Warsaw Photographic Assocs., Inc. v. Comm'r of Internal Revenue
| Decision Date | 14 January 1985 |
| Docket Number | Docket No. 2113-79. |
| Citation | 84 T.C. 21,84 T.C. No. 3 |
| Parties | WARSAW PHOTOGRAPHIC ASSOCIATES, INC., Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent |
| Court | U.S. Tax Court |
OPINION TEXT STARTS HERE
Ten shareholders of S, holding about 20 percent of S's common stock and none of its preferred, created a new corporation, P. The 10 shareholders' S common stock holdings ranged from about 1 percent to about 4 percent; their P stock holdings were each 10 percent. Pursuant to a plan, (a) S transferred substantially all of its assets to P and (b) P transferred $21,000 to S, P assumed S's obligations under certain leases and with respect to work in progress, and P issued additional shares of its stock to the 10 shareholders. These additional shares were in proportion to the 10 shareholders' holdings in P and not to their holdings in S.
HELD: (1) The transaction is not a D reorganization, because it failed to comply with the requirements of sections 368(a)(1)(D) and 354(b)(1), I.R.C. 1954, regarding distribution of stock. Liquidation-reincorporation cases are distinguished. P is not entitled to deduct S's net operating losses and is not entitled to compute depreciation on S's bases in the transferred depreciable assets.
(2) P is not entitled to increase its bases in the transferred assets on account of the fair market value of the additional shares issued to the 10 shareholders.
P incurred certain legal expenses in connection with the organization of P and the transaction with S. P deducted the full amounts of these expenses on its income tax return for the year of its incorporation.
(3) P is not entitled to amortize these amounts under section 248, I.R.C. 1954, because P failed to make any election in the form required by the regulations under this section; P's deduction on its income tax return is inconsistent with any possible election under this section.
(4) Those amounts to which section 248, I.R.C. 1954, does not apply are to be added to the bases of certain 10-year assets, and depreciation deductions and investment credit are to be recomputed.
P entered into a purchase and sale agreement with C and with MP, an executive of C. Part of the agreement was MP's covenant not to compete for a stated term of 6 years. P paid the consideration for this covenant over a period of 31 months.
(5) P's payments for the covenant not to compete are amortizable and deductible over the covenant's life (6 years) and not over the period the payments were made (31 months). RICHARD M. CAMPBELL and KEVIN C. REILLY, for the respondent.
ROBERT A. JACOBS, NICHOLAS J. CREME, and LEWIS KURFIST, for the petitioner.
Respondent determined deficiencies in Federal corporate income tax against petitioner for its taxable years ended June 30, 1974,1 June 30, 1975, and June 30, 1976, in the amounts of $70,040, $58,239, and $34,685, respectively.
After concessions by both sides, the issues for decision are as follows:
(1) Whether a transaction involving a transfer of assets to petitioner qualifies as a reorganization under section 368(a)(1)(D), 2 Thereby entitling petitioner to succeed to the transferor's net operating losses under section 381(a)(2), and giving petitioner a carryover basis (under sec. 362) in the assets acquired from the transferor. 3
(2) If the transfer does not qualify as a reorganization, then whether petitioner is entitled to increase its bases in the assets transferred to it, on account of the fair market value of its shares issued in connection with the transfer.
(3) Whether legal fees incurred by petitioner in acquiring Studios' assets are organizational expenses and whether petitioner made an election under section 248 to amortize them.
(4) Whether petitioner must amortize the price of a covenant not to compete over its stated term, 6 years, or over the shorter period in which the total actual payment was made, 31 months.
Some of the facts have been stipulated; the stipulation and the stipulated exhibits are incorporated herein by this reference.
When the petition was filed in the instant case, petitioner's principal office was in New York, New York.
From 1935 or earlier, Warsaw Studios, Inc, (hereinafter sometimes referred to as ‘Studios‘), 4 and its predecessors were engaged actively in the commercial photography business. Studios was so engaged until July 2, 1973. Studios' principal business was photography for sales catalogues; its clients included Sears, Roebuck & Co., Spiegel, Montgomery Ward, J.C. Penney, and Avon.
A certificate of incorporation for Studios was filed with the New York Department of State on June 30, 1964. Amendments to this certificate of incorporation were filed on December 28, 1964, and June 30, 1965. By the amendment filed June 30, 1965, Studios increased the number of its authorized shares by 5,250 shares, making the aggregate number of authorized shares 15,500. This amendment further provides that 15,000 of these shares are common shares with $1 par value. The remaining 500 shares are cumulative preferred with $1,000 par value. The cumulative dividends are at the rate of 3 percent annually. Before any dividend may be declared for common shareholders for a year, Studios would have to pay a 2-percent dividend to the preferred shareholders for that year, in addition to the cumulative 3-percent dividend to the preferred shareholders.
As of July 1, 1965, Studios had 325 outstanding shares of preferred stock, which had a total par value of $325,000. Warsaw & Co., Inc., a corporation owned solely by J. J. Warsaw,5 was the record owner of all of Studios' preferred stock.
By the end of July 1965, Studios' common stock was owned as set forth in table 1.
+--------------------------------------+
¦TABLE 1 ¦
+--------------------------------------¦
¦ ¦Number ¦
+---------------------+----------------¦
¦Owner ¦of common shares¦
+---------------------+----------------¦
¦Warsaw & Co., Inc. ¦7,549 ¦
+---------------------+----------------¦
¦Paul Diethelm ¦375 ¦
+---------------------+----------------¦
¦Woodbury Prentiss ¦250 ¦
+---------------------+----------------¦
¦Gilbert S. Shawn ¦250 ¦
+---------------------+----------------¦
¦Donald Riley ¦200 ¦
+---------------------+----------------¦
¦Kyril Bromley ¦172 ¦
+---------------------+----------------¦
¦John Basilion ¦162 ¦
+---------------------+----------------¦
¦James McFarline ¦155 ¦
+---------------------+----------------¦
¦James V. Oliver ¦142 ¦
+---------------------+----------------¦
¦Joseph G. Lewandowski¦134 ¦
+---------------------+----------------¦
¦Albert T. Warsaw ¦128 ¦
+---------------------+----------------¦
¦David Martin ¦128 ¦
+---------------------+----------------¦
¦Stephen Warsaw ¦88 ¦
+---------------------+----------------¦
¦Richard Dennis ¦175 ¦
+---------------------+----------------¦
¦Winfield S. Sinn, Jr.¦92 ¦
+--------------------------------------+
The shares owned by Albert T. Warsaw were repurchased by Studios; his stock certificate was cancelled on March 17, 1970.
The shares owned by Kyril Bromley were redeemed on or about April 19, 1973.
The shares owned by Paul Diethelm and Woodbury Prentiss were transferred to William J. Zad and Stephen Neil, respectively, on or about June 1, 1973. 6
James McFarline and Stephen Warsaw stopped being shareholders before June 27, 1973. 7
The following Studios shareholders were also employees of Studios: Gilbert S. Shawn; H. Donald Riley; John Basilion; James V, Oliver; Joseph C. Lewandowski; David Martin; Winfield S. Sinn, Jr,; William J. Zad; Richard Dennis; and Stephen Neil. These shareholders are hereinafter sometimes referred to individually as:
‘Shawn‘, ‘Riley‘, ‘Basilion‘, ‘Oliver‘, ‘Lewandowski‘, ‘Martin‘, ‘Sinn‘, ‘Zad‘, ‘Dennis‘, and ‘Neil‘, respectively, and hereinafter sometimes referred to collectively as ‘the 10 shareholders‘.
Studios leased office space at two locations in Manhattan, New York. One of these locations was in a building known as 183 Madison Avenue and 40 East 34th Street. The lease (hereinafter sometimes referred to as ‘the 34th Street lease ‘) for this space was for a term of 10 years and 5 months, to begin May 1, 1970, and to continue through September 30, 1980. The 34th Street lease was a standard form of office lease requiring Studios to pay a base annual rent of $17,800, plus, among other things, the following:
1. Additional rent equal to 1.5 percent of the increase in real estate taxes levied or imposed by the State or local governments, over the taxes ‘assessed for the tax year 1970/1971.‘
2. Additional rent equal to 1.5 percent of the increase in the amount of the building payroll and cleaning expenses, over such expenses for the calendar year 1970.
3. Additional sums for increases in the Lessor's cost of supplying electricity. This was to take the form of an increase in the annual base rent. 8
Studios, as a lessee, had the right to sublease the office space during the term of the lease, but only with the lessor's consent. If Studios were to default, then all of the rent for the remaining term of the 34th Street lease would become due (reduced by any amounts received by the lessor if the lessor chose to relet the space).
In connection with the 34th Street lease, Studios obtained an irrevocable letter of credit issued by the Irving Trust Company (hereinafter sometimes referred to as ‘the Bank‘) to Cross & Brown Company, the lessor under the 34th Street lease, in the amount of $100,000, J. J. Warsaw personally guaranteed this liability.
The other office space location was in a building known as 36 East 3lst Street. Studios entered into three leases (hereinafter sometimes referred to as ...
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