Lloyd-Smith v. Commissioner

MARJORIE FLEMING LLOYD-SMITH, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT. Lloyd-Smith v. Commissioner Docket No. 83575. United States Board of Tax Appeals 40 B.T.A. 214; 1939 BTA LEXIS 886; June 30, 1939, Promulgated *886 1. Where a taxpayer is compelled by circumstances to take over the administration of trusts of which she is a beneficiary and the management of her individually owned business properties, it is held that she is engaged in business and is entitled to deduct the expenses of an office manager and an office from her gross income. 2. The taxpayer was the beneficial owner of a three-eighths stock interest in the Sugar Pine Lumber Co. and a joint and several guarantor of bonds issued by that company. The stock of the company became worthless in 1932 and the bonds were defaulted. The taxpayer paid out certain sums in the taxable year 1933 in connection with the readjustment of her liability under the guaranty and the removal of her assets to another state to avoid suit. Held, the sums so expended are deductible as losses proximately resulting from a transaction entered into for profit, namely, the original investment in the stock of the company. 3. A two-year, unsecured promissory note of a corporation organized to take over the California properties of the taxpayer, received by the taxpayer together with all the capital stock of the corporation in exchange for the properties*887 transferred, held, is "other property" within the meaning of sections 112(c) and 113(a)(6) of the Revenue Act of 1932, rather than a "security." Charles C. Parlin, Esq., and James A. Fowler, jr., Esq., for the petitioner. Frank M. Thompson, Esq., for the respondent. LEECH *214 Petitioner in this proceeding seeks redetermination of a deficiency in income tax of $50,239.13 for the calendar year 1933. By an amended petition, petitioner requests a finding that there was an overpayment in the calendar year of $2,546.70. There are three issues presented. He first is whether petitioner is entitled to deduct $6,969.92 office expenses, and $45,003.93 legal and incidental expenses, incurred in connection with a readjustment of her guaranty of certain *215 bonds, as having been incurred within a trade or business within section 23(a) of the Revenue Act of 1932. The second is whether she is entitled to deuct the sum of $45,003.93, if it was not incurred in connection with a trade or business, as a loss arising out of a transaction entered into for profit under section 23(e)(2) of the Revenue Act of 1932. Finally, it is to be decided whether*888 petitioner may deduct the sum of $368,032.70 as a capital loss arising from the sale of a corporate note. FINDINGS OF FACT. Petitioner was the beneficiary of two trusts, hereinafter referred to as the mining trust and the general trust, created in her favor by the respective wills of her grandfather, Eldridge M. Fowler, and her mother, Clara H. Fleming, both of whom died in 1904. The subject matter of the mining trust consisted of Fowler's interest in Minnesota mining properties. Under this trust, the properties were to go to petitioner when she should reach the age of 40 years, but with the power to dispose of them by will at any time before she arrived at that age. The trustees were the testator's wife, his son-in-law, Arthur H. Fleming, who is petitioner's father, his daughter, Clara H. Fleming, and his daughter, Kate Fowler. The income therefrom was to be paid to Arthur H. Fleming, testator's wife, Clara H. Fleming, and petitioner in various proportions. By reason of the death of two of the beneficiaries, petitioner, in the taxable year, was receiving 92 percent of the income, and Arthur H. Fleming, her father, 8 percent. The trustees were given full powers of managerial*889 control over the properties. The general trust, created in petitioner's favor by the will of Clara H. Fleming, consisted of one-half of the residuary estate of the testatrix, and its terms were substantially similar to those of the mining trust. Petitioner was to receive the corpus outright upon reaching 40, with the power, meanwhile, to dispose of the property by will. The income was to be paid to Arthur H. Fleming until petitioner reached the age of 25, and out of this income Fleming was to provide for her support and education. Thereafter it was to be paid in its entirety to petitioner until she should reach 40, at which time the corpus was to vest in her or her testamentary appointees as the case might be. Here likewise, the trustees were given full managerial powers. The brother of Arthur H. Fleming, one Clarence Fleming, became a trustee of the general trust upon the death of Clara H. Fleming in 1904. Petitioner attained the age of 40 in 1934. In addition to her beneficial interests in the two trusts, petitioner owned various properties outright. These are more fully described below. *216 Prior to 1928, all of petitioner's properties and financial interests*890 had been administered by her father, Arthur H. Fleming, whose headquarters were in California. He had taken over the management of her affairs in 1904, following the deaths of her grandfather and mother, and, though he was never appointed guardian, she had given him her general power of attorney. He dominated the administration of the mining trust and the general trust. In 1922 he conveyed all his property in trust to the California Institute of Technology, reserving to himself powers of management and an annuity of $30,000. Beginning in 1924, petitioner and her husband, Wilton Lloyd-Smith, grew dissatisfied and seriously concerned at the way in which Arthur H. Fleming was handling her affairs. His expenditures of the trust funds seemed to them to be not only unduly large, but also improvident. He had made unsecured loans of petitioner's funds to the Sugar Pine Lumber Co., hereinafter called "Sugar Pine", of which he was president. He also invested $4,000,000 of petitioner's trust funds in the stock of that company, and in several other instances expended moneys belonging to the trusts in ways of which petitioner disapproved. Petitioner told him on several occasions that*891 she wished no more of her money invested in Sugar Pine, and objected vigorously to the other expenditures. In 1927 the Sugar Pine Lumber Co. decided to issue first mortgage guaranteed 6 percent serial bonds in the amount of $3,000,000, as a funding operation to pay off certain bank loans. The prospectus covering the issue stated the bonds would be unconditionally guaranteed as to payment of both principal and interest jointly and severally by Arthur H. Fleming, Marjorie Fleming Lloyd-Smith, and R. C. Gillis, who was another stockholder in Sugar Pine. Among other things, the circular represented the Sugar Pine owned timber reserves sufficient for 30 years' operations, and in general presented so attractive a picture that petitioner signed the guaranty, despite her previous attitude toward Sugar Pine. At the time, she owned, beneficially, through the medium of the general trust, a three-eighths stock interest in Sugar Pine. She made a special trip to California and signed the guaranty, thus making the issue possible, since the underwriting banks had refused to take it upon the guaranties of Fleming and Gillis alone. From this time onward, relations between petitioner and*892 Arthur H. Fleming over his business handling of her properties became even more difficult. Finally, she decided to set up her own administrative office in New York City. Pursuant to this decision, she sent Frank Naar, an accountant, to California in order that he might familiarize himself with the details of her affairs, and after eight months of study he *217 returned to New York in May of 1929. Henceforth, her properties, other than those contained in the mining and general trusts, were administered by her with the aid of Naar and others, from her New York office. These nontrust properties were located in several states and required active supervision. She owned all the stock in a gold and molybdenum mining corporation in Arizona, which employed 400 men and was under the local management of a mining engineer named George Naething. In 1932 petitioner caused the corporation to open and operate the mine. It was operated through 1933 under the supervision of petitioner from her New York office, Naething coming to New York frequently for conferences. She also owned the fee of the property on which the Hotel Statler was located in Detroit. In 1932 she conveyed it to*893 the Kenjockety Corporation, organized under the laws of New York, in exchange for all the corporation's capital stock. In California, she owned houses, beach front property, and unimproved land at Beverly Hills. The development of these properties was in the hands of a local agent. Finally she held a portfolio of marketable securities which were frequently changed by her direction. It became apparent in 1928 that Sugar Pine had an inadequate supply of timber and stood acutely in need of more in order to operate successfully. The financial condition of the company was bad and continued to grow worse. An interest payment and serial maturity on the bonds falling due April 1, 1932, was met, but only out of the proceeds of an insurance policy upon the life of the company's general manager, who had died the preceding year. It was certain that there would be a default on the bonds on September 1. Meanwhile, petitioner had revoked Arthur H. Fleming's general power of attorney on May 2, 1931. In April 1932, she brought about the resignation of Arthur H. Fleming from the presidency of the Sugar Pine Co. and a decision to close the plant. It was disclosed that R. C. Gillis was insolvent*894 and that Arthur H. Fleming had no funds of his own. Petitioner was the only interested person who was financially responsible. The creditors and bondholders were looking to petitioner to satisfy the major part of the guaranty, in view of Gillis' insolvency and advice from the California Institute of Technology that it did not intend to stand back of Fleming's guaranty. Faced with a threat by one of the creditor banks to attach all of her California assets, petitioner decided to remove all her California properties to New York. While she had been advised by counsel that in their opinion she had a legal defense to any action brought on the guaranty arising out of the false statements in the prospectus, she desired to have all suits brought against her in New York because *218 of the prejudice she was advised would exist in California in favor of the bondholders. The silverware and paintings inherited by petitioner from her mother but still in the possession of her father were shipped to New York. All petitioner's California bank accounts were transferred to New York. Arthur H. Fleming and his brother were forced to resign from the trusteeships of the mining and general*895 trusts, the books of the trusts were transferred to New York, and New York trustees were appointed. All of petitioner's California real estate was transferred to the Notram Corporation, organized under the laws of New York. All open accounts receivable, petitioner's stock in California corporations, and the stock of the Notram Corporation were transferred to the Jorwil Corporation, likewise organized under New York laws, and Jorwil thereupon issued to petitioner all of its capital stock and its two-year 6 percent unsecured note, in the amount of $303,000. These steps were completed by the end of August 1932. The trustees appointed in place of the Flemings were friendly to petitioner and performed only the nominal tasks of signing such papers as petitioner directed. Immediately upon their appointment, the supervision and management of the trusts were assumed and exercised by petitioner, with the assistance of her husband and the persons in charge of the New York office. The corpus of the mining trust consisted of mining properties located in Minnesota. These were mainly under long term leases with the United States Steel Co. Active work was required both in Minnesota and*896 New York. The leases called for specified mining methods and payments were based on grades of ore. The engineering staff employed by petitioner, in charge of one Van Slyke, was steadily engaged in verifying ores and in passing on the constantly changing methods and equipment used in mining. The New York office had to verify and audit all accounting records and pass upon problems arising in connection with the major leases and changes therein. Van Slyke often came to New York for conferences with petitioner and her husband. The corpus of the general trust consisted principally of interests in real estate and in California lumber operations. In Chicago, it included a 17-story office building, with tax arrearages of over $100,000, which was involved in constant litigation to clear its title; a hotel in financial difficulties which also had tax defaults against it; and a 7-story loft building operating at a loss. In Detroit, the trust owned interests in the 13-story Griswold Building, also suffering from financial trouble and tax arrears, and requiring immediate attention to save the fee for the owners; a department store; and an 8-story building. *219 The lumber interests*897 included in the corpus of the general trust consisted in part of accounts receivable in various lumber companies and in part of an investment of about $4,000,000 in Sugar Pine. Finally, the general trust owned various other accounts receivable, having a face value of about $2,000,000, and a salvage value of about $500,000. Petitioner, individually and beneficially through her trusts, owned a large number of marketable securities. In 1933 she bought and sold a total of 28,384 shares, paying out in the aggregate $381,148.38 and receiving $503,881.75. This trading, carried on in over 25 different securities, was handled through petitioner's office, along with her other business affairs, her purely personal affairs being taken care of by a private secretary at her home. Late in 1933, in view of the size and condition of petitioner's affairs, Wilton Lloyd-Smith, her husband, assumed the management of the properties under petitioner's ultimate direction. This was done as a means of securing a centralized authority. Beginning in 1932, and throughout 1933, petitioner actively supervised and managed her business affairs. Although relying in many instances on the judgment of her*898 husband and other assistants, all major decisions and policies were made or ratified by her. Petitioner engaged in these activities to protect her properties and to save and increase the income therefrom wherever possible. Those activities constituted a business which she carried on throughout 1933, participating therein almost daily. The expenses of her New York office for that year, totaling $6,969.92, were ordinary and necessary expenses of that business. On September 1, 1932, the Sugar Pine Lumber Co. went into default on its bonds, and a bondholders' committee was formed shortly thereafter. Seeking to enforce the guaranty, the committee found that Gillis was insolvent, that Arthur H. Fleming had transferred all his property in trust to the California Institute of Technology, that this institution denied the right of the bondholders to enforce the guaranty against it or the property which Fleming had transferred to it, and that petitioner would set up a vigorous defense in the New York courts to any action against her on the guaranty. Petitioner had determined to repudiate this guaranty, under which she was liable, jointly and severally with the other guarantors, to the*899 extent of $2,397,000, not only because it appeared that, in view of Gillis' insolvency and Fleming's lack of funds, she would be held for the entire amount, but also because she was advised by counsel that in their opinion the misrepresentations in the prospectus for the bond issue, on the faith of which she had become a guarantor, might give her a valid defense to any action on the guaranty. *220 Under these circumstances, a compromise plan of readjustment was worked out, the terms of which are not here material. Petitioner did not enter into the plan of readjustment because of any desire to save her investment in the stock of Sugar Pine, which was worthless at the close of 1932. She did so because of a wish to reduce her liability under the guaranty as much as possible. The removal of her assets to New York had the same motive. Sugar Pine was adjudged a bankrupt on June 13, 1933. In 1934 the mortgage bonds were foreclosed, and the ensuing foreclosure sale yielded about $120 per $1,000 of face value. No attempt was made to salvage any part of petitioner's stock equity in Sugar Pine. Petitioner, being the only guarantor who possessed ready funds, was required to*900 pay a substantial portion of the expenses of the bondholders' committee, and incurred expenses, paid during 1933, representing legal fees for services rendered in working out the plan of readjustment and in moving her assets to New York. These totaled $45,003.93, and she was not entitled to reimbursement for any part of this sum. All of this expenditure resulted directly from the readjustment of her liability on the Sugar Pine guaranty and proximately from the original investment of her trust funds in Sugar Pine stock. In December 1933, petitioner was in need of funds because of her expenses in connection with the Sugar Pine readjustment, her assumption of her father's expenses, and the diminution of her income on account of reduction of rentals from her various leases. She decided to sell a portion of the $303,000 note she had received from the Jorwil Corporation because she was advised it would entitle her to deduct a considerable loss for tax purposes. The note was split up to allow of the sale of a portion thereof. This portion was sold for $70,000, its face value. The cost of the assets transferred by petitioner to the Notram and Jorwil corporations on August 11, 1932, and*901 the total of their fair market values as of that date, were as follows: Cost, $2,636,778.49; fair market value on August 11, 1932, $477,606.19. One asset, an account receivable in the form of a note from Arthur H. Fleming to petitioner, in the amount of $56,954.63, was written down by petitioner to $1, because she did not desire to enforce its collection in 1932 and also thought collection was impossible. In 1937, Fleming's guardian, Fleming having been adjudged incompetent, transferred $22,000 in cash and property worth $20,000 or $30,000 to petitioner in payment of this liability. It was worth its face value in 1932 and has been included at that amount in the above mentioned total. OPINION. LEECH: The contested right to deduct the sum of $6,969.92 depends here on whether petitioner was engaged in "carrying on any trade *221 or business" during 1933, and, if so engaged, whether this amount constituted "ordinary and necessary expenses" of that business. Revenue Act of 1932, sec. 23(a). Respondent argues that petitioner was not carrying on any business during 1933 and that the questioned deductions represented personal and not business expenses, and were, therefore, *902 not deductible. Sec. 24(a) of the same revenue act. Business, as that term is used in this section of the revenue act, has been broadly defined as "That which occupies the time, attention, and labor of men for the purpose of a livelihood or profit." . See also . But "It is not necessary that one occupy a full day each day in carrying on one's activity to be considered to be regularly engaged in business. It is continuity of efforts devoted to the undertaking which constitutes a business regularly carried on," . Moreover, a business can be carried on, within the statute, by the taxpayer, through agents under his ultimate direction. ; ; ; . Respondent breaks petitioner's activities down and contends that no one of them alone constitutes the carrying on of a business. Thus it is said*903 that, although the several corporations which petitioner owned were in business, petitioner, as a stockholder, was not in that business but was a mere passive investor. It is urged likewise that, although the trusts of which petitioner was the beneficiary were in business, petitioner had no legal right to interfere in that business during 1933, since the trusts did not end until 1934. However, whether the taxpayer may be classed as a passive investor as to her investments in these wholly owned corporations and as a passive owner of a beneficial interest in these trusts, on the one hand, or was engaged in carrying on the business of protecting and handling what, together with other property, constituted her estate, is a question of fact. Certainly it can not be doubted that, as to her properties owned outright, the management of which she had assumed and directed throughout 1933, she was carrying on a business. It is likewise clear to us that the care and management of her investments in the gold mining corporation and the real estate company were not those of a passive investor but required and secured her active management and supervision. *904 The bulk of her estate consisted of her interests in the two trusts. She has already been held to be entitled to depletion deductions on properties constituting the corpora of these trusts, before their termination, on the ground that she then possessed every important attribute of ownership in those properties. . *222 See also ; certiorari denied, . But, whether she had a legal right to assume and manage these trusts before they expired by their terms, the controlling fact here is that, throughout 1933, she did supervise and direct the entire management of these trusts. See . The volume of petitioner's trading activities in respect of securities owned by her individually and through the trusts during the year 1933 satisfies us that no segregation of these activities, on the ground that they did not constitute the carrying on of business, is necessary. See *905 ; ; and . In short, confronted with the disturbing fact of her father's maladministration of her affairs and those of the trusts, she was apparently convinced that only under he own supervision, with the aid of trusted employees, could her far-flung estate be properly handled and protected. To this end she set up an office in New York City (see ) and centralized the management of her affairs there. She directed that management, in which she was engaged, practically daily. The evidence is convincing that, during 1933, petitioner was engaged in carrying on the business of managing and protecting her estate. The items totaling the disputed deduction of $6,969.92 were not personal expenses, as respondent contends, because petitioner employed a private secretary in her own home, where her personal matters were handled. The expenses of that establishment she does not seek to deduct. Thus, the amount of $6,969.92 here in issue was in its entirety an ordinary and necessary business expense*906 and is deductible as such. The right to deduct the item of $45,003.93 presents a different problem. This amount constitutes the expenditures made by petitioner in connection with the readjustment of her liability on the Sugar Pine bond guaranty, and was the payment of the obligation of the petitioner, no part of which she could recover. But whether the payment of this amount was an ordinary and necessary expense of carrying on the business of the taxpayer, is not necessary to answer, since she was not in the guaranty business. ; ; certiorari denied, . The transaction involving this guaranty began when $4,000,000 of the trust funds were invested in the stock of the Sugar Pine Lumber Co. The petitioner became a guarantor of that company's bonds because she had reason to believe that the company's use of the funds thus secured would increase the value of her beneficial interest in its stock. Undoubtedly that stock then had value. But the stock had *223 become worthless by the close of 1932. The payments in connection with the guaranty*907 were not made until 1933. Obviously, when petitioner thus made them, it was not with the idea of protecting or adding to her stock investment in the company. These expenditures occurred for the sole purpose of reducing her liability under the guaranty. As such, they are deductible as losses on a transaction entered into for profit. Revenue Act of 1932, sec. 23(e)(2). ; ; ; ; ; ; ; . Cf. . The last issue involves respondent's disallowance of a deduction for an alleged loss on the sale of the $70,000 note of the Jorwil Corporation. The petitioner contends that the exchange in which she received this note was tax-free under section 112(b)(5) of the Revenue Act of 1932; 1 that the stock and note, which she then*908 received for her property, were two classes of securities of the corporation, within the meaning of that section; and that her basis for the computation of gain or loss on her sale of the $70,000 note was an allocable part of the cost of the property thus transferred to the corporation. Sec. 113(a)(6) of the Revenue Act of 1932. The position of the respondent is (1) that the transaction involving the transfer of assets of petitioner to the Jorwil Corporation for all the stock in that corporation and its note for $303,000, was not an exchange*909 under section 112(b)(5), supra, but was a sale and the tax consequences, therefore, follow under section 112(a); and (2) that if the transaction was an exchange within section 112(b)(5), supra, the note of the Jorwil Corporation thus received by the petitioner was not within the meaning of the term "securities" used in that section, but, on the other hand, was within the category of "money" or "other property." We assume the transaction was an exchange within the statute. See . Thus we do not have the same question here that was considered in either Pinellas Ice & Cold*224 , or . See , affirming . The question for decision here is whether the note received from the Jorwil Corporation, in this exchange, was a security within the meaning of section 112(b)(5), section 112(c), and section 113(a)(6). In answering that question, we think neither the legislation itself nor its history 2 warrants*910 the disregard of the concept that this term includes only that which, in itself, reflects such a "continuing interest" in the property transferred to the corporation as would dignify it as within the meaning of "securities." See ; . Since the petitioner received all the issued stock of the Jorwil Corporation, she undoubtedly had a continuing interest in that corporation and in the properties which it then held. However, does the note which petitioner received and sold give her such an interest? Bonds of varying maturities have been held to represent such continuing interests and to be within the term "securities" as thus used. ;*911 ; . The Burnham case, supra, held that a ten-year, unsecured, confess-judgment, promissory note was within that category. However, we find no authority, in reason or otherwise, which we think supports the conclusion that the unsecured note of the Jorwil Corporation, for two years, without even a confessjudgment clause therein, rises to the dignity of the term "securities" used in section 112(b), supra.The petitioner, as the holder of that note, was in substantially the same position as that of an ordinary general creditor. It would scarcely be held that an ordinary creditor of a corporation, by reason of that status, held such a continuing interest in the corporation as to be the owner of a security, within the cited section. We think, rather, that the note of the Jorwil Corporation which the petitioner thus received was "other property" within that section and that the basis for the computation of gain or loss on its sale by the petitioner was its fair market value when petitioner received it. Sec. 113(a)(6). Since the record does not disclose that this fair market*912 value was other than the face of the note, the petitioner has not established any loss on the sale thereof. In view of our conclusion that the note is "other property" and that its basis is therefore the same as its market value on the date of the exchange, it is not essential to discuss the allocation of basis of the *225 note for which petitioner contends. The valuation of the assets, when transferred to the Jorwil Corporation, necessary in any such allocation, has been found from opinion testimony and circumstantial evidence offered by petitioner, to the admission of which respondent did not object. In only one instance we have refused to follow that testimony - the Arthur H. Fleming account receivable in the form of a note for $56,954.63. The write-down urged by petitioner is based on the sole ground that petitioner did not desire to enforce collection in the year of transfer, or deemed collection impossible. In 1937, $22,000 in cash and property worth $20,000 were transferred to petitioner on account of his liability, by the guardian of Arthur H. Fleming. Therefore, we have valued this item at its face amount as of the time of its transfer to the Jorwil Corporation. *913 Decision will be entered under Rule 50. Footnotes 1. SEC. 112. RECOGNITION OF GAIN OR LOSS. * * * (b) EXCHANGES SOLELY IN KIND. - * * * (5) TRANSFER TO CORPORATION CONTROLLED BY TRANSFEROR. - 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; but in the case of an exchange by two or more persons this paragraph shall apply only if the amount ofthe stock and securities received by each is substantially in proportion to his interest in the property prior to the exchange. ↩ 2. Seidman's Legislative History of Federal Income Tax Laws, pp. 341, 700; Miller, Hendricks & Everett, Reorganizations and Other Exchanges in Income Taxation, p. 90 (note); ↩