Silverman v. Commissioner

Sidney Gelfand and Wallace Musoff, for the petitioners.

Stanley. J. Goldberg, for the respondent.

 Docket No.    Petitioner           Deficiency

Seymour Silverman and Helen Silverman are husband and wife. At the time of the filing of their petitions herein, they legally resided at Lynnbrook, New York. Seymour Silverman filed a U.S. Gift Tax return for the calendar year 1968 with the district director of internal revenue, Brooklyn, New York. Mrs. Helen Silverman consented to have the gifts made during the calendar year 1968 considered as having been made one-half by her and the other half by her spouse.

Jack Silverman and Frances Silverman are husband and wife. At the time of the filing of their petitions herein, they legally resided at Woodmere, New York. Jack Silverman filed a U.S. Gift Tax return for the calendar year 1968 with the district director of internal revenue, Brooklyn, New York. Mrs. Frances Silverman consented to have the gifts made during the calendar year 1968 considered as having been made one-half by her and the other half by her spouse.

Modern Maid Food Products, Inc. (hereinafter referred to as "Modern Maid"), was organized on January 7, 1952, under the laws of the State of New York and has engaged in the business of manufacturing and selling breading and batter mixes for use by processors of shrimp, fish, and poultry, and the manufacturing and selling of prepared flour mixes for mass feeding outlets such as hospitals, restaurants, and hotels. The flour mixes are sold through wholesale grocers. Modern Maid is a successor to a partnership formed in 1933.

Modern Maid has two wholly-owned subsidiaries, Modern Maid Food Products of Louisiana, Inc., and Modern Maid Realty Corp., both incorporated under the laws of the State of Louisiana. The principal executive offices of Modern Maid were located at 110-60 Dunkirk Street, Jamaica, New York.

On April 22, 1968, the capitalization of Modern Maid, and the shares held by the respective shareholders, were as follows:

                             Common         Preferred

On June 28, 1968, the Commissioner of Internal Revenue issued his ruling with respect to Modern Maid's request of April 22, 1968.

On July 13, 1968, Modern Maid voted to adopt the proposed plan of reorganization, effective August 12, 1968. As a result of the reorganization, the outstanding capital stock of Modern Maid Food Products, Inc., was held as follows:

                          Class A       Class B       5% Common

* * * The party [the subscribing stockholder or his estate] * * * shall give to the Corporation written notice by certified mail of his intention, and such notice shall contain an offer to sell all his stock in accordance with the terms of this agreement, within thirty (30) days after the date of such notice, the stockholder giving such notice shall sell and the Corporation shall purchase all of such stockholder's stock.

The purchase price of each share was to be based on the value shown on the last Federal income tax return or on the annual financial statement, if such information was not on the return. The parties themselves could set any other value by agreement. Pursuant to this agreement, Modern Maid, in September 1968, sold 4,790 shares of its class B common stock to said employees and associates at $10 per share.

Gifts of class B common stock were made by Jack Silverman, Seymour Silverman and Harold Oppenheim on the dates and in the amounts set forth below:

 Date              Donor               Donee             No. of Shares

     Name

Beginning in March 1969, negotiations were initiated on behalf of Modern Maid with Ladenburg, Thalmann & Co., investment bankers, with a view towards the sale of stock of Modern Maid in a public offering.

A special meeting of the stockholders was called on June 16, 1969, to amend the certificate of incorporation of Modern Maid, and to take such other actions as were necessary in order to meet the conditions prescribed in the agreement with Ladenburg, Thalmann & Co. for a public offering of the common stock of Modern Maid.

At this meeting of June 16, 1969, an amendment to the certificate of incorporation was adopted authorizing a capitalization consisting of 2 million shares of common stock of a par value of $1 per share with voting rights, and 100,000 shares of convertible preferred stock with such designations, relative rights, preferences and limitations, as might be set by the board of directors; a further amendment was adopted to provide that no shareholder shall have preemptive rights; and the permissible number of directors was increased to not less than three and not more than nine. A plan of reorganization was thereupon adopted whereby each share of then issued and outstanding preferred stock would be exchanged for 8.75 shares of the new common stock, each share of presently issued and outstanding class A voting stock would be exchanged for 7 shares of the new common stock, and each share of the presently issued and outstanding class B voting stock would be exchanged for 6.5 shares of the new common stock.

At the same meeting, the proposal by Ladenburg, Thalmann & Co. for the underwriting and public sales of the shares of Modern Maid was approved and the appropriate authorizations to the offices and directors to proceed therewith were adopted.

Following the meeting of the stockholders on June 16, 1969, the exchange of the then outstanding class A common stock, class B common stock, and preferred stock was consummated in accordance with the plan adopted at the meeting.

On October 28, 1969, Ladenburg, Thalmann & Co. issued its prospectus whereby it made a firm commitment to underwrite and publicly sell 350,000 shares of the new common stock at $12 per share. It acquired 100,000 shares from the company and 250,000 from certain selling shareholders.

The Consolidated Balance Sheet of Modern Maid and its subsidiaries as of December 31, 1967, was as follows:

                    ASSETS

                                      Year, December 31,

                         Shares

Modern Maid's three major competitors with regard to its breading and batter mix products were Newlywed Baking Co. of Chicago, DCA Food Industries (formerly Donut Corporation of America), and Griffith Laboratories of Toronto, Canada. Its chief competitors in the prepared flour mix field were Pillsbury Flour Mills, General Mills, and DCA Food Industries.

There were no public sales of the common stock of Modern Maid prior to the underwriting by Ladenburg, Thalmann & Co., referred to above. No evidence was presented to show any public or other sales of stock in any company which might be considered comparable to Modern Maid. A multiple of ten times average earnings was a reasonable basis for the valuation of the class A common stock of Modern Maid.

As of August 21, 1968, and as of September 24, 1968, the fair market value of the class A common stock of Modern Maid was not less than $40 per share. As of the same date, the fair market value of the class B common stock was not less than $25 per share.

The petitioners had absolute control of Modern Maid. They proceeded to effect a plan of reorganization or recapitalization for the purpose of making a gift of an interest in the corporation to their children, at the same time affording an opportunity to selected employees and associates in the business to buy some stock in the corporation.

Pursuant to a plan of recapitalization effected August 12, 1968, the then outstanding 2,160 shares of common stock par value $100 per share were exchanged for 10 shares of class A common stock with a par value of $10 per share, 40 shares of class B common stock with a par value of $10 per share, and 11 shares of preferred stock with a par value of $100 per share. Simultaneously, by agreement dated August 12, 1968, Modern Maid issued 4,790 additional shares of class B common stock to selected employees and legal counsel for a price of $10 per share. Following these transactions, Modern Maid had outstanding 21,600 shares of class A common stock, 91,190 shares of class B common stock and 25,200 shares of preferred stock.

As a result of the recapitalization, Jack Silverman held 12,840 shares of class A common stock, 51,360 shares of class B common stock and 14,389 shares of preferred stock. On August 21, 1968, he made gifts in trust for the benefit of his children totaling 51,360 shares of class B common stock.

As a result of the recapitalization, Seymour Silverman held 6,450 shares of class A common stock, 25,800 shares of class B common stock, and 7,525 shares of preferred stock. On September 24, 1968, he made gifts in trust for the benefit of his children totaling the 25,800 shares of class B common stock.

For gift tax purposes, the petitioners reported a valuation of $10 per share for the class B common stock. In his notice of deficiency, respondent determined that the stock had a value of $48 per share. In his brief, respondent contends for a value of $25 per share. In their brief, petitioners argue that the valuation of $10 per share was too high, claiming a value of not more than $5 per share.

In this proceeding, the Court is not called upon to consider the tax consequences of the reclassification of the class B nonvoting shares into voting shares and the public offering of such shares. Until such event took place, all that the donees received was a nonvoting interest in a family-controlled corporation. However, we cannot ignore the realities of the situation.

The occasion for the subsequent exchange of the nonvoting stock for voting stock, in order that an interest in the corporation could be sold to the public, may not have been foreseen at the time of the recapitalization and gifts. This does not mean that a second step in the "giving process" was not contemplated at some future date, irrespective of that occasion. ⁴ If all petitioners had in mind was to make a gift of nonvoting common stock to their children, the parties probably would not be before this Court. The fact that the offer of the shares to the employees and associates at $10 per share was coupled with the restrictions on the sale of such shares under certain conditions at book value further confirms that none of the transactions involved in this proceeding can be measured as one would an arm's length sale such as would be made to a stranger.

The basis upon which petitioners would value the class B common stock is concisely stated in a hypothetical question proposed in petitioners' reply brief as follows:

* * * "How much would I invest to acquire 25,680 shares of Class B nonvoting, nondividend paying stock of Modern Maid Food Products, Inc. in August 1968 knowing the earning history and book value up to December 31, 1967, knowing those controlling the business had no plan or intention of going public, knowing that the substantial salaries and preferred dividends vitiated any incentive to declare dividends on the common stock, and knowing that the management intended to leave control to their children?"

Nothing in this record would support the hypothesis that "those controlling the business had no plan or intention of going public," nor can we attribute to petitioners, who controlled the voting stock, an intent to refrain from declaring dividends, increasing their salaries at will, and otherwise acting to the detriment of the nonvoting stockholders. On the contrary, petitioners were in a quasi-fiduciary relationship to the holders of the minority or nonvoting interests. ⁵ As such, they would be required to act in good faith as far as the rights of the minority are concerned. Pepper v. Litton, 308 U.S. 295 (1939); Zahn v. Transamerica Corporation, 162 F.2d 36 (C.A. 3, 1947). If that duty were breached, the minority shareholders could maintain a cause of action to prevent or redress any injuries. Doherty v. Mutual Warehouse Company, 245 F.2d 609 (C.A. 5, 1957). ⁶ The only statement with which we are in agreement is that the intent of petitioners was to leave control of the corporation to their children. We are really being asked to look at the first step in the fulfillment of that intent.

The expert testimony presented by petitioners with respect to the value of the class B common stock failed to take into account the fact that if petitioners intended to sell a substantial interest in Modern Maid - and the class B common stock represented approximately two-thirds of the equity after the preferred stock - they would have adopted a different course of action or there never would be a sale. Although Ladenburg, Thalmann & Co. was unquestionably the best qualified "expert" to express an opinion with respect to the value of the stock of Modern Maid, petitioners chose not to present the testimony of that firm.

An expert witness for respondent testified that the stock, giving consideration to its restricted character, had a fair market value as of the date of the gifts of $25 per share. His opinion is supported by a valuation for the common stock, as a whole, discounted for the lack of voting power and control. However, rather than look to opinion evidence with respect to the value of the class B common stock from an "outsider," the Court would be inclined to give greater weight to the relative value of the class B common stock which the petitioners, who still had control of the corporation, attributed to that stock in the ensuing transaction whereby both classes of stock were exchanged for a single class of voting common stock.

At the time of the gifts, there were outstanding 21,600 shares of class A common stock and 86,400 shares of class B common stock. Contemporaneously therewith, an additional 4,790 shares of class B common stock were sold to selected employees and associates, making a total of 91,190 shares of class B common stock outstanding.

A few months later, petitioners approved the terms of a second reorganization whereby the class A common stock would receive 7 shares of a new common stock and the class B common stock would receive 6.5 shares of a new common stock, thereby attributing to the class B common stock a value equal to 65/70ths of the value of the class A common stock. As a result, the holders of 21,600 shares of class A common stock acquired 151,200 shares of the new common stock and the holders of 91,190 shares of class B common stock acquired 592,735 shares of the new common stock. In this proceeding, neither party has directly challenged the basis for the exchange. In fact, petitioners' main objection was that the value attributed to either class of stock, as of the date of the agreement with Ladenburg, Thalmann & Co., should not be taken as evidence of value on the dates of the gifts.

Irrespective of the value attributed to the new common stock by Ladenburg, Thalmann & Co. in connection with a public offering, the fact that the old class B common stock was given a parity of 6.5 to 7 with the old class A common stock provides a yardstick with which to measure the value of the former as of the dates of the gifts. At that time, the Court would find that the class A common stock had a fair market value of about $40 per share. Using the subsequent exchange as a basis, this would result in a fair market value of $37 per share for the class B common stock.

Accordingly, considering the record before us, the Court finds that the fair market value of the class B common stock of Modern Maid, as of August 21, 1968 and as of September 24, 1968, was not less than $25 per share.

Decisions will be entered under Rule 155.

² All statutory references are to the Internal Revenue Code of 1954, as amended, unless otherwise indicated.

³ The financial data for the taxable years ended December 31, 1964 and 1965 and for the 6-month period ended June 30, 1968, are unaudited.

⁴ Petitioners offered proof that the transaction with Ladenburg, Thalmann & Co., which brought about the conversion of the class B nonvoting common stock, was not foreseen at the time of the gifts. This does not negate the respondent's claim that petitioner's future plans went beyond the first step, with which we are here concerned.

⁵ The only point on which the expert witnesses seemingly agreed was that the nonvoting stock should be treated the same as a minority interest in a closely-held corporation.

⁶ For a discussion with respect to the liability of the directors for failure to declare dividends, see Bittker and Eustice, Federal Income Taxation of Corporations and Shareholders, P 8.02, p. 8-6 (3d Edition, 1971).