Tilford v. Comm'r of Internal Revenue , Docket No. 1334-77.

Citation75 T.C. 134
Decision Date20 October 1980
Docket NumberDocket No. 1334-77.
PartiesHENRY C. TILFORD, JR., and BARBARA N. TILFORD, PETITIONERS v. COMMISSIONER of INTERNAL REVENUE, RESPONDENT
CourtUnited States Tax Court

OPINION TEXT STARTS HERE

Petitioner sold stock, subject to restrictions, in a corporation of which he was a majority shareholder, to employees in order to induce them to work for the corporation. Held: Capital loss deduction claimed by petitioner sustained, Downer v. Commissioner, 48 T.C. 86 (1967), followed. Sec. 1.83-6(d), Income Tax Regs., treating such transaction as capital contribution to the corporation, held invalid. Held, further, respondent's determination of ordinary income from sale of farm recapture property under sec. 1251, as a result of adjustments to the excess deductions account, sustained. H. Wayne Grant, Howell G. Clements, John T. Henniss, and James L. Bomar, for the petitioners.

John B. Harper, for the respondent.

IRWIN , Judge:

Respondent determined deficiencies in petitioners' income tax as follows:

+--------------------+
                ¦Year  ¦Deficiency   ¦
                +------+-------------¦
                ¦      ¦             ¦
                +------+-------------¦
                ¦1966  ¦$4,467.67    ¦
                +------+-------------¦
                ¦1967  ¦1,235.71     ¦
                +------+-------------¦
                ¦1969  ¦58,372.10    ¦
                +------+-------------¦
                ¦1970  ¦3,644.06     ¦
                +------+-------------¦
                ¦1972  ¦68,650.84    ¦
                +------+-------------¦
                ¦1973  ¦46,897.37    ¦
                +--------------------+
                

Due to concessions by petitioners, the only issues remaining for our consideration are:

(1) Whether section 831 denies petitioner a loss on the sale of stock of a corporation, in which he was the majority shareholder, made to employees of the corporation in order to induce them to work for it.

(2) Whether respondent correctly determined the excess deductions account for purposes of section 1251.

FINDINGS OF FACT

Some of the facts have been stipulated. The stipulation of facts together with the exhibits attached thereto are incorporated herein by this reference.

Petitioners Henry C. and Barbara N. Tilford filed joint income tax returns for the years 1966, 1967, 1969, and 1970 with the Southeast Service Center, Chamblee, Ga. They filed their joint income tax returns for 1972 and 1973 (as amended) with the Memphis Service Center, Memphis, Tenn. At the time they filed their petition herein, petitioners resided in Shelbyville, Tenn. Barbara N. Tilford is a petitioner herein only because joint returns were filed for the years in issue. Therefore, references to petitioner will be to Henry C. Tilford, Jr.

Issue 1. Capital Loss Deductions

Watco, Inc., is a Tennessee corporation, chartered in November 1968. Its principal offices are located in Shelbyville, Tenn. Watco is primarily engaged in the manufacture and sale of commercial signs.

Petitioner has been a principal officer and either the sole or majority shareholder of Watco since its incorporation. In most years, petitioner was Watco's president, and during the years in issue was chairman of the board of directors. By December 31, 1970, petitioner had invested $350,000 in Watco stock, owning 100 percent of its 170,000 issued shares, and had loaned it an additional $79,500.

Watco was started by petitioner and a friend, Eddie Watson. Petitioner was to put up the money, and Watson was to manage the company. When the company began operations, it manufactured a “vacuum form magnetic” sign which is affixed to the sides of trucks and cars to identify a business. It rented a small building and hired two employees. During 1969, the company grew to three or four employees but was losing money because of inadequate sales. By 1970, Watson had talked petitioner into enlarging the business to manufacture electric trailer signs in hopes of generating greater sales and earning a profit. This expansion necessitated the hiring of more employees and a move to a larger building.

Neither Watson nor petitioner had any knowledge or experience in manufacturing signs, and petitioner had to hire experienced personnel to manage both the manufacturing and marketing aspects of the company, as well as for administrative functions. As an inducement in hiring these key personnel—-Pat Driscoll, Dorothy Haithcote, and Ronnie Besaw—-they were told that they would eventually participate as owners in the business.

On March 29, 1971, petitioner sold portions of his Watco stock for $1 per share to Driscoll (4,500 shares), to Besaw (3,500 shares), to Haithcote (500 shares), to Mays Montgomery, a commercial salesman (750 shares), and to Ben Kingree, petitioner's attorney, who was also a director of Watco (750 shares). Each purchaser paid a total of $1 per share for all of the shares acquired. The amount of shares sold to each individual was based upon what petitioner considered to be his relative importance to the company. An additional 100 shares were sold in 1971 to Bayard Tarpley, a retired attorney who had previously done some work for both petitioner and Watco.

Petitioner considered it to be advantageous for these employees to be shareholders, and he sold the stock for $1 because he believed it had no market value. Petitioner reserved a right of first refusal to repurchase the stock at book value within 5 years in the event that a purchasing employee desired to sell his stock or in the event his employment with Watco was terminated (voluntarily or otherwise). The stock sold was deposited in escrow with the Peoples National Bank of Shelbyville in order to assure petitioner his rights under the contract.2 Additional stock was sold to Driscoll and Haithcote on December 22, 1972, on similar terms, although the contract with Haithcote had the additional provision that after 5 years, in the event Haithcote desired to sell the stock to a third party, petitioner had a right of first refusal to buy the stock at the price Haithcote was offered by the third party.

Watco continued to lose money after these employees were hired, and it had to borrow funds for current operations. Petitioner was required to guarantee these borrowings, as well as Watco's accounts payable, because of its poor financial condition, and by the end of 1971, the total amount guaranteed was over $300,000. Eventually, petitioner guaranteed over $900,000 of Watco's loans and accounts payable.

Due to large losses, petitioner considered selling, merging, or liquidating the business in late 1971, and hired a consultant, Barry Winston, for advice. After reviewing Watco's balance sheet, personnel, and facilities, Winston told petitioner he had to find a knowledgeable person to manage the company; otherwise, if he could not sell it, he should liquidate. Petitioner did not desire to liquidate the company, and Winston was then asked to find a qualified manager.

Winston also explored possibilities of merging with Winkler Sign Corp. but that transaction, as well as a possible sale to United Advertising Co., never materialized. There was one other company which looked seriously at the prospect of purchasing Watco, but it eventually rejected the idea because it determined that Watco was not a good investment.

After several months, in September 1971, Watco hired Nelson Early under a 2-year employment contract to help manage the company. At the time, petitioner told Early he thought Early should also become a shareholder in Watco, and in November 1971, petitioner sold Early 5,000 shares for $1 on the same terms as the previous sales. Petitioner also told Early that he would provide the additional capital that Watco needed in order to continue operations and expand.

After he hired Early, petitioner received an application for the job from Tom Watson. Watson came highly recommended and, after negotiations, was hired in late 1971. As part of his employment terms, Watson demanded stock in the company and in November 1971 purchased 22,000 shares from petitioner for $1 on the same terms as the previous sales. Petitioner assured Watson, moreover, that he would continue to put up money for the corporation. Watson then hired Leo Pitt; 4,000 shares were also sold to him at $1 in order to induce him to come to work for Watco. Pitt's contract concerning the Watco shares was similar to the previous contracts except that one of petitioner's rights was described as a “right at his sole option to repurchase stock” rather than a “right of first refusal.” It also contained a provision that if the stock was transferred without petitioner's being accorded the right to repurchase the stock, Watco had the right to refuse to transfer any stock certificate on its stock ledger. When Pitt left Watco in late 1972 or early 1973, petitioner repurchased the stock for $1. Pitt believed it had no value at that time.

Sales increased in 1972, and Watco expanded to about 40 employees. In order to obtain the sales, however, Watco was required to sell its signs below cost, and substantial losses were incurred. Watson then brought in an expert in manufacturing to reduce costs. Early then became disenchanted because of Watson's control and left Watco, pursuant to a mutually agreed upon recision of his contract. Early sold his shares back to petitioner for $1.

Watson also left later, due to personal problems, and sold back his shares to petitioner for $1. Petitioner, in turn, in October 1972, sold 18,000 of these shares to Robert Price (one of the original employees of the company) for $1. Petitioner later sold an additional 9,000 shares to Price for $1.

Watco hired Tom Cannon in 1973 to manage its national sales. Petitioner sold Cannon 24,500 shares of Watco for $1. In addition to the terms set forth in the original agreements, the stock was to be escrowed for 6 years instead of 5, and petitioner had the right to repurchase the stock at $1 if Cannon left Watco within 1 year. After 5 years, petitioner had the right of first refusal to repurchase at any price Cannon could otherwise obtain.3 Cannon then hired two salesmen, Jim McMullen and Jim Marren, who were also offered, and purchased from petitioner,...

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