25 T.C. 351">*352 Respondent determined deficiencies in income and excess profits taxes of petitioners in amounts and for years, as follows:

Certain adjustments made by respondent in both cases are uncontested. An alternative issue affirmatively raised by respondent in the pleadings has been abandoned. The sole controversy remaining to be resolved is whether petitioner in Docket No. 28539, American Pipe and Steel Corporation, is entitled to the tax benefits claimed in the consolidated returns which it filed for 1944, 1945, and 1946 by reason of its acquisition of the entire capital stock of Palos Verdes Estates, Inc.

FINDINGS OF FACT.

The stipulation of certain facts filed by the parties with an exhibit attached is adopted, and, by this reference, made a part hereof.

The petitioner in1955 U.S. Tax Ct. LEXIS 37">*39 Docket No. 28539 is the American Pipe and Steel Corporation (hereinafter referred to as American Pipe), a corporation organized under the laws of the State of Nevada on May 27, 1929. It maintains its principal place of business in Alhambra, California. American Pipe keeps its books of account and files its income tax rereturns on an accrual method of accounting on a calendar year basis.

The petitioner in Docket No. 28568 is W. G. Krieger Co., formerly Palos Verdes Estates, Inc., and hereinafter called Palos Verdes. Palos Verdes is a corporation organized under the laws of the State of California on March 11, 1935. Its name was changed to its present form by amendment of its articles of incorporation on April 13, 1953. During the taxable years at issue, it had its principal office in Alhambra, California. Palos Verdes keeps its books of account and files its income tax returns on an accrual basis of accounting. Prior to the acquisition of its capital stock by American Pipe, Palos Verdes used the fiscal accounting year ending on February 28. Effective 25 T.C. 351">*353 from December 2, 1943, this fiscal year was changed, with permission and approval of the respondent, to the calendar1955 U.S. Tax Ct. LEXIS 37">*40 year.

American Pipe filed consolidated income tax returns for each of the years 1943, 1944, 1945, and 1946 with the then collector of internal revenue for the sixth district of California at Los Angeles, in which returns were included the operations of Palos Verdes, as a wholly owned subsidiary, beginning with the period December 3, 1943, to December 31, 1943. Such returns showed consolidated normal tax net income or losses, which were the result of consolidating the net income and/or losses of the respective corporations, as follows:

The amounts stated in the Palos Verdes column and in the consolidated column for the taxable year 1944, reflect a carryover of claimed net operating loss of Palos Verdes for the period December 3, 1943, to December 31, 1943, deducted on the consolidated return filed for the year 1944 in the amount of $ 215,639.88. The amounts stated1955 U.S. Tax Ct. LEXIS 37">*41 in the Palos Verdes column and in the consolidated column for 1945 and 1946 reflect carryovers of claimed net operating losses for the first and second preceding years of Palos Verdes deducted on the consolidated returns filed for 1945 and 1946, in the amounts of $ 322,814.46 and $ 107,174.58, respectively.

At the time of filing the consolidated return for the year 1943, a separate return was also filed by Palos Verdes for the period begun March 1, 1943, and ended December 2, 1943, with the then collector of internal revenue for the sixth district of California. The books of Palos Verdes were closed for this purpose on December 2, 1943.

As of December 2, 1943, the principal assets of Palos Verdes consisted of approximately 695 lots in the vicinity of Palos Verdes, California. These lots had been sold and transferred by tax deeds to the State of California on or about July 1, 1938, for nonpayment of taxes for the year 1931-1932 totaling $ 97,406.39. Palos Verdes had been in poor financial condition since 1936. The period between 1938 and 1943 was the worst in its financial history. The lots owned by Palos Verdes were in a restricted residential area with a specified minimum cost1955 U.S. Tax Ct. LEXIS 37">*42 for houses built therein. These restrictions were supervised by lot owners who composed the Palos Verdes Homes Association and a committee known as the Art Jury. Originally in 1920, the lots held by Palos Verdes embraced a larger tract. As early as 1937, Palos Verdes had unsuccessfully tried to interest buyers and contractors in 25 T.C. 351">*354 combining with it in the erection of houses as an attraction for the sale of its remaining lots. Much of the property was wholly or partly without improvements as to roads and utilities. It had, in 1942, three employees, two of whom were on a part-time basis.

The stock control of American Pipe, during 1942 and all subsequent taxable years in issue in this proceeding, rested in Jack Lane and W. G. Krieger, who were partners or associates in the purchase of approximately 96 per cent of the outstanding shares thereof. Their interests in the shares were equal. At all times pertinent to the issues in these proceedings, Lane was the president of American Pipe and Krieger was secretary or secretary and treasurer.

Aside from a brief period, Lane had been associated with American Pipe since about 1928. He was vice president thereof from the time he1955 U.S. Tax Ct. LEXIS 37">*43 acquired his 48 per cent stock interest until in or about 1942 when he became president. He had previously been credit manager for about 10 years. Although largely self-educated, he had experience in various departments of an oil company, including the production and auditing departments. Lane had an extensive background in many phases of the local real estate business, including the development of tracts, management, and selling of properties through his own concern. He had long been familiar with real estate in the Palos Verdes area, having acquired a real estate broker's license in 1937, at which time he opened a real estate office 4 miles north of Palos Verdes.

American Pipe was principally engaged in the steel fabricating business, its main products being pipe and different types of tanks, fabricated products of steel, aluminum, and other alloys. Some of the larger items were field fabricated. More than 500 different products were manufactured. In May or the early part of June 1942, American Pipe received inquiries from the War Production Board, San Francisco, relative to bids for the building of 25,000 forge welded containers for lethal gas. Prior to this inquiry, American1955 U.S. Tax Ct. LEXIS 37">*44 Pipe had been engaged on its own, and through subcontractors, in other war contracts, manufacturing various types of material for the war effort.

The specifications for the lethal gas containers called for a particular process of manufacture, which process was unfamiliar to Lane and/or American Pipe. After consultation with American Pipe's engineer, on June 26, 1942, Lane submitted a quotation to the War Production Board which turned the matter over to the Chemical Warfare Service for further negotiations. At that time the tanks were being purchased by the Chemical Warfare Service for $ 190 each.

In July of 1942, after conferences with the Chemical Warfare Service, Lane felt that the contract was going to be awarded to American Pipe. On September 3, 1942, American Pipe received a written contract from the Chemical Warfare Service to produce 25,000 containers for $ 3,500,000.

25 T.C. 351">*355 Between May 29, and July 29, 1942, Lane had various meetings with Robert P. Archer at which the pending defense contract was discussed. Lane was also informed of the Palos Verdes situation by Archer and that its stock was then selling between 25 cents and 45 cents per share. Archer was interested1955 U.S. Tax Ct. LEXIS 37">*45 in the possibilities of profit to be made on the lots owned by Palos Verdes if he could acquire enough of the outstanding stock thereof to gain control. Archer had experience in the past with real estate and escrow transactions, having worked at the California Title Insurance Company, whose president was his father's law partner. He had been an appraiser with Fidelity Savings & Loan. He had had considerable experience in real estate generally. Since 1926, Archer had been a licensed real estate broker. Archer and Lane had formerly been associated in real estate business ventures as early as 1937 or 1938. They had known each other since 1930 or 1931.

On or about July 29, 1942, Lane suggested that Archer join the American Pipe organization as expediter on the defense contract which it appeared certain of getting. Archer wanted American Pipe's assistance in financing the acquisition of Palos Verdes. Lane and his associate Krieger agreed to lend Archer $ 2,500 for the purchase of Palos Verdes stock. Archer was employed by American Pipe as an "expediter" at $ 100 per week on August 12, 1942, on which date he was placed on the payroll as an "accountant." Archer had never engaged1955 U.S. Tax Ct. LEXIS 37">*46 in accounting work.

On August 18, 1942, an escrow account was opened with the Bank of America in the name of "R. P. Archer" with $ 1,000 advanced by American Pipe. Ultimately, American Pipe advanced between $ 6,000 and $ 7,000 and some 2,500 shares of Palos Verdes stock were obtained by Archer through the escrow procedure. This procedure was originally employed so that American Pipe could have control of the Palos Verdes shares should Archer fail to go through with his deal. At the time the escrow account was opened, Archer personally was without funds, had alimony commitments, and was very close to being "broke."

The formal offer to the then owners of Palos Verdes stock was made in a mimeograph form letter dated August 18, 1942, reading in part as follows:

To the Preferred Stockholders of Palos Verdes Estates, Inc.:

I hereby offer to purchase all of the outstanding preferred stock of Palos Verdes Estates, Inc. at a price of two dollars ($ 2.00) per share. This offer is good for fifteen (15) days from date hereof, and unless I can purchase seventy per cent (70%) of said stock within said time, I reserve the right to cancel this offer. If you desire to sell please sign the acceptance1955 U.S. Tax Ct. LEXIS 37">*47 provided below, endorse your certificate or sign the attached stock power, and forward the same together with the stock to Bank of America, Escrow Department, Redondo Beach, California, with the instructions provided below.

R. P. Archer, Nominee

25 T.C. 351">*356 Archer's efforts to obtain Palos Verdes stock were greatly aided by E. B. Haggot, the then president of Palos Verdes. Haggot had long been a close friend of Archer's and was personally indebted to him for many past favors and accommodations. At the time the escrow account was opened, there were unpaid and past due taxes on the lots owned by Palos Verdes totaling $ 80,000 to $ 100,000. There were about 3,500 shares of Palos Verdes stock outstanding. It was Archer's opinion that if he could acquire 70 per cent of such shares, then, by amending the articles of incorporation to allow levying an assessment against the stock, the recalcitrant stockholders would be forced to sell and complete ownership of the corporate structure could be obtained.

Having lost title to all its remaining real estate assets by reason of nonpayment of Los Angeles county taxes for the year 1931-32, and tax deeds therefor having been given by 1955 U.S. Tax Ct. LEXIS 37">*48 the tax collector to the State of California on July 1, 1938, Palos Verdes, on July 27, 1943, instituted an action in the Superior Court of the State of California against the State of California and other taxing authorities to set aside the tax sales and tax deeds with respect to 695 lots. On August 2, 1943, the court entered an interlocutory decree based upon a stipulation of the parties concerned, and set aside the tax sales and tax deeds to the lots involved in such action. The decree restored the rights of redemption free of interest, penalties, and costs, but limited the extension of time so to redeem by requiring payment of all such delinquent taxes, as corrected, to be made within 6 months after the decree became final.

More than a month before the commencement of the tax title redemption action, a sufficient percentage of shares had been acquired to enable the amendment of the articles of incorporation of Palos Verdes so as to permit the levying of assessments upon the stock of Palos Verdes; and, at a special meeting on June 23, 1943, the board of directors of Palos Verdes adopted a resolution to this end. On August 26, 1943, an assessment of $ 40 a share was levied and1955 U.S. Tax Ct. LEXIS 37">*49 the resolution, which so levied the assessment, provided for a certain day, September 27, 1943, for payment of such assessment, and further provided and fixed the time at which delinquent stock would be placed on sale or forfeited if unsold. The date originally selected for sale or forfeiture of Palos Verdes stock, October 15, 1943, was postponed until December 2, 1943.

None of the holders of record of Palos Verdes offered to pay the assessment of $ 40 plus 5 per cent delinquency penalty on each share of stock held by them. The only person to appear and bid upon any portion of stock offered at the assessment sale was Archer who bid upon and purchased 96 shares of stock, held by seven individuals, for 25 T.C. 351">*357 a total of $ 4,032. In bidding upon the 96 shares, Archer was acting for American Pipe and the funds used by Archer to purchase such shares were furnished to him for that purpose by American Pipe. Title to the 96 shares bid in by Archer was taken by Archer in his own name. The shares purchased through escrow and at the assessment sale constituted all of the outstanding stock of Palos Verdes. In confirming Archer's purchase of the 96 shares of stock, the directors, on December1955 U.S. Tax Ct. LEXIS 37">*50 2, 1943, the same day as the sale, declared all other shares forfeited for failure of any person to pay the assessment plus penalty thereon.

As a result of the purchase of 96 shares by Archer in behalf of American Pipe, on December 2, 1943, American Pipe became the owner of all the outstanding shares of stock of Palos Verdes. Such stock was obtained by American Pipe at a total cost of $ 11,248.96, which figure includes the $ 4,032 paid for the 96 shares purchased by Archer at the assessment sale, as well as the funds furnished to Archer for the purchase of approximately 2,600 shares through the escrow procedure.

Beginning with December 3, 1943, and continuing through the periods involved in these proceedings, Palos Verdes was a wholly owned subsidiary of American Pipe. Prior to its acquisition by American Pipe, the fiscal year of Palos Verdes ended on the 28th day of February, whereas American Pipe filed its returns on the calendar year basis. Both taxpayers used the accrual basis of accounting. American Pipe caused Palos Verdes' fiscal year to be changed to the calendar year effective from December 2, 1943, and American Pipe further caused consolidated returns to be filed for1955 U.S. Tax Ct. LEXIS 37">*51 the short 1943 period, as well as for the subsequent years here involved.

Beginning on December 23, 1943, Lane caused several advertisements to be run in local newspapers announcing "Liquidation Sale" of "Palos Verdes Estates," of two parcels totaling 437 lots. The advertisements stressed for "postwar construction or to investors." Lane's name appeared in these advertisements.

Shortly after December 23, 1943, Carl H. Dahlberg had a meeting with Lane. Dahlberg and Lane had known each other since 1932, when Dahlberg had first gone to work for Lane. In 1937 and 1938, Lane, Archer, Dahlberg, and Roy Dolley had been associated in a real estate venture in Glendale, California. Dolley was attorney for American Pipe during 1942 and 1943, and also represented Palos Verdes in its tax title redemption action brought in the California State court. At the time Dahlberg and Lane discussed the liquidation advertisements concerning Palos Verdes property and at the time of the hearing of these proceedings, Dahlberg still had an interest in the Glendale venture. Dahlberg is now vice president of American Pipe.

25 T.C. 351">*358 Between 1937 and 1942, Dahlberg had worked for Celotex Corporation, a corporation1955 U.S. Tax Ct. LEXIS 37">*52 in the building materials business. Celotex had licensed Drycemble Houses, Inc. (hereinafter called Drycemble) to use its products. In 1942, Dahlberg was employed by Drycemble as vice president in charge of sales. Drycemble manufactured prefabricated houses. In December 1943, Dahlberg opened an office for Drycemble in Los Angeles. At that time, that corporation was concerned exclusively with war housing projects, building materials being restricted to projects connected with the war effort. It was not the policy of Drycemble to acquire, nor had it acquired, any real estate tracts or groups of lots for the purpose of building thereon.

In December 1943, after viewing the Palos Verdes properties with Lane and others, Dahlberg was permitted to purchase 451 lots for $ 18,000. In addition, Dahlberg assumed back taxes of about $ 10,000 on these lots which were to come due 2 or 3 months after the original sale to him. The transaction by which Dahlberg obtained title to 451 lots of Palos Verdes did not involve Drycemble but was a personal transaction insofar as Dahlberg was concerned. The sale of the lots to Dahlberg by Palos Verdes with the approval of American Pipe was not a cash1955 U.S. Tax Ct. LEXIS 37">*53 transaction. Dahlberg gave therefor his personal, 4-year, 5 per cent note dated December 28, 1943, in the amount of $ 18,000. Shortly thereafter, when the taxes on lots obtained from Palos Verdes by Dahlberg became due under the stipulated court decree of August 2, 1943, Palos Verdes advanced the funds to Dahlberg to enable him to pay such taxes, for which Palos Verdes received his personal 4-year, 5 per cent note dated April 7, 1944, in the amount of $ 9,884.83. At no time did Dahlberg make any cash payments to Palos Verdes in connection with the lots obtained by him.

Some 4 years later, on January 28, 1948, Dahlberg reconveyed by grant deed to Lane personally and not acting for or on behalf of either American Pipe or Palos Verdes the lots remaining in Dahlberg's name which had not been lost for taxes. A contemporaneous agreement between Lane and Dahlberg recited that Dahlberg retained a contingent monetary interest in the lots deeded to Lane if Lane were able to sell them in excess of a stated amount; otherwise Dahlberg retained no legal or equitable interest in the lots. Under this agreement, the sales proceeds, as received, and only if and when any sales were made, were to1955 U.S. Tax Ct. LEXIS 37">*54 be first applied to delinquent taxes, penalty assessments, and other accruals and not until after such applications were proceeds to be applied on the Dahlberg notes. In December 1943, at the time Dahlberg obtained the lots from Palos Verdes, he was unable personally to supply any funds for them. In January 1948, at the time Dahlberg deeded the lots back to Lane individually, Dahlberg was unable to supply funds for taxes. In addition to these lots, Lane personally bid in for his own account at public sale held 25 T.C. 351">*359 in 1947, 197 lots, some of which included lots previously forfeited by Palos Verdes.

Two days following the sale to Dahlberg of the aforementioned 451 lots, Palos Verdes, on December 30, 1943, executed and delivered a grant deed to Dahlberg, and on the same date Dahlberg's wife executed a quitclaim deed to him so that he became the sole owner. The following day, December 31, 1943, the deeds were recorded.

The basis to Palos Verdes of the lots thus sold to Dahlberg in 1943 was $ 250,781.80, and the resulting loss was $ 232,781.80. This loss plus other deductions and costs was reflected on the consolidated returns filed for the short period from December 3, 1943, 1955 U.S. Tax Ct. LEXIS 37">*55 to December 31, 1943, by American Pipe and Palos Verdes as an operating loss of Palos Verdes.

On January 15 and 16, 1944, American Pipe caused the balance of the lots remaining after the Dahlberg sale to be put up for public auction. The public auction was under the direction of Dean S. Bedilion, a well-known local real estate auctioneer. The advertisements for this auction which appeared in local newspapers stressed the fact that the lots to be sold represented "The last of the better residential districts in Southern California." The lots which were sold at auction netted $ 16,185 after costs of sale. The basis to Palos Verdes of the lots sold was $ 183,797.91. The resulting loss of $ 167,612.91 was reflected on the consolidated returns filed for 1944. Some additional lots were sold at private sales, after the date of the auction, some of them for around $ 500 each. The remainder of the lots not redeemed or sold by Palos Verdes was lost under the terms of the final decree of the Superior Court entering judgment to quiet title in the State of California. This decree was entered on May 15, 1944. Final judgment in favor of Palos Verdes on all lots redeemed by payment of delinquent1955 U.S. Tax Ct. LEXIS 37">*56 taxes was entered on March 16, 1945. This judgment in favor of Palos Verdes, on all lots redeemed, operated for the benefit of its grantees, inasmuch as it no longer owned any lots in Palos Verdes tracts.

Subsequently, in 1947, the State of California put up for sale some of the lots unredeemed and lost by Palos Verdes. At this sale, Lane personally bought for his own account as many lots as he could afford to purchase at that time and now owns altogether approximately 300 lots.

At the outset of its attempted performance of the contract with the Chemical Warfare Service, American Pipe encountered serious trouble and experienced many problems with the manufacture of lethal gas containers. Such trouble consisted of problems with the heats and designs of the furnaces, specification gauges, obtaining priorities to and locating material, in building the new plant at Alhambra, and labor and inspection troubles. The inspection trouble 25 T.C. 351">*360 continued to the end of the contract. None of the containers which American Pipe completed were accepted for delivery by the appointed inspectors under the contract, but were placed in a suspense area for subsequent reinspection by a board of1955 U.S. Tax Ct. LEXIS 37">*57 military men. American Pipe had not maintained the schedule called for under the contract, partly through its own fault and partly because of conditions over which it had no control.

About a week prior to September 29, 1943, Lane heard that the Chemical Warfare Service contract was to be terminated and on that date he was notified in writing that the contract was terminated at the necessity and convenience of the Government, except that 300 containers should be prepared for acceptance by the Government. A separate letter of the same date contained a request that American Pipe submit, as soon as possible, data to serve as a basis for a settlement of the amount due American Pipe by reason of the termination, such as costs, proposals for a negotiated settlement, etc. The reason for the Government's termination of the contract was that a new type of lethal gas had been developed and that the American Pipe containers were not needed for such new type of gas.

On October 14, 1943, Lane wrote a letter in answer to that of the Chemical Warfare Service of September 29, 1943, in which he estimated that American Pipe's investment in the contract as of such date was approximately $ 1,290,000. 1955 U.S. Tax Ct. LEXIS 37">*58 This amount included a "V", or Government-guaranteed, loan with the Federal Reserve Bank for $ 1,020,000, about $ 100,000 of which had been used for purposes other than this contract. Lane concluded that American Pipe had invested approximately $ 368,000 in addition to borrowed funds. Lane also requested urgent consideration of the matter inasmuch as American Pipe had its accounts receivable assigned to the bank under the requirements of the "V" loan, was without operating funds, and for the further reason that American Pipe had a substantial backlog of war work.

The cost figures used by Lane included sums borrowed from the bank which had been used by American Pipe for the erection of American Pipe's new plant at Alhambra to manufacture the containers. After the figures were compiled later, in October 1943, American Pipe put in a claim, as requested and as a result of the contract termination at the convenience of the Government, in the amount of $ 1,252,000. Toward the end of 1943, final agreement as to a sum in the amount of approximately $ 1,050,000 was reached between American Pipe and the Government. American Pipe's separate profit and loss statement for 1943, per returns, 1955 U.S. Tax Ct. LEXIS 37">*59 reflected a net operating loss from the contract of $ 116,240.30 and, after adjustments for other deductions, total income of $ 339,560.36 was reduced to a net profit of $ 16,880.52 for 1943.

25 T.C. 351">*361 On November 25, 1943, Lane wrote a letter to the board of directors of American Pipe, as follows:

November 25, 1943

Board of Directors

American Pipe & Steel Corporation

230 Date Avenue

Alhambra, California

Gentlemen:

Last May, Robert P. Archer wrote us regarding the Palos Verdes Estates, Inc. and a copy of that letter is attached hereto. Of course, at that time we were not interested in his proposition, but during the interim I have occasionally discussed his situation with him and have followed the activities of the company.

Archer's original plan was to acquire controlling interest in the company in order to elect a new Board of Directors, which would seek to rehabilitate the company in the real estate business. The present Board of Directors, however, attempted this rehabilitation by making the stock assessable and wanted the stockholders to put up sufficient money to pay the taxes and proceed with the development and/or sale of its properties. The plan failed and Archer does1955 U.S. Tax Ct. LEXIS 37">*60 not have the funds to proceed with his original plans, therefore, he has informally proposed that we pay him his costs for his interest in the company and in such event he will seek to acquire the rest of the outstanding stock. This would give us Palos Verdes as a wholly owned subsidiary for approximately $ 13,000.00.

In the exhaustive study which I have made, I find that the lots owned by the company come under three classifications:

(1) Represents approximately 147 lots in the Lunada Bay Area. All lots in this are contiguous.

(2) Represents approximately 315 lots located in the uppermost part of the tract and covers about 115 acres. All lots in this area are contiguous.

(3) Represents approximately 235 to 250 lots scattered throughout the tract.