Edwards v. Comm'r of Internal Revenue

Decision Date02 May 1968
Docket NumberDocket Nos. 2369-66,2388-66.
Citation50 T.C. 220
CourtU.S. Tax Court


William A. Goffe, for the petitioners.

J. C. Linge, for the respondent.

In 1962, petitioners purchased stock and notes of a corporation for $75,000. The purchase contract allocated $5,000 to the stock and $70,000 to the notes. Held, amounts received by petitioners from the corporation on the principal of the notes did not constitute amounts received in exchange for such notes under sec. 1232(a), I.R.C. 1954.


Respondent determined deficiencies in petitioners' joint income taxes as follows:

                ¦(docket No. 2369—66)             ¦(docket No. 2388—66)         ¦
                ¦Year      ¦Deficiency            ¦Year     ¦Deficiency         ¦
                ¦1962      ¦$3,375.68             ¦1962     ¦$3,010.00          ¦
                ¦1963      ¦11,968.08             ¦1963     ¦11,436.23          ¦
                ¦1964      ¦5,714.48              ¦1964     ¦5,375.43           ¦

Both dockets were consolidated for trial and decision. Petitioners having conceded certain adjustments made by respondent, the sole issue remaining for decision is whether amounts received by petitioners on the principal of alleged corporate promissory notes are amounts received in exchange for indebtedness and therefore taxable as capital gains under section 1232(a)(1)1 or as distributions under sections 301 and 316 and therefore taxable in whole or in part as ordinary income.


Some of the facts have been stipulated. These facts and the exhibits attached thereto are incorporated herein by this reference.

R. M. Edwards (hereinafter sometimes referred to as Edwards) and Dorothy Edwards are husband and wife, as are Loyd Disler (hereinafter sometimes referred to as Disler) and Joy Disler, and had their legal residences in Tulsa, Okla., at the time of the filing of the petitions herein. Both couples filed their joint Federal income tax returns for the years here involved with the district director of internal revenue, Oklahoma City, Okla.2

In 1958, petitioners organized a corporation, Disler Engineering Corp. (hereinafter referred to as Disler Engineering), for the purpose of manufacturing and selling heat exchangers. Edwards' duties were primarily in the financial and management areas, while Disler's basically covered the engineering and sales areas. Until June 1962, the business was conducted in a leased plant located on Sand Springs Road in Sand Springs, Okla., and consisted of the assembling, finishing, and selling of heat exchangers made from parts fabricated by Patterson Steel Co. The company had prospered, with gross sales increasing from approximately $72,000 in 1958 to $1,266,212.85 in 1962 and had outgrown its facilities on Sand Springs Road. Unable to expand at that location, petitioners in 1961 began looking for a place to move Disler Engineering.

Birmingham Steel & Supply, Inc. (hereinafter referred to as Birmingham Steel), is an Oklahoma corporation organized in 1949. Its plant was also located on leased premises in Sand Springs, Okla. From 1959 to 1962, it operated as a fabricator of structural steel, including parts for heat exchangers, and also conducted a steel warehouse supply business. The steel supply business, which required a larger inventory and more working capital than did the fabricating business, had proved to be very unprofitable. In 1962, Birmingham Steel was phasing out this portion of its business.

Prior to 1962, Ovid Birmingham owned 76 percent of the issued and outstanding shares of Birmingham Steel. Sometime around February or March of 1962, he and the other stockholders decided to sell the Birmingham Steel business. Thereafter and prior to June 1962, Ovid Birmingham acquired all the stock in the hands of other stockholders. On June 12, 1962, Edwards and Disler, who had been contacted as prospective purchasers on the same day by one Stainer (an attorney and secretary of Birmingham Steel) and at Stainer's invitation, inspected the Birmingham Steel facilities, machinery, and equipment. When the inspection was concluded, Stainer asked Edwards to express an opinion on the worth of the entire plant and equipment and Edwards stated an amount of $75,000. At that time, Edwards knew nothing about the financial condition of Birmingham Steel.

Stainer immediately advised Ovid Birmingham that Edwards and Disler were interested in buying the plant for $75,000. Two days later, Stainer advised Edwards that the offer of $75,000 was accepted. Edwards replied that the $75,000 figure quoted by him was not intended as an offer, but agreed to consider making an offer after looking at the books and records of the company, including a balance sheet, so as to see what debts existed. Petitioners then went with Stainer to the Birmingham Steel office where they met Ovid Birmingham for the first time and were supplied with the following abbreviated financial

statement of the business as of that time.

                ¦SUBJECT TO AUDIT                                       ¦
                ¦                           ¦                           ¦
                Vouchers payable                                                    $65,526.00
                Accrued payroll                                                     6,712.44
                Accrued withholding and social security T4                          2,661.17
                Chattel mortgage on machinery and equipment                         581.99
                Notes payable—National Bank of Tulsa—secured by accounts receivable 20,417.58
                Total liabilities                                                   95,899.18
                Current assets
                Cash                                                                 3,923.93
                Accounts receivable less reserve for bad debts                       37,727.75
                Inventory                                                            110,000.00
                Total current assets                                                 151,651.68
                Fixed assets
                Machinery, equipment, tools, furniture, fixtures, etc.—book value    93,041.30
                Dec. 31,1961
                Total assets                                                         244,692.98

Petitioners considered the above statement and concluded that they would in fact be willing to pay $75,000 for the plant. They contemplated that Birmingham Steel would perform the prefabrication work on the heat exchangers previously done for Disler Engineering by Patterson Steel, thus enabling an expansion of this phase of the business. Petitioners also felt that they could utilize all the equipment in the Birmingham Steel plant, thereby meeting their general expansion needs.

On June 14, 1962, petitioners, accompanied by their accountant, Robert Bridges, and two other employees of Disler Engineering, resumed negotiations at the Birmingham Steel office. Bridges examined the books and records of Birmingham Steel to determine whether the financial statement previously furnished to petitioners was correct. The other two employees examined the inventory of Birmingham Steel. Ovid Birmingham desired to sell the entire business of Birmingham Steel. Negotiations centered around a sale by him to petitioners of all the issued and outstanding stock of the company. Petitioners offered to purchase all such stock for $75,000 based upon the financial statement they had received. It was then suggested that a letter of intent be prepared to reflect the agreement of the parties.

Letters of intent were prepared by Stainer but, before they were signed, Bridges discovered that the financial statement furnished petitioners did not reflect outstanding promissory notes of Birmingham Steel in the amount of $241,904.82. The notes held by Ovid Birmingham stood as follows at June 14, 1962:

                ¦Date of ¦Face      ¦Collateral¦Interest¦Due date              ¦
                ¦note    ¦amount    ¦          ¦        ¦                      ¦
                ¦        ¦          ¦          ¦        ¦                      ¦
                ¦3/17/61 ¦$3,000.00 ¦None      ¦No      ¦Demand.               ¦
                ¦4/ 1/61 ¦106,904.82¦None      ¦No      ¦4/1/62.               ¦
                ¦6/19/61 ¦500.00    ¦None      ¦No      ¦Demand.               ¦
                ¦12/18/61¦15,000.00 ¦None      ¦Yes     ¦12/18/62.             ¦
                ¦2/20/62 ¦26,500.00 ¦Machinery ¦Yes     ¦12 months installment.¦
                ¦        ¦          ¦          ¦        ¦                      ¦

Also as of June 14, 1962, Birmingham Steel had an outstanding note payable to the National Bank of Tulsa...

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