Rickaby v. Commissioner

Estate of Hamilton C. Rickaby, Deceased, Marcy W. Rickaby, Executrix, and Marcy W. Rickaby, Petitioners, v. Commissioner of Internal Revenue, Respondent Rickaby v. Commissioner Docket Nos. 55403, 56023 United States Tax Court 27 T.C. 886; 1957 U.S. Tax Ct. LEXIS 251; February 28, 1957, Filed *251 Decisions will be entered under Rule 50. Payments, on account of bonds purchased "flat" in 1942, made by the debtor in the tax years as interest applicable to periods before 1942 and resulting in recoveries in excess of petitioner's basis but less than the face of the bonds, held taxable as capital gains under section 117 (f), I. R. C. 1939. David G. Sacks, Esq., and Allan J. Parker, Esq., for the petitioners. Clarence P. Brazill, Esq., for the respondent. Opper, Judge. OPPER *887 These consolidated proceedings involve deficiencies, only part of which is in issue, of $ 648.76, $ 1,330, and $ 1,080*252 in income taxes for the calendar years 1950, 1951, and 1952, respectively. Hamilton C. Rickaby died on February 15, 1956, and his estate was substituted as a party herein. The sole question presented is whether amounts received by Marcy W. Rickaby, Hamilton's wife, in excess of her basis of certain bonds, purchased "flat," are taxable as capital gains attributable to the retirement of bonds under section 117 (f) or in full under section 22 (a). FINDINGS OF FACT. Some of the facts have been stipulated and are hereby found. Marcy W. Rickaby, herein called petitioner, filed joint income tax returns with her husband for each of the years involved with the collector (now director) of internal revenue for the second (now lower Manhattan) district of New York. In 1942 petitioner, at a cost of approximately $ 1,750, purchased $ 50,000 principal amount (with interest unpaid thereon) of series B debentures of Retail Properties, Inc., herein called Retail, formerly Schulte-United Properties, Inc., a corporation organized under the laws of Ohio. No allocation was made on the purchase between the claim representing the principal amount of the debentures and the unpaid interest, that is, they*253 were purchased "flat." By January 1, 1950, petitioner had recovered her original cost of these debentures and by September 1950 there existed a reasonable expectancy that the principal of these debentures would ultimately be collected. She received $ 1,500 in 1950, $ 3,500 in 1951, and $ 3,000 in 1952 from Retail on account of her ownership of these debentures. She and her husband reported these receipts, on their tax returns for the respective years, as amounts received on account of partial retirement of such debentures under the provisions of section 117 (f) of the Internal Revenue Code of 1939. On March 1, 1929, Schulte-United Properties, Inc., had issued approximately $ 6,500,000 principal amount of sinking fund 5 1/2 per cent gold debentures. Retail was unable to meet the interest payment due September 1, 1931, on these gold debentures. A debenture holder's protective committee was formed and a plan of reorganization, dated *888 February 3, 1932, was submitted to the debenture holders. Under the terms of that plan of reorganization, each holder of $ 1,000 in principal amount of gold debentures had the option to receive in exchange therefor $ 500 in principal amount*254 series A 5 per cent debentures and $ 600 of series B 6 per cent debentures to be issued under the provisions of a trust agreement between Retail and the Guardian Trust Company of Cleveland. The plan of reorganization also provided for a voting trust of the preferred and/or common stock of Retail, to terminate when the series A and series B debentures were discharged or upon such earlier date as a majority of the voting trustees in their discretion should determine. Approximately 95 per cent of the holders of the gold debentures accepted the exchange offer and received series A and series B debentures. The outstanding gold debentures which were not exchanged were redeemed on December 1, 1940, at 102 per cent of the principal amounts thereof plus interest accrued to the date of redemption. In 1940 tenders were requested of series A debentures to be purchased for retirement out of funds realized largely from the sale of certain property of Retail. In 1943 a notice of offer to purchase debentures was sent to all holders of both series A and series B debentures. Funds for this purpose were realized in part from the sale of one of Retail's properties at Pueblo, Colorado. Tenders were*255 requested at prices not in excess of bid and asked prices, which at that time were 82 and 84 plus accrued interest for series A and 12 3/4 asked flat for series B. A substantial number of both series was purchased pursuant to that offer. On March 19, 1947, $ 400,000 principal amount of series A debentures were called following the sale of certain of Retail's properties. On April 26, 1950, a notice of offer to purchase series B debentures was sent to holders thereof. In 1951 payment of an intercompany note by Retail Properties, Ltd., the wholly owned Canadian subsidiary of Retail, was made possible by the mortgage of that subsidiary's properties. All series A debentures then outstanding were redeemed and a payment equal to 40 per cent of the principal amount of the outstanding series B debentures was made. The series B debentures presented for partial payment were endorsed as follows: Forty percent (40%) of the principal amount of this Debenture has been paid. No interest will accrue subsequently to August 31, 1951 on the amount so paid. Interest accrued on the amount so paid at the rate of six percent (6%) per annum from November 1, 1934 to August 31, 1951 remains an obligation*256 of the Company evidenced by this Debenture. Retail paid holders of series B debentures, in the following years, amounts equal to the following percentages thereof and designated by Retail as interest for the periods specified as follows: *889 Year Percentage Interest period [3] Mar.1, 1932, to Aug. 31, 1932 [3] Sept. 1, 1932, to Feb. 28, 1933 [3] Mar.1, 1933, to Aug. 31, 1933 [3] Sept. 1, 1933, to Feb. 28, 1934 [4] Mar.1, 1934, to Oct. 31, 1934 [3] Nov.1, 1934, to Apr. 30, 1935 [3] May1, 1935, to Oct. 31, 1935 [3] Nov.1, 1935, to Apr. 30, 1936 [3] May1, 1936, to Oct. 31, 1936 [3] Nov.1, 1936, to Apr. 30, 1937 [3] May1, 1937, to Feb. 28, 1938 [3] Mar.1, 1938, to Oct. 31, 1938 Under the provisions of the trust agreement, interest on the series B debentures was payable currently only if Retail earned "surplus income," therein defined as gross income on an accrual basis for any given period minus all operating and nonoperating expenses (but excluding interest on series B debentures) and the net deficit, if any, accumulated from March 1, 1932, to the beginning of such period. These debentures*257 contained an unequivocal promise to pay both principal and accumulated interest no later than maturity. They were subject to redemption in whole or in part at any time after all the series A debentures ceased to be outstanding. The series B debentures were in registered form. No surplus income was earned by Retail from 1932 through 1950. From 1951 through 1955 payments were made out of surplus income with the exception of 1954 and 1955 in which years there was sufficient surplus income to make payment of only two-thirds of the amount paid to holders of series B debentures. On January 28, 1955, a notice was sent to holders of series B debentures offering to purchase at prices not in excess of $ 140 per $ 100 of original face amount of debentures. On September 9, 1955, the outstanding series B debentures were redeemed by using funds provided by (a) loans from the Prudential Insurance Company of America secured by mortgages of certain of Retail's properties, (b) a short-term bank loan, and (c) the balance of cash on hand. This action terminated the voting trust and placed control of Retail in the hands of the holders of the preferred stock. The value of the preferred stock of Retail*258 steadily increased during the period from 1947 through 1955, as indicated by the bid and asked quotations therefor. The series B debentures constituted capital assets in the hands of petitioner. The amounts received by petitioner during the years involved as payments on account of these debentures constituted payments in retirement thereof. *890 OPINION. When bonds which are making current payments of undefaulted interest are bought and sold, it is frequently, if not ordinarily, the practice to make an adjustment for the interest earned to the date of sale. In that event, the portion of the interest already paid for, is, when subsequently received, not income of any kind to the purchaser. L.A. Thompson Scenic Railway Co., 9 B. T. A. 1203. See Charles T. Fisher, 19 T. C. 384, 387, affd. (C. A. 6) 209 F. 2d 513, certiorari denied 347 U.S. 1014. In the present situation, however, interest was in default 1 when petitioner bought the bonds. Although a substantial amount had accumulated and was unpaid at the time, no segregation of the purchase price between principal*259 and interest was made by the parties. In other words, petitioner bought the bonds flat. By the time the present tax years commenced, sufficient payments had been made on the bonds so that petitioner had recovered her basis. But she had not yet received their face amount. Additional payments received in the tax years in excess of basis but still falling short of the principal due were reported by petitioner as capital gain. Respondent treated them as ordinary income, but not as "interest income." His statement on brief is: *260 Respondent agrees that the payments in question in the instant case are returns of capital as opposed to "interest income" but contends that unless petitioners can show that they are entitled to capital gains treatment under section 117, such payments are necessarily taxable as ordinary income under section 22 (a). See Corn Products Refining Company v. Commissioner (1955) 350 U.S. 46, 1955 P-H par. 72,023, rehearing denied, 350 U.S. 943. 2 [Emphasis added.] *261 Apparently the argument being made is that while this could never be interest income because it represented payments already in default when petitioner bought the bonds, see William H. Noll, 43 B. T. A. 496, it was ordinary income under section 22 (a), Internal Revenue Code of 1939, because the provisions of section 117 (f) do not reach it. 3*891 For this conclusion respondent relies on Rev. Rul. 55-433, 1955-2 C. B. 515, and this in turn on the contention that section 117 (f) does not apply because the obligation being paid was not "issued" by the corporation. *262 We think this proposition cannot be maintained. In the first place, other obligations than that to pay principal are considered to have been "issued" notwithstanding that they may not arise until a bond has been in existence for some time. In District Bond Co., 1 T. C. 837, for example, the debtor was permitted to redeem the bonds in advance of maturity upon payment of principal and interest to date and an additional "premium." We said (at page 840): Upon the retirement of bonds at a price in excess of cost, the resulting profit is treated for Federal income tax purposes as capital gain. Section 117 (f) of the 1938 Act. * * * With this exception [the interest], however, the proceeds are treated as receipts from the sale or exchange of the bonds, and there is nothing in the statute to remove premiums from this treatment. * * * [Emphasis added.] Again, while this petitioner had recovered her basis by the time the payments in controversy were made, she had by no means as yet collected the principal amount. There is hence no reason to assume that she would necessarily be receiving something over and above principal which might be characterized*263 as interest or some other kind of ordinary income. Cf. Charles T. Fisher, supra.But see Clyde C. Pierce Corp. v. Commissioner, (C. A. 5) 120 F. 2d 206, affirming a B. T. A. Memorandium Opinion. Assuming the debtor had the right to characterize what these payments constituted, see Huntington-Redondo Co., 36 B. T. A. 116; G. C. M. 2861, VII-1 C. B. 255, they should be attributed to interest which had already been defaulted when the bonds were purchased. If this is so, the obligation being already in existence was bought by petitioner along with the bond itself. Erskine Hewitt, 30 B. T. A. 962; William H. Noll, supra.No reason appears why it should not have constituted a capital asset which, when disposed of, would result in capital gain. Purchase of the bonds in question included in the price paid not only the title to the securities, but the right to receive interest accrued and unpaid. As to the petitioner the whole constituted a capital acquisition and the subsequent payment of the defaulted*264 interest was a return of a portion of his investment, regardless of the label attached by the payor. [R. O. Holton & Co., 44 B. T. A. 202, 205.] Finally, the purpose of section 117 (f) having been to assimilate amounts received on retirement to those resulting from sales or exchanges, we think it would do violence to the congressional purpose to hold that this payment was not capital gain. Respondent has conceded that the amount received was not "interest income" but was a "return of capital." We think he would be obliged to agree that *892 if this bond had been sold instead of being retired, amounts received in excess of basis from whatever source would be capital gain. Clyde C. Pierce Corp. v. Commissioner, supra;R. O. Holton & Co., 44 B. T. A. 202. a purchase, at a flat price, of securities of political subdivisions, which are in default, is a capital transaction. * * * a capital gain or loss on account thereof is to be determined by the difference between the amount paid, and the amount received therefor, wholly without regard to whether this amount is received, by resale of*265 the securities as a whole, resale of the bonds with coupons detached and a collection of the coupons, or by a collection of the whole principal and accrued interest from the political subdivision. [Clyde C. Pierce Corp. v. Commissioner, supra, at p. 208.] The highly artificial test of whether the ultimate payment of principal is likely leaves us wholly unconvinced. If this were the proper approach, the amounts in question should be viewed as the equivalent of interest, cf. Charles T. Fisher, supra, but respondent concedes, as indeed he probably must under Rev. Rul. 55-433, supra, that this is not interest income. If the principal is so clearly recoverable as to make these payments taxable as ordinary income, then why should petitioner be permitted first to recover her basis? Yet Rev. Rul. 55-433, supra, is clear that no tax will be due until basis has been recovered, a position perhaps forced upon respondent by such cases as Erskine Hewitt and William H. Noll, both supra. We see no more reason than in those*266 cases to resort to hairbreadth distinctions and questionable theories. See also, Allen Tobey, 26 T. C. 610. We conclude that, at least as applied to the present facts, Rev. Rul. 55-433, supra, is not a permissible construction of the statute and, accordingly, will not be followed. These amounts were properly reported by petitioner as capital gain. Decisions will be entered under Rule 50. Footnotes 1. Respondent makes no contention that this income had not accrued prior to purchase on the ground that interest payments before maturity were dependent on earnings, of which there had been none up to that time. Compare National City Lines v. United States, (C. A. 3) 197 F. 2d 754, with Campbell v. Sailer, (C. A. 5) 224 F. 2d 641↩. We accordingly treat this as a typical instance of interest due but defaulted prior to purchase. 2. It is clear that Corn Products Co. v. Commissioner, 350 U.S. 46, rehearing denied 350 U.S. 943, is no authority for this statement. There the Supreme Court held (at page 52): "Congress intended that profits and losses arising from the everyday operation of a business be considered as ordinary income or loss rather than capital gain or loss. The preferential treatment provided by § 117↩ applies to transactions in property which are not the normal source of business income. * * *" 3. SEC. 117. CAPITAL GAINS AND LOSSES. (f) Retirement of Bonds, Etc. -- For the purposes of this chapter, amounts received by the holder upon the retirement of bonds, debentures, notes, or certificates or other evidences of indebtedness issued by any corporation (including those issued by a government or political subdivision thereof), with interest coupons or in registered form, shall be considered as amounts received in exchange therefor.↩