Opinion
Docket No. 104873.
1942-12-1
CHENANGO TEXTILE CORPORATION, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.
C. Addison Keeler, Esq., for the petitioner. Henry C. Clark, Esq., for the respondent.
1. In 1929 petitioner purchased certain securities from one of its stockholders, agreeing to pay the purchase price 20 years later, with interest at 5 2/5 percent annually. A substantial portion of the securities was sold shortly thereafter. In 1935, in settlement of a suit by three of its stockholders charging that the original articles of incorporation, asking a return of all amounts paid in connection therewith, and for an order prohibiting any future payments, the petitioner and the vendor stockholder canceled the original agreement, the petitioner returning the unsold securities and, with respect to those which had been sold, the equivalent in cash as of the date of settlement, which amount was substantially less than the amount of the purchase price of the said securities under the original agreement. Held, that petitioner realized taxable gain in the year of settlement on the securities previously sold and that the settlement price is the basis for determining such gain.
2. At the time of the cancellation of the original agreement certain amounts due thereunder as interest remained unpaid, which amounts had been accrued in the years 1932, 1933, and 1934 on petitioner's books and deducted on its income tax returns for those years, but such deductions did not effect an offset of taxable income, since the reported net loss for each year substantially exceeded the deduction claimed for accrued but unpaid interest. Held, that the unpaid interest so voided does not constitute taxable Loan & Investment Co., 39 B.T.A. 981.
3. Respondent's disallowance of certain attorney fees as business expense deductions is sustained. C. Addison Keeler, Esq., for the petitioner. Henry C. Clark, Esq., for the respondent.
The respondent determined deficiencies in income and excess profits taxes for the year 1935 in the respective amounts of $43,368.34 and $15,282.85. The question presented is whether there was a gratuitous forgiveness of indebtedness owing by petitioner to one of its stockholders or merely a reduction in the purchase price of securities previously acquired from the said stockholder, and whether under either circumstance income was realized by petitioner. A second question is whether amounts paid or accrued as attorney fees constituted ordinary and necessary business expense deductions.
FINDINGS OF FACT.
A substantial portion of the facts has been stipulated and is found as stipulated.
Petitioner, a New York corporation, was organized in 1922. It filed its income and excess profits tax return for the year 1935 with the collector of internal revenue for the third district of New York. Its books were kept on the accrual basis at all times material to this proceeding.
On April 29, 1929, petitioner's outstanding capital stock consisted of 6,652 preferred shares with a par value of $100 per share and 35,332 no par value common shares. On that date and prior thereto Josephine Ruegg Till (formerly Josephine Ruegg) was the owner of 2,179 of the preferred shares and her son, Erhart Ruegg, was the owner of 34 of the preferred and 26,339 of the common shares. At all times from 1929 through 1936 Erhart Ruegg was treasurer of petitioner and Frank Lynch was its secretary.
Petitioner and a predecessor corporation had engaged in the silk manufacturing business since 1902. Alfred Ruegg, the former husband of Josephine Ruegg Till and the father of Erhart Ruegg, together with Lynch, had been in control of the business since that time. Alfred Ruegg died in 1923.
Petitioner's bylaws, adopted in December 1922, authorized the board of directors to appoint an executive committee composed of two or more directors and empowered to exercise all the powers of the board delegated to it. On August 13, 1923, the board appointed Erhart Ruegg and Lynch to constitute the executive committee, with authority to exercise all the powers of the board when it was not in session. Thereafter and continuously through the year 1934 the committee, consisting of these two directors, met regularly and exercised the powers so delegated to it. Its authority was not to terminate until revoked by the board.
During a few years immediately prior to 1928, and due largely to the advent of rayon, the petitioner's business had declined to the extent that its current earnings were insufficient to pay the dividends on its preferred stock, although its earnings theretofore had always been adequate. Petitioner's bankers, E. Naumberg & Co., were of the opinion that the petitioner should purchase stocks. The said banking concern had organized Chain Store, and recommended its stock as the type of investment petitioner should acquire. Upon that recommendation, in December 1928, petitioner first started purchasing corporate stocks. Between then and April 1929 it purchased the following stocks at a total cost of $511,375:
+----------------------------------+ ¦3,000¦Shares Chain Store ¦$75,000¦ +-----+--------------------+-------¦ ¦3,500¦Shares Goldman-Sachs¦403,975¦ +-----+--------------------+-------¦ ¦300 ¦Shares Radio ¦32,400 ¦ +-----+--------------------+-------¦ ¦ ¦ ¦511,375¦ +----------------------------------+
The shares were purchased through brokers and by April 1, 1929, there had been paid on the purchase price $278,200 in cash and $49,855 from the proceeds of the sale of 500 shares of Goldman-Sachs stock, leaving a balance due the brokers, after minor adjustments of interest and dividends, of $183,221.55.
Ruegg and Lynch, as the executive committee of petitioner, concluded that additional funds were needed in connection with the securities purchase program, and, knowing that Mrs. Till had outside capital, approached her with the idea of taking over her securities for the business. Ruegg handled his mother's business affairs and in such matters she always did what he advised. On April 29, 1929, Mrs. Till sold to petitioner her 2,179 shares of its preferred stock for $221,615 and a block of stock of other corporations for $428,385, or a total selling price of $650,000, which was substantially the then market value of the stock sold. The day following, she delivered the stocks to petitioner, receiving its receipt therefor, wherein petitioner acknowledged that it was indebted to her in the amount of $650,000 on account of such purchase. One week later, on May 6, 1929, petitioner and Mrs. Till executed a written agreement covering the above described purchase and sale of corporate stock and the payment of the purchase price, and reading in part as follows:
ARTICLES OF AGREEMENT, made this Sixth day of May, A.D. One Thousand and Nine Hundred and Twenty-nine (sic.) (1929), between Josephine Ruegg, now residing in the City of New York and State of New York, hereinafter called the party of the first part, and Chenango Textile Corporation, a corporation organized under the laws of the State of New York, with its principal office in the City of Binghampton and State of New York, hereinafter called the party of the second part.
First. The said party of the first part, for and in consideration of the sum of one dollar, by the party of the second part to the party of the first part, in hand paid, at and before the sealing and delivery of these presents, the receipt whereof is herewith acknowledged, and for the further consideration of the sum of six hundred fifty thousand dollars ($650,000.00) to be paid on the First day of October, A.D. One Thousand Nine Hundred and Forty-nine (1949), with interest as hereinafter mentioned, has granted, conveyed, bargained, sold, assigned and delivered, and by these presents, does grant, convey, bargain, sell, assign and deliver unto the said party of the second part, its successors, and assigns, all her right, title and interest in and to the securities described in paragraph Second thereof, together with the appurtenances, and all the estates and rights of the party of the first part hereto, provided, however, that if any time before the date fixed for the payment of the principal sum as aforesaid, Erhart Ruegg, son of the party of the first part, shall cease to be Treasurer of Chenango Textile Corporation, party of the second part, either by death, resignation, removal by Board of Directors, or otherwise, or if at any time default shall be made in payment of interest herein provided for space of ninety days after any payment thereof shall fall due, then the aforesaid principal sum shall become due and the payment of the same with interest, as aforesaid, besides costs of suit, may be enforced and recovered at once.
TO HAVE AND TO HOLD, all and singular, the above granted and described securities unto the said party of the second part, its successors and assigns forever.
Third. The party of the second part agrees to pay interest to the said party of the first part upon said principal sum mentioned in paragraph First at the rate of five and two-fifths (5 2/5) per cent per annum, in quarterly installments, on the 1st day of January, April, July and October, of each year until the said principal sum is due and payable. The said interest period shall commence on the First day of October, A.D. One Thousand Nine Hundred and Twenty-Nine (1929), and the first quarterly installment shall be due and payable hereunder on the First day of January, One Thousand Nine Hundred and Thirty (1930). And the said party of the second part further agrees to pay the said principal sum of six hundred fifty thousand ($ 50,000.00) dollars on the first day of October, A.D. One Thousand Nine Hundred and Forty-Nine (1949).
At a meeting held on May 6, 1929, petitioner's board of directors resolved that the 2,179 shares of its preferred stock acquired from Mrs. Till be held as treasury stock; that the said shares and all other stocks purchased from Mrs. Till be sold at any time and for such prices as the executive committee have the power to purchase any securities which in their judgment should be to the advantage and profit of petitioner and to borrow money or pledge petitioner's credit therefor; that the president, vice president, secretary and treasurer, or any one of them, should have the power to sell any securities owned by the petitioner.
At the annual meeting of petitioner's stockholders held on January 27, 1930, which was attended by all of the stockholders, a motion was passed approving and ratifying the purchase of the stocks from Mrs. Till and the execution of the agreement fixing the time for payment of the purchase price. At the time of the sale Mrs. Till was receiving an annual income from the stocks sold to the petitioner amounting to approximately $30,000, and the interest rate of 5 2/5 percent was fixed so that she would receive an annual income slightly in excess of that figure.
Interest due Mrs. Till under her contract with petitioner was paid in full for the years 1929, 1930, and 1931. Thereafter only a part of the interest was paid. The following table shows the amount of interest accrued on petitioner's books pursuant to the contract, the amount actually paid, and the arrearage for each of the years 1932 to 1934, inclusive:
+-----------------------------------------+ ¦ ¦Year¦Interest ¦Interest ¦Arrearage ¦ +----+----+----------+---------+----------¦ ¦ ¦ ¦accrued ¦paid ¦ ¦ +----+----+----------+---------+----------¦ ¦1932¦ ¦$35,100.00¦$4,025.00¦$31,075.00¦ +----+----+----------+---------+----------¦ ¦1933¦ ¦35,100.00 ¦12,250.00¦22,850.00 ¦ +----+----+----------+---------+----------¦ ¦1934¦ ¦23,333.40 ¦12,000.00¦12,333.40 ¦ +-----------------------------------------+
The full amount of interest accrued on the books was deducted on petitioner's income tax returns for the years involved, but the deductions of the accrued but unpaid interest for the three years 1932, 1933, and 1934 effected no offset against income, since petitioner reported a net loss for each year which substantially exceeded the deduction taken in that year for accrued but unpaid interest. Mrs. Till never elected to demand payment of principal upon the default of the interest payments, as she might have done under the provisions of the contract of May 6, 1929.
The shares acquired from Mrs. Till other than petitioner's preferred stock were deposited with brokers in 1929. The bulk of them were sold and the proceeds were used to pay the balance due the brokers on prior purchases and to pay for additional stock. The shares acquired from her which petitioner never sold consisted of 100 shares of Union Pacific Railroad Co. stock and 20 shares of American Gas & Electric Co. stock, with an aggregate cost of $23,500. On stock in one company, costing $8,000, petitioner received liquidating distributions of $6,200 in 1929 and $1,000 in 1934. All the other securities acquired from Mrs. Till, except 100 shares, were sold in the open market during 1929 for $373,570.36, resulting in a loss to petitioner of approximately $13,000. The said 100 shares were sold in 1933 for $3,000 and a loss of $7,000 was sustained thereby. Subsequent to the transaction with Mrs. Till, but during 1929, petitioner purchased an additional 1,500 shares of Goldman-Sachs stock for $158,433.50, and stock in other corporations as follows:
+------------------------------------------------------+ ¦ ¦Corporation¦Shares ¦Cost ¦ +----------------------+-----------+---------+---------¦ ¦ ¦ ¦purchased¦ ¦ +----------------------+-----------+---------+---------¦ ¦Shenandoah Corporation¦ ¦200 ¦$6,755.83¦ +----------------------+-----------+---------+---------¦ ¦Blue Ridge Corporation¦ ¦200 ¦7,154.17 ¦ +----------------------+-----------+---------+---------¦ ¦Chatham-Phoenix ¦ ¦100 ¦2,700.00 ¦ +----------------------+-----------+---------+---------¦ ¦Peoples Trust Co. ¦ ¦100 ¦37,500.00¦ +----------------------+-----------+---------+---------¦ ¦Securities Corporation¦ ¦45 ¦37,635,00¦ +----------------------+-----------+---------+---------¦ ¦Total ¦ ¦ ¦91,745.00¦ +------------------------------------------------------+
During the same period petitioner sold 2,700 shares of Goldman-Sachs stock for $123,737, sustaining a loss of $37,069.45, and sold the 100 shares of Peoples Trust Co., which had been converted into Marine Midland stock, for $38,928.80, realizing a gain of $1,428.80. These constituted its only securities transactions until 1933, when it bought a few shares of General Motors and General Electric stock, which were sold in 1934 at a gain of $275.50. In 1934 it also sold the 100 shares of Chatham-Phoenix stock for $1,793.74, at a loss of $906.26. By March 16, 1935, the remaining securities owned by the petitioner had depreciated to the extent that their market value on that date was only $29,741.94, while their cost had been $534,025.11. In 1936 petitioner disposed of 100 shares of Shenandoah Corporation and 100 shares of Blue Ridge Corporation stock for $9,725.90 and sustained a loss of $3,407.44. It also disposed of the balance of its Goldman-Sachs stock, the Chain Store stock, and the Radio stock in 1936, receiving therefor an aggregate of $49,112.89, a loss of approximately $432,000 being sustained. This left petitioner with a few securities which had cost $39,211.66 and were worth, on December 31, 1940, the amount of $1,353.13.
The petitioner's losses on the sale of securities from 1929 to 1936, inclusive, aggregated $469,786.82. Its income tax return for each of the years 1929 to 1940, inclusive, reported a net loss with the exception of 1930, when income of $26,639.27 was reported. The following table discloses the amount of the loss on securities transactions sustained in each year, together with the net loss as reported on the tax returns:
+-------------------------------+ ¦ ¦Net losses on ¦Net losses ¦ +----+--------------+-----------¦ ¦Year¦sale of ¦reported on¦ +----+--------------+-----------¦ ¦ ¦securities ¦returns ¦ +----+--------------+-----------¦ ¦ ¦ ¦ ¦ +----+--------------+-----------¦ ¦1929¦$26,178.16 ¦$25,361.71 ¦ +----+--------------+-----------¦ ¦ ¦ ¦(Income) ¦ +-------------------+-----------¦ ¦1930 ¦26,639.27 ¦ +-------------------+-----------¦ ¦1931 ¦3,897.91 ¦ +-------------------+-----------¦ ¦1932 ¦173,186.84 ¦ +-------------------+-----------¦ ¦1933¦7,000.00 ¦50,202.29 ¦ +----+--------------+-----------¦ ¦1934¦634.00 ¦23,064.81 ¦ +-------------------+-----------¦ ¦1935 ¦9,684.13 ¦ +-------------------+-----------¦ ¦1936¦435,974.66 ¦128,300.99 ¦ +-------------------+-----------¦ ¦1937 ¦87,441.63 ¦ +-------------------+-----------¦ ¦1938 ¦102,843.42 ¦ +-------------------+-----------¦ ¦1939 ¦75,549.40 ¦ +-------------------+-----------¦ ¦1940 ¦33,693.85 ¦ +-------------------------------+
Due to the statutory limitation on capital losses, the loss of $128,300.99 disclosed by the 1936 return excluded security losses sustained in that year of $427,505.02.
Under the petitioner's articles of incorporation it was provided that ‘So long as any of the First Preferred Stock is outstanding the corporation shall not, without the affirmative vote or written consent of the holders of record of at least three-quarters in amount of the First Preferred Stock then outstanding * * * create or issue bonds notes or other evidence of indebtedness maturing later than one year from the date of issue thereof.‘
On December 30, 1933, Mrs. Till, on request of Erhart Ruegg, took back the 2,179 shares of petitioner's preferred stock which had been held by petitioner since April 29, 1929, as treasury stock, and the amount of $217,900, being the par value thereof, was by agreement applied against the indebtedness of $650,000 owing by petitioner to her, leaving $432,100 as the balance due, exclusive of interest. In February 1934 Mrs. Till, also upon the request of Ruegg, agreed with the Irving Trust Co. in consideration of its advancing money or extending credit to petitioner, to subordinate her claim against petitioner to any claims which the Irving Trust Co., then had or might thereafter have against petitioner, and she further agreed not to accept from or permit any payment by petitioner on account of the principal of her claim so long as petitioner was indebted to the Irving Trust Co.
At the annual meeting of the stockholders of petitioner held on January 29, 1934, at which the voting privilege was limited to the holders of first preferred stock and 5,741 shares of a total of 7,290 first preferred shares outstanding were represented either in person or by proxy, a resolution was adopted approving the purchase of the securities from Mrs. Till in 1929 at a total cost of $650,000, the vote on the resolution being 5,501 shares for adoption and 225 shares against. By the same vote a resolution was adopted approving the agreement of May 6, 1929, which agreement fixed October 1, 1949, as the date on which payment for the securities acquired from Mrs. Till would become due. From the above it appears that 1,789 of the total of 7,290 first preferred shares outstanding were either voted against the resolution or were not voted at all. Had the 2,179 shares held by petitioner remained in the treasury and 1,789 shares not been voted or cast unfavorably, the resolution would have failed to receive the three-fourths vote required by the articles of incorporation.
On or about April 25, 1934, three individuals owning a total of 150 shares of petitioner's first preferred stock instituted an action in the New York State Supreme Court against the petitioner and Mrs. Till as defendants. It was alleged, among other things, that the purchase of the securities by petitioner from Mrs. Till in 1929 and the agreement fixing the date of payment at October 1, 1949, with interest at the rate of 5 2/5 percent annually, were ultra vires and illegal in that it violated that provision of the articles of incorporation which required a vote of three-fourths of the holders of petitioner's first preferred stock as a prerequisite to making notes or other evidences of indebtedness which were to mature later than one year after their date. It was further alleged that the purpose of the contract was to promote the interests of Ruegg and Lynch, holders of all the common stock, and Mrs. Till in disregard of the interests of the first preferred stockholders by treating the said contract of May 6, 1929, as a valid and binding contract, with rights in Mrs. Till superior to the rights of the first preferred stockholders, and as a result that the plaintiffs and all other first preferred stockholders similarly situated had been and would be irreparably damaged by the wrongful acts of petitioner and Mrs. Till.
In the alternative, it was alleged that the reissuance of the 2,179 shares of first preferred stock to Mrs. Till on December 30, 1933, was without consideration and in violation of the stock corporation law of New York and contrary to the rights of the first preferred stockholders under petitioner's articles of incorporation.
The relief demanded was that the agreement of May 6, 1929, between petitioner and Mrs. Till be declared illegal, invalid, void, and of no effect; that petitioner be directed to render and exhibit a full and complete account of its receipts, earnings, indebtedness, and disbursements and of its business affairs generally for each year from December 31, 1928, and that Mrs. Till be ordered and directed to return to petitioner all moneys received by her in pursuance of said agreement and that petitioner, its officers, and its directors be perpetually enjoined from paying Mrs. Till anything further under said agreement.
In the alternative, it was demanded that the agreement of May 6, 1929, be in all respects subordinated to the rights of the first preferred stockholders; that the act of petitioner in issuing the 2,179 shares of first preferred stock to Mrs. Till on December 30, 1933, be declared illegal, null, and without effect, and that Mrs. Till be ordered to surrender the said stock for cancellation; and, finally, that the plaintiffs be awarded their costs in the action and such other relief as might be just and equitable.
The petitioner and Mrs. Till made separate answers to the complaint. In substance, they denied that the transaction was ultra vires, illegal, and fraudulent and demanded dismissal of the complaint.
Thereafter, on or about March 16, 1935, all parties to the action entered into an ‘Agreement for Compromise and Settlement‘ for the purpose of settling the dispute. Up through 1934 interest had accrued to Mrs. Till under the agreement of May 6, 1929, in a total amount of $172,508.40, of which $106,250 had been paid, leaving $66,258.40 accrued but unpaid. The total dividends on the stocks sold by Mrs. Till to petitioner in 1929 and up to the date of the settlement had amounted to $109,547.62 and exceeded the amount which had been paid to her as interest up to that date by $3,297.62. Under the settlement the written contract of May 6, 1929, setting forth the terms of the sale of the securities by Mrs. Till to petitioner was canceled and each of them was forever released, absolved, and discharged from any and all liability or responsibility thereunder. It was also agreed that Mrs. Till should retain the 2,179 shares of petitioner's preferred stock which had been returned to her in 1933 and should receive back from petitioner 100 shares of Union Pacific Railroad Co. common stock and 20 shares of American Gas & Electric Co. preferred stock which were among the securities she had sold to petitioner in 1929 and were the only securities so sold which petitioner still owned. In addition to the stocks so returned to her, Mrs. Till received two promissory notes executed by petitioner in the amounts of $84,298.78 and $84,298.79, respectively, maturing in 60 and 120 days. These notes represented as nearly as possible the then current market value of the securities which petitioner had acquired from Mrs. Till but which had been sold or liquidated, plus $3,297.62, the amount by which the dividends on the stock which petitioner had acquired from Mrs. Till exceeded the amount which had actually been paid to her as interest under the May 6, 1929, agreement. Provision was made for the adjustment of the values of the securities covered by the notes as of the date of maturity of said notes; provided, however, that the adjustment should in no event effect a reduction of the total amount payable by more than $13,077.50 and that the corporation should not be liable for more than their face amount with interest at the rate of 6 percent. It was further agreed that, upon approval and ratification of the agreement by the stockholders, petitioner should pay the disbursements and expenses of Bruce Babcock amounting to $320, all expenses by that time or thereafter incurred by the preferred stockholders' protective committee in an amount not to exceed $85, and the counsel fees and disbursements of Keenan, Brink & Harrison, the firm mentioned as being attorneys for the plaintiff stockholders, amounting to $5,011.22. The two notes given to Mrs. Till under the settlement agreement were paid by petitioner in 1937.
The petitioner was solvent at all times up to and including January 1, 1936.
During the taxable year the petitioner paid to its attorneys for their fees and expenses in the above described action the amount of $3,532.21. In addition and in the same year it paid, pursuant to the settlement agreement, the expenses, charges, and fees of the attorneys for the plaintiff stockholders in the amount of $5,011.22, as stated above. It set up on its books in that year an accrued liability of $10,285.95 for services and expenses of the attorney who represented Mrs. Till in the action, payment of which petitioner had assumed. This latter amount was paid by petitioner in 1936. The amounts set forth in this paragraph, aggregating $18,829.38, were deducted by petitioner on its income tax return for 1935 as ordinary and necessary business expenses. The deduction was disallowed by the respondent, who stated in the notice of deficiency that these items ‘do not represent ordinary and necessary expenses of carrying on your trade or business within the meaning of Section 23(a) of the Revenue Act of 1934 but are deemed to constitute expenditures incurred in the acquisition of new capital.‘
OPINION.
TURNER, Judge:
The petitioner contends that there was a forgiveness of indebtedness to it by Mrs. Till; that Mrs. Till was one of its stockholders; that the forgiveness of the indebtedness was gratuitous; and that under article 22(a)-14 of Regulations 86, the gratuitous forgiveness of indebtedness to a corporation by one of its stockholders does not result in the realization of gain by the corporation. It relies on that sentence of the regulation reading as follows: ‘If a shareholder in a corporation which is indebted to him gratuitously forgives the debt, the transaction amounts to a contribution to the capital of the corporation.‘
It is the contention of the respondent that there was no gratuitous forgiveness of indebtedness and, the petitioner being solvent, there was realization of income through the cancellation or reduction of the indebtedness of petitioner to Mrs. Till.
In 1929 Mrs. Till, at the instigation of her son, who with Lynch constituted the executive committee of petitioner and managed and directed its affairs, sold certain securities to petitioner for an agreed price of $650,000. Her son and Lynch had represented to Mrs. Till that the transaction would operate to the advantage of petitioner, but there was no intention or thought that she should or was giving or donating anything to it. The price, according to the stipulation, was a fair price. The formal agreement executed approximately one week after delivery of the securities provided for payment of the agreed purchase price 20 years later and that Mrs. Till in the meantime should receive on the amount due interest at the rate of 5 2/5 percent annually. She had up to the time of the sale been one of petitioner's first preferred stockholders and the rate of interest was designed to provide her with an annual income over the 20-year period of an amount slightly in excess of the amount she was then receiving on the stocks sold to the petitioner, including the 2,179 shares of petitioner's first preferred stock. Rather obviously it was through the agreement and the delayed payment of the purchase price of the securities in 1949 that petitioner was to benefit. The earnings from its silk manufacturing business had slumped considerably due to the advent of rayon, and Erhart Ruegg and Lynch had decided to launch petitioner into the buying and selling of stocks and securities. The securities acquired from Mrs. Till were to supply some of the immediate cash needed for that purpose. Accordingly, most of the securities, other than the shares of petitioner's first preferred stock, were sold within a period of seven months and the proceeds were used to pay the indebtedness owing on certain stocks which had been bought previously and in the purchase of additional stocks. Several years later some of the holders of the first preferred stock took the position that the transaction with Mrs. Till, through the agreement to pay to her annually as interest 5 2/5 percent on $650,000 for a period of 20 years, was designed to and did place her in a position of preferment as to the earnings and distributions of the petitioner over all other preferred stockholders, contrary to the petitioner's articles of incorporation. A suit was filed by three preferred stockholders naming petitioner and Mrs. Till as defendants and alleging that the agreement in 1929 whereby Mrs. Till sold the various stocks to petitioner was ultra vires and illegal and in violation of petitioner's articles of incorporation. Among other things, it was pointed out that the articles prohibited the creation of any indebtedness by petitioner which was payable more than one year after date without the consent of three-fourths of the holders of the preferred stock outstanding. No such consent had been obtained at the time of the sale in 1929, nor until January 29, 1934, approximately three months before the filing of the suit by the preferred stockholders. In the meantime, on December 30, 1933, the preferred shares of the petitioner which had been acquired from Mrs. Till in the 1929 transaction had been returned to her and the $650,000 of indebtedness in her favor had been credited with an amount equal to the par value of the preferred stock so returned. These shares were obviously voted at the meeting of the preferred stockholders on January 29, 1934, which had approved the 1929 transaction between petitioner and Mrs. Till. In their suit the preferred stockholders asked that the contract of May 6, 1929, between petitioner and Mrs. Till be declared illegal, invalid, void, and of no effect, that Mrs. Till be ordered to return all moneys received, that the petitioner be required to present a full and complete account of its receipts and earnings and its indebtedness and disbursements over the period of years, and that the directors be perpetually enjoined from paying Mrs. Till anything further under the agreement.
In settlement of that suit Mrs. Till, petitioner, and the suing stockholders entered into an agreement the effect of which is in issue in this proceeding. A reading of the settlement agreement makes it at once apparent that the purpose sought to be accomplished, and in fact accomplished, was the complete cancellation of the agreement of May 6, 1929, and a return to Mrs. Till of all the securities received from her in 1929 or their equivalent in money as of the date of the settlement plus a further amount of $3,297.62 which, when added to the amount she had actually received as interest under the 1929 agreement, would equal the amount of dividends she would have received during the period from May 6, 1929, to the date of settlement had she continued to hold the stocks herself, the accrued but unpaid interest under the 1929 agreement being canceled along with the agreement itself. Mrs. Till had already had returned to her the 2,179 shares of petitioner's first preferred stock. All of the other stocks, except 100 shares of Union Pacific Railroad Co. stock and 20 shares of 6 percent preferred stock of the American Gas & Electric Co., had been sold by petitioner or liquidated. Instead of going on the market and buying similar shares to turn back to Mrs. Till, it was agreed that she should receive an amount approximating as nearly as practical the then current market price of the stocks in question, specified amounts being designated as the amounts at which the shares of the corporations which had been liquidated be carried into the transaction. This settlement agreement was carried out.
On such state of facts, we find nothing in the transaction to justify the conclusion that there was anything gratuitous about the settlement reached. In fact, the reasoning which would lead to a conclusion that there was a forgiveness of indebtedness to petitioner by Mrs. Till is not apparent. There was no claim or contention that the preferred stockholders who instituted the suit against petitioner and Mrs. Till did not do so in perfectly good faith, and certainly there was color to a number of their allegations, regardless of the fact that Mrs. Till, her son and Lynch might have thought and hoped that petitioner would be benefited through the use of the proceeds from the sale of Mrs. Till's securities in its stock dealing program. We do not need to conjecture on the outcome of the lawsuit if it had been litigated to a conclusion instead of being settled by an agreement of the parties. Obviously there was substantial consideration flowing from all parties and we are therefore concerned only with the settlement and its effect in the year 1935 for income tax purposes.
By that agreement the original transaction of 1929 was wiped out and canceled and a new transaction was substituted therefor. Such a transaction, standing alone, can not and does not result in the realization of gain by the acquiring party, whether it be said that the original sale price of the securities was scaled down to a lower level or the original agreement of sale was completely rescinded and a new one made in place thereof. Borin Corporation v. Commissioner, 117 Fed.(2d) 917, affirming 39 B.T.A. 712; Inkney Packing Co., 42 B.T.A. 823; Hirsch v. Commissioner, 115 Fed.(2d) 656; and A. L. Killian Co., 44 B.T.A. 169; affd., 128 Fed.(2d) 433. If the securities which were not returned to Mrs. Till under the settlement agreement had not previously been sold, but had been sold in a later year and we had such later year before us, we would have here exactly the same situation as existed in Borin Corporation v. Commissioner, supra. The difficulty in in this situation is that petitioner had sold the securities in question and had received and used the proceeds of sale in other dealings several years before the cost of the said securities to it had become finally fixed.
There can be no question that petitioner, by reason of the ultimate fixing of the purchase price of the said securities in 1935, benefited through actual realization in dollars by an amount equal to the difference between the purchase price of the securities and the amount at which they were sold. In the light, however, of the issues drawn in this case, two questions are presented, one, whether the amount by which petitioner benefited may be regarded as a capital contribution by Mrs. Till, and the other, whether it must be treated as profit realized from the sale of securities at a price in excess of their cost. We have already demonstrated by a review of the facts that there was no gratuitous forgiveness of any such amount of indebtedness on the part of Mrs. Till, and we are unable to find any other basis for concluding that a contribution to petitioner's capital was effected. Certainly there was nothing in the original transaction which indicated any thought or intention on the part of Mrs. Till or on the part of her son and Lynch that she should donate or contribute anything to the capital of petitioner corporation. She was simply selling securities to petitioner and the price it agreed to pay therefor was approximately that of the current market. Neither was there anything in the ultimate settlement agreement which indicated any contribution to petitioner by Mrs. Till. In the stockholders' suit it was claimed that the original agreement of sale was ultra vires, illegal, and void and that Mrs. Till was not entitled to the payment provided therein. By the settlement agreement the parties to the suit agreed that the original contract of sale should be canceled and of no effect and that the securities involved, or their equivalent in cash, should be returned to Mrs. Till. Regardless of her interest in the welfare of the petitioner corporation and her willingness to do whatever her son requested, Mrs. Till was settling a lawsuit and, in the light of what actually occurred, no one may properly say that she did not receive for herself everything to which she was rightfully and legally entitled. Certainly there is nothing in such an agreement that may be regarded as a contribution to anyone by any of the parties and it becomes at once apparent that if anything was realized by petitioner it was from the sale of the securities at an amount in excess of their cost and not by reason of any contribution on the part of Mrs. Till.
Our next query then is whether the ultimate fixing of the purchase price of the securities at an amount less than that at which they were sold, the sale having occurred in a prior year, brings the realization of gain therefrom into the year in which the price became fixed. Inasmuch as the cost of property is usually known and fixed before the sale and gain or loss is the difference between cost and the selling price, the realization normally occurs at the time of the sale. In some instances, however, the situation is in reverse in that the sale occurs and the terms thereof become fixed prior to the time when the buying price is known and determined, as in the case of short transactions on the securities exchange or the dealing in futures on the commodities exchange. In those instances the transactions become fixed and closed when the covering purchase is made, for at that time the cost becomes fixed and determined and it is known for the first time whether and what gain or loss results. We have a rather comparable situation here. While the transaction here was not a short sale in one year with a covering purchase in a later year, the rescission or cancellation of the original agreement and the making of the new agreement which finally fixed and determined the purchase price presents a parallel situation and the gain measured by the difference between the selling price of the said stocks in the prior years and the ultimate purchase price could have been realized only when the purchase price was finally fixed. In other words, realization of the gain was the consequence of the lower and ultimate purchase price.
For the reasons stated, gain equal to the difference between the selling price of the securities and the cost as fixed and determined by the settlement agreement in 1935 constitutes taxable income in that year. Carroll-McCreary Co. v. Commissioner, 124 Fed.(2d) 303, is accordingly not in point. As we view it, that case deals with an entirely different situation. Cf. Helvering v. Jane Holding Corporation, 105 Fed.(2d) 993; cer. den. 310 U.S. 653.
At the time of the settlement agreement in 1935, interest in the amount of $66,258.40 which had been accrued for the years 1932, 1933, and 1934 under the agreement of May 6, 1929, remained unpaid and, along with that agreement, was canceled by the 1935 settlement. The said interest had been claimed as deductions on petitioner's income tax returns for the years in which it had accrued, but it had effected no offset against income by reason of the fact that petitioner's reported net loss for each such year substantially exceeded the deduction taken for accrued but unpaid interest. On such facts, cancellation of the interest in the taxable year did not result in the realization of taxable gain by petitioner. Central Loan & Investment Co., 39 B.T.A. 981; National Bank of Commerce of Seattle, 40 B.T.A. 72; affd., 115 Fed.(2d) 875; Estate of James N. Collins, 46 B.T.A. 765.
The final issue involves the deductibility of attorney fees, and, of such fees deducted, only that paid to the petitioner's own counsel seems to us allowable. The fees paid for the account of the minority stockholders and of the petitioner's codefendant, however, do not appear to be the expenses of petitioner. As the petitioner concedes, ‘It is frankly not so clear that they are allowable as a deduction.‘ Respondent is accordingly sustained as to all but $3,532.21 of the fees paid. National Outdoor Advertising Bureau, Inc. v. Helvering, 89 Fed.(2d) 878; Kornhauser v. United States, 276 U.S. 145; Foss v. Commissioner, 75 Fed.(2d) 326; Blackwell Oil & Gas Co. v. Commissioner, 60 Fed.(2d) 257.
Reviewed by the Court.
Decision will be entered under Rule 50. OPPER, J., dissenting: It seems to me totally lacking in realism to conclude that this petitioner was in receipt of income of any kind by reason of the cancellation of the agreement obligating it to pay its preferred stockholder the originally agreed purchase price of the securities she had delivered. If this had been a transaction between strangers and the property remained in the vendee's possession, it might be permissible to regard the renegotiation as an adjustment of purchase price, even though that is not the theory upon which the proceeding was heard, nor the issue presented by the pleadings or arguments. See Hirsch v. Commissioner (C.C.A., 7th Cir.), 115 Fed.(2d) 656; cf. Frank v. United States (Dist. Ct., E. Dist. Pa.), 44 Fed.Supp. 729. But the difficulty with treating the income here as arising from the sale of the securities is that this was not a short sale nor a borrowing of securities nor anything of that nature and the property which petitioner originally sold was unquestionably its own and never considered nor treated otherwise. The cancellation of the note was not a true rescission, since the sale was in no respect any longer executory and it was impossible to restore the vendor to her original position. Furthermore, there was not, as in the case of a short sale, a covering purchase, or other similar dealing with the property in the tax year. Cf. Estate of George H. Flinn, 45 B.T.A. 874.
That, however, is a difficulty which does not seem to me to confront us, for the transaction was not between strangers but had its inception solely because of the stockholder-corporate relationship. The substance of it was that the stockholder loaned petitioner the money with which to buy her securities. This was done solely to benefit the corporation and she so testified. When this indebtedness was forgiven in the tax year before us it presented a familiar and usual situation. It need not be confused or complicated by considering the purchase and sale as the source of income, but can and it seems to be should be decided from the viewpoint of what it actually was— a gratuitous contribution to capital even though under some species of compulsion. This is a type of transaction specifically and satisfactorily disposed of by respondent's regulations which provide:
* * * If a shareholder in a corporation which is indebted to him gratuitously forgives the debt, the transaction amounts to a contribution to the capital of the corporation. * * * Regulations 86, Art. 22(a)-14.
No consideration whatever flowed from the corporation to petitioner for her renunciation of the claim she held against it. Since the litigation instituted by the minority stockholders was for the corporation's benefit, it may justifiably be inferred that the settlement of the litigation with its accompanying cancellation of the debt resulted in an advantage to petitioner, but this does not prevent the act from being gratuitous, for, to borrow the language of Carroll-McCreary Co. v. Commissioner (C.C.A., 2d Cir.), 124 Fed.(2d) 303, ‘such a construction of the regulation deprives it of any function whatever; for an indirect benefit of this character always results to the shareholder from a gift to his corporation.‘ Cf. Robert H. Scanlon, 42 B.T.A. 997.
And to add that the stockholder received the further benefit of a settlement of the litigation is to say no more than that the minority stockholders were satisfied to discontinue that proceeding upon the indirect consideration of the benefit which the stockholder was conferring upon petitioner by canceling the obligation. The termination of the litigation was thus a consequence of the gratuitous contribution by the stockholder; it did not prevent that contribution from being gratuitous in the sense that the stockholder received nothing from petitioner in exchange. ‘In our opinion the phrase 'gratuitously forgives the debt’ means simply that no consideration is paid by the corporation for release of the debt.‘ Carroll-McCreary Co. v. Commissioner, supra. Nor is there anything to the contention that what the stockholder received was a prepayment and hence worth more than what she was entitled to a number of years later. The obligation was in default and under its terms payment could have been enforced at any time.
No support for the conclusion reached here is to be derived from such cases as Helvering v. Jane Holding Corporation (C.C.A., 8th Cir.), 109 Fed.(2d) 933, certiorari denied, 310 U.S. 653. Release of an indebtedness which has led in prior years to a tax benefit may well cause a subsequent readjustment to create taxable income on the familiar theory that recovery of items once deducted is the equivalent of the receipt of income. In that case the court was evidently influenced by this view, ‘the controlling factors being the previous deductions offsetting income otherwise taxable and the subsequent release of the indebtedness before payment.‘ Under the facts we are considering here, in every year between the creation of the debt and its partial cancellation— except the year 1930 in which there were no security losses and the interest due was paid in cash— petitioner had a net loss without resorting to any deduction connected with the debt. Neither the capital losses attending disposition of the securities for which the debt was incurred nor the interest accrued in favor of the creditor was needed to compute its net loss in any year. Citizens State Bank, 46 B.T.A. 964. And see Revenue Act of 1942, sec. 116.
Finally, it seems inescapable that if the stockholder had made a cash contribution to the paid-in surplus of petitioner and petitioner had used those funds to pay off the obligation in full no material aspect of the entire situation would have been different. The litigation could clearly as well have been settled in that manner and the minority stockholders would have been exactly as well off. But there would then have been no excuse for resorting to the short-sale concept upon which the decision here is rested nor any factual basis for it. The use of petitioner's outstanding obligation instead of cash to pay for such a capital contribution was merely a short cut to the same end and can not, it seems to me, justify the result reached. It is a familiar doctrine that the offsetting of an obligation has tax effects no different from what would be the case if one who was not a creditor attained a similar result by a cash outlay. See Helvering v. Midland Mutual Life Insurance Co., 300 U.S. 216. That is the vital distinction from the cases relied upon in the prevailing opinion, none of which presented the stockholder-corporation relationship nor the problem of capital contribution.
I have no quarrel with the treatment accorded by the majority opinion to the forgiven interest or to the claimed deductions for attorney fees.