*1869 1. Upon the evidence held that a transaction whereby petitioner exchanged stock in one corporation for stock in another was consummated in the taxable year in question and that the respondent did not err in including in petitioner's gross income of such year the amount of profit upon such exchange.
2. Held, that a broker's fee paid by the petitioner in 1922 for negotiating the sale and exchange of stock is not deductible in the year paid as an ordinary and necessary business expense, but operates to reduce the ultimate profit upon such transaction.
*512 This is a proceeding for the redetermination of an asserted deficiency in income taxes for the calendar year 1923 in the amount of $8,703.72.
It is alleged that the determination of tax set forth in the deficiency letter is based on the following error:
(1) Explanation of Changes
Profit on sale and exchange of 50,000 shares of stock of the Huntington Beach Company, less commissions paid broker, is held to be $146,617.88 instead of $53,778.28 the amount*1870 shown on your return.
At the hearing the respondent moved to increase the deficiency to $11,047.47 by eliminating the deduction of $25,000 broker's fees which he had previously allowed.
Our findings of fact are based in part upon a stipulation entered into between the parties, in part upon the testimony of witnesses who testified at the hearing, and in part upon a deposition.
FINDINGS OF FACT.
The following findings of fact are taken from the stipulation entered into between the parties:
The petitioner, Florence G. Baldwin, is the same person as Florence M. Gates.
*513 Prior to December 12, 1922, the petitioner was the owner of 50,000 shares of the capital stock of Huntington Beach Company. The Standard Oil Company of California, a corporation, was at that time desirous of purchasing all of said shares for cash, payable in installments, for the sum of $20 per share, provided it could at the same time acquire additional shares of the Huntington Beach Company stock so that the total of the shares to be acquired by it would be 186,915 shares.
On December 12, 1922, an agreement was entered into by the petitioner and others with the Standard Oil Company of California*1871 for the sale to that company of 186,915 shares of stock of the Huntington Beach Company. That contract provided in part:
Whereas, pursuant to a certain option dated November 9, 1922, the purchaser agreed to purchase from the Sellers and from the Estate of C. W. Gates, deceased, and from the Estate of Harriett A. Webb, deceased, 186,915 shares of the capital stock of Huntington Beach Company for $20 per share, upon certain terms and conditions hereinafter specified, now this agreement WITNESSETH:
1st. The Purchaser has deposited with Pacific-Southwest Trust & Savings Bank, on account of the purchase price payable for the stock agreed to be sold by the Sellers, the sum of $4.00 per share.
2nd. The Purchaser agrees to pay the balance of said purchase price in four equal annual instalments, the first payment to be made on or before the 31st day of December, 1923, but the Purchaser may pay all or any part of any installment of said purchase price at any time prior to the time herein specified.
3rd. Interest on deferred payments shall be paid by the Purchaser quarterly at the rate of six (6) per cent. per annum.
4th. Certificates for said 186,315 shares of said stock, *1872 corresponding respectively to the holdings of the Sellers and of said Estates as shown on the attached list, have been issued in the name of the Purchaser, and have been endorsed in blank by the Purchaser and deposited in escrow with the Pacific-Southwest Trust & Savings Bank of Los Angeles, California. Upon completion of the payment of the said purchase price, together with the interest, for the stock evidence by any of said certificates, such certificate or certificates shall be delivered to the Purchaser. If the Purchaser shall fail to complete the payments herein specified at or before the time herein designated, said certificate shall be delivered to the Sellers and payments thereupon made by the Purchaser shall be retained by the Sellers as damages for the Purchaser's failure to complete said payments, without prejudice to the Sellers' rights to recover of the Purchaser the full amount of the Purchase price of said stock if the Sellers shall so elect.
* * *
7th. All dividends other than stock dividends on said shares shall be paid, so long as said escrow continues in force, directly to the Purchaser or its nominee. Stock dividends issued while said escrow continues shall*1873 be issued in the name of the Purchaser or its nominee, and shall be similarly endorsed in blank and deposited in said escrow upon the terms hereof, and shall pass to the Purchaser without further payment therefor, with the stock upon which such stock dividend is declared. Stock while escrowed shall be voted by the Purchaser or its nominee in whose name it is issued.
*514 8th. The sum of $4.00 per share deposited with the Pacific-Southwest Trust & Savings Bank shall be paid over to the Sellers, according to their respective interests as shown on the annexed list, upon receipt by said Bank of a certified copy of an order of confirmation by the Superior Court of Los Angeles County, California, confirming the sale by the Estate of C. W. Gates, deceased, to James E. Degnan of 55,113 shares of said Huntington Beach Company stock, in accordance with an agreement of even date herewith between the said Estate and said Degnan, or upon written notice from the Purchaser that the Purchaser elects to proceed with the purchase of the stock herein agreed to be sold without such confirmation of the sale of the stock of said Estate. In the event that such copy of order of confirmation is*1874 not received by said Bank on or before December 31, 1922, the sum of $4.00 per share, deposited by Standard Oil Company as aforesaid, shall be returned to it, unless on or before the 2nd day of January, 1923, it notifies said Bank that it elects to proceed with the purchase of the stock of said Sellers, in which case said sum of $4.00 per share shall be paid over to the Sellers as aforesaid.
The Pacific-Southwest Trust and Savings Bank acted as escrow agent for both parties to this agreement and continued to act as escrow agent for the parties throughout all the transactions herein mentioned.
Contemporaneously with the execution of the above agreement the petitioner, the Standard Oil Company of California, and the other parties whose names are signed thereto executed and delivered escrow instructions to the escrow agent, dated December 12, 1922, which provided in part as follows:
We also hand you herewith certificates of stock of Huntington Beach Company for one hundred eighty-six thousand three hundred and fifteen (186,315) shares, of which 131,202 shares are issued in the name of the Standard Oil Company, a California corporation, and 55,113 shares are issued in the name*1875 of James E. Degnan. All said certificates of stock are endorsed in blank.
We also hand you herewith two checks of the Standard Oil Company, one for $524,808. and one for $220,452.
In the event that you receive a certified copy of an order of confirmation confirming the sale of 55,113 shares of said Huntington Beach Company stock by the estate of C. W. Gates, deceased, to James E. Degnan on or before December 31, 1922, you will disburse the amount of said checks as follows:
To each of the persons formerly holding stock of Huntington Beach Company as shown on the annexed list, you will pay the sum of $3.50 per share, in accordance with the number of shares set opposite their respective names, and you will pay to David Blankenhorn, Inc., the sum of 50?? per share. If you do not receive such certified copy of order of confirmation on or before the 31st day of December, 1922, you will return said checks to Standard Oil Company unless the standard Oil Company directs you to pay to the sellers, other than the estate of C. W. Gates, deceased, the amount of $3.50 per share for the number of shares owned by such sellers as shown on the annexed list, and to David Blankenhorn, Inc., *1876 the sum of 50?? per share for the number of shares shown on the annexed list other than those held by the estate of C. W. Gates, deceased. You will then return to the Standard Oil Company the sum of $220,452. unless Standard Oil Company elects to extend the time within which such certified copy of order of confirmation may be presented to you, and upon *515 receipt of such order within such extended time you will pay to the estate of C. W. Gates, deceased, $3.50 per share, or $192,945.50, and to David Blankenhorn, horn, Inc. $27,506.50; otherwise return said sum of $220,452. to Standard Oil Company.
At the same time that these instruments were executed the petitioner surrendered 50,000 shares of stock in Huntington Beach Company and caused the same to be reissued in the name of Standard Oil Company, and deposited said certificate with the escrow agent.
A certified copy of an order of confirmation by the Superior Court of Los Angeles County, California, confirming the sale by the estate of C. W. Gates, deceased, to James E. Degnan of 55,113 shares of Huntington Beach Company stock was received by the escrow agent on December 22, 1922.
On January 10, 1923, the petitioner, *1877 by her agents, as parties of the first part, entered into a written agreement with the Standard Oil Company, as party of the second part, which provided in part as follows:
FIRST: The first parties have exchanged with the second party 9,807 shares of capital stock of HUNTINGTON BEACH COMPANY, a corporation under the laws of California, receipt whereof by the second party is hereby acknowledged for 3,269 of the shares of the capital stock of the second party, receipt whereof by the first parties is hereby acknowledged;
SECOND: The first parties have sold to the second party 40,193 shares of capital stock of said Huntington Beach Company at Twenty Dollars ($20.00) a share, which sum the second party agrees to pay to the first parties in the manner herein set forth;
THIRD: The second party agrees to pay the purchase price of said 40,193 shares in five equal annual installments, the first payment to be made on or before the 31st day of December, 1923; but the second party may pay all or any part of any installment of said purchase price at any time prior to the time herein specified.
FOURTH: Interest on deferred payments shall be paid by the second party quarterly at the rate*1878 of six (6%) per annum.
FIFTH: A certificate for said 40,193 shares of said stock has been issued in the name of the second party, and has been endorsed in blank by the second party and deposited in escrow with the Pacific-Southwest Trust & Savings Bank of Los Angeles, California. Upon completion of the payment of the said purchase price, together with the interest, for the stock evidenced by said certificate, such certificate shall be delivered to the second party. If the second party shall fail to complete the payments herein specified at or before the time herein designated, said certificate shall be delivered to the first parties and payments thereupon made by the second party shall be retained by the first parties as damages for the second party's failure to complete said payments, without prejudice to the first parties' rights to recover of the second party the full amount of the purchase price of said stock if the first parties shall so elect.
On the same day the petitioner executed and delivered to the escrow agent escrow instructions providing in part as follows:
*516 It is hereby AGREED that the 50,000 shares of stock of HUNTINGTON BEACH COMPANY transferred*1879 to the name of STANDARD OIL COMPANY by PACIFIC-SOUTHWEST WEST TRUST & SAVINGS BANK and W. S. CLAYTON as trustees for FLORENCE M. GATES and FLORENCE M. GATES and endorsed by said Standard Oil Company and delivered to Pacific-Southwest Trust & Savings Bank under the terms of the agreement dated December 12, 1922, between the undersigned, Pacific-Southwest Trust & Savings Bank and W. S. Clayton as trustees for Florence M. Gates, and others, as sellers, and Standard Oil Company, a corporation under the laws of California, as purchaser, shall be withdrawn and returned to said Pacific-Southwest Trust & Savings Bank and W. S. Clayton as trustees for Florence M. Gates and neither said agreement nor the escrow instructions of even date therewith executed by the parties to said agreement shall apply to said stock.
The sum of $200,000 deposited by Standard Oil Company as first payment under the said agreement for said 50,000 shares of stock shall be returned to Standard Oil Company.
The sale of said 50,000 shares to Standard Oil Company is hereby rescinded and annulled, and the escrow instructions given to Pacific-Southwest Trust & Savings Bank on December 12, 1922, shall be and the same*1880 are hereby modified to accord herewith. Copy hereof shall be delivered to said escrow holder.
In all other respects said agreement of December 12, 1922, and escrow instructions pursuant thereto, shall remain in full force and effect.
(Dated Jan. 10, 1923.)
On the same day the petitioner, by her agents, executed and delivered to the escrow agent escrow instructions dated January 10, 1923, to carry out the terms of the agreement of January 10, 1923, between the trustees for Florence M. Gates and the Standard Oil Company of California.
Pursuant to its agreement with the petitioner and others under date of December 12, 1922, the Standard Oil Company of California deposited with the escrow agent the sum of $200,000 on December 12, 1922. Thereafter on December 22, 1922, this sum of $200,000 was returned to the Standard Oil Company by the escrow agent. The Standard Oil Company issued its certificates to the petitioner for 3,269 shares of its capital stock on January 10, 1923, and this certificate was receipted for by the escrow agent and by the petitioner on January 22, 1923, and delivered to the petitioner in the same month and year.
David Blankenhorn acted as broker in*1881 the sale hereinbefore mentioned of 186,315 shares of a stock of Huntington Beach Company to Standard Oil Company as set forth in the agreement dated December 12, 1922. His commission for effecting the sale of all the stock mentioned in that agreement was $93,157.50. He received payment by check from the petitioner in the sum of $25,000 for his commission for effecting the sale of 50,000 shares of this stock belonging to Florence M. Gates Trust. This check was dated December 22, 1922, was received by Blankenhorn on December 22, 1922, and on the same *517 day was cashed and was cleared. On the same day Pacific-Southwest Trust and Savings Bank paid Blankenhorn the sum of $40,601 as commission on sale of 81,202 shares. On December 26, 1922, w. S. Clayton, trustee of the Gates estate, paid him the sum of $27,556.50 as commission on the sale of 55,113 shares belonging to the Gates estate. Blankenhorn had thus received his full commission for the sale of all of the 186,315 shares of Huntington Beach Company stock to Standard Oil Company on or before December 26, 1922.
A report was made by Internal Revenue Agents A. W. Miller and V. F. Kihm to the respondent on March 1, 1927, concerning*1882 the taxable year 1923 in which the agents computed the taxable gain of the petitioner on the disposition of these shares of stock as follows:
| SCHEDULE 1-B | |
| Capital Net Gain | |
| Sale of 40,193 shares capital stock of Huntington | $803,860.00 |
| Beach Co. at $20.00 per share to be paid in 5 annual installments | |
| Market value of above stock as of date of | 409,968.60 |
| acquisition, $10.20 per share | |
| Profit | 393,891.40 |
| Cash received year 1923 (1/5th) | $160,772.00 |
| Profit to be reported (1/5th) | 78,778.28 |
| Profit upon exchange of 9,807 shares of Huntington | 92,839.60 |
| Beach Co. Stock for 3,269 shares of Standard Oil Co. of Calif | |
| 171,617.88 | |
| Commission paid broker | 25,000.00 |
| Total capital net gain | 146,617.88 |
Profit computed upon exchange of 9,807 shares of Huntington Beach Co. capital stock for 3,269 shares of Standard Oil Co. capital stock as of January 10, 1923.
Huntington Beach Co. capital stock was acquired September 7, 1920, by gift from father. Her father died Oct. 20, 1920, and for purposes of Federal Estate Tax the market value of this stock as of date of death was fixed at $10.70 per share. In this return the market value as at the date of*1883 acquisition is shown at $10.20 per share and this valuation has been accepted.
The market value of Standard Oil Co. of Calif. capital stock is based upon the average selling price of 4,900 shares sold Jan. 10, 1923, as shown by Wall Street Journal, and is $59.00 per share.
| Computation of Profit | |
| Market value as of date of acquisition 9,807 shares | $100,031.40 |
| Huntington Beach Co. stock, at $10.20 per share | |
| Market value as of date of Exchange Jan. 10, 1923, 3,269 | 192,871.00 |
| shares of standard Oil Co. of Calif. stock at $59.00 per share | |
| Profit upon exchange | 92,839.60 |
*518 The respondent determined a deficiency in the amount of $8,703.72 for the year 1923 and petitioner was notified of said deficiency in a letter dated September 21, 1927.
The petitioner kept her books of account and made her income-tax returns upon the cash receipts and disbursements basis.
The following findings of fact are taken from other evidence in the record:
The petitioner is an individual citizen of the State of California, married and residing with her husband in Pasadena, Calif.
The petitioner had received the 50,000 shares of the capital stock of the*1884 Huntington Beach Company on September 7, 1920, as a gift from her father.
On December 13, 1922, W. S. Clayton, acting as petitioner's agent, made an offer to Standard Oil Company of California, to exchange the petitioner's 50,000 shares of stock of Huntington Beach Company for a proportionate number of shares of Standard Oil Company stock, giving a valuation of $20 per share to the Huntington Beach Company stock and a valuation of $60 per share to the Standard Oil Company stock. It was orally agreed between the parties that an exchange should be made upon that basis in so far as the Standard Oil Company had available stock for this purpose. It was known by the parties at this time that the Standard Oil Company did not have sufficient stock available to trade for the entire 50,000 shares of Huntington Beach Company stock, but it was estimated that it had about 3,300 shares to be used in this manner. The exact number of shares available could have been ascertained immediately, but owing to the fact that the Standard Oil Company was issuing a stock dividend and its transfer department was working overtime it was not done. The Standard Oil Company agreed to transfer as many shares*1885 as it could and that all papers necessary would be drawn up when the Standard Oil Company was ready to draw them up. At some later time it was ascertained by the parties that there were 3,269 shares of Standard Oil Company stock available for exchange. At the time of this oral agreement Clayton sent the following night letter to W. R. Hervey, who was also acting for Florence M. Gates:
W. R. HERVEY,Vice President Pacific Southwest Trust and Savings Bank Los Angeles, Calif.
Modified agreement only permits trust to get shares in exchange for first payment therefore hold check for Two hundred thousand first payment coming to Florence M. Gates trust for return to makers for exchange for their shares after January first without putting same through anybodys set of books also agreed with Blankenhorn to defer receipt of his commission which Florence will pay him in cash outside of this transaction.
W. S. CLAYTON.*519 The sum of $200,000 was returned to the Standard Oil Company by the escrow agent on December 22, 1922, because of the oral agreement between petitioner and the Standard Oil Company of California for the exchange of stock for stock.
On January 23, 1923, the*1886 Standard Oil Company of California wrote a letter to the escrow agent in part as follows:
Receipt is hereby acknowledged of Stock Certificate No. 338, representing 50,000 shares of Huntington Beach Company stock, withdrawn from escrow by the undersigned:
The undersigned will cause said certificate to be converted into two certificates; one representing 9,807 shares, the other 40,193 shares. Certificate representing 40,193 shares shall, on or before ten days from date hereof, be delivered to you to be held under terms of escrow instructions and agreement, both dated January 10, 1923, between Trustees for Florence M. Gates and the undersigned.
Said certificate for 40,193 shares to be issued to Standard Oil Company, a California corporation and to be endorsed in Blank.
During the years 1922 and 1923, the petitioner was not engaged in carrying on any regular business.
OPINION.
MCMAHON: The question here presented is whether the exchange by petitioner of 9807 shares of stock in the Huntington Beach Co. for 3269 shares of Standard Oil Company of California stock was effected in 1922 or whether it was effected in 1923. The only year before us is the year 1923. The respondent*1887 held that the exchange took place in 1923 and included a profit in petitioner's gross income for that year, resulting in the deficiency in question. If the transaction was consummated in 1923, any resulting gain must be recognized since the transaction is not one in which gain or loss is not recognized under the provisions of section 202(c)(1) of the Revenue Act of 1921, as amended by the Act of March 4, 1923, effective January 1, 1923. That section, as amended, provides:
(c) For the purposes of this title, on an exchange of property, real, personal, or mixed, for any other such property, no gain or loss shall be recognized unless the property received in exchange has a readily realizable market value; but even if the property received in exchange has a readily realizable market value, no gain or loss shall be recognized -
(1) When any such property held for investment or for productive use in trade or business (not including stock-in-trade or other property held primarily for sale, and in the case of property held for investment not including stock, bonds, notes, choses in action, certificates of trust or beneficial interest, or other securities or evidences of indebtedness*1888 or interest), is exchanged for property of a like kind or use.
The respondent also included in petitioner's gross income for the year 1923 one-fifth of the profit upon the sale by petitioner of 40,193 shares of Huntington Beach Company stock to the Standard *520 Oil Company of California. The purchase price was to be paid to petitioner in deferred payments, the first of which was to be paid in 1923. No question is raised by the petitioner as to this action of respondent.
The evidence discloses that on December 12, 1922, the petitioner entered into an agreement with the Standard Oil Company of California to sell to that company 50,000 shares of Huntington Beach Company stock. However, the next day it was orally agreed between Clayton, petitioner's representative, and representatives of the Standard Oil Company of California, that Standard Oil Company of California would transfer as much of its stock as it had available to petitioner in exchange for Huntington Beach Company stock upon the basis of three shares of Huntington Beach Company stock for one share of Standard Oil Company of California stock, and would purchase the balance of petitioner's Huntington Beach Company*1889 stock. However, on December 13, 1922, pursuant to the oral agreement, Clayton, who was also acting for Florence M. Gates, sent a night letter to the escrow agent advising him of the oral modification of the contract in the following terms:
Modified agreement only permits trust to get shares in exchange for first payment therefore hold check for Two Hundred thousand first payment coming to Florence M. Gates trust for return to makers for exchange for their shares after January first without putting same through anybodys set of books also agreed with Blankenhorn to defer receipt of his commission which Florence will pay him in cash outside of this transaction. [Italics supplied.]
From this we can not escape the conclusion that the parties intended that the exchange should take place after January 1, 1923. On the whole the remainder of the evidence tends to support this view. We therefore conclude that the exchange of Huntington Beach Company stock for stock of the Standard Oil Company of California took place in 1923 and that the profit derived by petitioner upon the exchange was income in that year. Upon the whole evidence we are satisfied that no income was received*1890 by the petitioner in 1922 as a result of this exchange.
At the hearing the respondent was allowed to amend his answer to affirmatively allege that the deficiency for the year 1923 should be increased by disallowing the deduction of $25,000 broker's fees which petitioner paid to Blankenhorn for negotiating the transaction, and which respondent had allowed in computing the deficiency in question. The evidence discloses that the fee was paid in 1922 for services for Blankenhorn in disposing of all of petitioner's 50,000 shares of Huntington Beach Company stock, and it is respondent's contention that the full amount should have been deducted in 1922. We do not agree with the respondent. Petitioner *521 was not in the business of dealing in securities and this fee did not constitute an ordinary and necessary business expense which is deductible from income of the year in which the expenditure is made. The $25,000 broker's fee operated to reduce the profit which petitioner derived upon the disposition of the entire 50,000 shares of Huntington Beach Company stock. See *1891 , and . This fee should be allocated between the two transactions (the sale of 40,193 shares of Huntington Beach Company stock and the exchange of 9,807 shares of Huntington Beach Company stock for other stock) in proportion to the amount of stock disposed of by petitioner in each transaction. Thus $4,903.50 of the fee will reduce the profit derived by petitioner in 1923 upon the exchange of Huntington Beach Company stock for Standard Oil Company of California stock. The remainder of the fee, $20,096.50, will reduce the profit derived by petitioner upon the sale of the 40,193 shares of Huntington Beach Company stock. This reduction of profit upon the sale of 40,193 shares will thus be reflected proportionately in each instalment payment made, including that made to petitioner in the year 1923 which is before us. Adjustments will be made under Rule 50 in conformity with the above.
Reviewed by the Board.
MURDOCK, concurring: The petitioner on a cash basis disposed of some property and received consideration therefor*1892 in 1923. The income resulting was income in 1923.
MARQUETTE agrees with the above.