author: Mellott:

text:
    J. T. Sneed, Jr., Petitioner, v. Commissioner of Internal Revenue, Respondent.
    Docket No. 45694.
    Promulgated November 15, 1935.

      Harry G. Weeks, Esq., Walter G. Bussell, Esq., and Charles F. Keffer, Esq., for the petitioner.

      O. W. SweoJeer, Esq., and E. G. Sievers, Esq., for the respondent.
   SUPPLEMENTAL OPINION.

Mellott:

Decision in the above case, reported at 30 B. T. A. 1121, was promulgated June 29, 1934. Therein we stated that judgment would be entered under Rule 50. Before the entry of such judgment, petitioner filed certain motions, one of which asked that final judgment be withheld until the Supreme Court handed down a decision in the case of William E. Herring v. Commissioner. While this motion was not formally acted upon, final judgment was nevertheless withheld. Decision has now been rendered in that case, and is reported in 293 U. S. 322.

A motion was also filed before us “ to correct certain findings of fact ”; another “ to reopen and hear further testimony ”; and a third, “ to modify the opinion ” to make it accord with the views of the Supreme Court expressed in Herring v. Commissioner, supra. All of these motions were argued on February 4, 1935, but were not formally ruled upon. However, we permitted the introduction in evidence of a deed from H. M. Sneed to J. B. Sneed, dated January 2, 1913, conveying an undivided one-fourteenth interest in about 75,424 acres of land, formerly owned by J. T. Sneed, deceased. This evidence removed one question which we had in mind when the original findings of fact were made. We now find that the interest received by petitioner from his brother J. B. Sneed was an undivided one-seventh interest. We therefore eliminate from our findings of fact shown on page 1123 the following language:

Petitioner inherited a one-seventh interest in his father’s estate, or a one-fourteenth interest in the partnership lands. Petitioner’s brother, J. B. Sneed, inherited a like interest. About this time, the latter was in serious difficulty and heavily in debt. On some of his indebtedness petitioner and other relatives were secondarily liable. By deed dated June 7, 1913, recorded on June 18, 1913, acknowledging receipt of a cash consideration of $50,000, J. B. Sneed conveyed to petitioner a one-seventh undivided interest in the lands formerly owned by the partnership. (The record does not explain why J. B. Sneed purported to convey a greater interest than he had, which both parties agree upon brief was a one-seventh undivided interest in the father’s estate.)

And substitute the following:

Petitioner inherited a one-seventh interest in his father’s estate, or a one-fourteenth interest in the partnership lands. Petitioner’s brother, J. B. Sneed, inherited a like interest, tie- — J. B. Sneed — afterwards acquired an additional one-fourteenth interest from his brother, H. M. Sneed, and was therefore the owner of an undivided one-seventh interest. About this time, J. B. Sneed was in serious difficulty and heavily in debt. On some of his indebtedness petitioner and other relatives were secondarily liable. By deed dated June 7, 1913, recorded on June 18, 1913, acknowledging receipt of a cash consideration of $50,000, J. B. Sneed conveyed to petitioner his undivided one-seventh interest in the lands formerly owned by the partnership.

Under the motion to modify the opinion, which we now formally grant, we reaffirm our published decision except as herein modified. We adhere to our former conclusion that no sale of the J. B. Sneed interest to petitioner was accomplished until after petitioner’s marriage, and that the lands representing the purchased interest in the estate should be classified as community property; that the bonuses received should be taxed as separate or community income in accordance with the classification of the properties under lease as shown by Exhibits 1 and 2; that the delay rentals should be taxed as community income; and that respondent’s notice of a deficiency for 1925, issued after the statutory period had expired, cannot be considered.

There remains for our present consideration only the question of the allowance or disallowance of claimed depletion on income received under the leases in the form of (1) bonuses, and (2) delay rentals.

In our original decision we held that depletion is inseparably related to production, and unless there is production, no depletion of reserve is in fact sustained and no allowance therefor may be made. We refused to follow the ruling permitting the deduction of an allowance for depletion from income received as bonuses on leases in the situation described as: “ No oil being produced when the bonus was received, but future production practically assured because of near-by wells and geological indications.”

The Supreme Court in the Herring case, supra, held that we were in error in requiring production as a prerequisite to an allowance of depletion, stating in its opinion:

Tbe situation presented by tbe administrative rulings is this: A bonus is not a receipt from a sale of a capital asset and may not be returned as sucb; it is income in tbe year received; if any depletion is to be allowed against tbe receipt, tbe allowance must be claimed for tlie year of receipt; it cannot be allowed in any later year; if the taxpayer computes depletion upon tbe basis of cost or March 1, 1913 value he may deduct depletion from a bonus payment, irrespective of the sinking of a well or tbe production of any oil or gas; if, however, be elects to avail himself of the alternative method of computing deduction at a per cent of gross income, though the nature of the deduction is unchanged, he may not have any unless there be production within the taxable year; if the production be but trifling he may take a full percentage deduction upon the entire bonus, however disproportionate the allowance to the actual extraction of oil during the year. To condition the allowance on actual production, however small, or the imminent probability of production, and to deal in refinements as to the degree of probability of future production is in many cases to deny any deduction where the taxpayer elects to compute it under 204 (c) (2) (fiat percentage of gross income from the property) and permit it where he elects to compute it under 204 (e) (on the basis of cost). But the nature and the purpose of the allowance is the same in both cases, and we find neither statutory authority nor logical justification for withholding it in the one and granting it in the other; much less for making the decision turn upon the circumstance that no production is obtained within the year in which the bonus is paid.

This decision is binding upon us, and we therefore hold that as to the compensation received as bonuses, during the year 1926, amounting to $210,857.18, depletion must be allowed. All the bonuses in question were received by petitioner in January (or in the early part of the year) 1926, upon leases for periods of 10 years, and none of such leases expired during 1926. We therefore do not have for consideration any question of tax liability in the year of termination of the lease, on account of bonus paid at the execution of the lease, and under which no gas or oil has been extracted. Upon that question we express no opinion.

There remains for our consideration petitioner’s contention that depletion should be allowed upon the sums received as “ delay rentals.”

The so-called “ delay rental ” is the amount received in connection with the execution of an oil and gas lease of which Exhibit No. 4 in evidence herein is a typical example. This document is called an “ oil and gas lease ” and provides that for and in consideration of the sum of $9,600 (which the parties denominate a “ Bonus ”) and of the covenants and agreements thereinafter contained, certain property is granted, leased and let unto a lessee for the sole and only purpose of mining and operating for oil and gas. The lease is to remain in force for a term of ten years and as long thereafter as oil or gas is produced, The lessee agrees to deliver to the lessor one-eighth part of all oil produced and saved; to pay the lessor one eighth of the net proceeds from the sale of gas; to permit the lessor to have gas free of cost for all stoves and inside lights in the principal dwelling and to pay the lessor one eighth of the net proceeds from the sale of gas used, including casinghead gas at the wells. It does not require a well to be drilled, but contains the' following clause:

If no well be commenced on said land on or before the 26th day of May, 1927 (one. year after its execution) this lease shall terminate as to both parties unless the lessee on or before that date shall pay or tender to the lessor, * * * the sum of $160 f$l per acre], which shall operate as a rental and cover the privilege of deferring the commencement of a well for twelve months from said date. In like manner and upon like payment or tender the commencement of a well may &a further deferred for like periods of the same number of months successively. [Italics supplied.]

The question is whether the payments required by the above clause, are depletable.

In Herring v. Commissioner, supra, it is said: “ The bonus is not proceeds from the sale of property but payment in advance for oil and gas to be extracted.”

But the payments here in question are not payments in advance for oil and gas to be extracted. They are not bonuses. Nor do we think that they are royalties. The word “ royalty ” as used in a gas lease generally refers to “ a share of the product or profit reserved by the owner for permitting another to use the property.” Hill v. Roberts, 284 S. W. 246; National Gas Co. v. Stewart, 90 N. E. 384. It is compensation for the privilege of drilling and producing oil and gas and consists of a share in the product. Bellport v. Harrison, 255 Pac. 52.

The payments in question are in the nature of liquidated damages or penalties for failure to drill upon, or exploit, the properties. They are made and are required, not for extracting the oil, gas, or minerals, but for failing to do so. They merely “ cover the privilege of deferring commencement of a well ”, but are not required to be made if the property is developed.

The view herein expressed is consistent with the views of the Texas courts. Thus, it has been held that such payments merely operate to confer on the lessee the privilege of deferring operations and are in the nature of rents on the whole land. (Caruthers v. Leonard, 254 S. W. 179.) The clause authorizing such payments merely grants an option to make them in lieu of development (Texas Co. v. Davis, 255 S. W. 601), and should be regarded as a temporary expedient to preserve the rights of the lessee pending the beginning of actual efforts toward development. (Rosson v. Bennett, 294 S. W. 660.)

In the case of Crossett Timber & Development Co., 29 B. T. A. 705, we had before us the question whether or not depletion should be allowed upon a sum received in settlement of a claim that the lessee had not produced from petitioner’s lands, gas in accordance with the operating agreement. We there said:

It was demanded and paid, not for the right to enter upon and drill the lands, but as a penalty for failure to do so; it was not income from the property, nor “ income derived from the extraction of the oil ” or gas from the property (Palmer v. Bender, 287 U. S. 551), but was in. the nature of damages for the lessee’s breach of contract in failing to exploit the property. The taxing statute makes no provision for the deduction in such cases of allowances for depletion, and we sustain the respondent’s refusal to permit a deduction.

We are convinced that the reasoning in that case is sound. The income which we have under consideration here, like the income which we had before us in that case, is not “ income derived from the extraction of the oil or gas.” It is more “ in the nature of damages ” for the lessee’s failure to exploit the property.

In the recent case of Commissioner v. Wilson, 76 Fed. (2d) 766, the Fifth Circuit expresses the same view in the following language:

The “ delay rentals ” on oil and gas leases are rents within the rule just announced. They accrue by the mere lapse of time like any other rent. They do not depend on the finding or production of oil or gas and do not exhaust the substance of the land. While having some likeness to a bonus payment which is held to be advance royalty; Murphy Oil Co. v. Burnet, 287 U. S. 299; Burnet, Commissioner, v. Harmel, 287 U. S. 103, 53 S. Ct. 74 [11 Am. Fed. Tax Rep. 1085] ; the delay rental is not paid directly or indirectly for oil to be produced, but is for additional time in which to utilize the land. We hold it to be rent.

We are therefore of the opinion, and we so hold, that no depletion should be allowed upon the income received as “ delay rentals.”

The opinion promulgated June 29, 1934, is accordingly modified, and petitioner is allowed depletion upon the income received during the year 1926, as bonuses, in the amount of $210,857.18. Respondent’s determination that no depletion is allowable upon the income received as “ delay rentals ” is approved.

Judgment will he entered imder Bule 50.


source: Caselaw Access Project

author: Smith:

license: Public Domain

text:
    Flanders Investment Company, Petitioner, v. Commissioner of Internal Revenue, Respondent. L. O. Gordon, Petitioner, v. Commissioner of Internal Revenue, Respondent.
    Docket Nos. 53907, 53940.
    Promulgated November 19, 1935.

      Edwin C. Austin, Esq., and Albert W. Torhet, C. P. A., for the petitioners.

      Chester A. Gwirm, Esq., for the respondent.
   OPINION.

Smith:

These proceedings, consolidated for hearing, involve deficiencies in income tax as follows:

The petitions filed in these proceedings allege that the respondent erred in the computation of the deficiencies of each petitioner in holding that the receipt of certain shares of stock is to be treated the same as the receipt of cash; also that the respondent erred in the determination of the deficiency against the Flanders Investment Co. in that he has “ treated the sale of capital stock owned by the petitioner of Muskegon Motor Specialties Company as resulting in a profit to the petitioner, having treated the basis of such stock to the petitioner as the cost to a prior owner instead of the cost to the petitioner ”; and in the case of L. O. Gordon that he “ has erroneously included as a part of the taxable income of the petitioner capital stocks of two Corporations, parties to the reorganization, which were not received by him.”

Most of the material facts in both proceedings have been stipulated.

In 1928 the Muskegon Motor Specialties Co., incorporated under the laws of Michigan, hereinafter called Muskegon (Michigan), and the L. O. Gordon Manufacturing Co., likewise a Michigan corporation, were engaged in the manufacture of cam shafts. The officers and stockholders of these companies desired to consolidate the two corporations under a Delaware corporation to be formed and to be called Muskegon Motor Specialties Co. The new corporation is hereinafter referred to as Muskegon (Delaware). The plan was for the Delaware corporation to sell a portion of its capital stock to bankers for cash, which cash was to be received by the stockholders of the two Michigan corporations in addition to certain shares of stock of the new Delaware corporation.

Under date of November 7, 1928, a circular letter was sent to the stockholders of Muskegon (Michigan) which read in part as follows:

Recently the officers and directors of this Company have had under consideration a plan for the reorganization of the Company and its merger or consolidation with L. O. Gordon Manufacturing Company, a Michigan corporation, having its office and plant in the City of Muskegon, Michigan. Negotiations to effect such reorganization of this Company have been carried on with the officers and directors of said L. O. Gordon Manufacturing Company for several weeks past with the result that the- following plan for the consolidation or merger of said companies has been unanimously agreed upon by the officers and directors of both companies, by all of the stockholders of L. O. Gordon Manufacturing Company, and by 96% of the stockholders of this Company, and is now submitted to the remaining stockholders of this Company for their approval.
*******
In exchange for the shares of no par value stock now held by the stockholders of this Company, there will be issued to said stockholders shares of Class B stock of said new or consolidated corporation on the basis of 16% shares of said Class B. stock for each share of no par value stock now issued and outstanding and in addition to said stock there will be paid to the holders of the no par value stock of the present company in cash the sum of $171.30 per share.

Muskegon (Delaware) was incorporated on November 24, 1928, with an authorized capital stock of 62,500 shares of class A stock and 187,500 common shares, only 125,000 of which were presently to be issued. On November 27, 1928, Muskegon (Delaware) entered into a contract with certain bankers for the sale to them, for $1,385,000 cash, of 62,500 shares of its class A stock and 15,000 common shares. The agreement provided in part:

2. Upon the closing date hereinafter mentioned, the Company will issue 110,000 additional shares of its common stock and will pay cash aggregating $1,445,004.17 to the owners of the outstanding capital stock of the Gordon Company, consisting of 2,000 shares of the par value of $100 each, and to the owners of the outstanding capital stock of the Muskegon Company, consisting of 4,500.9 shares without par value, in proportions heretofore agreed upon by and between such owners, in exchange for all of the outstanding capital stock of said two companies.
3. The Company agrees that , upon the acquisition of the entire capital stock of the Gordon Company, it will cause said company to declare a dividend upon its outstanding stock to the Company in the amount of $60,004.17, so that the net cash cost to the Company of the acquisition of the entire outstanding capital stock of the Gordon Company and of the Muskegon Company will be $1,385,000, exclusive of organization and legal expenses.

On the same date, November 27, 1928, the board of directors of Muskegon (Delaware) adopted the following resolutions:

Resolved, that this Company shall cause to be organized under the laws of Delaware, a subsidiary corporation with the name Midland Investors, Inc., or other suitable name to be approved by the President or Vice-President of this Company, with an authorized capital stock consisting of 5,000 shares without par value, and which shall have general power to invest in and buy, seli and otherwise deal in stocks and securities and other property and to own and develop patents and trade-marks of all kinds, and that this Company shall subscribe and pay for 5,000 shares of the capital stock of said corporation when organized on the basis of Forty-five Dollars ($45) a share, payable in cash.
Resolved, that the Board of Directors of this Company does hereby authorize the issue to or upon the order of Mr. L. O. Gordon of Muskegon, Michigan, of 35,000 shares of the Common Stock of the Company and the delivery to or upon his order duly endorsed in blank of certificates for said 5,000 shares of said subsidiary corporation when organized and the payment to or upon the order of said L. O. Gordon of Fifteen Thousand Four Hundred Ninety-two and 40/100 Dollars ($15,492.40) in cash, all in consideration of said L. O. Gordon causing to be transferred and delivered to this Company certificates for 560 shares of the capital stock of the L. O. Gordon Manufacturing Company, a Michigan Corporation, fully paid and non-assessable, constituting with 1440 additional shares thereof hereinafter mentioned, the entire outstanding capital stock of said corporation; and the payment to the Union National Bank of Muskegon, Michigan, for the benefit of the holder of the remaining 1,440 shares of the capital stock of said D. O. Gordon Manufacturing Company, in exchange for certificates representing said stock, fully paid and non-assessable, the sum of Four-Hundred Thirty-Three Thousand Five Hundred Seven and 60/100 Dollars ($433,507.60) in cash; said cash to be provided out of the proceeds of the issue of the 62,500 shares of Class A stock authorized at this meeting.
Resolved, that this Company shall cause to be organized under the laws of Delaware, a' subsidiary corporation with the name Norton Securities Company, or other suitable name to be approved by the President or Vice-President of this Company, with an authorized capital stock consisting of 3,750 shares without par value, and ?which shall have general power to invest in and buy, sell and otherwise deal in stocks and securities and other property and to own and develop patents and trade-marks of all kind, and that this Company shall subscribe and pay for 3,750 shares of the capital stock of said corporation when organized on the basis of One Hundred Dollars ($100) a share, payable in cash.
Resolved, that the Board of Directors of this Company does hereby authorize the issue to or upon the order of Mr. Fred L. Flanders of Muskegon, Michigan, of 75,000 shares of the Common Stock of the Company and the delivery to or upon his order duly endorsed in blank of certificates for said 3,750 shares of said subsidiary corporation when organized and the payment to or upon the order of said Fred L. Flanders of Three Hundred and Ninety-six Thousand Dollars ($396,000.00) in cash, all in consideration of said Fred L. Flanders causing to be transferred and delivered to this Company certificates for 4,500.9 shares of the capital stock of the Muskegon Motor Specialties Company, a Michigan corporation, fully paid and non-assessable, constituting the entire outstanding capital stock of said corporation; said cash to be provided out of the proceeds of the issue of the 62,500 shares of Class A stock authorized at this meeting.

The Norton Securities Co. and Midland Investors, Inc., were duly incorporated under the laws of the State of Delaware. Muskegon (Delaware) acquired all of the shares of stock of both corporations, paying therefor $375,000 and $225,000, respectively.

Muskegon (Delaware) acquired all of the outstanding shares of stock of Muskegon (Michigan) as follows: From the Flanders Investment Co. 2,228 shares, paying therefor $6,652.23 cash, 3,750 shares of Norton Securities Co., and 37,118% common shares of Muskegon (Delaware); from other stockholders 2,272.9 shares, paying therefor $389,347.77 cash, and 37,881% common shares of Muskegon (Delaware) . It acquired all of the shares of the L. O. Gordon Manufacturing Co. as follows; From L. O. Gordon and Margaret E. Gordon, his wife, 560 shares, paying therefor $15,492.40 cash, 5,000 shares Midland Investors, Inc., and 35,000 common shares of Muskegon (Delaware); from other stockholders 1,440 shares, paying therefor $433,507.60 cash.

Of the 560 shares of L. O. Gordon Manufacturing Co. acquired from L. O.- Gordon and Margaret E. Gordon, L. O. Gordon was the owner of 420 shares and Margaret E. Gordon of 140 shares. For these shares Muskegon (Delaware) paid the consideration noted above. The stock of Midland Investors, Inc., was issued 3,750 shares to L. O. Gordon and 1,250 shares to Margaret E. Gordon. The 35,000 common shares of Muskegon (Delaware) were issued 10,000 shares to Margaret E. Gordon, 20,900 shares to L. O. Gordon, and 4,100 shares to other parties.

The Flanders Investment Co. did not report as taxable income for the year 1928 the $6,652.23 cash received by it. Neither did it include as taxable income any part of the fair market value of the capital stock of Norton Securities Co., received by it. The respondent in the determination of the deficiency as shown by the stipulation of facts has treated the—

* * * sum of $6,652.23 and the value of 3,750 shares of Norton Securities Company stock as constituting taxable income to the petitioner.
The Commissioner of Internal Revenue in computing the taxable profit for the year 1928 has treated the basis of the Muskegon Motor Specialties Company (Michigan) common capital stock as: Basis of 2,350 shares acquired from Flanders and Company, $10,212.06; this amount has been increased by the cost of stock acquired! in 1928 less the selling price of stock sold in 1928, making the basis applicable to the 2,228 shares transferred to Muskegon Motor Specialties Company (Delaware), $6,867.06.

The stipulation in the case of L. O. Gordon is to the effect that the petitioner reported as taxable income for 1928 the cash received by him, $15,492.40, but did not include as taxable income any part of the fair market value of the shares of Midland Investors, Inc., which he also received. The respondent in the determination of the deficiency has treated the fair market value of the 5,000 shares of Midland Investors, Inc., the same as the receipt of so much cash.

An income tax return was filed by Margaret E. Gordon for the calendar year 1928.

The respondent has computed the cost of 560 shares of the L. O. Gordon Manufacturing Co. stock owned by L. O. Gordon, 420 shares, and Margaret E. Gordon, 140 shares, as being $13,000.

Fred L. Flanders was the president of Muskegon (Michigan) and became treasurer and chairman of the board of Muskegon (Delaware) . L. O. Gordon was president of the L. O. Gordon Manufacturing Co. and became president of Muskegon (Delaware).

In bringing about the reorganization of the two Michigan corporations Flanders spoke for the stockholders of Muskegon (Michigan) and Gordon represented the stockholders of the L. O. Gordon Manufacturing Co. The latter acquired proxies from all of the stockholders of the L. O. Gordon Manufacturing Co. (except from Margaret E. Gordon) for the purchase of their shares for cash (at different prices), and on December 6, 1928, assigned those proxies to Muskegon (Delaware), by which they were exercised.

The material portions of the Revenue Act of 1928 applicable to these proceedings are as follows:

SEC. 112. RECOGNITION OF GAIN OR LOSS.
(a) General rule. — Upon the sale or exchange of property the entire amount of the gain or loss, determined under section 111, shall be recognized, except as hereinafter provided in this section.
(b) JSxohanges solely in kind.—
* # ❖ * * # *
(3) Stock for stock on reorganization. — No gain or loss shall he recognized if stock or securities in a corporation a party to a reorganization are, in pursuance of the plan of reorganization, exchanged solely for stock or securities in such corporation or in another corporation a party to the reorganization.
* * * # * * *
(c) Gain from exchanges not solely in hind.—
(1) If an exchange would be within the provisions of subsection (b) (1), (2), (3), or (5) of this section if it were not for the fact that the property received in exchange consists not only of property permitted by such paragraph to be received without the recognition of gain, but also of other property or money, then the gain, if any, to the recipient shall be recognized, but in an amount not in excess of the sum of such money and the fair market value of such other property.
(2) If a distribution made in pursuance of a plan of reorganization is within the provisions of paragraph (1) of this subsection but has the effect of the distribution of a taxable dividend, then there shall be taxed as a dividend to each distributee such an amount of the gain recognized under paragraph (1) as is not in excess of his ratable share of the undistributed earnings and profits of the corporation accumulated after February 28, 1913. The remainder, if any, of the gain recognized under paragraph (1) shall be taxed as a gain from the exchange of property.
* * * * * * *
(i) Definition of reorganisation. — As used in this section and sections 113 and 115—
(1) The term “reorganization” means (A) a merger or consolidation (including the acquisition by one corporation of at least a majority of the voting stock and at least a majority of the total number of shares of all other classes of stock of another corporation, or substantially all the properties of another corporation), or (B) a transfer by a corporation of all or a part of its assets to another corporation if immediately after the transfer the transferor or its stockholders or both are in control of the corporation to which the assets are transferred, or (G) a recapitalization, or (D) a mere change in identity, form, or place of organization, however effected.
(2) The term “ a party to a reorganization ” includes a corporation resulting from a reorganization and includes both corporations in the case of an acquisition by one corporation of at least a majority of tbe voting stock and at léast a majority of tbe total number of shares of all other classes of stock of another corporation.

The petitioners contend that under the quoted provisions of the statute they are not taxable on the value of the shares of stock of the Norton Securities Co. and Midland Investors, Inc., which they received as part consideration for their shares in Muskegon (Michigan) and L. O. Gordon Manufacturing Co., upon the ground that the exchanges were made in pursuance of a plan of reorganization to which each of the corporations named was a party; that the general plan of reorganization by which Muskegon (Delaware) was created included the acquisition by that corporation of all the shares of stock of the Norton Securities Co. and Midland Investors, Inc., and that the latter corporations were therefore parties to that reorganization under the provisions of section 112 (i) (2) above. They further contend that if viewed separately a reorganization to which those corporations were parties took place when Muskegon (Delaware) acquired all the shares of stock of Norton Securities Co. and Midland Investors, Inc.

At the time these proceedings were submitted to the Board counsel for the respondent, in the presence of counsel for the petitioners, stated the position of the respondent to be this:

That the Midland Investors, Inc., and the Norton Securities Company, Inc., were not parties to tbe reorganization. If your honor will refer to the chart which has been admitted in evidence he will find that there were in existence the tw.o old companies, the Muskegon Motor Specialties Company of Michigan and the L. O. Gordon [Manufacturing] Company of Michigan. A new company was organized, the Muskegon Motor Specialties Company of Delaware. Into that company the two old companies were consolidated. That is strictly a consolidation within the meaning of the revenue acts, or any other acts; it is a consolidation, and there is no question about it.
That occurred November 24, 1928. A few days later, on December 3, 1928, the Midland Investors, Inc., and the Norton Securities, Inc., both of Delaware, were organized, for a purpose, the sole purpose being to hand over the surplus of these two old companies to the Flanders Investment Company, and L. O. Gordon, in the form of stock of those two holding companies, in order to avoid tax upon the gains that resulted from that transaction. That is the story here.
Had the money been paid in cash, or as part of the surplus earnings or undivided profits, it would have been taxable. Had it been placed in a savings bank and presented that certificate of deposit, it would have been a constructive receipt, and it would have been taxable. We can recognize no difference in the world between taking that surplus represented in the case of the Gordon company as $225,000 which became the sole asset of the Midland Investors company and the $375,000 which became the sole asset of the Norton Securities Company, passing that over to these two new corporations in exchange for its stock, those remaining the sole assets of those corporations, and passing over to the former stockholders all the stock of these two companies.
They owned all of tlie stock of the companies, and they bought investments in it and held their investment in corporate form rather than in individual capacities.

From the stipulated facts it does not appear just what the “ plan of reorganization ” of Muskegon (Michigan) and L. O. Gordon Manufacturing Co. into Muskegon (Delaware) was. At the hearing in these proceedings referred to above counsel for the petitioners stated: “ The plan of reorganization was evidenced by a series of documents; there is no single memorandum evidencing the plan.”

From the circular letter sent to the stockholders of Muskegon (Michigan) on November 7, 1928, it appears' that each of the stockholders of that company was to receive for each share of stock of the Michigan corporation 16% shares of the common stock of Muske-gon (Delaware) and cash in the amount of $171.30. This appears to have been what each of the stockholders, except the Flanders Investment Co., did receive. So far as the record shows the other stockholders of Muskegon (Michigan), owning 2,272.9 shares out of a total of 4,500.9 shares, had no knowledge that the Flanders Investment Co. was to receive, in lieu of a part of the cash to which it was entitled, shares of stock of the Norton Securities Co.

It does not appear that any circular letter was sent to the stockholders of the L. O. Gordon Manufacturing Co., which had only a few stockholders. L. O. Gordon, president of the company, obtained options from all the stockholders (except himself and wife) for the purchase of their shares of stock for cash. The amount per share to be paid to each varied greatly. L. O. Gordon assigned his rights in those options to Muskegon (Delaware) on December 6, 1928, and the latter acquired the shares of stock of such stockholders by paying in cash the option price. There is no evidence that such stockholders owning 1,440 out of 2,000 shares of the L. O. Gordon Manufacturing Co. had any knowledge of the proposed creation of Midland Investors, Inc.

It is also to be noted that under the contract made with the bankers by Muskegon (Delaware) all of the cash received from them was to be paid over to the stockholders of Muskegon (Michigan) and of the L. O. Gordon Manufacturing Co. in part payment for their shares in’ those companies.

It is further to be observed that Fred L. Flanders, president of Muskegon (Michigan) became treasurer and chairman of the board of Muskegon (Delaware), and that L. O. Gordon, president of the L. O. Gordon Manufacturing Co., became president of Muskegon (Delaware). They had a dominating voice in the conduct of the Delaware corporation. That company readily agreed to the plan of the Flanders Investment Co. and L. O. Gordon to have it organize the new corporations, Norton Securities Co, and Midland Investors, Inc., and issue their shares of stock! to them in lieu of a part of the cash to which they were entitled.

From the foregoing we think it is plain that the organization of the Norton Securities Co. and of Midland Investors, Inc., was no part of the plan for the reorganization of Muskegon (Michigan) and the L. O. Gordon Manufacturing Co. into the new corporation, Muskegon (Delaware).

The reorganization provisions of the Eevenue Act of 1928 (section 112) must be interpreted in the light of their setting. As stated by the Circuit Court of Appeals for the Second Circuit in Helvering v. Gregory, 69 Fed. (2d) 809:

* * * The purpose of the section is plain enough; men engaged in enterprises — industrial, commercial, financial, or any other — might wish to consolidate, or divide, to add to, or subtract from, their holdings. Such transactions were not to be considered as “ realizing ” any profit, because the collective interests still remained in solution. But the underlying presupposition is plain that the readjustment shall be undertaken for reasons germane to the conduct of the venture in hand, not as an ephemeral incident, egregious to its prosecution. * * *

In Gregory v. Helvering, 293 U. S. 465, it was stated;

When subdivision (B) (section 112 (i) (1), Revenue Act of 1928) speaks of a transfer of assets by one corporation to another, it means a transfer made “in pursuance of a plan of reorganization” (section 112 (g)) of corporate business; and not a transfer of assets by one corporation to another in pursuance of a plan having no relation to. the business of either, as plainly is the case here. * * *

The venture at hand her,e was the reorganization of the business being conducted by Muskegon (Michigan) and the L. O. Gordon Manufacturing Co. The evidence does not show that the creation of the Norton Securities Co. and Midland Investors, Inc., was germane to that reorganization. They acquired none of the assets of the old corporations and did not participate in the conduct of the business either before or after the reorganization. They merely received the cash which the petitioners were entitled to receive in exchange for their shares of Muskegon (Michigan) and the L. O. Gordon Manufacturing Co.

The facts here are similar to those in Ballwood, Co., 30 B. T. A. 644; affirmed per curiam, Ballwood Co. v. Commissioner (C. C. A., 3d Cir.), -Fed. (2d) - (July 16, 1935). In our opinion in the above cited case the Board said:

While the exchange in question, the so-called second step, was made pursuant to the original agreement, the terms of which are stated in the letter of February 19, 1929, we do not think that the agreement as a whole must be considered “ a plan of reorganization ” merely because it was so designated by the parties. Conceivably an agreement entitled “ a plan of reorganization ” might be drawn up that would involve a series of statutory reorganizations, each taxable or nontaxable in its execution according to its own conditions. Or there might be an agreement involving a plan of reorganization as only a minor feature. Certainly we would not say that every separate transaction taking place under such an agreement was made “ in pursuance of the plan of reorganization.” See E. F. Simms, 28 B. T. A. 988. The reorganization contemplated by the statute, or the plan of reorganization, is the one of which the exchange sought to be taxed formed a necessary or vital part. * * *

In onr opinion the Norton Securities Co. and Midland Investors, Inc., were not parties to the reorganization of Muskegon (Michigan) and the L. O. Gordon Manufacturing Co. Neither do we think that the acquisition by Muskegon (Delaware) of all of the shares of the Norton Securities Co. and Midland Investors, Inc., for cash constituted in either instance a reorganization within the intendment of the statute. Those transactions fall, we think, within the rule laid down by the Supreme Court in Gregory v. Helvering, supra. There, as here, assets were transferred by one corporation to a newly organized corporation the only function of which was to receive such assets tax-free. The Court there said, following the language above quoted:

* * * Putting aside, then, the question of motive in respect of taxation altogether, and fixing the character of the proceeding by what actually occurred, what do we find? Simply an operation having no business or corporate purpose — a mere device which put on the form of a corporate reorganization as a disguise for concealing its real character, and the sole object and accomplishment of which was the consummation of a preconceived plan, not to reorganize a business or any' part of a business, but to transfer a parcel of corporate shares to the petitioner. No doubt, a new and valid corporation was created. But that corporation was nothing more than a contrivance to the end last described. It was brought into existence fox-no other purpose; it performed, as it was intended from the beginning it should perform, no other function. When that limited function had been exercised, it immediately was put to death.
In these circumstances, the facts speak for themselves and are susceptible of but one interpretation. The whole undertaking, though conducted according to the terms of subdivision (B), was in fact an elaborate and devious form of conveyance masquerading as a corporate reorganization, and nothing else. The rule which excludes from consideration the motive of tax avoidance is not pertinent to the situation, because the transaction upon its face lies outside the plain intent of the statute. To hold otherwise would be to exalt artifice above reality and to deprive the statutory provision in question of all serious purpose.

The facts in the Gh-egory case show that the Averill Co. was an ephemeral corporation which was immediately dissolved after it had served its purpose. The stipulation of facts in the proceedings at bar does not show the dissolution of the Norton Securities Co. and Midland Investors, Inc. There are intimations in the statements made by counsel for the petitioners and also in the briefs filed by counsel for the petitioners that the Norton Securities Co. and Midland Investors, Inc., did not dissolve during the taxable year before us, namely, 1928. But whether they were dissolved or not appears to us to be immaterial in these proceedings. In any event it is not shown that they had any connection with the reorganized business.

In our opinion the respondent did not err in holding that the shares of stock of the Norton Securities Co. and of Midland Investors, Inc., received by the petitioners were “ other property ” within the contemplation of section 112 (c) (1) of the applicable taxing statute.

In the determination of the deficiencies the respondent has treated the fair market value of the 3,150 shares of Norton Securities Co. stock at the time received by the Flanders Investment Co. as being $315,000 and the fair market value of the 5,000 shares of Midland Investors, Inc., stock at the time received by L. O. Gordon and Margaret E. Gordon as being $225,000. The petitioners have offered no evidence that the fair market value of those shares was otherwise. The determinations of the respondent with regard to such fair market values are approved.

The petitioner, Flanders Investment Co., alleges in its petition that the respondent erred in the determination of the deficiency in treating “the sale of capital stock owned by the petitioner” of Muskegon (Michigan) “ as resulting in a profit to the petitioner, having treated the basis of such stock to the petitioner as the cost to a prior owner instead of the cost to the petitioner.”

The stipulated facts show that the Flanders Investment Co. acquired a part of its stock in a tax-free exchange. The respondent in computing the base has simply carried into effect the provisions of section 113 of the Revenue Act of 1928. On brief, the petitioner has not referred to this allegation of error and it must be deemed to have been abandoned.

One allegation of error contained in the petition of L. O. Gordon is that the respondent has attempted to tax the petitioner upon claimed profit from the sale of 560 shares of L. O. Gordon Manufacturing Co. stock, whereas the petitioner was the owner of only 420 shares, and that the respondent used a wrong base in the determination of the deficiency. The petitioner L. O. Gordon was the owner of only 420 shares of the L. O. Gordon Manufacturing Co. The correct base to be used in determining the profit of L. O. Gordon, as is apparent from the stipulation, is $21,000.

Reviewed by the Board.

Judgment will be entered for the respondent in Docket No. 53907 and under Rule 50 in Docket No. 539fO.


author: Leech :

text:
    Irene O. Kitselman, Executrix, Estate of C. M. Kitselman, Deceased, Petitioner, v. Commissioner of Internal Revenue, Respondent.
    Docket No. 77812.
    Promulgated November 19, 1935.

      J. Murray Ohehoweth, Esq., for the petitioner.

      Hugh Brewster, Esq., for the respondent.
   OPINION.

Leech :

The petitioner, a resident of Muncie, Indiana, and the duly qualified and acting executrix of the estate of C. M. Kitselman, who died November 27, 1930, a resident of Indiana, seeks redetermination of an income tax deficiency in the amount of $3,451.30 asserted against C. M. Kitselman, deceased, for the year 1930. Petitioner further seeks the determination of an overpayment of $572.67 in the decedent’s income tax for 1930.

Certain adjustments made by respondent, in his determination, are not in dispute. The sole error assigned is, the respondent’s dis-allowance of “ any deduction from gross income for 1930 for a loss sustained by the taxpayer in that year on $27,000.00 par value of bonds.”

The facts were stipulated. A resume of them will suffice here.

On January 1, 1930, petitioner’s decedent owned $27,000 par value of bonds which had a total March 1, 1913, value and/or cost basis to him of $20,500 as follows:

$9,000 par value bonds of Chicago, South Bend & Northern Indiana Ry. Co., acquired prior to March 1, 1913, at a cost not in excess of $9,000 and having a March 1, 1913, fair market value of_$9, 000
$8,000 par value bonds of the same company acquired in 1924 at a cost of_ $4,000
$4,000 par value bonds of La Porte & Michigan City Traction Co. acquired in 1914 and 1924 at a cost of- 3,000
$6,000 par value bonds of Northern Indiana Ry. Co. acquired in 1924 at a cost of_ 4,500

The Chicago, South Bend & Northern Indiana Ry. Co. (hereinafter referred to as the C. S. B. & N. I. Ry. Co.) was incorporated in 1907 under the laws of Indiana. It owned and operated a system of electric interurban and street railways. In 1927 its funded debt consisted of a principal and three underlying bond issues as follows:

Principal issue:
C. S. B. & N. I. By. Co. first mortgage 5 percent 30-year gold • bonds, due 1937, outstanding in principal amount_$3, 089, 000
Underlying issues:
La Porte and Michigan City Traction Co. (hereinafter referred to as the L. P. & M. C. T. Co.) 5 percent 25-year first mortgage gold bonds, due 1930, outstanding in principal amount__ 312,000
Northern Indiana By. Co. (hereinafter referred to as N. I. By. Co.) first consolidated 5 percent gold bonds, due 1936, outstanding in principal amount_,_ 588, 000
Indiana Bailway Co. (hereinafter referred to as I. By. Co.) first mortgage 5 percent gold bonds, due 1930, outstanding in principal amount_ '426,000

Each of the foregoing bond issues was secured by a separate mortgage on some part of the property then owned by the C. S. B. & N. I. Ry. Co., which was liable for the total debt represented by all of those bond issues. On July 1, 1921, the C.-S. B. & N. I. Ry. Co. defaulted in the payment of interest due on that date on the first three named bond issues and all interest payments due thereafter. Petitioner’s decedent did not own any of the I. Ry. Co. bonds on which there was no default. A receiver for the C. S. B. & N. I. Ry. Co. was appointed by the Federal District Court on July 9, 1927. The receiver operated the company’s properties until about February 1930.

Under date of July 21, 1927, a “ Deposit Agreement ” was executed, whereby there was appointed a “ Bondholders’ Protective Committee ” to represent the holders of the above mentioned bonds in default. Those bondholders electing to subscribe thereto, agreed to deposit their bonds with the designated depository, the National City Bank of New York, and receive in exchange the latter’s certificates of deposit. The committee was vested, “ as Trustees of an express trust”, with legal title to all bonds and coupons so deposited, with full power and authority to exercise all rights and privileges of the individual bondholders. In addition, the committee was given broad express powers to “prepare and adopt a plan and agreement of reorganization or adjustment ”; to “ sell or exchange the deposited bonds to waive any default by the C. S. B. & N. I. Ry. Co.; or to institute foreclosure proceedings.

The committee developed and proposed a plan and agreement designated “Reorganization of the C. S. B. & N. I. Ry. Co. Plan and Agreement, Dated October 11, 1929 ”, which was carried into effect during 1929 and 1930. In accordance with its provisions the bondholders who became parties thereto were required to pay to the committee, upon demand, $25 cash for each $1,000 par value of bonds left on deposit with the depository. Approximately 97 percent of the holders of the bonds in default became parties to the plan and agreement. At the instigation of the committee, in pursuance of the plan and agreement, the trustees of the mortgages securing the three issues of bonds in default, brought foreclosure proceedings in the Federal District Court. Pursuant to the court’s final judgment, decree and order of sale issued November 9, 1929, all the properties of the C. S. B. & N. I. By. Co. were sold in one parcel at public judicial sale on February 1, 1980, to representatives of the committee on a cash bid of $430,000 free and clear of all liens and encumbrances, except the lien of any taxes, assessments and water rents lawfully levied or assessed and also the lien of the first mortgage securing the I. By Co. bonds not in default. From the proceeds of such sale the receiver applied $56,038.91 to charges taking precedence over bonds and appropriated the balance to pro rata partial payment on the three bond issues in default. The amount of $63,508.28 of the bid price was paid to the receiver by the committee in cash out of the fund obtained from the bondholders pursuant to the plan and agreement. The balance of the bid price was paid by crediting on the bonds their pro rata share of the proceeds of the sale. The court ordered that such credits be endorsed on the bonds by the receiver as the amount paid thereon and entered deficiency judgments for the unpaid portion of the interest due thereon. Following the foreclosure sale, the C. S. B. & N. I. By. Co. had no assets of any kind with which it could ever pay or satisfy any part of the unpaid portion of the debt represented by the deficiency judgments and the bondholders had recourse, for the payment of such debt, only against that corporation. The C. S. B. & N. I. By. Co. was not formally dissolved in 1930, but following the foreclosure sale of all of its properties, it ceased to be active.

Pursuant to the plan and agreement the committee organized a new corporation, under the laws of Indiana, named Northern Indiana Bailways, Inc. Its articles of incorporation were filed with the Secretary of State of Indiana on February 3, 1930. To such corporation the committee transferred all of its interest in the properties purchased by it at the foreclosure sale and also the balance of the cash on hand from the fund subscribed by the participating bondholders. Subsequently the receiver deeded such properties to the Northern Indiana Bailways, Inc., as the nominee of the purchasers. In consideration for the properties so acquired, the Northern Indiana Bailways, Inc., issued and delivered to the committee on or about June 1, 1930, a part of its authorized no par common stock and bonds, which were distributed by the committee to the parties represented by it, in proportion to their interest in the property purchased at the foreclosure sale. The Northern Indiana Bail-ways, Inc., assumed liability for the I. By. Co. bond issue, which was extended by agreement with the holders of such bonds.

The plan and agreement so executed was developed solely by the bondholders’ protective committee as the representative, of that portion of the holders of the three issues of bonds in default, who subscribed to the plan and agreement. Neither the C. S.. B. & N. I. By. Co., its general creditors, stockholders, nor its bondholders of any issue other than those represented by the committee (nor any other corporation, stockholders or bondholders) took any part in the formation of the plan or the execution of the agreement, nor did they participate in the benefits or burdens of the plan or take any formal action of any kind pertaining to the proceedings under the plan, or acquire any interest in the Northern Indiana Bailways, Inc. The C. S. B. & N. I. By. Co. did not file in the office of the Secretary of State of Indiana, any articles of consolidation or merger.

Until 1930 the C. S. B. & N. I. By. Co. owned the stock and, under agreement, operated the properties of the Southern Michigan Bail-way Co., which defaulted on its first mortgage bonds in 1927. A receiver was appointed and a bondholders’ committee bid in the property of that company at a foreclosure sale. Such property, free and clear of all liens and encumbrances including second mortgage bonds, was transferred to the Northern Indiana Bailways, Inc., for $107,200 par value bonds and 4,824 shares of stock of the latter company, by an agreement executed in 1980. Neither the Southern Michigan Bailway Co., its stockholders, nor its bondholders had any part in formulating or executing the plan and agreement entered into by the bondholders of the C. S. B. & N. I. By. Co. Petitioner’s decedent owned no stock or bonds of the Southern Michigan Bailway Co.

Petitioner’s decedent deposited his $27,000 par value bonds with the depository and received the latter’s receipts therefor. He subscribed to the plan and agreement proposed by the committee and in 1930 paid to the latter the sum of $625 in discharge of his obligation to pay $25 for each $1,000 par value of bonds deposited.

The pro rata portion of the payment made by the receiver on the decedent’s $27,000 face value bonds and the pro rata part of the deficiency judgment applicable to the unpaid balance of his bonds were as follows:

In June 1930, petitioner’s decedent received from the committee his pro rata share of the stock and bonds of the Northern Indiana Railways, Inc., in the amounts of 553 shares and $9,175 principal amount of bonds, which he retained until his death in November 1930. Such securities were included in his estate, for Federal estate tax purposes, at a value of $2.25 per share for the stock and $35 per $100 face value for the bonds. He made no other disposition of the C. S. B. & N. I. Ry. Co., L. P. & M. C. T. Co., and N. I. Ry. Co. bonds on which he had received in 1930 a partial payment and a deficiency judgment for the unpaid balance of the principal amount.

Petitioner’s decedent kept only a memorandum record of his assets and income, in which he made a notation in March 1930 of his receipt of the depository’s receipts for the bonds deposited by him and also of his payment of $25 per $1,000 face value of bonds deposited.

The 1930 income tax return, filed by petitioner on behalf of C. M. Kitselman, deceased, shows a deduction of $15,858.25 as a “ Bad Debt ” on account of the unpaid balance of the bonds on which the C. S. B. & N. I. Ry. Co. had defaulted. The Commissioner disallowed the claimed deduction. He now contends that the 1930 transaction constituted a statutory reorganization resulting in an exchange of his securities in the old corporation for securities in the new corporation, upon which no gain or loss is recognized under section 112 (b) (3) of the Revenue Act of 1928. Petitioner contends that the; transactions carried out in 1930 with respect to the properties of the C. S. B. & N. I. Ry Co. and the N. I. Ry. Co., and the organization of the Northern Indiana Bailways, Inc., were not a statutory reorganization within the meaning of section 112 (i), supra. It is then argued, accordingly, that decedent was entitled to deduct in 1930, as a bad debt under section 23 (j) of the 1928 Act, the amount of either the principal amount of the bonds for which the deficiency judgment was entered and ascertained to be worthless in 1930, or, in the alternative, the excess of the decedent’s basis over the partial payment received on the bonds in 1930 or, again in the alternative, that he was entitled to deduct in 1930, as a “ loss ” under section 23 (e) of the same act, the amount by which that basis exceeded the sum recovered on the bonds in 1930.

In support of his contention respondent relies on First National Bank of Champlain, N. Y., 21 B. T. A. 415, and Rockford Dairy, Inc., 26 B. T. A. 501, wherein on facts similar in many respécts’tó those here involved, the Board held that there was a 'Statutory reorganization even though neither the old corporation nor its stockholders acquired any interest in the new corporation. Those decisions were rendered prior to Cortland Specialty Co. v. Commissioner, 60 Fed. (2d) 937; certiorari denied, 288 U. S. 599, and Pinellas Ice & Cold Storage Co. v. Commissioner, 287 U. S. 462. The latter two court decisions have definitely laid down the principle that one of the essentials of a statutory reorganization, as defined by the revenue acts, is a continuity of interest on the part of the transferor (or seller) corporation or its stockholders in the trans-' feree (or purchaser) corporation. To the extent that First National-Bank of Champlain, N. Y., supra, and Rockford Dairy, Inc., supra, are in conflict with such principle of law, they, of course, are ho longer authorities.

Here, it is clear that the transactions carried out in 1930 did not constitute a reorganization within the meaning of section 112 (b) (3), supra, since there was no reorganization as defined by section 112 (i), supra. The plan or agreement was both formulated and* executed solely by a portion of the bondholders of thé C. S. B. & N. I. Ry. Co., which was insolvent. At the judicial sale those bondholders, through their committee, became the purchasers of all of that railway company’s assets. The purchase price paid by them was used by the receiver to pay certain liabilities and to make a partial payment on the company’s outstanding bonds in default. The court entered deficiency judgments for the balance due the bondholders, to which extent the bonds became worthless in 1930. The then owners of the properties (formerly owned by C. S. B. & N. I. Ry. Co.) transferred their interest therein to a new corporation, the Northern Indiana Eailways, Inc., and received stock and bonds of the latter in proportion to their respective interest in the property so transferred to it. Neither the C. S. B. & N. I. Ry. Co. nor its stockholders were parties to the plan, nor did either that corporation or its stockholders acquire any interest in the Northern Indiana Eailways, Inc. On their part there was no continuity of interest in the new corporation and therefore no statutory reorganization. Cf. J. S. Rippel & Co., 30 B. T. A. 1146; Ballwood Co., 30 B. T. A. 644; affirmed per curiam, — Fed. (2d) — (C. C. A., 3d Cir., July 16, 1935); Newberry Lumber & Chemical Co., 33 B. T. A. 150.

Petitioner’s decedent owned $27,000 face value of C. S. B. & N. I. Ey. Co. bonds on which he received in 1930 a partial payment, credited on his bonds, in the amount of $2,607.94. While the unpaid balance of the bonds represented a worthless debt of the C. S. B. & N. I. Ry. Co. (Henry R. Huntting, 32 B. T. A. 495), petitioner’s claim for a worthless debt deduction of $24,392.06 ($27,000 face value less $2,607.94 recovered) is untenable, for such amount is in excess of his actual outlay or cost in acquiring the bonds.

Generally speaking, the income tax statutes are concerned only with actual realized losses. Weiss v. Wiener, 279 U. S. 333. The unpaid balance of decedent’s bonds became totally worthless in 1930 and he sustained a loss in that year, of his unrecovered investment therein. Forbes v. Commissioner, 62 Fed. (2d) 571. The amount of such loss was the excess of his basis of $20,500 over $2,607.94, the partial payment received in 1930, or the sum of $17,-892.06, which he was entitled to deduct from his gross income for 1930, pursuant to section 23 (e), supra.

The record herein does not establish that the taxes heretofore paid for 1930 were paid within two years of the filing of a claim for refund or the filing of the petition herein, as required by section 504 of the Eevenue Act of 1934.

Eeviewed by the Board.

Decision wild be entered pursuant to Rule 50.

         SEC. 132. RECOGNITION OE GAIN OR LOSS.
      (a) General rule. — Upon the sale or exchange of property the entire amount of the gain or loss, determined under section 111, shall be recognized, except as hereinafter provided in this section.
      (b) Exchanges solely in hind.—

        % * * * iji * #
      (3) Stock for stock on reorganization. — No gain or loss shall be recognized if stock or securities in a corporation a party to a reorganization are, in pursuance of the plan of reorganization, exchanged solely for stock or securities in such corporation or in another corporation a party to the reorganization.
      ***..* .
      ,(i) Definition of reorganisation. — As used in this section and sections 113 and 115—
      (1)- The term “ reorganization ” means (A) a merger or consolidation (including the acquisition by one corporation of at least a majority of the voting stock and at least a majority of the total number of shares of all other classes of stock of another corporation, or substantially all the properties of another corporation), or (B) a transfer by a corporation of all or a part of its assets to another corporation if immediately after the transfer the transferor or its stockholders or both are in control of the corporation to which the assets are transferred, or (C) a recapitalization, or (D) a mere change in identity, form, or place of organization, however effected.
      (2) The term “ a party to a reorganization ” includes a corporation resulting from a reorganization ,and includes both corporations in the case of an acquisition by one corporation of at least a majority of the voting stock and at least a majority of the total number of shares of all other classes of stock of another corporation.

       SEC. 23. deductions EROM GROSS INCOME.
      In computing net income there shall be allowed as deductions:
      *******
      (e) Losses hy individuals. — In the case of an individual, losses sustained during the taxable year and not compensated for by insurance or otherwise—
      *******
      (2) if incurred in any transaction entered into for profit, though not connected ;with the trade or business; * * *
      * * «i * * * *
      (j) Bad debts. — Debts ascertained to be worthless and charged off within the taxable year (or, in the discretion of the Commissioner, a reasonable addition to a reserve for bad debts) ; and when satisfied that a debt is recoverable only in part, the Commissioner may allow such debt to be charged off in part.


author: ARUndell :

text:
    Pacific Employers Insurance Company, Petitioner, v. Commissioner of Internal Revenue, Respondent.
    Docket No. 68722.
    Promulgated November 19, 1935.

      F. Britton McConnell, Esq., for the petitioner.

      Arthur L. Mwrray, Esq., for the respondent.
   opinion.

ARUndell :

The respondent determined a deficiency in petitioner’s income tax for the year 1930 in the amount of $1,193.45. Upon waiver by petitioner of several alleged errors there is presented but one issue for decision, namely,, the amount allowable as a deduction for “losses incurred” within the meaning of section 204(b) (6) of the Revenue Act of 1928. The parties have stipulated that, if the method of computing the amount allowable now advocated by petitioner is proper, there is an overpayment of $1,212.24, otherwise the deficiency determined by the respondent is correct.

The facts were stipulated and we incorporate the written stipulation by reference as our findings of fact.

The petitioner is an insurance company other than a life or mutual company. It is a California corporation, its business is confined solely to the State of California, and is regulated by the laws of that state. It operates under a certificate of authority issued by the Insurance Commissioner of California. Its principal business is the writing of workmen’s compensation insurance and approximately fourteen fifteenths of its net premium income was from this source in 1930. The balance of the premium income was from automobile liability, collision and property damage insurance, principally, and a small part from public liability and theft insurance.

In petitioner’s income tax return for 1930 it claimed a deduction for losses incurred in the amount of $882,632.55 computed as follows:

Losses paid_$865,801.55
Unpaid losses end of 1930_$660,980
Unpaid losses end of 1929- 644,149 - 16,831.00
Losses incurred. 882,632. 55

.Tbe amounts of the unpaid losses as set out above were determined from estimates of the .ultimate cost of final adjustment of each outstanding claim made by claims examiners, the total being the sum of the estimates on each claim. In making their estimates the claims examiners took into consideration a numb.er of elements which might affect the ultimate cost of adjustment.

Petitioner filed with its 1930 income tax return a portion of its “Annual Statement for the Year Ending December 81, 1930, of the Condition and Affairs of the Pacific Employers Insurance Company ” as shown on form “ Miscellaneous Stock Companies — Convention Edition 1930.” The portion of the statement so filed is from the “Annual Statement Approved by the National Convention of Insurance Commissioners ” referred to in section 204(b)(1) of the Revenue Act of 1928. The annual statement so filed contains in the list of “ Liabilities ” an item designated “ Reserve for accrued losses * * * $596,532.85.” It also contains in the “ Underwriting. and Investment Exhibit ” the following:

Losses paid_ $865, 801.55
Add unpaid losses December 31 of current year- 596, 532. 85
Total_:_ 1,462,334.40
Deduct unpaid losses December 31 of previous year- 440, 318. 52
Losses incurred during the year- 1, 022, 015. 88

The petitioner also filed the aforesaid annual statement with the Insurance Commissioner of California. The statement so filed contains an item of $33,879.10 designated “ Total reserve for unpaid liability losses ”, and also an item of $554,363.75 designated “ Total reserve for unpaid compensation losses.” These two items total $588,242.85. Adding to this an item of $8,290 listed “ Total net unpaid claims except 'liability and workmen’s compensation ” gives the figure of $596,532.85.

The items designated unpaid losses in the aimual statement are computed in accordance with the laws of California (sec. 602(a), Political Code) and represent the highest aggregate reserve, after deduction for reinsurance, called for at the beginning and end of the year by the California law. The unpaid losses in the above amounts represent sums which have been actually held by the petitioner.

The petitioner now claims as a deduction for “ losses incurred ” the amount of $1,022,015.88, computed as above set out, in place of the $882,632.55 claimed in its return. In both computations the item of “ losses paid ” is the same, $865,801.55. The difference between the parties is as to the amount of “ unpaid losses ” to be taken into consideration in determining the amount of “ losses incurred ” within the meaning of the statute.

Section 204 (b) of the Revenue Act of 1928 provides for the inclusion in gross income of investment and underwriting income “ computed on the basis of the underwriting and investment exhibit of the annual statement approved by the National Convention of Insurance Commissioners * * Among the deductions allowable in determining net income is that for losses, to be computed as follows (sec. 204 (b) (6)) :

To losses paid during the taxable year, * * * add all Unpaid losses outstanding at the end of the taxable year and deduct unpaid losses outstanding at the end of the preceding taxable year * * *.

The statutory provision for the use of the underwriting and investment exhibit is limited to the determination of gross income and does not follow through to the determination of net income. While the respondent has provided in article 992 of Regulations 74 that the “ exhibit is presumed clearly to reflect' true net income ”, he has in the same sentence limited the scope of that presumption by stating that the exhibit will be recognized and used as a basis “ in so far as it' is not inconsistent with the provisions of the Act.5' Further, “All items of the exhibit, however, do: not reflect an insure ánce company’s income as defined in the Act.” The proper use of the exhibit in determining income is that of a guide and not a limitation on the application of the statute. American Title Co., 29 B. T. A. 479; affd., 76 Fed. (2d) 332.

In the case of ordinary corporations and of life insurance companies and mutual insurance companies other than life, the taxing statute makes provision for deduction of certain reserves in computing net income. No such provision is contained in the provisions relating to insurance companies other than life or mutual. Consequently, companies in the latter classification, as this petitioner is, are not entitled to deduct reserves even though they may be required by state law. American Title Co., supra.

The deduction now sought by the petitioner is a deduction for a reserve. While the figure of $596,532.85 now claimed to be unpaid losses at the end of 1930 is so listed in the underwriting and investment exhibit, the supporting schedules, as above pointed out, clearly show that the figures making up this sum are reserves. The details of the supporting schedules show that the starting point in the computation of the amounts making up the $596,532.85 is a percentage of earned premiums. In the schedule of computation of “ Reserve for unpaid liability losses” the calculation is based on “ 60% of earned premiums ”, and in the “ Reserve for unpaid workmen’s' compensa-lion ” there is used “ 70% of earned premiums.” Some of the figures for 1929 are given, but not the final result, and from those given it appears that the calculation for that year was made in the same way. Thus the amount now claimed by the petitioner appears to be essentially a reserve, which is not available to this type of insurance company as a deduction in computing net income.

The amount claimed in the return filed by the petitioner and allowed by the respondent was the result of a careful calculation based on the claims filed with it. An examiner investigated each claim, took into consideration a number of factors, listed in the stipulation, which might affect the amount of petitioner’s liability and arrived at a sum that in his opinion the petitioner would be required to pay. These sums were totaled and the totals were listed by petitioner as the “ unpaid losses ” and approved by the respondent. In a case analogous on the facts, but arising under the different statutory provisions of the Revenue Act of 1918, deductions for losses calculated as in this case were allowed as “ accrued but unpaid losses.” Ocean Accident & Guarantee Corporation, Ltd. v. Commissioner, 47 Fed. (2d) 582.

We conclude that the method used by petitioner in reporting unpaid losses in its return was proper and that the method now advanced by it is not in accordance with the statute. The respondent’s determination is affirmed.

Decision will be entered for the respondent.


author: Arnold:

text:
    Ernest H. Hale, Petitioner, v. Commissioner of Internal Revenue, Respondent.
    Docket No. 67105.
    Promulgated November 19, 1935.

      Loren A. Butts, Esq., for the petitioner.

      A. L. Mw-raif, Esq., for the respondent.
   OPINION.

Arnold:

The respondent asserted a deficiency against petitioner for the calendar year 1980 in the amount of $6.75 and a penalty in the amount of $1.69 for delinquency in filing a return. The petitioner brings this proceeding for a redetermination of his tax liability for that year.

The petitioner is an individual, residing at 11351 Louisiana Avenue, Sawtelle, California. During the calendar year 1930, he was employed by the city of Los Angeles, California, as director of one of its public municipal playgrounds known as the Sawtelle Playground. He received from the city as salary for his services the sum of $2,100. He received no other compensation during the year. He was not married.

Petitioner was employed in the Playground and Eecreation Department, which is one of the departments of city government created by the charter of the city of Los Angeles. Other departments of the city government included Building and Safety, City Planning, Civil Service, Fire, Harbor, Health, Humane Treatment to Animals, Library, Municipal Art, Parks, Pensions, Police, Public Utilities and Transportation, Social Service, and Water and Power.

Section 191 of the city charter provides that for the financial support of the Department of Playground and Eecreation there is hereby appropriated an annual sum of not less than four cents (4c) on each one hundred dollars ($100.00) of assessed value of all real and personal property of the city as assessed for city taxes. Additional appropriations may be made from the general city funds. All money arising from either class of appropriations referred to, or received by the Department of Playground and Eecreation from fees, sales, gifts or otherwise in connection with the operation of the department, shall be placed to the credit of the Department of Playground and Eecreation in a fund to be known as the ‘ Playground and Eecreation Fund ’. No money in the Playground and Eecreation Fund shall be used for any purpose other than the financial support of the Department of Playground and Eecreation.”

Petitioner was not employed for any definite period, but was under the civil service regulations of the city and could not be discharged without cause. He was selected for employment from the civil service rolls. There were approximately thirty-five playgrounds maintained by the city of Los Angeles in 1930 and petitioner was subject to transfer to any one of them at the discretion of the superintendent of the department.

The Playground and Eecreation Department has control of the .playgrounds in the municipal centers of the city, of certain mountain camps situated on Government property outside of the city, and of the operation of swimming pools and municipal bathing beaches. None of these activities is engaged in for profit. In the mountain camps fees are charged to cover the expenses of food, transportation, etc., but the camp outlay is furnished by the city of Los Angeles. At the swimming pools and bathing beaches a fee of five cents is charged for towels and bathing suits to cover the laundry expenses and the use of the bathing suits. During the year 1930, the Playground and Eecreation Department derived income from these sources of approximately $125,000. During that year the operating expenses were approximately $755,000. There was no swimming pool at the ■ Sawtelle Playground in 1930. The playground was open to the public and no fees were charged.

The municipal playgrounds of the city of Los Angeles are equipped with athletic fields, baseball, football and soccer ball facilities, gymnasium and other athletic equipment, and facilities for handicraft work, club work, and children’s playgrounds.

As director of the playground petitioner organized games for the children, supervised the play of both children and adults and in general maintained a program for the best interests of the community.

The sole question before us is whether the salary received by petitioner as director of the playground is exempt from Federal income tax. If petitioner was employed by the municipality in the performance of an essential governmental function of the state his compensation is exempt. If, however, he was employed by the city in the performance of a proprietary or quasi-private function the exemption must be deified.

The charter of the city of Los Angeles is what is known as a freeholder’s charter, promulgated and adopted as provided by the “ Municipal Affairs ” ameiidment to the California Constitution in 1914. Under the constitution, as amended, the charter of Los Angeles is not only the organic law of the city, but it is also a law of the state within the constitutional limitation. C. J. Kubach Co. v. McGuire, 199 Cal. 215; 248 Pac. 676, and may not be abrogated by the legislature. Cf. Ex parte Braun, 141 Cal. 204; 74 Pac. 780; City of Los Angeles v. Central Trust Co., 173 Cal. 323; 159 Pac. 1169; Civic Center Assn. v. Railroad Commission of California, 175 Cal. 441; 166 Pac. 351; Ex parte Montgomery, 163 Cal. 457; 125 Pac. 1070. The powers of the city in municipal affairs are strictly construed and limited to those set out in its charter under the constitutional grant. Bank v. Bell, 217 Pac. 538; Storke v. City of Santa Barbara, 244 Pac. 158. The exercise of such powers is superior to a general law of the state on that subject. Keyes v. City and County of San Francisco, 173 Pac. 475.

We think it definitely settled by the great weight of authority that the establishment and maintenance of public parks by a municipality is a public or governmental function. Everett B. Sherman, 27 B. T. A. 1169; affd., Commissioner v. Sherman, 69 Fed. (2d) 755. Kellar v. City of Los Angeles, 179 Cal. 605; 178 Pac. 505; Williams v. City of Birmingham, 121 S. E. 14; Epstein v. City of New Haven, 132 Atl. 467; Petty v. City of Atlanta, 148 S. E. 747; Board af Park Commissioners v. Prinz, 127 Ky. 460; 105 S. W. 948. So also the maintenance of a public bathing beach is held to be a public function. Gensch v. City of Milwaukee, 190 N. W. 843; Nemet v. City of Kenosha, 172 N. W. 711. Bolster v. City of Lawrence, 225 Mass. 387; 114 N. E. 722.

The general .duty of - a city to preserve the public health of its citizens is governmental, City and County of Denver v. Maurer, 106 Pac. 875, and the right of the municipality to maintain such recreational facilities as public parks, bathing beaches and playgrounds rests on its duty to maintain public health. Board of Park Commissioners v. Prinz, supra; Commissioner v. Sherman, supra.

The care of the public health is, undoubtedly, a subject matter of general concern and how it shall be accomplished is a public question. When its accomplishment is left to the municipality it acts as a governmental agency and not in a proprietary capacity. Scibilia v. Philadelphia, 279 Pa. 549; 124 Atl. 273.

We think that in creating the Playground and Recreation Department of the city of Los Angeles, and providing for its financing through taxation, the city was exercising a power conferred upon it by the State of California essentially governmental in character and that the functions of this department are essentially public as distinguished from -quasi-private or proprietary functions. The fact that small fees are charged at mountain camps and for towels and bathing suits to .meet particular expenses incurred by individuals does not change its public character. Cf. Kellar v. City of Los Angeles, supra; Bolster v. City of Lawrence, supra; James v. City of Charlotte, 183 N. C. 630; 112 S. E. 423; Scibilia v. Philadelphia, supra.

Decision will be entered for the petitioner.


author: Aiittndell : Mellott,

text:
    Paul J. Bonwit, Petitioner, v. Commissioner of Internal Revenue, Respondent.
    Docket No. 53661.
    Promulgated November 19, 1935.

      Arthur B. Hyman, Esq., for the petitioner.

      I. Graff, Esq., for the respondent.
   OPINION.

Aiittndell :

In 1928 Bonwit Teller & Co. paid premiums in the amount of $46,434.90 on policies of insurance upon the life of the petitioner, who was president, a director and substantial stockholder of the corporation. The corporation deducted this amount as ordinary and necessary expenses and this deduction was allowed by the respondent. In the present proceeding the respondent has determined a deficiency in the petitioner’s income tax resulting from the inclusion of the whole amount of these premiums in his income for that year, and also the inclusion of certain dividends. Petitioner does not contest the dividend item. The question for decision is whether all or any part of the amount of premiums paid by the company constitutes income to the petitioner.

There is no specific provision of the statute which deals with this question. Respondent points out, however, that section 24 (a) (4) of the Revenue Act of 1928, set out in the margin, provides that premiums paid hy any employer on an insurance policy on the life of an officer or employee may not be deducted by the employer where the employer is directly or indirectly a beneficiary under the policy. Berizzi Brothers Co., 16 B. T. A. 1307; Merrimac Hat Corporation, 29 B. T. A. 690. The reason for the rule is obvious, since under section 22 (b) (1) life insurance proceeds are excluded from gross income. See Merrimac Hat Corporation, supra. From this premise respondent deduces as a necessary corollary the rule that premiums paid by a corporation on the life of one of its officers are income to that officer in the nature of additional compensation paid by the corporation, unless it can be shown that the corporation is the direct or indirect beneficiary of the policy. Under article 283 of Treasury Regulations 74 the fact that the corporation may derive a benefit from the increased efficiency of the officer or employee insured is said not to be a sufficient cause for disallowing a deduction to the corporation.

Following through the theory that premiums paid on policies under which the employer is the direct beneficiary are neither deductible by the employer nor income to the insured, counsel for respondent concedes that the premiums on the group of policies aggregating a face amount of $139,500 which the company applied for and under which it was the beneficiary are not taxable to the petitioner. ■ The exact amount of premiums paid on this group of policies is not shown; the determination of this amount may be left, as respondent concedes, to a recomputation.

The third group comprises policies in the aggregate face amount of $175,000. The ■ petitioner himself was the applicant for these policies, and the beneficiaries were either members of his family or his estate, premiums amounting to $9,551.05 were paid in 1928 by the company. In applying for and receiving these policies the petitioner voluntarily contracted an annual expense — “ a particular expense, which for millions of men and women has become a fixed charge.” Burnet v. Wells, 289 U. S. 670. The petitioner’s obligation to. meet this expense was lifted from his shoulders by his corporate employer’s assumption and satisfaction of it. “ The discharge by a third person of an obligation to him is equivalent to receipt by the person taxed.” Old Colony Trust Co. v. Commissioner, 279 U. S. 716. In that case the corporate employer agreed to and did pay the income taxes on the salaries of officers and members of the staff. The resolution providing for payment stated the purpose to be, “ to the end that said persons and officers shall receive their salaries or other compensation in full without deduction on account of income taxes.” There was no resolution designating the payment of taxes to be additional compensation. However, the Supreme Court reached the conclusion that “The taxes were paid upon a valuable consideration, namely, the services rendered by the employee and as part of the compensation therefor.” It requires no stretch of the imagination to arrive at the same conclusion here. Petitioner was an officer of the corporation and he alleges that the object of the corporation’s maintenance of the insurance was to promote “ greater efficiency among its officers.” It may be that the discharge of an obligation by a volunteer with whom the obligor had no business connection would be a gift and not income. But that is not the situation here.

The petitioner here had contracted an obligation to be met if the policies were to be kept alive, and it was met by his employer. In our opinion the principle of the Old Colony Trust case applies and the. amount of premiums paid by the company on the third group of policies was properly treated by the respondent as income to the petitioner.

We have left for consideration the premiums on the first group of policies, aggregating $500,000 in face amount. These policies were applied for by the company; the petitioner made no reservation in the policies of any right to change the beneficiary; and the premiums were paid by the company. The payment of premiums on these policies was not in discharge of any obligation incurred by the petitioner, as was true with respect to the policies last discussed. In several cases it has been held that the' paymeht of insurance premiums by an employer constituted additional compensation to the employee. See George Matthew Adams, 18 B. T. A. 381; N. Loring Danforth, 18 B. T. A. 1221; Frank D. Yuengling, 27 B. T. A. 782; affd., 69 Fed. (2d) 971. Those cases, however, are distinguishable from the one before us. In the Adams case the employee made application for the policy, he was permitted to designate the beneficiary, and the policy was issued to him. In the Danforth case a corporate resolution directed the employees to procure and have issued policies of insurance on their lives naming their wives as beneficiaries. In the Yuengling case the petitioner owned or controlled all the stock of the corporation which procured the policies to be issued on his life, and the proceeds of the policies were payable to a trustee for the benefit of the petitioner’s wife and children. It is to be noted that in all of these cases the beneficiaries were dependents of the taxpayers. In the Adams and Danforth cases the employees applied for and procured the insurance. In the Yueng-ling case the Circuit Court of Appeals pointed out that the insured was permitted to designate the beneficiary. In that case, too', Yuengling was in control of his corporate employers and was in a position to compel the payment of premiums.

In the present case the petitioner was not- the applicant for the insurance; he had no right to designate or change the beneficiaries; he was not in a position to compel the company to, either take out the insurance initially or to continue it in force. The petitioner did not receive the amount of the premiums, and there is no evidence that he or his employer intended or regarded (them as additional compensation. There is no provision of the taxing statute that specifically requires the inclusion in income of insurance premiums paid by an employer. They can not be included under the doctrine of the Old Colony Trust case, supra, for the payment was not in discharge of any obligation of the petitioner. Plainly there was no constructive receipt by the petitioner of the amount of the premiums. Burnet v. Wells, supra, is not applicable to this phase of the case. There the Court was considering the validity of an act of Cqngress which specifically treated as income of the grantor of a trust the amount of trust income used to pay premiums on insurance on the life of the grantor. The Court .said, The controversy is one as to the boundaries of legislative power.” The enactment was sustained. The decision does not stand for the proposition that insurance premiums would be treated the same way in the absence of specific legislation on the subject.

We find no warrant in the statute or in any judicial pronouncement for including in petitioner’s income the premiums paid by his employer on this group of policies. We hold it was error to treat the amount of such premiums as income to petitioner.

Eeviewed by the Board.

Decision will he entered wider Bule 50.

Mellott,

dissenting: The conclusion of the majority, that the amount paid for premiums on the group of policies aggregating $500,000 in face amount should not be considered income of the petitioner, seems to me erroneous.

We have held that premiums paid by corporations for insurance on the lives of officers and employees, where the corporation is not a beneficiary, constitute income to the insured. Frank D. Yuengling, 27 B. T. A. 782; affd., 69 Fed. (2d) 971, on authority of Burnet v. Wells, 289 U. S. 670. See also George Matthew Adams, 18 B. T. A 381; N. Loring Danforth, 18 B. T. A. 1221. That is especially true where, as here, the insured is president and director of a corporation, the majority of the stock of which is owned by him and members of his family.

The fact that the corporation was originally the named beneficiary is not, in my opinion, important. We are concerned only with the payments made for premiums during the year 1928, after the wife and sons had been named as beneficiaries. When the payments were made, the corporation had no right or power to change the beneficiary ; hence, the payments made by it were for the purpose of continuing in force policies in which it had no interest.

Under the circumstances, I feel that the amounts so paid constituted additional compensation to the petitioner, and should have been reported by him as income. Accordingly, I dissent from the portion of the opinion holding that the Commissioner erred in treating the amount of such premiums as income to the petitioner.

Black, Seawell, Matthews, and ArNOld agree with this dissent.

       Sec. 24 (a) (4). Premiums paid on any life insurance policy covering the life of any officer or employee, or of any person financially interested in any trade or business carried on by the taxpayer, when the taxpayer is directly or indirectly a beneficiary under such policy.