DocketNumber: Docket Nos. 1902-66, 1995-66
Citation Numbers: 52 T.C. 607, 1969 U.S. Tax Ct. LEXIS 96
Judges: Simpson
Filed Date: 7/2/1969
Status: Precedential
Modified Date: 10/19/2024
1969 U.S. Tax Ct. LEXIS 96">*96
52 T.C. 607">*607 The respondent determined deficiencies in the income tax of the petitioner, Zilkha & Sons, Inc. (Zilkha), of $ 19,268.66 for its taxable 1969 U.S. Tax Ct. LEXIS 96">*97 year ending November 30, 1960, and $ 21,598.65 for its taxable year ending November 30, 1961, and in the income tax of the petitioners, Jerome L. and Jane Stern (the Sterns), of $ 13,836.25 for the taxable year 1961. The only issue remaining for decision is whether certain payments received by Zilkha and by the Sterns should be treated for tax purposes as interest or as distributions of property by a corporation with respect to its stock. The resolution of this issue depends on whether certain so-called preferred stock held by the petitioners represents in substance a debt obligation or an equity investment.
FINDINGS OF FACT
Most of the facts have been stipulated, and those facts are so found.
Zilkha is a New York corporation which had its principal office in New York, N.Y., at the time its petition was filed in these cases. For 52 T.C. 607">*608 its taxable years ending November 30, 1960, and November 30, 1961, Zilkha filed its Federal income tax returns, using the accrual method of accounting, with the district director of internal revenue, Manhattan District, New York, N.Y.
The Sterns are husband and wife, who maintained their legal residence in New York, N.Y., at the time their petition1969 U.S. Tax Ct. LEXIS 96">*98 was filed in these cases. They filed their 1961 joint Federal income tax return, using the cash receipts and disbursements method of accounting, with the district director of internal revenue, Manhattan District, New York, N.Y.
During 1960 and 1961, Zilkha's principal business activities consisted of buying and selling notes and foreign drafts, engaging in foreign-currency transactions, and making and managing loans. Since the amounts of its loans were generally substantial in relation to its assets and lines of credit, Zilkha, after negotiating and consummating its loan transactions, generally sought participants to whom it could sell portions of the securities it acquired.
Zilkha had become interested in arranging a transaction with Community Research & Development, Inc. (CRD), now known as Rouse Co., and during the summer of 1960, Zilkha and CRD discussed a financial arrangement involving one of CRD's subsidiaries, Charlottetown, Inc. (Charlottetown), a Maryland corporation. Charlottetown had leased land under a 99-year lease and built a shopping center called Charlottetown Mall in Charlotte, N.C., which opened for business on October 28, 1959. CRD initially proposed that Zilkha1969 U.S. Tax Ct. LEXIS 96">*99 buy and lease back certain of Charlottetown's properties, but Zilkha rejected this proposal because it was uncertain of finding participants in such a transaction, and because it desired to obtain some sort of equity interest in Charlottetown.
On September 10, 1960, Zilkha, CRD, and Charlottetown entered into an agreement (the stock purchase agreement) under which Zilkha acquired from Charlottetown, for $ 1 million, 10,000 shares of Charlottetown's $ 9-dividend cumulative preferred stock of the par value of $ 1 per share. For purposes of the findings of fact, we shall refer to the investment as an investment in Preferred Stock, although we do not thereby intend to characterize it as such for tax purposes. Pursuant to the stock purchase agreement, Zilkha also acquired 200 shares of Charlottetown common stock from CRD for $ 200. These 200 shares represented 20 percent of the outstanding Charlottetown common stock, all of which was originally acquired by CRD for $ 1,000. Zilkha also undertook to acquire 2,000 additional shares of the Preferred Stock for $ 100 per share upon the completion of an office building on Charlottetown Mall. Early in 1963, subsequent to the completion of1969 U.S. Tax Ct. LEXIS 96">*100 the office building, Zilkha acquired the 2,000 additional shares of Preferred Stock for $ 200,000.
52 T.C. 607">*609 Subsequent to September 10, 1960, Zilkha sold some of each class of Charlottetown stock to others. Among the group of purchasers were the Sterns, each of whom purchased 18 shares of the Charlottetown common stock and 1,200 shares of the Preferred Stock.
In its taxable years ending in 1960 and 1961, Zilkha received from Charlottetown $ 6,667.50 and $ 27,000 which were treated by Zilkha and Charlottetown as distributions with respect to stock. In 1961, the Sterns received from Charlottetown $ 18,000 which was treated by the Sterns and Charlottetown as a distribution with respect to stock.
Charlottetown's sale of the Preferred Stock necessitated a change in its capital structure, and on September 8, 1960, it filed articles of amendment to its articles of incorporation. The articles of amendment authorized issuance of the Preferred Stock in addition to 10,000 shares of no par common stock. The relevant provisions of the articles of amendment with respect to the new capital structure of Charlottetown may be summarized as follows:
(1)
(2)
(3)
(4)
(a) Amend its charter or bylaws;
(b) Pay any dividends on, or make any distributions with respect to, its common stock;
(c) Make capital expenditures of more than $ 50,000 in any calendar year;
(d) Make any loans or purchase any securities;
(e) Borrow money, 1969 U.S. Tax Ct. LEXIS 96">*102 except up to an aggregate of $ 100,000 in the ordinary course of its business, and except for the purpose of redeeming all of the Preferred Stock; or
(f) Make any charges to capital surplus except for the payment of Preferred Stock dividends or for the redemption of the Preferred Stock.
52 T.C. 607">*610 The stock purchase agreement describes the rights and obligations of Zilkha, CRD, and Charlottetown and is comprehensive and highly complex. Many of its provisions are not relevant to the issue in these cases. The relevant ones may be summarized as follows:
(1)
(a) If Charlottetown fails to pay any Preferred Stock dividend within 5 days after it accrues;
(b) If Charlottetown fails to redeem all the Preferred Stock by September 1, 1970;
(c) If CRD or Charlottetown breach any material representation, warranty, or covenant of the Stock Purchase Agreement;
(d) If Charlottetown violates any material provision of its amended1969 U.S. Tax Ct. LEXIS 96">*103 articles of incorporation; or
(e) If Charlottetown becomes involved in any bankruptcy or insolvency proceeding.
(2)
(3)
(4)
(5)
(a)
(i) Loans previously described with respect to "Vacating Tenants";
(ii) Loans enabling Charlottetown to pay Preferred Stock dividends during a 3-month period at the end of which CRD may reacquire Charlottetown common stock purchased by Zilkha pursuant to its option;
(iii) Loans previously described with respect to "Discharge of Liens" to the extent1969 U.S. Tax Ct. LEXIS 96">*105 such loans are required to discharge liens in excess of $ 330,000; or
(iv) Loans previously described with respect to "Loans to Pay Dividends."
(b)
(i) Loans by CRD to Charlottetown previously described with respect to "Discharge of Liens" to the extent such loans are required to discharge liens up to $ 330,000;
(ii) Loans to Charlottetown necessary in the ordinary course of its business to the extent that such loans aggregate more than $ 100,000; or
(iii) Loans by CRD to Charlottetown to enable Charlottetown to pay Preferred Stock dividends but which loans are not required to be made by CRD.
The redemption of the Preferred Stock and the payment of all accumulated and unpaid dividends shall be accomplished before any payments can be made with respect to any of the previously described loans in connection with the liquidation, dissolution, winding up, bankruptcy, receivership, or reorganization of Charlottetown.
Although Zilkha believed in 1960 that Charlottetown1969 U.S. Tax Ct. LEXIS 96">*106 had great growth possibility, it also regarded the Preferred Stock as a risky investment. After a year of operation, Charlottetown was still not generating sufficient cash flow to meet all of its obligations out of current revenue. Furthermore, the success of Charlottetown depended to a large extent on the success of the Charlottetown Mall tenants, most of whose leases provided for rental payments based, in part, on sales.
During its fiscal years ending in 1960, 1961, and 1962, Charlottetown had no earnings and profits within the meaning of
52 T.C. 607">*612 Set forth below is a comparative statement of the assets, liabilities, and capital of Charlottetown as of May 31, 1960, August 31, 1960, May 31, 1961, and May 31, 1962:
May 31, 1960 | Aug. 31, 1960 | |||
Total assets | $ 4,523,184 | $ 4,463,343 | ||
Liabilities | ||||
Due to CRD | 1,023,234 | 1,109,556 | ||
Due to affiliated | ||||
company | ||||
Due to others | 3,686,540 | 3,631,202 | ||
Capital | ||||
Capital stock: | ||||
Common stock | $ 1,000 | $ 1,000 | ||
Preferred stock | ||||
Capital in excess of | ||||
par value of preferred | ||||
stock | ||||
Deficit | (187,590) | (278,415) | ||
(186,590) | (277,415) | |||
Total liabilities | ||||
and capital | 4,523,184 | 4,463,343 |
May 31, 1961 | May 31, 1962 | |||
Total assets | $ 4,411,263 | $ 5,434,510 | ||
Liabilities | ||||
Due to CRD | 235,869 | 1,139,354 | ||
Due to affiliated | ||||
company | 223,180 | |||
Due to others | 3,668,883 | 3,647,135 | ||
Capital | ||||
Capital stock: | ||||
Common stock | $ 1,00 | $ 1,000 | ||
Preferred stock | 10,000 | 10,000 | ||
11,000 | 11,000 | |||
Capital in excess of | ||||
par value of preferred | ||||
stock | 840,495 | 750,495 | ||
Deficit | (344,984) | (336,654) | ||
506,511 | 424,841 | |||
Total liabilities | ||||
and capital | 4,411,263 | 5,434,510 |
OPINION
The sole issue to be decided in this case is whether the payments received by the petitioners are interest or distributions with respect to stock. The petitioners take the position that their investment in Charlottetown was in form and in substance an acquisition of stock so that the payments which they received were nontaxable distributions since Charlottetown had no earnings and profits in the years of the distributions. On the other hand, the respondent determined that the investment was in substance a loan so that the payments were taxable as interest.
Although the traditional positions of the parties in a debt-equity controversy are1969 U.S. Tax Ct. LEXIS 96">*108 reversed in this case, the applicable law is the same. We must examine the investment and all the surrounding circumstances to determine what relationships were in substance created.
The petitioners, Charlottetown, and CRD all treated the1969 U.S. Tax Ct. LEXIS 96">*109 investment as a purchase of preferred stock. This treatment has been consistently carried through in documents relating to the purchase of the Preferred Stock, tax returns, financial statements, minutes of Charlottetown and CRD boards of directors meetings, and the amended articles of incorporation of Charlottetown. Of course, the treatment of a transaction by the parties to it is not dispositive of the issue, but it is some indication of the petitioners' intention in purchasing the Preferred Stock.
At the time of Zilkha's investment, Charlottetown's stockholder equity account showed a deficit of $ 277,415. 1969 U.S. Tax Ct. LEXIS 96">*110 from the sale of 100 1969 U.S. Tax Ct. LEXIS 96">*111 Although Charlottetown's prospects for successful operations were generally favorable in 1960, success was not then assured. Charlottetown Mall had only been in operation since 1959; it had sustained operating losses in its first year of business; its income depended to a large extent on the success of its tenants, since many of the leases provided for rentals based in part on sales. Inasmuch as there was no capital cushion under the Preferred Stock, the success of the petitioners' investment, as of September 10, 1960, depended largely on the 52 T.C. 607">*614 success of the Charlottetown business. Cf.
We find it impossible to believe that Zilkha would have made a loan of a million dollars when CRD provided so little equity and had a large prior claim for loans to Charlottetown. If Zilkha intended its purchase of the Preferred Stock to be a loan, we think it would have insisted that CRD's debt be either subordinated to the Preferred Stock or capitalized. The use of the Preferred Stock proceeds to pay1969 U.S. Tax Ct. LEXIS 96">*112 off Charlottetown's indebtedness to CRD is inconsistent with the contention that the Preferred Stock is a debt security.
The respondent contends that the petitioners' risk is illusory, since the holders of the Preferred Stock acquired various protections under the stock purchase agreement and the amended articles of incorporation of Charlottetown that tend to assure payment of dividends and redemption. The most important of these protections are the following: (1) The right of holders of the Preferred Stock to take over Charlottetown in the event of the failure to pay Preferred Stock dividends or the failure to redeem the Preferred Stock; (2) the obligation of CRD to make certain loans to Charlottetown; and (3) the subordination of certain prospective debts of Charlottetown, in varying degrees, to the Preferred Stock. However, these provisions do not substantially reduce the risk inherent in the Preferred Stock.
The acquisition by the holders of the Preferred Stock of voting control and complete stock ownership of Charlottetown, in the event of nonpayment of dividends or the failure to redeem, does not assure the payment of the dividends or the redemption of the stock. If Charlottetown1969 U.S. Tax Ct. LEXIS 96">*113 prospers, CRD, as the controlling stockholder, will surely see to the redemption of the Preferred Stock. The Preferred Stock is an outstanding interest in Charlottetown which poses a potential threat to CRD's continuing control and ownership and can presently restrict Charlottetown's activities in various ways. On the other hand, if Charlottetown does not succeed and cannot pay dividends and redeem the Preferred Stock from its own resources, CRD is not likely to provide the funds necessary for it to retain control and ownership of Charlottetown. The respondent argues that CRD will in all events see to the payment of dividends and the redemption of the Preferred Stock, since if it does not do so, it will lose its investment in Charlottetown. However, CRD's investment in Charlottetown has been principally by way of debt rather than stock -- CRD paid only $ 800 for all the Charlottetown stock it owns. That CRD would pay $ 1,200,000 to protect an investment of $ 800 in a failing company seems highly unlikely.
The stock purchase agreement obligates CRD to make the following loans to Charlottetown: (1) Loans enabling Charlottetown to discharge certain liens against Charlottetown Mall; 1969 U.S. Tax Ct. LEXIS 96">*114 (2) loans allowing 52 T.C. 607">*615 Charlottetown to redeem a portion of the Preferred Stock in the event certain tenants terminate their leases and satisfactory replacements are not found; and (3) loans enabling Charlottetown to pay Preferred Stock dividends until Charlottetown achieves a "net cash flow" for 2 consecutive years. The loans which CRD is required to make to Charlottetown do tend to assure the payment of dividends and the redemption of the Preferred Stock. However, the question is whether such loans substantially reduce the petitioners' risk, and we believe they do not. The contractor and subcontractor liens constitute only one source of financial difficulty to Charlottetown. The discharge of such liens is no assurance that Charlottetown will be able to discharge its other liabilities or that it will prosper. The provisions with respect to terminating tenants apply to only 3 tenants out of more than 50, and only if those tenants terminate their leases under specific circumstances. That only 3 tenants are involved and that those tenants may never terminate their leases under the prescribed conditions minimizes the assurance to the holders of the Preferred Stock that their1969 U.S. Tax Ct. LEXIS 96">*115 investment will be successful. The requirement that CRD loan Charlottetown sufficient funds to pay Preferred Stock dividends until Charlottetown achieves a "net cash flow" for 2 consecutive years is the most substantial protection accorded the Preferred Stock. If Charlottetown remains solvent and its stated capital continues unimpaired, 1969 U.S. Tax Ct. LEXIS 96">*116 Nor is the provision for the subordination of some loans to the Preferred Stock inconsistent with the conclusion that the stock represents an interest in equity. On September 10, 1960, it did not appear certain that a substantial portion of future Charlottetown debt would be of a kind that had to be subordinated to the Preferred Stock. As of May 31, 1961, at least $ 3,242,463 of Charlottetown debt was not subordinated to the Preferred Stock, whereas less than $ 82,765 was so subordinated. As of May 31, 1962, at least $ 3,924,020 of Charlottetown debt was not subordinated to the Preferred Stock, whereas approximately $ 677,696 was so subordinated. 52 T.C. 607">*616 10, 1960, we cannot conclude that such subordination altered the basic relationship between CRD and the petitioners. CRD has always had a severely limited equity investment in Charlottetown. Upon Zilkha's purchase of the Preferred Stock and the discharge of a substantial part of the CRD debt, CRD's investment in Charlottetown was reduced far below that represented by the Preferred Stock. Even had the CRD debt remained outstanding, 1969 U.S. Tax Ct. LEXIS 96">*117 it would have been a prior claim to the Preferred Stock. Of all the significant investments in Charlottetown, the Preferred Stock was the most dependent on the success of the business. The various protections accorded the Preferred Stock do not substantially minimize the petitioners' risk. Because of this risk and the consistent treatment of the Preferred Stock as equity, we conclude that the payments received by the petitioners from Charlottetown were distributions with respect to stock and not interest. The parties have argued extensively whether the petitioners have any effective right to participate in the management of Charlottetown, whether the arrangements for the redemption of the Preferred Stock constitute in effect a fixed maturity date, and whether the practical effect of the provisions1969 U.S. Tax Ct. LEXIS 96">*118 for the payment of dividends guarantee that such payments will be made. However, the arguments concerning these provisions are not highly persuasive. (1) The record shows that the Preferred Stock directors have taken an active role in the affairs of Charlottetown, 1969 U.S. Tax Ct. LEXIS 96">*119 and the fact that the holders of the Preferred Stock have some opportunity to participate in management is more indicative of an equity interest than of a creditor's rights. Nevertheless, the fact that CRD controls 12 seats on the board of directors, as opposed to only 2 controlled by the holders of the Preferred Stock, significantly reduces the power of the latter group to influence management decisions, and prevents us from heavily relying on this factor in favor of the petitioners. 52 T.C. 607">*617 (2) In some cases, it may be clear from the surrounding circumstances that there is in effect a fixed maturity date even in the absence of such a contractual provision. See 1969 U.S. Tax Ct. LEXIS 96">*121 It is apparent that the holders of the Preferred Stock have rights which render its redemption more probable than typical preferred stock. Yet, the chances of redemption of the Preferred Stock are not so great as to indicate that in fact there was a fixed maturity date for the repayment of the investment. (3) 52 T.C. 607">*618 The effect of these provisions is to enhance the likelihood of the payment of dividends. 1969 U.S. Tax Ct. LEXIS 96">*122 The existence of large amounts of surplus means that dividends can be declared; the possibility of losing control of the corporation, if they are not declared, creates a strong incentive for the board to declare them. Furthermore, CRD's obligation to loan the necessary funds means that cash would be available to pay dividends. On the other hand, if Charlottetown becomes insolvent, payment of the Preferred Stock dividends will be prohibited by applicable State law; 1969 U.S. Tax Ct. LEXIS 96">*123 The rights of the preferred stockholders are unusual and significantly increase the likelihood that dividends will be paid. However, these rights do no justify our concluding that dividends are in fact required to be paid. The respondent makes much of an alleged tax avoidance purpose behind the creation of the Preferred Stock. He states that the petitioners were tax-conscious individuals who sought to avoid the tax consequences of ordinary income. They knew that Charlottetown had no earnings and profits and was likely to have none for a substantial period of time. They also knew that Charlottetown was not in need of interest deductions to reduce its Federal income taxes. Accordingly, they structured the transaction so as to make it appear that the Preferred Stock is equity. However, our task is to determine what relationships were in fact created by these transactions and to apply to them the appropriate tax consequences. We have examined the stock purchase agreement and all the surrounding circumstances and concluded that in substance the petitioners acquired preferred stock. The fact that the petitioners gain certain tax benefits because their investment was in preferred1969 U.S. Tax Ct. LEXIS 96">*124 stock does not justify our disregarding the substantive nature of the transaction.
1. The record does not contain precise financial data for Charlottetown as of Sept. 10, 1960. However, such data has been supplied for Aug. 31, 1960. Since the evidence indicates that no significant change in Charlottetown's financial condition occurred between August 31 and September 10, we have treated the August 31 figures as also being applicable to September 10.↩
2. Charlottetown's articles of amendment to its articles of incorporation, as well as creating the Preferred Stock, also provided for a 10-for-1 stock split of its common stock. Thus, prior to the amendment, CRD owned 100 of 1,000 authorized shares of Charlottetown common stock; after the amendments, CRD owned 1,000 of 10,000 authorized shares.↩
3.
4. The evidence indicates that most of this subordinated debt was not absolutely subordinated to the Preferred Stock. The subordination was subject to lapsing, and did in fact lapse, upon the occurrence of certain events.↩
5. See fn. 2,
6. Charlottetown achieved such a net cash flow by the end of its fiscal year ending May 31, 1966.↩
Kraft v. Rochambeau Holding Co. , 210 Md. 325 ( 1956 )
Comtel Corporation v. Commissioner of Internal Revenue , 376 F.2d 791 ( 1967 )
Commissioner v. Milwaukee & Suburban Transport Corp. , 367 U.S. 906 ( 1961 )
Milwaukee & Suburban Transport Corporation v. Commissioner ... , 283 F.2d 279 ( 1960 )
United States v. South Georgia Ry. Co. , 107 F.2d 3 ( 1939 )
John Wanamaker Philadelphia v. Com'r of Int. Revenue , 139 F.2d 644 ( 1943 )
Ambassador Apartments, Inc. v. Commissioner of Internal ... , 406 F.2d 288 ( 1969 )
Wilbur Security Company v. Commissioner or Internal Revenue , 279 F.2d 657 ( 1960 )
commissioner-of-internal-revenue-v-earl-johnson-executors-commissioner , 267 F.2d 382 ( 1959 )