Roosevelt Hotel Co. v. Commissioner

Roosevelt Hotel Co., Petitioner, v. Commissioner of Internal Revenue, Respondent Roosevelt Hotel Co. v. Commissioner Docket No. 13030 United States Tax Court 13 T.C. 399; 1949 U.S. Tax Ct. LEXIS 80; September 28, 1949, Promulgated *80 Decision will be entered for the petitioner. Hotel Holding Co. defaulted on its bonds and the indenture trustee took possession in 1931 for the bondholders. In 1935 the bondholders, pursuant to a plan of reorganization, organized petitioner and bought in the property for the petitioner at foreclosure sale. Stock in petitioner was issued to the bondholders in proportion to their holdings. Cash held by the trustee and money borrowed by petitioner were placed in escrow to pay accrued taxes, other debts, and claims of nondepositing bondholders. Over 98 per cent in value of the bonds was exchanged for stock, the remainder being surrendered for a pro rata payment in cash from the escrow. Under the facts, held, petitioner acquired substantially all the property of Hotel Holding Co. pursuant to a plan of reorganization and solely for voting stock, within the meaning of section 112 (g), Internal Revenue Code, and is entitled to use its predecessor's basis. Dana Latham, Esq., and Austin H. Peck, Jr., Esq., for the petitioner. E. A. Tonjes, Esq., for the respondent. Arnold, Judge. Kern and Murdock, JJ., dissent. ARNOLD *400 The respondent determined deficiencies*81 for the years 1940 to 1943, as follows: Declared Year Income tax value excess Excess profits profits tax tax [1940] $ 5,564.26 $ 624.95 [1941] 9,093.63 5,789.79 [1942] 5,364.37 $ 86.15 25,647.52 [1943] 598.75 78,381.81 The controversy concerns the basis petitioner is entitled to use for determining depreciation and equity invested capital: (1) Whether this is the basis of a preceding owner, or the fair market value on acquisition, and, (2) if the latter, what that fair market value was. The stipulated facts are found as stipulated and are here summarized to the extent necessary for the purpose of this opinion. Other facts here stated are determined from the evidence submitted. FINDINGS OF FACT. Petitioner is a corporation, incorporated under the laws of California on June 10, 1935, with an authorized capitalization of 10,360 shares of common stock without par value. Its principal place of business is in Los Angeles County, California. Petitioner filed timely income and excess profits tax returns for the calendar years 1940 to 1943, inclusive, with the collector of internal revenue at Los Angeles, California. Petitioner's accounting records were kept*82 and returns were prepared on the accrual basis. The Hotel Holding Co. of Hollywood, Ltd., (hereinafter sometimes referred to as the Holding Co.) was a corporation organized under the laws of California on August 27, 1925. On April 1, 1926, the Holding Co. executed a trust indenture to the Citizens Trust & Savings Bank, a corporation, as trustee, for the purpose of securing the repayment of $ 1,100,000 par value of "The Roosevelt In Hollywood First Mortgage Six and One-half Per Cent Gold Bonds." Such trust indenture covered certain described real property *401 and any and all buildings or other improvements which at any time might be erected on such property or any part thereof. The Holding Co. covenanted to erect a 12-story and basement hotel and store building upon the property. The trust indenture provided that, in case of default in the payment of interest continuing for 30 days, or default in the payment of principal, or certain other defaults, the trustee, in its discretion and upon the written request of the holders of 25 per cent in amount of the bonds then outstanding, should enter into and upon and take and hold possession of the trust estate and use, operate, manage, *83 and control the trust estate and conduct the business of the corporation to the best advantage of the holders of the bonds secured by the indenture. It further provided that in the event of default the trustee, with or without entry, in its discretion and upon the written request of the holders of 25 per cent in amount of the bonds, might proceed to sell to the highest and best bidder the trust estate and all rights, title, interest, claims and demands of the corporation therein and thereto. The Citizens Trust & Savings Bank subsequently became, through merger, the Citizens National Trust & Savings Bank of Los Angeles. The proceeds of the bond issue were used, with other funds, to erect a hotel building. During the year 1930 the Holding Co. defaulted on its bonds, as the result of which a "Bondholders' Protective Committee" was formed by written agreement dated March 20, 1931, for the purpose of protecting the bondholders' interests. At the time of the formation of such committee there were outstanding bonds aggregating $ 1,036,000 in face value. Of these bonds, bonds aggregating $ 961,000 in face value were deposited with the committee prior to June 13, 1935. The bondholders' *84 protective agreement provided for deposit of bonds with the Citizens National Trust & Savings Bank of Los Angeles and that legal title to such bonds should be vested in the committee, and it authorized the committee in its discretion to purchase any or all of the property constituting the security for the bonds; to apply the bonds in satisfaction of any bid or purchase price in the event of the foreclosure or trustee's sale of the secured property; to pledge or assign any of the bonds or property for the purpose of raising funds necessary to carry out the trusts assumed; to take possession or control of, or operate all or any of the mortgaged property; to cause such property to be conveyed to any bank or trust company in trust for the bondholders; to organize a corporation for the purpose of taking title to the property; and to issue to the depositing bondholders such securities representing their interests as the committee might deem advisable. It further provided that the committee should have power, before any sale of the trust property was had, to make, enter into, or *402 become a party to any plan or agreement of reorganization or readjustment of the property or affairs*85 of the Holding Co. containing such terms and conditions as the committee might deem proper or advisable. Such plan or agreement might be effected by sale of the trust property or other property of the Holding Co. to a corporation or trust, or without any such sale. On or about May 1, 1931, pursuant to the provisions of the trust indenture and at the written request of the holders of bonds aggregating more than 25 per cent of the amount outstanding, the trustee took possession of the trust estate, consisting of land and a hotel building. The trustee also took possession of all the furnishings located in such hotel building although these were not a part of the trust estate. The trustee operated the hotel until May 1, 1934, at which time the trustee entered into an operating agreement with Thomas E. Hull, which agreement was later, on August 1, 1934, assigned by Hull to the Hollywood Roosevelt Hotel Co., a California corporation. Under the terms of this operating agreement the trustee received income in the form of rent, being a percentage of the gross amount received from room rentals, plus a percentage of other revenue, or a percentage of the net profits, whichever calculation*86 produced the higher rental. The agreement was for a term of 15 years from May 1, 1934. The operator was to pay property taxes and insurance premiums and to expend at least 5 per cent of the gross room rents for repairs and replacements. The action of the trustee in taking possession of the furnishings was validated by the Holding Co. by a bill of sale dated April 22, 1935, to the trustee. The operation of the property by the trustee had realized insufficient profits to meet the current taxes on the property. The trustee advanced funds to finance the operation. The operations by Hull showed an improvement in the first year. The bondholders' committee had considered selling the property, leasing it, or forming a new corporation to take title to it. The committee considered that foreclosure for the benefit of the bondholders could not be completed without payment of delinquent taxes, trustee's advances and fees, and legal expenses, and that money could not be procured to meet these expenses until operation appeared profitable. In 1935, when Hull's operation of the property showed progress and it was found that a loan on the property could be obtained, the committee adopted a plan*87 of reorganization and organized petitioner to take title to the property. The members of the committee became the first board of directors of the petitioner. The plan called for the sale of the property to petitioner, which would be authorized to issue 10,360 shares of common stock without par value. Bondholders would receive one share for each $ 100 face value of bonds held. Bondholders *403 who had not deposited their bonds could receive stock or receive their pro rata share in cash. The trustee, pursuant to the provisions of the trust indenture, held a public sale of the assets of the Holding Co. on June 13, 1935. The committee submitted a bid at such sale in the amount of $ 300,000. There were no other bids and the properties were declared sold to the committee for that amount. The bid price was paid by means of credit allowed for deposited bonds, and no cash was paid. The bondholders' committee assigned its bid to the petitioner and directed conveyance of the assets to it. On June 13, 1935, the trustee, by means of a trustee's deed and bill of sale, transferred the land, hotel building, and furnishings to the petitioner. The trustee determined the net amount realized*88 from the sale, after deducting proper expenses, to be $ 159,264.56, or 15.373 per cent of the face amount of the bonds outstanding. At the time of such sale there were outstanding bonds in the aggregate face amount of $ 75,000 not deposited with the committee. These bondholders were entitled to receive 15.373 per cent of the face amount of their bonds, or an aggregate amount of $ 11,529.75, which amount was held in reserve by the trustee to satisfy and discharge all nondepositing bondholders' claims. At the time of the sale, the assets of the Holding Co., in the possession of the trustee included cash in the amount of $ 32,672.24. The petitioner, on or about June 11, 1935, borrowed $ 300,000 from the Bank of America National Trust & Savings Association. This amount was placed in escrow with the Citizens National Trust & Savings Bank of Los Angeles, which also transferred to this escrow account $ 32,672.24 held as trustee. The total amount, $ 332,672.24, in the escrow account was paid or reserved pursuant to instructions of the committee, as follows: Service charge, appraisal and loan fees $ 9,341.00 Trustee's advances, loans and interest 2,010.48 Trustee's fees, expenses and interest 30,646.93 Legal, accounting and other services 19,500.00 Title fees and expenses 2,788.60 Delinquent taxes 67,724.52 Miscellaneous expenses 14,367.42 Thomas E. Hull, maintenance in excess of contract 33,154.06 Expenses of committee members 1,800.00 Reserve account for nondepositing bondholders 11,529.75 Reserve for pending law suit 20,000.00 Reserve for commission 12,000.00 Roosevelt Hotel, balance of escrow 27,809.48 *89 Pursuant to permission from the California Corporation Commissioner, 9,610 shares of stock of the petitioner were issued to the depositing *404 bondholders. At various times nondepositing bondholders owning an aggregate of $ 63,500 face value of bonds exchanged their bonds for stock and an additional 635 shares of stock were issued to them. The remaining nondeposited bonds, aggregating $ 11,500 in face value, were redeemed by the trustee at the rate of 15.373 per cent of the face value by the payment of $ 1,769.91 in cash. Following the foreclosure sale the Holding Co. had no assets and conducted no business. It was not formally dissolved, but was suspended on March 4, 1936, for failure to pay California franchise tax. The basis of the Hotel Holding Co. at June 13, 1935, for the land, building, and furnishings transferred to the petitioner was $ 1,651,856.59, allocated as follows: Land $ 320,000.00 Buildings: Cost $ 1,583,323.57 Less depreciation 307,508.16 1,275,815.41 Furnishings 56,041.18 Total 1,651,856.59 The petitioner's original books of account were set up as follows: ASSETS Cash due from trustee $ 54,809.48 Prepaid life insurance 906.00 Organization expense 450.00 Land $ 62,200.00 Building 302,700.00 Furniture and fixtures 49,752.24 414,652.24 Loan service fee deferred 9,341.00 Total assets 480,158.72 LIABILITIES Mortgage payable $ 300,000.00 1935-1936 property taxes accrued 20,423.91 Commission payable 12,000.00 Common stock 147,734.81 Total liabilities and capital 480,158.72 *90 In determining its net income for the period June 13 to December 31, 1935, and for the calendar years 1936 and 1937 for Federal income tax purposes, petitioner computed depreciation on the building and furnishings acquired on the sale by using as the basis therefor the amounts originally set up in petitioner's books, plus the cost of additions thereto. In determining its net income for the calendar year *405 1938 and all subsequent years for Federal income tax purposes petitioner computed depreciation on the building and furnishings by using as the basis therefor the amounts claimed by petitioner to represent the basis of such property to the Holding Co. at June 13, 1935, plus the cost of additions thereto. Petitioner filed claims for refund of Federal income tax paid for 1936 and 1937, based upon its contention that it is entitled to the use of the basis of the Holding Co. for the property. On May 1, 1931, the Holding Co. was unable to pay, in the regular course of business, its obligations as they matured, and this condition continued until its existence was terminated. OPINION. The first issue is whether petitioner is entitled to use, for computing depreciation and equity*91 invested capital, the basis of certain assets in the hands of the preceding owner, the Hotel Holding Co. of Hollywood, Ltd. Under section 113 (a) (7) of the Internal Revenue Code, 1 if property was acquired in 1935 by a corporation in connection with a reorganization and immediately after the transfer an interest or control in such property of 50 per cent or more remained in the same persons or any of them, the basis shall be the same as it would be in the hands of the transferor, with certain adjustments. Section 112 (g) defines "reorganization" as including "the acquisition by one corporation, in exchange solely for all or a part of its voting stock, of substantially all the properties of another, but in determining whether the exchange is solely for voting stock the assumption by the acquiring corporation of a liability of the other, or the fact that property acquired is subject to a liability, shall be disregarded." *92 Petitioner contends that it acquired the property from Hotel Holding Co. in a reorganization solely for voting stock, and therefore is entitled to use that predecessor's basis. Respondent contends (1) that the transfer of the property from Hotel Holding Co. to the petitioner was not pursuant to a plan of *406 reorganization and (2) that the properties were acquired by petitioner not "solely for voting stock," but for voting stock and cash. Respondent argues that no plan existed on May 1, 1931; that the intent of the committee at that time was to liquidate rather than to reorganize; that a plan, to qualify as a plan of reorganization, must provide for a continuation of the business, rather than liquidation; that the plan to form a new corporation was not made until four years after the trustee took control and, hence, the petitioner did not acquire the property from Hotel Holding Co. pursuant to a plan of reorganization, but acquired it from the committee which had held it for four years without a plan. In February 1942 the Supreme Court decided four cases relating to the reorganization provisions of the Internal Revenue Code. In Helvering v. Alabama Asphaltic Limestone Co., 315 U.S. 179,*93 the Court held that a reorganization occurred when the creditors of a corporation formed a new corporation, and acquired the assets for it at a judicial sale, excluding the former stockholders, the new corporation being entitled to use the predecessor's basis for purposes of depreciation and depletion. In Palm Springs Holding Corporation v. Commissioner, 315 U.S. 185, the same conclusion was reached. In the other two cases the Court held that a reorganization did not occur -- in Bondholders' Committee, Marlborough Investment Co. First Mortgage Bonds v. Commissioner, 315 U.S. 189, because the property had been acquired from persons other than the defaulting corporation, and the transaction was a purchase rather than a reorganization; and in Helvering v. Southwest Consolidated Corporation, 315 U.S. 194, because the property was not acquired "solely for voting stock" within the requirements of the statute. It is clear from these cases that where the holders of a corporation's bonds, having through default become the beneficial owners of its assets, form a new corporation in which*94 they are stockholders and cause the assets to be transferred to it, a reorganization occurs if the other statutory requirements are met. The continuity of interest essential to qualify the transaction as a reorganization exists. Here, well over 90 per cent of the bonds were deposited and their owners participated in the new corporation. It is not material that at the time the trustee took possession of the property to protect the bondholders' interests there was no plan of reorganization, or that the committee considered other means of best realizing on the defaulted bonds. There is no statutory requirement that a plan be immediately adopted, and to require this would disqualify as reorganizations many of the financial readjustments Congress intended to have included. It is inevitable that there be some delay in arriving at a solution satisfactory to the great majority of *407 interested bondholders or creditors. In Helvering v. Southwest Consolidated Corporation, supra, the plan was not adopted until eighteen months after the bondholders' committee took control, but the Supreme Court said that there would have been a reorganization except*95 for the requirement that the property be acquired solely for voting stock. The absence of a plan at the time the committee took control was not discussed. In the cited cases the Court expressed the view that the "legal procedure employed by the creditors is not material"( Palm Springs Holding Corporation, supra) and the "precise mechanics whereby the reorganization was consummated are not material" ( Bondholders' Committee, supra). The form in which the transaction was finally cast is controlling, not what the interested lienholders may have considered as an alternative. The bondholders' committee here adopted a plan by 1935, pursuant to which it caused petitioner to be incorporated, purchased the property at the trustee's sale held under the trust indenture executed by the Holding Co. to secure payment of the bonds, and had the trustee convey the property directly to petitioner. We conclude that petitioner acquired the property pursuant to a plan of reorganization. Respondent cites United States v. Santa Inez Co., 145 Fed. (2d) 667, where the Circuit Court of Appeals for the Ninth Circuit*96 held that there were two separate transactions where there was a foreclosure sale for the benefit of bondholders and stock in a new corporation was later issued to the bondholders and that gain resulted from the first transaction. Respondent argues that here there were two separate transactions, that in the first the bondholders' committee acquired the property in 1931, and hence the committee, rather than the Hotel Holding Co. was the transferor to petitioner. On this point we think the Alabama Asphaltic Limestone Co. case, supra, is controlling. There, as here, the committee bid in the assets and transferred the property to a corporation subsequently organized. The Supreme Court held the separate steps were integrated parts of a single plan. Here the committee was never the owner. There was no realizing transaction in 1931. The trustee acquired possession of the property for the bondholders in 1931 and retained possession until the sale in 1935, but its possession was under the provisions of the deed of trust, and not as owner. In 1935, upon the sale under the deed of trust, title passed from the Holding Co. to petitioner. There was no intervening owner, as in the*97 Bondholders' Committee case, supra. Respondent's second argument is that petitioner did not acquire the property of Hotel Holding Co. solely for voting stock, but for voting stock and cash. The petitioner borrowed $ 300,000, which, with $ 32,672.24 held by the trustee for the account of Hotel Holding Co., was placed in escrow to be used for payment of certain obligations, *408 including $ 11,529.75 reserved for payment of claims of the nonassenting bondholders. Respondent says the case is governed by Helvering v. Southwest Consolidated Corporation, supra, in which the committee borrowed $ 106,680 from a bank to pay off the nonassenting bondholders, the Supreme Court concluding that the corporation used cash, as well as voting stock, to effect the purchase of the property. Since these decisions of the Supreme Court we have had occasion to construe and apply them in a number of reorganization cases. In Southland Ice Co., 5 T. C. 842, certain cash held by the transferor was used to pay the nonassenting bondholders. We concluded that the new corporation acquired "solely for voting stock" substantially all*98 the assets of the transferor, some assets of the transferor having been used to satisfy the claims of nonassenting bondholders. A similar conclusion was reached in Westfir Lumber Co., 7 T. C. 1014. In that case we pointed out that no interest was purchased for new cash obtained through borrowing, through the sale of stock, or through any other transaction with a third party. In Peabody Hotel Co., 7 T. C. 600, we concluded that the new corporation acquired substantially all the property of a predecessor for a part of its voting stock and the assumption of liabilities of the predecessor. Included in the liabilities assumed were accrued real estate taxes, liabilities incurred by the bankruptcy trustee, and costs of the court proceedings. The taxpayer also sold stock for working capital. See also Claridge Apartments Co., 1 T. C. 163 (affirmed on other issues, 323 U.S. 141), and New Jersey Mortgage & Title Co., 3 T. C. 1277. These cases point the way to the decision here. At the time petitioner acquired it, the property was subject*99 to various charges such as accrued taxes, claims of the trustee for advances, claims of Thomas E. Hull for repairs and improvements in excess of those he had contracted to make, the claims of the nonassenting bondholders, legal and accounting charges, and expenses of the reorganization, and some funds were needed for operating capital. To the extent necessary to meet the claims of nonassenting bondholders, we may regard a part of the property as set aside for that purpose and not acquired by petitioner. There was cash held by the trustee sufficient for this purpose, if that be deemed necessary. Petitioner acquired the remainder of the property, substantially all the property of Hotel Holding Co., and gave as consideration voting stock and its assumption of the liabilities, save the claims of the bondholders not assenting. Borrowed funds were used to pay the assumed obligations and provide working capital. While this money was borrowed by petitioner concurrently with the acquisition of the property and placed in escrow to pay the liabilities, the result is the same as though petitioner had taken the property subject to the liabilities and later borrowed funds to pay the debts. *100 *409 The assumption of a liability of the predecessor or the fact that the property is subject to a liability is to be disregarded under the statute. Respondent contends that the borrowing of funds here brings the case within the scope of Southwest Consolidated Corporation, supra. There funds were borrowed to pay the nonassenting bondholders and the Court concluded that cash was used to acquire the property. Here petitioner acquired the property solely for voting stock. The borrowed cash was used for other purposes, the payment of the liabilities assumed, and was not used for the purchase of the interest of the nonassenting bondholders, who received their pro rata shares of the property itself from the trustee, not from petitioner. The cash needed to satisfy their claims was available among the transferor's assets and the petitioner did not furnish it, as in the Southwest Consolidated case, supra. Although the funds were commingled in the escrow, that is one of the mechanics of the transaction we may regard as immaterial. We conclude that the transaction was a reorganization and petitioner is entitled to use the basis of the Hotel Holding*101 Co. for the property. In view of our conclusion on the first issue, it is not necessary that we determine the value of the property on June 13, 1935. Decision will be entered for the petitioner. Footnotes 1. SEC. 113. ADJUSTED BASIS FOR DETERMINING GAIN OR LOSS. (a) Basis (Unadjusted) of Property. -- The basis of property shall be the cost of such property; except that -- * * * * (7) Transfers to corporations. -- If the property was acquired -- (A) after December 31, 1917, and in a taxable year beginning before January 1, 1936, by a corporation in connection with a reorganization, and immediately after the transfer an interest or control in such property of 50 per centum or more remained in the same persons or any of them, * * * * * * *↩ then the basis shall be the same as it would be in the hands of the transferor, increased in the amount of gain or decreased in the amount of loss recognized to the transferor upon such transfer under the law applicable to the year in which the transfer was made. * * *