*1207 1. The petitioners sold in 1928 shares of stock in a corporation which they had purchased in December 1927, through the exercise of an option to purchase given to them in 1922. Held, that the profits realized by them upon the sale constitute ordinary income and not capital gain.
2. The petitioners' profits from the stock in question were not realized either when they received the option to buy it, when its market value increased, or when they acquired it, but only when they sold it, and the measure of their profits is the difference between its purchase price and the sale price.
3. In their tax returns for 1928, the petitioners reported that the stock in question was acquired by them in 1922 and failed to disclose the true date of its acquisition or any other fact showing the nature of the transaction. Held, they are liable to the 5 per cent negligence penalty provided for by section 293(a) of the Revenue Act of 1928.
*1351 These proceedings, consolidated*1208 for hearing, are for the redetermination of deficiencies determined by the respondent for the year 1928 as follows:
| D. C. Bothwell: | |
| Tax | $10,141.89 |
| Penalty | 507.09 |
| J. F. Darby: | |
| Tax | 17,465.14 |
*1352 By amended answer in the case of J. F. Darby the respondent also claims the liability of that petitioner to the 5 per cent negligence penalty, amounting to $873.26.
The questions presented by these proceedings are:
(1) Whether a profit of $138,818.28 realized by J. F. Darby and a profit of $100,180 realized by D. C. Bothwell in 1928, from sales by them of 9,943 shares and 9,000 shares, respectively, of the capital stock of the Brazos Oil Corporation, were ordinary gains subject to normal tax and surtax or capital gains taxable at the rate of 12 1/2 per cent.
(2) Whether the petitioners are liable to the 5 per cent negligence penalty provided for by section 293(a) of the Revenue Act of 1928.
FINDINGS OF FACT.
The Brazos Oil Corporation (now known as the Darby Petroleum Corporation but referred to herein throughout as the Brazos Oil Corporation) was organized in 1918. Its authorized capital stock consisted of 500,000 shares, of which 201,000 were*1209 issued and outstanding on June 28, 1922. It owned all the issued and outstanding capital stock of the Brazos River Oil Corporation, a New York corporation (hereinafter referred to as the subsidiary company).
The Brazos Oil Corporation and the subsidiary company were not progressing as well as desired and in the early part of 1922 the officers of the former desired to secure, if possible, the services of J. F. Darby as general manager of both concerns, with particular attention to the affairs of the subsidiary company. Negotiations between them resulted in the execution of two contracts under date of June 28, 1922, the first being between Darby and the Brazos Oil Corporation and the second between Darby and the subsidiary company. Under the first mentioned contract Darby is referred to as being employed as the general manager of the Brazos Oil Corporation as well as general manager of the subsidiary company. The Brazos Oil Corporation was not to pay him any salary, but it agreed to cause the subsidiary company to enter into a separate contract with him under which he should receive $12,000 a year in return for giving "all necessary time and attention to the administration" of*1210 the affairs of the subsidiary company and "the promotion of its interests." The Brazos Oil Corporation in its contract with Darby granted him an option to purchase 181,000 shares of its capital stock at any time prior to June 30, 1927, at $2.56 per share, this being the sum determined by its board of directors as the fair value of such stock on June 26, 1922. This option was given upon the insistence of *1353 Darby that he would not serve the corporation and its subsidiary as general manager without an opportunity to acquire a large block of its stock and obtain the benefits in any success of the corporations which they might achieve under his management. The Brazos Oil Corporation agreed to deliver all or any part of the option stock to Darby or his nominees on receipt of payment for the same in cash at the rate of $2.56 per share. In the event of Darby's death his personal representative had the right to exercise the option within three months after the date of death and any assignee of Darby could exercise it at any time before the expiration of five months after the date of death.
It was provided further in the contract that prior to the expiration of the option no*1211 more capital stock should be issued than the 201,073 shares already outstanding plus the 181,000 shares covered by the option agreement and 20,000 shares which could be issued to employees upon the recommendation of Darby as general manager, with the approval of the board of directors. The holders of the stock outstanding when the contract was entered into would continue to hold a majority interest as indicated below:
| Shares outstanding on June 28, 1922 | 201,073 |
| Shares covered by option | 181,000 |
| Shares for employees | 20,000 |
| 402,073 |
The Brazos Oil Corporation agreed also under the contract that no dividends would be distributed by it except after prior reservation of the sum of $500,000 cumulative from future earnings.
Concurrently with the above described contract with the Brazos Oil Corporation, Darby entered into a separate contract with the subsidiary company under which he agreed to serve as its general manager at a salary of $12,000 a year.
Previous to June 28, 1922, Darby had been associated with D. C. Bothwell in a number of deals involving oil production and oil leases. He desired to have Bothwell associated with him in the management of the Brazos*1212 Oil Corporation. He therefore entered into a definite arrangement with that corporation that Bothwell should be employed by the subsidiary company to assist him, at a salary of $10,000 per year. To induce Bothwell to accept this employment, Darby agreed to permit him to buy 40,000 shares of the option stock of the Brazos Oil Corporation at any time before June 30, 1927, at $2.56 per share.
In 1926 the above mentioned options, the agreement between Darby and Bothwell, and the contracts of employment were renewed and extended to June 30, 1929. The only change other than the extension *1354 of time for the exercise of the options was that the option price was reduced from $2.56 per share to $2 per share.
Before entering into the contract of June 28, 1922, Darby was reluctant to assume the task of attempting to improve the affairs of the Brazos Oil Corporation and its subsidiary solely as general manager. He had no stock and would be subject entirely to the direction of the board of directors of the corporation. An arrangement was accordingly entered into under which a group holding a majority of the shares released their voting rights to a group of five trustees for*1213 the credit of the above mentioned option granted to Darby. Darby and Bothwell were made trustees and to assure that no matter of policy would be decided upon without the approval of one or the other, or both, of these men, it was agreed that no vote would be valid unless concurred in by four-fifths of the voting trustees.
Matters stood thus until 1927, when affairs of the subsidiary company had shown considerable improvement. In December 1927, Darby chose to exercise his option to the extent of purchasing 80,700 shares of Brazos Oil Corporation stock which he acquired directly from the corporation upon the payment of $2 per share. During 1928, and less than two years after the issuance of this stock to him, Darby sold 9,943 shares at a net profit of $138,818.28. In his income tax return for 1928 Darby reported this profit for income tax purposes as capital gain subject to tax of 12 1/2 per cent. The respondent held that it was an ordinary gain subject to the normal tax and surtax.
Bothwell also chose to exercise his option in December 1927, and at that time acquired 40,000 shares of the 181,000 shares covered by Darby's option as above set forth. For this stock he paid*1214 $2 per share. In 1928, less than two years after his acquisition of this stock, he sold 9,000 shares at a profit of $100,180. In his 1928 return he reported this sum for income tax purposes as a capital gain subject to tax at 12 1/2 per cent. The respondent has held that it was an ordinary gain subject to normal tax and surtax. In their tax returns for 1927 neither petitioner reported any income from the purchase of the stock in that year, even though the market price at the time of purchase was approximately $8 per share.
In their 1928 income tax returns both petitioners reported their Brazos Oil Corporation stock as having been acquired by them in 1922.
The Brazos Oil Corporation sustained net losses in income in substantial amounts in every year from 1922 to 1924.
In the determination of the deficiency in the case of D. C. Bothwell the respondent has added to the amount of the deficiency the *1355 5 per cent penalty for negligence in failing to disclose the nature of the operation by which the shares of stock of the Brazos Oil Corporation were acquired by him. He did not add to the deficiency determined in the case of Darby the negligence penalty of 5 per cent, *1215 but has asserted liability thereto in an amended answer filed at the hearing.
OPINION.
SMITH: The first question presented by these proceedings is whether the profit realized by each petitioner in 1928 upon the sale of shares of stock of the Brazos Oil Corporation is ordinary income taxable at both normal and surtax rates, or capital gain subject only to the 12 1/2 per cent tax. The amount of the profit in the case of each petitioner is not in dispute.
Section 111(a) of the Revenue Act of 1928 provides that "the gain from the sale or other disposition of property shall be the excess of the amount realized therefrom over the basis provided in section 113." Section 113(a) of the act provides in part: "The basis for determining the gain or loss from the sale or other disposition of property acquired after February 28, 1913, shall be the cost of such property." Section 101(a) of the Revenue Act of 1928 provides for a tax of 12 1/2 per cent of the amount of the capital net gain. "Capital gain" is defined in section 101(c)(1) of the act as meaning "taxable gain from the sale or exchange of capital assets consummated after December 31, 1921." "Capital assets" are defined in subdivision*1216 (8) of section 101(c) as meaning "property held by the taxpayer for more than two years."
Counsel for the petitioners makes an elaborate argument to the effect that the Brazos Oil Corporation stock sold by the petitioners in 1928 was property held by them more than two years. It is not denied, however, that the option for the purchase of the shares of stock sold in 1928 was exercised in December 1927. We think that the contention of the petitioners is entirely devoid of merit. Manifestly, if the petitioners had not exercised their option for the purchase of the shares of stock in question they would never have become the owners of it. As stated by the court in :
* * * But where the contract gives only an option to purchase, the purchaser can not be said to hold the price in trust for the vendor; and before he has elected to become a purchaser, it is contrary to all rules of reason and good sense to accord to him the rights of ownership.
The contention of the respondent that the stock was acquired by the petitioners in December 1927, at the time the option was exercised and the shares of stock purchased is sustained.
*1217 *1356 The petitioners make an alternative contention that if it be held that the income reported by them in 1928 as the profit upon the sale of the Brazos Oil Corporation shares was not capital gain under section 101 of the Revenue Act of 1928, then the profit was overstated because the petitioners used as cost the option price of the stock and not its fair market value in December 1927, when the option was exercised and the stock received. The contention of the petitioners upon this point is in short that the cost basis is not the price which the petitioners paid for their stock, but the fair market value thereof at the date of purchase. In support of this contention the petitioners rely upon the opinion of the Board in . The facts in that case were that the petitioner entered into an agreement to work for a corporation exclusively for a period of between four and five years. Under the contract he was to receive a cash salary and in addition "have the right and option to buy and receive" a certain number of shares of the capital stock of the corporation upon payment to the corporation of a nominal price for the stock. The*1218 corporation purchased the shares in the open market at a cost of several times the agreed price to the petitioner and placed them in escrow subject to the terms of the agreement. In the circumstances of the case the Board held that the contract was an employment contract and that each year as the petitioner exercised the option to purchase the shares of stock at a price for below the market the petitioner received income to the extent of the difference between the price which he paid for the stock and the fair market value. The situation in the instant proceedings is far different. There is no evidence here that the option price was less than the fair market price in 1922. In fact when there was a modification of the contract in 1926, the corporation recognized that the option price was in excess of the value of the stock in 1922 and voluntarily reduced the price from $2.56 per share to $2 per share. The Erskine case is distinguishable upon its facts.
The petitioners further refer to the case of Boulton v. Heiner, decided by the United States District Court, Western District of Pennsylvania, on November 5, 1932, at paragrph 2017 of the Prentice Hall 1932 Federal*1219 Tax Service. It was held by the court that, where a taxpayer obtained an option for the purchase of shares of stock at a given price under an agreement to serve the corporation for a number of years without salary, the cost of the stock to the taxpayer was the price paid for it plus the value of the services rendered by the taxpayer. The facts in the instant case do not show the value, if any, of the services performed by the petitioners to the corporations which they served over the amounts paid to them as salaries for their services.
*1357 The statute plainly states that upon the sale of property acquired subsequent to February 28, 1913, the basis for the determination of the gain or loss shall be the cost of such property. We can not determine from the evidence of record that the cost of the shares of the Brazos Oil Corporation stock sold by the petitioners in 1928 was in excess of $2 per share, the price which they actually paid for the stock. It is clear also that the stock was not held by them for the long as two years at the date of sale. The stock was sold in 1928 and acquired by the petitioners in 1927. The profits realized were clearly taxable as ordinary*1220 income and not at the rate of 12 1/2 per centum provided by section 101 of the Revenue Act of 1928.
The second question for our determination is whether the petitioners are liable to the negligence penalty provided by section 293(a) of the Revenue Act of 1928, which reads:
SEC. 293. ADDITIONS TO THE TAX IN CASE OF DEFICIENCY.
(a) Negligence. - If any part of any deficiency is due to negligence or intentional disregard of rules and regulations but without intent to defraud, 5 per centum of the total amount of the deficiency (in addition to such deficiency) shall be assessed, collected, and paid in the same manner as if it were a deficiency, except that the provisions of section 272(i), relating to the prorating of a deficiency, and of section 292, relating to interest on deficiencies, shall not be applicable.
The respondent makes the claim for the penalty upon the ground that the petitioners clearly had no ownership of the shares of stock which were sold in 1928 until they bought them in 1927; that in their return they did not set forth the circumstances under which they acquired the stock, but reported that they acquired it in 1922; and that there was nothing shown*1221 by the returns from which the respondent could have ascertained that the profit was not taxable as a capital net gain. The petitioners claim that their returns were made by certified public accountants and the certified public accountants were fully informed of the circumstances of the transaction and they assumed that the returns were made out in accordance with the law.
We are of the opinion that the petitioners are liable to the negligence penalty claimed by the respondent. As we see it there was no ground for any contention that the petitioners had "held" the stock in question for a period of more than two years at the date of sale. Each petitioner is charged with a knowledge of the law and clearly the requirement of the law with respect to capital gain is shown on the return form. In our opinion the petitioners are liable for the negligence penalty provided in section 293(a) of the Revenue Act of 1928. Cf. .