Opinion
Docket No. 107761.
1943-08-10
LEO WALLERSTEIN, PETITIONER v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.
Peter I. B. Lavan, Esq., and Albert A. Jones, Esq., for the petitioner. James C. Maddox, Esq., for the respondent.
1. All of the common stock of X corporation was owned by petitioner and his brother and the preferred stock was owned by their wives and by two valued employees of the corporation. The preferred stock was callable by the corporation at 120, and, after the payment of 7% dividends thereon, was entitled to additional dividends equivalent to any dividends declared on the common stock. Held, dividends paid to holders of preferred stock in accordance with its terms are not gifts of the common stockholders to the preferred stockholders.
2. X corporation in 1934 and 1935 reduced its common stock, thereby enhancing the value of the participating preferred stock and giving it a right to a greater proportionate share of the future earnings of the corporation. Held, the payment of the increased dividends to preferred stockholders in 1936 and 1937 did not constitute gifts from the common stockholders in those years.
3. Exclusions were erroneously allowed petitioner in previous tax years in connection with gifts of future interests to a trust for the benefit of petitioner's children. Held, such exclusions should be disregarded for the purpose of determining petitioner's total net gifts and the rates of tax applicable to petitioner's gifts in current tax years, even though the statute of limitations has run as to the previous years. Peter I. B. Lavan, Esq., and Albert A. Jones, Esq., for the petitioner. James C. Maddox, Esq., for the respondent.
The Commissioner determined a deficiency in petitioner's gift tax for the year 1936 in the amount of $41,736.79 and for the year 1937 in the amount of $8,920.31, by reason of including in petitioner's net gifts for those years amounts representing dividends received by four preferred stockholders of the Wallerstein Co., of which petitioner was a principal common stockholder.
FINDINGS OF FACT.
Petitioner is an individual citizen of the United States, residing at 1 West 81st Street, New York, New York, and he filed his gift tax returns with the collector of internal revenue for the third district of New York.
Prior to 1926 petitioner and his brother, Max Wallerstein, his wife, Dorothy C. Wallerstein, and his sister-in-law, Helen S. Wallerstein, engaged as partners in the manufacture and sale of chemical products and the conduct of a chemical laboratory and factory. The profits were divided 30 percent each to Leo Wallerstein and Max Wallerstein, the active partners, and 20 percent each to Dorothy C. and Helen S. Wallerstein, who were limited partners.
In 1926 the Wallerstein Co., hereinafter called the company, was incorporated under the laws of the State of New York. The business theretofore conducted by the said partnership and all of the capital stock of the Advance Chemical Co., a corporation whose stock was owned by the said Max and Leo Wallerstein, were transferred to the company in exchange for all its first and second preferred capital stock.
The entire capital stock of the company, as originally constituted, and the persons to whom it was issued, were as follows:
(a) 25,000 shares of common stock without par value, issued for $25,000 cash, one-half to petitioner and the other half to Max Wallerstein;
(b) 2,000 shares of 7 percent first preferred stock of the par value of $100 per share, 1,000 shares of which were issued to petitioner Leo Wallerstein and the remaining 1,000 shares to Max Wallerstein;
(c) 8,000 shares of 7 percent second preferred stock of the par value of $100 per share; 1,800 shares of which were issued to petitioner, 1,800 shares to Max Wallerstein, 1,700 shares to Helen S. Wallerstein, and 1,700 to Dorothy C. Wallerstein. This stock has since been wholly redeemed and does not figure in this controversy.
The certificate of incorporation originally provided, and as amended still provides, that the first preferred stock (about which this controversy centers) or any part thereof, might be redeemed at the option of the board of directors at $120 per share. The certificate of incorporation likewise originally provided, and as amended still provides, that the holders of the first preferred stock were entitled to cumulative dividends at the rate of 7 percent per annum, and, in addition, that they were entitled to receive such dividends for each share of first preferred stock as should be paid on each share of common stock.
On January 30, 1927, shortly after the formation of the company, petitioner sold to William Graf 125 shares of his holdings of first preferred stock at $100 per share, and on the same day Max Wallerstein sold to the said William Graf 125 shares of his holdings of first preferred stock at $100 per share. William Graf has since owned and still does own these 250 shares of first preferred stock. On January 31, 1927, petitioner sold to Benjamin Stroller 25 shares of his holdings of first preferred stock at $100 a share, and on the same day Max Wallerstein sold to Benjamin Stroller 25 shares of his holdings of first preferred stock at $100 a share. Except for the period from November 14, 1929, to November 24, 1935, Benjamin Stroller has owned and still owns said 50 shares of first preferred stock.
The voting power of the company is vested in the common stock.
William Graf and Benjamin Stroller were and still are valued employees and executives of the company. They had participated in the profits of the partnership for many years prior to the organization of the corporation, and the first preferred stock was sold to them to enable them, through dividends thereon, to share in the profits of the corporation. The provision of the certificates of incorporation permitting the board of directors to redeem this stock was inserted therein so that the company would have the power to redeem the stock from employees if it should be deemed undesirable that such employees continue to hold stock in the company.
On December 23, 1931, petitioner gave to his wife, Dorothy C. Wallerstein, the remaining shares of first preferred stock held by him, consisting of 850 shares. At the same time, Max Wallerstein gave to his wife, Helen S. Wallerstein, the remaining shares of first preferred stock held by him, consisting of 850 shares. At the time these gifts were made, in 1931, the business of the company was at its lowest ebb.
One of the principal products of the company was a process used extensively in the beer brewing business. Up to 1933, during prohibition, the business of the company steadily declined. After the repeal of prohibition in 1933 the business of the company substantially increased.
On December 27, 1934, the certificate of incorporation was amended so that the common stock of the company was changed from 25,000 shares without par value to 10,000 shares of the par value of $100 each. This amendment was made for the following reasons:
(a) The business of the Company was substantially increasing. William Graf was the key employee of the Company in connection with contacts with the brewing industry. The Company desired that he receive a larger share of the increased profits. By reducing the number of shares of Common stock, the holders of the First Preferred Stock (of which Graf was one) would receive a larger participation in any dividends declared by the Company.
(b) By changing the common stock from no par value to a par value of $100 a share, $931,592.19 was transferred from surplus to capital account; this was done to improve the credit structure of the company in view of its expanding business.
(c) This transfer from surplus to capital was likewise done so as to obviate any possible claim that the surplus of the Company was unreasonable large.
On December 8, 1935, the certificate of incorporation of the company was further amended in that the common stock was changed from 10,000 shares having a par value of $100 each to 8,000 shares without par value, and having a stated value of $1,000,000. The reasons for this amendment were similar to the reasons for the amendment made on December 27, 1934.
All of the dividends and participating dividends paid on the first preferred stock were paid directly to the respective record owners thereof, who deposited the same in their own bank accounts as their own property, and each record owner reported these dividends in his or her respective income tax returns. After petitioner gave his first preferred stock to his wife in 1931, none of these dividends was paid to or received by petitioner, nor were any of them applied directly or indirectly for his benefit.
During the years 1936 and 1937 the holders of the first preferred stock of the company were:
+------------------------------------------------------------+ ¦Dorothy C. Wallerstein ¦850 shares¦ +-------------------------------------------------+----------¦ ¦Helen S. Wallerstein ¦750 shares¦ +-------------------------------------------------+----------¦ ¦James S. Wallerstein (the son of Max Wallerstein)¦100 shares¦ +-------------------------------------------------+----------¦ ¦William Graf ¦250 shares¦ +-------------------------------------------------+----------¦ ¦Benjamin Stroller ¦50 shares ¦ +------------------------------------------------------------+
During the same period up to April 1, 1937, the holders of the common stock of the company were:
+---------------------------------+ ¦Max Wallerstein ¦3,900 shares¦ +--------------------+------------¦ ¦Leo Wallerstein ¦3,800 shares¦ +--------------------+------------¦ ¦Dorothy Wallerstein ¦200 shares ¦ +--------------------+------------¦ ¦James S. Wallerstein¦100 shares ¦ +---------------------------------+
On April 1, 1937, Max Wallerstein died and the holders of the common stock of the company for the period from April 1 to December 31, 1937, were:
+--------------------------------------+ ¦Estate of Max Wallerstein¦3,900 shares¦ +-------------------------+------------¦ ¦Leo Wallerstein ¦3,800 shares¦ +-------------------------+------------¦ ¦Dorothy C. Wallerstein ¦200 shares ¦ +-------------------------+------------¦ ¦James S. Wallerstein ¦100 shares ¦ +--------------------------------------+
From the inception of the company until February 19, 1937, the directors of the company were Max Wallerstein, Leo Wallerstein, and William Graf. Subsequent to February 19, 1937, the directors have been Leo Wallerstein, James S. Wallerstein, and William Graf.
None of the first preferred stock has ever been called for redemption. At a meeting of the directors of the company held on September 24, 1942, Leo Wallerstein proposed redemption of the first preferred stock of the company and voted in favor of the resolution. James S. Wallerstein and William Graf voted against the resolution.
After the death of Max Wallerstein, Helen S. Wallerstein, James S. Wallerstein and Leo Wallerstein were his executors. Leo Wallerstein resigned as executor on November 24, 1938. The common stock of the company owned by Max Wallerstein (which was the only stock in the company owned by him at the time of his death) was bequeathed to his wife, Helen S. Wallerstein, and his son James S. Wallerstein, in trust, the income therefrom to be paid to his wife during her lifetime, and upon the termination of the trust the principal thereof to be divided equally among his issue.
His executors and trustees, Helen S. and James S. Wallerstein, who since his death have held the common stock owned by him, have been opposed to the redemption of the first preferred stock, since both of them are owners in their own right of first preferred stock.
After Max Wallerstein's death, the relationship existing between petitioner, on the one hand, and Helen S. Wallerstein (widow of Max), on the other, were strained, and disputes took place between them. Thereafter, Helen S. and James S. Wallerstein relied upon their independent counsel for advice in connection with company matters, and they did not consult with petitioner concerning any of the policies of the company.
In the year 1936 the company paid to the then holders of the first preferred stock, in addition to the regular 7 percent cumulative dividend, a participating dividend of $150,060, and in 1937 a participating dividend of $140,000 (declared and paid after the death of Max Wallerstein on April 1, 1937). It is one-half of these participating dividends for these two years that the Commissioner claims were constructively given by the petitioner to the owners of the first preferred stock.
No part of the preferred stock dividends constituted gifts from the petitioner to the holders of such stock.
During 1935, 1936, and 1937 petitioner made certain gifts to a trust established in 1935 for the benefit of his children. These transfers constituted gifts of future interests. One exclusion was allowed by respondent in each of the years during which the gifts were made.
OPINION.
KERN, Judge:
The principal question which we are called upon to decide in this case is whether dividends paid to the holders of certain preferred stock of a corporation in which petitioner was a principal common stockholder, in excess of the 7 percent cumulative dividends specifically required, constituted gifts from the common stockholders to such preferred stockholders.
The preferred stock provided for cumulative 7 percent dividends before any dividends were paid to common stockholders and, in addition, for a dividend on every share of preferred stock equal to that paid on each share of common stock. Small blocks of the preferred stock had been sold to two old employees of the company by petitioner and his brother, who held in equal amounts all the common stock, but the greater part was given by petitioner and his brother to their respective wives in 1931.
Respondent does not question the validity of such sales and gifts, nor does he question the fact that the persons who received the stock by reason of such sales and gifts were the bona fide legal owners of the stock before and during the taxable years, nor does he make any contention that the corporation is a sham, or that he corporate cloak was improperly assumed or employed for illegal or fraudulent purposes.
Respondent freely admits the proposition that the owners of corporate stock are entitled to the dividends declared thereon. He narrows the question here to a proposition as to the ownership and control of the earnings of a corporation before any dividend is declared. That ownership, he contends is in the common stockholders by reason of their equitable interest in it, and the control is in the common stockholders, because they possess exclusive voting powers. He reasons, therefore, that when a part of those earnings are declared as a dividend to the preferred stockholders, by directors elected by or consisting of the common stockholders, such dividends are actually gifts from the common to the preferred stockholders.
This reasoning might be persuasive in a case where dividends are declared and paid on preferred stock in excess of the amounts called for by the terms of the preferred stock. But the fallacy of the argument becomes at once apparent in the light of the fact that, in this case, the preferred stockholders had at least as great an equitable interest in the funds as the common stockholders possessed, for they were entitled, under their contract, to share in it equally with the common stockholders. But the controlling fact here is that the interest of either class of stockholders in the profits of the corporation, before the declaration of the dividends, is merely an equitable one. The proposition that the legal ownership of corporate funds is in the corporation itself is too well settled to require discussion.
To contend that the common stockholders so controlled the corporation that they could prevent payment of dividends by the corporation to the preferred stockholders (not considering, for the moment the corporations right to redeem such stock) is to presuppose one of two unlikely things: first, that they would be sufficiently interested in depriving the preferred stockholders of dividends to deprive themselves also of any share in the profits; or, second, that they would, illegally, declare themselves dividends and refuse to declare the equal dividend to the preferred stockholders to which they were entitled under their contract. And, in either event, it would seem that any such action by the common stockholders would be subject to review and correction in a suit which the preferred stockholders might bring in a court of equity.
We do not believe that the mere existence of a right in the corporation, acting through its directors, to redeem preferred stock and thus stop the payment of dividends thereon, in itself renders dividends paid on the preferred stock gifts, either from the corporation, the directors, or, most remote of all, the common stockholders.
In fact, the respondent does not seriously urge that, standing alone, the right of the corporation to redeem the preferred stock, or the possession by the common stockholders of exclusive voting and management rights, or the participation by the preferred stockholders with common stockholders in dividends, or the family relationship existing between the stockholders, is sufficient to bring the payment of dividends or preferred stock within the comprehension of the gift tax act. We believe that the existence of all of them together leads to no different result.
Respondent makes the alternative contention that such dividends constituted a gift in 1936 and 1937 to the extent by which they exceeded the dividends which the preferred stockholders would have received had the number of shares of common stock not been reduced in 1934 and 1935.
We think it clear that if any gift from the common stockholders to the preferred stockholders resulted from the corporate act in reducing the number of its common shares, that gift took place in 1934 and 1935, when the reductions were effected, and not, recurringly, in later years, when dividends were paid to the preferred stockholders. The right to a proportionately greater share in the corporate earnings and a corresponding increase in value at once attached to the preferred stock as a result of that action. We do not express any opinion as to whether the reduction in the common stock effected in 1934 and 1935 which resulted in the increase of the preferred stockholders' share in the future profits constituted a gift to the preferred stockholders from the common stockholders at the time of the reduction, but we are convinced that the payment by the corporation of the increased proportionate shares by way of dividends in 1936 and 1937 did not constitute gifts by the common stockholders in those years.
We find against the respondent on this issue.
Petitioner during 1935, 1936, and 1937 made certain gifts to a trust created in 1935 for the benefit of his children. Petitioner and respondent are in agreement that these gifts constituted gifts of future interests.
The question now arises whether the exclusions erroneously allowed to petitioner in calculating his gift tax liability for previous tax years should be disregarded and the full amount of such gifts included in calculating petitioner's total taxable net gifts, not for the purpose of assessing deficiencies in his gift tax liability for the earlier years, but for the purpose of determining the rates of tax applicable to the gifts made in the later years now before us.
This question also arose in Lillian Seeligson Winterbotham, 46 B.T.A. 972, and it was decided there (p. 978) that the exclusions erroneously allowed for the earlier years should be disregarded for the purpose of determining the tax liability for the year in question. On the authority of that case, we conclude in favor of the respondent with respect to this issue.
Certain other questions relating to matters of computation have either been resolved by agreement of the parties or by our decision on the first issue herein.
Decision will be entered under Rule 50.