Five Star Mfg. Co. v. Comm'r of Internal Revenue, Docket No. 77398.

• Decision Date: 21 May 1963
• Docket Number: Docket No. 77398.
• Citation: 40 T.C. 379
• Parties: FIVE STAR MANUFACTURING COMPANY, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT
• Court: U.S. Tax Court

40 T.C. 379

FIVE STAR MANUFACTURING COMPANY, PETITIONER,

v.COMMISSIONER OF INTERNAL REVENUE, RESPONDENT

Docket No. 77398.

Tax Court of the United States.

Filed May 21, 1963

L. Lamar Beacham, for the petitioner.

Glen W. Gilson II, for the respondent.

The petitioner obtained a judgment for money borrowed against one of its two stockholders who owned 50 percent of its stock and upon order of the court the stockholder's stock was sold at public auction. The petitioner acquired the stock upon a bid of $56,000 and, as permitted by the court, made payment of its bid by crediting $56,000 on the judgment it had obtained against the stockholder. Held, that the petitioner's stock so acquired had a fair market value of at least $56,000 on the date of acquisition by the petitioner and that the petitioner is not entitled to deduct any amount, either as an ordinary and necessary business expense under section 162(a) of the Internal Revenue Code of 1954 or as a bad debt under section 166 of the Code, on account of the transaction.

ATKINS, Judge:

The respondent determined a deficiency in income tax for the taxable year ended June 30, 1957, in the amount of $18,377.89.

The issue presented is whether the petitioner is entitled to deduct for its taxable year ended June 30, 1955, the amount of $56,000, or any part thereof, credited on its books against the outstanding indebtedness of one of its two stockholders, upon its acquisition from such stockholder of 50 percent of its outstanding stock. Dependent on the decision of this issue is the amount of a net operating loss carryover to petitioner's taxable year ended June 30, 1957.

FINDINGS OF FACT

Some of the facts have been stipulated and are incorporated herein by this reference.

The petitioner is a corporation organized under the laws of the State of Minnesota and operating in the State of Mississippi with its mailing address at Clarksdale, Miss. It filed its income tax return for the taxable year ended June 30, 1955, with the district director of internal revenue at Fargo, N. Dak., and its income tax returns for the taxable years ended June 30, 1956, and June 30, 1957, with the district director of internal revenue at Jackson, Miss. Its principal business is manufacturing and distributing automobile heaters known as the ‘Freeman Headbolt Heater.’ The petitioner's stock was owned 50 percent by W. S. Kincade and 50 percent by H. E. Smith, Jr. Kincade was its president and general manager and Smith was its vice president, and the two of them, together with their wives, constituted the petitioner's board of directors.

The Freeman headbolt heater was covered by a patent issued to Andrew L. Freeman of Grand Forks, N. Dak., on November 8, 1949. On June 28, 1950, Freeman assigned under a ‘patent license agreement: the sole and exclusive right, for the term of the patent or renewal thereof, to manufacture, use, and sell this heater within the United States, its territories, dependencies, and possessions, to Kincade and Smith for a consideration of $80,000 plus royalties of 5 percent of the selling price of all such heaters manufactured, sold, and collected for, and in any event, a total minimum royalty of $10,000 per year.

On the same day Kincade and Smith, as permitted by the above-described agreement, leased and let the exclusive patent license to manufacture, use, and sell the heater to the petitioner for 10 years under a ‘lease and option’ for a consideration consisting of (a) $80,000, (b) payment to Kincade and Smith of 10 percent of the selling price of all heaters in excess of 200,000 sold by it within any annual accounting period, and (c) payment of royalties to Freeman and assumption of other obligations under the original patent license agreement.

The petitioner commenced the manufacture and distribution of the heaters during 1950 and remitted the proper royalties to Freeman until April 20, 1952. After that time Freeman received no accounting for royalties from the petitioner or from Kincade or Smith.

From an undisclosed time until early 1954 Smith withdrew from the petitioner, in the form of salaries, expenses, and moneys borrowed, in excess of $350,000, which included cost of transportation of himself and his family in traveling within the United States and to foreign countries, which he charged to the petitioner. At that time Smith owed the petitioner on promissory notes approximately $88,000.

In 1953 the petitioner borrowed $150,000 from the Bank of Clarksdale, Miss., on the personal endorsement of Kincade, since the petitioner could not borrow money in Clarksdale or in Grand Forks, N. Dak., without Kincade's personal endorsement. Of this amount the petitioner repaid the bank $100,000 and Kincade had to repay $50,000 out of his own pocket because of his endorsement. At the beginning of 1954 the petitioner owed Kincade approximately $296,000 for advances made by him to it.

In 1954 a series of lawsuits was commenced involving the petitioner and its two stockholders, with the results hereinafter described.

In April 1954 Freeman, since he had received no accounting for royalties since April, 1952, brought two suits in the District Court of the United States for the District of North Dakota, Northeastern Division, against the petitioner, Kincade, and Smith, one suit to recover back royalties and the other to cancel the patent license agreement between himself and Kincade and Smith.

In connection with the suit to recover unpaid royalties due under the license agreement, Freeman filed two writs of attachment, one dated April 14, 1954, covering 90,000 Freeman headbolt heaters in a warehouse in Grand Forks, N. Dak. (which represented approximately two-thirds of the petitioner's finished-goods inventory), and the other dated April 21, 1954, covering 213 extension cords and 4 vacant lots of the petitioner.

The court in the first suit awarded Freeman a money judgment of $62,994.31, which judgment was reflected on petitioner's balance sheet as of June 30, 1954, for past royalties due. On the failure of the various defendants to appear and answer Freeman's complaint in the other suit, the court entered a judgment dated July 6, 1954, cancelling the patent license agreement between Freeman and Kincade and Smith. Because Kincade paid a part of the judgment for past royalties and gave Freeman assurance of payment of the remainder, Freeman never executed on such judgment and never seized any of the inventory or other goods covered by the writs of attachment.

On July 13, 1954, Freeman entered into a new agreement with Kincade, personally,¹ for the licensing of the manufacture, use, and sale of Freeman headbolt heaters, which provided that a formal license agreement should be executed containing substantially the same provisions, including the right to sublicense, as were contained in the prior license agreement. Such agreement remained in effect until May 11, 1955, when a formal license agreement was made between them.

Sometime in early 1954 the petitioner made a demand upon Smith for payment of money which he owed it. Smith failed to pay, and instead, in March 1954 he filed suit in the District Court of the United States for the Northern District of Mississippi, Delta Division, against the petitioner and Kincade to have a receiver appointed for the petitioner. Cross-complaints and counterclaims were filed; the cause was heard by the court on May 5, 1954; findings of fact, conclusions of law, and opinion were made by the court on May 12, 1954; and judgment dated May 12, 1954, was entered on all complaints. The court decreed that the petitioner should recover from Smith the sum of $88,610 on Smith's promissory notes held by the petitioner, subject to a credit of $7,500 for rentals due Smith from the petitioner. Smith was given 30 days in which to pay the judgment rendered against him, and the court appointed a special commissioner to sell Smith's stock in the petitioner for the satisfaction of such judgment unless it was paid to the petitioner on or before June 12, 1954. The judgment provided that if the petitioner should be the successful bidder at such a sale, it would have the right to apply all or part of its judgment against Smith in satisfaction of the bid. The court also entered judgment in favor of Kincade against the petitioner in the total amount of $296,723.21 and against Smith in the total amount of $16,562.60. The court dismissed, on the merits, Smith's petition for appointment of a receiver.² It left open Smith's and Kincade's claims for salaries from May 1953 to the date of judgment.

Smith did not pay the judgment entered against him in favor of the petitioner by the date set by the court, June 12, 1954, and sale of his stock at public auction was held on June 25, 1954. The only persons who attended this sale were representatives of the petitioner, including Kincade, and Smith's attorney, and the only bid made at the auction was made by the petitioner in the amount of $40,000. On July 8, 1954, Smith filed a motion to deny confirmation of the sale at the aforementioned price, asserting that he had been unable to raise sufficient cash to pay the judgment and alleging that the bid was an inadequate price and that the stock was worth far in excess thereof, and moved for an order of the court for resale of the stock. In his motion Smith guaranteed a bid of $48,000 for such stock, plus all costs of resale, and filed therewith his bond in the sum of $80,000 to guarantee the bid and payment thereof. Smith's motion was granted by the court.

On July 19, 1954, the resale of Smith's stock in the petitioner was held and was attended only by representatives of the petitioner, including Kincade, and Smith's attorney. The only bid at such sale was made by the petitioner in the amount of $56,000, which bid had been approved by Kincade. Smith filed another motion for resale of the stock, but this motion was denied by the court by order dated July 26, 1954. The court also...