Mitchell v. Comm'r of Internal Revenue

• Decision Date: 30 April 1969
• Docket Number: Docket No. 2522-67.
• Citation: 52 T.C. 170
• Parties: WILLIAM L. MITCHELL AND MARIAN S. MITCHELL, PETITIONERS v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT
• Court: U.S. Tax Court

52 T.C. 170

WILLIAM L. MITCHELL AND MARIAN S. MITCHELL, PETITIONERS

v.COMMISSIONER OF INTERNAL REVENUE, RESPONDENT

Docket No. 2522-67.

Tax Court of the United States.

Filed April 30, 1969.

Harry S. Stark and Leonard J. Prekel, for the petitioners.

Robert T. Hollohan, for the respondent.

Respondent has determined that on a stock sale-purchase transaction, within the meaning of sec. 16(b) of the Securities Exchange Act of 1934, payment by petitioner to his employer of the difference between the sale price of the stock sold and the purchase price of the stock purchased, constitutes merely a capital loss under the principles enunciated in Arrowsmith v. Commissioner, 344 U.S. 6 (1952). Petitioner contends the payment constituted an ordinary and necessary business expense under sec. 162(a), I.R.C. 1954. Held, Arrowsmith principles not applicable. Held, further, petitioner's payment constituted deductible ordinary and necessary business expense.

WITHEY, Judge:

A deficiency in income tax has been determined by the Commissioner against petitioners for the taxable year 1963 in the amount of $12,364.28.

The only issue to be decided is whether respondent has erred in disallowing as an ordinary and necessary business expense deduction the amount paid by petitioner to his employer in response to an alleged violation of section 16(b) of the Securities Exchange Act of 1934 and allowing the deduction only as a long-term capital loss.

FINDINGS OF FACT

Some of the facts have been stipulated and are found accordingly.

William L. Mitchell (hereinafter referred to as petitioner) and Marian S. Mitchell were husband and wife with legal residence at Birmingham, Mich., at the time the petition was filed. They filed their joint Federal income tax return for the taxable year 1963 with the district director of internal revenue at Detroit, Mich.

Since 1958, petitioner has been a vice president in charge of styling for the General Motors Corp. (hereinafter referred to as General Motors).

On October 5, 1962, petitioner sold 2,736 shares of General Motors common stock of which 2,130 shares were sold at $54.75 per share. After commissions and taxes, he netted $115,535.89 on the sale of such shares.

On petitioners' 1962 income tax return, the sale was reported as the sale of a capital asset and they reported the gain on the sale as a capital gain.

On January 10, 1963, petitioner exercised a restricted stock option, which had been granted him in March 1959 under the General Motors Stock Option Plan, to purchase 2,130 shares of General Motors common stock at the option price of $45.82 per share. Petitioner paid a total of $97,596.60 for the shares.

At the dates of the sale and purchase of the stock above referred to, petitioner was not aware of the provisions of section 16(b) of the Securities Exchange Act of 1934 (hereinafter referred to as section 16(b)). His sale and purchase of the stock were made on the advice of counsel in the planning and organizing of his estate.

These transactions came to the attention of General Motors. General Motors then advised petitioner that in their opinion the transactions violated section 16(b),¹ and made a demand upon him for $17,939.29, representing the difference between the amount he received from the sale of 2,130 shares of General Motors stock on October 5, 1962, and the cost of acquiring a similar number of shares by exercising the stock option on January 10, 1963.

Petitioner was advised by counsel that there was theory under which he might not be liable to General Motors under section 16(b), but that he should nevertheless pay the requested amount. Pursuant to that advice, petitioner remitted $17,939.29 to General Motors in settlement of his alleged violation of section 16(b) but specifically did not admit his liability thereunder in so doing, and expressed his belief that he was not an ‘insider’ within the meaning of SEC rules and regulations. No administrative or judicial determination of petitioners' liability under section 16(b) had been made at the time of this payment.

Under Securities and Exchange Commission rules,² if petitioner had not voluntarily paid the $17,939.29 to General Motors, the alleged section 16(b) transaction would be required to be reported on the General Motors proxy statement, which is furnished annually to over 1 million stockholders and petitioner reasonable believed that such action might damage his business reputation and disadvantage his career with General Motors. Furthermore, had petitioner not made this payment, there was a substantial likelihood that General Motors would have instituted an action against him based on section 16(b) to recover that sum.

On petitioners' joint income tax return for 1963, they claimed an ordinary and necessary business expense deduction in the amount of $17,939.29, which amount represented the payment to General Motors.

ULTIMATE FINDING OF FACT

Petitioner's payment of $17,939.29 to General Motors was made to avoid injury to his business reputation and disadvantage to his career, embarrassment to General Motors and himself, and the expense of possible future litigation.

OPINION

Petitioner seeks to deduct the amount of the payment made to his employer as an ordinary and necessary business expense under section 162(a) of the Internal Revenue Code of 1954.³ The respondent, by his adjustment, has allowed a deduction only for a long-term capital loss on the theory of Arrowsmith v. Commissioner, 344 U.S. 6 (1952).

Petitioner's argument in favor of an ordinary and necessary business expense deduction is premised upon his contentions that: (1) He is in the business of rendering services to his employer, (2) that his payment of $17,939.29 to General Motors was not made because of a violation of section 16(b), and (3) that such payment was made solely to prevent damage to his business reputation, to prevent embarrassment to himself and his employer, to avoid the expense of litigation and to protect his position as an employee.

Respondent agrees that petitioner's employment as a corporate executive may constitute a trade or business separate and distinct from that of his employer, but takes issue with petitioner that any damage to his business reputation would have resulted from his failure or refusal to make the payment in question. In addition, by his allowance of a long-term capital loss to petitioner in the statement accompanying his notice of deficiency and by statements contained in his brief, respondent raises another issue which, so far as we have been able to determine, has not been previously decided. He contends that petitioner previously reported a capital gain on his sale of General Motors stock and that petitioner's payment of the alleged section 16(b) ‘profit’ was so closely related to the earlier sale as to require the payments' characterization as a capital loss under the rationale of Arrowsmith v. Commissioner, supra.⁴ In effect, he contends that the question whether or not petitioner made the payment to protect his business reputation is therefore irrelevant. We do not agree.

In Arrowsmith, the taxpayers received distributions upon the complete liquidation of a corporation and reported the resulting profit as capital gain. In a later year, the taxpayers, as transferees of the corporation's assets, paid a judgment against the corporation and claimed a deduction as an ordinary loss. The Supreme Court held that it was proper to consider the earlier transaction in order to classify the nature of the later loss, and determined that the liabilities paid in the later year were ‘directly related to’ and ‘tied together’ with the earlier liquidating distributions and, therefore, the later deductions should be treated as capital losses. From the Arrowsmith decision have flowed a number of other cases where, because of the integral connection of a taxable transaction in a later year to a taxable transaction in an earlier year, the character of the gain or loss in the later transaction is determined by the capital or noncapital nature of the gain or loss in the earlier one. Alvin B. Lowe, 44 T.C. 363 (1965), gain incurred by retention by seller of part of purchase price of stock after default by buyer, held to be capital gain; Rees Blow Pipe Manufacturing Co., 41 T.C. 598 (1964), affirmed per curiam 342 F.2d 990 (C.A. 9, 1965), amount paid by seller in satisfying judgment for misrepresentation in sale of building, held capital loss; Estate of James F. Shannonhouse, 21 T.C. 422 (1953), amounts paid by seller of realty to purchase in discharge of liabilities for breach of covenant of title, held capital loss.

In the instant case in 1962, when petitioner sold General Motors stock, he reported a long-term capital gain and paid the resulting tax. That gain was then his property without a claim against it on the part of anyone. It was a completed transaction. In 1963, petitioner purchased other shares of General Motors common stock at a price fixed by stock options owned by him. Upon this latter transaction, nothing of tax consequence took place. Only upon the sale or disposition of the purchased stock could it be said that anything with tax incidence had occurred. Secs. 1001, 1002, I.R.C. 1954. Because the purchase of the stock in 1963 took place within 6 months of the sale transaction, however, an entirely separate and distinct statute from the Internal Revenue Code was alleged to have come into operation, i.e., section 16(b) of the Securities Exchange Act of 1934. Violation of section 16(b) had no ipso facto tax effect whatsoever but merely creates an indebtedness between an ‘insider’ officer of a corporation and his corporate employer.

It is noteworthy that there is no relationship between the amount of the capital gain realized upon the sale transaction to which respondent would relate the loss and the amount which ‘inures' to the stock issuer under section 16(b). The fact is that a violation of section 16(b) could well...