Zilkha & Sons, Inc. v. Comm'r of Internal Revenue, Docket Nos. 1902-66

• Citation: 52 T.C. 607
• Decision Date: 02 July 1969
• Docket Number: 1995-66.,Docket Nos. 1902-66
• Court: United States Tax Court
• Parties: ZILKHA & SONS, INC., PETITIONER v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENTJEROME L. STERN AND JANE STERN, PETITIONERS v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT

52 T.C. 607

ZILKHA & SONS, INC., PETITIONER

v.COMMISSIONER OF INTERNAL REVENUE, RESPONDENTJEROME L. STERN AND JANE STERN, PETITIONERS

v.COMMISSIONER OF INTERNAL REVENUE, RESPONDENT

Docket Nos. 1902-66

1995-66.

Tax Court of the United States.

Filed July 2, 1969.

Victor S. Friedman, Richard O. Loengard, Jr., and Michael P. Oshatz, for the petitioner in docket No. 1902-66.

Harry Malter, for the petitioners in docket No. 1995-66.

Rudolph J. Korbel and Marwin A. Batt, for the respondent.

Held, certain corporate securities owned by the petitioners are stock, not debt, and accordingly, payments received by the petitioners on account of such securities are distributions with respect to stock and not interest.

SIMPSON, Judge:

The respondent determined deficiencies in the income tax of the petitioner, Zilkha & Sons, Inc. (Zilkha), of $19,268.66 for its taxable year ending November 30, 1960, and $21,598.65 for its taxable year ending November 30, 1961, and in the income tax of the petitioners, Jerome L. and Jane Stern (the Sterns), of $13,836.25 for the taxable year 1961. The only issue remaining for decision is whether certain payments received by Zilkha and by the Sterns should be treated for tax purposes as interest or as distributions of property by a corporation with respect to its stock. The resolution of this issue depends on whether certain so-called preferred stock held by the petitioners represents in substance a debt obligation or an equity investment.

FINDINGS OF FACT

Most of the facts have been stipulated, and those facts are so found.

Zilkha is a New York corporation which had its principal office in New York, N.Y., at the time its petition was filed in these cases. For its taxable years ending November 30, 1960, and November 30, 1961, Zilkha filed its Federal income tax returns, using the accrual method of accounting, with the district director of internal revenue, Manhattan District, New York, N.Y.

The Sterns are husband and wife, who maintained their legal residence in New York, N.Y., at the time their petition was filed in these cases. They filed their 1961 joint Federal income tax return, using the cash receipts and disbursements method of accounting, with the district director of internal revenue, Manhattan District, New York, N.Y.

During 1960 and 1961, Zilkha's principal business activities consisted of buying and selling notes and foreign drafts, engaging in foreign-currency transactions, and making and managing loans. Since the amounts of its loans were generally substantial in relation to its assets and lines of credit, Zilkha, after negotiating and consummating its loan transactions, generally sought participants to whom it could sell portions of the securities it acquired.

Zilkha had become interested in arranging a transaction with Community Research & Development, Inc. (CRD), now known as Rouse Co., and during the summer of 1960, Zilkha and CRD discussed a financial arrangement involving one of CRD's subsidiaries, Charlottetown, Inc. (Charlottetown), a Maryland corporation. Charlottetown had leased land under a 99-year lease and built a shopping center called Charlottetown Mall in Charlotte, N.C., which opened for business on October 28, 1959. CRD initially proposed that Zilkha buy and lease back certain of Charlottetown's properties, but Zilkha rejected this proposal because it was uncertain of finding participants in such a transaction, and because it desired to obtain some sort of equity interest in Charlottetown.

On September 10, 1960, Zilkha, CRD, and Charlottetown entered into an agreement (the stock purchase agreement) under which Zilkha acquired from Charlottetown, for $1 million, 10,000 shares of Charlottetown's $9-dividend cumulative preferred stock of the par value of $1 per share. For purposes of the findings of fact, we shall refer to the investment as an investment in Preferred Stock, although we do not thereby intend to characterize it as such for tax purposes. Pursuant to the stock purchase agreement, Zilkha also acquired 200 shares of Charlottetown common stock from CRD for $200. These 200 shares which was originally acquired by CRD for $1,000. Zilkha also undertook to acquire 2,000 additional shares of the Preferred Stock for $100 per share upon the completion of an office building on Charlottetown Mall. Early in 1963, subsequent to the completion of the office building, Zilkha acquired the 2,000 additional shares of Preferred Stock for $200,000.

Subsequent to September 10, 1960, Zilkha sold some of each class of Charlottetown stock to others. Among the group of purchasers were the Sterns, each of whom purchased 18 shares of the Charlottetown common stock and 1,200 shares of the Preferred Stock.

In its taxable years ending in 1960 and 1961, Zilkha received from Charlottetown $6,667.50 and $27,000 which were treated by Zilkha and Charlottetown as distributions with respect to stock. In 1961, the Sterns received from Charlottetown $18,000 which was treated by the Sterns and Charlottetown as a distribution with respect to stock.

Charlottetown's sale of the Preferred Stock necessitated a change in its capital structure, and on September 8, 1960, it filed articles of amendment to its articles of incorporation. The articles of amendment authorized issuance of the Preferred Stock in addition to 10,000 shares of no par common stock. The relevant provisions of the articles of amendment with respect to the new capital structure of Charlottetown may be summarized as follows:

(1) Dividends.— Cumulative annual dividends of $9 per share on the Preferred Stock accrue quarterly and are payable from the surplus or profits of Charlottetown when and as declared by its board of directors. Whenever dividends are not paid within 30 days after they accrue, the Preferred Stock becomes the only voting stock for all purposes until all unpaid and accumulated dividends are paid in full.

(2) Directors.— The holders of the Preferred Stock have the right to elect 2 of the 14 directors of Charlottetown.

(3) Redemption.— Charlottetown may redeem the Preferred Stock at any time for $100 per share plus all accrued and unpaid dividends. In the event the Preferred Stock is not redeemed by September 1, 1970, the Preferred Stock will become voting stock entitled to equal voting rights per share with the common stock.

(4) Corporate Action.— Without the consent of the holders of two-thirds of the outstanding Preferred Stock, Charlottetown may not—

(a) Amend its charter or bylaws;

(b) Pay any dividends on, or make any distributions with respect to, its common stock;

(c) Make capital expenditures of more than $50,000 in any calendar year;

(d) Make any loans or purchase any securities;

(e) Borrow money, except up to an aggregate of $100,000 in the ordinary course of its business, and except for the purpose of redeeming all of the Preferred Stock; or

(f) Make any charges to capital surplus except for the payment of Preferred Stock dividends or for the redemption of the Preferred Stock.

The stock purchase agreement describes the rights and obligations of Zilkha, CRD, and Charlottetown and is comprehensive and highly complex. Many of its provisions are not relevant to the issue in these cases. The relevant ones may be summarized as follows:

(1) Option to Purchase Charlottetown Stock.— CRD grants an 11-year option to Zilkha to purchase all of CRD's Charlottetown common stock for a total purchase price of $800. The option becomes exercisable only upon the occurrence of one or more of the following events:

(a) If Charlottetown fails to pay any Preferred Stock dividend within 5 days after it accrues;

(b) If Charlottetown fails to redeem all the Preferred Stock by September 1, 1970;

(c) If CRD or Charlottetown breach any material representation, warranty, or covenant of the Stock Purchase Agreement;

(d) If Charlottetown violates any material provision of its amended articles of incorporation; or

(e) If Charlottetown becomes involved in any bankruptcy or insolvency proceeding.

(2) Loans to Pay Dividends.— The stock purchase agreement requires CRD to loan Charlottetown such funds as may be necessary to enable Charlottetown to pay the quarterly Preferred Stock dividends. This obligation of Charlottetown terminates when Charlottetown achieves a ‘net cash flow’ (as that term is defined in the stock purchase agreement) for 2 consecutive fiscal years. By May 31, 1966, Charlottetown had achieved a net cash flow for 2 consecutive years, and CRD's obligation under this provision ceased.

(3) Discharge of Liens.— By September 10, 1960, liens in excess of $400,000 had been filed against Charlottetown's properties by various contractors. Charlottetown had set up a reserve of $330,000 for the discharge of these liens. The stock purchase agreement requires CRD to loan Charlottetown any amounts in excess of $330,000 necessary to discharge the liens and any part of the $330,000 which Charlottetown is unable to pay.

(4) Vacating Tenants.— Three tenants of Charlottetown Mall have the option to terminate their leases under certain conditions involving the erection of a new shopping center. If suitable replacement tenants are not found within 2 years and 30 days of such termination, Charlottetown must redeem a portion of the Preferred Stock computed on the basis of the lost rental revenue. CRD is obligated to loan Charlottetown the amount of money necessary for the above-described redemption and any funds necessary to enable Charlottetown to pay Preferred Stock dividends during the 2-year and 30-day period.

(5) Subordination of Loans.— The stock purchase agreement provides that certain loans to Charlottetown be either totally or partially subordinated to the rights of the holders of the Preferred Stock.

(a) Total Subordination.— The principal of the following loans from CRD to Charlottetown may not be repaid until all of the Preferred Stock is redeemed:

(i) Loans previously described with respect to ‘Vacating Tenants';

(ii)...