Rosen v. Comm'r of Internal Revenue , Docket No. 7179-71.

• Citation: 62 T.C. 11
• Decision Date: 08 April 1974
• Docket Number: Docket No. 7179-71.
• Parties: DAVID ROSEN AND VERA ROSEN, PETITIONERS v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT
• Court: United States Tax Court

62 T.C. 11

DAVID ROSEN AND VERA ROSEN, PETITIONERS

v.COMMISSIONER OF INTERNAL REVENUE, RESPONDENT

Docket No. 7179-71.

United States Tax Court

Filed April 8, 1974.

Jerome Kaplan, for the petitioners.

Alan E. Cobb, for the respondent.

Petitioner transferred all the assets and liabilities of a sole proprietorship to a corporation in which he owned 100 percent of the issued and outstanding stock. At the time of the transfer, the liabilities exceeded the assets and the corporation was, in fact, insolvent. Thereafter, petitioner unsuccessfully sought additional capital for the corporation. Petitioner at all times remained liable for the liabilities transferred to the corporation. Held: Petitioner nevertheless realized gain under sec. 357(c) to the extent that the liabilities entire amount of such gain determined to be ordinary under sec. 1245. Held, further, as a result of the gain realized under sec. 357(c), petitioners do not have a net operating loss for the taxable year 1967 which can be carried back to and used as a net operating loss deduction for the taxable year 1965.

QUEALY, Judge:

The respondent determined deficiencies in the Federal income tax of the petitioners for the taxable years 1965 and 1967 in the amounts of $3,481.33 and $87,010.81, respectively.

The principal issue for our determination is whether petitioner, David Rosen, realized gain under section 357(c)¹ in the taxable year 1967, on the transfer of all the assets and liabilities of his sole proprietorship to a corporation, in which he owned 100 percent of the outstanding stock, to the extent that the liabilities assumed exceeded his adjusted basis in the assets transferred.

The resolution of such issue will determine whether and to what extent petitioners have a net operating loss for 1967 which they would be entitled to carry back as a deduction to the taxable year 1965.

FINDINGS OF FACT

Petitioners are David and Vera Rosen, husband and wife, whose place of residence at all times pertinent herein was Philadelphia, Pa. Petitioners filed their joint Federal income tax returns for the taxable years 1965 and 1967 with the district director of internal revenue, Philadelphia, Pa. Vera Rosen is a party to this action only by virtue of having filed a joint return with her husband. Accordingly, further references to ‘petitioner’ will refer only to David Rosen.

Petitioner was engaged in the leasing and selling of coin box equipment and phonograph records. The major portion of his business was conducted through his wholly owned corporation, David Rosen, Inc., although he did have numerous other business entities carrying on related aspects of the business.

On May 14, 1965, David Rosen (hereinafter referred to as petitioner) entered into a distributorship agreement with Societa' Internazionale Fonovisione, S.p.A. (hereinafter referred to as SIF), a corporation organized and existing under the laws of the Republic of Italy. Under the distributorship agreement, petitioner received the exclusive right to distribute motion picture jukeboxes bearing the name ‘cinebox’ and ‘cinejukebox’ in the United States of America, its territories and possessions. Cinebox is a coin-operated machine equipped with a selector device which permits the seeing and hearing of preselected motion pictures. Cinejukebox possesses the same qualities of a cinebox except it provides an additional jukebox feature which permits a customer to choose between a motion picture or phonograph record. At the time the agreement was entered into, the cinejukebox was still in the development stages.

The agreement provided that petitioner had the right to assign the distributorship to a domestic U.S. corporation in which he owned 51 percent or more of the outstanding voting stock and which possessed a net worth of at least $100,000. If exercised, however, he would be precluded, without the written consent of SIF, from divesting himself of the minimum required control any time before May 31, 1967. In the event the assignee corporations agreed to assume liability for petitioner's obligations under the agreement, he would be released of any further liability thereunder.

The initial term of the agreement was from May 14, 1965, to May 31, 1967, automatically renewable for successive periods of 1 year for 10 consecutive years.

At the outset, petitioner operated his exclusive distributorship in the form of a sole proprietorship under the trade name Cinebox U.S.A. (hereinafter referred to as Cinebox). He elected to report the income and losses of the business on the accrual method of accounting. Its business consisted of leasing cineboxes and selling the films and parts which went with the machines.

The initial promotional effort by Cinebox involved the leasing of 60 cineboxes on a 25-week trial basis to distributors throughout the country. Although the machines were favorably received, there were numerous complaints about the inadequate selection and supply of films used in the machines. The results may be summarized as follows:

+---+
                ¦¦¦¦¦
                +---+
                

         Year ended 6 months Totals
                         12/31/66   6/30/67
                Receipts $43,900    $7,400   $51,300
                

Less
                Expenses     113,500 100,700 214,200
                Depreciation 157,700 30,100  187,800
                Net loss     227,300 123,400 350,700
                

The losses thus sustained were reflected in the individual income tax returns filed by petitioner for the years 1966 and 1967. The funds needed to meet the deficit in cash flow from such operations were provided by petitioner directly or by way of withdrawals from his wholly owned corporation, David Rosen, Inc.

Petitioner would deposit funds with David Rosen, Inc., earmarked for the cinebox operations in addition to permitting the amounts owed him by David Rosen, Inc., to accumulate in the ‘officer's account’ on the books of the corporation. Whatever advances were made by David Rosen, Inc., to satisfy the current operating expenses of the cinebox operations were repaid from these two sources.

With the successful development and testing of the new cinejukebox in early 1967, petitioner decided to transfer the cinebox operations to a corporation with the expectation that new financing from outside sources might be more readily available to cover the cost of purchasing and distributing the cinejukebox on a widespread commercial basis.

On July 1, 1967, petitioner transferred all the assets and liabilities of Cinebox to Filmotheque Discotheque, Inc. (hereinafter referred to as Filmotheque), a Pennsylvania corporation formed by him in June of 1966 and in which he held 100-percent control. Until the time the transfer occurred, Filmotheque had remained an inactive shell, having a capitalization of $1,000 from the issue of 1,000 shares at $1 each. As of June 30, 1967, the assets and liabilities of the cinebox business, which were taken over by Filmotheque, consisted of the following:

+-----------------+
                ¦Assets   ¦¦      ¦
                +---------++------¦
                ¦Cash     ¦¦$57.94¦
                +-----------------+
                

Inventory
                Cineboxes               $259,415.75
                Less: Depreciation      187,809.56  71,606.19
                Film                                41,470.28
                Prepaid finance charges             31,409.74
                Prepaid expenses                    217.43
                Total assets                        144,761.58
                

+------------------------------+
                ¦Liabilities and net worth   ¦¦¦
                +----------------------------++¦
                ¦                            ¦¦¦
                +------------------------------+
                

Accounts payable
                David Rosen, Inc  $33,727.33
                Escrow leasing    57,566.86  $91,294.19
                

Notes payable—current
                Continental Bank & Trust Co 55,000.00
                Lincoln National Bank       2,500.00
                Lincoln National Bank       42,315.74
                Globe Consumer Discount Co  13,520.00 113,335.74
                

Notes payable—long term
                Lincoln National Bank           54,166.90
                Globe Consumer Discount Co      33,280.00 87,446.90
                Loans payable—David Rosen                 159,957.54
                Total liabilities                         452,034.37
                Investment                                40,000.00
                Net loss                                  (347,272.79)
                Total net worth                           (307,272.79)
                Total liabilities and net worth           144,761.58
                

The adjusted basis of the above assets and liabilities in the hands of petitioner at the time of the transfer are identical to the balance sheet figures shown above.

With respect to the balance sheet entry of $159,957.54 shown as owing to petitioner individually, respondent concedes that such amount should not be considered a liability for purposes of the present inquiry since it merely represents capital contributions by petitioner to offset the prior operating losses of the business. As to the remaining obligations listed above, petitioner was and remained personally liable thereon for the full amount.

Filmotheque never maintained its own set of books and records. Instead, both before and after the transfer, operations of the cinebox business were recorded on an accounts receivable ledger card of David Rosen, Inc., which reflected both the receipt of revenues and the payment of expenses. The actual title on the ledger card itself was not changed from Cinebox to Filmotheque until the middle of November.

The inventory of machines was stored in a warehouse of David Rosen, Inc., where it has remained ever since. None of the inventory has been either sold or leased.

In November of 1967, 40 cineboxes were purchased by Filmotheque at a cost of $76,200, financed with a loan of $100,000 from Philadelphia National Bank. The loan was guaranteed by petitioner personally. In giving the loan, a bank official testified that it had no financial data on Filmotheque whatsoever. The cinejukeboxes have remained in a bonded warehouse as a consequence of failing to pay the import duties thereon.

The revenue and operating expenses of Filmotheque as reflected in summary form on its corporate income tax return filed for the taxable period ended December 31, 1967, consisted of the following:

+-------------------------------------------------+
                ¦Income:

...