Comm'r of Internal Revenue

Tax Court of the United States.Jul 31, 1946
7 T.C. 480 (U.S.T.C. 1946)
7 T.C. 480T.C.

Docket No. 6608.



Sidney B. Gambill, Esq., and A. G. Wallerstedt, C.P.A., for the petitioners. Karl W. Windhorst, Esq., for the respondent.

Cancellation of petitioner's indebtedness, representing money borrowed to purchase certain pledged securities, in return for transfer of the securities to pledgee, held not to result in taxable gain, notwithstanding that indebtedness exceeded adjusted basis of securities. Sidney B. Gambill, Esq., and A. G. Wallerstedt, C.P.A., for the petitioners. Karl W. Windhorst, Esq., for the respondent.

Petitioners seek redetermination of a deficiency in income tax for the year 1941 in the amount of $1,707.91.

The sole issue is whether petitioners realized a capital gain, as contended by respondent, or sustained a capital loss, as urged by petitioners, and the amount of either, if any, as a result of a transaction in which petitioner Charles Nutter assigned and transferred to the pledgee certain pledged securities in full settlement of the balance due on his demand notes, the balance due being in excess of his basis for the pledged securities.

Some of the facts have been stipulated.

The present findings of fact and opinion supersede the memorandum opinion entered herein January 8, 1946.


The stipulated facts are hereby found.

Petitioners, husband and wife, are residents of Pittsburgh, Pennsylvania, and filed their joint return for the period involved with the collector of internal revenue for the twenty-third district of Pennsylvania. It was prepared on the cash basis of accounting. (Hereinafter Charles Nutter will be referred to as petitioner.)

During the years 1925 to 1929 petitioner purchased various securities at an aggregate cost of $110,045.05. In negotiating the purchases he obtained loans from the First Portland National Bank of Portland, Maine (hereinafter referred to as the bank), giving his promissory notes to the bank and pledging the aforesaid securities as collateral thereon. The balance due on September 20, 1941, on the notes evidencing the indebtedness was $85,104.60, plus some accumulated interest.

Among the powers granted the pledgee bank under the pledge agreement was the power to sell and transfer any of the pledged securities without notice to petitioner at public or private sale, or to purchase them itself on the nonpayment of the liability on the notes and credit petitioner's account with the net proceeds thereof.

In 1940 the bank had sold some securities and applied the proceeds to petitioner's account. A portion of the pledged securities having a cost of $33,076.56 became worthless prior to 1941. The remaining collateral had greatly depreciated in value and on September 20, 1941, had a fair market value of $17,090.20.

The bank had often discussed with petitioner the matter of making some settlement of his obligation. On August 21, 1941, it wrote petitioner:

In reply to your letter of the 18th concerning settlement of your obligations now held by this Bank, the principal amount aggregating approximately $85,104.60, without reference to accrued interest, if you will submit an offer of approximately 10% of the amount of the indebtedness, say $8,500.00 with $1,000.00 cash payment and your unsecured demand note for $7,500.00 bearing interest at 2%, and agree to release without restrictions all collateral now held by us against your obligations, we will present the subject to our Directors for action.

Petitioner would not make such offer, but did propose to pay $1,000 in cash and assign over to the bank all of the securities which it held as collateral on his notes in settlement of his indebtedness. The bank accepted this offer and on September 20, 1941, petitioner transmitted to the bank his $1,000 check and the assignment of his securities and thereupon his notes for the unpaid principal of $85,104.60 were canceled and released to him.

He obtained $1,500 from his wife with which to consummate the transaction.

Prior to the settlement of his obligation with the bank, petitioner's liabilities exceeded his assets by $62,587.11:

+-----------------------------------------------------------------------------+ ¦Assets ¦Liabilities ¦ +---------------------------------------------------+-------------------------¦ ¦Securities ¦$150.00 ¦Bank ¦$85,104.60¦ +-----------------------------------------+---------+--------------+----------¦ ¦Securities pledged against bank loans ¦17,090.20¦Henley-Kimball¦8,500.00 ¦ +-----------------------------------------+---------+--------------+----------¦ ¦Notes receivable ¦600.00 ¦ ¦ ¦ +-----------------------------------------+---------+--------------+----------¦ ¦Insurance payable to wife ¦11,080.36¦ ¦ ¦ +-----------------------------------------+---------+--------------+----------¦ ¦Cash (including $1,500 obtained from ¦2,096.93 ¦ ¦ ¦ ¦wife) ¦ ¦ ¦ ¦ +-----------------------------------------+---------+--------------+----------¦ ¦ ¦31,017.49¦ ¦ ¦ +-----------------------------------------+---------+--------------+----------¦ ¦Deficit ¦62,587.11¦ ¦ ¦ +-----------------------------------------+---------+--------------+----------¦ ¦Total ¦93,604.60¦Total ¦93,604.60 ¦ +-----------------------------------------------------------------------------+

Petitioner's net worth after settlement was $4,427.29, but this amount did not give effect to current bills on an aggregate amount not in excess of $200 and the sum of $1,500 obtained from his wife.

In 1941 petitioner was employed as manager of the Chrysler factory branch, Pittsburgh, at an annual salary of $8,400.

Petitioner in his 1941 income tax return deducted as a long term capital loss $13,029.72, computed as follows:

+----------------------------------------+ ¦Total (cost of securities) ¦$110,164.05¦ +----------------------------+-----------¦ ¦Amount received in 1941 ¦84,104.60 ¦ +----------------------------+-----------¦ ¦Loss sustained ¦26,059.45 ¦ +----------------------------+-----------¦ ¦50 percent of loss allowable¦13,029.72 ¦ +----------------------------------------+

In the amended petition the allowable loss claimed was $32,064.15, computed as follows:

* * * a loss of $64,128.29 and a long-term capital loss of $32,064.15 therefrom, representing the difference between the cost to him of those securities that had not become worthless prior to 1941, $76,968.49, less the fair market value of said securities on the date they were sold and transferred to the bank, $12,840.20.

Respondent determined that there was a gain on the transaction of $7,136.11, and a long term capital gain (50 per cent) of $3,568.06, computed as follows:

+-----------------------------------------------+ ¦Selling price-total notes ¦$85,104.60¦ +------------------------------------+----------¦ ¦Less cash paid ¦1,000.00 ¦ +------------------------------------+----------¦ ¦ ¦84,104.60 ¦ +------------------------------------+----------¦ ¦Corrected cost of securities ¦76,968.49 ¦ +------------------------------------+----------¦ ¦Gain ¦7,136.11 ¦ +------------------------------------+----------¦ ¦Long term capital gain (50 per cent)¦3,568.06 ¦ +-----------------------------------------------+


OPPER, Judge:

Petitioner borrowed the major part of the purchase price of certain securities. Some of these became worthless prior to the taxable year, leaving in the hands of the creditor, as collateral, securities with a basis to petitioner of less than the amount remaining due on the loan. The question is whether petitioner realized gain, suffered a deductible loss, or did neither, when in the tax year he settled with his creditor by surrendering title to the securities and delivering to it $1,000 in cash.

As in Lutz & Schramm Co., 1 T.C. 682, 689, ‘ * * * the question is not whether (petitioner) realized income from the discharge or forgiveness of indebtedness, cf. United States v. Kirby Lumber Co., 284 U.S. 1; Lakeland Grocery Co., 36 B.T.A. 289; but is rather whether it realized gain from the disposition of * * * property.‘

The present transaction, however, was clearly in the nature of a purchase money borrowing. As in Helvering v. American Dental Co., 318 U.S. 322, 330, it ‘is more akin to a reduction of sale price than to financial betterment through the purchase by a debtor of its bonds in an arms-length transaction.‘ Unlike Helvering v. American Chicle Co., 291 U.S. 426, this was a face-to-face transaction between debtor and creditor. See Lewis F. Jacobson, 6 T.C. 1048. And unlike Lutz & Schramm, supra, it can not be said here that ‘The property was acquired on August 19, 1924, from a predecessor company, and the mortgage was not placed upon it until January 2, 1925. We, therefore, conclude that the petitioner borrowed the money * * * and used it for its own purpose and benefit.‘

We think it follows that petitioner merely surrendered property which had fallen in value below the amount which he had undertaken to pay for it, and hence that no gain resulted from that transaction. Cf. Hirsch v. Commissioner (C.C.A., 7th Cir.), 115 Fed.(2d) 656. ‘In this view, there is no substance in the Commissioner's differentiation between a solvent or insolvent corporation or the taxation of income to the extent of assets freed from the claims of creditors by a gratuitous cancellation of indebtedness. ‘ Helvering v. American Dental Co., supra, p. 330. On this doctrine cf. Texas Gas Distributing Co., 3 T.C. 57, and Main Properties, Inc., 4 T.C. 364, on the one hand, with Carlisle Packing Co., 29 B.T.A. 514, and J. K. McAlpine Land & Development Co., Ltd., 43 B.T.A. 520, 526, on the other.

It does not follow, however, that petitioner is entitled to claim any loss on the transaction. If he had paid for the property in cash and had thereafter secured a loan upon it, his argument might be more persuasive. But in that case he would be met by the necessity of treating the settlement with the creditor as a sale and of returning the resulting gain. Lutz & Schramm, supra. Because we have found here that this was in effect a purchase money transaction, the taxable gain phase of this proceeding has been decided in petitioner's favor. He can not at the same time have the benefit of the assumption that he paid for the property something of value which has been lost and for which he may have a deduction. He has in fact lost nothing of his own and has merely avoided payment of an obligation which could have resulted in a loss only if it had been enforced. In such a situation the loss is too illusory for the practical purposes of the tax law. See Eckert v. Burnet, 283 U.S. 140.

Any amount of cash contributed by petitioner is more than eliminated by the $33,000 of securities which are shown to have become worthless in a prior year.

Reviewed by the Court.

Decision will be entered under Rule 50.

DISNEY, J., dissents.

TURNER, J., dissenting: It is my view that Helvering v. American Dental Co., 318 U.S. 322, has nothing to do with this case. If I read the facts aright, they do not show that there was any forgiveness of indebtedness or scaling down of the purchase price of the property. There was a satisfaction of a loan to petitioner from a bank, the satisfaction being effected by the transfer of property having an ascertained cost basis to petitioner. If the answer to the question here is to be found in pronouncements of the Supreme Court, it is in my opinion found in Helvering v. Midland Mutual Life Insurance Co., 300 U.S. 216. The only difference I am able to find between the case before us and that of Helvering v. Midland Mutual Life Insurance Co. is that in the latter case the party litigant was the purchaser; in this case the party involved is the seller. What was said in that case could well have been said here. Referring to the contention that the transaction there was not a sale, the Supreme Court observed:

The company argues that taxation is a practical matter; that we should be governed by realities; that the reality is, that all the company got was the property; and that the property was worth less than the principal of the debt. The ‘reality‘ of the deal here involved would seem to be that respondent valued the protection of the higher redemption price as worth the discharge of the interest debt for which it might have obtained a judgment. Moreover, the company's argument ignores the needs of an efficient system of taxation. The administration of the income tax law would be seriously burdened if it were held that when a mortgagee bids in the property for a sum including unpaid interest, he may not be taxed on the interest received except upon an inquiry into the probable fair market value of the property. * * * There is nothing unfamiliar in taxing on the basis of the legal effect of a transaction. Income may be realized upon a change in the nature of legal rights held, though the particular taxpayer has enjoyed no addition to his economic worth. * * *

The company contends that to tax the mortgagee as upon interest received is inconsistent with the rule declared in Louisville Joint Stock Land Bank v. Radford, 295 U.S. 555 * * * , that the mortgagee is entitled to have ‘the mortgaged property devoted primarily to the satisfaction of the debt, either through the receipt of the proceeds of a fair competitive sale or by taking the property itself.‘ The charge of inconsistency is unfounded. The company exercised its right to have a sale. At the sale, it was free either to bid or to refrain from bidding. If it bid, it was free to bid such sum as it pleased. It chose to bid the full amount of principal and interest. Thus it obtained, in legal contemplation, full payment of the interest as well as the principal. To tax the company upon the full amount of interest received as a result of its own bid in no way impairs its rights as mortgagee. * * * If the bid had been insufficient to yield full payment of the mortgage debt, principal, and interest, the company would have been entitled to a judgment for the deficiency. If the company had refrained from bidding, and a stranger had bid more than the principal, the company would obviously have been taxable upon the excess up to the amount of the interest due. * * *

Although in this case we have before us the seller, not the purchaser, the reasoning of the Supreme Court is in my opinion equally applicable. The petitioner in this case owed money to the bank of the creditor and the securities disposed of were held as collateral. The bank could have had the securities sold on the market and, after applying the proceeds on the debt, still have had a claim for any deficiency in the repayment of its loan. For reasons agreeable to both parties, the securities were not sold on the market, but to the bank at a price equal to the debt. If the bank was willing to pay more for the shares than they were worth, certainly the petitioner in this instance may not complain. To him, it was full realization of gain, and it is my view that under the reasoning of the Supreme Court in Helvering v. Midland Mutual Life Insurance Co., supra, taxable gain was realized equal to the difference between the cost basis for the shares sold and the selling price.

I accordingly note my dissent.

VAN FOSSAN and LEECH, JJ., agree with this dissent.