Montgomery Bldg. Realty Co. v. Commissioner

Montgomery Building Realty Company, Petitioner, v. Commissioner of Internal Revenue, Respondent

Montgomery Bldg. Realty Co. v. Commissioner

Docket No. 6364

United States Tax Court

7 T.C. 417; 1946 U.S. Tax Ct. LEXIS 118;

July 30, 1946, Promulgated

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Decision will be entered under Rule 50.

Property acquired from petitioner's insolvent predecessor in exchange for issuance of all of petitioner's stock to predecessor's unsecured creditors, held, to retain transferor's basis for depreciation in petitioner's hands. Revenue Act of 1934, sec. 113 (a) (7).

Benjamin O. Johnson, Esq., for the petitioner.

F. L. Van Haaften, Esq., for the respondent.

Opper, Judge. Turner, J., dissenting.

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OPPER

This proceeding is brought for a redetermination of deficiencies in income, declared value excess profits, and excess profits tax as follows:

Year	Kind of tax	Deficiency
1940	Income tax	$ 1,881.85
	Declared value excess profits tax	12.92
1941	Income tax	396.94
	Declared value excess profits tax	103.01
	Excess-profits tax	777.75

The primary question is petitioner's basis for depreciation of an office building transferred to it by a predecessor corporation. The excess profits tax questions are initially dependent upon the primary question, solution of which automatically resolves the issue of the credit to which the petitioner is entitled. Petitioner filed its tax returns for the years involved with the collector for the district of South Carolina.

Charges of minor errors are abandoned by petitioner in his brief.

FINDINGS OF FACT.

The case was submitted upon a stipulation of facts. The facts so stipulated are hereby found accordingly. They disclose the following:

Petitioner's predecessor, Montgomery Building, Inc., sometimes referred to as the company, was a South Carolina corporation organized in April 1924 for the purpose of constructing and operating an office building. The original capitalization comprised a $ 600,000 first mortgage bond issue; an issue of $ 375,000 gold coupon notes which was the company's direct obligation; $ 500,000 of common stock, of which $ 377,500 was issued; and $ 500,000 of preferred stock, of which none was issued. Individual guarantees by the eleven original directors of the company supported the first mortgage and the gold coupon notes.

The building, a ten-story office and theatre structure, commenced operations in 1925. Its cost was $ 1,140,086.08, and it was constructed on land costing $ 125,468.50. An additional $ 75,000 was expended for an adjacent parcel of land. The total depreciation charged against the building by Montgomery Building, Inc., to the date of its transfer to petitioner on August 20, 1934, was $ 196,149.66.

The $ 375,000 gold coupon issue was refunded on maturity on May 1, 1930, with similar individual guarantees by the seven directors then surviving.

The operation of the building by Montgomery Building, Inc., was not a financial success, and in no year of its operation was its income sufficient to cover operations, expenses, taxes, and interest. The deficits were made up by the endorser directors. By 1933 they had advanced $ 318,884.03.

By July 1931 the company's financial state was such that a special stockholders' meeting was called for July 17, 1931, to consider a proposed plan for reorganization of the corporation. For lack of a quorum the meeting was adjourned to July 24, 1931, at which time the stockholders went on record as favoring abandonment of their interests on their failure to work out a refinancing plan within six months. A committee of four stockholders was appointed to devise a practical plan of reorganization.

On January 29, 1932, the company directors held a meeting at which it was stated that they were unable to borrow the money necessary for February 1 interest payments, and motions were carried "that the Board of Directors recommend to the stockholders that the Montgomery Building be sold subject to the first and second mortgages," and "that a committee composed of H. L. Bomar, W. S. Montgomery and A. R. Coleman look into the possibility of a general re-finance plan and report back to the Board of Directors as soon as possible."

On March 14, 1932, the stockholders' committee, appointed at the meeting of July 24, 1931, met with the directors and made its report. The report stated that their opinion and recommendation was that the stock in the company was worthless; that the money advanced by the directors be charged off; that a new corporation be organized for the purpose of taking over the building at a sale; that the new corporation have capital stock of $ 50,000, 7 per cent preferred stock, divided into 500 shares of $ 100 each, and 500 shares of no par value common stock; that the present stockholders be given the opportunity to subscribe to the new preferred in proportion as their stock bears to the new issue, or, on their failure to so subscribe, that the directors be given the opportunity to subscribe in proportion to their advances and liability; that the common stock be issued to the seven directors in designated amounts in consideration of their cancellation of the advances made by them to the corporation; that the new corporation should make an offer to the stockholders to take over the building and assume liabilities, including the mortgage and gold notes aggregating $ 849,994.48, that the foregoing should be done to avoid bankruptcy.

At the March 14, 1932, meeting a motion was carried that a meeting of the stockholders be called for the purpose of considering a resolution of the board of directors to sell the property at public or private sale and take steps to the ultimate dissolution of the corporation. A motion was also carried "that the directors approve the general features of a plan for the sale" of the property submitted by the stockholders' committee, and that a copy of the plan be submitted to the stockholders for action at the meeting to be called.

A meeting of the directors on April 11, 1932, unanimously accepted the plan.

The special stockholders' meeting was held April 18, 1932. The notice calling the meeting stated that its purpose was to consider a resolution adopted by the board to sell the property. At the meeting the following resolutions were unanimously passed:

Be It Resolved that the offices [sic] and Directors of the Montgomery Building, Inc. be authorized and empowered, to sell the building and other assets of Montgomery Building Inc, and to execute and deliver a proper deed therefor, either at private or public sale, to any person, or persons, or corporation who will agree to assume the outstanding first and second mortgage indebtedness aggregating approximately $ 849,994.48 and to take such steps as may be necessary looking to the ultimate dissolution [sic] of the corporation and the winding up of its affairs.

Resolved Further that if a new corporation is formed substantially along the lines suggested in the report of the special Stockholders Committee, that the present stockholders of Montgomery Building be given an opportunity to purchase the preferred stock of the new corporation in the same proportion which their present holdings bears to the total outstanding stock of the Montgomery building, said option to purchase to expire in 10 days from the date of this meeting.

On the same day a meeting of the directors was held at which the secretary was directed to give notice to the stockholders of their privilege of subscribing to the preferred stock of the proposed new corporation to be organized for the purpose of taking over the properties. No stockholders exercised the privilege of subscribing to preferred stock in the new corporation.

The company was unable to meet the payment due August 1, 1932, on its first mortgage bonds. Default followed on the refunding gold notes and on bank loans. These defaults delayed reorganization of the company and transfer of its assets to the new corporation as authorized by the stockholders' meeting of April 18, 1932, until suitable arrangements could be made with the holders of the defaulted securities providing for extension of the terms of payment. Under date of August 1, 1933, an extension agreement was entered into with the holders of the 7 per cent refunding gold notes providing for a five-year extension. By its terms it did not become effective until at least 91 per cent of the noteholders deposited their notes with the trustee, which occurred by December 28, 1933.

Under date of December 10, 1933, a notice to the holders of the 7 per cent gold notes informed them "that a plan has been prepared * * * which best preserves the interests of all parties involved." The notice also stated:

The reorganization plan, briefly, is for the First Mortgage holders to extend their issue for a period of ten years with a reduction of interest rate, but with the net income of the building pledged for payment of interest or sinking fund. The endorsers of the Gold Notes and the Estates also bound on these notes will place in the hands of Three Trustees: W. S. Manning, J. C. Evins, and H. M. Cleveland, the assets listed in the accompanying agreement, and these Trustees will have full authority to sell or dispose of these assets for a period of five years, during which time the Gold Noteholders are to receive interest at the rate of 4%. The Second Mortgage also securing your Notes will be extended for five years.

And further, in the notice it was stated:

* * * After the reorganization plan has been carried out, the present Common and Preferred Stocks will be cancelled, as authorized at stockholders' meeting, and new Common Stock consisting of 1,000 shares of no par value will be issued to the endorsers of the Gold Notes. This Common Stock will have full voting power and will be entitled to those rights accruing to all Common stockholders under the laws of South Carolina. None of this new stock is offered for general subscription, but is given to the endorsers in lieu of their cancelling the obligations of the Montgomery Building which they now hold and will be pledged by them with the Trustees for the benefit of the Gold Noteholders.

After the reorganization is completed, there will also be outstanding $ 420,000 First Mortgage 6% Ten Year Sinking Fund Bonds dated August 1, 1933, and due August 1, 1943. The 7% Endorsed Gold Notes due August 1, 1934, will continue to remain outstanding. The mortgage securing them will be extended for a five-year period. The holders of these Notes will receive 4% Five Year Certificates of Beneficial Interest. The Central National Bank, holding $ 38,000 note also signed by the endorsers, will receive a similar certificate.

The financial condition of the company was also set forth in the notice.

In May 1934 an extension agreement was reached with the first mortgage bondholders providing for an extension of 10 years from August 1, 1933, for payment of the remaining outstanding principal balance of $ 420,000.

On August 8, 1934, petitioner was chartered under the laws of the State of South Carolina. The minutes of its first meeting on August 8, 1934, recited the adoption of a resolution "that the Corporation [petitioner] be and it hereby is authorized and empowered to receive from the Montgomery Building, Inc., a deed to all of its property of every nature and description in consideration of the assumption by this corporation of the outstanding first and second [7 percent gold notes] mortgages covering said property, aggregating $ 852,562.89." On August 20, 1934, all of the assets of Montgomery Building, Inc., were transferred to petitioner. The common stock of petitioner consisted of 1,000 shares of no par value, which was issued under date of August 20, 1934, to the 7 endorser directors of the old company. It was divided as follows:

Certificate No.	Shareholder	Shares
1	W. S. Montgomery	207
2	V. M. Montgomery	197
3	R. E. Barnwell	148
4	B. T. Earle	136
5	H. A. Ligon	104
6	H. L. Bomar	104
7	J. N. Cudd	104

Following the transfer of all of its assets to petitioner, the corporate charter of the old company was surrendered and it was dissolved.

In the company's closing journal entries of August 20, 1934, appeared the following:

Deficit Account			199	$ 1,000.00
	Directors Accounts		23		$ 1,000.00
	W. S. Montgomery	$ 235.00
	V. M. Montgomery	227.00
	R. E. Barnwell	217.00
	B. T. Earle	97.00
	H. L. Bomar	77.00
	J. N. Cudd	77.00
	H. A. Ligon	70.00
		1,000.00
To incorporate upon the records the
amount agreed upon as full settlement of
all advances made by the above directors
as per minutes of meeting dated
The advances made by these directors was
credited to P. & L. on December 31, 1933,
journal entry page 27 but this charge was
not then entered.
Montgomery Building Realty Co			195	$ 894,070.72
	Sale of all Assets				$ 894,070.72
To record sale of all assets of the Company
as per minutes of -- -- by which the
purchaser assumes all liabilities
Sundries				894,070.72
	Montgomery Building Realty Co		195		894,070.72
Accounts Payable		$ 8,600.62	69
Accrued Taxes		6,997.54	46
Accrued Interest on Gold
Notes		11,830.00	65
Accrued Interest 1st mtge.
bonds		1,400.00	65
Trustees for note holders		423,767.56	201, 205
First mtge. bond holders		420,000.00	25
First mtge. bond holders int		20,475.00	203
Directors accounts		1,000.00	23
		$ 894,070.72
Closing income and expense accounts to
P. & L. from 1/1/34 thru 8/20/34
Deficit			199	19,507.12
	to
	Profit and Loss		100		19,507.12
Loss for 7 2/3 months (Jan. 1, 1934 thru
August 20, 1934) transferred to deficit
Reserve for depreciation			101	196,149.66
Reserve for doubtful notes			60	2,817.64
Reserve for doubtful accounts			61	5,230.88
Reserve for funds in closed banks			61	2,011.75
Sale of assets (cost of sales)			197	1,185,912.75
	to
	Real Estate		103		1,340,554.58
	Cash on hand				251.38
	Citizens & Southern Bank		75		4,819.48
	State Planters Bank & Trust Co		302		250.35
	Notes Receivable		19		5,300.70
	Accrued interest on notes		65		522.71
	Accounts Receivable		14		14,885.48
	Inventory -- Fuel		140		112.25
	Inventory -- Supplies		136		168.00
	Inventory -- Fixtures		59		276.50
	Unexpired Insurance		10		$ 5,501.83
	Prepaid Salaries		62		100.00
	Receiver -- Central Natl. Bank		300		1,544.84
	Receiver -- Spartan Savings		301		667.02
	Interest deferred -- Certificates of
	Deposit		110		17,167.56
				$ 1,392,122.68	1,392,122.68
Cost value of assets sold to Montgomery
Building Realty Co.
Deficit			199	291,842.03
	to
	Sale of all assets				291,842.03
Loss on sale of assets to the Montgomery
Bldg. Realty Co.
Capital Stock			20	377,500.00
Advances to stock subscriptions			20	610.00
	to
	Deficit				378,110.00
Offsetting capital stock by the amount of
the deficit account at 8/20/34, date of
sale to Montgomery Bldg. Realty Co.

Petitioner's opening journal entries of August 20, 1934, note "Land and Building $ 852,562.89."

Petitioner's opening journal entries also showed directors' accounts of $ 1,000 for the purchase of capital stock as follows:

W. S. Montgomery	$ 235
V. M. Montgomery	227
R. E. Barnwell	217
B. T. Earle	97
H. L. Bomar	$ 77
J. N. Cudd	77
H. A. Ligon	70
Total	1,000

Petitioner's balance sheets for its first period of operations, August 20, 1934, through December 31, 1934, are as follows:

	Aug. 20, 1934	Dec. 31, 1934
Cash	$ 5,321.21	$ 10,428.95
Notes and accounts receivable	12,660.37	15,077.85
Funds in closed banks	200.11	200.11
Inventories	556.75	466.10
Deferred charges	5,601.83	5,148.48
Land	200,468.50	200,468.50
Buildings	652,094.39	652,094.39
Total	876,903.16	883,884.38
Accounts payable	8,600.62	6,977.88
Bond interest	20,475.00	20,475.00
Accrued interest	13,230.00	10,500.00
Accrued taxes and wages	6,997.54	4,058.89
First mortgage	420,000.00	420,000.00
Second mortgage	406,600.00	418,430.00
Depreciation reserve	0	4,709.55
Capital stock	1,000.00	1,000.00
(Deficit)	0	(2,266.94)
Total	876,903.16	883,884.38

Petitioner's bylaws provided that its capital stock of 1,000 shares of no par value would be issued to each stockholder who fully paid for his stock.

On August 20, 1934, the old company had an authorized capital stock of 5,000 shares of a par value of $ 100 per share. The 7 endorser-directors of the old company to whom all of the stock of petitioner was issued were the owners of the following shares of the common stock of the old company on August 20, 1934:

	Shares
W. S. Montgomery	419
V. M. Montgomery	416
R. E. Barnwell	500
B. T. Earle	60
H. A. Ligon	10
H. L. Bomar	14
J. N. Cudd	50
Total	1,469

In addition to the 1,469 shares there were issued and outstanding in the hands of the public approximately 2,281 shares, leaving 1,250 shares unissued.

Following the issue of petitioner's stock to the seven endorser-directors as of August 20, 1934, the stock certificates were endorsed in blank and held as collateral for the benefit of the holders of the endorsed refunding gold notes of Montgomery Building, Inc., in accordance with provisions of the noteholders' deposit agreement dated August 1, 1933.

On the Federal income tax return for the period ended August 20, 1934, for the old company the following statement appears:

The Montgomery Building Inc. was dissolved Aug. 20, 1934 and the assets and liabilities as of that date were purchased by the Montgomery Bldg. Realty Co., which Company was chartered Aug. 11, 1934, State of South Carolina.

OPINION.

The correct depreciation basis for the property which petitioner acquired from its predecessor depends upon whether petitioner is entitled to take the basis of its transferor. That in turn goes back primarily to the question whether the transaction by which the property was acquired was a reorganization. Subdivision (a) (16) of section 113 of the Internal Revenue Code refers the basis of property acquired, as this was, in 1934, to the provisions of the 1934 Act. ¹

Section 113 (a) (7) of the 1934 Act, dealing with the basis after a reorganization, reads as follows:

(7) Transfers to corporation where control of property remains in same persons. -- If the property was acquired after December 31, 1917, by a corporation in connection with a reorganization, and immediately after the transfer an interest or control in such property of 50 per centum or more remained in the same persons or any of them, then the basis shall be the same as it would be in the hands of the transferor, increased in the amount of gain or decreased in the amount of loss recognized to the transferor upon such transfer under the law applicable to the year in which the transfer was made. * * *

The definition of a reorganization, which is identical in the 1934 Act, as amended, with that included in the code, speaks of a reorganization as, among other transactions, "the acquisition by one corporation, in exchange solely for all or a part of its voting stock, of substantially all the properties of another corporation * * *." This is literally what happened when petitioner ("one corporation") in exchange "solely" for "all" of its "voting stock" acquired all of the properties of its predecessor ("another corporation"). The conceded insolvency of the latter permits the continuity of interest requirement to be fulfilled by issuance of the new stock to the transferor's creditors. Helvering v. Alabama Asphaltic Limestone Co., 315 U.S. 179">315 U.S. 179; Palm Springs Holding Corporation v. Commissioner, 315 U.S. 185">315 U.S. 185. Here, unlike the transfer in Helvering v. Southwest Consolidated Corporation, 315 U.S. 194">315 U.S. 194, the acquisition was "solely" for all of petitioner's "voting stock." ² And "The fact that the new company's stock was issued to the old bondholders rather than to the old corporation is immaterial. Helvering v. New Haven & Shore Line R. R. Co., 121 Fed. (2d) 985." Louis E. Stoddard, Jr., 47 B. T. A. 584, 589; reversed, other grounds (C. C. A., 2d Cir.), 141 Fed. (2d) 76.

True, the new stock was not issued here to all the old creditors, but only to the holders of unsecured claims for advances to the old company. But, as the Court points out in the Alabama Asphaltic case, the full priority rule of Northern Pacific R. Co. v. Boyd, 228 U.S. 482">228 U.S. 482, applies equally to bankruptcy and equity reorganizations. The upshot is that first mortgage bondholders having a prior lien on property sufficient to satisfy their claims are entitled to maintain that position and to be placed ahead of creditors holding unsecured claims or subordinate liens. See Case v. Los Angeles Lumber Co., 308 U.S. 106">308 U.S. 106, 116. Bondholders whose rights and priorities are left unchanged, even though some other interests undergo an alteration, are not even affected by a reorganization and ordinarily have no standing to contest it. "A plan does not 'affect' the claims of creditors when they retain exactly what they had before: the claims of the bondholders in the case at bar are of this * * * kind." Gross v. Bush Terminal Co. (C. C. A., 2d Cir.), 105 Fed. (2d) 930. It is when such prior-lien creditors are asked to surrender a portion of their secured interests that a court will seek to compensate them by a share in the equity ownership. In re Barclay Park Corporation (C. C. A., 2d Cir.), 90 Fed. (2d) 595.

The converse of the full priority rule of Northern Pacific R. Co.v. Boyd is that a junior interest for which there remains in fact some value can not be excluded. Hence if stockholders have a remaining equity, the plan should make some provision for them. ³ By a similar process, it becomes necessary in evaluating a plan of reorganization to permit the most junior of the remaining interests to obtain a share of the equity ownership of the new reorganized enterprise, there being generally no lesser interest to which they can succeed.

Thus, when, in the present case, it became evident that the old stockholders retained no effective portion of the remaining value of the old company, the junior creditors could be excluded only on the theory that the value of the assets was insufficient to satisfy the holders of prior liens. In re Barclay Park Corporation, supra. Stated somewhat differently, if the first and second mortgage bondholders were sufficiently protected by the continuation of their lien and the assumption of their bonds, see Gross v. Bush Terminal Co., supra, the remaining value must have belonged to the general creditors, who, under the Alabama Asphaltic rule, thereupon became the equity owners. It is not necessary that there be a complete participation in the reorganized company by all the members of that class. For example, if the claims are assumed by the new corporation, or even if those of a small minority are discharged in cash, both the continuity of interest and the 50 per cent interest or control requirements are satisfied. Southland Ice Co., 5 T. C. 842. Added to this is the reasonable presumption that in any adversary transaction the ultimate agreement will appropriately incorporate the true value of the contending interests. Alcazar Hotel, Inc., 1 T. C. 872. We think it follows that the transfer of control to the junior creditors upon insolvency and the ownership by them of the equity in the new corporation, subject to the assumption and continuation of the prior rights of the mortgage bondholders, effectively carried through in the reorganization the ownership and control which had already become an economic reality, and that under the rule of the Alabama Asphaltic case the reorganization and basis provisions are applicable.

It may be that the further requirement of a 50 per cent interest or control "in the same persons" is not identical with the concept of continuity of interest. See Mertens Law of Federal Income Taxation, vol. 3, § 21.97. But, if not, it is difficult to see that the statutory requirement does not represent an a fortiori case. It permits only a 50 per cent interest without control and appears to require merely that some of the persons interested in the new corporation be the same, at least where they represent a majority of the equity owners of the predecessor. See Rex Manufacturing Co., 37 B. T. A. 984; reversed other grounds (C. C. A., 7th Cir.), 102 Fed. (2d) 325. In the present situation the virtual ownership and control of petitioner's predecessor by its general creditors and the issuance to them of all of petitioner's securities more than satisfy these conditions. Muskegon Motor Specialties Co., 45 B. T. A. 551, 559; affd. (C. C. A., 6th Cir.), 134 Fed. (2d) 904.

There having been a reorganization, section 113 (a) (7) does not require that it be tax-free. National Bank of Commerce of Seattle, 40 B. T. A. 72; affd. (C. C. A., 9th Cir.), 115 Fed. (2d) 875. But an adjustment is required for the gain or loss to the transferor, if any, recognized under the law in effect at the time the property was transferred. In this case that question is answered by the conclusion that there was no such gain or loss. The reorganization was tax-free under 112 (b) (4), reading "No gain or loss shall be recognized if a corporation a party to a reorganization exchanges property, in pursuance of the plan of reorganization, solely for stock or securities in another corporation a party to the reorganization." Clyde Bacon, Inc., 4 T.C. 1107">4 T. C. 1107.

The result is that petitioner succeeded to the basis of its transferor without adjustment on account of any gain or loss on the transfer, and that that basis should be used in making the computations for the year in issue. Respondent's determination is overruled.

Presentation of the excess profits issue appears to leave no necessity for further discussion. We have already determined that the property was acquired in a reorganization, rather than by purchase, and that it was in exchange for the issuance of petitioner's stock. "In this connection," respondent cites the provision of section 718 (a) (2) of the code, which reads in part: "* * * Such property shall be included in an amount equal to its basis (unadjusted) for determining loss upon sale or exchange." That basis having been determined, no further issue appears to remain. Likewise, the selection of the method for computing the tax as between that based on income and that based on equity invested capital should follow automatically.

Decision will be entered under Rule 50.

TURNER

Turner, J., dissenting: To say that the unsecured creditors, immediately prior to the transfer and exchanges herein, were in control of the old corporation within the rule of Helvering v. Alabama Asphaltic Limestone Co., 315 U.S. 179">315 U.S. 179, is, in my opinion, contrary to the facts of this case and results in an erroneous application of the statute. I accordingly note my dissent.

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Footnotes

• 1. SEC. 113. ADJUSTED BASIS FOR DETERMINING GAIN OR LOSS.

  (a) Basis (Unadjusted) of Property. -- The basis of property shall be the cost of such property; except that --

  * * * *

  (16) Basis established by revenue act of 1934. -- If the property was acquired, after February 28, 1913, in any taxable year beginning prior to January 1, 1936, and the basis thereof, for the purposes of the Revenue Act of 1934 was prescribed by section 113 (a) (6), (7), or (8)↩ of such Act, then for the purposes of this chapter the basis shall be the same as the basis therein prescribed in the Revenue Act of 1934.

• 2. Assumption of the predecessor's liabilities may be disregarded. Southland Ice Co., 5 T. C. 842↩.

• 3. "* * * Unless the property of the debtor exceeded in value the amount of the claims of creditors, the stockholders had no interest to protect or preserve. In re 620 Church Street Building Corporation, 299 U.S. 24">299 U.S. 24, 27. * * * To justify a retention of a stock interest by present stockholders of the debtor, it should appear that they have furnished an additional "consideration or have an equity in the estate of the debtor after the rights of creditors are fully provided for. * * *" Price v. Spokane Silver & Lead Co↩. (C. C. A., 8th Cir.), 97 Fed. (2d) 237, 245.