Atwell v. Commissioner

Webster Atwell et al., Petitioners, 1 v. Commissioner of Internal Revenue, Respondent Atwell v. Commissioner Docket Nos. 27596, 27597, 29775, 29776, 29777, 29778, 29779, 29780, 29781, 32202, 32203 United States Tax Court 17 T.C. 1374; 1952 U.S. Tax Ct. LEXIS 268; February 27, 1952, Promulgated *268 Decisions will be entered under Rule 50. 1. Income -- Realization -- Benefit -- Reduction of Indebtedness. -- The purchasers of the stock and a note of an insolvent corporation did not realize income from the transfer by the corporation, after the sale, of its cash to the seller to be credited on the note, since the intention of both buyers and seller was that the subject of the sale would be the stock and the amount of the note less the cash. 2. Income -- Realization -- Basis -- Allocation of Cost -- Undivided Interests in Overdue Notes. -- Purchasers of an insolvent corporation's overdue note for less than its face value were each issued later twenty identical notes each in the terms of the original note as evidence of their interests. Each purchaser turned in one of his twenty notes as the debtor paid off one-twentieth of the indebtedness. Held, each purchaser did not have to report income until he had first recovered the cost of his entire interest in the indebtedness since his twenty notes did not represent twenty divided interests in the original indebtedness of a kind requiring allocation of his entire cost basis proportionately to each note. Webster Atwell, Esq.,*269 Robert A. Wilson, Esq., and E. Crippen, Esq., for the petitioners. John W. Alexander, Esq., for the respondent. Murdock Judge. Kern, J., concurs in the result. MURDOCK *1375 The Commissioner determined deficiences in income taxes as follows: Dkt. No. Petitioner Year Amount 27596 Webster Atwell [1947] $ 6,125.46 27597 Laura Burgher Atwell [1947] 6,182.45 29775 Webster Atwell [1948] 1,064.29 29776 Laura Burgher Atwell [1948] 1,083.96 29777 Wm. A. Sailer [1947] 6,101.30 29778 Patricia O'Leary Sailer [1947] 6,101.31 29779 John P. Thompson [1947] 6,021.03 29780 Joe Clark Thompson III Trust "A" [1947] 1,349.79 29781 Jeremiah W. Thompson "A" Trust [1947] 3,622.93 32202 Wm. A. Sailer [1948] 4,077.52 [1949] 2,592.47 32203 Patricia O'Leary Sailer [1948] 4,077.52 [1949] 2,592.47 The petitioners assign as error the action of the Commissioner in determining a capital gain from each payment received on account of indebtedness of Texas Public Utilities Corporation instead of holding that those payments were returns of capital until they exceeded the basis of the indebtedness to the petitioners. The Commissioner, by amended answer, alleges that he erred*270 in failing to include in the income of each petitioner his proportionate share of $ 160,000 paid by Texas Public Utilities Corporation in 1947 for the benefit of its stockholders, the petitioners. FINDINGS OF FACT. The petitioners filed their returns for the taxable years with the collector of internal revenue for the second district of Texas. American Power & Light Company, hereafter called American, was the owner in the early part of May 1947 of 10,000 shares of no par value common stock of Texas Public Utilities Corporation, hereafter called Texas. American also owned at that time a promissory note of Texas in the amount of $ 2,500,000. The note was dated November 30, 1935. It represented a promise of Texas to pay the principal amount of the note on or before December 30, 1940 "with interest thereon before and after maturity, if, as and when earned, at the rate of Seven Per Centum (7%) per annum." The principal of the note prior to that time had been reduced to $ 2,200,000. The past due interest *1376 on the note at that time amounted to about $ 600,000. Texas at that time was engaged in the ice business. It was insolvent. American desired to sell the stock and the note*271 of Texas, which were the only securities of Texas outstanding at the time. It invited sealed bids for the note and the 10,000 shares of stock, with the understanding that $ 160,000 of cash which Texas had on hand would be paid over by Texas to American, reducing the principal of the note to $ 2,040,000. The petitioners and associates joined together and submitted the highest bid. Their bid was $ 711,000. One of their representatives on behalf of the others entered into a purchase agreement with American dated May 15, 1947. $ 71,100, or 10 per cent of the purchase price, was paid upon the signing of that purchase agreement. The agreement contained a provision that American proposed to cause Texas to pay American, on account of the principal of the note, all of the cash shown on the balance sheet of March 31, 1947. That cash amounted to about $ 160,000. That agreement was amended at the request of American by another dated May 19, 1947, providing that the purchasers would cause Texas to pay American $ 160,000 within 5 days after the closing date. This amendment referred to the same $ 160,000 by which the principal of the note was to be reduced, as understood before the bids *272 were made and as provided in the agreement of May 15, 1947. The purchasers agreed to the amendment purely as an accommodation to American for some reason not disclosed by the record. The purchasers paid American the balance of the $ 711,000 purchase price on or about May 29, 1947, and received delivery of the 10,000 shares of stock and the note. Texas, on June 3, 1947, issued its check for $ 160,000 to American. The petitioners became owners of portions of the stock of Texas and of undivided interests in the note. New stock certificates were issued to the various purchasers. The minutes of the meeting of the board of directors of Texas held on July 14, 1947, show the interest of each of the purchasers in the note of Texas and recite that there was a principal balance due on the note at the time of the purchase in the amount of $ 2,040,000. Those minutes contain the following: * * * In order for each of these purchasers to have his or her part of said note, it is proposed that this corporation issue, execute, and deliver its note to each of said purchasers in the amount set opposite each name, but that said note shall be, other than the amount so stated and the payee, exactly like*273 the original note of $ 2,500,000 in all respects, and said notes shall constitute the exact same obligation of said $ 2,500,000 note in every respect and provide that said notes shall be registered upon the books of this Company. After a full discussion, upon motion made, seconded and unanimously carried, *1377 IT WAS RESOLVED that this corporation issue a note to each of the purchasers of its $ 2,500,000 note in an amount representing the percentage that each of said purchasers bought of said $ 2,500,000 note, but otherwise said notes shall contain the same provisions as the original note, and that these new notes shall constitute the exact same obligation as the original note, and shall be registered upon the books of the Company; and the President and Secretary of this Company are authorized to execute and deliver said notes containing the provisions as herein set out and in the amounts as aforesaid, and shall cause the books of registry to be obtained and maintained and said notes to be registered therein, and that said notes shall provide for such registration. The officers of this Company are also authorized and directed to register in said books of registry the original*274 note in the sum of $ 2,500,000 showing in such books of registry the purchasers thereof, and the percentage of their purchase. Each of the purchasers, at or about July 14, 1947, received 20 notes, each one of which was in the amount of one-twentieth of his portion of the $ 2,040,000 of principal due. The notes were all alike except as to payee and amounts. The purchasers of the stock and of the note allocated $ 677,775.70 as the cost of the note and the remainder as the cost of the stock on the basis of the amounts at which each was carried on the books of Texas. A number of payments of $ 102,000 each on the principal of the indebtedness were made by Texas and its successor -- three during 1947, two during 1948, and two during 1949. The petitioners received their pro rata shares of those payments. As each payment was made one of the series of 20 notes was taken up and canceled. The petitioners did not report any income from the receipt of those payments on their returns for 1947 or 1948. The Sailers reported the excess of the total amounts received up to the end of 1949 over the total basis allocated to their share of the indebtedness as a long term capital gain for 1949. The*275 Commissioner, in determining the deficiencies, held that each payment was in full payment of the principal of one of the series of 20 notes, each note had as its basis one-twentieth of the owner's proportionate part of $ 677,775.70, and the excess of each payment over that proportionate part of the basis was gain, taxable as a short term capital gain. The stipulation of facts is incorporated herein by this reference. OPINION. The Commissioner claims an increased deficiency upon the ground that the $ 160,000 was income to the petitioners since it was paid under the amended purchase agreement by Texas to American on behalf of the petitioners and the other purchasers of the Texas stock. He has the burden of proof on this issue. The purchase price was $ 711,000, not $ 871,000. The evidence shows clearly that the purchasers never intended to purchase a note having a larger *1378 amount of principal due on it than $ 2,040,000 and it was the understanding throughout that the cash of $ 160,000 shown on the March 31, 1947, balance sheet of Texas was to go to American in order to reduce the principal of the note from $ 2,200,000 to $ 2,040,000. The slight change in the method of accomplishing*276 this result was a change in form but not in substance. The purchasers derived no benefit from the transfer of the $ 160,000 and it does not represent income to these petitioners under any tenable theory. . The Commissioner, relying upon the fact that the owners of the note had the debtor issue to them individual series of 20 notes each, contends that one-twentieth of the basis of each owner must be allocated to each note in the series so that a profit may be computed as each is canceled. The petitioners argue that there was great uncertainty, when they bought the note and later, of whether they would recover their cost and of how much profit, if any, they would have from the transaction; they have the right to recover their entire basis before being taxed on any gain under such circumstances; the series of notes did not change the situation taxwise but was merely for convenience in accounting as payments were made on the indebtedness; and the Commissioner is attempting to tax them upon a purely theoretical gain as if full payment of the indebtedness were assured and as if each retained note of the series had a value commensurate*277 with each one retired, both of which assumptions are contrary to the facts. Both parties start with $ 677,775.70, the portion of the total cost allocated to the note, so no question of that allocation is before the Court despite mention of it in the petitioners' brief. The present question would not have arisen if no notes had been issued to the individual purchasers of the indebtedness of Texas or if, as the resolutions provided, but one note had been issued to each purchaser, for in such cases clearly each purchaser of an undivided share of the indebtedness would have been entitled to recover his entire basis before being taxed with a gain on any excess. The purchasers chose to follow that same method of reporting the payments despite the issuance of the 20-note series because they felt it was the only safe and proper method in view of the inherent uncertainty as to the amount ultimately to be received by each from the insolvent debtor. The Commissioner would regard the 20 notes as identical units, each evidencing a divided interest in the indebtedness and each having a value equal to that of every other one in the series, so that the total basis of each owner could be allocated*278 in equal portions to each of the 20 notes just as if each taxpayer held 20 identical bonds. But there the Commissioner errs. It would have been proper to have allocated the total basis among the 20 notes if each had represented a definite separate interest in the *1379 indebtedness and had had a readily determinable fair market value. Each could then have taken that portion of the total basis which its fair market value bore to the fair market value of the twenty notes, and if payable pro rata and without preference the method of allocation used by the Commissioner would have been proper. For example, if there had been a prearranged plan designating which note would be canceled upon the first payment, which upon the second payment, and so forth, then it might have been possible to have determined the fair market value, or at least the approximate fair market value, of each note. Obviously, the first note to be paid would have had a fair market value approximating its face value, whereas the last notes to be paid might not have had any fair market value. A fair and proper allocation of the basis could have been made in proportion to the fair market value of each note in the*279 series. However, there was no prearranged plan for choosing the note to be canceled upon any particular payment or for pro rata payments on each without preference. Instead, each individual owner of an interest in the debt chose at random from his notes the one to be canceled on any particular payment. Thus, there was no way of determining the fair market value of each note in the series and no way, both fair and practical, of allocating the basis among the 20 separate notes. Indeed, the interest of each participant remained, for all practical purposes at least, a single undivided interest and did not become 20 separate divided interests upon the issuance of the series of 20 notes. Only because the interest of each purchaser remained an undivided interest in the total indebtedness was it satisfactory to each to have one of the series of notes retired and canceled with each payment made by the debtor. An owner of an interest in a debt can insist that payment be pro rata and without preference where there is no prior arrangement providing otherwise. The payments here were not made pro rata and without preference on each of the 20 notes issued to each owner of an interest in the*280 indebtedness, but, nevertheless, they were satisfactory because they were pro rata in so far as the undivided interest of each owner in the indebtedness was concerned. The participants were not in position to dispose of an individual note to an outside party, since the payments did not have to be pro rata and since there was no prearranged plan for a particular payment to be on a particular note. The facts distinguish the divided interest of a bondholder from whatever interests these series of notes gave to these petitioners and demonstrate that these notes did not serve to divide the interests 20 ways and were not separately marketable. The petitioners also point out that the debt was long past due, in default, and subject to a large amount of accumulated interest at the time the 20-series notes were issued, with the result, *1380 they argue, that those notes were not true promissory notes under the laws of Texas. That question need not be decided. Likewise immaterial is the question of what portion of the basis would be used if a purchaser sold a portion of his undivided interest in the indebtedness. It is sufficient for present purposes to hold that the 20-series notes*281 did not represent 20 divided interests in the indebtedness of a kind requiring an allocation of the basis for Federal income tax purposes under the circumstances here present. The use of the method demanded by the taxpayers may possibly result in larger taxes eventually, if the payments continue, but it is proper for them to use that method. Cf. , certiorari denied ; ; . Decisions will be entered under Rule 50. Footnotes 1. Proceedings of the following petitioners are consolidated herewith: Laura Burgher Atwell, Docket No. 27597; Webster Atwell, Docket No. 29775; Laura Burgher Atwell, Docket No. 29776; Wm. A. Sailer, Docket No. 29777; Patricia O'Leary Sailer, Docket No. 29778; John P. Thompson, Docket No. 29779; Joe Clark Thompson III Trust "A", Docket No. 29780; Jeremiah W. Thompson "A" Trust, Docket No. 29781; Wm. A. Sailer, Docket No. 32202; Patricia O'Leary Sailer, Docket No. 32203.↩