27 T.C. 37 (1956), 44520, Kolkey v. C.I.R.
|Docket Nº:||44520, 44818, 44850, 45063, 45064.|
|Citation:||27 T.C. 37|
|Opinion Judge:||PIERCE, Judge:|
|Party Name:||EMANUEL N. (MANNY) KOLKEY, ET AL., PETITIONERS, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.|
|Attorney:||Morton J. Harris, Esq., [1A] for the petitioners in Docket Nos. 44520 and 44850. Samuel E. Hirsch, Esq., for the petitioners in Docket Nos. 44818, 45063, and 45064. George T. Donoghue, Esq., John E. Owens, Esq., and Geoffrey J. Lanning, Esq., for the respondent.|
|Case Date:||October 18, 1956|
|Court:||United States Tax Court|
Three individuals who owned all the stock of corporation C, which had accumulated earnings and profits of approximately $598,000, entered into an agreement with tax-exempt organization S, whereby: A new corporation K was organized, with capital stock of $1,000, to take over C's business; S contributed the $1,000 and received all the stock; the individuals transferred to K all of their shares of C, and received $4,000,000 promissory notes of K, which were payable over an 11-year period, after prior provision for dividends to S; and the three individuals were given a 7-year contract to operate K's business, as ‘ managers.’ Thereupon, K took over all of C's net assets in complete liquidation; and paid the individuals $400,000 out of the assets so acquired, in cancellation of part of the notes. After K had operated for about 11 1/2 months with declining earnings, S sold all its shares of K's stock to the individuals, and withdrew from participation in the enterprise.
1. Held, that the $4,000,000 notes of K did not, in reality, represent corporate ‘ indebtedness,‘ but rather equity capital investments of the individuals.
2. Held, that, since there was no recognizable gain or loss on the liquidation of C, the ‘ earnings and profits' of C remained, for purposes of distribution, ‘ earnings and profits' of K ( Commissioner v. Sansome, 60 F.2d 931,certiorari denied 287 U.S. 667); and that the $400,000 thereafter paid by K to the individuals, constituted taxable dividends to them as equity capital investors.
3. Held, that K was not exempt from income tax, under section 101(6) of the 1939 Code.
4. Held, that K is not entitled to deductions for ‘ interest’ on certain of the above-mentioned notes, for the reason that such notes did not constitute corporate ‘ indebtedness'; nor is it entitled to a deduction for accrued interest on income tax for its first fiscal period, for the reason that its liability for the tax and such interest has not been conceded, and is still in dispute.
5. Held, further, that K's failure to file its returns within the time prescribed for such filing was due to reasonable cause and not due to willful neglect; and that, accordingly, it is not liable for additions to tax, under section 291(a) of the 1939 Code.
This proceeding involves deficiencies in income tax, and an addition to tax under section 291(a) of the 1939 Code, determined by the respondent as follows:
No. Calendar year Petitioner Deficiency to tax
44520 1949 Pauline Kolkey $104,335.88
44850 1949 Emanuel N. (Manny) Kolkey 104,335.88
45063 1949 Barnet Perel and Bertha Perel 32,412.34
45064 1949 Maurice L. Cowen and Rosalie Cowen 31,560.52
44818 March 5, 1949, to ) ( 110,327.73 $11,032.77
Feb. 28, 1950. )Kyron Foundation, Inc (
Ended Feb. 28, 1951. ) ( 43,199.33 8,639.87
All of these cases were consolidated for hearing. Several of the issues raised by the pleadings have been eliminated:
In Docket No. 44520, petitioner Pauline Kolkey has conceded that, by reason of her having filed a joint income tax return for the year involved with her then husband, petitioner Emanuel N. (Manny) Kolkey, she is jointly and severally liable for any deficiency which may be established in his case, being Docket No. 44850.
In Docket Nos. 45063 and 45064, the petitioners presented no evidence in support of their assignments of error respecting (a) additional income received through excess reimbursement of expenses, and (b) adjustment of income from a partnership; and also in Docket No. 45064, the petitioners presented no evidence in support of their assignment of error respecting the disallowance of a deduction for sales taxes. Accordingly, these issues are deemed to have been abandoned. In Docket No. 44818, the petitioner presented no evidence in support of its assignment of error respecting the disallowance of a deduction of $7,500 for travel and entertainment expenses for each of the taxable periods involved; and such issue is likewise deemed to have been abandoned. Also, in this Docket No., the petitioner has conceded that it is not entitled to deductions for (a) salaries and wages of $1,000 paid to William H. Paul and wife in the first taxable period, and (b) salaries and wages of $3,200 paid to Bent Darre and wife in the second taxable period; and the respondent has conceded that the petitioner is entitled to deductions in the second period, of $13,980 for sales expenses paid to Eden T. Brekke and Joseph Greenspahn, and also of $4,500 paid to Charles W. Mander for legal expenses. Effect will be given to all the foregoing in our decisions. The questions here presented are:
Pursuant to a plan agreed upon by three of the individual petitioners and a charitable organization: The petitioner Kyron Foundation, Inc., was organized with capital of $1,000 to acquire all the stock and succeed
to the business of an operating corporation controlled by the individuals, which had gross assets per books of more than $1,200,000, and earned surplus and undivided profits of approximately $598,000; the charity paid Kyron $1,000 and received all its authorized shares of stock; the individuals transferred to Kyron all stock of the operating corporation and received $4,000,000 of Kyron's notes, of which $400,000 was immediately satisfied out of assets taken over from the acquired corporation, and of which $3,600,000 was to be paid with interest over a 10-year period, out of profits of the continuing business; and the individuals were retained as ‘ managers' of the continuing business, under a 7-year management contract. After less than 1 year, the charitable organization sold its stock to the individuals and withdrew from all participation.
1. Did the $4,000,000 of corporate notes which the individuals received, represent a bona fide debtor-creditor relationship- so that the $400,000 payment thereon constituted proceeds from a sale of their capital investment in the business, and thereby became entitled to capital gains treatment? Or did such notes represent, in reality and irrespective of their form, a continued capital investment of the individuals in the business- so that said $400,000 payment constituted a taxable dividend? (This issue is the only one presented in the cases of the individual petitioners.) 2. Is Kyron Foundation, Inc., exempt from income tax, for both of its fiscal periods here involved, as a corporation organized and operated exclusively for charitable purposes, within the meaning of section 101(6) of the 1939 Code? 3. Assuming that Kyron Foundation, Inc., is not exempt from income tax, is it entitled to deduction for: (a) $86,949.67 which it accrued, in its first taxable period, as interest on certain of the corporate notes mentioned in question 1; (b) $90,000 which it accrued, in its second fiscal period, as interest on said corporate notes; and (c) $3,603.50 which it accrued, in its second period, as interest on the disputed income tax liability for the prior period, which is here in issue? 4. Assuming again that Kyron Foundation, Inc., is not exempt from income tax, is it liable, under section 291(a) of the 1939 Code, for an addition to the tax for each of the periods involved, by reason of failure to file its return within the time prescribed for such filing? FINDINGS OF FACT. Petitioners Emanuel and Pauline Kolkey were husband and wife during the taxable year 1949. Likewise, Maurice and Rosalie Cowen were husband and wife, as were also Barnet and Bertha Perel. Each Page 40 of these couples filed a joint income tax return for such year, with the then collector of internal revenue for the first district of Illinois. The deficiencies determined against the wives arise solely from their being parties to such joint returns. The husbands, who all had a direct interest in the transactions here involved, are hereinafter referred to as Kolkey, Cowen, and Perel. The petitioner, Kyron Foundation, Inc., hereinafter described more fully, is a Delaware corporation. It filed its return for each of its taxable periods here involved with the then collector of internal revenue for the second district of New York. In 1946, Kolkey who was the operator of a barbecue restaurant in Chicago, and Cowen and Perel who were law partners that engaged in various commercial enterprises, organized an Illinois corporation, known as World Wide Laboratories, Inc., to sell through the mails a preparation called ‘ Kyron,’ which was claimed to be a remedy for obesity. This preparation, which had been developed by Cowen with the assistance of a pharmacologist, was produced in the form of small tablets or pills, and sold with an enclosed booklet which set forth recommended menus to be used therewith, entitled ‘ Reducing the New Common Sense Way.’ Within about 3 months after said corporation commenced the distribution of its product, the Post Office Department served it with notice to show cause why a fraud order should not be issued, on the ground that it was engaged in a scheme to obtain money through the mails by means of false and fraudulent pretenses, representations, and promises. Thereafter, on July 30, 1947, Kolkey and Cowen filed an affidavit with the postal authorities, in which they said...
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