Ernest W. Brown, Inc. v. Commissioner

Ernest W. Brown, Inc., Petitioner, v. Commissioner of Internal Revenue, Respondent Ernest W. Brown, Inc. v. Commissioner Docket No. 58017 United States Tax Court 28 T.C. 682; 1957 U.S. Tax Ct. LEXIS 156; June 21, 1957, Filed *156 Decision will be entered for the respondent. 1. Deduction -- Loss -- Termination of Contracts and Business. -- The taxpayer has not shown its right to deduct in 1952 an alleged loss on contracts which, by their terms, could not survive the death in 1947 of the one man who was to perform the work under those contracts. 2. Id. -- Basis -- Transferee Takes Transferor's Zero Basis -- Secs. 112 (b) (5) and 113 (a) (8) and (b). -- The transaction in 1923 whereby the petitioner was named attorney in fact and manager and thereby succeeded to a profitable business formerly conducted individually by its sole stockholder was within sections 112 (b) (5) and 113 (a) (8) (A) and (b) so that the corporation acquired the zero basis of the stockholder-transferor for whatever property was transferred. John P. Lipscomb, Jr., Esq., for the*157 petitioner. Ellyne E. Strickland, Esq., for the respondent. Murdock, Judge. MURDOCK *682 The Commissioner determined a deficiency of $ 20,488.35 in the income tax of the petitioner for 1952. The only issue for decision is whether the petitioner sustained a deductible loss of $ 466,000 in 1952 as a result of the termination of its right to act as manager and attorney in fact for two insurance exchanges. FINDINGS OF FACT. The petitioner was incorporated under the laws of New York on August 22, 1922. Its return for the taxable year was filed with the director of internal revenue for the fourteenth district of New York. Ernest W. Brown was an individual who had been engaged for many years in the business of acting as attorney in fact and manager *683 for various unincorporated organizations known as exchanges of reciprocal insurance underwriters. He became attorney in fact and manager of such an exchange, known as Affiliated Underwriters, in June 1922. He then organized the petitioner and arranged with that exchange for the petitioner to take his place as attorney in fact and manager for that exchange beginning September 1, 1922. The agreement with Affiliated Underwriters*158 provided that the petitioner was appointed "Attorney-in-fact to act for us by its President, Ernest W. Brown, in carrying out the terms of this Agreement." The petitioner, in consideration of being substituted for Brown as attorney in fact and manager for Affiliated Underwriters and for the transfer to it by Brown of $ 600 of Liberty bonds, issued to Brown all of its 100 shares of no-par-value capital stock. He was made president and treasurer of the petitioner and continued in those offices until 1946 when he became chairman of the board and he held that office until his death in February 1947. Brown was the sole stockholder of the petitioner until January 1929. Brown had been manager and attorney in fact for New York Reciprocal Underwriters and Individual Underwriters for a number of years prior to December 1923. He made an offer to the petitioner dated December 27, 1923, to resign as attorney in fact and manager for those two organizations and to procure the appointment of the petitioner in his place as of January 1, 1924. Brown was to be the only individual with any authority to act for the subscribers of the underwriters, and the appointment of the petitioner was to cease*159 immediately if he ceased to act as president of the petitioner. The appointment of the petitioner as attorney in fact could be terminated by the underwriters at any time in their discretion with or without cause. The petitioner was to receive a commission of 5 per cent of all premiums or interest on insurance received by the underwriters. Brown's salary was to be fixed at not less than $ 50,000 per annum while the petitioner held powers of attorney from Affiliated Underwriters, New York Reciprocal Underwriters, and Individual Underwriters. The petitioner was to issue and deliver to Brown its 20-year 6 per cent fully paid notes or debentures of the par value of $ 500,000 dated December 31, 1923. The offer was accepted and carried out. Each debenture was executed on behalf of the petitioner by Brown as president-treasurer. The contracts with the three underwriters, which Brown gave up in favor of the petitioner, had cost him nothing. The petitioner received no consideration for the issuance and delivery to Brown of the $ 500,000 face value of debentures other than Brown's action in having it substituted for him as manager and attorney in fact for the two exchanges. *684 *160 The petitioner became manager and attorney in fact for Fireproof-Sprinklered Underwriters in 1925, for Metropolitan Inter-Insurers in 1928, and for American Exchange Underwriters in 1938. It assigned no value or cost to those three contracts. The petitioner paid $ 466,000 on the principal of the debentures between June 30, 1929, and December 31, 1952. The subscribers at the New York Reciprocal Underwriters and at the Individual Underwriters, acting through their respective advisory committees, terminated their agreements and their powers of attorney with the petitioner effective December 31, 1952. This terminated the income of the petitioner from those sources. The petitioner, on its income tax return for 1952, claimed a deduction of $ 600,000 as "Loss on cancellation of management contracts." The Commissioner, in determining the deficiency, disallowed that deduction. The stipulation of facts, including all exhibits made a part thereof, filed by the parties is incorporated herein by this reference. OPINION. The petitioner argues that it paid $ 466,000 to obtain contracts by which it acted as attorney in fact and manager for two reciprocal insurance exchanges; it was not entitled*161 to amortize the cost because the contracts had an indefinite life; the contracts were canceled by the exchanges in 1952; and a deductible loss of $ 466,000 was sustained at that time. The Commissioner, in his brief, defends the disallowance on the grounds that the issuance of the debentures was not a bona fide transaction at arm's length, the debentures did not represent a genuine indebtedness, and no cost basis for the canceled contracts has been established. The contract between Brown and the petitioner, represented by the offer of December 27, 1923, and its acceptance by the petitioner, expressly provided that the petitioner would provide the advisory committee of each exchange prior to December 31, 1923, with a letter signed by the petitioner's president and its directors containing, among others, the following condition: Our acceptance of the appointment of "Ernest W. Brown, Inc. by its President Ernest W. Brown" as attorney-in-fact for New York Reciprocal Underwriters (Individual Underwriters) is with the distinct understanding that Ernest W. Brown is the only individual connected with said corporation who has any authority to act for the subscribers at New York Reciprocal *162 Underwriters (Individual Underwriters); and, further, it is our understanding that should Ernest W. Brown cease to act as President of Ernest W. Brown, Inc. for any reason whatsoever, said corporation's appointment shall thereupon immediately terminate; and we further agree that the appointment of this corporation as such *685 attorney-in-fact may be terminated by you at any time in your discretion, with or without cause, after written notice to us. It is apparent from that provision that the appointment of the petitioner as attorney in fact and manager for these two exchanges pursuant to which the $ 500,000 face value of bonds were isued to Brown, could not survive Brown's death in 1947, and if the petitioner had any loss it occurred prior to 1952. Likewise, the conclusion is inescapable that since the petitioner acted as attorney in fact and manager for these two exchanges after Brown's death in 1947 and until the end of December 1952, it must have been acting under some new arrangement, the cost of which has not been shown in this record and, therefore, the petitioner has not shown that it is entitled to any deductible loss for 1952 as a result of the cancellation at the*163 end of 1952 of those undisclosed new arrangements. The case would also have to be decided against the petitioner on the ground that its basis for loss on the two 1924 contracts and the business flowing therefrom was zero. A corporation is allowed to deduct for a loss sustained during the taxable year, not compensated for by insurance or otherwise, to the extent of the adjusted basis provided in section 113 (b). Section 113 provides that the adjusted basis for determining such loss shall be the same as it would be in the hands of the transferor if the property was acquired after December 31, 1920, by a corporation by the issuance of its securities in connection with a transaction described in section 112 (b) (5). See sec. 113 (a) (8) (A) and (b). Section 112 (b) (5) provides that no gain or loss shall be recognized if property is transferred to a corporation by one or more persons solely in exchange for stock or securities in such corporation and immediately after the exchange such person or persons are in control of the corporation. The $ 500,000 of bonds which Brown received as sole consideration for his acts were securities in the petitioner corporation within the meaning of*164 section 112 (b) (5), and both before and immediately after the petitioner acquired the contracts and business in question Brown was the sole stockholder of the petitioner. The power of attorney and the designation as manager for New York Reciprocal Underwriters and Individual Underwriters, which Brown held, and the profitable business which they enabled him to conduct had cost him nothing. Nor did his alter ego, the petitioner, pay the exchanges anything for the contracts and the accompanying right to conduct the profitable business so long as Brown headed the petitioner and did the work. The only consideration paid by the petitioner went to Brown. The petitioner argues that section 112 (b) (5) does not apply because the powers of attorney and the designations as manager for *686 New York Reciprocal Underwriters and Individual Underwriters, which Brown held, were nonassignable and could not be and were not transferred to the petitioner by Brown in exchange for the $ 500,000 of debentures. It nevertheless argues that Brown gave full value for the debentures. It describes what happened as follows: Petitioner acquired the business of managing two reciprocal insurance exchanges, *165 Individual Underwriters and New York Reciprocal Underwriters, which had been in existence since 1881 and 1891, respectively. This business had been conducted by Brown since 1918 and was to be carried on by Brown on behalf of petitioner. Brown on one day held the powers of attorney, was manager for the two exchanges and, as a result, was conducting a profitable business, whereas on the next day the petitioner held the powers of attorney, was the manager and, through Brown alone, was conducting the same profitable business. Whatever went from Brown to the petitioner was in consideration of the issuance to Brown of the $ 500,000 of debentures. Cf. John W. Walter, Inc., 23 T. C. 550. Brown had a zero basis for whatever he had that went over to the petitioner, and under the provisions of the Internal Revenue Code referred to above the petitioner took the same zero basis which Brown had. Therefore, whenever those particular contracts terminated the petitioner had no deductible loss. It is academic to discuss whether Brown in effect transferred the contracts themselves or whether he transferred some intangible in the nature of goodwill, the right to benefit*166 financially through representing the exchanges as attorney in fact and manager. Whatever went from Brown to the petitioner, went with a zero basis. There is lurking in this case a suggestion that the debentures might have been issued for valuable services performed by Brown in obtaining the two contracts for the petitioner. The petitioner does not state directly any such argument, but in any event it need not go unanswered. The exchanges wanted Brown alone, no other, to represent them but they were willing to have him do it under corporate name, since that was his desire. The exchanges continued to look to him alone to do the work involved. Neither he nor the petitioner had any expenses or employees in those years other than Brown himself and his salary. The whole arrangement whereby the petitioner corporation was substituted for Brown was couched in such terms as to leave no doubt that Brown was to continue to do all the work even though his alter ego, the petitioner corporation, was named as the attorney in fact and manager for each exchange. The change appears to have been for Brown's benefit only, although there is a suggestion that eventually the corporation might *167 in some way continue to conduct the business without Brown. Actually, it did continue to conduct the business for a short time after his death in 1947, but, as already stated, *687 under some undisclosed new arrangement. It does not appear that Brown did any more in December 1923 than merely state to the exchanges his desires to have his corporation substituted for him individually as attorney in fact and manager for these two exchanges. Thus, it does not appear from this record that the debentures actually were issued for valuable services of Brown in procuring the contracts and business for the petitioner. It appears, instead, that he merely effected a transfer of the business from himself individually to the corporation, whose principal, if not only, substance was himself and his ability to perform the work. He died in 1947 and these contracts did not survive that event. Decision will be entered for the respondent.