Berch v. Commissioner , 35 B.T.A. 385 ( 1937 )

S. H. BERCH, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.

ROSE BERCH, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.

Berch v. Commissioner

Docket Nos. 64746, 64747.

United States Board of Tax Appeals

35 B.T.A. 385; 1937 BTA LEXIS 884;

January 29, 1937, Promulgated

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CAPITAL GAIN OR ORDINARY INCOME. - Prior to August 1925 petitioner Berch owned all the stock of holding company B, which owned 20 percent of the stock of holding company C, which in turn owned all the stock of two operating companies. All the stockholders of C gave to outside interests an option to purchase for cash all the stock of the operating companies. Corporations C and B were liquidated in that order and Berch thus acquired 20 percent of the stock of the operating companies. The cash to purchase the stock was deposited by the outside interests. The holders of 80 percent took all cash; Berch took part cash and part stock in a new corporation which acquired all the stock of the operating companies. In July 1927 Berch sold some of the stock of the new corporation. Held, that in the above transaction there was no reorganization to which holding company B was a party. In so far as it was concerned the plan was one to sell its interest in the operating companies for cash. Consequently, its liquidation and distribution of the operating companies' stocks to Berch was not a tax-free transaction and he may not under the capital gain provisions add to the period August 1925 to July 1927 any of the prior period in which he owned the stock of the holding company B.

Robert P. Smith, Esq., and Arthur H. Deibert, Esq., for petitioners.

Elden McFarland, Esq., and John F. Greaney, Esq., for the respondent.

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ARUNDELL

These proceedings, duly consolidated for hearing and report, involve deficiencies in income tax for 1927 in the amount of $18,244.73 in Docket No. 64746 and $18,150.25 in Docket No. 64747.

Issues originally raised as to the amount of gain on the sale of Western Dairy Products Co. stock and a claimed loss on the sale of California debentures have been abandoned by the petitioners. One issue is left for decision, namely, whether the respondent erred in treating the gain on the sale of Western Dairy Products Co. stock as ordinary income. Petitioners contend that the gain was capital gain, taxable at the 12 1/2 percent rate.

The evidence consists of a stipulation of facts, with exhibits, supplemented by oral testimony.

FINDINGS OF FACT.

We find the facts to be as stipulated, and set forth herein only those facts necessary to an understanding of the issue presented.

Petitioners, now residents of California, were residents of Washington in and prior to 1927. From October 1922 to August 5, 1925, petitioner S. H. Berch owned all the stock of the Berch Ice Cream Co. of Seattle, Washington. The Berch Ice Cream Co. owned 20 percent of the stock of the Crystal Investment Co., the other 80 percent being owned by associates of Berch, either directly or through holding companies. The Crystal Investment Co. owned all the stock of the Velvet Ice Cream Co. and the Seattle Ice Cream Co., both located in Seattle, and hereinafter called the Velvet and Seattle companies.

In the latter part of 1924 Spencer Trask & Co., brokers, entered into negotiations with Berch for the purchase of the business of the Velvet and Seattle companies, with a view to creating an organization to handle all the dairy and ice cream business along the entire Pacific coast. On or about July 20, 1925, Berch's associates orally agreed with him to sell all the stock of the Velvet and Seattle companies for $1,250,000. Berch was to negotiate the sale.

On August 3, 1925, the owners of all of the stock of the Crystal Investment Co. and Spencer Trask & Co. entered into an option agreement, which was called "Escrow Letter and Contract" and was addressed to the Dexter Horton National Bank of Seattle. The agreement recited that the owners of the Crystal Investment stock had given Spencer Trask & Co. the right until October 15, 1925, "to purchase all of the capital stock" of the Velvet and Seattle companies for $1,250,000. The agreement continued as follows:

In confirmation of this and in order to carry out a sale, we have deposited with you, indorsed in blank, certificates of stock * * * [followed by a list of certificate numbers covering all the stock of the Velvet and Seattle companies]. Upon receipt by you of $1,250,000 for us before October 16, 1925, time being of the essence, you will deliver these certificates of stock to Spencer Trask & Co., or their nominees; otherwise you will redeliver the certificates to us.

Spencer Trask & Co. herewith deposit with you Ten Thousand Dollars ($10,000) to apply toward the purchase price of the stocks above described if the right to purchase be exercised, or to be paid by you to us in the proportions below indicated, as liquidated damages if the right to purchase be not exercised * * *.

If the option be exercised, the money received as the price of the stocks sold shall be paid to us in the following proportions: three-fifths to Kassel and Rebecca Gottstein Co., F. V. Fisher and J. L. Gottstein, one-fifth to Associated Dairies, Inc., and one-fifth to Berch Ice Cream Company.

On the same date, August 3, 1925, the same group of stockholders delivered to the escrow holder of the Seattle and Velvet stocks an "Instruction Letter", authorizing the escrow holder to use $250,000 of the total consideration to buy class A stock of the proposed new corporation and to distribute such stock and the balance of the cash in the same proportions as set out in the letter above quoted. Berch's associates later decided not to take the $250,000 in stock, but took all cash. On the same date Berch individually entered into a separate agreement with Spencer Trask & Co. in which it was recited that Berch and Spencer Trask & Co. had agreed that Berch was to receive first issue class A stock of a new company in the amount of $250,000 based on the price to be paid by Spencer Trask & Co. for their allotment of stock. It was further agreed therein that Berch was also to receive 35 percent of the total first issue class B stock and additional class A stock to the value of $20,000.

The first issue of stock of the new company was to consist of 35,000 shares of class A (nonvoting) stock and 116,000 shares of class B (voting) stock. Spencer Trask & Co. were to buy the class A stock at $40 per share and sell to the public at $45 per share. Berch's portion of the first issue class A stock amounted to 6,250 shares, which he agreed to take in lieu of cash.

On August 5, 1925, the Crystal Investment Co. was, by appropriate corporate action, ordered dissolved, and the stock it owned in the Velvet and Seattle Ice Cream companies was distributed to its stockholders. Thereafter on the same date the Berch Ice Cream Co. was dissolved and it distributed to its sole stockholder, Berch, its assets. The only asset of the Berch Ice Cream Co. was its stock in the Crystal Investment Co. Final orders dissolving the Crystal Investment Co. and the Berch Ice Cream Co. were issued November 4, 1925.

On or about August 10, 1925, all of the stock of the Velvet and Seattle companies was deposited with the Dexter Horton National Bank in escrow, and Spencer Trask & Co. deposited $10,000 in accordance with the escrow letter of August 3, quoted above. On August 25, 1925, Spencer Trask & Co. instructed the escrow holder that it was not to pay Berch the $250,000 to which he would be entitled out of the $1,250,000; that, pursuant to Berch's agreement, Spencer Trask & Co. would deliver 6,250 shares of stock of a new company to the escrow holder for Berch; and that the escrow holder should return the $250,000 to Spencer Trask & Co. The agreed consideration of $1,250,000 was deposited on August 26, and the escrow holder was instructed to distribute $1,000,000 thereof (less $10,000) to Berch's associates, leaving Berch's stock in the Velvet and Seattle companies and his interest in the consideration still in escrow.

From August 26 to October 8, 1925, Spencer Trask & Co. and Berch were the owners of all the stock of the Velvet and Seattle companies. Berch was elected president of each and managed their affairs until October 8, when the stock of both was taken over by the new corporation, the Western Dairy Products Co. The new corporation, hereinafter called Western Dairy, was incorporated on October 1, 1925. Berch became its first president and has been president ever since.

The entire first issue of Western Dairy stock, consisting of 80,000 shares of class A and 117,000 shares of class B stock, was issued to Spencer Trask & Co. and Berch. Part of the first issue of stock was exchanged for the stock of the Velvet and Seattle companies. Berch, as owner of 20 percent of the Velvet and Seattle stock, was entitled to receive in exchange therefor, in accordance with his agreement with Spencer Trask & Co., 6,750 shares of class A and 40,600 shares of class B stock. By reason of the class A stock offered to the public being oversubscribed, Berch received only 2,250 shares of that class, and gave up his right to 4,500 shares, receiving instead cash in the amount of $180,000. The consideration actually received by Berch for his 20 percent interest in the Velvet and Seattle company stocks was $180,000 cash and 2,250 shares of class A and 40,600 shares of class B Western Dairy stock.

Immediately after the formation of Western Dairy all of its stock was owned by Berch and Spencer Trask & Co. Berch's interest in the stock of Western Dairy amounted to 21.75 percent.

The Velvet and Seattle companies have not been dissolved, but they have carried on no business since October 1925. Their corporate entities have been preserved, with their stock reduced to a nominal amount, in order to retain the trade names under which they operated.

In July 1927 Berch sold 736 shares of Western Dairy class A stock and 17,200 shares of the class B stock. He reported a profit in his income tax return and a tax thereon computed at the capital gain rate. The respondent held that the stock had been acquired on August 5, 1925, and that the gain was taxable at ordinary rates.

OPINION.

ARUNDELL: The question for decision is whether the profit realized on the sale of Western Dairy stock in July 1927 was capital gain or ordinary income. Berch actually held the Western Dairy stock less than two years. Whether any period can be added to the period of actual holding of that stock depends upon whether or not it was acquired under circumstances prescribed by section 208(a)(8) of the Revenue Act of 1926, set out in the margin. ¹ Stated broadly, that section provides that the period during which a taxpayer has held stock or securities received on a nontaxable exchange or upon a nontaxable distribution may include the period in which he held the property exchanged therefor or the stock in the distributing corporation. In more detail, it provides that in computing time for capital gain purposes a taxpayer may add to the period that he actually held particular property (a) the period of holding property exchanged therefor if the exchange was such that the property takes the same basis as that exchanged therefor, (b) the period of holding the particular property by some other person if it has the same basis in the taxpayer's hands as in the hands of the other person, and (c) the period of holding the particular property by a corporate owner if the taxpayer received it as a nontaxable dividend under section 203(c). The provisions that we have referred to under (b) may be read out of the case at the outset, inasmuch as there was no prior holding of Berch's Western Dairy stock by another person.

First, then, is the question of whether Berch acquired the Western Dairy stock in such an exchange that it took the same basis as the property exchanged therefor. The petitioners say that Berch acquired the Western Dairy stock in a nontaxable exchange under the reorganization provisions (section 203(b)(2)), hence, it took the same basis as his stock in the Berch Ice Cream Co. under section 204(a)(6), and that consequently the time that he held the stock of the Berch Ice Cream Co. (1922 to 1925) should be added to the time of holding the Western Dairy stock. They contend that the Berch Ice Cream Co., the Velvet and Seattle companies, Spencer Trask & Co., and Western Dairy were all parties to the reorganization.

The respondent assumes, and we agree, that the exchange by Berch and Spencer Trask & Co. of all the stock of the Velvet and Seattle companies for stock of Western Dairy ws a nontaxable exchange that came within section 203(b)(2) as an exchange of stock in a corporate party to a reorganization for stock in another corporate party. It came within the definition section as the acquisition by one corporation of at least a majority of all classes of stock of another corporation. Sec. 203(h)(1). That exchange took place on October 8, 1925, less than two years from the time of sale of Western Dairy stock. By reason of the transaction being nontaxable and the Western Dairy stock having the same basis in Berch's hands as the stock of the Velvet and Seattle companies, it is proper to go back to the time of Berch's acquisition of the stocks of the Velvet and Seattle companies in computing the time of holding. That acquisition occurred on August 5, 1925, when the Crystal Investment Co. and the Berch Ice Cream Co. were ordered dissolved, and their assets distributed to their stockholders.

The next step is to determine whether any period prior to August 5, 1925, should be added on. This depends, under the first part of section 208(a)(8), on whether there was a nontaxable reorganization to which the Berch Ice Cream Co. was a party, and under the last part of that section on whether the distribution whereby Berch acquired the Velvet and Seattle stocks was a nontaxable distribution.

We are of the opinion that the Berch Ice Cream Co. was not a party to a reorganization under the statutory provisions here involved. The original plan conceived by Spencer Trask & Co. was to obtain control of the Velvet and Seattle companies by purchase. Berch and his associates orally agreed to sell their interests for cash. The written option of August 3, to which the Berch Ice Cream Co. was a party, was an option to sell for cash. Berch, individually, agreed to take stock of the new company. Even under his individual agreement the transaction was in substance a purchase for cash and the use of part of the cash to buy stock of the new company. The parties have stipulated that Spencer Trask & Co. deposited the full $1,250,000 which is referred to in the basic document - the option - as the "purchase price." It was not contemplated that the Berch Ice Cream Co. would acquire any of the stock of the new corporation. It or its stockholders were, under the agreement, to receive cash. Nor was it intended that the new corporation would acquire the stock or assets of the Berch Ice Cream Co. It is stipulated that the only asset of the Berch Ice Cream Co. was its stock in the Crystal Investment Co. That stock did not enter into the transaction in any way. Thus the Berch Ice Cream Co. was not in any way a party to the reorganization effected between the Velvet and Seattle companies and the Western Dairy Products Co. Consequently, the period that Berch held the stock of the Berch Ice Cream Co. can not be added in under the part of section 208(a)(8) which refers to exchanges coming within section 204.

We are further of the opinion that the case does not come within the last provision of section 208(a)(8), which allows the tacking of periods where the property exchanged is "securities received upon a distribution where no gain is recognized to the distributee under the provisions of subdivision (c) of section 203." We quote section 203(c):

(c) If there is distributed, in pursuance of a plan of reorganization, to a shareholder in a corporation a party to the reorganization, stock or securities in such corporation or in another corporation a party to the reorganization, without the surrender by such shareholder of stock or securities in such a corporation, no gain to the distributee from the receipt of such stock or securities shall be recognized.

We have pointed out above that there was no plan of reorganization in this case to which the Berch Ice Cream Co. was a party. The plan to which it was a party was strictly a plan to sell as distinguished from one to reorganize. The general rule of the statute is to treat as taxable income gains realized by stockholders on corporate liquidations, and only those transactions coming squarely within the exception may escape tax. . The petitioners seem to think that the dissolution and liquidation of the Berch Ice Cream Co. were by inference necessary steps in the plan for the absorption of the Velvet and Seattle companies by Western Dairy because of an agreement by Berch and his associates not to engage in the manufacturing or wholesaling of ice cream or to be officers or stockholders in or otherwise associated with a corporation engaged primarily in such manufacturing or wholesaling. They do not, however, give any reasons why this covenant could not be observed in other ways than by dissolution and liquidation.

For the foregoing reasons we hold that the petitioners have not brought themselves within provisions of section 208(a)(8) and they may not add to the period beginning August 5, 1925, any of the prior period in which Berch held the stock of the Berch Ice Cream Co. The period from August 5, 1925, to July 1927, being less than two years, the gain realized was ordinary income and properly so treated by the respondent.

There is no issue as to the division of the income on a community property basis.

Reviewed by the Board.

Decision will be entered for the respondent.

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Footnotes

• 1. SEC. 208. (a) For the purposes of this title -

  (1) The term "capital gain" means taxable gain from the sale or exchange of capital assets consummated after December 31, 1921;

  * * *

  (8) The term "capital assets" means property held by the taxpayer for more than two years (whether or not connected with his trade or business) * * *. In determining the period for which the taxpayer has held property received on an exchange there shall be included the period for which he held the property exchanged, if under the provisions of section 204 the property received has, for the purpose of determining gain or loss from a sale or exchange, the same basis in whole or in part in his hands as the property exchanged. In determining the period for which the taxpayer has held property however acquired there shall be included the period for which such property was held by any other person, if under the provisions of section 204 such property has, for the purpose of determining gain or loss from a sale or exchange, the same basis in whole or in part in his hands as it would have in the hands of such other person. In determining the period for which the taxpayer has held stock or securities received upon a distribution where no gain is recognized to the distributee under the provisions of subdivision (c) of section 203 of this Act or of the Revenue Act of 1924, there shall be included the period for which he held the stock or securities in the distributing corporation prior to the receipt of the stock or securities upon such distribution. ↩