.T.A. 492, followed. F. N. Furber, Esq., for the petitioners. E. C. Adams, Esq., for the respondent.
The petitioners in these consolidated proceedings seek a redetermination of deficiencies in income tax for the year 1941 as follows:
+---------------------------------------------+ ¦Petitioner ¦Docket.¦Deficiency¦ +--------------------------+-------+----------¦ ¦Marjorie N. Dean ¦10018 ¦$10,082.55¦ +--------------------------+-------+----------¦ ¦Virginia Dean Grant-Lawson¦10019 ¦1 917.10¦ +--------------------------+-------+----------¦ ¦Ethel X. Northup ¦10020 ¦2,025.00 ¦ +---------------------------------------------+
The question presented is as to whether or not the petitioners realized a capital gain when, in the recapitalization of the North Star Woolen Mills Co., they exchanged stock having a $50 par value for no par value preferred stock with a cumulative return of $5 per share, at a ratio of one share of $50 par value stock for 1 1/4 shares of preferred stock.
FINDINGS OF FACT.
A part of the facts developed at the hearing were stipulated. We adopt the stipulation.
Marjorie N. Dean, the petitioner in Docket No. 10018, is a citizen of the United States residing in England and filed her Federal income tax return for the calendar year 1941 with the collector of internal revenue for the district of Maryland at Baltimore, Maryland. Virginia Dean Grant-Lawson, the petitioner in Docket No. 10019, is a citizen of the United States residing in England and filed no Federal income tax return for the calendar year 1941, but income tax of $577.50 on her income for that year was withheld at the source and paid to the collector of internal revenue for the district of Minnesota at St. Paul, Minnesota. Ethel X. Northup, the petitioner in Docket No. 10020, filed her Federal income tax return for the calendar year 1941 with the collector of internal revenue for the district of Minnesota, St. Paul, Minnesota. These returns were filed and petitioners' books are kept upon a cash receipts and disbursements basis.
North Star Woolen Mills Co. (hereinafter called North Star) for many years prior and subsequent to 1941 manufactured blankets and other textile articles.
Prior to December 1941 its capital stock consisted of 8,000 shares of one class having a par value of $50. The issued stock was held as follows:
+-----------------------------------------------------------------------------+ ¦ ¦Shares ¦ +--------------------------------------------------------------------+--------¦ ¦William G. Northup ¦705 ¦ +--------------------------------------------------------------------+--------¦ ¦William B. Northup and his sister, Marjorie N. Dean, as trustees ¦ ¦ ¦under ¦ ¦ +--------------------------------------------------------------------+--------¦ ¦testamentary trust created by their father's last will and testament¦800 ¦ +--------------------------------------------------------------------+--------¦ ¦J. N. Lindeke ¦200 ¦ +--------------------------------------------------------------------+--------¦ ¦Ethel X. Northup, petitioner in Docket No. 10020 ¦1,00 ¦ +--------------------------------------------------------------------+--------¦ ¦William G. Northup, as executor of the estate of his deceased ¦ ¦ ¦mother, ¦ ¦ +--------------------------------------------------------------------+--------¦ ¦Leila T. Northup ¦475 ¦ +--------------------------------------------------------------------+--------¦ ¦Marjorie N. Dean, petitioner in Docket No. 10018 ¦845 ¦ +--------------------------------------------------------------------+--------¦ ¦Virginia Dean Grant-Lawson, petitioner in Docket No. 10019, daughter¦ ¦ +--------------------------------------------------------------------+--------¦ ¦of Marjorie N. Dean ¦105 ¦ +--------------------------------------------------------------------+--------¦ ¦Marjorie Dean, daughter of Marjorie N. Dean ¦105 ¦ +--------------------------------------------------------------------+--------¦ ¦Estate of Leila Lewin-Harris, deceased, daughter of Marjorie N. Dean¦105 ¦ +--------------------------------------------------------------------+--------¦ ¦Directors' qualifying shares ¦2 ¦ +--------------------------------------------------------------------+--------¦ ¦Total ¦4,342 ¦ +-----------------------------------------------------------------------------+
For many years prior to 1941 North Star had become increasingly a one-man company, with William G. Northup having the entire executive responsibility. In 1939 Northup's chief assistant urged upon him the necessity of developing executive employees having a financial interest in the company who would be secure in their positions in event of the death of William G. Northup, when the stock control of the company would fall into the hands of women having no experience with the company, much of said stock being held by nonresidents of this country.
Shortly thereafter this manager resigned and the same proposition was urged upon Northup by one of his directors and subsequently by his banker at a time when North Star was obtaining large amounts of its needed capital from bank borrowings and when it was contemplating the purchase of a new mill at Lima, Ohio. Northup then, complying with this advice and with the triple purpose of preventing the company from falling under the voting control of inexperienced women, of inducing new executive talent to take a financial interest in the company in addition to the salary received, and of placing the stock of the company in a position so that it would be attractive to investors, devised a plan the more pertinent features of which were:
The capital of the corporation was to consist of 14,000 shares, of which 8,000 would be common stock of the par value of $50 and 6,000 would be preferred shares without par value. The directors were to reserve the right to designate the number of preferred shares to be issued at any one time and the dividend rate therefor. The redemption value, in the event of the dissolution of the company, was not to exceed $115 for each preferred share and the preferred shares were to have no voting power unless one year's dividend was passed.
On December 17, 1941, the stockholders, at a special meeting, approved this plan as an amendment to the articles of incorporation and adopted a resolution that each holder of an outstanding share should be given the privilege of exchanging one of said shares for 1 1/4 of the preferred shares; that the cumulative dividends on the preferred shares would be $5 and the redemption amount, in the event of dissolution of the company, would be $100. All stock other than the preferred was reclassified as common shares. On the same date the articles of incorporation were amended. On December 24 the board of directors approved the resolution passed by the stockholders and provided that the common stock should have a stated value of $125 per share and that, of each $100 consideration received for each share of $5 cumulative preferred stock, $40 should constitute stated capital and $60 paid-in surplus.
On December 31, 1941, the surplus account of North Star contained the following entries:
+---------------------------------------------------------------------------+ ¦Add: ¦ ¦ +---------------------------------------------------------------+-----------¦ ¦Excess of consideration over stated value of preferred stock as¦ ¦ +---------------------------------------------------------------+-----------¦ ¦determined by Board of Directors, issued in exchange for ¦ ¦ +---------------------------------------------------------------+-----------¦ ¦common stock ¦$169,125.00¦ +---------------------------------------------------------------+-----------¦ ¦Deduct: ¦ ¦ +---------------------------------------------------------------+-----------¦ ¦Premium on common stock surrendered in exchange for ¦ ¦ +---------------------------------------------------------------+-----------¦ ¦preferred stock, based on value as determined by directors ¦169,125.00 ¦ +---------------------------------------------------------------------------+
The list of the stockholders exchanging old shares for preferred shares is as follows:
+-----------------------------------------------------------------------------+ ¦Stockholder ¦Shares ¦New preferred ¦ ¦ ¦exchanged ¦shares received ¦ +-----------------------------------------------+----------+------------------¦ ¦Marjorie N. Dean, the petitioner in Docket No. ¦845 ¦1,056 1/4 ¦ ¦10018 ¦ ¦ ¦ +-----------------------------------------------+----------+------------------¦ ¦Virginia Dean Grant-Lawson, the petitioner in ¦105 ¦131 1/4 ¦ ¦Docket No. 10019 ¦ ¦ ¦ +-----------------------------------------------+----------+------------------¦ ¦Marjorie Dean ¦105 ¦131 1/4 ¦ +-----------------------------------------------+----------+------------------¦ ¦Ethel X. Northup, the petitioner in Docket No. ¦1,000 ¦1,250 ¦ ¦10020 ¦ ¦ ¦ +-----------------------------------------------+----------+------------------¦ ¦William G. Northup, as executor of the estate ¦200 ¦250 ¦ ¦of Leila T. Northup, deceased ¦ ¦ ¦ +-----------------------------------------------+----------+------------------¦ ¦Total ¦2,255 ¦2,818 3/4 ¦ +-----------------------------------------------------------------------------+
For the five-year period prior to 1941 the earnings per share and the dividends per share of North Star were as follows:
+----------------------------+ ¦Year¦Net earnings ¦Dividends¦ +----+-------------+---------¦ ¦ ¦per share ¦per share¦ +----+-------------+---------¦ ¦1936¦$22.40 ¦$15.00 ¦ +----+-------------+---------¦ ¦1937¦(3.21) ¦15.00 ¦ +----+-------------+---------¦ ¦1938¦(8.33) ¦None ¦ +----+-------------+---------¦ ¦1939¦1.75 ¦None ¦ +----+-------------+---------¦ ¦1940¦17.00 ¦10.00 ¦ +----------------------------+
Beginning with 1942 and continuing through 1944 war demands suddenly simplified North Star's problem with respect to needed capital, but made more difficult the acquisition of new executive talent. During eighteen months of this period North Star was producing for the Government 100 per cent. However, during this period two new managers were employed, with the inducement that if successful they would be privileged to acquire stock in the company. One of these managers remained with the company and made tentative arrangements to acquire stock. On September 6, 1945, the articles of incorporation were amended to authorize an increase in the number of shares of common stock, the increase to be accomplished by reducing the par value of the new issue to $5 per share.
On September 13, 1945, the directors by resolution limited the number of $5 preferred shares to 2,818 3/4, being those outstanding, and on September 26, 1945, authorized the issuance of 3,000 of preferred nonvoting shares with cumulative dividends of $4 per share. At the September 13 meeting the directors also authorized a sale of new common stock to the new manager and a number of lesser employees. This stock was duly purchased prior to February 1946 and negotiations were initiated to sell the new stock issue to owners not connected with the company, but these negotiations were not consummated at the time of the issuance of the deficiency notice.
The recapitalization of December 1941 did not channel to the preferred stockholders accumulated earnings of North Star. It was done to accomplish a business purpose of North Star and no capital gain was realized.
OPINION.
HARLAN, Judge:
Petitioner contends that by virtue of the provisions of sections 112(b)(3) and 112(g)(1)(E), I.R.C.,
North Star, in December 1941, accomplished a reorganization for which no gain or loss is recognized to the stockholders.
Decisions will be entered for the petitioners. SEC. 112. RECOGNITION OF GAIN OR LOSS.(b) EXCHANGES SOLELY IN KIND.—(3) STOCK FOR STOCK ON REORGANIZATION.— 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 or in another corporation a party to the reorganization.(g) DEFINITION OF REORGANIZATION.— As used in this section * * * and in section 113 * * *(1) The term ‘reorganization‘ means * * * (E) a recapitalization. -------- Notes:
Inclusive of 25% penalty, in the amount of $183.42 for failure to file a return within the time prescribed by law, which penalty is not involved in these proceedings.
Respondent argues that the reorganization, consisting of a recapitalization, was but a subterfuge whereby a part of North Star's surplus was channeled to the preferred stockholders and that the taxpayers thereby received taxable capital gain in the year when the preferred stock was received.
When this recapitalization occurred it would seem to be established that petitioners' contention had been approved by the Board of Tax Appeals in Elmer W. Hartzell, 40 B.T.A. 492. In that case the taxpayer had received preferred stock in exchange for his common stock in pursuance of a plan of the stockholders so designed that the older stockholders of the corporation would turn the corporate management over to a group of younger stockholders and that the latter would acquire all of the voting common stock, while the older stockholders would receive the nonvoting preferred stock. The Board approved this recapitalization as a tax-free reorganization. This decision was later acquiesced in by the Commissioner. (C.B. 1939-2, p. 16.)
However, in the case at bar the Commissioner contends that the present case is controlled by the recent decisions of the United States Supreme Court and the Court of Appeals for the Seventh Circuit in the recent cases of Adams v. Commissioner, 331 U.S. 737; Bazley v. Commissioner, 331 U.S. 737; and Heady v. Commissioner, 162 Fed.(2d) 699.
In the Bazley case the taxpayer and his wife owned all of the capital stock except one qualifying share. There were 1,000 shares with a par value of $100 each. Under the recapitalization plan each old share was exchanged for 5 new shares having no par value and a stated value of $60. In addition debenture bonds of a face value of $400,000, payable in 10 years but callable at any time, were distributed pro rata among the stockholders. The corporation had an earned surplus of $855,783.82. The Supreme Court, in sustaining the decision of the Tax Court, held that for a recapitalization to constitute a tax-free reorganization it must not ‘exempt from payment of a tax what is a practical matter of realized gain.‘ More particularly, the Court said:
In the case of a corporation which has undistributed earnings the creation of new corporate obligations which are transferred to stockholders in relation to their former holdings so as to produce for all practical purposes the same result as the distribution of cash earnings of equivalent value cannot obtain tax immunity because cast in the form of a recapitalization-reorganization.
The Court held that the debentures issued were virtually cash because they were callable by a corporation controlled by those holding the debentures.
The Adams case in its legal aspects was similar to the Bazley case.
In Heady v. Commissioner, supra, two stockholders owning all of the stock in a corporation, which consisted of 1,000 shares of no par value, desired to sell the stock. Realizing no success, a plan was devised to employ a practical manager having special ability and background to operate the corporation and ultimately purchase the stock. The corporation was recapitalized by substituting 1,000 shares of $1 par value stock for the old issue and issuing debenture bonds in the amount of $135,000. The corporate surplus was $103,000. The debenture bonds were issued pro rata to the old stockholders. The contract of employment with the new manager permitted him to buy the capital stock of the corporation as rapidly as he was able to retire the debenture bonds, so that when the bonds were retired he would own the corporate assets. The Court held that the purpose of this recapitalization was not a corporate business purpose, but merely a business purpose of the stockholders, and said:
The effect of this was to syphon off that part of the book value of the shares attributable to profits and earnings accumulated after February 28, 1913, thereby effecting a distribution of those earnings and profits.
A number of distinctions between the case at bar and the three cases relied upon by the Commissioner would seem to be apparent. In the case before us, no debenture obligations were issued. The preferred stock was not distributed in proportion to the common stockholdings, but in exchange therefor; the petitioners retained no control when they surrendered their common shares. The purpose behind the distribution of preferred shares in the case at bar was admitted to be to transfer voting control from one group of stockholders to another, and an issue of debenture bonds or preferred stock in proportion to the stockholdings would have been useless for this purpose.
The respondent argues that the setting aside in the surplus account of $169,125 for the purposes set forth in our findings was tantamount to the conversion of this amount of the corporate reserves to the ultimate use of the preferred stockholders.
We would be unable to support the respondent's premise or to accept his conclusions as affecting any capital gain to the preferred stockholders in 1941 even if the premise were true. In the Bazley case the Court, in commenting upon bookkeeping entries in the corporation's books in that case, stated that, whatever their effect might be on the corporate books, such entries could not affect the substantive rights of the security holders as represented in the inherent nature of their securities. We are unable in the case at bar to see in what manner the bookkeeping of North Star could add to or take from the preferred stockholders' interest, even though an admitted reserve were set up. We shall not attempt to pass upon the effect of these bookkeeping entries, except to note that the petitioner on brief states that the addition of $169,125 to the reserve was obtained by multiplying the number of preferred shares issued, 2,818 3/4 by $60, the excess of the consideration received for a preferred share over its stated value of $40, and that the deduction of the same $169,125 was obtained by multiplying the number of common shares exchanged, 2,255, by $75, which is the excess of the stated value of a common share over its par value. While all of this is somewhat confusing, two facts would seem to be very simple: (1) In 1941 the preferred stockholders received no gain, either capital or income, as a result of said entries; and (2) since the amount added to the surplus equals the amount deducted therefrom, the surplus at the end of the transactions seems to be unaffected.
The respondent also complains that there was no intention at the time of the authorized issue of the preferred stock to issue it to all stockholders, and he therefore questions the bona fides of the transaction. It is to be noted in the Hartzell case that the same situation existed, although the result was achieved by a more roundabout course than in the case at bar.
The respondent also complains that the recapitalization lacked sincerity because nothing was accomplished by the recapitalization, at least until after September 1945, when the common stock was split into ten shares for one and a new issue of $4 preferred stock was authorized.
It is to be noted, however, that after the 1941 recapitalization a new manager was employed, who testified that, if the possibility of the corporation devolving upon inexperienced women upon the death of William G. Northup had continued and if he had not been promised the right to purchase into the corporate stock, he would not have been interested in remaining with the company. This promise made to this manager was carried out in September 1945, by the authorized sale of stock to him and other employees.
It is also to be noted that the intervention of the war produced new problems making the recapitalization contemplated in December of 1941 no longer such an urgent necessity and at the same time the new problems made such a recapitalization more difficult than it was in December of 1941. However, with the close of the war the directors of North Star proceeded as was planned in 1941 and a large portion of the stock sales and the plans for stock sales initiated in September 1941 would not have been possible without the reorganization of 1941 unless a similar reorganization could have been effected prior to September of 1945.
It is therefore our conclusion that the law of the Elmer W. Hartzell case, supra, is controlling under the facts in the case at bar.
Reviewed by the Court.