Johnson v. Comm'r of Internal Revenue

• Decision Date: 08 April 1982
• Docket Number: Docket No. 15102-80.
• Citation: 78 T.C. 564
• Parties: JAMES HERVEY JOHNSON, PETITIONER v. COMMISSIONER of INTERNAL REVENUE, RESPONDENT
• Court: U.S. Tax Court

78 T.C. 564

JAMES HERVEY JOHNSON, PETITIONER

v.COMMISSIONER of INTERNAL REVENUE, RESPONDENT

Docket No. 15102-80.

United States Tax Court

Filed April 8, 1982.

T was the owner of 120 shares of class B stock of Missouri Pacific Railroad Co. (MoPac). There were only two classes of stock, A and B. One share of each class was entitled to one vote. The A stock was entitled to a noncumulative annual preferred dividend not to exceed $5 per share and a preferred distribution limited to $100 per share on liquidation. The B stock was entitled, without limitation, to annual dividends and distribution on liquidation after the requirements of the A stock were satisfied. In substance, the B stockholders were the equity owners of MoPac. However, approximately 98 percent of the total number of shares of both classes of stock consisted of A shares, and the remaining 2 percent consisted of B shares. Thus, in view of the disproportionate distribution of votes between the two classes, the A stock was in control of MoPac to the exclusion of the equity owners represented by the B stock (except in the case of a merger or consolidation where the assent of a majority of each class was required). Sharp differences developed between A and B stockholders, involving not only the B stockholders' complaint that they were being improperly deprived of adequate dividends, but also the A stockholders' acute dissatisfaction with the B stockholders' apparently retaliatory refusal to agree to a merger that was strongly desired by the A stockholders. The situation was further complicated by the fact that 63 percent of the A stock was owned by Mississippi River Corp. (MRC) and 53 percent of the B stock was owned by Alleghany Corp. (Alleghany). Thus, MRC in effect controlled the A stock and in turn MoPac, and was pitted against Alleghany, which controlled the B stock. Litigation followed against MoPac, MRC, and others that was converted into a class action on behalf of all class B stockholders. The principal litigants were Alleghany, MRC, and MoPac. Although several causes of action were alleged, the thrust of the complaint was that the MRC-controlled board of directors of MoPac unfairly withheld dividends from the B stockholders.

After extensive pretrial procedures, a settlement agreement was entered into by Alleghany, MRC, and MoPac. The agreement was approved for all parties by the trial court. Pursuant to the settlement, MoPac was recapitalized: each share of class A was exchanged for 1 share of new voting preferred, convertible into 1 share of new common; and each share of class B was surrendered for 16 shares of new common and $850 cash. In addition, MRC was required to make a tender offer of $100 per share of new common (up to a specified number of shares) to the former class B stockholders, but Alleghany, alone, was required in turn to tender its new common to MRC.

As a result of the settlement agreement, T surrendered his 120 shares of old class B stock and received from MoPac in exchange 1,920 shares of MoPac's new common plus $102,000 cash. Also, he voluntarily sold 1,376 shares of his new common to MRC for $137,600. Held:

1. The restructuring of MoPac was a “recapitalization” within the purview of sec. 368(a)(1)(E), I.R.C. 1954, and therefore a “reorganization” under sec. 368(a)(1).

2. Since T had no obligation to sell any of his new common to MRC, his sale of the 1,376 shares of new common was a transaction wholly separate from the recapitalization. Accordingly, he may not combine the $102,000 cash distribution with the $137,600 proceeds of sale and treat the sum ($239,600) as the proceeds of sale of the 1,376 shares, which he sought to classify as capital gain to the extent it exceeded the basis of the 1,376 shares.

3. Taking into account T's basis in his old class B stock and treating the new common as having a value of $100 per share, T realized gain on the surrender of his old class B stock in an amount exceeding the $102,000 cash distribution; pursuant to sec. 356(a)(1), the gain is therefore recognized only to the extent of the $102,000 cash (boot). Further, that $102,000 cash distribution “had the effect of the distribution of a dividend” (sec. 356(a)(2)), and, in the circumstances of this case, is taxable as such in its entirety. Sebastian D'Amico, for the petitioner.

Kevin M. Bagley, for the respondent.

OPINION

RAUM , Judge:

The Commissioner determined a deficiency of $52,008.13 in petitioner's income tax for the taxable year ended December 31, 1974. The principal issue is whether a $102,000 cash distribution received by petitioner, as part of an exchange of stock for stock plus cash in a recapitalization of the Missouri Pacific Railroad Co. is taxable to him as a dividend, pursuant to sections 368(a)(1)(E) and 356(a)(1) and (2), I.R.C. 1954, or whether such cash may, in the circumstances of this case, be lumped together with other cash received by him as proceeds of a sale of a portion of his new stock, thus permitting the aggregate sum of cash to be taxed as capital gain to the extent of the excess over basis of the shares thus sold. The case was submitted on the basis of a stipulation of facts.

At the time the petition was filed, petitioner was a resident of San Diego, Calif. His 1974 income tax return was filed with the Internal Revenue Service Center in Fresno, Calif.

During the years 1968 and 1969, petitioner purchased 120 shares of class B stock of the Missouri Pacific Railroad Co. (MoPac), at a cost of $165,100. Just prior to this time, in December of 1967, a class B stockholder of MoPac filed suit against MoPac and several other defendants, alleging violations of the class B stockholders' dividend rights and setting forth other possible causes of action. In September of 1968, it was ordered that the lawsuit be maintained as a class action on behalf of all class B stockholders.

As a consequence of settlement of that litigation, MoPac was recapitalized. Petitioner, as a class B stockholder, received in 1974 from MoPac, in exchange for each share of his class B stock, $850 cash and 16 shares of new common stock. At the same time, he sold (at $100 a share) 1,376 of his 1,920 new common shares to the Mississippi River Corp. (MRC), which was the majority stockholder of the former class A shares. Although petitioner apparently treated the recapitalization as a nontaxable reorganization in respect of the stock for stock exchange, his characterization of the $850 per share ($102,000 total) cash distribution from MoPac was substantially different. Petitioner aggregated this MoPac cash with the $137,600 which he received from MRC upon the sale of the 1,376 shares of his new common to MRC, and he sought to have all of this cash taxed as capital gain to the extent that it exceeded his basis in the 1,376 shares sold. The Commissioner, on the other hand, determined that the $102,000 cash distribution by MoPac was taxable as a dividend (ordinary income), and that the sale of the 1,376 shares of new common to MRC for $137,600 was a separate transaction taxable in the same manner as the sale of any capital asset. We hold that the Commissioner was correct.

A proper analysis of the problem requires some understanding of the complex events leading up to the foregoing recapitalization of MoPac. The following brief summary of those events is intended to serve as a background for considering the matter before us.

Reorganization proceedings involving the Missouri Pacific Railroad Co. began in 1933. After much litigation, a reorganization finally took effect in 1956, from which two classes of stock emerged: class A, issued to the former preferred stockholders, and class B, issued to the former common stockholders. Each share of both classes had one vote, but class A stockholders were entitled to a noncumulative dividend, not to exceed $5 per share annually, and a preferred distribution of $100 per share in the event of liquidation. Class B stock was entitled, in the discretion of the board of directors, to receive dividends without limitation after the $5 dividend was paid with respect to the class A stock, and, upon liquidation, the entire equity in excess of the class A preference. Since the number of class A shares amounted to about 98 percent of the total number of both classes outstanding, the class A stockholders had the power to elect MoPac's board of directors and exercise voting control in other respects.

After ensuing litigation which finally reached the Supreme Court, it was determined that in matters involving mergers, consolidations, or a corporate restructuring affecting the rights of either class, the assent of a majority of each class was required. Levin v. Mississippi River Fuel Corp., 386 U.S. 162 (1967). In effect, this gave the class B stockholders a veto over any proposed reorganization. The class B stockholders in fact prevented a merger which was strongly desired by the class A stockholders and exacerbated the friction between the classes. In this connection, a prime source of conflict between the two classes was the refusal of the board of directors to declare any class B dividends in excess of $5 per share each year, notwithstanding the apparent availability of ample funds for substantial additional dividends. Thus, the true equity owners of MoPac's stock were denied access to its earnings by a class of stock that had a severely restricted equity interest in the corporation. In short, there was “a basic conflict between the two classes, with the equity ownership principally in the B stock, but with effective operating control in the A stock.” Levin v. Mississippi River Corp., 59 F.R.D. 353, 358 (S.D. N.Y. 1973), affd. sub nom. Wesson v. Mississippi River Corp., 486 F.2d 1398 (2d Cir. 1973), cert. denied 414 U.S. 1112 (1973).

The situation was further complicated by the composition of each of the two classes of shareholders. Alleghany Corp. (Alleghany) was the owner of about half of MoPac's...