Comm'r of Internal Revenue

Tax Court of the United States.Jun 22, 1943
2 T.C. 197 (U.S.T.C. 1943)
2 T.C. 197T.C.

Docket Nos. 110034 111589.



Harrison Lillibridge, Esq., for the petitioners. William G. Ruymann, Esq., for the respondent.

The petitioners and others advanced money to a corporation. Each received the corporation's notes, and six-tenths of a share of stock for each $1,000 advanced. No other stock was issued except that inter, after advancements of money had ceased, after default upon interest on all notes and upon principal of a part, some stock was issued as additional compensation or bonus for services. The corporation had no other assets or capital, except the advances so made. Held that the petitioners owned securities, and upon dissolution of the corporation loss therein was properly considered and limited as loss from sale or exchange of capital assets, within the meaning of section 23(g)(2) and (3) of the Internal Revenue Code. Harrison Lillibridge, Esq., for the petitioners. William G. Ruymann, Esq., for the respondent.

These proceedings, duly consolidated, involve the redetermination of income tax deficiencies for the year 1939 in the following amounts: Docket No. 110034, $438.04; Docket No. 11589, $1,860.37. In Docket No. 110034, the petitioners allege an overpayment in the amount of $3.51.

The single question for decision is whether the petitioners are entitled to deductions for the full amounts of certain worthless promissory notes owing to them, or whether only a percentage of the losses resulting from worthlessness may be taken into account in computing net income.


Edward G. Janeway and Elinor W. Janeway are husband and wife, residing in Oyster Bay, New York, and having a business address at 40 Wall Street, New York City. They filed their joint return for the taxable year with the collector for the second district of New York. Robert McC. Shields resides in Darien, Connecticut, and has a business address at 61 Wall Street, New York City. He filed his return for the taxable year with the collector for the second district of New York.

In 1934 petitioner Edward G. Janeway interested petitioner Shields in the exploration and development of certain mining claims which were then owned by C. Sewell Thomas, of Denver, Colorado. A corporation, named Thomas Associates, Inc., was organized under the laws of the State of Colorado in March 1934 for the purpose of acquiring the claims and developing them through use of the skill and knowledge of C. Sewell Thomas. Thomas Associates, Inc., had an authorized capital stock of 1,000 shares without par or nominal value, none of which was subscribed for by the incorporators and none of which was ever subsequently issued or sold, except as hereinafter set forth.

The articles of incorporation of Thomas Associates, Inc., named as directors petitioner Edward G. Janeway, C. Sewell Thomas, and Alexander M. White. At the first directors' meeting, held March 8, 1934, the following resolution was adopted:

That for the purpose of financing the affairs of this company and to provide working capital therefor, the President (or Vice-President) be and they are hereby authorized, empowered and directed to borrow upon and as evidence thereof, to issue notes in the name of the company in denominations of $1000.00 or multiples thereof, up to an aggregate amount of $50,000.00, payable on or before two (2) years after date and bearing interest at the rate of six per cent (6%) per annum, conditioned further upon the understanding that no dividend be paid by the corporation so long as any of said notes remain unpaid.

Further that the original subscriber or holder of said note or notes, in consideration therefor, shall be and receive capital stock in this company on the basis of 6/10ths of a share thereof for each $1000.00 principal of said notes subscribed and paid for at par.

Thereafter advances were made to the corporation by the persons named below, on the dates and in the amounts set opposite their names:

+----------------------------------------------+ ¦Edward G. Janeway, March 14, 1934 ¦$5,000¦ +---------------------------------------+------¦ ¦Robert McC. Shields, March 14, 1934 ¦5,000 ¦ +---------------------------------------+------¦ ¦Alexander M. White, Jr., March 14, 1934¦5,000 ¦ +---------------------------------------+------¦ ¦( March 14, 1934 ¦2,000 ¦ +---------------------------------------+------¦ ¦C. Sewell Thomas, ¦ ¦ +---------------------------------------+------¦ ¦( July 10, 1934 ¦3,000 ¦ +----------------------------------------------+

Each received a promissory note of the corporation for the amount or amounts advanced, and shares of stock at the rate of six-tenths of a share for each $1,000 advanced. The maturity date of the notes was March 20, 1936. They contained provisions for semiannual payments of interest to be computed at the rate of 6 percent per annum.

At a meeting of the directors held October 4, 1934, resolutions were adopted reciting the prior resolution of March 8, 1934, and the advances totaling $20,000 made thereunder, and providing as follows:

RESOLVED: that the Corporation issue and sell at par, $18,000 notes of the Corporation, to be dated on or about October 4, 1934, as to one-half (1/2) thereof, and on or about November 1, 1934 as to remaining one-half (1/2) thereof; to bear interest at 6% per annum; and to become due July 15, 1935; the said notes to be taken up by Messrs. E. G. Janeway as to $6,000, A. M. White Jr. as to $6,000, and R. McCormick Shields as to $6,000; and be it further

RESOLVED: that under the provisions of the resolution adopted March 8, 1934, the subscribers to the notes to be issued hereunder, shall in consideration therefor be entitled to receive capital stock in this Company on the basis stated in said resolution, viz., six-tenths (6/10) of a share of such stock for each $1,000 of principal of the said notes subscribed and paid for at par; and be it further,

RESOLVED: that the Officers of the Corporation are hereby authorized and directed to do any and all acts and things necessary to put the foregoing resolutions into effect.

Thereafter, Janeway, Shields, and Alexander M. White, Jr., made advances in amounts totaling $6,000 each, and each received promissory notes for the same amount and shares of stock of Thomas Associates, Inc., in the proportion specified in the resolutions. The notes matured on July 15, 1935, and contained provisions for the payment of interest at the rate of 6 percent per annum, payable semiannually.

During 1935 Janeway, Shields, Alexander M. White, Jr., and C. Sewell Thomas made additional advances of amounts totaling $1,000 in the case of each to Thomas Associates, Inc. Pursuant to the directors' resolution of March 8, 1934, the corporation issued to each a note for $750, dated January 8, 1935, maturing May 1, 1935, and a note for $250, dated May 24, 1935, and payable by its terms on the same day. The notes provided for payment of semiannual interest at the rate of 6 percent per annum, and contained recitals that they were issued as part of the series of notes authorized by the resolution of March 8, 1934. No stock was issued to any of the note holders in connection with any of these last advances made during 1935.

With the exception of a note for $250 issued to petitioner Shields at the time of his last advance to Thomas Associates, Inc., all of the notes issued to the petitioners are in evidence. They have no interest coupons and are not in registered form. Those issued in connection with the advances made in March 1934 contained a covenant by the corporation that ‘no dividends shall be declared or paid on any of its capital stock so long as any of the notes of this series remains unpaid in whole or in part.‘ Notes issued for the subsequent advances contained no such express covenant, but each of such notes did contain a recital to the effect that it was one of a series of notes not to exceed a total amount of $50,000, duly authorized by the board of directors by resolution of March 8, 1934. All the notes were entered as ‘Notes Payable‘ on the books of the corporation.

During 1934 and 1935 no stock of Thomas Associates, Inc., was issued except in connection with the advances represented by the promissory notes. Thus, at the end of 1935 the total number of shares issued and outstanding was 22.8, all of which were held by Janeway, Shields, Alexander M. White, Jr., and C. Sewell Thomas. The number of shares held by each, and the amounts of money theretofore advanced by each, were as follows:

+--------------------------------------+ ¦ ¦Shares¦Advances¦ +----------------------+------+--------¦ ¦Edward G. Janeway ¦6.6 ¦$12,000 ¦ +----------------------+------+--------¦ ¦Robert McC. Shields ¦6.6 ¦12,000 ¦ +----------------------+------+--------¦ ¦Alexander M. White, Jr¦6.6 ¦12,000 ¦ +----------------------+------+--------¦ ¦C. Sewell Thomas ¦3.0 ¦6,000 ¦ +----------------------+------+--------¦ ¦Total ¦22.8 ¦42,000 ¦ +--------------------------------------+

No cash or property was ever paid to the corporation for the issuance of any of its stock (except for the question herein involved). The only consideration for the issuance of the shares outstanding at the end of 1935 had been the advances made by the note holders. Except for 250 shares issued January 31, 1936, to C. Sewell Thomas, as a bonus or additional compensation for services, no other stock was ever issued. At the time of the directors' meeting of March 8, 1934, the corporation owned no assets of any kind. The first advances totaling $20,000 were used for the purchase of mining claims and equipment. The money represented by the notes issued pursuant to the resolution of October 4, 1934, was used for the purchase of additional mining claims.

Thomas Associates, Inc., realized an undisclosed amount of income during its early existence. However, its earnings were never sufficient to enable it to meet the interest payments due on its notes, although in 1934 it did accrue the 1934 interest as a liability on its books. Nothing was ever paid on account of the principal indebtedness or interest, and no dividends were ever paid to stockholders.

Janeway, in addition to his directorship, held the office of vice president of the corporation. As such, and through frequent correspondence and meetings with C. Sewell Thomas, the manager, he kept in touch with the affairs of the corporation, and was familiar with its financial condition. Shields knew from frequent inquiry of Janeway that the venture was not proving profitable, and that there was no money available for payment of either principal or interest on the notes. Both men decided to ‘let the principal ride‘ in the hope that sufficient earnings for payment might be realized at a future time. In 1939 the stockholders decided that the prospects did not justify continuation of the business. At a meeting held December 22, 1939, it was unanimously voted that the charter be surrendered and the corporation be dissolved. Dissolution having been effected, Shields and Janeway, in 1939, ascertained their notes to be worthless and charged off the indebtedness as uncollectible. Each claimed a bad debt deduction of $12,000 on his return for the taxable year. The respondent determined that the losses were capital losses, and that the allowable deduction in each instance was $6,000.

Other adjustments to reported net income are not in issue.


DISNEY, Judge:

The petitioners contend that they were mere creditors of Thomas Associates, Inc., that the notes held by them became worthless in the taxable year and were charged off, and that they properly deducted the entire amount thereof as worthless debts in the taxable year. One of the amendments to section 23(k) of the Internal Revenue Code, made by section 124(a) of the Revenue Act of 1942, has the effect of making the deduction for worthless debts depend solely upon the fact of worthlessness, and eliminates the necessity of an ascertainment of worthlessness and an actual charge-off by the taxpayer. Under section 124(d) of the 1942 Act, that amendment is effective with respect to taxable years beginning after December 31, 1938, and is therefore applicable here. The respondent, not denying the worthlessness, contends, in effect, simply that the petitioners held capital assets because ‘beneath the outward appearance of the so-called 6% notes was a conception of a contribution to the capital of Thomas Associates, Inc.,‘ and that therefore section 117 of the Internal Revenue Code, was properly applied by the allowance under the schedule of section 117 of deduction of only 50 percent of the amounts claimed by the petitioners. This requires consideration of section 23(g)(2) and (3) of the Internal Revenue Code, defining shares of stock as securities and providing that if such securities become worthless and are capital assets, the loss resulting shall ‘be considered‘ as a loss from sale or exchange, for mere worthlessness of stock, without sale or exchange would not, in the absence of section 23(g)(2) and (3) permit application of the schedule set forth in section 117.

SEC. 124. DEDUCTION FOR BAD DEBTS, ETC.(a) GENERAL RULE.— Section 23(k) (relating to bad debts and securities becoming worthless) is amended to read as follows:‘(k) BAD DEBTS.—‘(1) GENERAL RULE.— Debts which become worthless 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, in an amount not in excess of the part which becomes worthless within the taxable year, as a deduction. This paragraph shall not apply in the case of a taxpayer other than a bank, as defined in section 104, with respect to a debt evidenced by a security as defined in paragraph (3) of this subsection. This paragraph shall not apply in the case of a taxpayer, other than a corporation, with respect to a non-business debt, as defined in paragraph (4) of this subsection.‘

SEC. 117. CAPITAL GAINS AND LOSSES.(b) PERCENTAGE TAKEN INTO ACCOUNT.— In the case of a taxpayer, other than a corporation, only the following percentages of the gain or loss recognized upon the sale or exchange of a capital asset shall be taken into account in computing net income:50 per centum if the capital asset has been held for more than 24 months.

SEC. 23, DEDUCTIONS FROM GROSS INCOME.In computing net income there shall be allowed as deductions:(g) CAPITAL LOSSES.—(2) SECURITIES BECOMING WORTHLESS.— If any securities (as defined in paragraph (3) of this subsection) become worthless during the taxable year and are capital assets, the loss resulting therefrom shall, for the purposes of this chapter, be considered as a loss from the sale or exchange, on the last day of such taxable year, of capital assets.(3) DEFINITION OF SECURITIES.— As used in this paragraph (2) of subsection the term ‘securities‘ means (A) shares of stock in a corporation, and (B) rights to subscribe for or to receive such shares.

Our examination of this interesting question convinces us that the petitioners held securities under section 23(g)(2) and (3). The substance, and not the form of what was done, controls for the tax purpose here involved. Although the parties did set this matter up on the corporate records as one of issuing notes plus stock, and although the petitioners contend that the stock was a mere bonus in consideration of the loan of money to the corporation, in our view one salient fact requires a negative answer to such contention: All of the corporate stock issued in connection with the advancements of money was issued in direct proportion to the amount of money put out by the stockholders; that is to say, that for each $1,000 advanced by the two petitioners, by White and by Thomas, the other stockholders, each received six-tenths of a share of stock. The fact that for the last $1,000 advanced by each no stock was issued was, under the evidence, mere inadvertence. It was issued, as was all the other stock, under the resolution of March 8, 1934, providing for the issuance of the six-tenths share of stock for each $1,000. Considering the fact of such issuance in precise proportion to the amount of money advanced by the stockholders, we can not hold the stock, although issued in small quantities, to be a mere bonus, of no consequence to the present question; for the fact that the stock was issued in small quantities is immaterial, since the entire stock issue was only 22.8 shares.

Not only are the petitioners not mere creditors, but also stockholders, but when they received the notes and stock they received pro rata control of the corporation through ownership of its stock in proportion to the amount of money advanced. Had the corporation earned large amounts of money, the petitioners would have been entitled to the whole thereof, that is, in accordance with their portion of the 22.8 shares of stock extant. In such a situation, we think we may not regard the stock as a mere bonus given because of the loan of money, as in substance the petitioners view the matter. The effect was that in return for the money and in exact proportion thereto, the petitioners and the other stockholders received a capital interest in and control of the corporation, and all of its assets, earnings, and profits. The effect would have been in nowise different had 1,000 shares issued for each $1,000 contributed, for the stockholders, including the petitioners, controlled the corporation just as effectively with 22.8 shares of stock as they would have with several thousand shares, they having, though in small amount, the entire capital stock. Though, as petitioners argue, it was their intention to receive notes for the money put out by them, it was also their intention to receive, and they did receive with the other stockholders in like position as to advancements, the entire issued capital stock of the corporation and all the control and value it entailed, in proportion to the money which went into the corporation. Though the advances made were, by the issuance of the notes, given the appearance of loans, the possibility of repayment was no stronger than the business and its possible success. No other money was paid in for stock, so that the advances constituted the corporation's only source of working capital.

Ordinarily a loan to a corporation, if not otherwise secured, has the assurance of capital having been paid into the corporation so that the assets purchased therewith are subject to the payment of the loan. Here the ‘loans‘ constituted the sole capital, with no other assets subject to repayment. The effect of what was done is the same as if the petitioners and the other stockholders purchased the stock with the money advanced, and became pro rata owners of the corporation. The fact that at a later period, after they had ceased advancing money, they permitted the issuance of 250 shares of stock to Thomas as bonus or additional compensation for services, does not alter essentially the fact that the petitioners, at the time of acquisition of their stock and notes, made a capital contribution to the corporation proportionate to stock issued. In the taxable year they still retained not only the notes but the stock. Under such circumstances, it is our opinion that the petitioners stock comes within the definition of securities under section 23(g)(3) and that, such stock having become worthless during the taxable year, the loss resulting therefrom must ‘be considered as a loss from the sale or exchange, on the last day of such taxable year, of capital assets.‘ It is not argued that the petitioners holdings, whether considered stock or notes, were not capital assets. Nor is any question raised as to the proper percentage being applied by the Commissioner to the amounts involved if section 117 is applicable.

We therefore conclude and hold that the Commissioner did not err in allowing deduction of only 50 percent of the losses sustained by the petitioners in the taxable year.

Decision will be entered for the respondent.