Steadman v. Commissioner

         UNITED STATES COURT OF APPEALS FOR THE SIXTH CIRCUIT

This is an appeal by the Commissioner of Internal Revenue from a decision of the Tax Court reported as Charles W. Steadman, 50 T.C. 369 (1968). Therein the Tax Court held valid the taxpayers' claim of an ordinary loss deduction for the year 1962, in the amount of $80,000, being taxpayers' purchase price for shares of corporate stock which became worthless in the year 1962. The Commissioner contends here, as he did in the Tax Court, first that the loss did not occur in the year 1962; and second, that the loss was a capital loss which could not be deducted from ordinary income as a business loss. The Tax Court ruled against the Commissioner on both contentions. Five dissenters, however, held that the loss did not occur in the year 1962, but did not rule upon the Commissioner's second contention. They said:

"In view of the conclusion [that the loss did not occur in 1962] there

Charles Steadman was a partner in a Cleveland law firm. His practice was primarily in the field of corporate finance and organization. In the spring of 1960, one Paul E. Richards contacted Steadman with regard to a plan for the acquisition and amalgamation of several musical instrument companies into a single, integrated manufacturing and marketing organization. Richards offered Steadman the position of general counsel and assured him that he would remain general counsel of the proposed corporation so long as Richards retained control of its management. Based on the nature of the proposed organization, and the prospect of many acquisitions and mergers, generating substantial legal fees, Steadman estimated that something over $30,000 per year in legal fees would accrue to him as general counsel. Under Steadman's partnership agreement with his law firm, all of these fees, less a percentage to cover the overhead expenses of the law firm, would go to Steadman.

The establishment of the contemplated corporation was carried out as set forth in the Tax Court opinion, as follows:

"Petitioner accepted Paul Richard's offer and, as a first step in

By the summer of 1961, it became apparent that further financing was critically necessary to complete plans for further acquisitions. American Research & Development Corp. which was already the holder of $750,000 face value of Richards Musical Instruments, Inc. convertible debentures, offered to provide additional finacing by purchasing newly issued shares in the amount of $350,000, conditioned upon an increase in the number of directors to ten, five to be selected by the debenture holders. Implicit in this offer was a bid by American Research for control of Richards Music. American Research made it clear that such control would be followed by a change in management and the concentration of legal activities in the Boston law firm handling the business of American Research. Steadman was thereby made aware that acceptance of the American Research offer and plan would likely cause him to lose his position and income as general counsel of Richards Music. To maintain his position, it was imperative that some other financing arrangement be secured. In response to American Research's offer, the Board of Richards Music passed a resolution authorizing the issuance of 140,000 new shares of capital stock in the amount of $350,000, but to be offered first to the shareholders of record, at $2.50 per share. Steadman was already the owner of 12,000 shares of Richards Music which he had earlier purchased. These shares are not here involved. The shareholders of record, other than Steadman, were willing to purchase only 70,000 shares. Through a New York brokerage house, Steadman arranged the purchase of the remaining 70,000 shares, 32,000 held for his own account and financed by a Cleveland bank's loan to Steadman. Steadman's loss of $80,000 when the shares he purchased for that amount became worthless is the subject matter of this litigation.

Subsequent to this purchase, Richards Music suffered business losses, the extent of which were not revealed fully until an external audit by Ernst & Ernst, covering the calendar year 1962, was furnished on March 27, 1963. This external audit revealed a net deficit in shareholder's equity of $456,109.19, a net operating loss of over $1.3 million, and an excess of current liabilities over current assets of over $100,000. These figures supported the fears of the Board, aroused in December of 1962, that the management of Richards Music had been presenting the Board with false figures and that Richards Music was, in reality, in dire financial straits. The Board met in January of 1963, replaced Paul Richards as president and began consideration of what could then be done with Richards Music. Business operations continued through 1963, but the Ernst & Ernst audit for that year confirmed the fact that Richards Music had no prospect for continued existence. On April 15, 1964, a Chapter XI bankruptcy proceeding was filed in federal district court. Steadman's shares had become, and remained, worthless.

We consider the questions presented in this order:

1. The year of loss.

The Tax Court held that Steadman's $80,000 loss occurred in the year 1962. The Commissioner contends that it occurred in 1963. Resolution of such contest involves a finding of fact. The Tax Court found as a matter of fact that the loss occurred in 1962. Unless we can say that such finding was clearly erroneous, we are not at liberty to set it aside. Commissioner of Internal Revenue v. Duberstein, 363 U.S. 278, 289, 80 S. Ct. 1190, 4 L. Ed. 2d 1218 (1960). The Commissioner's brief to this Court states the rule as follows:

"The cases in this area are consistent with the Regulations; they have

"There are, however, exceptional cases where the liabilities of a

"The worthlessness of a stock as of a particular year is a question of

2. Was the loss deductible from ordinary income.

Our earlier factual recital sets out the emergency that prompted Steadman to borrow $80,000 to purchase the 32,000 shares of Richards Music. He had already owned 12,000 shares as a capital investment, the loss of which is not claimed here. The only reasonable view that can be taken of Steadman's borrowing of $80,000 to acquire the shares here involved is that he did so to protect his position as general counsel for Richards Music and the earnings necessarily flowing from such position. Such was the holding of the Tax Court. The Commissioner recognized this in his statement to us that,

"The taxpayer here, an attorney, purchased stock in a client

"Whether an asset normally considered capital in nature is an integral

"If securities are purchased by a taxpayer as an integral and

We hold that Steadman's $80,000 loss in 1962 was deductible from ordinary income.

The judgment of the Tax Court is affirmed.

     "An external audit, dated March 27, 1963, prepared by Ernst and