Centel Communications Co. v. C.I.R.

• Decision Date: 17 December 1990
• Docket Number: No. 89-3650,89-3650
• Citation: 920 F.2d 1335
• Parties: -373, 90-2 USTC P 50,603 CENTEL COMMUNICATIONS COMPANY, Successor in interest to Fisk Telephone Systems, Inc., Successor in interest to Fisk Telephone Systems, Inc. and Subsidiaries, Petitioner-Appellant, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.
• Court: U.S. Court of Appeals — Seventh Circuit

Page 1335

920 F.2d 1335

67 A.F.T.R.2d 91-373, 90-2 USTC P 50,603

CENTEL COMMUNICATIONS COMPANY, Successor in interest to Fisk Telephone Systems, Inc., Successor in interest to Fisk Telephone Systems, Inc. and Subsidiaries, Petitioner-Appellant, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.

No. 89-3650.

United States Court of Appeals Seventh Circuit.

Argued Sept. 10, 1990.

Decided Dec. 17, 1990.

Ethel R. Kaplan, McDermott, Will & Emery, Michael M. Conway, David B. Goroff, Frederic L. Hahn, Jay H. Zimbler, George R. Goodman, Hopkins & Sutter, Chicago, Ill., for petitioner-appellant.

Peter K. Scott, I.R.S., Richard Farber, Gary R. Allen, Steven Parks, Dept. of Justice, Tax Div., Appellate Section, Charles S. Casazza, U.S. Tax Court, Washington, D.C., for respondent-appellee.

Before CUMMINGS, CUDAHY and EASTERBROOK, Circuit Judges.

CUMMINGS, Circuit Judge.

The Tax Court held that Centel Communications Company ("Centel") was not entitled to deduct on its 1980 return the value of stock warrants issued to three of its stockholders in 1978 and exercised by them in 1980. At the same time, the Tax Court held that the three stockholders had no additional income when they exercised their warrants in 1980. We affirm.

I. BACKGROUND

Fisk Telephone Systems ("Fisk"), the predecessor of Centel, was formed by Lloyd K. Davis, Rex B. Grey and Fisk Electric Co. ("Electric") in 1971 to engage in the business of selling, leasing and maintaining private and commercial phone systems. In September 1973 Davis, Grey and Electric owned 47% of Fisk's common stock.

During its early years, Fisk showed net losses. It obtained a series of bank loans to carry on its essential operations. Davis and Grey personally guaranteed these loans, and Electric also guaranteed loan repayment by executing indemnification and subordination agreements in favor of the lender. Davis, Grey and Electric provided the guarantees to ensure the survival of Fisk and protect their investments in the company. Fisk's business began improving in 1974, and in 1975 the company showed a profit for the first time. In May of 1978, in recognition of the risks assumed by Davis, Grey and Electric, Fisk granted them warrants authorizing each to purchase 50,000 additional shares of Fisk at $1 per share. The warrants were restricted in that they could only be exercised at specified times prior to May 1, 1982. The three stockholders exercised their warrants in February 1980, just one month before Centel acquired Fisk in a tax-free reorganization. In the reorganization Davis, Grey and Electric traded in the 150,000 shares they had acquired upon exercising their warrants. They received Centel stock worth $1,860,000 more than they had paid for the 150,000 shares in Fisk. At the same time Centel agreed to release Davis, Grey and Electric from their obligations under the guarantees.

In its 1980 tax return Centel claimed a tax deduction in the amount of approximately $1,860,000, pursuant to Section 83(h) of the Internal Revenue Code. ¹ That section allows a deduction for the transfer of property made "in connection with the performance of services." The $1,860,000 figure represented the value of the warrants at the time they were exercised in 1980. However, Davis, Grey and Electric each had reported only $35,000 income in 1978, the figure representing the appraised value of the warrants at the time of issue.

To avoid being "whipsawed" ² by the inconsistent positions taken by Centel and the three stockholders in question, the Commissioner of Internal Revenue deliberately made inconsistent deficiency determinations with respect to the parties. He determined in his notice of deficiency to Centel that Section 83 did not apply to the transfer of the warrants because they were not transferred "in connection with the performance of services." The warrants, in his opinion, were to be treated as constructive dividends to Davis, Grey and Electric and as non-deductible distributions by Centel. Therefore he disallowed in full the deduction Centel had claimed under Section 83(h) in its 1980 tax return.

On the other hand, in the notices of deficiency issued to Davis, Grey and Electric, the Commissioner took the position that Section 83 did apply to the warrant transaction because the warrants were transferred "in connection with the performance of services." The Treasury Regulations promulgated under Section 83 direct that options without a "readily ascertainable" fair market value at the time of issuance be taxed only when the option is exercised. Treas.Reg. Sec. 1.83-7 (1978). In this case the Commissioner believed that the value of the options was not readily ascertainable on the date of issuance. Thus under Section 83 he asserted that the three stockholders received taxable income upon exercise of the Fisk warrants in 1980 in the amount of $621,200 each. ³ Centel was entitled to a corresponding deduction in that same year.

As a result of the Commissioner's intentionally inconsistent positions, Centel, Davis, Grey and Electric all petitioned the Tax Court for a redetermination of their asserted deficiencies. The Tax Court consolidated the cases in view of the "whipsaw" situation presented.

Before the Tax Court, Centel asserted that Section 83 governed the tax consequences of the warrant transaction, that the warrants did not have a readily ascertainable value in 1978, and that under Section 83(h) it was entitled to deduct in 1980 the value of the warrants when they were exercised that year.

To the contrary, Davis, Grey and Electric argued that Section 83 was not applicable to the warrants because they were not received in connection with the performance of services within the meaning of Section 83. They thought the warrants were more aptly characterized as dividends because they were given to company stockholders. Davis, Grey and Electric also argued that the warrants were properly taxed in 1978 because the value of the warrants was apparent at that time. At trial, the Commissioner introduced expert testimony to establish that the warrants did not have a readily ascertainable value in 1978 while Davis, Grey and Electric introduced contrary testimony.

The Tax Court excused the Commissioner from filing an opening brief, reasoning that the Commissioner's role in the litigation was essentially that of a stakeholder who wished only to obtain consistent tax treatment of the transaction. The Commissioner did file a post-trial brief. In it he stated that Section 83 did not apply to the transaction because the guarantees the stockholders supplied were not the performance of a service within the meaning of Section 83.

Though the Commissioner in his post-trial brief agreed with the stockholders that Section 83 did not apply to the transaction, he did not recommend that the stockholders prevail. For the first time the Commissioner argued that, under the "open transaction" doctrine, which applies to options not granted in return for services, any treatment of the income and deductions should have been deferred to 1980 even if Section 83 did not apply. The "open transaction" doctrine was enunciated in Burnet v. Logan, 283 U.S. 404, 51 S.Ct. 550, 75 L.Ed. 1143 (1931). Under the doctrine, taxpayers report income and deductions attributable to warrants without an "ascertainable" value only upon exercise of the warrants. The evidence at trial, in the Commissioner's opinion, established that the warrants' value was not ascertainable in 1978. Thus the taxpayers properly should have reported their income and deductions in 1980 when the stockholders exercised their warrants and the warrants' value was apparent.

Davis, Grey and Electric moved to strike the Commissioner's new argument about the applicability of the "open transaction" doctrine. They pointed out that the trial had focussed solely on Section 83 issues and contended that the late introduction of the "open transaction" theory prejudiced their case. Centel naturally supported the Commissioner's position and opposed the motion to strike.

The Tax Court granted the stockholders' motion and struck the portions of the Commissioner's brief devoted to the "open transaction" doctrine. The issue was stricken with respect both to the stockholders and Centel. On the merits, the court held that Section 83 did not apply to the warrant transaction. The court reasoned that Davis, Grey and Electric had executed guarantees in Fisk's favor to protect their own investments and not to perform services for the company. Fisk's grant of warrants to the stockholders thus was not "in connection with" any performance of services. In these circumstances, the stockholders had properly declared income in 1978 and earned no additional income in 1980. Centel's 1980 deduction was disallowed.

The Tax Court also considered and rejected Centel's alternative argument that its 1980 deduction was proper under Treasury Regulations Sec. 1.61-15. The Tax Court held that the regulation, like Section 83, only applied to transactions involving the performance of services.

We agree with the Tax Court that neither Section 83 nor Treasury Regulations Sec. 1.61-15 is applicable to the warrant transaction at issue in this case. We also hold that the Tax Court did not abuse its discretion in refusing to consider the "open transaction" argument advanced by the Commissioner in his post-trial brief. We therefore affirm its judgment against Centel. ⁴

II. ANALYSIS

A. The Tax Court's Refusal to Consider the Applicability of the "Open Transaction" Doctrine.

Centel argues vigorously that the Tax Court was obligated to accept the Commissioner's "open transaction" analysis and approve Centel's 1980 deduction on that basis. Centel construes the statements made in the Commissioner's post-trial brief as admissions and contends that the Tax Court abused its discretion by striking the portions of the brief favorable to Centel.

The Commissioner did recommend that Centel prevail in a...