Respondent determined deficiencies in petitioners’ joint income taxes as follows:
R. M. EDWARDS AM DOROTHY EDWARDS
(docket No. 2369-66)
Year Deficiency
1962_$3, 375. 68
1963_ 11,968.08
1964_ 5, 714. 48
Loyd W. Disler and Joy Disler
(docket No. 2388-66)
Year Deficiency
1962_$3,010.00
1963_ 11, 436. 23
1964_ 5, 375. 43
Both dockets were consolidated for trial and decision. Petitioners having conceded certain adjustments made by respondent, the sole issue remaining for decision is whether amounts received by petitioners on the principal of alleged corporate promissory notes are amounts received in exchange for indebtedness and therefore taxable as capital gains under section 1232(a) (l)1 or as distributions under sections 301 and 316 and therefore taxable in whole or in part as ordinary income.
FINDINGS OF FACT
Some of the facts have been stipulated. These facts and the exhibits attached thereto are incorporated herein by this reference.
R. M. Edwards (hereinafter sometimes referred to as Edwards) and Dorothy Edwards are husband and wife, as are Loyd Disler (hereinafter sometimes referred to as Disler) and Joy Disler, and had their legal residences in Tulsa, Okla., at the time of the filing of the petitions herein. Both couples filed their joint Federal income tax returns for the years here involved with the district director of internal revenue, Oklahoma City, Okla.2
In 1958, petitioners organized a corporation, Disler Engineering Corp. (hereinafter referred to as Disler Engineering), for the purpose of manufacturing and selling heat exchangers. Edwards’ duties were primarily in the financial and management areas, while Disler’s basically covered the engineering and sales areas. Until June 1962, the business was conducted in a leased plant located on Sand Springs Road in Sand Springs, Okla., and consisted of the assembling, finishing, and selling of heat exchangers made from parts fabricated by Patterson Steel Co. The company had prospered, with gross sales increasing from approximately $72,000 in 1958 to $1,266,212.85 in 1962 and had outgrown its facilities on Sand Springs Road. Unable to expand at that location, petitioners in 1961 began looking for a place to move Disler Engineering.
Birmingham Steel & Supply, Inc. (hereinafter referred to as Birmingham Steel), is an Oklahoma corporation organized in 1949. Its plant was also located on leased premises in Sand Springs, Okla. From 1959 to 1962, it operated as a fabricator of structural steel, including parts for heat exchangers, and also conducted a steel warehouse supply business. The steel supply business, which required a larger inventory and more working capital than did the fabricating business, had proved to be very unprofitable. In 1962, Birmingham Steel was phasing out this portion of its business.
Prior to 1962, Ovid Birmingham owned 76 percent of the issued and outstanding shares of Birmingham Steel. Sometime around February or March of 1962, he and the other stockholders decided to sell the Birmingham Steel business. Thereafter and prior to June 1962, Ovid Birmingham acquired all the stock in the hands of other stockholders. On June 12,1962, Edwards and Disler, who had been contacted as prospective purchasers on the same day by one Stainer (an attorney and secretary of Birmingham Steel) and at Stainer’s invitation, inspected the Birmingham Steel facilities, machinery, and equipment. When the inspection was concluded, Stainer asked Edwards to express an opinion on the worth of the entire plant and equipment and Edwards stated an amount of $75,000. At that time, Edwards knew nothing about the financial condition of Birmingham Steel.
Stainer immediately advised Ovid Birmingham that Edwards and Disler were interested in buying the plant for $75,000. Two days later, Stainer advised Edwards that the offer of $75,000 was accepted. Edwards replied that the $75,000 figure quoted by him was not intended as an offer, but agreed to consider making an offer after looking at the books and records of the company, including a balance sheet, so as to see what debts existed. Petitioners then went with Stainer to the Birmingham Steel office where they met Ovid Birmingham for the first time and were supplied with the following abbreviated financial statement of the business as of that time.
Estimated Condition of Birmingham Steel & Supply, Inc.,
Subject to Audit
Liabilities
Vouchers payable_$65, 526.00
Accrued payroll_ 6, 712. 44
Accrued withholding and social security T4_ 2, 661.17
Chattel mortgage on machinery and equipment_ 581. 99
Notes payable — National Bank of Tulsa — secured by accounts receivable _ 20,417. 58
Total liabilities_ 95, 899.18
Assets
Current assets:
Cash_ 3,923. 93
Accounts receivable less reserve for bad debts. 37,727. 75
Inventory _ 110,000. 00
Total current assets_151, 651.68 Fixed assets:
Machinery, equipment, tools, furniture, fixtures, etc. — book value Dec. 31, 1961_ 93,041.30
Total assets_ 244,692. 98
Petitioners considered the above statement and concluded that they would in fact be willing to pay $75,000 for the plant. They contemplated that Birmingham Steel would perform the prefabrication work on the heat exchangers previously done for Disler Engineering by Patterson Steel, thus enabling an expansion of this phase of the business. Petitioners also felt that they could utilize all the equipment in the Birmingham Steel plant, thereby meeting their general expansion needs.
On June 14, 1962, petitioners, accompanied by their accountant, Robert Bridges, and two other employees of Disler Engineering, resumed negotiations at the Birmingham Steel office. Bridges examined the books and records of Birmingham Steel to determine whether the financial statement previously furnished to petitioners was correct. The other two employees examined the inventory of Birmingham Steel. Ovid Birmingham desired to sell the entire business of Birmingham Steel. Negotiations centered around a sale by him to petitioners of all the issued and outstanding stock of the company. Petitioners offered to purchase all such stock for $75,000 based upon the financial statement they had received. It was then suggested that a letter of intent be prepared to reflect the agreement of the parties.
Letters of intent were prepared by Stainer but, before they were signed, Bridges discovered that the financial statement furnished petitioners did not reflect outstanding promissory notes of Birmingham Steel in the amount o.f $241,904.82. The notes held by Ovid Birmingham stood as follows at June 14,1962:
[[Image here]]
Also as of June 14,1962, Birmingham Steel had an outstanding note payable to the National Bank of Tulsa in the amount of $90,000. This note had originally been executed on August 14,1961, to be due in 91 days; but it had been extended so that, at the time of the negotiations, the due date was August 13,1962. The note was secured by 2,823 shares of Texaco, Inc., common stock owned by Ovid Birmingham and his personal guaranty. The corporation’s note payable to the bank was canceled on June 15, 1962, upon execution by Ovid Birmingham of a personal note to the bank for $90,000 secured by the Texaco stock. At the same time, Birmingham Steel executed its own unsecured note to Ovid Birmingham for $90,000, due in 90 days and bearing interest at the rate of 5% percent per annum.
The above notes (including the one replacing the note payable to the National Bank of Tulsa) had been issued to Ovid Birmingham as evidence of several temporary advances of funds made by him to Birmingham Steel. At the time Ovid Birmingham loaned such funds, he intended them to be temporary advances and not additional permanent investments of capital, his expectation being that Birmingham Steel would make enough money to repay him for his advances. The notes were not subordinated to other obligations of Birmingham Steel. Those advances represented by the notes dated December 18,1961, and June 15, 1962, had been borrowed by Ovid Birmingham from the National Bant of Tulsa, such borrowings being secured by Texaco stock, as previously indicated, and by 400 shares of Standard Oil Co. of Ohio stock also owned by Ovid Birmingham. The advanced funds covered by the note dated February 20, 1962, had been borrowed by Ovid Birmingham from Morris Plan of Oklahoma. During 1961 and part of 1962, stockholders of Birmingham Steel other than Ovid Birmingham had advanced no funds to the corporation.
The funds borrowed by Birmingham Steel from Ovid Birmingham were used for operating expenses and inventory and were reflected as outstanding debts on the corporate books, records, and income tax returns and on financial data furnished to Dun & Bradstreet. The notes were not included in the abbreviated financial statement made available to Edwards and Disler because it was thought that this would discourage potential purchasers.
The letter of intent, which was signed by Edwards and Disler on June 14,1962, stated as follows:
This letter will confirm our offer to purchase from you all of the outstanding stock issued by Birmingham Steel & Supply, Inc., an Oklahoma corporation, for the purchase price of $75,000.00, and this letter may be used as a letter of intent for said purchase. It is understood and agreed, however, that this purchase is subject to the approximate correctness of an estimated financial statement of said Corporation which was issued by you, said statement listing total liabilities in the approximate amount of $95,899.18, total current assets in the approximate amount of $151,651.68, and total fixed assets in the approximate amount of $93,041.30, and further realizing there might be a slight difference, either plus or minus, to said accounts. To include assignment of notes payable executed by Company to Seller.
Birmingham executed a substantially identical letter of intent. The last sentence, referring to the assignment of the notes, was handwritten and added at the time of signing to reflect Bridges’ discoveries.
On June 15,1962, the parties executed and closed a contract prepared by Stainer, providing for sale of the stock and notes of Birmingham Steel (including the note executed by Birmingham Steel to Ovid Birmingham on J une 15,1962) to petitioners, who agreed to pay $5,000 for the stock and $70,000 for the notes. Ovid Birmingham agreed to deliver to petitioners the stock certificates and the notes endorsed without recourse in exchange for $1,000 at the closing and a promissory note for $74,000, payable in 120 monthly installments of $821.55 each, including interest at the rate of 6 percent.
The allocation of the purchase price was made either by Stainer or Griffith Baxter (who prepared the Birmingham Steel tax returns). Neither petitioners nor Bridges suggested the allocation. Ovid Birmingham was anxious to dispose of Birmingham Steel before the company incurred further operating losses; it made no difference to him how the sale was accomplished, so long as he received the amount of $75,000. Petitioners understood that they were purchasing the stock for $5,000 and the notes for $70,000 and that the notes remained outstanding obligations of Birmingham Steel.
Birmingham Steel had net income of $22,111.20 in 1956 and $47,339.19 in 1957; it incurred losses of $2,585.66 in 1958, $59,750.85 in 1959, $70,234.39 in 1960, and $42,870.57 in 1961.
The liabilities and capital account of Birmingham Steel at various dates is represented by the following table:
[[Image here]]
After taking over Birmingham Steel, petitioners discontinued the steel supply business, letting Birmingham Steel take over the fabricating work on heat exchangers previously done by Patterson Steel. Disler Engineering became the sales and engineering corporation, with Birmingham Steel becoming strictly a manufacturing corporation. Birmingham Steel’s sales rose to $557,261.79 in 1962, $1,900,844.38 in 1963, and $3,192,437.17 in 1964. Disler Engineering’s taxable income also increased during the same period to $22,934.38 in 1962, $74,449.21 in 1963, and $103,161.28 in 1964.
For the years in issue, Birmingham Steel reported net income (before application of net operating loss carryovers) and earned surplus balances (as of December 31) in the following amounts:
Year Net income Earned surplus
1962- $14, 490. 08 ($145, 509. 76)
1963_ 82, 486. 74 (28, 112. 82)
1964_ 191, 109. 63 73, 529. 00
During the years involved herein, Birmingham Steel paid the following amounts as repayments on the notes which had been assigned to petitioners by Ovid Birmingham:
Year Edwards Disler
1962--- $10,952.41 $10,952.41
1963- 50, 000. 00 50, 000. 00
1964----- 15,000.00 15,000.00
By 1966, Birmingham Steel had paid the notes in full. The expansion in its business during 1962, 1963, and 1964 was achieved without further additions to its capital; and, with the exception of accrual items and trade accounts payable, there were substantial reductions in indebtedness during these same years.
Payments on the notes received by petitioners in 1962 (a total of $21,904.82) were treated as a return of capital and were not reported on petitioners’ tax returns. In 1963, they reported $28,100 as return of capital and the balance ($71,300) as long-term capital gain. In 1964, $19,395.18 was reported as return of capital and the balance ($10,604.82) as long-term capital gain.
Respondent, in his notices of deficiency, determined that all payments in 1962,1963, and 1964 were distributions with respect to stock and that the amounts received by petitioners were includable as ordinary income to the extent of the earnings and profits of Birmingham Steel in each of the respective years.
ULTIMATE RINDING OR RAGT
The promissory notes in issue constituted valid outstanding indebtedness of Birmingham Steel in the hands of Ovid Birmingham but did not retain such character when purchased by petitioners.
OPINION
Petitioners purchased Ovid Birmingham’s entire interest in Birmingham Steel Corp. for a total price of $75,000. Such interest was represented by Ovid’s 100-percent stock ownership plus his purported creditor status with respect to some $240,000 of alleged promissory notes owed him by the corporation. The purchase contract allocated $70,000 of the price to the notes and $5,000 to the stock. Subsequently, petitioners received payments purportedly in retirement of the notes and it is their contention that such payments were taxable as amounts received in exchange for an indebtedness within the intendment of section 1232(a) (1) of the 1954 Code.3 The basic thrust of that section is to designate payments in retirement of certain “evidences of indebtedness” as having been received in an “exchange,” usually resulting in capital gains or loss treatment.
Respondent argues that the payments are instead taxable as dividends under sections 301 and 316.4 He urges that the funds represented by the purported notes were, in reality, capital contributions by Ovid to the corporation and that, consequently, in purchasing such notes, petitioners actually acquired equity interests. Alternatively, he contends that, even if we were to characterize the notes as bona fide indebtedness in the hands of Ovid, such characterization should not automatically carry over to petitioners via their purchase. Thus, respondent insists that petitioners never negotiated for the notes per se and, at all times, intended them to represent contributions to the capital of the corporation.
The question involved in respondent’s first contention is essentially one of fact, with the burden of proof upon the taxpayer. Gilbert v. Commissioner, 262 F. 2d 512 (C.A. 2, 1959), affirming a Memorandum Opinion of this Court; Gooding Amusement Co. v. Commissioner, 236 F. 2d 159 (C.A. 6, 1956), affirming 23 T.C. 408 (1954); C. M. Gooch Lumber Sales Co., 49 T.C. 649 (1968). We think that, on the basis of the record before us, petitioners have carried their burden in this respect and we conclude, and have so found, that the notes in question constituted bona fide indebtedness in the hands of Ovid Birmingham. We see no reason to detail the various elements which led us to this factual conclusion, particularly since, in any event, we conclude that respondent should prevail on his alternative contention.
We reject petitioners’ assertion that if tbe notes were bona fide indebtedness in tbe hands of Ovid Birmingham, they automatically retained this character after the transfer. The nature of the instruments in the hands of petitioners, for tax purposes, is likewise a question of fact. There is no dispute as to the subsidiary factual elements involved. The dispute revolves around the ultimate factual determination to be made and we are satisfied that, on all the facts and circumstances herein, the notes did not constitute bona fide indebtedness after the transfer from Ovid to the petitioners.
Circumstances somewhat similar to those herein arose in Jewell Ridge Coal Corporation v. Commissioner, 318 F. 2d 695 (C.A. 4, 1963), affirming a Memorandum Opinion of this Court. There the taxpayer (Jewell) desired to purchase a railroad (Railroad) incident to its proposed operation of a coal mine. The purchase contract provided for acquisition of all existing Railroad stock plus assignment to the purchaser of Railroad’s entire indebtedness (represented by notes and open account) to its three shareholders. At that time, the books of Railroad showed a substantial surplus and even the scrap or salvage value of Railroad’s assets exceeded its liabilities by approximately $13,000. Of the $132,500 paid, $127,322.10 (or 96 percent) represented the face amount of such indebtedness and was allocated thereto and the remaining $5,177.90 (or 4 percent) was allocated to the stock. In a Memorandum Opinion denying petitioner’s subsequent claim to a bad debt deduction for the amount of such indebtedness, we stated that—
in practical reality petitioner acquired the railroad by paying to or on behalf of its owners a total amount of $132,500, and in reality this sum represented petitioner’s original cost of tbe railroad. Tbe fact that tbe transaction was cast in a form which reflected an indebtedness of * * * [Railroad] to petitioner in tbe sum of $127,322.10 and a stock investment of only $5,177.90 (resulting in obviously thin capitalization of * * * [Railroad] should be disregarded in considering tbe realities of 'the situation for tax purposes. [Jewell Ridge Coal Corp., T.C. Memo. 1962-194 (21 T.C.M. 1048, 1055.)]
In affirming, the Court of Appeals for the Fourth Circuit made the following comment which we think particularly relevant herein:
Even assuming tbe original obligation of $127,322.10 was a deb# owing to * * * [tbe Railroad shareholders] — and this may be questioned for they were then the sole stockholders, with tbe bulk of their claim arising in much tbe same manner as Jewell’s — it could readily be converted into capital in tbe Jewell acquisition. That would be the result, though unintended by Jewell, if the circumstances of the assumption by Jewell of the claim against the Railroad constituted in fact a capital investment. [318 F. 2d 695, 699.]
Similarly, we think it clear that the notes became part of the capital, and not bona fide indebtedness, of Birmingham Steel upon their acquisition, by petitioners herein.5 Birmingham was in a substantial deficit position and the entire purchase price was only a fraction of the face amount of the notes. In this context, our determination herein follows a fortiori from Jewell Ricige Coal Corporation, supra. Beyond this, there is no escape from the essential fact that petitioners’ prime objective at all times was to acquire the physical assets of Birmingham Steel. Their original intention was to pay $75,000 towards this end— i.e., the amount they considered the assets to be worth in an wnen-cvmbered state. Only at the last minute did they learn of the outstanding corporate notes to Ovid Birmingham. Such notes were hastily thrown in with the deal. The acquisition was still consummated at the initially contemplated price of $75,000, there never being any suggestion that the assignment of the notes warranted any additional consideration.
It may be argued that Jewell Ridge can be distinguished on the ground that the notes involved were not considered bona fide indebtedness in the hands of the seller. Even assuming that such is the case, the rationale of both this Court and the Court of Appeals is crystal clear and we see no reason not to apply it to the facts herein. We also recognize that, if the ownership of the notes and the stock of Birmingham Steel had been separated, the notes being transferred to another party (or, for that matter, retained by Ovid Birmingham), we might well reach a different result. But, even assuming such would be the case, it has no bearing on the issue now before us. In such a situation, the notes could be considered as having an independent significance. For that matter, even where there is no separation of ownership, the notes nevertheless might be recognized as bona fide indebtedness if the facts and circumstances show that they were accorded independent significance — a situation which clearly was not present in the instant case.
That the operations of Birmingham Steel were subsequently financially successful should not be permitted to obscure the fact that, as of the time of acquisition, no debtor-creditor position between Birmingham Steel and petitioners could realistically be considered to exist. The casual treatment of the notes, and the complete lack of any independent significance attaching to them in the transaction speaks volumes. Repayment was dependent upon the complete turnaround of the business. Admittedly petitioners’ payments were made to Ovid Birmingham and none of them found their way into the hands of Birmingham Steel. But this does not detract from the fact that the face amount of the so-called notes, which were thrown in with the stock for which the payments were made, was in the fullest sense “at risk.” From petitioners’ standpoint, the assignment of the notes served merely to remove substantial outstanding claims against the corporation whose stock they were acquiring. It in no way altered their constant and single-minded objective — i.e., to acquire the physical assets of Birmingham Steel through purchase of the outstanding equity interest. To hold otherwise would be to exalt form over substance. Cf. Kimbell-Diamond Milling Co., 14 T.C. 74 (1950), affirmed per curiam 187 F. 2d 718 (C.A. 5, 1951). See also J. A. Maurer, Inc., 30 T.C. 1273 (1958); 1432 Broadway Corp v. Commissioner, 160 F. 2d 885 (C.A. 2, 1947), affirming 4 T.C. 1158 (1945).
In order to reflect certain concessions by petitioners,
Decisions will be entered u/nder Bule 50.
Reviewed by the Court.
All references are to tlie Internal lteveni;e Code of 1954, as amended,
Dorothy Edwards and Joy Disler are parties to this proceeding solely by reason of having filed joint returns with their husbands; hereinafter, the term “petitioners” will refer only to the husbands.
SEC. 1232. BONDS AND OTHER EVIDENCES OP INDEBTEDNESS.
(a) General Rule. — Ror purposes of this subtitle, in the ease of bonds, debentures, notes, or certificates or other evidences of indebtedness, which are capital assets in the hands of the taxpayer, and which are issued by any corporation, or government or political subdivision thereof—
(1) Retiüement. — Amounts received by the holder on retirement of such bonds or other evidences of indebtedness shall be considered as amounts received in exchange therefor (except that in the case of bonds or other evidences of indebtedness issued before January 1, 1955, this paragraph shall apply only to those issued with interest coupons or in registered form, or to those in such form on March 1,1954).
SBC. 301. DI'STRIBÜTIONS op property.
(a) In General.- — Except as otherwise provided in this chapter, a distribution of property (as defined in section 317(a)) made by a corporation to a shareholder with respect to its stock shall be treated in the manner provided in subsection (c).
*******
(c) Amount Taxable. — In the case of a distribution to which subsection (a) applies—
(1) Amount constitutino dividend.- — That portion of the distribution which is a dividend (as defined in section 316) shall be included in gross income.
(2) Amount applied against basis. — That portion of the distribution which is not a dividend shall be applied against and reduce the adjusted basis of the stock.
(3) Amount in excess op basis.—
(A) In genekal. — Except as provided in subparagraph (B), that portion of the distribution which is not a dividend, to the extent that it exceeds the adjusted basis of the stock, shall be treated as gain from the sale or exchange of property.
(B) Distributions out of increase in value accrued before march i. 1913.— That portion of the distribution which is not a dividend, to the extent that it exceeds the adjusted basis of the stock and to the extent that it is out of increase in value accrued before March 1,1913, shall be exempt from tax.
SEC. 316. DIVIDEND DEFINED.
(a) General Rule. — For purposes of this subtitle, the term “dividend” means any distribution of property made by a corporation to its shareholders—
(1) out of its earnings and profits accumulated after February 28, 1913, or
(2) out of its earnings and profits of the taxable year (computed as of the close of the taxable year without diminution by reason of any distributions made during the taxable year), without regard to the amount of the earnings and profits at the time the distribution was made.
See also Barclay Co., T.C. Memo. 1964-279, heavily relied upon by respondent, which case is substantially similar to the one herein both on its facts and legal context (i.e., sec. 1232(a) (1)). There, however, the alleged indebtedness was found as a fact to represent equity investment in the hands of the original holder. We went on to agree with respondent’s further contention that “Solmonson and his group did not in substance purchase ‘notes’ * * * but made an additional equity investment.” T.C. Memo. 1964-279 (23 T.C.M. 1695, 1709). It is not quite clear whether we would have reached the same result had the notes been found to represent valid indebtedness in the hands of the seller, although, in this regard, we note that Jewell Ridge Coal Corporation was cited with approval.