Mandel v. Commissioner

Stella K. Mandel, Petitioner, et al., 1 v. Commissioner of Internal Revenue, Respondent Mandel v. Commissioner Docket Nos. 4144, 4145, 4146, 4147, 4148, 4149, 4150, 5708 United States Tax Court 5 T.C. 684; 1945 U.S. Tax Ct. LEXIS 91; September 10, 1945, Promulgated *91 Decision will be entered under Rule 50. On a tax free split-off reorganization a building corporation issued its stock and bonds in exchange for approximately 35 percent of the assets of the old company, which as a part of the same transaction distributed the stock and bonds to its shareholders. The major portion of the assets acquired by the building corporation had been acquired by the old company prior to 1913. At the date of the transfer the old company had accumulated earnings since March 1, 1913, of approximately $ 11,000,000. Held, the building corporation "inherited" approximately 35 percent of the old company's earned surplus, which amount was thereafter available for dividend distribution; held, further, the bond issue in question did not serve to distribute the "inherited" earnings. Commissioner v. Sansome, 60 Fed. (2d) 931. Harry B. Sutter, Esq., Samuel H. Horne, Esq., and Whitney B. Flershem, C. P. A., for the petitioners. Charles J. Munz, Jr., Esq., for the respondent. Arundell, Judge. ARUNDELL *684 These consolidated proceedings involve redetermination of deficiencies in income tax as follows: Docket No. [4144] $ 3,004.68 $ 2,655.16 [4145] 391.22 758.50 [4146] 2,682.55 4,449.42 [4147] 718.49 625.52 [4148] $ 431.25 $ 584.38 [4149] 148.70 302.99 [4150] 288.12 400.53 [5708] 650.82 1,323.99 $ 142.41 *92 The single issue presented is whether distributions in the amounts of $ 60,000 and $ 50,000 paid in 1939 and 1940, respectively, by the Mandel Building Corporation on its preferred stock were out of earnings and profits accumulated after March 1, 1913, so as to constitute taxable dividends in the hands of the stockholders. In two of the dockets, Edwin F. Mandel, No. 4146, and Eugene D. Mandel, No. 5708, there are separate stipulations disposing of issues peculiar to those cases. Those stipulations will be given effect in recomputation under Rule 50. The facts have been stipulated by the parties and we accept the stipulation as our findings. In so far as they are material to the decision herein, the facts are as follows: *685 FINDINGS OF FACT. Throughout the years here in question the petitioners owned shares of 7 percent noncumulative preferred stock of Mandel Building Corporation (hereinafter referred to as the building corporation), which stock they had owned for more than 24 months prior to January 1, 1939. The petitioners received distributions on this stock of $ 3 per share in 1939 and $ 2.50 per share in 1940. Total distributions in 1939 and 1940 amounted to $ 60,000*93 and $ 50,000, respectively. The number of shares of 7 percent noncumulative preferred stock owned by each petitioner and the amounts of distributions received in the years 1939 and 1940 are as follows: Docket Shares [1940] No. held distribution distribution Stella K. Mandel [4144] 3,212 $ 9,636.00 $ 8,030.00 Frank E. Mandel [855] 2,565.00 2,137.50 Edwin F. Mandel [4146] 2,561 7,683.00 6,402.50 Albert E. M. Louer [854] 2,562.00 2,135.00 S. Mortimer Auerbach [625] 1,875.00 1,562.50 Estate of Albert S. Louer, deceased, Albert E. M. Louer and Arthur Perrow, coexecutors [854] 2,562.00 2,135.00 Babette Mandel Bird Trust u/w No. 28878, Chicago Title & Trust Co., trustee [854] 2,562.00 2,135.00 Eugene D. Mandel [645] 1,935.00 1,612.50 Mandel Brothers (hereinafter called the old company) was incorporoated in 1898, under the laws of Illinois. At that time it acquired a retail merchandise and department store business in Chicago, Illinois, which had formerly been a partnership enterprise. It continued to own and operate the real estate, buildings, merchandising assets and all equipment therewith until April 27, 1926. *94 Its net worth as of that date, per the books of the company, was $ 18,976,612.77 and it had undistributed earnings accumulated after March 1, 1913, of $ 11,231,614.66. On April 27, 1926, Mandel Brothers, the old company, changed its name to Mandel Stores Corporation. At the same time it transferred to a newly created Delaware corporation named Mandel Brothers, Inc., merchandising and other assets having a book value of $ 12,049,621.05, and it transferred to a newly created Illinois corporation, named Mandel Building Corporation, substantially all of its real estate, furniture and fixtures, machinery, and other tangible personalty, having a total book value of $ 6,683,344.88. The old company retained certain miscellaneous assets of a then book value of $ 243,646.84. Each such transfer was in exchange for the issuance of the transferee's stock and securities pursuant to a plan of reorganization or exchange in which gain or loss was not recognized. The building corporation issued, in exchange for the assets which it received, $ 8,000,000 of 7 percent first mortgage bonds and $ 4,000,000 *686 of common stock, represented by 40,000 shares at a par value of $ 100 each. Of the $ *95 6,683,344.88 total assets transferred to the building corporation in the reorganization, the old company had acquired $ 4,439,174.06 before March 1, 1913, and had acquired $ 2,244,170.82 after March 1, 1913. No part of the $ 11,231,614.66 undistributed earnings of the old company accumulated after March 1, 1913, was taken up or thereafter reflected on the books of the building corporation. On November 12, 1935, the shares of common stock were exchanged, in another reorganization or exchange in which gain or loss was not recognized, for 20,000 shares of 7 percent noncumulative preferred stock with a par value of $ 50 per share and 20,000 shares of common stock of no par value, but with a stated value of $ 10 per share. From April 27, 1926, to December 31, 1938, the building corporation made distributions and had losses in the aggregate amount of $ 2,216,613.18. During the same period it had profits and other credits to surplus account aggregating $ 350,685.77. The excess of the debits to surplus over credits to surplus was $ 1,865,927.41. For the year 1939 it sustained an operating loss of $ 55,813.03 and it likewise sustained an operating loss of $ 43,621.68 for the year 1940. *96 The resolutions of the board of directors of the building corporation authorizing the distributions in question recited that each was from paid-in surplus and not from earnings and profits, and directed that the preferred stockholders be advised of that fact. The corporation filed annual information returns on Form 1096, reporting the distributions in 1939 and 1940 as paid from other than earnings and profits accumulated since March 1, 1913. On their income tax returns for 1939 the petitioners did not report any of the distribution received by them during that year on the building corporation preferred stock. In their 1940 returns all but one of the petitioners reported a portion of the distribution received by them in that year as ordinary dividends. The proper officers of the building corporation filed with the Illinois secretary of state statements of the reduction or elimination of paid-in surplus pursuant to state law. The distributions made in 1939 and 1940 were not made pursuant to a plan of partial or complete liquidation of the building corporation and no part of the preferred stock was surrendered by the stockholders or redeemed or canceled by the corporation. Of their*97 distributions on the building corporation preferred stock in 1940, petitioners, on their tax returns, treated the following amounts as ordinary dividends taxable to them: Stella K. Mandel $ 2,895.51 Frank E. Mandel 770.40 Edwin F. Mandel 2,308.41 Albert E. M. Louer $ 769.43 S. Mortimer Auerbach Estate of Albert S. Louer, deceased, Albert E. M. Louer and Arthur Perrow, coexecutors 769.45 Babette Mandel Bird Trust u/w No. 28878, Chicago Title & Trust Co., trustee 769.47 Eugene D. Mandel 581.52 *687 The Commissioner determined that the distributions in 1939 and 1940 were out of earnings and profits accumulated after March 1, 1913, and that they were dividends as defined in section 115 (a) of the Internal Revenue Code, so as to require that the amounts thereof received by each petitioner be included in full in the income of the respective petitioner for said years. OPINION. Relying upon the principle first enunciated in the now well known Sansome case (Commissioner v. Sansome, 60 Fed. (2d) 931; certiorari denied, 287 U.S. 667) that accumulated earnings and profits of a transferor corporation follow*98 its assets into the hands of a transferee on a tax-free reorganization, so as to be available for dividend distribution, the respondent has held that petitioners-stockholders herein are taxable in full upon the amounts received by them as a result of the 1939 and 1940 distributions. It is the respondent's position that the earned surplus of the old company acquired after March 1, 1913, followed its assets, proportionately, into the hands of the transferee corporations at the time of the tax-free reorganization in 1926. At the date of the transfer the old company's assets had a book value of $ 18,976,612.77. On the same date it had undistributed earnings accumulated after March 1, 1913, of $ 11,231,614.66. The book value of the assets transferred to the building corporation in exchange for the issuance of its stocks and bonds was $ 6,683,344.88. The ratio of the assets transferred to the old company's total assets was 35.22 percent, thus a like percentage of the earned surplus, or $ 3,955,774.68, was transferred to the building corporation and was thereafter available for dividend distribution. Since the prior distributions made and losses incurred from operations by the building*99 corporation exceeded its net profits from operations and other credits to surplus account by only $ 1,865,927.41, there remained $ 2,089,847.27 of the "inherited" earnings available for distribution on January 1, 1939. The losses from operations, amounting to $ 55,813.03 in 1939 and $ 43,621.68 in 1940, still left earnings more than sufficient in amount to cover the distribution of $ 60,000 in 1939 and $ 50,000 in 1940. Thus, the respondent argues that the above mathematics clearly demonstrates that the distributions in question *688 were from earnings and profits, so as to make them taxable as dividends in the hands of the stockholders. On the other side, the petitioners contend that of the six million some-odd dollar asset value transferred to the building corporation, $ 4,439,174.06 was represented by specific tangible assets which had been acquired by the old company prior to March 1, 1913, before the earnings in question had been accumulated. These assets consisted of land, buildings, and other tangibles. It is asserted that they represented capital only and that no surplus is properly chargeable to them. Petitioners argue that in neither the Sansome case nor in*100 later cases in which the doctrine has been applied was there any specification or identification of assets acquired by the transferor corporation prior to March 1, 1913, and those acquired subsequent thereto, so as to permit of an allocation to specific assets in which the earned surplus of the company was actually invested. It is contended that, if there be a presumption that the earned surplus of a corporation is ratably invested in all of its assets, such presumption must fall upon a proper showing that certain specific assets were acquired by the company prior to March 1, 1913, and thus represented the investment exclusively of pre-1913 capital, paid-in surplus, or earnings. On such premise petitioners argue that the assets specifically identified as pre-1913 should be deducted from the corporation's total asset value, leaving only the assets in which the post 1913 earned surplus might reasonably have been invested. In the instant proceeding the sum of $ 4,439,174.06 representing the agreed upon book value of the pre-1913 assets, when deducted from $ 18,976,612.77, the book value of all assets, leaves assets of $ 14,537,438.71, in which the post-1913 earnings are said to be *101 invested. Of the total value, assets amounting to $ 2,244,170.82 were transferred to the building corporation, being 15.437 percent of the asset value. Hence, it is contended that 15.437 percent of the total earned surplus of $ 11,231,614.66, amounting to $ 1,733,824.35, is the ratable proportion of the earned surplus which was transferred to the building corporation. Since the building corporation's debits to its surplus account exceeded credits thereto by $ 1,865,927.41 in 1938, the building corporation had no accumulated earnings or profits out of which the 1939 and 1940 distributions could have been made. The petitioners' theory of allocation raises a question which does not appear to have been heretofore specifically presented and settled in the decided cases, though inherent in a number of them. However, as a general proposition, the method of allocation urged by the respondent finds abundant support in decided cases. See Barnes v. United States, 22 Fed. Supp. 282; Estate of Howard H. McClintic, 47 B. T. A. 188 (appealed, C. C. A., 3d Cir., and settled by stipulation in compromise); *689 Senior Investment Corporation, 2 T. C. 124*102 (appeal pending, C. C. A., 6th Cir.). In the instant transaction it clearly appears that there is a substantial identity of the old company in the several corporations involved and that there is a continuity of proprietary interests so as to make the rationale of the above cases applicable. We think it is immaterial that the petitioners have been able to identify certain of the assets transferred to the building corporation as having been acquired by the old company prior to 1913. The assets of the old company at their book value on the date of the transfer reflected the company's total earned surplus, and there was no corresponding relationship between the individual asset items on the one side and the earned surplus account on the other. Even if it were possible for the petitioners to identify the specific asset items into which the earned surplus had been poured and establish the exact amount of the surplus poured into each item, we would not be warranted in approving the method of allocation contended for by the petitioners. In Estate of Howard H. McClintic, supra, where an original transferor corporation had retained assets of sufficient value*103 to more than offset the accumulated earned surplus there in question and where the petitioners therein strenuously urged that the Sansome rule was inapplicable, we pointed out that an asset does not ordinarily partake of a character permitting its classification as between capital on the one hand and surplus on the other, and that it is not the practice to maintain books of account or balance sheets in such a way that a division or allocation could be made by inspection of the asset or of its accounting treatment. Moreover, the limitations suggested by the petitioners would lead to immense administrative problems not only on the part of the Bureau of Internal Revenue, but also on the part of taxpayers, and would lay the groundwork for many uncertainties. Capital existing on March 1, 1913, thereafter retains its character, not in the specific asset items in which it is then reflected, but in amount or value. Hence, the value of the assets as of that date provides the measurement for the taxpayer's gain or loss on the subsequent sale or exchange of the property, subject, of course, to adjustments provided by law, and it affords a basis for measuring profits or earnings from the*104 operations of the business, likewise as provided by law. In so far as the instant proceeding is concerned, we see no hardship that will result from the application of the rule urged by the respondent, and it seems clear that the case should fall within the rationale of those cases which provide for allocation according to the asset value received. Accordingly, we find that the Mandel Building Corporation is properly chargeable with the receipt of earned surplus in the amount of $ 3,955,774.68 at the reorganization in April 1926. See Murchison's Estate v. Commissioner, 76 Fed. (2d) 641. *690 As an alternative issue the petitioners contend that, whatever the accumulated earnings received by the building corporation, they were distributed in the $ 8,000,000 of 7 percent first mortgage bonds issued by the building corporation on April 27, 1926. It is argued that, since the amount of that distribution would more than offset any earnings or profits allocated to the building corporation, the 1939 and 1940 distributions could not have been out of earnings. Section 203 (g) of the Revenue Act of 1926, in effect at the date of the reorganization here*105 in question, specifically provided that a distribution pursuant to a plan of reorganization, by or on behalf of a corporation a party to the reorganization, of its stock or securities, or stock or securities in a corporation a party to the reorganization, should not be considered a distribution of earnings or profits for the purpose of determining the taxability of subsequent distributions by the corporation. Further, section 203 (b) (2) and (3) of the same act, set out in the margin, 2 bears out the stipulation of the parties that the reorganization was one in which gain or loss was not recognized, and the provisions thereof, taken in the light of section 115 (h) of the Internal Revenue Code, which provides that a distribution of stock or securities shall not be considered a distribution of earnings or profits of any corporation if no gain to the distributee was recognized by law, seem clearly to establish a second statutory prohibition preventing the bond issue in question from being a distribution of earnings and profits. That section 115 (h) has the effect here given to it, see Senate Finance Committee Report No. 2156, 74th Cong., 2d sess. (C. B. 1939-1 (part 2) at pages 678, *106 690), which is set out in the margin. 3 *107 *691 First mortgage bonds, such as those here in question, fall within the meaning of the term "securities" as used in the statute. See Commissioner v. Freund, 98 Fed. (2d) 201, and cases cited therein. The cases upon which petitioners rely do not appear to support their argument. In Alice H. Bazley, 4 T. C. 897, we held that the reorganization lacked a legitimate business purpose and was not entitled to recognition for purposes of Federal taxation. These views make it unnecessary to consider the question of petitioners' basis for the preferred shares. Decision will be entered under Rule 50. Footnotes 1. Proceedings of the following petitioners are consolidated herewith: Frank E. Mandel; Edwin F. Mandel; Albert E. M. Louer; S. Mortimer Auerbach; Estate of Albert S. Louer, deceased, Albert E. M. Louer and Arthur Perrow, Co-executors; Babette Mandel Bird Trust u/w No. 28878, Chicago Title & Trust Co., Trustee; and Eugene D. Mandel.↩ 2. RECOGNITION OF GAIN OR LOSS FROM SALES AND EXCHANGES. Sec. 203. * * * (b) * * * (2) 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. (3) No gain or loss shall be recognized if a corporation a party to a reorganization exchanges property, in pursuance of the plan of reorganization, solely for stock or securities in another corporation a party to the reorganization.↩ 3. Section 115 (h). Effect of Distributions on Earnings and Profits. The rule, under existing law, with respect to the effect on corporate earnings or profits of a distribution which, under the applicable tax law, is a nontaxable stock dividend or a distribution of stock or securities in connection with a reorganization or other exchange, on which gain is not recognized in full, is that such earnings or profits are not diminished by such distribution. In such cases, earnings or profits remain intact and hence available for distribution as dividends by the corporation making such distribution, or by another corporation to which the earnings or profits are transferred upon such reorganization or other exchange. This rule is stated only in part in section 115 (h) of the Revenue Act of 1934, and corresponding provisions of prior Acts, but is the rule which is applied by the Treasury and supported by the courts in Commissioner v. Sansome (60 Fed. (2d) 931); United States v. Kauffman (62 Fed. (2d) 1045); Murcheson v. Comm↩. (76 Fed. (2d) 641). While making no change in the rule as applied under existing law, the recommended amendment is desirable in the interest of greater clarity.