Downer v. Comm'r of Internal Revenue

• Citation: 48 T.C. 86
• Decision Date: 27 April 1967
• Docket Number: Docket No. 2082-65.
• Parties: J. K. DOWNER AND EDITH DOWNER, PETITIONERS V. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT
• Court: United States Tax Court

48 T.C. 86

J. K. DOWNER AND EDITH DOWNER, PETITIONERS V. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT

Docket No. 2082-65.

Tax Court of the United States.

Filed April 27, 1967.

Jerry D. Luptak and Basil M. Briggs, for the petitioners.

Charles R. Abbott, for the respondent.

In 1961, petitioner transferred 100,000 shares of stock in the corporation to an employee of the corporation to induce him to continue to work for the corporation. Petitioner retained 325,000 shares. Held, the transaction was a ‘sale or exchange’ and petitioner sustained a capital loss.

TANNENWALD, Judge:

Respondent determined a deficiency in petitioners' income tax for the taxable year 1961 in the amount of $36,365.31. Petitioners have claimed an overpayment of income taxes for 1961 in an unspecified amount. After concession by petitioners of certain issues, there remains for us to decide whether petitioners are entitled to a deduction in 1961 in respect of stock transferred in that year and, if so, the nature and amount of such deduction.

FINDINGS OF FACT

Some of the facts have been stipulated and are found accordingly.

Petitioners are husband and wife and resided in Saginaw, Mich., at the time of the filing of the petitioner herein. They filed their joint Federal income tax return for 1961 with the district director of internal revenue at Detroit, Mich. Any reference to ‘petitioner’ shall be to J. K. Downer, his wife, Edith, being a party to this proceeding merely by having joined in the 1961 return.

During the period involved in this proceeding, the Downer Aircraft Co. (hereinafter referred to as the corporation) was engaged in the manufacture and sale, through dealers, of a four-place, low-wing, single-engine airplane for civilian use known as the Bellanca. It was still engaged in the same type of business at the time of trial. In 1960 and 1961, the corporation had severe working capital problems and required additional substantial capital to continue in business.

The corporation decided to make a public offering of the corporation's stock through underwriters to residents of the State of Minnesota. The underwriters agreed to underwrite the sale of 425,000 shares at $1.15 per share, of which 15 cents was brokerage commission. The underwriters later changed their minds and, on December 15, 1960, simply agreed with the corporation to use their ‘best efforts' to sell the 425,000 shares.

The underwriters filed an application for registration with the Minnesota Securities Commission in November 1960, which registration was finally approved in March 1961. Immediately prior to the order approving the registration, the underwriters canceled the December 15, 1960, agreement with the corporation. Because the corporation could find no other underwriters to handle the public offering, it decided to sell its own stock directly to the public and obtained a new order from the Minnesota Securities Commission authorizing such procedure. The corporation hired Irving L. Turner, an experienced broker in over-the-counter sales, to help sell its stock to the public. Turner attempted by various means to sell the stock, including contacting other brokers, personal telephone calls to prospective customers, advertisements in the local newspapers, and exhibiting the Bellanca airplane on the plaza of the First National Bank of Minneapolis and on the steps of the State Capitol Building in Minneapolis, taking orders from people on the street. Despite Turner's efforts, the public offering was a failure as far as the corporation was concerned.

In February 1961, prior to the public offering, the corporation hired Carl B. Wootten as vice president and sales manager. Wootten was an experienced airplane executive who had spent his entire working life in the aircraft industry and had skills and industry contacts sorely needed by the corporation. Petitioner induced Wootten to join the corporation on the basis that the proposed public offering would generate sufficient funds to provide adequate working capital, permit establishment of a nationwide sales organization, and support airplane production sufficient to generate substantial profits. Prior to Wootten's being hired by the corporation, his salary, benefits, and conditions of employment were discussed and agreed upon with petitioner but the arrangement was never reduced to writing. Petitioner was content to rely on Wootten's integrity in the performance of his duties.

The failure of the public offering made it impossible for Wootten to establish a sales organization. Instead, Wootten was forced to devote his time and talents to the unsuccessful solicitation of money for working capital.

During 1961, Wootten had other opportunities for employment, of which petitioner was aware, but Wootten was unwilling to leave the employ of the corporation because he ‘just couldn't leave Mr. Downer in a lurch.’

In the spring of 1961, Wootten recommended to petitioner a possible merger with Hammond Aircraft Oc., a small west coast airplane manufacturing company owned by one Tirey Ford. Wootten had met Ford in 1940 and had been associated with him in the aircraft industry during the years 1940 through 1946, developing a business relationship and close friendship with him.

In July 1961, petitioner was keenly interested in accomplishing a merger with Hammond, believing it would be beneficial to the corporation. In July 1961, petitioner took Wootten with him to San Francisco to discuss the merger with Ford.

During the merger negotiations, petitioner decided to transfer 100,000 shares of his corporation stock to Wootten with the hope and expectation that: (1) Wootten would be induced to remain with the corporation regardless of the outcome of the negotiations and (2) Wootten would use his influence with Ford to help accomplish the desired merger. On July 6, 1961, petitioner wrote Wootten that he would assign 100,000 shares of stock in the corporation to him. Prior to that time Wootten had no idea that petitioner intended to transfer any of the corporation's stock to him. Petitioner's motive for the transfer of the 100,000 shares of stock was never communicated to Wootten. Petitioner and Wootten had never discussed Wootten's having a proprietary interest in the corporation. At no time did petitioner ask for or receive from Wootten, nor did Wootten offer to give to petitioner, any commitment in return for the stock transfer. However, Wootten either knew or reasonably should have known the considerations which motivated petitioner to transfer the shares.

At the time petitioner wrote Wootten, his shares of the corporation were in escrow with the Fidelity Bank & Trust Co. of Minneapolis, as required by the Minnesota Securities Commission. The commission on November 7, 1961, authorized the transfer of the 100,000 shares to Wootten on the condition that Wootten leave the shares in escrow under the same terms and conditions as were applicable to petitioner. The 100,000 shares were transferred to Wootten in 1961 sometime after November 7.

Both at the time he wrote Wootten and immediately prior to the approval of the Minnesota Securities Commission, petitioner owned 425,000 shares of the corporation, constituting in excess of two-thirds of the then issued and outstanding shares. The 100,000 shares of stock had an adjusted basis for Federal income tax purposes of at least $100,000.

The merger negotiations were discontinued when petitioner discovered Hammond was not in a better financial position than the corporation.

Wootten remained as superintendent and executive officer of the corporation until December 1962, terminating his employment because the corporation could no longer pay his salary.

During the period May through December 1961, there were numerous cash sales of the corporation's stock at $1.15 per share in lots ranging from 10 shares to 3,000 shares, with the average sale covering 200 to 250 shares. A total of 106,853 shares were thus sold. During 1962, cash sales were made of 72,502 shares at $1.15 per share in similar-sized lots, although one lot consisted of 10,000 shares. A few sales in small lots were made in March 1963, also at $1.15 per share. The purchasers were primarily unsophisticated investors who were willing to spend relatively small sums to speculate on a cheap unlisted stock without regard to the underlying financial structure.

During the period May through December 1961, 58,211 shares were exchanged for debts of the corporation at $1.15 per share and during 1962, 6,342 shares were similarly exchanged at the same price.

The book value of the stock, taking into account a revaluation surplus, was $1.7150 per share as of September 30, 1960, and $0.9348 per share as of September 30, 1961. The revaluation surplus was supported by an independent appraisal. Eliminating the revaluation surplus, there was a deficit of $107,108 in stockholders' equity or a book value of minus $0.90 as of September 30, 1960. By September 30, 1961, this deficit had been eliminated and the book value per share was plus $0.37724.

For the fiscal years ended September 30, 1960, 1961, and 1962, the corporation's gross receipts from sales were $1,078,381, $256,390, and $71,531, respectively. The corporation never operated at a profit. Its Federal income tax returns showed net operating losses of $130,929, $65,231.75, and $80,372.44, respectively.

During the summer of 1961, petitioner made two offers to sell the remaining 325,000 shares to prospective investors for $50,000, which offers were rejected. After Wootten left the employ of the corporation, petitioner in 1963 sold 28,000 shares and in 1964 sold 52,000 shares, at $0.05 per share.

The fair market value of the 100,000 shares transferred by petitioner to Wootten was $15,000.

On his 1961 return, petitioner claimed an ordinary deduction of $90,000 for his loss on the 100,000 shares, representing the difference between his adjusted basis of $100,000 and the alleged increase of...