Earl v. Commissioner , 4 T.C. 768 ( 1945 )

Guy C. Earl, Jr., Petitioner, v. Commissioner of Internal Revenue, Respondent

Earl v. Commissioner

Docket No. 582

United States Tax Court

4 T.C. 768; 1945 U.S. Tax Ct. LEXIS 227;

February 13, 1945, Promulgated

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Decision will be entered under Rule 50.

In 1927 petitioner was controlling stockholder and general manager of a newspaper publishing company which organized a separate corporation to operate its radio station. The publishing company and petitioner each acquired stock therein. Later petitioner was married. In 1931 the publishing company got into financial difficulties and all of its stock was sold to new interests. Petitioner acquired the publishing company's stock in the radio corporation from the new owners for a nominal amount, paid with community funds, and developed the station by means of his own efforts. During the period 1931 to 1936 petitioner received only a nominal salary as compensation for his services. In 1936 the station was sold and petitioner made a large profit on his stock. The proceeds were invested and petitioner and his wife reported the income from these investments as community income. Held, that petitioner's control of the publishing company is not sufficient to impute ownership to him of its radio corporation stock and that the stock, having been purchased with community funds subsequent to his marriage, is community property; held, further , that the stock in the radio corporation acquired by petitioner prior to his marriage was his separate property, but that that part of the increase in its value due to uncompensated services of petitioner subsequent to his marriage is community property.

Dana Latham, Esq., for the petitioner.

Byron M. Coon, Esq., and Harold D. Thomas, Esq., for the respondent.

Hill, Judge. Murdock, J., dissenting. Disney and Harron, JJ., agree with this dissent.

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HILL

This proceeding involves income tax deficiencies for the years 1940 and 1941 in the amounts of $ 3,618.52 and $ 1,052.65, respectively. Petitioner and his wife filed separate income tax returns for these years. They divided the income from certain investments and claimed expense deductions from that income on the ground that the investments were a part of their community property. The respondent determined deficiencies in petitioner's tax by adding to his reported income the amount reported by his wife, ruling that the investments and the income therefrom were petitioner's separate property. The question to be decided is the ownership of the investments that produced the income for these years. The correctness of other adjustments made by respondent turns on the ownership of this property.

FINDINGS OF FACT.

Petitioner is a native of California and was married in 1927. He has resided continuously since that time with his wife in the city of Los Angeles. His Federal income tax returns for 1940 and 1941 were filed with the collector of internal revenue for the sixth collection district of California.

Prior to 1927 petitioner was the president, general manager, and controlling stockholder of the Los Angeles Express Publishing Co., which published the Los Angeles Evening Express, a daily newspaper, hereinafter referred to as Express. In 1924 that company's predecessor had begun operating a radio broadcasting station with the call letters KNX. The radio broadcasting business was in its infancy. Petitioner took an active part in the radio station from the very beginning and took a keen interest in attempting to work out the various problems that confronted this new venture.

In 1927 petitioner caused to be organized on behalf of Express a California corporation named the Western Broadcasting Co., hereinafter called Western, to operate the radio station. A separate organization was regarded as desirable by petitioner in order (1) to take advantage of a reassignment about to be made of channels, frequencies, and power for radio broadcasting and (2) to facilitate the raising of working capital for development of the business. Petitioner's associates and fellow stockholders in Express did not share petitioner's enthusiasm over the future of radio and desired that the radio station be operated and financed as a separate entity. Also, the radio business was ready for increased Government regulation and control and petitioner felt that it would receive more favorable treatment if the radio business were conducted separately. At the time Western was organized Express had invested $ 5,986.21 in the radio station. KNX was transferred to Western for 1,500 shares of capital stock of the par value of $ 100. Express retained 760 shares and the balance was sold for cash. Subsequently these shares were deposited by Express with the trustee under a bond issue as an additional security. Prior to his marriage in 1927 petitioner acquired 390 shares of Western as his separate property, at the cost of $ 49,000.

From the very outset Western operated under severe handicaps. There were two other radio stations in the Los Angeles area and in 1928 the Federal Radio Commission forced Western to move its transmitter from Hollywood because of the power of the station Western wished to license. Eventually, the Radio Commission approved a location in the San Fernando Valley and Western commenced operations with a power of 5,000 watts on a national frequency. The hills separating North Hollywood and the San Fernando Valley area from downtown Los Angeles weakened the KNX signal in Los Angeles. As a result local advertisers were not inclined to patronize KNX and the station operated at a loss. Petitioner and Express made up the deficit each year. Western's financial position remained precarious and shaky until 1934.

During the period 1927 to 1931 the radio broadcasting industry generally was at war with the newspaper publishers throughout the country. The radio stations had entered the advertising field and were making appreciable inroads in newspaper revenues from this source. Newspaper advertising and magazine advertising had fallen off in this depression period, but radio advertising had increased. Other newspapers in Los Angeles owning radio stations had disposed of them and by 1931 the Express was the only Los Angeles paper with a radio station affiliate.

In 1929 the Express ranked third in the matter of circulation of the Los Angeles papers. The resulting business depression caused it to be the first to feel the loss of advertising revenues. Advertisers tended to concentrate their expenditures in the larger papers and those newspapers with the smaller circulation were the first to feel the pinch. By late 1930 Express was unable to pay the principal on a $ 1,000,000 bond issue and owed $ 300,000 for newsprint to the Crown Paper Co. Its owners, including petitioner, were faced with the problem of raising new capital or attempting to sell the paper in order to salvage something from their investments. The Crown Paper Co., as the largest creditor, was instrumental in forcing the Express to take steps for a sale. On January 30, 1931, petitioner, as president of Express, had just about concluded a deal for the transfer of the paper to the representatives of the Crown Paper Co. and the bondholders. On that day these creditors and petitioner had arranged for a final meeting the following morning to consummate the deal. A Mr. Salisbury, one of the attorneys for Crown Paper Co. was a friend of petitioner and a neighbor of the attorney for the Hearst interests. On leaving the conference on that day petitioner suggested to Salisbury that he communicate with the Hearst attorney to see if Hearst would be interested in buying the paper for $ 2,000,000 in order to prevent eastern interests from coming into Los Angeles and making the paper a rival of Hearst's Los Angeles paper. Salisbury was promised a commission by petitioner if the deal went through. That evening Hearst's representatives, having received the approval of Hearst, met with petitioner and negotiated for the purchase of all the outstanding stock of Express for the sum of $ 2,000,000, less outstanding liabilities. Lawyers and auditors were called in to prepare the contract and go over the books of account so that the deal could be consummated before the creditors' meeting the following morning. While the contract was being written up and stock options from remaining stockholders of Express were being secured, petitioner asked the Hearst representatives what disposition was to be made of Western stock. He knew that Hearst was one of the leaders of newspaper opposition to the radio business and pointed out that he was going to be out of a job, that he owned several hundred shares of Western stock and would like very much to acquire this stock, stating that, whatever price was paid, Express would benefit by just that much. Western had been losing money and there were continual demands on Express for more money to meet operating expenses. Express owned a membership in the Annandale Country Club which had cost $ 1,000. The membership and Western stock were carried on its books under the item "Stock & Club Membership," with a value of $ 77,000. The club membership was regarded as a definite liability because under local custom it was impossible to resign, and dues and other assessments kept piling up. It was finally agreed that petitioner should have the 760 shares of Western stock for $ 10 on the condition that he take the membership in the country club. Petitioner was not a golfer and the only reason he took the membership was that he could thereby acquire the Western stock. The new owner of Express had no interest in the radio station and felt that it was a losing proposition and a definite liability. The new manager of Express was one of the leaders of newspaper opposition to radio. The Hearst interests were glad to dispose of these assets, which were regarded as worthless. Both of these transactions were completed. The purchase price of $ 10 was paid by petitioner that evening from community funds. The $ 10 was full and complete consideration for the transfer, Western stock having no value in the open market. The 760 shares of Western stock were subsequently transferred to petitioner by the trustee of the bond issue.

During the interval from 1931 to 1936 petitioner devoted all his time and energies to the operations of Western. New and original programs were developed. Power was increased. Petitioner organized a firm to solicit advertising and made a definite bid for its share of the national advertising business, which gradually came its way. By 1936 KNX was one of the leading independent stations in the country. It operated on 50,000 watts, a power reserved for only the largest stations. It had large and loyal audiences for its programs in all the Pacific Coast states. Petitioner's aggressive management and original ideas publicized the activities of KNX and revenues from advertising increased rapidly from year to year. During the period from 1931 to 1934 the business still lost money because of the continuous efforts by petitioner and his staff to enlarge, expand, and improve its programs and service. During 1934 Western earned $ 54,686.55 and in 1935 it earned $ 138,160.13. During this period dividends of $ 1 a share per month were paid.

Prior to 1935 petitioner received no salary from Western for his services. During 1935 and 1936 he received a total of $ 5,500 as compensation, which was not adequate or reasonable. At least one of the executives working with him received as high as $ 35,000 annually, and several others received salaries over $ 10,000. For reasons of his own, he preferred to see his efforts rewarded by an increase in the value of stock rather than by taking money out of the business in the form of compensation for services. This philosophy of petitioner had its origin in his early newspaper days and he carried it over into the radio broadcasting business.

National Broadcasting Co. had an outlet in Los Angeles, but Columbia Broadcasting System, the other major network, had none. In March 1936 petitioner consummated a series of negotiations with Columbia whereby it was agreed that Columbia was to buy all of the outstanding stock in Western for approximately $ 1,200,000. Petitioner owned 1,150 shares of 1,500 and received $ 913,897.59 for his shares.

The money received by petitioner from this sale was invested in properties which produced the income reported by petitioner and his wife in 1940 and 1941 as community property income, which income respondent determined to be petitioner's separate property.

In addition to the 760 shares of Western acquired by petitioner in 1931, he owned 390 shares which were his separate property.

The increase in value of Western's stock from a nominal amount in 1931 to almost $ 800 a share in 1936 was primarily due to petitioner's services and his management of the business. Reasonable compensation for his services during the years 1931 to 1935 would be as follows:

1931	$ 25,000
1932	25,000
1933	35,000
1934	35,000
1935, Jan., Feb., March, 1936	50,000
Total	170,000

OPINION.

In order to decide the single issue presented it is necessary to trace the ownership of the investments which produced the income reported by petitioner and his wife for the years 1940 and 1941. It is solely a question of fact and the legal principles involved are few. The sale of Western stock to Columbia in 1936 produced these investments, and the first question to decide is whether the 760 shares of Western's stock acquired in 1931 were separate or community property and the second is what part, if any, of the proceeds of the sale of the 390 shares acquired before marriage is community property.

Respondent has determined that the 760 shares were petitioner's separate property and that the investments made with the proceeds of the sale to Columbia are petitioner's alone and the income therefrom is taxable to him. Respondent is asking us to hold that the 760 shares acquired by Express in 1927 in exchange for its radio business were in reality the separate property of petitioner and acquired by him prior to his marriage. His argument is ingenious and clever. However, the conclusion is inescapable that respondent is really demanding that we ignore the corporate entity of Express and declare that Express held this stock in trust for petitioner. We see no sound reason for so holding. There is no question here of fraud or tax evasion. The "doctrine of corporate entity fills a useful purpose in business life." . In the case before us it should not be disregarded, and we so hold. It is unnecessary to review the lengthy testimony, much of which we have set out in our findings. We have found that these shares were acquired by petitioner in 1931 for $ 10, paid with community funds, and that at the time $ 10 was a fair price for the stock. Western had lost money since it commenced operations, it was a continuous financial drain on Express. The Hearst interests were hostile to the radio business, along with the other newspaper publishers of the country. They were glad to be rid of Western stock and the Annandale Country Club membership. At the time the deal for the transfer of KNX was worked out on January 30, petitioner was so eager to unload the Express on Hearst that there were no restrictions on its sale. It was only after the deal was made and petitioner had personally received Hearst's approval that he began to negotiate for the stock. At all times prior to sale to petitioner in 1931 title to the stock was in Express. The proceeds of the sale attributable to these shares are community property, and investments made and the income therefrom belong to the community.

The 390 shares owned by petitioner prior to 1931 were his separate property. We have found that some of the increase in value of such stock during the period 1931-1936, prior to the sale to Columbia, was due to petitioner's excellent management and his services. Had he been adequately paid for such services, the total proceeds of the sale to Columbia would have been the separate property of petitioner. ; . Cf. . However, it is conceded that the compensation which petitioner received for such services was grossly inadequate. We have found that the reasonable value thereof for the year 1931 and subsequently through March 1936 aggregated $ 170,000 and that he was paid only $ 5,500. It follows that the unpaid balance of the amount of such reasonable compensation, or $ 164,500, constituted a contribution by the marital community of petitioner and his wife to the increase in value of the entire 1,500 shares of Western's outstanding capital stock realized as gain in the sale to Columbia. That portion of such gain realized on the sale of the 390 shares attributable to the community contribution of $ 164,500 was community property and mathematically is 390/1500 of $ 164,500. The remainder of the realized gain on the sale of the 390 shares was petitioner's separate property.

Since the income with which we are concerned was produced from property purchased with the proceeds of the sale of the stock in question, the proportion of separate and community interest in such income is the same as that obtaining with respect to the proceeds of sale of such stock as hereinabove determined.

Decision will be entered under Rule 50.

MURDOCK

Murdock, J., dissenting: The findings of fact in this case show that the radio corporation stock was practically worthless, or at most worth only a nominal amount, in 1931, so that the separate property which the petitioner had in the 390 shares of stock of that corporation was worth little or nothing at that time. The petitioner devoted all of his time and energies to the operation of the radio corporation from 1931 to 1936. It is found as a fact that the increase in value of the stock from a nominal amount in 1931 to almost $ 800 a share in 1936 was due primarily to the petitioner's services and his management of the business. He was a member of the community during that period. Thus, this increase in value was due primarily to the industry, skill, and activities of the community, and under the community property law of California proceeds of the sale of the 76 percent of the stock of the corporation owned by Earl and his wife would all be community property except that Earl should have returned to him as separate property the value of his 390 shares at the time the community took over management of the property in 1931, plus a reasonable return on that amount, including any natural increase in the value of those shares not due to the activities of the community. This, I think, would be a different amount of separate property than is determined under the majority opinion in this case, in which undue emphasis is placed upon the source of the few dollars representing the cost and value of the shares in 1931.