Denison v. Commissioner

• Citation: 36 TCM (CCH) 1759,1977 TC Memo 430
• Decision Date: 22 December 1977
• Docket Number: 5565-74.,Docket No. 5485-74
• Parties: Robert J. Denison v. Commissioner. George F. Baker, III v. Commissioner.
• Court: United States Tax Court

36 TCM (CCH) 1759

1977 TC Memo 430

T.C. Memo. 1977-430.

Robert J. Denison v. Commissioner.

George F. Baker, III v. Commissioner.

Docket Nos. 5485-74, 5565-74.

United States Tax Court.

Filed December 22, 1977.

Emil Sebetic, Sidney O. Friedman, and Michael A. Varet, 30 Broad St., New York, N.Y., for petitioners. Michael A. Menillo, for the respondent.

Memorandum Findings of Fact and Opinion

TANNENWALD, Judge:

Respondent determined the following deficiencies in petitioners' Federal income taxes:

                  Docket No.                1970         1971
                   5485-74 ............. $ 87,778.00    $293.00
                   5565-74 .............  137,708.00      -0-
                

Petitioner in docket No. 5485-74 having conceded the deficiency for 1971, the issues remaining for our decision are:

(1) Whether payments received by petitioners in exchange for their relinquishment of their rights to acquire interests in a corporation are taxable as capital gain or ordinary income; and

(2) Whether Baden Securities International Corporation, a small business corporation of which petitioners were shareholders, is entitled to a deduction for automobile expenses and a loss incurred on the sale of an automobile.

Findings of Fact

Some of the facts have been stipulated and are found accordingly. The stipulation of facts and attached exhibits are incorporated herein by this reference.

Petitioner Robert J. Denison (Denison) is an individual who resided in New York, New York, at the time of filing his petition herein. Petitioner George F. Baker, III, (Baker) is an individual who resided in New York, New York, at the time of filing his petition herein. Both petitioners filed their income tax returns for the year in question with the Office of the Internal Revenue Service at New York, New York.

Petitioners were associated in business with Richard B. Nye (Nye).¹ Petitioners and Nye were experienced in security analysis and portfolio management. In 1969, the three men were the sole general partners of First Security Company, a limited partnership with assets of approximately $12,000,000, which was engaged in making equity investments in securities. They were also the sole shareholders of Baden Securities Corporation and Baden Securities International Corporation, which acted as investment advisors to offshore funds, one of which had assets of about $40,000,000. In addition, petitioners and Nye, together with a London bank, were sole shareholders of Woodwall, Incorporated, an investment advisor to an offshore equity fund.

City Investing Company ("Investing") is a publicly owned corporation listed on the New York Stock Exchange which is experienced in real estate. In March, 1969, Nye proposed to Investing that it sponsor separate funds which would invest in real estate and securities and that a new corporation be organized, to be owned jointly by Investing and by petitioners and Nye, which would directly or through subsidiaries, manage and render investment advice to these funds.

Petitioners and Nye thought the relationship would be beneficial to them because Investing had experience in real estate which they lacked. The proposal was attractive to Investing because petitioners and Nye were well respected and Investing believed their participation would help attract capital. They recorded their agreement in a Memorandum of Understanding ("Memorandum"), dated April 17, 1969, as follows:

1. A new corporation called City Security Corporation ("CSC") will be formed in an appropriate jurisdiction in the United States. The outstanding capital stock of CSC will be owned 62½% by City Investing Company, or a whollyowned subsidiary of City Investing Company, and 37½%² by Baden Securities Corporation, or Messrs. Baker, Denison and Nye.

2. Messrs. Baker, Denison and Nye will be entitled, at their election, to one or sic three seats on the Board of Directors of CSC and will each become Vice Presidents of CSC. Additional members of the board and officers of CSC may be nominated by City Investing Company.

3. Three funds will be formed:

a. an offshore fund to be sold in Europe whose investments will be primarily in United States real estate,

b. a domestic real estate trust, to be sold in the United States whose investments will be primarily in United States real estate, and

c. a private fund of up to $50,000,000 to be contributed by City Investing Company.

4. All advisory and management functions relating to the above funds will be handled by CSC or wholly-owned subsidiaries of CSC. Such functions will include:

a. real estate management;

b. real estate brokerage;

c. investment advice.

5. It is City Investing Company's intention to build an "in-house" investment management capability and, to that end, City may hire one or more financial analysts or fund managers to become employees of CSC or subsidiaries. Nevertheless, it is understood that Messrs. Baker, Denison, and Nye will be available for investment advisory functions, in their capacity as officers of CSC, for not less than two years from the date the first fund is functioning.

6. It is intended that, at an appropriate time, shares of CSC will be offered to the public and that such offerings may include shares owned by the stockholders of CSC.

It was contemplated that the new corporation, City Security Corporation, ("Security"), would have full-time employees to take care of day-to-day operations. Petitioners expected to be available for general advice as to security investments and Investing was expected to be available for general advice as to real estate investments. Neither petitioners nor Investing were to be compensated for these services. Although it was not expected that they would be required to invest much capital, it was understood that petitioners, Nye, and Investing would all contribute their pro rata share to the extent necessary.

Security was incorporated on May 19, 1969, and Denison was designated a director. It was agreed that, at least for the time being, petitioners and Nye would not be officers as the Memorandum provided. Stock certificates of Security were not issued until 1973.

C.I. Mortgage Group, the only fund that was actually formed, was a domestic real estate trust organized in Massachusetts under a Declaration of Trust on May 15, 1969. Petitioners and Nye participated with Investing in finding personnel to operate Mortgage Group and in meeting with counsel and underwriters with respect to a contemplated public offering of securities of Mortgage Group. Because of unfavorable conditions in the securities market in the summer of 1969, the public offering was postponed. In order to achieve a favorable operating record in the meantime, it was agreed that Mortgage Group, through Lehman Brothers ("Lehman"), should attempt a private placement of its securities to raise $20,000,000. Investing and one of its subsidiaries each invested $5,000,000 in common stock. Petitioners and Nye caused a fund which they managed to invest $2,000,000 in debentures and warrants.

In the fall of 1969, market conditions improved and Investing decided to proceed with a public offering of Mortgage Group's securities. In connection with this offering, Investing informed petitioners and Nye that the manager of Mortgage Group would be owned solely by Investing. As a result, petitioners and Nye asserted a claim for breach of contract against Investing. On the basis of estimated earnings of Security and the price-earnings ratio of comparable management companies, they estimated their damages at a couple million dollars. Subsequently, Investing, petitioners, and Nye reached a settlement whereby petitioners, and Nye assigned all their interests under the Memorandum to Investing for the sum of $250,000 each.

Baden Securities International Corporation ("Baden") was organized by petitioners and Nye in January, 1969, to act as investment advisor to a Netherlands Antilles Fund. They were the sole shareholders of Baden and, except for a brief period in 1970, were also the sole employees. The corporation's office was at 245 Park Avenue, New York, New York, in 1970. For the year at issue, Baden filed a United States Small Business Corporate Income Tax Return.

Petitioners' and Nye's activities consisted of meeting with and transporting current and prospective clients (many of whom were wealthy Europeans) and meeting with salesmen, security analysts and other portfolio managers. To provide transportation to these meetings and for clients, Baden purchased a 1969 Cadillac in February, 1970, and hired chauffeurs to drive it. Baden sold the car at a loss on November 16, 1970.

Opinion

The first issue for our decision is whether the payments received by petitioners from Investing are taxable as capital gains, as petitioners contend, or as ordinary income, as respondent contends. Resolution of this issue depends, first, upon whether the petitioners' rights under the Memorandum constituted capital assets under section 1221³ and, second, upon whether the transfer of these rights to Investing constituted sales or exchanges under section 1222.

On the first question, respondent argues that petitioners were to receive stock in exchange for services, that the receipt of stock would have been taxable to them as compensation, and that the settlement received in lieu thereof is, therefore, taxable as ordinary income. Petitioners, on the other hand, contend that the stock would have been a capital asset and that an executory contract to acquire a capital asset is itself a capital asset.

It is well settled that an amount received as a substitute for ordinary income is taxable as ordinary income even though a property right has technically been transferred. See Hort v. Commissioner 41-1 USTC ¶ 9354, 313 U.S. 28 (1941); Commissioner v. P.G. Lake, Inc. 58-1 USTC ¶ 9428, 356 U.S. 260 (1958). Similarly, there is no question that an executory contract to acquire a capital asset is itself a capital asset. Turzillo v. Commissioner 65-2 USTC ¶ 9490, 346 F. 2d...