Clark v. Commissioner , 7 T.C. 192 ( 1946 )

Lenore Scullin Clark, Petitioner, v. Commissioner of Internal Revenue, Respondent. Harry Scullin and Bernice W. Scullin, His Wife, Petitioners, v. Commissioner of Internal Revenue, Respondent

Clark v. Commissioner

Docket Nos. 7807, 7808

United States Tax Court

7 T.C. 192; 1946 U.S. Tax Ct. LEXIS 146;

June 20, 1946, Promulgated

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Decision will be entered for the respondent.

In 1937 in a nontaxable reorganization under section 77-B of the Bankruptcy Act, the trustees under the will of John Scullin, deceased, exchanged debentures which had a cost basis to them of $ 1,452,000 for 29,940 shares of preferred stock in the newly organized corporation. In the same reorganization, but under a separate section of the plan of reorganization, the trustees received 79,840 warrants to purchase common stock in the new corporation "in lieu of and in satisfaction for all accrued, accumulated and unpaid interest upon said debentures." These stock warrants the trustees immediately distributed to the beneficiaries of the testamentary trust. In the taxable year, petitioners sold some of these stock warrants and claimed deductions for capital losses by reason of such sales. The Commissioner disallowed the claimed losses and computed capital gains. Held, the Commissioner is sustained because the stock purchase warrants had no cost basis to the trustees of the testamentary trust or to petitioners.

Emmet T. Carter, Esq., for the petitioners.

Gene W. Reardon, Esq., for the respondent.

Black, Judge.

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BLACK

These proceedings have been consolidated. In Docket No. 7807 the deficiency involved is $ 10,533.52 for the year 1941, and in Docket No. 7808 the deficiency involved is $ 10,651.42 and is likewise for the year 1941. The issue, which is common to both proceedings, is whether the petitioners incurred a capital loss when they sold certain stock warrants in the taxable year and are entitled to deduct same in the computation of their net income, as petitioners contend, or whether they realized a taxable gain in such sales and are taxable thereon, as the Commissioner has determined. The Commissioner, in his notice of deficiency to Lenore Scullin Clark, Docket No. 7807, explained the adjustment which he was making as follows:

(a) It is held that you realized a taxable long-term capital gain of $ 926.35 on the sale of 19,860 warrants to purchase common stock of the Scullin Steel Company instead of a deductible long-term capital loss of $ 32,936.50, as originally claimed by you.

A similar explanation was made in the deficiency notice to Harry Scullin and Bernice W. Scullin, his wife, in Docket No. 7808. Both petitions contain appropriate assignments of error contesting the correctness of these adjustments. They present the only issue which we have to decide. The Commissioner made other minor adjustments in his determination of the deficiency, but these are not contested and, therefore, present no issue.

FINDINGS OF FACT.

For the most part the facts have been stipulated by the parties and we adopt the stipulation as our findings. Other facts are found from the evidence adduced at the hearing.

The petitioners are residents of St. Louis County, Missouri, and the returns for the taxable year 1941 were filed on the cash receipts and disbursements basis with the collector of internal revenue for the first district of Missouri.

John Scullin died testate May 28, 1920, and under his will he left his estate in trust. The trustees of the trust estate are the Mercantile-Commerce Bank & Trust Co., Harry Scullin, and Thomas C. Hennings, all of St. Louis, Missouri. The trust-creating indenture provides that the net income of the trust, after payment of certain specific bequests of income, shall be distributed in equal shares to Harry Scullin, Lenore Scullin Clark, May Scullin deGheest (adult children of decedent), and Stella Wade Scullin (daughter-in-law of decedent), with the proviso that if the income of the trust in any year be less than sufficient to distribute $ 1,000 per month to each of the beneficiaries, then to permit such distributions the deficiency shall be taken from the corpus of the trust. There is no other provision in the trust-creating indenture authorizing the trustees to invade corpus for the benefit of the beneficiaries prior to the termination of the trust. The income of the trust has at all times been sufficient to cover all payments required to be made to such beneficiaries.

The trustees under the will of John Scullin, deceased, were the owners and holders of $ 1,497,000 principal amount of 6 1/2 per cent debenture bonds of Scullin Steel Co., a Delaware corporation, which was acquired by the then trustees under the will in October 1926 at a cost basis of $ 1,452,090.

The Scullin Steel Co. (hereinafter referred to as the debtor) filed in the United States District Court for the Eastern District of Missouri, Eastern Division, a petition for reorganization under the provisions of section 77-B of the Bankruptcy Act, as amended. On May 21, 1937, the debtor filed in said court a modified plan of reorganization which provided for the organization of a new company which was to have an authorized issue of 29,940 shares of preferred stock of the par value of $ 50 per share and 395,510 shares of common stock of no par value. The plan also provided that any holder of preferred stock of the new company should have the right to convert it into common stock of the new company on the basis of 1 share of preferred stock for 1 1/4 shares of common stock. The plan also provided for the allocation and distribution of the authorized 29,940 shares of preferred stock of the new company to the holders of the $ 1,497,000 of outstanding debenture bonds of the debtor on the basis of 20 shares of such stock for each $ 1,000 principal amount of such debenture bonds, which debenture bonds should then be canceled, together with the coupons evidencing interest thereon. The plan also provided that 260,510 shares of the authorized common stock of the new company be reserved for stock purchase warrants to be issued by the new company and for the conversion of new bonds and new preferred stock. The plan also provided for the issuance and distribution of 524,840 stock purchase warrants dated as of May 1, 1937, in bearer form, entitling the holder for each 4 of such warrants to subscribe for 1 share of common stock for $ 10 per share within 5 years from May 1, 1937. Stock purchase warrants in the amount of 79,840 were to be issued to the holders of the debenture bonds in lieu of and in satisfaction for all accrued, accumulated, and unpaid interest upon the debenture bonds on the basis of 53 1/3 warrants for each $ 1,000 face amount of debenture bonds of the debtor company. The modified plan of reorganization was approved by order entered by the District Court on September 10, 1937. Pursuant to this modified plan of reorganization, a new company was organized under the name of the Scullin Steel Co., a Missouri corporation, and the securities described in the modified plan of reorganization were issued.

Pursuant to the approved plan of reorganization, the trustees under the will, in a nontaxable reorganization, received on or about December 20, 1937, 29,940 shares of 5 per cent preferred stock of the par value of $ 50 per share on the basis of 20 preferred shares for each $ 1,000 face value of debenture bonds, and 79,840 stock purchase warrants dated as of May 1, 1937, which entitled the holder of 4 of such warrants to subscribe for 1 share of common stock of the new company within 5 years from the date of the warrants upon the payment of $ 10 for each share so subscribed. The preferred stock possessed equal voting rights with the common stock issued by the new Missouri corporation. These warrants were immediately distributed by the trustees in 1937 to the beneficiaries of the trust, but neither the trustees of the trust nor the beneficiaries thereof reported any income in their income tax returns for the year 1937 upon the receipt of such warrants.

During the taxable year 1941 some of the warrants were sold by petitioners and long term capital losses were claimed by them in their respective income tax returns as follows:

	Harry Scullin	Lenore Scullin
		Clark
Warrants sold	19,960	19,860
Net selling price	$ 4,157.78	$ 1,852.69
Basis claimed	68,066.71	67,725.69
Loss	63,908.93	65,873.00
Claimed as deductions (50%)	31,954.46	32,936.50

The Commissioner determined that the warrants to purchase new common stock of the Scullin Steel Co. had a zero basis and that, consequently, petitioners realized long term capital gains of $ 2,078.89 (50 per cent of $ 4,157.78) recognizable to Harry Scullin and $ 926.35 (50 per cent of $ 1,852.69) recognizable to Lenore Scullin Clark.

The basis claimed by petitioners in their respective income tax returns for the warrants sold by them in 1941 was determined by attributing or allocating the cost of the old debenture bonds of Scullin Steel Co. to the new preferred stock and warrants based upon values of $ 13 per share for the preferred stock and $ 1.12 1/2 for each warrant. Consequently, petitioners assigned a cost basis of $ 3.41 for each warrant sold by them in 1941. The above value of $ 13 attributed to the preferred stock of the new company was arrived at by taking the conversion value of the common into the purported value of the preferred stock, i. e., the purported average value of the common stock times 1 1/4 (1 share of preferred stock could be converted into 1 1/4 shares of common stock). None of the preferred stock has been sold.

There were 300 shares of common stock of the new company sold during the week ended December 31, 1937, at a low of $ 7 and a high of $ 7.50, or an average of $ 7.25 per share. During the month of January 1938 there were 3,195 shares of common stock of the new company sold at a low of $ 5.50 and a high of $ 7 3/8, or an average of $ 6 7/16 per share.

There were 2,580 stock purchase warrants of the new company sold during the week ended December 31, 1937, at a low of 90 cents and a high of $ 1, or an average of 95 cents per warrant. During the month of January 1938 there were 5,410 of such warrants sold at a low of 50 cents and a high of $ 1.23, or an average of 87 cents per warrant. We find that the stock warrants had a fair market value of 95 cents each at the time they were received by the trustees in December 1937.

OPINION.

The only issue which we have to decide in these proceedings is whether petitioners had a capital loss when they sold certain stock warrants in the taxable year, or whether, as respondent contends, they had no loss, but rather a capital gain.

The parties are in agreement as to the amounts of money for which petitioners sold their stock warrants in 1941 and they are in agreement as to the cost basis of the debentures which the trust in 1937 exchanged under the plan of reorganization. What the parties do not agree about is the cost basis of the stock warrants which were sold in the taxable year. Petitioners claim a cost basis of $ 3.41 for each warrant, which has been arrived at by allocating a part of the cost of the debentures to the stock warrants on a basis of comparison between the fair market value of the warrants at the time they were received and the alleged fair market value of the preferred stock at the time it was received. Respondent has determined that petitioners' cost basis of the warrants was zero when they were received and that consequently all that they received for the warrants, after deducting the cost of selling them, was gain and was taxable at capital gain rates. We think respondent's determination must be sustained.

Petitioners in their brief rely heavily upon Morainville v. Commissioner, 135 Fed. (2d) 201. The petitioners in their brief point out that the contention of the Commissioner as stated by the court in the Morainville case was as follows:

In sum, the Government contends that the dividend of two shares of Series B, representing arrears in dividends on each share of Second Preferred Stock, was subject to tax as income, for the reason that it is a dividend in payment of the arrears; that it was payable only at the option of the stockholder; that it was unnecessary for the stockholder to exchange his original holding of stock in order to receive the stock representing the accrued dividends; and that, therefore, the distribution of the stock as dividends covering arrears in dividends, was a transaction separate from the exchange of the shares of Series B stock for the previously designated Second Preferred Stock.

The petitioners seem to argue that we have essentially the same issue here as was present in the Morainville case and that, therefore, we should hold against the Commissioner as the court did in the Morainville case.

But the Commissioner is making no such contention as he made in the Morainville case. He is not contending here that, when the trust in 1937 received the stock warrants in complete settlement of the past due interest on the debentures, it received taxable income equal to the fair market value of the warrants. He concedes that the trust was not in receipt of taxable income when in 1937 it received the stock warrants under the circumstances detailed in our findings of fact. In fact it has been definitely stipulated that both the 29,940 shares of 5 per cent preferred stock and the 79,840 stock warrants were received by the trustees in a nontaxable reorganization. We do not have the year 1937 before us, but if we did, we would, of course, have to hold under the facts as stipulated that neither the trustees of the will of John Scullin nor the petitioners were in receipt of income when they received the preferred stock and stock warrants in exchange for the debentures and all accrued and unpaid interest due thereon. Hence we think that cases like Morainville v. Commissioner, supra, are not applicable, because the Commissioner is not making the same contention as he there made. In the Morainville case and other similar cases cited by petitioners, no question concerning the determination of cost basis upon subsequent sale of the securities received in the exchange was involved.

What the Commissioner is contending in the instant case, as we understand it, is substantially this: (1) Under the plan of reorganization the trustees under the will of John Scullin definitely exchanged debentures which had a cost basis of $ 1,452,000 for 29,940 shares of preferred stock. Hence all the cost basis of the debentures must be allocated to the preferred stock and none of it can be allocated to the stock warrants. (2) Under the plan of reorganization the trustees specifically received the 79,840 stock warrants in lieu of and in satisfaction for all accrued, accumulated, and unpaid interest upon said debentures, but, because the exchange was in a nontaxable reorganization and none of such accrued and unpaid interest had ever been returned as taxable income, the cost basis of such stock warrants must be held to be zero under section 113 of the Internal Revenue Code. We think the facts support the Commissioner in these contentions. The plan of reorganization, which was approved by the court and was carried out, is in evidence. Section VII thereof provides for "Allocation of capital stock of new company." It reads in part as follows:

It is proposed that the capital stock of the New Company shall be allocated and distributed as follows:

A. 29,940 shares of Preferred Stock to the holders of $ 1,497,000 of outstanding Debentures on the basis of 20 shares of such stock for each $ 1,000 principal amount of such Debentures, which Debentures shall then be cancelled, together with the coupons evidencing interest thereon.

It seems clear to us that, because of the above provision, the $ 1,452,000 stipulated cost of the debentures should be prorated among the 29,940 shares of preferred stock, and if and when the trustees of the John Scullin trust sell any of these preferred shares, gain or loss will then be realized for tax purposes.

Section IX of the plan of reorganization provides for "Issuance and distribution of stock purchase warrants." This section IX provides in part as follows:

There shall be issued Stock Purchase Warrants dated as of May 1, 1937, in bearer form, which will entitle the holder for each four of such warrants to subscribe for one (1) share of Common Stock for Ten Dollars ($ 10.00) per share within five (5) years from the date thereof. An aggregate of 524,840 warrants shall be issued as follows:

* * * *

B. 79,840 thereof to the holders of the Debentures, which warrants are in lieu of and in satisfaction for all accrued, accumulated and unpaid interest upon said Debentures, on the basis of 53 1/3 warrants for each $ 1,000 face amount of Debentures.

It therefore seems clear from the foregoing that the trustees received these stock purchase warrants strictly in settlement of the past due interest on the debentures and for nothing else, and, while the receipt of such warrants was not taxable income to the trustees because it was part of a plan of reorganization, it also did not serve to give them any cost basis for the stock warrants. The stock warrants cost neither the trustees nor the beneficiaries of the trust anything when distributed to them. Of course the claim of the trustees for accumulated and unpaid interest on the debentures was a valuable right, but since this unpaid interest was never taken into income by the trustees, it had no cost basis to them. Petitioners do not contend that the past due and unpaid interest on the debentures had any cost basis to them. What they are contending is that the $ 1,452,000 stipulated cost of the debentures should be allocated between the preferred stock and the stock purchase warrants. But for reasons we have already stated we reject this contention. Therefore, in 1941, when petitioners, beneficiaries of the trust, sold the warrants here involved, they had no cost basis under section 113 of the code and all that they received, less expense of selling, represented gain to them. That gain the Commissioner has determined shall be taken into account at capital gain rates, and in this determination we sustain him.

So far as we can see, there is nothing in this holding which is in conflict with Morainville v. Commissioner, supra;Skenandoa Rayon Corporation v. Commissioner, 122 Fed. (2d) 268, affirming 42 B. T. A. 1287; South Atlantic Steamship Line, 42 B. T. A. 705, and other cases along the same line cited by petitioners in their brief. So far as the question we have here to decide is concerned, we do not think they are in point.

Decision will be entered for the respondent.