Sisto Financial Corp. v. Commissioner , 47 B.T.A. 425 ( 1942 )

SISTO FINANCIAL CORPORATION, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.

Sisto Financial Corp. v. Commissioner

Docket No. 105982.

United States Board of Tax Appeals

47 B.T.A. 425; 1942 BTA LEXIS 692;

August 4, 1942, Promulgated

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1. Neither a six-month corporate promissory note, secured by a mortgage and other collateral, nor demand notes are "securities" within the meaning of section 112(b)(3) of the Revenue Act of 1936, even though the holder of these notes was a heavy stockholder of the maker and, in fact, controlled it.

2. Such notes here merely evidence a creditor-debtor relationship between the maker of the notes and the owner so that when the maker satisfied such notes by the transfer of stock owned by the maker in another corporation no exchange giving rise to gain or loss occurred under section 112 of the same revenue act.

Robert C. Vincent, Esq., and Albert E. Hadlock, Jr., Esq., for the petitioner.

J. C. Maddox, Esq., for the respondent.

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LEECH

Respondent determined deficiencies in income and excess profits taxes for the calendar year 1936 in the respective amounts of $57,154.03 and $14,688.48. The principal issue is whether petitioner realized taxable gain on the receipt of 159,899 shares of stock of the Barium Stainless Steel Corporation in 1936, in satisfaction of an indebtedness due it aggregating $242,389, including principal and interest. A subordinate issue involves the petitioner's right to deduct the amount of an alleged loss on the sale of stock.

The proceeding was submitted on a stipulation, including a number of exhibits, together with oral testimony. The facts as stipulated are hereby found. We mention herein only such facts as are deemed necessary in view of our conclusion.

FINDINGS OF FACT.

The petitioner is a corporation organized under the laws of the State of New York, with its principal place of business in New York City. Its return for the calendar year 1936 was filed with the collector of internal revenue at New York City. At all times material hereto the petitioner was engaged in the business of investing its funds in securities.

The Barium Steel Corporation (hereinafter called Barium) was a corporation organized under the laws of the State of Ohio on August 3, 1933. It was engaged from 1933 to 1936 principally in carrying on experimental research and the installation of equipment for the manufacture of stainless and other high grade alloy steels. On August 31, 1936, it transferred all its assets and business to the Barium Stainless Steel Corporation (hereinafter called Stainless), as hereinafter more fully set forth.

Stainless is a corporation organized under the laws of the State of Delaware on August 15, 1936, which thereafter has been engaged in the business of producing stainless and other high grade alloy steels.

Petitioner was on the accrual and calendar year bases for Federal income tax purposes for the taxable year 1936.

During the period in controversy, petitioner, Barium, Stainless, and J. A. Sisto & Co. were in fact dominated and controlled by J. A. Sisto.

In 1934 petitioner purchased from J. A. Sisto & Co. for $23,829.77 demand 6 percent promissory notes in that principal amount made by Barium to J. A. Sisto & Co. for cash advances. In 1934 petitioner advanced $50,000 to Barium in return for its 6 percent promissory notes in that principal amount due in six months or less, secured by a second mortgage and other collateral. Petitioner made additional advances from time to time to Barium aggregating $148,491.99, for which it gave petitioner its demand 6 percent promissory notes in that principal amount. The total principal amount of all those notes was $222,321.76. These were all the notes held by petitioner for its own account on July 31, 1936, the date of the balance sheet of Barium used as the basis for the reorganization hereinafter referred to. Nothing had ever been paid on account of principal. The interest on all these notes was never paid and the interest thus in arrears aggregated $20,067.24 on July 31, 1936. In addition, petitioner had advanced to Barium for the account of J. A. Sisto personally $1,600, for which petitioner had received a 6 percent demand promissory note of Barium in the same amount. This note was on July 31, 1936, and thereafter held by petitioner for J. A. Sisto. The accrued interest on such note also unpaid amounted to $52 on July 31, 1936, making a total due on that note of $1,652. The books of Barium at July 31, 1936, showed a total indebtedness to petitioner for principal of and interest on notes of $244,041, $242,389 of which was on notes held by petitioner for its own account and $1,652 of which was on the note held by petitioner for the account of J. A. Sisto personally.

In accordance with the specific conditions of an offer and acceptance to which petitioner agreed, Barium on August 3, 1936, transferred all its assets and business to Stainless, subject to a purchase money mortgage to the Canton Steel Products, Inc., for a principal amount of $115,000, as previously reduced, but free of liability on the notes held by petitioner; and Stainless assumed all obligations of Barium except obligations to petitioner and certain obligations for services which were satisfied by Barium out of the stock it received for the transfer of its assets. Such transfer of assets and assumption of obligations were effected on August 31, 1936. In exchange for these assets, Stainless issued to Barium 232,400 shares of its voting common stock of $1 par value per share, these shares thereupon being all the capital stock of Stainless issued and outstanding. Barium then distributed this stock as follows:

24,900 shares to all holders of class A common stock of Barium, except Canton Steel Products, Inc., as hereinafter noted, on the basis of 15 shares of Stainless common stock for 1 share of Barium class A stock

14,000 shares to the class B common stockholders of Barium on a share for share basis

5,000 shares to C. F. Norsworthy and

7,500 shares to W. L. Woodward on account of management services rendered by them to Barium theretofore unpaid for

20,000 shares to J. A. Sisto & Co. on account of services rendered Barium in connection with the development of such corporation, the proposed sale of its assets to the issuer, etc.

161,000 shares to petitioner in consideration of its waiving of its mortgage and claim against Barium totaling $244,041 and consenting to the sale and transfer of the assets of Barium to Stainless. Of these 161,000 shares distributed to petitioner, 1,101 shares were allocated to the $1,600 note of Barium held by petitioner for J. A. Sisto personally and the $52 interest thereon in arrears, and these shares were turned over by petitioner to him, leaving 159,899 shares allocated to the $222,321.76 principal of notes held by petitioner for its own account and the $20,067.24 interest in arrears thereon.

At the time of the distribution by Barium of the 232,400 shares of Stainless as hereinbefore set out, there were outstanding:

1,910 shares of class A common stock of Barium out of 6,000 authorized. 625 of such 1,910 shares were held by or on behalf of the petitioner. 250 of said 1,910 shares were held by or on behalf of Canton Steel Products, Inc., purchase money mortgagee, which surrendered them without exchanging them for Stainless common stock. Each class A share was preferred as to assets in event of liquidation to the extent of $45 per share.

14,000 shares of class B common stock of Barium out of 20,000 shares authorized. 8,745 of these 14,000 shares were held by or on behalf of the petitioner.

Of the 159,899 shares of Stainless common stock, of a par value of $1, which petitioner received in 1936 in satisfaction of the Barium notes for $242,389, which petitioner owned for its own account, 32,879 shares were disposed of by petitioner from September 25 to the end of the year 1936, as follows: From September 25 to September 30 of that year it sold 29,000 shares at $3 1/8 per share; on October 14 of that year it conveyed 500 shares to one Robert Laffern in compensation for valuable services he had rendered to petitioner; on November 16 of that year petitioner sold 1,000 shares to one Frank E. Gibson at a price of $1 per share, which was below cost and below its then fair market price. This sale was made at this price to compensate Gibson for rendering valuable services to petitioner. In December of the same year petitioner sold 2,379 shares at $4 per share.

In its return for the taxable year 1936 petitioner reported each of those 1936 transactions involving its Stainless stock, using as a basis for each such share in its hands 242,389/159,899 or $1.516. In so doing it reported gains on all but the November transaction, in which it reported a loss of the difference between its cost and the price at which it was sold to Gibson.

OPINION.

LEECH: In its income tax return for 1936, the petitioner treated the transaction in which it received Stainless stock from Barium in satisfaction of Barium notes held by the taxpayer, as an exchange of securities for stock in a nontaxable reorganization under section 112(b)(3) of the Revenue Act of 1936. Consistent with this treatment it then reported capital gain on its disposition of that Stainless stock in 1936, using as a basis its cost of the Barium notes. Respondent, in his deficiency notice, determined that the Stainless stock disposed of by petitioner in 1936 was not received by it in a nontaxable reorganization but in a taxable exchange of property, in the form of Barium notes for Stainless stock, under section 112(a) of the same act. He then valued the Stainless stock at $3 per share when received by the petitioner, and computed the taxable gain to petitioner on such exchange in the amount of the difference between the cost to petitioner of the notes and the aggregate value, at $3 per share, of the Stainless stock received by the petitioner in satisfaction thereof. Thus computed, this gain was $237,308. Accordingly, he then used the basis of $3 per share for the Stainless stock in computing petitioner's gain on the disposition of part of such stock in the taxable year, and reduced the returned gain accordingly.

Here both parties maintain their original positions except that petitioner alternatively contends that the fair market value of the Stainless stock when received by it was not $3 per share, as determined by respondent, but was no greater than its cost of the satisfied Barium notes.

The principal argument of respondent is that the notes of Barium owned by petitioner were not "securities" within the meaning of section 112(b)(3), supra. He says Barium's financing evidenced by these demand and short term promissory notes "was current, not permanent. * * * Petitioner's ownership of the notes gave it no interest in the assets of Barium. * * * It [Barium] thus used the medium of the common stock of the new company [Stainless] to collect a debt never intended as anything other than current financing of an enterprise to be paid immediately when that enterprise was in receipt of funds. * * * They [the short term and demand promissory notes of Barium] were evidence of indebtedness but they were hardly securities."

We agree. Admittedly petitioner was a stockholder in Barium. Nevertheless, its position here must rest alone on the character of the notes of Barium which it held. ; affd., ; certiorari denied, . Cf. ; . The six-month promissory note of $50,000 secured by a second mortgage and other collateral, as well as the demand notes of Barium owned by petitioner, were evidences only of current financing for operating expenses. The loans evidenced by these notes gave petitioner no proprietary interest in Barium. By virtue of such loans petitioner became a mere creditor of Barium and the evidencing notes are not "securities" within the meaning of section 112(b)(3), supra. See also ; ; certiorari denied, ; .

Petitioner relies heavily on ; certiorari denied, . In that case, however, the notes involved were for 10 years and were issued under such circumstances as to be characteristically equivalent to bonds which were refinanced with the notes. The other cases cited by petitioner are even more readily distinguishable.

Respondent also argues that section 112(b)(3) does not apply here for another reason. He says there was no exchange of the Barium notes for stock and securities since Barium merely satisfied its own indebtedness to petitioner. Nevertheless, in spite of this position, respondent's conclusion is that the satisfaction of Barium's notes to petitioner by Barium's transfer of its Stainless stock to petitioner, constituted an exchange taxable under section 112(a), supra. We think this conclusion is an obvious non sequitur.

J. A. Sisto in fact dominated and controlled the affairs of the partnership of J. A. Sisto & Co., Barium, Stainless, and petitioner. Nevertheless, as was specifically provided in the negotiations leading up to the transaction, it was actually Barium and not Stainless which contracted to and did satisfy Barium's notes by the transfer of its Stainless stock received by Barium for its assets. Respondent, in effect, concedes this on brief.

We have held that the Barium notes were not "securities" but were mere evidences of Barium's indetedness to petitioner. When Barium transferred its Stainless stock to petitioner in satisfaction of that indebtedness, it simply paid its own debts. There was therefore no more of an exchange within section 112(a) than there was within section 112(b)(3). Barium received nothing. ; ; . Barium simply sold its Stainless stock to petitioner for an amount equal to the indebtedness thus satisfied. ; affd., . Petitioner purchased that stock at a price equal to the amount evidenced by the notes due it from the seller. As was said in our recent decision in , in a comparable situation:

* * * In each case the transaction is treated as if the transferor had sold the assets for cash equivalent to the amount of the debt and had applied the cash to the payment of the debt. * * *

See also ; ; . In view of this conclusion the question of fair market value of the Stainless stock when received by the taxpayer from Barium has not been considered.

Petitioner in returning its net income for 1936 reported gain on three of its transfers in that year of Stainless stock thus received. It claimed a loss on the other transfer. In the computation of that gain and loss petitioner used $1.516 as its basis per share. This amount was the cost to petitioner of the Barium notes plus accrued unpaid interest, allocated equally to the Stainless shares thus received. That basis was correct. But we have held that petitioner did not receive these shares in a nontaxable exchange in August 1936 under section 112(b)(3) of the Revenue Act of 1936, as it contends, but that petitioner purchased them at that time. Therefore all, instead of part of the gain, is taxable since the stock sold had been held for less than a year.

In reference to the secondary issue, petitioner sold 1,000 shares of its Stainless stock received in connection with the satisfaction of the Barium notes in the taxable year at $1 per share, which was then below its fair market value and $546.29 below its cost to petitioner. Petitioner made this sale at this price to an individual in compensation for valuable business services rendered to the petitioner. On its Federal income tax return for 1936 petitioner deducted as a loss the difference between its cost and the selling price of this stock under section 23(f) of the Revenue Act of 1936. In the determination of the deficiency respondent denied the deduction of this loss. In its petition initiating this proceeding petitioner not only assigns error in that action, but alternatively claims the right to deduct this amount as a business expense under section 23(a) of that act. Obviously, it is not deductible as a loss because it was paid for services. ; ; ; . But, since no question has been raised as to its reasonableness, we think it is deductible as compensation under the same statutory provision.

Decision will be entered under Rule 50.