Frantz v. C.I.R.

• Citation: 784 F.2d 119
• Decision Date: 19 February 1986
• Docket Number: No. 154,D,154
• Parties: -874, 54 USLW 2476, 86-1 USTC P 9249 Leroy FRANTZ, Jr. and Sheila Frantz, Petitioners, v. COMMISSIONER OF INTERNAL REVENUE, Respondent. ocket 85-4062.
• Court: United States Courts of Appeals. United States Court of Appeals (2nd Circuit)

Page 119

784 F.2d 119

57 A.F.T.R.2d 86-874, 54 USLW 2476, 86-1

USTC P 9249

Leroy FRANTZ, Jr. and Sheila Frantz, Petitioners, v. COMMISSIONER OF INTERNAL REVENUE, Respondent.

No. 154, Docket 85-4062.

United States Court of Appeals Second Circuit.

Argued Oct. 1, 1985.

Decided Feb. 19, 1986.

Patrick J. Carr, New York City (Eagle & Fein, P.C., New York City of counsel), for petitioners.

David Pincus, Appellate Section, Tax Div., Dept. of Justice, Washington, D.C. (Glenn Archer, Jr., Asst. Atty. Gen., Washington, D.C., Fred T. Goldberg, Jr., Chief

Counsel, Washington, D.C., of counsel, for respondent.

Before LUMBARD, MANSFIELD and WINTER, Circuit Judges.

MANSFIELD, Circuit Judge:

Leroy Frantz, Jr. and his wife Sheila Frantz (hereinafter referred to in the singular as the "taxpayer" since Mr. Frantz was the principal actor in the relevant transactions) appeal from a decision of the United States Tax Court, Sterrett, C.J., entered on January 29, 1985 (reported at 83 T.C. 162), holding that their non-pro-rata surrender of their preferred stock in a closely-held corporation controlled by them, Andree Biallot, Ltd. (ABL), and their cancellation of indebtedness for advances made to ABL for the purpose of enabling it to improve its financial statements and to attract outside financing, were capital contributions rather than ordinary losses deductible under Sec. 165(c)(2) of the Internal Revenue Code of 1954 (hereinafter I.R.C.), 26 U.S.C. Sec. 165(c)(2). ¹ The taxpayer also appeals from the Tax Court's decision that the taxpayer's common stock in ABL did not qualify under I.R.C. Sec. 1244, 26 U.S.C. Sec. 1244, ² for allowance of an ordinary loss of $50,000 on sale of a small business stock. We affirm.

The material facts are not disputed. On June 30, 1971, the board of directors and shareholders of ABL, a New York corporation that had been experiencing financial difficulties in the conduct of a perfume business, adopted a plan of reorganization whereby it would offer stock pursuant to Sec. 1244. Prior thereto ABL had issued 1,677 shares of common stock for which it had received $219,250. During the period from September 25, 1970, to February 1 1971, the taxpayer had made advances of $80,000 to the corporation. Under the reorganization plan 41,925 shares of new preferred stock were issued by ABL in exchange for the company's outstanding 1,677 shares of the previously-issued common. As part of the plan a composition with creditors of ABL was negotiated whereby creditors classified as "Class C" creditors exchanged their claims against it totalling $383,840 for 76,768 shares of its new preferred. As one of these participating creditors, the taxpayer received 16,000 shares of new ABL preferred stock in exchange for claims of $80,000 for prior advances to ABL.

The June 30, 1971, reorganization plan authorized ABL to issue over a two-year period 500,000 shares of its common stock with a par value of $.01 per share on the understanding that the "maximum amount to be received by the Corporation in consideration of the stock to be issued pursuant to this plan or as a contribution to capital shall be $500,000." Upon adoption of the plan 276,250 new ABL common shares were issued to the taxpayer for $150,000, of which $2,762.50 represented payment for the stock at par value and $147,237.50 payment to capital surplus. At the same time 148,750 new common shares were issued at par value ($.01 per share) to the following:

Thomas M. Biallo, President ...... 85,000 shares

Patrick J. Carr, Executive Vice

President ...................... 42,500 shares

Francis X. Weston, Treasurer ..... 21,250 shares

Thus the taxpayer was elected Chairman of the Board and became owner of 65% of ABL's outstanding common and 13% of its preferred.

During the period from June 1971 through July 1973 the taxpayer advanced approximately $208,600 to ABL, of which $50,000 represented senior indebtedness for which the taxpayer received a non-interest bearing note. The financial condition of the company, however, continued to deteriorate. As a result, on May 4, 1973, the taxpayer entered into a written agreement with ABL whereby he surrendered all of his ABL preferred stock and cancelled "all notes and accounts receivable" due him, which he contributed "to the capital of the Company". In exchange, ABL agreed to accept the taxpayer's "contribution ... to its capital" in order to improve the company's financial statements and attract new capital from other sources. On November 9, 1973, the taxpayer entered into a similar agreement with ABL whereby he agreed to surrender "all notes and accounts receivable" due from ABL as a "contribution to ... capital". No similar surrender of shares or forgiveness of indebtedness was made by any other ABL stockholder. Thus the taxpayer's 65% ownership of ABL's outstanding common remained unaffected by the taxpayer's contributions to capital.

On December 27, 1973, the taxpayer sold his 276,250 shares of ABL common stock for $8,000, reflecting a loss of $142,000. For the year 1973 the taxpayer claimed ordinary losses of $210,600 for the surrender of the accounts and notes receivable to ABL, $32,000 for surrender of the preferred stock, and $50,000 under Sec. 1244 on the sale of common stock. In addition, he claimed a long-term capital loss of $92,000 on the sale of the common stock. The Commissioner disallowed the claimed ordinary losses on the surrender of the notes, accounts receivable and preferred stock, on the ground that they represented contributions to capital. However, the taxpayer was allowed to increase the basis of the common stock by the amount of the surrendered preferred stock, notes and accounts receivable, thereby increasing the long-term deductible capital loss claimed on the sale of the common stock.

On November 26, 1979, the taxpayer filed a petition in the Tax Court for redetermination of the tax due, claiming that the surrenders to ABL of his preferred stock and earlier advances resulted in a loss "incurred in [a] transaction entered into for profit" within the meaning of I.R.C. Sec. 165(c)(2). The Commissioner denied the material allegation that certain of the items were deductible as ordinary losses and further alleged that the taxpayer had improperly deducted $50,000 under Sec. 1244 as an ordinary loss on the December 1973 sale of the common stock, asserting that it must be treated as a long-term capital loss.

The taxpayer continued to claim that the surrender of the preferred stock and claims arising from $158,600 in advances were deductible as ordinary losses under a line of Tax Court cases holding that a shareholder's non-pro-rata surrender of stock to his corporation or to third parties in order to benefit the corporation results in an immediately deductible ordinary loss. Smith v. Commissioner, 66 T.C. 622 (1976), rev'd sub nom., Schleppy v. Commissioner, 601 F.2d 196 (5th Cir.1979); Duell v. Commissioner, 19 T.C.M. 1381 (1960); Estate of Foster v. Commissioner, 9 T.C. 930 (1947), acq. 1948-1 C.B. 2; Miller v. Commissioner, 45 B.T.A. 292 (1941), acq., 1941-2 C.B. 9, acq. revoked and nonacq. substituted, 1977-2 C.B. 2; Budd International Corp. v. Commissioner, 45 B.T.A. 737 (1941), acq., 1942-2 C.B. 3, acq. revoked and nonacq. substituted, 1977-2 C.B. 2, rev'd on other grounds, 143 F.2d 784 (3d Cir.1944), cert. denied, 323 U.S. 802, 65 S.Ct. 562, 89 L.Ed. 640 (1945); Clement v. Commissioner, 30 B.T.A. 757 (1934); City Builders Finance Co. v. Commissioner, 21 B.T.A. 800 (1930); Burdick, Executrix v. Commissioner, 20 B.T.A. 742 (1930), aff'd, 59 F.2d 395 (3d Cir.1932); Wright v. Commissioner, 18 B.T.A. 471 (1929), modified, 47 F.2d 871 (7th Cir.1931); see also Scherman v. Commissioner, 74 F.2d 742 (2d Cir.1935) (allowing immediate deduction for loss relating to transfer of shares to employee of the corporation); Tilford v. Commissioner, 75 T.C. 134 (1980), rev'd, 705 F.2d 828 (6th Cir.), cert. denied, 464 U.S. 992, 104 S.Ct. 485, 78 L.Ed.2d 681 (1983) (capital loss allowed on stock transfer to employee); Downer v. Commissioner, 48 T.C. 86 (1967) (capital loss allowed on stock transfer to employee).

The Tax Court ruled in favor of the Commissioner. Relying on recent decisions of the Fifth Circuit in Schleppy v. Commissioner, 601 F.2d 196 (5th Cir.1979), and the Sixth Circuit in Tilford v. Commissioner, 705 F.2d 828 (6th Cir.), cert. denied, 464 U.S. 992, 104 S.Ct. 485, 78 L.Ed.2d 681 (1983), it overruled the position taken by it for more than 50 years to the effect that each sale or surrender of stock must be treated as a discrete, fragmented, divisible transaction that closes with the sale or surrender itself. Instead it adopted the view that, when a stockholder surrenders his preferred stock on a non-pro-rata basis to a corporation for the purpose of improving the company's financial statement and enhancing the value of the stockholder's retained common, the transaction does not close until sale of the common. Under this analysis the taxpayer's surrender of the preferred stock in the present case did not result in a loss incurred in a "trade or business," I.R.C. Sec. 165(c)(1), and was not a transaction entered into for profit within the meaning of I.R.C. Sec. 165(c)(2), but was an "open" non-taxable transaction, the result of which, as far as gain or loss is concerned, could not be determined until the retained common stock was sold. 83 T.C. at 178-81. Accordingly the Tax Court ruled that the surrender constituted a capital contribution which would increase the basis of the taxpayer's common stock by the acquisition cost of the preferred and the amount of the surrendered notes and accounts receivable. In thus reversing its 50-year stand, the Tax Court noted that its prior position "tended to encourage a conversion of eventual capital losses into immediate ordinary losses" and amounted to a "judicial repeal of Sec. 165(g), which treats a loss on worthless stock as a 'loss from the sale...