Development Corporation of America v. Commissioner

• Decision Date: 24 March 1988
• Docket Number: Docket No. 8538-80.
• Citation: 55 TCM (CCH) 455,1988 TC Memo 127
• Parties: Development Corporation of America v. Commissioner.
• Court: U.S. Tax Court

55 T.C.M. (CCH) 455 (1988)

T.C. Memo. 1988-127.

Development Corporation of America v. Commissioner.

Docket No. 8538-80.

United States Tax Court.

Filed March 24, 1988.

Alyce C. Halchak and Morris R. Sherman, 19 W. 44th St., New York, N.Y., for the petitioner. Richard J. Sapinski, Robert A. Stern, and William S. Garofalo, for the respondent.

Memorandum Findings of Fact and Opinion

PARKER, Judge:

Respondent determined deficiencies in petitioner's Federal income tax for the calendar years 1973 and 1975 in the amounts of $286,163 and $481,446, respectively. As a result of the judicial determination of a suit between petitioner and Henry D. Mayer,¹ petitioner is no longer contesting the deficiency determined for 1973. After concessions by petitioner, the issues for decision are:

(1) Whether petitioner's acquisition in 1969 of all of the stock of Mayer Construction Company, Inc., was solely in exchange for its voting common stock so as to constitute a tax-free reorganization under section 368(a)(1)(B)² and thereby give petitioner a carryover basis in the Mayer stock. Petitioner now contends that the 1969 acquisition was not a tax-free "B" reorganization and that it is entitled to a higher cost basis in the Mayer stock. This issue turns on whether or not petitioner gave something in addition to its stock, i.e., "boot," to acquire the Mayer stock.

(2) Whether petitioner is entitled to either a bad debt deduction or a worthless securities deduction in 1975 in connection with its wholly owned subsidiary, Mayer Construction Company, Inc., or with its Mayer stock. This depends on factual and legal issues in addition to the basis question above:

(a) Whether petitioner can avoid the nonrecognition provisions of section 332 in connection with the liquidation of its Mayer Construction subsidiary in 1975;

(b) Whether petitioner's advances to Mayer Construction Company, Inc., were loans or contributions to capital; and

(c) If petitioner's advances were loans, whether the liquidation of Mayer Construction Company, Inc., followed by the transfer of all of its assets to another of petitioner's wholly owned subsidiaries constituted in substance a reorganization under section 368(a)(1)(D) so that any loss or bad debt is recognized, if at all, in 1979, a year not before the Court.

Findings of Fact

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

At the time of the filing of the petition in this case, petitioner, Development Corporation of America (hereinafter "DCA") was a Florida Corporation having its principal offices in Hollywood, Florida. DCA timely filed Form 1120 returns (on a consolidated basis with its subsidiaries) for the years 1973 and 1975.³ At all times relevant to this proceeding, DCA was a publicly held company whose shares were traded on the over-the-counter market prior to November 3, 1970 and on the American Stock Exchange thereafter.

DCA, acting through some 30 to 60 operating subsidiaries, is engaged primarily in the business of real estate, home building, land development, and commercial development. Prior to 1969 DCA's business was primarily confined to the State of Florida. Prior to the transaction at issue, DCA's founders, principal officers, and largest stockholders were Alvin Sherman, Irving Fishman, and Edward Lempka. They owned 26.1 percent, 7.3 percent and 9.2 percent, respectively, of DCA's 736,943 shares of issued and outstanding stock. At that time DCA had only one class of stock issued and outstanding, i.e., voting common stock having a par value of $.10 per share. DCA's tax counsel since 1957 has been Morris Sherman (unrelated to Alvin Sherman), a New York attorney primarily engaged in the practice of tax and corporate law.

From 1958 through 1969, Henry Mayer was engaged in the business of constructing and selling homes, primarily in Ocean and Camden Counties, New Jersey. During the year 1969, Mr. Mayer, his wife, Marianne, and their minor children were the controlling stockholders of Mayer Construction Company, Inc. (hereinafter "Mayer Construction"), Barnegat Light Development Corporation, Inc. (hereinafter "Barnegat"), and Coast Realty Company, Inc. (hereinafter "Coast"). Mayer Construction, Barnegat and Coast were New Jersey corporations through which Mr. Mayer's home construction and sales activities were conducted.

The Acquisition Agreement

In approximately April of 1969, Mr. Mayer placed an ad in the Wall Street Journal offering his three businesses for sale. DCA, through its vice president for acquisitions, George Samuels, responded to the ad and entered into negotiations with Mr. Mayer. Mr. Mayer then met in Florida and in New Jersey with Alvin Sherman, president of DCA, to negotiate the terms of DCA's acquisition of the Mayer companies.

DCA had a cash shortage at the time and did not have the cash to buy the Mayer companies. Also Mr. Mayer did not want to incur the tax liability on the gain that would result from a sale of his companies, particularly if he received only stock and no cash in the transaction. DCA and Mr. Mayer agreed that the acquisition was to be accomplished through a tax-free reorganization consisting of an exchange solely of DCA voting common stock for all outstanding shares of the Mayer companies. DCA also believed at that time that an exchange solely for stock, requiring no cash, would allow DCA a pooling of interest with the Mayer companies for financial accounting purposes for the entire year of the acquisition, 1969. DCA understood that a taxable transaction would have created a large tax liability for Mr. Mayer which he could not pay if the transaction included no cash. Therefore, both DCA and Mr. Mayer sought a tax-free reorganization under Internal Revenue Code section 368(a)(1)(B).

By letter dated June 25, 1969 to Alvin Sherman, Mr. Mayer set forth his understanding of the various items they had been discussing in their negotiations up to that point. Those items included the following proposals.⁴ Prior to the acquisition by DCA, the three Mayer companies were to merge, with Mayer Construction to be the surviving corporation. The stockholders of Mayer Construction were to receive DCA stock consisting of an initial "payment" equivalent to eight times the earnings of the consolidated Mayer companies for the fiscal year ending September 30, 1969, plus additional "compensation" based on six times the average excess earnings of the consolidated Mayer companies over the next three years. The payment of the additional "compensation" was to be made at the end of the three-year period. As a wholly owned subsidiary of DCA, Mayer Construction would pay DCA a management fee equal to three-quarters of one percent of the first $2,000,000 of sales and one percent of the sales thereafter. Mr. Mayer was to be placed on the board of directors of DCA. All stock issued by DCA was to be of a restricted nature. All of the major DCA stockholders were to be entitled to participate in any secondary stock offering which was to be registered in the same proportion as the holdings of all other restricted stockholders. All restrictions were to cease at the end of the three-year period. The holders of restricted stock were to vote with management during that period. DCA was to arrange loans to Mayer Construction, as required by Mayer Construction, to be used to acquire additional land and to provide additional working capital to finance the expansion of operations and the increased inventories such expansion would require. The interest rate on loans by DCA was to be the same rate that DCA paid for its money. DCA was to indemnify Henry Mayer and Marianne Mayer against losses on present and future corporate obligations personally guaranteed by them. The initial loan requirements were anticipated to be approximately $400,000, with as much as $1 million required over the next two years. Some of these proposals were later incorporated in the lawyers' drafts and in the final agreement; others were not.

Morris Sherman, DCA's tax counsel, was requested by DCA to represent it in drafting the agreement for the acquisition of the Mayer companies. He prepared the first draft of such an agreement. A copy of Mr. Mayer's letter of June 25, 1969 had been sent to Morris Sherman on July 2, 1969, along with George Samuels' comments thereon. Mr. Mayer's annotated letter, along with oral instructions from Alvin Sherman, formed the basis for Morris Sherman's first draft. In preparing the initial and all subsequent drafts of the agreement, Morris Sherman was aware that the parties to the agreement wanted the transaction to be a tax-free reorganization under section 368(a)(1)(B). Morris Sherman was an experienced tax lawyer who knew the legal requirements for such a tax-free reorganization.

With regard to Mr. Mayer's stated desire to be placed on the board of directors, Morris Sherman told Alvin Sherman that any such undertaking by DCA to place Mr. Mayer on the DCA board would constitute "boot," something other than solely voting stock received in the exchange, and jeopardize the tax-free nature of the exchange. Neither Morris Sherman's various drafts nor the final agreement contained any reference to Mr. Mayer's acquiring a seat on the board of directors of DCA. On July 24, 1969, Morris Sherman completed his initial draft of the proposed acquisition agreement and it was delivered to Mr. Mayer on the same day for review.

Mr. Mayer, at the recommendation of his accountant, retained the services of David Beck, a New Jersey attorney primarily engaged in the practice of tax law, to represent him and the other shareholders of the Mayer companies in the acquisition by DCA. Upon receipt of Mr. Sherman's initial draft, Mr. Mayer, who is not a lawyer, reviewed it and prepared a list of his comments. He then forwarded both the draft and his comments to David Beck on July 25, 1969. Mr. Beck was an...