Smith v. Commissioner

*80 These proceedings were brought for a redetermination of the income tax liability of petitioners Albert E. Smith, O. G. Dreher, and Carlton W. *1073 Smith, for the taxable year 1933, in the respective amounts of $417.24, $202.32, and $6,876.79.

The primary issue involves the proper basis for determining gain or loss on sale or shares of junior preferred stock, and its resolution is dependent on whether a 1930 stock dividend of junior preferred stock on American Envelope Co. common stock is a true stock dividend coming within the rule of Eisner v. Macomber,252 U.S. 189, or whether it is income within the rule of Helvering v. Gouran,302 U.S. 238. Other issues relate to the capital or noncapital character of the gains from the sale of such stock within the year or its declaration and receipt, whether the "recapitalization" of the corporation for the purpose of issuing the stock dividend is a "reorganization" under the statute (sec. 112(i), Revenue Act of 1932); and the effect of the adjustment provisions of section 113(b)(1)(D) of the Revenue Act of 1932 on the case at bar.

From the stipulated facts in each individual case and the exhibits attached thereto we make the following findings of fact.

*81 FINDINGS OF FACT.

The American Envelope Co. is and was prior to July 1, 1933, an*1074 Ohio corporation with its principal office at West Carrollton, Ohio.

On July 1, 1933, its authorized capital stock consisted of 8,000 shares of preferred stock and 6,000 shares of common stock. Of its authorized stock, there were issued and outstanding on that date 3,573 shares of preferred stock, hereinafter referred to for identification purposes as class A preferred stock, and 3,025 shares of common stock. The class A preferred stock and the common stock were not owned proportionately by the stockholders of the corporation, and not all of the class A preferred stock was owned by the common stockholders.

On July 1, 1933, a special directors' meeting of the American Envelope Co. was held. The president of the company reported that it was deemed desirable to conserve the company's cash position and to make a dividend distribution payable in stock. Thereupon a resolution was passed providing for an amendment to the articles of incorporation of the company authorizing the issuance of 1,250 shares of class B preferred stock of the company. The action of the directors was approved by the stockholders at a special stockholders' meeting held the same day. On July 5, 1933, the*1075 articles of incorporation of the American Envelope Co. were amended in accordance with the foregoing resolutions.

On July 11, 1933, the regular quarterly meeting of the board of directors of the American Envelope Co. was held, at which meeting the directors duly passed a resolution declaring a 30 percent stock dividend on the common stock, payable in the newly created class B preferred stock to the holders of common stock of the corporation of record as of July 1, 1933.

On July 15, 1933, at the time of the receipt of the dividend referred to above, the fair market value of the class B preferred stock received as a dividend was, for the purpose of this proceeding only, $100 per share, and the fair market value of the common stock, was, for the purpose of this proceeding only, $275 per share.

At the time of the distribution of the class B preferred stock as a stock dividend, the American Envelope Co. had on hand sufficient earnings and surplus accumulated subsequent to February 28, 1913, to pay a cash dividend in an amount equal to the fair market value of the class B preferred stock on the date of distribution, had it been desirable to do so.

Holders of class A preferred*1076 stock were entitled to dividends, payable quarterly at the rate of 7 percent per annum and no more, which dividends were to be paid or set apart before any dividends were declared on the common stock. Such dividends were cumulative, and *82 deficiencies had to be met in full (without interest) before dividends were paid on common stock. In event of dissolution or liquidation of the corporation holders of class A preferred stock were to be paid $105 per share, together with accrued dividends. The remaining assets were to be distributed to holders of common stock.

The class A preferred stock could be redeemed at any time at the option of the corporation at $102 or $105, depending on the date of redemption, plus accrued dividends.

The exclusive voting power was vested in holders of common stock, except holders of class A preferred were entitled to vote separately as a class for the election of two members of the board of directors; and if the corporation failed to pay class A preferred stock dividends in full for two successive years, holders of such stock became entitled to vote as a class to the exclusion of the holders of common stock for all save one of the entire*1077 board of directors.

So long as more than 5,000 shares of class A preferred were outstanding, cash dividends on common stock were limited to 6 percent per annum on par value, unless the corporation's net earnings applicable to common stock dividends in the year equaled or exceeded $100,000, in which event cash dividends aggregating not more than $50,000 could be declared on common stock in that year.

So long as any class A preferred stock was outstanding, no cash dividends were to be paid on common, nor were "net quick assets" to be converted into fixed assets, unless the "net quick assets" after the payment of the dividend or conversion into fixed assets, equaled or exceeded the par value of outstanding class A preferred stock; except that if class A preferred stock outstanding exceeded 5,000 shares the "net quick assets" could be reduced to $500,000.

Class A preferred stockholders' rights were subject to change and mortgage liens could be created only on approval of three-fourths in interest of class A preferred stock.

The right to stock dividends was vested exclusively in holders of common stock.

The class B preferred stock expressly was made junior to the class A*1078 preferred stock.

The class B preferred stockholders were entitled to dividends as and when declared at the rate of 7 percent per annum, and no more. Such dividends were to be paid after the dividends on the class A preferred stock were paid, and before any dividends were paid on common stock. These dividends were also cumulative.

On dissolution or liquidation class B preferred stockholders were to be paid $100 per share, together with accrued dividends, before common stockholders were to receive anything. After such payment the holders of common stock were to receive the remaining assets pro rata.

*83 The company had the right at any time, at its option and with or without notice, to purchase the class B preferred stock at the price of $100 per share.

The issuance of the class B preferred stock in no way affected the rights to dividends, priority on liquidation, or conditional voting rights of the class A preferred stockholders.

Petitioner Carlton W. Smith was the record holder of 1,210 shares of common stock of the corporation on July 1, 1933. that stock was all acquired more than two years prior to July 1, 1933, and cost the taxpayer, for the purpose of*1079 this proceeding only, $131,661.88. Pursuant to the resolution referred to above, he received as a dividend on July 15, 1933, 363 shares of the class B preferred stock of the corporation.

During the calendar year 1933 Carlton W. Smith sold 223 shares of the class B preferred stock, which he received as a stock dividend in the manner hereinabove mentioned, for $22,283.66, and, prorating a portion of the cost to him of the common stock which he owned to the class B preferred stock which he sold, determined a capital gain on the sale of $3,618.76, which he reported on his Federal income tax return for the calendar year 1933.

Petitioner Albert E. Smith was the record holder of 250 shares of common stock of the corporation on July 1, 1933. That stock was acquired, and the cost thereof, for the purpose of this proceeding only, was as follows:

Pursuant to the resolution referred to above, he received as a dividend on July 15, 1933, 75 shares of class B preferred stock of the corporation.

Albert*1080 E. Smith sold 32 shares of the class B preferred stock which he received as a stock dividend in the manner hereinabove mentioned, as follows:

*84 He prorated a portion of the cost to him of the common stock which he owned to the class B preferred stock which he sold, and determined a total profit of $115.84 on the sales which he reported in his Federal income tax return for the calendar year 1933 as profit from the sale of capital assets.

Petitioner O. G. Dreher was the record holder of 263 shares of common stock of the corporation on July 1, 1933. That stock was acquired, and the cost thereof, for the purpose of this proceeding only, was, as follows:

Pursuant to the resolution referred to above he received as a dividend on July 15, 1933, 78.9 shares of class B preferred stock of the corporation.

During the calendar year 1933 he sold 28 shares of the class B*1081 preferred stock, which he received as a stock dividend in the manner hereinabove mentioned, for $2,767 and, prorating a portion of the cost to him of the common stock which he owned to the class B preferred stock which he sold, determined a capital loss on the sale of $354.79, which he reported in his Federal income tax return for the calendar year 1933.

Respondent in each case held that the distribution of class B preferred stock was a distribution of a taxable dividend to the extent of its fair market value when received; and that this value becomes the cost basis for computing gain or loss on a subsequent sale of the stock.

OPINION.

VAN FOSSAN: The recently promulgated opinion of this Board in Frank J. and Hubert Kelly Trust,38 B.T.A. 1014, is decisive of most of the contentions in the present case. There is a factual difference in that in Frank J. and Hubert Kelly Trust, the preferred stock was received as a dividend on common stock, which was the only class of stock theretofore authorized and outstanding, while in the cases at bar the class B preferred stock was received as a dividend on common, the dividend preferred stock being junior to other*1082 preferred stock authorized and outstanding at the time. This difference, we believe for present purposes, is of no effect in the face of the rule governing these cases enunciated in Koshland v. Helvering,298 U.S. 441, and Helvering v. Gowran,302 U.S. 238, followed in Frank J. and Hubert Kelly Trust and hereinafter discussed.

*85 Frank J. and Hubert Kelly Trust, supra, held that the stock dividend there involved was, by statute, specifically exempt from taxation as a stock dividend (see Helvering v. Gowran, supra ); and the same is true with respect to the stock dividend here in question. (Sec. 115(f), Revenue Act of 1932.) Albeit the stock dividend is itself exempt from taxation, the question as to whether it is income (Koshland v. Helvering, supra, and Helvering v. Gowran, supra ) or a proliferation of capital (Eisner v. Macomber,252 U.S. 189) is still pertinent in order that the correct basis upon which gain or loss should be computed may be decided.

The determinative issue thus presented is whether the common stockholders*1083 received an interest substantially different in character or extent from that previously held, when they received as a stock dividend on their common stock the class B preferred stock of the same company, which was junior to other preferred stock already issued and outstanding. Frank J. and Hubert Kelly Trust, supra;Tillotson Manufacturing Co.,27 B.T.A. 913, 917; affd., 76 Fed.(2d) 189.

In our opinion there is no question but that the stock received possessed substantially different attributes from the common stock. The character of the stock on its face is different. Manifestly, common stock and junior preferred stock are not possessed of the same rights. See Fletcher's Cyclopedia of the Law of Private Corporations, vol. 11, sec. 5283, and Page's Annotated Ohio General Code, secs. 8667-8671. With particular reference to the stocks here in question, we have found that holders of the common stock had the exclusive right to stock dividends; that on dissolution they were entitled pro rata to the company assets after fixed priorities and accrued dividends on preferred stock had been met; that after the stock dividend in question, *1084 the class B preferred stockholders were entitled to dividends as and when declared at the fixed rate of 7 percent per annum, payable quarterly and cumulative; that holders of class B preferred stock on dissolution were to be paid $100 per share, plus accrued dividends, before pro rata distribution was made to holders of common stock; that class B preferred was at all times junior to the so-called class A preferred; that class B preferred could at any time be repurchased by the company at the fixed price of $100 per share; and that voting rights were exclusively in holders of the common stock, except that if any when class A preferred dividends were two years in arrears then holders thereof had voting rights.

It must readily be seen that the common stockholders of the American Envelope Co., by the 30 percent dividend in class B preferred stock, payable on their stock, received new and distinct rights of a class B preferred stockholder. They were given preference rights in future income not theretofore secured to them, as well *86 as fixed rights on dissolution or liquidation. (Magill, Taxable Income, p. 45 et seq.) Although there is the factual difference, hereinbefore mentioned, *1085 between the case at bar and Frank J. and Hubert Kelly Trust, supra, the distinctions there drawn between common and preferred stock are here apposite:

Petitioner's counsel contends that after the issuance of the preferred stock all of the stockholders were in exactly the same position as before. He points out that the interest each had through the ownership of common shares was thereafter represented in the same proportion by the common and preferred shares combined, and concludes that their position before and after the dividend was as similar as it was in Eisner v. Macomber, supra.With this, however, we are unable to agree. The preferred shares were nonvoting, entitled to 7% cumulative dividends, and preferred on dissolution. It has been stated that although generally the discretion of the directors as to the payment of dividends to common stockholders will not be interfered with by a court, "different rules apply with respect to the right of holders of preferred stock to invoke the aid of a court to order the declaration and payment of dividends on their stock." *1086 Cratty v. Peoria Law Library Association,219 Ill. 516; 76 N.E. 707, 708. If this be so, the preferred stock for this reason alone conferred upon the stockholders a new and different privilege. But entirely apart from this, the undeniable difference in the situation of the stockholders is that their interest, after the dividend, became to some extent transferable in parts where before it could be disposed of only as a whole. Before the dividend, it is true, a stockholder could have sold a portion of his common shares. But, as pointed out in the Macomber case, supra, p. 212, it is "in the nature of things impossible for one to dispose of any part of such an issue without a proportionate disturbance of the distribution of the entire capital stock." After the preferred stock was issued this was no longer true. Petitioner's donors, by transferring the preferred stock, as in fact they did, could then dispose of a part of their interest in the earnings and assets of the corporation without in any way disturbing the distribution of voting control. Or they could retain the preferred stock as representing a property interest and divest themselves*1087 of the powers of management. We find it impossible to conclude that this situation did not result in a substantial alteration of the interest of the stockholders. And the fact that, if they disposed of the dividend stock, their earnings from the corporation might be reduced is of no significance, since the same would be true in the event of a distribution in cash or in kind.

Petitioners contended as an alternative that the recapitalization of the American Envelope Co., attendant to the issuance of the class B preferred stock, was a "reorganization" of the company within the meaning of sections 112 and 113 of the Revenue Act of 1932. Such a contention is conclusively answered in Frank J. and Hubert Kelly Trust, supra. It is there said:

Finally, it is contended in a brief filed by amici curiae that apportionment of the basis is required by sections 112 and 113 of the Revenue Act of 1934, on the ground that the dividend stock was distributed pursuant to a reorganization, the definition of which includes recapitalization. The same argument was inferentially rejected in Pearl B. Brown, supra, p. 908. Whether or not the arrangement could have been considered*1088 a reorganization, it seems to us clear *87 that it was not made "in pursuance of a plan" as that term is used in section 112, at least in so far as this record shows. And, in any event, acceptance of this position requires us to assume that Helvering v. Gowran, supra, was erroneously decided. This we are unable to do.

The Kelly case likewise indicates the Board's position on the question relative to the applicability of section 113(b)(1)(D) of the Revenue Act of 1932 here injected by respondent. In that case we postponed a determination of the question until a case arises in which the disposition of the original stock is involved. We make the same ruling here.

The further issue relative to the capital or noncapital character of the gain arising from the sale of the stock received by petitioners as a stock dividend must be resolved in favor of respondent. We have held above that the stock dividend here in question is not a pure stock dividend within the case of Eisner v. Macomber, supra, and as such constitutionally exempt from tax. On the contrary, it is income. The holding period necessary to characterize it as capital*1089 gain is two years (sec. 101, Revenue Act of 1932), and as the Supreme Court has said in Helvering v. Gowran, supra, "In no sense can it [the dividend stock] be said to have been 'held' by Gowran prior to its declaration." The class B preferred stock here was sold in the same year in which the dividend was declared. The gain, therefore, is not a capital gain.

Decision will be entered under Rule 50.