Mills v. Comm'r of Internal Revenue, Docket No. 86865.

• Decision Date: 24 July 1964
• Docket Number: Docket No. 86865.
• Citation: 42 T.C. 769
• Parties: MALDEN KNITTING MILLS, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT
• Court: U.S. Tax Court

42 T.C. 769

MALDEN KNITTING MILLS, PETITIONER,

v.COMMISSIONER OF INTERNAL REVENUE, RESPONDENT

Docket No. 86865.

Tax Court of the United States.

Filed July 24, 1964.

Kenneth W. Bergen and Josiah A. Spaulding, for the petitioner.

Robert B. Dugan and Albert R. Doyle, for the respondent.

1. Held: Petitioner's purported purchase on February 14, 1955, of 3,000 shares of certain stock, ‘dividend on,‘ from Keizer & Co., a securities dealer, and purported resale of the 3,000 shares, ‘ex dividend,‘ to Keizer & Co. on February 15, 1955, reversing the transaction, were a sham. Accordingly, petitioner is not entitled to a short-term capital loss deduction in connection with the alleged resale and a dividends-received deduction in respect of an amount received from Keizer & Co. which purported to represent dividends on the 3,000 shares.

2. Held, petitioner may not deduct its so-called out-of-pocket expenses in connection with the foregoing transaction either (i) as a loss upon sale of an ‘option,‘ under sections 1234(a) and 165, I.R.C. 1954, or (ii) as an ordinary and necessary business expense under section 162(a).

The Commissioner determined a deficiency in petitioner's income tax for its fiscal year ended November 30, 1955, in the amount of $65,827.36, part of which is no longer in controversy. The issues remaining for decision are: (1) Whether petitioner realized a short-term capital loss in the amount of $17,805 on February 15, 1955, on its purported sale of 3,000 shares of Chicago, Milwaukee, St. Paul & Pacific Railway Co. preferred stock, ex dividend, which it had purportedly purchased the previous day, and whether petitioner is entitled to a dividends-received deduction in the amount of $12,750 based upon its receipt of $15,000 which purported to represent a dividend on the 3,000 shares of stock; (2) whether, assuming that the foregoing matters are decided against petitioner, it is entitled to deduct its ‘out-of-pocket’ costs in the amount of $2,805, in connection with the above transaction, either as a loss on the sale of an ‘option’ or as an ‘ordinary and necessary’ business expense.

FINDINGS OF FACT

The facts stipulated by the parties and exhibits introduced in evidence are incorporated herein by this reference.

Malden Knitting Mills, hereinafter referred to as Malden, a Massachusetts corporation organized on January 1, 1918, in Malden, Mass., is a manufacturer of sweaters and knitted fabrics. It timely filed its Federal income tax return for its fiscal year ended November 30, 1955, on an accrual basis, with the district director of internal revenue at Boston, Mass.

Samuel C. Feuerstein has been associated with Malden since its inception and has been its president for the past 20 or 25 years.

Gerald Glunts, hereinafter referred to as Glunts, is an attorney and a certified public accountant and a partner in an accounting partnership, James D. Glunts & Co. He has been Malden's auditor for approximately 25 years and has advised Malden in respect of accounting, financial, and tax matters.

J. Benn Keizer, hereinafter referred to as Keizer, is a member of Keizer & Co., Inc., hereinafter referred to as Keizer & Co., a corporate brokerage firm doing business in Boston. He has been in the securities business for approximately 25 years. Neither Keizer & Co. nor its officers and employees were, in 1955, members of a listed stock exchange. However, during 1955 Keizer & Co. was a securities dealer registered with the Securities and Exchange Commission. Keizer & Co. did not employ any salesmen, and Keizer alone handled sales on its behalf.

In 1954 Glunts brought up to Keizer a plan for tax avoidance for the benefit of corporate taxpayers, involving the purchase of stock of another corporation, ‘dividend on,‘ to be followed by a sale of the same stock, ‘ex dividend.’ The purpose of this plan was to take advantage of a corporate tax reduction by utilization of the 85-percent dividend credit in the following manner: Under normal conditions the market price of stock would drop by the amount of the dividend when the stock went ex dividend, but the seller of the stock would remain entitled to receive the dividend; the anticipated tax advantage of Glunts' plan would be that the corporate taxpayer would become entitled to a short-term capital loss deduction in the amount of the loss on the sale, but the offsetting dividend that it would receive would be exempt from tax to the extent of 85 percent thereof in accordance with section 243 of the 1954 Code. Keizer was cognizant of the steps to be taken in order to obtain the desired tax consequences for clients of Glunts. Glunts advised some of his clients to enter into such transactions. These transactions involving Glunts' clients were discussed with Keizer, who arranged to execute them for these clients.

In 1954 or early in 1955, Glunts requested Keizer to advise him of any stocks which were about to pay substantial dividends. In February 1955, Keizer reported to Glunts that a $5 dividend would be paid on the 5-percent noncumulative, Series A, 100 par value preferred stock of the Chicago, Milwaukee, St. Paul & Pacific Railway Co., hereinafter referred to as Railway stock, on March 11, 1955, to stockholders of record on February 19, 1955, and that the stock would go ex dividend on February 15, 1955.

At some time prior to February 14, 1955, Glunts told Feuerstein that Malden could realize a substantial tax benefit from the purchase of Railway stock, dividend on. He explained to him that Malden would receive the dividend and thereby become entitled to a dividends-received deduction in the amount of 85 percent of the dividend received and that if the price of the stock, ex dividend, fell by an amount approximating the amount of dividend, as could usually be expected, Malden could sell the stock and realize a short-term capital loss which could be applied against any capital gains realized by Malden prior to the termination of its fiscal year.

Feuerstein decided that he, in behalf of Malden, would enter into the transaction suggested by Glunts. In so doing, Feuerstein relied heavily on Glunts' advice. Glunts recommended that the transaction be handled through Keizer & Co. and suggested to Feuerstein that he discuss the matter with Keizer. Prior to his entering into this transaction Feuerstein had known Keizer only casually. Glunts also suggested to Keizer that he get in touch with Feuerstein in connection with the proposed transaction.

On either February 13 or 14, 1955, Keizer telephoned Feuerstein and told him that Glunts had ‘asked me to tell * * * (you) * * * that * * * (you) could use 3,000 shares.’ Feuerstein agreed to ‘purchase,‘ in behalf of Malden, the suggested number of Railway shares.

Prior to his purported purchase in behalf of Malden of 3,000 shares of Railway stock, Feuerstein did not make a study of the stock market in respect of the Railway stock, nor did he study the financial history of the Chicago, Milwaukee, St. Paul & Pacific Railway Co.

A confirmation slip of Keizer & Co. bearing the date February 14, 1955, and a settlement date of February 18, 1955, purports to show that Keizer & Co., as principal for its own account, had sold to Malden 3,000 shares of Railway stock, dividend on, for $52 per share; the total amount of the alleged sale was $156,000. Similarly, on February 14, 1955, Keizer & Co. purported to sell as principal to four other clients of Glunts a total of 17,370 shares of Railway stock at the same price of $52 a share, with a settlement date of February 18, 1955. Thus, Keizer & Co.‘s purported sales of Railway stock to Malden and the other four clients of Glunts on February 14, 1955, were in the aggregate amount of 20,370 shares.

Railway stock was traded on the New York Stock Exchange in 1955. On February 14, 1955, the low price for this stock was 51 5/8 and its high was 52 5/8. Approximately 16,600 shares of this stock were traded on the New York Stock Exchange on February 14, 1955.

At the time of its purported sale of the Railway stock to petitioner, Keizer & Co. did not have any Railway stock in its inventory and it did not thereafter acquire any such stock for delivery to petitioner.

On the next day, February 15, 1955, when the Railway stock went ex dividend, Malden and the other four clients of Glunts referred to above, each purported to sell its Railway stock, in the aggregate amount of 20,370 shares, back to Keizer & Co. at 46 1/8. On that day 42,500 shares of Railway stock were traded on the New York Stock Exchange at a price between a low of 45 5/8 and a high of 47. A confirmation slip of Keizer & Co. bearing the date February 15, 1955, and a settlement date of February 21, 1955, purports to show Malden's sale of its 3,000 shares; and the books of Keizer & Co. reflect the same settlement date for the alleged sales by the other four clients of Glunts.

Malden's purported purchase of 3,000 shares of Railway stock on February 14, 1955, was on margin, involving a loan of 40 percent of the market value of the security purchased. Accordingly, on or before February 18, 1955, the settlement date for Malden's alleged purchase, it paid Keizer & Co. $93,600 (60 percent of the total alleged purchase price of $156,000). At approximately the same time, about February 18, 1955, Keizer & Co. sent petitioner a check in the amount of $75,795. This amount represented the difference between the total net purchase price of the 3,000 shares purportedly sold on February 15, 1955 by Malden to Keizer & Co. ($138,195)¹ and the debit balance in Malden's margin account.

Thereafter, on March 11, 1955, Keizer & Co. sent its check in the amount of $15,000 to Malden, purporting to represent the amount of dividends on the 3,000 shares of Railway stock allegedly purchased by Malden on February 14, 1955.

Malden's sole purpose in entering into the foregoing transaction was to obtain tax benefit.

In its income tax return for the fiscal year ended November 30,...