Astoria Marine Constr. Co. v. Commissioner

Astoria Marine Construction Co., Petitioner, v. Commissioner of Internal Revenue, Respondent Astoria Marine Constr. Co. v. Commissioner Docket No. 11392 United States Tax Court 12 T.C. 798; 1949 U.S. Tax Ct. LEXIS 195; May 20, 1949, Promulgated *195 Decision will be entered under Rule 50. A corporation, financially distressed, paid a creditor $ 500 in full settlement of notes for $ 26,000. The creditor accepted the settlement only because an investigation had convinced him that he could collect no more. (1) The difference of $ 25,500, held, not excludable from gross income as a gift under section 22 (b) (3), Internal Revenue Code. Commissioner v. Jacobson, 336 U.S. 28. (2) On the evidence, held, that the corporation was insolvent before and after the compromise settlement, and hence no taxable income resulted from it. Dallas Transfer & Terminal Warehouse Co. v. Commissioner, 70 Fed. (2d) 95. Frank H. Spears, Esq., for the petitioner. John H.*196 Pigg, Esq., for the respondent. Johnson, Judge. JOHNSON *799 The Commissioner by several adjustments determined deficiencies of $ 1,222.86 and $ 10,668.72 in petitioner's income tax for 1940 and 1941, a deficiency of $ 913.42 in declared value excess profits tax for 1940 and a deficiency of $ 17,337.69 in excess profits tax for 1941. Petitioner assails the inclusion in 1940 income of the difference between its indebtedness due on certain notes and the lesser amount for which it settled its obligation. It also claims deduction of a net operating loss carry-over for 1940 and for 1941, which deduction depends on decision of the prior issue. The case was submitted on a stipulation and exhibits, which we hereby incorporate as findings of fact, and upon oral testimony. FINDINGS OF FACT. Petitioner, an Oregon corporation with principal place of business at Astoria, Oregon, is engaged in the construction and repair of boats and barges. It keeps its books and prepares its income tax returns on an accrual basis, and it filed its income and excess profits tax returns for 1940 and 1941 with the collector of internal revenue for the district of Oregon. For some years petitioner *197 purchased for use in its business a creosoted, rot-resistant lumber from the Crossett Western Co. of Wauna, Oregon. On November 20, 1936, it borrowed $ 7,000 from C. H. Watzek, the manager of that company, giving its 6 per cent promissory note for the amount. In 1938 petitioner submitted the successful bid for construction of a vessel for the U. S. Coast and Geodetic Survey, but, being in poor financial condition, it had to procure additional capital before a surety company would issue the required performance bond. Joseph M. Dyer, its principal stockholder, president, and manager, approached Watzek for more funds, and Watzek loaned petitioner $ 20,000, receiving from it two $ 10,000 notes, payable on demand after completion of the vessel. The $ 20,000 was deposited by petitioner in a special bank account and was used for construction of the vessel. The vessel was completed in 1940 at a loss of over $ 22,000. Watzek demanded payment of the $ 20,000 loan evidenced by the two notes and of $ 6,000 still due on the first note. He had protracted negotiations with Dyer, examined petitioner's financial condition, its obligations, and accounts receivable, and had an appraisal made of*198 its properties. He tried to sell the notes at a discount, but could find no buyer. Dyer offered him $ 500 in settlement of the whole indebtedness of $ 26,000, and on November 8, 1940, he accepted petitioner's certified check for that amount, believing that $ 500 was all he could collect. He delivered the notes to petitioner. At the time of this settlement petitioner's assets comprised about five acres of tidewater lands, improved with a small dwelling and *800 shop; machinery, equipment and tools; and inventory of lumber, nails, bolts, oakum, and other supplies for repair work; and accounts receivable of $ 3,908.94. The assets were carried at a total of $ 31,393.97, but had a market value not in excess of $ 11,000. Notes, taxes, and accounts payable, apart from the $ 26,000 owed to Watzek, aggregated $ 11,792.11. Petitioner was doing very little business and its plant and capital were inadequate. After the United States entered the war petitioner procured business, and it has since prospered. Watzek claimed and was allowed to deduct as a bad debt represented by the notes $ 6,000 in 1939 and $ 19,500 in 1940. On its income tax return for 1940, petitioner omitted from gross*199 income the difference between the $ 26,000 owed on the notes and the $ 500 paid in settlement, claiming that this difference of $ 25,500 was abnormal income attributable to other years and not taxable by virtue of section 22 (b) (9), Internal Revenue Code. It has never filed with the Commissioner its consent to the regulations prescribed under section 113 (b) (3). The Commissioner added the $ 25,500 to income. For the year 1939 petitioner sustained a net operating loss of $ 9,353.97. OPINION. Petitioner settled notes on which it was obligated to Watzek in the amount of $ 26,000 for a cash payment of $ 500. They were not purchase money notes, and petitioner bore no relation to the seller other than that of debtor. Petitioner seeks to characterize the $ 20,000 loan, which was needed and used in constructing the vessel for the U. S. Coast and Geodetic Survey, as part of a transaction or venture on which it lost money. But such a view was considered and rejected by this Court in petitioner's prior proceeding, Docket No. 1868, involving tax deficiencies for 1939. We adhere, on this record, to the conclusion therein reached that a purely debtor-creditor relation existed between petitioner*200 and Watzek, and the compromise of the indebtedness did not minimize petitioner's loss on construction of the vessel. The gain of $ 25,500 comes within the meaning of gross income as defined by section 22 (a), Internal Revenue Code. United States v. Kirby Lumber Co., 284 U.S. 1; Helvering v. American Chicle Co., 291 U.S. 426. And it is not to be excluded therefrom as a gift under section 22 (b) (3), because: * * * the seller sought to get as high a price as he could * * * and the buyer sought to pay as low a price as he could. * * * There is nothing in the evidence or findings to indicate that he [the seller] intended to transfer or did transfer something for nothing * * * [Commissioner v. Jacobson, 336 U.S. 28.] But at the time that petitioner made the compromise settlement, its obligations were in excess of $ 37,000 and the book value of its assets *801 was only $ 31,393.97. It was apparently insolvent, and in such a situation the discharge of the Watzek notes released assets only to the extent that the value of assets remaining in petitioner's hands after the settlement*201 exceeded its remaining obligations. Only this excess may be deemed income subject to tax. Texas Gas Distributing Co., 3 T. C. 57; Lakeland Grocery Co., 36 B. T. A. 289. Petitioner introduced the testimony of three witnesses concerning the value of its various properties. Their testimony was vague and general in nature, but it is persuasive that petitioner's lands, buildings, and equipment, which were carried on the books at over $ 21,000, were worth only a fraction of that figure. We are also convinced that not more than 75 per cent of its accounts receivable of $ 3,908.94 could be collected. We have found that the total value of assets after discharge of the $ 26,000 debt did not exceed $ 11,000. As remaining obligations exceeded this amount, no assets were freed from the claims of creditors by discharge of the notes, and the Commissioner erred in including the $ 25,500 in petitioner's taxable income. Dallas Transfer & Terminal Warehouse Co. v. Commissioner (C. C. A., 5th Cir.), 70 Fed. (2d) 95; Main Properties, Inc., 4 T. C. 364; Highland Farms Corporation, 42 B. T. A. 1314;*202 Madison Railways Co., 36 B. T. A. 1102. Petitioner assigned as a second error the Commissioner's failure to allow deduction of a net operating loss carry-over in the amount of $ 16,675.29 for 1941. The parties are agreed on petitioner's right to such a deduction in case the prior issue is decided in petitioner's favor. It should accordingly be reflected in a recomputation of the tax. Decision will be entered under Rule 50.