Mittelman v. Commissioner

Maurice A. Mittelman and Carmyle Mittelman, Petitioners, v. Commissioner of Internal Revenue, Respondent Mittelman v. Commissioner Docket No. 1568 United States Tax Court 5 T.C. 932; 1945 U.S. Tax Ct. LEXIS 59; October 18, 1945, Promulgated *59 Decision will be entered under Rule 50. 1. Taxpayer in 1940 transferred to X corporation all his stock in that corporation, plus a sum in cash, receiving in exchange therefor all the stock in Y and Z corporations, which had been owned by X. The stock received by X was not retired, but was carried on its books as treasury stock. Held, the transaction was a "sale or exchange" of his stock by the taxpayer and his gain thereon is to be computed under section 117, Internal Revenue Code. 2. Taxpayer's basis for computing gain on the above transaction determined. 3. The contract for the sale of taxpayer's stock provided that, if any recovery should be had on certain assets listed as doubtful or worthless, one-half of such recoveries should be paid to taxpayer or to Y and Z corporations, as he might designate. In 1940, pursuant to designation by taxpayer, the sum of $ 2,872.39 was paid one-half each to Y and Z corporations. Held, following Helvering v. Horst, 311 U.S. 112, and Helvering v. Eubank, 311 U.S. 112, such amount constituted gain to taxpayer in 1940. Sidney N. Weitz, Esq., for the petitioners. Lawrence R. Bloomenthal, Esq., for the respondent. Van Fossan, Judge. VAN FOSSAN *932 The respondent determined a deficiency in income tax for the year 1940 against Maurice A. Mittelman and Carmyle Mittelman in the sum of $ 12,040.45. By amendment to his answer, the respondent seeks to increase the deficiency by $ 4,916.33, or to a total deficiency of $ 16,956.78. The issues are: (1) Whether the gain realized by the petitioners from the exchange*61 in 1940 of 435 shares of class B stock in Goetz-Mittelman, Inc., is taxable as a distribution in partial liquidation or as a long term capital gain; (2) The determination of the proper cost basis of the stock so transferred to be used in computing the gain derived from this transaction; and (3) Whether the petitioners are taxable upon the amount of $ 2,872.39 paid to certain corporations as the nominees of Maurice A. Mittelman, one of the petitioners herein. Issues (2) and (3) were affirmatively raised by the respondent in the amendment to his answer. FINDINGS OF FACT. Most of the facts have been stipulated. The following summary of facts will serve to present the issues raised: *933 The petitioners are husband and wife, residing at Cleveland, Ohio. The return for the year in controversy was filed with the collector of internal revenue at Cleveland, Ohio. For convenience, Maurice A. Mittelman will hereinafter be referred to as the petitioner. On March 11, 1930, there was organized under the laws of Michigan a corporation known at I. Miller Salon, Inc. On April 12, 1933, its name was changed to Goetz-Mittelman, Inc., and on February 8, 1940, its name was changed to A. M. Goetz, *62 Inc. The corporation will be referred to throughout as Michigan. Michigan was engaged in the business of selling footwear at retail and operated a store for this purpose in the city of Detroit, Michigan. Michigan was organized with an authorized capital of $ 10,000, consisting of 100 shares of common stock of the par value of $ 100 per share. On April 17, 1933, its authorized capital was changed to $ 150,000, consisting of 170 shares of class A stock of the par value of $ 100 per share and 1,330 shares of class B stock of the par value of $ 100 per share. As of April 17, 1933, it issued and there were outstanding 165 shares of class A stock and 1,160 shares of class B stock. Adolph M. Goetz was the owner of 165 shares of class A stock and 580 shares of class B stock. The petitioner was the owner of 580 shares of class B stock. On January 14, 1935, the two stockholders, Adolph M. Goetz and the petitioner, each donated 145 shares of class B stock to Michigan. On January 25, 1940, the capitalization of Michigan was reduced to $ 83,500 by reducing the par value of class B stock to $ 50 per share. At the same time the sum of $ 66,500 was transferred to surplus. On January 31, 1940, *63 and for several years prior thereto Michigan owned all the issued and outstanding stock of I. Miller Stores, Inc., a New York corporation (hereinafter called New York), engaged in the sale of footwear at retail at Buffalo, New York, and all the issued and outstanding stock of Goetz & Mittelman, Inc., a Delaware corporation (hereinafter called Delaware), engaged in the sale of footwear at retail in Cleveland, Ohio. On January 13, 1940, the petitioner entered into an agreement in writing with Adolph M. Goetz which provided, among other things, that the petitioner should deliver to Michigan all the shares of class B stock therein owned by him, to wit, 435 shares, and in addition thereto, should deliver to Michigan a sum of money to be determined in accordance with a formula set forth in article III of the agreement, which was thereafter, allegedly in accordance with said formula, determined to be $ 18,399.71, all in exchange for all the outstanding shares of the capital stock of New York and Delaware, which shares were then owned by Michigan. *934 The formula set forth in article III of the agreement provided as follows: S. D. Leidesdorf & Co., certified public accountants (hereinafter*64 referred to as Leidesdorf), shall prepare separate balance sheets of Michigan, New York, and Delaware, on an unconsolidated basis as of the close of business on January 31, 1940. The taking of inventory and the pricing thereof shall be as directed by Leidesdorf. Such adjustments, transfers, payments, and exchanges shall be made as the parties may agree upon (or in the event of the failure of the parties to agree in whole or in part, as Leidesdorf may designate) as will result in the net assets of Michigan (as of January 31, 1940) exceeding the aggregate net assets of New York and Delaware (as of January 31, 1940) by the sum of Sixteen Thousand Five-Hundred Dollars ($ 16,500). The amount of cash to be paid by the petitioner in accordance with the foregoing formula was erroneously computed as follows: Book value of Goetz & Mittelman, Inc. (Delaware) stock $ 42,905.09 Book value of I. Miller Stores, Inc. (New York) stock 43,703.99 Aggregate of book value of stock delivered to Maurice A. Mittelman 86,609.08 Book value remaining net assets of Goetz-Mittelman, Inc. (Michigan) 84,709.37 Difference between book values 1,899.71 Excess of remaining net assets of Goetz-Mittelman, Inc. (Michigan) as required by agreement and representing par value of 165 shares of class A stock issued and outstanding 16,500.00 Total amount to be paid by Maurice A. Mittelman 18,399.71 *65 Article XII of the agreement provided in part as follows: When and as Michigan or Goetz receives any payments or distributions on account of the items described in subdivisions A, B, C, D, and E of Section 4 of Paragraph III hereof (assets of Michigan to which no value was given), then Michigan or Goetz, as the case may be, shall forthwith pay one-half of such payment to Mittelman or Delaware or New York, whichever Mittelman may designate. The agreement was carried out as of January 31, 1940, when the petitioner delivered to Michigan the 435 shares of class B stock of that company owned by him, plus the sum of $ 18,399.71, and thereupon received from Michigan all the issued and outstanding shares of stock of New York and Delaware. In March 1941, subsequent to the consummation of the above transaction, it was discovered that the correct amount which the petitioner should have been required to pay was $ 9,199.86, or one-half of the amount required to make the book value of the assets remaining to Michigan exceed by $ 16,500 the book value of the assets taken by the petitioner, as required by the agreement, *935 and representing the par value of 165 shares of class A stock issued*66 and outstanding. Demand was made upon S. D. Leidesdorf & Co. by the petitioner for the return of $ 9,199.85 representing the overpayment by the petitioner. When this demand was ignored, action was instituted by the petitioner on June 20, 1941, against S. D. Leidesdorf & Co. in the Supreme Court of the State of New York for alleged damages in connection with the services performed by S. D. Leidesdorf & Co. in the audit and examination of the books of account and records of New York and Delaware. Thereafter, on or about August 18, 1941, this action was settled by payment of the sum of $ 8,000 by S. D. Leidesdorf & Co. to the petitioner. The entire amount of $ 8,000 was paid over by S. D. Leidesdorf & Co., but the latter received reimbursement of $ 6,407.78 from Michigan; the remainder of $ 1,592.22 was borne by S. D. Leidesdorf & Co. The shares of stock in Michigan owned by the petitioner were represented by certificate No. 6 for 435 shares. The reverse side of the certificate had imprinted on it a power of attorney for the transfer thereof, which was executed in blank by the petitioner. Certificate No. 6, together with certificate No. 7 for 290 shares, which had been issued to*67 Michigan under date of January 14, 1935, and constituted a donation to that corporation from Adolph M. Goetz and the petitioner, were exchanged on March 2, 1940, for certificate No. 2 for 725 shares, issued by Michigan in favor of itself. Since January 31, 1940, the 435 shares of class B stock received from the petitioner have been held by Michigan as its property. In connection with the foregoing transaction, certain adjustments were made to the surplus account of Michigan. Capital surplus was adjusted to allow for the reduction in par value from $ 100 per share to $ 50 per share of the class B stock. This resulted in a net increase in capital surplus from $ 37,000 to $ 80,500. The earned surplus stood at $ 69,820.05 as of February 1, 1935. From this amount various deductions were made, which were partially offset by an entry showing $ 18,399.71 as due from the petitioner, resulting in a deficit in earned surplus as of January 31, 1940, in the amount of $ 15,650.92. Had the correct determination of the amount due from the petitioner been made at the time the transaction was originally consummated, he would have been called upon to pay only $ 9,199.85 instead of $ 18,399.71 *68 and the deficit in earned surplus as of January 31, 1940, would have been in the amount of $ 24,841.77. *936 Michigan carried the 435 shares of class B stock delivered to it by the petitioner on its balance sheet as of June 30, 1940, in the following manner: Class B stock -- par value $ 50 per share: Authorized 1,330 shares $ 66,500.00 Unissued 170 shares 8,500.00 Issued 1,160 shares 58,000.00 Less: Treasury stock * 725 shares 36,250.00 Outstanding 435 shares 21,750.00 It has continued to carry the shares of stock since that date as set forth above. Michigan has not purchased any of the shares of stock owned on January 13, 1940, by the other stockholder of that corporation, A. M. Goetz. The business conducted by Michigan has been operated continuously and uninterruptedly except that after January 31, 1940, the corporation no longer owned the capital stock of New York and Delaware. These last two corporations operated retail businesses in the cities of Cleveland, Ohio, *69 Buffalo, New York, and Rochester, New York, and they continued to operate them until the corporations were dissolved in February 1941 by the petitioner, the sole stockholder, who has since operated the businesses as sole owner. The book value of the shares of stock of Delaware delivered to the petitioner was $ 42,905.09 and the book value of the shares of New York delivered to the petitioner was $ 43,703.99. On the return for 1940 petitioner reported a net long term capital gain from the sale or exchange of capital assets in the amount of $ 23,814.49. The computation of such net long term capital gain was explained by reporting a sale of the 435 shares of stock in Michigan acquired in the years 1922 and 1928 and allegedly sold on January 31, 1940, for a gross sale price of $ 86,609.08, which represented a gain of $ 47,628.97 over the cost basis, which basis represented the amount originally paid for the capital assets, plus the cash delivered by the petitioner in addition thereto. Fifty percent, or $ 23,814.49, was taken into account as a long term capital gain. The respondent determined a deficiency of $ 12,040.45 on the ground that the gain realized from the foregoing transaction*70 was 100 percent taxable as a partial liquidation under section 115 (c) of the Internal Revenue Code. The cost to the petitioner of 435 shares of class B stock owned by him and delivered to Michigan was $ 20,580.40 and represented the amount originally paid to him by Michigan. In addition thereto, *937 the cost basis used by the petitioner and accepted in the notice of deficiency included the sum of $ 18,399.71 which was paid by the petitioner to Michigan at the time of delivery of the 435 shares of class B stock. However, it is now stipulated that the correct cost basis of the 435 shares is $ 20,580.40, plus such additional amount as shall be determined herein. The balance sheet of Michigan prior to the transfer of assets to the petitioner, adjusted to reflect the correct amount of cash which should have been paid by the petitioner, can be summarized as follows: Assets prior to exchange $ 242,326.75 Less liabilities 71,008.30 Net assets 171,318.45 Transferred to Mittelman at book values 86,609.08 Remaining interest of Goetz -- A and B stock 84,709.37 Less 165 shares Goetz A stock at $ 100 par value 16,500.00 Interest of Goetz B stock 68,209.37 Cash due to equal one-half of the difference in value of assets transferred 9,199.86 77,409.23 *71 Had the correct amount due from the petitioner been paid rather than the amount erroneously determined as being due from him, the balance sheet of Michigan after the transfer of assets would have shown the items set forth in the following summary: Total assets Goetz-Mittelman Inc. (Michigan) as of January 31, [1940] $ 164,917.53 Less liabilities 71,008.30 Total net assets 93,909.23 Less par value A stock owned by Goetz 16,500.00 Book value of 435 shares B stock 77,409.23 The income tax return made by the petitioners for the calendar year 1940 disclosed a tax liability of $ 5,928.76. An amended return for the calendar year 1940 disclosed a tax liability of $ 3,706.18, but this amended return was withdrawn by the petitioners on December 2, 1941. Petitioners paid to the collector of internal revenue, Cleveland, Ohio, for the tax assessed for the calendar year 1940, the sum of $ 5,928.76 in four quarterly installments, the last installment, amounting to $ 1,482.19, having been paid on December 13, 1941. In accordance with paragraph XII of the agreement dated January 13, 1940, between Adolph M. Goetz and the petitioner, there was distributed the aggregate sum of $ 12,013.78*72 in 1940, 1941, 1942, and 1943 on account of realizations upon the items described in subdivisions *938 A, B, C, D, E, and F of section (4) of paragraph III of the agreement. Pursuant to designation by the petitioner, as provided in paragraph XII, the sum of $ 2,872.39, available to the petitioner in 1940, was distributed as follows: $ 1,436.20 to New York and $ 1,436.19 to Delaware, and each of these corporations included the amount received in the income reported by it in its return for the year 1940. In the year 1941 the sum of $ 1,693.87 was available for distribution and was paid to the petitioner in that year and was included by him in the income reported in the joint return of the petitioners for the year 1941. In the year 1942 the sum of $ 1,933.34 was available for distribution and was paid to the petitioner in that year and was included by him in the income reported in the joint return of the petitioners for the year 1942. In the year 1943 the sum of $ 107.29 was available for distribution and was paid to the petitioner in that year and was included by him in the income reported in the joint return of the petitioners for the year 1943. The record further discloses*73 that the petitioner incurred expenses in the sum of $ 814.65 in connection with the action against S. D. Leidesdorf & Co. OPINION. The first issue for our decision is whether the exchange by the petitioner in 1940 of 435 shares of class B stock of Michigan, plus a sum of money, for all the capital stock of New York and Delaware constituted a sale or exchange of capital assets or a distribution in partial liquidation. The petitioner contends that the transaction constituted a sale or exchange of capital assets and that under section 117 of the Internal Revenue Code, he is taxable upon only 50 percent of the gain arising therefrom. The respondent has determined that the transaction constituted a distribution in partial liquidation and that by virtue of section 115 (c) of the code the petitioner's gain is all taxable. The material portions of that section (prior to its amendment by the Revenue Act of 1942) are set forth below. 1 *74 The Internal Revenue Code contains its own definition of a partial liquidation. Section 115 (i) of the code provides: Definition of Partial Liquidation. -- As used in this section the term "amounts distributed in partial liquidation" means a distribution by a corporation in complete cancellation or redemption of a part of its stock, or one of a series of distributions in complete cancellation or redemption of all or a portion of its stock. *939 The stipulated facts show that as of January 31, 1940, the petitioner, in accordance with his agreement with Goetz, delivered to Michigan his 435 shares of class B stock of that company, together with a sum in cash, and received in exchange therefor all the stock of the New York and Delaware corporations. The shares so exchanged by the petitioner were never canceled or retired by Michigan, but have been carried on its books as treasury stock. There has been no reduction in the capitalization of Michigan. Our task is to determine whether this transaction falls within the statutory definition of a partial liquidation. The problem here involed was discussed in some detail in Alpers v. Commissioner, 126 Fed. (2d) 58.*75 There the court observed: * * * The Board and the courts have made a distinction between acquisition by a corporation of its own stock for the purpose of retiring it, that is, for "complete cancellation or redemption," and acquisition for the purpose of holding it as "treasury stock" until reissued. Acquisitions of the first type are within section 115 (c). Hammans v. Commissioner, 2 Cir., 121 F. 2d 4; Amelia H. Cohen Trust v. Commissioner, 3 Cir., 121 F. 2d 689; Britt v. Commissioner, 40 B. T. A. 790, affirmed 4 Cir., 114 F. 2d 10; Souther v. Commissioner, 39 B. T. A. 197. Purchases of the second type are not, and the gain resulting therefrom is taxable under section 117 (a). William A. Smith v. Commissioner, 38 B. T. A. 317; W. C. Robinson v. Commissioner, 42 B. T. A. 725. * * * the respondent has made no contention that the distinction between retired stock and treasury stock is not justified by the statute, and we shall assume that it is. Clearly, *76 in the case before us there was no "complete cancellation or redemption" of the petitioner's shares. They were retained by Michigan as treasury stock and could have been reissued at any time. The respondent contends that the setting aside of doubtful or worthless assets and making provision for payment of one-half of any recovery thereon to the petitioner shows an intention to wind up the business and liquidate the corporation. We do not so view these actions. The petitioner and Goetz were desirous of dissolving their business association and, as shown by their agreement, had decided on a formula for dividing the assets evenly. Certain assets thought to be doubtful or worthless were given no value. Thus it was natural to provide that in case recovery should be had on any of these items the petitioner should receive half of the amounts so recovered. The respondent's contention that the business of Michigan was greatly curtailed is not supported by the evidence. The record shows that its business has continued uninterruptedly since the events here involved transpired. True it is, as the respondent points out, the business of Michigan was reduced to the extent that it no longer*77 owned New York and Delaware. However, Michigan received a substantial consideration in exchange for the stock of these two corporations. *940 Furthermore, whether or not the business activities of the corporation were curtailed is not dispositive of our present question. "The statute applies, not to a distribution in liquidation of the corporation or its business, but to a distribution in cancellation or redemption of a part of its stock." Hamilton Allport, 4 T. C. 401. Since there was no cancellation or redemption of any part of the corporation's stock here, we must conclude that the transaction was in fact what it purported to be -- a sale of the stock -- and that the gain arising therefrom is taxable as such. See William A. Smith, 38 B. T. A. 317; W. C. Robinson, 42 B. T. A. 725; Harold F. Hadley, 1 T. C. 496. The next issue involves the determination of the basis upon which to compute the petitioner's gain. This issue was affirmatively raised by the respondent in the amendment to his answer and hence the burden of proof with respect thereto *78 is upon him. The issue arises out of the controversy between the petitioner and the accounting firm of S. D. Leidesdorf & Co. concerning the alleged overpayment by the petitioner of $ 9,199.85 in connection with the exchange in 1940 of his stock in Michigan. In computing his gain on the transaction the petitioner used a cost basis of $ 38,980.11, made up of the sums of $ 20,580.40, the cost of his shares of class B stock, and $ 18,399.71 cash paid to Michigan. In 1941 it was discovered that the accounting firm had erred in computing the amount of cash payment in that it should have been $ 9,199.86 rather than $ 18,399.71. The petitioner made demand on S. D. Leidesdorf & Co., the accounting firm, for $ 9,199.85, the amount of the overpayment, and when the demand was ignored instituted action for alleged damages in this sum. The action was at length settled by the payment of $ 8,000 to the petitioner by the accounting firm. The accounting firm was reimbursed by Michigan for this payment to the extent of $ 6,407.78. In the amendment to his answer the respondent reduced the petitioner's basis to $ 29,780.26, representing the cost of the stock plus the amount the petitioner would have*79 been required to pay in cash had the accountant's error not been made. He now concedes that the petitioner should not be required to use a basis smaller than an amount representing the value of his stock plus the net cash actually paid by him. He therefore contends that the petitioner's basis should be reduced from $ 38,979.11, 2 used in the 1940 return and accepted in the notice of deficiency, to $ 30,979.11, 2 the difference representing the $ 8,000 received by the petitioner in settlement of his action against S. D. Leidesdorf & Co. He argues further that, in any event, since $ 6,407.78 of the $ 8,000 received by the petitioner emanated from Michigan, the petitioner's basis should be adjusted to the extent of such amount. *941 In support of this contention the respondent relies upon Borin Corporation, 39 B. T. A. 712;*80 affd., 117 Fed. (2d) 917. In that case the taxpayer in 1930 entered into a contract for the purchase of certain dry ice machinery. In 1932, before the original contract had been fully performed, the parties canceled their original agreement and entered into a new purchase contract. The Board held that the taxpayer's basis for computing gain or loss on the sale of the machinery in 1934 was the price fixed in the second contract. The facts in the instant case, in our opinion, are materially different from those in the Borin case, supra. There the parties to the original agreement canceled their contract and substituted another therefor. In the case at bar, however, no new contract was entered into between the petitioner and Goetz. The petitioner prosecuted his claim, not against the other party to the contract or the corporation to which he had made the overpayment, but against one not a party to the contract. His claim was not founded upon the contract, but upon the alleged tortious act of the accounting firm. The respondent admits that no new contract was entered into here. However, he contends that the rule of the Borin case is applicable*81 because a large part of the money received by the petitioner actually came from Michigan and because the accountants regarded themselves as acting on behalf of Michigan in paying the $ 8,000 to the petitioner. While certain correspondence between Michigan and S. D. Leidesdorf & Co. was introduced showing their agreement to divide between them the payment to the petitioner, there is nothing to indicate that he was in any way a party to these collateral negotiations. There is no evidence that either Goetz or the petitioner considered the subsequent events to be a modification of their original contract. So far as the record shows, the contract was completely executed in 1940, when the petitioner delivered his shares of stock and paid the sum of $ 18,399.71. We are consequently of the opinion that the receipt by the petitioner in 1941 of the $ 8,000 was a result of a separate transaction, founded upon an entirely different claim, and that the petitioner's cost basis is the sum of $ 38,780.11, as used by him in his 1940 return. Whether the sum received by the petitioner in 1941 was, as he contends, a "return of capital" rather than taxable income is a question we do not decide, since*82 it involves a taxable year not presently before us. The final issue concerns the payments made to New York and Delaware in 1940 under the terms of the contract between petitioner and Goetz. Article XII of the agreement provided that if Michigan or Goetz should receive any recovery on account of certain assets which had been set aside as doubtful or worthless, one-half of the amounts so recovered should be paid to the petitioner or to Delaware or New York, whichever the petitioner might designate. Pursuant to designation by the petitioner, the sum of $ 2,872.39 available to the petitioner *942 in 1940 was distributed $ 1,436.20 to New York and $ 1,436.19 to Delaware. The petitioner did not report these sums in his income tax return for 1940. The respondent contends that these sums should be added to the petitioner's income for that year. Clearly these sums were available to the petitioner in 1940. Under the agreement he could choose either to receive them himself or could designate that they be paid to New York or Delaware. Accordingly, under the doctrine of Helvering v. Horst, 311 U.S. 112, and Helvering v. Eubank, 311 U.S. 122,*83 such amounts constitute gain to the petitioner. Since they were paid pursuant to the contract of sale, however, such sums constitute long term capital gain and are taxable only to the extent of 50 percent of the amount thereof. The respondent concedes that in computing the deficiency he erroneously failed to give the petitioner credit for a final payment of 1940 income tax amounting to $ 1,482.19 which was paid on December 13, 1941. This error can be corrected in the recomputation under Rule 50. Decision will be entered under Rule 50. Footnotes *. The 725 shares of treasury stock consist of 290 shares donated to the corporation in January 1935 and the 435 shares received from Maurice A. Mittelman as of January 31, 1940.↩ 1. SEC 115. DISTRIBUTION BY CORPORATIONS. * * * * (c) Distributions in Liquidation. -- Amounts distributed in complete liquidation of a corporation shall be treated as in full payment in exchange for the stock, and amounts distributed in partial liquidation of a corporation shall be treated as in part or full payment in exchange for the stock. The gain or loss to the distributee resulting from such exchange shall be determined under section 111, but shall be recognized only to the extent provided in section 112. Despite the provisions of section 117↩, the gain so recognized shall be considered as a short term capital gain. * * * 2. These figures, used in the respondent's brief, are apparently the result of an error in addition. The correct amounts should be $ 38,980.11 and $ 30,980.11, respectively.↩