Comm'r of Internal Revenue

Tax Court of the United States.Sep 30, 1949
13 T.C. 468 (U.S.T.C. 1949)
13 T.C. 468T.C.

Docket No. 18443.



Arthur V. McDermott, pro se. Stephen P. Cadden, Esq., for the respondent.

Petitioner is entitled to a deduction of the amount of $1,000 in the taxable year 1944, as a capital loss carry-over of a nonbusiness and debt loss sustained in 1943. Arthur V. McDermott, pro se. Stephen P. Cadden, Esq., for the respondent.

This proceeding involves an income tax deficiency for the calendar year 1944 in the sum of $148.01.

The contested issue is whether petitioner is entitled to a nonbusiness bad debt deduction to the extent of $1,000, or is limited to the amount of $750 allowed by the respondent as a long term capital loss. This issue is resolved by the answer to the question of whether, when petitioner conveyed his one-eighth interest in certain real property to Emerson Holding Corporation for its note for $12,500, a debt to petitioner was created or petitioner invested that amount in the company.


Petitioner is an individual, residing in the city of New York, New York. He and his wife filed a joint income tax return for the calendar year 1944 with the collector of the internal revenue for the third district of New York.

Petitioner was one of the three trustees and executors of the estate of his mother, Mary E. McDermott, who died on May 23, 1930. Petitioner, an attorney, had general charge of the affairs of the estate. Included in the decedent's estate was a loft-type commercial building in New York City, occupied by four tenants. This property was assessed in 1931, for estate tax purposes, at $105,480. Under the will of Mary E. McDermott, title to this property passed to her eight children, including petitioner.

In July 1936 the Emerson Holding Corporation (hereinafter referred to as Emerson) was incorporated, and the eight heirs conveyed their interest in the aforementioned real property thereto for a recited consideration of $108,418. The corporation was formed because of the difficulty of securing unanimity of opinion among the heirs with respect to the management and operation of the property.

The officers and directors of Emerson were members of the McDermott family. Petitioner was the president of Emerson and had general charge of its affairs throughout its existence.

In consideration for the transfer of the title to the aforesaid real property, Emerson issued to each of the eight heirs its unsecured promissory note for the amount of $12,500. Three of the heirs received additional notes aggregating $8,418, making up the total consideration for the conveyance.

Simultaneously with the transfer of the real property, each of the eight heirs transferred to Emerson certain cash, securities, and accounts receivable aggregating $5,533.36, in exchange for five shares of its no par common stock. Other than the aforesaid 40 shares, no other stock was ever issued. No shares were sold by any of the heirs. No dividends were ever paid by the corporation.

After it acquired this property, Emerson took over the complete operation and management of the same. It negotiated new leases, made renewals of leases, maintained its own bank account, paid its obligations exclusively from its own funds and, during the period of its existence, expended $7,752.34 in capital improvements. The gross income from rentals for the period August 1, 1936, to February 28, 1942, was $63,654.50, and its gross operating costs during that period were $28,386.16. The net operating income for the year 1941, the last full year of operation, was $6,796.56. During the period August 1, 1936, to December 31, 1942, it paid interest on the outstanding notes in the aggregate amount of $38,098.19.

In February 1942 the real estate was taken under condemnation by the city of New York at a valuation of $87,000, bringing to an end the operations for which the corporation was organized. Emerson was allowed to remove certain fixtures and furniture and dispose of them for its own account.

The liquidation of the assets and the distributions to the noteholders were not completed until December 1, 1943. As of December 31, 1943, the sole assets of Emerson consisted of cash and accounts receivable aggregating $1,356.48, and its liabilities of $29,285.63 consisted exclusively of an unpaid balance due on the notes held by the eight noteholders. The corporation was dissolved on November 22, 1944, at which time its sole asset was $955.02 in cash, which was subsequently paid out for legal and liquidating expenses. During the liquidation Emerson paid to petitioner $9,000 on the note of $12,500.

The note issued by Emerson to petitioner reads as follows:

NEW YORK, N.Y., August 1, 1936

On Demand, as hereinafter provided, Emerson Holding Corporation promises to pay to the order of Arthur V. McDermott the sum of Twelve Thousand Five Hundred Dollars ($12,500.) with interest at the rate of 6%, payable quarterly or monthly at the option of the corporation. Value received.

This note is one of eight notes, all of like amount and bearing the same date, and shall not be due or payable unless and until the owners and holders of five of said notes join in a demand for payment.

All rights and benefits under the statute of limitations are hereby waived.




Petitioner deducted on his 1944 income tax return $1,000 as a nonbusiness bad debt on account of the aforesaid note.

In his deficiency notice the respondent allowed petitioner a deduction of the amount of $750 as a long term capital loss, with the following explanation:

Note received July 1936 from Emerson Holding Corp., in exchange for 1/8 share of property $12,500.00. Proceeds at time of sale of property.

+----------------------------------------------------------------+ ¦ ¦ ¦ +--------------------------------------------------+-------------¦ ¦by Corporation ¦9,000.00 ¦ +--------------------------------------------------+-------------¦ ¦Balance uncollectible ¦3,500.00 ¦ +--------------------------------------------------+-------------¦ ¦50% deductible as Capital Loss ¦1,750.00 ¦ +--------------------------------------------------+-------------¦ ¦Deducted in 1943 ¦1,000.00 ¦ +--------------------------------------------------+-------------¦ ¦Deductible in 1944 ¦750.00 ¦ +--------------------------------------------------+-------------¦ ¦On return ¦1,000.00 ¦ +--------------------------------------------------+-------------¦ ¦Difference ¦250.00 ¦ +--------------------------------------------------+-------------¦ ¦ ¦ ¦ +----------------------------------------------------------------¦ ¦This loss is held to be a capital loss and not a bad debt. * * *¦ +----------------------------------------------------------------+

On August 1, 1936, a debt of $12,500 from Emerson to petitioner was created. At the time the debt was created, petitioner was not engaged in the business of making loans.


LEECH, Judge:

The sole question on which the issue here must be decided is whether, when petitioner conveyed his one-eighth undivided interest in certain real property to Emerson in consideration of its promissory note, the transaction resulted in the creation of a debt from Emerson to petitioner in the amount of the note, or an investment in Emerson of the same amount. This issue presents a question of fact. Cohen v. Commissioner, 148 Fed.(2d) 336; Janeway v. Commissioner, 147 Fed.(2d) 602. The intent of the parties as to the nature of the transaction controls. Wilshire & Western Sandwiches, Inc. v. Commissioner, 175 Fed.(2d) 718.

Emerson was formed in 1936 to hold and operate a business property then owned by eight heirs of the estate of Mary E. McDermott. This corporation was organized and operated for a legitimate business purpose from the time of its incorporation until its principal asset was taken over by condemnation for public purposes. It earned considerable operating income, paid its obligations, except those here involved, made capital repairs, kept complete books of account, and maintained its own bank account. Although the noteholders and the stockholders were the same individuals, Emerson was a distinct and separate taxable entity. See Moline Properties, Inc. v. Commissioner, 319 U.S. 436. The respondent has so treated it and does not here argue otherwise. The relationship of petitioner to Emerson might have been established as that of a stockholder, a creditor, or both. What do the facts and the proper inferences to be drawn therefrom establish as bearing on the intention to create a debt of that $12,500 rather than make an investment?

Petitioner, for the transfer of his undivided one-eighth interest in the real property received Emerson's unsecured promissory note for $12,500, bearing interest at 6 per cent per annum. The value of the interest conveyed was the equivalent of the face amount of the note. The corporation, between 1936 and 1942, paid the interest provided for in the note. The parties themselves thus treated the transaction as creating a debtor and creditor relationship and not a proprietary interest. Cf. Grant G. Simmons, 4 T.C. 478, 483.

Also, as bearing upon the intention of the parties, is the important fact that, in addition to the promissory notes received by the heirs for conveying title to the real property, the heirs transferred additional personal property in the form of cash, securities, and receivables valued at $5,533.16, in consideration of which Emerson issued to each heir five shares of its no par common stock, representing his proprietary interest in the corporation. The notes and the stock were issued for entirely distinct kinds of property, which indicates rather clearly the intent of the heirs to differentiate between their respective interests as creditors and as stockholders. Furthermore, it appears from this record that three of the heirs, not including petitioner, received additional notes representing loans aggregating the sum of $8,418. Thus the interest of the eight heirs as creditors and as stockholders was not identical.

The respondent relies principally upon the cases of Joseph B. Thomas, 2 T.C. 193, and Edward G. Janeway, 2 T.C. 197, in support of his theory that petitioner and the other heirs had each made a capital contribution. In both of those cases the stock issued or to be issued was in exact proportion to the advances, so that the financial interest of each stockholder was exactly the same, whether treated as a creditor or stockholder. That condition does not obtain in the instant case. Furthermore the property for the conveyance of which the debts were created and the stock was to be issued was identical. As we have previously pointed out, in the case at bar the notes were issued for the transfer of real property and the stock was issued for the transfer of personal property.

The condition that five of the noteholders were required to join in demand for payment is not in any sense controlling. Such limitation might render the notes nonnegotiable. However, no authority has been cited, nor do we know of any holding, that nonnegotiable paper can not evidence a debt.

The sound inference to be drawn from this record is that, as was intended, a debt of $12,500 from Emerson to petitioner was created. We have so found as an ultimate fact.

The petitioner was not in the business of making loans, and, since the debt of $12,500 resulting from the unsecured loan of $12,500 which he made in 1936 was collectible only to the extent of $9,000 in 1943, petitioner sustained a nonbusiness bad debt loss in that year in the amount of $3,500. Under section 23(k)(4), nonbusiness bad debts are considered as capital assets held for not more than six months. Under section 117(d)(2), short term capital losses, in the case of individuals, may be deducted to the extent of such gains, plus the net income of the taxpayer, or $1,000, whichever is smaller. On the record, the $1,000 limitation applies to petitioner.

We therefore conclude that petitioner is entitled to a deduction of $1,000 in 1944, under section 117(e), as a capital loss carry-over from the prior year. The respondent erred in treating it as a long term capital loss sustained in 1944, and deductible to the extent of only $750.

Petitioner concedes he is not entitled to a deduction of the sum of $300 claimed on his return as entertainment and travel expenses and disallowed by the respondent.

Reviewed by the Court.

Decision will be entered under Rule 50.