The opinion of the court was delivered by: LEVET
OPINION, FINDINGS OF FACT and CONCLUSIONS OF LAW.
The plaintiffs-taxpayers Edmund A. Prentis, Lazarus White, Charles B. Spencer, Inc. and Spencer, White & Prentis, Inc. (Spencer) seek to recover $129,000 of income tax deficiencies assessed by the Commissioner of Internal Revenue. The plaintiffs paid the deficiencies and preserved their right to recover the amounts by the timely filing of claims for refund. This action presents two separate and distinct claims for refund.
The case was tried to the court without a jury. After hearing the testimony of the parties, examining the exhibits, the pleadings, the briefs and proposed findings of fact and conclusions of law, this court makes the following Findings of Fact and Conclusions of Law:
I. THE TAX TREATMENT OF THE TRANSACTION OF JUNE 1951 INVOLVING THE STOCK OF RIVER CONSTRUCTION CORPORATION.
1. Spencer, White & Prentis, Inc. changed its name in 1952 to Edmund A. Prentis, Lazarus White, Charles B. Spencer, Inc., and a new corporation was formed to take and use the original name. In the following items having to do with River only the original Spencer, White and Prentis, Inc. (now Edmund A. Prentis, Lazarus White, Charles B. Spencer, Inc.) is involved.
2. River Construction Corporation (River) was incorporated as a Delaware corporation on April 29, 1947. The purpose of the formation of River was to bid on the construction of Lock No. 27 on the Chain of Rocks Canal near Granite City, Illinois, an aid to the navigation of the Mississippi River for the United States Army, Corps of Engineers; and, if successful, to perform such construction project.
3. River's original stockholders and their stock subscriptions were as follows:
20% Turner Construction Company 5000 shs. at $100 $ 500,000
20% Raymond Concrete Pile Company 5000 shs. at $100 $ 500,000
20% Winston Bros. Company 5000 shs. at $100 $ 500,000
20% Spencer, White & Prentis Inc. 5000 shs. at $100 $ 500,000
10% Al Johnson Construction Co. 2500 shs. at $ 100 $ 250,000
10% Morrison-Knudsen Company, Inc. 2500 shs. at $ 100 $ 250,000
Spencer paid $ 500,000 for its stock on or about June 24, 1947.
4. An agreement among the stockholders (each was a corporation) of River, dated May 1, 1947, provided, among other things, that unless River was the successful bidder on the construction project it would be dissolved, and that if it were awarded such such contract it would not undertake any other project until Lock 27 was substantially completed, and then only by unanimous consent of the stockholders. The agreement also provided that each of the stockholders would be represented on the six-man board of directors, that none would sell its stock without the consent of the others, and that each stockholder would give River, without charge, the benefit of the advice and experience of its officials. (Ex. 7)
5. On May 28, 1947, River submitted its bid for the construction of Lock 27 of the Chain of Rocks Canal to the United States Army, Corps of Engineers, in the sum of approximately $ 17,394,000, and was finally awarded the contract in the sum of $ 16,626,000. The contract, thereafter from time to time, was increased and decreased by modification until the final contract award became $ 17,710,866.48. Before Lock 27 was finished the United States Army, Corps of Engineers, awarded River a contract for the installation of a 54" pipe line under the Chain of Rocks Canal. This pipe line contract, as finally adjusted, amounted to $ 613,873.54.
6. In June 1947, each of the six stockholders made commitments in writing to the United States Fidelity and Guaranty Co. and its co-sureties (1) to pay the amounts of their original stock subscriptions indicated above and (2) if at any time additional funds were required to finance the contract, Turner, Raymond Concrete & Pile Company, Spencer and Winston Bros. Company would each pay an additional $ 300,000 and Al Johnson and Morrison-Knudsen would each pay an additional $ 150,000 to the capital account of River.
7. The construction work for the project was performed by River under the direction of a project manager. Fred Spencer, an employee of Spencer, was the first project manager. Thereafter, in March 1950, he was replaced by Robert Dunlop. However, in addition to the project manager, representatives of the six stockholders actively aided in the project by visiting the project, counselling and advising.
8. By 1950 the stockholders realized that the construction project would incur substantial financial losses. To meet its financial requirements River borrowed substantial funds from banks and from its stockholders. Turner loaned $ 120,000 on March 20, 1950. This loan was repaid on July 31, 1951. Spencer also loaned $ 120,000 which was repaid on July 30, 1951.
9. In early 1950, Al Johnson Construction Co. and Winston Bros. Co. expressed a desire to terminate their interests in River. The other stockholders, however, were unwilling to make an agreement with Winston Bros. or Al Johnson or retire their stock for any more than it would ultimately be worth after the Lock 27 and pipe line jobs were completed and the accounts closed. At the time there were pending claims against the Army Corps of Engineers of contingent and uncertain value, and in addition the amount of the losses which would finally result on the jobs could not then be determined. (Ex. 8)
10. An agreement was finally reached whereby River agreed to redeem the Al Johnson and Winston Bros. stock for $ 36 per share, subject to a reduction in the redemption price equal to the retiring shareholders' pro rata share of the final losses to be incurred on the Lock 27 and pipe line jobs. (Ex. AC, pp. 31, 32) Five per cent of the agreed amount was to be paid down, and non-interest bearing, non-assignable, non-negotiable notes, subordinate to all claims and payable only upon the closing of all accounts and settlement of all of River's obligations were to be given for the balance.
The price of the stock, $ 36 a share, was fixed by subtracting the expected loss from the original capital stock and then adding an amount equal to the maximum conceivable amount which any of the stockholders thought could be recovered on the claims and dividing the total by the number of shares. They then added an amount for "contingent recoveries" so that there was no possibility that the stock would be worth $ 36 per share. (24;
11. In order to consummate the transaction relating to the redemption of the Al Johnson and Winston Bros. stock, River's capitalization was reduced from $ 100 to $ 25 per share and $ 1,875,000 was transferred on the books from the capital stock to a capital surplus account. On December 20, 1950, Winston Bros. Co. and Al Johnson transferred to River their stock and received notes for $ 171,000 and $ 85,500 respectively.
12. In May 1951, the remaining stockholders other than Morrison-Knudsen Company decided to withdraw in a similar manner to Al Johnson and Winston Bros. Co. On May 18, 1951, a stockholders' meeting was held and the stockholders had discussions with respect to the value to be assigned to the shares of stock, the pending claims and their validity. The stockholders then estimated that the losses would be about $ 1,900,000. (Ex. 15) The possibility of further losses in closing out the job and the contingent value of the claims made it impossible to reach any agreement as to a realistic fixed value of the stock. (Ex. AC, p. 20)
13. In June, 1951, the construction project was substantially complete. The major part thereof, known as Lock 27, was 96.43 per cent complete, and the remainder, known as the pipe line, was 99.2 per cent complete. (Ex. 12)
Under date of June 1, 1951, Turner and Spencer, together with Raymond Concrete Pile Company, each agreed to sell its River stock to River for $ 44 per share, payable $ 2.20 per share in cash and the balance by promissory note in a form hereinafter described. Morrison-Knudsen Company, Inc., who was to remain as the sole original stockholder of River, agreed to contribute $ 125,000 to River to enable River to make this purchase of its own stock. The agreement provided that the responsibility for the conduct of the affairs of River thereafter would fall entirely on Morrison-Knudsen Company, Inc., who would forthwith elect its own slates of directors and officers for River. (Ex. 16)
14. The stockholders fixed the redemption price for the stock based upon the most anybody thought could be recovered on the claims (36) using the following "assumed case for computation," which is set forth in the minutes of the meeting of the Board of Directors of River of June 18, 1951 (Ex. 15):
Original capital stock 2,500,000
Expected loss Lock 27
and Pipe Line 1,900,000
Extra Work Orders in process not shown on books 17,000
Attorneys' valuation of claims 85,000
Apparent value on liquidation 25,000 shares
(original amount of stock issued) $ 28.40
Distribution $ 125,000 over 15,000 shares 7.14
Provision for contingent recoveries 8.46
By the above calculation the Board of Directors fixed a value of $ 44 per share. Due to the speculative claims which were included by the Board of Directors in arriving at the $ 44 figure, there was no factual possibility that the plaintiff's shares would be worth more than $ 44 per share. (36) Additionally, the $ 1,900,000 expected losses could not be determined with any degree of certainty since the job was still in progress. The ultimate actual loss was $ 2,087,900, nearly $ 200,000 greater than the amount assumed. Additionally, in reaching the amount of $ 44 per share, the computation mistakenly assumes 25,000 shares outstanding and fails to take into account that the 7,500 shares owned by Al Johnson and Winston Bros. Co. had, on paper, been reduced by River. Similarly, the computation mistakenly assumes that $ 702,000 would be available in the capital account for distribution to shareholders, and fails to take into account that the capital account had, on paper, been reduced to $ 532,000 by the redemption of the Al Johnson and Winston Bros. stock for notes and cash amounting to $ 270,000. Hence, at least on paper, only $ 532,000 was available in the capital account for distribution among the holders of 17,500 shares; the holder of each share would be theoretically entitled to approximately $ 24 from the capital account, or about $ 4 less than the $ 28.40 the Board of Directors of River assumed. Also, there was a mathematical error in the computation since $ 702,000 divided by 25,000 equals $ 28.08 per share rather than $ 28.40.
15. In June 1951, Turner and Spencer each sold all of their River stock to River for $ 220,000, payable $ 11,000 in cash on delivery of the stock and the balance by promissory note. The note provided as follows:
"FOR VALUE RECEIVED River Construction Corporation promises to pay unto Spencer, White & Prentis Inc. the sum of $ 209,000 at the Guaranty Trust Company, 140 Broadway, New York, New York, without interest and under the following terms and conditions:
"1. This note is executed and delivered in consideration of the sale by Spencer, White & Prentis Inc. to River Construction Corporation of five thousand (5,000) shares of the stock of River Construction Corporation, payment for which is to be made in the following manner: $ ...