Lyon, Inc. v. Commissioner of Internal Revenue

• Decision Date: 13 April 1942
• Docket Number: No. 8994.,8994.
• Parties: LYON, Inc., v. COMMISSIONER OF INTERNAL REVENUE.
• Court: U.S. Court of Appeals — Sixth Circuit

127 F.2d 210 (1942)

LYON, Inc., v. COMMISSIONER OF INTERNAL REVENUE.

No. 8994.

Circuit Court of Appeals, Sixth Circuit.

April 13, 1942.

Elden McFarland, of Washington, D. C. (Elden McFarland, of Washington, D. C., G. A. Donohue, of New York City, and Ike Lanier, of Cincinnati, Ohio, on the brief), for petitioner.

Samuel H. Levy, Sp. Asst. to Atty. Gen. (Samuel O. Clark, Jr., Asst. Atty. Gen., and J. Louis Monarch and Samuel H. Levy, Sp. Assts. to Atty. Gen., on the brief), for respondent.

Before SIMONS, ALLEN, and MARTIN, Circuit Judges.

SIMONS, Circuit Judge.

The ultimate question to be decided in this review is whether the respondent correctly determined the basis for depreciation of patents owned by the petitioning taxpayer. This depends upon whether the taxpayer acquired the patents in pursuance of a reorganization. If it did, the proper base is $56,411.90, the cost of the patents to the transferrer. If it did not, the base is $1,146,201.21, which was the fair market value of the patent applications at the time of their transfer. Deficiencies were determined in income taxes for the years 1934 to 1937, inclusive, by rejecting the taxpayer's deductions for depreciation on the fair value basis, and recomputing its taxes by an allowance for depreciation on the cost basis. The Board of Tax Appeals upheld the respondent.

It will aid understanding of the problem if we narrate the steps taken by the principal stockholder of the taxpayer, to defer or avoid substantial tax burdens, and detail his frankly avowed purposes as we refer to the statutory provisions upon which he relied, and the contemporaneous development of the law interpreting them. The taxpayer is a corporation organized June 6, 1930, under the laws of Delaware, and its principal stockholder is G. Albert Lyon. Prior to May 3, 1930, Lyon was engaged in the manufacture of metal covers for automobile tires, in Detroit. He was also the owner of numerous applications for American and Canadian patents relating to tire covers, and owned machinery and equipment for their manufacture. In February, 1930, he negotiated with the Houdaille-Hershey Company for the sale of his business and patent applications, and on May 3, a contract was consummated whereby Lyon, or a corporation to be formed by him, would sell the Houdaille-Hershey Company the tire cover business and Lyon would grant it an exclusive license to manufacture under his patents. At the time of the agreement the book value of Lyon's assets, exclusive of patent rights, was $203,572.30, and he carried patent rights on his books at cost of development, $56,411.90. The contract also granted to the purchaser an option to buy the patents.

Since the patent rights were found by the Board to have had at the time a fair market value of over a million dollars, it will readily be seen that Lyon's tax situation at once became to him a matter of great concern. He consulted counsel and was advised that if he transferred his assets to a temporary corporation in exchange for all of its stock, and then caused the temporary corporation to transfer the assets so received to a permanent operating corporation in exchange for less than 80% of its stock, neither the transfer to the temporary corporation nor its transfer to the permanent corporation would be subject to tax, and the permanent corporation would be entitled to use, as the cost of the assets, their value at the time they were acquired. A plan in accordance with this advice was put into effect. On June 12, 1930, Lyon transferred his tire cover business, including patent applications, subject to the agreement of May 3, to a corporation organized by him under the style "Lyon Development Company, Inc.," and received in exchange all of the corporation's stock. Two days later, on June 14, this corporation transferred the assets received from Lyon, likewise subject to the contract of May 3, to the petitioner in exchange for 885 shares of petitioner's Class A voting stock and 1600 shares of its Class B non-voting stock. The stock received by the temporary corporation constituted 79.27% of the taxpayer's total stock. On June 13, 1930, Lyon's wife, Elizabeth Aikens Lyon, transferred certain stocks owned by her to the taxpayer in exchange for 650 shares of its Class A voting stock, which resulted in all of the stock being owned by the Lyons.

The formation of the two corporations and the several transfers, were steps in pursuance of a preconceived plan and were approved by appropriate resolutions of the directors of the two companies. Since its acquisition of the Lyon assets the taxpayer has been actively engaged in the manufacture and sale of automobile parts and accessories other than those connected with the tire cover patents, and has been collecting royalties under the license agreement. In November, 1930, the temporary corporation, Lyon Development, Inc., distributed all of its assets, consisting only of stock of the taxpayer to Lyon, and in 1937 it was formally dissolved by the State of Delaware for nonpayment of franchise taxes. The respondent assessed a deficiency for 1930 (not here involved) against Lyon, on the ground that a sale of his assets, other than patents, had been effected by him personally, and Lyon paid the tax. Why no deficiency was assessed or tax paid for 1930, by reason of a sale of patent rights, does not appear.

Lyon's plan was to sell his tire cover business and patent applications in such manner that the tax upon any gain derived therefrom would be postponed, and the corporation formed to hold the patents enabled to use a basis for depreciation, stepped up from Lyon's cost to current fair value. The first part of his purpose was in part achieved by the transfer of all of his assets to the temporary corporation in exchange for all of its stock. This was a tax-free transaction within § 112(b) (5) of the Revenue Act of 1928, 26 U.S.C.A. Int.Rev.Acts, page 377, which provides that: "No gain or loss shall be recognized if property is transferred to a corporation by one or more persons solely in exchange for stock or securities in such corporation, and immediately after the exchange such person or persons are in control of the corporation; but in the case of an exchange by two or more persons this paragraph shall apply only if the amount of the stock and securities received by each is substantially in proportion to his interest in the property prior to the exchange."

By virtue of § 113(a) (6), 26 U.S.C.A. Int.Rev.Acts, page 381, however, the basis for valuing the transferred assets remained the same in the hands of the corporation as when they were owned by Lyon. The stepped up basis was sought to be achieved by the transfer of the assets to a second corporation, and thereby not only to effect a tax-free reorganization but to make applicable to depreciation base § 113(a) (7) of the same statute, which provides: "(7) Transfers to corporation where control of property remains in same persons. If the property was acquired after December 31, 1917, by a corporation in connection with a reorganization, and immediately after the transfer an interest or control in such property of 80 per centum or more remained in the same persons or any of them, then the basis shall be the same as it would be in the hands of the transferor, increased in the amount of gain or decreased in the amount of loss recognized to the transferor upon such transfer under the law applicable to the year in which the transfer was made. This paragraph shall not apply if the property acquired consists of stock or securities in a corporation a party to the reorganization, unless acquired by the issuance of stock or securities of the transferee as the consideration in whole or in part for the transfer."

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