Lagerquist v. Commissioner
| Decision Date | 07 April 1987 |
| Docket Number | Docket No. 1953-85. |
| Citation | 1987 TC Memo 185,53 TCM (CCH) 530 |
| Parties | George A. Lagerquist and Margaret E. Lagerquist v. Commissioner. |
| Court | U.S. Tax Court |
E.M. Murray and Matthew W. Stanley, 2200 First Interstate Plaza, Tacoma, Wash., for the petitioners. Michael R. McMahon, for the respondent.
Memorandum Findings of Fact and Opinion
Respondent determined the following deficiencies in petitioners' Federal income taxes:
Year Deficiency
1977 ............................. $ 1,531
1978 ............................. 597,269
1979 ............................. 18,200
After concessions, the issues for decision are (1) whether certain notes issued to petitioner in a section 3511 transaction were "securities" or "other property" and, if the notes were "other property," (2) the fair market value of the notes on the date of the section 351 transaction.
Some of the facts have been stipulated, and the facts set forth in the stipulation are incorporated in our findings by this reference. Petitioners George A. Lagerquist (petitioner) and Margaret E. Lagerquist resided in Tacoma, Washington, when their petition was filed. Petitioners filed joint Federal income tax returns for the years in issue with the Internal Revenue Service Center in Ogden, Utah.
As of the trial of this case petitioner had been active in the wood products industry for over 50 years. In August 1978, petitioner held majority interests in five wood products firms ("the Galco companies"). Galco Wood Products operated a lumber yard in Tacoma, Washington; each of the other Galco companies sold building materials in Alaska. Petitioner was chairman of the Galco Wood Products board of directors and an officer in each of the other Galco companies.
In 1978, the Galco companies faced an uncertain future. Construction of the Alaska Pipeline had spurred demand for building materials, and the cost of materials purchased by the Galco companies for resale to contractors rose rapidly. As the Galco companies' need for cash became more acute, rising interest rates restricted the companies' ability to borrow funds. The Galco companies were soon unable to finance inventories sufficient to meet their customer's needs. Without additional capital, the companies could not continue to expand their operations in Alaska.
Petitioner repeatedly and unsuccessfully attempted to find a purchaser for the Galco companies. Henry Van Baalem, then president of Galco Wood Products, courted Laird Norton Company (Laird Norton), a potential purchaser. Booth Gardner, then president of Laird Norton, told Van Baalem that Laird Norton did not have assets sufficient to acquire the Galco companies. Laird Norton was also reluctant to acquire the Galco companies because it had never operated large contractor-oriented lumberyards. Laird Norton's United Building Centers division (UBC) operated approximately 115 archaic lumberyards located near declining mid-western farming communities. UBC's small yards catered primarily to "do-it-yourselfers." Laird Norton consequently felt that it had neither the assets nor the expertise necessary to acquire and operate the Galco companies.
Laird Norton and the owners of the Galco companies (the contributing shareholders) eventually agreed to form an entirely new corporation (LNC). Laird Norton contributed the assets of UBC; the contributing shareholders contributed their interests in the Galco companies. Laird Norton exercised its negotiating leverage by insisting that it receive at least 80 percent of the issued LNC stock. The remaining LNC stock was insufficient to compensate the contributing shareholders for their interests in the Galco companies. The contributing shareholders consequently received LNC stock, LNC 5-percent subordinated convertible debentures, and LNC 8-percent subordinated notes. The notes were not intended to compensate the contributing shareholders for any specific assets of the Galco companies, nor were the notes intended to enable LNC to meet its current liabilities. Several minor shareholders received cash.
Petitioner agreed to allow the owners of minority interests in the Galco companies to choose consideration for their interests first. He received only what was left after the other contributing shareholders had chosen. Although petitioner would have preferred to receive only stock, he received LNC subordinated convertible debentures in the principal amount of $3,962,500 and two LNC notes in principal amounts totaling $1,727,900, in addition to 99,484 shares of LNC stock. Petitioner was the largest minority shareholder of LNC.
Petitioner originally understood that he was to receive one 10-year note. LNC instead issued two notes running for consecutive terms of 4 or 5 years. Each note was in the principal amount of $863,950 payable in five equal annual installments of $172,790, with 8-percent interest payable quarterly on the unpaid balance. LNC did not have the right to prepay all or any portion of the notes. The 8-percent interest payable on the notes was comparable to rates available on significantly more secure, seasoned issues and was, therefore, a below market rate. The first principal payment on the first note was payable on August 15, 1978, the date of the exchange; subsequent principal payments were due on August 15 in each of the succeeding 4 years. Interest only was payable on the second note until the first principal payment on August 15, 1983; subsequent principal payments were due on August 15 in each of the succeeding 4 years. Note balances due to the contributing shareholders initially exceeded $5 million and, by the end of LNC's first 4 months of corporate life, totaled approximately $4,600,000. LNC timely paid all principal and interest payments due before the date of trial.
The notes were unsecured and unregistered. Although otherwise fully negotiable, the notes provided that, because they were not registered, they could not be transferred on LNC's books, offered, sold, or pledged without the concurrence of LNC's counsel.
The notes were subordinate to LNC's present and future indebtedness to banks and institutions. The notes were also subordinate to all present and future long-term debt of LNC. The notes were given equal status with LNC's originally issued subordinated convertible debentures.
The notes were subject to LNC's right to offset remaining installments of principal against certain liabilities of each noteholder. In the subscription agreement, the contributing shareholders agreed to indemnify LNC against any loss resulting from breach of the contributing shareholders' representations and warranties. For a period of 2 years following the closing of the subscription agreement, each contributing shareholder could thus be held liable for his or her proportionate share of any undisclosed debts or liabilities of the Galco companies. LNC could offset each noteholder's proportionate share of such debts or liabilities against remaining installments of principal. A problem involving one of the Galco companies' Alaskan personnel suggested that certain financial information submitted by the Galco companies was misrepresented and threatened to trigger the offset provisions of the subscription agreement. The subscription agreement also provided for a right of offset against the debentures and a pledge of 50 percent of each contributing shareholder's stock in LNC.
LNC did not agree to retain liquid assets necessary to make note payments. LNC's December 31, 1978, balance sheet portrayed the company's financial position as follows:2
L N CORPORATION
CONSOLIDATED BALANCE SHEET
DECEMBER 31, 1978
(in thousands)
AssetsLiabilities and Shareholder's Equity
CURRENT ASSETS: CURRENT LIABILITIES
Cash .................................................... $ 2,168 Current maturities of long-term debt ................. $ 772
Accounts receivable, less allowances of $475 ............ 14,587 Notes payable ........................................ 5,620
Notes receivable from shareholder ....................... 1,144 Accounts payable ..................................... 5,319
Receivable from Laird Norton Company .................... 134 Accrued expenses ..................................... 3,697
Other receivables ....................................... 438 Income taxes payable ................................. 1,866
Inventories, at the lower of cost (principally first-in, _______
first-out) or market .................................. 27,079 Total current liabilities .................... 17,274
Prepaid expenses ........................................ 117
______
Total current assets .................................... 45,667 ACCRUED DEFERRED COMPENSATION ........................ 825
______
PROPERTY AND EQUIPMENT, at cost
Used in operations — DEFERRED INCOME TAXES ................................ 127
Land .................................................... 4,441
Buildings ............................................... 12,421 NOTES AND CONTRACTS PAYABLE, net of current maturities. 1,721
Equipment and fixtures .................................. 6,213
Accumulated depreciation ................................ (8,186) SUBORDINATED DEBENTURES, net of current maturities
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