498 F.2d 631

JIM WALTER CORPORATION, Plaintiff-Appellant, v. UNITED STATES of America, Defendant-Appellee.

No. 73-3656.

United States Court of Appeals, Fifth Circuit.

July 31, 1974.

*632Harry H. Root, III, Norman Stallings, Thomas C. MacDonald, Jr., Tampa, Fla., for plaintiff-appellant.

Scott P. Crampton, Asst. Atty. Gen., Tax Div., Rodger M. Moore, Atty., Meyer Rothwacks, Chief, App. Sec., Dept, of Justice, Washington, D. C., John L. Briggs, U. S. Atty., Jacksonville, Fla., Bennet N. Hollander, Atty., Tax Div., Arthur L. Bailey, Atty., Justice Dept., Washington, D. C., Ronald H. Watson, Asst. Atty., Tampa, Fla., for defendantappellee.

Before TUTTLE, COLEMAN and AINSWORTH, Circuit Judges:

TUTTLE, Circuit Judge:

The sole issue in this refund suit is whether the district court correctly held that taxpayer Jim Walter Corporation could not deduct as an ordinary and necessary business expense under section 162 of the Internal Revenue Code the net amount of $750,120 paid to purchase 188,000 outstanding FR B Warrants in June, 1959.1 The disallowance of this *633deduction required the taxpayer to pay an extra $390,065.21 in federal taxes for its taxable year ending August 31, 1959, plus payment of interest in the amount of $115,133.36, the total refund claim of the taxpayer being $505,198.59.

I. FACTS

The facts of this case are not in dispute. Jim Walter Corporation (hereinafter Walter) was organized in 1955 to carry on the business of building shell homes formerly conducted by Walter Construction Company, a partnership. Over 90% of the shell homes sales were financed by the taxpayer for the purchasers. As a result the taxpayer corporation experienced a continuing need for capital. The rather unorthodox capitalization plan of Walter included, inter alia, 9% bonds and 370,000 B Warrants (250,000 to the former partners and 120,000 to purchasers of the portfolios) for consideration of $.01 per warrant.2 One B Warrant entitled, inter alia, the owner at any time prior to December 31, 2000, upon payment of $80 to the corporation to receive one share of the common stock of Walter and two $25 9% subordinated and unsecured bonds, due December 31, 2000; after December 31, 2000, the owner was entitled upon tender of $30 to the corporation to receive three shares of common stock.3 It was conceived that as financing was needed by Walter, the warrants would be exercised.

In 1957, the 250,000 B Warrants held by the former partners were modified and changed to FR (First Refusal) B Warrants at the suggestion of the underwriters in connection with a public offering of corporate securities in that year.4 The 1957 underwriters and the *634taxpayer were concerned that the B Warrants, if exercised, would cause the corporation to issue a large number of shares of common stock and bonds, and would subject the corporation to potential interest payments of $840,000 annually or a total of $34,000,000 until December 31, 2000, the maturity date of the 9% bonds. Under the FR B Warrants the taxpayer corporation at its option had the following conversion choices: (1) upon receipt of $80 and the warrant, to issue three shares of common stock of Walter (after the 3-for-l stock split in 1958) and two $25 9% subordinated bonds — same as the “original” option under the B Warrants; or (2) upon payment of $30 and the warrant, to issue three shares of common stock (after the 3-for-l stock split in 1958) — the “stock only” option; or (3) to repurchase the warrant for $4 or $6 depending on corporate net earnings — the “repurchase” option.5

In 1959, there was a 3-for-l split of the stock of Walter and thereafter, in 1959, there was another separate public offering of securities of Walter.6 The 1959 underwriters, too, were concerned about the possibility that the FR B Warrants might be exercised, causing the issuance of substantial debt obligations^ — 9 million dollars of 9% bonds, carrying a potential 34 million dollars in bond interest over the years until 2000.7 Apparently the underwriters’ concern was also directed at the prospect of issuing additional shares of common stock, resulting in a serious dilution of shareholder equity and the effect on earnings per share (which also might have a bearing on future stock issuances). Therefore, in June, 1959, the taxpayer corporation repurchased 188,000 FR B Warrants held by the former partners for $4 per warrant or a total of $752,000.

On its federal income tax return for the taxable year ended August 31, 1959, the corporation claimed a deduction in the amount of $750,120, the net amount between the $752,000 repurchase payment and the $1,800 consideration it had received in 1955 upon issuance of the underlying B Warrants.

The stock under the June, 1959, underwriting was issued to the public at $34 per share, and the 9% bonds at 105% of their face amount. Walter asserted that it legally and morally could not permit the exercise of these FR B Warrants under the “original” stock/bond option or the “stock only” option, because that would have caused Walter to issue stocks to four primary stockholders at $10 per share when the stock had a market value of $34, which would have resulted in a breach of fiduciary duty by the insiders.

The 62,000 FR B Warrants which remained outstanding after June, 1959, were either transferred to Walter employees under a stock option or were called in by Walter for $4 or $6 each according to their terms.

*635At the district court, the taxpayer corporation claimed it was entitled to an ordinary and necessary business expense deduction in the amount of $750,120, the net payment for the 188,000 FR B Warrants, because the 1959 repurchase originated with the 1957 conversion of B to FR B Warrants which clearly was implemented for the deductible business purpose of saving interest, or, because the payment was analogous to a deductible premium paid to repurchase a corporation’s bonds. The government contended, and the district court agreed, that the origin of the warrant repurchase was the 1959 reformation of the corporation’s capital structure and thus was capital in character, and that eliminating liability for long term high interest was simply the potential consequence upon the taxpayer’s capital structure created in earlier years, and therefore, under United States v. Gilmore, 372 U.S. 39, 83 S.Ct. 623, 9 L.Ed.2d 570 (1963), the payment for the FR B Warrants was a nondeductible capital expenditure. Furthermore, the repurchase could not be construed as a redemption of indebtedness, and thus the bond premium deduction analogy was not controlling.

II. ORIGIN AND CHARACTER OF THE DEDUCTION

The principle that deductibility depends on the origin and character of the claim was first set forth in United States v. Gilmore, supra, where the Supreme Court stated:

“[T]he origin and character of the claim with respect to which an expense was incurred, rather than its potential consequences upon the fortunes of the taxpayer, is the controlling basic test of whether the expense was ‘business’ or ‘personal’ and hence whether it is deductible or not ” 8

In Gilmore, the payment of legal fees in a divorce proceeding was held to have originated with the divorce, and thus deemed personal in nature and nondeductible. Even though the fees arguably were incurred to protect the taxpayer’s income producing assets, this was a potential consequence and was not controlling.

Proper application of the origin test asserts appellant taxpayer, would have been to find that the 1959 repurchase stemmed from the creation of the first refusal provisions of the FR B Warrants, which clearly were instituted for the deductible business purpose of saving interest, and that the collateral consequence of altering Walter’s capital structure should not be controlling. It is urged that the legal barrier to issuing $34 stock at $10 per share to insiders precluded exercise of the “stock only” option thus requiring the taxpayer corporation to exercise the “repurchase” option to avoid the bond interest under the “original” stock/bond option. Walter does not contend that the 1957 modification and the 1959 repurchase of warrants should be treated as a single transaction, or that the 1959 payment related back to the 1957 modification, but only that since Walter had no real choice in 1959 because of the 1957 modification, the reasons for the earlier modification should control.

The appellant taxpayer argues that this analysis of the origin and character of the 1959 repurchase is correct for two reasons. First, the 1959 repurchase was not part and parcel of, but independent of, the 1959 offering. The FR B Warrants were not part of the securities being offered, nor was Walter itself issuing securities to the public. Even if the repurchase is considered a condition imposed by the underwriters, a condition of underwriting is not necessarily an underwriting expense or an expense of issuing stock. For example, if underwriters required the issuing corporation to lease buildings from stockholders to assure continuity of business, the lease payments, if reasonable would be deduct*636ible and would not be treated as expenses of the offering. Walter, of course, benefitted from the public offering to the extent that it received proceeds from the conversion of the A Warrants, but Walter did not participate in the proceeds of the public offering. Repurchasing at this particular time of the offering, asserts the taxpayer, was only a matter of convenience to Walter as it was receiving proceeds from the exercise of the A Warrants with which to pay the $4 per warrant. The independence of the FR B Warrant repurchase is further evidenced by the fact that to the extent that the balance of the FR B Warrants were not converted under an employees’ benefit plan, they were eventually called in and repurchased by Walter in 1961.

Secondly, and more persuasively, the appellant taxpayer urges that this analysis is consistent with this Court’s application of the origin test in Five Star Manufacturing Corp. v. Commissioner, 355 F.2d 724 (5th Cir. 1966), and United States v. Smith, 418 F.2d 589 (5th Cir. 1969). These decisions, assert the taxpayer, set forth the principle that although expenses of recapitalizations or other capital structure changes are generally nondeductible capital expenses, such expenses which arise for a valid business purpose other than altering the capital structure are deductible under the origin test. In Five Star, this Court, in reversing the Tax Court, permitted the taxpayer corporation to deduct as an ordinary and necessary business expense the cost of acquiring the interest of a 50% stockholder. Two individuals each owned 50% of the stock of the company, which was in serious straits and near receivership. The presence of one of the individuals as a shareholder was preventing the company from entering into an agreement with an outsider which was necessary for the survival of the company. The company purchased all of that shareholder’s stock at judicial sale, and claimed a section 162 deduction for the entire purchase price. This Court concluded, supra 355 F.2d at 727:

“To be deductible as a business expense, the payment must be both ordinary and necessary. It seems unquestionable that the payment to Smith to terminate his interest in Five Star was a necessary expense. ... It can scarcely be held that the payment to Smith was for the acquisition of a capital asset, but rather one which would permit Five Star again to use assets for income production by freeing its management from unwarranted fetters.”

Appellant taxpayer also relied heavily on United States v. Smith, supra, where this Court remanded the case to the district court to determine whether the taxpayer corporation assumed a certain liability of the partnership in the acquisition of its operating assets, and if so, whether the later satisfaction of that liability was a deductible expense of a part of the cost of acquiring the operating assets. The district court had found that the taxpayer had paid the liability in order to save its business, and therefore the payment was a noncapital expenditure. The Smith court instructed -the district court to focus not on the purpose and effect of the payment of the debt, but on the reasons for the initial assumption of the liability, and, to allow a deduction if the primary purpose for the assumption was other than the acquisition of assets.9

*637In conclusion, the appellant taxpayer asserts that Five Star and Smith stand for the broad principle that if an expense of recapitalization or other capital structure changes serves a business purpose other than the acquisition of property, it is deductible even though it may appear to be, or in fact is, a part of a capital transaction. A court should look not to simply the change in the capital structure, but instead to whether the payment was primarily for a business purpose other than the acquisition of a capital asset.

The government makes the following convincing and clarifying response to the appellant’s contentions that the district court erroneously applied the Gilmore origin test of deductibility. While not explicitly stated, the court’s discussion indicates that it found the origin of the $752,000 payment to have been in the retirement %f outstanding stock warrants. It found the character of the payment from its relationship to a change in the corporation’s capital structure. On the other hand, the court noted the potential consequences of the payment was to avoid possible interest expenses on bonds which may have been issued in the future under the warrants. As examined earlier, the origin and character of the payment, not its potential consequences on the fortunes of the taxpayer, is controlling under Gilmore.10 Therefore, the repurchase origin, being in the 1959 offering, and not with the 1957 conversion, cloaked the repurchase with a capital character.

*638 This finding of a capital origin and character under ¡¡Gilmore is supportable on two grounds — either one of which alone is sufficient to sustain the judgment of the district court. First, the district court’s judgment is sustainable on the basis that, as the court found, the $752,000 payment to repurchase was required by the underwriters in connection with the 1959 public offering. Thus, the repurchase of the warrants was a recapitalization expense associated with the corporation’s issuance of stocks and bonds. It has been uniformly held that expenses incurred in connection with the acquisition or issuance of corporate stock and other reorganization or recapitalization expenses ordinarily are nondeductible capital expenditures. United States v. Hilton Hotels, 397 U.S. 580, 90 S.Ct. 1307, 25 L.Ed.2d 585 (1970); Woodward v. Commissioner, 397 U.S. 572, 90 S.Ct. 1302, 25 L.Ed.2d 577 (1970); Estate of Meade v. C. I. R., 5th Cir., 489 F.2d 161 (1974); General Bankshares Corp. v. Commissioner, 326 F.2d 712 (8th Cir. 1964); Johnson v. Commissioner, 56 F.2d 58 (5th Cir. 1932). Although the taxpayer asserts the repurchase of the warrants was not part and parcel of the 1959 offering and that the requirement of buying the warrants was not imposed on the corporation but only the warrant holders, these contentions are not supported by the record, which indicates that the corporation agreed to this requirement and determined prior to the public offering to repurchase the warrants at $4 each. Moreover, the prospectus for the 1959 offering indicates that the corporation’s repurchase was an integral part of the transaction.11

Secondly, the capital nature of this transaction is supported by the fact that the repurchase payment could be construed to have extinguished only the corporation’s obligations to issue stock under the warrants. Under the FR B Warrants the corporation had three options: (1) “original” stock/bond option; (2) “stock-only” option; and (3) “repurchase” option. Thus, the corporation was not obligated to issue bonds, and, only if it refused to issue stock, was it required to repurchase the warrants. Thus as the district court observed, supra at n. 10, the cash payment could be interpreted to have merely extinguished the holder’s right to the corporation’s stock. On this basis the $752,000 expenditure only resulted in an alteration of the corporation’s capital structure by its extinguishment of stock rights. The previously cited decisions, which have held that expenses of recapitalizations or other changes in capital structures are nondeductible capital expenditures, again clearly apply.

The final fatal flaw in appellant’s arguments is that Five Star and Smith simply do not establish that any type of primary business purpose will *639suffice to convert an otherwise nondeductible expense of recapitalization or other changes in capital structures into a deductible item. The expenditures in those two cases were made to save the corporation from dire and threatening consequences. The court in Five Star stressed the extraordinary factual situation which showed a business emergency. Similarly the district court in Smith found that the corporation paid the liability in order to save its business and therefore the payment was a non-capital expenditure. In the instant case no similar emergency business purpose was -presented; in fact, the district court expressly pointed out that the corporation was prospering.11a We think the principle followed in the two cited cases should not be extended beyond the facts of the cases.

The recent decision of this Court in Estate of Meade v. C.I.R., 5th Cir., 489 F.2d 161 (1974),12 analyzed the origin test at length and reemphasized the import of the decisions by the Supreme Court in Woodward v. C.I.R., supra, and its companion case, United States v. Hilton Hotels Corporation, supra which held that legal expenses in appraisal proceedings in connection with a purchase of a dissenting shareholders’ stock that was required under local law were nondeductible capital expenditures arising out of the acquisition of a capital asset. Estate of Meade further analyzed the Woodward and Hilton Hotels holdings:

“The primary purpose of their expenditures in the appraisal proceedings, taxpayers argued, related not to the acquisition of title, but to the price to be paid for the stock, and, therefore, their expenditures should not be characterized as acquisition costs.
“In rejecting the taxpayers’ claims in Woodward and Hilton Hotels, the Supreme Court found the primary purpose test inapplicable to the situations before it: ‘A test based upon the taxpayer’s “purpose” in undertaking or defending a particular piece of litigation would encourage resort to formalisms and artificial distinctions.’ Woodward v. C.I.R., 397 U.S. at 577, 90 S.Ct. at 1306. Instead, the Court adopted the ‘origin’ test, choosing to consider the origin and character of the claim for which the expenditures were made. On the basis of that test, the Court held that the determination of a purchase price by litigation is clearly part of the process of acquisition and should be treated as part of the cost of the stock that the taxpayers acquired. In so holding, the Court noted that ‘ancillary expenses incurred in acquiring or disposing of an asset are as much part of the cost of that asset as is the price paid for it.’ Woodward v. C.I.R., 397 U.S. at 576, 90 S.Ct. at 1305.”

Due to the recent rejection of a primary purpose test for determining deductibility of expenses incurred in acquisition of capital assets in Estate of Meade, we cannot accept appellant taxpayer’s argument that Five Star and Smith set forth any broad principle that if an expense of recapitalization or other capital structure reformation serves a business purpose other than the acquisition of property it is deductible, even though it may appear to be or in fact is, a part of a capital transaction. Rather, we read Smith and Five Star as being limited to situations where a payment to purchase a capital asset, though capital in nature, is necessary to the taxpayer’s survival. See H. and G. Industries, Inc. v. C.I.R., 3rd Cir., 495 F.2d 653 (1974).

*640III. BOND PREMIUMS: ANALOGOUS?

Appellant' taxpayer contends that the repurchase payment for the warrants should be treated as a premium paid to repurchase debt obligations. Under Treas.Reg. § 1.61-12(c) (1), which was in effect during the taxable year in issue, a premium paid by a corporation to purchase its bonds at a price in excess of the face value or issuing price is a deductible expense.12a

Walter concedes that no bonds or debt obligations were repurchased, but only urges that the underlying principle of bonds premium deduction, i. e. to avoid future interest costs, should extend to stock warrants convertible into debt securities where the payment has the same purpose. It is urged that the payment of the modification and the subsequent repurchase of the FR B Warrants — to save on future interest payments — is identical to the purpose supporting the deductibility of bond premiums. How-

ever, contrary to taxpayer’s position, the warrant repurchase payment cannot be treated analogously to a deductible premium paid to repurchase outstanding bonds, convertible or not, or any other type of debt obligations, because the underlying premise of the bond premium deduction, i. e. to save future interest, is inapplicable where the corporation’s payment did not cancel any bonds or any other type of debt obligation and where the district court found that the payment originated with the 1959 offering rather than the 1957 conversion. Under the first refusal provisions of the warrants the taxpayer corporation at its option could refuse to issue bonds. Therefore, it cannot be said that the 1959 warrant repurchase payment here can-celled any outstanding debt obligations.

The court cannot construe the regulation in such a fashion as suggested by taxpayer. The payment was not for a “purchase by a corporation of its bonds.”

This is decisive.

The judgment is affirmed.

Jim Walter Corp. v. United States
498 F.2d 631

Case Details

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Jim Walter Corp. v. United States
Decision Date
Jul 31, 1974
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498 F.2d 631

Jurisdiction
United States

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