4 T.C. 897">*897 By these consolidated proceedings petitioners challenge respondent's determination of deficiencies in their income tax for the year 1939 as follows: J. Robert Bazley, $ 214,170.52; and Alice H. Bazley, his wife, $ 35,734.49. J. Robert Bazley will sometimes hereinafter be referred to for convenience as petitioner.

The primary question involved is whether the petitioners are taxable, as charged by respondent, with having received ordinary income during the taxable year to the extent of the face value of bonds of J. Robert Bazley, Inc., received in that year. A subsidiary question is whether the transaction pursuant to which the bonds were transferred to petitioner constituted a tax-free reorganization.

The record was made on a stipulation of facts and evidence adduced at the hearing. Those facts hereinafter appearing which are not from the stipulation are otherwise1945 U.S. Tax Ct. LEXIS 217">*219 found from the record.

FINDINGS OF FACT.

The stipulated facts are hereby found accordingly.

Each of the petitioners for the calendar year 1939 filed a separate income tax return with the collector of internal revenue for the first district of Pennsylvania on or before March 15, 1940. Their books and their income tax returns were on a cash basis, except for a hauling business which petitioner conducted as a sole proprietor and which is on an accrual basis. J. Robert Bazley, Inc., is on an April 30 fiscal year basis of accounting and files its Federal tax returns on that basis. Petitioners reside in Pottsville, Pennsylvania.

J. Robert Bazley, Inc., was incorporated under the laws of the Commonwealth of Pennsylvania on May 1, 1930, with an authorized capital 4 T.C. 897">*898 of 1,000 shares of a par value of $ 100 per share. On February 1, 1939, this stock was owned as follows:

All of the foregoing constituted the board of directors of the corporation.

Petitioner was the president and treasurer. He is a contracting engineer with a degree of mechanical engineering from the University of Michigan and 33 years' 1945 U.S. Tax Ct. LEXIS 217">*220 experience as a mining and consulting engineer. The corporation engaged in general heavy contracting business, including road building, the moving of industrial facilities, installation of heavy foundations and steel work, and removing the overburden from coal to facilitate its mining by the open-pit method. Shortly prior to the year 1939 the corporation was almost entirely engaged in its mining operations. At this time it first considered going into road building work, which is hazardous and requires considerable working capital. Many road building contractors have failed.

The yearly average of the corporation's employees during the years 1937 to 1940 approximated 400, of which approximately 25 were classified as key employees, including superintendents, engineers, and foremen. The latter's average yearly compensation was $ 4,500. The corporation maintained throughout the period 1938 to 1941, inclusive, a consistent rate of compensation for its employees.

Reasons for adopting the transaction hereinafter described, involving the issuance of additional common stock and of debenture bonds, were that the original shareholders, by obtaining debenture bonds for their stockholdings, 1945 U.S. Tax Ct. LEXIS 217">*221 would receive a security which was much less fluctuating and more readily marketable, particularly in case it was necessary for a deceased shareholder's estate to liquidate his investment in the corporation in order to meet inheritance taxes or for other purposes, and that if it became necessary to sell some portion of their investment in the corporation the debenture bonds could be sold without reducing the Bazley family stock control of the corporation; that the contemplated entry into the hazardous road building business made it desirable to put the original stockholders in possession of bonds which would place them in a position of sharing alike with creditors to the extent of the debentures instead of ranking after creditors if the business did not succeed; that as of February 1939 the corporation had plant and equipment of a value ($ 719,782.41 as of April 30, 1939) which was large in relation to the $ 100,000 par value of the capital stock outstanding, and, since the equipment had been purchased by the use of funds acquired through the accumulation of $ 855,783.07 4 T.C. 897">*899 of earnings and profits after the organization of the business in 1930, it was thought advisable to reflect1945 U.S. Tax Ct. LEXIS 217">*222 a more permanent dedication to corporate use of these earnings by reducing the surplus available for dividends and transferring a portion thereof to the capital stock account and another portion to the long term debt represented by 20-year debenture bonds.

On February 6, 1939, a special meeting of the corporation's board of directors was held, at which petitioner announced that the meeting was called to discuss the advisability of reorganizing and recapitalizing the corporation. He read to the board the proposed plan of reorganization and advocated its adoption, stating that the plan had been discussed with counsel for the company and with the company's accountants and that the consensus of their opinion was that the plan was advantageous to the corporation and its stockholders. A motion was duly presented and unanimously carried that the plan be adopted. Authority was also granted to make the necessary increase in the capital stock of the company.

The plan of reorganization recited that the capitalization as of February 1, 1939, was 1,000 shares of $ 100 par value common stock, or $ 100,000 and earned surplus of $ 855,783.82. The plan provided for issuance of 5,000 shares of 1945 U.S. Tax Ct. LEXIS 217">*223 common stock of no par value (with a stated value of $ 300,000) earned surplus of $ 255,783.82 and $ 400,000 principal amount of 6 percent debenture bonds. The corporation was to issue, in exchange for the old stock, the new stock and the debenture bonds, after which the old stock was to be canceled. Bonds were to be dated February 1, 1939, and payable February 1, 1959. They were callable in whole or in part and bore interest at the rate of 6 percent per annum. On February 16, 1939, the owners of the outstanding capital stock of the corporation held a special meeting pursuant to resolutions adopted by the board of directors at the February 6, 1939, meeting and took formal action approving the proposed plan of reorganization and passed resolutions authorizing the necessary corporate action for its consummation.

On March 6, 1939, the Commonwealth of Pennsylvania approved the amendments to the company's articles of incorporation increasing the authorized common stock.

In accordance with the resolution adopted at the meeting of the shareholders of J. Robert Bazley, Inc., held on February 16, 1939, the capital structure of the company, which prior to the consummation of the terms of1945 U.S. Tax Ct. LEXIS 217">*224 said agreement was as follows,

4 T.C. 897">*900 was changed as shown by the corporation's books of account, as follows:

Pursuant to the plan, the stockholders on March 16, 1939, delivered their 1,000 shares of common stock to the corporation and received from the corporation the 5,000 shares of its new common stock and debenture bonds in the aggregate principal amount of $ 400,000. The old common stock was canceled by the corporation.

The following schedule reflects the distribution of the common shares and the 20-year 6 percent debenture bonds of the corporation prior and subsequent to the consummation of the plan:

1945 U.S. Tax Ct. LEXIS 217">*225 The 5,000 shares of the new common stock and the $ 400,000 face amount of 20-year debenture bonds so issued had a fair market value on March 16, 1939, of not less than $ 300,000 for the common stock and $ 400,000 for the bonds.

J. Robert Bazley, Inc., and petitioners have never sold or offered to sell any of its stock to its key employees. After the recapitalization petitioner went to Europe in the summer of 1939 and when he returned he did not believe the business situation was favorable, due in part to the unsettled situation in Europe.

The net additions to plant and equipment of J. Robert Bazley, Inc., increased from $ 719,782.41 at April 30, 1939, which had been purchased by the use of the accumulation of earnings and profits since the organization of the business in 1930, to $ 1,051,933.03 at April 30, 1944.

On April 25, 1939, the board of directors of J. Robert Bazley, Inc., declared a dividend on the common stock of $ 14 per share, or a total of $ 70,000, which was paid in cash on April 28, 1939.

The earnings and dividends of J. Robert Bazley, Inc., for the fiscal years ended April 30, 1934, through and including 1944, were as follows: 4 T.C. 897">*901

There was no legitimate purpose of the corporate business of J. Robert Bazley, Inc., in the issuance and distribution to the stockholders of $ 400,000 in debenture bonds.

Respondent in his notice of deficiency increased the taxable incomes of petitioner and his wife by $ 319,200 and $ 80,400, respectively, "representing the fair market value of bonds of J. Robert Bazley, Inc., received in exchange of common stock of that corporation."

OPINION.

It is respondent's position that although the exchange of the common stock held by petitioner in J. Robert Bazley, Inc., for new common stock and bonds of the same company conforms superficially to the provisions specifying nonrecognition of gain, the transaction lacked a legitimate business purpose and hence fails to comply with the true statutory requirements. Gregory v. Helvering, 293 U.S. 465">293 U.S. 465. Looking only at the language of the reorganization section, there was a technical recapitalization; that is, a reorganization within the statutory definition of section 112 (g) (1) (D). Annis Furs, Inc., 2 T.C. 1096;1945 U.S. Tax Ct. LEXIS 217">*227 Clarence J. Schoo, 47 B. T. A. 459; appeal dismissed (C. C. A., 1st Cir.). And since there was an exchange of stock for stock and securities in the same corporation, the language of the section forbids recognition of gain or loss. Sec. 112 (b) (3).

But that mere formal compliance is not sufficient, at least since the decision in the Gregory case. Hence the real issue is whether it has been satisfactorily established that there was a true business purpose for the operation by which petitioners were enabled to substitute for the entire outstanding stock of the corporation other stock possessing the same attributes and, in addition, instruments in the form of bonds representing newly created fixed obligations of the corporation as to both principal and interest. A mere desire to effect a change in the form in which their property interests were held, but in such a manner 4 T.C. 897">*902 as to escape the tax consequences otherwise called for, would not under the Gregory case furnish the necessary validating purpose. Louis Wellhouse, Jr., 3 T.C. 363. In that situation it would be of no consequence whether the transaction1945 U.S. Tax Ct. LEXIS 217">*228 should be treated in part as an exchange of stock for stock under section 112 (b) (2) of the Internal Revenue Code, ¹ since no claim is made that any gain was realized upon that phase of the transaction. If in course of the surrender, cancellation, and redemption of the old stock and the issuance of the new stock and bonds, petitioners received a distribution which was essentially equivalent to the declaration of a taxable dividend, ² as respondent contends they did by means of the receipt of the bonds, the fair market value of that distribution would be taxable to them as a dividend under the provisions of section 115 (g).

1945 U.S. Tax Ct. LEXIS 217">*229 Thus, in Edith B. Bass, 45 B. T. A. 1117, we held under somewhat similar circumstances that the redemption of stock of the taxpayer, accompanied by the issuance of other stock, was in part essentially the equivalent of a taxable dividend. This decision, it is true, was reversed (C. C. A., 1st Cir.), 129 Fed. (2d) 300, but upon the reasoning that, since there was no effort there to capitalize accumulated earnings and the earned surplus remained available for future dividend action on the part of the corporation, the similarity to a dividend disappeared. The Circuit Court said in part (pp. 304, 305, 309):

* * * Congress itself has defined the term "dividend" in § 115 (a) of the Act as meaning any distribution made by a corporation to its shareholders, whether in money or in other property, out of its earnings or profits. * * *

* * * *

Whether profits are to be capitalized is not a mere matter of bookkeeping; there are important business differences according as one course or the other is pursued. If profits are capitalized by means of a stock dividend such profits are no longer available for the declaration of a dividend1945 U.S. Tax Ct. LEXIS 217">*230 at the discretion of the directors but become part of the permanent capital of the corporation, thereby tending to enhance the corporation's credit. If profits are not capitalized they may be distributed as dividends some time in the future; and it would be a contradiction 4 T.C. 897">*903 in terms to say there has been in any sense a "distribution" out of "earnings or profits" when such earnings have been expressly held intact in the surplus account for possible future distribution.

* * * *

Gregory v. Helvering, 1935, 293 U.S. 465">293 U.S. 465, 55 S. Ct. 266">55 S. Ct. 266, 79 L. Ed. 596">79 L. Ed. 596, 97 A. L. R. 1355, cited by the Board, is no authority for the position taken. * * * In substance, assets of the corporation were distributed to its shareholders and the corporation's surplus was correspondingly reduced. In these circumstances the distribution was held taxable as a dividend. In the case at bar, however, there was a permanent revision of the capital structure pursuant to a plan of recapitalization having a genuine business purpose. The transaction was not a tax-dodging subterfuge. There was in fact no "distribution" out of "earnings1945 U.S. Tax Ct. LEXIS 217">*231 or profits."

* * * *

* * * Of course, the fact that there has been no increase in the aggregate wealth of the shareholders does not in itself establish that they have not received a dividend. United States v. Phellis, 1921, 257 U.S. 156">257 U.S. 156, 257 U.S. 156">171, 42 S. Ct. 63">42 S. Ct. 63, 66 L. Ed. 180">66 L. Ed. 180. On the other hand, neither does this fact establish that the stockholders have received a dividend. On that issue the fact is colorless. What distinguishes the present transaction from a stock dividend is that here no portion of the surplus was capitalized.

Under the present facts this reasoning would be inapplicable. Not only did the issuance of fixed obligations inevitably capitalize and imprison a corresponding amount of earned surplus, by reason of the proportionate increase in liabilities as compared with assets and the consequent reduction of surplus; but a specific and declared purpose of the operation was to incorporate in the bonded indebtedness the company's investment in machinery and equipment which was recognized to have been paid for out of accumulated earnings. ³ If the principles upon which the Bass case was reversed are1945 U.S. Tax Ct. LEXIS 217">*232 followed and the test there designated is applied, the result thus remains the same. Cf. Louis Wellhouse, Jr., supra.The elimination by the process here adopted of an equivalent segment of accumulated earnings which would otherwise have been available for the declaration of subsequent dividends requires that this action itself be characterized as a distribution out of earnings and hence as the equivalent of the declaration of a taxable dividend.

1945 U.S. Tax Ct. LEXIS 217">*233 On the present record and upon detailed review of all of the aspects urged on behalf of petitioners, we have felt compelled to the conclusion set forth in our findings of fact that no legitimate corporate 4 T.C. 897">*904 business purpose existed for the so-called recapitalization. Such objectives as to create a security more desirable for the stockholders as being less fluctuating in value, more regular and certain in its income, easier to market for inheritance tax payments, and furnishing greater safety against claims of corporate creditors are easily understandable from the standpoint of the stockholders. They furnish persuasive reasons why the stockholders wanted to change the form of their investment. But, as we have said, a desire to encompass such an exchange without occasioning the tax consequences usually attendant upon those transactions would not supply the necessary purpose as a business or corporate object. And certainly it would be a contradiction in terms to agree with petitioner that the desire to incorporate the undistributed profits into invested capital so as to render them immune from future invasion could be such a business purpose when this very act can be regarded1945 U.S. Tax Ct. LEXIS 217">*234 as creating the resemblance to a dividend which the statute subjects to tax. Bass v. Commissioner, supra.

The purpose most insistently advanced as justifying the exchange was the asserted desire to make the new stock available in larger volume and smaller units for distribution among key employees whose interest in the company it was desired to retain. Such an object would be acceptable as a legitimate purpose of the corporate business. Jacob Fisher, 46 B. T. A. 999. But we are unable to satisfy ourselves that such a purpose was ever in fact entertained. After five years, the distribution has never taken place. And no excuse advanced to justify the delay in convincing. Every one points rather in the direction of the assumption that one or another of the same reasons can always be resorted to to cause a further postponement. And most suggest that, if valid, they should have operated to postpone or prevent the "recapitalization" itself, rather than the subsequent distribution.

Thus it is suggested that in the spring of 1939, when the new stock became available, the company's contracts were up for renewal, in the1945 U.S. Tax Ct. LEXIS 217">*235 fall the European war commenced, by the following spring the company's earnings statement was unfavorable, and by the end of 1941 this country itself entered the war. But the contract situation was known before the new stock was authorized; the outbreak of war was a factor in the business picture, both uncertain in its effect and typical of other business hazards; the coal business was known to be "up and down"; and the average earnings for the significant years and particularly those for fiscal 1941 are not appreciably at variance with the figures for the company's previous history.

The hazardous nature of the road building business upon which the company was about to embark furnishes an adequate ground 4 T.C. 897">*905 for the apprehension on the part of the stockholders which led to the partial transformation of their investment into fixed obligations, but it is diametrically at variance with the assumption that at the same time the earnings could be so stable and secure as to meet the stated prerequisite for participation on the part of the employees. Finally, the increased corporate earnings since the entry of this country into the war would seem to furnish the anticipated inducement1945 U.S. Tax Ct. LEXIS 217">*236 to institute the plan at least by that time, and the fear that war bond purchases might suffer is hard to credit. We are consequently forced to the conclusion that the undisputed facts speak with a clearer voice than the unsupported testimony of petitioner; and that, since the two are inconsistent, the former must shape our ultimate decision. We have accordingly found a complete absence of legitimate corporate business purpose within the Gregory principle.

Such cases as Clarence J. Schoo, supra;Edgar M. Docherty, 47 B. T. A. 462; appeal dismissed (C. C. A., 1st Cir.); and Annis Furs, supra, may be distinguished from the present proceeding on grounds similar to those upon which Jacob Fisher, supra, was distinguished from Edith B. Bass, supra. Here, as in the Bass case, "the record fails to disclose any business purpose of substance" in the transaction. Without attempting to set out the details appearing in the facts of the various cases cited, it is enough to say that in each a benefit to the corporation of greater or less1945 U.S. Tax Ct. LEXIS 217">*237 consequence appears as an anticipated result of the reorganizations there undertaken. In the present proceeding, as we have found, the benefits to the business are negligible and insubstantial. The individual stockholders may well have endeavored to establish a foundation for participating in the corporate profits without subjecting the distributions to taxation as dividends. For a subsequent redemption of the bonds would not only fail to qualify as the equivalent of a taxable dividend under 115 (g), but would fall precisely within the terms of section 117 (f) as an item of capital gain, ⁴1945 U.S. Tax Ct. LEXIS 217">*238 with the accompanying limitations on taxability. ⁵ But such a purpose, if it existed, would fail to release the operation from the rule in the Gregory case. "Putting aside, then, the question of motive in respect of taxation altogether * * * what do we find? Simply an operation having no business or corporate purpose * * * not to reorganize a business or any part of a business, but to 4 T.C. 897">*906 transfer a parcel of corporate * * * [securities] to the petitioner."

Decision will be entered for the respondent.

Smith, J., dissenting: The majority opinion recognizes that on the facts there was a "technical" recapitalization and reorganization of J. Robert Bazley, Inc., in 1939, but holds that the reorganization lacked "a legitimate business purpose" and therefore must be denied recognition for tax purposes, under the doctrine of Gregory v. Helvering, 296 U.S. 465">296 U.S. 465.

In the Gregory case the Court disregarded, as a mere sham, a corporate entity which was created for the sole purpose of effecting a tax-free transfer of corporate assets to stockholders and which was dissolved immediately after it had served its purpose in carrying out the artifice.

I do not think that the principle of the Gregory case is applicable here. It seems to me that the evidence shows a legitimate business reason, perhaps several legitimate business reasons, for the recapitalization. Some of those reasons are plainly set out in the findings of fact. The evidence discloses a further reason, which1945 U.S. Tax Ct. LEXIS 217">*239 is not shown in the facts; namely, that under the recapitalization there was set up the basis for an annual deduction of $ 24,000 of interest on the debenture bonds which were issued in exchange for common stock. Petitioner J. Robert Bazley testified:

A. Furthermore, it seemed to us in conference with this management, that this plan of issuing common stock and debentures would also secure for the corporation certain benefits inasmuch as the fixed charges on the bonds would have the purpose of reducing Federal and State taxes, and it would also enlarge the percentage of dividends on the reduced value of the stock inasmuch as the value of the stock had been reduced.

It seems to me that this reason alone, that is, the reduction of taxable income, might be deemed sufficient to give substance to the recapitalization. The Court observed in the Gregory case that: "The legal right of a taxpayer to decrease the amount of what otherwise would be his taxes, or altogether avoid them, by means which the law permits, can not be doubted," citing United States v. Isham, 17 Wall. 496; Superior Oil Co. v. Mississippi, 280 U.S. 390">280 U.S. 390;1945 U.S. Tax Ct. LEXIS 217">*240 Jones v. Helvering, 71 Fed. (2d) 214.

In Commissioner v. Capento Securities Corporation, 140 Fed. (2d) 382, the Circuit Court of Appeals for the First Circuit held, affirming 47 B. T. A. 691, that the issuance by a corporation of its preferred stock for its outstanding bonds constituted a recapitalization, and 4 T.C. 897">*907 therefore a statutory reorganization. The purpose of the recapitalization there, which was held to be a legitimate one, was to facilitate the securing of loans from the banks. Distinguishing 296 U.S. 465">Gregory v. Helvering, supra, where "the purported 'reorganization' though following the literal language of the statutory definition, was an operation having no business or corporate purpose," the Court observed that:

* * * There resulted a permanent revision of the capital structure of Raytheon Production Corporation pursuant to a plan of recapitalization -- a normal business procedure dictated by the necessity of raising new capital. In such circumstances it is the purpose of the nonrecognition provisions of the Act to save the taxpayer from an immediate recognition of 1945 U.S. Tax Ct. LEXIS 217">*241 a gain, where, in a popular and economic sense, there has been a mere change in the form of ownership and the taxpayer has not really "cashed in" on the theoretical gain, though a gain may have accrued in a constitutional sense. * * *

See also Bass v. Commissioner (C. C. A., 1st Cir.), 129 Fed. (2d) 300.

I think that the finding of the Tax Court in this case that the reorganization of J. Robert Bazley, Inc., lacked a true business purpose is contrary to the evidence.