Smith v. Comm'r of Internal Revenue , Docket Nos. 1959–74

• Decision Date: 29 June 1976
• Docket Number: Docket Nos. 1959–74,4109–74.
• Parties: DAVID N. SMITH AND JUDITH A. SMITH, PETITIONERS v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENTRONALD E. SCHLEPPY AND LEONETTE R. SCHLEPPY, PETITIONERS v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT
• Court: U.S. Tax Court

66 T.C. 622

DAVID N. SMITH AND JUDITH A. SMITH, PETITIONERS

v.COMMISSIONER OF INTERNAL REVENUE, RESPONDENTRONALD E. SCHLEPPY AND LEONETTE R. SCHLEPPY, PETITIONERS

v.COMMISSIONER OF INTERNAL REVENUE, RESPONDENT

Docket Nos. 1959–74

4109–74.

United States Tax Court

Filed June 29, 1976.

Held: (1) On the basis of the facts of record, the transfer by two of petitioners of stock to a corporation of which they were the major but not sole shareholders is determined to be without consideration except the improvement of the financial condition of the corporation, but is not a contribution to capital since the transfer was non-pro-rata with respect to other shareholders; (2) since the transfer was without consideration, no sale or exchange of the stock occurred and therefore the transfer resulted in an ordinary loss to each of the two petitioners of the amount of his basis in the stock transferred, Estate of William H. Foster, 9 T.C. 930 (1947), followed; J.K. Downer, 48 T.C. 86 (1967), distinguished; (3) the facts of record do not show that the primary reason of either of the two petitioners for transfer of some of his stock to the corporation was to protect his employment with the corporation rather than to protect his investment interest in the corporate business, therefore neither petitioner is entitled to a business expense deduction for the value of the stock he transferred to the corporation; (4) the number of shares of stock transferred by petitioners and the year in which the transfer was made determined from the facts of record; and (5) the petitioners Smith are liable for an addition to tax under sec. 6653(a), I.R.C.1954. Richard G. Holloway and William E. Duncan, Jr., for the petitioners.

Albert L. Sandlin, Jr., and Howard J. Kalson, for the respondent.

SCOTT, Judge:

Respondent determined deficiencies in Federal income tax of petitioners David N. Smith and Judith A. Smith for the calendar years 1968 and 1969 in the amounts of $7,333 and $4,916, respectively, and additions to tax under section 6653(a), I.R.C.1954,¹ in the amounts of $367 and $246, respectively. Respondent determined deficiencies in Federal income tax of petitioners Ronald E. Schleppy and Leonette R. Schleppy for the calendar years 1969 and 1970 in the amounts of $45,888 and $4,518, respectively, and an addition to tax under section 6651(a)(1) for the calendar year 1970 in the amount of $385. David N. and Judith A. Smith filed an amendment to petition claiming an overpayment in tax for 1969 with a net operating loss for that year which they contend results in a net operating loss carryback to 1968 and an overpayment for that year.

Some of the issues have been disposed of by agreement of the parties, leaving for our decision the following:

(1) Whether either David N. Smith or Ronald E. Schleppy or both suffered any loss or realized any gain during the calendar year 1969 from surrender by each of them to a corporation of which they were principal officers and controlling stockholders of a portion of the shares of stock each held in the corporation;

(2) Whether either David N. Smith or Ronald E. Schleppy or both are entitled to an ordinary and necessary business expense deduction for the calendar year 1969 of the value of the shares of stock surrendered by them to the corporation and, if so, the amount of the deduction;

(3) Whether David N. Smith and Judith A. Smith are entitled to a net operating loss deduction for the calendar year 1968 as a result of a carryback of a net operating loss sustained in 1969 by virtue of a deduction arising from the surrender of Mr. Smith's stock to the corporation; and

(4) Whether David N. Smith and Judith A. Smith are liable for an addition to tax for negligence or intentional disregard of rules and regulations under section 6653(a) for the calendar years 1968 and 1969.

FINDINGS OF FACT

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

At the time of the filing of their petition in this case, David N. Smith (Mr. Smith) and Judith A. Smith, husband and wife, resided in Atlanta, Ga. They filed joint Federal income tax returns for the calendar years 1968 and 1969 with the Director of the Internal Revenue Service Center, Chamblee, Ga.

At the time of the filing of their petition in this case, Ronald E. Schleppy (Mr. Schleppy) and Leonette R. Schleppy, husband and wife, resided in Stanford, Conn. They filed joint Federal income tax returns for the calendar years 1969 and 1970 with the Director of the Internal Revenue Service Center, Chamblee, Ga., and the Director of the Internal Revenue Service Center, Andover, Mass., respectively.

On January 2, 1968, Communication & Studies, Inc. (C. & S. or the corporation), was incorporated under the laws of the State of Georgia with its principal business office in Atlanta, Ga. C. & S. was engaged in the business of directly selling home reference works, which generally included one or more sets of encyclopedias, dictionaries, children's books, and classics, to consumers on an installment sale basis. The corporation established branch offices throughout the continental United States.

The corporation's authorized capital structure was 2 million shares of one class of common stock. The shareholders were entitled to one vote on a noncumulative basis for each share held, to receive any declared dividends, and to acquire the net assets of the corporation upon its liquidation.

The corporation's initial capitalization was $200,000 of which Mr. Schleppy and Mr. Smith contributed $120,000 and $80,000, respectively, and for which they received 510,000 and 340,000 shares of the corporation's common stock, respectively. The cost basis of each share of stock held by Mr. Schleppy and Mr. Smith from their initial acquisition was $0.235. At its inception C. & S. had a commitment of a line of credit of $1 million with an Atlanta bank that could be extended to as much as $4 million. The corporation's loan agreement with the local bank permitted C. & S. to borrow an amount equal to 65 percent of its current accounts receivable which were pledged along with substantially all of its other assets to the bank to secure the loan. The loan agreement prohibited the corporation from declaring any dividends without the bank's approval. Mr. Schleppy and Mr. Smith personally guaranteed the payment of the bank's loan to C. & S.

During the existence of the corporation, Mr. Schleppy was the chairman of its board of directors and its president. He was responsible for the overall management of the corporation. Mr. Smith was a director and executive vice president of C. & S. and was primarily responsible for sales. Herbert S. Perman (Mr. Perman) was initially a vice president for finance, treasurer, assistant secretary, and director of the corporation. Mr. Schleppy, Mr. Smith, and Mr. Perman were members of the executive committee. Dominick Langello (Mr. Langello) was a vice president for branch administration and a director of the corporation. Mr. Perman and Mr. Langello were each issued 10,000 shares of stock by the corporation upon its formation.

Officials of the bank advised the officers of C. & S. that the corporation should increase its equity. On January 6, 1969, Mr. Schleppy on behalf of C. & S. and Roger D. Bensen (Mr. Bensen) on behalf of Shareholders Associates, Inc. (Associates), a regulated investment company located in New York, N.Y., which was a subsidiary of Shareholders Capital Corp., entered into an agreement (the agreement) for the sale and purchase of C. & S.'s convertible notes (notes) and shares of its common stock in a private sale exempt from the requirements of the Federal Securities and Exchange Act of 1933. The agreement generally provided that C. & S. would authorize the issuance of $1 million principal amount of its 7–percent convertible subordinated notes due January 1, 1974, and an aggregate of 83,333 shares of its common stock at par and would sell to Associates such notes for $1 million and such shares for $500,000. It further provided that the notes were generally subordinated to the corporation's long-term indebtedness, except for funds borrowed under the loan agreement with the local bank, and long-term rental obligations created or incurred prior to the maturity of the notes and otherwise permitted under the agreement. The holders of any of the outstanding notes which C. & S. sold to Associates had the right to convert all or any portion in units of $100 of the principal amount of such notes into common stock of C. & S. at a price of $7 per share.² At a conversion price of $7 per share, the holders of the notes had the right to obtain 142,858 shares upon the conversion of all the notes. The conversion price and number of shares issuable on conversion were to be adjusted to prevent any dilution of the rights of the holders of the notes. Additionally, the corporation was required to reserve a sufficient number of shares of its authorized common stock for issuance in the event the conversion privilege was exercised by the holders of the notes. While the notes were outstanding, the agreement provided that C. & S. would not distribute any dividend other than a stock dividend nor “redeem, retire, purchase or otherwise acquire” any shares of its outstanding capital stock. The agreement provided that C. & S. was not to create, incur, or guarantee any long-term indebtedness, excluding its loan agreement with the local bank, to which the notes would be subordinated unless the holders of 2/3 of the outstanding principal amount of the notes gave their prior approval. The agreement provided that C. & S. would not permit any subsidiary to create, incur, or guarantee any liability with respect to any indebtedness unless such was owed to C. & S. or another of its subsidiaries or was an indebtedness of C. & S. guaranteed by such subsidiaries. The agreement provided that neither the corporation nor its subsidiaries were to make investments in or loans to any...