Brown v. Commissioner , 27 T.C. 27 ( 1956 )

Warren H. Brown, et al., ¹ Petitioners, v. Commissioner of Internal Revenue, Respondent

Brown v. Commissioner

Docket Nos. 50179, 50180, 50181, 50182, 50183

United States Tax Court

27 T.C. 27; 1956 U.S. Tax Ct. LEXIS 67; 27 T.C. No. 3;

October 18, 1956, Filed

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Decisions will be entered under Rule 50.

1. Petitioner corporation acquired assets from a partnership pursuant to an installment sales contract under the terms of which the consideration was to be paid in 10 equal annual installments. Title to the assets was reserved in the partners until the full purchase price was paid. Held, the sales contract was not stock or securities within the meaning of section 112 (b) (5), I. R. C. 1939, and the gain realized by the transferors on the transaction was recognized.

2. Held, further, the basis to the transferee corporation of the assets acquired by it is the cost of the assets. Sec. 113 (a), I. R. C. 1939.

3. Useful lives and salvage values of certain items of equipment used in logging and sawmilling business determined.

W. D. Eberle, Esq., for the petitioners.

John H. Welch, Esq., and Wilford H. Payne, Esq., for the respondent.

Withey, Judge.

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WITHEY

The respondent has determined deficiencies in petitioners' income tax for the years and in the amounts as follows:

Name	Docket No.	Year	Deficiency
Warren H. Brown	50179	1947	$ 2,024.20
Jayne J. Brown	50183	1947	2,024.20
Warren H. Brown and Jayne J. Brown	50179	1948	4,419.82
	50183	1949	10,811.69
Carl E. Brown	50180	1947	1,980.66
		1948	1,873.67
Ida H. Brown	50182	1947	1,980.66
		1948	1,910.17
Carl E. Brown and Ida H. Brown	50180	1949	10,653.14
	50182
Brown's Tie & Lumber Co	50181	1947	26,805.56
		1948	25,049.84
		1949	30,095.41

In addition to the foregoing, respondent in amended answers has claimed increased deficiencies against petitioners for 1947 and 1948 as follows:

Name	Year	Increase in
		deficiency
Warren H. Brown	1947	$ 3,732.91
	1948	7,494.92
Carl E. Brown	1947	3,674.96
	1948	3,455.78
Ida H. Brown	1947	3,672.95
	1948	3,494.92
Jayne J. Brown	1947	3,732.91
	1948	7,494.92
Brown's Tie & Lumber Co	1947	9,198.10
	1948	8,278.30

The issues presented for our determination are the correctness of the respondent's action (1) in determining that the assets acquired by petitioner Brown's Tie & Lumber Company retained the same basis as they had in the hands of the partners prior to the transfer; (2) in determining that the installment agreement executed by Brown's Tie & Lumber Company on January 2, 1947, was without substance and in the nature of stock or securities within the meaning of section 112 (b) (5) of the Internal Revenue Code of 1939; and (3) in disallowing a portion of the deductions taken by Brown's Tie & Lumber Company as depreciation on equipment used in its business during the taxable years in question.

FINDINGS OF FACT.

Some of the facts have been stipulated and are found accordingly.

Petitioners filed their income tax returns for 1947, 1948, and 1949 with the then collector of internal revenue for the district of Idaho. In addition, a partnership information return was filed on behalf of Brown's Tie & Lumber Company, a partnership, for each of the foregoing years.

Brown's Tie & Lumber Company, a copartnership, hereinafter referred to as the partnership, was formed on January 1, 1938, to engage in the business of logging, milling, and marketing of lumber and other wood products. The partners were Carl E. Brown and Ida H. Brown who owned a one-half interest in the partnership as their community property, Warren H. Brown and Jayne J. Brown who owned a one-eighth interest as their community property, and Dorothy C. Brown, Margaret J. Brown, and Elizabeth Brown Harwood, the children of Carl and Ida Brown, each of whom also owned a one-eighth interest. On December 31, 1945, Warren acquired the one-eighth interest of each of the other children and thereby became the owner of a one-half interest. Carl was designated manager and Warren assistant manager of the partnership.

During 1946 there developed a serious disagreement between Carl and his son, Warren, as to the management of their business. The basis for the disagreement between the two was insistence by Warren upon the extensive expansion of their business, while Carl, fearful that adverse economic variations in business generally might and probably would endanger the continued existence of the business, especially since it was conducted largely upon the basis of borrowed funds, was consistently insistent that no expansion program be adopted. As a result of the friction, they attempted to sell their lumber business and conducted negotiations with two prospective purchasers during the latter part of 1946. In connection with the foregoing negotiations, Warren and Patrick J. Hayes, the office manager of the partnership, appraised the assets of the business and prepared an itemized list showing the market value of each asset.

During 1946 the partnership frequently borrowed from the First Security Bank of Idaho amounts ranging from $ 50,000 to $ 160,000. Such loans for the most part were unsecured, short-term obligations maturing in not more than 90 days. J. L. Driscoll, president of the First Security Bank of Idaho, had advised and assisted Carl and Warren in business matters for many years. In the fall of 1946, Driscoll urged the Browns to incorporate their partnership business. Driscoll was particularly concerned with possible difficulty in the collecting of loans of the bank in the event of the death of either of the partners or their wives since the partnership interests would then become involved in probate and inheritance tax proceedings.

Driscoll recommended to the partners that they consult J. L. Eberle, an attorney practicing in Boise, Idaho, with respect to the incorporation of their partnership business. The Browns authorized Driscoll to contact Eberle and to authorize him on their behalf to incorporate their business. The articles of incorporation subsequently were prepared and executed and were filed at Boise, Idaho, on December 30, 1946.

Brown's Tie & Lumber Company, hereinafter referred to as the corporation, is a corporation organized under the laws of Idaho with its principal place of business at McCall, Idaho. The authorized capital of the corporation is $ 500,000, divided into 5,000 shares of common stock of $ 100 par value per share. The two principal stockholders, officers, and directors of the corporation at the time of its formation and at all times here material were Carl, president, and Warren, secretary.

The first meeting of the shareholders and officers of the corporation was held on December 31, 1946, and at that time the proposed transfer of the partnership assets was considered. Carl then refused to consent to the conveyance of the logging and milling equipment to the corporation for additional stock because he feared that he would by so doing jeopardize his investment by subjecting all of the assets of the partnership to the risk of an expansion program to which he was bitterly opposed.

Upon the refusal of Carl on December 31, 1946, to consent to the transfer of all of the partnership assets to the corporation, the petitioners, Carl and Warren, on behalf of the partnership, transferred current assets, including cash, accounts receivable, and inventory, and certain land and timber of the partnership, to the corporation. The assets which were transferred were sufficient to enable the corporation to conduct a lumber sales and marketing business had the directors desired to lease or contract the logging and milling operations, as was the general practice among timber operators in Idaho at that time.

The total book value of the foregoing assets on the date of transfer was $ 358,448.96. The fair market value of the assets transferred on December 31, 1946, was $ 451,228.44, the difference of $ 92,779.48 representing appreciation in the value of the timber. The corporation assumed all of the partnership liabilities as of December 31, 1946, totaling $ 181,067.75, set up an open account payable to the partnership for $ 181.21, and issued to the partners jointly a stock certificate for 1,772 shares of its common stock having a par value of $ 177,200. Thus, valuing the timber and other assets at their fair market value, the corporation issued stock for assets having a net worth of approximately $ 270,000. The stock received by the partners in exchange for the assets conveyed to the corporation on December 31, 1946, was in proportion to their interests in the property prior to the exchange.

Immediately following the first meeting of the shareholders of the corporation, Carl consulted J. L. Eberle regarding possible methods of arranging for the use of the remaining assets. Carl was advised that the partnership might contract with another party to handle the logging and milling operations and let the corporation market the lumber, or lease the logging and milling equipment to another logger and sawmill operator to cut and process the timber on behalf of the corporation. He was advised, as a third alternative, that the partners might sell the logging and milling equipment on a retaining contract, reserving title to themselves until the purchase price was paid.

On January 2, 1947, Carl informed J. L. Eberle that he would be willing to arrange for the transfer of the remaining partnership assets to the corporation on an installment sales contract. Thereupon, on behalf of the corporation, an installment agreement was executed bearing the date of January 2, 1947, and providing for the sale of the remaining assets of the partnership to the corporation for $ 605,138.75, payable in 10 equal annual installments, with interest at the rate of 4 per cent per annum. Payments were to be made to the partners without regard to the earnings of the corporation. No agreement was made by the partners not to enforce collection of the foregoing payments and interest. Title to the property transferred thereunder was reserved in the partners as seller. The corporation was given the right to anticipate the payments and to discharge its outstanding obligation at any time. Further, the corporation was required to keep the transferred assets insured for the benefit of both the buyer and seller as their interest might appear.

On January 2, 1947, under the installment contract the partnership transferred to the corporation its remaining assets, including the millsite, sawmill and equipment for the logging and milling of timber, trucks, automobiles, and other assets formerly used by the partnership. The book value to the partnership of the assets so transferred was $ 270,480.73. The adjusted basis of the foregoing assets was $ 279,602.60. The difference, in the amount of $ 9,121.87, between the book value of the foregoing assets to the partnership and their adjusted basis represents an adjustment by the respondent for depreciation taken for prior years. The fair market value of these assets on January 2, 1947, was $ 605,138.75. The valuation figures assigned to the assets sold to the corporation were the same figures as determined in the appraisal made by Warren H. Brown and Patrick J. Hayes in the summer of 1946 when the partners were contemplating a sale of their partnership business to another lumber company.

All of the installment payments with interest provided in the installment agreement executed January 2, 1947, which became due during the years in issue have been paid.

The sale of the assets by the partnership to the corporation which was contracted on January 2, 1947, has been consistently treated as a sale by the parties thereto, and the proceeds received under the installment sales contract executed on that date have been reported by the partners on their income tax returns as long-term capital gains.

After the incorporation of the partnership business, the First Security Bank of Idaho extended additional credit to the corporation by raising its borrowing limits to approximately $ 300,000. This extension of bank credit enabled the corporation to purchase additional equipment and timberland which it had previously been unable to obtain. Accordingly, the business activities of the corporation subsequently were expanded. More than $ 600,000 was invested by the corporation in equipment during the period 1947 through 1949. During those years the corporation realized an average net profit of approximately $ 170,000 annually.

The useful life of the logging equipment, including trucks, tractors, and automobiles used by the corporation in its logging and sawmill operations, was 4 years. The life of a 45-ton equipment trailer used in the operations was 3 1/3 years. The useful life of mixers, teletalk devices, electric hammers, and boilers was 5 years. The life of bus bodies, lumber carriers, and sundry equipment was 4 years. The useful life of office equipment was 7 1/2 years and of camp equipment was 5 years. The sawmill and sawmilling equipment and the automotive and logging equipment used by the corporation in its logging operations had no salvage value because of their distance from market at the time of the expiration of their useful life.

OPINION.

Petitioners contend that the execution of the installment contract on January 2, 1947, constituted a sales transaction, separate and distinct from the exchange of December 31, 1946, and created a valid debtor-creditor relationship between the partners and the corporation. Petitioners therefore maintain that the gain realized on the transaction should be recognized, and that the corporation is entitled to utilize the fair market value of the assets at the time of the transfer as its basis for depreciation pursuant to section 113 (a) of the 1939 Code. ²

The respondent has taken the position that the exchange of assets for stock which took place on December 31, 1946, and the execution of the installment sales contract on January 2, 1947, together with the transfer of assets pursuant thereto, should be regarded as steps in a single transaction; that the installment contract between the partners and the newly formed corporation was without substance and, in fact, represented equity capital; and that the entire transaction in substance was an exchange of property for stock or stock and securities of a corporation controlled by the transferors. Consequently, the respondent contends that no gain is recognized in the transaction pursuant to the provisions of section 112 (b) (5) of the Code, ³ and that the basis to the transferee corporation of the partnership assets received by it is the same as that in the hands of the transferors immediately prior to the exchange under section 113 (a) (8)⁴ of the Code.

In support of his position, respondent relies on our decisions in Estate of Herbert B. Miller, 24 T. C. 923 (on appeal C. A. 9), and Gooding Amusement Co., 23 T. C. 408, affd. 236 F.2d 159">236 F. 2d 159. Both cases involve the incorporation of a partnership, and in each case the partnership assets were transferred to the new corporation in exchange for stock and notes. The noteholders in each instance were partners in the transferor and were in control of the corporation immediately after the exchange.

In Estate of Herbert B. Miller, supra, the new corporation was created with a predominant debt structure (86 to 1 debt-stock ratio) and with no apparent business reason for so low a capitalization. The assets transferred by the partners to the corporation in exchange for the notes there in issue constituted substantially everything the corporation owned. Further, we there expressed doubt as to whether the claims of the noteholders were sufficiently secured so as to be upheld against the claims of general creditors. We held that the transferors had no bona fide intention to create a debtor-creditor relationship with the corporation, that the notes executed by the corporation were in fact representative of risk capital and in the nature of stock, and that since the transaction fell squarely within the provisions of section 112 (b) (5) of the Code, no gain was recognized to the transferors.

In the instant case, however, the petitioners invested assets worth $ 270,000 in capital stock, whereas the installment sales contract created a corporate obligation in the amount of $ 605,138.75. Thus, the corporation was adequately capitalized, there being a debt-stock ratio of approximately 2 to 1. The obvious business reason for the execution of the installment sales contract here in question, and the transfer of the rights to the use and possession of a portion of the partnership assets to the corporation pursuant thereto, reserving title in the transferors, was the categorical refusal of Carl Brown to accept the risks attendant upon a further capital investment in the new corporation.

Under Idaho law, the reservation in the transferors of title to personal property sold under an installment sales contract gives the transferor a right to possession and ownership superior to the rights of all other creditors of the transferee. Idaho Code Ann. 1947, sec. 64-801, 802; Sparkman v. Miller-Cahoon Co., 273">282 Pac. 273. The real estate included in the contract of sale remains the property of the partners so long as they retain record title. Idaho Code Ann. 1947, sec. 55-812.

The Gooding Amusement Co. case, supra, is similarly distinguishable. There, as in Estate of Herbert B. Miller, supra, the corporation issued notes to the partnership, rather than execute a contract of sale reserving title in the transferors, as here. Unlike the sales contract here in question, the notes issued to the transferor by the Gooding Amusement Company were subordinated to the claims of other creditors. Moreover, the majority of the notes there issued remained unpaid long after maturity, whereas the record herein discloses that all the installments due during the years in issue on the sales contract executed by the corporation on January 2, 1947, have been paid, with interest thereon. Further, we placed reliance on the failure of the taxpayers in Gooding Amusement Co., supra, to show that nontax considerations motivated the decision to accept the short-term judgment notes of the corporation in exchange for a portion of the assets transferred to it. We have described heretofore the independent business purpose underlying the execution of the installment sales contract here in issue. Finally, the ratio of debt to equity financing in the Gooding Amusement Co. case was 6.5 to 1, as compared with a 2 to 1 ratio here. We there held that no gain or loss was recognized under the provisions of section 112 (b) (5) of the Code on the ground that the notes received by the transferors in exchange for a portion of the assets transferred to the corporation were in fact evidence of equity capital.

Respondent insists that the corporation here, as in the two foregoing decisions, could not have operated without all of the partnership assets. The record discloses, however, that Carl E. Brown was advised of the possibility of contracting the partnership logging and milling operations, as was the practice among timber operators in central Idaho at that time, and operating the newly formed corporation as a sales and marketing outlet. The assets transferred to the corporation on December 31, 1946, in exchange for stock were sufficient to enable the corporation to conduct a sales and marketing business. The partnership assets which the partners at that time refused to convey to the corporation in exchange for stock were the logging and milling equipment. Thus, by separating the harvesting and processing operations from the marketing activities, the corporation could have continued to operate as a sales outlet without acquiring the assets purchased by it on January 2, 1947.

For the foregoing reasons, we are of the opinion that neither Estate of Herbert B. Miller, supra, nor Gooding Amusement Co., supra, is controlling of the situation presented here.

Respondent contends that the installment payments and interest received by the partners and treated by them as the proceeds of a sale actually constitute distributions in the nature of dividends. In support of his argument on this point, respondent calls to our attention the fact that no formal dividends had been declared by the corporation although the corporation had earnings and profits during the years in issue. Accordingly, respondent suggests that, inasmuch as each partner received more than $ 16,000 in payments and interest from the corporation during each of the years in question, no formal dividend declaration was necessary. The record discloses, however, that the corporation invested substantial amounts in additional equipment and timberland, thereby expanding its activities during the years in question, leaving little or no cash available for the payment of dividends.

The courts have recognized that the consecutive steps involved in the incorporation of a business, occurring in immediate sequence, may nevertheless be entirely different in nature and therefore separate and distinct legal transactions, although closely related in time and purpose. Sun Properties, Inc. v. United States, 220 F. 2d 171; Marjory Taylor Hardwick, 33 B. T. A. 249; W. A. Hoult, 23 B. T. A. 804. Such a conclusion is strengthened by the additional fact that the consecutive transactions have separate business purposes. See W. A. Hoult, supra.

Sun Properties, Inc. v. United States, supra, is directly in point here. There, the taxpayer corporation was formed by its sole stockholder on August 25, 1947. On September 1, 1947, the stockholder conveyed 2 lots to the corporation in exchange for 7 shares of stock. On September 15, 1947, the sole owner transferred a warehouse to the taxpayer pursuant to an agreement providing for payment to the transferor of consideration in the amount of approximately $ 125,000, payable at the rate of $ 4,000 semiannually, without interest. The purchase price was equal to the fair market value of the warehouse. The payments to be made to the sole stockholder were not dependent upon the earnings of the corporation and the contract, although unsecured, was not subordinated to the claims of general creditors. The United States Court of Appeals for the Fifth Circuit found, on the entire record, that the transaction consummated on September 15, 1947, constituted a bona fide sale by the stockholder to the corporation, rather than a contribution to capital.

The facts apparent from the record before us would seem to require a similar conclusion here. In view of the apparent intention of the parties, the form of contract here in question, the reservation of title in the transferors until the full purchase price is paid, the obvious business considerations motivating the partners to cast the transaction in the adopted form, the substantial investment by the transferors in stock of the corporation, the superior position of the transferors' claims to the claims of the other corporate creditors, the fact that the contract price was equal to the stipulated fair market value of the assets transferred thereunder, the contract provision calling for fixed payments to the partners without regard to corporate earnings, the provision requiring the payment of interest to the transferors at a reasonable rate, the absence of an agreement not to enforce collection, and the subsequent payment of all installments which became due under the contract during the years in issue, we are persuaded that the transaction which was consummated on January 2, 1947, was a bona fide sale as petitioners contend.

Respondent contends in the alternative that the installment sales contract represents a security under section 112 (b) (5) of the 1939 Code. Securities, as that term is used in section 112 (b) of the Code, have been held to be instruments in the nature of bonds, debentures, or other obligations representing long-term advancements to the issuing corporation. John W. Harrison, 24 T. C. 46, affd. 235 F. 2d 587; Camp Wolters Enterprises, Inc., 22 T. C. 737, affd. 230 F. 2d 555; Wellington Fund, Inc., 4 T. C. 185. The question whether an evidence of indebtedness constitutes a security does not depend for its resolution upon a simple determination of the length of time the obligation is to run, but depends rather upon an over-all evaluation of the nature of the debt so as to ascertain whether or not the instrument issued evidences a continuing interest in the affairs of the corporation. Camp Wolters Enterprises, Inc., supra.The installment contract in question was not intended to insure the partners a continued participation in the business of the transferee corporation, but was intended rather to effect a termination of such a continuing interest. We are aware of no decision in which an installment sales contract reserving title in the seller has been held to qualify as a security within the meaning of section 112 (b) (5) of the Code, and respondent has cited none. Although in certain particulars the contract may resemble a bond, essentially it partakes of the nature of a contract of sale, and in our view does not constitute a security within the meaning of section 112 (b) (5) of the Code.

In view of the foregoing, we hold that the execution of the installment sales contract on January 2, 1947, was a transaction separate and distinct from the exchange which was consummated on December 31, 1946, and created a valid debtor-creditor relationship between the transferors and the corporation. Consequently, under section 113 (a) of the 1939 Code, the basis for depreciation of the assets acquired by the corporation on January 2, 1947, is the cost of the assets to the corporation, which in this case is equal to the far market value thereof on the date of acquisition.

Our findings of fact as to the useful lives of various items of equipment used by the corporation during the years in issue and our findings with respect to salvage value as to a portion of such equipment dispose of all matters involved in the issue relating to depreciation.

Decisions will be entered under Rule 50.

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Footnotes

• 1. Proceedings of the following petitioners are consolidated herewith: Carl E. Brown, Docket No. 50180; Brown's Tie & Lumber Company, Docket No. 50181; Ida H. Brown, Docket No. 50182; and Jayne J. Brown, Docket No. 50183.↩

• 2. SEC. 113. ADJUSTED BASIS FOR DETERMINING GAIN OR LOSS.

  (a) Basis (Unadjusted) of Property. -- The basis of property shall be the cost of such property; * * *↩

• 3. SEC. 112. RECOGNITION OF GAIN OR LOSS.

  (b) Exchanges Solely in Kind. --

  * * * *

  (5) Transfer to corporation controlled by transferor. -- No gain or loss shall be recognized if property is transferred to a corporation by one or more persons solely in exchange for stock or securities in such corporation, and immediately after the exchange such person or persons are in control of the corporation; but in the case of an exchange by two or more persons this paragraph shall apply only if the amount of the stock and securities received by each is substantially in proportion to his interest in the property prior to the exchange. Where the transferee assumes a liability of a transferor, or where the property of a transferor is transferred subject to a liability, then for the purpose only of determining whether the amount of stock or securities received by each of the transferors is in the proportion required by this paragraph, the amount of such liability (if under subsection (k) it is not to be considered as "other property or money") shall be considered as stock or securities received by such transferor.↩

• 4. SEC. 113 (a). Basis (Unadjusted) of Property. -- The basis of property shall be the cost of such property; except that --

  * * * *

  (8) Property acquired by issuance of stock or as paid-in surplus. -- If the property was acquired after December 31, 1920, by a corporation --

  (A) by the issuance of its stock or securities in connection with a transaction described in section 112 (b) (5) (including, also, cases where part of the consideration for the transfer of such property to the corporation was property or money, in addition to such stock or securities), or

  (B) as paid-in surplus or as a contribution to capital, then the basis shall be the same as it would be in the hands of the transferor, increased in the amount of gain or decreased in the amount of loss recognized to the transferor upon such transfer under the law applicable to the year in which the transfer was made.↩