Respondent determined a deficiency in petitioner's income tax for the calendar year 1941 in the amount of $113,021.44.
Aside from one small item not in dispute, the deficiency results from respondent's finding that an exchange by petitioner of common stock of the Newark Theatre Building Corporation for new common stock and debenture bonds of the same corporation in January 1941, in connection with the plan of recapitalization of that company, resulted in the distribution of a dividend to petitioner constituting fully taxable income.
The petitioner contends that the transaction was a recapitalization and reorganization within the meaning of section 112 of the Internal Revenue Code and was not a distribution of a dividend; and, in the alternative, he contends that there was a loss from the transaction rather than a gain, that if there was a gain it was taxable as a capital gain, and that if it is to be treated as a dividend it was a dividend of no value.
FINDINGS OF FACT.
Petitioner is an individual, residing in New Jersey, and he filed his income tax return for the calendar year 1941 with the collector of internal revenue for the fifth district of New Jersey.
He was the president and principal stockholder of the Newark Theatre Building Corporation, a New Jersey corporation. On January 26, 1941, he owned 5,903 shares of a par value of $100 each, out of a total of 5,914 shares issued and outstanding. The authorized capital was 6,000 shares.
Petitioner and his brother were originally engaged in business together as partners. Later on, they conducted their business affairs through corporations organized by them, and in connection with the financing of the Newark Theatre Building Corporation's operations, both individuals guaranteed the indebtedness of that corporation secured by a mortgage on its property. In 1935 they divided their business interests, and petitioner became the principal stockholder of the Newark corporation. Thereafter, his brother repeatedly demanded that he be relieved of his liability on the bonds. The Prudential Insurance Co., which held the mortgage, declined to release him, and petitioner foresaw the necessity of making other financial arrangements when the Prudential mortgage matured in 1941.
On December 6, 1940, the directors of the corporation met to consider the desirability of "revamping the capital structure of the company." The president pointed out that, in his opinion, the whole capital structure was not well balanced, and that it was not good business to have so top-heavy a capital set-up. He stated that a simple plan of recapitalization could be evolved which would bring about the desired change at comparatively little expense to the company; that he had consulted legal and accounting counsel, who could see no difficulty in consummating the plan of recapitalization.
The following plan was then proposed and adopted:
(1) A reduction in the authorized capital stock from $600,000, represented by 6,000 shares of a par value of $100 each, of which 5,914 shares, or $591,400 were issued and outstanding, to $295,700, to be divided into 5,914 shares without nominal or par value.
(2) The issuance of debenture bonds in the aggregate principal amount of $295,700, bearing interest at the rate of 6 percent per annum, payable semiannually, the principal to be payable in 20 years from the date thereof, plus 5,914 shares of the new no par common stock, in exchange for the present shares of capital stock, on the basis of one $50 bond and one share of no par value common stock for each of the present $100 par value shares surrendered.
The directors adopted the appropriate resolution to amend the certificate of incorporation to provide for the reduction of authorized capital, and the issuance of no par value stock, and the stockholders duly ratified and approved the actions of the directors with respect thereto.
It was anticipated that there would be a saving of New Jersey franchise taxes in excess of $400 per year and a reduction of the corporation's Federal income tax liability in substantial amounts each year by the deduction of the interest paid on the bonds.
The recapitalization was carried out in exact accordance with its terms. Petitioner on January 27, 1941, surrendered his 5,903 shares of $100 par value stock and received for each share thereof one share of no par value stock of a stated value of $50, and one $50 debenture bond. The bondholders were to rank pari passu with unsecured creditors in event of dissolution.
On the books of the corporation the old par capital stock account was debited with $591,400, the new no par capital stock account was credited with $295,700, and the balance of $295,700 was credited to a "Debentures Payable" account. The surplus account was not affected.
Subsequently, petitioner gave to each of his two sons who worked with him in the business of the corporation debenture bonds of the face value of $24,000, or a total of slightly more than 16 percent of his holdings. He duly reported these transfers for gift tax purposes and attributed to the bonds their full face value, paying gift tax thereon.
The corporation's balance sheet as of December 31, 1940, was as follows: ASSETS REAL ESTATE: Land, 193-195 Market St. ................... $471,400.00 Buildings ................... $472,935.00 Less depreciation ........... 245,926.20 ----------- 227,008.80 ---------- $698,408.80 Land, 286-288 Market St. .................... 108,000.00 Building and improvements ... 91,214.88 Less depreciation ........... 44,333.41 ----------- 46,881.47 Equipment, heating plant .... 718.72 Less depreciation ........... 479.13 ----------- 239.59 ---------- 155,121.06 EQUIPMENT: Theatre furniture and fixtures .............. 61,703.37 Less depreciation ........................... 56,230.87 ---------- 5,472.50 OTHER: Cash in banks ............................... 42,107.02 Deposit a/c Gus Pappas ...................... 100.00 Accrued interest receivable ................. 77.81 Unexpired insurance ......................... 503.66 Rents receivable ............................ 635.00 Notes receivable, Premier Amusement ......... 41,500.00 ---------- 84,923.49 ---------- Total assets .......................................... 943,925.85 ========== LIABILITIES FIXED: Mortgage payable, 286-288 Market St. ........ $60,000.00 Mortgage payable, Prudential ................ 231,250.00 ---------- $291,250.00 Accounts payable ............................ 1,031.75 Accruals: Federal capital stock tax .................. 452.10 Interest on mortgages ...................... 2,890.63 Federal income and declared value excess profits tax ............................... 9,772.32 ---------- 13,115.05 ---------- Total liabilities ................................... 305,396.80 CAPITAL: Common stock ........................................... 591,400.00 Surplus, donated surplus ............................... 1,500.00 Surplus ................................................ 45,629.05 ----------- Total liabilities and capital ........................ 943,925.85
The balance sheet as of December 31, 1941, was as follows: ASSETS REAL ESTATE: Land, 193-195 Market St. ................ $471,400.00 Buildings .................. $472,935.00 Less depreciation .......... 264,843.60 ----------- 208,091.40 ----------- $679,491.40 Land, 286-288 Market St ................. 108,000.00 Building and improvements .. 91,214.88 Less depreciation .......... 48,061.53 ----------- 43,153.35 Equipment, heating plant ... 718.72 Less depreciation .......... 527.05 ----------- 191.67 ----------- 151,345.02 ----------- 830,836.42 OTHER: Cash in bank ............................ 44,537.88 Deposit (Gus Pappas Agent a/c) .......... 100.00 Unexpired insurance ..................... 2,224.58 Rents receivable ........................ 2,354.58 Notes receivable (Premier Amusement Corp.) 38,000.00 ----------- 87,217.04 ----------- Total assets ......................... 918,053.46 =========== LIABILITIES FIXED: Mortgage payable, 286-288 Market St. .... $56,000.00 Mortgage payable, 193-195 Market St. .... 206,250.00 ----------- $262,250.00 Debentures payable ..................................... 295,700.00 CURRENT: Accounts payable ........................ 532.25 Accrued taxes ........................... 281.25 Accrued interest ........................ 4,056.63 Reserve for Federal income tax (1940) ... 274.38 Reserve for Federal income tax (1941) ... 4,840.13 ----------- 9,984.64 ----------- Total liabilities ..................................... 567,934.64 CAPITAL: Common stock issued (5,914 shares N. P. V.) ............ 295,700.00 SURPLUS: Donated surplus ........................................ 1,500.00 Net operating surplus .................................. 52,918.82 ----------- Total liabilities and capital ....................... 918,053.46
The earnings and profits of the corporation accumulated after February 28, 1913, up to December 31, 1940, were $157,225.05, and up to December 31, 1941, were $164,874.47, of which $111,596 had been capitalized by stock dividends declared in prior years. The accumulated earnings and profits of the corporation available for distribution on January 26, 1941, were not less than $164,514.82.
The debentures regularly earned and paid the interest due on them.
The debentures received by petitioner had a value when received of not less than $164,208.82.
The capitalization and distribution of debentures above described had no legitimate business purpose.
OPINION.
OPPER, Judge:
An opinion in this proceeding was promulgated on April 26, 1945 ( 4 T.C. 1186) which, pursuant to subsequent order, was referred to the Court for review and is to be considered superseded by the present opinion.
As in Alice H. Bazley, 4 T.C. 897, the first question for disposition here is whether the nonrecognition provisions of section 112 are applicable to the receipt by petitioner of debentures in a transaction involving the cancellation of previously outstanding common stock and the issuance of new no par common. This in turn depends upon whether we can find as a fact that there was a legitimate purpose of the corporate business for the distribution to petitioner of the debentures.
The resolution of this problem requires an examination of the purposes of the "reorganization," as presented by petitioner. The first of these, designated as the "principal" purpose, was a belief that the existence of debenture bonds, available for use as collateral, would facilitate the refinancing of the corporation's mortgage indebtedness, then impending. Petitioner testified that he believed debenture bonds might be more acceptable than common stock if additional collateral were required in negotiating a new loan. The refinancing arrangements were successfully concluded, but the record is completely silent as to whether the bonds were used in that connection. We may fairly assume, therefore, that they were not.
We are not impressed with the validity or the existence of this alleged purpose. It is difficult to see how debenture bonds of this nature, inferior to the mortgage lien itself, would have been as attractive to a mortgage bondholder of the corporation as common stock, which would at least have provided the creditor, already secured by a mortgage on the debtor's property, with some additional security in the form of a voice in the management of the corporation in the event of default and pending foreclosure.
The second reason for the "reorganization," according to petitioner, was his desire to give some securities of the corporation to his two sons, who were associated with him in the business of the corporation, without surrendering any of his stock control over the company. He did give them bonds of a total face value of $48,000, representing about 16 percent of his holdings. This was obviously a personal reason having no connection with the corporate business.
The remaining two reasons may be considered together. They were the saving of corporate income tax resulting from the right to deduct interest paid on the bonds, and the saving of New Jersey franchise tax resulting from the decrease in the amount of stock. These purposes are equally unavailable when considered from the standpoint of the corporate business. As a result of the procedure adopted the corporation undertook an annual obligation of 6 percent of $295,150 in interest charges in order to secure the reduction of a few hundred dollars in state franchise taxes and of an indeterminate amount of Federal income tax which would necessarily be less than the interest obligation. If the money were to be borrowed from strangers, it seems evident that this could not but be a losing transaction for the corporation. As we said in De Nobili Cigar Co., 1 T.C. 673, 679; affd. (C.C.A., 2d Cir.), 143 F.2d 436:
* * * no explanation is offered why it was necessary, or even sound policy from the corporation's point of view, to capitalize earnings * * * and thus to pay 6 percent for the use of funds which petitioner [the corporation] was already free to use * * *
See Talbot Mills, 3 T.C. 95; affd. (C.C.A., 1st Cir.), 146 F.2d 809; certiorari granted, 325 U.S. 844.
That the dominant stockholder rather than a stranger happened to be the person to whom the interest would be paid can account for the company so conducting itself in spite of the disadvantage to it. But while furnishing an explanation for the action, it offers no evidence of any independent benefit to the corporation itself as distinguished from the reciprocal advantage to petitioner as an individual from the receipt of the interest payments, and thus falls short of constituting the corporate business purpose which we are required to find in such cases. Gregory v. Helvering, 293 U.S. 465; Alice H. Bazley, supra.
Once the transaction is removed, as we accordingly think it must be, from the scope of section 112, a distribution of the corporation's debentures can partake of the nature of a taxable dividend to the same extent as any other distribution of property or of the stock of a wholly different corporation. Doerschuck v. United States (Dist.Ct., E. Dist. N.Y.), 274 Fed. 739; see Peabody v. Eisner, 247 U.S. 347. Our inquiry is then directed to whether under the provisions of section 115 (g) the distribution was essentially equivalent to a taxable dividend. Edith B. Bass, 45 B. T. A. 1117; reversed (C.C.A., 1st Cir.), 129 F.2d 300. The contention is made that because the corporation's book surplus was undisturbed there could have been no dividend distribution. For that position, to be sure, the reversal in Edith B. Bass, supra, can be cited as at least partial authority. With the greatest deference, however, we remain of the opinion that the decision of the Board of Tax Appeals in that case was correct, and we feel obliged to adhere to it rather than to follow the reasoning of the opinion of reversal.
A similar argument was made in Alice H. Bazley, supra, but we found it unnecessary to deal with it under the facts there brought forth.
The argument that by a bookkeeping entry purporting to make a distribution from capital and without disturbing earned surplus a corporation can be held to have accomplished that result seems to us to lose sight of the express statutory provision and to treat as cause what is in reality effect. Except for a distribution in liquidation, we must start with the premise that "every distribution is made out of earnings or profits to the extent thereof and from the most recently accumulated earnings or profits," because the statute so commands in unmistakable language. We do not understand there is any suggestion that these were distributions in liquidation and nothing in the record warrants the assumption that they were. Internal Revenue Code, sec. 115 (c) and (i). If as a consequence there were earnings and profits, the distribution was a dividend or its essential equivalent, and the effect upon the corporation's earned surplus for purposes of future tax computation would be to reduce it, regardless of the treatment of that surplus on the corporation's books. Cf. Commissioner v. Bedford Estate, 325 U.S. 283; August Horrmann, 34 B. T. A. 1178. "* * * 'earnings and profits' in the tax sense although it does not correspond exactly to taxable income does not necessarily follow corporate accounting concepts either." Wheeler v. Commissioner, 324 U.S. 542. We are accordingly unable to agree that the mere dealing with the capital account in such a way that the distribution is treated on the corporate books as a diminution of capital rather than of earned surplus can have any binding influence on the determination which we are required to make. That is the effect of Edith B. Bass, supra, where we said, p. 1121:
Internal Revenue Code, section 115 (b):
"(b) SOURCE OF DISTRIBUTIONS. — For the purposes of this chapter every distribution is made out of earnings or profits to the extent thereof, and from the most recently accumulated earnings or profits. Any earnings or profits accumulated or increase in value of property accrued, before March 1, 1913, may be distributed exempt from tax, after the earnings and profits accumulated after February 28, 1913, have been distributed, but any such tax-free distribution shall be applied against and reduce the adjusted basis of the stock provided in section 113."
* * * The issuance of the preferred stock in the present case gave to the recipients an interest different from that represented by their former stockholdings. That was the intent and purpose of the change. The corporation had more than sufficient earnings accumulated after February 28, 1913, to pay a dividend equal to the value of this preferred stock. The petitioner concedes that the issuance of stock involving the capitalization of earnings could result in a taxable dividend, but contends that this was a "split-up" involving merely a change in the character and number of shares by which existing capital continued to be represented and was not a taxable dividend. It is immaterial that the corporation did not capitalize any earnings to support the issuance of the preferred stock, since section 115 (b) provides that "every distribution is made out of earnings or profits to the extent thereof. * * *"
This statement seems warranted by the observation in Helvering v. Gowran, 302 U.S. 238, that:
* * * under section 115 (b) * * * [the distribution of preferred stock] was presumed to have been made "out of earnings or profits to the extent thereof, and from the most recently accumulated earnings or profits." In no sense, therefore, can it be said to have been "held" by Gowran prior to its declaration. Since the proceeds were therefore not "capital gains," they were taxable at the normal and surtax rates applicable to ordinary income.
Having found, as we think we must, that such earnings as the corporation had were distributed by means of the debentures to the extent of their value, it becomes necessary to examine the amount of those earnings and the fair market value of the debentures. The outer limit of taxability in that event will be the fair market value of the property received under section 115 (j) and the amount of earnings and profits of the corporation available for distribution under section 115 (a). On the first subject it is conceded that the corporation had undistributed earnings as of the close of the year 1940 of $45,629.05. In addition there had been deductions from earned surplus on account of the distribution of prior nontaxable stock dividends in the amount of $111,596, which must be added to the corporate earnings available for distribution. August Horrmann, supra. The distribution was not made on December 31, 1940, however, but on January 26, 1941. There is no evidence whatever from which we can determine what earnings and profits were available on that date. Respondent has found them to be a figure somewhat, though slightly, less than the amount shown on the balance sheet as of the end of the current year. Under the circumstances we can not say that petitioner has sustained his burden of proving that respondent's determination was erroneous in this respect. Dorothy Whitney Elmhirst, 41 B. T. A. 348, 354-360.
Internal Revenue Code, section 115 (j):
"(j) VALUATION OF DIVIDEND. — If the whole or any part of a dividend is paid to a shareholder in any medium other than money the property received other than money shall be included in gross income at its fair market value at the time as of which it becomes income to the shareholder."
Internal Revenue Code, section 115 (a):
"(a) DEFINITION OF DIVIDEND. — The term 'dividend' when used in this chapter (except in section 203 (a) (3) and section 207 (c) (1), relating to insurance companies) means any distribution made by a corporation to its shareholders, whether in money or in other property, (1) out of its earnings or profits accumulated after February 28, 1913, or (2) out of the earnings or profits of the taxable year (computed as of the close of the taxable year without diminution by reason of any distributions made during the taxable year) without regard to the amount of the earnings and profits at the time the distribution was made."
Similarly, the fair market value of the debentures is in effect conceded to be their face amount, although petitioner contends that the common stock was thereby reduced drastically below its original basis to him. But the debentures carried interest, which has been duly met, and were a claim to corporate assets which took preference over that of the stockholders. To say nothing of petitioner's own contemporaneous gift tax valuation, the corporate assets, even at petitioner's present figure, are sufficient to justify our finding of the value of the debentures from the standpoint of collectibility upon default. Although these figures are strenuously contested by respondent, who insists that the corporate assets were of sufficient value to cover both the debentures and petitioner's original basis for the stock, we are mindful that this is not a gain or loss situation and requires no determination as to the value of the stock. Edith B. Bass, supra, refers to the:
* * * opinions in United States v. Phellis, 257 U.S. 156, and Rockefeller v. United States, 257 U.S. 176, in which the Court had said that the test of taxability of a corporate distribution lies in its effect upon the individual stockholder rather than upon the corporation or the stockholders as a group, and it does not matter that the value of the stock on which the distribution was made was thereby decreased. The normal result of declaring a dividend of any kind is to reduce the value of stock theretofore outstanding. * * *
If the debentures were worth at least as much as the corporation's earned surplus, which they undoubtedly were, respondent's determination must be sustained, and any further discussion is beyond the necessary confines of the present question. In the light of those circumstances we have found as a fact only that the fair market value of the debentures was at least as great as the dividend determined by respondent to have been received. It follows that respondent's determination must be sustained in the amount found by him.
Reviewed by the Court.
Decision will be entered for the respondent.