H. W. Porter & Co. v. Commissioner

H. W. Porter & Co., Inc., and Subsidiary, Petitioner, v. Commissioner of Internal Revenue, Respondent H. W. Porter & Co. v. Commissioner Docket No. 17773 United States Tax Court 14 T.C. 307; 1950 U.S. Tax Ct. LEXIS 269; February 28, 1950, Promulgated *269 Decision will be entered under Rule 50. 1. The taxpayer corporation purchased from a deceased stockholder's estate and later sold to other stockholders and employees certain shares of its own stock. Under a provision of the corporate charter designed to keep control in the organizing group, all shares of which a stockholder wished to dispose or died possessed had to be first offered to the taxpayer at book value, and in practice it bought them, held them as treasury stock, and later made sales of them at book value to other stockholders and employees. Held, the taxpayer corporation was not dealing in its own shares "as it might in the shares of another corporation" within the meaning of section 29.22 (a)-15, Regulations 111, and the excess of the selling price above that paid for such shares was not taxable as gain. 2. An addition to a reserve for bad debts, held on the evidence to be reasonable in amount and deductible. George E. H. Goodner, Esq., and Scott P. Crampton, Esq., for the petitioner. John T. Rogers, Esq., for the respondent. Johnson, Judge. Hill, Disney, and Opper, JJ., dissent. JOHNSON *307 The Commissioner determined a deficiency of $ 19,374.50 in petitioner's excess profits tax for 1943 in part by adding to income reported a gain on the sale of petitioner's own shares, acquired and held in its treasury, to stockholders and employees. He also disallowed an addition to a reserve for bad debts. Petitioner contends that its sale of shares was a nontaxable capital transaction and that its addition to the bad debt reserve was reasonable and deductible. It also assigns errors in the Commissioner's computation of invested capital and excess profits tax credit which reflected the determination of gain on the sale of shares. Another assignment of error was abandoned. FINDINGS OF FACT. Petitioner H. W. Porter & Co. (hereinafter called Porter), a New Jersey corporation, with principal office at Newark, New Jersey, *271 owns all the stock of Reid Hayden, Inc. (hereinafter called Hayden), a Maryland corporation, with principal office at Baltimore, Maryland. For 1943 Porter and Hayden filed consolidated income, declared value excess profits, and excess profits tax returns with the collector of internal revenue for the fifth district of New Jersey. The books of both are kept and the tax returns prepared on an accrual basis of accounting. For years prior to 1943 each corporation filed separate tax returns. Porter, organized in 1927, and Hayden, organized in 1924, were formed by former employees of the Johns-Manville Co. to engage in *308 the installation of insulating equipment and for the sale of insulating machines and appliances. Porter's organizers were H. W. Porter, who had been manager for the contracting business of the Johns-Manville Co. in the New Jersey area, and four associate employees. Hayden's organizers were W. Reid Hayden, who had been manager in the Baltimore area, and associate employees. The Johns-Manville Co. discontinued its contracting business and gave the two corporations exclusive rights to represent it in the respective territories in which their organizers had previously*272 served. Both corporations have since furnished and installed under contract with customers insulation for the heating and cooling of buildings, factories, ships, and other structures; both have given engineering advice, written specifications, and made estimates for proposed contracts. They have also sold insulation equipment to others, but such sales have been only a minor part of their business. By its charter Porter was authorized to issue 200 class A and 2,800 class B shares of common stock without par value. The class A share entitled the holder to a vote in corporate affairs; the class B share did not. Both classes were entitled to participate equally in the distribution of profits. The charter provided further that the holder of class A shares could transfer them only to others then holding stock; class B shares could be issued to others, but only with the written consent of a majority of class A stockholders, and: The stockholders of either class shall not have the right to assign or transfer their stock * * * unless * * * first offered to the company at a price equal to the value * * * as shown by the books. If the company should not buy within 30 days, then the shares*273 had to be offered at book value to other stockholders, who would have 30 days within which to buy. In the event of a stockholder's death the company, and then the other stockholders, had like rights of purchase. Shares acquired by the company: * * * shall be alloted to other members of that class of stock than the stockholders so selling in proportion to their holdings of that class of stock, or to such of them as shall be willing to accept and pay for the same at the price fixed as aforesaid or they may be held by the company. The charter further provided that the above restrictions might be waived by the unanimous consent of all stockholders of the class of shares involved in respect of a specific proposed transaction. The purpose of the transfer restrictions was to keep control of Porter within the organizing group of associates. Initially 200 class A and 1,500 class B shares were issued to the five organizers at $ 50 a share and thereafter additional class B shares were issued in small amounts to stockholders and employees at from $ 50 to $ 80 a share. All 2,800 *309 class B shares were outstanding by January, 1938. Porter acquired shares of Hayden, getting control*274 of that company in 1928 and all of its stock in 1934. The two companies were thenceforth operated as a unit, having the same officers and directors and a common management. On numerous occasions from 1931 to 1943 Porter acquired its own shares from stockholders or their estates, and it disposed of these shares to other stockholders or to its employees. It carried policies of insurance on the lives of its large stockholders to provide funds for the acquisition of their shares at death. It also acquired an employee's shares on his severance from service. Upon the original issuance of a share the $ 50 received for it was credited to capital account, and when in some instances more than $ 50 was received, the excess was credited to capital surplus. In acquiring a share, Porter did not reduce its capital stock account, but held the share as "treasury stock," paying no dividends on it until reissue. Of the price paid for a share, Porter charged $ 50 to a treasury stock account and any excess to capital surplus. The certificate was mutilated by perforation, and pasted to its stub in the stock book. On Porter's subsequent disposition of the share a new certificate was issued, and *275 the price received was credited $ 50 to treasury stock and any excess to capital surplus. The prices at which shares were acquired and reissued were roughly equal to book value, and Porter never lacked ample funds for acquisitions. Prior to 1943 the aggregate prices received for reissued shares exceeded those paid in the acquisition of such shares. Porter never bought or sold its own shares except in transactions with its stockholders or employees. It acquired shares in other corporations, but carried them in an investment account. On November 14, 1942, F. J. Byrne, a director and one of Porter's five organizers, died, owning 30 class A and 526 class B shares of its stock. A few months before his death he and the other directors had agreed on $ 100 as the proper price of a share after some discussion and disagreement, Byrne himself having suggested $ 80. The directors also agreed to direct by will that their respective executors offer to sell the estate's shares to Porter at that price. Byrne so directed in his will, and on February 3, 1943, Porter purchased from Byrne's estate the 556 shares, paying therefor $ 55,600, of which $ 30,000 was provided by Porter's insurance policy*276 on Byrne's life. In the recording of this transaction the treasury stock account was originally charged with $ 27,800, capital surplus with $ 3,280, and earned surplus with $ 24,520. During 1943 Porter and Hayden enjoyed an unprecedented volume of business, mostly connected with war contracts, and the book value of the Porter shares by July 31 had risen to about $ 160 each. On that date Porter reissued 10 of the class A shares and 226 of the class B shares, which had belonged to Byrne, receiving therefor $ 150 each, or *310 $ 35,400, which was $ 11,800 more than the amount paid in the acquisition of that number. An accountant who was engaged to audit the books and prepare income tax returns for 1943 took note of an instruction accompanying the excess profits tax return form to the effect that "Stock held in the treasury of the issuing corporation is an inadmissible asset" in the computation of invested capital, and he thereupon changed the recording of petitioner's acquisition of the Byrne shares and entered the entire $ 55,600 paid therefor in the treasury stock account. The remaining 320 shares acquired from Byrne's estate, to which $ 32,000 of the price paid was attributable*277 and which were still held as treasury stock at the end of the year, were entered as an asset at that figure and so reported on a balance sheet attached to the return. The $ 16,000 of the price, or $ 50 a share, which had been charged to surplus at the time of acquisition was eliminated from the surplus accounts. In computing the consolidated net income of Porter and Hayden for 1943, the Commissioner determined a short term capital gain of $ 11, 800 from the sale of the 236 shares of Porter stock on July 31, and reflected this adjustment in the computation of excess profits tax. Porter and Hayden each maintained a reserve for bad debts on their books and deducted this reserve on their income tax returns. They had several hundred trading accounts, which varied greatly in amount. During the years 1934-1943 the aggregate of such accounts receivable and the reserves for bad debts in amount and percentage of the accounts were as follows: H. W. Porter & Co. Reid Hayden, Inc. Year Accounts Reserve Per cent Accounts Reserve Per cent — 1934 — $ 43,836 $ 2,678 6.1 $ 80,352 $ 3,858 4.8 — 1935 — 39,684 2,500 6.3 67,724 3,862 5.7 — 1936 — 38,537 2,000 5.2 71,915 4,102 5.7 — 1937 — 54,402 2,500 4.6 103,394 5,223 5.1 — 1938 — 39,211 2,500 6.4 68,942 4,449 6.5 — 1939 — 40,406 2,500 6.2 77,453 3,513 4.5 — 1940 — 85,046 4,252 5.0 195,614 9,774 5.0 — 1941 — 105,877 4,252 4.0 234,567 8,968 3.8 — 1942 — 119,105 4,196 3.5 487,610 8,256 1.7 — 1943 — 196,988 5,910 3.0 450,891 13,526 3.0 *278 The amount of the reserve was determined by the accountant, with the approval of the directors, and in arriving at it consideration was normally given to an "age list," showing the accounts 30, 60, and 90 days old, and in 1943 also to the factor of renegotiation and termination of war contracts. During the years 1937-1943 Porter charged to the reserve $ 2,844 of bad debts, but later collected $ 970 on those charged. Hayden charged to its reserve $ 7,175, but later collected $ 5,884. In the year 1943 Porter charged $ 95 and collected $ 307; Hayden charged nothing and collected $ 1,192. Of Porter's current *311 accounts receivable at the end of 1943, those 30 days old aggregated $ 35,445.93; those 60 days old, $ 4,077.60; those 90 days old, $ 3,500.69. Of Hayden's current accounts receivable at the end of 1943, those 30 days old aggregated $ 102,791.07; those 60 days old, $ 3,686.69; those 90 days old, $ 4,794.26. The 1943 reserve of Porter was increased over the 1942 reserve by $ 1,809.23 and that of Hayden by $ 5,270.49, or a consolidated addition of $ 7,079.72. This addition was reasonable. The Commissioner disallowed it as a deduction. OPINION. Petitioner assigns error*279 in the determination that it realized a taxable gain of $ 11,800 upon the sale in 1943 of 236 shares of its own stock held in treasury. While readjustments in capital structure are not taxable, it is now settled that, if a corporation deals in its own shares "as it might in the shares of another corporation," the resulting gain is subject to (A)-15 tax, sec. 29.22 (a)-15, Regulations 111; ; certiorari denied, ; ; . In applying the principle this Court has deemed such dealings, when not carried out for the purpose of a prospective profit, but to satisfy a contractual obligation, equalize shareholdings, , eliminate a participant wishing to retire, , or implement a profit sharing plan for employees, ,*280 as not dealings which the corporation might carry out in the shares of another corporation, and has held the resulting profit on disposition nontaxable. On facts substantially similar to those here established, we applied the same reasoning and reached the same conclusion in , and in . The former decision was reversed by the Court of , and the latter by the . We are not unmindful of these reversals of our holdings, but we note that in each case the opinion of the Court of Appeals was by a divided court. Moreover, after a careful consideration of the facts and the question here involved, a question which we have a number of times considered over a period of years, we are respectfully constrained to follow our holdings in these and the other cases mentioned above for the reasons therein stated. We have reached the conclusion that petitioner here was not dealing in its own shares "as it might in *281 the shares of another corporation," and we accordingly reverse respondent's determination of a taxable gain of $ 11,800 on petitioner's disposition of the 236 shares in 1943. *312 Petitioner assigned error as to invested capital and excess profits tax credit, but the errors alleged as to them were predicated solely upon the Commissioner's treatment of the $ 11,800 as taxable gain, and disposition will be made under Rule 50. Petitioner also complains of the Commissioner's disallowance of $ 7,079.72 of its deduction for bad debts. Porter and Hayden each maintained a reserve for bad debts. In 1943 Porter increased its reserves from $ 4,196 to $ 5,910; Hayden, from $ 8,256 to $ 13,526. The $ 7,079.72 disallowed represents the consolidated increases. In defense of his disallowance respondent argues that the amount of the reserves without any increase was more than ample to cover the companies' bad debts in the light of their past experience. He stresses that large collections had been made on debts which had been charged to the reserves, and for the years 1937-1943 he makes a computation of the aggregate charges and subsequent collections. These figures do indicate that the reserves*282 had been adequate in past years, and it is also true that during 1943 charges against the reserves were negligible -- much less than in any preceding year. But 1943 was a very abnormal year. While the corporate accounts receivable aggregated less than $ 112,000 in 1939, when the two reserves were together $ 6,013, they aggregated nearly $ 650,000 in 1943, and more than $ 154,000 of these accounts was over 30 days past due at the end of the year. It is not reasonable to suppose, as respondent would have us do, that the multiple increase in petitioner's volume of business during the war years would be unaccompanied by an increase in the amount of bad debts. ; affirmed on another point, . And, under the circumstances prevailing during that period, past experience with less business volume loses its normal value as an index to the reasonableness of an addition to reserves. For, as we said in ; affirmed on another point (C. C. A., 6th Cir.), : * * * A method or formula*283 that produces a reasonable addition to a bad debt reserve in one year, or a series of years, may be entirely out of tune with the circumstances of the year involved. * * * As increased, the two reserves were only $ 19,436, or 3 per cent of accounts receivable. They were only 12 1/2 per cent of the accounts 30 days or more past due at the end of the year. Petitioner's claim is well within the bounds of reason, and we find that the additions to the reserves were proper. The Commissioner's disallowance of their deduction is reversed. Decision will be entered under Rule 50.