Egly v. Commissioner
| Decision Date | 18 May 1988 |
| Docket Number | Docket No. 29753-85. |
| Citation | 55 TCM (CCH) 877,1988 TC Memo 223 |
| Parties | Martha H. Egly v. Commissioner. |
| Court | U.S. Tax Court |
Louis T.M. Conti and W. Lee Autman, Jr., for the petitioner. Eugene J. Wien, James C. Fee, Jr., and Lisa Primavera-Femia, for the respondent.
Memorandum Findings of Fact and Opinion
Respondent determined a deficiency in petitioner's 1977 Federal income tax in the amount of $1,133,913. The issues for decision are (1) whether petitioner is entitled to a deduction for a loss on worthless stock and if so, in what amount, and (2) if not, or if the loss is in an amount less than $2,970,000, whether petitioner is entitled to carryforwards and carrybacks of investment tax credits and net operating losses.
Some of the facts have been stipulated; the stipulations of facts and attached exhibits are incorporated herein by this reference.
Petitioner resided in Philadelphia, Pennsylvania when she filed her petition in this case.
Shortly after his marriage to petitioner, petitioner's first husband,1 Otto Henze, founded Penn Fishing Tackle Manufacturing Company ("Penn Fishing") in the early 1930's. After the death of Otto Henze in 1949, the stock in Penn Fishing was owned 1/3 by petitioner and 2/3 by a trust for the benefit of the Henze children. Petitioner was named president of Penn Fishing in the early 1950's and remained in that office until 1963. At that time, her son, Herbert Henze, took over the presidency of Penn Fishing, and petitioner became chairperson of Penn Fishing's Board of Directors.
Penn Fishing manufactures and distributes rods, reels, and other accessories used in sport fishing. Under the guidance of the Henze family, Penn Fishing has been and still is one of the leading companies in the sport fishing industry, concentrating mostly in salt water and big game tackle. As Herbert Henze noted, "When you see a man who catches a big shark, he probably used a Penn reel."
Petitioner was chairperson of Penn Fishing until 1977, at which time she sold all her Penn Fishing stock to the corporation and resigned from any positions she had as an officer or director of Penn Fishing.2 Petitioner realized $3,000,000 from the sale of her Penn Fishing stock. Her basis in the stock, which she had acquired upon her husband's death in 1949, was $30,000. She therefore reported a long term capital gain on her 1977 income tax return in the amount of $2,970,000. Respondent does not dispute the treatment of the sale of the Penn Fishing stock on petitioner's tax return.
The terms upon which petitioner sold her Penn Fishing stock were as follows: (1) petitioner's debts to Penn Fishing in the approximate amount of $742,000 were forgiven; (2) petitioner received a check in the amount of $258,000 from Penn Fishing; (3) Penn Fishing assumed petitioner's bank loan from Philadelphia National Bank in the amount of $1 million; and (4) Penn Fishing issued to petitioner a $1 million note which was payable to her in ten equal yearly installments.3
Michael Manchester became acquainted with petitioner and her children in 1960 when he was hired by Penn Fishing to perform private investigatory services. Shortly thereafter, petitioner and Mr. Manchester became constant companions and, after a few years, began living together. Petitioner and Mr. Manchester never married because of the fact that Mr. Manchester was married to someone else; he never obtained a divorce on account of religious restrictions. Mr. Manchester and petitioner were still living together in her house at the time of trial.
In the course of his private detective and claims investigation business in Philadelphia, Mr. Manchester became aware of Rad-O-Lite, Inc. ("Erie"). Erie was incorporated in 1957, had its principal place of business in Erie, Pennsylvania, and engaged in designing, manufacturing, installing, and leasing traffic signals and burglar and fire protection systems. On November 9, 1960, Mr. Manchester paid Erie $25,000 for an exclusive franchise to distribute Erie's burglar and fire protection systems in the areas of Philadelphia and Atlantic City, New Jersey. By way of a check dated November 6, 1960, petitioner had paid Mr. Manchester the $25,000 he needed to acquire the franchise. Petitioner's payment to Mr. Manchester was evidenced by an Agreement in which petitioner agreed to lend the $25,000 to Mr. Manchester in exchange for payment, in lieu of interest, of one half of the net profit after taxes which Mr. Manchester would derive from the franchise. The agreement provided that Mr. Manchester agreed to repay the $25,000 to petitioner within 30 months from the date of the agreement. No repayment of the loan ever was made by Mr. Manchester.
Shortly thereafter, on January 24, 1961, two agreements were entered into by Mr. Manchester and Erie, and a third agreement was entered into by petitioner, Mr. Manchester, Erie, and certain of Erie's stockholders. The effects of the agreements were as follows: Mr. Manchester's Erie franchise was expanded; petitioner and Mr. Manchester each received 2,500 shares of stock in exchange for Mr. Manchester's assignment to Erie of a burglar protection device invented by him — the Rad-O-Phone; and petitioner, Mr. Manchester, and three other individuals (who were friends and relatives of petitioner) were issued an additional total of 50,800 Erie shares in exchange for payments by petitioner to Erie in the sum of $63,500.
On July 19, 1961, petitioner and Mr. Manchester loaned Erie $200,000. The loan was secured by the assignment to petitioner and Mr. Manchester of Erie's accounts receivable and five of its patents. In addition, the loan agreement granted petitioner and Mr. Manchester the right "to form a corporation known as Rad-O-Lite, Inc. of Philadelphia." Petitioner individually provided the $200,000 that was loaned to Erie.
Rad-O-Lite of Philadelphia, Inc. ("ROLP"), was incorporated on February 8, 1962 for the purpose of manufacturing, selling, leasing, and installing burglar alarm systems and traffic control systems. The initial incorporators were petitioner, Mr. Manchester, and Vincent P. Haley. Petitioner was president of ROLP, and Mr. Manchester was vice president. Petitioner and Mr. Manchester each were issued 2,500 shares of ROLP stock. In exchange for the ROLP stock, Mr. Manchester transferred his Erie franchise to ROLP, and Mr. Manchester and petitioner transferred to ROLP their interests in the $200,000 Erie loan and the Erie assets securing the loan. Mr. Manchester and petitioner, however, did not transfer any of their Erie stock to ROLP.
Erie continually had financial difficulties and a need for additional capital, so on March 13, 1962, petitioner, Mr. Manchester, and ROLP loaned Erie an additional $152,000, which was secured by Erie's accounts receivable and inventory and a pledge of 45,000 shares of Erie stock from three Erie shareholders. Later in 1962, ROLP and its shareholders demanded payment of that $152,000 loan. Instead of the loan being repaid, however, an agreement was reached under which petitioner, Mr. Manchester, and ROLP purchased an additional 100,000 shares of Erie stock (15,000 of which were already in their possession pursuant to the March 13 pledge) from a principal shareholder in Erie in exchange for $40,000.4
After several unprofitable years, Erie eventually filed forms with the Commonwealth of Pennsylvania to acknowledge that it went out of existence on June 30, 1965. In 1966 the assets of Erie were sold at a sheriff's sale. At about that time, ROLP5 acquired the patents securing the $200,000 loans; the patents, however, were transferred pursuant to the security interest arising out of the loan agreement, not through the sheriff's sale. Petitioner never received any cash repayments of her loans to Erie or on her investment in Erie stock.
On petitioner's 1970 individual income tax return, she reported a $25,000 ordinary loss from property identified as "Rad-O-Lite, Inc. — Sec. 1244 Prop." The 1970 return reported that that property was acquired in 1962, was sold in December 1970, had a cost basis of $26,000, and was sold at a gross sales price of $1,000.
Subsequent to the initial incorporation of ROLP, in which petitioner and Mr. Manchester each were issued 2,500 shares of stock, it is unclear how the ownership of the ROLP shares was divided between the two shareholders. As of July 1971, however, ROLP represented, in its election to be taxed under subchapter S of the Code,6 that its stock was owned as follows: petitioner — 4,675 shares (93.5 percent); Mr. Manchester — 325 shares (6.5 percent). The subchapter S election stated that Mr. Manchester had acquired his 325 ROLP shares in 1970. The stock ownership did not change until sometime in 1976 or 1977, when petitioner became the owner of 100 percent of the ROLP shares according to the ROLP corporate income tax return filed for the year ending June 30, 1977.
ROLP's subchapter S election was first in effect for the fiscal year beginning July 1, 1971. ROLP filed tax returns as a subchapter S corporation for three years. ROLP filed income tax returns as a corporation taxed under subchapter C for the fiscal years ending June 30, 1975, June 30, 1976, and June 30, 1977. ROLP also had filed returns as a corporation taxed under subchapter C for the early years of its existence in the 1960's. As is shown by its corporate income tax returns, ROLP was never a profitable corporation, ROLP's tax returns reported gross receipts and net losses as follows:
Year Ending Gross Receipts Reported Net Loss
12/31/62 ............................. $ 13,905.88 $ 52,309.02
12/31/63 ............................. Not Available 39,527.11
12/31/64 ............................. 23,043.29 128.12
12/31/65 ............................. 46,552.09 212.13
12/31/66 ............................. 2,517.50 1,697.58
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