text:
    James F. Curtis, Petitioner, v. Commissioner of Internal Revenue, Respondent.
    Docket Nos. 85567, 91589.
    Promulgated February 9, 1939.

      Norbome P. Gatlmg, Jr., Esq., for the petitioner.

      James C. Maddox, Esq., for the respondent.
   OPINION.

Smith :

These proceedings are for the redetermination of deficiencies in petitioner’s income tax as follows:

The issues presented are (1) the amount of the personal exemption and credit for dependents to which the petitioner is entitled for the years 1932 and 1934; (2) whether the petitioner is entitled to a bad debt deduction of $60,000 in each of the years 1932 and 1934 because of the worthlessness in part, or in whole, of a debt owing to him by the Mercurt Co. for moneys advanced to the corporation; (3) whether petitioner is entitled to a loss deduction in 1935 of $1,200 representing the cost of a share of the capital stock of Engineers’ Land Corporation which he ascertained to be worthless in that year; and (4) whether the fees received by the petitioner for services as a notary public in 1932, 1934, and 1935 are includable in his gross income for those years for Federal income tax purposes. The several issues will be disposed of in their numerical order.

Issue 1. — During 1932 and 1934 the petitioner was married and living with his wife, Laura M. Curtis. During 1932 he had three dependent children under 18 years of age who received their chief support from him and during 1934 he had two such dependents.

Petitioner and his wife filed separate income tax returns for 1932. In her return for that year the wife claimed the full amount of the personal exemption, $2,500, and credit for dependents, $1,200, allowable to the marital community. Her return showed an ordinary net income of $1,241.93. Petitioner’s return for that year showed no net income and no claimed personal exemption or credit for dependents. No such exemption or credit was allowed the petitioner in respondent’s deficiency notice for 1932.

As respondent points out in his brief, the question of the amount of the personal exemption and credit for dependents to which the petitioner may be entitled for 1932 becomes moot for the reason that it is now conceded that petitioner is entitled to a loss deduction of $60,000 for 1932 which wipes out his net income for that year. We therefore pass the question.

In the deficiency notice for the year 1934 respondent allowed the petitioner a personal exemption of $2,500 and credit for three dependents in the amount of $1,200. By amended answer the respondent affirmatively alleges that the amount allowable to the petitioner in 1934 for personal exemption and credit for dependents was only $3,300, the petitioner having but two dependent children under 18 years of age during that year, and asks that petitioner’s taxable income for 1934 be redetermined accordingly, and that the deficiency for 1934 be increased. For 1934 the petitioner was entitled to a personal exemption of $2,500 and to a credit for dependents of $800. Recomputation will be made under Rule 50.

Issue H. — In September 1925 petitioner and his brother-in-law, William H. Merriam, organized a corporation known as “Mercurt Co., Inc.,” to engage in the real estate business in Nassau County, New York. They each subscribed for five shares of capital stock at $20 per share which was all the stock that was issued. It was agreed that petitioner would furnish the necessary capital for the company’s business operations in the form of loans or advances and that Merriam would manage the business. Petitioner served as president and Merriam was vice president.

The corporation engaged in a number of transactions in real estate in Nassau County, both as broker and on its own account. Over the period 1925 to 1932, inclusive, the petitioner made loans to or advances to the corporation on open account of about $250,000 for the purpose of acquiring real estate and paying taxes and carrying charges thereon and paying the operating expenses of the business. Most of these advances were made to the corporation prior to January 1, 1932. Those made after that date were principally for taxes, mortgage interest, and like purposes. The corporation gave the petitioner its promissory note for approximately $75,000 representing loans made early in 1932. Thereafter, the petitioner advanced funds to the corporation on open account.

Only a small portion of petitioner’s loans or advances to the corporation were ever repaid. On December 31,1932, there was a balance due the petitioner on the books of the corporation of about $190,000. The corporation’s only asset of any substantial value at that time was a tract of undeveloped land of approximately 46 acres located at Manhasset, Nassau County, New York. This property had been acquired by the corporation at a cost of approximately $232,500. It was encumbered by mortgages on December 31,1932, of approximately $124,000. There were unpaid interest on the mortgages of $3,720 and unpaid taxes on the property of $2,586.51. The fair market value of the property at that time was about $3,500 per acre, or $162,750 for the whole tract.

From 1930 until November 1933 repeated efforts were made by the corporation and the petitioner to sell the property, but they were unsuccessful. Foreclosure proceedings were begun by the mortgagee in September 1933. On November 24, 1933, the corporation by agreement with the mortgagee deeded the property to a third party for a consideration of $7,500 cash and a release from further obligation on the mortgages. The $7,500 cash was then turned over to the petitioner by the corporation.

At the close of 1933 the corporation had ceased to do business and had no tangible assets except a small amount of cash — less than $50— and office supplies of no substantial value. The corporation was finally dissolved in August 1934.

In his income tax return for 1932 the petitioner charged off as worthless $60,000 of the corporation’s indebtedness to him. As stated above, the respondent now concedes that “the amount of $60,000 deducted as a partial bad debt on the return for the year 1932 was proper and is sustained by the evidence of record in this appeal.” With this deduction the petitioner had no net income for 1932.

In his 1933 income tax return petitioner charged off an additional $50,000 of the corporation’s indebtedness to him. The year 1933 is not involved in these proceedings, so that the correctness of the charge-off in that year is not in controversy. It appears, however, that the respondent has ruled that the entire indebtedness was deductible as worthless in the year 1933. In his 1934 return the petitioner charged off an additional $60,000 of indebtedness which the respondent has disallowed in his deficiency notice and which is here in controversy.

The evidence shows quite plainly, we think, that the debt became totally worthless in 1933. During that year the corporation disposed of its only asset of any value, the tract of real estate referred to above, and ceased its business activities. The respondent correctly disallowed the deduction of any part of the indebtedness in 1934.

Issue 3. — During 1928 petitioner became a member of the “Engineers’ Golf Club” situated near his home at Roslyn, New York. In addition to the regular initiation fees and dues, and as a prerequisite to membership in the club, petitioner purchased for $1,200 one share of the capital stock of the Engineers’ Land Corporation. This corporation owned the land on which the golf course was situated and leased it to the golf club. The petitioner resigned from the club some time in 1931, 1932, or 1933 and attempted to surrender his share of stock in the Engineers’ Land Corporation and receive back its cost. He was not permitted to do this, however. Some time in 1932 the Engineers’ Land Corporation went into receivership under foreclosure proceedings brought by the mortgagee. The petitioner ascertained some time in 1935 that the stockholders would probably not recover anything from the receivership and deducted the cost of his share of stock, $1,200, in his income tax return for that year. The deduction was disallowed by the respondent in his deficiency notice “as representing a personal expense.”

• Even assuming that petitioner’s purchase of the share of stock of the Engineers’ Land Corporation was a transaction entered into for profit, which the evidence in no wise indicates (cf. Samuel Riker, Jr., Executor, 6 B. T. A. 890), the deduction of the cost of the stock in 1935 would have to be disallowed for the reason that there is no showing of any identifiable event fixing the loss as one of that year. An investment for profit in the stock of a corporation is deductible in the year in which the stock becomes worthless. De Loss v. Commissioner, 28 Fed. (2d) 803; Claude D. Cass, 32 B. T. A. 713; aff'd., 83 Fed. (2d) 841; Sol H. Goldberg, 36 B. T. A. 44. For all that the evidence of record shows the stock of the Engineers’ Land Corporation became worthless in 1932 when the foreclosure proceedings were begun or in one of the two succeeding years when the fact of and the extent of its insolvency must have been known or ascertainable. On the evidence before us the loss is not deductible in 1935.

Issue J. — This issue is submitted on stipulated facts and presents a single question of law, namely, whether the notarial fees received by the petitioner in 1932, 1934, and 1935 are exempt from Federal income tax by reason of constitutional immunity.

During the years 1932 to 1935, inclusive, the petitioner was a duly qualified and acting notary public in and for the Counties of Nassau and New York, State of New York. In his capacity as notary public petitioner during 1932, 1934, and 1935 protested, or caused to be protested, numerous unpaid checks, notes, drafts, and other negotiable instruments, for which he received fees of $26,574.20 in 1932, $22,643.42 in 1934, and $18,414.70 in 1935. In his income tax returns for those years petitioner reported the amounts so received but excluded them from taxable income on the ground that they were exempt from Federal taxation under the Constitution of the United States.

The respondent contends that the fees received by the petitioner for services as notary public are not within the constitutional exemption.

Notaries public in the State of New York are appointed by the secretary of state for a term of two years. They are required to take an oath of office. Their powers and duties are prescribed by statute and are in part as follows:

§ 101. Appointment (met number of notaries publ/io. The secretary of state shall appoint such number of notaries public in and for the several counties of the state as may be necessary, and of such number he is authorized to appoint at least one notary public for each bank applying therefor. The appointment of a notary public whose appointment takes effect on the thirty-first day of March shall be for a term of two years, expiring on the thirtieth day of March. * * *
§ 105. Powers and, duties of notary public. A notary public has authority:
1. Anywhere within the state to demand acceptance and payment of foreign and inland hills of exchange, and of promissory notes, and may protest for the nonacceptanee or nonpayment thereof, to exercise such powers and duties as by the law of nations and according to commercial usage, or by the laws of any other government, state or country, may be performed by notaries.
2. In the county in and for which he shall have been appointed and elsewhere, as provided in section one hundred and two of this chapter, to administer oaths and affirmations, to take affidavits and certify the acknowledgment or proof of deeds and other written instruments to be read in evidence or recorded in this state, in all eases in which commissioners of deeds may now take and certify the same, and under the same rules, regulations and requirements prescribed to said last-mentioned officers, not inconsistent with any of the provisions of this chapter; * * * [Art. 10, book 18, McKinney’s Consolidated Laws of New York, Annotated].

Neither the Eevenue Act of 1932 nor the Act of 1934 contains any specific provision for the exemption of the compensation received by officers or employees of a state or political subdivision thereof, such as appears in section 1211 of the 1926 Act applicable to 1924 and prior years. However, the Commissioner has ruled in Eegulations 77, promulgated under the 1932 Act, article 643, that:

Compensation paid to its officers and employees by a State or political subdivision thereof for services rendered in connection with the exercise of an essential governmental function of the State or political subdivision, including fees received by notaries public commissioned by States, is not taxable. * * *

Article 116-2 of Eegulations 86, promulgated under the 1934 Act, contains the following provision:

* * * Compensation received for services rendered to a State or a political subdivision thereof is to be included in gross income unless (a) the person receives such compensation from the State or political subdivision as an officer or employee thereof, and (6) the services are rendered in connection with the exercise of an essential governmental function. The commissions of receivers appointed by State courts and the fees received by notaries public are taxable.

Neither the Board nor any of the Federal courts, so far as we have been able to ascertain, has passed upon the question of the taxability by the Federal Government of the fees received by a notary public serving under state appointment.

Assuming that the petitioner as notary public was an officer of the State of New York, within the meaning of that term as defined in Metcalf & Eddy v. Mitchell, 269 U. S. 514, the question remains whether the tax which the Federal Government undertakes to levy upon the emoluments of his office would impose a constitutionally forbidden burden upon the state government.

This question in substantially the same form as here presented has been under consideration by the Supreme Court in a number of recent cases including Helvering v. Gerhardt, 304 U. S. 405; Helvering v. Therrell; Helvering v. Tunniclife; McLoughlin v. Commissioner, and Helvering v. Freedman, 303 U. S. 218. It was held in the Gerhardt case that the employees of the Port of New York Authority were not exempt from income tax on the salaries which they received for such services. It was held in the Therrell, Tunnicliffe, and Freedman, cases that the immunity from Federal income tax did not extend to the compensation received by attorneys for services in liquidating insolvent state banks, and in the MeLoughlin case that the compensation received by an attorney for services in liquidating insurance companies in the State of New York was not exempt. In the Gerhardt case the Court said that there were two guiding principles of limitation for holding the tax immunity of state instrumentalities to its proper function:

* * * The one, dependent upon the nature of the function being performed by the state or in its behalf, excludes from the immunity activities thought not to be essential to the preservation of state governments even though the tax be collected from the state treasury. * * * The other principle, exemplified by those cases where the tax laid upon individuals affects the state only as the burden is passed on to it by the taxpayer, forbids recognition of the iihmunity when the burden on the state is so speculative and uncertain that if allowed it would restrict the federal taxing power without affording any corresponding tangible protection to the state government; even though the function be thought important enough to demand immunity from a tax upon the state itself, it is not necessarily protected from a tax which well may be substantially or entirely absorbed by private persons. Metcalf & Eddy v. Mitchell, supra; Willcuts v. Bunn, 282 U. S. 216.
❖ # ❖ * * * *
* * * When immunity is claimed from a tax laid on private persons, it must clearly appear that the burden upon the state function is actual and substantial, not conjectural. Willcuts v. Bunn, supra, 231. * * *
* * * The state and national governments must co-exist. Each must be supported by taxation of those who are citizens of both. The mere fact that the economic burden of such taxes may be passed on to a state government and thus increase to some extent, here wholly conjectural, the expense of its operation, infringes no constitutional immunity. Such burdens are but normal incidents of the organization within the same territory of two governments, each possessed of the taxing power.

In the instant case it does not appear that the imposition of the tax on the income of the taxpayer would result in any “actual and substantial” burden on the functions of the state government. All of the compensation received by the taxpayer for his services as notary public was in the form of fees collected from those for whom he performed the ’ services. The State of New York contributed none of the funds. No attempt has been made to show that the tax sought to be levied would add any financial burden upon the state or in any way hinder its functions of government.

Granting that the duties of a notary public in the State of New York are of such a nature as to stamp them essentially governmental in character, it still does not follow, as we read the court’s opinion in the Gerhardt case, that by reason of that fact alone the compensation received by an individual for his services in performing such duties is exempt from Federal income tax. For, as was said in the Gerhardt case, “even though the function be thought important enough to demand immunity from a tax upon the state itself, it is not necessarily protected from a tax which well may be substantially or entirely absorbed by private persons.” Following the Gerhardt case the Circuit Court of Appeals for the Second Circuit held, in Saxe v. Shea, 98 Fed. (2d) 83, that the compensation received by an attorney for services as referee or special guardian in certain cases, under appointment by the Supreme Court of New York and the Surrogate’s Court of New York County, was not within the constitutional immunity. Quoting from the Supreme Court’s opinion in the Ger-hardt case, including the excerpt above, the court said:

* * * The tax upon such compensation will be absorbed by the taxpayer without effect upon the state, as fully as the tax upon that part of his income arising from his professional employment as an attorney at law. In the light of the Q-erharét opinion we believe that the source of the appellant’s compensation is alone to defeat his claim of constitutional immunity from federal income taxes, although prior to that decision the lower courts had expressed divergent views on this question. * * *

We think that the cases cited above, particularly the Gerhardt case, are controlling in the instant case, and that they declare a rule which places the notarial fees received by this petitioner beyond the limitation of the immunity from Federal income tax.

Reviewed by the Board.

Judgments will be entered under Rule 50.


source: Caselaw Access Project

author: SxeRnhageN :

license: Public Domain

text:
    Sidney W. Winslow, Jr., Petitioner, v. Commissioner of Internal Revenue, Respondent.
    Docket No. 88605.
    Promulgated February 9, 1939.

      G. Clifton Owens, Esg., for the petitioner.

      Paul E. Waring, Esg., for the respondent.
   OPINION.

SxeRnhageN :

The amount of $45,473.40 received by petitioner from the insurer prior to the taxable year 1934 represents 17 annual installments of $2,000 each ($34,000) and dividends of $11,473.40. No part of this had been reported by petitioner as income in the years received. Now the Commissioner determines that the commuted value of the $100,000 to be paid in 50 annual installments of $2,000 each, agreed by the parties to be $53,000, is the amount exempt from tax; that this exemption has already been applied to $45,473.40, leaving $7,526.60 still subject to the exemption; that the exemption of this $7,526.60 must be spread ratably over the remaining 33 years of periodic payments; and that hence only the pro rata amount of $228.08 is the exempt portion of the $2,581.40 received in 1934, thus adding $2,353.32 to 1934 income to be taxed.

Assailing this determination, the petitioner argues that the entire payment of $2,581.40 is tax-exempt; that at least $2,000 thereof is, and that even if the Commissioner’s theory is correct, his computation is incorrect in that he uses all unreported income from installment payments of prior years to reduce the amount to be exempted on future installments, thereby seeking to correct past errors by present adjustments.

Section 22 (b) (1), Eevenue Act of 1934, provides for the exemption from tax of:

(1) Lite insurance. — Amounts received under a life insurance contract paid by reason of the death of the insured, whether in a single sum or otherwise (but if such amounts are held by the insurer under an agreement to pay interest thereon, the interest payments shall be included in gross income).

Such a provision (except that “in installments” was used in lieu of “or otherwise”), was enacted as section 22 (b) (1), Eevenue Acts of 1932 and 1928, and section 213, Eevenue Act of 1926. Section 213, Eevenue Act of 1924, and previous acts exempted:

(1) The proceeds of life insurance policies paid upon the death of the insured.

The change in the 1926 Act was intended:

* * * to prevent any interpretation which would deny the exemption in the case of installment payments, * * *

and the parenthetical clause was added:

* * * In order to prevent an exemption of earnings where the amount payable under the policy is placed in trust upon the death of the insured and the earnings thereon paid * * *. [Conference Report, H. R. 1, 69th Cong., 1st sess., p. 33.]

The phrase “or otherwise” in the 1934 Act supplanted “or in installments” in the 1932 Act to make it clear:

* * * that the proceeds of a life-insurance policy payable by reason of tne death of the insured in the form of an annuity are not includible in gross income. [Finance Committee Report No. 558, 73d Cong., 2d sess., p. 23.j

Congress has thus clearly manifested an mtention to exempt amounts received by the beneficiary of a policy, “paid by reason of the death of the insured” in installments or in annuities, and has departed from language which might be construed to exempt only the amount “paid upon the death of the insured”, or at that time.

Both the plain wording of the section and its legislative history show that the $2,000 installments were intended to be fully exempted from tax, for they were received by reason of the death of the insured and were expressly receivable as installments. The Commissioner so construed the exemption under early acts in several rulings. After the Board’s decision of Edith M. Kinnear, 20 B. T. A. 718, in 1980, the rule was changed. Bespondent now relies on the Kirmear case as support for the change of administrative rule and for the determination here. Kinnear was the beneficiary of a policy on her father’s life, which, as originally written, entitled her to $25,000 upon proof of the insured’s death. But by request of the insured the policy had been endorsed to provide that:

* * * settlement of the full proceeds of this policy shall be made with Edith M. Kinnear, the beneficiary, in accordance with the provisions of Option A, payable monthly, without privilege of revocation or surrender.

Option A provided that upon the insured’s death the company should hold the proceeds of the policy until the death of the beneficiary and pay 3 percent annual interest thereon. By another provision the payments were to be increased, as they were here, by annual dividends of the company. Kinnear argued under the 1926 Act that the statute:

* * * does not contemplate a situation where the insured by direction prior to his death has instructed the insurance company to retain the principal amount of the policy and pay to the beneficiary only the interest and dividends, without privilege of revocation or surrender on the part of the beneficiary.

The Board rejected the argument. It reviewed the above cited Committee reports, addressed itself to the taxable status of interest and dividends on policy proceeds which the insured had required the company to hold, and found no reason in the beneficiary’s lack of power to alter the arrangement for a failure to apply strictly the language of the parenthetical clause. This case is authority only for the taxation of interest and dividends on an amount which might have been paid in a lump sum at the time of death but which because of the insured’s unalterable directions was held by the company.

The Commissioner, however, used it as warrant for a change in his former rulings, and in G. C. M. 13796, XIII-2 C. B. 41 (Oct. 2,1934), cited it in holding that the successive statutes:

* * * exclude from gross income only the principal sum of tbe capital value of a life insurance policy as of the time of the insured’s death, and do not exclude any amounts which are added to such principal sum (when it is paid in installments) by reason of the running of time. * * *

He thought it logical:

* * * that Congress intended to exclude from gross income only the proceeds of life insurance policies which are reportable for estate tax purposes. * * *

and reasoned that:

* * * “proceeds” when allowed to remain with the insurance company earn additional amounts which ****** accrue by reason of the running of time or by reason of the fact that final settlement is postponed to a date beyond the date of death. * * *

Whether such an arrangement with the company was made by the beneficiary or by the insured was regarded as immaterial. Since the Kvrvnear decision considered only interest and dividends on the face amount of the policy which was retained by the company, it falls short of supporting the treatment in G. C. M. 13796 of insurance proceeds received by reason of the insured’s death.

The gist of G. C. M. 18796 was incorporated in Regulations 86, article 22 (b) (1) — 1:

* * * amount exempted is the amount payable had the insured or the beneficiary not elected to exercise an option to receive the proceeds of the policy or any part thereof at a later date or dates. If the policy provides no option for payment upon the death of the insured, or provides only for payments in installments, there is exempted only the amount which the insurance company would have paid immediately after the death of the insured had the policy not provided for payment at a later date or dates. * * *
*******
(b) * * * If the proceeds are payable in installments for a fixed number of years, * * * the amount that would have been payable by the insurance company immediately upon the death of the insured (if payment at a later date had not been provided for) is to be divided by the total number of installments payable over the fixed number of years for which payment is to be made, andi the quotient represents the portion of each installment to be excluded from gross income. The amount of each installment in excess of such excluded portion is to be included in gross income. * * *

Under this regulation the commuted value of proceeds, as of the date of the insured’s death, is the maximum exemption no matter how or when payable or why.

Respondent defends this article by quoting from the Kiwnear opinion that a beneficiary is taxable on earnings from a policy:

* * * where the amount payable * * * has been placed in trust by the insured under an, agreement that the earnings thereon shall be paid to the beneficiary. * * *

But the $2,000 installments were not earnings on an amount payable. Respondent cites United States v. Heilbroner, 100 Fed. (2d) 379, affirming 22 Fed. Supp. 368, which is substantially similar to Kin- near, supra. Heilbroner was the beneficiary of insurance policies on the life of her husband, who died after directing the company to hold the face amounts for payment to children on his wife’s death and to pay the wife interest and dividends annually apportioned to the policies by the issuing companies during her lifetime. In holding such interest and dividends taxable, the court treated them as:

* * * sums paid by tbe companies for the retention and use of the face amounts of the various policies without impairment of the obligations ultimately to pay the principal amounts of the several policies to the remaindermen.

The arrangement was thought to be similar to the establishment of a trust for the payment of interest on principal to a beneficiary. It was thought:

* * * reasonable to suppose that Congress intended to exclude from gross income only the proceeds of policies which are reportable for estate tax purposes. * * * This interpretation * * * prevents an insured from eliminating from taxation income arising from the proceeds of a life insurance policy by making it payable to the beneficiary for a period during which the payment of the principal sum is suspended.
*******
* * * The amounts to be held under an agreement to pay interest are the proceeds of the policies at whatever time receivable after the death of the insured.

This rationale establishes that the income from the retained face amount of a policy is taxable and conversely implies that the face value remains the “proceeds” no matter when paid.

In our opinion, the wording of the statute, that amounts received in installments by the beneficiary and paid by reason of the death of the insured, covers each $2,000 installment, and each is therefore exempt from tax in its entirety when paid.

This holding is harmonious with decisions' that from the standpoint of the payer periodic payments of a principal amount in installments give no deduction of a part thereof as if it were interest. Daniel Brothers Co. v. Commissioner, 28 Fed. (2d) 761; Henrietta Mills, Inc. v. Commissioner, 52 Fed. (2d) 931; Corbett Investment Co. v. Helvering, 75 Fed. (2d) 525; MacDonald v. Commissioner, 76 Fed. (2d) 513; Penn Mutual Life Insurance Co. v. Commissioner, 92 Fed. (2d) 962.

There is, however, no support for the petitioner’s argument that the additional amount of $581.40 received by petitioner in 1934 is likewise exempt. This was a distribution out of the earnings of the corporation appropriately called in the bond an “excess interest dividend.” While it was paid by virtue of the corporation’s contractual obligation, it was a gain to petitioner currently derived from the principal invested. In its essential nature it resembles the earnings held taxable in Heilbroner and Kinnear, supra. This “excess interest dividend” was not received solely “by reason of the death of the insured”, as was the $2,000; it was paid also by reason of the withholding of the future installments of the principal amount and their profitable investment by the corporation. Thus they are not squarely within the statutory exemption and are like any other income from an investment.

Decision will be entered wnder Rule 50.

        O. D. 433, 2 C. B. 91; L. O. 995, 2 C. B. 90; O. D. 612, 3 C. B. 120; O. D. 767, 4 C. B. 231; O. D. 1010, 5 C. B. 100; G. C. M. 10843, XI-2 C. B. 22.


author: Disney :

text:
    John Graf Company, Petitioner, v. Commissioner of Internal Revenue, Respondent.
    Docket No. 91828.
    Promulgated February 9, 1939.

      E. O. Pommerening, Esq., for the petitioner.

      John D. Kiley, Esq., Emil J. Nelson, Esq., Carrol Walker, Esq., and Irene Feagin, Esq., for the respondent.
   OPINION.

Disney :

The respondent contends that the petitioner in the taxable year received a $3,000 account receivable in merchandise and discounts, that all events necessary to fix the liabilities of the parties had occurred, the Starr Canning Co. being absolutely liable, and that therefore petitioner, reporting income on tbe accrual basis, had $3,000 income in that year; whereas the petitioner contends that there was a contingency preventing fixation of liability and accrual of income, in that the Starr Canning Co. was liable to pay the discounts only in the event of beer being ordered by the petitioner. Although we do not think the contingency in this case is of the nature involved in Edwards Drilling Co., 35 B. T. A. 341, cited by petitioner, or that a similar principle is involved in Shafpa Realty Corporation, 8 B. T. A. 283, or Automobile Underwriters, Inc., 19 B. T. A. 1160, also cited and relied upon by petitioner, nevertheless, we believe that there is lacking in the instant situation the definiteness of liability to pay, upon which the application of the accrual system of accounting is based. The underlying thought is that pecuniary obligations payable to the taxpayer are considered discharged when incurred, United States v. American Can Co., 280 U. S. 412. These must be unconditional obligations, Lucas v. North Texas Lumber Co., 281 U. S. 11; and they must be definitely payable, American National Co. v. United States, 274 U. S. 99. The obligation of the Starr Canning Co. was not definitely payable, but depended upon and was proportionate to purchases made by the petitioner, at its volition.

It is plain from the contract that it was the intent that the discounts might materialize in years other than the taxable year, or might not be realized at all, depending upon the measure of fulfillment of a contract, optional in that respect with the petitioner. In general, income tax concerns itself with realized gains or losses. Lucas v. American Code Co., 280 U. S. 445. We can not think the fact that the option was in the petitioner removes the element of uncertainty or contingency which ordinarily prohibits application of ideas of accrued income, for the contingencies of business, that is as to whether petitioner’s business would, or would not, justify it in ordering additional beer from the Starr Canning Co., is a contingency as real as that of condition in liability for payment by an obligor, which is commonly held to prevent accrual of income. Taxation is practical, Tyler v. United States, 281 U. S. 497. Although the Starr Canning Co. was under liability to pay the discounts, this was subject to a condition — the requirements of the petitioner in its business of selling beer. Realistic approach to this question compels the conclusion that petitioner’s income would not be accurately reflected by the inclusion therein of discounts, the receipt of which was not certain. Although the payment thereof could be compelled by the petitioner, it was conjoined with and dependent upon further business expenditures by it. We do not think such a contingent element should enter into the computation of income. In Buret v. Logan, 283 U. S. 404. in holding that there was no realization of gain until taxpayer recovered the capital investment, the Court said that payments were “only conditionally promised.” The promise was equally conditional here. We hold that the inclusion of any amount above $727.50 in the petitioner’s income for the year 1984 was error.

On the question of depreciation the petitioner oifered two witnesses — the first, the petitioner’s bookkeeper and accountant, and the second, the accountant and credit man for a company engaged in the manufacture and sale of bottling machinery. Petitioner’s bookkeeper-accountant testified in general that from his experience in keeping the books based on trade-in and “things like that” the life of most of the machinery would be seven or eight years at the most. The accountant and credit man for the bottling company manufacturing bottling machinery testified as to the value of certain machines, to wit: That the life of the “Cem Filler” was five years; that of the “Dixie Filler”, six years; that of the “Boyal Filler”, four years; and that of a bottle washing machine, eight to ten years. Evidence as to life of four certain items of machinery with a total valuation of approximately one-half of the value of the entire machinery upon which petitioner claims depreciation (about $22,500 out of machinery with a total value of $45,267.58) does not constitute sufficient showing to overcome the presumption of the correctness of respondent’s determination in disallowing $1,497.22 out of depreciation claimed of $4,409.16, we having no record of the depreciation claimed upon each piece of machinery and the figures used by both respondent and petitioner being lump sums covering all the machinery. Moreover, evidence that the “Boyal Filler”, which cost $7,750, was traded in on new machinery at $3,000 at a time when depreciation taken left it a book value of $5,289.84, and that the “Dixie Filler”, which cost $3,300, was traded in on new machinery at $1,700 at a time when depreciation taken left it a book value of $2,007.50, does not, we think, determine the question of depreciation. Such transactions reflect, if anything, the market value of machinery at the time thereof and not the amount of depreciation suffered. Figures used in trade-in or exchange of machinery are not the criterion of depreciation. There is here, moreover, no evidence that the trade-in figure was actual fair value at the time. For the same reason the testimony of petitioner’s own bookkeeper-accountant shows on its face that the witness was not qualified to give an estimate of the life of the machinery, since he based his opinion upon trade-in figures.

Although the record shows that the respondent used a basis of 12% years as against 10 years claimed by the petitioner, these percentages are composite rates, based not upon each piece of machinery, but upon the total value of all machinery, and the 12% year basis is not inconsistent with, the length of life as to four certain items testified to by the accountant of the company manufacturing bottling machinery. Moreover, the respondent proceeded under the regulations provided in such cases, and these have not been shown to be invalid. We think the petitioner has not shown error in the respondent’s treatment of depreciation and the disallowance of $1,497.22 from petitioner’s claim in that regard is therefore approved.

In our opinion the petitioner has not shown error in the treatment accorded by the respondent to its claim of deduction for bad debts. We do not think these debts were ascertained to be worthless in 1934. It is true that in that year they were in a sense written off, following a report by a collecting agency to whom the accounts were, as a last effort, turned over in December 1933. But long prior to that time credit had, to a large extent, been cut off from the debtors represented in these accounts, the accounts had become slow, various salesmen had tried to collect, the manager and bookkeeper had determined that petitioner could not collect the accounts, and they had been placed upon a suspense ledger in the year 1933. The respondent disallowed $2,494.82 out of $5,618.71. More than $2,494.82 was represented by accounts the last purchases in which were made in 1929,1930, and 1931, and more than that amount is represented by accounts where credit had been cut off from the debtor not later than 1932; and petitioner has not shown the amounts marked off in 1934 not to be included in such old accounts. Moreover, there is no evidence as to what efforts were made by the collecting agency to realize upon the accounts. A person of ordinary prudence, under similar circumstances, would have ascertained worthlessness prior to the taxable year. Ellen Hyde Scovill, 36 B. T. A. 1214.

Under such circumstances, we hold that the petitioner has not shown error in the determination made as to bad debts by the respondent.

The last question for our consideration is as to whether certain losses are subject to the limitation on capital losses. First, claim is made that electric water coolers were property held primarily for sale to customers in the ordinary course of trade or business, and were not therefore capital assets. These water coolers, however, were put out by the petitioner in order to sell spring water, under a written contract which very plainly, we think, provides primarily that the contract is one of leasing and not of sale and that the sale is secondary. In addition to the fact that the contract throughout refers to the parties as lessor and lessee and to the renting of the water cooler from the lessor for a period of 24 months at a monthly rental, the contract merely gives the lessee an option to purchase. The coolers were purchased in order to sell spring water. We hold that the water coolers were not primarily held for sale in the ordinary course of trade or business, and that they were capital assets, under section 117 (b) of the Revenue Act of 1934.

Secondly, petitioner contends that certain beer kegs and cases were also property held by the taxpayer primarily for sale in the ordinary course of trade or business, and were not capital assets. These kegs and cases were used in selling beer to customers. A deposit was made for each by the buyer of beer contained therein, and a credit given for the deposit when the barrel or keg was returned. When the petitioner discontinued the manufacture of beer, the kegs and cases were sold. This evidence, in our opinion, clearly fails to demonstrate that these kegs and cases were primarily held for sale in the course of trade or business, and respondent’s denial of such claim is affirmed.

The petitioner on brief concedes respondent’s position that losses on certain fillers are capital losses, and as to the losses on such fillers respondent’s determination is therefore affirmed.

Decision will be entered wider Bule 50.


author: Disnet:

text:
    Charles E. Adams, Petitioner, v. Commissioner of Internal Revenue, Respondent.
    Docket No. 88274.
    Promulgated February 9, 1939.

      Raymond N. Beebe, Esq., Raymond O. OusJrna, Esq., and Donald R. Richberg, Esq., for the petitioner.

      Oonway Kitchen, Esq., and E. 0. Hanson, Esq., for the respondent.
   OPINION.

Disnet:

The question for determination here is whether benefits flowing to the petitioner under the option agreement were by way of compensation to him, or whether the transaction was a mere purchase and sale of stock, the gain or loss thereon to be determined at the time of resale of the stock, tie did not resell any of the stock in the taxable year.

We have very recently determined this question in Delbert B. Geeseman., 38 B. T. A. 258, and in Gordon M. Evans, 38 B. T. A. 1406. On facts in both proceedings very similar to those herein, we held that the acquisition of stock by the petitioner did not constitute the receipt of compensation.

Eespondent suggests that Delbert B. Geesemam, supra, is distinguishable in the same manner as Rossheim v. Commissioner, 92 Fed. (2d) 247, and that the latter is distinguishable because in the instant proceeding the petitioner could not exercise the option prior to December 26, 1933, though the option' was granted and accepted on April 18, 1933. We think there is no such distinction between the present proceeding and DeTbert B. Geesemam,, supra, and Rossheim v. Commissioner, supra, for examination of the former discloses that, as in the instant proceeding, the option was not exercisable at the date given. It was offered on March. 11,1931, but the optionee could not purchase before September 1, 1931. Likewise in Rossheim v. Commissioner, supra, the optionee could purchase only when the stock, which was at the time of option selling from $30.50 to $45 per share, should sell on the market at $55 per share in lots of 1,000 shares. We find, therefore, in this respect no reason to deviate from our conclusions in Delbert B. Geeseman, supra. In Gordon M. Evans, supra, the option was offered on September 13, 1929, but provided for delivery of stock not earlier than December 1, 1929, and it is apparent that the situation is not essentially different from that in the instant proceeding.

Respondent suggests as further distinction that the option herein could be canceled at any time by the trustees. This fact does not appear in Delbert B. Geeseman, supra, or in Gordon M. Evans, supra; but in our opinion, the contention is too broad. There was not an absolute right to cancel the option. It could be canceled, so far as not already exercised, only for good cause (which specifically should not include, increase in market value of the stock), if the board of directors of the corporation deemed such action for the best interests of the stockholders of the company. We can not think that such a qualified power to cancel the option would cause each sale of stock to constitute a new transaction, or sever the connection with the original agreement of option. Moreover, the evidence showed that the object of this provision, as understood by both parties to the agreement at the time, was to safeguard against possible legislation which might have the effect of making consummation of the agreement illegal. Respondent vigorously excepted to such evidence on the theory that it tended to modify or contradict the written option, but such rule governs only as between the parties to an agreement, and not to this proceeding. James D. Boone, 27 B. T. A. 1064. As we construe the provision for cancellation, the corporation could have canceled the option only upon a showing of good cause. We think the record herein fairly negatives such good cause. The option was not canceled, and the optionee satisfied the corporation that he was fully able financially to make payment. We are therefore unable to find in the cancellation provision any distinction between this proceeding and Delbert B. Geeseman, supra, and Gordon M. Evans, supra. The principles there enunciated control here. The option price was not substantially different from the fair market price at the date of the option. Indeed, the option was at a price slightly higher than the market price at the time. There was undoubtedly connection between petitioner’s position as an employee and the granting of the option to him, but it did not amount, by any means, to the option being granted as compensation for services rendered. In Omaha National Bank v. Commissioner, 75 Fed. (2d) 434, referring to the optionee, it was stated:

* * * Undoubtedly he had been accorded this right of purchase because he was a valued employee of the company and it wished to retain his services. * * *

Yet it was held that the option was not compensation for services rendered. The distinction between compensation for services and the granting of an option to employees in order to benefit the company by making the employees more interested in the welfare of the company has, in that case, and in Delbert B. Geeseman, Gordon M. Evans, and Rossheim v. Commissioner, all cited above, been fully, and we think soundly, set forth, so that further extended discussion is not here necessary. The situation in the present proceeding offers no difference in principle and no facts to indicate payment of compensation for services rendered, more than in the cases above noted. Indeed, in Gordon M. Evans, supra, there was some language indicating that the agreement was “designed to compensate those who continue to give to the. company their best efforts”, etc., though it was contradicted by other provisions of the agreement; whereas the evidence herein tends throughout, we think, to negative any agreement to compensate for services. Compensation for services was handled on a different basis, dependent upon the earnings of the corporation; the granting of the options to purchase stock had no such limitation. We think the situation amounted to nothing more than an incentive to loyal support of the organization much in the same manner as approved in the cases above cited.

Respondent’s reference to article 22 (a) (1) of Regulations 84 and to similar provisions in prior regulations does not, in our opinion, offer reason for deviating from the opinion already expressed above and in previous cases, for the various cases upon this subject have not permitted, and obviously should not permit, the regulations to add anything to the statute.

We therefore hold that the petitioner did not have income in the taxable year represented by the difference between the option price and the fair market value of the stock in the corporation.

Decision will he entered for the petitioner.


author: Leech :

text:
    John D. Fackler, Petitioner, v. Commissioner of Internal Revenue, Respondent.
    Docket No. 89253.
    Promulgated February 10, 1939.

      John D. Fachler pro se.

      H. D. Thomas, Esq., for the respondent.
   OPINION.

Leech :

The first issue is whether the amounts paid during the two taxable years as prepaid interest were deductible under section 23 (b) of the Revenue Act of 1934. That section allows the deduction of “All interest paid or accrued within the taxable year on indebtedness.” Section 41 of the same revenue act provides that taxable income shall be computed on the basis by which the taxpayer’s books are kept, unless this basis does not clearly reflect income.

Respondent contests the deduction of the item here, only because it was prepaid.

Since the contrary does not appear in the statute, the term “interest” must be construed according to its ordinary meaning. Old Colony Railroad Co. v. Commissioner, 284 U. S. 552.

It has been defined to be “the compensation allowed by law, or fixed by the parties, for the use or forbearance of money, or as damages for its detention.” See Joseph W. Bettendorf, 3 B. T. A. 378. That the payments here were made in advance for bona fide purposes does not affect the fact that they were made as “the compensation * * * fixed by the parties, for the use * * * of money.” See Crosby v. Wyatt, 10 N. H. 318. They thus constituted interest within the meaning of the statute. Since petitioner kept his books and made his income tax returns on the cash basis, he is, therefore, entitled to the contested deduction unless its permission would work a distortion of his income under section 41. But, distortion of the petitioner’s income would not result here from the deduction of this prepaid interest payment any more than it would from the payment in one of the current taxable years for interest covering an elapsed period of more than those years. See Welch v. De Blois, 94 Fed. (2d) 842. And that does not prevent the deduction. Cf. Central National Bank of Cleveland, Administrator, 35 B. T. A. 489; Jungkind Photo Supply Co. v. Remmel (U. S. Dist. Ct., E. Dist. Ark., Feb. 5, 1926). The effect of denying it here would be to place petitioner on an accrual basis asi to one item on his return and leave him on a cash basis as to the remainder. Such inconsistency is not permissible. Merchants National Bank, 6 B. T. A. 1167; John I. Chipley, 25 B. T. A. 1103.

Respondent cites Julia Stow Lovejoy, 18 B. T. A. 1179, and Alland & Bro., Inc. v. United States (U. S. Dist. Ct. Mass., 1928), 28 Fed. (2d) 792, as supporting his denial of these deductions. Those cases are distinguishable in that the disputed deductions there were held to be capital expenditures or otherwise not within the specific deductions permissible under the revenue acts. See also United States Playing Card Co., 15 B. T. A. 975; Chicago, Rock Island & Pacific Railway Co., 13 B. T. A. 988; Bonwit Teller & Co., 17 B. T. A. 1019. Here, whatever other designation, by analogy, may be applied to the disputed items — they are “interest” payments and are thus deductible within the specific provisions of the statute. That they may not have been ordinary or necessary expenses of business of the taxpayer is not a requisite to their deduction under the statute.

The petitioner is sustained on the first issue.

The second and third issues will be discussed jointly. The second issue involves the proper treatment here of the past due taxes for 1931 and 1932 and the taxes for 1933, due in 1934. The third issue concerns petitioner’s recovery in 1934 of $2,680.34 on his right of action against the Sloan-Prospect Corporation, the underlying lessee.

It is clear on the face of the lease that the payment of the current taxes was regarded by the parties as current rental. Respondent now concedes this and agrees that the 1933 taxes were deductible as rent for the year 1934 when paid by petitioner. However, the past due taxes have a different status. In 1933, by the agreement incorporating the lease, petitioner intended to and did acquire a lease for 99 years, subject to an underlying lease; and, in addition thereto, a right of action against the underlying lessee. We think the lease is clear on this point and that this effect is not impaired by the lessor’s separate assignment of the original lease to petitioner, nor the other writings in evidence. At the time the petitioner entered into the lease, the unpaid 1931 and 1932 taxes, amounting to $7,934.66, had-become liens against the premises pursuant to the Ohio General Code, section 5671. Central United National Bank, 33 B. T. A. 588. Petitioner’s assumption of the liability to pay those past due taxes constituted the consideration he paid for his overlying lease and the right of action against the underlying lessee. Lifson v. Commissioner, 98 Fed. (2d) 508; Alland & Bro., Inc. v. United States, supra; Leamington Hotel Co., 26 B. T. A. 1004; Merchants Bank Building Co., 32 B. T. A. 1072. The assumption of that liability was the equivalent here of a cash payment in that amount. Respondent concedes this. However, that consideration was not allocated nor is it allocable on this record between the lease and the right of action against the underlying lessee, Sloan-Prospect Corporation. Hiram R. Lloyd, 34 B. T. A. 301. Cf. C. H. Mead Coal Co., 28 B. T. A. 599; modified, 72 Fed. (2d) 22.

Petitioner, by his receipt of the disputed sum of $2,680.34 in 1934 from that corporation, has thus recovered that amount of his capital so expended. It follows that this amount can not be taxed as income of petitioner for 1934, but, though it may well be that petitioner can not recover further on account of his claim against Sloan-Prospect Corporation, he still has the lease for which the entire capital outlay was also made. He is, therefore, not now entitled to the deduction of any amount by way of loss or otherwise except the pro rata annual amount necessary to recoup the balance of his unrecov-ered capital over the period of the lease.

Decision, will ~be entered wider Rule 50.

       SEC. 23. DEDUCTIONS FROM GROSS INCOME.
      In computing net income there shall be allowed as deductions :
      * * is * * * *
      (b) Interest. — All interest paid or accrued within the taxable year on' indebtedness, except on indebtedness incurred or continued to purchase or carry obligations (other than obligations of the united States issued after September 24, 1917, and originally subscribed for by the taxpayer) the interest upon which is wholly exempt from the taxes imposed by this title.

       SEC. 41. GENERAL RULE.
      The net income shall be computed upon the basis of the taxpayer’s annual accounting period (fiscal year or calendar year, as the ease may be) in accordance with the method of accounting regularly employed in Keeping the boohs of such taxpayer; but if no such method of accounting has been so employed, or if the method employed does not clearly reflect the income, the computation shall be made in accordance with such method as in the opinion of the Commissioner does clearly reflect the income. If the taxpayer’s annual accounting period is other than a fiscal year as defined in section 48 or if the taxpayer has no annual accounting period or does not Keep books, the net income shall be computed on the basis of the calendar year. (For use of inventories, see section 22 (c).)


author: Hill:

text:
    E. T. Weir, Petitioner, v. Commissioner of Internal Revenue, Respondent.
    Docket No. 85324.
    Promulgated February 10, 1939.

      Earl F. Reed, Esq., for the petitioner.

      Arthw W. Gamduff, Esq., and Chester O. Guy, Esq., for the respondent.
   OPINION.

Hill:

We are to determine in this case, first, whether petitioner is entitled, under section 23 (e), Revenue Act of 1932, to deduct from his gross income for 1932 the sum of $21,296.25 representing a capita] loss sustained by him in that year from the sale of 250 shares of preferred stock of the Bellefield Co. In denying such deduction, respondent stated in the deficiency letter:

7. In your return you claimed a loss of $21,296.25 on a transaction involving tlie Bellefield Company stock. It is field that the claimed deduction is based on a transaction which the Bureau can not recognize as giving rise to a loss deductible for income tax purposes.

Petitioner purchased the stock in 1925 and 1926 at a cost of $25,000, •and sold it in 1932 for the net sum of $3,703.75. Petitioner erroneously assumed that respondent denied the deduction on the ground that the transaction was not bona fide, and offered evidence to establish the circumstances surrounding the sale, which shows that it was made in good faith, and that he had no understanding or agreement with the purchaser, or anyone else, to reacquire the stock. But respondent raises'no question concerning the bona fides of the transaction, nor that petitioner in fact sustained a loss in the amount claimed. Respondent contends only that the loss was in the nature of personal or living expense, not allowable as a deduction under the provisions of the statute above quoted. For reasons presently appearing, it is unnecessary to determine the correctness of respondent’s contention that the loss was in the nature of personal or living expense.

The allowance of deductions from gross income for tax purposes is a matter within the sound discretion of Congress, and a taxpayer claiming a deduction must be able to point to an applicable statute and show that he comes clearly within its terms. New Colonial Ice Co. v. Helvering, 292 U. S. 435, 440; Van Vleck v. Commissioner, 80 Fed. (2d) 217; Davis v. United States, 87 Fed. (2d) 23.

Tbe statute applicable in the instant proceeding is quoted in footnote 1, supra, and in order to show that he comes within its terms, petitioner plainly has the burden of proving not only that the deduction represents a real loss resulting from a bona fide transaction, as he has done, but also that the loss was incurred either (1) in trade or business, or (2) in a transaction entered into for profit, though not connected with the trade or business. There is no contention that the loss in controversy was incurred in petitioner’s trade or business, and there is nothing in the record to suggest that such was the case.

In his brief petitioner argues that it is a legitimate inference from the facts in the record, although admitting there is no specific proof, that the Schenley Apartments were operated for the profit of the Bellefield Co., and that the stock which petitioner purchased was an ordinary investment which was expected to result in dividends to the owner, whether he was a tenant or not. We do not think petitioner’s burden of proof may be viewed so lightly. We may not indulge the assumption, predicated upon mere inference or conjecture, that the transaction giving rise to the claimed loss deduction was entered into for profit. Petitioner’s own testimony does not tend to support such a conclusion. He testified as follows:

Q. Why did you sell it (the Bellefield stock)?
A. To go back to the earlier years, when we moved into the Schenley Apartments, I wanted to have some ownership, so that I could have some influence in helping maintain certain standards— * * * The Bellefield Company owned the apartments, yes sir. We expected to live there permanently, and I bought 250 shares of stock, so that I would be a stockholder in the apartment, and I held the stock until 1932.

Petitioner stated that prior to the expiration of his lease he entered into negotiations for a substantial reduction of the rental, but at that time was unable to secure a satisfactory adjustment. Pie then testified:

* * * at the same time I was building a home outside of the city, about 40 miles, so we decided we would not renew the lease, and would move out of the apartment. That being the case, I had no interest in owning any stock in the apartment, so I told Mr. Hesse to sell the stock.

Subsequently, the rental having been reduced, petitioner decided to renew his lease and remain as a tenant. Accordingly, he repurchased the same stock which he had previously sold. He testified in that connection:

* * * we decided to make a lease with them on the basis of $10,000 a year; and I told Mr. Hesse that, if we were to stay there as tenants, I would want to own the stock for the same purpose for which I bought it, and I told Mr. Hesse to buy the stock back.

Petitioner was a man of substantial means; his net income as determined by respondent for the taxable year 1932 was $292,154.68. Obviously, he could well afford to gratify Ms desire to exercise some control over the management of the company which owned the apartments in which ho resided, through ownership of its stock, without regard to whether or not such stock constituted a profitable investment. In our opinion petitioner’s testimony does not establish that his purchase of the stock in the Bellefield Co. was a transaction entered hito for profit. He has wholly failed to establish that the deduction claimed comes within the purview of the applicable statute.

Respondent’s determination of the first issue is approved.

The second issue is whether or not respondent erred in including in petitioner’s gross income the amounts paid during the taxable years to petitioner’s former wife by the trustee pursuant to the provisions of the trust instrument referred to in our findings of fact above. On May 29, 1924, petitioner executed the trust agreement, which was also signed by the trustee and petitioner’s then wife, Mary K. Weir. Two days later, on May 31, the wife filed a libel for divorce and on December 23 of the same year the court granted her an absolute divorce without any provision for property settlement or alimony. The parties resided in Pennsylvania.

The first paragraph of the trust instrument recited that petitioner (grantor) transferred to the trustee the property therein described, in consideration of the release by his wife (the beneficiary) of all right of dower and any other interest which she had in his estate or property growing out of or in anywise connected with the marriage relation, as set out in the third paragraph of the instrument. In the fourth paragraph, petitioner released his right of curtesy in the estate or property of his wife. Thus, the trust instrument clearly constituted a settlement of the property rights of petitioner and his wife, and obviously was executed in contemplation of the divorce action which was instituted by the wife two days thereafter. The income of the trust property was payable to petitioner’s wife during her lifetime, and petitioner guaranteed that the amount of such income, in addition to the use of the residential property or the income therefrom if rented or sold, would not be less than $18,000 per annum. If the income in any year should be insufficient to pay to his wife such sum, petitioner agreed to make up the deficiency. All trust expenses, including income and other taxes levied on the $18,000, were to be paid by petitioner. Upon the death of the wife, the trust was to be terminated and the property distributed among the three children of herself and petitioner.

Respondent contends that the income of the trust which was paid to petitioner’s former wife during the years 1932 and 1933 is properly taxable to him under the doctrine of Douglas v. Willcuts, 296 U. S. 1, wherein it was held that the income of a trust used to discharge a legal obligation of the grantor is taxable to the grantor. Numerous subsequent decisions both of the Board and the courts have followed the cited case, and other cases, distinguishable on the facts, have been held not to come within the stated rule. Application of the rule clearly depends upon whether the trust income was used to discharge a legal obligation of the grantor, whatever may be the precise nature of such obligation. In the Douglas case, supra, the trust income was held taxable to the grantor, because under the trust agreement, made pending divorce, such income was payable to the wife in lieu of alimony and property rights, and discharged the grantor’s general legal obligations to support, made specific by decree. Some of the subsequent decisions, in so far as pertinent, will be discussed below.

While petitioner concedes that the doctrine of Douglas v. Willcuts, supra, and similar decisions, is that the grantor of the trust is taxable upon the trust income where it is currently applied to the satisfaction of a continuing obligation on the part of the grantor, he contends that in the instant case there was no continuing obligation on the part of the grantor. He argues that the trust agreement embraced a fully executed transaction in that each party made an immediate release of a contingent dower or curtesy interest in the other’s property, and petitioner made an irrevocable and immediate grant of the trust estate to Mrs. Weir and their three children. Petitioner further points out that when the wife was granted an absolute divorce in 1924, under Pennsylvania law petitioner was relieved of his obligation to provide support and maintenance, and thereafter he was under no legal duties whatsoever to his former wife.

We can not agree with petitioner’s argument. Under the facts presented, his position, we think, is untenable. There was a continuing legal obligation on the part of the petitioner, created by the trust instrument, which was discharged pro ta/nto by payments in the taxable years of the trust income to his former wife. Petitioner in effect acquired the interest of his wife in his estate or property in consideration of his agreement to pay her $18,000 per year during her lifetime, in addition to the use of or income from the residential property. The trust was in the nature of collateral security to insure payment of the agreed compensation. Whether or not the income of the trust was sufficient, petitioner was obligated to pay to his wife the stipulated amount.

If the trust had not been created and petitioner had used the income from the property to pay to his former wife the annual amount agreed upon as consideration for the release of her dower interest in his estate, there can be no doubt that such income would be taxable to him. The creation of the trust as a means of securing payment does not render the income any the less attributable to petitioner. Under the trust agreement the income was to be used to satisfy his legal obligation arising from the contract. Also, the fact that the agreement was irrevocable and upon the death of petitioner’s former wife the trust property is to be distributed to' their three children, is immaterial. He retained the beneficial interest in the property during her lifetime by requiring the income to be used to discharge his contractual obligation.

It is unimportant whether or not petitioner made a profitable bargain with his wife. It is true that he released his right of curtesy in her estate and she released her dower interest in his property, but such release on the part of the one was not necessarily the moving consideration for the release on the part of the other. The wife may have owned but little if any property, and petitioner may and apparently did possess an estate of very large value. In any event, petitioner agreed to pay his wife, in consideration of her release, the sum stipulated in the trust instrument, and obviously the parties did not contemplate that petitioner should be relieved of his obligation in the event the wife obtained a divorce.

The fact that the wife was subsequently granted an absolute divorce, without any provision for property settlement or alimony, and thereafter petitioner was under no legal duty to her growing out of the marital relation, does not in anywise vitiate the obligation assumed by petitioner pursuant to the terms of the trust agreement. In Robert Glendinning et al., Executors, 36 B. T. A. 486; aff'd., 97 Fed. (2d) 51, we held that a legal obligation arose from the trust agreement itself, and the income was, therefore, taxable to the husband, the grantor of the trust, notwithstanding that in the absence of such agreement his obligation to support and maintain his wife would have been terminated under the law of Pennsylvania by her divorce and remarriage.

In Helvering v. Brooks, 82 Fed. (2d) 173, reversing 31 B. T. A. 70, the essential facts were similar to those of the instant proceeding. There the husband created an irrevocable trust which provided for the payment of $12,000 per year to the wife out of the trust income, as a settlement of their property rights arising from the relationship of the marriage. The wife was then suing her husband for divorce, and the decree subsequently entered contained no provision as to alimony or property rights of the wife. The court held that the income was taxable to the husband, saying:

The taxpayer argues that there is a distinction between an agreement to pay alimony and an agreement for the settlement of property rights between husband and wife. The asserted distinction is without substance on the present issue. Whether the trust income is used to discharge the husband’s duty, made specific by agreement, to support the wife, or to discharge an obligation to pay tier agreed, sums for a release of rights in his property, can not be material in determining tbe taxability of tbe husband. Tbe creation of a trust the income of which is to be used to discharge any legial obligation of the settlor enables him to enjoy the benefit of the income; hence the income is properly taxable to him (citing authorities which include among others Douglas v. Willouts, supra). Indeed, in the Douglas case itself the trust provisions for the wife were in settlement not only of alimony but also “of any and all dower rights or statutory interests in the estate” of the husband, and the court pointed out * * * that this did not affect the essential quality of the payments. [Italics supplied.]

Cf. Commissioner v. Hyde, 82 Fed. (2d) 174, reversing 31 B. T. A. 256; Albert C. Whitaker, 33 B. T. A. 865, 868; and Thorne Donnelley, 37 B. T. A. 90.

Petitioner cites Henry Oliver Rea, 35 B. T. A. 1132, as controlling under the facts of the present case. Such contention overlooks an important difference in the facts. In that proceeding we held that the trust income, which was payable to the wife during her lifetime and after her death to the two children, with contingent remainder over to the grantor, constituted a mere gift to the wife. The transfer was wholly without consideration, and the payment of the income to the wife did not discharge any legal obligation of the grantor. This is plainly indicated by the following quotation from our opinion at page 1134:

The trust agreement does not show on its face that it was created to provide income for the support of the wife or in lieu of alimony, or that it constituted a settlement of the rights of the parties growing out of the marital relationship existing between them. It does not refer to a contemplated separation of the parties and contains no waiver or relinquishment by the wife of support or of her interest in petitioner’s estate. * * * The instant proceeding is distinguishable from the above eases [including Douglas v. Willcuts, supra] involving income from trusts created by the husband for the wife in that therein either the separation agreement, decree of the court, or stipulation of the taxpayer and the Commissioner disclosed that the income involved was provided for and paid in lieu of alimony or the wife’s interests in the husband’s property. Furthermore, in all of the above cases there was an existing legal obligation on the part of the taxpayer, which obligation was discharged with the income derived from the trust created by the taxpayer.

Cf. Edward T. Hall, 36 B. T. A. 398.

Petitioner also cites Commissioner v. Tuttle, 89 Fed. (2d) 112, affirming 31 B. T. A. 782, as controlling in the present proceeding. However, the opinion of the court clearly distinguishes that decision on two material points from the case at bar. It was there held that the income from a trust created for the benefit of the taxpayer’s wife was not taxable to him for the reason, first, that under Michigan law the settlement was not alimony but analogous to a lump-sum property settlement. The second point stressed by the court was that the transfer was absolute, and there remained' no continuing obligation on the part of the taxpayer for support or maintenance, and no debt to be paid out of his income, either actually or constructively. Upon the creation of the trust the grantor’s obligations to his wife under both, the contract and the decree were fully and finally liquidated.

On the second issue respondent’s determination is approved.

Decisión will be entered wider Bule 50.

       SEC. 23. deductions FROM GROSS INCOME.
      In computing net income there shall be allowed as deductions :
      * # s * * * *

      (e) Losses by Individuals. — * * * in the case of an individual, losses sustained during the taxable year and not compensated for by insurance or otherwise—
      (1) if incurred in trade or business; or
      (2) if incurred in any transaction entered into for profit, though not connected with the trade or business; * * »


author: Van Fossan : Disney,

text:
    Schmoll Fils Associated, Inc., Petitioner v. Commissioner of Internal Revenue, Respondent.
    Docket Nos. 87536, 88000.
    Promulgated February 10, 1939.

      George A. Speigelberg, Esq., for the petitioner.

      John R. Wheeler, Esq., and William G. Buymann, Esq., for the respondent.
   OPINION.

Van Fossan :

The sole question in issue is whether the nonmatur-ing debentures issued by the petitioner are essentially certificates of preferred stock or are evidences of indebtedness. If the former, the semiannual payments thereon made by the petitioner are to be treated as dividends; if the latter, they constitute interest and are deductible as such under the statute.

In deciding questions of this character, our consideration is premised on certain basic principles, but the decision in each case turns upon the facts of that case. Northern Fire Apparatus Co., 11 B. T. A. 355; Proctor Shop, Inc., 30 B. T. A. 721; aff'd., 82 Fed. (2d) 792. The name given to a security is not determinative, but it is not to be ignored nor is it lightly to be assumed that the parties have given an erroneous name to their transaction. I. Unterberg & Co., 2 B. T. A. 274; Kentucky River Coal Corporation, 3 B. T. A. 644; H. R. DeMilt Co., 7 B. T. A. 7. The intention of the parties must be accorded great weight. Commissioner v. National Grange. Mutual Liability Co., 80 Fed. (2d) 816, affirming 31 B. T. A. 666. Therefore, we must look to the “debenture” itself; to the antecedent acts and the intent of the parties as expressed in the record; and to the records and actions of the petitioner reference the matter.

The respondent contends first that the debenture is so similar in terms to the preferred stock certificate as to be practically equivalent thereto and that, taken as a whole, the debenture exhibits stock ownership characteristics which “transcended all other interests.”

We do not agree. When the petitioner purchased all its preferred stock from the stockholders it terminated the relationship of corporation and preferred stockholders. The issuance of the debentures created a new and different contractual relationship with the purchasers of the debentures, the former stockholders. Their rights as preferred stockholders differed in certain basic respects from those which accrued as debenture holders.

The preferred stock was expressly so called and provided for payment of dividends. The holders of preferred stock had certain voting powers in event of contemplated dissolution, or on the question of the issue of additional preferred stock with preference over present preferred stock, or other change in preferences of preferred stock.

By express words appearing on the face of the debentures the corporation “acknowledged its indebtedness” and “promises to pay interest at the rate of Seven (7%) per cent per annum.” The debenture holders had no voting rights in any event and had no voice in management. The rights at law of a preferred stockholder differ materially from those of a debenture holder.

The word “debenture” is variously defined, but all to the same tenor — that it evidences a debt. Thus, in Bouvier’s Law Dictionary, “any instrument (other than a covering or trust deed) which either creates or agrees to create a debt in favor of one person or corporation or several persons or corporations or acknowledges such debt”; and in Funk and Wagnall’s Standard Dictionary, “an instrument, in the nature of a bond, given as an acknowledgment of a debt and providing for repayment out of some specified fund or source of income.”

Thus, though the terminology employed is only evidentiary and not conclusive, if any presumption exists, it is that the creation of an obligation styled a “debenture” is in recognition of a debt. Moreover, it would seem clear, on the face of the record, that the petitioner intended to create the debentures as an evidence of indebtedness. All of its preliminary resolutions and acts, together with the terminology used, so show. The corporate records and the treatment of the debentures in reports to the State of New York are consistent only with the debtor-creditor relationship.

The respondent’s argument that the debenture is essentially preferred stock is based chiefly on the facts that it does not contain a provision that the holder may unconditionally demand his money at a fixed time and that the “so-called” interest payment is payable out of the profits of the petitioner exclusively.

It has consistently been held that the provision that the obligation contains no fixed final due date or becomes payable at the option of the maker does not destroy its character as an indebtedness. In Helvering v. Richmond, Fredericksburg & Potomac Railroad Co., 90 Fed. (2d) 971, the court, in affirming the Board (33 B. T. A. 895) said:

The fact that the principal of the guaranteed stock is not demandable by the stockholder in the absence of default in the payment of the guaranteed dividends is not conclusive of a stock investment. In the light of the other attributes of the stock, this indicates rather a debt as to which there is a right of renewal so long as the interest is paid when due. There is nothing in the fact that the debt evidenced by the preferred stock is not payable at a fixed time which throws upon the holders thereof any of the risks with respect to the corporate enterprise which are characteristic of the position of the stockholder.

See also National Grange Mutual Liability Co., supra; Brush-Moore Newspapers, Inc., 37 B. T. A. 787.

To support bis contention tbat the provision requiring interest to be paid exclusively out of profits brands the debenture as stock, respondent relies on Commissioner v. O. P. P. Holding Corporation, 76 Fed. (2d) 11, affirming 30 B. T. A. 337; and Jewel Tea Co. v. United States, 90 Fed. (2d) 451.

In the O. P. P. Holding Corporation case the court affirmed the decision of the Board that the debenture bondholders in question wore in fact creditors. Though the discussion of the law by the court gives us some pause, we find no support for respondent’s position in the decision in this case.

In the Jewel Tea Co. case the question related to the deduction of premiums paid on retirement of preferred stock, the facts there being very different from those before us.

In H. R. DeMilt Co., supra, we had for consideration a case where the debentures bore interest payable out of the net profits arising from the business of the company. There we said that such fact was not controlling. We think that is equally true in the case at bar.

Bearing resemblances both to preferred stock and to corporate indebtedness, as the debentures do, the case is not free from doubt. Our problem is to determine to which type the resemblance is greater. Considering the apparent intent of the corporation, the expressed terms of the debenture, the factual and legal incidences of the same, and tlie absence of voting power or of otter right in corporate management, we are of the opinion that the debentures evidence the relationship of debtor and creditor and that the interest paid was, accordingly, deductible.

Reviewed by the Board.

Decision will be entered under Bule 50.

KeRN dissents.

Disney,

dissenting: I must dissent. Although feeling that the relation of debtor and creditor is lacking in the instant proceeding because of the lack of a definite time of maturity (Jewel Tea Co. v. United States, 90 Fed. (2d) 451), I shall discuss principally the fact that payment of interest is limited by being payable only from profits. In Commissioner v. O. P. P. Holding Corporation, 76 Fed. (2d) 11, the court laid down, I think, the sound distinction between a shareholder and a creditor as reflected in the difference between obligations being payable regardless of surplus, or payable limited to earnings. The court said:

* * * The final criterion between creditor and shareholder we believe to be the contingency of payment. The shareholder is entitled to nothing, prior to liquidation, except out of earnings. Even on liquidation, at least in New York, arrears of cumulative dividends are confined to earnings. Michael v. Cayey-Caguas Tobacco Co., 190 App. Div. 618, 180 N. Y. S. 532. These debenture bondholders were not so limited. The interest could be deferred, but it was not lost, though the company had no earnings; it could be collected, together with the principal, in 1954, from the corpus of the debtor’s property, regardless of whether there should be a surplus. See Warren v. King, 108 U. S. 389, 399, 2 S. Ct. 789, 27 L. Ed. 769. This distinction marks the vital difference between the shareholder and the creditor. The shareholder is an adventurer in the corporate business; he takes the risks, and profits from success. The creditor, in compensation for not sharing the profits, is to be paid independently of the risk of success, and gets a right to dip into the capital when the payment date arrives. The courts have very frequently been called upon to determine whether the rights of a claimant are those of shareholder or creditor. Each ease has turned on its special facts, and to cite them all would not be useful, if it were possible. We think all the decisions which we have examined may be harmonized by adopting the criterion above suggested. The decision of this court in Re Fechheimer Fishel Co., 212 P. 357, is entirely consistent with this view. There interest on the so-called bonds was to be paid only out of earnings, and upon liquidation or dissolution the whole residue of the corporate assets after payment of the debts was to go to the bondholders. * * *

In Warren v. King, 108 U. S. 389, though there were other circumstances, such as participation with common shares after payment of a certain percentage on both preferred and common stock, the Court emphasized, as reason for holding that there was no relation of debtor and creditor, the fact that the holder of the certificate could have no income unless there were net earnings; that interest was not to be paid “absolutely, as to a creditor, but only out of net earnings, the same fund out of which the dividends on common stock are to be paid. * * * Creditors may resort to the body of their debtor’s property for interest as well as principal. But these holders of preferred stock are limited, for any income or interest, to the net earnings.”

In Finance & Investment Corporation v. Burnet, 57 Fed. (2d) 444, the court stressed, among other reasons for holding that payments to preferred stockholders were dividends and not interest under section 234 (a) (2) of the Revenue Act of 1926 (the same as section 23 (b), Act of 1932, so far as here involved), the fact that the payments were out of net earnings, and that no express time is fixed for payment, without the exercise of an option at the election of the stockholder or the corporation. In the instant case there is, of course, no such right of election on the part of the certificate holder to receive payment of principal.

In Mercantile Trust Co. v. Baltimore & Ohio Railroad Co., 82 Fed. 360, there was involved a subscription by the State of Maryland to the Baltimore & Ohio Railroad Co. The Maryland statute provided that before any subscription to stock should be made, the stockholders of the company should bind the company to guaranty to the state payment “out of the profits of the organization” of 6 percent per annum until the profits enabled payment of a dividend of 6 percent, after which the state should be entitled to a perpetual dividend of 6 percent and no more (that is, no repayment of principal). The state had a right to six directors. The instrument was given, as required by the act. It was:

* * * Held that, the interest and dividends of the state being payable from “profits,” it did not become a creditor of the company, but a preferred stockholder, having no equitable lien on the property of the company which entitled the holders of the stock to dividends from the earnings of the road in the hands of receivers in preference to the payment of interest on mortgage indebtedness subsequently contracted.

In the body of the opinion, it is stated:

* * * If it had been the intention of the legislature that the position of the state should be that of creditor, or analogous to that of creditor, there would be no reason for resricting its rights to a payment out of profits. A creditor might be restricted to payment out of revenue, or out of net revenue, or out of revenue from which enough has been taken to pay operating expenses, repairs, and fixed charges; but a creditor who is never to be paid the principal of his debt, and is to have only an annual sum, and is restricted, as to that annual sum, to a payment out of profits, is but a preferred stockholder. * * *

Emphasis is placed upon the fact that payment is to be made out of profits, and to the fact that, if there were no profits, there would be no payment.

In the field of life insurance, effect has been given both to the fact that repayment of a “loan” was from a certain fund and to the lack of maturity, for it has been held that where a life insurance policy requires the insurer to advance on the sole security of the policy, sums less than the reserve thereon, the relation of debtor and creditor between the parties is not created. In Wagner v. Thieriot, 197 N. Y. S. 560, so holding, emphasis is laid upon the fact that the so-called “loan” upon the policy was “on the sole security thereof”, that the liability of the insurer was by such advancement fro tamto lessened, that the company was not in a position to press a claim against the estate of the decedent as a creditor, and that the beneficiary was entitled to receive only the amount of the policies, less the so-called “loan.” To the same effect is In re Hirsch, 4 Fed. Supp. 708, wherein it is held that repayment of a “loan” upon a policy is not, strictly speaking, a debt, but is an advancement entailing no personal liability, and merely reducing the amount which the insurance company may be called upon to pay, the insurance company having no claim provable in bankruptcy. In Board, of Assessors v. New York Life Insurance Co., 216 U. S. 517, the same conclusion is reached, and it is held that where a policyholder simply withdraws a portion of the reserve on his policy and there is no personal liability, it is not a loan or credit upon which the company can be taxed as such, even though a policyholder gives a note upon which interest is necessarily charged to adjust the account. The Court stated: “The so-called liability of the policyholder never exists as a personal liability, it never is a debt, but is merely a deduction in account from the sum that the plaintiffs ultimately must pay. In settling that account, interest will be computed on the item for the reason that we have mentioned, but the item never could be sued for, any more than any other single item of a mutual account that always shows a balance against the would-be plaintiff.” In Williams v. Union Central Co., 291 U. S. 170 (179), Board of Assessors v. New York Life Insurance Co., supra, is relied upon, in a similar situation of an advance against the reserve of a policy, and it was again affirmed that such advances do not create personal liability, or a debt of the insured, but are merely deductions from the sum that the company ultimately must pay — even though the advance is called a loan, and interest is computed in settling the account.

I believe that the position of the debenture holder here was that of having a lien or security upon a fund, the profits, for payment of interest, with no positive obligation to pay such interest and no obligation whatever to pay principal, and therefore no debt. The debenture twice refers to the principal money as “hereby secured.” A holder of security is not thereby a creditor, in the sense of being able to enforce personal liability. The instrument evidencing security is not evidence of the debt, which ordinarily is in the form of a note. Without such evidence of debt, the holder of security can not enforce in bankruptcy, or otherwise, a claim against the general assets of the person giving the security. The holder of security, in effect, has a contract to participate to a limited extent in certain assets. That, I think, is the position of the debenture holder here as to the interest. He is a participant, preferred over common stockholders during the taxable years in question here. We do not have before us the situation which might arise in the event of bankruptcy, dissolution, or liquidation. But even in that contingency, and as to principal, I think the relation of debtor and creditor did not exist between debenture holder and corporation; for the debenture holder is still only a participant' — a participant in whatever estate and entitled to share in whatever estate or assets the corporation has upon such bankruptcy, dissolution, or liquidation. The corporation as a going concern is under no obligation to pay the principal and payment thereof can in nowise be enforced. The only right which the debenture holder has as to principal is not against the corporation, but against its estate in bankruptcy, dissolution, or liquidation. One so circumscribed as to collection is not, it seems to me, a creditor; certainly his position, so limited to some portion of whatever assets are left upon the demise, so to speak, of the corporation, is more analogous to that of shareholder than of a creditor of the corporation.

In bankruptcy, that which is received by the distributee is commonly referred to as a dividend, which not only is the same term applied to distributions to shareholders, but serves to emphasize the fact that it is received as the result of a division of the assets of the bankrupt. Even sharper emphasis is accentuated in the instant matter, for the debenture provides that, after debts to banks and bankers, debenture holders shall receive “dividends or other payments.” A distribution of principal, possible only through dissolution, liquidation, or bankruptcy (in the absence of voluntary redemption) is thus plainly seen as not payment, but as sharing in a division of the assets of the corporation, by operation of law, necessarily on a plane of equality with all similarly situated. This is the nature of the right of a shareholder, or stockholder.

Moreover, the agreement that in the event of bankruptcy, liquidation, or dissolution the debenture holder would be in a position inferior to that of banks and bankers demonstrates that the debenture holder has a position inferior to that of a creditor — for the simple reason that no bank or banker (unless holding security, which is not the provision stated in the debenture) could arrogate to himself a position over that of common creditors. To do so would be to claim preference forbidden by law. Therefore every common creditor, on equality with banks and bankers, would take precedence over the debenture holder, by his own covenant and agreement — and he would be left a position less than that of common creditor. By the terms of the debenture he surrendered any better position. So long as common creditors held claims to be satisfied the debenture holder could not participate. This, however, is the position of a shareholder.

Moreover, as a matter of fact, there is nothing to indicate that the debts of the corporation were not entirely held by banks or bankers. By assignment of any other debts to banks or bankers they could become holders of all of the corporate debts. Such, banks and bankers, however, not being required to be secured creditors, it is obvious that petitioner has not shown that the debenture holders did not occupy a position inferior to and junior to that of the only creditors, and they common creditors — the position of a participant with common stockholders in the corporate assets after application thereof to satisfaction of rights of common creditors. This is the status, at best, of a preferred stockholder.

Another fact demonstrates analogy to stockholding: For two years no dividends were payable to common stockholders, surplus being accumulated during that time to pay the debenture interest — which was cumulative. The taxable years in question come within those two years, and we are constrained therefore to consider only the situation within that period. Vermont-Hydro Electric Corporation, 29 B. T. A. 1006; Pantlind Hotel Co., 23 B. T. A. 1207. Plainly, then, the debenture holders in the taxable years had a preference over common stockholders. If they were creditors, they were preferred creditors, for ordinary creditors have no right to have dividends (within the earnings) withheld from common stockholders. Yet they were not preferred creditors, for banks and bankers had priority over them, even though having unsecured claims. Patently this discloses a participation, for two years and including the taxable years, in a fund which would otherwise have belonged to and would have been distributable to, the stockholders. An ordinary creditor, in order to participate therein, would, in the absence of voluntary payment, have been obliged to levy upon such fund in order to preclude its distribution as dividends to common stockholders. The debenture holders, however, had a covenant or agreement beforehand protecting them in payment from the two-year surplus. This covenant I believe to be of the essential nature of sharing with the stockholders. It protected against the weakness in the ordinary creditor’s position, and is inconsistent therewith. I note that in In re Fechheimer Fishel Co., 212 Fed. 357, referred to above in Commissioner v. O. P. P. Holding Corporation, the court considered as characteristic of stock, and not characteristic of bonds, the same situation here involved in the taxable years, i. e., the fact that the debenture bond should be entitled to receive out of the earnings interest before any dividend should he paid on the stock, and that such interest should be cumulative. I conclude that the debenture holder is a shareholder, both during the two-year, period and in case of bankruptcy, liquidation, or dissolution, and that petitioner is not entitled to deduction for interest paid. Though definitions of “debt” or “indebtedness” vary greatly in breadth or strictness of view, dependent upon the statute or law being construed, deductions, such as interest, under the revenue law are to be strictly construed. A fair, and not a strict, definition of debt “contemplates not only an obligation upon the debtor to pay, but a reciprocal right on the part of the creditor to enforce payment by appropriate proceedings. 1 Jones on Mortgages (7th Ed.) § 265.”' — Guilford-Chester Water Co. v. Guilford, 141 Atl. 880 (883). Such right, to enforce payment as to principal, the debenture holder did not possess. He could only share with the stockholders in case of dissolution, liquidation, or bankruptcy. I can discern no reason for allowing a taxpayer to deduct interest upon principal for the payment of which he is not bound and is in nowise interested, for it is payable only out of his estate (bankrupt, dissolved, or liquidated) and therefore of interest only to those who share therein. The right of the debenture holders to interest was limited to profits and during the taxable years was preferred over the common stockholders.

Sternhagen and Harron agree with this dissent.