Fred H. Lenway & Co. v. Commissioner

69 T.C. 620, 1978 U.S. Tax Ct. LEXIS 187

• Court: United States Tax Court
• Decided: January 30, 1978
• Docket: Docket No. 6370-74
• Status: Published

Opinions

Tannenwald, Judge:

Respondent determined a deficiency in petitioner’s Federal income tax for its fiscal year ended January 31,1968, in the amount of $115,705. This deficiency occurred as a result of the disallowance of an ordinary loss deduction claimed by petitioner for its fiscal year ended January 31, 1971, and carried back to its fiscal year ended January 31,1968.

The issue to be determined is the deductible character of certain losses sustained by petitioner during its fiscal year 1971.

FINDINGS OF FACT

Some facts have been stipulated and are so found.

Petitioner Fred H. Lenway & Co., Inc., is a California corporation with its principal place of business in San Francisco, Calif., at the time the petition herein was filed. At all times material herein, petitioner was engaged in a metal trading business covering both import and export. Southern California Chemical Co. (hereinafter referred to as SCC) is a California corporation engaged in the production of metallic chemicals. Since 1964, petitioner and SCC owned and operated as a joint venture a chemical and metallurgical plant in Ironton, Ohio (hereinafter referred to as the joint venture), specializing in reclaiming metals, especially molybdenum and tungsten, from residues and petroleum by-products.

The joint venture also owned a large amount of bulk bismuth catalyst and a bismuth smelter. The smelter was located at SCO’s place of business and was acquired for the purpose of extracting bismuth.

Since November 1966, the joint venture had a contract with General Electric Co. to convert tungsten residues into synthetic scheelite for delivery to the General Electric plant in Cleveland, Ohio. This business grew in volume and in 1968 the joint venture obtained a contract from General Electric to extract tungsten from approximately 10,000 tons of low-grade residues.

Due to the limited production capacity of the Ironton, Ohio, facility, the joint venture could only process approximately 1,000 tons of residues a year for General Electric. The joint venture therefore began to look for additional facilities to acquire for expansion purposes.

On September 1, 1968, petitioner acquired property on which was situated the only tin smelter in the United States. The property (hereinafter the Texas property) was located in Texas and included approximately 120 acres of land.

On February 17, 1969, petitioner and SCC organized the Gulf Chemical & Metallurgical Corp. (Gulf) under the laws of the State of Texas. The articles of incorporation provided for authorized capital of 1 million shares of $10 par value stock.

On March 21, 1969, pursuant to section 351,¹ petitioner and SCC transferred inventory consisting of bismuth-bearing catalysts and bismuth metal to Gulf in exchange for common stock as follows:

Petitioner SCC Total

Net equity .$236,095 $193,169 $429,264

Shares issued . 22,000 18,000 40,000

Percent ownership .55% 45% 100%

After Gulf’s incorporation, the joint venture transferred its bismuth smelting operation to Gulf and caused Gulf to take over the General Electric contract. All remaining operations of the joint venture continued to be carried out at its plant in Ironton, Ohio.

Gulf conducted its operations on the Texas property, which it leased from petitioner at a rental of $10,000 per month. The lease granted Gulf an option to purchase such property for $1 million cash. Both petitioner and SCC anticipated that Gulf’s operations would produce substantial profits during its first year of production.²

Some time prior to September 10, 1969, Associated Metals & Minerals Corp. (Associated) began investigating the possible acquisition of petitioner. Associated is one of the largest privately owned companies engaged in the business of international trading in ore and metals. It also operates miscellaneous manufacturing facilities in the United States and overseas. In the process of its investigation of petitioner, Associated became interested in participating in Gulf. As a result, a series of meetings among representatives of petitioner, Gulf, SCC, and Associated were held. The main purpose of the meetings, the first of which was held on September 10,1969, was to discuss the terms for the acquisition by Associated of a one-third interest in Gulf.

During the course of the negotiations and in anticipation of Associated acquiring a one-third interest in Gulf, Associated advanced to Gulf as loans during the months of September, October, and November 1969, a total of $1,200,000 which was evidenced by three promissory notes.

The negotiations culminated in a written contract as of February 1, 1970, among petitioner, SCC, Gulf, and Associated.

Because the contract contemplated the issuance of preferred and common stock to Associated by Gulf, the articles of incorporation of Gulf were amended on February 27, 1970, to increase the corporation’s authorized capital of 1 million shares of $10 par value stock to 1,020,000 shares consisting of 20,000 shares of $50 par value preferred stock and 1 million shares of $10 par value common stock.

On March 2,1970, the closing of the transaction contemplated by the contract took place in Galveston, Tex.

At the closing, pursuant to the terms of the contract, several transactions took place, including the following:

(1) Associated purchased from Gulf 20,000 shares of Gulf preferred stock for $1 million and 20,000 shares of Gulf common stock for $1 million. The $2 million purchase price was paid at the closing as follows:

Cancellation of the three promissory notes evidencing Gulf?s indebtedness to Associated .$1,200,000.00

Interest accrued on the above notes .32,499.90

Cash . 767,500.10

2,000,000.00

(2) Petitioner and SCC each transferred 4,000 shares of Gulf common stock to Gulf as a capital contribution.³

(3) Petitioner and SCC transferred to Gulf as a capital contribution all operating assets relating to the joint venture, including, but not limited to, the real property owned by them in Ironton, Ohio, together with all fixed assets located in the Ironton plant.

(4) SCC paid $125,000 to Gulf as a capital contribution.

(5) Petitioner sold the Texas property to Gulf for $610,000.

(6) Gulf granted to SCC and petitioner options to purchase 3,000 and 1,000 shares of Gulf common stock, respectively, at $50 per share.

(7) The contract contained certain representations and warranties by the parties, including a representation and warranty by petitioner and SCC to Associated that the net worth of Gulf as of June 30,1970, should not be less than $2,500,000. To secure compliance with such warranty and pursuant to the terms of the contract, petitioner delivered to Associated 18,000 shares of Gulf common stock and SCC delivered to Associated 14,000 shares of Gulf common stock.

The warranty provision in the contract, as amended, pertaining to Gulf’s net worth on June 30, 1970, provided in part as follows:

3.10 The net worth of Gulf as at June 30, 1970 shall be not less than $2,500,000, as determined by a certified audit * * * . In the event of the breach of this representation and warranty:

(a) If the net worth of Gulf as at said date is $2,400,000 or more, SCC and Lenway shall each, at the respective option of each, within thirty days after the delivery of the said certified audit, either contribute to Gulf one-half of the amount of the difference between the net worth as at June 30, 1970 and $2,500,000, or, failing so to do, its right to the return of 2000 Common Shares of Gulf under 8.1 below, and the option granted to it by Gulf under 8.2 below and all its rights thereunder shall thereupon cease, terminate and come to an end.

(b) If the net worth of Gulf is less than $2,400,000, then SCC and Lenway shall each, at the respective option of each, within thirty days after the delivery of said certified audit, each [sic] either contribute to Gulf one-half of the amount of the difference between the net worth as at June 30, 1970 and $2,500,000, or, failing so to do, its right to the return of 2000 Common Shares under 8.1 below and the option granted it by Gulf under 8.2 below, and all its rights thereunder shall thereupon cease, terminate and come to an end, and, in addition, it shall at its option either (i) pay to Gulf as a capital contribution one-half of each deficiency or (ii) transfer to Gulf sufficient of its Common Shares at the book value thereof as at June 30,1970 to equal for each one-half of the difference between the net worth of Gulf at June 30, 1970 and $2,500,000.[⁴]

Additionally, the contract expressly limited petitioner’s liability under such warranty as follows:

The liability of SCC and Lenway for breach of any representation, warranty or covenant contained in this Agreement is limited to their Common Shares of Gulf, and nothing herein contained shall impose any personal liability upon either SCC or Lenway, and in no event shall a deficiency or other money judgment be rendered against either of them by reason of any such breach.

The contract also contained the following provisions:

8. Further Covenants of Gulf

8.1 If as at December 31, 1970, 1971 or 1972, the net worth of Gulf as determined by Price Waterhouse & Co., or any other nationally recognized certified independent public accountants, is $3,000,000 or more, Gulf shall return 2000 Common Shares each to SCC and Lenway of the Common Shares contributed to Gulf by them under 5.4.

8.2 Gulf shall, on the Closing Date, grant SCC and Lenway options to purchase 3000 and 1000 Common Shares of Gulf, respectively, at $50 per share, which options, unless sooner terminated under 3.10 above, shall be exercisable by SCC and Lenway, respectively, until March 31,1975, and if either SCC or Lenway does not exercise its option in full by said date, the other may exercise the balance until April 30,1975.

On June 30, 1970, the net worth of Gulf was $1,625,981. Such amount was $874,019 less the $2,500,000 net worth warranted by petitioner and SCC pursuant to the contract.

In September 1970, petitioner was furnished a balance sheet which reflected a deficiency of $874,019 in the net worth of Gulf as at June 30,1970. Petitioner was financially able to obtain the $437,010 in order to make its required contribution to Gulf and thus retain its stock ownership, but elected not to do so.

OPINION

As a result of the transaction among petitioner, SCC, and Associated, petitioner’s stock interest in Gulf terminated in 1970. It claimed an ordinary loss based on “abandonment” in the amount of $254,518.⁵ Petitioner asserts that it is entitled to an ordinary loss under section 165(a) on the ground either (1) that there was no “sale” or “exchange,” with the result that the limitation of section 165(f) does not apply, or (2) that its Gulf stock was not a capital asset under the principles enunciated in Corn Products Co. v. Commissioner, 350 U.S. 46 (1955), or (3) the loss of the shares resulted from a guaranty designed to promote Gulf’s business “which contained what used to be an integral part of petitioner’s business” (petitioner’s opening brief, p. 31). Respondent disputes petitioner’s contentions and urges that petitioner’s loss should be treated as a capital loss. For the reasons which hereinafter appear, we agree with respondent.

We can readily dispose of petitioner’s contention that its stock in Gulf was not a capital asset. Aside from the fact that the record herein is devoid of any probative evidence that the operations of Gulf were so integrally related to petitioner’s operations as to bring it within the principles enunciated in Corn Products Co. v. Commissioner, supra, we are satisfied that petitioner had a substantial investment motive in acquiring and holding its Gulf stock. Consequently, Corn Products is inapplicable and the stock constituted a capital asset in petitioner’s hands. W. W. Windle Co. v. Commissioner, 65 T.C. 694 (1976), appeal dismissed 550 F.2d 48 (1st Cir. 1977).⁶

Greater difficulty is encountered in the resolution of petitioner’s other two contentions. In large measure, such resolution involves charting a path to decision which takes into account the potential impact of several lines of cases dealing with issues comparable to those involved herein: (a) the loss of collateral given to secure a nonrecourse obligation (e.g., Millar v. Commissioner, 67 T.C. 656 (1977); Fox v. Commissioner, 61 T.C. 704, 714-715 and n. 7 (1974)); (b) fulfillment of guaranty obligations upon the termination of a taxpayer-shareholder’s relationship with a corporation (e.g., Federal Bulk Carriers, Inc. v. Commissioner, 558 F.2d 128 (2d Cir. 1977), affg. 66 T.C. 283 (1976); United States v. Keeler, 308 F.2d 424, 432-434 (9th Cir. 1962); Siple v. Commissioner, 54 T.C. 1 (1970); Santa Anita Consolidated, Inc. v. Commissioner, 50 T.C. 536 (1968)); and (c) the transfer of shares by a shareholder where the benefits flowing therefrom inure directly to the corporation and only indirectly to the shareholder (e.g., Smith v. Commissioner, 66 T.C. 622, 647-650 (1976); Downer v. Commissioner, 48 T.C. 86 (1967)). Admittedly, the parties herein have not adopted such a broad perspective of the issues requiring resolution, but we are satisfied that such a perspective is appropriate if we are to dispose of these issues consistent with the view of the Ninth Circuit expressed in United States v. Keeler, supra at 434, that, in situations of this kind, the ultimate determination should be made “with reference not to hard and fast rules, but to the facts developed in each particular case.” In short, the transaction should be viewed as a whole. See Siple v. Commissioner, supra at 10.

Turning now to the specifics of the transaction among petitioner, SCC, and Associated, it is clear that the warranty of Gulf's net worth at $2,500,000 as of June 30, 1970, was induced only in part by petitioner’s hope for enhancement in the value of the Gulf shares which it retained — an element that, standing alone, might well be insufficient to preclude an ordinary loss deduction (see cases collected in Smith v. Commissioner, supra, and Downer v. Commissioner, supra). But there were further inducements to petitioner, not only in the form of the sale of its Texas plant facility to Gulf at a profit, which it properly reported as a capital gain,⁷ but, more significantly, the right to the return of 2,000 of the shares petitioner contributed to Gulf, in the event that the net worth of Gulf was $3 million or more on December 31, 1970, 1971, or 1972, and an option to acquire an additional 1,000 shares (or 4,000 shares if SCC did not exercise the option given to it with respect to 3,000 shares) at $50 per share effective until March 31 (or April 30), 1975, unless sooner terminated because of the warranty provision. Insofar as the instant case is concerned, the essence of the transaction reflects the receipt by petitioner of contingent rights to increase its shareholder position in Gulf as the quid pro quo⁸ for a contingent obligation to transfer additional shares to Gulf, the implementation of which obligation would result in a reduction (and, as it turned out, the elimination) of that position. Presumably, these contingent rights and obligations were equal in value. Cf. United States v. Davis, 370 U.S. 65 (1962); Downer v. Commissioner, supra.

We think that, properly viewed, the transaction had its origin in the 1970 agreement among petitioner, SCC, and Associated and that the implementation of the warranty undertaking should not be considered as a transaction separate from that agreement. Such a view justifies the conclusion that petitioner bargained for benefits for its undertakings to transfer its shares in Gulf, both initially and by way of implementation of the warranty which it gave, and that it should be considered as having agreed to transfer its Gulf stock in exchange for such benefits. Cf. Gawler v. Commissioner, 60 T.C. 647 (1973), affd. per curiam 504 F.2d 425 (4th Cir. 1974); sec. 1234. The facts that the implementation of the undertaking came at a later date and resulted in a termination of petitioner’s interest do not require a different conclusion. Cf. Arrowsmith v. Commissioner, 344 U.S. 6 (1952); see Siple v. Commissioner, supra at 11. The benefits inuring to petitioner were much more distinct and capable of measurement than was the situation in Smith v. Commissioner, supra. And clearly they created a situation quite different from that involved in deciding the tax treatment to be accorded an owner of property who allows it to be used to satisfy a nonrecourse obligation which it secures, such as existed in Fox v. Commissioner, supra; Stokes v. Commissioner, 124 F.2d 335 (3d Cir. 1941); Polin v. Commissioner, 114 F.2d 174 (3d Cir. 1940); and Jamison v. Commissioner, 8 T.C. 173 (1947), heavily relied upon by petitioner.⁹ Similarly, these benefits go beyond the cases involving mere enhancement in value of a taxpayer’s retained investment and make it unnecessary for us to elaborate on the distinction between stock surrendered to the issuing corporation and stock transferred to a third party.¹⁰ See Downer v. Commissioner, supra at 91-92.

We are satisfied that, in the foregoing context, the arrangements among petitioner, SCC, and Associated “from start to finish were the embodiment of a capital transaction.” See Siple v. Commissioner, supra at 10. Accordingly, on the facts herein, the transaction falls more within the ambit of Federal Bulk Carriers, Inc. v. Commissioner, supra; United States v. Keeler, supra; Siple v. Commissioner, supra; and Downer v. Commissioner, supra, than of Fox v. Commissioner, supra; Smith v. Commissioner, supra; and Santa Anita Consolidated, Inc. v. Commissioner, supra. Such being the case, petitioner’s entire loss is a capital loss.

Decision will be entered for the respondent.

Reviewed by the Court.

Scott, J., dissents.

1 Unless otherwise indicated, all statutory references are to the Internal Revenue Code of 1954, as amended and in effect during the taxable period of issue.

2 However, Gulf was neither a source of supply nor a customer of petitioner. In fact, petitioner listed its Gulf stock as an investment on its books and Federal income tax returns.

3 The certificates representing the 8,000 shares so contributed to Gulf by petitioner and SCC were subsequently canceled by Gulf on Mar. 2,1970, leaving the following shares issued and outstanding at that time:

Common Preferred

Petitioner .18,000

SCC .14,000

Associated . 20,000 20,000

Total .52,000 20,000

4 If one of the two corporations elected not to contribute one-half of such difference to Gulf, the other could contribute the full amount of such difference and receive a commensurate amount of Gulf stock from the noncontributing corporation.

5 The parties have stipulated that this is the measure of petitioner’s loss, although the record does not reveal how this amount can be correlated with the figure of $236,095 shown on petitioner’s tax return for the fiscal year ending Jan. 31,1971, as its investment in Gulf as of the beginning of such year. It is also not clear from the record whether petitioner’s claimed loss is limited to the 18,000 shares “abandoned" or includes the 4,000 shares contributed by petitioner to Gulf pursuant to the agreement with Associated. However, the parties have not made any argument relating to this point, and, in any event, it is without significance in view of the rationale for decision herein.

6 See also Bell Fibre Products Corp. v. Commissioner, T.C. Memo. 1977-42.

7 Petitioner’s return for the fiscal year ended Jan. 31,1971, showed an original cost of $766,550, less depreciation of $190,250, and a selling price of $610,000, or a profit of $33,700. The record contains two appraisals of the facility antedating petitioner’s acquisition which indicate a fair market value substantially in excess of what petitioner paid and, ergo, substantially in excess of what it received on the sale of Gulf. But these appraisals were offered and received in evidence only for the purpose of showing that they were taken into account in the bargaining among petitioner, SCC, and Associated and not as evidence of value as such in early 1970.

8 We think this inducing impact existed irrespective of whether petitioner and SCC, on the one hand, or Associated, on the other, wanted the March 1970 agreement. In this connection, we note that there is some evidence that the provision for the warranty of Gulf’s net worth on the down side was generated by a demand by petitioner and/or SCC for an option to acquire additional shares if the hoped-for success of Gulf’s operations had come to pass.

9 It is arguable whether these cases continue to have their original vitality in light of the subsequent decision of the Supreme Court in Crane v. Commissioner, 331 U.S. 1 (1947). See Millar v. Commissioner, 67 T.C. 656, 660-661 (1977). Cf. Russo v. Commissioner, 68 T.C. 135 (1977). But see Fox v. Commissioner, 61 T.C. 704, 715 n. 7 (1974), a case which involved an unusual set of circumstances.

10 Petitioner transferred 18,000 shares to Associated as collateral for its warranty of net worth. The record is not clear as to whether, when petitioner decided to use these shares to implement its warranty obligation, the shares were retained by Associated or tranferred to Gulf in accordance with the provisions of the 1970 agreement that, under such circumstances, petitioner’s obligation was to transfer the shares to Gulf, but, under our rationale herein, such lack of clarity is not significant.