Berry Petroleum Co. v. Comm'r of Internal Revenue, 28578-91.

• Decision Date: 22 May 1995
• Docket Number: No. 28578-91.,28578-91.
• Citation: 104 T.C. 584,104 T.C. No. 30
• Parties: BERRY PETROLEUM COMPANY and Subsidiaries, Petitioner, v. COMMISSIONER OF INTERNAL REVENUE, Respondent.
• Court: U.S. Tax Court

104 T.C. 584
104 T.C. No. 30

BERRY PETROLEUM COMPANY and Subsidiaries, Petitioner,
v.
COMMISSIONER OF INTERNAL REVENUE, Respondent.

No. 28578-91.

United States Tax Court.

May 22, 1995.

[104 T.C. 585]

Gerard J. Kenny, Scott M. Knutson, and J. Michael Brennan, Irvine, CA, for petitioner.

Jeffrey L. Heinkel, Barbara M. Leonard, and Michael Steiner, San Jose, CA, for respondent.

[104 T.C. 586]

CONTENTS

+----+
                ¦Page¦
                +----+
                

OVERVIEW OF ISSUES AND CONCLUSIONS
                

I. GENERAL FINDINGS OF FACT
                II. ISSUES 1 AND 2: LOSS CLAIMED ON EXPIRATION OF AFEX OPTION AND DEDUCTIBILITY
                 OF WIEGAND LITIGATION COSTS
                

 A. FINDINGS OF FACT
                

 1. Afex Option
                 2. Wiegand Litigation
                 3. Ultimate Findings of Fact
                

 B. OPINION
                

 1. Afex Option
                

 a. Respondent's Motion To Strike Mr. Hoffman's Testimony
                 b. Disallowance of Loss Claimed on Expiration of Afex Option and Allocation
                 of Ostensible Price of Afex Option to Petitioner's Cost of Norris Stock
                

 i. Lack of Economic Substance of Afex Option under Valuation Analysis 611
                 ii. Substance v. Form ----
                

 2. Disallowance of Current Deduction for Wiegand Litigation Costs
                

III. ISSUE 3: EFFECTS OF SECTION 382 ON USEFULNESS OF NET OPERATING LOSS
                 CARRYOVERS
                

 A. FINDINGS OF FACT
                

 1. General Findings of Fact
                 2. Ultimate Findings of Fact
                

 B. OPINION
                

 1. Background
                 2. Section 382-Net Operating Loss Carryovers Generally
                 3. Continuity of Business Enterprise-Section 382(c)(1)
                 4. Fair Market Value of Teorco
                 5. Redemption or Other Corporate Contraction-Section 382(e)(2)
                 6. Substantial Nonbusiness Assets-Section 382(l)(4)
                

BEGHE, Judge:

Respondent determined deficiencies of $662,013, $126,693, and $366,536 in petitioner's Federal income tax for 1987, 1988, and 1989, respectively.

Unless otherwise indicated, section references are to the Internal Revenue Code in effect for the years in issue, and Rule references are to the Tax Court Rules of Practice and Procedure.

[104 T.C. 587]

OVERVIEW OF ISSUES AND CONCLUSIONS

Some issues have been settled, including the deductibility of certain expenses of preparing a registration statement for a postponed public offering of petitioner's stock. The issues remaining for decision are the “Afex option” issue, the “Wiegand litigation” issue, and the “section 382” issue.

The Afex option issue concerns the deductibility of the $1.2 million ostensibly paid by petitioner to acquire an option that expired unexercised in 1987 to purchase certain Oklahoma gas leases. We hold the claimed loss nondeductible because we find that the payment to acquire the option was in fact part of the purchase price of 80 percent of the stock of a corporation (Norris) acquired by petitioner in the same transaction as the option and from the same interests that granted the option.

The Wiegand litigation issue concerns whether petitioner may currently deduct as ordinary and necessary trade or business expenses the costs of defending a class action lawsuit for breach of fiduciary duty brought on behalf of the minority shareholders of Norris who sold their stock on the public market following petitioner's acquisition of control of Norris (selling class) or who exchanged their Norris stock for petitioner's stock in the merger in which Norris became a wholly owned subsidiary of petitioner (merger class). We find that the Wiegand litigation had its origins in petitioner's acquisition of the Norris stock, and hold that petitioner's costs to defend the Wiegand litigation are not deductible.

The section 382 issue concerns the section 382 limitation on the consolidated postacquisition annual taxable income of petitioner's affiliated group that may be offset by the preacquisition loss carryovers of an acquired corporation (Teorco). Our conclusions on the section 382 issue have the effect of substantially reducing, but not eliminating, the annual consolidated taxable income that petitioner claimed could be offset by Teorco's preacquisition net operating loss carryovers.

[104 T.C. 588]

I. GENERAL FINDINGS OF FACT

The parties have stipulated some of the facts, and the stipulations of fact and exhibits thereto are incorporated in our findings of fact.

At all relevant times, Berry Petroleum Co. (Berry or petitioner) was a Delaware corporation, maintaining its principal office in Taft, California. For 1987, 1988, and 1989, petitioner filed Federal consolidated income tax returns, including thereon its subsidiary, Bush Oil Co. (Bush), previously known as Norris Oil Co. (Norris). On the 1988 and 1989 returns, C.J. Co., a wholly owned subsidiary of Bush whose stock had been purchased by Bush in 1988, was also included.

At all relevant times, Norris/Bush had only one class of outstanding capital stock, designated as common stock. Effective December 1, 1986, petitioner purchased 80.56 percent of the stock of Norris from ABEG Hydrocarbons, Inc. (ABEG). Effective June 26, 1987, petitioner acquired the remaining Norris stock, and Norris became a wholly owned subsidiary of petitioner when a new, wholly owned subsidiary of petitioner was merged into Norris. Immediately after the merger, Norris changed its name to Bush.

At all relevant times, Harvey L. Bryant was president, chief executive officer, and a member of the board of directors of petitioner, and Jerry V. Hoffman was petitioner's vice president and chief financial officer.

II. ISSUES 1 AND 2: LOSS CLAIMED ON EXPIRATION OF AFEX OPTION AND DEDUCTIBILITY OF WIEGAND LITIGATION COSTSA. FINDINGS OF FACT 1. Afex Option

ABEG was a Nevada corporation 100-percent owned by an Australian entity (Entrad, wholly owned by Abraham Goldberg) engaged in real estate development, textiles, and the oil and gas business. American Frontier Exploration, Inc. (Afex), a Delaware corporation, was a wholly owned subsidiary of ABEG engaged in the oil and gas business.

Joseph Stanley Dorobek II was president of both ABEG and Afex until they ceased to exist in 1990, and was also president of Norris until December 1, 1986.

[104 T.C. 589]

As early as 1983, petitioner had been aware of Norris and had become interested in acquiring Norris' principal asset, Rincon. Rincon consisted of four leases of certain oil-producing properties located in the Rincon field in coastal waters off the coast of Ventura County, California.¹ At some time in 1983 or 1984, petitioner had contacted Norris and discussed the possibility of merging Norris and petitioner, but no action was taken at that time.

Prior to March 1, 1986, ABEG had acquired approximately 42 percent of the issued and outstanding common stock of Norris and had thereby become its largest single shareholder. As a result of Norris' financial difficulties, ABEG and Norris negotiated a financial restructuring during the first half of 1986 under which Norris issued an additional 8,266,666 shares of Norris common stock to ABEG; ABEG in return paid Norris' principal lender $1,750,000 in satisfaction of an indebtedness of Norris, paid the California State Lands Commission $1 million to provide a sinking fund that would allow Norris to preserve its rights to Rincon, and reduced by $350,000 aggregate debt of $3,002,700 owed by Norris to ABEG. The restructuring became effective on June 30, 1986, and ABEG's aggregate payments of $3.1 million for the 8,266,666 Norris shares represented a per-share consideration of $0.375. At that point, ABEG owned 10,097,616 out of a total of 12,596,884 outstanding shares of Norris stock, or 80.16 percent. During July 1986, ABEG purchased an additional 50,000 shares of Norris stock (raising its total Norris holdings to 10,147,616 shares, or 80.56 percent) at a per-share price of $0.33.

In late March 1986, petitioner approached Norris' management to discuss a merger or other combination under which petitioner would acquire at least 80 percent of the Norris stock in exchange for shares of petitioner's common stock. Petitioner initiated this approach as a result of publicity concerning Norris' negotiations with its principal lender and the California State Lands Commission. Mr. Hoffman had been familiar with the Rincon field for some time, and Mr.

[104 T.C. 590]

Bryant had tracked the publicly available information. Norris and ABEG rejected petitioner's initial proposal for a stock-for-stock deal. At the time of petitioner's initial approach, ABEG still intended to conduct gas and oil operations through Norris and Afex.

Petitioner continued to seek a merger with Norris. On April 15, 1986, Mr. Hoffman sent a letter to Mr. Goldberg restating petitioner's desire to acquire ABEG's Norris stock in exchange for stock in petitioner. On or about July 24, 1986, Mr. Dorobek, on instructions from Mr. Goldberg, met Messrs. Bryant and Hoffman to discuss petitioner's possible acquisition of Norris. The negotiations which began at this time continued until late September 1986, when petitioner and ABEG entered into an agreement in principle whereby petitioner would acquire all of ABEG's Norris stock for cash.

Petitioner's first written offer for Norris, dated August 25, 1986, was for a merger in which petitioner, in exchange for the issuance of its own common stock, would acquire all of the stock of Norris. The approximate total value of the shares in petitioner that ABEG would have received under petitioner's first offer was $5-6 million, a value of approximately $.50-$.60 per share of ABEG's Norris stock. After showing initial interest in the offer, Mr. Dorobek, on September 18, 1986, informed petitioner that ABEG did not wish to continue its involvement in Norris' business, and that a stock-for-stock exchange, as opposed to a cash sale, was therefore unacceptable.

In the meantime, on September 9, 1986, Mr. Hoffman had consulted with petitioner's attorneys, and on September 12, 1986, petitioner's board of directors had met and authorized petitioner's management to negotiate with Norris. As early as September 12, 1986, petitioner had intended to form a partnership or joint venture to develop Rincon. Immediately after hearing from Mr. Dorobek of ABEG's rejection of the...