H. B. Zachry Co. v. Comm.

Decision will be entered under Rule 50.

Robert J. Bird, Chester H. Johnson, O. D. Hite, and Edmund M. Gregorie, Jr., for the petitioner. Harold Friedman, for the respondent.

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Respondent determined income tax deficiencies against petitioner for the taxable years 1961 and 1962 in the amounts of 327,940.14 and 692,528.21, respectively.

Petitioner has apparently abandoned the argument made at trial that respondent has the burden of proof with respect to allegations contained in the amended answer. The parties have resolved the issues pertaining to the year 1962 and have agreed upon the deficiency, subject to the Court's disposition of the main issue in controversy. Likewise, several issues pertaining to the year 1961 have been conceded or settled by the parties, leaving for our decision the single issue of whether petitioner realized taxable income through a series of transactions with its subsidiary, Zachry Minerals, Inc. In order to resolve this issue, several questions are presented by the parties, namely:

1. Did a carved-out oil payment from petitioner to Zachry Minerals, Inc., constitute "property" within the meaning of section 351, ¹ I.R.C.

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1954, so that its transfer to a newly organized subsidiary for all of the subsidiary's stock results in a nontaxable exchange under section 351(a)?

2. If the carved-out oil payment was "property" within the meaning of section 351, were certain transactions in June 1961 all part of a single integrated transaction, thereby resulting in a section 351 exchange with "boot" of 649,000 to petitioner?

3. Is the taxable income, if any, resulting from and recognized in such transactions taxable as ordinary income or as long-term capital gain?

4. If gain is recognized to petitioner on the assignment of the carved-out oil payment, is the income recognized immediately on the exchange or is the petitioner taxable on the income from the oil produced only as the oil is produced? FINDINGS OF FACT

Some of the facts have been stipulated by the parties. The stipulation of facts and the exhibits attached thereto are incorporated herein by this reference.

H. B. Zachry Co. (hereinafter called petitioner) is a Delaware corporation with its office and principal place of business in San Antonio, Tex., at all times relevant to this case, and particularly as of the time of filing the petition herein. Petitioner filed its Federal corporation income tax returns for the taxable years 1961 and 1962 with the district director of internal revenue at Austin, Tex. It maintains its books and filed its income tax returns on the basis of the accrual and completed-contract method of accounting.

Petitioner has been engaged in the business of general contracting for many years. As part of its business activities, it bids on various types and sizes of local, State, and Federal construction projects. Its bidding capacity or strength is based on its bonding capacity, and its bonding capacity is based on a multiple times the net current assets. ² Depending on the project, a construction company's bonding capacity varies from 10 to 15 times the company's net current assets.

H. B. Zachry (hereinafter called Zachry) is an individual who owned substantially all of petitioner's common stock during the years 1961 and 1962.

Gasoline Production Corp. (hereinafter called Gasoline Production) was merged into petitioner on or about June 30, 1959. As a result of this merger, petitioner owned various types of interests in oil, gas, and mineral properties situated in Texas and Louisiana at the beginning of 1961.

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Gasoline Production was operated as a division of petitioner during 1961 and 1962. Among the assets and liabilities acquired by petitioner as a result of its merger with Gasoline Production was a note in the amount of 750,000 which was due to the First City National Bank of Houston, Tex., on January 30, 1962. This note became a current liability on petitioner's books on January 31, 1961; and as of that date it affected petitioner's bonding and bidding capacity.

Petitioner's officers held discussions with regard to improving its bidding strength. Pursuant to these discussions, Zachry Minerals, Inc. (hereinafter called Minerals), was organized on June 20, 1961, under the laws of the State of Texas. The purpose of Minerals' organization was "to take care of [petitioner's] needs from a current position angle."

On June 26, 1961, petitioner's board of directors held a special meeting to discuss the advisability of acquiring all of the authorized shares of stock of Minerals and, if deemed advisable, "to determine the best method and manner in which to acquire same." Zachry presided at the meeting.

On June 28, 1961, the board of directors of Minerals held a special meeting, Zachry presiding. The directors approved a motion making the First City National Bank a depository for funds of Minerals. Authority was given for funds to be withdrawn from said depository on the signature of any two of six named persons or on the signature of Zachry alone. The directors also approved "the exchange of all the authorized shares of the corporation for certain property" of petitioner and authorized Zachry "to borrow money and obtain loans and to sell, lease, mortgage or otherwise dispose of the corporation's real or personal property or any interest therein."

On June 28, 1961, an agreement was executed between Minerals and petitioner which provided for the exchange of all 10 authorized shares of Minerals' stock in return for certain property. This property was the assignment of a carved-out oil payment, payable out of one-eighth of the interest which Gasoline Production had in several specifically listed oil and gas properties. This assignment was to remain in effect until Minerals received 650,000 plus an amount equivalent to 6-percent interest on the unliquidated balance. This assignment was to be effective as of June 30, 1961, and 10 shares of Minerals' stock were issued to petitioner on June 28, 1961. At the time of transfer, petitioner's tax basis in the property transferred to Minerals was 17,992.12. The 10 shares of Minerals' common stock had a value of 452,800 as of June 28, 1961, while the oil production payment had a fair market value of 470,000 on that date.

On June 28, 1961, petitioner issued 6,328 shares of preferred stock to Minerals; 5,493 shares were original issue stock and 835 shares were

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treasury stock. The stock certificate was executed by Zachry as president. This transaction was recorded in petitioner's journal voucher as follows:

         Sub. acct.

Please issue 649,000 of Preferred Stock to Zachry Minerals, Inc. (Check exact name with legal) -- and charge their a/c -- They have already paid it. We have credit of 649,000.00 in acct #152-205.

Zachry Minerals is buying 649,000 worth of Zachry Co Preferred stock as of 6-30-61 -- We will charge them 2 1/2% premium (16,225.00) -- We will charge them 16,200 even -- and issue stock for 632,800 or 6328 shares in name of Z. Minerals --

On or about June 29, 1961, Minerals borrowed 650,000 from the First City National Bank on a 30-day note with interest at the rate of 5 1/2 percent per annum. Zachry had done business with the bank for a number of years. As required by the bank, he endorsed the note in his individual capacity and at the same time executed it in his position as president of Minerals. Relevant portions of the loan application, dated June 30, 1961, read as follows:

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 LOAN REQUESTS:    $ 650,000 to take up debt to us under name of Gasoline

Petitioner did not furnish an explanation of its transactions with Minerals on its 1961 income tax return. On its Federal income tax return for the period from June 20, 1961, through May 31, 1962, Minerals attached the following statement regarding these transactions:

STATEMENT OF TRANSFEREE CORPORATION ON TRANSFER OF PROPERTY TO CONTROLLED CORPORATION

Pursuant to the provision of Regulations 1.351-3(b), the following is submitted:

(1) On June 20, 1961, H. B. Zachry Company transferred to taxpayer corporation a 650,000 carved out oil payment on certain of its producing properties in exchange for all of the capital stock in taxpayer corporation.

(2) The basis of the carved out oil payment in the hands of H. B. Zachry Co. adjusted to date of transfer was 17,992.12. (3) Information with respect to the Corporation capital stock:

                                                             Before    After

(5) The transferors did not receive any money in connection with transaction.

(6) No property other than the stock of the taxpayer Corporation passed to the transferors in connection with transaction.

(7) No liabilities of the transferors were assumed by the taxpayer corporation.

In its Federal income tax returns for the fiscal years ended May 31, 1962, and May 31, 1963, Minerals reported gross income from oil and gas (this being income from the above-described oil payment) of 66,624.43 and 70,610.77, respectively.

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In the taxable year ended May 31, 1963, petitioner transferred an additional 3,000 shares of its preferred stock to Minerals for 300,000. After this transaction, Minerals held 9,328 shares of petitioner's preferred stock.

Minerals reported income from dividends of 31,640 in its taxable year ended May 31, 1962, and in the same amount for the taxable year ended May 31, 1963. These amounts represented dividends from the preferred stock in petitioner held by Minerals.

Minerals was liquidated in September 1963 in a "tax free liquidation of a wholly owned subsidiary." In this liquidation Minerals distributed its 9,328 shares of preferred stock to petitioner. Following this transaction, both Minerals' common stock and the 9,328 shares of petitioner's preferred stock were canceled.

Since 1942 the petitioner has had outstanding, in varying amounts, one class of preferred stock of 100 par value. This stock has never been distributed as a dividend but rather for cash, property, or services rendered. It has never been sold at a discount. During the taxable years 1960, 1961, and 1962 there were approximately 65 preferred stockholders. Some of these were employees, some were corporations affiliated with petitioner, and others were strangers. During such years there were 14,000, 23,344, and 20,379 shares of preferred stock outstanding. Petitioner declared dividends regularly on its preferred stock.

In his notice of deficiency dated December 3, 1965, respondent explained his adjustment on the disputed issue in the following manner:

It is determined that you realized and failed to report ordinary income during the taxable year in the amount of 649,000.00, representing the proceeds of a check of 649,000.00 received from and through Zachry Minerals, Inc. on or about June 29, 1961. Accordingly, your taxable income is increased in the amount of 649,000.00. OPINION

On June 28, 1961, the petitioner and Minerals entered into an agreement under the terms of which petitioner exchanged a carved-out oil payment in the amount of 650,000 for all 10 authorized shares of Minerals' common stock. On June 29, 1961, Minerals borrowed 650,000 from the First City National Bank of Houston, using Zachry's personal endorsement as the required collateral, with the intent of retiring this note on a term payout basis as an oil loan. On the same day Minerals paid petitioner the amount of 649,000 in exchange for 6,328 shares of petitioner's preferred stock. These funds enabled petitioner to retire a current liability, namely a note owed by Gasoline Production, thereby increasing its bonding capacity.

The primary issue in this case is whether these transactions constitute a taxable exchange to petitioner.

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Petitioner contends that its transfer of a carved-out oil payment in exchange for Minerals' common stock was a section 351 ³ transfer on which no gain or loss should be recognized. Petitioner further contends that it sold preferred stock to Minerals in a separate transaction and that no gain or loss resulted from such sale under the provisions of section 1032. ⁴

Respondent counters by arguing that the carved-out oil payment does not constitute "property" within the meaning of section 351(a), thereby making petitioner's transfer of such oil payment for Minerals' common stock a taxable exchange which does not qualify for nonrecognition under that section. Alternatively, respondent argues that the various transactions between petitioner and Minerals were interrelated steps in a single transaction and that the exchange was, in substance, a section 351 transfer of an oil payment by petitioner in exchange for common stock and taxable "boot" of 649,000.

Respondent's argument that the carved-out oil payment transferred by petitioner to Minerals is not "property" within the meaning of section 351(a) is untenable. Indeed, he misplaces his reliance on Commissioner v. P. G. Lake, Inc., 356 U.S. 260 (1958), and Fleming v. Commissioner, 241 F. 2d 78 (C.A. 5, 1957), reversed sub nom. Commissioner v. P. G. Lake, Inc., supra. In the Lake case the taxpayer reported the assignment of an oil payment, which was consideration for the cancellation of an indebtedness to its president, as a sale of property resulting in a long-term capital gain. The Supreme Court found that the taxpayer was converting future income into present income rather than selling income-producing property which had increased in value; it therefore held that the consideration received by the taxpayer for such oil payment rights was taxable as ordinary income. In the Fleming case the taxpayers assigned oil payments in exchange for real estate on the theory that it was an exchange of like kind property under section 112(b)(1) of the Internal Revenue Code of 1939 (sec. 1031, 1954 Code). The Supreme Court held that "The exchange cannot

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satisfy that test where the effect under the tax laws is a transfer of future income from oil leases for real estate." Neither of these cases involved the nonrecognition of income under section 351, but rather the tax consequences of a sale or exchange of an oil payment under other provisions of the Internal Revenue Code. Whereas Lake and Fleming dealt with the problem of capital gain versus ordinary income, we are here concerned solely with the historic exemption of transfers to a controlled corporation where the taxpayer's interest in the property continues although the form of ownership is changed. Under section 351, Congress has provided for the nonrecognition of gain or loss if "property" is transferred, solely for stock or securities, to a corporation controlled by the transferor. If the transfer so qualifies, there is no exception because it involves the assignment of an oil payment. Consequently, we think the respondent is wrong in his assertion that Lake and Fleming hold that an assignment of a carved-out oil payment may never be made under a nonrecognition provision without immediate tax consequences.

As an alternative to this interpretation of Lake and Fleming, respondent contends that the carved-out oil payment transferred by petitioner does not constitute "property" within the meaning of section 351 because it is an assignment of a pure income right. In Lake, the Supreme Court, citing with approval certain Court of Appeals and Texas decisions, started from the premise that oil payments are interests in land. Moreover, in Lemar v. Garner, 121 Tex. 502, 50 S.W. 2d 769, the Texas Supreme Court said that:

rents or royalties payable under oil and gas mineral leases are severable and separable from the ownership of the surface estate and are property rights * * *

On the authority of such decisions, we hold that an oil payment is "property." Respondent has not made any suggestion to the contrary except that it is a "pure income right." Even if the oil payment is a "pure income right," it has present value and is an interest in land. ⁵ Therefore, we view it as "property" within the common law definition and within the intendment of section 351. ⁶

The parties agree as to the basic facts in this case. Petitioner admits that the transactions between itself and Minerals on June 28, 29, and 30, 1961, were interrelated and entered into for the purpose of transforming a current liability into a liability in the form of preferred

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stock, thereby increasing petitioner's bonding capacity. From this the respondent maintains that petitioner's transfer of an oil payment for Minerals' common stock and its subsequent sale of preferred stock for cash must be treated as one transaction for purposes of section 351, first contending that the issuance of its preferred stock was a sham and, secondly, that the two transactions were inseparable steps in an integrated transaction.

We reject the contention that the sale of petitioner's preferred stock was other than a normal arm's-length purchase of stock by Minerals. It is true that there was a sale between related parties, but that in itself does not destroy its validity. Sun Properties v. United States, 220 F. 2d 171 (C.A. 5, 1955); Warren H. Brown, 27 T.C. 27 (1956); and Marjory Taylor Hardwick, 33 B.T.A. 249 (1935). Facts relevant to the transactions convince us that petitioner's sale of its preferred stock to Minerals was not taxable in view of the provisions of section 1032. ⁷ Petitioner has had similar preferred stock outstanding since 1942; in 1961 there were over 60 stockholders who held over 23,000 shares of this preferred stock; dividends have always been paid regularly; and petitioner's preferred stock has never been distributed as a dividend or sold at a discount. Likewise, while Minerals paid a slight premium for the 6,328 shares which it received in 1961, the dividends received still represented a yield of 4.9 percent on its investment, and Minerals reported dividends of 31,640 from this source in each of the taxable years ending May 31, 1962, and May 31, 1963. These factors show that the exchange of 6,328 shares of preferred stock by petitioner for cash in the amount of 649,000 had economic reality and qualified as a section 1032 exchange of stock for property.

We turn next to the factual question of whether the transfer of oil payments for common stock and the transfer of preferred stock for cash constituted a single integrated transaction or two separate transactions. Respondent states, and we agree, that "a single transaction may not be broken into various elements to avoid a tax." Here, however, petitioner did not attempt to avoid a tax. Respondent candidly acknowledges that petitioner had alternatives through which its primary purpose, namely the removal of a current liability to increase its bonding capacity, could have been achieved without causing a taxable exchange. Instead, the petitioner went through two separate transactions, each of which had validity in substance as well as form. In the first transaction, petitioner received all of Minerals' authorized

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common stock in exchange for an oil payment which had present value and on which Minerals realized and reported income in subsequent years. In the second transaction, petitioner received cash in an amount equal to the fair market value of the preferred stock which it sold to Minerals and paid a dividend equal to 5 percent of its par value in subsequent years. There was a valid business purpose for each of these transactions standing by itself.

Among various criteria applied by the courts in determining whether a series of steps should be treated as a single indivisible transaction or whether they should retain their separate identities are (1) the intent of the parties, (2) the mutual interdependence of the steps, (3) the time element, and (4) the ultimate result. American Bantam Car Co., 11 T.C. 397 (1948), affirmed per curiam 177 F. 2d 513 (C.A. 3, 1949), certiorari denied 339 U.S. 920. First, with respect to the intent of the parties, we have found that the two transactions were separate in terms of their substance as well as their form. Second, with respect to their mutual interdependence, the courts have looked at whether the steps were so substantively interdependent that the legal relations created by one transaction would have been fruitless without the completion of the others. ACF-Brill Motors Co. v. Commissioner, 189 F. 2d 704 (C.A. 3, 1951), affirming 14 T.C. 263 (1950); American Bantam Car Co., supra; American Wire Fabrics Corporation, 16 T.C. 607 (1951); and Southwell Combing Co., 30 T.C. 487 (1958). Here, although the steps were interrelated as a matter of planning, they were not in our opinion substantively interdependent within the meaning of the decided cases. Testimony of key witnesses reveals that the First City National Bank would not have made the loan on the oil payment without Zachry's personal signature as collateral. This creates an inference that the loan was made, at least in part, on Zachry's personal endorsement rather than the value of the oil payment. The oil payment had a present fair market value of 470,000 on June 28, 1961, while the loan from the bank was for 650,000. Thus, Minerals could have borrowed at least a substantial portion of this money from the First City National Bank only on Zachry's personal signature. Consequently, the transfer of its oil payment was not a prerequisite to the sale of petitioner's preferred stock to Minerals; and, to this extent at least, the transactions were not so substantively interdependent that one had to follow the other in order to achieve the hoped for end result. Cf. Gregory v. Helvering, 293 U.S. 465 (1935); Kimbell-Diamond Milling Co., 14 T.C. 74 (1950), affirmed per curiam 187 F. 2d 718 (C.A. 5, 1951), certiorari denied 342 U.S. 827; and Southwell Combing Co., supra.

While the two transactions in question happened within 3 days of each other, this is not by itself a controlling factor. Consecutive transactions

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in immediate sequence may be entirely different in nature and therefore separate and distinct. Cf. Sun Properties, Inc. v. United States, supra, and W. A. Hoult, 23 B.T.A. 804 (1931). In the present case, as we have previously indicated, the facts warrant such a conclusion of separateness.

Respondent relies heavily on Fred L. Dickey, et al., Executors, 32 B.T.A. 1283 (1935), for the proposition that the overall purpose, prearrangement, and control over completion of the transaction are decisive in determining whether separate steps shall be treated as one. See also First Seattle D. H. Nat. Bank v. Commissioner, 77 F. 2d 45 (C.A. 9, 1935); and First National Bank, et al., Executors, 34 B.T.A. 631 (1936), affd. 107 F. 2d 141 (C.A. 6, 1939). In Dickey, the taxpayer offered to exchange fixed assets in the form of clay and coal properties for the stock of a newly formed corporation, contingent upon the corporation's purchase from him, for cash, of current assets connected with the operation of the properties. The transfer was carried out according to the above plan, the taxpayer alleging that there were two separate and distinct steps to the transaction. This Court found, on such facts, that the transfers were but parts of a whole whereby the taxpayer exchanged all of his assets for cash and stock of the corporation.

We think the Dickey case is distinguishable on its facts from the instant case. In Dickey, the taxpayer attempted to transfer, in separate but concededly contingent and therefore substantively interdependent steps, the assets required to complete the formation of the new corporation. He did not, however, present any substantive reason for this division into separate steps, and the new corporation clearly needed both the fixed and the current assets before it could begin operation. In contrast, the only asset which the petitioner in this case had to transfer to Minerals to enable Minerals to carry out its corporate function was the oil payment. The purchase by Minerals of petitioner's preferred stock was a separate investment; to be sure, Minerals could have loaned money to petitioner rather than purchase the preferred stock. Moreover, the mere fact that closely related assets are transferred to a corporation in separate transactions is not determinative of whether the transactions should be treated as one. Certainly the courts have not treated them together when the taxpayer has given sufficient justification for treating them separately. See and compare Sun Properties, Inc. v. United States, supra; Warren H. Brown, supra; and Marjory Taylor Hardwick, supra.

In our opinion the petitioner herein created two separate transactions. Since each transaction had substance by itself as well as a business purpose, we reject respondent's contention that, because of their interrelatedness, there were two steps to be treated as one transaction

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for tax purposes. Indeed, we look askance at his suggestion that the petitioner, having followed a legitimate, authorized, and well-recognized nontaxable course of action in order to arrive at a specific result, could have reached the same result by following a different but taxable course of action. Under these circumstances we decline respondent's invitation to relegate petitioner to a taxable course of action. Cf. Edward P. Clay, 46 T.C. 505, 511 (1966).

Accordingly, we hold that petitioner's transfer of the oil payment to Minerals in exchange for its common stock was a nontaxable exchange under section 351, and that its sale of preferred stock for cash qualified as a nontaxable exchange under section 1032. Petitioner therefore realized no taxable gain from the two transactions. Having reached these conclusions, we need not consider the two remaining questions, viz, whether gain from the transactions is taxable as ordinary income or long-term capital gain and the year in which any gain should be recognized.

Decision will be entered under Rule 50.

² Net current assets are the excess of current assets over current liabilities. Current assets are those items which are cash or easily convertible thereto. Current liabilities are those items which are due within a 12-month period.

³ SEC. 351. TRANSFER TO CORPORATION CONTROLLED BY TRANSFEROR.

(a) General Rule. -- No gain or loss shall be recognized if property is transferred to a corporation (including, in the case of transfers made on or before June 30, 1967, an investment company) by one or more persons solely in exchange for stock or securities in such corporation and immediately after the exchange such person or persons are in control (as defined in section 368(c)) of the corporation. For purposes of this section, stock or securities issued for services shall not be considered as issued in return for property.

(b) Receipt of Property. -- If subsection (a) would apply to an exchange but for the fact that there is received, in addition to the stock or securities permitted to be received under subsection (a), other property or money, then --

(1) gain (if any) to such recipient shall be recognized, but not in excess of -- (A) the amount of money received, plus (B) the fair market value of such other property received; and (2) no loss to such recipient shall be recognized.

⁴ SEC. 1032. EXCHANGE OF STOCK FOR PROPERTY.

(a) Nonrecognition of Gain or Loss. -- No gain or loss shall be recognized to a corporation on the receipt of money or other property in exchange for stock (including treasury stock) of such corporation.

⁵ We do not have before us in this case the question of whether, even if sec. 351 applies, the income from the carved-out oil payment continues to be taxable to the transferor under Commissioner v. P. G. Lake, Inc., 356 U.S. 260 (1958).

⁶ Sec. 351 does not contain a definition of the term "property." However, the known inclusions and exclusions strongly suggest that the term encompasses whatever may be transferred. Significantly, "services" are explicitly excepted by sec. 351(a). Such a singular and extraordinary exception denotes the scope of the term "property" under the rule of statutory construction -- expressio unius est exclusio alterius.

⁷ See the broad language used in sec. 1.1032-1(a), Income Tax Regs., which provides, in part, as follows:

(a) The disposition by a corporation of shares of its own stock (including treasury stock) for money or other property does not give rise to taxable gain or deductible loss to the corporation regardless of the nature of the transaction or the facts and circumstances involved. [Emphasis supplied.]