Lea v. Commissioner

HELEN SPERRY LEA, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT. EDWARD G. SPERRY, EXECUTOR OF THE ESTATE OF ELMER A. SPERRY, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT. EDWARD G. SPERRY, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT. ELMER A. SPERRY, JR., PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT. EDWARD G. SPERRY, ADMINISTRATOR OF THE ESTATE OF ZULA A. SPERRY, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT. Lea v. Commissioner Docket Nos. 74287, 74296, 74297, 74298, 74299. United States Board of Tax Appeals 35 B.T.A. 243; 1937 BTA LEXIS 902; January 12, 1937, Promulgated *902 A corporation, all of whose stock was owned by the petitioners, caused the organization of corporation B for the concentration of title to certain assets owned by it, negotiations for the sale of which assets were being conducted with a prospective purchaser, D. The original intention of the buyer was to acquire control of the assets through a purchase of all of the stock of B corporation. This plan was abandoned in favor of one to buy certain patents. Thereafter corporation A transferred said patents, which it and the prospective purchaser agreed had a value of $1,000,000, to B in exchange for the issuance of all of its stock, pro rata to the petitioners. On the same day, Elmer A. Sperry, who received 29 percent of the stock of B, purchased the remainder of B's stock from the other petitioners for $710,000, giving his notes in payment thereof. The stock of B corporation and the patents were passed to Elmer A. Sperry as a matter of convenience. The offer of A to exchange assets for B's stock, the acceptance of the offer by B, the transfer of the assets, the issuance of the stock and the sale thereof, all occurred the same day, and on the same day B liquidated and distributed*903 its assets to Elmer A. Sperry, its sole stockholder, who three days later sold the assets to E, a corporation formed and owned by D, for $1,000,000 cash, which the seller used to pay his notes. Held: (1) The organization of B, the transfer of assets by A to B and the distribution of B's stock to stockholders of A was not a reorganization within the meaning of section 112(i)(1)(B) of the Revenue Act of 1928, not being within the corporate business of either corporation, nor was the distribution of stock "in pursurance of a plan of reorganization" under section 112(h) of the same act. (2) The amounts received by the respective petitioners out of the proceeds of sale of the assets are taxable as ordinary dividends of A corporation, to the extent of the earnings of A corporation, including the profit upon the sale of said patents. Francis L. Casey, Esq., Walter S. Orr, Esq., and A. C. Newlin, Esq., for the petitioners. J. E. Marshall, Esq., J. L. Devany, Esq., and Paul Waring, Esq., for the respondent. DISNEY *244 These proceedings were consolidated for hearing and report and involve the redetermination of deficiencies in income*904 tax for 1929 as follows: Docket No. Deficiency 74287 $8,283.22 74296 28,065.29 74297 11,967.30 74298 10,948.07 74299 49,002.98 The sole question in each proceeding is whether the respondent erred in taxing certain amounts received by the petitioners as ordinary dividends. The petitioner in Docket No. 74296 waived a question relating to the deductibility of an amount as traveling expenses. FINDINGS OF FACT. Elmer A. Sperry, who died June 16, 1930, and Zula A. Sperry, who died March 11, 1930, were husband and wife. Edward G. Sperry is administrator of the estate of Zula A. Sperry and executor of the estate of Elmer A. Sperry. The other petitioners are children of the decedents. The Sperry Research Corporation, whose name prior to January 17, 1929, was Sperry Gyroscope Co., hereinafter referred to as the Research Corporation, is a New York corporation which prior to January 21, 1929, was engaged in the manufacture and sale of gyroscopes, gyroscopic compasses, searchlights, fire control apparatus, various naval and aircraft equipment, and other products. Thereafter its business was confined to investments. *245 The Sperry Development*905 Co., hereinafter referred to as the Development Co., was organized in 1922 under the laws of Delaware, with a capitalization of 13,335 shares of class A stock and 66,665 shares of class B stock, to experiment with and develop patents of Elmer A. Sperry, and to keep such activities separate from the manufacturing business of the Research Corporation. Both classes of stock had the same rights, except that the class A stock had the exclusive voting power. In consideration of the transfer to it of stocks, bonds, patents, and patent rights by Elmer A. Sperry, and securities by Zula A. Sperry, the corporation issued 3,466 shares of its class A stock and 17,328 shares of its class B stock to Zula A. Sperry and the remainder of its stock to Elmer A. Sperry. The stock was acquired by them at a cost of $436,892.35 and $1,848.037.68, respectively. Between 1923 and 1926 Elmer A. Sperry gave 12,000 shares of his class B stock to each of his three children. In December 1928 negotiations were commenced by North American Aviation, Inc., for the purchase of the business of the Research Corporation. The Research Corporation and the petitioners, as stockholders of that corporation and the Development*906 Co., were represented in the discussions by an attorney. From information developed during the course of conferences, the representatives of the interested parties concluded that many of the patents under which the Research Corporation was manufacturing articles were not owned by it, but were the property of the Development Co. As the result of this opinion, the prospective buyer suggested the formation of a new corporation for the purpose of taking title to the patents and patent rights held by each corporation. The parties agreed that if such a method were adopted the prospective buyer would acquire control of the assets in question through the purchase of all of the stock of the new corporation at a cost of $1,000,000, which amount the parties agreed would be the fair market value of the stock. The Searchlight Patent Corporation, hereinafter referred to as the Patent Corporation, was organized on December 28, 1928, under the laws of Delaware, with an authorized capital stock of 10,000 shares without par value. Thereafter, but prior to January 18, 1929, North American Aviation, Inc., abandoned the plan proposed by it to acquire control of the assets through ownership of stock*907 of a subsidiary and decided to purchase the property directly from Elmer A. Sperry. On January 18, 1929, the Development Co. offered to transfer a certain group of patents and patent rights to the Patent Corporation in consideration of the issuance of all of its capital stock pro rata to the offeror's stockholders. The offer was accepted and the transfer made on January 18, 1929, on which date the Patent Corporation issued 2,900 shares of its stock to Elmer A. Sperry, 2,600 shares to *246 Zula A. Sperry, and 1,500 shares to each of their three children in accordance with the terms of the offer. The persons to whom the stock was issued did not surrender any of the stock they held in the Development Co. The patents were passed to Elmer A. Sperry, and not to all the five stockholders, as a matter of convenience, because it would be difficult to split the patents up; and Elmer A. Sperry, as a matter of convenience, was made the sole stockholder of the Patent Corporation. Thereafter, on January 18, 1929, Elmer A. Sperry purchased all of the stock holdings of his wife and three children in the Patent Corporation for $100 per share, giving in payment thereof his personal notes. *908 Also on January 18, 1929, the Patent Corporation was liquidated and all of its assets, consisting of patents and patent rights acquired by transfer from the Development Co. for all of its stock, were on that same date distributed to Elmer A. Sperry, its sole stockholder, as a liquidating dividend. Substantially all of the patents and patent rights transferred to the Patent Corporation were acquired by the Development Co. after it was organized. About 50 of them were inventions of Elmer A. Sperry. About 35 other individuals were the inventors of the other patents and patent rights. On or about January 20, 1929, North American Aviation, Inc., organized the Sperry Gyroscope Co. for the purpose of taking title to the patents and patent rights. All of the stock of the Sperry Gyroscope Co. was purchased by North American Aviation, Inc. On January 21, 1929, Elmer A. Sperry sold the assets to the Sperry Gyroscope Co. for $1,000,000 cash. With this cash he paid the personal notes, totaling $710,000, which he had given his wife and three children in payment of their stock in the Patent Corporation, leaving $290,000 for himself as a return on the 2,900 shares of stock issued to him. *909 The activities of the Patent Corporation during its existence consisted only of issuing its stock for patents and patent rights transferred to it by the Development Co. and distributing such assets to its sole stockholder in liquidation. The fair market value on January 17, 1929, of the assets of the Development Co. was $6,850,260.73, which valuation includes a fair market value of $1,000,000 for the patents and patent rights transferred to the Patent Corporation. The assets had the same fair market value on January 21, 1929. The depreciated cost on January 17, 1929, to the Development Co. of the assets valued at $1,000,000 was $108,758. Depreciation of such assets from January 17, 1929, to the time of their acquisition by the Sperry Gyroscope Co. was $250. Up to the time of the transfer of the patents and patent rights to the Patent Corporation, the Development Co. had undistributed earnings and profits of not less than $51,015.28 available for dividends. *247 Thereafter the amount was not more than such sum unless the Development Co. realized earnings from the transfer of the property. The Research Corporation and the Development Co. are still in existence and*910 operating their respective businesses. In the income tax returns filed by the respective petitioners, the stock issued to them by the Patent Corporation was treated as having been received in a reorganization of the Development Co., and the profit realized on its disposition was reported as capital gain. The gain reported by the wife and children was computed by using as a basis a proportionate part of the cost of their stock in the Development Co. The other petitioner, Elmer A. Sperry, used as a basis for the 2,900 shares he acquired from the Patent Corporation a figure arrived at by the same method. For the remaining 7,100 shares he used cost of $710,000, the amount paid to his wife and children for the stock. In his determination of the deficiencies, the respondent disregarded the organization and dissolution of the Patent Corporation. He eliminated the capital gain from the returns, and added to the net income reported by Elmer A. Sperry, his wife, and each of the other petitioners, the sums of $290,000, $260,000, and $150,000, respectively, as a distribution of patents by the Development Co., taxable as an ordinary dividend. OPINION. DISNEY: 1. The petitioners*911 contend that they acquired the Patent Corporation stock in a nontaxable transaction within the meaning of section 112(g) and (i)(1)(B) of the Revenue Act of 1928, set forth in the margin, 1 and, accordingly, that it was proper for them to report the profit they derived from the disposition of the stock as capital gain. The respondent adheres to the conclusion he reached in the determination of the deficiencies, that the transfer of the assets to the Patent Corporation did not result in a reorganization and that the fair market value of the patents is taxable to the petitioners as an ordinary dividend. *912 *248 In ; affd., , the taxpayer owned all the stock of A corporation, which owned shares of stock of B corporation. For the purpose of enabling her to sell the stock of B corporation for her individual profit, and to reduce income tax liability, she organized C corporation, to which B corporation's stock was transferred for the issuance of C's stock to the taxpayer. Three days later C corporation dissolved and liquidated by distributing its assets, consisting of B's stock, to the taxpayer. In holding that the transfers were not within the meaning of the statute, the court remarked: * * * But the underlying presupposition is plain that the readjustment shall be undertaken for reasons germane to the conduct of the venture in hand, not as an ephemeral incident, egregious to its prosecution. To dodge the shareholders' taxes is not one of the transactions contemplated as corporate "reorganizations." * * * * * * All these steps were real, and their only defect was that they were not what the statute means by a "reorganization," because the transactions were no part of the conduct of the*913 business of either or both companies; so viewed they were a sham, though all the proceedings had their usual effect. * * * Herein, in exchange for part of the assets of the Development Co., the petitioners, as sole stockholders thereof, received, pro rata, all of the capital stock of the Patent Corporation without surrendering any of their Development Co. stock. So far as these facts are concerned, the transaction could be said to be in conformity with the words of section 112(i)(1)(B). But it is now settled by the Gregory case that to come within the meaning of that provision, the substance of the transfer must agree with its form and it must be "in pursuance of a plan of reorganization" to make it nontaxable, as under subdivision (g), the applicable provision here. Did the substance of the transaction herein agree with its form? Was the stock "distributed in pursuance of a plan of reorganization"? The petitioners argue that the facts here meet the business purpose test laid down in the Gregory case. If after the transfer to the Patent Corporation the stock distribution made to the petitioners was "in pursuance of a plan of reorganization", was a business purpose, *914 their contention should be sustained. But an analysis of all the evidence discloses to us that the transfer to the Patent Corporation and the distribution of its stock was not germane to the conduct of any business purpose of the Development Co.'s business or properties, or to intent to operate them as the business of the Patent Corporation. The offer of the Development Co. to exchange the assets for stock of the Patent Corporation, the acceptance of the offer, the transfer of *249 the assets for stock, the issuance of the stock and the sale of the stock so acquired by the wife and children of Elmer A. Sperry to him at a price in conformity with the selling price of the patents and patent rights, and the liquidation of the Patent Corporation and distribution of the patents as liquidating dividend to Elmer A. Sperry, all occurred on January 18, 1929, as parts of a transaction used for convenience to place Elmer A. Sperry in a position to sell the patents directly to the Sperry Gyroscope Co. The Patent Corporation was used merely as a conduit through which to pass the title, although it had been decided prior to the transfer of the assets to the Patent Corporation, that the*915 purchaser should take title to the patents through Elmer A. Sperry, instead of purchasing the stock of the Patent Corporation as originally contemplated. The situation is indistinguishable on principle from that passed upon by us in , and the facts are closely analogous to those in that case. Therein we held that within the intendment of the revenue act there was no reorganization, and that the corporate acts of the several entities involved were valid and effect must be given thereto, where the newly created corporation, in consideration of properties transferred, issued its stock to the original corporation, corresponding to the Development Co. herein, and such stock was issued to the stockholders of the original corporation as a dividend. Following that case, we conclude that the Patent Corporation and all of the transactions between it and the Sperry family served no corporate business purpose, but constituted, as in the Gregory case, "an elaborate and devious form of conveyance masquerading as a corporate reorganization, and nothing else", and we hold that the stock distribution herein was not "in pursuance*916 of a plan of reorganization." 2. By regarding the patents and patent rights as a dividend by the Development Co., taxable at their fair market value of $1,000,000, the respondent adopted the procedure he followed in the Gregory case. While it did not fully agree with the Commissioner's method, the Circuit Court of Appeals in that case approved the result on the ground that the tax was the same whether the Commissioner's method was adopted or the tax was computed on the value of the shares of stock of the new corporation. No question appears to have been raised in that case as to the amount of earnings available for dividends. Herein, prior to the submission of the proceedings the parties stipulated that at the time the Development Co. exchanged the patents and patent rights for stock of the Patent Corporation it had earnings of not less than $51,015.28 available for dividends. After the briefs were filed a further stipulation was filed agreeing that after such transfer the earnings subject to dividend payments *250 were not more than that sum unless increased by earnings or profits derived from the sale of the assets. On brief the petitioners contend that, if we*917 rule against them on the reorganization question (as we have done), the dividend taxable to them should be limited to $51,015.28 and that the remainder of the amount of $1,000,000 ultimately received for the patents and patent rights should be applied against the cost of their stock of the Development Co. The statute defines the term "dividend" as "any distribution made by a corporation to its shareholders, whether in money or in other property, out of earnings or profits accumulated after February 28, 1913." Sec. 115(a), 1928 Act. If any distribution is not out of earnings or profits, the amount is treated as a return of capital to the extent of the shareholder's basis of his stock. Sec. 115(d). The extent of the earnings or profits of the Development Co. in excess of $51,015.28 available for dividends depends upon the amount of earnings or profits, if any, it derived from the disposition of the patents and patent rights. In , we held also that the dividend declared by the Tribune Co., corresponding to the Development Co. herein, was an ordinary taxable dividend. Herein the dividend was not actually declared, but a distribution*918 may be taxed as a dividend without corporate action formally declaring same. , affirming ; ; . The transaction herein resulted in a disposition for $1,000,000 of corporate assets having a cost basis of $108,758. The Development Co. constructively received this amount for the benefit of its stockholders, the petitioners. . The profit of $891,242 derived from the exchange when added to the $51,015.28 agreed earnings increased its earnings available for dividend payments to $942,257.28. ;. The Development Co. is not before us and it is not necessary to decide whether or not the profit so realized constitutes taxable income to it. We hold that of the $1,000,000 received by the petitioners, $942,257.28 constitutes a distribution of earnings of the Development Co., taxable to them in proportion to their stock holdings, the remainder being a return of capital. *919 To that extent we sustain the determination of the respondent that the petitioners received taxable dividends from the Development Co. Reviewed by the Board. Decision will be entered under Rule 50. Footnotes 1. SEC. 112. (g) Distribution of stock on reorganization. - If there is distributed, in pursuance of a plan of reorganization, to a shareholder in a corporation a party to the reorganization, stock or securities in such corporation or in another corporation a party to the reorganization, without the surrender by such shareholder of stock or securities in such a corporation, no gain to the distributee from the receipt of such stock or securities shall be recognized. * * * (i) Definition of reorganization. - As used in this section and sections 113 and 115 - (1) The term "reorganization" means * * * (B) a transfer by a corporation of all or a part of its assets to another corporation if immediately after the transfer the transferor or its stockholders or both are in control of the corporation to which the assets are transferred. ↩