*22 Decisions will be entered for the petitioners in Docket Nos. 54568, 54570, 54687, 54688, 54722, 55426, and 55427.
Decisions will be entered under Rule 50 in Docket Nos. 54569, 54572, and 54723.
Petitioners owned less than 50 per cent of the stock of Pocahontas Tanning Company. In 1947, they were approached by representatives of Howes Leather Company, Inc., with an offer to buy their Pocahontas stock, along with that of other stockholders, so that Pocahontas could be merged into Howes. Petitioners agreed to and did sell their stock to Howes, and Pocahontas was merged into Howes on September 19, 1947. Petitioners received short-term notes and 20-year first mortgage bonds in payment for their stock. Respondent determined that petitioners had exchanged their Pocahontas stock pursuant to a plan of reorganization, and that a part of the value of the short-term notes which they received represented their ratable share of Pocahontas's undistributed earnings and profits accumulated since February 28, 1913, and was therefore taxable as a dividend pursuant to section 112 (c) (2), I. R. C. 1939. Held, even though Pocahontas were merged into Howes, the merger was not a "statutory*23 merger or consolidation" within the meaning of the Code, since petitioners were only creditors of Howes and retained no proprietary interest therein after the merger; they sold their Pocahontas shares and the entire gain realized on such sale is taxable as a long-term capital gain.
*434 This proceeding involves the following deficiencies in income tax for the year 1947:
| Docket No. | Petitioner | Deficiency |
| 54568 | W. H. Truschel and Louise Truschel | $ 1,559.00 |
| 54569 | Security Trust Company, trustee, Emma F. Hoffman Trust | 199,259.17 |
| 54570 | W. H. Truschel and Rosa M. Truschel | 5,510.56 |
| 54572 | Security Trust Company, trustee, Thomas McKay | |
| Hearne Trust | 3,677.62 | |
| 54687 | Mary Virginia Paull | 18,574.96 |
| 54688 | Mary Milton Hearne | 5,485.01 |
| 54722 | Louise H. Rownd | 9,770.05 |
| 54723 | Security Trust Company, trustee, Thomas McKay | |
| Hearne Trust (for Lucy M. Hearne) | 3,677.62 | |
| 55426 | Rita S. Cochran | 6,295.43 |
| 55427 | Daniel W. Cochran | 44,905.95 |
The issues are: (1) Whether the petitioners received a distribution which was equivalent to a dividend upon the exchange of their stock in an "old" corporation for bonds and short-term notes of a "new" corporation into which the "old" one was merged; (2) if so, the amount of the dividend per share which they received; and (3) whether the statute of limitation bars assessment and collection of the deficiencies*25 in issue.
Some of the facts were stipulated.
FINDINGS OF FACT.
The stipulated facts are so found and are incorporated herein by this reference.
All of the petitioners were residents of Wheeling, West Virginia, during the year 1947, and filed timely returns for such year on a cash basis with the former collector of internal revenue at Parkersburg.
Prior to September 19, 1947, the Pocahontas Tanning Company, hereinafter referred to as Pocahontas, was a West Virginia corporation engaged in the business of manufacturing and selling sole leather for use in the manufacture of shoes. The company was organized in 1903 by members of the Hoffman family, and from that time up to the period here in question had always been managed by members of that family. For many years prior to 1947, Pocahontas purchased the hides which it tanned into sole leather from, and also sold such leather through, Howes Brothers Company, a corporation, whose principal office was in Boston, Massachusetts. Over the years, a friendly relationship had existed between the two companies. Howes Brothers owned 24 per cent of the Pocahontas stock.
From the early 1930's until his death on July 10, 1947, John J. Hoffman, *26 3d, was president of Pocahontas. For some time prior to his death he had been unable to perform his duties as president, and his nephew, Daniel W. Cochran, one of the petitioners herein, performed many of those duties.
*435 Some of the principal officers of Howes Brothers Company attended Hoffman's funeral at Wheeling on July 12, 1947. At that time they asked Cochran to come to a meeting in Boston which was to be held on July 18, 1947. Cochran attended the Boston meeting on that date, at which time he learned that Howes Brothers and certain other corporations affiliated with it were to be merged into a new corporation known as Howes Leather Company, Inc., hereinafter referred to as the Leather Company. The Leather Company was a Delaware corporation, the charter of which provided it was organized exclusively for charitable or educational purposes and that it was incorporated solely for the benefit of New York University. The charter also provided that no part of its income or property could inure to the private benefit of any stockholder, director, or officer. It was not to engage in propaganda or otherwise attempt to influence legislation. It had broad powers to engage *27 in business and to acquire and hold property. It had three classes of directors. The class A and one-third of the class C directors were elected by the stockholders; the class B and one-third of the class C directors were elected by the bondholders; and the remaining one-third of the class C directors were elected by a majority of the stockholders together with a majority of the bondholders. A majority of the class A and class B directors was necessary to constitute a quorum of the directors. The shareholders elected the corporation's officers. The Leather Company's authorized capital stock consisted of 10 shares of $ 100 par value each. The merger of Howes Brothers and the other affiliated corporations into the Leather Company was consummated on August 12, 1947.
At the Boston meeting on July 18, officials of Howes Brothers advised Cochran that the stockholders of Pocahontas could sell their stock to the Leather Company if they wished to do so. Cochran agreed to discuss the proposal with other stockholders when he returned to Wheeling. Late in July and again in August, representatives of Howes Brothers and the Leather Company came to Wheeling and discussed the proposed purchase*28 of the Pocahontas stock with Cochran and other stockholders. They proposed that the same formula used in the purchase of the stock of Howes Brothers and the other corporations be used in fixing the purchase price per share of the Pocahontas stock, namely, that such price would be based on the appraised value of the real estate owned by Pocahontas and the fair market value of all of its other assets. During the time here material, Pocahontas had outstanding 10,700 shares of stock. The petitioners herein owned 2,986 of such shares.
After the August meeting, the Pocahontas stockholders agreed to sell their stock to the Leather Company, and on September 19, 1947, Pocahontas was formally merged into the Leather Company. Based *436 upon the agreed-upon formula, the Pocahontas stockholders received $ 570.88 per share for their stock which was paid by the following obligations:
3 1/2 per cent notes of Howes Leather Company, Inc., of the face value of $ 930,909.54 ($ 114.18 per share) dated September 19, 1947, due and paid on October 19, 1947;
3 1/2 per cent notes of Howes Leather Company, Inc., of the face value of $ 698,141.39 ($ 85.63 per share) dated September 19, 1947, due and*29 paid January 15, 1948;
3 1/2 per cent 20-year first mortgage bonds of Howes Leather Company, Inc., of the face value of $ 2,268,979.90 ($ 278.30 per share) delivered to the stockholders of Pocahontas. These bonds were dated August 12, 1947, and are due by August 12, 1967; and
3 1/2 per cent 20-year first mortgage bonds of Howes Leather Company, Inc., of the face value of $ 756,353.81 ($ 92.77 per share) delivered to the Old Colony Trust Company, Trustee, of Boston, Massachusetts, in accordance with the instrument of merger.
None of the petitioners herein have been officers, directors, or employees of the Leather Company except that Daniel W. Cochran continued as an employee for a period of 19 months after the merger, and in 1956, for the first time, was elected a director of the Leather Company.
On September 19, 1947, the undistributed, accumulated earnings of Pocahontas since February 28, 1913, totaled $ 1,312,941.75. Pocahontas owned a minority interest in another corporation which had subsidiaries. All such corporations had undistributed, accumulated earnings on the date of the merger.
On September 19, 1947, after the merger of Pocahontas into the Leather Company, the Leather*30 Company had outstanding approximately $ 22,663,000 of first mortgage bonds, of which $ 3,025,333.71 in face amount had been issued to and for the account of the Pocahontas stockholders. The Leather Company bonds were due and payable without exception on August 12, 1967, and bore fixed interest at the rate of 3 1/2 per cent per annum, payable semiannually. In the event of default in interest payments, the bonds became due and payable forthwith and resort could be had to the properties of the Leather Company securing the bonds. To the extent of the mortgaged property, the bondholders were prior to all other creditors and were on a parity with all other creditors with respect to any property not subject to the mortgage. The properties securing the bonds consisted of all lands, rights, and interests in lands which the Leather Company owned; all plants, buildings, factories, warehouses, and all machines and machinery which it owned; and all trademarks and trade names.
*437 On the returns which they filed for 1947, the petitioners reported the exchange of their Pocahontas stock for the notes and bonds of the Leather Company as a sale, and the gain realized as a long-term capital*31 gain. They reported the cash actually received during the year on the installment basis, as provided in section 44 (b). 2 The respondent determined that the petitioners had exchanged their Pocahontas stock in a partially nontaxable reorganization, and that $ 161.05 per share of the short-term notes which they received represented a taxable dividend under section 112 (c) (2).
*32 The petitioners filed timely returns for the year 1947. The deficiency notices were not mailed until the months of June or September, 1954. The petitioners executed waivers extending the time for assessment and collection of deficiencies only if they had omitted from gross income an amount which was properly includible therein in excess of 25 per cent of the amount of gross income which was stated on their returns. An understatement of gross income in an amount in excess of 25 per cent of the amounts reported on the returns occurred only if the petitioners received dividends as determined by the respondent in the deficiency notices.
OPINION.
The parties here agree that Pocahontas was merged into the Leather Company in September 1947, but they disagree on whether that merger was a "statutory merger or consolidation" within the meaning of section 112 (g) (1) (A). 3 The respondent contends that it was. He argues that petitioners exchanged their Pocahontas stock for bonds and notes of the Leather Company pursuant to the agreed-upon plan for such a reorganization within the meaning of section 112 (b) (3), 4 and that the notes which petitioners received, *438 to the extent of*33 $ 161.05 per share of their Pocahontas stock, represented a distribution of earnings and profits accumulated after February 28, 1913, and was therefore taxable as a dividend pursuant to section 112 (c) (1) and (2). 5
*34 While the petitioners concede that there was a merger, they deny that it was a "statutory merger or consolidation" within the meaning of the statute. They contend, under the doctrine of LeTulle v. Scofield, 308 U.S. 415">308 U.S. 415 (1940), and Roebling v. Commissioner, 143 F. 2d 810 (C. A. 3, 1944), affirming a Memorandum Opinion of this Court dated June 30, 1943, certiorari denied 323 U.S. 773">323 U.S. 773 (1944), that in addition to the formal framework of a merger there must also be a continuity of proprietary interests to satisfy the requirements of the statute. They argue that when they exchanged their Pocahontas stock for bonds and notes, their proprietary interests ceased and they were only creditors of the Leather Company, and, hence, that there was no statutory reorganization but a sale on which only a long-term capital gain was realized.
We agree with the petitioners that the exchange of their stock for bonds and notes was a sale and not a statutory reorganization. In LeTulle v. Scofield, supra, one corporation exchanged all of its properties for cash and the bonds*35 of another corporation and then distributed such cash and bonds to its stockholders. Neither the selling corporation nor its stockholders reported gain on the transaction on the theory that there had been a tax-free statutory reorganization. The Supreme Court held that there was no statutory reorganization because the stockholders of the selling corporation did not continue their proprietary interests in the purchasing corporation. In reaching the same conclusion on similar facts, the Court of Appeals said, in Roebling v. Commissioner, supra at p. 812:
though there was * * * a "true statutory merger" under [State law] * * *, (1) such "true statutory merger" is insufficient without more to qualify as a "reorganization" *439 under the Revenue Act, and (2) that a "continuity of interest" * * * must still be present to establish a true reorganization.
The respondent attempts to show the necessary continuity of interest here by arguing that the bonds which petitioners received were the equivalent of stock, and, hence, he contends that the real effect of the transaction was an exchange of stock for stock despite the name which was given to the*36 security instruments which the petitioners received. We do not agree with the respondent that the bonds here in question were the equivalent of stock. We think it clear that the bonds which petitioners received were, in fact, evidences of indebtedness and did not represent shares of equity capital. The bonds had a fixed maturity date; they bore a fixed rate of interest; and they gave the holders a preferred position over stockholders and other creditors. Cf. John Kelley Co. v. Commissioner, 326 U.S. 521">326 U.S. 521 (1946). The only provision in the bonds which might indicate a proprietary interest in the corporation was that the bondholders were entitled to elect one-half of the corporation's board of directors. But on this record, that one provision, standing alone, does not change the character of these bonds from evidences of a debtor-creditor relationship to evidences of an equity capital investment. Helvering v. Richmond, F. & P. R. Co., 90 F. 2d 971 (C. A. 4, 1937), affirming 33 B. T. A. 895 (1936). See Ohio Furnace Co., 25 T. C. 179 (1955). The respondent*37 also, in arguing that the bonds represented an equity capital investment, points to the so-called "thin capitalization" of the Leather Company in that it had outstanding some 22 million dollars of bonds and only $ 1,000 of capital stock. In the circumstances of this particular case, we attach no significance to that fact. In the ordinary thin capitalization case, the alleged bondholders or noteholders and stockholders are the same persons. Colony, Inc., 26 T. C. 30 (1956), affd. 244 F. 2d 75 (C. A. 6, 1957), certiorari granted 355 U.S. 811">355 U.S. 811 (1957); Erard A. Matthiessen, 16 T. C. 781 (1951), affd. 194 F. 2d 659 (C. A. 2, 1952); Isidor Dobkin, 15 T. C. 31 (1950), affd. 192 F. 2d 392 (C. A. 2, 1951). That is not true here. We think it is not unusual to find only a minimum amount of capital stock outstanding when the new corporation into which others have been merged is a nonprofit organization. Ohio Furnace Co., supra.
The petitioners became creditors*38 of the corporation and not stockholders by exchanging their Pocahontas stock for the Leather Company's bonds and notes. Creditors are not owners, and when petitioners changed their status from stockholders to creditors, their continuity of ownership interest was broken and they ceased to have any proprietary interest in the new company. There was therefore no *440 statutory reorganization but only a sale on which petitioners realized a long-term capital gain. LeTulle v. Scofield, supra;Roebling v. Commissioner, supra.
The respondent relies heavily on Emanuel N. ( Manny) Kolkey, 27 T. C. 37 (1956), on appeal (C. A. 7 and C. A. 2, June 12, 1957), in support of his position. That case is so entirely different from the one before us that no purpose would be served by comparing its facts with those here. Suffice it to say that we concluded there that the exchange of stock for notes did not create a bona fide debtor-creditor relationship resulting from a true purchase and sale. We held that the notes, in truth, represented an equity investment by the old stockholders in the*39 continuing business. Our findings there showed beyond any doubt that the purported sale was only a sham under which the old stockholders "could masquerade as 'creditors', and withdraw earned surplus and profits in the guise of capital gains." That is not true here.
We note that on the date of the merger, Pocahontas had a substantial amount of undistributed earnings which had accumulated since February 28, 1913. That fact, however, does not convert what was truly a sale into a reorganization. Ralph M. Heintz, 25 T. C. 132 (1955).
Since there was no statutory reorganization, the petitioners could not have received a dividend when they sold their Pocahontas stock, and it is unnecessary to decide whether the respondent's determination of the amount of the alleged dividend was correct.
In determining the deficiencies in Docket No. 54570, the respondent disallowed $ 127 claimed as a medical expense for 1947. The waiver signed by petitioners in that docket gave the respondent the right to assess and collect deficiencies only if they had omitted from gross income an amount properly includible therein which was in excess of 25 per cent of the amount of gross*40 income stated in their returns. Since an understatement in excess of 25 per cent could result only if the petitioners had received dividends when they sold their stock, it follows that since they did not receive any dividends, there were no understatements in excess of 25 per cent of reported income. Assessment and collection of any deficiency determined for the year 1947 in that docket is therefore barred by the statute of limitation.
Decisions will be entered for the petitioners in Docket Nos. 54568, 54570, 54687, 54688, 54722, 55426, and 55427.
Decisions will be entered under Rule 50 in Docket Nos. 54569, 54572, and 54723.
Footnotes
1. The following proceedings have been consolidated herewith: Security Trust Company, Trustee, Emma F. Hoffman Trust, Docket No. 54569; W. H. Truschel and Rosa M. Truschel, Husband and Wife, Docket No. 54570; Security Trust Company, Trustee, Thomas McKay Hearne Trust, Docket No. 54572; Mary Virginia Paull, Docket No. 54687; Mary Milton Hearne, Docket No. 54688; Louise H. Rownd, Docket No. 54722; Security Trust Company, Trustee, Thomas McKay Hearne Trust (for Lucy M. Hearne), Docket No. 54723; Rita S. Cochran, Docket No. 55426; Daniel W. Cochran, Docket No. 55427. Mary E. Ewing, Docket No. 55425, and Estate of John G. Hoffman, 3rd, Deceased, Earl E. Seabright, Executor, Docket No. 55539, originally consolidated herewith, have been disposed of, pursuant to respondent's concession, by order and decision of no deficiencies entered August 8, 1957.↩
2. SEC. 44. INSTALLMENT BASIS.
(b) Sales of Realty and Casual Sales of Personality [Personality]. -- In the case (1) of a casual sale or other casual disposition of personal property * * * for a price exceeding $ 1,000 * * * if * * * the initial payments do not exceed 30 per centum of the selling price * * * the income may, under regulations prescribed by the Commissioner with the approval of the Secretary, be returned on the basis and in the manner above prescribed in this section. [A taxpayer may return as income that proportion of the installment payments actually received in that year which the gross profit realized or to be realized when payment is completed, bears to the total contract price.] As used in this section the term "initial payments" means the payments received in cash or property other than evidences of indebtedness of the purchaser during the taxable period in which the sale or other disposition is made.↩
3. SEC. 112. RECOGNITION OF GAIN OR LOSS.
(g) Definition of Reorganization. -- * * *
(1) The term "reorganization" means (A) a statutory merger or consolidation * * *↩
4. SEC. 112. RECOGNITION OF GAIN OR LOSS.
(b) Exchanges Solely in Kind. --
* * * *
(3) Stock for stock on 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.↩
5. SEC. 112. RECOGNITION OF GAIN OR LOSS.
(c) Gain from Exchanges Not Solely in Kind. --
(1) If an exchange would be within the provisions of subsection (b) (1), (2), (3), or (5), or within the provisions of subsection (1), of this section if it were not for the fact that the property received in exchange consists not only of property permitted by such paragraph or by subsection (l) to be received without the recognition of gain, but also of other property or money, then the gain, if any, to the recipient shall be recognized, but in an amount not in excess of the sum of such money and the fair market value of such other property.
(2) If a distribution made in pursuance of a plan of reorganization is within the provisions of paragraph (1) of this subsection but has the effect of the distribution of a taxable dividend, then there shall be taxed as a dividend to each distributee such an amount of the gain recognized under paragraph (1) as is not in excess of his ratable share of the undistributed earnings and profits of the corporation accumulated after February 28, 1913. The remainder, if any, of the gain recognized under paragraph (1) shall be taxed as a gain from the exchange of property.↩