ON APPEAL FROM THE UNITED STATES TAX COURT
Gibbons and Rosen,*fn* Circuit Judges and Layton, District Judge.
The taxpayers, Karl and Hilda Hope, appeal from a decision of the United States Tax Court determining a deficiency in income tax for the taxable year 1960 in the amount of $985,459.00. The Commissioner has filed a protective appeal from the Tax Court decision determining an overpayment of $137,775.00 in the year 1961. Taxpayer has filed a cross appeal with respect to the year 1961.
The taxpayers have filed calendar year tax returns on the cash receipts and disbursements method of accounting. Prior to the years in issue Karl Hope was the sole stockholder of Perfect Photo, Inc. In 1959 a public offering of 150,000 shares of Perfect Photo stock was made at $14.00 a share. Of these shares 90,000 were sold by Karl Hope, and 60,000 by the Corporation. This left 210,000 shares in Hope's hands. He sold 3,600 shares in January, 1960, at $37.11 a share, and during 1960 he expressed an interest in selling his remaining 206,400 shares. At that time Perfect Photo employed Karl Hope's brother, Henry Hope, as a vice-president in charge of technical aspects of the business. It also employed Warren G. Grabb, a management engineer, and Henry J. Sentiff, a certified public accountant, both of whom were engaged in the company's financial affairs. The company stock was then traded on the American Stock Exchange.
Sentiff approached Harriman Ripley and Company, Inc. of New York, (Harriman Ripley) an underwriter of securities, about financing the purchase of Karl Hope's 206,400 shares. He then obtained from Karl Hope an agreement granting Sentiff and Grabb the right, for a period of thirty days from June 15, 1960, to purchase the 206,400 shares for $4,000,000.00. However, Sentiff was then advised by Harriman Ripley that Federal Reserve Board margin regulations, limiting loans for purchase of securities, would prevent its financing of the purchase by Sentiff and Grabb. As an alternative Harriman Ripley proposed that it purchase the 206,400 shares, at a price of $19.38 per share, for a total of $4,000,032.00, and that it give Sentiff and Grabb options until December 31, 1961, to purchase 75% of the acquired stock at the same price. Sentiff told Karl Hope that Harriman Ripley would purchase his stock, but at that time did not mention the options.
On June 25, 1960, the details of the purchase arrangement including the options to Sentiff and Grabb, were made known by Harriman Ripley to the attorney for Karl Hope, who was also general counsel, secretary, and a director of Perfect Photo. The attorney was informed that Karl Hope could not be included as an optionee without risking violation of the Federal Reserve Board margin regulations. A meeting then took place between Karl Hope, his brother Henry, Sentiff and Grabb, during which Karl Hope learned that Sentiff and Grabb were to benefit from the transaction by virtue of their options, and that he could not share in those benefits because of the margin regulations. At the meeting it was agreed that Henry Hope would be included as an optionee for 77,400 shares.
On July 15, 1960, Karl Hope, in the presence of his attorney, executed a contract to sell to Harriman Ripley, for its own account and as agent for other purchasers, 206,400 shares of Perfect Photo stock for $19.38 a share. Karl Hope's obligation to complete the sale was conditioned upon the delivery by Harriman Ripley of options and proxies to Henry Hope for 77,400 shares, to Sentiff for 38,700 shares and to Grabb for 38,700 shares, all at $19.38 a share. Karl Hope attended the closing on July 27, 1960, with his attorney. All the conditions of sale having been met, including the delivery of the options and proxies to Henry Hope, Sentiff and Grabb, Karl Hope transferred 206,000 shares of Perfect Photo stock to Harriman Ripley and received checks totaling $4,000,032.00.
During June and July, 1960, Perfect Photo stock traded on the American Stock Exchange between a low of $40 1/2 and a high of $66 7/8 per share. In September, 1960, an article appeared in Business Week stating that Karl Hope had sold his Perfect Photo stock for $20 a share when it was trading at over $50 a share. He then became dissatisfied with the transaction, and consulted a new attorney. On that attorney's advice he maintained the proceeds of sale in liquid position, as cash in the bank, $2,369,000.00, tax exempt municipal bonds, $1,575,000.00, and marketable common stock, $429,000.00. On his behalf his attorney attempted unsuccessfully to negotiate a rescission of the sale. On December 21, 1960, Karl Hope filed a complaint in the United States District Court for the Eastern District of Pennsylvania against Harriman Ripley, Sentiff and Grabb, alleging a conspiracy to defraud him and seeking rescission. The complaint alleged that Henry Hope had acquiesced in a rescission and would perform such acts and execute any documents necessary to effectuate it.
The December 21, 1960 lawsuit resulted in a settlement on March 24, 1961, on these terms:
(1) Karl Hope paid $350,000.00 to Sentiff and Grabb in consideration of their assignment to him of their options to purchase a total of 77,400 shares of Perfect Photo from Harriman Ripley. (Sentiff and Grabb had resigned as officers and directors of Perfect Photo on March 3, 1961.)
(2) Henry Hope assigned to Karl his option to purchase 77,400 shares of Perfect Photo without receiving any consideration.
(3) Henry Hope, Sentiff and Grabb returned the proxies for 154,800 shares of Perfect Photo ...