Steadman v. Comm'r of Internal Revenue
| Decision Date | 22 May 1968 |
| Docket Number | Docket No. 224-66. |
| Citation | 50 T.C. 369 |
| Parties | CHARLES W. AND DOROTHY F. STEADMAN, PETITIONERS v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT |
| Court | U.S. Tax Court |
OPINION TEXT STARTS HERE
William F. Snyder, for the petitioners.
John P. Graham, for the respondent.
Petitioner, an attorney, purchased 32,000 additional shares of stock in a corporation to protect his position as its secretary and general counsel. The corporation's organizational concept called for extensive acquisitions and mergers involving considerable legal planning. The corporation suffered a large loss in 1962 causing a deficit in the shareholders' equity and was adjudicated bankrupt in 1964. Held, the corporation's stock became worthless in 1962. Held further, petitioner is entitled to deduct the loss occasioned by the worthlessness of the 32,000 shares as an ordinary loss under sec. 165(a), I.R.C. 1954.
Respondent determined a deficiency in the income tax of petitioners for the year 1962 in the amount of $67,138.73.
The parties have made concessions which can be given effect in the Rule 50 computation. Two issues remain for decision: (1) Whether 32,000 shares of common stock of Richards Musical Instruments, Inc., held by petitioner became worthless in 1962, and, if so, (2) whether petitioners are entitled to a deduction in 1962 of $80,000, their cost basis in the shares, as an ordinary loss under section 165(a), I.R.C. 1954,1 or as a capital loss under section 165(g).
Some of the facts have been stipulated and are found accordingly.
Charles W. Steadman (herein called petitioner) and Dorothy F. Steadman, husband and wife, were residents of Shaker Heights, Ohio, on the date they filed their petition in this proceeding. They filed a joint Federal income tax return for calendar year 1962 with the district director of internal revenue at Cleveland, Ohio.
During 1962, and for a number of years prior thereto, petitioner was an Ohio attorney who was a partner in the Cleveland firm of Marshman, Hornbeck, Hollington, Steadman and McLaughlin. His practice was principally in the field of corporate finance and organization.
Paul E. Richards was advised of petitioner's practice in the corporate law field and, in the spring of 1960, consulted him with regard to a plan for the acquisition and amalgamation of several musical instrument companies into a single manufacturing and merchandising organization which would market a complete line of musical instruments, thereby eliminating many of the overhead expenses inherent in the independent operations.
After extensive discussions of these plans, petitioner was offered the position of general counsel to the proposed corporate organization and was assured that he would remain in that capacity so long as Paul Richards maintained control of its management. At that time petitioner estimated, on the basis of Paul Richards' immediate and long range plans for organization and acquisition, a potential of $30,000 to $40,000 a year in legal fees for his work for the organization. Under the partnership arrangement in petitioner's law firm, he would receive all fees from Richards Music after a percentage was subtracted to cover his share of the overhead expenses of the firm.
Petitioner accepted Paul Richard's offer and, as a first step in executing the plan, organized the Richards Music Corp. (herein referred to as Richards Music) as the principal corporate entity. Then, on December 30, 1960, the Blessing Band Instrument Co. was merged into Richards Music, and the stock of the Martin Band Instrument Co. and the assets of the Reynolds Bank Instruments Co. were acquired by Richards Music. The resulting entity became operational at this time with petitioner as its secretary, general counsel, and member of the board of directors. In early 1962, the name of Richards Music Corp. was changed to Richards Musical Instruments, Inc.
To finance the merger and acquisition, Richards Music borrowed $750,000 from American Research & Development Corp. of Boston, Mass. (herein referred to as American Research), in exchange for 6-percent convertible subordinate debentures, which were convertible into common stock of Richards Music at $3 per share.
Immediately following the merger and acquisitions, the board of directors o? Richards Music consisted of nine members, five (including petitioner) representing the shareholders, three representing American Research, and one representing the Wurlitzer Co. which had acquired notes and debentures of Richards Music in return for the stock of the Martin Band Instrument Co.
By the summer of 1961 it became apparent to the board of directors of Richards Music that the financing obtained through the sale of the convertible debentures was insufficient to complete the plan of acquisition. At that time the 173,200 outstanding shares of the closely held corporation's common stock were owned as follows:
+-------------------------------+
¦ ¦Number of ¦
+-------------------+-----------¦
¦Name ¦shares ¦
+-------------------+-----------¦
¦ ¦ ¦
+-------------------+-----------¦
¦Paul Richards ¦66,000 ¦
+-------------------+-----------¦
¦Bessie Richards ¦20,000 ¦
+-------------------+-----------¦
¦Gilbert Marshner ¦18,000 ¦
+-------------------+-----------¦
¦John Harbison ¦1,000 ¦
+-------------------+-----------¦
¦Frank Konn ¦1,000 ¦
+-------------------+-----------¦
¦Karl Blessing ¦27,600 ¦
+-------------------+-----------¦
¦Fred Blessing ¦27,600 ¦
+-------------------+-----------¦
¦Charles W. Steadman¦12,000 ¦
+-------------------+-----------¦
¦ ¦173,200 ¦
+-------------------------------+
At a special meeting of the board of directors on June 30, 1961, American Research and other debenture holders offered to purchase shares of Richards Music common stock (if and when issued) at $2.50 per share in an amount up to $350,000. The offer was conditioned upon the appointment of a 10-member board of directors for Richards Music containing 5 persons selected by the debenture holders. Implicit in this offer was the bid for effective control of the corporation which would inure to American Research by virtue of its veto power on the board of directors and the number of shares of common stock which it owned and controlled through the conversion feature of the debentures.
In response, the board of directors passed a resolution authorizing the issuance of additional shares of common stock at a price of not less than $2.50 per share, the total dollar amount of the issue to be at least $350,000 but not more than $500,000. The resolution provided that the shares be offered first to the shareholders of record at $2.50 per share, then, if the subscriptions by the shareholders were deemed insufficient to meet the financial needs of the company, to the debenture holders at $2.50 per share, and finally to private investors at not less than $2.50 per share.
A vice president of American Research informed petitioner that American Research was considering, in the event its offer to purchase the new issue of Richards Music stock was accepted, the replacement of the management of Richards Music and the concentration of its legal activities in Boston with a firm located there which handled American Research's legal affairs. Petitioner discussed with several of the shareholders and with his law associates the offer made in the board resolution of June 30, 1961. A partner advised him that purchase of Richards Music stock solely as an investment would be ‘very speculative.’ Petitioner was concerned, however, that the shareholders equal American Research's offer of $350,000 in subscriptions. After it appeared that other shareholders were willing to subscribe to only 70,000 additional shares, petitioner arranged to finance subscription to the remaining 70,000 shares. At a board of directors meeting of Richards Music on July 20, 1961, oral offers for subscriptions at $2.50 per share of Richards Music common stock, yet to be issued, were made as follows:
+-------------------------------+
¦ ¦Number of ¦
+-------------------+-----------¦
¦Name ¦shares ¦
+-------------------+-----------¦
¦ ¦ ¦
+-------------------+-----------¦
¦Paul E. Richards ¦40,000 ¦
+-------------------+-----------¦
¦Karl Blessing ¦20,000 ¦
+-------------------+-----------¦
¦Fred Blessing ¦10,000 ¦
+-------------------+-----------¦
¦Charles W. Steadman¦70,000 ¦
+-------------------+-----------¦
¦ ¦140,000 ¦
+-------------------------------+
Upon at least three previous occasions petitioner advanced funds to other business enterprises, viz, A. C. Rice Storage, Elmire Deliveries and Leaseco Corp., for the principal purpose of retaining them as legal clients.
The board of directors authorized the issuance and sale of the 140,000 shares to the four shareholders, subject to the approval of 51 percent of the debenture holders. The remaining 60,000 shares authorized by the June 30, 1961, resolution were offered for sale at $2.50 per share in the following order of priority: First, to the debenture holders; second, to the shareholders; and third, to approved parties on a private placement investment letter basis.
By majority vote, the shareholders and the debenture holders approved the issuance of the 140,000 additional shares as authorized by the board of directors. The offer for the sale of the 60,000 remaining shares was terminated by the board of directors at a regular meeting on September 20, 1961.
The 70,000 shares subscribed to by petitioner were issued in the name of Gordon Graves & Co., a New York brokerage firm. The financing by Gordon Graves & Co. was arranged by petitioner, and 32,000 of the shares issued to that company were held for his account. Petitioner paid...
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