Carman v. Commissioner

William W. Carman, Petitioner, v. Commissioner of Internal Revenue, Respondent Carman v. Commissioner Docket No. 16796 United States Tax Court 13 T.C. 1029; 1949 U.S. Tax Ct. LEXIS 10; December 21, 1949, Promulgated *10 Decision will be entered under Rule 50. Petitioner, in the recapitalization of company A, exchanged as of the date of January 1, 1939, A's bonds of a face value of $ 25,000 for bonds and stock of the reorganized company A. As of such date there was accrued unpaid interest on such bonds in the amount of $ 3,590.06. The effective date of the reorganization was January 1, 1939, but the actual exchange of the securities was not made until 1944. On the latter date petitioner also received from the reorganized company A a certain amount of cash, the cash so received representing adjustment payments in lieu of amounts which petitioner presumably would have received as interest and dividends had the securities which he received in 1944 actually been issued to him on January 1, 1939. Held, only the exchange of the securities which were considered as having been exchanged as of January 1, 1939, comes within the provisions of section 112 (b) (3) of the Internal Revenue Code, and as to the securities so exchanged no gain or loss is recognized; held, further, that the accumulated and unpaid interest in the amount above indicated on the old company A $ 25,000 face value bonds exchanged*11 by petitioner was part of such securities and that the securities received in exchange by petitioner included common stock of the reorganized company A in the amount of 116 3/4 shares of the stipulated value equal to the amount of such accumulated unpaid interest on such bonds; held, further, that the adjustment payments in cash were not within the exchange, and they are taxable as ordinary income. Harold F. Noneman, Esq., for the petitioner. J. Frost Walker, Jr., Esq., for the respondent. Hill, Judge. HILL *1030 The respondent determined a deficiency in petitioner's income tax for the calendar year 1944 in the amount of $ 3,552.40. Certain adjustments made by respondent are not contested. The primary question is whether certain securities and cash received by petitioner from the Western Pacific Railroad Co. in a reorganization under section 77 of the Bankruptcy Act constituted a payment of interest and dividends taxable in full, or whether such transaction comes within the provisions of section 112 (b) (3) and (c) ( 1) of the Internal Revenue Code. FINDINGS OF FACT. Part of the facts were stipulated, and they are so found. Petitioner is an individual, with an office in New York, New York. His income tax return for the year involved was filed with the collector of internal*13 revenue for the second district of New York. During 1944 petitioner owned $ 25,000 face value first mortgage 5 per cent coupon bonds, series A (hereinafter referred to as the old bonds), of the Western Pacific Railroad Co. (hereinafter sometimes referred to as the company), due in 1946. The dates of acquisition and cost of the old bonds to petitioner were as follows: Date Face value Cost Mar. 1, 1934 $ 10,000 $ 3,550.00 Oct. 19, 1937 5,000 893.75 Feb. 26, 1938 5,000 1,000.00 Apr. 29, 1940 5,000 862.50 Total 25,000 6,306.25 On the dates of acquisition of the old bonds interest was in arrears from September 1, 1933. The total amount of interest due from *1031 September 1, 1933, to the dates of acquisition of the old bonds by the petitioner was $ 2,132.55. From 1929 the company had outstanding 475,000 shares of common stock and 283,000 shares of preferred stock, each having a par value of $ 100 per share. It also had outstanding first mortgage 5 per cent bonds, series A (old bonds), having a face value of $ 49,290,000. At the time of the reorganization, hereinafter referred to, there was secured indebtedness aggregating $ 25,895,099.88. The interest*14 on the bonds was in arrears in its entirety from September 1, 1933. On August 2, 1935, the company filed a petition in the United States District Court for the Northern District of California, Southern Division, San Francisco, stating that it was unable to meet its debts as they matured and that it desired to effect a reorganization under section 77 of the Federal Bankruptcy Act. The Interstate Commerce Commission subsequently certified the plan of reorganization, after which hearings on that plan were held in the District Court, pursuant to the provisions of section 77 of the Bankruptcy Act. The plan of reorganization, approved by the Interstate Commerce Commission on June 21, 1939, provided in part as follows: The effective date of the plan shall mean the date from which interest shall run on the new securities provided in the plan, namely, January 1, 1939. * * * * A. The effective date of said plan shall be January 1, 1939. * * * * P. The existing securities of the debtor shall be treated as follows: * * * * 2. Holders of existing first-mortgage bonds shall receive for each $ 1,000, principal amount thereof, together with $ 266.66 2/3 of interest accrued and unpaid thereon to *15 January 1, 1939, approximately $ 400 of income-mortgage 4 1/2-percent bonds, series A, being 40 percent of the principal amount of said existing bonds; $ 600 of 5-percent preferred stock, series A, being 60 percent of the principal amount of said bonds; and 4.67 shares of common stock, being common stock taken at the price of $ 57 a share for 100 percent of said accrued and unpaid interest. On August 15, 1940, the District Court entered its opinion (34 Fed. Supp. 493) and order approving the said plan of reorganization. An appeal from that order was taken to the Circuit Court of Appeals for the Ninth Circuit, which reversed the order of the District Court (124 Fed. (2d) 136). Appeal was then taken to the United States Supreme Court, which on March 15, 1943, reversed the Circuit Court of Appeals and affirmed the District Court, approving the plan of reorganization (318 U.S. 448). On October 11, 1943, the District Court entered its order finding that all requirements of the confirmation of the plan of reorganization of the company under section 77 had been complied with and that the *1032 plan of reorganization*16 should be confirmed. In addition it approved the designation of a reorganization committee. On August 23, 1944, the reorganization committee filed its petition with the District Court, requesting, among other things, the approval of the general mortgage income bonds and the making of certain adjustment payments. The parts of that petition relative to this proceeding are as follows: 7. The form of indenture for the General Mortgage Income bonds (Exhibit B) submitted to the Court herewith necessarily includes (Sec. 5.03) the determinations made by your petitioners, subject to the approval of the Court, of the "available net income" of the properties of the debtor during the period from January 1, 1939 to December 31, 1943, as required by Subdivision L of the plan of reorganization and the allocation of this income in accordance with the equitable rights under the plan of the participating creditors who will receive the new securities. The plan clearly contemplates that, as between the classes of interested creditors, the available net income of the debtor for any period after January 1, 1939, until the reorganized company comes into ownership and possession of the properties of the*17 debtor shall be treated as if the reorganized company had come into such ownership and possession of the properties on January 1, 1939, and had issued as of that date the new securities issuable under the plan, other than the $ 10,000,000 First Mortgage Bonds, Series A, and contemplates that for the period after January 1, 1939, until the reorganized company comes into ownership and possession of the debtor's properties, the persons to whom the new securities are issuable shall be entitled to receive appropriate payments in lieu of the interest and dividends to which they would presumably have been entitled under the provisions of the plan, if the plan had been consummated on January 1, 1939. 8. All the securities to be issued in this reorganization will be issued to first mortgage bondholders and secured creditors of the debtor. No provision is made under the plan for unsecured creditors or for owners of preferred or common stock of the debtor company. During the period from January 1, 1939, through the calendar year 1943, the properties of the debtor, which have been under the management of the Trustees appointed by this Court, have shown substantial earnings which would have *18 been available for interest and dividends. The Reorganization Committee, under its duty to carry out the plan pursuant to its terms and intent, and subject to the approval of this Court, has determined that there should be made to said first mortgage bondholders and secured creditors at the time they surrender the obligations of the debtor which they now hold, and receive in satisfaction thereof the new securities authorized under the plan, certain adjustment payments in cash representing the amounts which said first mortgage bondholders and secured creditors might presumably have received on the new securities which they are to receive under the plan, if such securities had actually been in existence since January 1, 1939, and payments of interest and dividends made thereunder. 9. In determining the amounts of adjustment payments which it is proposed to make, at the time of the consummation of the plan, to carry out the intent of the plan as to recognition as between the various classes of creditors of their equitable right to participate in earnings on the same basis as if the new securities had actually been issued on January 1, 1939, your petitioners have reviewed the earnings*19 records of the properties of the debtor for the period from January 1, 1939, through the calendar year 1943. * * * * *1033 13. After full consideration of the purpose and intent of the plan, your petitioners have determined and recommend to the Court for approval that an aggregate amount of $ 12,684,271.54 be paid to the present first mortgage and secured creditors, at the time of the consummation of the plan, representing their equitable right as provided in the plan to participate in earnings of the properties during the period from January 1, 1939, through December 31, 1943, to be paid at the time they surrender the obligations of the debtor now held by them for the new securities authorized under the plan. 14. The cash held by the debtors Trustees is such that, without endangering the cash resources of the reorganized company, such adjustment payments may be made to such bondholders and secured creditors. 15. Petitioners recommend that upon the distribution of the new General Mortgage 4 1/2% Income Bonds, Series A, preferred Stock, Series A, and common stock, under provisions of the plan of reorganization, the debtor's Trustees make or cause to be made, through the exchange-depositary*20 to be approved by the Court by one or more checks as may be convenient, adjustment payments in cash as follows: (a) with each General Mortgage 4 1/2% Income Bond, Series A, issued and distributed under the plan, a cash payment of 22 1/2% of the principal amount thereof: (b) with each share of Preferred Stock, Series A, issued and distributed under the plan, a cash payment of $ 15.82; and (c) with each share of common stock, issued and distributed under the plan, a cash payment of $ 9.00. * * * * The District Court on September 14, 1944, ordered as follows: Now, Therefore, it is hereby Ordered, Adjudged and Decreed: (1) That paragraph 2 of subdivision P of the plan of reorganization be and hereby is construed as requiring (a) the issuance of 4.67 shares of new common stock (provided for in the plan) in payment of accrued and unpaid interest, to January 1, 1939, of $ 266.66 2/3 on each $ 1,000 principal amount of the debtor's outstanding First Mortgage bonds, and (b) an aggregate issue of 230,184.767 shares of such common stock in respect of the aggregate of accrued and unpaid interest, to January 1, 1939, upon all such bonds outstanding; (2) That the Reorganization Committee make provision*21 for the issuance of 4.67 shares of new common stock in payment of accrued and unpaid interest to January 1, 1939, of $ 266.66 2/3 on each $ 1,000 principal amount of the debtor's outstanding First Mortgage bonds: * * * * On September 25, 1944, the District Court entered its order approving and authorizing mortgage indentures and adjustment payments. Such order contained, inter alia, the following: 2. That the indenture relating to the General Mortgage Income Bonds contemplated by the plan of reorganization [set forth in part herein] (Exhibit "B" filed with the petition) with the corrections and changes submitted by petitioners at the hearing on September 25, 1944, and the form and denomination of Series A Registered Bond and the form of Trustee's Certificate of Authentication set forth in said Exhibit "B", be and hereby are approved as to substance and general form subject to such minor changes as the Reorganization Committee, upon advice of counsel, may deem advisable; * * * * *1034 5. That the Trustees of the debtor's estate be and hereby are directed to make or cause to be made at the time of the consummation of the plan, through the exchange depositary to be approved*22 by the Court, in such manner as may be convenient, adjustment payments in cash, in the aggregate amount of $ 12,681,086.52, or such lesser or greater amount as may be required to make payments to individual creditors to the nearest cent, and in such individual amount or amounts as shall equal the total of or each of the following, as the Reorganization Committee may determine: (a) With each General Mortgage 4 1/2% Income Bond, Series A, issued and distributed under the plan, a cash payment of 22 1/2% of the principal amount thereof; (b) with each share of Preferred Stock, Series A, issued and distributed under the plan, a cash payment of $ 15.81; (c) with each share of common stock, issued and distributed under the plan, a cash payment of $ 9.00; * * * * On November 27, 1944, after a hearing held upon order of the reorganization committee, the District Court entered an order directing the revesting of the property of the debtor in the debtor company and fixing the date of December 29, 1944, as the date for the consummation of the plan and authorizing and directing the carrying out of the plan and the issuance of securities thereunder pursuant to section 77. Upon completion of the *23 recapitalization, which constituted a reorganization under the provisions of section 112 (g) of the Internal Revenue Code, the capital stock of the company consisted of 318,591.367 shares of no par common stock, having a stated value of $ 18,546,200 and 318,502 shares of 5 per cent participating preferred stock, having a par value of $ 100 a share. Its bonded indebtedness consisted of $ 10,000,000 in 4 per cent first mortgage bonds, series A, and $ 21,219,000 in general mortgage income 4 1/2 per cent bonds, series A. On December 29, 1944, petitioner surrendered to the reorganization committee the old bonds in the face amount of $ 25,000 and all rights and claims appertaining thereto and solely in exchange therefor received pursuant to the plan of reorganization the following: Fair market Securities and cash Face value value on date of receipt New general mortgage income 4 1/2% bonds (hereinafter referred to as income bonds) $ 10,000 $ 9,325.00 150 shs. $ 100 par 5% participating preferred stock, series A (hereinafter referred to as preferred stock) 15,000 9,862.50 116 3/4 shs. common stock 3,590.06 Cash 5,672.25 Total 28,449.81 The $ *24 5,672.25 in cash received by petitioner as set forth in the preceding paragraph consisted of the adjustment payments required to be made under the plan of reorganization, being *1035 22 1/2% of $ 10,000 principal amount of the income bonds received upon the exchange $ 2,250.00 $ 15.81 for each of 150 shares of the preferred stock received upon the exchange 2,371.50 $ 9 for each of 116 3/4 shares of the common stock received upon the exchange 1,050.75 Total 5,672.25 Other than as set forth above, petitioner surrendered to and received from the reorganization trustees, or reorganized company, no money, securities, or other property. No physical document other than $ 25,000 face value bonds was surrendered at the time of the exchange. Petitioner, on his income tax return for 1944, treated the exchange referred to as a reorganization through recapitalization (sec. 112 (g), I. R. C.). He reported as recognized gain the sum of $ 5,672.25, the amount of the money, and took into account as long term capital gain 50 per cent thereof, or $ 2,836.13. Petitioner reported none of the securities received from the reorganized company as taxable income, but regarded*25 such securities as having been received in a tax-free exchange under the provisions of section 112 (b) (3) and section 112 (c) (1) of the Internal Revenue Code. In a statement attached to the notice of deficiency, under "Explanation of Adjustments," respondent stated as follows with respect to the deficiency herein involved: (a) and (b) -- It is held that $ 4,758.26 of the following received by you from the Western Pacific Railroad Company constitutes ordinary income taxable in full under the provisions of the Internal Revenue Code: 116 3/4 shares of new common stock of said company for interest on old bonds from 9/1/33 to 12/31/38 at $ 30.75 per share $ 3,590.06 Cash of $ 9.00 per share on said common stock 1,050.75 Interest on new 4 1/2% income bonds from 1/1/39 to 12/31/43 2,250.00 Total $ 6,890.81 Less: return of capital on purchase of old bonds 2,132.55 Taxable income $ 4,758.26 It is further held that the profit on the exchange of old First Mortgage 5% Bonds, Series A, of the Western Pacific Railroad Company for new bonds, cash and preferred stock is taxable as a capital gain to the extent of the cash received in the amount of $ 2,371.50, 50% of which*26 is $ 1,185.75, in accordance with the provisions of section 117 of the Internal Revenue Code. Accordingly, ordinary net income reported by you has been increased in amount of $ 4,758.26 and capital gain of $ 2,836.13 reported by you has been decreased in amount of $ 1,650.38. OPINION. In the transaction involving the exchange of petitioner's old bonds for the securities and cash of the company under *1036 section 77 of the Bankruptcy Act, respondent contends that section 112 (b) (3) and (c) ( 1) of the Internal Revenue Code 1 is not applicable because (1) the issuance of 116 3/4 shares of common stock by the company in 1944 for interest due petitioner as owner of old bonds from September 1, 1933, to December 31, 1938, constituted ordinary income to the extent of $ 3,590.06, less $ 2,132.55 attributable to the period prior to petitioner's purchase of the old bonds which respondent determined constituted a return of capital to petitioner; (2) $ 2,250 of the cash received by petitioner in 1944 was in effect payment of interest at the rate of 4 1/2 per cent on the bonds issued on December 29, 1944, as though such bonds actually had been issued on January 1, 1939, and hence constituted*27 ordinary income to petitioner during the year involved; and (3) the $ 1,050.75 received by petitioner on the 116 3/4 shares of common stock issued to him in 1944 was for dividends in arrears and is taxable to the petitioner as ordinary income received in that year. *28 Petitioner argues, however, that "No portion of such stock, securities and money so received may be treated as interest and taxed as ordinary income"; that "This entire exchange meets the requirements of sections 112 (b) (3) and 112 (c) (1) of the Internal Revenue Code and should be taxed solely as prescribed therein." This is true, he says, because his claim for interest against the debtor (the company) was an integral part of the security representing the entire indebtedness and any stock or securities or property received in exchange therefor was received in exchange for a security within the meaning of the above mentioned sections. Respondent's basic argument with respect to contention (1) above is that in the transaction involved petitioner surrendered securities (the old bonds) plus a claim for interest in the amount of $ 3,590.06 which was paid by the issuance to him of 116 3/4 shares of common stock of the recapitalized company as heretofore outlined. He then adds that "because the claim for interest is not a security its surrender *1037 to the corporation for the 116 3/4 common shares cannot qualify as a tax-free exchange under section 112 (b) (3). There is no doubt*29 that those shares of stock issued for the interest in arrears comprised part of the exchange pursuant to the plan of reorganization, as required by section 112 (b) (3). It thus appears that the answer to our problem lies in the determination of whether petitioner's claim for interest should be considered apart from the bonds, or an integral part of the bonds so that both the principal debt and interest may be termed a "security" within the meaning of that section. After an examination of many authorities on this question, we conclude that the interest may not be considered separately from the principal debt; that each coupon is a part of each bond; and that both together constitute the security. Fletcher, in his Cyclopedia of the Law of Private Corporations, section 2734, states: However, coupons are part of a bond and are affected by its infirmity as well as endowed with its strength and their character is not changed by detaching them from the bond. In section 2737 the following appears: A coupon is part of the debt covered by the mortgage which secures its bonds; and when a coupon is detached from the bond and is owned by one person while another owns the bond, the coupon is*30 still a lien under the mortgage. Matured coupons are "a constituent part of the mortgage debt, and an assignment of them carries with it by implication an interest in the mortgage security." A definition of securities in section 23 of the Internal Revenue Code recognizes that the coupon is considered part of the security. Section 23 (k) (3) provides as follows: (3) * * * the term "securities" means bonds, debentures, notes, or certificates, or other evidences of indebtedness, issued by any corporation * * * with interest coupons or in registered form. See also Bailey v. County of Buchanan, 115 N. Y. 297; 22 N. E. 155; Real Estate Trust Co. of Philadelphia v. Pennsylvania Sugar Refining Co., 237 Pa. 311; 85 Atl. 365; Oster v. Building Development Co., 213 Wis. 481; 252 N. W. 168, 172. It is thus apparent that there has been compliance with section 112 (b) (3). There is support for our conclusion herein in cases decided by this and other courts. In South Atlantic Steamship Line, 42 B. T. A. 705,*31 the taxpayer in the course of the recapitalization of a corporation exchanged preferred stock upon which cumulative dividends were in arrears for new stock, bonds, and cash. The respondent contended that certain of the securities received by the taxpayer in the exchange were for dividends in arrears on the old stock and were taxable as a corporate dividend. We stated that "the right of the preferred shareholders to receive the dividend arrears was not one which could *1038 be divorced from the shares upon which it was based." Although this case involved dividends, not interest, in arrears, we nevertheless believe the rationale controls here. See also Skenandoa Rayon Corporation, 42 B. T. A. 1287; affd., 122 Fed. (2d) 268; certiorari denied, 314 U.S. 696; Commissioner v. Food Industries, Inc., 101 Fed. (2d) 748; Humphryes Manufacturing Co., 45 B. T. A. 114; Knapp-Monarch Co., 1 T. C. 59; affd., 139 Fed. (2d) 863; 142 Fed. (2d) 456; Globe-News Publishing Co., 3 T. C. 1199;*32 Okonite Co., 4 T. C. 618; affd., 155 Fed. (2d) 24; certiorari denied, 329 U.S. 764. Respondent argues, however, that South Atlantic Steamship Line, supra, is not authority for our conclusion in the case at bar. He points out that we said in that case that the dividends were in arrears, but had not been declared. He reasons that, if the claim had been for dividends declared prior to the reorganization, "then such claim is separate from and independent of the stock, and must qualify or fail as a 'security' by reason of its own present attributes, wholly apart from its origin." He then compares interest due on a bond to a declared dividend, concluding that neither should be considered part of the security. This argument avails respondent nothing, for, as we have pointed out before, interest due the holder of a bond is part of the principal debt which it represents. The two are not separate and may not be considered apart. We agree with respondent, however, as to contentions (2) and (3), i. e., that the cash adjustment payments do not fall within the purview of section*33 112 (b) (3) and (c) (1). Section 112 (b) (3) provides that no gain or loss shall be recognized if stock or securities of a party to a reorganization are "in pursuance of the plan of reorganization, exchanged solely for stock or securities in such corporation * * *." In the case here there was both a plan of reorganization and an exchange. But it is important to note that, although the exchange was not consummated until 1944, the effective date of the plan of reorganization was January 1, 1939. Hence, we must look to that date to determine which securities were to be included in the exchange and, therefore, which securities come within the provisions of the code sections involved. Those securities were as follows: $ 25,000 face value of old bonds, together with interest due on such bonds in the total amount of $ 3,590.06, for new general mortgage 4 1/2 per cent callable, series A, income bonds of a face value of $ 10,000, plus 150 shares of $ 100 par 5 per cent participating preferred stock, or a total par value of $ 15,000, plus 116 3/4 shares of common stock, the fair market value of which was stipulated at $ 3,590.06. *1039 The petitioner states that: * * * That date [January*34 1, 1939] is significant only as the starting point for the determination of the extent of the rights of all participants in the reorganization. It was not until more than four years thereafter that the Supreme Court affirmed the decision of the District [Court] approving the plan, and it was not until its subsequent acceptance by the vote of creditors in 1943 and the entry on October 11, 1943 of an order by the District Court confirming the plan that anyone had any definitive idea of what he would get out of the reorganization. * * * That date is significant for more than being the "starting point" of the reorganization; it was the effective date of the plan. It is the rights of the participants in the reorganization as of that time that we are interested in here for the purpose of determining the applicability of the sections of the code in question. It is true that respondent, both in the notice of deficiency and the stipulation, treated the $ 2,371.50 cash received by petitioner with the 150 shares of preferred stock issued to him in 1944 as capital gain. This would seem to indicate that respondent agreed with petitioner that the adjustment payment should be accorded taxability*35 within section 112 (b) (3) and (c) (1). We do not have before us the question of the correctness of such action by respondent. However, despite the fact that respondent so treated such item and thus eliminated it from our consideration here, we are convinced that under the facts and applicable law we can not do otherwise than hold that the other "adjustment payments" do not fit within the above cited sections. All of the cases cited by petitioner, some of which were discussed and mentioned above, are distinguishable so far as issues (2) and (3) are concerned, for in none of them was there involved adjustment payments made after the effective date of the plan of recapitalization or reorganization. In view of our holding, it is not necessary to discuss the alternative issue raised by respondent. Decision will be entered under Rule 50. Footnotes 1. SEC. 112. RECOGNITION OF GAIN OR LOSS. * * * * (b) Exchanges Solely in Kind. -- * * * * (3) Stock for stock on reorganization. -- No gain or loss shall be recognized if stock or securities in a corporation a party to a reorganization are, in pursuance of the plan of reorganization, exchanged solely for stock or securities in such corporation or in another corporation a party to the reorganization. * * * * (c) Gain from Exchanges Not Solely in Kind. -- (1) If an exchange would be within the provisions of subsection (b) (1), (2), (3), or (5), or within the provisions of subsection (1), of this section if it were not for the fact that the property received in exchange consists not only of property permitted by such paragraph or by subsection (1) to be received without the recognition of gain, but also of other property or money, then the gain, if any, to the recipient shall be recognized, but in an amount not in excess of the sum of such money and the fair market value of such other property. * * * *↩