*1401 1. Amounts paid by a partnership in settlement of litigation to compel executors to perfect the transfer of a stock exchange membership which the partnership had purchased from the decedent and as attorneys' fees for services in such litigation, held, not deductible.
2. The gain from the exchange by a holder of debentures of an old corporation having liabilities in excess of assets, for shares in a new corporation and warrants to purchase shares in a third corporation, held, limited to the value of the warrants, since the exchange was in a statutory reorganization under section 112(g)(1)(c), Revenue Act 1936, the control having been retained by shareholders, debenture holders and secured and unsecured creditors of the old corporation.
*1178 The Commissioner determined deficiencies in 1936 income tax of Albert E. Schwabacher, $6,603.16; May K. Schwabacher, $4,439.17; James H. Schwabacher, $3,527.30; and Sophie D. Schwabacher, $3,406. (1) He disallowed a partnership deduction claimed as an ordinary and*1402 necessary expense, and (2) he held that an exchange of debentures for shares and other property was not tax free.
FINDINGS OF FACT.
Albert E. Schwabacher and James H. Schwabacher, residents of San Francisco, California, are members of the partnership of Schwabacher & Co. They and their wives filed separate returns on the community property basis. 2
1. The partnership was engaged in buying and selling stocks and bonds on the New York Stock Exchange and in the general brokerage business. One of the partners, Ehrich, was a member of the Exchange and from the time he became a partner in 1931 he wanted the partnership to buy his seat or a half interest in it. The firm resisted because they "did not care to invest in an asset which was more or less nonnegotiable and a fixed asset such as a stock exchange seat." After constant requests by Ehrich for advances, the firm yielded; in 1934 it took a six-month option to buy the seat, 3 and the seat was purchased for cash and nonnegotiable notes payable in 1936 and 1937. When, soon thereafter, Ehrich offered the notes for sale at a discount, *1403 the firm was distressed and wanted to end his partnership in the firm. In 1935 they bought back their notes from him and sent him a check. They sought a new floor partner; and when they found one, Ehrich agreed to retire and transfer his seat. After some delay, the necessary transfer papers were signed by Ehrich and filed with the New York Stock Exchange on December 11, 1935. The next day Ehrich committed suicide. A temporary arrangement was made with another member of the Exchange to act for the firm on the floor until the transfer should be made to the new partner. Claims against the seat were filed with the Exchange by creditors of Ehrich, and the Exchange would not complete the transfer of membership without the signature of the executors of Ehrich's estate. The executors would not agree to the transfer, and suit to compel the transfer was instituted by the firm. Complaint was filed February 6, 1936. In order to avoid a long litigation and a delay estimated at several years, the firm in May 1936 settled the litigation by paying $25,000. The transfer *1179 of the membership was then completed. The purpose of agreeing to the settlement was to put an end to the expense, *1404 inconvenience, and uncertainty of litigation and the temporary arrangement as to representation on the Exchange floor, and also because of the effect on the firm brokerage transactions which at that time constituted more than half the firm's business and profits. Later in 1936 the partnership paid the bill for $8,540.08 rendered by the lawyers for services and expenses in the litigation.
2. Prior to 1936, Albert E. Schwabacher bought $39,000 face amount of debentures of General Theatres Equipment, Inc. (old company), at a cost of $1,304.50, and May K. Schwabacher bought $10,000 face amount of such debentures at a cost of $745.47. The debentures were held by these petitioners more than two and less than five years. In 1936, in exchange for such debentures, Albert E. Schwabacher received 390 shares of General Theatres Equipment Corporation (new company) having a value of $7,068.75 and warrants having a value of $2,252.25 to purchase 68 1/4 units of shares of Twentieth Century*1405 Fox Film Corporation; and May K. Schwabacher received 100 such shares having a value of $1,812.50 and warrants having a value of $577.50 to purchase 17 1/2 such units. The gain realized by Albert E. Schwabacher on this exchange was $8,016.50, and the gain realized by May K. Schwabacher was $1,644.53.
The exchange of old company debentures for new company shares and warrants to buy Twentieth Century Fox shares was made pursuant to a "Plan and Agreement of Reorganization" of the old company, which was in financial difficulty, its liabilities exceeding its assets and a receiver having been appointed. The plan was carried out. The old company's assets were transferred to the new, and the new company's shares were issued to shareholders and creditors of the old company, as follows: 274,545 shares to debenture holders; 164,275 shares to holders of secured claims; 6,997 shares to holders of miscellaneous claims; and 155,280 through warrants to preferred and common shareholders.
The agreed facts are incorporated herein by reference.
OPINION.
STERNHAGEN: 1. The petitioners claim that in determining the partnership income a deduction is required of the $25,000 paid in 1936 in*1406 settlement of the litigation to compel the transfer of Ehrich's stock exchange membership and the $8,540.08 attorneys' fees. Both parties agree that the same considerations affect the question of deduction of each of the two items.
*1180 There is no conflict in the evidence and no dispute as to the facts, although many of them were not stipulated and were introduced by testimony.
The petitioners' contention must be rejected. The payment was an additional cost of the membership in the Stock Exchange which was not an expense of carrying on the trade or business but an investment in one of the essential assets of the business, the use of which was to be felt steadily in the firm's stock exchange transactions for an indefinite period. The technical question of ownership of the seat and of the right of the partnership to be a member of the exchange is of no significance in this controversy. The 1936 payments were made for the same purpose as the earlier payment to Ehrich, i. e., to secure the use of a stock exchange membership. Essentially the rationale of the 1936 payments is not affected by whether the estate's refusal to execute the transfer papers was unethical, as*1407 it apparently was. Even though it were a "hold up" to which petitioners were willing to yield, the price was not an ordinary and necessary expense of doing business, but was a means of clearing the way for getting the use of what it had bought from Ehrich. It is no more deductible than the payments in ; ; .
The deduction was properly disallowed.
2. The Commissioner would tax the entire gain to Albert E. Schwabacher and May K. Schwabacher which it is agreed they realized in the exchange by them of their debentures in the old Theatre Equipment company for shares in the new company and warrants to buy Twentieth Century Fox Film shares. The petitioners demand that under section 112(c)(1), Revenue Act of 1936, the gain is to be recognized only to the extent of the agreed value of the warrants. It is not disputed that they held the debentures more than two and less than five years and that only 60 percent of the recognizable gain is to be taxed. The question upon which there is disagreement is whether there was a*1408 "reorganization" under section 112(g)(1)(C). 4
There is no essential difference here from the "reorganizations" under the same section which existed in ; certiorari denied, ; ; *1181 (on review C.C.A., 10th Cir.). The doctrine of those cases is that the term "stockholders" in subdivision (C) is not to be literally applied only to holders of shares but is to be interpreted broadly enough to include bondholders and other creditors who, because of the excess of liabilities over assets of the corporation, have become "pretty much the corporation" *1409 and are like stockholders in that they have a beneficial, if not a technical, ownership of the corporation. In this view, the "stockholders" were, after the transfer of the old company's assets to the new, the owners of more than 80 percent of the combined voting power of the stock of the new corporation. Upon the authority of those decisions, the Commissioner's determination upon the point must be reversed and the recognition of taxable gain limited to the agreed value of the warrants to buy Twentieth Century Fox Film shares.
Decisions will be entered under Rule 50.
Footnotes
1. Proceedings of the following petitioners are consolidated herewith: James H. Schwabacher; May K. Schwabacher; and Sophie D. Schwabacher. ↩
2. For convenience, the term petitioners will be used to refer to the husbands alone. ↩
3. While under the rules of the Exchange the firm could not become a member, in practical effect its use of the seat through a floor partner is for present purposes taken as equivalent to ownership. ↩
4. SEC. 112. RECOGNITION OF GAIN OR LOSS.
* * *
(g) DEFINITION OF REORGANIZATION. - As used in this section and section and section 113 -
(1) The term "reorganization" means * * * (C) a transfer by a corporation of all or a part of its assets to another corporation if immediately after the transfer the transferor or its stockholders or both are in control of the corporation to which the assets are transferred. ↩