Petition for Writ of Certiorari — Pfeiffer Electric Co. v. Texas

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Office Supreme Court, US.

RFlilsE Dp

FEB 16 1963

In The

SUPREME COURT OF THE UNITED STATES

October Term, 1962

No. 8 3 8

CHARTER WIRE, INC.,

: _ Petitioner,

vs.

UNITED STATES OF AMERICA,

p Réspondent.

PETITION FOR A WRIT OF CERTIORARI

TO THE UNITED STATES COURT OF APPEALS

_ FOR THE SEVENTH CIRCUIT

RICKARD He LAURITZEN

Counsel for Petitioner

1532 Bankers Building

2Q8 East Wisconsin Avenue

Milwaukee 2, Wisconsin

Of Counsel: = i.

IRVING A. PUCHNER

1532 Bankers Building

208 East Wisconsin Avenue

Milwaukee 2, Wisconsin

a ee

RL ATT RAAT SEE IT

HAMMERSMITH-RORTMEVER CO. MILWAUKEE

Page

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Jurisdiction AE PORT IE ESSE TOR EN EEE CROPS ee

Questions’ Presented a wen re a ee

Statutes and Regulations Involved ................. hoc "2

Oe ee ee 3

Reasons for Granting Writ 20.00.02... tees “8

SS LE OR A 19

ee SE TROLL AEDS SE ace ROSEN 21

LEI OEE EE REMERON RE 28

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AUTHORITIES CITED

Cases °

Brake & ‘Electric Sales Corp. v. United States, 287

_ SRARE Saha SER EINE RIES Byres ea tec rN 10

Byerlite Corporation v. Williams, 286 F. BO BOS oxke. 8

Comm'r. v. H. P. Hood & Sons, 141 F. 2d 467 .......... 8

Comm’. v. O. PF. Holding Corp., 76 F. 2d-11 ........ 8

Gilbert v. Comm’r., 248 F 2d 399 and 262 F. 2d 512... 12

Gloucester Ice & Cold Storage Co. v. C. I. R., 298

ie (Seen salipaeciial ..8, 9, 10, 15, 16

Gooding Amusement Co. v. Comm’r., 236. F. 2d 159.. 12

Jennings v. United States,<272 F. 2d 842 ........ 8, 11, 12, 16

Jennings v. United States, 58-2 USTC 9842 ........8, I, 12°

Kraft Foods Company v. Comm’r., 232 F.2d 118 ....8, 17

- ii °

<Page

Miller's Estate v. Comm’'r., 239 F. 2d 729 8, 16

——- + ol . s

Nassau Lens Co. v. Comm’y., 308 F.2d 39 00... s

Ortmayer v. C. 1. R., 265 F. 2d 848, 853-855 8, 16

Potter Electric Signal and Manufacturing Co. v. y

C.t. R26 F. 28 OO, OS Ea 18

Sun Properties v. UlS., 220 F. 2d 171 ............ ciowes ae

Talbot Mills v. Comm’r., i46 F. 2d 809, 812 .......... 8

United States v. Title Guaranty & Trust Co., 133 F.

| fy, BERG Seta ne INNO HOLST PS ERE Ue Ie OE 8

Washmont Corpgration v. Hendricksen, 137 F. 2d

306 ..... seseetee Bones assuiaiesasaansmeusnnananubydaasinashinenpsinsioceninannilensnbbn " S

Wilshire & Western Sandwiches Co. v. Comm’r., 175 _ -

“A. SoRnymbnanince acter bacheass wee BS TS 8

; Statutes

Internal Revenue Code of 1939, Sec. 23(b),

Ipternal Revenue Code of 1954, Sec. 163(a),

(26 U.S.C. 1958 ed., Sec. 163(a) ) .ce-tececenssnrsens 2

MB USC. GF: i osiadacaccpaartics 18"

28 U.S.C. § 1254(1) Be SR Coir eh Ee 2

2B U.S.C, § 1346 (a) (1) cccceccccccccccceceeccecessessssssesse 3

Miscellaneous -

16 Tax Law Review 1, 63, 66, 71... eens 12-15

In The

SUPREME COURT OF THE UNITED STATES

October Term, 1962

No.

”~. r.

CHARTER WIRE, INC,,

Petitioner,

’ > rf

vs. | a

UNITED STATES OF AMERICA.

Respondent.

PETITION FOR A WRIT OF CERTIORARI _

TO THE UNITED STATES COURT OF APPEALS

FOR THE SEVENTH CIRCUIT

Petitioner prays that a Writ of Certiorari*issue to re-

; Neg the judgment of the United States Court of Appeals

for’*the Seventh Circuit dated and entered in the above

entitled case on November 28, 1962.

OPINIONS BELOW

The opinion of the Court of Appeals for the Seventh

Circuit entered November 28, 1962, is reported at 309 F.

2d 878. The Findings of Fact, Discussion and Conclusions

> of Law of the District Court for the Eastern District of

Wisconsin are reported unofficially at 61-2 USTC 9769

and also appear-at pages 147-161 of the printed Appendix

filed in the Court of Appeals.. Copies of the opinion and

judgment of the Court of Appeals are attached hereto

as Supplements A and B respectively.

JURISDICTION

The jurisdigtion of this Court is invoked under 28

USC § 1254(1).

QUESTIONS PRESENTED

1. Were three instruments executed by Petitioner

May |, 1946, (A. 98-102) and delivered to three partners

-In partial payment of the partners’ interest in the part-

nership ‘assets an indebtedness of the Petitioner within

the meaning of Section 23(b) of the Internal Revenue

Code of 1939 and Section 163(a) of the Internal Revenue

Code of 1954. (“A.” in this petition refers to the appendix

filed in the Circuit Court of Appeals and certified to this .

court as part of the record. )

2. Was an instrument executed by Petitioner Feb-

ruary 15, 1954, in an arm’s length transaction with a

party not@in close relationship, (A. 102-3) pursuant to

an agreement-to be employed by, purchase stock in, and

_ loan money to Petitioner (A. 105-10) an indebtedness

within the meaning of Section 23(b) of the Intggnal Rev- |

enue Code of 1939 and Section 63 ra

Revenue Cote of 1954:

STATUTES INVOLVED

The taxable years 1952-1955 are involved, and there-

fore the applicable statutory provisions involved are

Section 23(b).of the Internal Revenue Code vf 1939 and

Section 163(a) of the Internal Revenue Code of 1954, the

pertinent parts of which are printed in Supplement C.

: Ps .

“i STATEMENT OF CASE

The District Court has jurisdiction of this action under

the provisions of Title 28 USCA 1346(a) (1).

A partnership, Charter Wire Company, organized in

1935 with $3,822.25 of capital, consisted of A. W. Mel-

lowes, C. N. Mellowes, his son, and W. L. Scheller

(A. 4+). “Ehe business of the partnership was the draw-

ing of wire. (A. 10) On January 1, 1946, the market

value and net worth of the partnership was $240,000.00.

(A. 17) The interest.of each partner in the assets of the

partnership was as follows; ee |

on Dollar Value

Name Percentage of Total © of $240,000.00

A.W. Mellowes HH - 8 $105,840.00

C. N.°Mellowes — HEI 105,840.00

W.L.Schellers 11.8 28,320.00

‘The three partners organized Petitioner as a corpora-

tion with 680 shares-of capital stock of a par value of

$1.00 per share.’ The stock was subscribed and paid for

by each partner approximately in*proportion to his part-

nership interest. (A. 7)

The business of the partnership, having a vation of

$240), 000.00, was transferred to petitioner for notes of

the petitioner aggregating $66,805.74, representing ghe

value of the partnership assets as carried on its books,

issued to each partner in proportion to his. -partne rship

interest. (A. 7) All the notes were identical in form. (A.

_ 98-103) Each note bore interest at the rate of 6% per

annum, payable monthly; was payable January 31, 1956,

and in part or in full prior thereto at the option of pe-

‘ition and payable in the event of the death of a payee

in ten équal semi-annual installments.

The excess value of the partnership over .the face of

the notes was represented in the common sto¢k. To give

each partner his just share of that excess value, the com-

mon stock had to be subscribed for by each partner in,

proportion to his partnership interest. As of January 1,

1956, the investment of ‘the three partners in the a

ration was as follows: (A. 7, 17) 5

Name Common Stock ’ Notes

, AW. Mellowes * . 76,713.33 29,473.12

W. L. Scheller 20,447.61 7,859.50

» 173,874.26, 66,805.74

Prior to December 31, 1953, recapitalizations oc-

curred in which the stgck was divided into “B” voting

and “A” non-voting *shares, and the number of shares

was increased 12-3. Each partner retained, however, the

same proportion of’stock and notes as he had in the

partnership at the time of the organization of petitioner

except that C. N. Mellowes transferred his note to Mary

Mellowes in 1946 and A. W. Mellowes disposed of 9500

shares of his “A” stock, leaving him a balance of 4750 |

after 1951. (A. 114) P

The three partners became the officers and directors

of the partnership. (A. 8)

At'the time petitioner acquired the partnership busi-

ness, the partnership owed the Marine National Ex-

change Bank $25,000.00. (A. 7, 36) Not until 1953,-

during which year the pet worth of the partnership in-

creased from $195,560, to $247,173.55 (A. 113), did

the petitioner borrow more and then the increase was of.

short duration. Petitioner’s borrowings were generally

small. (A. 11-2) _ *

The average annual earnings of the partnership during

the last five years of its existence were $62,476.29 (A. 17)

and averaged neatly that much for the ten years it was

g i? business. (A. 8). A. W. Mellowes and W. L. Scheller

were full-time employees of National Lock Washer

Company until June 30, 1951. (A.. 28)

Petitioner's net worth, as per books, grew from

$25,446.19 on December 34, 1946, the end of the first

year-of operations, to $533,495.20 at the end of 1985 and

$803,909.82 at the end of 1958. (A. 113) From January

|, 1946, through 1958 petitioner had net earnings before

taxes of $1,694,049.94. (A. 113)

Petitioner had an excellent credit rating from the be-

ginning (A. 35) and a perfect record for discounting

bills. (A. 37, 54) The Trial Court stated: (A. 154)

“It (Petitioner) enjoyed an excellent credit rating

and could have borrowed money at a lower rate of

interest than the rate provided fof in the three notes

to stockholders.. However, it is not established that

a lower rate would be required where the method

of financing was on the basis of long-term unsecured

notes such as were given for the partnership assets.”

On March 3, 1947, about one year after the incorpo-

rat.on of petitioner, the three stockholders of petitioner,

-at the request of petitioner’s bank, subordinated their

notes to the’ obligation of the bank. (A. 63-4, 11) The sub-

ordination agreement was. terminated March 2, 1954.

(A. 11) Marshall never subordinated his note. (A. 11)

Subordination was not deemed important at the time

because stockholders had no question about being able

‘to pay off both bank and notes. TA. 64)

No agreement existed between stockholders at any-

time to maintain a fixed proportionality between peti-

tioner’s capital stock and debts to stockholders. (A. 35),

| §

The notes to stockholders were carried on the books

of petitioner as debt obligations (A. 156) and interest

was paid regularly except for the iast three months of

1947 when it was accrued ’and paid in January, 1948.

(A. 17, 11) At that time petitioner during a steel short-

age had a strike. Petitioner was unwilling to stop ship-

ments, although its plant was not operating, because pe-

titioner was afraid that shipments delayed would never

be delivered. Petifioner up to that timé had a perfect

record of discounting bills and did not want to break

that record. (A. 36-7, 54)

Both the Court of ‘Appeals and the District Court

found that:the notes (Exhibits711- I+) (A.98-104) were

paid by petitioner and cancelled. (A. 155, Supp. A. 24)

The resolution of the Directors of the petitioner pro-

viding for the redemption of the notes is dated February

18, 1954. The same resolution provided that new notes

bearing interest at the rate of 5 per cent per annum,

. payable monthly dated April 1, 1954, ,and maturing

March 31, 1960, be offered to stockholders. (A. 113) De-,

cision of the noteholders to take up the new notgs was

not made immediately, but within two weeks’ of the

cancellation of the notes, the corporate checks received

by the noteholders in payment of the old notes were en-

dorsed back te petitioner and new notes, dated April 1,

1954, and maturing January 31, 1960, were issued. (A,

i+) The new notes reduced the interest from ‘6 per cent

to 5 per cent, extended’ the maturity’ for an additional

four vears and eliminated the privilege of prepayment on

an interest bearing date and the provision for automatic

maturity on the death of a holder. (A. 98-103, 111-112)

e-,

In 1953, nearly eight years after it was .organized,

petitioner because it ngeded new executive talent en-

~ : 7

gaged in negotiations ‘for the hiring of Marshall, a long

time friend of C. N. Mellowes, (A. 154) and before

World War I1, a former employee of the partnership,

Charter Wire. Company. (A. 72) Marshall agreed to.

come with petitioner if he could buy an interest in it.

He was willing to invest as-much as $50,000.00 in peti-

tioner’s, stock. The shareholders of petitioner. were re-

luetant to sell any stock to Marshall ‘but finally agreed

to offer Marshall 3800 shares of common stock at book

value for a price of $27,625.28: (A. 154) A. W. Mel-

lowes consented to the sale of stock to Marshall only if

the number of shares offered to Marshall was less than ~

4,000 as A. W. Mellowes and Scheller ‘wanted to retain

yoting control of petitioner (Ly. 33), and only if Mar-

shall, in case of .the termination of his employment or

his death gi to resell his shares to petitioner at book

value. fA. 3

At the same aa at which he communicated to

Marshall Petitioner's offer to sell 3800 shares of stock, .

C. N. Mellowes suggested to Marshal! that he, loan pe-

titioner $10,000.00, to create harmony among the stogk-

‘holders. (A. 154) At the time the loan was suggested

petitioner could have obtained a $10,000.00 loan from

a-bank. (A. 154) Marshall loaned petitioner $7,427.23.

(A. 15) Macshalt was interested only in stock interest

in a corporation in which he was to be part of the man-

agement. The domjnant purpose of the loan was not

the need of the petitioner for funds but..to assure har-

monious relations among stockholders. (A. 169) With

its excellent credit rating, the petitioner could ,have

readily borrowed money from the banks and probably

at a more favorable rate than the 6 per cent rate granted”

to Marshall. (A. 160) The note to Marshall, however,

dated February 15, 1954, ran to Januaty 31, 1956, and

8 e

; ,

was unsecured. Marshall borrowed money to make the.

loan at 334% (Supp. A. 24) but from a bank and se-

cured the loaf with collateral and the endorsement of

his father-in-law. (A. 78)

REASONS FOR GRANTING THE WRIT

Transaction with Partners Who Organized Petitioner.

- The decision of the court below in the instant case is

in direct conflict (1) with the decision of the First Cir-

cuit in Gloucester Ice & Cold Storage Co. v. CI.R., 298

F. 2d 183, Comm’r. v. H. P. Hood & Sons, 141 F. 2d 467,

and the dissenting opinion of Judge Magruder ‘of the

First Circuit in Talbot Mills o Comm’r., 146 F. 2d 809,

812, adopted in Gloucester Ice & Cold Storage Co. v.

C.I.R., supra; (2) with the decisions of the Second Cir-

cuit in Kraft Foods Company v. Comm’r., 232 F. 2d 118,

Comm'r. v. O. P. P. Holding Corp:, 76 F. 2d 11, and

Nassau Lens Co. v. Comm’r., 308 F. 2d 39; (3) ‘with

the decisions of the Sixth Circuit in United States v.

_ Title-Guaranty Co., 133 F. 2d 990, and Byerlite Qorpo- .

ration v. Williams, 286 F. 2d 285; and (4) with the

decisions of the Ninth Circuit in Wilshire & Western

Sandwiches Co.v. Comm’r., 175 F.2d 718, Miller's Estate

v.-Comm’r., 239 F. 2d 729, and Washmont Corporation

v. Hendricksen, 137 F. 2d 306. » |

The decision of the court below is also in direct con-

flict with its own decisions in Jennings v. United States,

272 F. 2d 842, (See_also Jennings v. United States, 68- -2

_ USTC §9842 which\indicates exact proportions of stock

ownership.and loans) and Ortinayer v. C.1.R., 265 r.

2d 848, 853-855. :

®.

9 ;

: os

In all of the foregoing cases debt obligations were held

valid under circumstances much less favorable to the

taxpayer than in the instant case.

In Gloucester Ice &® Cold Storage Co. v. C.IR.,

(CCA 1) 298 F. 2d 183, the taxpayer deducted $7,000.00

it paid to the holders of its debenture bonds as a payment |

of interest on indebtedness. The. interest was paid on

- debentures of which 84°c were issued in exchange for

preferred stock and 16‘; for new money. The proceeds —

from the debentures, plus a bank loan, were used to ac-

quire nearly all the capital stock of an ice business.

The court, in its opinion, stated (Pages 184-5) :

“* * * The Commissioner disallowed the deduc-

tion on the ground that the payments constituted

dividends within the meaning of Par. 115 and Par.

316 (a) of the respective Codes. The Tax Court

agreed with: the Commissioner. It conceded that the

bonds ‘satisfied all uf the formal requirements to

‘ make the instruments effective as debt obligations’

and that the ‘record establishes they were treated as

debt obligations with interest payments made when

due and appropriate accruals to a sinking fund to .

provide for their retirement at maturity.’ Never-

theless, purporting to look through>form to sub-

stance, it held that the debenture holders had placed

their money at the risk of the business, and therefore

in effect were stockholders so that payments to them

were dividends, because (1) the bonds were held

iN approximate proportion to the shares of stock,

(2) the proceeds of the debentures were used to

purchase a fixed asset, i. e., a majority of the stock

of Cape Pond Ice Company, -(3) the bonds were

issued simultaneously with the call of the preferred

stock for redemption and (4) the debt-to-equity ratio

was disproportionately high, being 15 to 1. We do

not agree with the Tax Court.

“The debenture bonds certaiply are evidence of

debt in form as the Tax Court found. They are also

clear evidence of debt in thear substantive provisions

as well, for by their terms they impose an unqualified

obligation to pay interest quarterly on fixed dates

at a fixed rate, they impose an unqualified obliga-

tion to pay a fixed principal amount on a day certain

and within a reasonable time, and they confer upon

-their holders no voting rights or voice in the man-

agement of the obligor under any circumstances

whatever. Neither is there any evidence, or indeed

any suggestion, of some sotto voce understanding

that interest would be paid on the bonds only out of

income or that the principal amoynt would not or

would not likely be paid at maturity as in Brake &

' Electric Sales Corp. V. United States, 287 F. 2d

426 (C.A. 1, 1961). Moreover, there is no evidence

that the petitioner was in such a shaky financial con-

dition or that\its business prospects were so dark

that in reason the parties to transaction could hot

have expected the petitioner to meet its obligations

on its bonds as they fell due * * *”

* * * * &

‘“* * * Tn both form and substance the debentures

aré out and out evidence of the petitioner's in-

debtedness. Nor is there anything to suggest that

the bonds4vere a sham in that they did not embody

the true intention of the parties, or that they did not

or in reason could not have been understood to ob-

ligate the petitioner directly according to their

terms. Compare Brake & Electric Sales Corp. v.

United States, supra. * * * ” |

.+—_)_}_@—_*@

“There being no element of subterfuge or artifice

to escape tax consequences, the bonds speak for them-

selves. And they speak in clear and unmistakable

terms of indebtedness. Therefore there are no dis-

puted questions of fact relevant to the issue to be

decided. Inferences cannot avail against patent facts.”

In Wilshire €& Western Sandwiches v. Comm'r.,

(CCA 9) 175 F. 2d 718, four persons formed a corpo- ®

ration to go into the restaurant business. The purpose

of incorporating was to participate with general creditors

for part of their investment in the event that business

was unsuccessful. The incorporators also regarded loans

as a better investment than stock to obtain returns on

and repayment of their capital outlay. The incorporators

decided against borrowing from a bank because they

considered the receipt of interest desirable. Other per-

tinent factors were as follows: Stock and notes were

issued in equal proportion; one incorporator testified he

expected to be repaid the loan only if taxpayer Serr ae

for the purpose; another testified he expected to b€ pard——————

out of current earnings and would not have insisted on

payment to the detriment of the corporation; interest was

not paid when duc; final payment of principal was late;

and initial book entries did not treaf’Rotes as loans.

The court reversed the tax court and held that the

notes were valid debt obligations.

Neither the district court nor the Court of Appeals

in the instant case refer to Jennings v. United States,

(CCA 7) 272 F. 2d 842, which is an appeal from Jen-

nings v. United States, 58-2 USTC 9842. In that case

the facts that (a) practically all the stock was held in

nearly equal proportions by husband and wife, (b) loans

were made to the corporation by the stockholders in pro-

portion to stock holdings, (¢) no interest was paid from

1935 to 1948, (d), accrued interest Was Waived on three

occasions, (e) indebtedness to stockholders was payable

only when directors deemed it advisable, and (f) by

transferring by agreement the liability entry “netes pay-

able” on the books of the corporation to a “net worth”

entry “contributed.or paid in surplus” subordinated the

stockholder indebtedness to claims of general creditors

and delayed payment indefinitely did‘not deter the Sev-

enth Circuit Court of Appeals from holding the advances

by stockholders valid debt obligations. The facts in the

instant case are more favorable to Petitionér than they

were to the taxpayer iff the Jennings case.

In “Corporate Indebtedness to Shareholders: Thin

Capitalization and Related Problems” by William M.

Goldstein, 16 Tax Law Review |, it is stated:

~“* * * The fact that there is no special treatment

of many aspects of corporate indebtedness to stock-

holders has given rise to an inordinate amount of

litigation resulting in a plethora of conflicting judi-

cial opinions, a vast amount of legal literature and

several proposals for legislative action.”

* <A reading of the decisions in the cases cited herein-

above from’the First, Second, Sixth and Ninth Circuits,

as well as the conflicting decisions in the Seventh Cir-

cuit in the instant case and the Jennings cases together

with Gilbert v. Comm'r., (CCA 2) 248 F. 2d 399 and

262 F. 2d $12, Gooding Amusement Co. v. Comm'r.,

(CCA 6) 236 F. 2d 159, and the decisions in the cases

cited in the opinion of the court of appeals in the instant

case indicate the need for this Court to establish criteria

— —which if-satisfied would constitute an instrument adebt

obligation. The need for°such criteria has been recog:

nized and adoption urged by the American Law Institute,

the American Bar Association, and the Advisory Group

on Subchapter C (16 Tax Law Review 1, 63, 66, 71).

The criteria listed by the American Law Institute,

which if satisfied would constitute an instrument a debt

obligation, are: (16 Tax Law Review 63)

“(1) an ee obligation to pay a sum certain

in money;

(2) maturity on or before a fixed date;

(3) issuance for adequate consideration or. as a

dividend;

(+) no subordination to trade creditors generally;

- . . ©

(5) no voting rights, except on default;

(6) interest payments, if any, to be independent of

earnings and to be paid by the maturity date of the prin-

cipal amount.”

The pjoposal of the American Bar Association is to

add’ a new section, 317. (c), to the Code, to read: (16

‘Tax-Law Review 66-7)

“(c¢) DEBT. — For gall purposes of Subtitle A,

indebtedness of a corporation shall be deemed to

include (but shall not be limited to) any unconds

tional obligation of a corporation to pay on demand

or oma specified date a sum certain in money in-

curred for an adequate consideration in money or

money's worth:

(1) When the obligation is not subordinated by

its terms to the claims of trade creditors generally;

and |

(2) When, by the terms of the obligation, ulti.

mate payment, if any, for use of the principal amount

is not dependent upon the earnings of the corpora-

tien, and is unconditionally due not later than the

maturity date of the principal amount; and

(3) When th€®'principal amount of obligations

in the aggregate by stockholders does not exceed by

more than ten to one the fair value of the stock held

in the aggregate by stockholders immediately after

the obligations are issued; or

(+) In the event that an obligation fails to meet —

one or more of the other requirements of this sub

section, the taxpayer claiming it to be indebtedness

establishes by preponderance of the evidence that

such failure was due to the business requirements

of the corporation.”

Ww illiam M. Goldstein in 16 Tax aw Review |, page

7\ states:

“THE PROPOSAL OF THE ADVISORY

“GROUP ON SUBCHAPTER C

“In its report to the Ways and Means Committee,

the Advisory Group recommends the adoption of

a statutory definition of indebtedness of a corpora-

tion. It cites the Gilbert case as evidence of the need

for such an amendment and says that it is intended

* to benefit small incorporated businesses and their

owners. The new section is supposed to provide an

area of safety fot obligations ‘of the clearest’ sort

without prejudicing the taxpayer's chances of show-

ing that other types of indebtedness come within the

meaning of the various Code provisions.’

* * * * *

“The proposed new section 317(c) reads as

follows: , :

indebtedness of a corporation shall include in all

events (but shall not be limited to) any uncondi-

tional obligation in writing of a corporation to pay

on demand on or before a specified and not unreason-

at.ly distant date a sum certain in money incurred

upon a distribution to shareholders or for an adequate

consideration in money or money's worth and under

circum: ances which do not negative any reasonable

expectation of payment, if —

(1) «the obligation is not by agreement sub-

ordinated to the claims of trade creditors gen-

erally, and alice

(2) payment, if any, for use of the principal

amount is not excessive, is not dependent upon the

15 :

earnings of the corporation, and is unconditionally

due not later than the maturity date of the principal

amount, and

(3) the obligation dues not entitle the obligee to -

“vote upon the election of directors of the corpora-

tion, and

(+) in case the obligation is initially held or

guaranteed by a shareholder of the corporation, im-

mediately after the obligation is created the prin-

cipal amount of all obligations of the corporation

held or guaranteed by its shareholders does not ex-

ceed by more than five- to-one the fair value of the |

outstanding stock of the corporation or the total of /

the capital and surplus paid-in with respect thereto,

whichever is greater.”

The need for more uniform rules in the Courts of

Appeal of the Circuits was deemed urgent enough for

these important bar groups to take action.

The instruments (A. 98-103) executed by Petitioner

satisfy the Criteria advocated by the foregoing three

groups.

The form of the notes (A. 98-103); :the book entries

setting up the notes as debt obligations (A. 17); pay-

ment of ‘aterest (A. 17); payment of principal of the

notes (A. 155); a ratie of capital to debt of $173,874.26

to $66,825.74 (A. 17, 7); the record of. earnings of the

partnership (A. 11, 17), all these indicate as stated in

Gloucester Ice & Cold Storage Co. v. C. 1. R., (CCA 1)

208 F. 2d 183, 185, that “in both form ahd substance”

the notes are out and out evidence of indebtedness. ——

‘The facts enumerated in the decision of the Court of

Appeals in the instant case are the type of facts which the

Tax Court in Gleuceiter Ice & Cold Storage Co. v. CI.R.,

298 F. 2d 184-85, held in purporting “to look through ~

form to substance” made the bends in effect stock and

the interest dividends but which the First Circuit Court

of Appeals in reversing the Tax Caer disregarded

stating, page 185, “ ... There being no element of sub-

terfuge or artifice to escape tax consequences, the bonds

speak for themselves. And they speak in clear and un-

mistakable terms of indebtedness. . . Inferences can-

not avail against patent facts...” :

The fact relied on by the Court of ieee: Ri the

Seventh Circuit that the stock and notes of Petitioner

were issued in equal proportions does not indicate the

notes were not valid debt obligations as that was: the

natural result of the incarporation of a partnership busi-

ness where the capital structure consists of notes and stock.

Miller’s Estate v. Comm’r., (CCA 9) 239_F. 2d 729.

The fact as stated by the Court of Appeals that. the

stockholders of Petitioner subordinated their notes to the

obligations of a bank is a normal occurrence in the op-

eration of a business which needs credit. Subordination

of notes to only one creditor is no different in effect than

giving a bank other security which it could have re-

quired in lieu of subordination. Subordination was not

.considered important by the Court of Appeals for ihe

Seventh Circuit in Jennings v. U. S., 272 F. 2d 842, 845,

and Ortmayer v. C.I.R., 265 F. 2d 848, 853-854."

' The fact as stated by the Court of Appeals that the

assets of the partnership exchanged for ‘the notes of the

— corporation were found to be essential to the conduct of

Petitioner's business is a natural result of the incorpo-

ration of a partnership. (Miller's Estate v. Comm'r.,

(CCA 9) 239 F. 2d 729) From the reasoning of the

Seventh Circuit, it would follow you cannot issue debt

obligations to partners upon incorporation of a partner-

ship. |

The fact relied upon by the Court of Appeals that

Petitioner called in the notes prior to maturity and is-

sued new notes witha different maturity has no sig-

nificance. Petitioner did only what the terms of the notes

authorized. (A. 98-103) — a |

The fact that payment Of interest-on the notes was

suspended for three months, relied upon by the Court of

Appeals, resulted from a shortage of cash arising from

a sttike, from a reluctance of Petitioner to discontinue

steel shipments, although its plant was not operating,

because of fear that shipments delayed would never be

delivered, and from a/ desire to continue a perfect rec-

ord for discounting, bills. ‘“IThese appear reasonable

grounds for deferring interest payments for three months.

The fact relied upon by the Court of Appeals that

Petitioner did not set up a sinking fund does apt indicate

an intention not to retire the notes st maturity in the

face of a ratio of a debt to equity investments of $66,-

$25.74 to $173,874.26 (A. 17,7) at the time*of incorpo-

ration, in -the face of partnership carnings averaging

$62,476.29 for the five years prior to its incorporation

(A. 17) and a net worth of $240,000.00 at the time of

incorporation, in the face of large corporate earnings

and net worth (A. 113) with small and infrequent bank

borrowings (A. 11-12), and in the face of the actual

payment of the notes prior to maturity (Av 155), no

noteholder being under legal obligation to subscribe-for

the new notes offered. (A. 113)

Transaction with Marshall.

The decision of the court below in the instant case is

in direct conflict with a decision in the Second Circuit,

Kraft Foods Company v. Comm’'r., 232 F. 2d 118. 128;

with a decision in the: Fifth Circuit, Sun Properties v.

U7. §., 220 F. 2d 171; with a decision in the Eighth Cir-

cuit, Potter Electric. Signal and Manufacturing Co.. v.

C.1.R., 286 F. 2d 200; and a decision in the Ninth Cir-

cuit, Wilshire & Western Sandwiches, Inc. v.§ Comm'r.,

175 F. 2d 718.

In Wilshire & Western Sandwiches, Inc. v. Comm’r.,

175 F. 2d 718, 720, the court stated :

“* * * Tt is apparent that had the dealings been

with an independent thyfd party no question as to

the propriety of the inferest deduction could have

been raised * * * ”

» In Potter Electric Signal and Manufacturing Co. +.

CI.R., 286 F. 2d 200, the Potter Trust purchased a

building and leased it to petitioner. The Potter Trust

owned all the outstanding common stock ‘and 300 of the

365 shares of petitioner’s preferred. The. question was

as to the reasonableness of the rent. The court of appeals,

page 203, held the following rule of law applicable:

“s* * * Where there is a close relationship be-

tween lessor and lessee and in addition thereto there

is no arm’s length dealing en them, an inquiry

into what constitutes reasonable rental is necessary.’ ”’

For the purpose of. Par. 267, the 1954 Code* disallows

a deduction for losses from sales or exchanges of property

and deduction of expenses on interest on transactions be-

tween same taxpavers. They are defined as members of

a family, an individual and a corporation more than

50°. of the stock of which in value is owned by the in-

dividual, two companies more than 50°, in value of the

stock of each of which is owned by the same individuals

and certain fiduciary relationships.

*26 U.S.C. § 267

The transaction between petitioner and Marshall was

at arm’s length. Each tried to make the best bargain

possible. (A. 29-35, 73-77, 79-81) Aside from a prior

business associatioa and close friendship with C. N. Mel-

lowes, there’ was ww relationship between the parties.

(A. 29, 30) Marshall had a job paying him approx-

imately $12,000.00 a vear, (A. 75) the same salary at

which he was hired by petitioner, plus a bonus in an.

undetermined amount. (A. 104-5) Marshall was not in-

terested primarily in a°job/ He also wanted a stock in-

terest in a company with a gooderowth potential. A.W.

Mellowes at first was dnwilling to sell Marshall stock,

He suggested a profit sharing arrangement. (A. 31)

A. W. Mellowes finally consented to the sale of stock

provided the humber of shares purchased by Marshall

was less than that owned by Scheller as A. W. Mellowes

wanted voting control to be in himself and Scheller. (A

33)

It is important that the confusion that exists in the

acea of defiaing debt obligations be not enlarged by per-

mitting courts to give a meaning to arm's length trans-

actions other than®that which appears upon the face of

the instruments giving the transaction effect.

> S ; af

or 4

CONCLUSION

For che foregoing reasons, this petition for a ‘Writ of

Certiorari should be granted.

Respectfully submitted,

RICKARD H. LAURITZEN

Counsel for Petitioner

' 1532 Bankers Building

., 208 East Wisconsin Avenue

Milwaukee 2, Wisconsin

Of Counsel:

« IRVING A. PUCHNER

1532 Bankers Building «% ©

208 East Wisconsin Avenue

Milwaukee 2, Wisconsin

‘

‘ae

ne ee “

Me, a!

sate Eek ah ;

ee SUPPLEMENT A

IN THE -

U pas ltED STATES COU RT OF APPEALS

FOR THE SEVENTH CIRCUIT

nee ers —

Nos. 13695, 13696 SEPTEMBER TERM, 1962 SEPTEMBER

SESSION, 1962

CHARTER WIRE, INC., On Appeg! from the

Plaintiff-Appellant, judgments of the

: | {United States Dis-

™ ; trict Court for the

\ stern District of

UNITED STATES OF AMERICA,

Ww) Isconsin.

‘i Defendant-A ppellee. '

November 28, 1962.

Before SCHNACKENBERG, CASTLE and SWYGERT, Circutt

Judges.

SWYGERT, Circuit Judge. This is an appeal from a judg-

ment dismissing two consolidated actions by taxpayer,

Charter Wire, Inc., for refunds of income tax for the

years 1952 through 1955. During this period taxpayer

paid to néteholders, who were also its sole shareholders,

a total of $15,489.38 and deducted the payments as in-

terest on its tax returns. The Commissioner of Internal

Revenue determined that the payments represented div-

idend distributions rather than interest on “indebtedness”

as contemplated by Section 23(b) of the Internal Rev-

enue Code of. 1939' and. Section 163(a) of the Internal

Revenue Code of:1954. The District Court, in dismiss-

ing the actions sustained the determination.

Taxpayer, a Wisconsin corporation, is engaged in the

business of drawing and rolling wire. It was formed in

1946 to take over the assets and business of a partnership

composed of Alfred W. Mellowes, Charles N. Mellowes,

and William L. Scheller. At the time of incorporation,

the partnership had a book value net worth of $66,805.74,

and a going concern value of $240,000. The original cap-

ital of the partnership was $3,822.65. The average an-

nual earnings of the partnership during the last five years

of its existence were $62,476.29.

The partnership assets were transferred to the corpora-

tion.in exchange for six per cent promissory notes in the

amount of $66,805.74. The notes were issued to the

former partners in the following proportions: -

; | . Percentage

Amount of Note Total

Alfred W. Mellowes 5.-0-$29473.12000 4G

Charles N. Mellowes .......... 29,473.12 44.1%

W liam" L. Scheller _......... 7,859.50 11.8¢%

_ “ee woe. 66,805.74 100.0;

' Internal Revenue Code of 1939:

SEC. 23. DEDUCTIONS FROM GROSS INCO

In computing net income there shall be allowed 2s

uctions :

* * * * *

(b) Interest.—All interest paid or accrued within the taxable

year on indebtedness, * * *.

* * - 8 * +

(26 U. S. C. 1952 ed., Sec. 23.)

Section 163(a), Internal Revenue Code of 1954 (26 U.S. C. 1958

ed., Sec. 163), is substantially the same as the section set out above.

Ai)

| -

In exchange for $680, one dollar par value stock was

issued to the former partners in the following proportions:

Number of

Amount .— Shares Percentage

Contributed Issued — of Total

300 44.1

Alfred W. Mellowes ....4300.00

Charles N. Mellowes .... 300.00 300 44.1;

William L, Scheller <”. 80.00 80 11.8%

ti Nita a deat 680.00 680) 100.0%

The stock included the good will value of the enterprise.

In 1950 and 1951 taxpayer recapitalized by issuing two

classes of stock, one voting and one non-voting, in ex-

change for the original issue. The proportionate holdings

of the three stockholders remained unchanged.

From March, 1947 to March, 1954 the stockholders

subordinated their-notes ‘to obligations arising from éor-

porate borrowjng from the Marine National Exchange

Bank of Milwaukee.

Interes¥ has been regularly paid on the notes save for

one three-month period during the latter part of 1947.

In that year, the taxpayer's production was hampered by

a six week strike. The strike occurred during a steel

shortage. Taxpayer was ugwilling to stop. steel ship-

ments from its Suppliers, although its plant was not op-

erating, because it felt that any shipments delayed would

newer be delivered. To meet its trade obligations and

because of a desire to maintain its record of discounting

bills, and takjag into consideration the tight cash position

of the corporation, the directors voted to suspend payment

+ of interest on the notes given in exchange for the partner-

ship assets. Interest was suspended dering October, No-

vember, and December, 1947. Back interest covering

this pefiod was paid in 1948.

Taxpayer in 1953 negotiated for the hiring of one J.

Willard Marshall for an executive position. Marshall

agreed to come with the corporation only if he could buy

an interest in it. He was willing to invest up to $50,000

in corporate stock. The shareholders were reluctant to

sell any of the stock but finally offered to sell Marshall

3,800 shares of common for $27,625.28. At the same

meeting Charles-N. Mellowes siggested Marshall loan

the corporation $10,000. Marshall finally agreed to loan

$7,427.23 at six per cent interest. He borrowed this

money from a bank at three and three-fourths per cent

interest. His “loan” bore the same ratio to the total

amount represented by the stockholders’ notes as his share

of voting stock bore to the total voting stock then issued.

Pursuant to a resolution of the board of directors in

February, 1954 the four notes of the stockholders (in-

gluding Marshall's), which had a maturity date of Jan-

Stary 31, 1956, were paid by corporate checks and the

notes were cancelled. ‘The checks were endorsed back to

the corporation within two weeks and, in conformance

with the resolution, new five per cent promissory notes

were issued having a maturity date of January 31, 1960.

The new notes eliminated tHe provision of the original

notes which provided that they were to mature auto-

mafigally on the death of the holder.

At all times the notes in question were carried as debt

obligations on the books of the corporation.

The burden’ of establishing that the advances were

loans is upon the taxpayer. Arlington Park Jockey Club

v. Sauber, 262 F. 2d 902 (7th Cir. 1959). Even though

the taxpayer has various explanations for each of its

actions taken separately, the finding that the totality of

facts indicates a risk-capital investment should not be set

aside unless we are prepared to say that the District Court

was clearly erroneous. Brake & Electric Sales Corp. v.

United States, 287 F.2d 426 (Ist Cir. 1961). A- review

of the undisputed facts and a reading of the clear, concise

analysis of these facts contained in the opinion filed by

the District Court convinces us that we would be making

an unwarranted departure from the “clearly erroneous” .

doctrine were we to reverse the District Court's de-

termination.

There is no doubt that the stockholders of taxpayer at

all times held their notgs. in direct proportion to their

equity ownership in the corporation. This raises a strong

inference that the loans represented capital investment.

Arlington Park jockey Club v. Sauber, supra. The stock-

holders’ subordination of their notes to the obligations

held by the bank was properly considered by the District

Court as bearing on the true nature of the transactions in

(3rd Cir. 1.62).

The Gsets of the partnership exchanged for the notes

of the corporation were found to be essential to the con-

duct of the taxpayer's business. This is another factor

that may be used to weigh the balance in favor of the

District Court's determination. Brake & Electric Sales

Corp. v. United States, supra. In the latter case the ab- |

sence of an unfavorable or disportionate debt-equity ratio

Was not deemed controlling, and the finding of an equity

relationship was‘affirmed on the basis of other consider-.

ations. ‘Taxpayer here argues strongly that it had an ex-

tremely favorable debt-equity ratio during the entire

period in question and we can find nothing in the record

which would lead us to believe otherwise; however, we

believe the many other factors present warrant an affirm-

ance of the decision.

Expectation of payment at maturity is a good indica-

tion of the existence of a debt. This expectation, how-

ever, must be more than a theoretical one, and in retro-

spect if it can be shown that the stockholders making the

advances were little concerned about the matter of pavy-

ment of the principal when due, then the taxpayer's

position is greatly weakened.

Here there was no evidence of a sinking fund having

been established to provide for retirement of the notes

at maturitv—a fact given considerable weight in estab-

lishing the existence of a debtor-creditor relationship in

Gloucester Tce & Cald Storage Go. et. G. if R.., 298 F.

2d 183 (Ist Cir. 1962). The record shows that the note-

holders had complete eontrol-of the corporation and on

several occasions exhibited their primary concern for

their position as stockholders in preference to that of

creditors. The stockholders subjugated their role as

creditors when it was for the corporation’s benefit. They

called in the notes prior to maturity, issued new notes

with a differént maturity date, subordinated their notes

»without protest to that of a bank when asked to do so,

and suspended payment of interest for one three-month

period; thus they appear to have been little interested in

their role as creditors. Their conduct as above related

makes it apparent that they relied on their control as

stockholders for security rather than on their status as

creditors.

We further agree with the District Court in tts analysis

of the nature of the loans made to Marshall. ‘Vhe District

Court noted:

“Especially damaging to the ta....ayer’s suggested in-

terpretation of the facts of tais case are the transac-

tins with respect to the loan made to the corpora-

tion by Marshall. Upon the urging of Charles N.

Meiloaves that the funds supphed would atd in com-

pany expansion and that the loan would make him

temore like the other stockholders, Vlarshall, who

Was interested inoonly an equity investment, made

the Toan requested. “Po illustrate that this was not

such a loan as would entitle taxpayer to a deduction

for anterest paid thereon, we note that the dominant

purpose of the loan was not the need of the Corpora-

tion tor such funds, but to assume harmonious rela-

tions with other stockholders. Pts abundantly clear

that with its excellent credit rating, the cOrporaniony

could have readily borrowed money trom the banks,

and probably at amore tavorable rate than the 6°,

rate granted to MiarsNall Phe tact that Marshall

Was able to borrow the Jnoney necessary to make the

loan to the corporaefin at sooo). consistent with

this finding. After the consummation of the stock

purchase and loan agreement, Miarshall owned [0

of each class of stock and 10°, of the outstanding

metes owed to. stockholders. This proportronality

could be maintained as long as Marshall remained

in the employ of the corporation since the Corpara

tion had an exclusive option to buy. Viarshall’s «tock

in the eveat that he should desire to dispose of At dur:

ing his litetime, and if it exercised the option, the

corporation was also obliged to purchase his note in

the same proportionate amount. The dealings with

Marshall clearly indicate that the taxpayer and its

shareholders treated the ‘leans’ as an integral portion

af the contributed capital of the corporation.” (bem,

phasts supphed. )

The judgment of the District Court is affirmed.

A true Copy: \

‘Teste:

Clerk ot the United States Gourt ot

Appeals for the Seventh Circurt.

SUPPLEMENT B

UNITED STATES COURT OF APPEALS

FOR THE SEVENTH CIRCUIT

Wednesday, November 28, !962

Before .

Hon. ELMER J. SCHNACKENBERG, C = cuit Judge

Hon. LATHAM CASTLE, Circuit Judge

Hon. LUTHER M. SWYGERT, Circuit Judge.

No. 13695-13696

-«

Appeals from the.

United States Dis-

trict Court for the

Eastern District of

CHARTER WIRE. INC.,

Plaintiff--1ppellant,

vs.

UNITED STATES OFPA MERICA,

Defendant-Appellee.

& \

Wisconsin.

‘This cause came on to be heard on the transcript of

the record from the United States District Court for the

Eastern District of Wisconsin, and was argued by counsel

On consideration whereof, it is ordered and adjudged

by this court that the judgments of the said District Court

in this cause appealed from be, and the same are hereby

AFFIRMED, in accordance with the opinion of this

Court filed this day.

SUPPLEMENT C

“Sec. 23. Deductions from Gross Income.

“In computing net income there shall be allowed as

deductions:

Ss «.

“(b) All interest paid or accrued within the taxable

years on indebtedness except on indebtedness incurred or

continued to purchase or carry obligations (other than

obligations of the United States issued after September

24, 1917, and originally subscribed for by-the taxpayer)

the interest upon which ts wholly exempt. from taxes im-

posed by this chapter.”

INCOME TAX REGULATIONS 118

3.23 (b)-1 Interest. Interest paid or accrued within

the year on indebtedness may be deducted from gross in-

come, except that interest on indebtedness incurred or con-

tinued to purchase or carry obligations, such as municipal

bonds, first Liberty loan 3!) percent bonds, or (in case

of a taxpayer not an original subscriber) obligations of

the United States issued after September 24, 1917, the

interest upon Which is wholly exempt from tay is not

deductible. Interest paid or accrued within the vear on

indebtedness incurred or‘continued to purchase or carry

(a) obligations of the United States issued after Sep-

tember 24, 1917, the interest upon which is not wholly

exempt from the taxes imposed by title I of the Act, or

— (b) (inghe case of an original subscriber) obligations of

the United States issued after September 24, 1917, the

interest upon which is wholly exempt from the taxes im-

posed by title I of the Act, is deductible in accordance

with the general rule.

Interest paid by the taxpayer on a mortgage upon real

estate of which he is the legal or equitable owner, even

though the taxpayer is not directly liable upon the bond

or note secured by such mortgage, may be deducted as

interest on his indebtedness. Payments made for Mary-

land or Pennsylvania ground rents are not deductible as

interest but may, if a proper business expense, be deducted

as rent. ,

Interest calculated for cost-keeping or other purposes

on account of capital or surplus invested in the business

which does not represent a charge arising under an inter-

est-bearing obligation, is not an allowable deduction from

gross income. Interest paid by a corporation on scrip

dividends is an allowable deduction. So-called interest

on preferred stock, which is in reality a dividend thereon,

can not be deducted in computing net inyome. (See, how-

ever, §$3.22(a)-I8 and section 121 of the Act.) In the

case of banks and loan or trust companies, interest paid

within the year on deposits such as interest paid on moneys

received for investment and secured by interest-bearing

“eertificates of indebtedness issued by such bank or loan

or trust company may be deducted from gross income. As

to other amounts of interest aot deductible under section

23(b) of the Act, see section 24(c), as added by the

Revenue Act of 1937 (50 Stat. 828; 26 U.S.C., Sup. III,

24(c)).*f [As amended by T.D. 4791, Jan. 14, 1938, 3

F.R. 100] |

1954 INTERNAL REVENUE CODE

“S163. Interest

(a) General rule——There shall be allowed as a de-

duction all interest paid or accrued within the taxable

year on indebtedness.

Code of Federal Regulations

an rans Title 26 Internal Revenue 1954

$1. 163-1(a) Exegpt as otherwise provided in’ sections

4. 267, inclusive, interest paid or aceried within the

taxable year on indebtedness shall be allowed as a de-

duction in computing taxable.income.”

This is a copy of a public record, reproduced as it was published. It is not legal advice, and it may not be the version a court would rely on. Check the official source before you cite it.