Shoe Corp. of America v. Comm'r of Internal Revenue

• Citation: 29 T.C. 297
• Decision Date: 20 November 1957
• Docket Number: Docket No. 60554.
• Parties: SHOE CORPORATION OF AMERICA, A CORPORATION, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.
• Court: United States Tax Court

29 T.C. 297

SHOE CORPORATION OF AMERICA, A CORPORATION, PETITIONER,

v.COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.

Docket No. 60554.

Tax Court of the United States.

Filed November 20, 1957.

David Ginsberg, Esq., and Robert J. Bird, Esq., for the petitioner.

Lyman G. Friedman, Esq., for the respondent.

A shareholder of petitioner was plaintiff in a stockholder's derivative suit in which petitioner and some of its officers and directors were joined as defendants. The derivative suit was primarily brought to enjoin petitioner's officers and directors from issuing certain class B stock to petitioner's management which would have resulted in the perpetuation of control of the petitioner in the same family. As a result of such suit the officers and directors were permanently enjoined from issuing the class B stock and the plaintiff's legal and accounting fees and expenses were taxed to petitioner by the District Court. Petitioner's claimed deduction for such fees was disallowed by respondent. Held, the amount paid by petitioner as costs pursuant to the decree of the District Court is deductible as an ordinary and necessary business expense within the meaning of section 23(a)(1)(A), I.R.C. 1939.

BRUCE, Judge:

The respondent determined the following deficiencies in the income tax of petitioner:

+--------------------+
                ¦Year  ¦Deficiency   ¦
                +------+-------------¦
                ¦1951  ¦$1,647.30    ¦
                +------+-------------¦
                ¦1952  ¦118,778.73   ¦
                +--------------------+
                

The only issue remaining for decision involves respondent's determination that certain litigation expenses incurred by petitioner in 1952 in a stockholder's suit against petitioner and its officers and directors did not constitute an allowable deduction under the provisions of section 23(a) of the Internal Revenue Code of 1939.

FINDINGS OF FACT.

The stipulated facts are incorporated herein by this reference.

The petitioner is an Ohio corporation with its office and principal place of business in Columbus, Ohio. At all times material herein its principal business has been the manufacture and sale of shoes at retail. Petitioner's Federal income tax returns for the calendar years 1951 and 1952 were filed with the director of internal revenue at Columbus, Ohio.

Prior to December 26, 1947, the petitioner was known as the Schiff Company. On that date petitioner's name was changed to Shoe Corporation of America.

Petitioner's outstanding capital stock has consisted of no-par common stock which was and still is actively traded on the American Stock Exchange. In 1950 a new cumulative preferred stock was created and 4,364 shares were issued. At all times material herein, with one exception, petitioner's officers and directors have been stockholders of petitioner and all have actively participated in the conduct and management of petitioner's business, which business has been successful and profitable.

In October 1947, petitioner's management formulated a plan of recapitalization of petitioner's outstanding stock. One of the stated purposes of the proposed plan of recapitalization was to continue the existing management in control of petitioner's business by the creation, issuance, and sale of class B common shares without par value. At this time the authorized capital stock of petitioner consisted of 500,000 shares of no-par common stock, of which 227,750 were outstanding, and 50,000 cumulative preferred shares, none of which were outstanding. The recapitalization plan provided for an increase in petitioner's authorized capital stock to consist of 250,000 shares of cumulative preferred stock, $100 par value, 2,000,000 class A shares, and 600 class B shares. The outstanding 222,750 shares of common stock were to be split 2 for 1, and exchanged for 445,500 shares of class A. The preferred stock and the class A were to have full voting rights and were jointly entitled to elect 7 directors out of a proposed board of 12 directors. The new class B stock, consisting of 600 shares, was to have identical dividend and liquidation rights with the class A stock, and in addition it would have the sole right to elect 5 directors out of the board of 12 directors, and would have such veto power, voting as a class, as was granted by the Ohio law. The plan further provided that the 600 shares of class B stock would be issued at a price per share equal to the price at which a share of class A stock was then selling on the New York Curb Exchange, and that the 600 shares of class B stock be issued in varying amounts to the then members of petitioner's management and their families, all of whom were related to petitioner's president, Robert W. Schiff. At this time 30 per cent of petitioner's stock was owned by the Schiff family.

At the direction of petitioner's president a special meeting of shareholders of the petitioner was called for November 3, 1947. A proxy statement prepared by petitioner's then management was mailed to all shareholders of record. As required by law a draft of the proxy statement was submitted to the Securities and Exchange Commission prior to its issuance to the shareholders. The Securities and Exchange Commission issued a deficiency letter criticizing the plan with respect to the creation and issuance of the 600 shares of class B stock to the ‘Schiff family,‘ and pointed out that the management was attempting to obtain five-twelfths of the voting power for the election of directors and a veto power with respect to matters requiring a majority vote of all classes of stock, at a cost of some $10,000, whereas the purchase at then market values of common shares having five-twelfths of the voting power would involve an investment of approximately $3,250,000.

At least two of petitioner's stockholders protested to petitioner's management about the proposed plan of recapitalization and one shareholder filed suit in the Ohio courts to enjoin the issuance of the class B common stock.

At a special meeting of petitioner's shareholders on November 3, 1947, the plan of recapitalization as outlined in the proxy statement was approved by a majority of petitioner's shareholders. Subsequently, petitioner's management filed with the secretary of state of the State of Ohio amended articles of incorporation providing for the carrying out of the plan for recapitalization of petitioner's stock.

Margaret K. Kahn has been a stockholder of petitioner since 1941. On January 2, 1948, she filed a derivative suit in the United States District Court for the Southern District of Ohio against petitioner's officers and directors to restrain them from the issuance of any class B stock as authorized by the proposed plan of recapitalization. The petitioner was named as a defendant. Subsequently Margaret filed a second amended and supplemental complaint against the same defendants seeking to recover certain profits and assets alleged to be improperly diverted from petitioner. In the second amended and supplemental complaint the plaintiff alleged, among other things:

TWENTY-FIRST: That the defendant directors, in causing the defendant Shoe Corporation to create the said new issue of 600 shares of Class B common stock, and in modifying the original terms and conditions of said stock as hereinbefore set forth, and in proposing to sell the said stock to the individual defendants and other members of the Schiff family at the nominal price arbitrarily fixed by them, did not act and are not acting in the best interests of the defendant Shoe Corporation and all of its stockholders for a legitimate business and corporate purposes, but were and are prompted by selfish motives and solely for the improper and illegal purpose of converting themselves in effect from minority to majority stockholders and securing a perpetual control and domination of the defendant corporation and its subsidiaries for their own private benefit and for the benefit of said Schiff family.

TWENTY-SECOND: That if the issuance and sale of said 600 shares of Class B common stock as proposed is not enjoined, the individual defendants and those associated with them will be guilty of breach of duty as follows:

(a) * * * That by the proposed device of issuing the Class B common stock for the sum of approximately $9,600.00, the defendants would in effect obtain the voting power of a majority of the voting stock and would profit to the extent of approximately $2,000,000 at the expense of the defendant corporation and all its stockholders.

TWENTY-FOURTH: That unless the defendants are enjoined from issuing and selling the said 600 shares of Class B common stock as above set forth, the injury to the corporation will be irreparable.

A temporary restraining order against the issuance of any of the class B stock under the proposed plan was issued by the District Court.

Subsequent to the filing of the Kahn suit petitioner's management adopted a modification of the plan of recapitalization. On July 17, 1948, the amended plan of recapitalization was submitted to petitioner's shareholders at a meeting called for that purpose. A majority of petitioner's shareholders approved the modified plan of recapitalization. Petitioner's amended articles of incorporation embodying the changes approved by the shareholders on July 17, 1948, were filed with the secretary of state for the State of Ohio.

The litigation commenced by Margaret K. Kahn in January 1948 was subsequently tried in June 1950 and June 1951. Findings of fact and conclusions of law were filed January 23, 1952. The opinion of the District Court was filed on the same day and is reported in 105 F.Supp. 973. The findings of fact of the District Court included, among other things, the following:

15. The avowed purpose of the plan was to ‘enable the Schiff interests to elect a majority of the Board.’

31. The fair and reasonable value of the 600 shares of Class B stock to be issued to the ‘Schiff family’ as proposed under either the original or amended plans was substantially in excess of the...