McCaffrey v. Commissioner ( 1935 )

WILLIAM T. MCCAFFREY, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.

McCaffrey v. Commissioner

Docket No. 58743.

United States Board of Tax Appeals

33 B.T.A. 378; 1935 BTA LEXIS 758;

November 6, 1935, Promulgated

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CAPITAL GAIN. - Where certain stock, through the sale of which petitioner realized a gain in 1928, had been acquired by him through the exercise, in that year, of an option for its purchase, and, consequently, such stock, not having been held by him for two years, did not constitute capital assets within section 101(c)(8) of the Revenue Act of 1928, such realized gain is subject to normal and surtax and not the rate for capital gain.

Edward Schoeneck, Esq., for the petitioner.

M. B. Leming, Esq., for the respondent.

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LEECH

The respondent determined a deficiency in income tax against petitioner for the calendar year 1928 in the amount of $40,821.40. The only issue involved is whether the sum of $367,306.56, constituting a gain realized by petitioner in 1928, on a sale of stock, is taxable as capital gain under section 101 of the Revenue Act of 1928, or is subject to normal tax and surtax, as ordinary gain. It was returned by petitioner as capital gain. Petitioner contends that the stock in question was acquired by him through the exercise of an option in January 1925, and, thus, had been held by him for more than three years at the time of its sale on August 11, 1928. Respondent's position is that the option to purchase the stock was not exercised by petitioner until March 13, 1928, five months prior to its resale by him and, consequently, it was not a capital asset within the definition of section 101(c)(8) of the Revenue Act of 1928.

FINDINGS OF FACT.

Petitioner is the president of the Lincoln Bank & Trust Co. of Syracuse, New York. From 1917 to 1920 he was a bank examiner for the State of New York and in the latter year became vice president of the Dunkirk Trust Co. of Dunkirk, New York. Prior to 1924 the petitioner became vice president of the Lincoln-Alliance Bank of Rochester, New York. At that time there were two national and seven state banks in Rochester.

In May 1924, the affairs of the two national banks of Rochester became involved and the banks of the city, representing the Clearing House Association, feared the precipitation of a bank run. A meeting of the Clearing House Association was held, as a result of which a new national bank was organized under the name of the National Bank of Rochester. The stock of the new bank was taken by the seven state banks and the directors of the two national banks. This stock had a par value of $100 a share and was subscribed for at $125 per share, giving the new bank a paid-in surplus. The new bank then took over the assets and assumed the liabilities of both the involved national banks. The shares taken individually by the seven state banks totaled 5,930, out of the total issue of 12,000 shares.

Petitioner, as a representative of the Lincoln-Alliance Bank of Rochester, participated actively in the organization of the new bank and shortly after its organization was induced by one Haight, who had been elected its president, to come with the bank as vice president. Haight had formerly been a bank examiner for the State of New York, in charge of the district in which petitioner was employed as a bank examiner, and their association had been intimate.

When Haight assumed the presidency of the New National Bank of Rochester, he had been given, by the seven state banks of that city, options to purchase the stock acquired by each in the new bank. As an inducement to petitioner to become associated with him in the management of the new bank, Haight agreed to share these option rights with petitioner. This agreement was understood and approved by the seven banks in question. The purpose of the granting of the option was to stimulate the activities of Haight and petitioner in developing the new bank and getting it upon a sound basis.

Shortly after petitioner took office with the new bank, formal option agreements were executed by each of the seven banks owning stock in the National Bank of Rochester. By each of these agreements, which were similar in form, an option was granted to petitioner and Haight jointly, to purchase the stock of the optionor at any time prior to May 17, 1929, for $125 per share and interest at the rate of 6 percent per annum from May 17, 1924, less the amount of any dividends and interest thereon that might have been paid on the stock out of the earnings of the bank prior to the time of the exercise of the option. It was further provided that in case both Haight and petitioner should cease to be officers of the National Bank of Rochester, the option would then terminate. The option agreement in each case provided as follows:

The said Haight and McCaffrey may exercise this option at any time prior to the expiration or termination thereof as herein provided by giving to the Bank written notice thereof, which notice shall state the number of shares of stock which they desire to purchase; and the said Bank upon receipt of such notice, agrees to immediately sell, assign and transfer to the said Benjamin D. Haight and William T. McCaffrey, or to such person or corporation as shall be designated by them, the shares of stock so purchased, upon receiving payment therefor.

On January 16, 1925, Haight died. At that time none of the options in question had been exercised. A day or two after Haight's death certain of the directors of the National Bank of Rochester suggested the appointment of one Foulkes, a director of the bank and a prominent manufacturer, as his successor in the presidency. Foulkes called on petitioner and discussed with him the question of his taking office and suggested that, in such case, he be given a joint interest in the options to acquire the stock. Petitioner refused to agree to this suggestion. However, in view of the fact that Haight was dead and that the options might be terminated through action of the board of directors in eliminating him as an officer of the National Bank of Rochester, he felt his position in respect to the option was not secure, especially since Foulkes, as president, desired an interest in the option, which interest petitioner denied him. In the meantime, petitioner's name had been suggested for appointment to succeed Haight as president of the bank, and petitioner thereupon called upon one Lannin, who was president of the Clearing House Association and, as such, had had general charge of the organization of the National Bank of Rochester and the allotting to the individual banks of that city the amount of the stock of the new bank to be subscribed by each. Lannin since that time had informally represented the several banks in a general way in matters affecting the new bank.

Petitioner explained to Lannin the conditions facing him and was advised by the latter that he could protect himself by exercising the options to purchase the stock. Petitioner thereupon assured Lannin that he would exercise the options. a few days later petitioner was elected president of the National Bank of Rochester.

Early in the year 1928 the petitioner borrowed approximately $250,000 from one Costich, a wealthy man of Rochester and a personal friend, and, through his assistance, secured an agreement from the Chemical National Bank of New York City to lend $750,000 additional upon the security of the optioned stock. Thereupon, on March 13, 1928, he wrote the seven state banks in Rochester, which had executed the options, directing each to forward their stock to the Chemical National Bank and payment would be made for it. This was done in each case. The purchase price of the stock was computed at $125 per share plus 6 percent interest from May 17, 1924, to March 13, 1928. The stock, so delivered, was paid for by the Chemical National Bank from the proceeds of its loan of $750,000 and the Costich loan of approximately $250,000, and was held by it as security for its loan.

Following this petitioner caused the organization of a corporation, known as the Rochester Holding Corporation, to which he transferred his equity in the stock so held by the Chemical National Bank, in consideration for the issue to him of 2,965 shares of common and 1,867 shares of preferred stock of the Rochester Holding Corporation, plus the assumption by that company of liability for the payment of the Chemical National Bank and Costich loans. At the time this stock was issued to petitioner, it was the only issued and outstanding stock of the corporation, except qualifying shares issued for the purpose of organization. Upon taking over petitioner's equity in the bank stock, the Rochester Holding Corporation sold an additional issue of its preferred and common stock for sufficient cash to pay the two loans mentioned, and obtained unencumbered title to the sotck. Thereupon the Rochester Holding Corporation gave an option to one Rand, of Buffalo, New York, for the purchase of this stock of the National Bank of Rochester, at $275 per share, which option was exercised by Rand. Prior to the delivery of the stock to Rand the Rochester Holding Corporation was liquidated and its assets, consisting wholly of the stock of the National Bank of Rochester, were distributed to its stockholders, including petitioner, and delivery, under the option to Rand, was made by such stockholders and the consideration of $275 per share received by them. The profit to petitioner, realized in the year 1928, is agreed to have been the sum of $376,306.56.

The seven options granted by the state banks of Rochester to petitioner to purchase their individual holdings of the National Bank of Rochester stock were exercised by petitioner on March 13, 1928.

OPINION.

LEECH: Our finding that petitioner did not exercise the seven options in question until March 13, 1928, determines the issue submitted. That conclusion was reached after careful examination of the record and consideration of the argument of counsel. Petitioner contends that the options were exercised in January 1925, but we think the clear weight of the evidence is against that contention.

Petitioner argues that in January 1925 he exercised all seven of these options by calling upon one Lannin and stating to him that he was willing, and would consider himself unqualifiedly bound, to take the optioned stock. It is his position that Lannin was a qualified representative of the seven banks, that such statement made to him was effective as an exercise of the option with each of those banks, and that thereafter, he was unqualifiedly bound to accept delivery of the stock.

In the first place the record does not show to our satisfaction that Lannin was empowered and authorized to represent the several banks in any change or modification of the several option agreements. These agreements provided specifically that the exercise of the option rights should be in writing by the optionee, designating the amount of the stock in respect of which he desired to exercise his option. It appears that Lannin was the president of the Rochester Clearing House Association and, no doubt, the several banks looked to him to keep them advised and generally direct matters in connection with the newly organized bank, in which, through necessity, they had taken interests. His action for these banks so far as the record discloses, was entirely informal and premised upon the position he occupied in the association composed of the several banks. The argument of petitioner's counsel that, even if Lannin had not been authorized by the several banks to act for them in the exercise of the options, these banks had ratified and confirmed his representation, is without merit. We do, however, call attention to the fact that the delivery of stock, under the orders given by petitioner on March 13, 1928, is no evidence of confirmation of any action taken theretofore by Lannin. This order was within the period of the option in each case, and, irrespective of any conversation between petitioner and Lannin, was an express exercise of the option, in the manner prescribed by its terms.

Moreover, it is difficult to reconcile his statement of a definite verbal agreement with Lannin, with other facts appearing here. We are without Lannin's testimony, due to his death prior to the hearing, but the testimony of most of the witnesses produced by petitioner in an endeavor to prove statements by Lannin to them, substantiating an understanding between petitioner and the latter, constituting a definite exercise of the options, not only fails to substantiate petitioner's position, but strongly indicates that no such agreement was reached.

Arthur B. Clark, later vice president of petitioner's bank, but in 1925 a New York state bank examiner, when introduced as petitioner's witness at the hearing, testified that in making an examination of the Merchant's Bank of Rochester, one of the optionor banks, some two months after Haight's death, he noted in its schedule of assets its holdings in National Bank of Rochester stock and, as the law prohibited investments of this character by that bank, he questioned this item and was referred to Lannin for advice as to the exact status of the investment. He further testified that on questioning Lannin the latter advised him that he "expected Mr. McCaffrey would exercise an option he held on this stock." This advice was given Clark by Lannin subsequent to the conversation of petitioner with Lannin which petitioner here asserts was definite exercise of the option. Foulkes, another witness for petitioner and a director in the National Bank of Rochester in 1925, testified that following petitioner's conference with Lannin he called on the latter and was advised that "he understood from his talk with McCaffrey that the option was going to be exercised." The testimony of both of these witnesses indicates strongly that Lannin's understanding of his talk with the petitioner was merely that the latter had assured him of his intention to exercise the options. It is shown that following petitioner's talk with Lannin no change was made by the seven banks on their records, evidencing the transfer of any beneficial interest in the stock to petitioner. The stock remained in their investment accounts. No indebtedness was set up as due from this petitioner. Likewise, in March 1928, upon receipt from petitioner of directions to deliver the stock to the Chemical National Bank, the several banks computed the purchase price at $125 a share, plus interest from May 17, 1924, to that date, whereas, under the option contract they would have been entitled to a sum computed at $125 per share, plus interest from May 17, 1924, to the date in January 1925 when petitioner contends the options were exercised, and interest upon this total sum to the date of delivery of the stock, if petitioner's contention as to the date of exercise of the option were correct.

The record further shows that, upon the sale of this stock through the Rochester Holding Co. at $275 per share, the question was raised by the executor of Haight's estate as to its right to participate in the profit accruing to petitioner, upon the ground that Haight was the joint owner of the options and participated in a joint venture with petitioner. It is established that petitioner effected a settlement of this claim by payment of $50,000 of the amount received upon the sale of stock and that it became necessary to secure the approval by the probate court of that settlement. In this connection petitioner filed with that court his affidavit, purporting to set out in detail the facts in connection with the granting and exercise of the seven options. In this affidavit, presented to the court, and the basis for the court's approval of the settlement made, petitioner states that, at the time of Haight's death, and for two years following that time, the position of the National Bank of Rochester was very hazardous and the future value of the stock was very uncertain. He stated further in his affidavit that in March 1928, he "became concerned about the option held by him for the purchase of the stock from the banks, inasmuch as deponent realized that should he die, or for any reason his position with the National Bank of Rochester should cease, the option for the stock would fall", and that "the options were exercised by deponent on March 13, 1928 * * *."

In addition to this evidence which, obviously, has great weight against petitioner's assertion of a definite and unqualified exercise of the seven options in January 1925, it is difficult to believe that a binding agreement would be thus executed by two careful business men, both bankers of experience, involving the acquisition of approximately $1,000,000 in property without that action being reduced to writing or evidenced in some way more definite than the mere recollection of the parties. The utmost care was taken in the drafting of the option agreements. These contracts are full and complete. They prescribe specific conditions and the particular mode of exercise to be followed. That the exercise of the options under these circumstances would be effected by a verbal statement, in the course of an informal conversation without even so much as a subsequent confirmation by letter, seems, at the least, a most unusual method, and one denoting a lack of business care and judgment utterly inconsistent with men of the character of the petitioner and Lannin, as revealed by the record.

It may well be that petitioner, now, after the lapse of many years, is convinced that his assurance to Lannin represented an unconditional and binding exercise of the options, but the evidence to the contrary indicates overwhelmingly to us that Lannin took from that conference no understanding of an absolute and unconditional exercise of the options, but only an assurance that petitioner would exercise them before their expiration. Cf. ; .

Having found that the options in question were not exercised until March 13, 1928, the same year in which the stock was sold, and the profit here in controversy realized, it follows that such profit, accruing from the sale of assets held less than two years, is not subject to the rate for capital gain but to normal tax and surtax.

Judgment will be entered for the respondent.