Turnbow v. Commissioner

Grover D. Turnbow and Ruth H. Turnbow, Petitioners, v. Commissioner of Internal Revenue, Respondent Turnbow v. Commissioner Docket No. 69429 United States Tax Court 32 T.C. 646; 1959 U.S. Tax Ct. LEXIS 148; June 12, 1959, Filed *148 Decision will be entered under Rule 50. Petitioner, who owned all of the stock of Supply, exchanged all of such stock for shares of stock of Foremost Dairies, Inc., and $ 3,000,000. He reported gain limited to $ 3,000,000, less expenses, under section 112(c)(1), 1939 Code. Respondent determined that gain in excess of $ 3,000,000 was taxable because section 112(c)(1) was not applicable. Held, the provisions of section 112(c)(1) are applicable and petitioner's gain is recognized but only in an amount which does not exceed the cash payment. M. W. Dobrzensky, Esq., and S. H. Dobrzensky, Esq., for the petitioners. Nat. F. Richardson, Esq., for the respondent. Harron, Judge. HARRON *646 The Commissioner determined deficiencies in income tax for the taxable years 1952 and 1953 in the amounts of*150 $ 264,037.43 and $ 14,786.26, respectively. The question is whether or not section 112(c)(1), 1939 Code, applies to a transaction in which petitioner received cash and stock in an acquiring corporation in exchange for all of the stock in another corporation, which became a subsidiary of the acquiring corporation, so that the taxable gain to be recognized is limited to the amount of cash received. FINDINGS OF FACT. The petitioners, residents of San Francisco, California, filed joint income tax returns for the taxable years with the collector of internal revenue for the first district of California. Since the issue to be decided relates only to Grover D. Turnbow, he is referred to hereinafter as the petitioner. Petitioner owned all of the outstanding stock of International Dairy Supply Co. (a Nevada corporation) and International Dairy Engineering Co. (a California corporation). International Dairy Supply Co. (a Nevada corporation) owned 60 per cent of the stock of Diamond Dairy, Inc., and a group of individuals represented by petitioner owned the remaining 40 per cent of the stock of Diamond Dairy, Inc. Foremost Dairies, Inc., a New York corporation (hereinafter called Foremost), *151 which has its principal place of business in Jacksonville, *647 Florida, is engaged in the business of processing and distributing milk, cream, and other dairy products. International Dairy Supply Co. (hereinafter called Supply 1) had, and still has, its principal office in San Francisco. The main part of its business was furnishing reconstituted milk and milk products to the Armed Forces of the United States, located outside the country, under contracts with the United States. Supply prepared dehydrated milk and milk products in this country and shipped such products to plants, which it operated in foreign countries, where the dehydrated milk and milk products were converted into liquid milk, chocolate drinks, ice cream, and similar products. Since it began business, 95 per cent of Supply's gross income has been derived from sources other than sources within the United States. In 1952, Supply was a party to a contract with the United States which had been executed in 1948 and which was a continuing contract in good standing. Supply also had a contract with the United States to furnish milk products to the Armed Forces in the Far East Command. *152 In 1952, there was only one class of stock of Supply issued, namely, voting capital stock. There were 5,000 shares outstanding, all of which were owned by Grover D. Turnbow. In 1952, International Dairy Engineering Co. (hereinafter called Engineering) was engaged in constructing a plant at Atwater, California. Its total outstanding stock consisted of 100 shares, which were owned by Turnbow. In 1952, the outstanding capital stock of Diamond Dairy, Inc. (hereinafter called Diamond), consisted of 25,000 shares, of which Supply owned 15,000 shares, 60 per cent, and individuals owned 10,000 shares, 40 per cent. In 1951, Foremost and Turnbow began negotiations and entered into an agreement under which Foremost was to acquire all of the stock of the three corporations above named in what was intended to be a tax-free reorganization. Upon completion of preliminary matters in the early part of 1952, a supplemental agreement, called Amendatory Agreement, was executed by Foremost and Turnbow on February 11, 1952. The amendatory agreement is incorporated herein by this reference. It included in inter alia, the reorganization plan. Under the reorganization plan the following was to be*153 done: (1) Foremost was to acquire from Turnbow all of the capital stock of Supply (5,000 shares), and Turnbow was to receive in exchange 82,375 shares of the common stock of Foremost, plus $ 3,000,000. Supply was thereby to become a wholly owned subsidiary of Foremost; *648 it was to continue in the operation of its business. (2) Foremost was to acquire from Turnbow all of the outstanding capital stock of International Dairy Engineering Co. (100 shares), and Turnbow was to receive in exchange 60,000 shares of the common stock of Foremost. International Engineering was thereby to become a wholly owned subsidiary of Foremost, and it was to continue in the operation of its business. (3) Under the first exchange of stock, Foremost would gain control of 60 per cent of the capital stock of Diamond Dairy, Inc., which was owned by Supply. Having acquired control of Diamond, Foremost, pursuant to the plan of reorganization, was to acquire the minority stock of Diamond, 10,000 shares, by giving 10,000 shares of Foremost common stock in exchange for 10,000 shares of capital stock of Diamond, which Turnbow agreed to deliver. Neither Supply, Engineering, Diamond, nor Foremost was to*154 make any distribution to its respective shareholders in pursuance of the plan of reorganization, or otherwise. It was contemplated, under the reorganization plan, that the number of directors of Supply and Engineering would be changed so that Turnbow would maintain three directors thereon and Foremost would elect three directors; that Supply would create an executive committee consisting of three members, two of which would be nominated by Foremost; that Turnbow would be the president and general manager of Supply and of Engineering, and that Turnbow's nominee would be president and/or general manager of Diamond; that Turnbow's salary would be in the same amount as the salary of the president of Foremost; that the president of Foremost might become the vice president of Supply and of Engineering, and the chairman of the executive committee of each company; that Turnbow would become a member of the board of directors and of the executive committee of Foremost, and would have the right to nominate two directors, in addition to himself, to Foremost's board of directors; that Turnbow would be elected chairman of Foremost's executive committee; and that Turnbow would execute a formal agreement*155 with Foremost not to compete with either Supply, Engineering, or Foremost in the type of business carried on by each, other than the business of farming, cattle raising, or the farm production of milk. Furthermore, it was contemplated by the parties that there would be two divisions of the business of Foremost, the Eastern division, and the Western and International division; and that Turnbow would be known as the general manager of the Western and International division, and Paul E. Reinhold (the president of Foremost) would be known as the general manager of the Eastern division. The closing date under the 1952 agreement was March 3, 1952. Prior to the closing date Turnbow was to do the following things: *649 He was to purchase a ranch and certain personal property for cash from Engineering, and he was to convey all title to a patent application to Engineering. Also, he was to pay $ 500,000 to Engineering as a capital contribution, and it was agreed that the plant which Engineering was constructing at Atwater would cost in excess of $ 600,000, and would be completed, substantially, by April 15, 1952. Turnbow was, further, to purchase for cash from Supply certain notes receivable*156 of three stockholders of Diamond for $ 61,142, and a note of a Dr. Kempf for $ 3,150. The terms of the agreement of February 11, 1952, were carried out. On March 3, 1952, the exchange of the stock of Supply for stock of Foremost was consummated, and Turnbow received 82,375 shares of the common stock of Foremost (a minority interest) in exchange for all of the capital stock of Supply. Turnbow also received cash from Foremost in the amount of $ 3,000,000. Since his expenses in connection with the exchange were $ 15,007.23, the net amount of the cash he received was $ 2,984,992.77. On March 3, 1952, the 82,375 shares of common stock of Foremost had a fair market value of $ 15 per share. In the exchange of the stock of Supply, Foremost acquired all of the issued and outstanding shares of stock of Supply, of all classes. In the exchange, petitioner acquired only the 82,375 shares of common stock of Foremost and cash in the amount of $ 3,000,000 ("boot"), and Foremost acquired only all of the issued and outstanding shares of the voting capital stock of Supply. In the income tax return of the petitioner for 1952, he reported long-term capital gain from the above-described transaction *157 in the amount of $ 2,984,992.77, under the provision of sections 112(b)(3) and 112(c)(1). The Commissioner's determination was as follows: In 1952 you exchanged 5,000 shares of International Dairy Supply Company capital stock for $ 3,000,000.00 in cash and 82,375 shares of capital stock of Foremost Dairies, Inc. You determined that the gain to be recognized was limited to the amount of cash received. In your return you reported a gain of $ 2,984,992.77 ($ 3,000,000.00 less $ 15,007.23 expense of exchange). It is held that the entire gain realized upon the exchange constituted taxable income. The adjustment to the income reported in your return is computed as follows: Amount received on exchange: Cash $ 3,000,000.00 82,375 shares of Foremost Dairies, Inc. valued at $ 15.00 a share 1,235,625.00 Total received $ 4,235,625.00 Less: Basis of stock exchanged $ 50,000.00 Expenses per return 20,981.80 Add'l. legal fees allowed 951.26 71,933.06 Gain recognized $ 4,163,691.94 Gain reported 2,984,992.77 Additional gain recognized $ 1,178,699.17 Adjustment to income -- 50 per cent $ 589,349.59 *650 OPINION. Petitioner owned all of*158 the outstanding stock of Supply, which was voting stock. In 1952, he received in exchange for all of his stock in Supply 82,375 shares of common stock of Foremost and $ 3,000,000 in cash, so-called "boot." The question before us is limited to whether the provisions of section 112(c)(1) of the 1939 Code 2 apply to the transaction. Respondent has determined that section 112(c)(1) does not apply and, that therefore, the entire gain is taxable under section 112(a). *159 Petitioner contends that, in considering whether section 112(c)(1) applies to the transaction, it is necessary and proper to look to section 112(b)(3) 3after omitting the cash payment involved in the transaction. Respondent contends that there must be a qualifying reorganization within the meaning of section 112(g)(1)(B) 4 before section 112(c)(1) can come into play insofar as section 112(c)(1) refers to an exchange within the provisions of section 112(b)(3). *160 Subsection (b) of section 112 allows various exceptions from subsection (a), which states the general rule that the entire amount of the gain shall be recognized upon the sale or exchange of property. Subsection (b) deals with exchanges solely in kind, whereas subsection (c) deals with the treatment of gain from exchanges which are not solely in kind, but only if an exchange would be within (1), (2), (3), or (5), if it were not for the fact that the property received in exchange consists not only of property permitted by (1), or (2), or (3), or (5), but *651 also of other property or money. Directing our attention to section 112(b)(3), it is noted that among the requirements contained therein is the specification that the property involved must be stock or securities which is exchanged solely for stock or securities. Both of the sections involved here, subsection (b)(3) and subsection (c)(1), are provisions of long standing which were reenacted in the successive revenue acts which preceded the 1939 Code. In both the regulations of the Commissioner and in this Court's interpretation of section 112(c)(1), it has been understood that in order to give effect*161 to the provisions of section 112(c)(1) the method to be followed is first to omit the item of cash (or other property) from the transaction and then to determine whether the exchange would be within subsection (b)(3). Otherwise, section 112(c)(1) would have no meaning in the context of its references to particular subsections of section 112(b). In , this Court concluded that the method of applying the statute was as follows: It is necessary therefore to determine whether or not the exchange of * * * stock for * * * stock would be within the provisions of subsection (b)(3) if the item of cash had been omitted and only * * * stock had been received in exchange for * * * stock. [Italics supplied.] In , reversing , on the basis of a question which was not reached by this Court, the following was stated: Thus we may conclude that, in determining when these so-called "boot" provisions apply, Congress intended that the transaction is to be considered separately and apart*162 from the "boot" received in determining whether it meets the nonrecognition provisions. If the transaction, absent the "other property or money," fulfills the requirements of section 112(b)(3), then gain is to be recognized to the extent that "boot" is received. In the instant case, but for the cash received in exchange for * * * common stock of Binkley, the transaction would have met the "solely" requirement of section 112(g)(1)(B) and fallen within the scope of section 112(b)(3). To the extent that "boot" was received, gain would be recognized under our interpretation of section 112(c)(1). * * * The view expressed in , corresponds with the opinion which was expressed by this Court in the Bonham case. Our problem here is whether we should adhere to our understanding of the method to be followed in determining whether section 112(c)(1) applies in an exchange of stock solely for stock, plus money. Consideration has been given to the respondent's regulation, Regs. 118, sec. 39.112(g)-4 (issued September 26, 1953, and applicable to taxable years beginning after December 31, 1951), which is set forth in the*163 margin. 5 Regs. 111, sec. 29.112(g)-4 (issued by respondent in *652 October 1943 and applicable to taxable years beginning after December 31, 1941), contain provisions which are identical with Regs. 118, sec. 39.112(g)-4. The provisions of section 112(c)(1) of the 1939 Code were reenacted in substantially identical language in section 351(b) of the 1954 Code, and respondent's regulations promulgated under the 1954 Code, section 1.351-2(a) restate in substantially identical language what was stated in Regs. 111, sec. 29.112(g)-4, and Regs. 118, sec. 39.112(g)-4. *164 Thus, there has been a long-standing and continuous construction of section 112(c)(1) (and the corresponding section in the earlier revenue acts) which has remained unchanged over the years in the face of the several reenactments of the statutory provision, as well as the amendment in the 1934 Act of section 112(g)(1)(B), when there was introduced into subsection (g)(1)(B) the word "solely," in harmony with the provisions of subsections (b)(2), (b)(3), (b)(4), and (b)(5) which also contained the word "solely," and contained "solely" for many years. The respondent's regulations, therefore, are deemed to have received the approval of Congress. ; . Respondent has not offered any explanation for his departure in this case from his long-standing interpretation of section 112(c)(1) set forth in his regulations. In this circumstance, and since this Court's view of the method to be followed in applying the provisions of section 112(c)(1) is in accord with the respondent's long-standing regulations, we do not find cause for changing our construction*165 of section 112(c)(1), and in this case we conclude that it should be followed. The respondent's error is that he has seen fit here not to omit the item of cash in determining whether the transaction of petitioner and Foremost involved an exchange of the stock of Supply solely for stock of Foremost within the provisions of section 112(b)(3). Accordingly it is held, that but for the cash received by petitioner in the transaction involving the exchange of all of the stock of Supply for part of the stock of Foremost, the exchange would have met the "solely" requirement of section 112(g)(1)(B) and fallen *653 within section 112(b)(3). . Therefore, under section 112(c)(1) the gain to petitioner may not be recognized in an amount in excess of $ 2,984,992.77, which is the net amount of $ 3,000,000 less allowable expenses. Recomputations are required under Rule 50 because of concessions or abandonment of the parties in respect to other adjustments. Decision will be entered under Rule 50. Footnotes 1. The parties also refer to this corporation as International.↩ 2. SEC. 112(c). Gain From Exchanges Not Solely in Kind. -- (1) If an exchange would be within the provisions of subsection (b) (1), (2), (3), or (5), or within the provisions of subsection (l), of this section if it were not for the fact that the property received in exchange consists not only of property permitted by such paragraph or by subsection (l) to be received without the recognition of gain, but also of other property or money, then the gain, if any, to the recipient shall be recognized, but in an amount not in excess of the sum of such money and the fair market value of such other property.↩ 3. SEC. 112. RECOGNITION OF GAIN OR LOSS. (a) General Rule. -- Upon the sale or exchange of property the entire amount of the gain or loss, determined under section 111, shall be recognized, except as hereinafter provided in this section. (b) Exchanges Solely in Kind. -- * * * * (3) Stock for stock on reorganization. -- No gain or loss shall be recognized if stock or securities in a corporation a party to a reorganization are, in pursuance of the plan of reorganization, exchanged solely for stock or securities in such corporation or in another corporation a party to the reorganization.↩ 4. SEC. 112(g). Definition of Reorganization. -- As used in this section * * * -- (1) The term "reorganization" means * * *, or (B) the acquisition by one corporation, in exchange solely for all or a part of its voting stock, of at least 80 per centum of the voting stock and at least 80 per centum of the total number of shares of all other classes of stock of another corporation, * * *↩ 5. Sec. 39.112(g)-4 Exchanges in reorganization for stock or securities and other property or money. (a) If in an exchange of stock or securities in a corporation a party to a reorganization, in pursuance of the plan of reorganization, for stock or securities in the same corporation or in another corporation a party to the reorganization, there is received by the taxpayer other property (not permitted to be received without the recognition of gain) or money, then (1) As provided in section 112(c)(1), the gain, if any, to the taxpayer will be recognized in an amount not in excess of the sum of money and the fair market value of the other property, but (2) The loss, if any, to the taxpayer from such an exchange is not to be recognized to any extent (see section 112(e)). (b) The application of paragraph (a) of this section may be illustrated by the following example: Example↩. A, in connection with a reorganization, in 1952, exchanges a share of stock in the X Corporation purchased in 1929 at a cost of $ 100 for a share of stock of the Y Corporation (a party to the reorganization), which has a fair market value of $ 90, plus $ 20 in cash. The gain from the transaction is $ 10 and is recognized and taxed as a gain from the exchange of property. But see section 117. However, if the share of stock received had a fair market value of $ 70, the loss from the transaction of $ 10 would not be recognized.