*1086 1. Sales of securities, made under restrictive conditions to limited class of purchasers, and where there is no public offering of the securities, do not establish the fair market value thereof.
2. Where fair market value of securities, issued in payment for assets, is not established by record of sales or other evidence, the value of the assets at the basic date is to be treated as the equivalent of the value of the securities, and is to be used as cost basis for computing depreciation allowances, amortization, and gain or loss upon subsequent sale.
3. Fair market value of assets acquired in exchange for securities, to be used as cost basis, determined.
*483 In these proceedings which, upon motion, were consolidated, petitioner assails respondent's determinations of deficiencies in income tax for the period August 1, 1925, to June 30, 1926, of $124,732.59; for the fiscal year ended June 30, 1927, of $51,820.55; and for the fiscal year ended June 30, 1928, of $29,143.66.
The controversy concerns the basis to be used for computing depreciation, *1087 amortization and gain or loss upon resale of assets. More narrowly, the issue is: What is the fair market value of securities issued by petitioner in payment for the assets of its predecessor, which is to be used as the cost basis of the assets? In determining that issue here we must make two inquiries: First, whether the fair market value of the securities so issued is established by the record of sales, or other evidence of market, and, if so, what it was; and, second, if the value is not so established, what was the fair market value of the assets received in exchange which may be used as the equivalent of the value of the securities, and the cost basis? The pleadings disclose a further issue relating to the deductibility of accrued local property taxes of $18,810 for the period ending in 1926, $21,120 for the fiscal year ending in 1927, and $26,250 for the fiscal year ending in 1928. Respondent now admits error in disallowing the claimed deductions of these amounts. Upon settlement, effect will be given to this concession.
FINDINGS OF FACT.
Petitioner was incorporated on June 19, 1924, under the laws of Wisconsin as the Gillette Tire & Rubber Co. and subsequently changed*1088 its name to Gillette Rubber Co. It transacted no business *484 until August 1, 1925, when it acquired the net assets and business of another Wisconsin corporation of the same name (hereinafter called the old company) located at Eau Claire, Wisconsin.
In payment for these assets petitioner issued its securities. The par value of the securities so issued, and the fair market value thereof as determined by respondent were as follows:
| Fair market value | ||
| as determined by | ||
| Par value | respondent | |
| Bonds (6%, 20 year, sinking fund) | $768,450.87 | $384,225.43 |
| Preferred stock | ||
| (Redeemable at company's option any time) | 691,160.00 | 345,580.00 |
| Common stock (100,000 shares) | 540,000.00 | 540,000.00 |
| ----------------------------------- | ||
| Total | 1,999,610.87 | 1,269,805.43 |
For the purpose of computing depreciation, amortization and gain or loss on resale, these assets were set up by petitioner on its books, and were valued by respondent (that is in his deficiency notice he allocated amongst them the fair market value of the securities as he determined it), as follows:
| As set up by | As valued by | ||
| petitioner | respondent | ||
| Fixed assets: | |||
| Land | $110,000.00 | $19,540.00 | |
| Depreciable assets: | |||
| Replacement cost | $1,252,012.29 | ||
| Less depreciation | 235,536.28 | 1,016,476.01 | 180,460.00 |
| --------------------------------------------- | |||
| Total fixed assets | 1,126,476.01 | 200,000.00 | |
| Inventories: | |||
| Raw materials | $421,020.81 | ||
| Work in process | 159,841.85 | ||
| Finished goods | 158,811.42 | ||
| Supplies | 35,827.71 | ||
| --------------- | |||
| 775,501.79 | |||
| Contracts for raw rubber | 528,838.18 | 136,963.86 | |
| Expense prepayments | 11,026.81 | 11,026.81 | |
| Notes and accounts receivable | 727,621.41 | 727,621.41 | |
| Cash | 740,138.97 | 740,138.97 | |
| ----------------------------- | |||
| Total assets | 3,909,603.17 | 1,815,751.05 | |
| Less liabilities assumed | 545,945.62 | 545,945.62 | |
| ----------------------------- | |||
| Net assets | 3,363,657.55 | 1,269,805.43 |
*1089 On April 13, 1922, the old company had been placed in equity receivership by the United States District Court for the Western District of Wisconsin. Shortly thereafter its bondholders had filed a foreclosure suit in the same court. Frank C. Hermann was appointed receiver in both proceedings and, as such, had operated the old company's property and business until August 1, 1925.
In connection with this receivership there was formed to represent the creditors, both bondholders and unsecured creditors, a reorganization committee composed of George H. Wheeler, H. W. Sehl, and H. R. Kent, the last named being chairman.
*485 On the day following its incorporation (June 20, 1924) petitioner and the reorganization committee jointly promulgated a plan for the reorganization of the enterprise of the old company, and petitioner entered into an agreement with such of the bondholders and other creditors of the old company as deposited their claims with certain depositaries, also parties to the agreement. The purpose of this agreement was to carry the plan into effect.
The plan of reorganization contemplated the ultimate acquisition by petitioner of the property of the old company, *1090 and provided for the issuance, to depositing creditors, of petitioner's -
(1) Bonds to the extent of 60% and preferred stock to the extent of 15% of old bonds deposited;
(2) Bonds to the extent of 60% and cash to the extent of 40% of preferred claims deposited; and
(3) Preferred stock to the extent of 30% of general claims deposited.
The preferred stock was to have no voting power except when dividends thereon might be in arrears.
Hermann agreed with the committee to underwrite the cash requirements of the plan to the extent of $315,000, to continue in the management of the company, and to purchase from any unsecured creditor, at 50 percent of its face value, any of petitioner's preferred stock which such creditor might have acquired under the plan. As consideration for his agreement with the committee the plan contemplated that Hermann should receive all of petitioner's common stock, 100,000 no-par-value shares, and also $50,000 of its preferred stock at 70 percent of the face value thereof. Hermann's position as underwriter was made known to and approved by the court prior to the promulgation of the plan. By the terms of the agreement power to declare the*1091 plan operative and to carry it into effect was vested solely in the reorganization committee.
In addition to those of his undertakings which were set forth in the plan, Hermann made other agreements with the reorganization committee, which he subsequently performed but which were excluded from the plan itself because counsel for the committee advised that they would jeopardize its consummation. These agreements were:
(1) That 51 percent, or 51,000 shares, of the common stock should be placed by Hermann in a voting trust and used to secure management for the new company; and
(2) That the remaining 49 percent, or 49,000 shares, should be offered to the stockholders of the old company at not more than $5.40 per share.
This price of $5.40 was known to be a favorable price, offering an opportunity for the old stockholders to recoup their losses. This offer was one of the conditions upon which the reorganization committee *486 adopted the plan and ultimately declared it operative, and was designed to obtain for the new company, the good will of the old stockholders, most of whom resided within the territory comprising the company's principal prospective market. This offer*1092 by Hermann was communicated to the old stockholders and was accepted by about 433 of them, who thus acquired 34,993 shares, being over 70 per centum of the amount offered.
In January 1925 the court entered a decree of foreclosure finding that the old company's indebtedness to its bondholders for principal and interest amounted to $1,468,148.90 and ordering the property subject to the lien of such indebtedness sold. This order was subject, inter alia, to the provision that no bid of less than $200,000 should be considered, but that the purchaser might make payment by surrendering for cancellation bonds of the old company and interest coupons pertaining thereto, and receiving credit for the amount of cash which the holders of such bonds and interest coupons would be entitled to receive if the entire purchase price were paid in cash.
This upset price of $200,000 had no relation to the actual value of the plant as an operating unit. It represented the junk value of the plant as an empty shell, and was intended to establish a minimum amount in which a share should be had by those bondholders who had not assented to the plan nor deposited their bonds thereunder, and who favored*1093 dismantling the plant, taking their shares of the proceeds of the sale thereof as junk and so pocketing their losses. At the time of fixing this upset price of $200,000 the court was aware of the provisions of the plan, having been fully advised before accepting Hermann as underwriter. It was aware also that there were outstanding bonds of the old company of $1,161,800 par value, the holders of a large percentage of which had assented to the plan and had deposited their bonds thereunder, and would receive upon its consummation, not any part of the upset price of $200,000 in cash, but rather 75 percent of the par value of their bonds in bonds and preferred stock of the new company.
Pursuant to the court's order the real estate was sold to Kent, acting as chairman of the reorganization committee and as trustee for the depositing bondholders. Kent's bid was $200,000, payment of which was made by surrendering for cancellation $1,395,222.57 (95.03277 percent of $1,468,148.90) of bonds of the old company and accrued interest thereon, and by paying $9,934.46 in cash which went to those holders of the bonds of the old company who would not consent to the plan. This sale was approved*1094 by the court and the property was conveyed to petitioner by a mesne conveyance through Kent. A deficiency judgment in the amount of $1,229,000 was entered.
*487 By further order the court accepted "the offer of the Gillette Tire and Rubber Company for all of the assets in the possession of the Receiver" and appointed a special master in chancery to supervise the carrying out of the plan, and a special commissioner to execute the details attending the transfer of the property. This order then provided that as soon as petitioner should have done all the things "in said plan contemplated to be done by said company", and as soon as Kent should have conveyed to petitioner "all the property purchased by the said Kent at the foreclosure sale", then the receiver should convey and assign to petitioner "all the money, contracts, property and other assets in his possession as such receiver", and the cash, bonds, and stock called for by the plan should be distributed "to the creditors and bondholders of the Gillette Rubber Company as in said plan provided." The terms of the plan were modified, with the approval of the court, so that the 100,000 shares of common stock should have*1095 a par value of $5.40 each instead of being without par value. The sole purpose of this change was to avoid incorporation fees imposed by the State of Wisconsin on no-par-value stock.
The operations of the business by the receiver resulted in a net income for the periods and in the amounts as follows:
| April 13 to December 31, 1922 | $229,107.19 |
| Calendar year 1923 | 264,959.32 |
| January 1 to April 30, 1924 | 129,637.20 |
| May 1 to December 31, 1924 | 248,182.14 |
| January 1 to July 31, 1925 ($403,681.48 per Pet. Ex. 64, | |
| plus $189,321.42, per Pet. Ex. 6-A, p. 304) | 593,002.90 |
The receiver's production of tires and tubes for the months of June and July, 1924, and July 1925, were as follows:
| Tires | Tubes | |
| June 1924 | 18,344 | 46,986 |
| July 1924 | 20,379 | 52,575 |
| July 1925 | 58,389 | 133,071 |
In June 1924 the plant was operating at only 40 percent of the capacity at which it was operating at the time of acquisition by petitioner.
The receiver's average monthly sales for periods immediately preceding the promulgation of the plan and intervening between that incident and August 1, 1925, were:
| January 1 to April 30, 1924 | $267,151.56 |
| May 1 to December 31, 1924 | 291,813.97 |
| January 1 to July 31, 1925 | 587,668.96 |
*1096 *488 During the time when the plan was being formulated, the reorganization committee and counsel for the receiver made efforts to secure an underwriter for the cash requirements of the plan in exchange for some or all of the common stock of the proposed new company, on which it might realize cash by sale thereof to the public. To this end at least nine established underwriting firms were approached, as well as a number of individuals, but all rejected the project for various reasons, chiefly perhaps because the issuing organization bore the name of a company for several years operated under management of creditor's committee and receiver, because the securities were proposed in odd denominations not readily salable, and because the total issue was too small to be profitably marketed by the underwriter.
From the issuance of petitioner's securities and throughout the remainder of 1925, and the year 1926, petitioner's officers and the chairman of the committee received many inquiries from holders thereof who wished to convert them into cash. All inquirers were told that there was no known market where offers were being made to buy these securities, but that certain of petitioner's*1097 officers, as well as petitioner itself, might buy limited quantities if the holders were willing to sell them at about one half face value.
There were some transactions in all three classes of petitioner's securities. In August 1925, and shortly thereafter, about 35,000 shares of common stock, offered in accordance with Hermann's agreement with the committee, were sold at par. Except for six individuals, all the purchasers were former stockholders of the old company. The six outsiders (who purchased but relatively few shares) were either associates of Hermann or former customers of the company. Thereafter, up to February 1928 (beyond which we have no record), there were about 28 transfers of this stock, involving approximately 5,600 shares, all of which were transfers from stockholders to officers of the company, or among members of the same family, or between business associates.
Except for a few transfers among members of the same family, following the original issuance of the preferred stock, there were almost no transfers thereof except from the holders (creditors of the old company) to petitioner or its officers. Up to June 30, 1926, petitioner purchased 20,175 1/3 shares, *1098 having a par value of $302,630, for $164,620. Of these purchases, represented by 16 transactions, 19,232 1/3 shares came from Hermann. During the year ended June 30, 1927, petitioner purchased 1,719 1/4 shares, par value $25,787.75, for $15,343.25 - nearly all from Hermann and other officers of the company. By March 31, 1929 (details *489 of the intervening period being lacking), petitioner had purchased a total of $402,533.75 par value of preferred stock for $230,875.59, and had either applied to or set aside for the retirement of the remainder outstanding, $288,626.25.
Between the date of issuance and the end of 1925, petitioner, by six transactions, acquired $64,230.87 par value of its bonds for $33,713.78. Of these bonds $58,900 par were purchased from one creditor at 50 percent; the other purchases were of small amounts - all at 50 percent except two bonds $60of each for which par was paid to company employees. During the year 1926 there were but two purchases - two $60 bonds bought at 50 percent. In addition, petitioner took over $3,180.87 par value of bonds held as collateral, entering them on its books at $3,128.78. During the first half of 1927 petitioner, *1099 by purchases from its officers or their associates, and two purchases from creditors, acquired $95,180 par value of bonds for $67,839. Up to March 31, 1929 (details as to the intervening period being lacking), petitioner purchased $189,550.87 par value of its bonds for $124,672.78.
The plant acquired by petitioner was particularly well designed for the manufacture of tires. It had adequate buildings and equipment of first-class construction and condition and natural protection from fire hazards. It was served by three railway lines and was within trucking distance of the Twin Cities, distributing centers for the northwest market. Good supplies of water and power were available, the community offered an adequate supply of dependable labor. At the time, conditions in the tire-manufacturing industry generally were satisfactory. Under the receiver the plant had been operated successfully and its business greatly increased. Petitioner was adequately supplied with working capital; it had valuable inventories of raw materials, goods in process, finished goods, and supplies, and owned contracts for large amounts of rubber at prices considerably below the market. The demand for tires*1100 was increasing, and the outlook for petitioner's business prosperity was excellent.
The only issue with respect to depreciation pertains to the basis to be used in the computation thereof, respondent having accepted as correct the rates used by petitioner.
Petitioner's books were kept and its returns were made on the accrual basis. Its inventories were kept and reported on the basis of cost or market, whichever was lower.
During the taxable years here involved, petitioner sold certain of the depreciable assets so acquired at August 1, 1925, and used its book values of such assets as bases for determining gain or loss thereon. Respondent substituted for the amounts used by petitioner *490 other amounts which bore or were intended to bear the same ratio thereto as $200,000 bears to $1,126,476.01. The amounts used by petitioner and respondent, and the extent of respondent's reduction, are as follows:
| Basis per | Basis per | Respondent's | |
| petitioner | respondent | reduction | |
| Period ended June 30, 1926 | $7,042.41 | $1,250.31 | $5,792.10 |
| Year ended June 30, 1927 | 29,460.97 | 5,946.67 | 23,514.30 |
| Year ended June 30, 1928 | 7,052.46 | 1,436.29 | 5,616.17 |
*1101 The fair market values as of August 1, 1925, of the fixed assets, of the inventories, and of the contracts for rubber, all of which were acquired by petitioner in exchange for its securities, were those amounts set up by petitioner on its books, and set out in schedule hereinabove.
OPINION.
GOODRICH: The parties agree, and upon examination we accept their conclusion, that petitioner's acquisition of the assets of the old company and the distribution of its securities did not constitute a statutory reorganization. Consequently, the cost basis of the assets in the hands of the old company does not carry over and it becomes necessary to determine the basis of the assets in the hands of petitioner. It is clear that the fair market value of the securities issued in payment for the assets is the cost basis for the assets in petitioner's hands. 1 Likewise, it appears that if the fair market value of the securities so issued cannot be determined from the record of sales thereof, or other evidence pertaining to the securities, then the value to be assigned to them, and to be taken as the cost basis of the assets in petitioner's hands, is the fair market value of the assets for which*1102 they were exchanged. 2
Respondent, in computing the deficiencies here in controversy, determined the fair market value of the securities issued by petitioner to be $1,269,805.43; took that amount as the cost basis of the assets acquired and allocated it amongst them. Upon brief he revises his determination, arriving at a basis of $1,487,564.36, which he obtains by valuing the bonds at 75 percent of par, the preferred stock at 50 percent of par, and adding the*1103 cash paid to the preferred creditors *491 and the liabilities of the old company assumed by petitioner. From this computation of value he excludes petitioner's common stock, for reasons to which we will later refer.
But we agree with petitioner in its contevtion that the fair market value of these securities at the basic date cannot be determined by the evidence pertaining strictly to the securities; that there was no market for them; that there were no transactions in them which would reflect their fair market value, as that phrase has been so often judicially defined. True enough, as respondent points out, and as we have found as a fact, there were sales of considerable amounts of these securities, but all these transactions were consummated under peculiar conditions and limitations. The securities were not freely bought and sold; the sales were made to a restricted class of purchasers, and under peculiar compulsion. Efforts to arrange a public offering were unavailing.
The common stock, for instance (or rather a part of it - the balance having been issued and deposited to secure company management), was sold to the former stockholders of the old company under an*1104 agreement entered into more than a year before the stock was issued, at a price known to be a low one, purposely made so to secure the good will of those stockholders and give them a chance to recoup. None of it was publicly offered; only six outsiders were permitted to buy it, and they for particular reasons and in small amounts. The preferred stock and bonds were not sold to the public, but were issued pro rata to the creditors of the old company. Hermann, the underwriter, and controller of the new company, offered to buy in the preferred stock within a specified time at one-half its face value. The creditors faced a dilemma - whether to turn in their stock and thus save a part of their claims, or hold it in hope of one day making a larger collection. Whether they were advised of the facts pointing to prosperity for the new company does not appear; it seems doubtful. No purchaser could be found except Hermann and, later, the company. So with the bonds; there was no place to sell them except to the company itself, and its officers, who proceeded to pick up offerings at their own prices.
Sales made under such conditions do not establish a fair market value, 3 nor can later*1105 sales, made at increased prices because, as time passed, it was realized the company's operations were to be successful, relate back to the basic date to do so. And the fact that well known underwriting firms refused to put these issues on the public *492 market is another consideration leading to our conclusion that, viewing only the securities issued by petitioner on August 1, 1925, we cannot determine their fair market value at that time.
It becomes necessary, then, to determine the fair market value of the assets exchanged for the securities which is to be taken as the equivalent of the value of the securities and as the cost basis for the assets in petitioner's hands. As to that, the evidence satisfies us that the fair market values of the fixed assets, *1106 of the inventories, and of the contracts (which are the only ones upon the valuation of which the parties differ) were the amounts at which these were set up on petitioner's books. Therefore, we have found as a fact that, at August 1, 1925, these assets were of the values set out in the schedule contained in our findings. They should be used as the equivalent of the fair market value of the securities for which exchanged, and as the cost basis for determining depreciation and gain or loss upon subsequent sale.
In determining the deficiencies here in controversy, respondent considered that petitioner issued all its securities in payment for the assets taken over from the old company. He now says he erred in so doing; that all the common stock and $50,000 par value of the preferred were sold to Hermann for cash and should be eliminated from the consideration given by petitioner in exchange. Some months after trial of the case, having meantime requested and been granted additional time within which to file his brief, respondent moved to file amended answers to the petitions (which he said conformed his pleadings to the proof) affirmatively pleading this error and making claim*1107 to increased deficiencies. Petitioner opposed the filing of the amended answers, chiefly upon the grounds that the proof did not bear out respondent's affirmative allegations, and because the motion to file this further pleading was not timely, and that to grant it would be an abuse of discretion, since the case had been tried upon the issues as originally framed and the hearing had been concluded.
Whether respondent's motion was timely, we need not decide. We deny it, and refuse the amended answer, for the reason that the allegations thereof are not supported by the proof of record.
Reviewed by the Board.
Judgment will be entered under Rule 50.
MURDOCK, dissenting: Stock and bonds of the purchaser formed the consideration paid for the assets. No assets were acquired by the issuance of the common stock, instead it was issued to Hermann for other purposes. The total par value of the bonds and preferred stock issued for assets amounted to $1,459,610.87. The assets certainly *493 did not cost the petitioner approximately $2,000,000 more than the par value of these securities. If one were to assume that the common stock was issued for assets, *1108 still a value of about $20 per share would have to be attributed to it in order to absorb the difference between the par value of the bonds and preferred stock and the cost of the assets as determined in the prevailing opinion. The cost of the assets as determined by the Commissioner should be approved.
Footnotes
1. Sec. 204(a), (c), Revenue Act, 1926; sec. 111(a), sec. 113, sec. 114, sec. 23, Revenue Act, 1928, as to basis for determining gain or loss and allowances for depreciation. ↩
2. For statements and discussion of this rule see: William Ziegler, Jr.,1 B.T.A. 186">1 B.T.A. 186; Wallis Tractor Co.,3 B.T.A. 981">3 B.T.A. 981; George A. Ricker,10 B.T.A. 11">10 B.T.A. 11; John Glackner Realty Corporation,11 B.T.A. 151">11 B.T.A. 151; Kanawha City Co.,13 B.T.A. 912">13 B.T.A. 912; Jefferson Livingston,18 B.T.A. 1184">18 B.T.A. 1184; Reliance Investment Co.,22 B.T.A. 1287">22 B.T.A. 1287; Biscayne Bay Islands Co.,23 B.T.A. 731">23 B.T.A. 731; Stollwerck Chocolate Co.,4 B.T.A. 467">4 B.T.A. 467↩.
3. In addition to decision cited in footnote 2 above, see: Premier Packing Co.,12 B.T.A. 637">12 B.T.A. 637, and Cases there cited; Helvering v. Kendrick Coal & Dock Co., 72 Fed.(2d) 330; Essex Motors,22 B.T.A. 804">22 B.T.A. 804; Walter v. Duffy,287 Fed.41; Phillips v. United States, 24 Fed.(2d) 195; Heiner v. Crosby,↩ 24 Fed.(2) 191.