Nugent-Head Trust v. Commissioner , 17 T.C. 817 ( 1951 )

Marie W. F. Nugent-Head Trust, S. Griswold Flagg and The Pennsylvania Company for Banking and Trusts, Trustees, Petitioners, v. Commissioner of Internal Revenue, Respondent

Nugent-Head Trust v. Commissioner

Docket No. 29799

United States Tax Court

17 T.C. 817; 1951 U.S. Tax Ct. LEXIS 36;

November 26, 1951, Promulgated

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Decision will be entered under Rule 50.

Petitioners held 6 per cent cumulative preferred stock in a corporation as part of the corpus of a trust. During the taxable years, the corporation redeemed part of such preferred stock in order to reduce the annual liability arising from dividends thereon. Held, the money received from such redemptions is taxable as capital gain and not as ordinary income since the payments were not made at such time and in such manner as to be essentially equivalent to taxable dividends.

C. Walter Randall, Jr., Esq., for the petitioners.

William H. Best, Jr., Esq., for the respondent.

Rice, Judge.

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RICE

The respondent determined income tax deficiencies for the years 1945, 1947, and 1948 in the amounts of $ 56,559.62, $ 51,910.67, and $ 53,812.36, respectively. At the hearing it was orally stipulated that there is no deficiency in income tax for the taxable year 1948. Other adjustments relating to the taxable years 1945 and 1947 are set forth in the stipulations of facts.

The sole issue for our determination is whether certain payments made by a corporation in partial redemption of preferred stock held by petitioners were made at such time and in such manner as to be essentially equivalent to taxable dividends under section 115(g) of the Internal Revenue Code.

Some of the facts were stipulated.

FINDINGS OF FACT.

The stipulated facts are so found and are incorporated herein.

The petitioners are the duly qualified trustees of a testamentary trust created under the will of Stanley Griswold Flagg, Jr. (hereinafter referred to as Stanley), who died in 1934. Stanley G. Flagg & Co., Inc. (hereinafter referred to as the Corporation), was founded by Stanley G. Flagg in 1854 and is engaged in the manufacture of fittings and other products for the plumbing trade. It was operated as a sole proprietorship for many years and later as a partnership with Stanley (whose will created the trust here in question) and his son, S. Griswold Flagg III (one of the trustees herein; and hereinafter referred to as Griswold), as partners. The business was incorporated in 1922 under the laws of Pennsylvania, at which time the partners exchanged their interests in the business for capital stock. In 1934, immediately prior to the death of Stanley, the Corporation had outstanding 13,000 shares of common stock and 17,137 shares of $ 100 par cumulative 6 per cent preferred stock held as follows:

Common Stock	Shares
Stanley G. Flagg, Jr	7,990
S. Griswold Flagg, III (son of Stanley G. Flagg, Jr.)	5,000
S. Griswold Flagg, IV (grandson of Stanley G. Flagg, Jr.)	10
Total	13,000
Preferred Stock	Shares
Stanley G. Flagg, Jr	14,989
S. Griswold Flagg, III (son of Stanley G. Flagg, Jr.)	1,973
Estate of Elizabeth W. Flagg (deceased wife of Stanley G. Flagg, Jr.)	175
Total	17,137

By his will Stanley bequeathed all of the common stock owned by him and 7,494 shares of the preferred stock owned by him to Griswold. The remaining 7,495 shares of preferred stock owned by him at the time of his death were, together with other miscellaneous securities and cash then valued at $ 38,129.59, bequeathed to the trustees herein in trust, the income therefrom to be paid to the testator's daughter, Mrs. Marie W. F. Nugent-Head (hereinafter referred to as Marie), for life with succeeding life estates to her children in equal shares and remainders as they might appoint by will or, in default thereof, to their heirs. The stock has a cost basis of $ 61.74 per share in the hands of petitioners.

The 175 shares of preferred stock which were held by the estate of Elizabeth W. Flagg, deceased, at the time of the death of Stanley, were purchased by the Corporation in small lots between May 1935, and April 1943, and held in its treasury until January 24, 1945, when they were canceled by the Corporation.

By December 31, 1935, the Corporation was in arrears in the payment of dividends on its 6 per cent cumulative preferred stock in the amount of approximately $ 312,565. No dividends had been paid on its common stock since 1932 when it paid a dividend of $ 1.50 per share. Thereafter it paid no dividends on its common stock until 1945. By December 31, 1940, the Corporation was in arrears in payment of dividends on its preferred stock in the amount of approximately $ 438,000. The Corporation began paying off the arrearages in dividends on its preferred stock in 1941, and by the close of 1944 had paid all such arrearages.

At a special meeting of the board of directors of the Corporation on January 24, 1945, it was resolved to call 1,962 shares of the preferred stock for redemption on April 2, 1945, at $ 105 per share as provided in the stock certificate. Redemption was to be pro rata among the preferred stockholders as per the books of the Corporation on February 20, 1945. Such holdings at that time were as follows:

Shareholder	Common	Preferred
	Shares	Shares
S. Griswold Flagg III	8,500	8,927
S. Griswold Flagg IV Trust	1,990	180
David H. K. Flagg Trust	2,000	180
Dorothy Mary Flagg Trust	500	180
S. Griswold Flagg IV	10	0
Marie W. F. Nugent-Head Trust	0	7,495

Such redemption took place on April 2, 1945, as follows:

	Shares redeemed
Shareholder		Cash paid
S. Griswold Flagg III	1,032	$ 108,360
S. Griswold Flagg IV Trust	21	2,205
David H. K. Flagg Trust	21	2,205
Dorothy Mary Flagg Trust	21	2,205
Marie W. F. Nugent-Head Trust	867	91,035
Total	1,962	$ 206,010

On July 11, 1945, the petitioners filed their first account as trustees with the Orphans' Court of Delaware County, Pennsylvania, accounting for the gain which they had received on the redemption of such preferred stock and claimed the entire amount received as a principal item. On August 13, 1945, Marie wrote to Griswold objecting to the redemption of the 867 shares of preferred stock held in trust by petitioners, but no formal objection on her behalf was made at the audit of the first account of the trustees which was approved by the court and confirmed absolutely on January 18, 1946.

In the years 1945, 1946, and 1947, the Corporation paid dividends on its common stock in the amounts of $ 1, $ 7, and $ 20, respectively.

At the special meeting of the board of directors of the Corporation on November 12, 1946, it was resolved to call 2,000 shares of the preferred stock for redemption on January 2, 1947, at $ 105 per share, redemption to be pro rata in proportion to the respective holdings on the books of the Corporation as of November 23, 1946, which were as follows:

Shareholder	Common	Preferred
	Shares	Shares
S. Griswold Flagg III	8,500	7,895
S. Griswold Flagg IV Trust	1,990	159
David H. K. Flagg Trust	2,000	159
Dorothy Mary Flagg Trust	500	159
S. Griswold Flagg IV	10	0
Marie W. F. Nugent-Head Trust	0	6,628

Such redemption occurred on January 2, 1947, as follows:

	Shares
Shareholder	redeemed	Cash paid
S. Griswold Flagg III	1,053	$ 110,565
S. Griswold Flagg IV Trust	21	2,205
David H. K. Flagg Trust	21	2,205
Dorothy Mary Flagg Trust	21	2,205
Marie W. F. Nugent-Head Trust	884	92,820
Total	2,000	$ 210,000

Petitioners advised Marie's attorneys on November 14, 1946, that 884 shares of preferred stock held by them were to be redeemed in January 1947. By letter dated December 23, 1946, mailed to her attorney, Marie questioned whether the petitioners were acting in her best interest in not objecting to this second redemption call.

In January 1947, the authorized number of shares of preferred stock was reduced to 15,863 shares, all other provisions of the stock certificates remaining the same.

At a special meeting of the Board of Directors of the Corporation on October 21, 1947, it was resolved to call 2,000 shares of the preferred stock for redemption on January 2, 1948, at $ 105 per share, redemption to be pro rata. Petitioners advised Marie's attorney of the action of the Board on the same day.

On November 25, 1947, a petition was filed in the Orphans' Court of Delaware County on Marie's behalf calling for a citation to account, and a decree was filed ordering petitioners to show cause why they should not file an account. A temporary restraining order was entered enjoining the petitioners from surrendering for redemption or sale or otherwise disposing of the stock of the Corporation then held by them as trustees or otherwise. On December 10, 1947, petitioners filed their answer with the court, and on the same day filed their second account. Exceptions to such account were filed on February 3, 1948, on behalf of Marie and her two daughters, the succeeding life tenants.

On January 2, 1948, the Corporation placed the call money in escrow, and noted the cancellation of 2,000 shares of preferred stock on its books. Litigation continued in regard to the second account until 1950. On May 22, 1950, the Supreme Court of Pennsylvania reversed a decree of the Orphans' Court of September 22, 1948, making permanent its restraining order in Marie's favor; and on August 5, 1950, the Orphans' Court, in conformity with that opinion, entered its decree dismissing the life tenants' exceptions to the account but retaining jurisdiction as to the attorneys' fees for the trustees and the amount of compensation to be paid the trustees, and confirming the account as filed in all other respects.

The earnings and profits of the Corporation, accumulated after March 1913, as of the close of each of the years 1945 and 1947 were in excess of the amounts paid out by the Corporation in each of those years upon the redemption and cancellation of the shares of the called preferred stock. In all the redemptions of such stock, there was a reduction in the stated capital of the Corporation in the amount of $ 100 per share and of surplus in the amount of $ 5 per share.

The preferred stock certificates provided, in part, as follows:

All or any part of the Preferred Stock may, by a majority vote of the Board of Directors, be redeemed at any dividend period after its issue upon thirty days notice at the price of One Hundred and Five Dollars ($ 105) per share, together with all dividends accumulated and unpaid thereon. In the event that less than the whole amount of Preferred Stock outstanding is to be redeemed, the shares to be called for redemption shall be determined either pro rata or by lot, as may be determined by the Board of Directors and in such manner as they may determine. The rights, privileges, terms and conditions of the Preferred Stock issued and outstanding shall not be subject to alteration or change without the consent of the holders of at least three-fourths of the Preferred Stock outstanding, given either in writing or by vote in person or by proxy at a meeting duly called for that purpose, nor shall the company, without like consent of the holders of at least three-fourths of the Preferred Stock outstanding create any mortgage, lien or encumbrance of any kind on any part of its assets or authorize the issuance of bonds or notes maturing more than one year from the date thereof, but this prohibition shall not operate to prevent the giving of purchase money mortgages or other purchase money liens on property to be hereafter acquired by the corporation nor the acquisition of property subject to mortgages, liens or, encumbrances thereon existing, nor to the pledging by the corporation as security for loans made to it in the regular and current conduct of its business of any stocks, bonds or other securities owned by it, * * *.

Following Stanley's death in 1934, the Corporation obtained the services, as vice-president, of an individual who had previously had 25 years' experience analyzing capital structures of going businesses. He also became a director of the Corporation at that time. The new vice president, shortly after his employment, discussed at the Corporate meetings the possibility of doing something about the preferred stock, since he felt it was a drag on the company and such stock should be reduced or its dividend rate should be lowered if possible. Since the petitioner trust owned more than 25 per cent of the preferred stock, it was impossible to get a reduction in the dividend rate because the corporate trustee would not consent to any such reduction, nor was the Corporation in any position at that time to redeem part or all of the preferred stock because of the arrearages of the dividends existing which it was unable to pay.

During the War, the Corporation made sufficient profits to begin to pay the dividend arrearages on the preferred stock; and as soon as all such arrearages were paid, put into effect a plan to partially redeem some of the outstanding preferred stock. The details of such redemption have been set forth above.

The corporate trustee of the petitioner trust was agreeable to the redemption since 92 per cent of the trust consisted of such preferred stock, and it felt that a greater diversity of investments for the corpus would be sounder.

The proceeds from the redemption of petitioners' stock, which were received in 1945 and 1947, were not made at such time and in such manner as to be essentially equivalent to taxable dividends to petitioners.

OPINION.

The sole question is whether partial redemptions of petitioners' stock by the Corporation in 1945 and 1947 were made at such time and in such manner as to be essentially equivalent to taxable dividends to this petitioner trust and, therefore, governed by section 115 (g) of the Internal Revenue Code rather than by section 115 (c). ^{William H. Grimditch, 37 B. T. A. 402 (1938).}

It is difficult for us to see how money received by petitioners for the partial redemption of their preferred stock could be "essentially equivalent" to taxable dividends. In order for section 115 (g) to apply, the distribution must be made at a time and in a manner essentially the same as it would have been had the Corporation declared and paid a taxable dividend. The petitioner trust owned only preferred stock in the Corporation, and had never held any common stock. All dividends on preferred stock at the times of redemption were paid up. If the Corporation had declared dividends in lieu of redeeming the preferred stock, such dividends could only have been distributed to the common stockholders because all preferred dividends, including arrearages, were paid up.

As shown by our findings of fact, Marie contested the third redemption in the courts, and it was only after a long battle culminating in the Supreme Court of Pennsylvania that the trust received the money for the third redemption. The purpose prompting the redemptions was the desire of the Corporation's officers and directors to reduce the liability for the 6 per cent cumulative dividends on the preferred stock. Prior to the redemptions, this amounted to over $ 100,000 a year; and during the 1930s, large arrearages (over $ 400,000) had arisen for such dividends. Two of the Corporation's competitors had recapitalized, one under section 77-B of the Bankruptcy Act; and the vice president of the Corporation, as soon as he became employed by it in 1934, began to discuss the possibility of in some manner reducing such an annual liability. It was impossible to decrease the rate of dividends, since the preferred stock certificates called for a 75 per cent approval of preferred stockholders before any reduction in dividends could be made. Petitioner trust held over 25 per cent of such preferred stock, and the corporate trustee, in order to protect the income beneficiaries of the trust, refused to consent to any dividend reduction.

If such redemptions were held to constitute dividends as regards petitioners herein, a peculiar basis question would arise. Petitioners, prior to any redemptions, held 7,495 shares of preferred stock of the Corporation having a basis of $ 462,741.30. If the distributions to petitioners upon the stock redemptions were held to constitute dividends, the cost basis for such redeemed stock would be allocable to the remaining stock, thus increasing the cost basis per share; and, as the amount of stock approached zero, the basis of the stock per share would reach fantastically high values which could never be recovered. William H. Grimditch, 37 B. T. A. 402 (1938), is distinguishable from the instant case. In that case, this tribunal said "* * * in all of the instances referred to, the record owners are the wives of the holders of substantially the same proportion of common stock, which had been turned over to them as gifts shortly before the stock was redeemed." This statement was made in answer to the contention that at the time of redemption some of the preferred stockholders did not own any common stock. In the instant case, there is no such relationship between petitioners and any common stockholder which would be equivalent to one economic unit. See also Stein v. United States (Ct. Cl., 1945), 62 F. Supp. 568">62 F. Supp. 568. What we have said above is limited to the facts of the instant case, and we have not considered the results of the redemptions here under consideration as they affect taxpayers who might have been both common and preferred stockholders. The results need not be identical in all cases. Compare the result in James F. Boyle, 14 T. C. 1382 (1950), affd. (C. A. 3, 1951) 187 F.2d 557">187 F. 2d 557, certiorari denied October 8, 1951, with the result in Carter Tiffany, 1443">16 T. C. 1443 (1951).

Under such circumstances, we hold that respondent erred in his determination that the money received by petitioners in 1945 and 1947 in redemption of the preferred stock of the Corporation was essentially equivalent to taxable dividends.

Decision will be entered under Rule 50.

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Footnotes

• 1. SEC. 115. DISTRIBUTIONS BY CORPORATIONS.

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  (c) Distributions in Liquidation. -- Amounts distributed in complete liquidation of a corporation shall be treated as in full payment in exchange for the stock, and amounts distributed in partial liquidation of a corporation shall be treated as in part or full payment in exchange for the stock. The gain or loss to the distributee resulting from such exchange shall be determined under section 111, but shall be recognized only to the extent provided in section 112. In the case of amounts distributed (whether before January 1, 1939, or on or after such date) in partial liquidation (other than a distribution to which the provisions of subsection (h) of this section are applicable) the part of such distribution which is properly chargeable to capital account shall not be considered a distribution of earnings or profits. * * *.

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  (g) Redemption of Stock. -- If a corporation cancels or redeems its stock (whether or not such stock was issued as a stock dividend) at such time and in such manner as to make the distribution and cancellation or redemption in whole or in part essentially equivalent to the distribution of a taxable dividend, the amount so distributed in redemption or cancellation of the stock, to the extent that it represents a distribution of earnings or profits accumulated after February 28, 1913, shall be treated as a taxable dividend.

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  (i) Definition of Partial Liquidation. -- As used in this section the term "amounts distributed in partial liquidation" means a distribution by a corporation in complete cancellation or redemption of a part of its stock, or one of a series of distributions in complete cancellation or redemption of all or a portion of its stock.↩

• 2. For example, if the Corporation continued calling a certain amount of preferred stock annually (petitioners' preferred stockholdings decreasing to one share), and such redemptions were held to constitute taxable dividends, such share would have a cost basis of $ 462,741.30. Petitioners aptly call this a "disappearing cost basis." This one share could be called by the Corporation at $ 105, and a $ 462,636.30 loss would result since petitioners held no common stock against which such cost basis could be applied.↩