Datamation Services, Inc. v. Commissioner, Docket No. 855-74.

• Court: United States Tax Court
• Writing for the Court: RAUM
• Citation: 1976 TC Memo 252,35 TCM (CCH) 1092
• Decision Date: 16 August 1976
• Docket Number: Docket No. 855-74.
• Parties: Datamation Services, Inc. v. Commissioner.

35 TCM (CCH) 1092
1976 TC Memo 252

T.C. Memo. 1976-252.

Datamation Services, Inc.
v.
Commissioner.

Docket No. 855-74.

United States Tax Court.

Filed August 16, 1976.

Irwin B. Robins, for the petitioner. Michael A. Menillo, for the respondent.

Memorandum Findings of Fact and Opinion

RAUM, Judge:

The Commissioner determined deficiencies in petitioner's Federal corporate income taxes in the amounts shown below:

 Year Ended Deficiency
                 12/31/64 ........... $ 6,191
                 12/31/67 ........... 44,586
                 12/31/68 ........... 148,479
                

The deficiencies resulted from a determination of the Commissioner that a certain

35 TCM (CCH) 1093

1970 loss was capital rather than ordinary. This determination first reduced the claimed 1970 net operating loss which petitioner had carried back to 1967 and 1968, and then the resulting recomputation of 1967 income affected an investment credit carryback from 1967 to 1964. The two issues before us are: (1) whether the stock of petitioner's wholly-owned subsidiary ("CSEC") was a capital asset, so that the loss sustained by petitioner upon the sale of the stock in 1970, was capital rather than ordinary; and (2) whether petitioner's investment in the subsidiary became worthless in 1970 prior to the sale so that the loss would be treated as ordinary under section 165(g) (3), I.R.C. 1954.¹

Findings of Fact

The parties have filed a stipulation of facts which, together with the exhibits attached thereto, is incorporated herein by this reference.

Petitioner, Datamation Services, Inc. ("Datamation"), was incorporated under the laws of the State of New York on December 22, 1958. Its principal office is located at 461 Eighth Avenue, New York, New York.

1. Was the "CSEC" stock owned by petitioner a capital asset? During the relevant years, Datamation's business consisted of providing a variety of data processing services to educational institutions, hospitals, and industrial, commercial, financial, and professional organizations. To provide these services, Datamation used computers and related data processing equipment and techniques.

In its business, Datamation employed computer programmers to organize and translate business problems into specific procedures and instructions for the computers. During 1968 about 65 of Datamation's employees worked as programmers. Although Datamation experienced a shortage of programmers in 1968, and in fact turned away some business that it could have handled if it had had additional programmers, its need for programmers declined in 1969, and it was no longer faced with a shortage.

Datamation hired most of its programmers through employment agencies. In general, programmers hired through agencies not only had attended schools where they were taught programming, but also had obtained actual working experience, often as programmers in the ranks of large insurance companies. Other programmers were recruited through word-of-mouth recommendations. And, in addition, Datamation hired some programmers directly upon their graduation from computer programming school. During the years in issue, there were many computer programming schools in New York City.

Datamation's business increased substantially between 1964 and 1968, as shown in the following table:

 Year Revenues Net Income
                 1964 ................. $1,205,550 $ 82,635
                 (Unaudited)
                 1965 ................. 2,170,129 194,950
                 (Unaudited)
                 1966 ................. 2,918,648 197,194
                 1967 ................. 3,461,371 158,205
                 1968 ................. 3,957,960 293,694
                

In 1969, the company was believed to be one of the ten largest organizations providing diversified data processing services in the greater New York City area.

By 1968 Datamation had adopted a policy of expansion by the acquisition of other companies. In May of 1969, Datamation issued a prospectus in which the following statement appears:

Acquisition and Franchising Policy

The Company has adopted a policy of actively seeking acquisitions. Although the Company is presently engaged in preliminary discussions with other companies, it has not reached any agreement or understanding regarding specific acquisitions. There can be no assurance that the Company will successfully complete any acquisition or that, if completed, such acquisition will be advantageous to the Company.

Datamation's officers investigated the possibility of acquiring (1) a market research company whose business generated a great deal of computer work; (2) a manufacturer of continuous form paper used by computers; and (3) a school for the training of computer programmers. However, the only company which Datamation

35 TCM (CCH) 1094

actually acquired was CSEC,² a corporation involved in the operation of computer training schools as well as other businesses. And it is the proper characterization of the loss Datamation sustained as a result of its investment in CSEC which is the subject of the present controversy

Before CSEC was acquired, Datamation's officers considered two alternative methods by which Datamation could acquire a computer programming school. The two alternatives are reflected in the minutes of a Special Meeting of the Board of Directors of Datamation Services, Inc., held on August 1, 1968, as follows:

Mr. Thomas Connors President of Datamation reported on the investigation of Data Processing Training Schools. He reported that all schools located to date had either just started business or had grown so big that it would be impractical for Datamation Services, Inc. to acquire them. He suggested that a more feasible program might be for the company to start its own school. After some discussion, it was generally agreed that the next approach would be to try to locate a top man, experienced in these types of schools, and try to make arrangements with him to organize a school for Datamation Services, Inc.

At some time not indicated by the record, representatives of Datamation asked the landlord of the building in New York City where Datamation maintained its principal place of business if it would be possible to operate a school on the third floor of the building in space which was already leased by Datamation. The record does not indicate with specificity the substance of the questions asked of the landlord, nor does it present any response he may have made.

On October 24, 1968, Mr. Connors again reported to Datamation's Board of Directors with respect to the computer training school project. The minutes of that meeting of the Board disclose the following discussion:

Mr. Connors reported that an individual had been located who, on initial investigaion, appeared to be quite capable of establishing a school for the company. He wanted $25,000 advance to write a new text, plus $25,000 per year salary and a 20% interest in the school. It was suggested that Mr. Connors, Mr. White and Mr. Goodfriend meet with this prospect at the earliest possible date and that a Proudfoot Report on the gentleman be obtained to assist in further evaluation of this project.

The "individual" mentioned in the abovequoted minutes was Robert Farr.

After several meetings with him, Datamation's officers

decided not to employ Mr. Farr to start a school for us, because * * * we determined that he would not operate the type of school that we were interested in. He wanted $25,000 in salary, and $25,000 to write a curriculum, and a percentage of the school. He wanted other things, and we didn't really think that the type of curriculum and school that he would have started for us was what we wanted.

In November, 1968, Datamation first learned that it might be able to acquire a corporation named Computer Systems and Educational Corporation, Inc. ("CSEC"). The primary business of CSEC was the operation of technical schools for the training of computer programmers and operators in Hartford, Connecticut, and Providence, Rhode Island, as well as a school for electronic technicians in Boston, Massachusetts.

It appears that the corporate structure of CSEC was undergoing certain rearrangements during 1968 and early 1969. However, as of March 7, 1969 (the date CSEC was ultimately acquired by Datamation), CSEC functioned primarily, if not exclusively, through its wholly owned subsidiaries, which consisted of the following:

35 TCM (CCH) 1095
                __________________________________________________________________________________________________
                 Name Location Nature of Operation
                __________________________________________________________________________________________________
                 Financial General Corporation Connecticut Financed tuition of
                 students at CSEC
                 schools
                 International Academy, Inc. of Hartford, School for computer
                 Connecticut (hereafter "Hartford Conn.* programmers and
                 School") operators
                 Computer Processing Corporation Hartford, Computer Service
                 (hereafter "Hartford Conn.* Bureau
                 Service Bureau")
                 Computer Processing Institute Providence, School for computer
                 of Rhode Island, Inc. (hereafter R.I. programmers and
                 "Providence School") operators
                 Massachusetts Radio And Electronics Boston, Mass. School for electronics
                 School, Incorporated** technicians
                 (hereafter "Mass. Radio")
                 International Academy, Inc. of Massachusetts Inactive***
                 Massachusetts
                 International Academy, Inc. of Maine Inactive***
                 Maine
                __________________________________________________________________________________________________
                 * The Hartford school and the Hartford service bureau shared facilities and equipment
                 ** As of January 1, 1968, and apparently as of December 31, 1968, Mass. Radio was a wholly-owned
                subsidiary of Financial General Corp. The record does not disclose the circumstances under
                which it became a wholly-owned subsidiary of CSEC.
                 *** The inactive subsidiaries had no assets whatsoever.
                

All of the CSEC schools were approved by appropriate state rehabilitation agencies and by the Veteran's Administration rehabilitation agency. The schools were licensed by appropriate state authorities. By May 27, 1969,...