Mather & Co. v. Commissioner of Internal Revenue
| Decision Date | 03 January 1949 |
| Docket Number | No. 9432.,9432. |
| Citation | 171 F.2d 864 |
| Court | U.S. Court of Appeals — Third Circuit |
| Parties | MATHER & CO. v. COMMISSIONER OF INTERNAL REVENUE. |
Frederick H. Spotts, of Philadelphia, Pa. (Thomas Stokes, of Philadelphia, Pa., William E. Koken, of Washington, D. C., and Pepper, Bodine & Stokes, of Philadelphia, Pa., on the brief), for petitioner.
S. Walter Shine, of Washington, D. C. (Theron Lamar Caudle, Asst. Atty. Gen., George A. Stinson and Lee A. Jackson, Sp. Assts. to Atty. Gen., on the brief) for respondent.
Before MARIS, McLAUGHLIN, and O'CONNELL, Circuit Judges.
The instant appeal raises the question of the propriety of a deduction for losses claimed by petitioner to have been incurred in the separate sales of two pieces of realty. We agree with the conclusion of the Tax Court that, under the applicable statutory provisions, the basis of petitioner, in computing its gain or loss on the sales, was "the same as that of the property in the hands of" the transferor to petitioner.1
Charles Mather founded in 1887 an insurance firm. As of October 29, 1926, there were four partners: Charles and three children named Victor, Gilbert, and Josephine. According to their partnership agreement, "the only contribution to Capital Account made by" the four was the $150,000 invested in their Walnut Street, Philadelphia, premises, to which total they had given as follows: Charles, $52,500 (35%); Victor, $37,500 (25%); Gilbert, $30,000 (20%); and Josephine, $30,000 (20%). The net earnings of the partnership were to be divided in the same percentages. This agreement also contained a number of provisions designed to keep the business a family enterprise.
On October 29, 1946, the four partners signed an agreement which called for incorporation of the firm, with a capital stock of $510,000, of which $500,000 was 6% cumulative preferred stock, par value $100 per share, and $10,000 was voting common stock, par value $10 per share. All partnership assets and good will, save those of its New York office, were transferred to the corporation.
The issuance of shares in the corporation took the following form:
(1) In tangible assets the partnership had $1,484,978.78, of which $1,299,978.78 were "current assets" (cash, notes and accounts receivable, and bank stock), $150,000 was the declared value of the partnership real estate, and $35,000 was the declared value of the furniture and fixtures; and the accounts payable of the partnership, which petitioner assumed, totalled $1,299,978.78 (identical with the "current assets"). The $185,000 excess of partnership assets over partnership liabilities was represented by 1850 shares of preferred stock, of which Charles was given 648 shares (35.03%), Victor 462 (24.97%), Gilbert 370 (20%), and Josephine 370 (20%).
(2) Charles, as authorized by the October 29 agreement, conveyed premises at Arch Street, premises at Chestnut Street — both of which were separately owned by him — and gave petitioner a $50,000 promissory note in exchange for the remaining 3150 shares of preferred stock. The Arch Street property at that time had a fair market value of $350,000, and was encumbered by a mortgage of $150,000; the Chestnut Street property, then having a fair market value of $115,000, was encumbered by a mortgage of $50,000. Consequently, it may be seen that Charles conveyed two pieces of realty worth $265,000 more than the mortgages to which they were subject, plus giving a $50,000 note, or the equivalent of $315,000 for the 3150 preferred shares.2
(3) The common stock was issued in exchange for the good will of the going business. Charles, Victor, and Gilbert were each given 250 shares; Josephine, 50, of which 3 were initially issued to three other individuals for the purpose of qualifying them as directors; and the remaining 200 shares became treasury stock. The common stock then had an agreed value of $50 per share.
Petitioner claimed and was allowed depreciation deductions on the buildings on the Arch Street and Chestnut Street properties — which buildings were worth $60,000 and $30,000, respectively, at the time of incorporation — until they were demolished in 1934 and 1936 respectively.
The Arch Street premises were sold for $20,000 on December 31, 1942, and the Chestnut Street property for $2500 on December 30, 1943. The bona fide nature of these sales is not questioned. Asserting that its cost basis of these properties was $290,000 ($350,000 minus $60,000) and $85,000 ($115,000 minus $30,000) respectively, petitioner claimed a loss of $270,000 on its 1942 income tax return, plus its expenses of sale, and a loss of $82,500 on its 1943 income tax return, plus its expenses of sale. Respondent, on the other hand, successfully maintained in the Tax Court the theory that the incorporation of the partnership was a tax-free exchange, so that petitioner's cost basis on the Arch and Chestnut Street properties was the cost of these properties to Charles Mather.
Was the 1926 transaction a tax-free exchange?
Section 203(b) (4) of the Revenue Act of 1926, 26 U.S.C.A. Internal Revenue Acts 1924 to Date, page 149, reads as follows:
"No gain or loss shall be recognized if property is transferred to a corporation by one or more persons solely in exchange for stock or securities in such corporation, and immediately after the exchange such person or persons are in control of the corporation; but in the case of an exchange by two or more persons this paragraph shall apply only if the amount of the stock and securities received by each is substantially in proportion to his interest in the property prior to the exchange."
This provision, a reenactment of Section 203(b) (4) of the Revenue Act of 1924, 43 Stat. 256, had been preceded by Section 202 (c) (3) of the Revenue Act of 1921, 42 Stat. 230, which was interpreted in Labrot v. Burnet, 1932, 61 App.D.C. 47, 57 F.2d 413. The legislative history of this provision indicates that its purpose was to establish "new rules for those exchanges or `trades' in which, although a technical `gain' may be realized under the present law, the taxpayer actually realizes no cash profit." Halliburton v. Commissioner, 9 Cir., 1935, 78 F. 2d 265, 269. With this background, we proceed to the initial question whether or not the exchange effectuated in accordance with the agreement of October 29, 1926, was tax-free within the meaning of Section 203(b) (4) of the Revenue Act of 1926, without reference to amendments thereto which we shall consider hereinafter.
The parties agree that the answer to this question depends upon whether "the amount of the stock and securities received by each is substantially in proportion to his interest in the property prior to the exchange," all other requirements of the section being here present. Summarizing the facts stated above, in the form of a table, we find the exchange to have had the following result:
Net Value Net Value
Transferred Received Gain Loss
Charles Mather ............ $393,750 $392,300 $1450
Victor Mather ............. 56,250 58,700 $2450
Gilbert Mather ............ 45,000 49,500 4500
Josephine Mather .......... 45,000 39,500 5500
________ ________ _____ _____
540,000 540,000 6950 6950
Petitioner asserts that the proper method for calculating each partner's proportionate interest in the property is to divide the gain or loss each was occasioned by the net value each transferred. Under this theory, Josephine suffered a 12.2% loss and Gilbert a 10% gain, or a spread of 22.2%.3 This they contend is not "substantially in proportion" to their interests prior to the exchange. Respondent, on the other hand, urges that the statute requires that the proportionate interest transferred by each be compared with the proportionate interest each received. Using this system, we note that Josephine suffered a 1.02% loss and Gilbert a 0.84% gain, or a spread of 1.86%.4
Each approach can cite respectable authority in its favor. After careful consideration, we are of the opinion that the position of respondent, which is in conformance with that indicated in Hartford-Empire Co. v. Commissioner, 2 Cir., 1943, 137 F.2d 540, 542, certiorari denied 1943, 320 U.S. 787, 64 S.Ct. 196, 88 L.Ed. 473, and Budd International Corp. v. Commissioner, 3 Cir., 1944, 143 F.2d 784, 791, certiorari denied, 1945, 323 U.S. 802, 65 S.Ct. 562, 89 L.Ed. 640, is correct. Our conclusion is based upon three cogent factors:
(1) The purpose of the statutory provision demonstrably being to eliminate the incidence of taxation from transactions contemplating and effectuating only technical gains and losses, we think the facts at bar clearly call for such a result. We note that, although Charles did report gain from the sale of the Arch Street and Chestnut Street properties on his 1926 individual income tax return, neither he nor Josephine claimed deductions for the losses suffered, nor did Victor or Gilbert report their gains from transfer of the partnership assets to the corporation. That any "profit" or "loss" could even be asserted here was a consequence only of capitalization of good will, and an apparently arbitrary apportionment of its value among the partners,5 since the preferred stock, representing all the tangible assets of the enterprise, was issued almost exactly in accordance with the capital contribution of each of the partners.
(2) The statutory provision requires that the interest acquired by each person be in substantial "proportion to his interest in the property prior to the exchange." (Emphasis supplied.) The interpretation advanced by petitioner gives recognition to neither of the italicized words. "Property" here can mean only $540,000. The interest of Josephine in...
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