*1084 DEPRECIATION - BASIS WHERE PARTNERSHIP TRANSFERRED PROPERTY TO CORPORATION AND OWNERS OF THE PARTNERSHIP PROPERTY REMAINED IN CONTROL OF THE CORPORATION. - Where the owners of a partnership business agreed with a third party in the latter part of 1923 that they would organize a corporation and transfer all the partnership assets to it and that in consideration therefor all the preferred stock and two-thirds of the common stock should be issued to the partnership and the remaining one-third of the common stock to the third party in consideration of his contributing to the services of the corporation his knowledge of the decorating trade and his acquaintance with architects, but where the facts also show that when the partnership actually made the written offer in January, 1924, to transfer the partnership assets to the corporation, the offer stated that it was in consideration of the corporation issuing to the partners all of its stock, both common and preferred, and where the resolution of the corporation accepting said offer also stated that all the stock was to be issued to said partners and where all the stock was in fact issued to said partners, except three qualifying shares, *1085 and where no stock was issued to the third party, except one qualifying share, until in April, 1929, held, on the facts, that the transaction by which the petitioner acquired the partnership assets was of the kind described in section 112(b)(5) of the Revenue Act of 1928, and that, therefore, under the provisions of sections 114 and 113(a)(8) of the Revenue Act of 1928, the basis upon which depreciation is to be allowed with respect to such transferred assets is the cost to the transferor partnership.
*337 In this proceeding the petitioner seeks a redetermination of its income tax liability for the calendar year 1928, for which year the respondent has determined a deficiency of $1,359.07. The errors assigned by petitioner will be stated in the opinion.
FINDINGS OF FACT.
The petitioner is a corporation, organized under the laws of the State of New York on January 16, 1924, with an authorized capital stock of $800,000, consisting of $500,000 preferred and $300,000 common. Only the common stock had voting rights, except in the event of the nonpayment*1086 of dividends for a period of two years, when the holders of the preferred stock also acquired voting rights.
At the date of its organization, the petitioner acquired all of the assets and assumed all of the liabilities of a partnership known as *338 Schmieg & Company, composed of Karl Schmieg and Henry Kotzian, which had been engaged in the manufacture of fine furniture on special order since 1908. In consideration for the transfer, the petitioner agreed to issue to the partnership 3,000 shares of its common stock and 3,570 shares of its preferred stock.
Karl Schmieg and Henry Kotzian became partners in 1908 and operated their business under the name of Schmieg & Company, continuously through 1923. No one else was interested in the partnership. For many years prior to 1923 the partnership sold most of its product to W. & J. Sloane, a retail furniture store and decorating establishment. The business which the partnership had with W. & J. Sloane was conducted with Wilson Hungate, manager of the decorating department of W. & J. Sloane. In 1923 Hungate proposed to Schmieg and Kotzian that they form a corporation to engage in the business of manufacturing fine furniture*1087 to order. An oral agreement was made by which Schmieg and Kotzian were to transfer their business to the corporation and they were to receive preferred stock of the corporation for the partnership assets and in addition two-thirds of the common stock. Hungate was to contribute his knowledge of the decorating trade, his acquaintance with architects and his general knowledge and experience in the decorating business and was to receive one-third of the common stock.
The corporation was organized and thereafter, on January 16, 1924, the partnership of Schmieg and Kotzian made the following offer to the corporation to transfer to it the partnership assets:
* * *
We do hereby offer to sell, assign and convey to your company the above-mentioned business, including all rights, title and interest in and to the same and good will thereof, and the lease, stock on hand and in process of manufacture raw materials, tools, machinery, fixtures, appurtenances, bills and accounts receivable, contracts, and personal property of every name and description used in the conduct of said business and owned by said firm and to accept in consideration and full payment of said sale, transfer and conveyance, *1088 three thousand shares of common stock and 3,570 shares of preferred stock of your company, and also the assumption by your company of all outstanding indebtedness all as of January 1, 1924.
If this proposition is accepted said shares of stock are to be issued to the undersigned or our nominees or assigns in such proportion as may be designated by us.
Hungate had no interest in the partnership and his name did not appear in the offer relative to the transfer of the assets.
The proposition was accepted by appropriate resolution of the corporation on January 21, 1924, reading as follows:
Resolved that said offer as set forth in said proposition be and is hereby approved and accepted and that in accordance with the terms thereof, this company shall, as full payment of said property and business, issue and deliver 3,000 shares of common stock and 3,570 shares of preferred stock of *339 this company to the said firm of Schmieg & Company or to their nominees and assigns, in such proportions as may be designated by them and shall also assume the indebtedness of said firm.
Hungate resigned his position with W. & J. Sloane and joined the petitioner, after the date of the*1089 organization of petitioner, in January, 1924.
At the date of organization, the preferred stock of the petitioner was issued to Schmieg and Kotzian in equal amounts. The common stock was issued as follows:
| Shares | |
| Karl Schmieg | 1,499 |
| Henry Kotzian | 1,498 |
| Wilson Hungate | 1 |
| Godfrey Nelson (attorney) | 1 |
| Frank Sheridan (employee) | 1 |
Because of the pendency of certain litigation against him, Hungate did not want any of the stock issued in his name. Other than one qualifying share, no stock was issued in the name of Hungate until April 23, 1929, when he received a certificate for 999 shares. Hungate did not pay anything to Schmieg and Kotzian for these shares.
On January 2, 1925, it was decided to give 30 shares of common stock to an employee of the corporation, Frank Sheridan. For that reason new certificates of stock were issued and thereafter ownership of the common stock stood on the books of the corporation as follows:
| Shares | |
| Karl Schmieg | 1,484 |
| Henry Kotzian | 1,483 |
| Frank B. Sheridan | 31 |
| Wilson Hungate | 1 |
| Godfrey Nelson | 1 |
The 1,484 shares standing in the name of Schmieg were issued in two certificates, one for 990 shares and*1090 the other for 494 shares. The 1,483 shares standing in the name of Kotzian were issued in two certificates, one for 989 shares and the other for 494 shares. The two certificates for 494 shares each were held by Kotzian in his own safe deposit box in an envelope marked "Wilson Hungate."
In January, 1926, Karl Schmieg and Henry Kotzian guaranteed payment of $9,678.94 by Hungate to a creditor who had obtained judgment against him. To secure them against any loss resulting from such guarantee, Hungate executed an assignment to Schmieg and Kotzian as collateral, all "his right, title and interest in and to any capital stock of Schmieg, Hungate and Kotzian, Inc."
On the first day of December, 1926, nearly three years after the organization of petitioner, Hungate executed a mortgage to petitioner to secure the payment of $5,000. This $5,000 was money which the corporation let him have to settle a judgment against him for *340 $13,000. As security for the money loaned he executed a mortgage on his right to receive stock in the corporation. The language used in creating the security obligation is as follows:
The party of the second part [Hungate] hereby assigns, transfers, *1091 sets over and conveys to the party of the first part, to the extent of five thousand ($5,000) dollars, his right to an agreed distribution of stock in Schmieg, Hungate and Kotzian, Inc. [Italics supplied.]
No dividends on the common stock were declared until April 23, 1929, and Hungate at that time received such dividend on the entire amount of his stock, it having been issued to him on the same day and he being the owner of record on said date. Dividends on the preferred stock of petitioner have been paid regularly from 1924 to the date of hearing of this proceeding.
In the determination of the deficiency, the respondent considered the plant and equipment assets acquired by the partnership prior to 1918 fully depreciated in 1928, and allowed depreciation at the rate of 10 per cent on the additions made by the partnership during the years 1920 to 1923, inclusive, and by the petitioner during the years 1924 to 1927, inclusive. It is agreed between the parties that if the proper basis for depreciation is the cost to the partnership, the above method is correct.
At the hearing the respondent admitted error in failing to allow depreciation of $174.82 on the additions during*1092 the year 1928 and a deduction for amortization of improvements to leased premises in the amount of $828.96.
OPINION.
BLACK: In a recomputation of the deficiency, effect should be given to the stipulation of the parties that petitioner is entitled to an additional depreciation deduction of $174.82 for 1928, and a deduction for amortization of improvements to leased premises in the amount of $828.96.
The remaining question involved in this proceeding may be stated thus - Where a partnership composed of two members transfers all of its assets to a corporation for all of its capital stock, both common an preferred, under the circumstances detailed in our findings of fact, is the basis for determination of the depreciation of the assets received by the corporation limited to the cost to the partnership?
It is the contention of the respondent that the transactions outlined in our findings of fact, by which the petitioner acquired the assets of the partnership, constitute a nontaxable exchange within the meaning of section 112(b)(5) of the Revenue Act of 1928. If this contention is true, then, under the express provisions of sections 114(a) and 113(a)(8) of the Revenue Act of*1093 1928, the basis for the *341 determination of the depreciation allowance is the cost to the partnership. .
The petitioner, because of the oral agreement made between Hungate and the two partners of Schmieg and Company, in 1923, prior to the organization of the corporation, maintains that the transaction is not a nontaxable exchange, since the element of control, as defined by section 112(j) is not present. The question, therefore, resolves itself into whether or not the transaction was a nontaxable exchange, and that depends upon a construction of the meaning of section 112(j). It reads:
(j) Definition of control. - As used in this section the term "control" means the ownership of at least 80 per centum of the voting stock and at least 80 per centum of the total number of shares of all other classes of stock of the corporation.
Now it is admitted by petitioner that Schmieg and Kotzian owned all the preferred stock and two-thirds of the common stock of petitioner, but petitioner contends that Hungate was the owner of the other one-third of the common stock, although it was not held in his name. If petitioner has*1094 met the burden or proof and shown that Hungate, immediately after the transfer of partnership assets from the partnership of Schmieg and Company to the corporation, Schmieg, Hungate and Kotzian, Inc., was the owner of one-third of petitioner's common stock within the meaning of the above quoted language of the statute, then there was not the control in Schmieg and Kotzian prescribed by the statute. It would follow that the transaction was a taxable one and petitioner would get a new base for the determination of gain or loss and depreciation. Has petitioner met the burden of proof on this point to overcome respondent's determination? We think not. Certain facts connected with the transaction are undisputed. Among these are the written offer submitted by the partners to the corporation to convey to it the partnership assets, which recited that the consideration for such conveyance should be the issuance of the entire capital stock of the newly organized corporation to Schmieg and Kotzian, the partners, and the assumption by the corporation of all the partnership liabilities; the resolution of acceptance by the corporation of this offer recites that the corporation shall issue to*1095 said partners all of its capital stock in payment for the assets; all the stock was in fact issued to the partners, Schmieg and Kotzian, except three qualifying shares, one of which was issued to Hungate. No other shares were issued in Hungate's name until in April, 1929.
Therefore, under these undisputed facts, we hold that, notwithstanding the verbal agreement which Hungate had with Schmieg and Kotzian in 1923 (described in our findings of fact), the actual *342 transaction which was put through in January, 1924, was a sale of the assets of the partnership to the newly organized corporation in consideration for the issuance of all the stock to Schmieg and Kotzian. They became the owners of the stock and were in control of the corporation, within the meaning of section 112(j) of the Revenue Act of 1928. The formal acts of the parties are to be given substantive effect in the determination of tax liabilities. , affirmed from the bench without opinion by the United States Circuit Court of Appeals for the Seventh Circuit, April 21, 1931; *1096 .
The fact that Schmieg and Kotzian ultimately transferred one-third of the stock to Hungate does not affect the situation. When, after the sale of assets by the partnership to the corporation, the partners, Schmieg and Kotzian, who had received all the stock, transferred some of it to Hungate, they were merely exercising a right of ownership. The situation does not require that the original owners shall remain indefinitely in control after the exchange. It is only necessary that the owners of the property transferred shall be immediately in control of the corporation to which the transfer of property is made. .
Therefore, on this issue we hold for respondent, and in so doing we do not think we are in conflict with our decision in , a case strongly urged by petitioner in behalf of its contention herein. We think the facts in that case are distinguishable from those of the instant case. The parties are in agreement as to how the depreciation shall be computed and at what rate, once the basis has been determined. Our*1097 decision disposes of that only remaining question.
Reviewed by the Board.
Decision will be entered under Rule 50.