Court Opinion

ID: 4607647
Source: CourtListenerOpinion
Date Created: 2020-11-20 19:41:06.484973+00
Date Added: 2024-06-11T07:53:34.006796
License: Public Domain

M. W. Ellis, Petitioner, v. Commissioner of Internal Revenue, Respondent.  Mina W. Ellis, Petitioner, v. Commissioner of Internal Revenue, RespondentEllis v. CommissionerDocket Nos. 111595, 111596United States Tax Court3 T.C. 106; 1944 U.S. Tax Ct. LEXIS 213; January 24, 1944, Promulgated *213 Decisions will be entered under Rule 50.  Held, that certain "conditional rights certificates" were not "evidence of indebtedness" under section 117 (f), I. R. C., and that sums received by taxpayers upon surrender of such certificates were taxable as ordinary income, not as long term capital gain.  Leland W. Scott, Esq., for the petitioners.Edward C. Adams, Esq., for the respondent.  Van Fossan, Judge.  Murdock and Smith, JJ., dissent.  Black, J., concurring.  Leech, Disney, and Kern, JJ., agree with the concurring opinion.  VAN FOSSAN *106  The respondent determined deficiencies in income tax for the year 1940 in the sum of $ 4,307.61 against M. W. Ellis and $ 4,478.39 against Mina W. Ellis.  An issue involving the deduction of $ 1,817.24 by petitioner M. W. Ellis for ordinary and necessary business expense has been stipulated by the parties and will be settled under Rule 50.The sole issue now in controversy is whether a corporate distribution received by each of the petitioners in 1940 constituted the receipt of ordinary income, taxable in its entirety, or whether it constituted the receipt by each petitioner of a capital gain.FINDINGS OF FACT. *214  The facts were stipulated and as so stipulated are adopted as findings of fact.  In so far as material to the issue presented, the facts are as follows:The petitioners are residents of Charles City, Iowa, and filed their Federal income tax returns for the year 1940 with the collector of internal revenue for the district of Iowa.Oliver Farm Equipment Co., hereinafter called the company, is a corporation organized under the laws of Delaware on February 13, 1929.  On January 14, 1931, the total authorized shares of stock were 3,050,000, divided into three classes: 300,000 shares of prior preferred stock, 750,000 of convertible participating stock, and 2,000,000 of common stock. The convertible participating stock was a preferred stock, the holders of which were entitled to cumulative quarterly dividends at the rate of $ 3 per annum before any dividend could be declared on common stock.On January 15, 1931, the certificate of incorporation was amended so that the total authorized shares of the company were 1,550,000, all without par value, divided into 300,000 shares of prior preferred and 1,250,000 shares of common stock. Pursuant to this amendment, each share of the company's convertible*215  participating stock issued and outstanding was converted into one share of new common stock and each share of old common stock was converted into one-fourth share of new *107  common stock. Certificates representing the new stock were issued and the old stock surrendered.On January 15, 1931, unpaid dividends of $ 1.62 1/2 per share had accumulated on the convertible participating stock.On January 14, 1931, a resolution was passed by the board of directors providing as follows:Resolved, that this Corporation shall recognize the right of the holders of the Convertible Participating Stock as indicated in the said certified list, to receive from this Corporation the sum of $ 1.62 1/2 a share, being an amount equivalent to the unpaid dividend accumulated on the said stock to January 15, 1931, if any dividend is declared and set aside on the Common Stock of this Corporation.Resolved, that the recognition of the said right shall in no way obligate this Board at any time to declare or set aside a dividend on the Common Stock of this Corporation, and that the right of the said holders of the Convertible Participating Stock (and the right of any assignee of any such holder) to receive*216  such amount shall not constitute a debt of or claim against this Corporation unless and until a dividend is declared upon its Common Stock.* * * *Pursuant to this resolution, certificates evidencing this right, hereinafter called conditional rights certificates, were issued to the holders of record of the convertible participating stock. These conditional rights certificates were in the following form:No. 5408Representing Conditional Rights Upon     SharesOliver Farm Equipment CompanyIncorporated under the laws of the State of DelawareThis Certifies that     or registered assigns, shall be entitled to receive from Oliver Farm Equipment Company (Hereinafter called the "Company"), if and when any dividend shall be declared and set aside by the Company upon its Common Stock, an amount equivalent to the dividendaccrued upon     shares of the Convertible Participating Stock of the Company to and including January 15, 1931 (the date of the filing and recording of the Certificate of Amendment to the Certificate of Incorporation of the Company whereby each share of the said Convertible Participating Stock was reclassified into one share of the Common Stock of the*217  Company), being the sum of One Dollar Sixty-two and one-half Cents ($ 1.62 1/2) on each of the said shares.  This Certificate does not represent a debt of or claim against the Company, unless and until it shall declare and set aside a dividend upon its Common Stock, and the Board of Directors of the Company is not and shall not be under any obligation at any time to declare any dividend upon such Common Stock.This certificate and all the conditional rights and interest of the holder hereof hereunder may be transferred of record upon surrender hereof, duly indorsed for transfer, to the Transfer Agent hereinafter named, at its principal office in the Borough of Manhattan, in The City of New York, State of New York.  If and when any payment shall be made hereunder, only the then record owner *108  hereof upon the records of the said Transfer Agent shall be entitled to receive the same.The registered owner of this certificate shall not be entitled to any of the rights of a stockholder. This certificate is not valid until countersigned by the Transfer Agent.Oliver Farm Equipment Company,By T. A. Freeman, SecretaryCountersigned for identification:City Bank Farmers Trust*218  Company,(New York)Transfer Agent,By D. E. HewittAuthorized OfficerDated    At the same time a letter, signed by the president of the company, was addressed to the holders of the convertible participating stock. It contained the following material statement:Under the laws of Delaware, the holders of the Convertible Participating Stock of record at the close of business on the date of the filing of the aforesaid amendment to the Certificate of Incorporation, on January 15, 1931, had a vested right to receive an amount equivalent to the dividend accrued and unpaid on such stock to and including such date, if and when any dividend shall be declared and set aside on the Common Stock of the Company.  The Board of Directors has authorized the issue of certificates to the holders of Convertible Participating Stock of record as of January 15, 1931, evidencing this conditional right, which do not in any respect constitute a claim against or a debt of the Company unless and until a dividend is declared and set aside on its Common Stock. The total amount of such accumulated dividend is $ 1.62 1/2 per share of the old Convertible Participating Stock.A certificate representing*219  the conditional right upon the Convertible Participating Stock registered in your name as of January 15, 1931, is enclosed.  This certificate is transferable on the books of the Transfer Agent, City Bank Farmers Trust Company, and the transferee will succeed to all the rights of his transferor therein.* * * *This letter, together with conditional rights certificates representing the number of shares held, was mailed to each of the holders of the convertible participating stock. The company's board of directors took no further action respecting the accumulated dividends on the convertible participating stock on or prior to January 14, 1931.Petitioner M. W. Ellis had been a holder of the company's convertible participating stock, and in 1931 he received 14,600 of these conditional rights certificates pursuant to the action of the company's board of directors described above.  On August 31, 1936, he received 292 additional conditional rights certificates as a distribution from City Bank Farmers Trust Co., trustee under a trust agreement created by the petitioner's father, C. D. Ellis, during the latter's lifetime.  C. D. Ellis died in 1933 and these conditional rights certificates*220  were included in his gross estate for Federal estate tax purposes at no value.*109  Petitioner Mina W. Ellis acquired 18,380 conditional rights certificates for the year 1931 pursuant to the action of the board of directors. Neither petitioner included these certificates in gross income for Federal income tax purposes in the year in which they were acquired.The company had sufficient earnings in 1940 from which to pay in full all of said certificates issued and outstanding, and on November 28, 1940, the following resolution was passed by the board of directors:Resolved, that this corporation does hereby elect and determine to pay in full all outstanding Conditional Rights Certificates pertaining to this corporation's previously authorized Convertible Participating Stock, payment to be made on and after December 2, 1940, to registered holders, at the office of City Bank Farmers Trust Company, 22 William Street, New York, as and when such certificates are surrendered for cancellation.Thereafter, in December 1940, the petitioners surrendered their certificates for cancellation.  M. W. Ellis received therefor the sum of $ 24,199.51; Mina W. Ellis received the sum of $ 29,867.50. *221  The petitioners kept their accounts and filed their Federal income tax returns on the cash basis.These amounts were considered by the petitioners as long term capital gain, and 50 percent of the amount received was reported by them in their Federal income tax returns for the year 1940.  The respondent held them to be dividends, taxable in their entirety, and assessed the above mentioned deficiency against each petitioner for the balance.OPINION.The issue before us is whether the amounts received by the petitioners upon the surrender of their conditional rights certificates are to be treated for income tax purposes as ordinary income or as long term capital gains.The petitioners contend that the amounts so received by them constitute a long term capital gain, and present several alternative arguments to support their contention.  Their principal argument is that the conditional rights certificates were certificates of indebtedness of the company and that the amounts received upon their surrender were amounts received upon the retirement of "certificates or other evidences of indebtedness issued by any corporation * * * in registered form," within the meaning of section 117 (f) *222  of the Internal Revenue Code.  1It is noted at the outset that the certificates stated that they were not to represent a debt of, or claim against, the corporation unless and *110  until the board of directors should declare a dividend on the common stock and that the board should in no way be obligated at any time to declare a dividend on the common stock. The petitioners assert, however, that these conditional rights certificates nevertheless represented a debt of the company because, under Delaware law, the right to accumulated dividends is a property right in the*223  nature of a debt.  They cite Keller v. Wilson & Co., 115">190 Atl. 115; Consolidated Film Industries, Inc. v. Johnson, 197 Atl. 489; and Shanik v. White Sewing Machine Corporation, 19 Atl. (2d) 831.We do not understand the law of Delaware to go so far.  The cases cited by the petitioners are generally to the effect that once dividends have accumulated on preferred stock the preferred stockholders have a right to have these dividends paid before any dividend is declared on the common stock and that this right can not be taken away by charter amendment or otherwise, without the consent of the stockholder. So far as the dividends are concerned, we do not construe these cases as giving to the preferred stockholder anything more than a right to accumulated and unpaid dividends on his stock, payable when and if a dividend is declared on the common stock.It is evident from the terms of the conditional rights certificates, and from the letter of the president of the company which accompanied them, that the company did not intend to create an indebtedness and attempted to conform to this *224  rule.  This right to a preference at some future and indefinite date does not give rise to a debt of the company or a right of the stockholders which can be enforced at law prior to the declaration of a dividend. The Delaware courts have held that this rule does not prevent a corporation from making changes in its capital structure which will reduce the probability of actual payment of the dividends, Shanik v. White Sewing Machine Corporation, 15 Atl. (2d) 169; affd., 19 Atl. (2d) 831, and that a stockholder is not a creditor of the corporation in the sense that he may sue at law for dividends in arrears.  Morris v. American Public Utilities Co., 122 Atl. 696.The conditional rights certificates were a formal acknowledgment or recognition of the right of the holders of the convertible participating stock to receive the accumulated dividends on their stock before the common stockholders should receive any dividend, but they were based upon no new consideration and created no new right.  They merely evidenced the continuation of a right of these stockholders which they already possessed *225  as such stockholders and which would have continued to exist had the conditional rights certificates never been issued.The right of a stockholder to an undeclared dividend is not an enforceable right, nor does it create any indebtedness on the part of a corporation.  It is the declaration of the dividend which creates both the dividend itself and the right of the stockholders to demand *111  and receive it.  Fletcher, Cyclopedia of the Law of Private Corporations (Permanent Edition), vol. 2, sec. 5321; Morris v. American Public Utilities Co., supra. Consequently the conditional rights certificates were not "certificates of indebtedness" of the company and section 117 (f) has no application.The case of George Peck Caulkins, 1 T. C. 656, on appeal to the Circuit Court of Appeals for the Sixth Circuit, cited by the petitioners in support of their argument, involved facts so substantially different from those before us that it is of no value here as a precedent.The petitioners' second argument may be summarized as follows: Assuming that the conditional rights certificates were not certificates of indebtedness at the*226  time they were issued, the resolution of November 28, 1940, whereby the board of directors elected to pay the certificates, had the effect of converting them into certificates of indebtedness, i. e., of converting conditional obligations of the company into unconditional obligations.  This conversion, the petitioners argue, constituted a "constructive exchange" of one form of security into another form of security in pursuance of a plan of reorganization, within the provisions of section 112 (b) (3) of the Internal Revenue Code.  It is said that after this "constructive exchange" the conditional rights certificates were "certificates of indebtedness * * * in registered form," and the amounts received on their retirement are to be considered amounts received in exchange therefor under section 117 (f).  The petitioners conclude that, following the terms of section 113 (a) (6), the basis of the "unconditional obligations" is the same as that of the "conditional obligations" and thus under the provisions of section 117 (h) (1), in determining the period for which the unconditional obligations were held, there is to be included the period for which the conditional obligations were held, *227  giving rise to the receipt by each petitioner of a long term capital gain.We need discuss but one phase of this argument, since it will dispose of the petitioners' entire theory.  The petitioners assert that the resolution of November 28, 1940, effected a recapitalization, thus bringing the transaction within the purview of section 112 (b) (3).  This position is untenable.  The conditional rights certificates formed no part of the capital structure of the company.  Helvering v. Southwest Consolidated Corporation, 315 U.S. 194">315 U.S. 194. They were not capital stock, since they possessed none of the ordinary characteristics of capital stock and the certificates themselves stated that the owners should not be entitled to any of the rights of a stockholder. They were not a part of the long term funded debt of the company since, at least prior to November 28, 1940, they did not constitute a debt of the company.  Further, there was no sale or exchange of securities or capital assets effected by the resolution of November 28, 1940.  The resolution merely recited that the corporation elected to pay the certificates, and *112  we see no reason for ascribing to*228  the board of directors an intent different from the one fully and plainly set out in the language of the resolution.The petitioners further contend that the amounts received by them can not be considered dividends, as held by respondent, because section 115 (a) 2 defines a dividend as "any distribution made by a corporation to its shareholders"; that the stock on which the dividends had accumulated had been retired so that the conditional rights certificates and the right to receive the amount thereon existed independently of any issue of stock; that since the certificates were transferable it was not necessary to be a stockholder in order to receive payment on them but only to be a registered owner of one or more certificates; and, finally, that the certificates stated that the holders thereof were not to be entitled to any of the rights of a stockholder. Consequently, petitioners argue, payment of the conditional rights certificates was not a distribution by the corporation to its shareholders and thus not a dividend within the meaning of section 115 (a).*229  The question before us is broader than the definition of the amounts received. It matters not that the Commissioner labeled the payments "dividends." Our question is: Were the payments taxable as ordinary income?  Addressing ourselves to the stated argument, however, we are of the opinion that the payments were dividends within the statutory definition.  (See footnote 2.)The petitioners apparently also overlook the fact that the conditional rights certificates were issued only to the holders of the convertible participating stock as evidence of their right to receive the dividends which had accumulated on their stock before a dividend could be received by the common stockholders. Had the dividends been paid in cash at the time of the recapitalization of the company in 1931, there would have been no doubt as to their character as dividends. Their character was not changed because payment was deferred until the company was in a better financial condition.The conclusion seems to us inescapable that the amounts received by the petitioners were taxable in their entirety as ordinary income.Decisions will be entered under Rule 50.  BLACK Black, J., concurring: I concur in the*230  result reached in the majority opinion.  I agree that the certificates in question were not "certificates or other evidences of indebtedness" within the meaning of section 117*113  (f), I. R. C., when issued by the Oliver Farm Implement Co.  The language in the certificates themselves which reads: "This certificate does not represent a debt of or claim against the company, unless and until it shall declare and set aside a dividend upon its common stock" (italics supplied), prevents them from being classed as certificates of indebtedness at the time issued.  However, when the corporation on November 28, 1940, passed a resolution to pay in full all of these outstanding "conditional rights certificates" on December 2, 1940, such certificates became to all intents and purposes certificates of indebtedness from that time on.  But, as such, petitioners held them for only four days.In order for the taxpayers to have their gains taxed as long term capital gains under the provisions of section 117, I. R. C., they must have held these "certificates of indebtedness" for a period of more than 18 months.  It is true the petitioners had held the "conditional rights certificates" for a*231  much longer period than 18 months but during all that period, up to November 28, 1940, they did not represent "certificates or other evidences of indebtedness issued by the corporation," within the meaning of section 117 (f).Therefore, I do not think that the period prior to November 30, 1940, can be counted in the period of holding required by section 117 (a) (4).  For this reason I do not think petitioners can avail themselves of the provisions of section 117 (f) which would otherwise have been available to them if their "conditional rights certificates" had been certificates of indebtedness from the outset.  Footnotes1. SEC. 117. CAPITAL GAINS AND LOSSES.* * * *(f) Retirement of Bonds, Etc.  -- For the purposes of this chapter, amounts received by the holder upon the retirement of bonds, debentures, notes, or certificates or other evidence of indebtedness issued by any corporation (including those issued by a government or political subdivision thereof), with interest coupons or in registered form, shall be considered as amounts received in exchange therefor.↩2. SEC. 115. DISTRIBUTIONS BY CORPORATIONS.(a) Definition of Dividend. -- The term "dividend" when used in this title (except in section 203 (a) (3) and section 207 (c) (1), relating to insurance companies) means any distribution made by a corporation to its shareholders, whether in money or in other property, (1) out of its earnings or profits accumulated after February 28, 1913 * * *.↩