Hartzel v. Commissioner

ELMER W. HARTZEL, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT. Hartzel v. Commissioner Docket No. 78769. United States Board of Tax Appeals 40 B.T.A. 492; 1939 BTA LEXIS 843; August 23, 1939, Promulgated *843 Held, that taxpayer who received new stock in a corporation reorganized, through recapitalization, in exchange for stock in the corporation owned by him before its recapitalization received such new stock pursuant to a plan of reorganization and the profit realized therefrom is not recognizable for tax purposes. D. W. Maxon, Esq., and Cletus G. Roetzell, Esq., for the petitioner. Henderson A. Melville, Esq., for the respondent. TYSON *492 In this proceeding the respondent determined a deficiency of $7,408.08 in petitioner's income tax for the calendar year 1931. Petitioner assigns as errors: (1) The inclusion in his income by respondent of an alleged profit of $59,270.29 as resulting from an exchange of stock through a recapitalization of the Hardware & Supply Co. in 1931; (2) the failure of respondent to find that the entire transaction from which the profit is alleged to have arisen fell within the provisions of section 112(b)(3) of the Revenue Act of 1928 instead of under the provisions of section 112(a) of that act; and (3) the determination by respondent that the new preferred stock of the reorganized Hardware & Supply Co. had*844 a market value of $110 per share and the new common stock a value of $143.38 per share. FINDINGS OF FACT. Petitioner is a resident and citizen of Akron, Ohio. In 1931 he was secretary of the Hardware & Supply Co., an Ohio corporation, hereinafter referred to as the company, and just prior to the exchange of his stock as hereinafter shown, owned 450 shares of the company's common stock of the par value of $100 per share. *493 The authorized and outstanding capital stock of the company was, until its reorganization through recapitalization, $1,000,000, consisting of 10,000 shares of common stock of the par value $100of per share, all of which was owned by 13 stockholders. Six of these stockholders, hereinafter referred to as the older stockholders, owned 7,550 of such shares of stock. Seven of them, hereinafter referred to as the younger stockholders, and including petitioner, owned the remaining 2,450 shares. Of the older stockholders, one was president and one was treasurer. Of the younger stockholders, one was general manager, one, the petitioner herein, was secretary, and one each of the other five was in charge of a department of the business. All of the*845 older stockholders, ranging in age from 60 to 70 years, had children, none of whom were identified with the affairs of the company. The younger stockholders were apprehensive, in 1931 and prior thereto, that some of the older stockholders might die and their holdings of stock go to their children, and that the voting control of the company would thus pass into the hands of people totally unfamiliar with its affairs. They were also apprehensive that after the control had so passed they might be displaced from the positions they held with the company and thus be left with nothing except their small block of common stock "to show" as a result of the many years they had worked for the company. For several months the younger stockholders discussed this situation and ways and means by which they might secure a greater voice in the management of the company. Later, they discussed the situation with the older stockholders and all together they orally agreed upon a plan whereby the company would be reorganized and issue to the older stockholders all its preferred stock and to the younger stockholders all of its new common stock. Finally, all stockholders instructed an attorney to work*846 out the details necessary to effectuate what had been agreed upon. The attorney drafted an agreement which, when read to them, the stockholders protested against on the grounds that it did not conform with their oral agreement, in that they had orally agreed that "before they got through with the reorganization" the older stockholders would own all the preferred stock and the younger stockholders would own all the common stock of the reorganized company, whereas, the agreement as drafted provided for a pro rata distribution by the company of both the new preferred and new common stock to each stockholder and then for an exchange by the younger stockholders of their preferred stock with the older stockholders for their common stock, and an exchange by the older stockholders of their common stock with the younger stockholders for their preferred stock. The attorney explained to them that the provision in the agreement, as drafted, for the pro rata distribution of both the new *494 preferred and new common stock to each stockholder was merely a "detour" to comply with Ohio laws in filing the certificate of reorganization, but that exactly the same result as that which was intended*847 to be accomplished by their oral agreement would be accomplished by the further provision in the written agreement for the exchange of stock among their older and younger stockholders through the issuance direct by the company of the new preferred stock to the older stockholders and the new common stock to the younger stockholders without the necessity of an actual exchange of the stock between the stockholders themselves. After this explanation by the attorney, all of the stockholders signed the agreement. The written agreement was dated February 10, 1931, and provided, inter alia, that the Hardware & Supply Co. be reorganized with an authorized capital stock consisting of 12,000 shares of 7 percent cumulative preferred stock of the par value of $100 per share and 5,000 shares of no par value common stock, but of a stated value of $50 per share; that a certificate of reorganization should be filed with the Secretary of State of Ohio; that the stated capital of the reorganized corporation at the time of filing the certificate should be $1,415,000, which would be an amount equal to the aggregate par value of the preferred stock thereafter outstanding plus $50 per share allotted*848 as stated capital to the common stock without par value thereafter outstanding; and "that eleven thousand seven hundred (11,700) shares of said new preferred stock, and forty-nine hundred (4,900) shares of said new no par value common stock shall be issued in place of the outstanding shares of stock of said corporation, the only stock outstanding being ten thousand (10,000) shares of common stock of a par value of One Hundred Dollars ($100.00) per share on the basis of one and 17/100 shares of preferred and 49/100 of a share of common for each share of the stock of said corporation now outstanding, which will result in the stockholders holding shares of capital stock in the reorganized corporation as follows: Holdings under plan "Present holdings Preferred No par common J. E. Good 2,620 3,065.40 1,283.80 W. W. Wohlwend [930] 1,088.10 455.70 Nellie M. Bunnell 1,760 2,059.20 862.40 Bertha W. Morgan 1,760 2,059.20 862.40 H. E. Andress [30] 35.10 14.70 Walter Flower [450] 526.50 220.50 Elmer Hartzel [450] 526.50 220.50 Cecil Welker [450] 526.50 220.50 Fred H. Steffens [450] 526.50 220.50 Hoyt Smith [450] 526.50 220.50 Hesket Kuhn [450] 526.50 220.50 O. C. Conlan [100] 117.00 49.00 Joseph S. Hunt [100] 117.00 49.00 10,000 11,700.00 4,900.00" *849 *495 The agreement further provided that it was the desire of all the stockholders that the older stockholders should own all the preferred stock of the reorganized corporation and that the younger stockholders should own all of the no par value common stock thereof; that to that end the older stockholders would exchange the no par value common shares to which they would be entitled for the preferred shares to which the younger stockholders would be entitled and the younger stockholders would exchange the preferred shares to which they would be entitled for the no par common shares to which the older stockholders would be entitled, in such manner that each of the older stockholders should receive his pro rata share of the aggregate of the preferred shares to which the younger stockholders would be entitled and so that each of the younger stockholders would receive his pro rata share of the aggregate of the common shares to which the older stockholders would be entitled, with the result that the stock holdings of the respective stockholders of the company would be as follows: Shares of preferred Shares of no par common J. E. Good 4,060.13 W. W. Wohlwend 1,441.17 Nellie M. Bunnell 2,727.42 Bertha W. Morgan 2,727.42 H. E. Andress 46.50 Walter Flower 697.36 Elmer Hartzell [900] Cecil Welker [900] Fred H. Steffens [900] Hoyt Smith [900] Hesket Kuhn [900] O. C. Conlan [200] Joseph S. Hunt [200] 11,700.00 4,900 *850 The agreement further provided that instead of issuing pro rata to each stockholder his proportionate share of preferred and common stock, as in the first tabulation set out above, the reorganized company was authorized and directed to make distribution of such shares direct to its stockholders in the proportions and amounts stated in the second tabulation set out above, "thereby accomplishing the results agreed to by all the stockholders without the necessity of an actual exchange." With regard to the preferred stock, the agreement further provided, inter alia, that the annual dividends thereon should have priority over the common stock and be cumulative; that annually on or before December 31 in each of the years 1933 to 1937, both inclusive, the company should, out of its surplus profits if sufficient after all dividends on the preferred stock had been paid or set apart, acquire by redemption or purchase at least 2 percent of the largest amount in par value of the preferred stock which had been at any one time issued and outstanding at 110 percent of its par value plus accrued and unpaid dividends thereon if acquired by redemption and at not to exceed *496 said redemption*851 price if acquired by purchase; that on or before December 31 of each year after 1937 and until all the preferred stock should have been redeemed the company was to so acquire annually at least 3 percent of the largest amount in par value of the preferred stock which had been at any one time issued and outstanding; that none of the preferred stock acquired or redeemed by the company should be reissued, but all should be canceled and retired; that at all stockholders' meetings until the number of outstanding shares of preferred stock should have been reduced by redemption and/or purchase and cancellation and retirement thereof to 4,900 shares or under, both the preferred and common stock as a class, should have equal voting power, that is to say, each share of preferred and each share of common stock shall have such a number of votes that the entire number of votes which the entire outstanding preferred stock would be entitled to cast shall equal the total number of votes which the entire outstanding common stock would be entitled to cast; that when the number of preferred shares outstanding should have been reduced to 4,900 shares or under, each share of the capital stock of the*852 company, both preferred and common, should thereafter be entitled to one vote; that if the company at any time defaulted in the payment of dividends to be made in each year on its preferred stock or if the company should fail for any two consecutive years to earn the amount of the annual dividends on the preferred stock, then and until the default in the preferred dividends should have been made good and/or until the company should have again earned its preferred dividends the entire voting power should be vested in the preferred stock, but upon such defaults being made good the voting power should again be vested in the preferred and common shares "as hereinabove provided"; that the amount of the authorized preferred stock should not be increased; that the holders of the preferred stock would not be entitled to share in any stock dividends or to subscribe for or purchase any part of the present authorized or any future increase of common stock of the company; that so long as any preferred stock was outstanding no dividends should be paid on the common stock until the payment of all dividends on the preferred stock and the retirement of the stipulated amount of preferred stock each*853 year should have been provided for; that the dividends on the common stock should in no event exceed the sum of $5 per share per annum; that upon voluntary liquidation of the company or voluntary distribution of its assets or upon any merger or consolidation of the company there should be paid to the holders of the preferred stock $110 per share plus all accrued and unpaid dividends thereon before any sum should be paid to or any assets distributed among the holders of the common stock; that upon involuntary liquidation or dissolution of the company, the holders of the preferred stock should be paid the sum of $100 per *497 share plus all accrued and unpaid dividends thereon before any sum should be paid to or any assets distributed among the holders of the common stock. On February 18, 1931, a special meeting of the board of directors, at which all the directors were present, was held. The agreement of the stockholders of February 10, 1931, was read to the board and by resolution what was designated as a plan of reorganization was unanimously adopted. This plan embraced in its material substance, and in almost identic language, all that part of the agreement of the stockholders*854 as above set out except that part relating to and providing for the direct issuance by the company to the old stockholders of all the new preferred stock and to the younger stockholders of all the new common stock. The same resolution provided that the plan adopted be presented to the stockholders for their consideration and authorized the proper officers of the company to do all things necessary to put the plan in operation if and when it was adopted by the stockholders. On February 18, 1931, a special meeting of the stockholders of the company was held, at which all stockholders were present. The plan of reorganization, as adopted by the board of directors, was read to the stockholders and a resolution approving and adopting such plan was passed by unanimous vote. By that same resolution the president and secretary of the company were authorized and instructed to execute and file with the Secretary of State of Ohio the certificate of reorganization containing a copy of the plan of reorganization as adopted. At the same meeting of the stockholders a second, separate resolution was unanimously adopted as follows: WHEREAS, all of the stockholders of The Hardware & Supply*855 Company have heretofore entered into a written agreement by the terms of which certain of the stockholders have agreed that they will exchange the preferred stock to which they will be entitled upon the plan of reorganization being carried out, for the common stock to which the other stockholders will be so entitled so that 11,700 shares of preferred stock and 4,900 shares of common stock, to be issued as a result of the reorganization, shall be owned as follows: Preferred No par common J. E. Good 4,060.13 W. W. Wohlwend 1,441.17 Nellie M. Bunnell 2,727.42 Bertha W. Morgan 2,727.42 H. E. Andress 46.50 Walter Flower 697.36 Elmer Hartzel [900] Cecil Welker [900] Fred H. Steffens [900] Hoyt Smith [900] Hesket Kuhn [900] O. C. Conlan [200] Joseph S. Hunt [200] 11,700.00 4,900 *498 and WHEREAS, said stockholders have further agreed in writing that The Hardware & Supply Company may make distribution of the 11,700 shares of preferred stock and 4,900 shares of no par value common stock to be issued by it in exchange for the present outstanding capital stock of the company as a result of said plan of reorganization in the*856 proportions and amounts last above stated, thereby accomplishing the results agreed to by all of the stockholders, without requiring a further exchange of securities. NOW, THEREFORE, BE IT RESOLVED That The Hardware & Supply Company be and it hereby is authorized and directed in carrying out said plan of reorganization to issue the 11,700 shares of preferred stock and 4,900 shares of no par common stock of the reorganized corporation to the stockholders of The Hardware & Supply Company in the following proportions and amounts upon the surrender by each said stockholder of the shares of the capital stock of The Hardware & Supply Company now owned by said stockholders: Preferred No par common J. E. Good 4,060.13 W. W. Wohlwend 1,441.17 Nellie M. Bunnell 2,727.42 Bertha W. Morgan 2,727.42 H. E. Andress 46.50 Walter Flower 697.36 Elmer Hartzel [900] Cecil Welker [900] Fred H. Steffens [900] Hoyt Smith [900] Hesket Kuhn [900] O. C. Conlan [200] Joseph S. Hunt [200] 11,700.00 4,900 and that the issuance of such stock as above stated shall be considered as a full compliance with the terms of said plan of reorganization.*857 [Italics ours.] On February 28, 1931, a certificate of reorganization of the Hardware & Supply Co. was filed with the Secretary of State of Ohio, which certificate set forth, inter alia, that part of the written agreement of the individual stockholders as adopted by the board of directors and as adopted by the first resolution of the stockholders at their special meeting of February 18, 1931. The certificate of reorganization contained the following clause, providing for pro rata distribution of the stock, which was identical with a clause in the plan as adopted by the board of directors and by the first resolution of the stockholders at their special meeting and which was also in substance the same as a clause in the written agreement of all the stockholders of February 10, 1931, as hereinbefore set out, to wit, "Eleven thousand seven hundred (11,700) shares of said preferred stock and forty-nine hundred (4,900) shares of said no par value common stock shall be issued in lieu of the shares of stock of said corporation now outstanding, to wit: ten thousand (10,000) shares of *499 common stock of a par value of One Hundred Dollars ($100.00) per share, such exchange*858 to be on the basis of one and 17/100 shares of preferred stock and 49/100 of a share of no par value common stock for each share of the stock of the said corporation now outstanding." After the filing of the certificate of reorganization, the new preferred stock was issued by the company direct to the older stockholders and the new common stock was issued direct to the younger stockholders upon the surrender by them of their respective old shares, in accordance with the second resolution of the meeting of the stockholders above set out, the petitioner receiving 900 shares of no par value common stock, but of a stated value of $50 per share, in lieu of the 450 shares of $100 par value common stock held by him prior to the reorganization. Neither petitioner, nor any stockholder, received through the reorganization of the company anything other than such new stock for the surrender of their old shares. In his deficiency notice respondent determined that the transaction, or transactions, by which petitioner received 900 new common shares in the reorganized company in lieu of the 450 old common shares of the company owned by him prior to its reorganization, constituted a taxable exchange*859 under section 112(a) of the Revenue Act of 1928, 1 and has included in petitioner's income as a profit thereon the amount of $59,270.29. OPINION. TYSON: Petitioner contends that the issuance by the company direct to the older stockholders of all the new preferred stock and direct to the younger stockholders of all the new common stock, in lieu of the old common stock theretofore respectively held by them, constituted part of an entire transaction of exchange of such took which was in pursuance of and embodied in a plan of reorganization, within the provisions of section 112(b)(3) of the Revenue Act of 1928, 2 and that consequent gain or loss therefrom is not to be recognized. *860 Respondent concedes that there was a reorganization, through recapitalization, within section 112(b)(3), supra, in so far as the reorganized company was authorized to issue the new preferred and new common stock for the outstanding old common stock on a pro *500 rata basis. However, he contends that the reorganization was completed when the certificate of recapitalization was filed with the Secretary of State of Ohio authorizing the issuance of new preferred and common stock on a pro rata basis and that the new preferred and new common stock "were issued for all intents and purposes in accordance with the terms" of that certificate; that when thereafter the older stockholders received direct from the reorganized company all its preferred stock in lieu of the old common stock theretofore owned by them, and when the younger stockholders received direct from the company all its new common stock in lieu of the old common stock theretofore owned by them, such latter transactions were separate and independent ones and constituted no part of the reorganization, but constituted a taxable exchange of shares in the reorganized company between the stockholders in their individual*861 capacities; and that the fact that the stockholders, by their individual agreement and by resolution in their formal special meeting, authorized and instructed the company to "do the exchanging for them does not change the picture." The question then occurs whether the issue by the reorganized company of all its preferred stock direct to the older stockholders and of all its new common stock direct to the younger stockholders, in lieu of the old common stock held by such stockholders, was in pursuance of a plan of reorganization within the purview of section 112(b)(3), supra, as contended by petitioner. We think it was. The plan was initiated by written agreement of all the individual stockholders with the definite object in view of finally placing in the ownership of the old stockholders all the preferred stock and in the ownership of the younger stockholders all the common stock for the sole purpose of giving the younger stockholders a greater voice in the control of the company because of certain contingencies which might arise in the future, i.e., that some of the older stockholders might die, their stock go to their children, and voting control of the company thus pass*862 into the hands of people totally unfamiliar with its affairs, who might displace the younger stockholders from the positions they held with the company. The plan so initiated by the individual stockholders embraced a provision for such direct issuance by the company of its new preferred stock to the older stockholders and of its new common stock to the younger stockholders. The plan as so initiated was adopted and approved by unanimous vote of all the stockholders in official meeting, through the medium of two resolutions passed at that meeting, the second of which, after expressly authorizing and instructing the proper officers of the company to issue all the preferred stock *501 direct to the older stockholders and all the common stock direct to the younger stockholders, stated further "and that the issuance of such stock" in that manner "shall be considered as a full compliance with the terms of said plan of reorganization." It is true that the method adopted in the plan to effectuate the desired result, i.e., that when the whole plan was consummated the younger stockholders would own all the new common stock and the older stockholders would own all the new preferred*863 stock, included what may be termed a "detour" (the provision for the pro rata distribution of the new stock). However, this "detour" was used because of real or feared impediments of the Ohio State Statutes with regard to what was requisite to be set out in a certificate of recapitalization. "Detours" similarly occasioned have not prevented this Board and the courts from holding that reorganizations in which "detours" occurred were, nevertheless, effectuated within the reorganization statutes. , affirming ; certiorari denied, ; ; ; cf. . But respondent contends, in effect, that even if the plan of reorganization embraced all steps, as claimed by petitioner, including the direct issuance to the older stockholders of all the new preferred stock and the direct issuance of all the new common stock to the younger stockholders in lieu of pro rata distribution, yet, nevertheless, the reorganization did not come within the ambit*864 of section 112(b)(3), supra, because even in such event the interests of the various stockholders in the company, including the petitioner, after recapitalization was consummated, were different in that (a) the older stockholders received in exchange preferred for common stock and (b) the voting interests of the stockholders were so changed as to greatly increase the value of the stock of the younger stockholders, including petitioner, thus interrupting the continuity in interest of the stockholders necessary to a reorganization within the meaning of the applicable statute. As to the receipt of new preferred for old common stock by the older stockholders, the following authorities establish the principle that such would not exclude the reorganization from the provisions of section 112(b)(3), supra. ; cf. , affirming ; certiorari denied, ; and . As to the contention that the younger stockholders had a greater voting power after the reorganization of*865 the company and consequently the value of the new stock received by them was greater than the value of the old stock exchanged therefor, it is unnecessary to *502 say more than that they, as well as the older stockholders, acquired through their new stock a definite, substantial, and continuing interest in the reorganized company. ; ; ; and . Cf. ; and . We conclude that the respondent erred in the respects stated in petitioner's assignment of errors Nos. (1) and (2) and accordingly hold that the exchange here involved, by petitioner of his old stock in the Hardware & Supply Co. for new stock in that company after its reorganization, did not result in recognizable gain by the petitioner. There was much testimony as to the value of the new preferred and common stock received by the various stockholders*866 as a result of the reorganization of the Hardware & Supply Co. However, our conclusion that the exchange of stock was one in which gain is not recognizable obviates the necessity of our making findings as to such values and of deciding the issue presented by petitioner's assignment of error No. (3). Decision will be entered under Rule 50. Footnotes 1. SEC. 112. RECOGNITION OF GAIN OR LOSS. (a) General rule.↩ - Upon the sale or exchange of property the entire amount of the gain or loss, determined under section 111, shall be recognized, except as hereinafter provided in this section. 2. (b) Exchanges solely in kind. - * * * (3) STOCK FOR STOCK ON REORGANIZATION. - No gain or loss shall be recognized if stock or securities in a corporation a party to a reorganization are, in pursuance of the plan of reorganization, exchanged solely for stock or securities in such corporation or in another corporation a party to the reorganization. ↩