Hawke v. Commissioner , 35 B.T.A. 784 ( 1937 )

E. R. HAWKE, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.

Hawke v. Commissioner

Docket Nos. 76507, 76508.

United States Board of Tax Appeals

35 B.T.A. 784; 1937 BTA LEXIS 835;

March 31, 1937, Promulgated

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1. For a number of years prior to 1930 the petitioner was employed as manager of a branch store of J. C. Penney Co. at Modesto, California, under contracts which enabled him to purchase shares of stock of the company at prices less than their fair market value. In 1928 and 1929 he acquired under the contracts a number of shares of the stock at much less than their fair market value. He did not include in his income tax returns for those years any amount in respect of the acquisition of the shares. Held, that on the sale of some of the shares by the petitioner in 1930 and 1931 the basis for the purpose of computing gain or loss is the amount of cash which the petitioner paid in acquiring them.

2. In 1930 the petitioner contracted to purchase certain shares of stock in payment for which he gave his promissory note in the amount of $50,000. He paid $30,803 upon the note in 1931. The shares were later found to have been illegally issued and were canceled. In 1933 the petitioner brought legal proceedings for the rescission of the contract to purchase the stock and for the return of the amount of $30,803 paid on his promissory note. The action is still pending. Held, that the amount of $30,803 paid upon the note in 1931 is deductible from petitioner's gross income as a loss of that year.

Alan W. Davidson, Esq., and D. A. Sargent, C.P.A., for the petitioner.

Dean P. Kimball, Esq., for the respondent.

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SMITH

These proceedings, consolidated for hearing, involve income tax deficiencies for 1930 and 1931 of $12,726.67 and $25,061.41, respectively. The principal question in issue is the basis to be used in the computation of profit from the sale of shares of stock of the J. C. Penney Co. which were acquired in 1928 and 1929 at bargain prices as a result of agreements between that company and the petitioner.

A further issue is presented as to the deduction of a claimed loss upon an investment made by the petitioner in shares of stock of the Master Holding Corporation, Ltd., a Delaware corporation. The petitioner claims that the loss was sustained in either 1930 or 1931.

FINDINGS OF FACT.

The petitioner is an individual, residing at Modesto, California. In 1927 and for many years prior thereto he was and had been an employee and stockholder of the J. C. Penney Co., a corporation. He was also manager of the corporation's store at Modesto under an oral employment contract. Under the corporate set-up each store was individually capitalized under what was known as a classified common stock structure, there being a separate stock classification for each store. The petitioner, as of December 31, 1926, was the owner of 60 shares of the classified common stock of class 97 (the Modesto, California, store), which was one-third of the shares issued for that store and under which he was entitled to receive one-third of the profits resulting from the operation of the store.

In April 1927, due to a reorganization of the J. C. Penney Co., the 60 shares of classified common stock of the Modesto store owned by the petitioner were called in and in full payment or exchange therefor the petitioner received 100 shares of the preferred stock of the company. On April 25, 1927, the J. C. Penney Co. reemployed the petitioner as manager of the Modesto, California, store under a written contract. This contract provided for payment to the petitioner as "added compensation, in addition to the regular salary", one-third of the net earnings of the store, less certain reserves. It also gave him the right to buy at book value a sufficient number of shares of common stock of the company, the earnings on which, based upon the net earnings of the company for the last full calendar year, equalled in amount two-thirds of the petitioner's one-third share of the earnings of the Modesto store. Such right was exercisable by the petitioner when he ceased to be manager of the store; by his legal representative in the event of his death; or by petitioner upon the termination of the contract by the company.

On March 18, 1929, the J. C. Penney Co. advised the petitioner by letter that it had elected to terminate the employment contract of April 25, 1927, and that pursuant to the terms of paragraphs "fourth" and "sixth" of the contract petitioner had the right to buy 971 shares of common stock at a price of $28 per share. Petitioner exercised this right and immediately thereafter bought 971 shares at $28 per share. The fair market value of the shares at the time was $367.50 per share. The market value of the total 971 shares was $356,842.50. The petitioner paid $27,188 for them.

The petitioner was reemployed by the J. C. Penney Co. as manager of the Modesto, California, store by written contract dated April 15, 1929, as of January 1, 1929. The new contract did not include any stock purchase rights and the percentage of store earnings to which petitioner was entitled as compensation was materially reduced.

In June 1927 the J. C. Penney Co., by act of its board of directors, announced a plan under which store managers who successfully operated their stores and met certain requirements would be given the opportunity to purchase so-called "expansion stock" (common stock) of the company at a price per share to be determined each year by the board of directors. In order to qualify for the purchase of stock a manager had to comply with all of the following:

(1) Manage a store (with interest in its profits) for one calendar year;

(2) Make 7 percent or more net profit on the volume;

(3) Have 8 percent or more of the volume in cash, as of December 31.

To determine the number of shares a qualifying manager could purchase the percentage of the store earnings to which he was entitled (in petitioner's case one-third, in accordance with his employment contract) was used as a basis. If the manager made the foregoing cash requirements he was given the right to purchase shares of the so-called "expansion stock" to the extent of 50 percent of his percentage of the store earnings. If he had trained a man who was used by the company to open and manage a new store, he was given the right to purchase the shares of "expansion stock" to the extent of the remaining 50 percent of his percentage of the store earnings. Under date of April 10, 1928, the J. C. Penney Co. advised petitioner that his management of the Modesto, California, store had qualified him for the right to purchase "expansion stock" and that he was eligible to participate to the extent of 100 percent of his 1927 earnings, he having met the financial requirements qualifying him to the extent of 50 percent of the earnings, and in addition, trained a man used by the company, which qualified him for the remaining 50 percent of his earnings. Petitioner's percentage of the store's earnings for 1927 having amounted to $18,689, he was allotted 187 shares of common stock at a price of $100 per share, the price of the stock determined by the board of directors. On or about April 23, 1928, petitioner exercised his right to purchase and bought 187 shares at a price of $100 per share. The fair market value of the shares at the time was $325 per share.

Under date of March 27, 1929, the J. C. Penney Co. again advised petitioner that he had qualified to purchase "expansion stock" under the 1927 plan based on his store operation for the year 1928. The petitioner's percentage of his store's earnings for the year 1928 amounted to $21,085.69, but, having failed to train a man used by the company, he was given the right to purchase stock only to the extent of 50 percent of his earnings, or $10,542.85. The board of directors having fixed the price of the stock at $120 per share, the petitioner was allotted 88 shares at a total cost of $10,560. On or about March 27, 1929, the petitioner exercised his right to purchase the 88 shares of stock and paid therefor $10,560. The fair market value of the shares at the time was $30,844, or $350.50 per share.

The petitioner filed his income tax returns for the years 1928 and 1929 on March 15, 1929, and March 15, 1930, respectively. No waivers of the statute of limitations with respect to the years 1928 and 1929 have been filed by the petitioner. The petitioner did not include as income in his income tax returns for 1928 or 1929 the differential between the respective prices paid for the shares of stock referred to above and their fair market values at the respective dates of acquisition, because he did not understand that the differential constituted taxable income to him in 1928 and 1929, nor did the respondent assess any additional income taxes for the years in question on account of the failure to include in gross income the differentials referred to. The statute of limitations has now barred any additional assessment for either of the years.

The petitioner's attention was first called to the provisions of article 51 of Regulations 74 some time in the latter part of 1932, or the early part of 1933, following a conference with a field agent of the Bureau of Internal Revenue regarding a deficiency notice on his income tax return for 1930.

Each year the J. C. Penney Co. advised its store managers concerning the preparation of their income tax returns, particularly with reference to the amount of the compensation paid to them by the company which they were required to include in gross income, and likewise advised the store managers of the cost basis to be used in determining gain or loss on stock bought from the company which was sold during the taxable year. The J. C. Penney Co. took the position that the difference between what their managers paid for the stock sold to them at so-called "bargain prices" and the fair market value of the shares of stock on the dates of acquisition was not additional compensation and was not required to be included in the tax returns.

The petitioner did not personally prepare his income tax returns. Those for 1928 and 1929 were prepared by his secretary, Mrs. Penney, with the advice and assistance of a deputy collector at Modesto. All correspondence between the petitioner and the J. C. Penney Co. relating to stock purchases was submitted to the deputy collector in the preparation of the returns for 1928, 1929, 1930, and 1931 and the cost basis of the stock communicated to the petitioner by the J. C. Penney Co. was relied upon by the petitioner and by the deputy collector in the making of the returns.

In 1930 and 1931 the petitioner sold certain shares of stock of the J. C. Penney Co. which he had acquired in 1928 and 1929 in the manner above described. In the determination of the deficiencies herein the respondent has used as the cost of the shares to the petitioner the amounts which he actually paid in the acquisition of them.

The differentials between the amounts paid for shares of J. C. Penney Co. stock in 1928 and 1929 and their fair market values at the dates of acquisition were not paid to the petitioner as compensation for services rendered. The cost to the petitioner of the shares of J. C. Penney Co. sold by the petitioner in 1930 and 1931 was the amounts of cash which he paid to the J. C. Penney Co. in acquiring them.

In September 1930 petitioner executed and delivered to E. E. Pratt his promissory note for $50,000 for common and preferred shares of the Master Holding Corporation, Ltd., a Delaware corporation, of a par value of $60,000. The transaction was one entered into for profit. During 1931 the petitioner paid on account of this note $30,803, leaving a balance due on the principal of $19,197 still unpaid. In September 1930 the petitioner received from the corporation certificates for his stock. On April 2, 1930, the Department of Investment, Division of Corporations, of the State of California, duly issued its permit to the above named corporation permitting the sale and issuance of its securities upon the following terms: "to sell units consisting of one share of preferred and one share of Class A Common Capital Stock at a price of $50.00 per unit, in cash, or for 50 per cent in cash, the balance by promissory note of the subscriber payable within six months from date of subscription." This permit to issue stock was in full force and effect at the time of the issuance of the stock certificates to the petitioner. But the corporation received nothing of value either from the petitioner or from Pratt in consideration of the issuance of the stock. At the time of issuance the corporation charged Pratt's personal account with $60,000, which was "paid" on March 31, 1931, by the sale by Pratt to the corporation of certain shares of stock of the Guardian Holding Corporation, a California corporation. Pratt obtained the shares of Guardian Holding Corporation from that corporation without paying any consideration therefor. In 1932 the shares of stock which had been "sold" by Pratt to the Master Holding Corporation were canceled by the Guardian Holding Corporation and, as a consequence, the Master Holding Corporation, on December 31, 1932, canceled the credit of $60,000 applied to Pratt's personal account at the time of the "dummy" sale of the Guardian Holding Co. stock and also canceled the shares of stock which had been issued to the petitioner in September 1930. The shares of stock of the Guardian Holding Co. issued to the petitioner were void and worthless from the date of issuance. The petitioner did not discover the irregularity in the issuance of the stock he had received until the latter part of 1932. In 1933 the petitioner commenced legal proceedings against Pratt for the rescission of his transaction and the repayment to him of the $30,803 paid on the note and the return of his promissory note. No repayment was ever made by Pratt, nor was the petitioner's note returned to him, and the action is still pending, with no final determination thereof having been obtained.

The petitioner made his income tax returns for 1930 and 1931 on a cash receipts and disbursements basis.

The petitioner sustained a deductible loss in 1931 of $30,803 representing the amounts which he paid on his promissory note to Pratt in that year.

OPINION.

SMITH: The first question for our determination in these proceedings is whether, in computing petitioner's gain or loss on the sales in 1930 and 1931 of shares of stock of the J. C. Penney Co. which he had acquired in 1928 and 1929 under his contracts with the company, the basis is the amount of cash which he paid to the company for the shares, or their fair market value on the dates of acquisition. Section 113(a) of the Revenue Act of 1928 provides the basis for determining gain or loss as follows:

(a) Property acquired after February 28, 1913. - The basis for determining the gain of loss from the sale or other disposition of property acquired after February 28, 1913, shall be the cost of such property; except that * * *.

The exceptions stated are not applicable in these proceedings. The basis is "cost."

We must assume that Congress used the term "cost" in its commonly understood meaning as the amount of money which a man pays out in the acquisition of property. This is especially true where a man keeps his accounts and makes his returns, as did the petitioner, on a cash receipts and disbursements basis.

That the term "cost" ordinarily has this meaning is instanced by a supplemental stipulation of facts filed with this Board in these proceedings on July 21, 1936, a few days after hearing evidence in the case. Such supplemental stipulation reads as follows:

It is hereby stipulated by and between the parties hereto by their respective counsel, that if the Board finds that the petitioner is entitled to use values at dates of acquisition instead of cost for such of the stocks of J. C. Penney Company, sold in 1930 and 1931 as are involved herein, there is a loss from the sales of J. C. Penney Company stocks, including the shares herein involved, of $2,924.34 for the year 1930, and for 1931 there is a profit of $20,101.73, instead of profits of $79,584.34 and $214,774.25 for said years respectively, as determined by the respondent on the basis of cost; and if the Board finds that the basis to be used for the stocks of J. C. Penney Company involved herein is cost, then the profits from the sales of all J. C. Penney Company stocks, including the shares herein involved, are in the amounts determined by the Commissioner.

Of course, the Board in these proceedings must use "cost" as the basis; for that is the basis laid down by the statute. What the parties intended to stipulate as cost in the above stipulation was the amount paid by the petitioner to the J. C. Penney Co. for the shares. This amount was different from the fair market value.

Where property is acquired at a bargain price the amount paid therefor, nevertheless, represents the cost. ; ; ; .

Where shares of stock are received as compensation for services they must be included in gross income at their fair market value in the year when received; for the statute requires that there shall be included in gross income: "gains, profits, and income derived from salaries, wages, or compensation for personal services, of whatever kind and in whatever form paid." (sec. 22(a), Revenue Act of 1928.) ; ; ; certiorari denied, . It has also been held that, where a man as a part of his compensation is permitted to purchase stock from his employer at a price below the market and the employer takes as a deduction from gross income as an ordinary and necessary expense the differential between the fair market value of the stock and the cost of the stock to the employer, the amount of the differential is income to the petitioner in the year in which the stock was acquired. , and cases cited therein. In all such cases the cost to the taxpayer of the shares acquired is the fair market value of the shares. The taxpayer, being in such a case taxed upon the differential in the year of the acquisition of the stock, is not to be taxed again upon the differential in the year of sale; for it must be assumed that it was not the intention of Congress that the taxpayer should be taxed twice in respect of the same income. This is in accordance with the Commissioner's regulations. Thus, in article 51 of Regulations 74, promulgated under the provisions of the Revenue Act of 1928, the respondent has made the following regulation under "What included in gross income":

Where property is sold by a corporation to a shareholder, or by an employer to an employee, for an amount substantially less than its fair market value, such shareholder of the corporation or such employee shall include in gross income the difference between the amount paid for the property and the amount of its fair market value. In computing the gain or loss from the subsequent sale of such property its cost shall be deemed to be its fair market value at the date of acquisition by the shareholder or the employee. * * *

From the position of this article in Regulations 74 there can be no doubt that it was the intention of the Commissioner to permit the addition to the cost basis prescribed by the statute of the differential only in a case where the taxpayer was taxed upon the differential in the year in which the shares were acquired. This is the interpretation placed upon the regulation in , which we think is the correct interpretation.

The contentions of the petitioner upon this point derive some support from , and . In both of these cases the taxpayers were permitted to purchase shares of stock at less than their fair market value. In the years in which they acquired the shares they did not report as income and were not taxed upon the differential between the amounts paid for the shares and their fair market value. Both courts held, however, reversing the Board, that upon a sale of their shares in later years the cost basis prescribed by the statute was not merely the outlay of cash made by the taxpayers in acquiring the stocks, but such amounts plus the differential. In the Salvage case it appeared that Salvage was permitted to acquire shares of Viscose Co. stock at a price of $100 per share when the fair market value of each share was $1,164.70. Under the contract by which he was permitted to acquire such shares the taxpayer agreed that he would not engage at any time throughout his life in any competing business without the company's consent. The court held that that was a valuable consideration and served to enhance the cost basis prescribed by the statute. The court relied upon article 31 of Regulations 65, which is identical with article 51 of Regulations 74 to the extent quoted above, and interpreted that regulation to give the taxpayer a stepped-up basis regardless of whether the taxpayer was taxed upon the differential in the year when the shares were acquired or not. In this particular the court's opinion is in conflict with the opinion of the United States Circuit Court of Appeals for the Tenth Circuit in the Farren case.

The Government argued before the Circuit Court of Appeals for the Second Circuit in the Salvage case that the taxpayer was estopped to use a stepped-up basis upon the sale of the shares in 1929 because he had not returned as income the amount of the differential in his income tax return for 1922, the year in which the shares were acquired. In its opinion the Board did not base its holding upon the ground of estoppel and, indeed, did not refer to it. The court's decision in the Salvage case was affirmed by the Supreme Court in . Apparently the only question before the Supreme Court on the Government's application for a writ of certiorari was whether the taxpayer was estopped to claim that the difference between the fair market value of the shares acquired in 1922 and the amount paid for the shares should be added to the cash paid by Salvage for the shares in determining the cost basis. Upon this point the Supreme Court stated:

We find no reason to disagree with the judgment of the court.

The defense of estoppel was not before the Board. Under what we regard as the correct practice, S.Ct. 185, 80 L.Ed. , decided December 9, 1935, the court should have passed the point. Furthermore, the facts disclosed give it no support.

Manifestly, the Supreme Court did not pass upon the question as to whether the cost to Salvage of his shares was the amount of cash which he paid for them or their fair market value at the date of acquisition.

In , the respondent pleaded estoppel as he has done in these proceedings and the plea was sustained upon the authority of ;; ; ; ; and . A writ of certiorari was granted by the Supreme Court in the Farren case, but the proceeding was dismissed by the Supreme Court on stipulation of counsel on October 26, 1936, . In view of the statement made by the Supreme Court in the Salvage case that the facts disclosed by that case gave no support to the doctrine of estoppel, it is doubtful whether the plea is good in these proceedings.

The Board is of the opinion, however, that the cost to the petitioner of the J. C. Penney Co. shares sold during the taxable year, but purchased in 1928 and 1929, was the amounts of cash paid for the shares, and that the petitioner is not entitled to any stepped-up basis on the theory that the differential between the amount paid for the shares and their fair market value was paid to him as compensation for services. They were not so understood either by the J. C. Penney Co. or the petitioner. The interpretation placed upon the contracts by the parties thereto is of great importance.

The facts in these proceedings clearly show that the petitioner had an option to purchase the shares of stock at prices to be fixed by the company. He was under no compulsion to exercise the option. The actual amount he paid for the shares is not open to dispute. His out-of-pocket cost of the shares was the amounts cash which he paid for them and nothing more. If the term "cost" is to be given the connotation which we believe was intended by Congress and by the Commissioner's regulations, the amounts of cash paid out for the shares is the total cost basis.

In , it was held that where the company's contract entitled the employee to buy 500 shares of stock at an agreed price and obligated the company to allow credits on the purchase price equal to dividends on 500 shares, and if after seven years the credits did not equal the purchase price, the company was nevertheless to deliver 100 shares, and if three years thereafter the credit still did not equal the purchase price of the remaining stock the company would deliver 150 additional shares, and did deliver the 150 shares during the taxable year, the taxable gain realized by the employee upon the receipt of such 150 shares was the amount of the credits made to the employee on the agreed purchase price of the 150 shares, and that the difference between the agreed purchase price and the fair market value of those shares was not income of the taxpayer because it was not a realized gain. Upon the principle announced in that case we think it would have to be held in this case that the excess of the fair market value over the agreed price was not compensation paid for services in the year when the shares were acquired. The determination in a given case must be made upon the facts present in the case. We are of the opinion that the facts which obtain in these proceedings do not warrant a conclusion that the cost basis laid down by the statute is any other than the amount of cash which the petitioner paid for his shares in 1928 and 1929.

The second question presented is whether the petitioner sustained a deductible loss in either 1930 or 1931 by reason of his transactions with E. E. Pratt. The certificate which the decedent received from the Master Holding Corporation, Ltd., in 1930, was void, since it was not issued in accordance with the permit which had been granted to the company for the sale of stock by the Department of Investment, Division of Corporations of the State of California. See ; ; ; . In , it was stated:

* * * the shares of stock of Master Holding Corporation that had been issued to her [plaintiff] were null and void, [the lower court] finding that they had been issued in violation of the terms of the permit, in that no sale of "Master" stock had taken place, but merely a transfer of stock of Guardian Holding Corporation.

The petitioner's tax returns for 1930 and 1931 were made upon a cash receipts and disbursements basis. Although he gave a promissory note to Pratt in 1930 in the amount of $50,000, he made no payment upon the note in that year. He can not, therefore, claim that he sustained any deductible loss in 1930.

Although in his income tax return for 1931 the petitioner did not claim any loss in respect of his payments of $30,803 on the note to Pratt in that year, he has made such claim in his petition in Docket No. 76507. The respondent contends that the petitioner is not entitled to claim a deduction for this loss in 1931, upon the ground that the petitioner did not learn that his certificate for the shares of stock was worthless until 1932 and that shortly thereafter he brought suit against Pratt and others for the recovery of the amount paid and the return of the promissory note, upon which a balance was still owing. His contention is that the petitioner can not take a loss until he can prove that he can not recover from Pratt.

We are of the opinion that there is no merit in this contention. The possibility of recovery from Pratt is too remote to warrant the postponement of the taking of the claimed loss. See , where the court held that a general building contractor's claim against defaulting subcontractors for damages in the amount by which the cost of completing their work exceeded the amount received by the general contractor was too contingent to be considered compensation for loss already realized by the taxpayer within the statute authorizing the deduction of losses not "compensated for by insurance or otherwise." Cf. , and cases therein relied upon.

The question of when a loss is sustained by a taxpayer is a question of fact. Because a taxpayer may in a subsequent year recoup a part of the loss is no ground for denying the deduction of the loss in a year when all the surrounding and attendant circumstances indicate a loss has been sustained. . The plain facts are that the petitioner in 1931 paid $30,803 for shares of stock that were unlawfully issued and had no legal status. The amount paid was lost, we think, in 1931.

The facts in these proceedings upon the point in issue are similar to those which obtained in Miniger v. Denman, Fed.Supp. (U.S. Dist. Ct. No. Dist. Ohio). There the plaintiff owned stock which he had paid for in part by giving his demand note payable in 60 days. The court held "that to the extent that the purchase price of said stock is represented by said note, the loss thereon is properly deductible not at the time the stock became worthless, but at the time of payment of said note, if, when and to the extent that said note shall be paid." See also .

In , it was held that, where one party had to make good the defalcation of another party, he was entitled to the deduction only in the year in which he actually paid the money, and not in the year when he discovered the loss.

In , it was held that a taxpayer who in 1921 suffered a loss by fire which was not covered by insurance and recovered judgment for damages for a part of the loss, which judgment was reversed by the State Supreme Court in 1925, was not entitled to deduct such loss for 1925, since the entire deduction occurred in the year 1921, which was the only year in which the loss could be taken.

The petitioner is entitled to the deduction from gross income of 1931 of $30,803 representing the payment made on his note in that year. Any amount recovered by him in subsequent years will be taxable in the year in which the recovery is made.

Reviewed by the Board.

Judgment will be entered under Rule 50.

ARUNDELL, VAN FOSSAN, TURNER, ARNOLD, and DISNEY concur only in the result.

LEECH dissents on the first point.