Hawke v. Commissioner of Internal Revenue

• Decision Date: 26 February 1940
• Docket Number: No. 9191.,9191.
• Parties: HAWKE v. COMMISSIONER OF INTERNAL REVENUE.
• Court: U.S. Court of Appeals — Ninth Circuit

109 F.2d 946 (1940)

HAWKE v. COMMISSIONER OF INTERNAL REVENUE.

No. 9191.

Circuit Court of Appeals, Ninth Circuit.

February 26, 1940.

Alan W. Davidson, of Oakland, Cal. (Francis O. Hoover, of Modesto, Cal., of counsel), for petitioner.

Samuel O. Clark, Jr., Asst. Atty. Gen., and Sewall Key, Ellis Slack, and S. Dee Hanson, Sp. Assts. to Atty. Gen., for respondent.

Before GARRECHT, HANEY, and STEPHENS, Circuit Judges.

STEPHENS, Circuit Judge.

This appeal involves income taxes for the years 1930 and 1931. The Board of Tax Appeals, upon petition of the taxpayer, redetermined deficiencies and the taxpayer has petitioned us for a review of the decision of the Board.

Taxpayer was employed by the J. C. Penney Company, a corporation, in 1913, and remained continuously in its employ until May, 1933. From 1919 until he left the employ of the Company in 1933 he was the manager of the Company's Modesto, California store. Under the corporate set up of the J. C. Penney Company, each of its stores was individually capitalized, there being a separate stock classification for each store. Taxpayer was permitted to, and did, purchase one-third of the classified common stock of said store. Under an oral contract of employment he received a salary of $75 per month, and, in addition, received one-third of the profits of the store because of his ownership of one-third of the classified stock of that store. In April, 1927, due to a change in the corporate structure of the J. C. Penney Company, taxpayer's classified common stock of said store was called in by the Company, and taxpayer received in full exchange therefor 100 shares of the preferred stock of the Company. At the same time he was reemployed by the Company as manager of the Modesto store, under a written contract of employment which became effective as of January 1, 1927. Said contract provided, among other things, that the taxpayer would continue as manager of said store and would devote his entire time and the best of his ability to the successful prosecution of his duties as such. It was agreed on the part of the Company as follows: "Commencing January 1, 1927, to pay to such Associate taxpayer each year as added compensation, in addition to the regular salary received by him the same fractional portion of the net earnings of said store for which said Associate is manager as he would have been entitled to, had he continued to own and hold said shares of classified common stock which he has delivered to the Company for conversion. * * *"

The contract contained a further provision, without any recital as to whether or not the benefits referred to therein were additional compensation to the taxpayer, as follows: "The Company further agrees with the Associate that when by reason of death, disability, or for any other reason, the Associate shall cease * * * to be the manager of such store, the Company will sell to him (or if he ceases to be manager by reason of death, then to his legal representatives or next of kin) at the then book value, and he or his legal representatives or next of kin shall have the right to purchase by paying such price, a sufficient number of shares of common stock of the Company, the earnings on which based upon the net earnings of the Company for the last full calendar year, will equal in amount two-thirds of the Associate's proportion * * * of the average annual net earnings of such store for three full calendar years * * *".

There is an additional provision that if the Board of Directors of the Company deemed it necessary or advisable, by reason of structural corporate changes, reorganization, dissolution or sale of corporate assets, the Company could terminate the contract at the end of any calendar year upon paying to the taxpayer the amount due to him under the terms thereof and upon permitting him to exercise his right to purchase the stock which he is given a right to purchase therein.

In 1929 the Company terminated the contract, and the taxpayer exercised his right thereunder to purchase 971 shares of stock for $27,188, which represented the then book value of said shares. The fair market value of such stock was at that time $356,842.50.

In June, 1927, the Company announced a plan under which store managers who successfully operated their stores and met certain requirements would be given the opportunity to purchase so-called "expansion stock" (common stock) of the Company at a price per share to be determined each year by the Board of Directors. In order to qualify for the purchase of this expansion stock a manager had to comply with all of the following:

(1) Manage a store (with interest in its profits) for one calendar year;

(2) Make 7 per cent or more net profit on the volume;

(3) Have 8 per cent or more of the volume in cash, as of December 31.

To determine the number of shares a qualifying manager could purchase, the percentage of the store earnings to which he was entitled (in taxpayer's case one-third under his employment contract) was used as a basis. If the manager met the foregoing requirements he was given the right to purchase expansion shares to the extent of 50 percent of his percentage of store earnings. If he had trained a man who was used by the Company to open and manage a new store, he was given the right to purchase expansion shares to the extent of the remaining 50 percent of his percentage of store earnings.

In April, 1928, the Company advised the taxpayer that his management of the Modesto store had qualified him for the right to purchase expansion stock, and that he was eligible to participate to the extent of 100 per cent of his 1927 earnings. Taxpayer's percentage of the store's earnings for 1927 having amounted to $18,689, he was allotted 187 shares of stock at a price of $100 per share, the price of the stock determined by the Board of Directors. Taxpayer exercised his right to purchase, and bought these 187 shares at $100 per share. The fair market value of the shares at the time of purchase was $325 per share.

In March, 1929, the Company advised the taxpayer that he had qualified for the purchase of further expansion stock based on his operations for the year 1928. Taxpayer was allotted 88 shares, which he purchased for $120 per share, the price fixed by the Directors. The fair market value of the shares at the time was $350.50 per share.

Taxpayer filed his income tax returns for the years 1928 and 1929 on March 15, 1929 and March 15, 1930, respectively. No waivers of the statute of limitation with respect to either of said years have been filed by the taxpayer. He did not include as income the differential between the respective prices paid for the shares of stock referred to above and their fair market value at the respective dates of acquisition, because he did not understand that the differential constituted taxable income to him in those years. No additional assessments were made by the Commissioner for those years, and the statute of limitations has now barred any additional assessments.

In 1930 and 1931 the taxpayer sold certain shares of stock of the J. C. Penney Company which he had acquired in 1928 and 1929 in the manner above described, and in reporting his profit on the sale thereof used as his cost basis the fair market value at the time of acquisition. The Commissioner determined deficiencies, using as the cost basis the actual cash outlay of the taxpayer in the acquisition of the shares.

The Board of Tax Appeals affirmed the Commissioner's determination, and the present appeal followed.

The Board found, with respect to the acquisition of said stock by the taxpayer, that "the excess of the fair market value over the agreed price was not compensation paid for services in the year when the shares were acquired".

The Commissioner argues that even assuming that the finding of the Board to the effect that the differential did not represent additional compensation is in error, still the taxpayer is not entitled to use the fair market value at the time of acquisition as his cost basis in determining the profit arising from the subsequent sale. The taxpayer in claiming the right to use the fair market value as his cost basis relies upon Art. 51 Treasury Regulation 74 promulgated under the Act in question, which reads as follows:

"Art. 51 What included in gross income. * * * Where property is sold by * * * an employer to an employee, for an amount substantially less than its fair market value, such * * * employee shall include in gross income the difference between the amount paid for the property and the amount of its fair market value. In computing the gain or loss from the subsequent sale of such property its cost shall be deemed to be its fair market value at the date of acquisition by the * * * employee. * *"

The argument of the Commissioner is that the last quoted sentence of said Article applies only in cases where the taxpayer has reported and paid a tax on the differential at the time he received the same.

If in fact a taxpayer paid a portion of the purchase price of the stock with his own services, we do not agree to the conclusion of the Commissioner. The treasury regulation is merely a recognition of the principle that a broad rather than restricted meaning must be given the word "cost", and a taxpayer should not be deprived of its provisions merely because he was not taxed during the year of acquisition.

The above discussion, of course, assumes that there is no basis for working out an estoppel against the taxpayer. The Commissioner contends that in the instant case the taxpayer is estopped from now asserting that the differential constituted income during the years of acquisition, because of his failure to report the same as income for those years.

We do not agree that the facts give rise to an estoppel. It is clear from the evidence that petitioner made a full disclosure of the transactions to the deputy collector, who assisted in preparing the taxpayer's...