Opinion ID: 272737
Heading Depth: 1
Heading Rank: 3

Heading: Basis for Depreciation of Machinery

Text: 25 Spencer appeals from the district court's decision accepting the basis for depreciation set by the Commissioner for machinery transferred from Spencer's predecessor in 1952. The Commissioner disallowed $30,442.46 in depreciation for the tax year ending June 30, 1953, on the ground that Spencer was limited to the adjusted basis of the machinery in its predecessor's hands ($215,304.80) because the machinery had been transferred as part of a tax free transaction under Section 112(b) (4) and (b) (5). 6 Spencer contends that the proper basis is its cost ($381,112.83) and that the depreciation was improperly disallowed. A detailed statement of facts is necessary to show why we disagree with the district court. 26 The predecessor had been formed in 1919 under the name of Spencer, White & Prentis, Inc. (Old Spencer) to engage in construction and civil engineering. By 1952, the founders of this successful business wished to allow their younger associates to acquire the business and its name, but to provide the new blood with a smaller stake (lower capitalization) for the risky construction business than that possessed by Old Spencer. 27 In June 1952 Old Spencer reorganized. A new company having the name Spencer, White & Prentis, Inc. (New Spencer), was formed with the following authorized capital structure: 28 Authorized Capital ............ $1,100,000 4% cumulative participating (to the extent of 15% of net profits after income taxes) preferred stock — 100,000 shares per value $10 .............. 1,000,000 Common stock Class A — 300 shares per value $100 ....................... 30,000 Common stock Class B — 700 shares per value $100 ....................... 70,000 29 At the same time, Old Spencer changed its name to Edmund A. Prentis, Lazarus White, Charles B. Spencer, Inc. 30 On June 16, 1952, New Spencer transferred 16,020 shares of preferred stock to Old Spencer in exchange for $160,200 cash; 300 shares of New Spencer's Class A common were also transferred for $14,802.18 cash, $5,800 in furniture and fixtures, and $9,397.82 in prepaid insurance. On June 26, New Spencer transferred $50,000 in cash and its promissory note for $331,112.83 to Old Spencer in exchange for the old company's plant and equipment. These assets had been valued by a group of the younger employees, and Judge Levet found that this valuation was fair. The transaction took the form of a sale conditioned upon payment of the six-month interest-bearing promissory note. 7 The net effect of these transactions (including those referred to in footnote 7 supra) was as follows: 31 Old Spencer Received 16,020 shares preferred stock ...................... $160,200 300 shares Class A common stock ...................... 30,000 Two promissory notes ......... 407,862.83 ___________ $598,062.83 New Spencer Received Furniture, fixtures and pre-paid insurance ......... $ 15,197.82 Plant and equipment .......... 381,112.83 250 shares, Drilled-In-Caisson stock ...................... 101,750 Cash ......................... 100,002.18 ___________ $598,062.83 32 The promissory note was paid on January 7, 1953. 8 On the next day, 620 shares of New Spencer's Class B common were issued to ten employees who had also worked for Old Spencer. (By March 1, 1954, the remaining 80 authorized Class B shares had been issued to three other employees.) 33 After the reorganization, New Spencer took up the jobs in progress and the construction business of the old company, and the new blood was gradually worked into the top levels of management. Old Spencer remained in existence, but it did no construction work. It retained a valuable New York state license to practice engineering, and its business was shifted to engineering consulting under this license. Such consulting, which New Spencer is not licensed to undertake, is practiced by Old Spencer today. 34 The two companies filed a consolidated tax return for the taxable year ending June 30, 1953. Claiming that Old Spencer's sale of the machinery was a taxable transaction separate from the formation of New Spencer, the group paid a capital gain for Old Spencer on this sale, and based New Spencer's depreciation deduction for the machinery upon a stepped-up basis of $381,112.83. 35 The Commissioner disallowed part of New Spencer's depreciation on the ground that the various transactions of June 1952 were part of a unified plan of reorganization; that the entire plan, and hence each of its steps, was tax free under Sections 112(b) (4) and (b) (5); and that New Spencer therefore had a carryover basis on the machinery under Section 113(a) (7) or (a) (8). 36 Judge Levet agreed with the Commissioner. He found that Old Spencer wholly owned New Spencer up until January 1953 and that the old company remained in control through all of 1953, see Section 112(h). He then concluded that the intent of the parties, timing, ultimate result and mutual interdependence of the transactions of June 1952 were such that the machinery sale was a step in a unified reorganization of Old Spencer qualifying under Section 112(b) (4) or a unified incorporation of New Spencer qualifying under Section 112(b) (5). Finally, he held that the six months promissory note was a security within the meaning of Sections 112(b) (4) and (b) (5) and thus that there was no gain recognized by Old Spencer on the transaction under Section 112(c) (1) or Section 112(d) (2). From these conclusions, it followed that New Spencer's basis for depreciation of the machinery equalled Old Spencer's adjusted basis, Sections 113(a) (7) and (a) (8). Compare Portland Oil Co. v. Commissioner of Internal Revenue, 109 F.2d 479 (1 Cir.), cert. denied, 310 U.S. 650, 60 S.Ct. 1100, 84 L.Ed. 1416 (1940). 37 Our discussion of this complex question will proceed upon the following hypothesis: the judgment below can be affirmed only if all the following questions are answered in the Commissioner's favor. (A) Were the transactions of June 1952 properly viewed as steps in a unified plan? (B) Did taxpayers fail to establish that the promissory note received in exchange for Old Spencer's plant and machinery was not a security? If the note was other property, did taxpayers establish that they realized gain on the unified transaction? (C) Assuming a unified plan of reorganization, and regardless of the status of the promissory note, was the plan properly placed within the coverage of Sections 112(b) (4) and (b) (5)? In light of our answers to (B) and (C), this issue must be remanded for further proceedings.
38 Taxpayers contend that the transaction of June 26, 1952, was an independent sale of Old Spencer's plant and equipment to New Spencer in which the latter's basis became its cost. However, we agree with Judge Levet that the New Spencer-Old Spencer transactions of June 1952 were steps in a unified scheme. The test for determining this question was most succinctly stated by the Tax Court in American Bantam Car Co., 11 T.C. 397, 405 (1948), aff'd per curiam, 177 F.2d 513 (3 Cir. 1949), cert. denied, 339 U.S. 920, 70 S.Ct. 622, 94 L.Ed. 1344 (1950): 39 Were the steps so interdependent that the legal relations created by one transaction would have been fruitless without a completion of the series? 40 See Commissioner of Internal Revenue v. National Bellas Hess, Inc., 220 F.2d 415 (8 Cir. 1955); ACF-Brill Motors Co. v. Commissioner of Internal Revenue, 189 F.2d 704 (3 Cir.), cert. denied, 342 U.S. 886, 72 S.Ct. 176, 96 L.Ed. 665 (1951). 41 The issuance of New Spencer preferred and Class A common to Old Spencer, and the sale of Old Spencer's operating assets to New Spencer, were clearly parts of a basic plan to form a new corporation to take over the construction business. The plan contemplated the transfer of Old Spencer's good will, operating assets, and sufficient cash to continue operations to the new company. Old Spencer would remain only in the consulting business and would receive from New Spencer preferred stock and a promissory note, rather than all common stock, so that the new blood could eventually acquire 70% ownership of the new company. Under these circumstances, it should be immaterial for tax purposes that the parties accomplished their goals by means of two or three transactions in June of 1952 instead of one. We consider Judge Levet's finding of a unified scheme unassailable. Compare Hartford-Empire Co. v. Commissioner of Internal Revenue, 137 F.2d 540 (2 Cir.), cert. denied, 320 U.S. 787, 64 S.Ct. 196, 88 L.Ed. 473 (1943).
42 Viewing the June 1952 transactions as a unit, they fall within the general definition of a Section 112(b) (5) tax free transfer since Old Spencer was in complete control of New Spencer at the end of June 1952. In addition, the plan was obviously a D reorganization, Section 112(g) (1) (D), and hence tax free under Section 112(b) (4). But a further question is whether Old Spencer recognized gain on this plan, since Sections 113(a) (7) and (a) (8) permit a stepped-up basis to the extent of gain recognized. 43 No gain is recognized under Sections 112(b) (4) and (b) (5) only if the transferor corporation (Old Spencer) received solely    stock or securities of the transferee. If other property, or boot was received, gain if proven would be recognized to Old Spencer under Section 112(c) (1) or Section 112(d) (2), to the extent of such other property. An examination of the net assets received by Old Spencer in the June transactions, page 533 supra, reveals that it received preferred stock and Class A Common, which are clearly securities, and the promissory note of $331,112.83 (the disputed second note will be disregarded). Taxpayers contend that Judge Levet wrongly classified this note as a security and that Old Spencer could therefore recognize gain to the extent of some $331,000. On this record, we agree. 44 In a long line of cases, it has been held that the term securities in Section 112(b) (4) does not include short term bonds and notes. See, e. g., LeTulle v. Scofield, 308 U.S. 415, 60 S.Ct. 313, 84 L.Ed. 355 (1940); Pinellas Ice & Storage Co. v. Commissioner of Internal Revenue, 287 U.S. 462, 53 S.Ct. 257, 77 L.Ed. 428 (1933); Cortland Specialty Co. v. Commissioner of Internal Revenue, 60 F.2d 937 (2 Cir. 1932), cert. denied, 288 U.S. 599, 53 S.Ct. 316, 77 L.Ed. 975 (1933); Roebling v. Commissioner of Internal Revenue, 143 F.2d 810 (3 Cir.), cert. denied, 323 U.S. 773, 65 S.Ct. 131, 89 L.Ed. 618 (1944). This construction was adopted to insure that tax free status was only conferred upon transactions in which a meaningful continuity of ownership interest existed. See Helvering v. Minnesota Tea Co., 296 U.S. 378, 56 S.Ct. 269, 80 L.Ed. 284 (1935). 45 The question here is somewhat different because the entire transaction admittedly possessed sufficient continuity to qualify as tax free, and therefore whether the short term note is other property only affects the extent to which some gain may be immediately recognized. However, the same word securities is at issue in both situations, and this court has held that notes which do not meet the continuity test of Pinellas and LeTulle are not securities within the meaning of Section 112(b) (5). Lloyd-Smith v. Commissioner of Internal Revenue, 116 F.2d 642, cert. denied, 313 U.S. 588, 61 S.Ct. 1111, 85 L.Ed. 1543 (1941). The same approach was adopted sub silentio by the Fifth Circuit in Camp Wolters Enterprises v. Commissioner of Internal Revenue, 230 F.2d 555, cert. denied, 352 U.S. 826, 77 S.Ct. 39, 1 L.Ed. 2d 49 (1956), despite a contrary argument by the Commissioner, see 230 F.2d p. 558, n. 3. And, like this case, Camp Wolters involved the ultimate question of the basis of assets transferred. We conclude that the note received by Old Spencer must be examined to determine whether it meets the Pinellas definition of a security. See Pacific Public Serv. Co. v. Commissioner of Internal Revenue, 154 F.2d 713 (9 Cir. 1946). 46 The Tax Court summarized the test to be applied in determining whether a particular note is a security in the Camp Wolters case: 47 The test as to whether notes are securities is not a mechanical determination of the time period of the note. Though time is an important factor, the controlling consideration is an overall evaluation of the nature of the debt, degree of participation and continuing interest in the business, the extent of proprietary interest compared with the similarity of the note to a cash payment, the purpose of the advances, etc. 22 T.C. 737, 751 (1954). 48 Judge Levet in applying this test, concluded that, Here, there is no doubt that an overall evaluation of the transactions of June 1952 yield[s] the conclusion that the promissory note given by the New Company to the Old Company was a security within the meaning of Sections 112 (b) (4) and (b) (5). 49 Although the Class A common and the preferred stock received by Old Spencer were securities, New Spencer's note must be independently analyzed. The record reveals that the note was for a short term (six months), and that it was paid by the New Company's check on January 7, 1953. An extremely short term note such as this which is paid nearly on time does not confer any proprietary interest on its holder in most situations. For this reason, this court has held that considerably longer termed notes were not securities. Lloyd-Smith v. Commissioner of Internal Revenue, supra (two years); L. & E. Stirn, Inc. v. Commissioner of Internal Revenue, 2 Cir., 107 F.2d 390 (1939) (one to five years, paid in ten months). Given the bona fide intent of the owners of Old Spencer to reduce their equity holding in New Spencer, we cannot accept on so slight a record the assertion that the promissory note in question thwarted this intent by adding to Old Spencer's securities holding and equity interest in the new company. 50 The government in its brief on appeal does not attempt to support Judge Levet's ruling that the promissory note was a security. Instead, it urges us to affirm on the ground that the taxpayers have not sustained their burden of showing that Old Spencer in fact incurred a taxable gain on the transfer of its machinery. In theory the government's argument is of course sound because taxpayers must establish both the existence of boot to enable recognition, and the fact of gain on the transfer, before a stepped-up basis is permitted under Sections 113 (a) (7) and (a) (8). See Camp Wolters Enterprises, supra. But here the contention is unworthy of detailed consideration. Among other things, the government attempts to establish the lack of a gain through computations which ignore the inconsistency pointed out in footnote 7 supra. Moreover, the government asserts that no value was proven for New Spencer's stock whereas it was stipulated that the preferred was issued for cash. We think the taxpayers put in enough evidence below to warrant the conclusion that at least some gain was realized by Old Spencer. 51 Therefore, on the facts before us, we would conclude that the promissory note received by Old Spencer was not a security, and that the case must be remanded to determine the amount of gain properly recognized by Old Spencer and the concomitant step-up properly allocable to New Spencer's basis. But in remanding the case, we do not preclude the government from reopening the question of whether the promissory note should be classed as a security. As we noted in footnote 8 supra, the record indicates that New Spencer issued $350,000 in preferred stock to Old Spencer on January 7, 1953. If this stock issuance was in substance a part of the redemption of the promissory note, then the question of whether the note was a security may take on a new light. 9 Under these circumstances, in remanding this part of the case, we do not foreclose further consideration of this issue.
52 Unfortunately, the foregoing are not the only problems which may appear on remand, for another legal issue is left open by this incomplete record. The Commissioner asserted, and Judge Levet held, that the transactions of June 1952 were part of a unified scheme. But the scheme as identified by all included the transfer of significant equity ownership of the new company to various younger employees of the old. This transfer of control seems an essential part of the overall plan, indeed, a part without which the transactions of June 1952 no doubt would not have taken place. 53 No stock was issued to employees until January 8, 1953, when 620 shares of New Spencer's Class B common were issued to ten employees. Eighty more shares were issued over the next 26 months. Although there was a seven-month delay and more from the incorporation of New Spencer, the delay was logically explained by the taxpayers' attorney: 54 So when they actually sat down to decide, in the plan as it actually developed, who was going to get stock in the new company and how much stock they were going to get in the new company, for a great many of the men there was no question about it at all, but there was a question of how deep you wanted to go with the plan and how much you wanted each of the juniors to have    While these matters were being worked out, time slipped by. The plan itself was never doubted at all. 55 Under these circumstances, we think it can be seriously argued that the issuance of at least the first group of Class B shares should be considered as part of the unified scheme. The cases indicate that a substantial time lapse will lessen the likelihood that independent transactions will be unified, see American Bantam Car Co., supra; Schmieg, Hungate & Kotzian, Inc., 27 B.T.A. 337 (1932), but no case has placed a flat time limit on the unified plan doctrine. In this case, seven months is not a long delay in such a corporate reorganization. And the mutual interdependence of this phase seems clear. We conclude that the facts before us support an inference that the lower court took too restrictive a view of the scope of the plan in question. 56 If the issuance of some or all of the 700 shares of Class B common is unified with the June 1952 transactions, it cannot be determined on this record whether the plan falls within the definition of a tax free transfer under either 112(b) (4) or (b) (5). Of course, if the machinery transfer was not tax free, then New Spencer would be entitled to a stepped-up basis on the machinery. 57 Whether the requirements of Section 112(b) (4) would be met turns on whether the expanded plan was a reorganization within the meaning of Section 112 (g) (1). It would only be a C reorganization if Old Spencer had transferred substantially all its assets to New Spencer, which seems open to question in light of the retained engineering license. To qualify as a D reorganization, Old Spencer or its shareholders or both must be in control of New Spencer immediately after the transfer. Control is defined in Section 112 (h) as the possession of at least 80 per centum of the total combined voting power of all classes of stock entitled to vote. It appears from the exhibits that 455 of the first 620 shares of Class B shares were issued to shareholders of Old Spencer. Recipients of the final 80 shares owned no stock in the old company. Assuming that the Class A and Class B common are both voting shares, and that a share of each has the same voting power in New Spencer, facts which cannot be determined on this record, then Old Spencer and its shareholders controlled New Spencer if only the first 620 shares of Class B and all the Class A are included in the 80% computation. If the final 80 shares of Class B are included, control did not lie in Old Spencer and the unified plan failed to qualify under Section 112(b) (4). 58 The question whether the requirements of Section 112(b) (5) would be satisfied under this view of the unified plan is equally difficult. This section requires that one or more persons be in control of New Spencer after the transfers. Since all the Class B shareholders were in the category persons, the control provision here is obviously satisfied. See Von's Inv. Co. v. Commissioner of Internal Revenue, 92 F.2d 861 (9 Cir. 1937). But inclusion of the Class B holders brings into question the proviso to 112(b) (5) which stated: 59 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. 60 Because the record fails to reveal what property the Class B shareholders transferred to New Spencer, we cannot decide whether this proviso was satisfied. However, even assuming that the Class B holders transferred property commensurate in value to the stock they received, we note that there remains the question whether the note received by Old Spencer created a disproportion which takes the transfer out of 112(b) (5). This question is apparently one of first impression. 61 The proviso caused such disagreement and confusion during its existence that the Court of Appeals could not agree even on a formula to apply in determining the relative degree of disproportion. Compare Hawaiian Freight Forwarders, Ltd. v. Commissioner of Internal Revenue, 196 F.2d 745 (9 Cir. 1952); L. W. Tilden, Inc. v. Commissioner of Internal Revenue, 192 F.2d 704 (5 Cir. 1951); Mather & Co. v. Commissioner of Internal Revenue, 171 F.2d 864 (3 Cir.), cert. denied, 337 U.S. 907, 69 S.Ct. 1049, 93 L.Ed. 1719 (1949); Bodell v. Commissioner of Internal Revenue, 154 F.2d 407 (1 Cir. 1946); Budd International Corp. v. Commissioner of Internal Revenue, 143 F.2d 784 (3 Cir.), cert. denied, 323 U.S. 802, 65 S.Ct. 562, 89 L.Ed. 640 (1944); United Carbon Co. v. Commissioner of Internal Revenue, 90 F.2d 43 (4 Cir. 1937). The proviso was eliminated in 1954 when Section 112(b) (5) was recodified as Section 351 of the Internal Revenue Code of 1954, the legislative history explaining that the proportion test had created more uncertainty and confusion than it was worth. See H. R. Rep. No. 1337, 83d Cong., 2nd Sess. (1954), 3 U.S.Code Cong. and Admin.News 1954, pp. 4025, 4065, 4254-4255. 62 Thus, we have little guidance with respect to this proviso's proper interpretation. Its literal language, when combined with the parties' intent to shift equity interest to the new blood, seems to imply that Old Spencer's receipt of the note created a disproportion in the stock and securities received by each of the transferors. However, the decision may well hinge on whether the note received by Old Spencer was a security. Under these circumstances, we think the parties should be given an opportunity to focus the relevant facts and arguments on remand. Compare Blair v. Commissioner of Internal Revenue, 91 F.2d 992 (2 Cir. 1937); Bell v. Commissioner of Internal Revenue, 139 F.2d 147 (3 Cir. 1943).