1945 U.S. Tax Ct. LEXIS 36">*36 Decision will be entered under Rule 50.
Common stock subscription warrants were acquired by petitioner along with shares of common stock, as a unit. Held, the warrants had value when received by petitioner; held, further, under the circumstances there is no practical basis upon which an allocation of cost as between the warrants and the stock can be made.
5 T.C. 1104">*1105 The Commissioner has determined a deficiency of $ 4,221.63 in the petitioner's income tax liability for 1940.
The questions involved are whether certain stock subscription warrants which petitioner acquired with common stock, 1945 U.S. Tax Ct. LEXIS 36">*37 as a unit, had value at the time he received them and, if so, whether there is a practical basis upon which an allocation of cost between the common stock and warrants can be made for the purpose of computing the gain or loss on a sale of the warrants alone. One minor adjustment made by the respondent is not contested by petitioner and will be given effect under Rule 50.
For the most part, the facts have been stipulated by the parties and we adopt the stipulation as our findings. Other facts are found from the evidence adduced at the hearing.
FINDINGS OF FACT.
The petitioner is an individual, residing at Lock Haven, Pennsylvania. He filed his individual income tax return for 1940 with the collector of internal revenue for the twelfth district of Pennsylvania, Scranton, Pennsylvania.
In 1931 petitioner and C. G. Taylor formed the Taylor Aircraft Co., a Pennsylvania corporation, hereinafter referred to as the old company, for the manufacture and sale of airplanes. From its commencement the company made progress in the field of light airplane manufacture. Through the technical knowledge and ability of the petitioner and his organization, research, and experimentation, the company1945 U.S. Tax Ct. LEXIS 36">*38 obtained the approval of the Department of Commerce for the production of 5 models of aircraft. Production increased from 20 planes in 1931 to 680 in 1937. In 1936 petitioner became the sole stockholder of the Taylor Aircraft Co.
On November 13, 1937, in connection with an exchange upon which gain or loss was not recognized, all of the assets and liabilities of the Taylor Aircraft Co. were transferred to the newly organized Piper Aircraft Corporation, hereinafter called the new company, in exchange for the issuance by the latter company of 80,000 shares of its $ 1 par value common stock and 57,000 common stock subscription warrants. Originally petitioner received 60,000 warrants, but he returned 3,000 to the corporation immediately thereafter. The parties agree that such exchange was "tax free," with no change in basis. Under the plan of reorganization the stock and warrants were issued to 5 T.C. 1104">*1106 the petitioner, who had surrendered his stock in the Taylor Co. to that corporation for cancellation. Shortly after the transfer above mentoined the Taylor Co. was dissolved. No allocation of value was made between the 80,000 shares of common stock and the 57,000 subscription warrants1945 U.S. Tax Ct. LEXIS 36">*39 at the time they were delivered to the petitioner.
Under its certificate of incorporation, as amended, the Piper Aircraft Corporation was authorized to issue 271,500 shares, divided into 21,500 shares of convertible preferred stock with no nominal or par value, having a stated capital applicable thereto of not more than $ 10 per share, and 250,000 of common stock of the par value of $ 1. The voting rights were confined to the common stock, except that if at any time after March 1, 1940, 4 or more quarterly dividends were in arrears, the preferred shareholders were entitled to elect a majority of the board of directors until the arrears in dividends and the current quarterly dividend had been paid. The three incorporators of the Piper Co. were petitioner, William T. Piper, Jr., and Theodore V. Weld.
The common stock subscription warrants issued by the Piper Corporation evidenced the right of the holder thereof to subscribe at any time and from time to time on and after April 1, 1938, to April 1, 1941, for one share of $ 1 par value common stock for each warrant held, at the following prices: On or before April 1, 1939, $ 5 per share; after April 1, 1939, but on or before April 1, 1945 U.S. Tax Ct. LEXIS 36">*40 1940, $ 6 per share; and after April 1, 1940, but on or before April 1, 1941, $ 7 per share.
One of the major purposes of the reorganization was to obtain new capital. The new company expected to raise $ 200,000 by the issuance of convertible preferred shares, with two common stock subscription warrants attached to each share at a unit cost of $ 10. The prospectus stated that there was no present intention of offering the common stock to the public other than to the extent that the convertible preferred was initially convertible and to the extent that subscription warrants might be exercised. Petitioner wanted the subscription warrants in question issued to him so that he would have or could retain controlling interest in the corporation, in view of the fact that the 20,000 units, later changed to 21,500 units, involving rights to subscribe to a total of 105,750 shares of common stock which the corporation proposed to sell, carried rights to subscribe to 90,000 shares of the company's common stock. Petitioner would not have carried out the reorganization if there had been no method of protecting his voting control.
It was originally intended that the public offering of the preferred1945 U.S. Tax Ct. LEXIS 36">*41 stock warrant units would be made concurrently with the issuing of the stock and rights acquired by petitioner, but the former was held back by reason of delay in obtaining an approval from the Securities & Exchange Commission.
5 T.C. 1104">*1107 The balance sheet of the Piper Aircraft Corporation, as of November 13, 1937, reflected that the excess of its assets over its liabilities (excluding capital stock) was $ 80,000. It did not reflect the good will and going concern value carried over from the Taylor Co., nor did it reflect any value for the five certificates of approval issued by the Department of Commerce authorizing the manufacture of five models of airplanes, underlying which was a great amount of research, experimentation, and testing of the parts of the planes and the planes themselves, which represented a large amount of money. Another valuable intangible asset acquired by the Piper Corporation was an airplane sales organization, which was regarded as one of the best in the airplane industry. The land and buildings were carried on the books at $ 96,146.64, although the original cost to former owners a few years previous was $ 831,000. The plant was very well adapted to the1945 U.S. Tax Ct. LEXIS 36">*42 purposes of the company and a large portion of floor space was available for future expansion.
No stock of any kind or class other than the aforementioned 80,000 shares of common stock received by the petitioner was issued or offered for sale by Piper Aircraft Corporation until March 3, 1938, when 21,500 units, each unit representing one share of convertible preferred stock and two subscription warrants of the type above mentioned, were offered to the public at $ 10 per unit. Each share of convertible preferred stock was convertible at the holder's option into 2 1/2 shares of common stock. No allocation of value was made between the preferred stock and the warrants sold as a unit.
On February 29, 1940, additional common stock of the corporation was offered for general sale at $ 8.75 per share.
Between July 14, 1938, and February 27, 1939, 8,000 shares of common stock were issued by the corporation in payment of brokers' underwriting commissions in connection with the issuance of the preferred stock.
The date of the first exercise of subscription warrants was December 18, 1939, when a holder exercised warrants with respect to 400 shares of common stock.
The following are the market1945 U.S. Tax Ct. LEXIS 36">*43 quotations on the subscription warrants in 1940: March 8, 1940, bid 3/4; October 8, 1940, bid 2 1/2; asked 3 1/2. Moody's Manual of Investments, Industrials, 1942, at page 1116, lists the price range of Piper Aircraft Corporation's common stock as follows:
| 1941 | 1940 | 1939 | 1938 | |
| High | 7 | 9 1/2 | 4 | 4 |
| Low | 4 1/2 | 7 1/2 | 1 | 1 |
5 T.C. 1104">*1108 The earnings of the Piper Co. for the fiscal years 1938 through 1941 are as follows:
| Fiscal year ended -- | Net income | Taxes | Earnings per |
| share | |||
| Sept. 30, 1938 | $ 32,038.45 | $ 8,010.02 | $ 0.22 |
| Sept. 30, 1939 | 117,523.49 | 22,027.08 | .92 |
| Sept. 30, 1940 | 198,186.54 | 37,344.96 | 1.08 |
| Sept. 30, 1941 | 323,194.80 | 110,891.75 | 1.44 |
Petitioner sold his 57,000 subscription warrants for $ 28,500 on March 6, 1940. Expenses incident to the sale were $ 22.80. Prior to petitioner's sale of his warrants there were no sales, in the market or otherwise, of Piper Aircraft Corporation subscription warrants.
The warrants had value at the date of their receipt by petitioner, but their fair market value at that time was not ascertainable.
Petitioner used a total cost basis of $ 117,757.93, and in computing his income tax liability for 19401945 U.S. Tax Ct. LEXIS 36">*44 he allocated a basis of $ 37,757.93 to the subscription warrants, arriving at a total loss of $ 9,280.73. Of that amount, he deducted 50 percent as a long term capital loss. The respondent agrees that for the purposes of this proceeding a total cost basis of $ 117,757.93 may be used.
The respondent disallowed the deduction and held that the subscription warrants acquired with the shares of common stock on November 13, 1937, had no fair market value at that time; that they had a basis of zero; and that the amount received, less selling expenses, on the sale of such warrants in 1940 was taxable as a capital net gain (50 percent thereof).
OPINION.
The petitioner exchanged his investment in the old company for shares of common stock and common stock subscription warrants in the new company. The exchange was one in which no gain or loss was recognized. No allocation of value was made between the stock and the subscription warrants at the time they were issued to petitioner. Petitioner subsequently sold the warrants in 1940, at 50 cents each, or for a total consideration of $ 28,500. The respondent takes the view that the warrants had neither fair market value nor actual value at 1945 U.S. Tax Ct. LEXIS 36">*45 the date of issuance, November 13, 1937, and, consequently, that they had a basis of zero for the purpose of determining gain or loss on the sale or exchange thereof by petitioner. From that position it follows that the petitioner would be taxable upon the sale receipts at the applicable capital gains rate, and that his total investment would be represented by the shares of common stock which he has not disposed of.
5 T.C. 1104">*1109 The petitioner contends that the warrants had value at the time they were acquired and, while conceding that his allocation of some $ 37,000 to them was nothing more than his best guess, he argues that such amount is as appropriate as any other amount that could be determined from the facts and circumstances. In the alternative he contends that, if no allocation can be made with reasonable certainty, recognition of gain or loss should be deferred until he has recovered his cost.
The Internal Revenue Code does not provide a method for allocating the cost, or other basis for determining gain or loss, to each class of securities acquired as a unit. However, the rule has become established that, where a mixed aggregate of assets is acquired in one transaction, 1945 U.S. Tax Ct. LEXIS 36">*46 the total purchase price shall be fairly apportioned between each class so as to determine profit or loss on subsequent sale of specific assets in the group. If such apportionment be impractical, no profit shall be realized until the cost shall have been recovered out of the proceeds of sales. See Philip D. C. Ball, 27 B. T. A. 388, 394; affd., 69 Fed. (2d) 439, without discussion of this point; Mertens, Law of Federal Income Taxation, vol. 3, p. 378. In H. A. Green, 33 B. T. A. 824, 828, we observed that respondent's regulations had for a number of years provided for such apportionment of cost and for deferment of recognition of gain until cost was recovered where allocation is impractical. It was pointed out that article 1567 of Regulations 62 1 (interpreting the Revenue Act of 1921) had provided that allocation of cost should be made in proportion to the fair market value of each class of securities at the date of receipt, and that while subsequent regulations do not contain the exact language, the quoted provision lays down a principle equally applicable under subsequent revenue acts. 1945 U.S. Tax Ct. LEXIS 36">*47 Indeed, under the revenue acts and the Sixteenth Amendment only so much of the proceeds of a sale of property as represents a realized profit over and above the cost of the property sold is taxable as income.
The parties do not question the application of the rule to the instant case, and each of them has set forth the footnoted excerpt from Regulations 103, section 19.22 (a)-8, 2 as being applicable. In addition, the respondent has set forth the further provision of that section, dealing 5 T.C. 1104">*1110 with the sale of rights to subscribe, which is set out in the margin. 3 It appears that the rule is given the same effect under both provisions. The latter provision seems to be specifically concerned with the sale of stock rights which are distributed1945 U.S. Tax Ct. LEXIS 36">*48 by a corporation to its stockholders but which do not give rise to income under section 115 (f). The warrants in question were not distributed to petitioner in respect of any stock then held by him in the corporation, but came to him through an exchange by which he acquired the stock and the warrants as a mixed aggregate of assets.
1945 U.S. Tax Ct. LEXIS 36">*49 We think the respondent erred in attributing the entire cost to the shares of common stock. It can not be said that the warrants had no value simply because they could not be exercised to immediate financial advantage at the time they were issued. The right to subscribe at fixed prices over the prescribed period is the very consideration bargained for by a purchaser, and the fact that they were highly speculative and entirely prospective is no basis, in the circumstances here present, for denying to them any value. Collin v. Commissioner, 32 Fed. (2d) 753; Commissioner v. Swenson, 56 Fed. (2d) 544.
Moreover, the petitioner received 80,000 shares of common stock, plus the right to subscribe to 57,000 additional shares at any time during the 4-year period. The result of the transaction was such that petitioner was assured of control of the company, at least during that period and thereafter if he chose to exercise his options under the warrants. There was a question of the future management of the company, as it would affect earnings and dividends. This right of management and control, which was vested in the1945 U.S. Tax Ct. LEXIS 36">*50 common stock, was itself valuable, and must have entered into the consideration of the purchaser. Collin v. Commissioner, supra.The petitioner testified that he would not have entered into the plan unless it had been possible for him to retain voting control.
The warrants occupied a status different from that of a stock interest. They were not reflected in the capital account of the corporation and did not represent an absolute equitable ownership therein. As emphasized above, their value sprang from the right or privilege of exercising them during a definite period of time and at specific prices 5 T.C. 1104">*1111 to acquire a stock interest. About the only way the fair market value could be measured would be from trading experience with respect to them, that is, sales or bid and asked prices, or from the amount of savings which might have been immediately realizable from their exercise. Evidence given by the only two witnesses was that the warrants had value, but that any value which could have been placed on them at that time would have been entirely speculative. The circumstances here are such that there is no way in which we can ascertain the1945 U.S. Tax Ct. LEXIS 36">*51 fair market value of the warrants for purposes of allocating the cost between them and the common stock. Unlike the situation in Philip D. C. Ball, supra, the petitioner herein has produced the available and admissible evidence, substantially all of which has been stipulated by the parties.
Does it follow that the respondent must prevail if the petitioner is unable, in view of the circumstances, to establish the fair market value of the warrants at the time of their receipt? We think not. It is clearly established that they were valuable when received and that consideration was paid for them. Moreover, during the period in which they were to run they were quoted from 3/4 to 3 1/2, and the fact remains that petitioner was able to dispose of his for some $ 28,000. To deny the petitioner the benefit of the rule in this case would be an injustice, for under that very rule recognition of gain or loss is postponed if there be no practical basis upon which an allocation can be made. Surely, when it is shown that the warrants had value, even though the measurement thereof be impossible, a determination of no value by the respondent is arbitrary and should1945 U.S. Tax Ct. LEXIS 36">*52 be laid aside. See Helvering v. Taylor, 293 U.S. 507">293 U.S. 507, and Miles v. Safe Deposit & Trust Co., 259 U.S. 247">259 U.S. 247.
In Edwin D. Axton, 32 B. T. A. 613, we pointed out that although one of the stocks in question undoubtedly had some value, a consideration of all of the evidence indicated with reasonable certainty that no figure could be satisfactorily fixed upon to represent its value when received and that under such circumstances the entire cost should be recovered before gain or loss on the transaction was reportable. See also Kirkland v. Burnet, 57 Fed. (2d) 608; Sallie Strickland Tricou, 25 B. T. A. 713; affirmed without discussion of this point, 68 Fed. (2d) 280.
There is some question regarding the market value of the common stock at the time it was received. However, in the view we take of the matter that is not now significant. For a proper allocation of cost we would have to determine the market value of both the stock and the warrants. Where there is no market value, as is the situation1945 U.S. Tax Ct. LEXIS 36">*53 with respect to the warrants, there is no practical basis upon which an allocation can be made and the taxpayer is entitled to recover his 5 T.C. 1104">*1112 entire original basis before gain or loss will be recognized. H. A. Green, supra.
Decision will be entered under Rule 50.
Footnotes
1. Art. 1567. * * * the proportion of the original cost, or other basis, to be allocated to each class of new securities is that proportion which the market value of the particular class bears to the market value of all securities received on the date of the exchange. * * * ↩
2. Sec. 19.22(a)-8. Sale of stock and rights↩. -- * * * If common stock is received as a bonus with the purchase of preferred stock or bonds, the total purchase price shall be fairly apportioned between such common stock and the securities purchased for the purpose of determining the portion of the cost attributable to each class of stock or securities, but if that should be impracticable in any case, no profit on any subsequent sale of any part of the stock or securities will be realized until out of the proceeds of sales shall have been recovered the total cost.
3. Although the issuance by a corporation to its shareholders of rights to subscribe to its stock may not under section 115(f) give rise to taxable income, gain may be derived or loss sustained by the shareholder from the sale of such rights. In the case of stock in respect of which were acquired stock subscription rights which did not constitute income to the shareholders within the meaning of the Sixteenth Amendment to the Constitution, and in the case of such rights, the following rules are to be applied:
(1) If the shareholder does not exercise, but sells, his rights to subscribe, the cost or other basis, properly adjusted, of the stock in respect of which the rights are acquired shall be apportioned between the rights and the stock in proportion to the respective values thereof at the time the rights are issued, and the basis for determining gain or loss from the sale of a right on one hand or a share of stock on the other will be the quotient of the cost or other basis, properly adjusted, assigned to the rights or the stock, divided, as the case may be, by the number of rights acquired or by the number of shares held.↩