*1463 A corporation and its stockholders agreed upon a plan to procure additional working capital for the corporation, which involved a surrender of 75 percent of outstanding stock by the stockholders, an amendment of the corporate charter to provide for class A and class B stock in place of the old preferred and common, the issuance of 25 percent of new stock for 25 percent of old retained by stockholders, and the purchase of new stock by certain stockholders. Petitioner surrendered 75 percent of his stock and claimed a loss equal to the cost of the stock surrendered. Held, that under the plan as consummated, a recapitalization resulted, and no gain or loss is recognizable under section 112(b)(3) of the Revenue Act of 1928.
*900 This proceeding involves a deficiency of $3,541.11 in income tax for the calendar year 1928. The issue is whether respondent erred in disallowing a claimed deduction of $22,500, representing the cost of 75 shares of preferred and 240 shares of common stock of the James Motor Valve Co.
FINDINGS*1464 OF FACT.
The petitioner is a practicing attorney in the city of Detroit. In August 1928 he owned 100 shares of preferred and 320 shares of common stock of the James Motor Valve Co., a Michigan corporation organized for the purpose of manufacturing and selling motor valves. Petitioner's stock was purchased subsequent to March 1, 1913, at a total cost of $30,000.
In August 1928 the James Motor Valve Co., hereinafter referred to as the company, had an authorized capital of 1,500 shares of preferred stock of $100 par value per share and 3,000 shares of common stock of no par value. At that time 1,808 shares of the common were issued and outstanding, 742 1/2 shares were treasury stock, and *901 449 1/2 shares were unissued stock. Of the preferred stock, 830 shares were issued and 670 unissued.
The stock of the company was owned by 17 stockholders, petitioner being one of the largest.
In August 1928 the financial condition of the company had become so involved that a plan was devised whereby additional working capital could be raised. Under the proposed plan the stockholders agreed with each other and with the company that, "for the purpose of reorganizing said Company*1465 and providing stock for sale to provide funds," they would donate and give to the company 75 percent of their stock, and agreed, upon demand, to deliver all their certificates endorsed in blank to two trustees. The trustees were to hold the stock in trust pending an amendment to the articles of association which would convert the common stock into 3,000 shares of class B, no par stock, and the preferred into 1,000 shares of class A, no par stock. The class A stock was to have "a cumulative preference dividend of $7.00 per share per annum," while the class B stock was entitled to a $5 dividend "when and as declared" after payment of dividend on class A stock. Any further distributions were to be equally divided between class A and class B stock. Both classes of stock carried voting rights.
The agreement, which is incorporated herein and made a part hereof by reference, further provided for the action of the stockholders as follows:
To surrender upon the completion of said amendment to the Articles of Association of said Company for the purpose of obtaining new financing for the further continuation of the business of said Company in the sum of not less than TWENTY-FOUR THOUSAND*1466 ($24,000.00) DOLLARS, said certificates of stock belonging to us respectively and delivered to said Trustees, endorsed in blank, and to accept in lieu thereof shares of Class "A" no-par stock in an amount equivalent to twenty five (25%) per cent of the number of shares of preferred stock so delivered to said Trustees and shares of Class "B" no-par stock in an amount equivalent to twenty five (25%) per cent of the number of shares represented by the certificate of no-par stock delivered to said Trustees, issued in our respective names and to be delivered to us, and for the purpose of accomplishing said amendment to the Articles of Association, we and each of us to hereby appoint the said above named Trustees, J. H. James and C. Redman Moon or either of them our true and lawful proxy and attorneys for us and in our name, place and stead to appear at a special stockholders' meeting of said Company to be held at the office of the Company September - , 1928, and/or any adjournments thereof, and then and there to cast a number of votes to which we and each of us are respectively entitled to cast for the amendment of said Articles of Association, and also to authorize the issuance by the*1467 Board of Directors of not exceeding FIFTY THOUSAND ($50,000.00) DOLLARS of six (6) years six (6%) per cent debenture notes of the Company, upon such terms as may be by the Directors decided upon, and subject to an indenture to be executed by said Company to the Trustees, said debenture notes to be used for liquidating so far as may be possible, accounts and notes *902 payable of said James Motor Valve Company for doing any other or different business which may regularly come before said special stockholders' meeting.
On or before September 25, 1928, the stockholders had deposited their stock under the agreement and new capital in the sum of $25,750 had been paid in to the trustees by the following stockholders, who were entitled to class A and class B stock as set forth:
| Stockholder | Date | Amount | Shares of | Shares of |
| paid | class A | class B | ||
| stock re- | stock re- | |||
| ceived at | ceived at | |||
| 2.15 for 1 | 4.86 for 1 | |||
| H. E. Butcher | 9-22-28 | $5,000 | 107.5 | 234 |
| Mrs. Cramer | 9-24-28 | 500 | 10.75 | 23.5 |
| M. C. DeWitt | 9-24-28 | 7,500 | 161.25 | 351 |
| Walter F. Haass | 9-24-28 | 7,500 | 161.25 | 351 |
| J. H. James | 9-15-28 | 4,500 | 96.5 | 210.5 |
| U. Grant Race | 9-25-28 | 750 | 16.5 | 3.5 |
| Total | 25,750 | 553.5 | 1,205 |
*1468 On September 25, 1928, the stockholders authorized the amendment of the articles of association so as to change the capital structure in accordance with the proposed plan. The amendment was signed October 23, 1928, and filed with the secretary of state on October 27, 1928.
Pursuant to the foregoing plan the trustees surrendered the old stock, which was canceled, and new stock was issued as follows:
| Class A | Class B | |
| Returned to old stockholders (25 percent) | 207 1/2 | 452 |
| Sold to old stockholders | 553 1/2 | 1,205 |
| Treasury stock | 69 | 893 1/2 |
| Unissued | 170 | 449 1/2 |
| Total authorized | 1,000 | 3,000 |
As a result of the transaction aforementioned, petitioner received 25 shares of class A stock and 80 shares of class B stock, representing 25 percent of his original holdings in the preferred and common stocks of the company. For his investment of $7,500 in the company on September 24, 1928, petitioner received 161.25 shares of class A stock and 351 shares of class B stock. The other stockholders who invested additional capital in the company received class A and class B stock in the same ratio.
In his return for 1928 the petitioner deducted $22,500*1469 as a loss, upon the theory that by surrendering three fourths of his stock he had lost 75 percent of his original investment.
The respondent disallowed the deduction and petitioner appealed from his determination.
*903 OPINION.
ADAMS: The petitioner contends that since his proportionate interest in the company was changed as a result of the consummation of the plan outlined, he has sustained "a loss equal to the cost to him of the two-thirds of his original stock given to new capital, plus the proportion of the cost of the one-twelfth of his original stock surrendered to the Company's treasurer which the stock issued for the new capital bore to the outstanding stock of the Company after the transaction, less the increment to the value of his retained stock by reason of the addition of the new capital." Stated differently and in terms of dollars and cents, petitioner says he is entitled to deduct $20,704.94 instead of $22,500 originally claimed on his return. He cites the decisions of ; affirming and modifying the Board's decision in *1470 ; ; affirming the Board's decision in ; and , as supporting his position.
The respondent contends that the transaction falls clearly within the terms of section 112(b)(3) of the Revenue Act of 1928; 1 that the term "reorganization" includes a recapitalization, section 112(i)(1); 2 that the agreement under which the reorganization and recapitalization was effected was entered into by all the stockholders and the corporation; that the stock was deposited with the trustees for the use of the corporation; that the corporation canceled the old stock and issued in lieu thereof new shares of class A and class B stock to the same stockholders; that these facts show a reorganization was accomplished; and that under section 112(b)(3) no gain or loss was realized by petitioner upon the exchange of preferred and common stocks for class A and class B stocks. Respondent cites *1471 ; ; and , and asserts that the decision in the *904 Wright case, supra, is not in point. He directs attention to the circumstances considered in the Burdick case, supra, which would, according to the Board, constitute a reorganization, and contends that this proceeding falls squarely within the circumstances there considered.
*1472 In determining this question we must first consider whether the transaction amounted to a reorganization as defined in section 112(i). The first two situations covered in the statutory definition are inapplicable because only one corporation is involved, but either (C) or (D) thereof could apply, given the proper circumstances. Considering the facts before us, it is obvious that if there has been a reorganization of the company it must have occurred as a result of a recapitalization.
A recapitalization connotes a change or a readjustment in the capital structure, either by an increase or by a decrease of the outstanding capital stock and bonds. Cook on Corporations, 8th ed., vol. 5, p. 4103, sec. 883, defines a reorganization as "a business arrangement whereby the stock and bonds of the company are readjusted as to amount, income, or priority, or * * *. An agreement * * * to scale down the securities, is generally held not binding on any stockholder or bondholder who objects. * * * This mode of reorganization is but a recapitalization. It is a voluntary agreement of all stockholders and creditors to change and increase or decrease the capitalization or debts, or both. *1473 " (Italics supplied.)
In this proceeding it is clear that there was a change in the capital structure of the company. Prior to August 1928 it had an authorized capital of 3,000 shares of common stock of no par value and 1,500 shares of preferred stock of $100 par value. After the consummation of the agreement, the capital structure consisted of 3,000 shares of class B, no par stock, 1,000 shares class A, no par stock, and a proposed plan for the issuance of $50,000 of six-year 6 percent debenture notes to be used to liquidate accounts of the company.
The fact that the plan agreed to by the stockholders and the company provided for trustees who were to act for certain purposes does not bring this proceeding within the doctrine of the Wright and the Burdick cases, supra. There was no surrender of stock for the purpose of bringing in a new management; the surrender was for the purpose of reorganizing and refinancing the company. If we consider only the first step in the plan agreed to, namely, the 75 percent reduction, the stockholders would be in exactly the same position as that obtaining in benjamin *1474 , affirmed in , where the Board held that a 25 percent reduction in second preferred stock outstanding, together *905 with a change in value of common stock from $100 par to no par, and the issuance of 200 shares of no par common for each share of outstanding common of $100 par value, constituted a recapitalization, with no gain or loss to the petitioner.
The question naturally arises, therefore, whether the purchase of additional stock by petitioner alters the situation and justifies the deduction of 75 percent of the original cost of his stock as a loss. The mere statement of the question indicates its weakness. Petitioner has simply invested an additional $7,500 in the company as a result of the refinancing necessary to continue operations. There has been a recapitalization of the company, and since the definition of a reorganization includes a recapitalization, petitioner is governed by the statutory provisions applicable to reorganizations.
The exchange of stock for stock within the meaning of section 112(b)(3), supra, occurred when petitioner turned in his shares of*1475 preferred and common, receiving in exchange therefore the new class A and class B stock of the company. His proportionate interest in the company was unchanged at this point. Upon the investment of the additional $7,500 his proportionate interest changed in accordance with his increased investment. After the consummation of the plan petitioner had a capital investment of $37,500, represented by class A and class B stock then in his possession. Gain or loss from his investment will result upon the sale or other disposition thereof.
In a recent decision, , the respondent proposed to tax the petitioner upon a gain realized from a recapitalization. The Board refused to permit the taxing of the gain because the readjustment of existing interests through the issuance of preferred stock and the reduction of common stock resulted in a recapitalization, and under section 112(b)(3) no gain or loss could be recognized. See also ; *1476 ; .
The , cited by petitioner, is clearly distinguishable on its facts from the instant proceeding.
Decision will be entered for the respondent.
Footnotes
1. SEC. 112. (b) Exchanges solely in kind. -
* * *
(3) STOCK FOR STOCK IN REORGANIZATION. - No gain or loss shall be recognized if stock or securities in a corporation a party to a reorganization are, in pursuance of the plan of reorganization, exchanged solely for stock or securities in such corporation or in another corporation a party to the reorganization. ↩
2. SEC. 112. (i) Definition of reorganization. - As used in this section and sections 113 and 115 -
(1) The term "reorganization" means (A) a merger or consolidation (including the acquisition by one corporation of at least a majority of the voting stock and at least a majority of the total number of shares of all other classes of stock of another corporation, or substantially all the properties of another corporation), or (B) 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, or (C) a recapitalization, or (D) a mere change in identity, form, or place of organization, however effected. ↩