Opinion · United States Tax Court

Beckett v. Commissioner

Beckett v. Comm’r, 41 T.C. 386 (T.C. 1963)

Type: Opinion
Court: United States Tax Court
Jurisdiction: Federal
Date: 1963-12-20
Topic: general

OPINION Since the record in this case is voluminous and the testimony of the witnesses in many respects confusing and in some respects contradictory, we believe it well to state in summary our view of the reasons which motivated Bryan and Federighi to enter into the agreement of October 18, 1954, and the primary purpose of each of them for making this agreement before proceeding to discuss the issues raised by the parties. As of July 1,1954, Bryan and his brother owned all the stock of a corporation which was operating primarily a retail and wholesale hardware business. The operation of this business had been unprofitable for many years and by 1954 Bryan had concluded that it was not feasible to make sufficient changes in the hardware business of this corporation to convert it into a profitable operation. For this reason he had decided to liquidate this business of the corporation, Maxwell Hardware, and had begun to take the necessary steps for this liquidation. Bryan wanted to proceed with the liquidation of the retail and wholesale hardware business and the use of any of the other corporate assets in such a manner as to obtain the highest possible value therefrom for himself and his brother as common stockholders of Maxwell Hardware.

Citator

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Authority status: pending
Cited by: 25 opinions

BECKETT v. COMMISSIONER OF INTERNAL REVENUE,41 T.C. 386(1963)

ARTHUR T. BECKETT AND GERTRUDE E. BECKETT, ET AL.,^fn*PETITIONERS, v.

COMMISSIONER OF INTERNAL REVENUE, RESPONDENT

Docket Nos. 95309-95311.

United States Tax Court.

Filed December 20, 1963.

A corporation which had sustained approximately $1 million of losses in a hardware business entered into an agreement with two partners engaged in numerous real estate development activities as partners and controlling stockholders of corporations, whereby a real estate department was established to develop a subdivision, the funds therefore being furnished by the two partners through purchases of the preferred stock in the corporation for an amount which was approximately two-fifths of the then value of the common stock of the corporation. The real estate department was operated independently of the other corporate business. The agreement provided that the real estate department should not be discontinued for a period of 6 years, that the preferred stockholders should not sell their stock for this period, and thereafter if the department were discontinued at the option of either the corporation or preferred stockholders, the preferred stock should be redeemed by distribution in kind of 90 percent of the department's assets to the preferred stockholders. A voting trust agreement was established to restrict the control of the common stockholders over the corporation for a period of 5 years. The hardware business was discontinued and the real estate business operated at a profit. From these real estate profits were deducted as loss carryovers the net operating losses which had been previously sustained by the hardware business. The agreement between the corporation and the new preferred stockholders was entered into on October 18, 1954, and was therefore governed by the provisions of Internal Revenue Code of 1954.Held:The principal purpose of the real estate partners in entering into the agreement of October 18, 1954, was to obtain the benefit of the loss carryover of the hardware business against the anticipated profits of the real estate subdivision business. Nevertheless, since the corporation in its corporate entity entered many business arrangements with respect to the real estate subdivision the transaction was not such a sham as to permit disregarding the corporatePage 387entity and taxing the profits from the real estate subdivision to the two partners.Held, further,limited strictly to the factual situation here involved, the net operating loss carryover from the hardware business is not allowable as a deduction against the earnings of the real estate subdivision under the principles of the case ofLibson Shops, Inc. v.Koehler,353 U.S. 382(1957), even though the transaction does not fall within any of the changes-in-ownership situations set forth in sections 269 and 382, I.R.C. 1954.

George N. Koster, Valentine Brookes, Paul E. Anderson,andRichard A. Wilson,for the petitioners.Charles W. Nyquist,for the respondent.

SCOTT,Judge:

Respondent determined deficiencies in the income taxes of petitioners for the years and in the amounts as follows:

Docket Fiscal No. Petitioners period Deficiency ended —

95309 Arthur T. Beckett and Gertrude E. Beckett .............................. 12/31/54 $7,446.27 12/31/55 58,944.16 12/31/56 91,259.11 12/31/57 51,767.72 12/31/58 98,664.79 ---------- 308,082.05 ==========

95310 Frederick J. Federighi and Mary Helen Federighi ...................... 12/31/54 7,479.45 12/31/55 63,433.89 12/31/56 91,702.71 12/31/57 41,520.71 12/31/58 99,401.00 ---------- 303,537.76 ==========

95311 Maxwell Hardware Co .................. 1/31/57 47,770.04 1/31/58 102,075.89 1/31/59 111,952.58 1/31/60 64,048.83 ---------- 325,847.34

Pursuant to joint motion of the parties after the granting by the Court of a continuance in certain of the cases here involved, a severance of issues in the cases of A. T. Beckett and Gertrude E. Beckett and Frederick J. Federighi and Mary Helen Federighi was granted, and the issues involved in those cases concerning the taxability to the individual petitioners of income reported by petitioner Maxwell Hardware Co. during each of the years involved in each of the individual cases was consolidated for trial with the sole issue involved in the case of Maxwell Hardware Co. Therefore, the issue for decision in the instant case with respect to the individual petitioners is whether income reported by Maxwell Hardware Co. from an operation which it denominated its real estate department should properly have been included in the partnership income of a partnership known as Beckett and Federighi, and thus reported in the returns of the individual petitioners who were partners in that partnership for each of the calendar years 1954, 1955, 1956, 1957, and 1958.Page 388

The issue with respect to the corporate petitioner Maxwell Hardware Co. is whether that company is entitled to carry over against its income from the operations which it denominated its real estate department net operating losses sustained by the corporation prior to its establishment of its real estate department. The issue in the case of the Maxwell Hardware Co. is an alternative issue since respondent recognizes even though no such indication is given in his notice of deficiency, that if in fact the income from the real estate department is the income of the partnership of Beckett and Federighi, this income is not includable in the income of Maxwell Hardware Co., and therefore the issue with respect to Maxwell Hardware Co. becomes moot.

FINDINGS OF FACT

Some of the facts have been stipulated and are found accordingly.

Petitioner Maxwell Hardware Co. (hereinafter referred to as Maxwell Hardware) is a corporation incorporated under the laws of the State of California on March 28, 1922. It filed its Federal income tax returns for its fiscal years ending January 31, 1957, 1958, 1959, and 1960, with the district director of internal revenue at San Francisco, Calif. The returns for each of these years were filed on an accrual method of accounting.

Petitioners Arthur T. Beckett and Gertrude E. Beckett, husband and wife residing in Orinda, Calif., filed joint Federal income tax returns for each of the calendar years 1954, 1955, 1956, 1957, and 1958, with the district director of internal revenue at San Francisco, Calif. Each of these returns was filed on the cash method of accounting.

Petitioners Frederick J. Federighi and Mary Helen Federighi, husband and wife residing in Orinda, Calif., filed joint Federal income tax returns for each of the calendar years 1954, 1955, 1956, 1957, and 1958 with the district director of internal revenue at San Francisco, Calif. Each of these returns was filed on the cash method of accounting.

Arthur T. Beckett (hereinafter referred to as Beckett) and Frederick J. Federighi (hereinafter referred to as Federighi) are and were throughout the years here involved members of a partnership known as Beckett and Federighi. This partnership throughout all the years here involved had its offices at 1441 Franklin Street, Oakland, Calif., and was engaged in a wide variety of business activities including the construction business, the ownership and operation of rental properties, the holding of real estate for investment, the operation of a restaurant, participation in an insurance brokerage business, and providing office space, bookkeeping services, and other servicesPage 389for a number of corporations which were owned or controlled by Beckett and Federighi.

Among the corporations owned or controlled by Beckett and Federighi which had their offices at 1441 Franklin Street, Oakland, Calif., were: University Rentals, Inc.; Davis Street Rental, Inc.; Eden Development Co.; 98th Edes, Inc.; East Bay Mortgage Co.; East Bay Mortgage Service, Inc.; Ashland Building Materials Co.; W. E. Hamby Construction Co.; 1441 Franklin, Inc.; and East Bay Mortgage Realty Co. Beckett and Federighi were officers of each of these corporations, with the exception of 1441 Franklin, Inc., of which the wife of each of them was an officer. East Bay Mortgage Realty Co. of which Federighi was president and Beckett, treasurer, and the two were controlling stockholders in 1954, had during that year an experienced and competent real estate sales organization. Eden Development Co., all of the stock of which was owned by Beckett and Federighi and members of their families in 1954, and of which Beckett was president and Federighi secretary, was a builder and developer of property with a net worth at the close of its fiscal year ended March 31, 1954, of $380,166.56.

On November 24, 1952, Beckett and Federighi entered into a contract to acquire by trade approximately 308 acres of land (hereinafter referred to as Bay-O-Vista) located in San Leandro, Calif. The provisions of this contract were detailed but in general divided the property into three separate parcels which were to be acquired at various times, the time limitation on the acquisition of the first parcel being July 1, 1953, the second, July 1, 1954, and the last parcel, July 1, 1955. The total agreed valuation of the 308 acres was $462,000. Prior to entering into the contract of November 24, 1952, to acquire the Bay-O-Vista property, Beckett and Federighi employed an engineering firm to prepare a boundary survey and tentative sketches of possible usage for the property.

By May of 1954, Beckett and Federighi had acquired the first two parcels of the property and filed certain plans for the proposed use of the first parcel with the city planning commissioner of the city of San Leandro, and on May 13, 1954, requested permission to proceed with rough grading of the tract even though final approval had not been given to the plan. This tract of property was very hilly and in fact was sometimes referred to by Beckett and Federighi as the Hill property. It was primarily suitable for subdivision into lots. Because of the hilly nature of the property the development costs would be substantially in excess of the development costs of flat land, and therefore it would be necessary to obtain a substantially higher price for the lots because of the added expense. Development of a subdivision property of this type entails certain risks. It was the general practice of Beckett and Federighi in their subdivision developments to havePage 390the development undertaken either in conjunction with a corporate financier or through a corporation in order to limit the risk involved in connection with the subdivision. Beckett and Federighi had less experience in subdivisions that were to be sold as lots only than in developing subdivisions in which they built the houses on the lots and sold the entire package. Also, Beckett and Federighi's experience with subdivisions was primarily with flat land.

On June 11, 1954, Beckett and Federighi were advised by the board of education of the city of San Leandro that an adequate elementary school site would have to be provided in their subdivision. Federighi thereafter conducted negotiations with the board of education and in 1957 the San Leandro Unified School District filed a complaint in eminent domain naming Beckett, Federighi, and a number of "Does" as defendants.

Prior to the incorporation of Maxwell Hardware in 1922, a company under this name had been operated by John Maxwell as a sole proprietorship. John Maxwell was the grandfather of John Maxwell Bryan and Carleton F. Bryan, the sole stockholders of Maxwell Hardware as of October 17, 1954.

At all times from its incorporation up to October 17, 1954, the only stock of Maxwell Hardware had been common stock, and it had been owned by John Maxwell or members of his family including his son-in-law, Carleton F. Bryan, Sr. Maxwell Hardware as the sole proprietorship of John Maxwell and from its incorporation in 1922 until sometime during its fiscal year ended January 31, 1955, was engaged in the retail and wholesale hardware business.

Around 1920 John Maxwell had acquired some property which sometime during the late 1920's was developed as a subdivision consisting of approximately 500 houses by a corporation which during the mid-twenties was a wholly owned subsidiary of Maxwell Hardware. This subdivision was known as Maxwell Park and was in Oakland, Calif. At various times during its corporate existence Maxwell Hardware has also owned real estate used in its hardware business, certain other rental real estate, and two ranches. Prior to 1954 one of the ranches was sold and the other was placed in a separate corporation, the stock of which was distributed to the stockholders of Maxwell Hardware. Also at various times the real property was in a subsidiary company of Maxwell Hardware known as Maxwell Investment Co., which subsidiary was dissolved in 1953.

On its income tax returns for its fiscal years ended January 31, 1951, through January 31, 1955, Maxwell Hardware showed its principal business as "retail hardware." Each of these returns was a consolidated return of Maxwell Hardware and subsidiaries. The return for the fiscal year ended January 31, 1954, showed only onePage 391subsidiary, Maxwell Wholesale Hardware Co., whose principal business activity was shown as wholesale hardware and beside this designation was checked the word "inactive." For the fiscal year ended January 31, 1955, the only subsidiary shown likewise was Maxwell Wholesale Hardware Co. Maxwell Hardware's consolidated return for its fiscal year ended January 31, 1953, in addition to showing as a subsidiary Maxwell Wholesale Hardware Co., showed Maxwell Investment Co., and also showed a notation of its dissolution. The consolidated return for the fiscal year ended January 31, 1952, showed as subsidiaries Maxwell Wholesale Hardware Co. and Maxwell Investment Co. and showed the business of Maxwell Investment Co. as real estate investments, and the return of Maxwell Hardware and subsidiaries for its fiscal year ended January 31, 1951, showed in addition to Maxwell Wholesale Hardware Co. and Maxwell Investment Co., Grimmett Sport Shop as a subsidiary with its principal business activity listed as sporting goods.

For the fiscal year ended January 31, 1951, the audit report of Maxwell Hardware and subsidiaries shows net income of Maxwell Investment Co. before Federal taxes of $46,075.32, the income being derived primarily from two properties referred to as the Isabella Street property and Shattuck Avenue property and from two farm properties consisting of a Butte County ranch and Contra Costa County ranch. The building on Isabella Street was a warehouse building, and the building on Shattuck Avenue was a building with commercial occupants on the first, floor and apartments and offices on the higher levels. The audit report for the fiscal year ended January 31, 1952, showed net income of Maxwell Investment Co. in the amount of $35,240.50 being derived primarily from the same properties that produced the income for the fiscal year ended January 31, 1951, but showed that the Butte County ranch was sold during that year for $500,000 with a profit on the sale of $199,209.54. The audit report for the fiscal year ended January 31, 1953, showed net income from farm properties and city properties of $30,766.63, and the similar report for the fiscal year ended January 31, 1954, showed included in Maxwell Hardware's income, rents from properties leased to others with a statement "Excess of expense over income — Property leased to others $15,611.83." A notation in this report showed that Maxwell Investment Co. was dissolved on January 29, 1953, and that the farm property in Contra Costa County was transferred as of March 2, 1953, to a new corporation, Bryan Land Co., in return for stock, which stock was distributed to the shareholders of Maxwell Hardware in proportion to their shareholding. The audit report for the fiscal year ended January 31, 1955, showed an excess of income over expense or property leased to others of $8,403.77. In its fiscalPage 392years ended January 31, 1951 through 1955, Maxwell Hardware sustained net operating losses in the following amounts:

Fiscal year ended Jan. 31 —Amounts

1951 ....................................... $202,461.01

1952 ....................................... 111,995.09

1953 ....................................... 344,413.76

1954 ....................................... 137,824.45

1955 ....................................... 298,067.48 ------------ 1,094,761.79

Prior to 1948 the hardware business of Maxwell Hardware had been a successful operation and had resulted in profits. In 1948 Maxwell Hardware began to lose money and continued to do so for several years thereafter.

John M. Bryan (hereinafter referred to as Bryan), who was born in 1925, began to work for Maxwell Hardware in 1947 at which time his father was president of the company. His father's health became poor around 1949 and Bryan took on more duties in connection with the business of Maxwell Hardware and in 1951 became president of that company. In 1951 when Bryan became president of Maxwell Hardware it had seven retail hardware outlets. Several of these stores were not modern stores, and its main downtown store was not only not modern but had no parking facilities. Maxwell Hardware also had labor contracts which were more costly than its competitors' contracts, and on its downtown store had a lease which had been negotiated when property values were higher in that location than they had come to be in 1951, and the term of the lease had not yet expired.

For a number of years Maxwell Hardware had been a customer of the Central Bank of Oakland, Calif. (hereinafter referred to as Oakland Bank).¹During the years 1952, 1953, and 1954, Bryan on behalf of Maxwell Hardware frequently discussed the financial position of that company with T. P. Coates (hereinafter referred to as Coates), an officer of the Oakland Bank. Bryan and Coates discussed the causes of the losses which were being sustained by Maxwell Hardware and ways of reversing this trend. Coates advised Bryan to curtail the hardware business of Maxwell Hardware and to undertake some other business in which there would be better prospects of profits.

During the years 1952 and 1953, four of the retail hardware outlets of Maxwell Hardware were closed so that as of the beginning of 1954, the company had three retail hardware stores and a wholesale hardware department remaining in operation. Maxwell Hardware had large inventories in relation to its sales and at the time Bryan began considering the curtailment of operations these inventories were overvalued. By December 1954 Maxwell HardwarePage 393had closed all its hardware outlets but continued for sometime thereafter to collect outstanding accounts receivable from prior hardware sales and to liquidate its hardware assets.

As of January 31, 1954, the books of Maxwell Hardware reflected total capital stock and earned surplus of $878,144.40. As of that date it had pledged land and buildings with a net book value of $482,200.54 as security for notes payable to insurance companies with unpaid balances totaling $431,743.42. The current assets of Maxwell Hardware as of that date consisted of cash of $87,720.38, accounts receivable of $815,593.26 less allowance for losses thereon of $44,000 leaving $771,593.26 of which $621,786.65 was pledged to secure a bank loan of $450,000, merchandise inventory of $551,884.78, prepaid expenses and other current assets of $33,970.14, and other assets of $24,008.29. It had property, plant, and equipment less depreciation thereon of a book value of $656,362.74. Its only outstanding stock as of that date was 6,438 shares of common stock of a par value of $100 per share.

In 1953 or early 1954 the Oakland Bank would not lend further moneys to Maxwell Hardware on an open account basis but would make loans on accounts receivable on a current basis. The financial statements prepared for Maxwell Hardware for its fiscal year ended January 31, 1955, showed a net loss from hardware operations in the amount of $369,586.67. The hardware department conditional sales contracts were pledged as security for a $250,000 note and the hardware department land and buildings remained pledged as security for notes payable to insurance companies totaling $494,685.46. As of this date, the company also had liabilities on unexpired leases on the store premises which it had closed down. The downtown store rental was about $80,000 a year and the lease still had a few years to run.

Sometime around the middle of 1954, Federighi visited Coates in his office. Federighi was a customer of the Oakland Bank having both partnership and corporate accounts in the bank. At that time Coates discussed with Federighi the fact that Maxwell Hardware had suffered losses and suggested that Federighi contact Bryan. Coates advised Bryan of his talk with Federighi and told Bryan that Federighi might get in touch with him. Subsequently Federighi did contact Bryan and called at Bryan's office. Although previous to this time Federighi had made certain purchases from Maxwell Hardware, he had not known of the ownership or operations of that company and had not met Bryan prior to the date that he called at his office around the middle of 1954. Bryan is not related by blood or marriage to either Beckett or Federighi or the wife of either of them.

During the period between the middle of 1954 and October 18, 1954, negotiations were conducted between Bryan and Federighi and variousPage 394drafts of proposed agreements were prepared by their respective attorneys. Beckett did not participate directly in the negotiations but was kept informed by Federighi. Bryan was not willing to sell any common stock of Maxwell Hardware. Bryan felt that with the tax loss that Maxwell Hardware had, the company was in a very advantageous position to find a profitable business to go into, and he was interested in going into such a business for himself and his brother, the other owner of common stock, and had no interest in selling common stock to anyone else.

During the negotiations neither Federighi nor Beckett made any study of the books or financial statement of Maxwell Hardware or of the audit reports of that company. They did make some inquiries of Coates with respect to the company and did have their accountant look at certain financial records of the company, but no employee of Beckett or Federighi made any complete study of the financial data of Maxwell Hardware.

Under date of October 18, 1954, Beckett, Federighi, and Bryan as president of Maxwell Hardware, executed a document which stated as follows:

THIS AGREEMENT, made and entered into this 18th day of October 1954, by and between MAXWELL HARDWARE COMPANY, a California corporation, hereinafter called "CORPORATION" and A. T. BECKETT, hereinafter called "BECKETT" and F. J. FEDERIGHI, hereinafter called "FEDERIGHI".

WITNESSETH:

(a) Corporation, for many years, has owned and held, and now owns and holds for and as investment, property located on Isabella Street, Oakland, California, commonly known as the Isabella Street property, and property located at Shattuck and Addison Streets, Berkeley, California, commonly known as the Francis Shattuck Building;

(b) Corporation in the past developed, subdivided into lots a tract of land known as MAXWELL PARK in the City of Oakland, California, built homes on such lots, sold, financed and arranged for the financing of same;

(c) Corporation desires to re-enter into the business of developing, subdividing into lots unimproved tracts of land and to engage in the business of building homes and selling lots with or without homes thereon, and desires to establish a department for the purpose of carrying on such real estate business, which department or business shall be known as "MAXWELL'S REAL ESTATE DIVISION", and is hereinafter referred to as "DEPARTMENT";

(d) Corporation has no one in its employ capable of managing and operating such Department profitably and successfully;

(e) Federighi has profitably and successfully managed and operated real estate subdivisions and is capable of managing and operating said Department profitably and successfully. Corporation therefore desires to employ Federighi as manager of such Department;

NOW, THEREFORE, in consideration of the premises, and of the promises, covenants and agreements hereinafter set forth and other good and valuable consideration received by each of the parties from the other, IT IS HEREBY AGREED, as follows:Page 395

1. Corporation, in the conduct of and as a part of its business, will engage in the business of purchasing, selling, and otherwise dealing in real estate, including owning, developing and subdividing into lots undeveloped tracts of land, and building homes thereon, and selling lots with or without homes thereon.

2. Corporation does hereby hire and employ Federighi as its manager of said Department from year to year, commencing with the 1st day of October, 1954, at the annual salary of $15,000.00, payable in monthly installments.

3. Federighi shall bear the title of Vice-President, and shall have complete control and be in full charge of said Department. Corporation will appoint and elect Federighi as such Vice President.

4. Federighi accepts employment as such manager and agrees to give such energy, ability and skill as shall be reasonably necessary in the performance of his duties and to perform them in an efficient, trustworthy and businesslike manner. He shall cause all expenses and debts of the Department to be paid when due and should they not be paid when due, any officer of the Corporation may withdraw money from the Department's cash balance or use other assets of the Department to pay such obligations. However, he, as Vice-President and manager of the Department, shall have complete authority to initiate or defend in behalf of the Corporation any contest, suit or other form of action or procedure with respect to any claim, charge or debt arising out of the operations of the Department which, in his judgment, should be contested for the best interests of the Corporation, and any and all expenses of such contest shall be all expense of the Department and be paid out of assets of the Department.

5. For the purpose of enabling Corporation to effectively watch and supervise the operation of said Department, and to avoid commingling of the affairs of said Department with the affairs of the other departments of Corporation, said Department will maintain records, books of account, and bank accounts separate from the records of account at the Corporation's other departments.

6. Corporation will sell to Beckett and Federighi and Beckett and Federighi each will purchase from Corporation 1000 shares of the Preferred stock of Corporation if and when issued, of the par value of $100.00 each, plus transfer tax. The designations, preferences, voting powers and relative participating optional or other special rights, qualifications, limitations or restrictions of the preferred stock and the common stock of the Corporation shall be as follows:

(a) The holders of the Preferred shares shall be entitled, when and as declared by the Board of Directors, to dividends at the annual rate of, but not exceeding, 6% of the par value of such shares, payable in preference and priority to any payment of any dividend on Common shares and payable semiannually or otherwise, as the Board of Directors may from time to time determine. The right to such dividends on preferred shares shall not be cumulative and no rights shall accrue to holders of preferred shares by reason of the fact that dividends on said shares are not declared in any prior period.

(b) In the event of any liquidation, dissolution or winding up, whether voluntary or involuntary, of this corporation, before any amount shall be paid to the holders of Common shares, the holders of the Preferred shares shall be entitled to receive, out of the assets of this corporation whether such assets are capital or surplus, an amount equal to the par value of the Preferred shares and the dividends declared and unpaid thereon and, after payment to the holders of Common shares of an amount equal to $100.00 per share, the remaining net assets, if any, of the Corporation shall be ratably distributed as follows: 80% thereof among the holders of the Preferred shares, and 20% thereof among the holders of the Common shares.Page 396

(c) Except as otherwise provided by statute, the holders of Preferred shares shall have no voting power, and the voting power for the election of directors and for all other purposes shall be vested in the holders of the Common stock.

7. It is recognized by the parties that it will undoubtedly require several years to firmly establish a sound Real Estate Department, and it is understood and agreed that Federighi should have ample time and the full cooperation of the Corporation in his efforts to develop said Department and place same on a stable and successful basis. The parties agree that a reasonable length of time to allow for the establishing of said Department would be at least six (6) years, and the Corporation agrees that it will not attempt to close up said Department for such period, except upon the unanimous vote of the Board of Directors, and the holders of the Preferred stock agree that they will not sell their stock for such period of six years.

(a) After the expiration of six (6) years from the date hereof, if the holders of said Preferred stock desire to sell their said stock, they must first offer it to the Corporation, and the Corporation in such event must redeem said stock, upon the following terms:

(i) If the book value of all of the net assets of the Department shall be less than the total par value of all of the outstanding preferred shares, then the net assets of the Department shall be ratably distributed among the holders of said shares.

(ii) If the book value of all of the net assets of the Department shall be greater than the aggregate par value of all of the outstanding shares of said preferred stock, then the net assets of said Department shall be distributed among the holders of said shares on the basis of the par value per share plus the per share portion of 90% of the book value of the net assets of said Department in excess of the aggregate par value of all of the said Preferred shares outstanding.

(iii) The purchase price per share shall be paid, as far as possible, in kind at the book value thereof, from the assets of the Department, and the remainder in cash on hand in said Department.

(b) On the other hand, if or from the expiration of six years from the date hereof the Corporation shall desire to close said Department, or for any reason should wish to acquire the said Preferred stock, or if any one of the holders of the Common stock should die prior to the expiration of said six years, the Corporation may redeem in whole, and not in part or parts, all of the said Preferred shares outstanding at the redemption price and upon the terms hereinabove set forth in Subparagraphs (i), (ii), and (iii) hereof, upon giving notice at least twenty (20) days prior to the date fixed for such redemption to the holders of record of said Preferred shares at their addresses appearing on the books of the Corporation.

(c) If, after notice of redemption is given and prior to the date fixed for the redemption of said Preferred stock, the Corporation deposits with, conveys, assigns, and transfers to any bank or trust company in the City of Oakland, State of California, the assets of said Department sufficient to redeem said shares as in Paragraphs 7(a), (i), (ii) and (iii) above provided, in trust for the purpose of redeeming the shares called for redemption with irrevocable instructions and authority to the bank or trust company to pay, convey, assign, transfer the trust property in payment of the redemption price of the shares to their respective holders upon the surrender of their share certificates, then from and after the date of such transfer, conveyance and deposit, the shares so called shall be deemed to be redeemed. Such deposit, transfer, assignment and conveyance shallPage 397be deemed to constitute full payment of the shares to their holders and from and after the date of such deposit, transfer and conveyance, the shares shall be deemed no longer outstanding and the holders thereof shall cease to be shareholders with respect to said shares and shall have no rights with respect thereto except the right to receive from the bank or trust company the redemption price of the shares without interest upon the surrender of their certificates therefor.

8. (a) The term "book value", as used in paragraph 7 hereof in reference to assets, means the cost of such assets, less any depreciation reserve against such assets, as recorded on the books and records of the Department.

(b) The term "net assets", as used in paragraph 7 hereof, means the depreciated cost of the assets of the Department, less the liabilities of the Department, as shown by the books and records of the Department.

(c) The assets of the Department shall consist of cash of $200,000.00 obtained from the sale of said preference shares of the Corporation, or any property in which such cash, or any part thereof, is invested, plus (1) any assets acquired through investment of money borrowed by the Department, or through investment of net earnings and less (2) any assets actually used to pay any net losses of the Department (

and

any

dividends

referred

paragraph

hereof

.) The liabilities of the Department shall include all liabilities actually incurred by the Department for purchase of assets or for any transaction connected with the conduct of the business of the Department.

(d) Net earnings of the Department shall be determined in accordance with sound accounting principles, and shall be the excess of the income of the Department over its expenses. Expenses of the Department shall be all the expenses in connection with the operation of the Department and shall include the following:

(1) All expenses of setting up the Department including all attorneys and accounting fees.

(2) All interest paid on money borrowed for the operation of the Department, but not including any interest on money borrowed by the Corporation for any other purpose or on loans outstanding at the time said Department is set up.

(3) All expenses of operating and carrying on the business of the Department, including manager's salary, salary of employees, accounting and legal expenses, commissions and brokerage, telephone, supplies, insurance and all other expenses whatsoever that are applicable and necessary for carrying on its operations or maintaining the Department. The Department will also be charged for all real estate taxes, personal property taxes and all other taxes directly pertaining to its operations. These expenses shall not include, either in whole or in part, any of the salaries of corporate officers other than the salary of the Department Manager, or any other corporate expense not directly attributable to the operations of the Department.

(4) With reference to Federal Taxes on income, it is agreed that, inasmuch as the Hardware business has been in existence for a longer period than the Real Estate Division, it should have the advantage of the lower tax on the first $25,000.00 of net earnings, and accordingly the Real Estate Division shall be charged at all times on its net taxable earnings at the maximum tax rate, however, not to exceed the amount of the tax liability.

(5) An allowance for depreciation upon the assets of the Department in an amount equal to that which is allowable as a deduction for income tax purposes.

(6) As and for the share of the Department's general overhead expense the sum of $100.00 per month commencing February 1, 1955, and in addition thereto a sum equal to 20% of the fiscal annual net income of the Department, less income taxes charged to the Department as provided in Paragraph (4) immediatelyPage 398preceding, for the fiscal year beginning February 1, 1957, and a like sum, similarly calculated, for each fiscal year thereafter.

(7) All expenses enumerated in subparagraphs (1), (2) and (3) immediately preceding shall be paid out of the assets of the Department; expenses enumerated in subparagraph (4) and subparagraph (6) immediately preceding shall be paid by transfer of assets from the Department to other departments of the Corporation; and the depreciation allowance provided for in paragraph (5) immediately preceding shall be maintained as a reserve against assets of the Department.

9. Notwithstanding any provision contained in this Agreement, the Corporation will not purchase any of said Preferred shares until any and all expenses, charges, and liabilities of said Department to date of such purchase shall have been fully paid and satisfied or adequately provided for, and until Corporation shall have adequate security against all claims which might be made against the Corporation after the date of purchase arising out of the operation of the Department.

10. The certificates evidencing the shares of the said Preferred stock hereinabove referred to shall contain the following statement:

"The stock evidenced by this certificate is subject to the terms, covenants and agreements contained in that certain Agreement dated the _____ day of October, 1954, entered into between Maxwell Hardware Company and certain of its shareholders. A copy of said Agreement is attached hereto and made a part hereof."

11. The officers of the Corporation, and the Manager of the Department, without the authorization of Corporation's Board of Directors, shall not, in any manner, obligate the Corporation, and enter into any contracts or indentures, except obligations and transactions in the ordinary course of business.

12. This Agreement shall bind the successors and assigns of Corporation and shall bind the heirs, devisees, legatees, executors, administrators and assigns of BECKETT and FEDERIGHI.

IN WITNESS WHEREOF, the parties hereto have hereunto subscribed their names the day and year first hereinabove written.

This document was drafted by the attorney representing Bryan and the attorney representing Federighi and Beckett after these two attorneys consulted with a third attorney.

Under date of October 27, 1954, a certificate numbered 502 which stated in part, "This is to certify that F. J. Federighi is the holder of 1,000 shares of the Preferred stock of the par value of $100.00 each of Maxwell Hardware Company, transferable on the books of the Corporation upon the surrender of this Certificate properly endorsed," was issued to Federighi. Thereafter were set forth the provisions contained in paragraphs 6 (a), (b), and (c) of the agreement of October 18, 1954, heretofore set forth in full. On the same date an identical certificate was issued to Beckett, except for the name appearing thereon. The stock records of the Maxwell Hardware show that immediately thereafter the outstanding stock of Maxwell Hardware stood in the following names:Common stock— 6,438 shares, $100 par value per share issued and outstanding:

John M. Bryan ................................. 3,219 shares Carleton F. Bryan, Jr. ........................ 3,219 shares

Preferred stock— 2,000 shares, $100 par value per share issued and outstanding:

Arthur T. Beckett ............................. 1,000 shares Frederick J. Federighi ........................ 1,000 shares

Page 399

The common stock was the only voting stock or security of Maxwell Hardware.

Under date of October 18, 1954, Bryan and Carleton Bryan, the only common stockholders of Maxwell Hardware, entered into an agreement with the Oakland Bank whereby they placed their common stock in a voting trust which was to remain in effect until January 31, 1961. Under the terms of the voting trust agreement the trustee, the Oakland Bank, was directed to vote for Coates and Bryan as two of the three directors of Maxwell Hardware. At the time of entry into this agreement on October 18, 1954, it was understood that Federighi would be the third director of Maxwell Hardware. The voting trust was created at the request of Beckett and Federighi. There was also an oral agreement between Bryan, Beckett, and Federighi that Bryan would not be vetoed on any reasonable business investment that he wished to make on behalf of Maxwell Hardware.

During the negotiations leading up to the execution of the document dated October 18, 1954, heretofore set forth in full, Federighi had expressed the opinion that the Bay-O-Vista real estate development would produce a profit of about a million dollars. Bryan expected the common stockholders of Maxwell Hardware to profit to the extent of about $150,000 if the real estate development made a million dollar profit. Beckett's understanding of the arrangement was that the stockholders' share of the profits which would go to the common stockholders of Maxwell Hardware would be 20 percent and that he and Federighi through their ownership of the preferred stock certificates provided for in the agreement of October 18, 1954, would receive 80 percent of the profits from the Bay-O-Vista real estate development.

At the time he executed the document dated October 18, 1954, Bryan had no intention of turning over the management of the Isabella Street property or the Shattuck Avenue building to the real estate department of Maxwell Hardware. Neither Bryan nor anyone in the employ of Maxwell Hardware during the year 1954 prior to October 18, had had any experience in the management or operation of any business engaged in the subdivision and development of real estate.

Shortly after October 18, 1954, Beckett and Federighi each paid into Maxwell Hardware $100,000 and the $200,000 so paid in was turned over to the real estate department of Maxwell Hardware. Prior to October 18, 1954, in addition to John M. Bryan, Carleton F. Bryan, Jr., and Henry Irving had been directors of Maxwell Hardware. Shortly after October 18, 1954, both Carleton F. Bryan, Jr.,Page 400and Henry Irving resigned as directors of Maxwell Hardware and Coates and Federighi were elected to the board of directors. Also, shortly after October 18, 1954, Federighi was appointed a vice president of Maxwell Hardware and was assigned as manager of the real estate department.

By deed dated October 26, 1954, 111.81 acres of the Bay-O-Vista property was deeded to Maxwell Hardware by Beckett and Federighi, and Maxwell Hardware drew its check in favor of Beckett and Federighi in the amount of $195,667.50, which amount was stated to be in payment of the land transferred to Maxwell Hardware. A policy of title insurance insuring the title to the 111.81 acres of land deeded by Beckett and Federighi to Maxwell Hardware in the amount of $195,667.50 was issued to Maxwell Hardware by the Oakland Title Insurance Co. on October 29, 1954.

At about the same time that the deed transferring the 111.81 acres from Beckett and Federighi to Maxwell Hardware was delivered to Maxwell Hardware, Beckett and Federighi signed a document entitled "Memorandum of Option Agreement" which stated as follows:

This will serve to confirm our oral agreement giving MAXWELL HARDWARE Co. an option to purchase two hundred thirty-five (235) acres of the acreage owned by us south and east of Estudillo Avenue and Foothill Boulevard, San Leandro, California, shown on Drawing No. 5160 prepared by J. Y. Long Co., Engineers, upon the following terms:

(a) Said option must be exercised, at least as to Parcels A and D shown on the Drawing not later than November 20, 1954; otherwise this option shall be null and void.

(b) Provided such option is exercised upon parcels A and B as specified above, the option covering the whole or any part of the balance of the two hundred thirty-five (235) acres may be exercised at any time or times not later than November 20, 1956.

(c) The price per acre for the land shall be computed at the Release Values shown on the aforesaid Drawing plus a gross profit to us of 32.65%.

(d) The purchase price of the land upon which such option is exercised shall be paid in cash within ten (10) days after the agreement or purchase same.

(e) This option is not transferable in whole or in part.

There appears in the minutes of a meeting of the board of directors of Maxwell Hardware held on October 27, 1954, a resolution, "That this corporation develop and subdivide into lots the real property located on San Leandro Boulevard and in connection with same, establish a real estate division."

At a meeting of the board of directors held December 3, 1954, the following resolution was adopted:

RESOLVED: That the corporation proceed to improve the land heretofore acquired by it from A. T. BECKETT and F. J. FEDERIGHI, and that a loan inPage 401the sum of $132,000.00 for the improvements thereof, being lots 1 to 71 inclusive, in Tract No. 1361, be secured from the First Western Bank²and that any two of the officers be, and they are hereby authorized to execute the necessary note therefor.

During the time that Bryan and Federighi were negotiating prior to entering into the agreement of October 18, 1954, Federighi had discussed financing the Bay-O-Vista subdivision with Coates, and Coates had told him that money would be loaned by the Oakland Bank to develop the property, secured by a deed of trust on the property. On December 3, 1954, a note of Maxwell Hardware signed by Bryan, its president, and Carleton F. Bryan, Jr., its secretary, in the amount of $132,000 was executed in favor of the Oakland Bank and this note was secured by a deed of trust which was also executed by Maxwell Hardware by Bryan and Carleton F. Bryan, Jr. The note was payable 1 year after date and bore 5 percent interest, and although secured by a deed of trust had no provision that such security limited the liability of the maker thereon. The note was not endorsed or guaranteed personally by any officer, stockholder, or employee of Maxwell Hardware. Only $96,000 of the amount of this note was actually drawn from the bank prior to January 31, 1955.

On December 10, 1954, the real estate commissioner of the State of California issued a final subdivision report on tract 1361, San Leandro, Calif., consisting of 19.5 acres divided into 71 parcels in which it was stated that the preliminary report dated November 29, 1954, shows title vested in Maxwell Hardware Co., a corporation. Subsequently, other property out of the Bay-O-Vista subdivision was deeded by Beckett and Federighi to Maxwell Hardware and amounts paid by Maxwell Hardware to Beckett and Federighi therefor, which amounts Federighi determined to represent the fair market value of the property. In each instance the amount paid resulted in a profit over the cost of the property to Beckett and Federighi.

Other subdivision plats were filed by Maxwell Hardware and other amounts borrowed on notes of Maxwell Hardware and deeds of trust similar to those described in connection with the first tract of the Bay-O-Vista subdivision were executed, the security in each instance being a deed of trust on the real estate being developed with the amount advanced to Maxwell Hardware on the note. None of the notes was endorsed or guaranteed personally by Bryan, Federighi, Beckett, or any other person. The outstanding balances of the loans payable with respect to these notes secured by the Bay-O-Vista property as of January 31, 1955, 1956, 1957, 1958, 1959, and 1960Page 402were $21,290,³$108,046.75, $335,375, $294,500, $208,400, and $86,800, respectively.

During the years here involved Bryan continued as president of Maxwell Hardware and during these years as lots were sold to various purchasers from the Bay-O-Vista subdivision he executed most of the deeds as president of Maxwell Hardware. During the years here involved in addition to being president of Maxwell Hardware, Bryan was employed as a stockbroker.

The books of Maxwell Hardware were divided into two sections, one entitled "The Hardware Department" and the other, "The Real Estate Department," and the records, books of account, and bank accounts were separately kept for the two departments. The real estate department's books were originally kept by Vincent Stack, a certified public accountant with offices at 1441 Franklin Street, Oakland, Calif., who was the accountant for Beckett and Federighi and various corporations in which they were stockholders. Prior to 1958 Stack died and after his death the books of the real estate department of Maxwell Hardware were kept by employees of Beckett and Federighi and a payment was made from the real estate department of Maxwell Hardware to the partnership of Beckett and Federighi for such bookkeeping services.

Subsequent to October 18, 1954, most of the documents dealing with the Bay-O-Vista subdivision were in the name of Maxwell Hardware and were signed by Bryan as president of that company. The performance bonds in connection with putting of utilities into the area, the contracts with various companies for grading and other types of work and zoning, and other real estate applications were in most instances signed by Maxwell Hardware by Bryan, its president. Certain bills in connection with the development of the Bay-O-Vista subdivision which came in addressed to Beckett and Federighi were, in accordance with Federighi's instructions to the bookkeeping employees in his office, returned to the sender to be resubmitted in the name of the Maxwell Hardware Co. Some of the correspondence with respect to the Bay-O-Vista subdivision was conducted in the name of Beckett and Federighi. The liability insurance policy issued to Beckett and Federighi also covered Maxwell Hardware, as well as a number of other corporations in which Beckett and Federighi were interested. The salary income to Federighi and Beckett for the years 1954 and 1955 was as follows:Page 403

Source Beckett Federighi1954

University Rentals, Inc., Oakland, Calif. .......... $1,012 $1,012 Davis Street Rentals, Inc., Oakland, Calif. ........ 1,800 1,800 Eden Development Co., Oakland, Calif. .............. 17,200 17,200 98th Edes, Inc., Oakland, Calif. ................. 150 150 East Bay Mortgage Co., Oakland, Calif. ............. 21,000 22,500 East Bay Mortgage Service, Inc., Oakland, Calif. ............................................ 15,000 13,500 Ashland Building Material Co., Oakland, Calif. ..... 6,000 6,000 W. E. Hamby Construction Co., Oakland, Calif. ...... 2,700 2,700 ------ ------ 64,862 64,8621955

University Rentals, Inc., Oakland, Calif. ......... 608 608 Davis Street Rentals, Inc., Oakland, Calif. ....... 1,800 1,800 Eden Development Co., Oakland, Calif. ............. 7,200 7,200 East Bay Mortgage Co., Oakland, Calif. ............ 6,000 6,000 East Bay Mortgage Service, Inc., Oakland, Calif. ............................................ 12,000 12,000 Ashland Building Material Co., Oakland, Calif. ............................................ 6,000 6,000 W. E. Hamby Construction Co., Athens, Tenn. ....... 3,600 3,600 E. B. M. Realty Co., Oakland, Calif. .............. 1,275 1,275 Maxwell Hardware, Oakland, Calif. ................. 10,000 10,000 ------ ------ 48,483 48,483

Originally sales of lots in the Bay-O-Vista subdivision were handled by independent brokers on a commission basis and in each of the years where this arrangement was followed, there appears as an expense item in the books of the real estate department of Maxwell Hardware, "Commissions paid."

In 1959 Maxwell Hardware obtained a real estate broker's license under the name of Bay-O-Vista Realty and employed a salesman to sell lots in Bay-O-Vista. In general the advertising in connection with the Bay-O-Vista subdivision featured the name Bay-O-Vista. However, on one sign at the subdivision, in small letters under the name Bay-O-Vista appeared the name Maxwell Hardware Co. and in some newspaper articles concerning the Bay-O-Vista development the name of the developer appeared as Maxwell Hardware.

The cutting, filling, grading, and leveling work on the Bay-O-Vista subdivision which was done to install streets, sidewalks, gutters, and storm sewers and to provide the facilities for water, gas, and electrical services was done under contract by contractors other than the partnership of Beckett and Federighi, the contracts being between the contractor and Maxwell Hardware and in most instances these contracts being signed on behalf of Maxwell Hardware by Bryan, its president.

A small portion of the work on the Bay-O-Vista subdivision was done by the partnership of Beckett and Federighi and for this work the partnership billed the real estate department of Maxwell Hardware, and a payment on such billing was made to the partnership.

In July 1962 there was an agreement among Bryan, Carleton F. Bryan, Federighi, and Beckett to a plan of liquidation of MaxwellPage 404Hardware. Prior to this time Maxwell Hardware had paid a total of $609,021.45 to Beckett and Federighi for land in the Bay-O-Vista subdivision and had paid a total of $1,530,471.74 in costs for grading, installing utilities, and similar work in connection with this subdivision and had prepared for sale in the subdivision 527 lots. Throughout the years here in issue both Beckett and Federighi consistently reported ordinary losses from many of their various business operations and from most of these operations reported capital gain in amounts which more than offset the reported ordinary losses. The transfers of the Bay-O-Vista land to Maxwell Hardware were reported by Beckett and Federighi as capital gains transactions.

No funds of the hardware department were transferred to the real estate department of Maxwell Hardware at any time from the formation of the real estate department until the agreement to liquidate Maxwell Hardware in 1962. A total amount of approximately $157,000 was transferred from the real estate department to the hardware department during these years and this amount was considered as a loan by the real estate department to the hardware department. There was no repayment by the hardware department to the real estate department of any of this amount, but it was adjusted at the distribution of assets upon liquidation. The agreement of liquidation entered into in July 1962 contained detailed provisions as to the property to be distributed to the Bryans and to Beckett and Federighi, but in general the distribution of the assets of the real estate department went to Beckett and Federighi and the other assets to Bryan and Carleton F. Bryan. The distribution in general was made primarily in kind.

After the termination of the voting trust agreement, Bryan and Carleton F. Bryan had control of all of the voting stock of Maxwell Hardware and it was Bryan who was insistent upon liquidation of the company. As part of the agreement of liquidation Beckett and Federighi assumed any income tax liability that might be due by Maxwell Hardware in connection with the deficiencies at issue in this proceeding and neither Bryan nor Carleton F. Bryan have a financial interest in the outcome of the present case of Maxwell Hardware.

The common stock of Maxwell Hardware owned by Bryan and Carleton F. Bryan as of October 18, 1954, had a fair market value of $500,000. The books and record of Maxwell Hardware show that its various departments operated at the following amounts of profits or losses during the period or years indicated:Page 405

Period or year Hardware Real estate Oil department Total department department

Feb. 1, 1954, to Sept. 30, 1954 ........... ($151,617.48) ____________ ____________ ($151,617.48) Oct. 1, 1954, to Jan. 31, 1955 ........... (217,969.15) $86,100.79 ____________ (131,868.36) Fiscal year ended Jan. 31:

1955 ............ (369,586.63) 86,100.79 ____________ (283,485.84)¹1956 ............ (54,673.28) 80,382.12 ____________ 25,708.84 1957 ............ (52,868.77) 153,446.45 $4,088.18 104,665.86 1958 ............ 24,807.92 200,178.57 22,513.26 247,499.75 1959 ............ 6,882.89 224,511.73 8,160.12 239,554.74 1960 ............ (14,604.55) 174,600.37 (12,128.48) 147,867.34

Under date of July 30, 1959, a report of an internal revenue agent for the calendar years 1954, 1955, 1956, and 1957 was sent to Federighi, and under date of August 20, 1959, Federighi filed a protest against that report, in which among other things he protested the inclusion in his income of portions of the earnings of Maxwell Hardware and to which was attached a copy of the agreement of October 18, 1954, between Maxwell Hardware and Beckett and Federighi. The statement was made that the entire business relations between Maxwell Hardware and Beckett and Federighi were entered into at arm's length and were detailed in the agreement executed October 18, 1954. The primary purpose of Beckett and Federighi in entering into the agreement of October 18, 1954, with Maxwell Hardware was to enable the profits which they anticipated would be made in the development of the Bay-O-Vista subdivision to be offset by net operating losses which had been sustained by Maxwell Hardware in prior years. There were business reasons for the development of Bay-O-Vista by a corporation instead of by Beckett and Federighi as individuals or partners. The development and sale of lots in the Bay-O-Vista subdivision was not substantially the same business as the business engaged in by Maxwell Hardware prior to October 18, 1954.

In the years 1954, 1955, 1956, 1957, and 1958 respondent increased the reported net income of each Beckett and Federighi by amounts which he designated as ordinary income and explained as follows:

It has been determined:

1) That profits realized from a certain real estate venture known variously as the Real Estate Department and/or Division of the Maxwell Hardware Company, and/or Bay-O-Vista Development, and/or San Leandro properties, in substance were realized by you and Arthur T. Beckett⁴individually and/or in partnership and that, as a consequence, you are taxable for your share of such profits, determined hereinafter, pursuant to the provisions of Sections 61 and 482 of the 1954 Internal Revenue Code.

For each of its fiscal years ended January 31, 1957, 1958, 1959, and 1960, respondent increased the reported net income of Maxwell Hardware by the disallowance of a claimed net operating loss deduction,Page 406the deduction being disallowed in the amounts of $104,640.86, $247,474.75, $239,529.74, and $147,842.34, for these years, respectively. Respondent explained this adjustment for each of these years as follows:

It has been determined that the income from which such deduction was claimed was not realized from the same business which incurred such losses and that you are, therefore, not entitled to such deduction. It has been further determined that you acquired the business which sustained such losses primarily for tax avoidance purposes, hence such losses would not in any event be deductible on your returns. Accordingly, the deduction claimed is disallowed and your taxable income is increased in the amount of $104,640.86. [1957. For other years the explanation was the same but the amount disallowed differed.]

OPINION

Since the record in this case is voluminous and the testimony of the witnesses in many respects confusing and in some respects contradictory, we believe it well to state in summary our view of the reasons which motivated Bryan and Federighi to enter into the agreement of October 18, 1954, and the primary purpose of each of them for making this agreement before proceeding to discuss the issues raised by the parties. As of July 1, 1954, Bryan and his brother owned all the stock of a corporation which was operating primarily a retail and wholesale hardware business. The operation of this business had been unprofitable for many years and by 1954 Bryan had concluded that it was not feasible to make sufficient changes in the hardware business of this corporation to convert it into a profitable operation. For this reason he had decided to liquidate this business of the corporation, Maxwell Hardware, and had begun to take the necessary steps for this liquidation. Bryan wanted to proceed with the liquidation of the retail and wholesale hardware business and the use of any of the other corporate assets in such a manner as to obtain the highest possible value therefrom for himself and his brother as common stockholders of Maxwell Hardware.

Although the corporation was pressed for cash because of its unprofitable operations over a period of a number of years, the book value of its assets was such that the corporate book net worth was over $800,000. Bryan was aware that by liquidating Maxwell Hardware, its total assets would produce substantially more than the $500,000 which he felt to be the fair market value of the common stock of the corporation and therefore had no desire to dispose of that common stock. Since the corporation had a net operating loss carryover of over $1 million with no reasonable prospects of earnings over the succeeding 5 years either from the hardware business or any other business in which that corporation had been previously engaged sufficient to enable it to use this net operating loss, Bryan was anxious to findPage 407some arrangement to profit from Maxwell Hardware's net operating loss to the advantage of the common stockholders of Maxwell Hardware. The corporation did not have available funds to enter into a new business and therefore needed additional capital for any new business venture. Bryan had discussed his problem with his banker, Coates.

Federighi and Beckett owned or had a contract to acquire raw land which they intended shortly to proceed to develop, having taken the preliminary steps to determinue that development into residential lots of the major portion of this real estate was feasible. They had also determined that they desired to develop the property through a corporation in order to limit their personal liability in connection with the development. Because of the hilly nature of the land substantially more in development expenditures would be required over the years during which it was contemplated that the development work would be done than the value of the undeveloped land. Beckett and Federighi were looking into an arrangement for developing this real estate in the most profitable manner feasible with a limitation on their personal liabilities in its development.

When Federighi was discussing his problems with his banker, Coates, the latter suggested that Federighi and Bryan might work out some arrangement. Federighi and Bryan decided that an arrangement whereby the development of the Bay-O-Vista land might be done through the corporate form of Maxwell Hardware was feasible, reserving to Federighi the control of the development of this land without unduly restricting Bryan in other activities with respect to Maxwell Hardware, and agreed that for the benefit of the net operating loss carryovers of Maxwell Hardware less whatever portion thereof might be needed to offset earnings of Maxwell Hardware other than from the development of the real estate, Federighi and Beckett were willing to pay 10 percent of the profits from the Bay-O-Vista development. Bryan and Federighi then had lawyers draw up an agreement which was to contain the necessary provisions: (1) To permit Bryan to continue in control of the business of Maxwell Hardware other than the development of the real estate, (2) to give Federighi control of the real estate development limiting the liability of Federighi and Beckett in connection therewith, (3) to provide a time limit after which Bryan could dissolve the corporation if he so desired or Beckett and Federighi could draw out their interest therein, (4) to protect Federighi and Beckett in retaining all but 10 percent of the real estate development profits and in receiving distribution in kind if Bryan decided to dissolve the corporation or close its real estate development operations or they decided to withdraw from the corporation after the agreed period, (5) to leave with the Bryans the equitable interest in the assets of the corporation other than those ofPage 408the real estate development, and (6) to insure that the manner of handling the transaction would be such that the net operating loss carryovers of Maxwell Hardware would be usable to offset profits from the real estate development in determining Federal income taxes.

It is respondent's position with respect to the case involving the individual petitioners that Beckett and Federighi entered into the arrangement with Maxwell Hardware solely for tax avoidance purposes, that the entire transaction was a sham, that in substance the Bay-O-Vista subdivision was owned throughout the years 1954 through 1958 by Beckett and Federighi as partners, and the income earned therefrom was in fact their income.

It is petitioners' position that the transaction was not a sham, that the facts do not support that it was a sham, that the transaction was entered into for a legitimate business purpose and not primarily for the purpose of avoidance of taxes, that in effect respondent is attempting to ignore the corporate entity of Maxwell Hardware insofar as the operation of its real estate department is concerned, and that the facts do not justify ignoring the corporate entity of Maxwell Hardware. Petitioners argue that the net operating loss deduction which had been sustained by Maxwell Hardware prior to October 18, 1954, was not the motivating fact which influenced Beckett and Federighi to enter into the agreement of October 18, 1954.

We have found that the primary purpose of Beckett and Federighi in entering into the agreement with Maxwell Hardware was to obtain the use of the loss carryover against profits from the development of the Bay-O-Vista tract. Federighi and Beckett both testified that they would have entered into this agreement had the net operating loss not been available. Since from the very beginning of negotiations all parties knew of the existence of the net operating loss, it is obvious that a statement by any witness of what he would have done had the net operating loss not been available is at best an opinion, and under the circumstances here involved is pure conjecture. It was the fact of Maxwell Hardware's losses that caused Coates to have Federighi and Bryan meet. Bryan in his testimony stated that he felt because of these losses he had an advantage in going into a profitable business. He did with some reservations state that he probably would have entered into the agreement even if Maxwell Hardware had not had the net operating loss carryover. Federighi never offered any rational explanation of the advantages that he thought resulted from the arrangement with Maxwell Hardware as distinguished from developing the Bay-O-Vista subdivision through one of the corporations which he and Beckett already owned or controlled or a corporation that might be formed by them. The logical explanation of the advantage Federighi expected to obtain was the use of the net operating loss carryover of Maxwell Hardware against expected earnings from thePage 409development of the Bay-O-Vista property. Cf.Weyl-ZuckermanCo.,23 T.C. 841, affd.232 F.2d 214(C.A. 9, 1956).

Federighi's statement that the credit of Maxwell Hardware would be valuable in the development of Bay-O-Vista is unconvincing in view of the evidence that Maxwell Hardware was not in a position to borrow on open account, that it was contemplated that the financing of the Bay-O-Vista development would be from the $200,000 paid in by Beckett and Federighi plus borrowings on the security of the land, and that Coates had already indicated that the bank would finance the project on such security. The reference to Maxwell Hardware's having once participated in a real estate development as a reason for having that corporation develop the Bay-O-Vista land is unconvincing in view of the remoteness of the time of that participation and the fact that no one in the employ of Maxwell Hardware in October 1954 had any experience in real estate developments.

No money from the hardware department of Maxwell Hardware was ever supplied to the real estate department, but the real estate department made transfers to the hardware department. The agreement of October 18, 1954, with respect to how the taxes were to be prorated in allocating the earnings of the hardware department and the real estate department of Maxwell Hardware shows that the parties all had in mind the benefits which would result from the net operating loss. No logical reason why Beckett and Federighi would be willing to let the common stockholders of Maxwell Hardware have 10 percent of the profits of the Bay-O-Vista development, except for the use of the net operating loss carryover, is shown by the record in this case. Cf.Urban Redevelopment Corp. v.Commissioner,294 F.2d 328(C.A. 4, 1961), affirming34 T.C. 845.

The conclusion that the primary reason why Beckett and Federighi entered into the agreement with Maxwell Hardware was to obtain the use of that company's net operating loss to offset the earnings of the Bay-O-Vista development does not dispose of the issue here present. The transfer of the property to Maxwell Hardware was by a legitimate deed, and the notes, though secured by the real estate, were notes of Maxwell Hardware that had the real estate not been sufficient security would have been a call if necessary upon the general assets of that company. The performance bonds were likewise given by Maxwell Hardware and the deeds to the property to the various purchasers were given by Maxwell Hardware. After the agreement of October 18, 1954, was entered into, Federighi acting as a vice president of Maxwell Hardware proceeded to have Bryan as president of the company sign many documents to obligate the company in all respects in the development of the Bay-O-Vista subdivision.

It is true as respondent points out that occasional documents appear in the name of Beckett and Federighi, primarily in situations wherePage 410some third party was mistaken as to the ownership of the Bay-O-Vista subdivision. In most instances Federighi had an employee of the partnership have a correction made on the document. It is also true that Federighi managed the real estate department with very little assistance from Bryan, other than Bryan's signing of various documents. We also recognize as respondent points out that in any case involving a question of whether the form of a transaction differs from its substance, the form of the transactions is likely to be in accordance with a plan to give the appearance of substance.

One of the major arguments of respondent centers upon the provision in the agreement of October 18, 1954, contained in paragraph 7, to the effect that the corporation agrees that it will not attempt to close up the real estate department for a 6-year period except upon the unanimous vote of the board of directors and the holders of the preferred stock agree that they will not sell their stock for such 6-year period and after the 6-year period if the holders of the preferred stock desire to sell their stock they must first offer it to the corporation and the "corporation in such event must redeem said stock" upon the terms thereafter set forth. The redemption terms basically are that in the event the net assets of the real estate department are greater than the aggregate par value of the preferred stock, the par value of the preferred stock shall be paid out of these assets and 90 percent of the excess distributed to the holders of the preferred stock, the distribution to be made insofar as possible in kind at book value from the assets of the department and in the remainder in cash on hand in the department. If the book value of all the net assets is less than the par value of all the outstanding preferred stock, then the total assets of the department are to be distributed ratably among the holders of the preferred stock. If after 6 years the corporation desires to close the department or acquire the preferred stock, the corporation may redeem the preferred stock in whole but not in part under the same terms as the holders of the stock are permitted after 6 years to require its redemption. There is in this provision also the exception that if anyone of the holders of the common stock should die prior to the expiration of the 6-year period, the corporation may redeem in whole but not in part. This agreement in effect provided for two businesses to operate as one corporation and 90 percent of the profits of one of those businesses to go to the holders of the preferred stock if that portion of the business were discontinued. In corporations generally upon dissolution all accumulated profits are distributed to the stockholders. Therefore, this provision does not, as respondent contends, show that the transaction was a sham. The provision, with the exception noted, requires the continuance of the real estate department for 6 years but does not provide that it must terminate thereafter.Page 411

Respondent refers to this part of the agreement of October 18, 1954, as providing for a "round trip" of the real estate such as was involved inWeyl-Zuckerman Co., supra. However, the instant case differs fromWeyl-Zuckerman Co., supra,not only because it was contemplated that the real estate department of Maxwell Hardware would in fact develop and sell real estate from the Bay-O-Vista tract, but also because there was a real business purpose to having this development done by a corporation. Cf.Southern Ford Tractor Corporation,29 T.C. 833(1958). Under these facts the transfer of the property to Maxwell Hardware was not a sham. In calling this transaction a sham respondent is in effect contending that insofar as the real estate department is concerned, the corporate entity of Maxwell Hardware should be disregarded. It is well settled that taxation is a real matter and that transactions that are sham and unreal may be disregarded so that the income therefrom is taxable to the true earner thereof.National Carbide Corp. v.Commissioner,336 U.S. 422(1949), and cases cited in footnote 20 thereof. However, where there is a business purpose in transferring property to a corporation and after the transfer the corporation uses the property in its business, the transaction is not sham or unreal.Moline Propertiesv.Commissioner,319 U.S. 436(1943);John F. Nutt,39 T.C. 231(1962), on appeal (C.A. 9, July 11, 1963).

In the instant case Maxwell Hardware as a corporate entity entered into contracts for the borrowing of money to finance development of the Bay-O-Vista property. None of the notes was endorsed by any officer or stockholder of Maxwell Hardware. Maxwell Hardware executed deeds transferring property to various individuals. The corporation took other action with respect to the property as we have detailed in our findings. These actions certainly amount to business activity of a real nature. Under the facts here present we conclude that the corporate entity of Maxwell Hardware insofar as its real estate department is concerned cannot be disregarded for tax purposes even though the primary reason that Beckett and Federighi entered the agreement with Maxwell Hardware was to obtain benefits from that corporation's net operating loss carryover.

Although respondent in his notice of deficiency referred to section 482 of the Internal Revenue Code of 1954,⁵he does not argue the application of this section and in effect concedes that unless the transfer of the Bay-O-Vista land to Maxwell Hardware is considered a sham, section 482 is inapplicable in this case.

Since in our opinion the earnings from the Bay-O-Vista development are taxable to Maxwell Hardware during the years here involved, it is necessary for us to determine whether the net operating lossesPage 412sustained by Maxwell Hardware prior to the establishment of the real estate department are properly to be used in the fiscal years ended January 31, 1957 to 1960, as a reduction in the taxable income of Maxwell Hardware from that department. In our view, were the provisions of the Internal Revenue Code of 1939 applicable to this case, Maxwell Hardware would not be entitled to deduct the net operating loss carryover. The facts simply stated are that Maxwell Hardware discontinued its hardware business on which it had sustained losses, issued some preferred stock to new stockholders, and with the payment received entered a real estate development business the profits of which were to go primarily to the preferred stockholders. There is no more "continuity of business enterprise" here than inLibson Shops, Inc. v.Koehler,353 U.S. 382(1957). In that case a number of corporations all owned by the same interests were merged. Prior to the merger some of the corporations had been operating at losses and others had been operating at profits. After the merger the businesses which had been operated by the corporations which had sustained losses continued to operate at losses and the businesses which had been operated by the corporations which had made profits continued to operate at profits. The court held that to allow the net operating loss carryovers of the businesses which had been loss operations to reduce the taxable income from other businesses which had been and continued to be profitable operations was contrary to the intent of the statute. Certainly if the premerger losses of one business cannot be averaged with the post-merger profits of another as held inLibson Shops,Inc. v.Koehler, supra,the "precombining" losses of a hardware business cannot be averaged with the "postcombining" profits of a real estate development business. Such an averaging does not comply with the intent of Congress to average "the fluctuating income of a single business."

In theLibson Shopscase the continuing corporation was not the corporation that had sustained the losses. However, as we stated inJulius Garfinckel Co.,40 T.C. 870,875(1963), on appeal (C.A. 2, Nov. 15, 1963), "in many cases decided by this and other courts since the decision inLibson Shops,it has been held the doctrine ofLibson Shopsprevents the carry-over even though it is the loss corporation that is seeking to carry over its own pre-merger or preacquisition loss." While the precise facts here involved differ from those involved inJulius Garfinckel Co., supra,and each of the cases cited therein,⁶the principle that the carryover privilege is not available unless there is a "continuity of business enterprise" is equally applicable here. InPage 413Huyler's38 T.C. 773(1962), on appeal (C.A. 7, May 16, 1963), we discussed the development of the "entity concept" in determination of the use of net operating loss carryovers and concluded that such carryovers were not deductible unless there was a continuity of business enterprise even though the corporation seeking the deduction was the same legal entity that sustained the operating losses in the prior years. InHuyler's, supra,we stated at page 781, with respect to the entity concept, that:

The result of these earlier cases was to create uncertainty in the application of the statutory provisions relating to net operating loss carryovers, so that neither the Government nor taxpayers could accurately predict the consequences of corporate changes. Survival of tax attributes appeared to depend primarily on the form of the transactions, and on the technical skill with which they were effected. Thus the "entity concept" theory tended to penalize taxpayers who were either poorly advised or who, for nontax reasons, found it necessary to extinguish the loss entity.

In the recent case ofFederal Cement Tile Co.,40 T.C. 1028(1963), we sustained respondent's disallowance of loss carryovers where the corporation seeking the carryover was the loss corporation which had acquired by merger the profitable different kind of business of another corporation. InFederalCement Tile Co., supra,all the stock of the loss corporation had been sold to the owners of the stock of the profitable corporation shortly prior to the merger of the profitable corporation into the loss corporation. This same factual situation of a sale of all the stock of the loss corporation to the owners of a profitable business shortly before the acquisition of the profitable business by the loss corporation is present in a majority of the cases in which net operating loss deductions have been disallowed to the loss corporation because of there being no continuity of business enterprise in the activity which produced the profits. In some cases the owners of the stock of the loss corporation already owned a profitable business or stock of a corporation doing a profitable business and caused the loss corporation to acquire the profitable business. In some cases the owners of the stock of the loss corporation acquired the stock of a profitable business shortly before causing the merger of the profitable corporation into the loss corporation. In the instant case Beckett and Federighi who owned the land which they contemplated developing as a profitable business did not acquire any common stock of Maxwell Hardware. Neither the Bryans who owned all the common stock of Maxwell Hardware nor the corporation acquired the Bay-O-Vista land or any rights therein prior to October 18, 1951. From all the evidence in this case we are convinced that the combination of the potentially profitable business with the loss business was skillfully arranged in this manner in order that there would be no acquisition of control of a corporation by Beckett and Federighi or acquisitionPage 414by Maxwell Hardware of property of another corporation within the meaning of section 269. We think it clear that the provisions of section 269 are not applicable here because of the absence of the type of acquisition provided for therein. However, there appears to us to be no reason why the method whereby the different and profitable business was acquired by the loss corporation should control the issue of whether under the decision in theLibson Shops, Inc. case, the net operating losses sustained by the hardware business of Maxwell Hardware may properly be used to reduce the taxable income from the real estate subdivision. The holding in theLibson Shops, Inc. case was that the fact that section 129 of the Internal Revenue Code of 1939 (the predecessor of section 269) was inapplicable did not automatically entitle the taxpayer to the claimed carryover. In theLibson Shops, Inc. case the Code provision was inapplicable because the primary purpose of the acquisition was not tax avoidance, whereas in the instant case the provision is inapplicable because the nature of the acquisition does not come within the statute. However, the reason for the lack of applicability of the Code provision does not appear to be controlling. The final sentence of the Court's opinion in theLibson Shops, Inc. case is: "We conclude that petitioner is not entitled to a carry-over since the income against which the offset is claimed was not produced by substantially the same business which incurred the losses." Although only one corporation is involved in the instant case, the two departments are so unrelated as in substance to place two separate business entities into one corporate entity.

In the instant case the income against which the offset is claimed was not produced by substantially the same business which incurred the losses. Petitioners argue that the development of the Bay-O-Vista subdivision was not a new business for Maxwell Hardware. From the evidence we have found to the contrary. The evidence does not establish, as petitioners contend, that Maxwell Hardware had previously engaged in a subdivision development. The most favorable interpretation that can be placed on the evidence with respect to the development of Maxwell Park is that it was done by a subsidiary of Maxwell Hardware. However, even if the evidence did support petitioners' contention that Maxwell Hardware had during the late 1920's engaged in developing a subdivision, such a fact would not establish that the subdivision business was not a substantially different business from the hardware business which produced the net operating losses which petitioners claim should be offset against income from the Bay-O-Vista development. The latest year that is mentioned as the end of development of Maxwell Park is 1933, 17 years prior to the first year of a net operating loss here claimed as a carryover. Neither do we consider the fact that a subsidiary corporation of Maxwell Hardware through its fiscal year ended January 31, 1953, and Maxwell HardwarePage 415thereafter (having acquired its subsidiary's assets upon the subsidiary's dissolution), engaged in the rental of two properties, shows, as petitioners contend, that the Bay-O-Vista development was substantially similar to the business engaged in by Maxwell Hardware prior to October 18, 1954. Under the facts of this case which we have set forth in some detail, we do not consider the holding of two pieces of property primarily for use in the business of a related corporation, but receiving a small amount of rental income from outside interests, to be substantially the same business as developing the Bay-O-Vista property. It might even be questionable whether the rentals of parts of these properties to outside interests during the period here involved prior to October 18, 1954, were of sufficient importance to constitute a business separate from the rentals for business use by the related corporations, but we need not consider this question. Certainly, this record fails to show that prior to October 18, 1954, outside rentals were other than incidental to the use of the property in the business of related corporations. If this case were governed by the provisions of the Internal Revenue Code of 1939, it is our view thatLibson Shops, Inc. v.Koehler, supra,and the many cases which have applied the holding in that case, where there has been no change in the corporate entity claiming the deduction, would dispose of the issue here raised favorably to respondent.

Petitioners, however, contend thatLibson Shops, Inc. v.Koehler, supra,and cases relying on the principle there announced are inapplicable where the change in the corporate structure or the nature of the corporate business occurred after the enactment of the Internal Revenue Code of 1954. Petitioners point to the statement inHuyler's, supra,that section 382(a) has no applicability to changes in ownership and changes in business occurring before June 22, 1954, and also to the discussion as to the applicability of the provisions of section 382(a)(1)(C) inGoodwyn Crockery Co.,37 T.C. 355(1961), affd.315 F.2d 110(C.A. 6, 1963). Obviously, the statement inHuyler's, supra,is no indication whether the continuity of business enterprise requirement applied inLibsonShops, Inc. v.Koehler, supra,is inapplicable to corporate changes made after June 22, 1954.Huyler's, supra,merely states that the provisions of section 394(b) expressly provide that the special limitations of section 382 apply only to changes in ownership and business occurring on or after June 22, 1954.

InGoodwyn Crockery Co., supra,there is no discussion in either the opinion of this Court or of the Circuit Court of the "continuity of business enterprise principle" as laid down in theLibson Shops, Inc. case. The entire issue discussed inGoodwyn Crockery Co., supra,is whether within the meaning of section 382(a)(1)(C), that corporation after a change of stock ownership continued to carry on a trade or business substantially the same as that conducted before the changePage 416of ownership. It may be that the same principles would govern the issue of whether the income against which the net operating loss deduction is claimed was produced by substantially the same business which incurred the losses as required by the holding in theLibson Shops, Inc. case and the issue of whether a corporation is carrying on "a trade or business substantially the same as that conducted before" the change of ownership within the meaning of section 382(a)(1). If such is the case, it might be that where the change in ownership provision of section 382(a)(1)(C) applied, the principle of theLibsonShops, Inc. case would be inapplicable since the statute now specifically provides the extent to which the net operating loss shall be disallowed under such circumstances. However, as petitioners themselves point out, the instant case does not fall within the provisions of either section 381 or 382.

We are not persuaded by petitioners' citation to legislative history that since the enactment, of sections 381 and 382 the principle laid down inLibson Shops, Inc. v.Koehler, supra,has no application to net operating loss carryovers where all relevant transactions occur after June 22, 1954. In the first place it is to be noted that theLibson Shops, Inc. decision was rendered by the Supreme Court approximately 3 years after the enactment of the Internal Revenue Code of 1954 and even the decision of the District Court was not rendered until 1955. Furthermore, we think it clear as we noted inHuyler's, supraat 781, that the enactment of the detailed provisions of sections 381 and 382 of the Internal Revenue Code of 1954 was to prevent legal forms from controlling where a loss carryover would survive a reorganization and because the legislative attempt to avoid "trafficking" in net operating losses by the provisions of section 129 of the Internal Revenue Code of 1939 had proved ineffectual. In fact the very portion of the committee report quoted in petitioners' brief⁷shows that sections 381 and 382 were intended to remove the uncertainty as to when a net operating loss carryover would survive a corporate reorganization. As petitioners point out, respondent in his own rulings has stated that the principle announced in theLibson Shops, Inc. case does not apply to mergers which come within the provisions of sections 381 (a) and (c).⁸Page 417

It appears that the type of statutory merger involved inLibson Shops, Inc., supra,is one of the circumstances in which section 381 specifically provides for survival of the net operating loss carryover. This, however, does not control the issue whether the principle ofLibson Shops, Inc. is applicable to a case where no such tax-free reorganization as is referred to in section 381 has occurred.

Section 382 provides for the disallowance of the net operating loss deduction to the loss corporation itself in whole or in part in case of purchase of the stock of the loss corporation by unrelated persons in specified amounts or redemption of the stock where after such purchase or redemption the corporation substantially changes its trade or business. In the instant case no useful purpose would be served in discussing the various provisions in detail since it is clear that the issuance of the preferred stock to Beckett and Federighi does not come within any of these provisions. SeeFawn Fashions, Inc.,41 T.C. 205(1963), for discussion of application of sections 269 and 382 to the factual situation there present. The problem is whether by specifying the various circumstances in section 382 in which net operating loss deductions would be disallowed in whole or in part where a change in stock ownership has occurred followed by a change in the corporate business, Congress intended to provide that in all other instances the loss corporation would be entitled to deduct its net operating loss carryover from earnings from a different business enterprise unless such deduction fell within the prohibition of section 269.

Certainly this question is not one which is free from doubt. It is further complicated by the fact that theLibson Shops,Inc. case was predicated largely on the fact that even though a corporation, the result of a merger, might technically be the same legal "entity" and to this extent the same "taxpayer" as all the merged constituent corporations, it was not the same "taxpayer" for the purposes of the net operating loss carryover where there was no continuity of business enterprise. In this respect it is to be noted that section 122(b) of the Internal Revenue Code of 1939 provided that if "the taxpayer" has a net operating loss it shall be a net operating loss carryover whereas the comparable section of the 1954 Code, section 172(b)(1)(B), merely provides that a net operating loss "shall be" a net operating loss carryover, the reference to "the taxpayer" being omitted. The omission of reference to "the taxpayer" in section 172(b) of the 1954 Code was mentioned in a footnote to the opinion in theLibson Shops, Inc. case. There is no indication in the committee reports with respect to section 172 of the Internal Revenue Code of 1954 that Congress viewed the wording of section 172 so as to omit the reference to "the taxpayer" toPage 418be a substantive change.⁹We do not consider that by this change in wording Congress intended to provide for one of the very evils the provisions of section 382 were intended to remedy, the "trafficking" in loss carryovers.¹⁰

Petitioners' theory that only in cases which fall directly within the provisions of section 382 or section 269 would the net operating loss carryover be denied to a taxpayer, would invite the well advised and technically skillful to "traffic" in net operating loss carryovers. Since the provisions of sections 382 and 269 as to ownership changes are precise and definite, all that would be necessary would be to create a relationship such as that provided for in the instant case which brings in new capital, new stockholders, and a new business without falling precisely within any statutory proscription. We cannot credit to Congress the issuance of an invitation to indulge in a practice which the stated purpose of the enactment is to control, the "trafficking" in net operating loss carryovers. We therefore hold that under the particular facts of this case and the principle of theLibson Shops, Inc. case, Maxwell Hardware is not entitled to offset against the earnings of its real estate department in its fiscal years 1957, 1958, 1959, and 1960, the losses which its hardware business had sustained in prior years. In so holding, we do not intend to establish a broad legal principle but merely to apply already established principles to an unusual factual situation.Decisions will be entered under Rule 50.Page 419

Proceedings of the following petitioners are consolidated herewith: Frederick J. Federighi and Mary Helen Federighi, docket No. 95310, and Maxwell Hardware Co., a corporation, docket No. 95311. ↩
The record does not show the explanation of the difference in this amount and the stipulated net operating loss of Maxwell Hardware for this year of $298,067.48, but neither party has raised any issue as to this difference. ↩
The Central Bank of Oakland, Calif., was merged into the San Francisco Bank on January 30, 1954, and later its name was changed to First Western Bank and Trust Co. ↩
This is the same bank with merely a change in name referred to heretofore as the Oakland Bank. ↩
The record is confusing as to when the balance of the $96,000 drawn on the $132,000 note was repaid and it is possible that this figure, though apparently agreed to by the parties, is incorrect. ↩
The notice to Beckett referred, of course, to "you and Frederick J. Federighi." ↩
All references are to the Internal Revenue Code of 1954 unless otherwise indicated. ↩
Following our statement quoted fromJulius Garfinckel Co.,40 T.C. 870,875(1963), are the following cases:Mill RidgeCoal Co. v.Patterson,264 F.2d 713;Willinghamv.UnitedStates,289 P.2d 283;Commissionerv.Virginia Metal Products,Inc.,290 F.2d 675, reversing33 T.C. 788;J. G. Dudley Co.,36 T.C. 1122, affd.298 F.2d 750;Huyler's,38 T.C. 773;Norden-Ketay Corp. v.Commissioner,319 F.2d 902, affirming a Memorandum Opinion of this Court. ↩
The following is quoted by petitioners from S. Rept. No. 1622, to accompany H.R. 8300 (Pub.L. 591), 83d Cong., 2d Sess., p. 52 (1954):

"Present practice rests on court-made law which is uncertain and frequently contradictory. Your committee agrees that whether or not the items carryover should be based upon economic realities rather than upon such artificialities as the legal form of the reorganization.

"The bill provides for the carryover of these tax attributes or items from one corporation to another in certain tax-free liquidations and reorganizations. * * *

"The new rules enable the successor corporation to step into the 'tax shoes' of its predecessor corporation without necessarily conforming to artificial legal requirements which now exist under court-made law. * * *" ↩
Rev. Rul. 58-603, 1958-2 C.B. 147. Rev. Rul. 59-395, 1959-2 C.B. 475. ↩
See H. Rept. No. 1337, to accompany H.R. 8300 (Pub.L. 591), 83d Cong., 2d Sess., p. A56 (1954), where reference is made to only two substantive changes neither of which is this change in wording. See also S. Rept. No. 1622, to accompany H.R. 8300 (Pub.L. 591), 83d Cong., 2d Sess., pp. 31-32 (1954), and Conference Rept. No. 2543 to accompany H.R. 8300, pp. 30-31. ↩
Certainly the following statement in H. Rept. No. 1337, to accompany H.R. 8300 (Pub.L. 591), 83d Cong., 2d Sess., p. 42 (1954), in respect to sec. 382 does not indicate any such intent:

"This special limitation on net operating loss carryovers provides an objective standard governing the availability of a major tax benefit which has been abused through trafficking in corporations with operating loss carryovers, the tax benefits of which are exploited by persons other than those who incurred the loss. It treats a business which experiences a substantial change in its ownership, to the extent of such change, as a new entity for such tax purposes." ↩