*909 1. The owner of certain patents, having made a contract to license their use by H Co. and to sell necessary machinery to the latter, adopted a plan whereby: (1) The patents and other property were transferred to L Co., subject to the aforesaid contract, in exchange for all of L's capital stock; (2) L Co. then transferred all of its assets, consisting of what it had received from the owner, to petitioner in exchange for less than 80 percent of petitioner's capital stock; (3) the owner's wife simultaneously transferred other securities to petitioner in exchange for the balance of its capital stock; (4) L Co. transferred its entire assets, now consisting of almost 80 percent of petitioner's capital stock, to the owner and was dissolved. The plan was adopted so as to postpone any tax on the owner in respect of the sale of the patents and to give petitioner a "stepped-up" basis for depreciation of the patents. In the year of the transaction, respondent imposed no tax upon either the owner or L Co. in respect of their successive transfers of the patents. Held:
(a) Respondent's determination that the patents were acquired by petitioner in a statutory reorganization may not be challenged*910 by petitioner, even though L Co. was a mere conduit and the transaction not for a business purpose. Higgins v. Smith,308 U.S. 473">308 U.S. 473, followed.
(b) The basis for depreciation of the patents in the hands of petitioner is their bais in the hands of L Co. which is their cost to the original owner. Revenue Act of 1934, sec. 113(a)(6).
2. Petitioner is entitled to deduct the unpaid balance of a secured note as a debt ascertained to be, and charged off as, worthless, where the maker had become bankrupt prior to, and the collateral was found to have become worthless in, the taxable year.
*1094 These proceedings, all involving the same petitioner, seek redetermination of deficiencies in income and excess profits taxes as follows:
| Docket No. | Calendar year | Income tax | Excess profits tax |
| 93858 | 1934 | 1,303.15 | |
| Do | 1935 | 19,922.20 | $6,847.76 |
| 96546 | 1936 | 37,077.90 | |
| 99832 | 1937 | 36,444.20 |
The issues are (1) whether, for the purpose of deductions for depreciation*911 of a patent, petitioner should use, as a basis, the cost to *1095 it or the cost of the patents to the prior owner, and (2) whether petitioner is entitled to deduct the sum of $9,938.44 as a debt ascertained to be worthless and charged off in 1935.
FINDINGS OF FACT.
Petitioner is a corporation, organized June 6, 1930, under the laws of Delaware, and having its principal office and place of business in Detroit, Michigan. Its authorized capital stock consisted of 1,600 shares of class A voting stock and 1,600 shares of class B nonvoting stock, both classes having a par value of $100 per share.
On and prior to May 3, 1930, G. Albert Lyon was engaged in the business of manufacturing metal covers for automobile tires in Detroit at a plant located upon real property which he had contracted to purchase. He was the owner of numerous applications for American and Canadian patents relative to the metal covers, and also was the owner of the machinery and equipment used in the manufacture of the latter. He had been engaged for some time in developing the technique of manufacturing the covers and had sold a few of them, but the income thereby realized had been less than the expenses*912 of operation.
In February 1930, the Houdaille-Hershey Co., a manufacturer of automobile parts and accessories, became interested in Lyon's process for making metal tire covers, and negotiations were begun looking to the purchase by the Houdaille-Hershey Co. of Lyon's business and patent applications. On May 3, 1930, Lyon entered into a contract with representatives of the Houdaille-Hershey Co. whereby he, or a corporation to be formed by him, agreed to sell the company his tire cover business and to grant an exclusive license to manufacture the tire covers under his patent applications for a consideration of $500,000, plus a sum, afterwards to be determined, representing the cost of certain machinery and equipment purchased by Lyon after February 17, 1930. Under the license agreement, Lyon was entitled to royalties, and the Houdaille-Hershey Co. was given an option to purchase Lyon's patents and improvements for $2,000,000.
At the time of the execution of the agreement, $100,000 of the purchase price was paid to Lyon in cash, leaving a balance of $400,000 plus an additional amount for new machinery and equipment as aforesaid. This latter amount was eventually determined to*913 be $85,199.31. Pursuant to the agreement, Lyon deposited all documents necessary to transfer title to his tire cover business and the license agreement with an escrow agent, instructing the latter to deliver such documents and license agreement to the purchaser upon payment of the balance of the price.
*1096 At the time of the agreement, Lyon carried the assets to be sold thereunder, exclusive of patent rights, on his books at $203,572.30. The patent rights were carried on his books at their cost to him of $56,411.90.
Prior to the execution of the above agreement, Lyon consulted counsel with a view to securing advice as to reducing or postponing income tax liability in connection with the sale. He was advised that if he transferred his assets to a temporary corporation in exchange for all its stock and then caused the temporary corporation to transfer the assets so received to a permanent corporation in exchange for less than 80 percent of the permanent corporation's stock, neither the transfer to the temporary corporation nor the transfer to the permanent corporation would be subject to tax and the permanent corporation would be entitled to use, as the cost of the*914 assets, their value at the time of their receipt by it.
A plan in accordance with this advice was put into effect. On June 12, 1930, Lyon transferred all the assets of his tire cover business, subject to the agreement of May 3, 1930, together with his patent applications, subject to the agreement to grant the license, to the "Lyon Development Company, Inc.," a corporation organized May 5, 1930, in exchange for 24,852 shares of the capital stock of the latter, constituting its total capitalization. The Lyon Development Co. set up the assets on its books of account as follows:
| Capital assets (land, buildings, machinery, etc.) | $192,327.53 |
| Patents | 2,000,000.00 |
| Good will | 381,627.70 |
On June 14, 1930, the Lyon Development Co. transferred all the assets received from Lyon and its interest in the license agreement, all subject to the contract of May 3, 1930, to petitioner, in exchange for 885 shares of petitioner's class A voting stock and 1,600 shares of class B nonvoting stock. The stock thus received by the Lyon Development Co. constituted 79.27 percent of petitioner's total outstanding stock. The fair market value of the assets transferred therefor was $1,485,199.31.
*915 Lyon & Wilson, Inc., was a corporation organized in 1926. On June 13, 1930, Lyon owned 5,175 shares of its capital stock and his wife, Elizabeth Aikens Lyon, owned 1,387 1/2 shares. On that day, Lyon made a gift to his wife of 5,175 shares of Lyon & Wilson, Inc., stock. Respondent does not question the bona fides of the gift. Thereafter, and on the same day, Elizabeth Aikens Lyon transferred the said 5,175 shares, together with the 1,387 1/2 shares she already owned, to petitioner in exchange for 650 shares of petitioner's class A voting stock. The value of this stock at the time of its acquisition by petitioner was $662,351.19.
*1097 The formation of the Lyon Development Co., the transfer of assets to it by Lyon, the retransfer of the same assets by it to petitioner, and the transfer of Lyon & Wilson, Inc., stock by Elizabeth Aikens Lyon to petitioner, were steps taken in pursuance of a preconceived plan. Lyon gave his wife the 5.175 shares of Lyon & Wilson, Inc., stock so that she would have 6,562 1/2 shares thereof to transfer to petitioner in exchange for 650 shares of its stock. All the steps of the plan were approved by appropriate resolutions of the directors*916 and stockholders of the Lyon Development Co. and petitioner.
On June 16, 1930, the purchasers under the contract of May 3 deposited $485,199.31, the total balance due of the purchase price, with the escrow agent. The amount so paid to the escrow agent was deposited in petitioner's bank account. On the same day, the documents transferring title to the tire cover business, together with a license agreement executed by the Lyon Development Co., granting the purchasers an exclusive license to manufacture the tire covers under the Lyon patents, were delivered to the purchasers by the escrow agent.
The basic patent under the patent applications on the tire cover process was duly issued on June 2, 1931. Petitioner, pursuant to previous assignments, thus became the owner thereof, and has been ever since. The royalties received by petitioner from the Lyon Cover Co. (the corporation organized by Houdaille-Hershey Co. to act as purchaser under the agreement of May 3, 1930, and as manufacturer of the tire covers) were as follows:
| 1930 | $50,687.15 |
| 1931 | 144,933.71 |
| 1932 | 44,725.86 |
| 1933 | 60,137.77 |
| 1934 | 98,991.46 |
| 1935 | 145,226.73 |
| 1936 | $125,686.12 |
| 1937 | 32,823.06 |
| 1938 | 16,047.40 |
| 1939 (3/4) | 8,642.08 |
| Total | 727,901.34 |
*917 The fair market value of the patent applications at the time of their transfer from the Lyon Development Co. to petitioner was $1,000,000. Neither the Houdaille-Hershey Co. nor its subsidiary, the Lyon Cover Co., ever exercised the option, granted in the agreement of May 3, 1930, to purchase the patent applications and/or patents.
During the month of July 1930 a check in the amount of $9,850.44 for the royalties under the license agreement for the period beginning May 1, 1930, and ending June 30, 1930, was issued by the licensee payable to the Lyon Development Co. The check was endorsed over to G. Albert Lyon, who deposited it in his personal bank account, and his account on the books of petitioner was then charged with $2,462.61, being the portion thereof allocable to petitioner for *1098 the period between June 15 and June 30, 1930, inclusive. An allocable portion of the $9,850.44 royalties was earned during the period through which the Lyon Development Co. held title to the patent applications.
Petitioner's balance sheet as of the close of 1930 reflected the transactions with the Lyon Development Co. and Elizabeth Aikens Lyon as follows:
| Assets | |
| Cash | $345,284.90 |
| Stock of domestic corporations | 1 650,000.00 |
| Other investments | 139,049.13 |
| Land, buildings, machinery, etc | 11,417.06 |
| Patents | 2,000,000.00 |
| Accrued royalties | 18,095.05 |
| Total | 3,163,846.14 |
| Liabilities | |
| Salaries | $587.61 |
| Reserve for depreciation | 63,725.49 |
| Capital stock | 313,500.00 |
| Paid in surplus, less earned surplus | 2,786,033.04 |
| Total | 3,163,846.14 |
In addition to collecting royalties under the license agreement, petitioner has been actively engaged ever since its formation in the development, manufacture, and sale of automobile parts and accessories, other than those connected with the aforesaid tire cover patents. It neither declared nor paid dividends in 1930 and 1931.
After the Lyon Development Co. had transferred the assets received from Lyon to petitioner and had received 885 shares of petitioner's class A stock and 1,600 shares of petitioner's class B stock, its balance sheet reflected the transaction as follows:
| Assets | Liabilities | ||
| Stock of domestic corporations | $2,485,200 | Capital stock (Common) | $2,485,200 |
Its balance sheet remained the same as above as of the close of 1931. It filed income tax returns for 1930 and 1931, showing no tax due. In November 1930 it distributed its only asset, petitioner's stock, to G. Albert Lyon. It was formally dissolved in 1937 by Delaware, the state of its incorporation, for nonpayment of franchise taxes.
The Commissioner assessed a deficiency*919 for 1930 against G. Albert Lyon on the ground that a sale of assets, other than patents, had been effected by Lyon personally. Lyon paid the tax so assessed. In the course of conferences with respondent in regard to Lyon's liability, every fact in connection with the transactions between Lyon, the Lyon Development Co. and petitioner was fully discussed, and all documents setting forth the various steps in the plan were submitted to respondent.
In 1931, petitioner loaned $10,000 to one Theodore Appleby, a business man residing in Asbury Park, New Jersey, and received as collateral for the loan Appleby's stock in the Standard Land Co. The latter was a corporation owned by Appleby, one Ackerman, and another. The assets of the corporation consisted of unimproved real *1099 estate in and near Asbury Park which was being held for an advance in value. Appleby became bankrupt about a year later, but meanwhile had reduced the loan to $9,938.44. Ackerman died in 1935, and Lyon, as an officer of petitioner, learned that the taxes on the real estate owned by the Standard Land Co., its only asset, had not been paid over a period of years. The city of Asbury Park threatened suit*920 and finally took the property over in 1935 for about $2,000 of unpaid taxes. Petitioner then properly determined the debt to be worthless. Thereupon petitioner charged off the balance of Appleby's debt as worthless.
OPINION.
LEECH: This case presents a deliberate attempt by G. Albert Lyon to dispose of his tire cover business and patent applications in such a way that not only would any tax upon him by reason of their disposition be postponed, but also the corporation to be formed to hold the patents would be entitled to use a stepped-up basis for depreciation. Although the law does not condemn this intent, , it requires that the transactions be closely scrutinized to discover whether they may be held to have consummated that intent. .
The initial transfer from Lyon to the Lyon Development Co. in exchange for all its stock was tax-free within section 112(b)(5) of the Revenue Act of 1928 and the basis of the transferred assets then remained the same in the hands of that company. Sec. 113(a)(6) of the same act. The transfer of the same assets from the Lyon Development*921 Co. to petitioner was planned in such a way that petitioner would be entitled to use the basis of the cost of the patent applications to it, rather than their lower basis in the hands of the Lyon Development Co. Accordingly, Lyon gave his wife Lyon & Wilson, Inc., stock so that she might exchange it for 650 shares of petitioner's class A stock. Meanwhile the Lyon Development Co. exchanged the assets in its hands for 885 shares of petitioner's class A stock and 1,600 shares of petitioner's class B stock.
The exchanges between Elizabeth Aikens Lyon and petitioner, on the one hand, and the Lyon Development Co. and petitioner, on the other, were planned to have a double effect. The stock received by the Lyon Development Co. constituted only 79.27 percent of petitioner's capitalization. Thereby, so it was thought, the application of section 113(a)(7) of the Revenue Act of 1928, requiring the transferee to use the transferor's basis if the property was acquired in connection with a reorganization and immediately thereafter an interest or control of the property of 80 per centum or more remained in the same persons, would be prevented. And, since the interests of Mrs. Lyon and Lyon*922 Development Co. in the property *1100 transferred, prior to the exchange, were not substantially proportionate to the amounts of stock of petitioner respectively received by them, 1 the application of sections 112(b)(5) and 113(a)(8) of the Revenue Act of 1928, requiring use of the transferor's basis if the transferee acquired the property in a section 112(b)(5) transaction, would likewise be prevented. See ; . Thus, as the plan went, Lyon would pay no immediate tax, but petitioner would be able to use a stepped-up basis.
*923 The same result was sought to be accomplished in , but failed because in the transactions corresponding to the exchanges here between Elizabeth Aikens Lyon and petitioner and the Lyon Development Co. and petitioner, the stock received was substantially proportionate to the properties transferred and the whole arrangement fell within section 112(b)(5).
Respondent does not now urge that the transactions come within section 112(b)(5). His position is, however, that petitioner has reckoned without section 113(a)(12) of the Revenue Act of 1934, which reads as follows:
If the property was acquired, after February 28, 1913, in any taxable year beginning prior to January 1, 1934, and the basis thereof, for the purposes of the Revenue Act of 1932, was prescribed by section 113(a)(6), (7), or (9) of such Act, then for the purposes of this Act the basis shall be the same as the basis therein prescribed in the Revenue Act of 1932.
An identical counterpart of the foregoing appears in the Revenue Act of 1936, with the same section number. Thus, says respondent, petitioner's basis for depreciation in the taxable years 1934 to 1937, inclusive, *924 is governed by section 113(a)(7) of the Revenue Act of 1932, which reads as follows, so far as here material:
If the property was acquired after December 31, 1917, by a corporation in connection with a reorganization, and immediately after the transfer an interest or control in such propety of 50 per centum or more remained in the same persons or any of them, then the basis shall be the same as it would be in the hands of the transferor * * *.
The next step of his argument is that petitioner acquired its property in connection with a reorganization, as that term is defined in section 112(i)(1)(A) of the Revenue Act of 1932, namely "a merger or consolidation (including the acquisition by one corporation of * * * substantially all the properties of another corporation)."
*1101 Petitioner acquired all of the property of the Lyon Development Co., and the latter received more than 50 percent of petitioner's stock. There is no doubt that the transaction falls literally within sections 112(i)(1)(A) and 113(a)(7), if a statutory reorganization may be properly held to have occurred. Hence, if such a holding is proper, petitioner will have to use the Lyon Development Co.'s basis, *925 which in turn is the basis of the patents in the hands of G. Albert Lyon, by reason of the provisions of sections 113(a)(8) and 112(b)(5). This latter basis is $56,411.90, while the cost of the patents to petitioner is $1,146,201.21. 2
Petitioner argues that the acquisition of all the property of the Lyon Development Co. by petitioner did not constitute a statutory reorganization, inasmuch as*926 that company was a mere conduit for the transmission of assets of Lyon to petitioner, and stock in petitioner to Lyon. This transaction, it is said in effect, was "Simply an operation having no business or corporate purpose - a mere device which put on the form of a corporate reorganization as a disguise for concealing its real character, and the sole object and accomplishment of which was the consummation of a preconceived plan, not to reorganize a business or any part of a business, but to transfer a parcel of corporate shares to the [taxpayer]" (see ), and that no reorganization therefore occurred. Petitioner cites Gregory v. Helvering as supporting its position.
Respondent rests on an attempted distinction of the facts in that and the present case.
Thus, the record shows that while the Lyon Development Co. was formally organized, it performed only three corporate functions: It held the assets received from G. Albert Lyon on June 12, 1930, until June 14, 1930, at which time it retransferred them to petitioner; it held 885 shares of petitioner's class A stock and 1,600 shares of petitioner's class B stock from June 13, 1930, until*927 November 1930, at which time it transferred petitioner's stock to G. Albert Lyon; and it filed income tax returns for 1930 and 1931. It also earned some royalties during the two days it held the Lyon patent applications and the license agreement, but there is no evidence that such royalties were actually paid to it. Any corporate meetings which were held were only in connection with the foregoing activities. Following its distribution of petitioner's stock to G. Albert Lyon, *1102 it performed no other corporate function until it was dissolved in 1937.
However, whether these facts afford any sound basis for distinguishing the situation here from that present in the Gregory case seems unimportant.
Respondent imposed a tax upon G. Albert Lyon for the year 1930, which was the year in which the transaction now before us was carried out, to the extent to which Lyon received gain in the sale of assets other than the tire cover patents, to the Houdaille-Hershey Co. See . Lyon paid this tax. Neither Lyon nor the Lyon Development Co. returned or paid tax on the transfer of the patents and patent rights involved*928 here, to petitioner. Fully informed of all the details of the exchanges among Lyon, the Lyon Development Co., Elizabeth Aikens Lyon, and petitioner, respondent chose not to tax that transfer. It is, then, reasonably to be inferred that he considered the exchange between the Lyon Development Co. and the petitioner to constitute a tax-free reorganization under the law as it had then been construed. Petitioner and respondent thus took the position that the Lyon Development Co. was not a mere conduit in this transaction and that the transfer of its assets to petitioner by that company was not just a fiction, for tax purposes, but was indeed a reality.
However, in , the Supreme Court held that "* * * the Government may not be required to acquiesce in the taxpayer's election of that form for doing business which is most advantageous to him. The Government may look at actualities and upon determination that the form employed for doing business or carrying out the challenged tax event is unreal or a sham may sustain or disregard the effect of the fiction as best serves the purposes of the tax statute." [Emphasis supplied.] *929 So, in the light of Gregory v. Helvering, and the record, the acquisition of Lyon's assets by petitioner through the Lyon Development Co. as a mere conduit, may have been, as petitioner argues, a mere device - a disguise - a fiction - but the Government is not compelled to so regard it in the special circumstances before us here. It may and here does continue to treat this fiction as real. It follows that the present transaction did constitute a statutory reorganization for the purposes of this proceeding.
We conclude that petitioner must use as a basis for the depreciation of its patents the cost of those patents to the Lyon Development Co. which was their cost to G. Albert Lyon. Sec. 113(a)(6), Revenue Act of 1934.
*1103 On the second issue, we hold that petitioner is entitled to deduct in 1935 the unpaid balance of the loan to Appleby as a debt ascertained to be worthless and charged off in that year. Since Appleby had previously become bankrupt, there was no prospect of repayment other than out of the collateral, the Standard Land Co. stock. Petitioner discovered in 1935 that the collateral stock became worthless in that year by reason of the tax sale*930 of the sole asset of Standard Land Co., and charged off the balance then owing. Its right to the deduction thereupon arose. .
Reviewed by the Board.
Decision will be entered under Rule 50.
Footnotes
1. This represents the stock of Lyon & Wilson, Inc., received from Elizabeth Aikens Lyon. ↩
1. The property acquired by petitioner had a total value of $2,247,550.50. Mrs. Lyon received 20.73% of petitioner's stock, worth $445,187.22, but had contributed property (Lyon & Wilson stock) worth $662,351.19. Lyon Development Co. received 79.27% of petitioner's stock, worth $1,702,363.28, but had contributed property worth $1,485,199.31 (taking the patent applications to be worth $1,000,000 and the other assets to be worth $485,199.31, or what the purchaser was to pay for them under the agreement of May 3, 1930). ↩
2. The actual value of the patents, as disclosed by uncontradicted expert testimony, and which is substantiated by the subsequent royalty history, was $1,000,000. The other assets were worth $485,199.31, the amount for which they were sold. The stock received from Mrs. Lyon was worth $662,351.19. The total value of the assets received by petitioner was $2,147,500.50, and its stock was worth that amount. . Petitioner paid out 79.27% of its stock for the assets contributed by Lyon Development Co., which had a value of $1,702,363.28. But the patents constituted only 67.33% of the assets held by Lyon Development Co. ($1,000,000 out of $1,485,199.31), and therefore only 67.33% of the stock, or $1,146,201.21, was paid for the patents. ↩