McDonald v. Comm'r of Internal Revenue

• Decision Date: 16 April 1969
• Docket Number: Docket No. 429-67.
• Citation: 52 T.C. 82
• Parties: ARTHUR D. MCDONALD AND JESSIE L. MCDONALD, PETITIONERS v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT
• Court: U.S. Tax Court

52 T.C. 82

ARTHUR D. MCDONALD AND JESSIE L. MCDONALD, PETITIONERS

v.COMMISSIONER OF INTERNAL REVENUE, RESPONDENT

Docket No. 429-67.

Tax Court of the United States.

Filed April 16, 1969.

H. Milton Innerfield, for the petitioners.

Ferdinand J. Lotz III, for the respondent.

1. The petitioner, who owned all of the outstanding nonvoting preferred stock of E & M and substantially all of its outstanding common stock, entered into an agreement with Borden, under which E & M redeemed his preferred stock at par and thereafter Borden acquired all of E & M's outstanding stock in exchange for its own stock. Held, the redemption of the petitioner's preferred stock was not essentially equivalent to a dividend.

2. The petitioner failed to show that he is entitled to any part of a deduction for legal fees disallowed by the respondent.

SIMPSON, Judge:

The respondent determined a deficiency of $26,545.90 in the petitioners' income tax for the taxable year ending December 31, 1961. There are two issues for decision: (1) Whether a redemption of stock by a corporation pursuant to a plan for the acquisition of such corporation is essentially equivalent to a distribution of a dividend; and (2) whether, on the facts presented, a legal fee is deductible under section 212 of the Internal Revenue Code of 1954¹ or under any other section of that Code.

FINDINGS OF FACT

Some of the facts have been stipulated, and those facts are so found.²

The petitioners, Arthur D. and Jessie L. McDonald, are husband and wife and resided at Middleport, N.Y., at the time the petition was filed in this case. They filed their joint Federal income tax return for the year ending December 31, 1961, using the cash receipts and disbursements method of accounting, with the district director of internal revenue, Buffalo, N.Y. Arthur D. McDonald will be referred to hereinafter as the petitioner.

E & M Enterprises, Inc. (E & M), whose place of business was and is in Middleport, N.Y., was organized on January 9, 1947. E & M was the successor by a tax-free incorporation of a partnership in which the petitioner as one of two equal partners had a tax basis of $43,600, For his share of the partnership assets, the petitioner received in exchange 10 shares of the common stock of E & M with a par value and basis in the petitioner's hands of $10 per share and 435 shares of E & M's 870 noncumulative, nonvoting preferred stock with a par value and basis in the petitioner's hands of $100 per share. Upon incorporation, the petitioner's equal partner, William L. Carnegie, received 435 shares of the preferred stock and 10 shares of the common stock in exchange for his interest in the partnership. At the same time, the petitioner's brother, Stanley D. McDonald, who worked for, but had no interest in, the partnership, received 1 share of the common stock.

On April 3, 1948, the petitioner entered into an agreement with E & M regarding the disposition of his preferred stock. This agreement provided that on the petitioner's death, E & M would purchase such stock at its book value. It further provided that in the event the petitioner desired to sell such stock during his life, he was required to notify E & M, which was given an option to purchase such stock at its then book value. A similar agreement was executed between Mr. Carnegie and E & M. In 1954, E & M redeemed all of Mr. Carnegie's stock, preferred and common, and his interest was eliminated. Thereafter, and until the transactions with the Borden Co. hereinafter described, the petitioner owned all of the stock of E & M except for Stanley's one share of common. The petitioner continued to be, as he had been before the termination of Mr. Carnegie's interest, the dominant figure in E & M's operations.

E & M was engaged in the manufacture of tools, dies, and special equipment. From 1958 to 1961, its volume of business was approximately $1 million per year. It employed an average of 65 to 70 people, reaching a peak of 92 people, and had an average weekly payroll of $8,000. E & M's operations required substantial amounts of cash, much of which was obtained by loans from the Marine Trust Co. of Middleport.

From the date of its incorporation until April 21, 1961, E & M paid formal dividends on its preferred stock in the total amount of $11,745. Such dividends were paid at the rate of 6 percent on the 870 shares of preferred stock outstanding prior to the redemption of Mr. Carnegie's interest, and were paid in quarterly amounts of $1,305 for nine quarters from April 1951 through April 1953. After April 1953, no formal dividends were paid on the preferred stock.

In late 1960, the Borden Co., a large corporation whose one class of stock was listed on the New York Stock Exchange, expressed an interest in acquiring some of E & M's assets. Though the petitioner discussed an asset purchase with Borden, no offer on such terms was ever made. In March 1961, after auditing E & M's books and viewing its legal documents, Borden made a verbal offer to purchase the petitioner's preferred and common stock and Stanley's common stock in exchange for 5,500 shares of Borden's common stock. Although the petitioner accepted such offer, it was never consummated. After the March offer, Borden's representatives took copies of E & M's records back to Borden's New York City office. In early April, Borden submitted to the petitioner an offer to purchase the E & M stock for Borden stock— a proposed ‘Plan of Reorganization.’ This plan was accepted and executed by the petitioner, Stanley, E & M, and Borden on April 12, 1961. It recited the existence of the April 3, 1948, agreement between the petitioner and E & M and provided that prior to closing the petitioner would offer to E & M, and E & M would redeem, his 435 shares of preferred stock for its book value of $43,500. The plan further provided that on closing, the petitioner would transfer his 10 shares of E & M common stock in exchange for 4,399 shares of Borden's common stock, and that Stanley would transfer to Borden his 1 share of E & M common stock in exchange for 440 shares of Borden's common stock. The difference between the 5,500 shares of Borden common stock originally offered for the business and the 4,839 shares agreed on in the plan represents the amount of $43,500 to be paid to the petitioner by E & M in redemption of his preferred stock. Closing was set for April 28, 1961.

During the discussions concerning the plan, the petitioner pointed out to Borden that E & M did not have sufficient cash to carry out the redemption. As a result, on Borden's recommendation, the petitioner had E & M obtain a short-term bank loan from the Marine Trust Co. of Middleport in the amount of $60,000 on April 21, 1961. This transaction was not reflected in the plan of reorganization. Of this loan, $43,500 was to be used to effectuate the redemption of the petitioner's stock, and the balance was to be used to satisfy bonus and back-pay obligations of E & M. At the time the loan was made, the bank had a copy of the April 12 agreement and knew that Borden was shortly to assume ownership of E & M.

On April 21, 1961, E & M, pursuant to the terms of the April 3, 1948, agreement, elected to and did redeem the 435 shares of the petitioner's preferred stock for $43,500, an amount equal to the petitioner's basis in that stock. As of that date, E & M had earnings and profits of not less than $237,149.29. After the redemption, the petitioner's 10 shares and Stanley's 1 share of E & M's common stock constituted all the outstanding stock of the company.

On April 28, 1961, the deal was closed in New York City. The petitioner exchanged his 10 shares of E & M's common stock for 4,399 shares of Borden's common stock, and Stanley exchanged his 1 share of E & M's common for 440 shares of Borden common. Borden thereupon took over the operations of the company and continued to run it to the date of the trial in this case. The petitioner was retained as an employee of E & M until December 1962, and thereafter continued to do odd jobs at Borden's request.

At the closing, Borden gave the petitioner a check in the amount of $96,000 payable to E & M for deposit with the Marine Trust Co. of Middleport. Of that amount, $60,000 was used to pay off the April 21 bank loan, and the balance was used for operating cash.

Prior to the reorganization, E & M paid the petitioner approximately $40,000 a year as salary and bonus. He had no need for the cash received on the redemption of his preferred stock. The petitioner in 1961 wanted to sell his business to Borden but was indifferent as to whether he received 5,500 shares of Borden stock or received $43,500 in cash from E & M on redemption plus the 4,399 shares of Borden stock. Both the idea of redemption of the E & M preferred stock and the idea of obtaining a bank loan to accomplish it originated with Borden. To the date of the trial in this case, the petitioner continued to hold the 4,399 shares of Borden stock received in the transaction.

On his tax return for 1961, the petitioner reported the redemption of his preferred stock in E & M as the sale or exchange of a capital asset held for more than 6 months in which the amount received, $43,500, equaled his basis in such stock, giving rise to no gain or loss. He reported the exchange of his E & M common stock for Borden common stock as a tax-free exchange.

In 1961, the petitioner paid $832.94 to the law firm of Lewis, Sims, and May, Esqs., for various legal services rendered to him, The bulk of such legal fees was for services in connection with the exchange of stock with Borden. No part of such fees was shown to be paid for services giving rise to an income tax deduction in 1961.

OPINION

We are presented with the vexing problem of deciding whether a redemption of corporate stock in the circumstances of this case should be treated as a sale or as the distribution of a dividend. The respondent considers the redemption of the petitioner's...