Towers & Sullivan Mfg. Co. v. Commissioner

TOWERS AND SULLIVAN MANUFACTURING COMPANY, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT. Towers & Sullivan Mfg. Co. v. Commissioner Docket No. 40508. United States Board of Tax Appeals 25 B.T.A. 922; 1932 BTA LEXIS 1450; March 21, 1932 Promulgated *1450 Cancellation of an indebtedness held not to constitute income to the debtor. D. J. Gantt, Esq., for the petitioner. T. M. Mather, Esq., and L. W. Creason, Esq., for the respondent. MATTHEWS *922 This is a proceeding for the redetermination of a deficiency in income tax in the amount of $1,781.72 for the fiscal year ending May 31, 1925. The petitioner alleges that the respondent erred in allowing a net loss for the fiscal year ending May 31, 1923, in the amount of only $27,247.77, to be applied against income for the year ending May 31, 1925, instead of in the amount of $130,901.43, the difference arising from the inclusion in income for the fiscal year 1923 by the respondent of an amount of $103,653.66, representing a cancellation of indebtedness. The proceeding was submitted upon the pleadings and a stipulation from which we make our findings of fact. FINDINGS OF FACT. The petitioner is a corporation, with its principal office in Rome, Georgia. In determining the deficiency in income tax of the petitioner in the amount of $1,781.72 proposed in the sixty-day deficiency letter dated July 13, 1928, for the fiscal year ended*1451 May 31, 1925, the respondent *923 reduced the petitioner's net income for the fiscal year 1925 by a net loss for the fiscal year ended May 31, 1923, in the amount of $27,247.77, which is less than the net loss claimed as a deduction on petitioner's return. In the fiscal year 1923 the petitioner was indebted to creditors in the amount of $317,218.89. Of this amount $160,779.84 represented indebtedness incurred directly by petitioner in the purchase of materials and supplies. The remainder, $156,439.05, represented money borrowed and used in the purchase of materials and supplies. The creditors agreed in that year to cancel 25 per cent of the total amount of indebtedness, or $79,304.72, and the remaining 75 per cent, or $237,914.17, was paid to the creditors - $119,914.17 in cash and $118,000 in preferred stock of the petitioner corporation - pursuant to the composition agreement between the creditors and the petitioner. The petitioner in its return for the fiscal year 1923 included the amount forgiven, $79,304.72, in its gross income and also an amount of $24,348.94 which represented accrued interest on the indebtedness as of May 31, 1923, making a total of $103,653.66. *1452 Of this $24,348.94 accrued interest, the amount of $20,904.96 was deducted by the petitioner from its gross income on its return for the fiscal year 1923. The respondent in determining the petitioner's tax liability for the fiscal year 1923 included in gross income the amount of $103,653.66, representing the amount of indebtedness forgiven and accrued interest, and allowed the amount of $20,904.96 as a deduction. He also deducted from gross income the amount of $116,028.33, representing a write-off of inventory on the petitioner's books during the same fiscal year. The petitioner now contends that it erred in including the amount of $103,653.66 in its gross income; that such amount did not constitute income and that the total amount of the net loss sustained in 1923 was $130,901.43, being the amount of $27,247.77 allowed by the respondent as a net loss, plus the above amount of $103,653.66. All of the materials and supplies for which the indebtedness of $317,218.99 was incurred were exhausted and deducted from gross income of the petitioner either in the fiscal year ended May 31, 1923, or in later years, either by way of a direct write-off of inventory or through costs*1453 of goods sold. The balance sheets of the petitioner corporation show a deficit of $221,922.88 as at May 31, 1922. The balance sheets as at May 31, 1923, May 31, 1924, and May 31, 1925, show a surplus of $56,872.13, $92,456.36, and $118,296.88, respectively. The petitioner keeps and has at all times kept its books and made its income-tax returns on the accrual basis of accounting. *924 OPINION. MATTHEWS: This Board has held in a number of cases, beginning with that of Meyer Jewelry Co.,3 B.T.A. 1319, that the cancellation of an indebtedness does not constitute income to the debtor. See John F. Campbell Co.,15 B.T.A. 458; affd., Burnet v. Campbell Co., 50 Fed.(2d) 487; Eastside Manufacturing Co.,18 B.T.A. 461; Progress Paper Co.,20 B.T.A. 234; E. B. Higley & Co.,25 B.T.A. 127; and Commissioner v. Simmons Gin Co., 43 Fed.(2d) 327. In the case of John F. Campbell Co., supra, a corporation engaged in the sugar and rice brokerage business was indebted to its creditors in a large amount. In 1921 these creditors agreed*1454 to accept 75 per cent of their claims in cash and accounts receivable, and to forgive the remaining 25 per cent. We held that the amount forgiven did not constitute income and the Court of Appeals of the District of Columbia, in affirming our holding, said: We agree with the Board's decision. It is plain that early in 1921 the taxpayer was in financial distress, and was probably insolvent, and that its creditors conceled part of their claims against it in order to secure payment of the balance of their claims. This relief enabled the taxpayer to continue business and to realize a profit in the years 1922 and 1923. It is public history that the time in question witnessed great disturbance in such business as the taxpayer was then engaged in. This forbearance did not produce taxable income to the taxpayer. "Income" within the purview of the revenue acts has been defined to be "gain derived from capital, from labor, or from both combined," and includes "profit gained through a sale or conversion of capital assets." Stratton's Independence v. Howbert,231 U.S. 399, 415; *1455 Doyle v. Mitchell Bros. Co.,247 U.S. 179, 185; Eisner v. Macomber,252 U.S. 189, 206, 207. "In determining the definition of the word 'income' thus arrived at, this court has consistently refused to enter into the refinements of lexicographers or economists and has approved, in the definition quoted, what it believed to be of the commonly understood meaning of the term which must have been in the minds of the people when they adopted the Sixteenth Amendment to the Constitution." Merchants' L. & T. Co. v. Smietanka,255 U.S. 519. We do not believe that the term "income" as commonly understood applies to the partial cancellation by a creditor of a debt due to him from a disabled debtor, in order that such debtor may thereby be enabled to pay the balance of the debt. "The fact that after the transaction the plaintiff's balance sheet had improved was not sufficient to constitute 'a gain derived from capital.' If anything it was a gain accruing to capital, and, as such, under the Eisner and Phellis cases, was not taxable income." *1456 Kerbaugh-Empire Co. v. Bowers,300 Fed. 938; Aff'd 271 U.S. 170. In the instant proceeding the petitioner's balance sheet for the fiscal year 1922 shows a deficit of $221,922.98, and the balance sheet for the fiscal year 1923 shows a surplus of $56,872.13. The goods and merchandise for which the indebtedness herein was incurred had declined in value, as shown by the write-off of inventory, and the *925 petitioner was unable to pay its debts. In such a situation the creditors entered into a composition agreement to take 75 per cent in cash and stock and to forgive the remainder. We think that these facts bring the case within the holding in John F. Campbell Co., supra.The petitioner did not realize any taxable income in the fiscal year 1923. Even excluding the amount forgiven from gross income, the petitioner had a net loss for this year of $27,247.77. In such a situation we do not see how the amount forgiven can constitute income, but there is "a mere diminution of a loss." See *1457 Simmons Gin Co., supra, and Bowers v. Kerbaugh-Empire Co.,271 U.S. 170. As a result of this action on the part of its creditors, the petitioner was enabled to continue in business and to make a profit during the next few years, but, as the court said in the Campbell Co. case, this was not sufficient to constitute "gain derived from capital." We are, therefore, of the opinion that the amount of $79,304.72, which was 25 per cent of the entire amount of the indebtedness, does not constitute income to the petitioner and should not be included in its gross income for the fiscal year 1923. The amount of $24,348.94, accrued interest, consisted of $20,904.96 which had accrued and was deducted in the fiscal year 1923, and the amount of $3,443.98 which had accrued in a prior year. Inasmuch as the composition with the creditors was made during the fiscal year 1923, this had the effect of canceling the petitioner's liability for interest due and therefore it should not have deducted any accrued interest for that year. It therefore follows that the respondent did not err in including the amount of $20,904.96 in gross income for the fiscal year 1923. *1458 The amount of $3,443.98, which had accrued in a prior year, is in the same category with the principal amount of $79,304.72, and does not constitute income to the petitioner in the fiscal year 1923 and should not be included in its gross income for that year. Judgment will be entered under Rule 50.