author: Leech:

text:
    Raymond J. Moore and Corinne B. Moore, Petitioners, et al.,
      v. Commissioner of Internal Revenue, Respondent.
    Docket Nos. 102439-102442, 102447, 102535, 104344.
    Promulgated December 18, 1941.

      Stanley S. Waite, Esq., for the petitioners.

      Oa-rroll Wa.lher, Esq., for the respondent.

       Proceedings of the following petitioners are consolidated herewith: E. S. Funsten ; E. M. Funsten; A. H. Kolmer and Grace M. Koliher; R. Fairfax Funsten; and R. IS. Funsten III.

   OPINION.

Leech:

Under Docket Nos. 102439, 102442, and 104344, the wife of the petitioner in interest is joined for the reason that joint returns were filed, but hereinafter only the husband in each case will be referred to as the petitioner.

The petitioners are all officers and/or employees of the R. E. Funsten Co. of St. Louis, Missouri, hereinafter designated as the company, and all filed their returns for the years here involved with the collector of internal revenue for the first district of Missouri.

On October 18, 1937, the company, by action of its directors, formally adopted a pension plan for its officers and employees to be thereafter selected in accordance with their value to the business, under which certain payments were to be made annually by the company to a trustee and administered by the latter under the direction of the manager of the plan, designated by the company, by providing for the payments of benefits or annuities to those officers and employees of the company upon their reaching the age of 65 years.

The St. Louis Union Trust Co. was designated as trustee under a formal declaration of trust. Ten of the officers and/or employees of the company were selected for participation in the benefits and were awarded specified endowments or annuities at age 65 or to be received by their designated beneficiaries at the death of the participant prior to that age. Among these were the six petitioners herein.

It was specifically provided by the pension plan and deed of trust that no portion of the funds paid each year by the company to the trustee was thereafter to be controlled or used for the benefit of the company in any way but was to inure to the sole benefit of the participants in the plan. As provided by the plan the amount of $33,261.60 was paid in 1937 by the company to the trustee as the original payment. This amount was invested in combination life insurance and annuity contracts on the lives of these petitioners and the other participants in the plan. These contracts of insurance were issued upon applications by the manager of the pension plan, who was joined in each instance by the insured upon whose life the policy was issued. Eight of the ten policies were issued by the Northwestern Mutual Life Insurance Co. and were in similar form. The remaining policies were issued by two other companies but the provisions were substantially similar and the type of insurance the same. Under each policy a fixed amount or an annuity was payable upon the insured reaching the age of 65. The face amount of the policy was payable upon the death of the insured before the maturity date.

Under all of these policies the beneficiary was the St. Louis Union Trust Co., trustee, and none of the insured had any right to change this beneficiary, but so long as they were participants in the pension fund they had the right to designate and change the beneficiaries of the death benefits payable by the pension fund. It was further provided that the payments to become due from the insurance company were to be made to the trustee without recognition of the insured or his heirs or representatives. By a rider to the policies it was provided that all rights stated in the policy as subject to exercise by the insured were to be exercised only by the trustee.

The pension fund provisions included the following:

In the event of the death of any pensioner before the pension becomes payable the entire proceeds of any life income contract or life insurance that may have been purchased on Ms or her life providing for payments equal to the amount of his pension, shall be paid to such person or persons and in such amounts and proportions, as shall have been designated by him or her in a written instrument addressed to the Trustee, or as designated in his or her last will and testament, or, in the absence of any such designations, to his or her administrators or executors.

In the two succeeding years, 1938 and 1939, payments were regularly made to the trustee by the company, which sums have been used by the trustee for the payment of the annual premiums on the policies in question. None of the policies here involved have matured and no payments have been made thereon by the companies issuing them.

Eespondent’s first contention is that the present employees’ pension plan is too broad in its provisions to fall within section 165 of the Eevenue Acts of 1936 and 1938, and is merely a plan whereby additional compensation is paid to certain officers and employees in the way of premiums upon insurance upon their lives.

We do not agree. The company has adopted a definite and specific plan to provide pensions and benefits payable to certain of its employees at 65 years of age or to their dependents if they die prior to reaching such age. These employees are chosen because of their value to the business of the company. To provide for the custody and maintenance of the funds which, under the plan, it pays in each year, a trustee has been formally appointed under a deed of trust. Under that plan and deed of trust the amounts paid by the company to the trustee pass from its possession and control, and are administered wholly for the benefit of the employees participating in the benefits awarded. Upon the payment of these moneys to the trustee the company loses all its rights thereto. It is evident that the creation of this plan and the trust is not a subterfuge by which earnings of the company are distributed to stockholders as such. Although the participant petitioners are stockholders, as well as employees, the monetary benefits were awarded to them as employees. These benefits bear no relation to their respective stock interests in the company. Cf. W. F. Parker, 38 B. T. A. 989. We think this trust is within the purview of section 165 of the Eevenue Acts of 1936 and 1938. Olson v. Commissioner, 67 Fed. (2d) 726; certiorari denied, 292 U. S. 637; K. R. Kingsbury, 31 B. T. A. 1126. See also T. D. 4973, C. B. 1940-1, p. 67.

This conclusion leaves only the question as to whether the expenditure by the trustee of the funds paid to the trust by the company, for premiums on combination life insurance and annuity' policies on the lives of the participants in the plan, constitutes a distribution of such funds by the trustee to these participants, under section 165, supra.

The respondent does not contend that if the trust is within the purview of section 165, supra, and if the present policies cover retirement annuities, the payments of premiums therefor by the trustee would constitute a distribution to the insured of the amount of the premium paid. Thus I. T. 3346, C. B. 1940-1, p. 62, includes the following:

* # * * * * *
(5) To the extent that the corporation’s share of such contributions is aiiplied toward the purchase of retirement annuity contracts for the benefit of employees, such amounts are not considered as having been received by the employees in the year or years in which such payments are so applied, and are not, therefore, required to be included in their returns for those years. Upon retirement the entire amount of each annuity payment will be taxable income to the employee if he made no contribution toward the purchase of the retirement annuity. If he made contributions, he will be taxed on the annuity payments in the manner and to the extent provided in section 22 (b) 2 of the Internal Revenue Code and article 22 (b) (2)-2 of Regulations 101.

Respondent's treatment of the entire premium in each case as income to the beneficiary of the policy when paid is based upon the assumption that these policies are in fact life insurance contracts until the insured reaches the age of 65, whereupon they are converted into annuity contracts. We think that assumption is unsound. All of the contracts were in effect from the payment of the first premium; by their terms they provided for annuity payments at the age of 65, and for this agreement the major portion of the premium is paid. There are two distinct features in the policies. One is a death benefit, and the other, a retirement endowment. The respective portions of the lump sum premium paid for the death benefit and the annuity are subject to computation. We think that the annuity feature of the contracts was not life insurance, but an annuity contract in form of an endowment from its issuance. In view of that conclusion, we hold that the payment of such portion of the premium as is applicable to that feature of the policies did not constitute a distribution and is therefore not taxable to these petitioners when paid by the trustee. Sec. 165, supra.

With respect to the death benefit feature of the contract, we think the answer is different. If these petitioners had taken out the poli-cíes on their lives, the benefits thereunder to be paid by the insurer to their designated beneficiaries, and the pension fund had merely been used as a source of payment of the premiums, these payments when made, would constitute income to the petitioners, since they would have received the direct benefits of these payments. N. Loring Danforth, 18 B. T. A. 1221. Although the conditions are not quite the same here, the distinction is so slight as not to be material. It is true that the present policies were taken out by and are the property of the trustee, to whom all the payments to be made thereunder by the insurers are payable. It is likewise true that the obligation of the insurer is not to the insured but to the trustee for the benefit of the pension fund, and that anything derived in the future in the way of either a lump sum payment or an annuity by the participating employee goes technically to him from the pension fund and not the insurer. However, the provisions of the pension plan permit the insured to designate the beneficiary of the payment which will be made by the pension fund in case of his death, and to change such beneficiary. It also provides that “In the event of the death of any pensioner before the pension becomes payable the entire proceeds of any life income contract or life insurance that may have been purchased on his or her life providing for payments equal to the amount of his pension, shall be paid to such person or persons and in such amounts and proportions, as shall have been designated by him or her in a written instrument addressed to the Trustee, or as designated in his or her last will and testament, or, in the absence of any such designations, to his or her administrators or executors.”

Considering the life feature of each of the policies here, together with the provisions of the pension plan, it would appear that from a practical standpoint the trustee is no more than a conduit from the insurer to the insured’s beneficiaries with respect to any payments made under the life insurance feature of each contract. In substance, each petitioner, in so far as the death benefit feature is concerned, stood in the same relation to the policy as if it were taken out by him upon his life and upon which the trustee paid the premiums for him.

We think, therefore, that payments by the trustee of that portion of the premium allocable to the life insurance features of these policies constituted distributions, to that extent, to the several petitioners and such portion of each premium is therefore taxable to them, respectively. Sec. 165, supra. See N. Loring Danforth, supra.

Reviewed by the Board.

Decisions will be entered under Bide 50.

Murdock, ArNOld, and DisNby dissent.

Hill dissents on points indicated in the headnote as numbers (1) and (2).

       SEC. 165. EMPLOYEES’ TRUSTS. [Act 1936.]
      A trust created by an employer as a part of a stock bonus, pension, or profit-sharing plan for the exclusive benefit of some or all of his employees, to which contributions are made by such employer, or employees, or both, for the purpose of distributing to such employees the earnings and principal of the fund accumulated by the trust in accordance with such plan, shall not be taxable under section 161, but the amount actually distributed or made available to any distributee shall be taxable to him in the .year in which so distributed or made available to the extent that it exceeds the amounts paid in by him. Such distributees shall for the purpose of the normal tax be allowed as credits against net income such part of the amount so distributed or made available as represents the items of interest specified in section 25 (a).
      [Noth. — Section 165 of the Revenue Act of 1938 is similar to the above in its provisions affecting the issue here presented.]


source: Caselaw Access Project

author: Van Fossan :

license: Public Domain

text:
    Estate of George M. Henderson, Deceased, Girard Trust Company, Executor, Petitioner, v. Commissioner of Internal Revenue, Respondent.
    Docket No. 104952.
    Promulgated December 23, 1941.

      Howard H. Yocum, Esq., for the petitioner.

      Eugene G. Smith, Esq., for the respondent.
   OPINION.

Van Fossan :

The sole issue, one purely of law, is whether or not Mary D. Henderson, wife of petitioner’s decedent, George M. Henderson, died intestate as to her residuary estate by reason of the violation of the rule against perpetuities or other infirmities inherent iii the terms of her will. The parties are in apparent agreement that if so, under the law of Pennsylvania, the estate of George M. Henderson would be entitled to one-third thereof, since he and his two children were the only heirs at law of his wife. (Purdon’s Pennsylvania Statutes Annotated, Title 20, ch. 1 § 2.)

Counsel for the respondent does not contend that the disposition by Mary D. Henderson of the income from the trust fund in the form of life estates therein was not valid. Hence it is unnecessary to discuss this point. However, he does argue that the entire principal, the income from which was bequeathed in the will, constituted her residuary estate and that she died intestate as to that estate.

Since the three subparagraphs (a), (b),and (c) of paragraph fifth of Mary D. Henderson’s will were couched in varying language and made separate provisions as to three beneficiaries, it is necessary to consider the paragraphs separately.

The law of the Commonwealth of Pennsylvania governing the vesting of estates follows the general rule and limits the period for the commencement of executory devises to “a life or lives in being and twenty-one years, allowing for the period of gestation.” In re Warren’s Estate, 320 Pa. 112; 182 Atl. 396.

“The rule against perpetuities is not one of construction, but of positive law, to be rigorously applied to true construction of wills, regardless of testator’s intention.” Headnote, In re Friday’s Estate, 313 Pa. 328; 170 Atl. 123. In that case the court stated:

The rule against perpetuities is a technical rule of law designed to measure the period during which the vesting of future interests may be postponed. It operates in frustration of the will or intent of the disposer of property. The rule should be applied boldly and without restraint in furthering the policy upon which it rests, but must be applied strictly according to its exact requirements. If the period testator has chosen may extend beyond the limits fixed by the rule, his provisions are void; but, if that period may not, under any circumstances, by the occurrence of events, extend beyond those limits, testator’s bequests are valid.

Subparagraph (a) of paragraph fifth of the will reads as follows:

(a) My Trustees are to pay over one-third of the income received from the trust funds to my husband, George M. Henderson, for and during the term of his natural life, and at his death the income of this one-third share shall go to my children, or their issue, share and share alike, per stirpes and not per capita, — the principal becoming a part of my residuary estate.

It is clear that this paragraph violated the rule against perpetuities. Under the above provisions the one-third interest in the trust funds may not ultimately vest within the limited period because the grandchildren of Mary D. Henderson who would take under the will may not be born until long after the death of the grandmother. In this situation it must be held that as to this interest the testatrix died intestate and the residuary estate passed to the heirs at law.

Subparagraph (b) reads as follows:

(b) Tbe income on a second one-tbird of my residuary estate shall go to my daughter, (Mrs.) Helen Sedgwick McHenry, during the term of her natural life, and at her death the income of this trust fund shall be paid to her surviving children share and share alike for and during the term of their natural Uves, with power to each of my daughter’s said children to will and bequeath their share of the principal. In the event of any of them dying intestate, then their share shall go to their brothers or sisters them surviving share and share alike.

The provision of this paragraph likewise is violative of the rule against perpetuities since it is possible the “surviving children” of the daughter may be born long after the death of the testatrix. The same consequence follows.

Subparagraph (c) is as follows:

(e) The third one-third share of the income of this trust fund, I direct shall be paid to my son, Robert Randolph Henderson, for and during the term of his natural life. In ease he dies unmarried or without issue, I direct that his share of the principal shall revert to my daughter, Helen Sedgwick McHenry.

This paragraph bequeaths a life estate to the son with no further provision as to the income. This bequest is valid and does not violate the rule against perpetuities.

The respondent contends, however, that while the will directs that in case the son dies unmarried or without issue his share of the principal shall pass to his sister, it makes no disposition in any other contingency and nowhere bequeaths to him any share. The respondent contends further that it would be impossible to determine what “his share of the principal” would be. We agree that the will is properly to be so criticized. The testatrix failed to dispose of any share that she might have thought or intended to give to her son or to his heirs or descendants. She made no clear devise of the corpus. Any attempted disposition failed for lack of definiteness. To read the paragraph as a devise of the corpus to the son would be to rewrite the will. Therefore, she died intestate as to that portion of the estate from which her son derived his income for life. In re Thompson’s Estate, 229 Pa. 542; 79 Atl. 173.

Thus it is, consequent on the above, that petitioner’s decedent takes not under the will, but by operation of law as provided in cases of intestacy.

The petitioner admits that the will was “inexpertly drawn” and as to paragraph (b), supra, violated the rule against perpetuities, but argues that the intention of the testatrix was apparent from the instrument itself and must control its construction, asserting that it was her dominant purpose to provide life interests for her husband and children. Had she been duly advised, it is claimed, she would have made disposition of the remainder with proper and legal limitations.

The simple fact is that with the exceptions above noted, testatrix’ will was so ineptly drawn as to be of no effect in law in passing title. The above quoted observations of the court in In re Friday’s Estate, supra, are pertinent. See also In re Thompson’s Estate, supra; In re Feeney’s Estate, 293 Pa. 273; 142 Atl. 284.

Decision will be entered under Bule 50.


author: Hill :

text:
    van Ameringen-Haebler, Inc., Petitioner, v. Commissioner of Internal Revenue, Respondent.
    Docket No. 101416.
    Promulgated December 23, 1941.

      J. F. Condon, Jr., Esq., for the petitioner.

      Charles Oliphant, Esq., for the respondent.
   OPINION.

Hill :

The sole issue for our determination is whether or not petitioner is entitled to a credit under section 26 (c) (1) or (c) (2) of the Kevenue Act of 1936. Petitioner contends that it is entitled to a credit under section 26 (c) (1), arguing that we must read the contracts together with the actions of petitioner and its officers as imposing a dividend restriction within the purview of section 26 (c)(1).

The basis for petitioner’s claim for credit under section 26 (c) (1) or section 26 (c) (2) must be found in the mortgage or deed of trust dated June 1, 1929, since that is the only instrument in evidence which was executed by petitioner prior to May 1, 1936. The provi-sioii of this instrument which relates to the restriction of dividend payments requires that petitioner “declare and/or pay no dividends whatever upon its common stock” so long as any bond is outstanding. Respondent contends that since this provision does not prohibit petitioner from paying dividends upon preferred stock there is no contractual restriction of dividends within the meaning of the statute.

We are of the opinion that the dividend restricting provision of the mortgage or deed of trust is not a provision which would be violated by the declaration of dividends upon the first preferred or preferred stocks of petitioner. Cf. Paraport Theatre Leasing Corporation, 44 B. T. A. 108. The arrears on the preferred stock of petitioner were greatly in excess of the net income of petitioner in the taxable years. Petitioner could have declared and paid a dividend on the first preferred or preferred stocks in payment of the arrearages. The fact that if petitioner had declared such a dividend continued operation of petitioner might have been impaired can not change the result. The statute is specific and allows the credit only where a provision, expressly dealing with the payment of dividends, of a contract executed by the taxpayer prior to May 1, 1986, would be violated by payment of a dividend. There is no provision in the contract under consideration which would be violated by payment of dividends other than on common stock. ' It is obvious, therefore, that petitioner is not entitled to a credit under section 26' (c)(1) of the Revenue Act of 1936.

Petitioner also contends that it is entitled to a credit under section 26 (c) (2) of the Revenue Act of 1936. Petitioner maintains that the mortgage or deed of trust dated June 1, 1929, required petitioner to pay bond amortization of $30,000 in each of the taxable years and that it did pay such amortization. Respondent admits that the mortgage instrument required petitioner to make the amortization payments in each of the taxable years and that the payments were made. He argues, however, that petitioner must be denied the credit on the ground that the mortgage instrument contained no provision expressly dealing with the disposition of earnings and profits of the taxable year which required the payment or irrevocable setting aside of amounts in discharge of a debt.

Petitioner’s argument on this point seems based on the premise that if petitioner were to pay the amortization on the bonds the payments must necessarily be made from earnings and profits. While we believe this premise to be false, the assumption of its truth would not entitle petitioner to prevail. The statute stipulates that the provision requiring the payments to be made be one dealing with earnings and profits of the taxable year. The controlling provision of the mortgage instrument of June 1,1929, merely required that petitioner “pay to the trustee on the first days of September, December, March and June in each and every year.” The mortgage instrument contains a provision which prevented a default or foreclosure on account of principal payments falling due prior to June 1, 1982, in the event that net profits of petitioner for the period of three months prior to the maturity date of such payment were less than $875. This provision, however, has no effect on events of the taxable year and can not be said to be one which “expressly deals with the disposition of earnings and profits of the taxable year.” Since there is no provision in the mortgage instrument for which the credit may be obtained, petitioner’s claim must fail. We do not feel that we may look to parol evidence to determine whether the mortgage instrument “expressly deals” with earnings and profits of the taxable years. Sandura Co., 45 B. T. A. 491.

In Lamm Lumber Co., 45 B. T. A. 1, we considered the case of a taxpayer which alleged that the circumstances were such that the payments were required to be made out of earnings and profits. There we held that, even where earnings and profits of the taxable year were applied to the payment made in discharge of a debt, such application without more is not sufficient to fulfill the requirement of the statute that the provision of the contract expressly deals with disposition of earnings and profits of the taxable year. More recently, in Eastern Building Corporation, 45 B. T. A. 188, 192, upon facts similar to those of the instant proceeding, we made the following statement:

Regardless of whether petitioner realized any earnings and profits in the taxable year, the regular annual payment was still required by the indenture of-trust. Without earnings, petitioner would have had to resort to some other manner of obtaining the necessary funds. This could have been done by applying accumulated surplus, if any, by the sale of assets, by issuing additional stocks or bonds, or by any other method of borrowing. Since the indenture does not require the payments to be from current earnings and profits or to be measured by current earnings and profits, it becomes immaterial whether the payments actually were out of earnings and profits of the taxable year. Provisions granting special exemptiqns are to be strictly construed. Helvering v. Northwest Steel Rolling Mills, 311 U. S. 46.

We are of the opinion that disposition of petitioner’s claim under section 26 (c) (2) of the Bevenue Act of 1936 is controlled by the Sandura, Lamm, and Eastern Building cases. Petitioner’s contention that section 26 (c) (1) and (2) as herein construed in its application to the facts here is unconstitutional and void is without merit. Helvering v. Northwest Steel Rolling Mills, Inc., 311 U. S. 46. Accordingly, respondent’s determination is sustained.

Decision will be entered for respondent.

       SEC. 20. CREDITS OF CORPORATIONS.
      In tho ease of a corporation the following credits shall be allowed to the extent provided in the various sections imposing tax—
      * * * * * * *
      (e) Contracts Restricting Payment op Dividends.—
      (1) Prohibition on payment op dividends. — An amount equal to the excess of the adjusted net Income over the aggregate of the amounts which can be distributed within the taxable year as dividends without violating a provision of a written contract executed by the corporation prior to May 1, 1936, which provision expressly deals with the payment of dividends. * * *
      (2) Disposition op profits op taxable year. — An amount equal to the portion of the earnings and profits of the taxable year which is required (by a provision of a written contract executed by the corporation prior to May 1, 1936, which provision expressly deals with the disposition of earnings and profits of the taxable year) to be paid within the taxable year in discharge of a debt, or to be irrevocably set aside within the taxable year for the discharge of a debt; to the extent that such amount has been so paid or set aside, ft ft ft


author: Mellott :

text:
    Forest Lawn Memorial Park Association, Inc., Petitioner, v. Commissioner of Internal Revenue, Respondent.
    Docket No. 102989.
    Promulgated December 26, 1941.

      Melvin D. Wilson, Esq., for the petitioner.

      Frank T. Horner, Esq., for the respondent.
   OPINION.

Mellott :

Petitioner’s first contention is that it is exempt from Federal income tax under the provisions of section 103 (5) of the Eevenue Act of 1932 and section 101 (5) of the Eevenue Acts of 1934 and 1936. These sections, which are identical in each act, provide that:

*******
The following organizations shall be exempt from taxation under this title—
(5) Cemetery companies owned and operated exclusively for the benefit of their members or which are not operated for profit; and any corporation chartered solely for burial purposes as a cemetery corporation and not permitted by its charter to engage in any business not necessarily incident to that purpose, no part of the net earnings of which inures to the benefit of any private shareholder or individual.

It has been held that the above section contains three statutory requisites for exemption, which are mutually independent, and that the presence of any of them creates an exemption. Commissioner v. Kensico Cemetery, 96 Fed. (2d) 594, affirming 35 B. T. A. 498. Petitioner contends that it qualifies for exemption under each and all of them.

Petitioner’s argument that it is a cemetery company owned and operated exclusively for the benefit of its members and hence within the first classification mentioned in the statute is not persuasive. The cemetery association (Forest Lawn Cemetery Association) probably qualifies under this provision, though whether it does or not is immaterial here. The provision was obviously intended to apply where individuals, by purchasing lots or rights of internment in a cemetery, thereby become entitled to membership in the association and to have a voice in its management. Under petitioner’s articles of incorporation no one is eligible for membership unless he owns property in the park of a value of at least $100, pays a membership fee of $10 and. such annual dues as the board of directors prescribe, and has been duly elected to membership. During the taxable years petitioner had approximately 25 members, it having deliberately limited its membership to not more than 30 in order that it not be handicapped, as was its predecessor, when meetings of membership were desired for the purpose of transacting business. Petitioner’s contention that its lot owners are its real members is also fallacious. They, at best, collectively constituted a reservoir from which members could be drawn.

The second requisite for exemption is much more favorable to petitioner. It provides for the exemption- of cemetery companies which “are not operated for profit.” Petitioner was organized in 1926 as a nonprofit cemetery corporation under the laws of California. The law permitting the organization of such corporations (sec. 593, Civil Code of California) prohibited the distribution of gains, profits, or dividends to the members thereof. Petitioner’s articles of incorporation specifically provide that it shall be operated without profit to any of its members, and its bylaws state that its profits must be expended in the improvement of the cemetery property or for the benefit of the association and can not be disbursed to any individual or corporation. The general manager of petitioner and one of its members both testified it was understood, when petitioner was organized, that its members would receive no dividends or distributions of any kind, and that even upon petitioner’s liquidation, its assets would not go to its members but would constitute a trust fund for the benefit of all the lot owners, to be used for the perpetual care and upkeep of the cemetery. The bylaw referred to above and the further provision that termination of membership should not entitle the member to participate in the assets of the corporation indicate that this understanding must, and will, be carried out..

Nor does the fact that petitioner derived some gain from its activities necessarily indicate that it is a cemetery company operated for profit. Obviously, it could not operate and maintain the large acreage devoted to cemetery purposes unless it realized some profit from its sales and services. On a number of occasions the courts and this Board have considered whether the conduct of certain activities at a profit justified the denial of an exemption which otherwise would have been allowed. Such activities have included use of properties by a corporation operated for religious, benevolent, scientific, and educational purposes to produce income through trading in wine, chocolate, and other articles, Trinidad v. Sagrada Orden de Predicadores, 263 U. S. 578; the conduct of an inn and the publication of books and periodicals, Unity School of Christianity, 4 B. T. A. 61; sale of oil to refineries, gas to distributing companies, farm products and water, and operation of a greenhouse and a cotton gin by an institution established for the care of orphans, Sand Springs Home, 6 B. T. A. 198; sale of ice and ice cream, Eugene Fruit Growers Association, 37 B. T. A. 993; publication and sale of a monthly magazine, American Society of Cinematographers, Inc., 42 B. T. A. 675; and lease of grazing rights, Koon Kreek Klub v. Thomas, 108 Fed. (2d) 616. The profit realized from these activities was, in each instance, exempted from income tax, emphasis being placed upon the destination of the income rather than its source. Where it was found that a corporation was organized for the purpose of engaging in an activity exempted from income tax, profits realized were held to be exempt if they were used to advance or further the tax-exempt purpose. As the Supreme Court stated in Trinidad v. Sagrada Orden de Predicadores, supra, “Evidently the exemption is made in recognition of the benefit which the public’ derives from corporate activities of the class named, and is intended to aid them when not conducted for private gain.” The predominant purpose for which petitioner was organized was to operate and maintain a cemetery for the interment of the dead. Any profits which it realized from any of its activities were used to advance and further this purpose, and, despite respondent’s contention to the contrary, hereinafter discussed, no part of its net earnings inured to the benefit of any private individual or shareholder. It was, therefore, not operated for profit and is entitled to the claimed exemption.

Practically all of respondent’s argument on brief is directed to the applicability of the third subdivision of the statute, which allows exemption to any corporation chartered solely for burial purposes as a cemetery corporation and not permitted by its charter to engage in any business not necessarily incident to that purpose, no part of the net earnings of which inures to the benefit of any private shareholder or individual. He contends that petitioner is not entitled to exemption under this provision because: (1) it engaged in several activities extraneous to the conduct of a nonprofit cemetery association; and (2) some of its profits inured to the benefit of private individuals. The activities listed as “extraneous” are the conduct of a mortuary, the sale of flowers, booklets, post cards, brochures, etc., and wedding services held in the two churches within the cemetery.

Petitioner urges that these activities are necessarily incident to its operation of a cemetery for burial purposes and cites several state court decisions. In State v. Lakewood Cemetery Association, 93 Minn. 191; 101 N. W. 161, a corporation organized under the laws of Minnesota for the purpose of procuring and holding lands to be used exclusively as a public cemetery or place for the burial of the dead, conducted a greenhouse in the cemetery for the purpose of growing flowers and plants to be used in beautifying the grounds. Any surplus stock not necessary for such use was sold for the benefit of the association. The Supreme Court of Minnesota held that the conduct of the greenhouse was not a use of the cemetery for other than cemetery purposes, and that the sale of the surplus flowers was but an incident to the general management. This court also held in State v. Lakewood Cemetery, 267 N. W. 510, that the same cemetery association was acting within its corporate rights and powers in engaging in the manufacture and sale to its lot owners of wooden and concrete burial vaults at a profit. To the same effect see Dries v. Evans Cemetery Co., 109 Pa. Super. 498; 167 Alt. 237.

In Wing v. Forest Lawn Cemetery Association, 15 Cal. (2d) 472; 101 Pac. (2d) 1099, an owner of burial-space in Forest Lawn Memorial Park brought an action against petitioner, the cemetery association, and the land company to enjoin the operation of a funeral director’s and embalming business on the premises of the cemetery. Section 608 of the Civil Code of California authorized corporations to acquire land to be held and occupied “exclusively as a cemetery for the burial of the dead.” The Supreme Court of the State of California interpreted the quoted phrase as permitting a cemetery company to operate a mortuary in the cemetery grounds, pointing out that, while cemeteries have been and are now used primarily for the burial of the dead, portions» of cemetery properties have been used for numerous other incidental purposes such as greenhouses, nurseries, chapels, administration buildings, tool houses, incinerators, storage for wooden and concrete vaults, and the manufacture of stone vaults, and that these and other practices had in many instances received judicial approbation. .The court said:

Manifestly the operation of a mortuary where bodies are prepared for interment or cremation is a much closer and more intimate incident of burial than the activities above referred to. We therefore conclude that cemetery lands may he used for such purposes as are incident to the burial of the dead, so long as the rights of the lot owners in their own lots and their rights of egress and ingress thereto are not invaded.

The court also said:

* * * we do not find that the operation of a mortuary is inconsistent with the holding and occupying of land “ewctusmely as a cemetery for the burial of the dead.”

Petitioner also calls our attention to two rulings issued by the respondent which seem to be contrary to the position which he now takes. In G. C. M. 20853, Cumulative Bulletin 1938-2, p. 166, he ruled that an association which operated a cemetery for the benefit of several churches was exempt from Federal income tax even though its income was derived from the sale of cemetery lots, wood and cement boxes, flowers, and from services rendered at funerals and in caring for the graves. In S. 991, Cumulative Bulletin No. 1 (1919), p. 198, he issued a similar ruling with respect to a cemetery company which manufactured and sold vaults, mausoleums, and other cemetery appliances and improvements, and also owned and operated greenhouses and conducted the business of florists. The latter ruling contains the statement that, “It seems clear that the greenhouse and florist business is but an incident of the cemetery.”

In our opinion all of the activities of petitioner, which respondent describes as extraneous to the conduct of a nonprofit cemetery organization, were carried on as incidents of petitioner’s principal function — the operation and maintenance of a cemetery for the burial of the dead. The cited cases and rulings strongly support this conclusion. It is true that some of the activities herein involved, such as the sale by petitioner of booklets, postcards, and pictures, and weddings held in the two churches within the cemetery without charge except for services, were not considered in the cases and rulings referred to above. It is clear, however, that they were engaged in by petitioner primarily for the purpose of advertising the cemetery and bringing to the attention of the public its beauty and desirability as a final resting place for the dead. If so, it seems that they were “necessarily incident” to the main purpose for which petitioner was created and hence within the ambit of the statute. (Sec. 103 (5) an,d 101 (5), supra.)

On brief respondent argues that the conduct of a mortuary, including as it does, all of the services normally rendered by an undertaker, is not a business exempt from income tax, and that to hold petitioner exempt from tax would be tantamount to exempting every individual or corporate entity engaged in the conduct of a mortuary or undertaking establishment. This argument is without merit. Exemption from tax under the statute could not be allowed to an undertaking establishment, the profits of which inure to the benefit of any private shareholder or individual. It can only be allowed to a cemetery association meeting the statutory requirements in recognition of the benefit which the public derives from its activities. Trinidad v. Sagrada Orden de Predicadores, supra. The statute recognizes that nonprofit organizations, operating and maintaining cemeteries for the burial of the dead, must of necessity be permitted to engage in activities necessarily incident to that purpose. The conduct of a mortuary in our judgment is such an activity. The fact that it is operated at a profit in competition with purely commercial ventures does not justify the denial of the exemption. “It is only when such profits or net income are used for private rather than public benefit that Congress has taxed them.” Unity School of Christianity, supra. Our holding that petitioner is exempt from tax does not and can not result in the exemption of every individual or corporate entity engaged in the conduct of a mortuary or undertaking establishment any more than the holding of the Board in the last cited case, e. g., exempted inn keepers and publishers from tax.

Kespondent’s contention that the profits of petitioner inure to the benefit of a private individual seems to be bottomed largely upon the fact that Eaton received substantial fees and commissions for his services and also received dividends from, or profited by the accretion to, the capital of the land and holding companies. The fees and commissions received by Eaton constituted reasonable compensation for his services in connection with the management and development of one of the largest and most beautiful cemeteries in the United States. While it is true that the land company received 50 percent of the gross proceeds of sales of lots and 60 percent of the gross proceeds of sales of niches, crypts, vaults, and other mausoleum-columbarium property, there is no evidence to support respondent’s statement on brief that the family of Eaton, through stock ownership, controlled either the land company or its parent company. Even if it be assumed that some of the stock of the parent or holding company was owned by Eaton and members of his family, though no showing to that effect has been made, and even if it be assumed that they benefited, as stockholders, from the profits which the land company realized from its transactions with petitioner, we do not think that this would justify a denial of the exemption to the petitioner. The statute requires only that no part of the “net earnings” of petitioner inure to the benefit of any private shareholder or individual. No part of petitioner’s net earnings was distributed to the land company or to Eaton. The profits realized by the land company from its dealings with petitioner, and the profits realized by petitioner from its sales and other activities are two separate and distinct matters. The profits of the land company are taxable because they inure to the benefit of its stockholders. The net earnings realized by petitioner are not taxable because they do not inure to the benefit of any private shareholder or individual. Neither the compensation paid to Eaton nor the amounts paid to the land company formed any part of petitioner’s net earnings. They were items which had to be deducted from its gross receipts in determining its net earnings. Cf. Commissioner v. Kensico Cemetery, supra.

While we prefer to rest our decision on the ground that petitioner is a cemetery company which is not operated for profit, and hence that it is exempt from tax under the second subdivision of the statute, we believe it also qualifies for exemption under the last subdivision. It follows that respondent erred in determining that petitioner was not exempt from Federal income tax.

Under issue two petitioner contends that it was prohibited by the provisions of a written contract executed by it prior to May 1, 1936, from paying dividends. Recognizing that its articles of incorporation do not constitute a written contract, it relies upon its membership certificates, which make each member, “subject to its articles of incorporation and bylaws and any and all amendments thereof * * *.” This, it says, constitutes a written contract and entitles it to the credit specified in section 26 (c) (1) of the Eevenue Act of 1936. In issue three petitioner urges that its failure to file timely income tax returns was due to reasonable cause and not to willful neglect, and that it is not therefore liable for any addition to tax under the provisions of sections 291 of the Revenue Acts of 1932 and 1934, and section 406 of the Revenue Act of 1935. Having held that petitioner is exempt from tax, it is unnecessary to decide either issue two or issue three.

Decision will he entered under Rule SO.


author: Leech :

text:
    Emma B. Maloy, Petitioner, v. Commissioner of Internal Revenue, Respondent.
    Docket Nos. 102526, 103339.
    Promulgated December 30, 1941.

      Ethan A. H. Shepley, Esq., and Hord W. Hardin, Esq., for the petitioner.

      OarroTl Walker, Esq., for the respondent.
   OPINION.

Leech :

We shall dispose first of the issue of the bar of the statute of limitations raised with respect to the deficiency determined for 1935. The two trusts in question were executed by petitioner in 1916. Under them she is entitled to the income of the trust corpus for life, with remainder over to her children. The deficiency asserted arises through the increase in her income for that year by the amount of the taxable capital gain received by the trustees upon a sale of certain trust assets, the entire proceeds of which sale have been retained as corpus and the percentage of gain taxable returned by the trustee. Respondent contends that petitioner is liable for tax upon the capital gains, as well as ordinary income of the trust, by reason of control retained by her in the trust instrument. Petitioner pleads and argues that, even were respondent correct in his contention, collection of any deficiency for the year 1935 is barred by the statute of limitations.

It is admitted that the bar of the statute has fallen in so far as the year 1935 is concerned unless the circumstances shown bring the question within section 275 (c) of the Revenue Act of 1934, providing:

If the taxpayer omits from gross income an amount properly includible therein which is in excess of 25 per centum of the amount of gross income stated in the return, the tax may be assessed, or a proceeding in court for the collection of such tax may be begun without assessment, at any time within 5 years after the return was filed.

The question is whether petitioner has omitted from gross income an amount properly includable therein which is in excess of 25 percent of the gross income as stated in the return. It is conceded that petitioner returned gross income in the amount of $43,413.17, but respondent contends that she has omitted capital gains in the amount of $22,155.32 received by these two trusts. Petitioner argues that even if capital gains in that amount, received by the trusts, were taxable to her, as respondent contends, only that portion thereof which was to be taken into account in computing her taxable income could be said to have been omitted, and this amount is admittedly less than 25 percent of the gross income reported.

We agree with petitioner. We think it evident that the term “gross income” as used in section 275 (c), supra, refers to the statutory gross income required to be reported on the return. The heading, “Gross Income”, on the form of the return calls for the inclusion there only of gross taxable income. That amount does not include that portion of capital gain which is not to be taken into account in computing taxable income, nor does it include nontaxable interest on Government securities. Section 275 (c) refers to the omission from gross income of an amount “properly includible therein”, which manifestly does not cover the nontaxable portion of the capital gain realized by the trusts, even if such gain was income to petitioner.

We hold that the assessment and collection of a deficiency for the year 1935 are barred.

In reference to the issues raised with respect to the years 1936 and 1937, the three trusts executed by petitioner, two of them in 1916 and the third in 1925, carried provisions which respondent contends empowered the petitioner, grantor, to revoke within the purview of section 166 of the Revenue Act of 1936, or, in any event, that she thereby retained such control over the administration of the corpus as to render her taxable on the income of each trust under section 22 (a) of the same act.

This provision, included in both of the trusts executed in 1916, reads as follows:

Provided, however, that during my lifetime they shall, when so requested by me in writing, sell any part or parts of said trust estate in the manner and for the consideration or considerations which I may in such request express, and they shall, whenever requested by me in writing so to do, invest any funds in their hands forming a part of the principal of said trust estate in the manner and by the purchase of such property as I may in such written request indicate; provided, always, that said Trustees may be able to obtain for such property to be sold the prices prescribed by me, and to purchase for the prices, and upon the terms prescribed by me, the property directed by me to be purchased, as aforesaid.

A similar provision, excepting tbe last proviso, was included in the trust executed in 1925. This was the only provision expressing a control retained by petitioner. By the two 1916 trusts the corpora were transferred to the St. Louis Union Trust Co. and a sister of the grantor, as trustees. The third trust deed made conveyance to that trust company as sole trustee. In each trust the trustees were granted power of management, control, conservation, sale, and reinvestment of the trust assets. In each, petitioner was made the life beneficiary of the income, with remainder over to designated parties. By subsequent indenture, dated December 30, 1935, petitioner transferred and assigned to her four children all her right, title, and interest under the trust executed by her in 1925.

For the years 1936 and 1937, the ordinary income received by the trustee under the two 1916 trusts was distributed by it to petitioner and reported in her returns for those years. The income for those years from the 1925 trust was distributed by the corporate trustee to petitioner’s children in accordance with the assignment theretofore made. These children were then of age and each individually returned the income received in such distribution. In those years the trustee of each of these trusts realized certain capital gains which were retained and added by the trustee to corpus. That portion of each of such gains subject to tax was reported upon the return filed by the trustee, and tax paid thereon.

Respondent argues that the provision of the trust instrument here-inbefore set out is so broad as to reserve to petitioner the right to revest in herself the corpus of each trust by requiring the trustee to convey such corpus to her for a nominal consideration and that petitioner is accordingly liable for tax on all income, including capital gains, of each trust under section 166, supra. We do not agree. If such a power had been retained, it would have been of great importance. Its exercise could have nullified the trusts. No such power is expressly reserved, although had that intent existed it would have been a simple matter to retain it in definite and unmistakable language. We think no construction of this provision as including such right, when it was not explicitly reserved, could have been made without a disregard of the cardinal duty of the trustee to safeguard and conserve the corpora of these trusts in the interest of both the life tenant and the remaindermen. In Charles T. Fisher, 28 B. T. A. 1164, and Percy N. Chandler, 41 B. T. A. 165, upon which respondent relies, the grantor specifically reserved to himself the right to reacquire the trust corpus, in one case at a nominal consideration fixed and in the other at any price that he desired to pay. Those cases are thus sharply distinguishable from the present one for that as well as other reasons. We think no right to require the sale to petitioner of the corpus of the trust at prices less than its market value was retained by the quoted provision.

The trust provision now under discussion is almost identical with that considered in Christopher L. Ward, 40 B. T. A. 225. There, as here, possession and control of the trust corpus had been delivered by the grantor to a corporate trustee under a trust for the benefit of the grantor’s wife and children. The trust instrument gave to the trustee the right to direct sales and reinvestments of trust corpus in substantially the same language as is used here. In that case, in holding that the retention, of such general power to direct investments could not be construed as giving the grantor the power to reacquire the trust corpus at less than its value, we said:

* * * The power of tlie petitioner to direct investments and sales of trust corpus was not a power to nullify a trust otherwise valid. Any exercise of such power to the detriment of the beneficiaries would he subject to restraint by a court of equity. A similar power in Benry A. B. Dunning, 36 B. T. A. 1222, was held not to require a disregard of the completed transfer to the trust and to tax the grantor on the trust income. We reach the same conclusion here.

On appeal, our decision in that case was reversed by the Third Circuit, 119 Fed. (2d) 207. The opinion of the court, however, implied no disagreement with our conclusion that the retention by the grantor of a power to direct investments did not bring that trust within section 166. The reason for the reversal was that on appeal the Commissioner, for the first time, raised the question of the applicability of section 22 (a) and, in view of the decision of the Supreme Court in Helvering v. Clifford, 309 U. S. 331, the proceeding was remanded to the Board for reconsideration by the Board to determine whether that section was applicable.

Our decision in Christopher L. Ward, supra, was followed by us in John P. Wilson, 42 B. T. A. 1260, where the facts were substantially similar. We adhere to the views expressed in those cases and hold that the trusts here involved do not come within the provisions of section 166.

Respondent argues alternatively that the income of these trusts was taxable to petitioner under section 22 (a) of the Revenue Act of 1936. We think that position, likewise, is unsound. The leading case on the point is Helvering v. Clifford, supra. The facts here bear slight resemblance to those in that case. Of the many rights and powers retained by the taxpayer in that case, only one is here reserved by the petitioner — the right to direct investments. Cf. Commissioner v. Betts, 123 Fed. (2d) 534. In the Clifford case the conveyance was for a short terna, only, with a reversion to the grantor, while here the conveyance is for the life of the grantor, with remainder over to her children. There the grantor retained possession and control of the securities in the trust by designating himself as trustee. He specifically retained the power not only to direct investments but to reinvest the income, and expressly exempted himself from restriction in the investment of trust funds. He retained the right to hold the securities in his own name as an individual. Moreover, the trust in that case contained other provisions restricting the rights and enjoyments of the beneficiaries in the income. Powers were there granted to the trustee, which were normally incidents of ownership.

Here the petitioner has transferred to a corporate trustee for all time the actual possession and control of the securities. Cf. Commissioner v. Barbour, 122 Fed. (2d) 165; Commissioner v. Woolley, 122 Fed. (2d) 167. She is to have only the income for life. Upon this income, for the years involved here, she has paid tax. Under the terms of the trust the corpus has passed beyond her control except as to its investment. It is impossible for her to use that corpus for her own purposes, directly or indirectly. This one power to direct investments which petitioner retained constituted no such “bundle of rights” as the Court in the Clifford case held to be a substantial retention of the benefits of ownership.

This leaves for consideration the issue with respect to the trust created March 20, 1935, by petitioner’s sister in income of which she was the beneficiary for life. In prior years the corporate trustee of this trust had invested part of the corpus in bonds for which it paid a premium above the face of the bond. Thereafter, and in the two taxable years here, under a recognized and accepted practice in trust institutions in St. Louis, the trustee credited to the income account of the trust the interest received on the bonds, less, in each case, an amount which, over the remaining term of the bond, would equal the premium paid. These amounts, deducted in each instance from the interest received, were credited by the trustee to the corpus account. This action was taken to maintain the corpus intact and avoid a distribution pf corpus to the life tenant.

In determining the deficiency, respondent, for the two years now in question, has increased petitioner’s income by the'amounts credited in such years by the trustee to the corpus account in the manner described. Respondent contends that these amounts constitute income distributable to petitioner and, consequently, taxable to her. He relies upon New York Life Insurance Co. v. Edwards, 271 U. S. 109, and Commissioner v. Central Republic Trust Co., 75 Fed. (2d) 708. These were cases where the owners of bonds undertook to deduct from income, as losses, the premiums paid in their purchase of the bonds. The deduction was denied on the ground that no actual losses had yet been sustained and could not be, until the bond was either sold or redeemed.

Here, we have a different question. No loss is claimed. Our inquiry is whether the petitioner is entitled to the amounts withheld from distribution to her and credited to corpus by the trustee to restore the amount of such corpus used by him in purchasing the security. It is clearly evident that if petitioner can not now force the trustee to pay to her the sums so applied, such amounts did not constitute income to her when'received by the trustee. The rule is well recognized that a trustee is under a legal duty to protect and conserve the trust assets and can not directly or indirectly distribute the corpus of the trust to the life tenant. Claude R. Branch, 40 B. T. A. 1044; affd., 114 Fed. (2d) 985. When the trustee invests the trust corpus in a wasting asset, this rule lays upon the trustee the obligation to withhold from distribution to the life tenant such portion of gross income as will make up this loss. Thus, the trustee may not distribute income from depre-ciable property without reserving and crediting to corpus the amount of such income representing the depreciation sustained. Freuler v. Helvering, 291 U. S. 35. It is recognized that the element of value in a bond, represented by the premium paid, decreases to the point where it passes out at maturity of the bond. We think, therefore, that the action of the trustee here was proper. The maintenance of the corpus in the interest of the remaindermen required it.

The petitioner is not taxable on these items of income set out in the stipulation as received by the trustee and credited to the corpus account of the several trusts.

Decision will be entered for the fetitioner.


text:
    Paul M. Nehring, Petitioner, et al.,
      v. Commissioner of Internal Revenue, Respondent.
    Docket Nos. 105406, 105407, 105408, 105409, 105410, 105411.
    Promulgated December 30, 1941.

      Thomas Dodd Healy, Esq., and Harold Stickler, Esq., for the petitioners- •

      John D. Kiley, Esq., for the respondent.

       Proceedings of the following petitioners are consolidated herewith: Elizabeth M. L. Nehring; Irene Edna Nehring; Paul A. Nehring, as Trustee of the Estate of Ruth Arlene Nehring, a Minor; Nehring Electrical Works ; and Paul A. Nehring,

   OPINION.

Van Fossan :

Kespondent submits as a matter of law that a contribution to a religious or charitable organization is not deductible unless the sum is actually paid to the donee.

As to corporations the law unquestionably is as respondent contends. The statute permits deductions for “contributions or gifts made within the taxable year.” Article 23 (q)-l of Eegulations 94 provides that

Corporations may deduct, for a taxable year beginning after December 31,1935, to tbe extent provided by section 23 (q), contributions or gifts to organizations referred to in that section, only for tbe taxable year in wbicb they are actually paid, regardless of when pledged and regardless of whether tbe boobs and récords of tbe corporation are kept on tbe cash receipts and disbursements basis or tbe accrual basis.

This regulation was promulgated by the Commissioner, with the approval of the Secretary, pursuant to the specific authority of section 23 (q) of the Revenue Act of 1936.' We believe it to be a valid and reasonable regulation. Therefore, as to the deductions claimed by the Nehring Co., which respondent allowed to the extent of sums paid out and denied as to the balance, we affirm the Commissioner.

As to the individual claims for deductions, the statutory situation is not quite so clear. The phraseology- of the statute is the same, i. e., “contributions or gifts made within the taxable year,” but there is no comparable regulation. Article 23 (o)-l does not lay down specifically that the sums must be “actually paid.”

It is to be noted that the individuals reported their income on a cash receipts and disbursements basis. A cogent argument could be predicated on this fact to the effect that since no cash was disbursed no deduction can be allowed. We need not, however, rest our decision on this single ground. The simple fact is that in the situation as it existed throughout 1936 and 1937, the taxable years, the individuals had not given up beyond recall their right to exercise dominion over the funds in question; they could have countermanded the instructions previously given the bookkeeper and withdrawn their several pledges. Walker v. Commissioner, 91 Fed. (2d) 297. There being no consideration, the gifts could not have been enforced nor could they have been held liable to anyone for such action. The action taken in the taxable years fell short of culminating the gifts. Whether in the peculiar set of facts the donations would have been allowable as deductions if the entries had been made on the books in the taxable years, we need not decide. For whatever consequence it has, the fact is the entries were not so made. Cf. Walker v. Commissioner, supra.

Under the facts here present it can not be held that petitioners “made within the taxable year(s)” the contributions in question. The majority of the payments out of the company funds actually took place in 1938, but that year is not before us.

Decisions will be entered under Bule 50.


author: Murdock :

text:
    Edith B. Bass, Petitioner, v. Commissioner of Internal Revenue, Respondent.
    Docket No. 105220.
    Promulgated December 30, 1941.

      Edward C. Thayer, Esq., and E. Barton Chapin, Esq., for tbe petitioner.

      Charles P. BeiUy, Esq., for the respondent.
   OPINION.

Murdock :

The petitioner argues that there was a recapitalization which, under the definition in section 112 (g) (1) (D) of the Bevenue Act of 1936, amounted to a reorganization and there was an exchange of stock for stock within section 112 (b) (3), so that no gain or loss from the transaction can be recognized. The Commissioner is not contending that taxable gain resulted from the transaction. He has determined that the issuance of the preferred stock to the holders of the common stock was a taxable dividend, and the issue is whether or not that determination is correct. The petitioner’s argument is somewhat beside the point, as are cases such as South Atlantic Steamship Line, 42 B. T. A. 705, and Skenandoa Rayon Corporation, 42 B. T. A. .1287, involving exchanges. She has not said in her briefs just what exchange she thinks took place, but she must reason either that one-half of the original common stock was exchanged for the preferred stock or that all of the original common stock was exchanged for the preferred and a different common stock, with the result, in either case, that the preferred could not have been received as a dividend on any of the original common stock, since that stock disappeared in the exchange. The Commissioner replies that the original common stock was not exchanged for new common stock and the preferred stock; instead, there was no real change in the common stock; the net result of the transaction was merely the issuance of the preferred stock; and the same result could have been reached directly by simply issuing the preferred stock. The petitioner argues that there was a substantial change in the common stock which made the last 600,000 shares quite different from the original 600,000 shares since each share “represented only half the interest it had formerly represented.” She concedes that the stock was the same in all respects save one, that in the beginning the stated value of the '600,000 shares was $6,000,000, whereas, afterwards, the stated value of the then outstanding 600,000 shares was $8,000,000. The question of whether or not for income tax purposes there was any substantial change in the common stock as a result of this transaction thus arises.

The stockholders themselves did nothing. The . voting trustees originally held a single certificate for 600,000 shares of common stock having no par value. The following events then took place on the same day: The voting trustees surrendered the certificate for 600,000 shares of common, a certificate for 300,000 shares of no par common, and a certificate for 30,000 shares of preferred were then made; the certificate for 300,000 shares of no par common was immediately canceled and a certificate for 600,000 shares of no par common was issued; changes were made on the books so that the aggregate stated value of $6,000,000, at which the original 600,000 shares of common were carried, was reduced to $3,000,000, and a stated value of $3,000,000 was put on the books for the 30,000 shares preferred. The voting trustees came to the transaction with a single certificate for 600,000 shares of no par common and went away with a certificate for 600,000 shares of no par common and a certificate for 30,000 shares of preferred.

It is proper to look through these steps to see what business purpose was accomplished and also to see what was accomplished for Federal income tax purposes. Cf. Gregory v. Helvering, 293 U. S. 465; art. 112 (a) (1), Regulations 94. The record fails to disclose any business purpose or substance in the surrender of the original certificate for 600,000 shares of no par common, the issuance of a certificate for 300,000 shares of that stock, the cancellation of that certificate, and the issuance of another certificate for 600,000 shares of the same kind of stock. The same result could have been reached, so far as this record shows, by merely issuing a certificate for 30,000 shares of preferred stock, allowing the voting trustees to retain the original certificate for 600,000 shares of no par common, and making book entries showing that 30,000 shares of preferred represented $3,000,000 of capital and the 600,000 common shares without par value had henceforth a stated value of $3,000,000. The stated value of the common stock could have been reduced without changing the certificate. All semblance of an exchange disappears if the steps taken in regard to the certificates for the common stock are disregarded.

. The stockholders in this transaction in reality surrendered nothing but merely received the new preferred stock. The common stock represented the entire ownership of the corporation prior to this transaction. After the transaction the preferred stock represented ownership to the extent of $3,000,000 only and the entire remaining ownership continued to be represented by the common stock. That is the usual result of a stock dividend. The result is not changed by reason of the devious route taken to accomplish it. Furthermore, the fact that there was a change in the stated value of the common stock on the books of the corporation does not change and is not inconsistent with the conclusion that there was a stock dividend issued.

The Supreme Court held in Koshland v. Helvering, 298 U. S. 441, that “where a stock dividend gives the stockholder an interest different from that which his former stockholdings represented he receives income.” The same Court held later, in Helvering v. Gowran, 302 U. S. 238, and in Helvering v. Pfeiffer, 302 U. S. 247, that a stock dividend paid in preferred stock to holders of common stock was income under the Constitution, even though it was exempt from tax under existing revenue acts. See also Frank J. and Hubert Kelly Trust, 38 B. T. A. 1014. The Court in those cases cited its earlier opinions in United States v. Phellis, 257 U. S. 156, and Rockefeller v. United States, 257 U. S. 176, in which the Court had said that the test of tax-ability of a corporate distribution lies in its effect upon the individual stockholder rather than upon the corporation or the stockholders as a group, and it does not matter that the value of the stock on which the distribution was made was thereby decreased. The normal result of declaring a dividend of any kind is to reduce the value of stock theretofore outstanding. The issuance of the preferred stock in the present case gave to the recipients an interest different from that represented by their former stockholdings. That was the intent and purpose of the change. The corporation had more than sufficient earnings accumulated after February 28', 1913, to pay a dividend equal to the value of this preferred stock. The petitioner concedes that the issuance of stock involving the capitalization of earnings could result in a taxable dividend, but contends that this was a “split-up” involving merely a change in the character and number of shares by which existing capital continued to be represented and was not a taxable dividend. It is immaterial that the corporation did not capitalize any earnings to support the issuance of the preferred stock, since section 115 (b) provides that “every distribution is made out of earnings or profits to the extent thereof.” The Commissioner did not err in taxing the distribution of the preferred as a dividend. The value of the stock has been stipulated.

Decision will be entered for the respondent.


author: Smith :

text:
    Lenox Clothes Shops, Inc., Petitioner, v. Commissioner of Internal Revenue, Respondent.
    Docket No. 101943.
    Promulgated December 30, 1941.

      Don M. Harlan, Esq., and T. S. Forward, G. P. A., for the petitioner.

      Philip M. Ciarle, Esq., for the respondent.
   OPINION.

Smith :

This is a proceeding for the redetermination of deficiencies in income and excess profits tax for the calendar years 1936 and 1937 as follows:

The questions in issue are:

(1) Whether the petitioner is entitled to file income tax returns for 1936 and 1937 on the installment basis.

(2) Whether the respondent erred in adding to the petitioner’s net incomes reported for 1936 and 1937:

Whether the respondent erred in disallowing the deduction from gross income of 1937 of:

Shrinkage in inventory_$6,741.31
Officers’ salaries_ 4,500.00
Bad debts_ 4,347.97

For convenience of treatment the several issues will be discussed separately.

Installment Basis.

The petitioner is a Michigan corporation which was organized on March 1, 1936. It filed its income tax returns for 1936 and 1937 with the- collector of internal revenue at Detroit.

The Kelly Furniture Sales Co. is a Michigan corporation with its principal place of business in Detroit. It sells furniture and other merchandise on the installment basis and for many years has made its returns upon the installment basis. In 1935 it opened a clothing department for the sale of women’s ready-to-wear. It began by selling for cash only. It found, however, that .its patrons demanded credit upon sales of articles of clothing the same as they were given credit in purchasing furniture and other merchandise from the company. In order to get trade the company was forced to make sales of women’s ready-to-wear upon the installment basis. All of the installment sales were made under title-retaining contracts. About the beginning of 1936 the company decided to expand its clothing department and sell men’s clothing as well as women’s ready-to-wear. It was further decided that it would be desirable to conduct the clothing department through a separate corporation.

Petitioner was organized on or about March 1, 1936, for the purpose of taking over the clothing department of the Kelly Furniture Sales Co. It acquired from that company its inventory of women’s wearing apparel and also installment accounts receivable in the amount of $2,693.66. It then acquired additional merchandise, including men’s clothing. It continued to make sales upon the installment basis the same as had been done by the former owner. During the years 1936 and 1937 from 85 to 90 percent of its sales were made on the installment basis. Each customer desiring to buy upon such basis signed a conditional sales agreement under which it was declared that title to the merchandise remained in the petitioner until fully paid for. The installment contracts generally provided that payments could be made over a period of from three months to one year. In some cases the installment payment period was less than three months and in a few cases, such as sales of fur coats, the credit period was for more than one year.

Articles of clothing sold on the installment basis were seldom repossessed by the petitioner. During its entire operations to date it has taken back under its title-retaining contracts only two fur coats.

The petitioner kept a card record of each article of clothing in stock. Upon this card was shown the cost of the article. Then, when a sale was made, the card showed the price at which the article was sold.

The petitioner kept its books of account in such a manner as to show the gross profit realized from its collections on installment contracts.

It filed, income tax returns for 1936 and 1937 upon the installment basis. It included in its gross profit the allocable part of the total profit which was received upon the installment collections made during each taxable year. That amount was shown, together with profits on cash sales, as its gross income. From such gross income it deducted salaries and other expenses which a taxpayer making its returns upon the installment basis is entitled to deduct.

In his deficiency notice the respondent stated:

On your return you reported Income on the installment basis.
It is found that the greater part of your sales are made on an extension of credit basis for from 2% weeks to 3 months, and therefore you do not qualify to report income upon the installment sales basis. It is also found that reporting income upon the installment sales basis does nor truly reflect income for the years 1936 and 1937. Tour income for said years has been computed on the accrual basis, in accordance with Section 31 of the Revenue Act of 1936 and the regulations promulgated thereunder.
Inasmuch as your method of reporting income has been changed from the installment sales basis to the accrual basis the balance of deferred income at December 31, 1936 in the amount of $15,809.88 is restored to income.

The deficiency notice shows the method by which the respondent determined the net income of the petitioner for each of the years 1936 and 1937 as follows:

1936
Adjustments to Net Income
Net income as disclosed by return- $1,238.16
Unallowable Deductions and Additional Income:
(a) Bad debts-$1,419.13
(b) Accrued income- 15, 809.88
(c) Discounts earned- 795.30 18,024.31
Net income as adjusted-$19,262. 47
1937
Adjustments to Net Income
Net income as disclosed by return-$6,118.30
Unallowable Deductions and Additional Income:
(a) Accrued income-$5,122.61
(b) Inventory- 6,741. 31
(e) Discounts_ . 46.17
(d) Advertising- 1,458.60
(e) Interest_ 196.79
(f) Michigan Sales tax- 48.66
(g) Overstatement deductions- . 60
(h) Officers salaries__ 4,500. 00
(i) Bad debts_ 4,347.97 22,462.71
Total. $28,581.01
Nontaxable Income and Additional Deductions:
(j) Unemployment insurance tax___ — -51.87
(k) Capital stock tax- 22.96 74.83
Net income as adjusted-$28,506.18

It will be noted that the respondent found in his deficiency notice that the greater part of the petitioner’s sales are made on an extension of credit basis for from two and one-half weeks to three months and that “therefore you do not qualify to report income upon the installment sales basis.” On brief the respondent contends that the evidence does not show that the extension of credit basis was for a longer period. We think, however, that'it does. The president of the petitioner testified that the usual term of credit was for a period of from three months to one year. The accounts receivable at the start of business on March 1, 1936, were in the amount of $2,693.66. At December 31, 1936, they were in the amount of $32,248.69, and at December 31, 1931, $49,121.64. The credit sales for 1937 were in the amount of $122,902.56. It would appear from the above facts and other facts contained in the record that the installment sales were generally for a period exceeding three months.

Section 41 of the Revenue Act of 1936 provides in part as follows:

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 case may be) in accordance with the method of accounting regularly employed in keeping the books of such taxpayer; but * .* * 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. * * *

Section 44 of the same act provides in part:

SEC. 44. INSTALLMENT BASIS.
(a) Dealers in Personal Property. — Under regulations prescribed by the Commissioner with the approval of the Secretary, a person who regularly sells or otherwise disposes of personal property on the installment plan may return as income therefrom in any taxable year that proportion of the installment payments actually received in that year which the gross profit realized or to be realized when payment is completed, bears to the total contract price.

The respondent contends that he has authority to deny to a taxpayer the installment basis of reporting in case he determines that the net income can not be correctly reflected by such basis; that, since he has found in his deficiency notice that “reporting income upon the installment sales basis does not truly reflect income of the years 1936 and 1937”, he is authorized to reject such basis of reporting. He has therefore attempted to put the petitioner upon the accrual basis.

The petitioner is a dealer in personal property “who regularly sells or otherwise disposes of personal property on the installment plan.” Under section 44 of the Revenue Act of 1936 the petitioner is entitled to make its returns upon the installment basis, provided they correctly reflect its net income. We are satisfied that they do. We have not here the complicated situation which was considered by the Board in Blum's, Inc., 7 B. T. A. 737. There a corporation had for many years been making its returns upon the accrual basis. It changed its method of reporting from the accrual basis to the installment basis in 1918 or 1919, but continued to accrue its expenses. We held that it was entitled to make such change.

The situation in the instant proceeding is much simpler. The petitioner began using the installment basis of reporting from the beginning of its business operations on March 1, 1936. In each of its returns for 1936 and 1937 it has reported as its gross income the profit included in its collections of installment sales during each year, and has made permissible deductions therefrom. This is in accordance with the Commissioner’s regulations. It made some errors in the reporting, but we are satisfied that these errors can easily be corrected.

The fact that the petitioner sells ready-to-wear clothing on the installment basis rather than pianos or furniture or other personal property is not material. Blum’s, Inc., supra, likewise sold men’s and women’s ready-to-wear upon the installment basis. To be sure, the clothing department was only one of the departments of that business, but we did not exclude the clothing department from the installment basis of reporting income.

We consider first the adjustment made by the respondent by adding to the net incomes reported for 1936 $15,809.88 and for 1937 $5,122.61 as “accrued income.” These amounts represented for 1936 the estimated profit to be realized upon the accounts receivable at December 31,1936, shown in the balance sheet as “deferred income”, and for 1937 the increase in such “deferred income.” Under the installment basis of reporting the petitioner is not required to account for such profit until the accounts receivable have been collected. The action of the respondent in adding these amounts to the petitioner’s reported net incomes for 1936 and 1937 is reversed.

The respondent also added to the petitioner’s gross incomes for 1936 and 1937 $795.30 and $46.17, respectively, for “discounts earned.” These amounts represent the petitioner’s gross profit on collections during 1936 and 1937 of installment accounts receivable taken over from the Kelly Furniture Sales Co. at March 1, 1936, of $2,693.66. But these amounts have already been included in the net incomes reported by the petitioner in its returns. The addition of these amounts is clearly a duplication regardless of whether the returns should be made on the installment basis or upon the accrual basis. The respondent does not contend otherwise in his brief. The action of the respondent upon this point is reversed.

Shrinkage in Inventory.

In its return for 1987 the petitioner deducted from gross income a reduction in the inventory made at the end of the year of $6,741.31. In its income tax return for 1936 the following instruction and answer appears:

6. State whether the inventories at the beginning and end of the taxable year were valued at cost, or cost or market, whichever is lower. If other basis was used, describe fully, state why used and the date inventory was last reconciled with stock.
[Answer] Cost.

It is the contention of the respondent herein that, inasmuch as inventories were not used by the petitioner in the computation of its net incomes for 1936 and 1937, and inasmuch as they are not necessary in the determination of the net incomes for either year, and since the petitioner in its return for 1936 elected to report its inventories on the cost basis, it may not change the basis of taking inventories for a subsequent year without the permission of the Commissioner, which clearly was not obtained in this case. It is the petitioner’s contention, on the other hand, that it did not intend to exercise an election by the answer which it made to the question propounded in the 1936 return. The testimony of the president is to the effect that the answer to the question made on the 1936 return was merely for the purpose of stating a fact; that the prices of merchandise did not decrease during the year 1936 and that therefore there was no' occasion for taking its inventories at December 31, 1936, at less than cost. The petitioner further submits that at the close of 1937 there was a decline in prices for merchandise, that such decline amounted on the average to at least 15 percent of the merchandise, and that for 1937 it was entitled to reprice its inventory at the close of 1937 so as to show an average decline in the value of its inventory of at least 15 percent.

We sustain the contention of the respondent upon this point. We think that the petitioner did elect to take its inventory in 1936 on the basis of “cost” rather than on the basis of “cost or market, whichever is lower.” The petitioner may not under the regulations of the Commissioner change- its basis without first having obtained permission of the Commissioner for such a change.

It is further to be noted that the profits for 1937 were computed upon the basis of cost of merchandise sold. In its return for 1937 the petitioner seeks to reduce its profit upon the collections of 1937 by an assumed loss which will result from sales in the future. We are of the opinion that in the circumstances of the case the petitioner is not entitled to the claimed deduction of the $6,741.31 in question.

Officers' Salaries.

The next question for consideration is whether the petitioner is entitled to deduct from the gross income of 1937 $4,500 representing the part of the salary which the petitioner owed its president, Charles E. Murphy, for that year. The salary credited to Murphy’s account for 1937 was $6,000. During 1937 the petitioner paid Murphy only $1,500, the balance of $4,500 was shown on the petitioner’s books of account at December 31, 1937, as an account payable. On March 1, 1938, the petitioner gave Murphy a promissory note in the amount of $4,500. Thereafter petitioner’s books of account showed a note payable to Murphy of $4,500 instead of an account payable. The note payable was satisfied on July 1, 1938, through the petitioner’s issuance to Murphy of $4,500 par value of its stock, which was accepted by Murphy as the equivalent of $4,500 cash. The petitioner claims the right to deduct from its gross income for 1937 the $4,500 in question.

The reason given by the respondent in his deficiency notice for the disallowance of the $4,500 is as follows:

Included in the deductions claimed on yoúr return for the year 1937 is accrued salary of C. R. Murphy and S. B. Murphy, his wife, in amount of $4,500.00 which was not paid during 1937 or during the first two and one-half months of 1938.
It appears that the accrual of $4,500.00 additional officers’ salaries for 1937 was merely a tentative entry and therefore said amount does not constitute an allowable deduction from gross income within the purview of Article 22 (a)-3, Regulations 94.

Article 22 (a)-3 of Regulations 94, referred to by the respondent in his deficiency notice, provides, so far as material: “If the services were rendered at a stipulated price, in the absence of evidence to the contrary such price would be presumed to be the fair value of the compensation received.”

The evidence relative to the deduction of the $4,500 salary which was disallowed by the respondent is most unsatisfactory. At the hearing of this proceeding the petitioner’s president, as a witness, was asked the question:

Q Was there any agreement between the corporation and yourself as to the amount of salary you were to receive for 1937?
A Not on the records, no.
Q You were paid, apparently according to the record here, $1,500 compensation in 1937. How was that paid, at the rate of $125 a month?
A I can’t tell you that. It was credited to my account. The boohs will show that.

The respondent does not question the reasonableness of an allowance of $6,000 as compensation for the petitioner’s president for 1937. The respondent claims that the $4,500 is not an allowable deduction under section 301 oí tlie Revenue Act of 1937 because it was not paid within 2% months after the close of the calendar year 1937. This would clearly be a sufficient ground for the disallowance of the claimed deduction provided Murphy or his family owned 50 percent or more of the capital stock of the petitioner. The evidence does not show whether he owned 50 percent or.more or less of the stock. The petitioner’s claim for the deduction of the $4,500 in question must be denied for lack of evidence.

Bad Debts.

The final point in issue is whether the petitioner is entitled to deduct from gross income for 1937 bad debts in the amount of $4,347.97. We have recognized in Blum’s, Inc., supra, that a taxpayer making its returns on the installment basis is entitled to deduct bad debts from gross income, but only in the amount that the bad debt charged oil represents the unrecovered cost of the merchandise included in the charge-off. The only reason given by the respondent in his deficiency notice for the disallowance of the bad debt deduction was “due to your failure to establish what amounts are allowable as bad debt charge-offs during the taxable year.”

The evidence plainly shows uncollectible installment accounts determined as worthless and charged off by the petitioner in 1937 in the amount of $4,347.97. The charge-off was made on the card records kept by the petitioner. Many of the accounts had been turned over to an attorney for collection. After much investigation it was found that a number of installment debtors who had not made any payments on their accounts for many months had moved from the city or could not be located. It further appears that the total amount of $4,347.97 of these bad debt accounts was charged off by journal entries.

In the compilation of the petitioner’s tax return for 1937 the accounts charged off were treated as collected. In other words, the profit to be reported in those accounts was returned as a part of petitioner’s gross income for 1937. This was in error. The petitioner was not required to include in its gross income the profit element in these bad debt charge-offs. That the petitioner had done so, however, is apparent from the following statement:

Installment accounts receivable 1/1/37-$32,248. 09
Installment sales 1937- 122,902. 06
155,151. 25
Installments collected 1937- 106,029. 61
Accounts receivable 12/31/37- 49,121.64

The balance sheet at December 31, 1937, after the charge-offs were made, shows accounts receivable $49,121.64. It is thus apparent that (.he $4,347.97 bad debt charged off is included in the $106,029.61 oí collections as the petitioner contends and as the petitioner’s president testified.

As we have indicated above, we held in Blurrds, Inc., supra, that the taxpayer was entitled to charge off as a bad debt only the unrecovered cost of the merchandise represented by the bad debts. The result of including in the petitioner’s collections for 1937 the bad debts charged off in the amount of $4,347.97 was to report in the gross income the element of profit in such uncollected accounts. The gross income is subject to adjustment to eliminate such profit. The petitioner is entitled to deduct as a bad debt the unrecovered cost included in the $4,347.97. Since the petitioner is entitled to a reduction of the gross income to the extent of the profit and to a deduction of the unrecovered cost as a bad debt, the result thus obtained is the same as was obtained by the treatment accorded to the transaction by the petitioner.

Accordingly, the action of the respondent in disallowing the exclusion from gross income of the profit and the deduction of the bad debt is reversed.

Eeviewed by the Board.

Decision will he entered wider Rule GO.

Tyson and KerN concur only in the result.

Mellott dissents.


text:
    Leslie H. Reed, Petitioner, v. Commissioner of Internal Revenue, Respondent. Charles C. Reed and Lillian H. Reed, Petitioners, v. Commissioner of Internal Revenue, Respondent. Lewis G. Larus, Petitioner, v. Commissioner of Internal Revenue, Respondent. Charles D. Larus, Jr., Petitioner, v. Commissioner of Internal Revenue, Respondent. John H. Reed, Petitioner, v. Commissioner of Internal Revenue, Respondent.
    Docket Nos. 102323, 102324, 102326, 102327, 102328.
    Promulgated December 30, 1941.

      Robert J. Hebcrle, Esq., and J. A. Leach., Jr., (J. P. A., for the petitioners.

      P. A. Bayer, Esq., for the respondent.
   OPINXOjST.

Hill :

Petitioner Leslie H. Reed claims in his petition the right to a bad debt deduction for the loss sustained in respect of the Investment notes held by him and that he erroneously claimed a deduction therefor as a capital loss in his income tax return. This petitioner also claims overpayment of tax which, he contends, would result from an allowance of a deduction of his loss as a bad debt.

The single issue for our determination is whether or not petitioners are entitled to deductions for debts ascertained to be partially worthless and charged off in the taxable year. Petitioners contend that they reasonably determined in 1936 that the collateral notes of Investment held by them were partially worthless and charged off the amounts of such worthlessness in their Federal income tax returns for that year. Respondent argues that the notes were exchanged for stock of Sutherland in the course of a tax-free exchange under which no loss can be recognized. He contends that, in any event, Investment ceased to exist in 1986, so that in the taxable year there was no debtor from which the debt was owing. He asserts that in the absence of a debtor there can be no debt and consequently no bad debt deduction. Finally, respondent maintains that, even if we should hold that petitioners are entitled to bad debt deductions, those parts of the deductions which represent collateral notes received by petitioners for accrued interest are not deductible because that interest had not been properly returned a,s income by petitioners.

Section 23 (k) of the Revenue Act of 1936 allows a deduction “in an amount not in excess of the part charged off” whore a taxpayer lias ascertained the debt to be partially worthless. Ho deduction for a partial bad debt need be taken even though the taxpayer has ascertained it to be partially worthless in a specific amount. He can either charge off the amount he has ascertained to be bad and take a partial bad debt deduction, or wait until some other event fixes the amount of his loss. This is entirely at the taxpayer’s option. Moock Electric Supply Co., 41 B. T. A. 1209.

The record discloses that in January 1936 petitioners -were advised of facts which rendered inescapable the conclusion that the debts represented by the Investment notes vrere partially worthless. The evidence does not disclose that prior to the acquisition of the Sutherland stock by petitioners there was an ascertainment of loss in any specified amount for bad debt or otherwise. The only evidence as to the amount of loss ascertained by petitioners is found in the computed loss taken as a deduction in their income tax returns. The computation of this loss was not made with respect to a debt wholly or partially worthless. It was not made with respect to debt at all. Such computation of loss wras made on the basis of the value of the stock received in exchange for the cancellation of the debt remaining after crediting cash payments and of the release of the mortgage securing such debts. The deductions taken in the returns represented capital losses sustained in exchange of property for stock of a corporation notwithstanding they were claimed in the returns as deductions for bad debts. Prior to such exchange there was no such ascertainment and charge-off in respect of total or partial worthlessness of debt as is required by section 23 (k) to warrant a deduction for bad debt. Upon the consummation of the exchange there remained no indebtedness of Investment or Miller to petitioners and, hence, no basis for a bad debt charge-off. We hold, l.heroíorc, (hat pcli tinner,s are not entitled in deductions for bad debts.

The parties to the proceedings have not presented or raised the question of whether the loss sustained was deductible as a capital loss, but, since it is our view that the loss was a capital loss instead of a loss for bad debt, we think such question inheres. It is apparent that whatever loss petitioners may have sustained resulted from and was determined by the exchange of their notes and the security back of them for stock of Sutherland. However, the petitioners insist that no such exchange was accomplished because the notes were not transferred to Sutherland. The facts show that the Investment notes were exchanged for the Miller notes, which in turn were delivered to the depositary for the noteholders’ committee. The depositary was instructed to deliver the Miller notes as Sutherland might direct. Sutherland directed the delivery to the trustee of the Miller mortgage. From the trustee, Sutherland received a release of that mortgage, thereby becoming the owner of the property free from any lien. The result was exactly the same as if the Investment notes had been transferred to Sutherland. We fail to perceive any reason why the transaction should not be viewed as a whole and held to be an exchange, even though neither the Investment notes nor the Miller notes were directly exchanged for the stock of Sutherland. Cf. Rockford Brick & Tile Co., 31 B. T. A. 537. All of the issued stock of Sutherland was received by the noteholders, including petitioners, in proportion to their respective interests in the property exchanged for the stock and, therefore, immediately after the exchange the noteholders were in control of Sutherland. We hold that it was an exchange within the meaning of section 112 (b) (5), Revenue Act of 1936, and that no loss can be recognized.

Decision will be entered for respondent.

       SEC. 112. RECOGNITION OF GAIN OR LOSS.
      * * * * o *

      (b) Exchanges Solely in Kind.—
      (5) Transfer to corporation controlled by transferor. — No gain or loss shall be recognized if property is transferred to a corporation by one or more persons solely in exchange for stock or securities in such corporation, and immediately after the exchange such person or persons are in control of the corporation; but in the caso of an exchange by two or more persons this paragraph shall apply only if the amount of the stock and securities received by each is substantially in proportion to his interest in the property prior to the exchange.