Opinion
Docket No. 108505.
1943-04-14
JOHN WANAMAKER PHILADELPHIA, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.
C. J. McGuire, Esq., and Philip Bardes, Esq., for the petitioner Dean P. Kimball, Esq., for the respondent.
1. In December 1920 petitioner increased its authorized capital stock to provide for the issuance of $1,000,000 of preferred stock. A certificate denominated preferred stock was thereafter issued, on which dividends of 6 percent per annum were required to be declared by the board of directors. Payments declared as dividends by the directors were made out of accumulated earnings in the taxable years at the specified rate; also some shares of the preferred stock were redeemed by the corporation in the taxable years at 110 percent of par. Upon dissolution, liquidation or sale of all assets, payment of the ‘preferred stock‘ was to be deferred to payment of the common capital stock at par. Held, the certificate represented preferred stock and not an indebtedness owing by the corporation, and the payments accrued thereon in the taxable years, as well as the redemption premiums paid, are not deductible from gross income as interest.
2. Deduction for partially worthless bonds issued under section 112(b)(5), Revenue Act of 1936, where a proceeding for reorganization of the issuing corporation under section 77B of the Bankruptcy Act was pending in the taxable year and petitioner in that year had accepted in writing a plan of reorganization pursuant to which the reorganization was consummated and the partially worthless bonds were exchanged for bonds and stock of a new corporation in a subsequent year. C. J. McGuire, Esq., and Philip Bardes, Esq., for the petitioner Dean P. Kimball, Esq., for the respondent.
This proceeding is for the redetermination of deficiencies in income tax for the fiscal years ended January 31, 1936, 1937, and 1938, in the amounts of $1,929.54, $2,637.92, and $73,227.89, respectively. The issues submitted for decision are (1) whether or not amounts accrued in the taxable years and paid by petitioner on its so-called preferred stock are deductible as interest, and (2) whether or not petitioner is entitled to take a bad debt deduction from gross income for 1938 in reference to certain corporate bonds. A third issue relating to another bad debt deduction was abandoned by petitioner at the hearing. The facts were stipulated by the parties and such stipulations are by reference here adopted in full as our findings of fact, but we set out below, in substance, only so much thereof as is deemed sufficient for present purposes.
FINDINGS OF FACT.
Petitioner is a Pennsylvania corporation, organized in 1907, with its principal office at Philadelphia. Its income tax returns for the years here involved were made on an accrual basis and were filed with the collector of internal revenue for the first district of Pennsylvania. Petitioner was organized to own and operate the large department store in Philadelphia known as ‘John Wanamaker.‘
Immediately prior to December 14, 1920, petitioner's authorized capital stock consisted of 75,000 shares of common stock, of the year value of $7,500,000, of which 73,995 shares were owned by John Wanamaker, the individual, 1,000 shares were owned by Rodman Wanamaker, and 5 shares were owned by William L. Nevin.
On December 14, 1920, petitioner's board of directors adopted a resolution (which on the same date was approved by the stockholders) to increase the authorized capital stock in the amount of $1,000,000, to be represented by 10,000 shares designated as preferred stock, subject to the following provisions:
(a) Said preferred capital stock shall receive annual dividends of six (6) per cent, and not more, to be declared by the Board of Directors, at the times and under the conditions referred to under Section (d), but shall participate in no dividends in excess of six (6) percent per annum. Said preferred capital stock shall not participate in the good will of the business of John Wanamaker Philadelphia.
(b) Said preferred capital stock shall have no voting power, nor shall the recipient of the interest to be derived therefrom have any interest direct or indirect, in the business of John Wanamaker Philadelphia, or any Corporations connected therewith, beyond the enjoyment of the amount of dividends declared on said preferred capital stock by the Directors of John Wanamaker Philadelphia.
(c) The holders of said preferred capital stock shall have no right of an accounting, inspection, or other privilege against the said corporation, or any corporations connected therewith, at any time or any direction, control or suggestion, in the management of the business of said Corporation, or of any Corporations connected therewith.
(d) After six months from the demise of John Wanamaker the within stock shall begin to bear interest, and, after one year from date thereof, the first dividend shall be declared thereon. On one year's written notice, after date of the first dividend, the Corporation shall purchase at One Hundred and Ten ($110) Dollars a share, all, or such part, of said preferred stock, not less than Fifty Thousand ($50,000) Dollars per annum, as it shall elect, and shall continue such purchases at the end of each fiscal year of the business of John Wanamaker Philadelphia, under said terms and conditions, until the entire issue of ten thousand (10,000) shares shall have been bought, at which time said preferred capital stock shall be delivered to John Wanamaker Philadelphia.
(e) Upon dissolution, voluntary liquidation, or sale of all the property and assets, of John Wanamaker Philadelphia the payment of the preferred capital stock shall be deferred to the payment of the common capital stock; after the common capital stock has been paid, in full, at par, the preferred capital stock shall be paid, in full, at par; after both the common capital stock and the preferred capital stock shall have been paid in full at par, any remaining assets, either in cash, or in property, shall be distributed pro rata among the holders of the common capital stock according to their respective holdings.
On December 14, 1920, the stockholders of the petitioner authorized the issuance of $1,000,000 of so-called preferred stock to John Wanamaker, the individual, for an indebtedness of $1,000,000 owed by petitioner on open account to John Wanamaker, the individual, and, in accordance with the instructions of such individual, a certificate of the so-called preferred stock was issued in the name of ‘Fidelity Trust Company, Trustee.‘ The book entries of petitioner reflecting this transaction debited the personal account of John Wanamaker, the individual, with $1,000,000 and credited the preferred stock account with the same amount.
The certificate of so-called preferred stock recited that ‘FIDELITY TRUST COMPANY, TRUSTEE, is the owner of ten thousand shares of preferred capital stock of John Wanamaker Philadelphia,‘ and that such shares of ‘preferred capital stock‘ were to be held subject to the provisions of subparagraphs (a) to (e), inclusive, incorporated in the certificate as set out hereinabove.
Petitioner's $1,000,000 of so-called preferred stock was outstanding during the taxable years except for redemptions during the period 1933-1937 in the aggregate amount of $250,000.
By letter dated December 15, 1920, John Wanamaker transmitted the certificate of so-called preferred stock to the Fidelity Trust Co. to be held by that company in trust for the benefit of his two daughters, Mary B. Warburton and Elizabeth W. MacLord, with instructions that as ‘the interest‘ was declared by the board of directors of the corporation such ‘income‘ was to be divided equally between the two daughters during their lifetime in semiannual payments, and upon the death of either, leaving issue, such issue was to enjoy the income previously received by the parent, with remainder over to the issue of the daughters or to Rodman Wanamaker, his heirs and assigns, upon contingencies not material here.
The Fidelity Trust Co. by merger became known as Fidelity-Philadelphia Trust Co., and continues to hold, as trustees, petitioner's so-called preferred stock.
On or about December 15, 1920, John Wanamaker made a gift to his son, Rodman Wanamaker, of all the common stock of petitioner owned by him, amounting to 73,995 shares.
Elizabeth W. MacLeod died without issue on February 11, 1927. Mary B. Warburton and her three children were living during petitioner's taxable years 1936-1938. Rodman Wanamaker died testate on March 9, 1928. During the taxable years petitioner's common stock was held for the benefit of Rodman Wanamaker's family by trustees appointed under his will. John Wanamaker died on December 12, 1922.
In accordance with the terms under which petitioner's so-called preferred stock was issued, it began to bear interest or dividends at the rate of 6 percent per annum, commencing on June 12, 1923, and petitioner paid such interest or dividends semiannually from that date to December 12, 1932, from which latter date no payments were made to December 12, 1935. Petitioner's earned surplus per books, for the fiscal years ended as indicated, was as follows:
+-----------------------------------+ ¦(A) January 31, 1933¦$10,510,885.58¦ +--------------------+--------------¦ ¦(B) January 31, 1934¦9,491,399.63 ¦ +--------------------+--------------¦ ¦(C) January 31, 1935¦9,465,026.23 ¦ +--------------------+--------------¦ ¦(D) January 31, 1936¦9,897,267.05 ¦ +-----------------------------------+
On December 5, 1935, Mary B. Warburton, surviving beneficiary of the trust above mentioned, filed a bill of complaint in the Court of Common Pleas, No. 1, of Philadelphia County, Pennsylvania, naming as defendants John Wanamaker Philadelphia, Fidelity-Philadelphia Trust Co., and others.
On May 1, 1937, the Court of Common Pleas entered its opinion in the proceeding, in which it was stated that the complainant, having been deprived of her income since June 1933 on the preferred stock of the Wanamaker Corporation, asked the court to award to her trustee the unpaid dividends or ‘interest‘ thereon. In its conclusions of law set out in the opinion, the court stated that from and after December 12, 1932, ‘John Wanamaker Philadelphia‘ was obligated to pay to the trustee six percent per annum on its preferred capital stock; that the plaintiff was entitled to a decree ordering the corporation to pay to the trustee ‘six percent, dividends from December 12, 1932‘ on such shares of preferred stock as were outstanding when such ‘annual dividends‘ fell due.
On June 12, 1937, a final decree was entered by the Court of Common Pleas in conformity with its opinion, ordering the defendant, John Wanamaker Philadelphia, to pay the plaintiff, Mary B. Warburton, the sum of $190,631.16, ‘being interest at 6% per annum from December 12, 1932, to the date of this Decree on the shares of the preferred stock‘ outstanding in the possession of the trustee.
The final decree of the Court of Common Pleas was unanimously affirmed by the Supreme Court of Pennsylvania in an opinion filed January 24, 1938 (329 Pa. 5). In its opinion, the Supreme Court stated that the question involved was whether the complainant was entitled to receive payments at the rate of 6 percent per annum on the 10,000 shares of stock of the corporation held in trust for her, or whether she was entitled to receive such payments only when the directors of the corporation declared the payments ‘as dividends.‘
On January 24, 1938, petitioner accrued on its books $164,677.06 representing interest or dividends on its so-called preferred stock, pursuant to final decision of the Supreme Court of Pennsylvania, and on February 9, 1938, paid that amount in satisfaction of the final decree of the Court of Common Pleas. The amount so accrued and paid was deducted by petitioner in its income tax return for the taxable year ended January 31, 1938, which deduction was disallowed by respondent.
The amount of $49,500, representing interest or dividends on petitioner's so-called preferred stock outstanding from December 12, 1935, to December 12, 1936, was accrued on its books and paid during its taxable year ended January 31, 1937, but was not deducted by petitioner in its income tax return for that year, being shown thereon as dividends. The amount was not allowed as a deduction by respondent.
The amount of $45,000 was also accrued in the fiscal year ended January 31, 1938, on petitioner's outstanding so-called preferred stock, and was paid in equal semiannual installments on June 12 and December 12, 1937. Such aggregate amount was deducted in petitioner's income tax return for the fiscal year stated, and the deduction was disallowed by respondent.
The amounts of interest or dividends accrued and paid in petitioner's fiscal years 1937 and 1938, just before mentioned, where declared as dividends by the board of directors of petitioner prior to the dates of accrual or payment, except the item represented by the payment on December 12, 1937.
In discharge of its obligations under subparagraph (d) of the certificate of so-called preferred stock, set out hereinabove, petitioner redeemed $50,000 of its so-called preferred stock for a cash payment of $55,000 in each of the calendar years 1933 to 1937, both inclusive. Petitioner deducted in its income tax returns for each of its fiscal years 1936, 1937, and 1938, the redemption premium of $5,000 paid in each year, which deductions were disallowed by respondent.
In the capital stock tax returns which petitioner filed for the fiscal years ended June 30, 1933 to 1937, inclusive, the so-called preferred stock was listed as capital stock, and the par value of the outstanding shares was included as part of the declared value for capital stock tax purposes. In each of the capital stock returns for the fiscal years ended June 30, 1935 and 1937, the retirement of 500 shares of so-called preferred stock was shown as a liquidating distribution.
Facts Relating to Issue 2.
Shelburne, Inc., was a New Jersey corporation, organized in 1921, the sole business of which was the operation of the Shelburne Hotel in Atlantic City, which it owned and which was substantially its only asset.
On July 1, 1925, petitioner acquired at par $375,000 of 6 1/2 percent bonds of Shelburne, Inc., dated July 1, 1925, and due July 1, 1940, which bonds were secured by a first mortgage on the Shelburne Hotel.
Petitioner continued to own the aforesaid bonds until shortly after October 27, 1939, when it exchanged them for stock and securities of Shelburne Hotel Corporation, pursuant to a reorganization of Shelburne, Inc., under the provisions of section 77B of the Bankruptcy Act of 1899, as amended.
Shelburne, Inc., defaulted in payment of the interest due on its first mortgage bonds on July 1, 1931, and no interest was ever paid on these bonds thereafter. Upon default in payment of the interest, the principal of the bonds became due and payable.
On July 13, 1931, proceedings were instituted in the Court of Chancery of New Jersey to foreclose the first mortgage on the Shelburne Hotel. Shortly after that date a bondholder's protective committee was formed, with which committee petitioner and other bondholders deposited their bonds. The court appointed receivers to take custody of and operate the hotel, and on June 29, 1933, a decree foreclosing the equity of redemption was entered by the court.
The foreclosure proceedings were never consummated by sale, and the custodial receivers operated the hotel from July 13, 1931, to March 11, 1939.
On May 9, 1936, Shelburne, Inc., at the instigation of the bondholders' protective committee, filed a petition in the United States District Court for the District of New Jersey to reorganize pursuant to the provisions of section 77B of the Bankruptcy Act, and a plan of reorganization dated November 1, 1937, was filed in the same court. The plan of reorganization was submitted to the bondholders for approval on December 20, 1937, and was accepted in writing by petitioner on January 4, 1938. In March 25, 1938, written acceptances had been executed and filed by the holders of more than 66 2/3 percent of the bonds. Some of these acceptances were received by the committee before January 31, 1938, and some thereafter.
Because of objections made by some of the security holders, the plan of reorganization was subsequently amended in a number of minor details, and, as so amended, the plan was confirmed and approved by the court on August 19, 1938. The principal change in the original plan related to the amount of money to be borrowed for the purposes of effecting the reorganization. The reorganization was subsequently accomplished in strict conformity with the plan, as amended. On December 28, 1938, the Shelburne Hotel Corporation, hereinafter called the new corporation, was organized under the laws of New Jersey.
Pursuant to the plan of reorganization, as amended, petitioner, shortly after October 27, 1939, received $187,500 par value of general mortgage, 20-year 6 percent income bonds and 3,750 shares of common stock of the new corporation in exchange for the $375,000 par value of bonds of the old corporation, Shelburne, Inc., owned by it. As a part of the same transaction, the assets of the old corporation, including the Shelburne Hotel, were transferred to the new corporation, which obtained possession thereof on March 11, 1939.
Immediately after the exchanges above referred to the first mortgage bondholders of the old corporation owned all the stock of the new corporation and received the stock and bonds of the new corporation substantially in proportion to their interests in the property prior to such exchanges. The par value of the bonds of the old corporation outstanding at July 13, 1931, the date on which the custodial receivers were appointed, was $2,629.500, which amount, with the exception of $8,000 subsequently redeemed, remained outstanding until exchanged for securities of the new corporation. The annual interest charges on such bonds so outstanding amounted to $170,397.50.
The annual earnings of the old corporation available to pay the annual interest charges on its bonds during the years 1931 and 1935-1937, inclusive (before making provision for such interest) averaged $63,025. For the years 1932-1934, inclusive, the old corporation sustained an average annual operating deficit of $24,790, not including interest charges.
During its taxable year ended January 31, 1938, petitioner received reports of appraisals made by two independent expert appraisers, which showed the fair market value of the Shelburne Hotel property was $926,175.36, and $1,250,000, respectively. The bonds of the old corporation were not listed on any security exchange, but throughout the month of January 1938 the over-the-counter market quotations were, bid 16, asked 18.
During the taxable year ended January 31, 1938, the treasurer of petitioner, acting in its behalf, concluded that the first mortgage bonds of the old corporation held by petitioner were worthless to the extent of 50 percent of the face value thereof. The same individual who was petitioner's treasurer was also a member of the bondholders' protective committee and participated in the formation of the plan of reorganization dated November 1, 1937. His conclusion, as treasurer of petitioner, of the partial worthlessness of the bonds occurred contemporaneously with the preparation of the proposal by the bondholders' committee which led to the reorganization plan.
In its income tax return for its taxable year 1938 petitioner computed its bad debt deductions on the reserve method. During the same year petitioner made an addition of $112,318.07 to its reserve for bad debts on account of trade accounts receivable ascertained in that year to be worthless, and in addition $187,500 was charged off petitioner's books with respect to the old corporation's bonds. The aggregate of the two additions in the amount of $299,818.07 was deducted by petitioner in its income tax return for its taxable year 1938, and of such deduction respondent disallowed the amount of $187,500.
OPINION.
HILL, Judge:
The first issue for decision is whether petitioner is entitled to deduct from gross income as interest the amounts accrued on its books in the taxable years in respect of the certificate of so-called preferred stock, or whether such amounts were nondeductible dividends. This involves the primary question of whether or not the certificate represented an investment in stock of the corporation, on which it declared and paid dividends, or a loan made to the corporation on which it paid interest at the rate of 6 percent. It is the generally accepted rule that the name given to the instrument is not conclusive and that inquiry may be made as to the real character, but it is not lightly to be assumed that the parties have given an erroneous name to their transaction. ‘Its true nature will be determined by looking to its terms and legal effect.‘ O.P.P. Holding Corporation, 30 B.T.A. 337, 340; affd., 76 Fed.(2d) 11.
The parties to the present transaction at the time the certificate was issued denominated it preferred stock, but petitioner on brief urges that the Supreme Court of Pennsylvania, in affirming the decree of the Court of Common Pleas, determined that the certificate represented an indebtedness because the payments thereon were referred to as interest, and that as to the nature of the instrument we are bound by such decision of the Pennsylvania court. We can not agree with petitioner's contention that either court judicially determined the character of the certificate or of the payments thereon. The Supreme Court of Pennsylvania in its opinion said that the question there involved was whether the complainant was entitled to receive ‘payments‘ at the rate of 6 percent per annum on the ‘10,000 shares of stock of the corporation‘ held in trust for her, or whether she was entitled to receive ‘such payments‘ only when the directors of the corporation declared ‘the payments as dividends.‘
In respect of a question such as we have here, ‘many are the criteria named to aid in the determination. Sometimes a particular one is called decisive,— or the most important test,— sometimes a combination of the elements sways the determination.‘ Commissioner v. Meridian & Thirteenth Realty Co., 132 Fed. (2d) 182. The question in the instant case is especially perplexing because of the contradictory terminology used in the certificate and related documents. The Supreme Court of Pennsylvania remarked in this connection that ‘it is unlikely this certificate has its counterpart in any issue of stock ever made, and its so-called preference is a somewhat dubious one, unless it be in carrying a guaranteed 6% dividend.‘
A brief summary of the apparently conflicting or inconsistent provisions of the certificate, and attendant circumstances, may be helpful. Prior to the issuance of the so-called preferred stock on December 15, 1920, the corporation, John Wanamaker Philadelphia, was controlled by John Wanamaker, the individual, who owned all but 1,005 shares of the 75,000 shares of authorized outstanding common stock. All steps in the transaction involved here obviously were taken pursuant to his directions. On December 14, 1920, formal action was taken by the directors and stockholders to increase the corporation's authorized capital stock in the amount of $1,000,000 of preferred stock, subject to the provisions of subparagraphs (a) to (e), inclusive, set out in our findings of fact above. Plainly such action would not have been necessary or appropriate if it had been Wanamaker's intention to cause his corporation to issue a certificate of indebtedness. In (a) it was provided that ‘said preferred stock shall receive annual dividends of six (6) percent and not more, to be declared by the Board of Directors.‘ In (d) it was provided that ‘after six months from the demise of John Wanamaker, the within stock shall begin to bear interest, and, after one year from date thereof, the first dividend shall be declared thereon.‘ It was further provided that the preferred stock should have no voting power; that the recipient of the ‘interest‘ to be derived therefrom, should have no interest in the business beyond the amount of the ‘dividends‘ declared on such stock; that the holder of such stock should have no right of an accounting or any direction in the management of the business, and should not participate in the good will of the business; that upon dissolution, voluntary liquidation or sale of all the assets of the corporation, the payment of the preferred stock should be deferred to the payment of the common capital stock at par; and that after payment of the common stock and of the preferred stock, at par, any assets remaining should be distributed among the common stockholders.
There was no express provision that the payments on the preferred stock should be made out of profits or otherwise, but only that 6 percent ‘dividends‘ should be declared annually thereon by the board of directors. If such payments were intended to be true dividends, they could, of course, only be made out of profits. It appears also that the payments in the taxable years were in fact made out of profits, since the corporation had accumulated earnings in each of those years greatly in excess of the dividends declared. Furthermore, the Supreme Court of Pennsylvania seems to have reached the conclusion that the payments were intended to be made out of earnings, since the court stated in its opinion that it was unmistakenly disclosed that John Wanamaker wished to provide a certain, secured income for his daughters and ‘concluded to do this by transmuting the million dollar indebtedness of the corporation to him into stock with a fixed annual payment thereon of six percent in the nature of a charge against the earnings of the corporation.‘
All amounts accrued and paid on the certificate in petitioner's fiscal years 1937 and 1938 were declared as dividends by its board of directors, except the item represented by the payment on December 12, 1937. All amounts accrued by petitioner in its taxable year 1938 were claimed as interest deductions in its income tax return for that year, but the amount accrued in 1937 was not claimed as a deduction; it was shown on its income tax return as dividends. In the capital stock tax returns filed by petitioner for the fiscal years 1933 to 1937, inclusive, the so-called preferred stock was listed as capital stock and its par value was included as part of the declared value for capital stock tax purposes. And in the capital stock tax returns for the fiscal years 1935 and 1937, the shares retired were shown as liquidating distributions.
From the foregoing summary of facts, it appears that John Wanamaker, the individual, did not clearly indicate his intention as to whether the corpus of the trust created by him was preferred stock or a certificate of of indebtedness; and petitioner corporation did not consistently treat the certificate as representing either preferred stock or an indebtedness, nor the payments made thereon as interest or dividends. Some of the provisions tend strongly to suggest that the certificate was preferred stock; others tend to indicate that the payments were regarded as interest.
In Commissioner v. Meridian & Thirteenth Realty Co., supra, reversing 44 B.T.A. 865, the court seems to have predicated its decision that the so-called preferred stock there involved was in fact preferred stock and not indebtedness on two grounds, (1) because the court concluded that the dividends were payable only out of earnings, and (2) because the preferred stock was subordinated to the rights of ordinary creditors. It is our opinion that the facts of the present case as strongly support the conclusion that the payments were to be made only out of earnings as did the facts of the cited case. In either case, if the payments were dividends, as they were declared to be, they could lawfully be paid only out of profits. The second and more conclusively established ground mentioned in the court's opinion, namely, the fact that the certificates were subordinated to the rights of ordinary creditors, is common to both cases.
In Pacific Southwest Realty Co. v. Commissioner, 128 Fed.(2d) 815, affirming 45 B.T.A. 426, it was held that the so-called preferred stock was in fact stock, notwithstanding the certificates contained the provision that in event the corporation failed to redeem the preferred stock as provided, the holder thereafter should have the right of a general creditor to sue for the principal value of the stock and for any accumulated unpaid dividends. The court pointed out that the right to sue as a general creditor never arose, because all dividends were paid and all outstanding preferred stock was redeemed in the two taxable years. The court concluded that the payments on the preferred stock were dividends, since all payments in the tax years were declared and paid in usual corporate procedure by action of the board of directors, and thus came within the provisions of section 115 of the Revenue Acts of 1936 and 1938, which define dividends generally as distributions out of earnings or profits.
The fact that preferred stock has a definite maturity date is not necessarily conclusive, nor is restriction of dividends to payments out of earnings alone conclusive, although such fact ‘has a direct relation to the character of the right involved.‘ The essential difference between a stockholder and a creditor lies in the fact that the stockholder makes an investment and takes the risk of the venture, while the creditor seeks a definite obligation payable in any event. Commissioner v. Meridian & Thirteenth Realty Co., supra. As stated in Paul & Merten's ‘Law of Federal Income Taxation,‘ section 8.29, one of the chief elements distinguishing a loan from stock ownership is the fact that a preferred stockholder does not have an equality with the general creditors of the corporation.
In the case at bar it was provided in the certificate that the ‘preferred stock‘ should receive annual dividends to be declared by the board of directors; substantially all payments accrued in the taxable years were in fact declared by the board of directors and were paid out of accumulated earnings; the holder of the certificate, in the event of failure of redemption, did not have the right of a general creditor to sue for the principal value of the stock; not only was the ‘preferred stock‘ subordinated to the rights of general creditors, but upon dissolution, voluntary liquidation or sale of all the corporate assets, payments of the preferred stock was deferred to payment of the common stock. Thus, the principal was not a definite obligation payable in any event, but was subject to the risk of the enterprise.
For the reasons indicated, we hold that the certificate in controversy was preferred stock and not indebtedness, and that petitioner is not entitled to deduct from gross income as interest the amounts of the accrued payments. It follows also that premiums paid upon redemptions were obligations of the corporation to a stockholder, and are not deductible. Pacific Southwest Realty Co., supra.
On the first issue, respondent's determination is approved.
The second issue is whether petitioner is entitled to deduct from gross income or for the taxable year 1938, as a partially worthless debt, 50 percent of its investment in bonds of Shelburne, Inc.
Petitioner made a determination of partial worthlessness of 50 percent of face value of the bonds and charged such amount off its books in the taxable year by way of addition to a reserve for bad debts. It claimed the amount as a deduction in its income tax return. Respondent disallowed the deduction.
Section 23(k) of the Revenue Act of 1936, under which petitioner claims the deduction, provides that there shall be allowed as deductions 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 as a deduction in an amount not in excess of the part charged off within the taxable year.
There is no doubt that these bonds would have been worthless in the taxable year to the extent claimed by petitioner had there been no pending plan of reorganization of the debtor corporation. However, respondent contends substantially that, because of the then pending plan of reorganization of the debtor corporation, which plan was subsequently carried into effect and pursuant to which petitioner exchanged its old bonds for bonds and stock of the new or reorganized corporation, its ascertainment of partial worthless of the old bonds can not be dissociated from the reorganization exchange and treated separately for income tax purposes; that the ascertainment of worthlessness occurred in connection with and as a part of the reorganization exchange, and hence neither gain nor loss can be recognized under the provisions of section 112(b)(5) of the Revenue Act of 1936.
SEC. 112. RECOGNITION OF GAN OR LOSS.(b) EXCHANGES SOLELY IN KIND.—(5) TRANSFER TO CORPORATION CONTROLLED BY TRANSFEROR.— No gain or loss shall be recognized if property is transferred to a corporation by one or more persons solely in exchange for stock or securities in such corporation, and immediately after the exchange such person or persons are in control of the corporation; but in the case of an exchange by two or more persons this paragraph shall apply only if the amount of the stock and securities received by each is substantially in proportion to his interest in the property prior to the exchange.
If respondent's contention is well founded, as in our opinion it is, then section 112(b)(5) is controlling under the stipulated facts set out hereinabove, and section 23(k), supra, is not applicable. Cf. Edith M. Greenwood, 41 B.T.A. 664, 667.
In the Greenwood case, the taxpayer during the taxable year exchanged her old bonds for new bonds having a lesser face value, pursuant to a statutory reorganization of the corporation under section 77B of the Bankruptcy Act, and we held that, because of the nonrecognition provisions of section 112(b)(3), she was not entitled to deduct the difference between the face amounts of her old and new bonds as a debt ascertained to be partially worthless in the taxable year. See also Hoagland Corporation, 42 B.T.A. 13; affd., 121 Fed.(2d) 962; Daniel MacDougald, 44 B.T.A. 1046; Louis E. Stoddard, Jr., 47 B.T.A. 584 (on appeal, C.C.A. 2d Cir.); and compare Reed v. Commissioner, 129 Fed.(2d) 908, affirming 45 B.T.A. 1130.
In substance, the transaction involved in the Reed case was held to be an exchange within section 112(b)(5), supra, preventing recognition of gain or loss, on parity of the reasoning applied in the other cases under section 112(b)(3). In its opinion the court said:
It seems clear to us that section 23(k) of the Revenue Act of 1936 is concerned with a debt which is continued to be held by the taxpayer and the allowance is in anticipation of a loss which will be occasioned when an accounting is made with the defaulting debtor. In the instant case, it is evident that there never will be an accounting. The petitioners effectively disposed of their Investment notes and thereby avoided such an accounting.
Accordingly, we feel that the above transfer of the Investment notes * * * for the Sutherland stock constituted an exchange within the intendment of section 112(b)(5) * * *
Nor does our decision impose an undue hardship on the petitioners inasmuch as the deductibility of the loss, if any, is merely postponed until the petitioners dispose of the stock received in the exchange. That is the proper time to claim a deduction for such loss as has been sustained.
In the case at bar, unlike the cases cited above, the reorganization was not completed, and the exchanges of bonds of the old corporation for bonds and stock of the new corporation were not made within the taxable year. However, it seems to us, under the circumstances disclosed here, that fact is not of controlling importance.
The proceeding for reorganization of the old corporation under section 77B of the Bankruptcy Act was instituted on May 9, 1936, and a plan of reorganization was filed with the court under date of November 1, 1937. The plan was submitted to the bondholders for approval on December 20, 1937, and was accepted in writing by petitioner on January 4, 1938. Thus, the plan was formulated, filed with the court, submitted to the bondholders, and accepted by petitioner all within its taxable year ended January 31, 1938. This same plan, with unimportant modifications, was subsequently accepted by the holders of the requisite percentage of outstanding bonds, was approved by the court, and was fully consummated. And it was pursuant to the plan that petitioner exchanged its old bonds for new bonds and stock. Petitioner's treasurer represented the corporation on the bondholders' protective committee, and also in its behalf made the ascertainment of partial worthlessness of the bonds owned by it contemporaneously with his participation in the formulation of the plan of reorganization. In the light of these facts, we think petitioner's ascertainment of partial worthlessness was so intimately a part of the reorganization exchange and so closely connected with the plan pursuant to which the exchange was made as to invoke application of the nonrecognition provisions of section 112(b)(5).
At one and the same time, petitioner's treasurer determined that the Shelburne bonds were worth only 50 percent of face value for purposes of the plan of reorganization, and also for the purposes of enabling petitioner to claim a bad debt deduction. ‘It has been held repeatedly that all of the different steps taken under a reorganization plan must be regarded as component parts of the plan and can not be treated as isolated transactions in determining the tax consequences.‘ United Gas Improvement Co., 47 B.T.A. 715, 725.
Henry R. Huntting, 32 B.T.A. 495, cited by petitioner, is distinguishable on the facts from the instant case. There, at the close of the taxable year the taxpayer had not bound himself to accept the terms of a plan of reorganization; in fact there was no plan then pending, although a plan of reorganization had been theretofore formulated and abandoned. In such circumstance, we concluded that the statute did not require the holder of a partially worthless bond to anticipate a possible reorganization of the issuing corporation at some time in the future.
It may be contended that the ascertainment of partial worthlessness of a debt with the view of a deduction for income tax purposes is not a step or is not involved in a plan of reorganization of a debtor corporation and that the question of the allowance of such deduction should be determined independently of such plan. Whether or not that is true in the abstract, the facts in the instant proceeding clearly indicate that the claimed deduction for bad debt was taken in contemplation of an expected consummation of the pending plan of reorganization.
Where, as here, petitioner through its appointed representative participated in the formulation and submission of a pending reorganization plan for the purpose of conserving and protecting the value of the same indebtedness in respect of which it seeks a bad debt deduction, and where, as here, the plan was in active process of adoption and consummation and had been formally agreed to by the taxpayer in the taxable year, we think a situation is presented that requires consideration of the deductions sought in the light of the purposes and anticipated consequences of the pending reorganization plan. It will be borne in mind that petitioner, together with all other first lien bondholders, was to participate in the proposed reorganization in proportion to the face value of the bonds held. One result of such reorganization would be that under the provisions of section 112(b) (5) no gain or loss occasioned thereby could be recognized for income tax purposes. In the light of the circumstances here presented it would obviously be an evasion of such result of reorganization to permit the bad debt deduction claimed. It would nullify the nonrecognition provisions of the reorganization statute to permit a taxpayer to secure through a bad debt deduction a recognition of his loss while he is actively participating in the prosecution of a reorganization plan which when consummated would deny such recognition.
The two statutory remedies can not be simultaneously invoked. A pending plan of reorganization precludes deduction for partial worthlessness of a debt which constitutes, in material part, the basis of the proposed reorganization.
The present case, in our opinion, falls within the rule applied in the Greenwood, Hoagland, Reed, and other decisions above cited.
The foregoing is reason sufficient for the denial of the deduction for bad debt. However, it is also pertinent to observe that, because of the pending plan of reorganization, the correctness of the amount of partial worthlessness of the bonds determined by petitioner as a basis for bad debt deduction is open to successful challenge.
The proposed plan of reorganization provided that the holders of the old bonds should exchange them for bonds in the new corporation in an amount equal to 50 percent of the amount of the old bonds and a proportionate share of a majority of the authorized capital stock of the new corporation. The testimony of petitioner's treasurer was that the old bonds were determined to be worth only 50 cents on the dollar both for the purpose of bad debt deduction and as a basis of reorganization. Apparently this value was based on the underlying asset value. All of such assets were under the plan to be transferred to the new corporation. Petitioner held no stock in the old corporation but under the proposed reorganization it was to receive a proportionate amount of a specified majority of stock of the new corporation in addition to bonds of equal value to the old bonds. It is reasonable to deduce from the facts stipulated and in evidence that such stock would have substantial value beyond that of assuring to the bondholders control of the corporate affairs. This conclusion is support not alone by the fact that the new corporation was to be recognized on a basis expected to enable it to operate at a profit and take care of service charges on its obligations, but it also finds support in the fact that under the plan of reorganization rights were to be issued to junior lien bondholders to subscribe for a minority of the capital stock of the new corporation at $30 per share. Hence, it would appear that the old bonds, in view of the prospect of the adoption and consummation of the reorganization, had a value in excess of 50 percent of face by reason of the potential value of the stock of the proposed new corporation.
The ascertainment of partial worthlessness of the old bonds was obviously made without reference to the advantages which the pending reorganization plan held in prospect and did not, therefore, reflect correctly the amount, if any, of such partial worthlessness. The claimed deduction for bad debt is so untimely connected in time and substance with the pending plan of reorganization that it can not be dissociated therefrom for separate consideration.
Accordingly, on the second issue, respondent's determination is approved.
Reviewed by the Court.
Decision will be entered for respondent.