Opinion
Docket No. 112416.
1944-02-23
KRAMON DEVELOPMENT COMPANY, INC., PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.
Jerome E. Malino, Esq., and Godfrey Cohen, Esq., for the petitioner. William F. Evans, Esq., for the respondent.
Petitioner's redemption at less than par of bonds issued by it for property of a value less than the face value amount of the bonds, petitioner at all times being insolvent, held, not to result in taxable gain. Dallas Transfer & Terminal Warehouse Co. v. Commissioner (C.C.A., 5th Cir.), 70 Fed.(2d) 95, followed. Jerome E. Malino, Esq., and Godfrey Cohen, Esq., for the petitioner. William F. Evans, Esq., for the respondent.
By this proceeding petitioner contests a portion of deficiencies in income tax for fiscal years ended April 30, 1939, and April 30, 1940, in the amounts of $2,885.18 and $3,340.41, respectively.
The question presented is whether petitioner realized taxable income as a result of purchases of its own bonds for amounts less than their face values. Disallowances of a deduction for depreciation is not challenged by the petitioner.
FINDINGS OF FACT.
In 1915 and 1916, respectively, two adjoining parcels of land located at the northeastern corner of Broadway and 94th Street, New York City, were improved by the erection on each of a twelve-story brick building. The two buildings were joined and furnished for use as a hotel known as Hotel Monterey. One of the two parcels was held in fee and the other under a leasehold running for 200 years from November 1, 1915. The ground rent for the leasehold was $10,500 per annum, with certain provisions for an increase.
In 1926 this property, hereinafter referred to as Hotel Monterey, was owned by the Broadway-94th Street Realty Co. On March 16 of that year that company issued its bonds in the face amount of $850,000. The bonds were known as the Monterey first mortgage fee and leasehold 6% serial gold bonds of Broadway-94th Street Realty Co. (hereinafter referred to as the ‘old bonds ‘) and were secured a deed of trust on the hotel property. Subsequent to the issuance of the old bonds but prior to 1932 certain of the bonds had been retired, leaving $726,000 in face amount outstanding in 1932. In 1932 default was made in the payment of principal ($49,000.02) and interest ($21,780) then due. There was also a default in the payment of taxes aggregating $42,090. It was stated in the application for a receiver that the gross annual income of the property had been $233,867.12— an amount insufficient to pay operating expenses, taxes, and interest on the mortgage. On September 13, 1932, a foreclosure proceeding was instituted in the Supreme Court of New York for New York County by the successor trustee, the Continental Bank and Trust Co. of New York, hereinafter referred to as the ‘old trustee.‘ The defendants in this action were Broadway-94th Street Realty Co., Bantri Realty Corporation, and others, the property having changed hands since the mortgage had been given.
The foreclosure was converted into a proceeding pursuant to sections 119 to 123, inclusive, of the New York Real Property Law. These sections were known as the Burchill Act, and were enacted during the depression (May 3, 1933) authorizing state court reorganizations involving holders of bonds secured by mortgages on real property held by trustees.
On October 4, 1934, a referee appointed by the court computed the amount due on the old bonds, together with trustee's fees, on that date to be:
+---------------------------+ ¦Principal ¦$726,000.00¦ +---------------+-----------¦ ¦Interest ¦118,052.34 ¦ +---------------+-----------¦ ¦Trustee's Fees ¦10,016.21 ¦ +---------------------------+
On October 22, 1934, a judgment of foreclosure and sale directed the referee to sell the property at public auction. By an order of May 29, 1935, a referee was appointed and directed to hear and report on plans of reorganization.
Pursuant to the provisions of a bondholders' deposit agreement of September 14, 1932, 72 percent of the outstanding old bonds had been deposited with the Monterey Hotel Bondholders' Committee, which was to act in behalf of the depositors. Under date of October 25, 1935,
ARTICLE III.
Sinking Fund.
Section 1. The Company covenants and agrees to establish and maintain a sinking fund (herein called the ‘Sinking Fund‘) for the purchase, redemption and retirement of Bonds for that purpose covenants and agrees to pay to the Trustee in trust, at or before the expiration of one year from the date hereof and at or before the expiration of every year thereafter, the sum of Ten Thousand Dollars ($10,000). The Company may, at its option, pay to the Trustee in trust, additional sums from to time to be applied by the Trustee in accordance with the provisions of this Article III.
Section 2. The Trustee shall apply the moneys so paid to it pursuant to the provisions of Section 1 of this Article III, as rapidly as may be practicable, either to the purchase, at public or private sale, of Bonds at current market prices, or, in its discretion, at the lowest prices at which Bonds at such time may be offered for sale to the Trustee, but not exceeding the current market price (if any) or, if not so purchasable, to the redemption of Bonds by lot; but in none of such events at a price in excess of the principal amount of the Bonds, plus accrued interest thereon. The Company may, in its discretion at any time, subject to the provisions of this Section 2, when the Trustee has in its possession sinking fund moneys request the Trustee to solicit tenders from the bondholders for the sale of bonds, under the provisions of this Article III.
Pursuant to the above sinking fund agreement petitioner paid the trustee $10,000 on May 3, 1938, and the trustee expended $9,992.50 of this amount to retire $29,500 face amount of the bonds during May 1938. On May 21, 1939, another $10,000 was paid by petitioner to the trustee and within a month thereafter, and prior to June 29, 1939, the effective date of Revenue Act of 1939, this amount was expended for the purchase of $31,400 face amount of the bonds. Pursuant to the trust indenture the repurchased bonds were canceled by the trustee and certificates of cancellation presented to petitioner.
The average price paid by the trustee in the repurchase operation of 1938 was $33.87 per $100 face amount of bonds. In 1939 the average price paid was $31.95 per $100 face amount of bonds. The prices paid were the market prices as of the date of purchase.
The market prices of the old bonds which were exchanged for the new bonds were as follows:
+----------------------------------------------------------------------+ ¦Date ¦Bid per $100¦Bonds bid¦Ask per $100¦Bonds offered¦ +--------------------+------------+---------+------------+-------------¦ ¦face amount ¦ ¦ ¦for ¦face amount ¦ ¦ +--------------------+-+----------+---------+------------+-------------¦ ¦ ¦(¦42 ¦3 ¦44 ¦3 ¦ +--------------------+-+----------+---------+------------+-------------¦ ¦March 1, 1937 ¦(¦41 1/2 ¦5 ¦43 1/2 ¦5 ¦ +--------------------+-+----------+---------+------------+-------------¦ ¦ ¦(¦ ¦ ¦46 ¦5 1/2 ¦ +--------------------+-+----------+---------+------------+-------------¦ ¦ ¦(¦43 ¦2 ¦45 1/2 ¦3 ¦ +--------------------+-+----------+---------+------------+-------------¦ ¦March 5, 1937 ¦(¦43 ¦3 ¦ ¦ ¦ +--------------------+-+----------+---------+------------+-------------¦ ¦March 12, 1937 ¦ ¦44 ¦3 ¦47 ¦3 ¦ +--------------------+-+----------+---------+------------+-------------¦ ¦March 19, 1937 ¦ ¦41 ¦4 ¦ ¦ ¦ +--------------------+-+----------+---------+------------+-------------¦ ¦March 24, 1937 ¦ ¦41 ¦3 ¦ ¦ ¦ +--------------------+-+----------+---------+------------+-------------¦ ¦March 30, 1937 ¦ ¦40 ¦3 ¦ ¦ ¦ +--------------------+-+----------+---------+------------+-------------¦ ¦April no quotations.¦ ¦ ¦ ¦ ¦ ¦ +--------------------+-+----------+---------+------------+-------------¦ ¦May 7, 1937 ¦ ¦33 1/2 ¦ ¦ ¦ ¦ +--------------------+-+----------+---------+------------+-------------¦ ¦ ¦(¦34 ¦ ¦ ¦ ¦ +--------------------+-+----------+---------+------------+-------------¦ ¦May 8, 1937 ¦(¦33 ¦ ¦ ¦ ¦ +--------------------+-+----------+---------+------------+-------------¦ ¦ ¦(¦34 1/2 ¦3 ¦ ¦ ¦ +--------------------+-+----------+---------+------------+-------------¦ ¦May 10, 1937 ¦(¦34 ¦ ¦ ¦ ¦ +--------------------+-+----------+---------+------------+-------------¦ ¦ ¦(¦33 ¦ ¦ ¦ ¦ +--------------------+-+----------+---------+------------+-------------¦ ¦ ¦(¦34 1/2 ¦3 ¦ ¦ ¦ +--------------------+-+----------+---------+------------+-------------¦ ¦May 15, 1937 ¦(¦34 ¦ ¦ ¦ ¦ +--------------------+-+----------+---------+------------+-------------¦ ¦May 17, 1937 ¦ ¦34 1/2 ¦5 ¦ ¦ ¦ +--------------------+-+----------+---------+------------+-------------¦ ¦May 28, 1937 ¦ ¦35 1/2 ¦4 ¦ ¦ ¦ +----------------------------------------------------------------------+
The S. W. Straus Co. placed a mortgage on the Hotel Monterey property for $850,000 in 1926. Real estate values in New York City dropped sharply during the subsequent depression beginning in 1930. If the $850,000 represented a fair value of the property in 1926 it would not necessarily have had that value in 1935 or later. The value of the property in 1935 was about the same as its value in 1937, 1938, and 1939, except for physical depreciation. Sales of property in the neighborhood of the hotel were very infrequent.
The hotel had 380 rooms of which 351 were available for rent. There were 300 bathrooms— nearly all the bathtubs were on legs and out of date. The buildings were fireproof, built of brick and steel, with concrete floors. Because of the terms of the lease the building on the leasehold was required to be built as a separate building, nothwithstanding that it was used with the improvement on the fee as one building. This requirement of the lease made necessary separate heating plants, separate elevators, additional staircases, and wider corridors than would otherwise have been necessary. These factors led to increased costs of operation.
The rooms in the hotel rented for approximately $40 per month and the property contained five stores rented, respectively, by a bank, a druggist, a restaurant, and two smaller shops.
Attached to the prospectus accompanying the plan for reorganization was an appraisal of the property made by Mark Rafalsky & Co. The value placed on the whole property, including the buildings by this appraisal, was $400,000 (leasehold property $150,000; fee $250,000). Furniture and equipment were not included in this figure. They were worth approximately $27,000 during the period 1937 to 1940. An income statement appearing in this prospectus stated that gross income for the year ended August 31, 1935, was $207,607.75. Expenses for that year before deduction of receivers' fees and expenses, interest on mortgage, and depreciation on buildings were stated to be $178,956.70, leaving a net income before the excluded expenses of $28,651.05. Net income before deductions for interest on the mortgage or real estate management fees was roughly $5,000.
For the fiscal years ended April 30, 1938, 1939, and 1940, respectively, gross income for income tax purposes was reported by petitioner to be $62,251.80, $71,013.70, and $70,985.77. For the fiscal year ended in 1939 petitioner reported in its income tax return a net loss of $1,713.83 and for the fiscal year ended in 1940 a net loss of $846.66. The net income for each of the last two years— the ones here in question— was computed without including any gain on the bond purchases previously described.
The assessed value of the real estate (including the portion held on leasehold) was $805,000 in 1935, $795,000 in 1937, $775,000 in 1938, and $765,000 in 1939. In New York City a leasehold is not assessed as such, but the fee is assessed. The value of the fee underlying the leasehold, which petitioner did not own, arrived at by capitalizing the annual rent at 6 percent, was approximately $175,000.
The value of the hotel property, including the furnishings, for the years in question was not more than $625,000.
In setting up its books petitioner included on the liability side of its balance sheet the face amount of the bonds, together with other indebtedness incurred in acquiring the property. Petitioner then made the asset side of its balance sheet equal its liabilities by allocating the amount appearing on the liability side among the various assets. In making this allocation tax assessments and insurance carried at the time the books were opened were taken into consideration. As a result, the buildings were carried as assets at $410,000, the land $210,325, leasehold $66,000, furniture and equipment $89,903.39, additions to building $26,640.37, and additions to furniture and equipment $12,206.65.
Petitioner reflected on its books the May 1938 sinking fund operations, which reduced the face amount of outstanding bonds by $29,500 through the expenditure of $9,992.50 by reducing its liabilities by the difference between the $9,992.50 and the $29,500. The corresponding change on the asset side was called an adjustment of the original purchase price. The 1939 sinking fund operations were similarly reflected by an adjustment to original purchase price.
On April 30, 1938, the balance sheet of petitioner appearing in its income tax return for the fiscal year ended on that date showed the following liabilities other than capital stock:
+--------------------------------------------------------+ ¦Accounts payable ¦$33 ¦ +------------------------------------------------+-------¦ ¦Bonds (original maturity date of 1 year or more)¦726,000¦ +------------------------------------------------+-------¦ ¦Loans payable ¦81,000 ¦ +------------------------------------------------+-------¦ ¦Security deposits ¦250 ¦ +------------------------------------------------+-------¦ ¦Total ¦807,283¦ +--------------------------------------------------------+
On April 30, 1939, a similar balance sheet showed the liabilities below:
+-------------------------------------------------+ ¦Accounts payable ¦$32.97 ¦ +--------------------------------------+----------¦ ¦Bonds, notes, etc. ¦ ¦ +--------------------------------------+----------¦ ¦(a) Original maturity less than 1 year¦3,094.78 ¦ +--------------------------------------+----------¦ ¦(b) Original maturity more than 1 year¦696,500.00¦ +--------------------------------------+----------¦ ¦Loans payable ¦52,250.00 ¦ +--------------------------------------+----------¦ ¦Total ¦751,877.75¦ +-------------------------------------------------+
And on April 30, 1940, an analogous balance sheet showed the following liabilities:
+-------------------------------------------------+ ¦Accounts payable ¦$67.70 ¦ +--------------------------------------+----------¦ ¦Bonds, notes and mortgages payable ¦ ¦ +--------------------------------------+----------¦ ¦(a) Original maturity less than 1 year¦2,305.46 ¦ +--------------------------------------+----------¦ ¦(b) Original maturity more than 1 year¦665,200.00¦ +--------------------------------------+----------¦ ¦Loans payable ¦26,000.00 ¦ +--------------------------------------+----------¦ ¦Security deposits ¦260.00 ¦ +--------------------------------------+----------¦ ¦Total ¦693,833.16¦ +-------------------------------------------------+
Exclusive of the hotel property, its assets did not at any time exceed $20,000.
Petitioner was insolvent at all times during each of the taxable years in issue.
In the notice of deficiency respondent determined the difference between the face amount of bonds retired in 1938 and 1939 and the amount expended in retiring them to be taxable income to petitioner in the year such bonds were retired.
OPINION.
OPPER, Judge:
This proceeding falls into the vexed category of controverted gain through the reduction of liabilities. See Helvering v. American Dental Co., 318 U.S. 322. The distinctions from the situation presented in that case, however, are obvious. Fifth Avenue-14th Street Corporation, 2 T.C. 516. But were it not for three other circumstances, the present case would fall squarely within United States v. Kirby Lumber Co., 284 U.S. 1. This petitioner issued its bonds for property, while in the Kirby case they were issued for cash. Subsequent developments indicate at least a limitation upon that ground of distinction. Commissioner v. American Chicle Co., 291 U.S. 426; cf. the same case below (C.C.A., 2d Cir.), 65 Fed.(2d) 454, and Commissioner v. Rail Joint Co. (C.C.A., 2d Cir.), 61 Fed.(2d) 751.
The discrepancy between the value of the property as we have found it and the face value of the bonds raises the question whether the latter were issued at par within the meaning of respondent's regulations. See Sacramento Medico Dental Building Co., 47 B.T.A. 315; cf. American Smelting & Refining Co. v. United States (C.C.A., 3d Cir.), 130 Fed.(2d) 883. But, if not, the Kirby case offers no guidance. Its reliance on the regulations, e.g., Regulations 62, art. 545, see Regulations 101, art. 22(a)(18), demonstrates the area in which its operation was intended to be confined, and indicates that the difference between purchase price and face value is significant only where there is not discount upon issuance. See Terminal Investment Co., 2 T.C. 1004, 1013. We have consistently taken this view and emphasized the issue price rather than par value in computing gain from the discharge of obligations. Consolidated Gas Co. of Pittsburgh, 24 B.T.A. 901; Norfolk Southern Railroad Co., 25 B.T.A. 925; Commissioner v. Norfolk Southern Railroad Co. (C.C.A., 4th Cir.), 63 Fed.(2d) 304; certiorari denied, 290 U.S. 672; Madison Railways Co., 36 B.T.A. 1107; Transylvania Railroad Co., 36 B.T.A. 333; but see L. D. Coddon & Bros., Inc., 37 B.T.A. 393; Corporacion de Ventas de Salitre Y Yoda de Chile v. Commissioner (C.C.A., 2d Cir.), 130 Fed.(2d) 141, 143. The question was apparently left out of consideration in Sacramento Medico Dental Building Co., supra, and perhaps remains open.
The ultimate and conclusive distinction from the Kirby case, however, is that the value of the property when acquired, which, under the evidence, showed only depreciation thereafter, left petitioner insolvent not only upon issuance of the obligations but both before and after the discounted purchases. That circumstance eliminates the realization of taxable gain on the ‘freeing of assets‘ theory of the Kirby case. Dallas Transfer & Terminal Warehouse Co. v. Commissioner (C.C.A., 5th Cir.), 70 Fed.(2d) 95; Lakeland Grocery Co., 36 B.T.A. 289; Highland Farms Corporation, 42 B.T.A. 1314; Texas Gas Distributing Co., 3 T.C. 57. ‘The petitioner's purchase and retirement of its own bonds during the taxable years simply reduced its outstanding liabilities. A reduction in outstanding liabilities which does not make a taxpayer solvent does not result in taxable gain,‘ Madison Railways Co., supra, 1109; cf., however, Helvering v. American Dental Co., supra. We accordingly find it unnecessary to examine the applicability of the ‘adjustment of purchase price‘ theory represented by Hirsch v. Commissioner (C.C.A., 7th Cir.), 115 Fed.(2d) 656; Killian Co., 44 B.T.A. 169; affd. (C.C.A., 8th Cir.), 128 Fed.(2d) 433; and Gehring Publishing Co., 1 T.C. 345; but see Commissioner v. Coastwise Transportation Corporation (C.C.A., 1st Cir.), 71 Fed.(2d) 104; certiorari denied, 293 U.S. 595.
That the property was worth substantially less than the face amount of petitioner's obligations seem to us an inescapable conclusion. On any theory of valuation, whether derived from the opinions of qualified witnesses, from the assessed valuation, from a capitalization of the prospective and actual earnings of the property, from a consideration of the condition of the general real estate market, or by reference to the market value of the bonds secured by the property, the result is similar. Neither the excessive valuation for bookkeeping purposes, Terminal Investment Co., supra, Commissioner v. Coastwise Transportation Corporation, supra, nor the discrepancy between the value we have found and the face amount of the obligations issued requires a disregard of these uncontroverted factors. American Smelting & Refining Co. v. United States, supra; Sacramento Medico Dental Building Co., supra; cf. Dodge Bros., Inc. v. United States (C.C.A., 4th Cir.), 118 Fed.(2d) 95. In fact, the figure we have included in our findings is approximately 50 percent greater than could soundly be substantiated by the record. It represents a maximum rather than an attempt to fix a value definite for all purposes. But the possibility of error is thus adequately discounted, and, since the figure adopted is yet so low as still to demonstrate petitioner's insolvency, it satisfies us that no contrary conclusion would be tenable. We accordingly view respondent's determination as erroneous.
Decision will be entered under Rule 50