Adair v. Commissioner

• Decision Date: 06 August 1985
• Docket Number: 22778-81.,9235-79,Docket No. 3881-79,22777-81
• Citation: 50 TCM (CCH) 620,1985 TC Memo 392
• Parties: William S. Adair and Florence O. Adair, et al. v. Commissioner.
• Court: U.S. Tax Court

50 T.C.M. (CCH) 620 (1985)

T.C. Memo. 1985-392.

William S. Adair and Florence O. Adair, et al.¹ v. Commissioner.

Docket Nos. 3881-79, 9235-79, 22777-81, 22778-81.

United States Tax Court.

Filed August 6, 1985.

H. G. Sparrow III, and Thomas D. Hammerschmidt, Jr., 800 First National Building, Detroit, Mich., for the petitioners in docket No. 3881-79.

Stephen Wasinger and Richard S. Soble, 2290 National Building, Detroit, Mich., for the petitioners in docket No. 9235-79. Michael K. Cavanaugh and Robert E. Arroyo, 233 S. Wacker Dr., Chicago, Ill., for the petitioner in docket Nos. 22777-81 and 22778-81. Beth L. Williams, for the respondent.

Memorandum Findings of Fact and Opinion

WHITAKER, Judge:

In docket No. 3881-79, respondent determined the following deficiencies in Federal income tax for the calendar year 1973:

                        Petitioners2                        Deficiency
                   William S. and Florence O
                     Adair ...............................       $ 6,651.75
                   John J. and Marianne E. Alf                   $49,164.72
                   Hayward V. and Sandra G
                    Burton ...............................           883.12
                   George W. and Betty L
                    Crawford .............................         1,252.50
                   Frank J. and Joyce E. Drayton
                    Jr.3 ............................         9,771.60
                   Thomas A. and Linda E
                    McAllister ...........................         4,565.50
                   Lester W. and Barbara
                    Washington ...........................        37,325.46
                

In docket No. 9235-79, respondent determined a deficiency in Donald R. and Cecile A. Borgeson's⁴ Federal income tax for 1973 in the amount of $85,616.80.⁵ In docket Nos. 22777-81 and 22778-81, respondent determined the following deficiencies in Clow's Federal income tax:

                Docket
                  No.                  1971               1972         1973
                22777-81 ......... $288,513.006      N/A           N/A
                22778-817 ...   80,514.00         $35,365.00   $124,573.00
                

The issues addressed in this opinion arise out of or are incident to:

(1) The issuance, in 1973, of contingent stock by Clow Corporation (Clow) as required under a 1971 agreement whereby Clow acquired Vulcan Laboratories, Inc. (Vulcan). Prior to the agreement, 99.73 percent of Vulcan stock was owned by petitioner Donald R. Borgeson (Borgeson) and certain petitioners in docket No. 3881-79; and

(2) the reissuance of a portion of said contingent stock to petitioners in docket No. 3881-79 upon the exercise of options granted to them by Borgeson.

Issues pertaining to said contingent stock were severed from the remaining issues in docket No. 22777-81 and consolidated herein.⁸ If the parties are unable to agree upon the value of the Clow stock at the times relevant to these proceedings, a separate trial to determine said value will be held. Thereafter, a computation under Rule 155⁹ will be necessary. The issues presently before the Court are:

(1) Whether petitioners in docket No. 3881-79 realized ordinary income in 1973 as a result of exercising options to purchase Clow preferred stock;

(2) in the event there was compensation income as described in issue (1), whether Clow is entitled to a corresponding deduction for compensation paid;

(3) if Clow is entitled to a deduction as described in issue (2), whether any portion of that deduction is reduced by Clow's imputed interest deduction; and

(4) whether the imputed interest with respect to contingent stock received by petitioners in docket No. 3381-79 upon the exercise of options they received from Borgeson is taxable, in whole or part, to said petitioners or to the Borgesons.

Findings of Fact

Some of the facts have been stipulated and are so found. At the time their petitions were filed, petitioners Adair, Alf, Burton, Crawford, Drayton, McAllister, and Borgeson resided in the State of Michigan. Petitioners Washington resided in Dunwoody, Georgia, at the time their petition was filed. Petitioner Clow, a Delaware corporation, had its principal office in Oak Brook, Illinois, at the time its petitions herein were filed.

Vulcan was incorporated in Michigan in 1962. At that time, 52 percent of its issued stock was owned by Borgeson and 48 percent was owned by James A. Porter. In 1967, Mr. Porter resigned from Vulcan and all of his stock was redeemed. From the time of the redemption until January 1969, Vulcan was wholly owned by Borgeson.

On January 24, 1969, Vulcan issued a stock bonus to six key employees "in consideration of their competent, diligent and extraordinary service" to Vulcan and "in appreciation for their loyalty to the company and for their substantial contributions to the growth and success" of Vulcan.¹⁰ Each stock bonus recipient paid one dollar as consideration for the shares received. The job position and approximate date of employment by Vulcan of the recipients, as well as the value of each bonus (based on book value of $15.19 per share), were as follows:

                                                                                                          Value of
                       Name                          Title                   Date of Employment11     Shares
                Alf ................ Vice President ..........................        1965               $6,379.80
                Washington ......... General Sales Manager ...................        1968                2,886.10
                Drayton ............ Manager, Engineering Sales and Detroit
                                      Sales Representative ...................        1960                  759.50
                Adair .............. Bookkeeper, Assistant Corporate Secretary        1964                  455.70
                McAllister ......... Chemist, Field Technical Director .......        1963                  455.70
                Dean ............... Field Engineer ..........................     1967-68                  455.70
                

Following the 1969 stock bonuses, the common stock of Vulcan was owned as follows:

                  Name               Shares      Percentage
                Borgeson .........   10,400        93.27
                Alf ..............      420         3.77
                Washington .......      190         1.70
                Drayton ..........       50          .45
                Adair ............       30          .27
                McAllister .......       30          .27
                Dean .............       30          .27
                                     ______       ______
                                     11,150       100.00
                

Vulcan increased each stock bonus recipient's reported wages, as shown on Forms W-2, and withheld income tax with respect thereto. Alf, Washington, Drayton, Adair, and McAllister, all petitioners in docket No. 3881-79, were aware that the 1969 stock bonus was compensation.¹² Consequently, each included said bonus as compensation income on their 1969 Federal income tax returns.

In or about November 1969, Borgeson was contacted by officers of Clow concerning the possible acquisition of Vulcan by Clow. Borgeson indicated he was willing to sell his controlling interest for cash but Clow countered with a proposal to exchange Clow stock for Vulcan stock. On December 18, 1969, the Vulcan minority shareholders executed a Power of Attorney appointing Borgeson their attorney infact to negotiate and consummate, in his sole judgment and discretion, the sale of their Vulcan stock to Clow.¹³

On January 28, 1970, a reorganization agreement ("Reorganization Agreement") was entered into by Clow and the Vulcan shareholders. In executing this agreement, Vulcan's minority shareholders relied entirely on Borgeson to represent their interests. They did not participate in the negotiations and never gave instructions, or made requests or expressions of dissatisfaction, as to the terms of the deal struck.

The Reorganization Agreement provided for the exchange of all outstanding stock of Vulcan for an aggregate of 16,500 shares of Series A Clow preferred stock¹⁴ ("preferred stock"), plus up to an additional 16,500 shares of such stock ("contingent stock") if the profits of Vulcan reached certain levels in Vulcan's fiscal year ending in 1972.¹⁵ The contingent stock was to be delivered within 2 montths after the close of Vulcan's 1972 fiscal year. No provision was made for the payment of interest on this contingent stock. The exchange provided for in the Reorganization Agreement was intended by all parties to the reorganization to be, and was treated by them as, a tax-free reorganization under section 368 (a)(1)(B). From the reorganization until December 31, 1973 Vulcan was a wholly owned subsidiary of Clow, at which time it was merged into, and became a division of, Clow.

As required in the Reorganization Agreement, on or about March 25, 1970, the closing date of the reorganization, each Vulcan shareholder executed and delivered to Clow an identical investment letter advising Clow that he or she: (1) Would receive and hold all Clow preferred stock received under the Reorganization Agreement as an investment and not for resale; (2) had no intention of selling or distributing any shares of said stock; and (3) if he or she thereafter decided to dispose of said stock, would do so only in accordance with the applicable laws and rules of the Securities and Exchange Commission and any applicable state law and, for a period of 3 years, would give Clow at least 10 days advance, written notice of any proposed transfer.¹⁶ The Reorganization Agreement explicitly prohibited any assignment except upon the written consent of the other parties. Clow was not required to register any of the preferred stock issued in the reorganization and, as of trial, such stock had not been registered.¹⁷ As of trial, neither the stock, rights to acquire said stock or options on said stock had ever been traded on any market.

The Reorganization Agreement did not specify the proportion of preferred stock or contingent stock to be issued to each of the existing Vulcan shareholders but required that, at least 5 days prior to closing, said shareholders jointly request, in writing, the allocation of preferred stock desired. On February 20, 1970, the Vulcan shareholders executed an agreement providing for the allocation of all Clow stock...