Peoples State Bank v. Commissioner

PEOPLES STATE BANK, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT. Peoples State Bank v. Commissioner Docket No. 91697. United States Board of Tax Appeals 38 B.T.A. 857; 1938 BTA LEXIS 815; October 13, 1938, Promulgated *815 A bank, operating under a reopening agreement with its depositors whereby its entire income and the proceeds of certain segregated assets equal in book value to its unpaid deposit liabilities were to be turned over to the depositors in exchange for their release of the remainder of such unpaid deposit liability, held, to have no taxable income for a year in which its income and that from the segregated assets did not equal capital losses incurred in the segregated assets. William P. Smith, Esq., for the petitioner. Frank B. Schlosser, Esq., and Elmer C. Holt, Esq., for the respondent. OPPER *857 This proceeding involves a deficiency in income tax for the year 1935 in the amount of $2,126.64. *858 FINDINGS OF FACT. From a stipulation of facts and appended documents the following facts are found, the numbered paragraphs being quoted from the stipulation: 1. That, petitioner was incorporated in 1905 under the laws of the State of Michigan, and chartered thereunder to conduct a banking business at the City of Holland in said State, it being so engaged on January 9, 1932, when it was determined insolvent by the State Banking*816 Commissioner and was closed and placed in receivership by appropriate proceedings. 2. That, on December 15, 1932, the Circuit Court, having jurisdiction of said matters, ordered and directed the levying of the statutory 100% assessment against petitioner's stockholders, for the benefit of the depositors, and same having been duly paid or otherwise accounted for, no further liability is assessable against said stockholders. 3. That, on June 28, 1933, the petitioner was reorganized and reopened under the direction of the Banking Department of The State of Michigan, and in accordance with the provisions of Act No. 8 of the Public Acts of 1932 of the State of Michigan. * * * 6. That, the charter granted by the State of Michigan to the Peoples State Bank, Holland, Michigan, has never been cancelled, and the reorganized bank since its reopening, has continued to operate thereunder. 7. That, the receiver of the said Peoples State Bank was discharged September 11, 1933, and the said reorganized Peoples State Bank was thereupon, by order of the Circuit Court for the County of Ottawa, Michigan, subrogated to all the rights and privileges theretofore conferred on said receiver*817 and became liable for the obligations contracted by him during the receivership. 8. That, the "Trust Fund," formed under the Reorganization Plan, as well as the reorganized bank, are under the direct supervision of the Michigan State Banking Commissioner and subjected to his periodical examination. The reorganization plan, as approved by the Circuit Court, was embodied in a "Depositors' Agreement" which was subscribed by persons representing at least 85 percent of the deposit liability of the bank, and was made mandatory on the remaining depositors by a court order. The depositors' agreement contained the following provisions: * * * that fifty per cent (50%) of the amount of my deposit in said bank shall be deducted from my balance as shown by the books of said bank, and shall be allocated to a TRUST FUND for the purpose of liquidating any assets transferred to such fund which may be considered questionable or undesirable, with the understanding that if any of the assets remaining in such bank as active assets become doubtful or undesirable at any time during the life of this agreement, the said bank may, with the approval of the State Banking Commissioner, substitute assets*818 of an equal amount from the TRUST FUND to the active assets of the bank, placing such doubtful assets thus removed from active assets in the TRUST FUND for the purpose of safeguarding at all times the remaining portion of my deposit not allocated to said TRUST FUND and all other deposits which may be made in said bank. * * * *859 It is a condition of this agreement that all assets of the Peoples State Bank that shall be charged off and not included as assets of the reorganized bank, such assets being of value but of a value too uncertain to be included as assets of the reorganized bank, shall be transferred to the TRUST FUND hereinbefore referred to, for the use and benefit of such reorganized bank and beneficiaries of the TRUST FUND, with the understanding that such assets are to be liquidated by such bank as rapidly as possible without too great sacrifice, and in such liquidation said bank shall have and exercise the same authority it would have if such trusteed assets were fully owned by it. In instances where the amount charged off represents depreciation in value of assets, it is understood that any increment in value of such depreciated assets at the termination*819 of this agreement shall pass to the credit of the TRUST FUND herein referred to, for the benefit of parties entitled to participate in the avails of such TRUST FUND. * * * A depositors' committee of Five shall be permitted to act with the directors during the existence of this agreement, and I hereby signify my approval of the depositors' committee consisting of the following named men * * * which committee shall represent the depositors during the life of this agreement. * * * At the expiration of the liquidation period of five years provided by this agreement, the so-called TRUST FUND shall be closed and there shall be distributed among the creditors entitled to participate therein, pro rata the avails of such fund up to the full amount due such creditors. Any funds or any accounts, collectible or otherwise, in excess of the full amount due such creditors at the time of the closing of the moratorium accounts as herein provided, shall be transferred to the assets of said bank. Before any such transfer of such assets, however, beneficiaries of the trust fund shall receive interest on amounts due them at the rate of 3% per annum. The depositors' agreement placed a moratorium*820 on that part of the deposits remaining after the allocation of 50 percent to the trust fund, and made a stated percentage of these remaining deposits available each year until the fifth year after the reorganization. This moratorium could be terminated or modified upon the agreement of the depositors' committee and the board of directors, if approved by the state banking commissioner. The agreement further provided: It is further agreed that all net profits accruing from the operation of the bank during the period that this agreement is in effect shall be credited to the TRUST FUND. It is also agreed, in consideration of all earnings being placed in the TRUST FUND, that any losses sustained by the bank during the period that this agreement is in force, shall be chargeable to the TRUST FUND. * * * Certificates of deposit, and Savings Pass Books, issued by the bank and outstanding in the hands of the depositors shall be surrendered and the contract of deposit altered in harmony with the provisions of the agreement. We further find, as stated in the stipulation of facts: 13. That, at the time of segregation of assets to the "Trust Fund," the amount which would be ultimately*821 realized therefrom was uncertain and indeterminable, and the segregation of the assets and "allocation" of deposits between the bank *860 and the "Trust Fund" in accordance with the Depositors' Agreement * * * was made by the State Banking Department, on the basis of the bank's book value thereof, as follows: Segregated Assets Reorganized Bank Assets: Loans & Discounts $421,011.39 $471,524.29 Mortgages 311,104.74 262,794.18 Bonds 10,510.00 117,278.47 Due from State Treas 85,503.69 Cash & due from Banks 63,423.75 3.19 Other Real Estate 80,893.64 Nat. Cr. Assn. Note 150.00 Banking House 75,000.00 Furn. & Fixt 20,000.00 Other Assets 7,287.29 986,553.57 939,931.06 Liabilities: Capital stock 150,000.00 Deposit Liability 836,553.57 939,931.06 986,553.57 939,931.06 14. Under authority of * * * the Depositors' Agreement, substitution of assets has been made by the bank from time to time, and as a result thereof and of the progress of the liquidation, the book value of the segregated assets on January 5, 1938, totalled $577,779.07, with the unpaid deposit liability thereunder $623,672.20. The "Trust Fund," established*822 under the reorganization plan * * * will expire June 28, 1938, and the depositors will receive payment of less than 50% of the portion of their deposits allocated thereto. Regarding the operations of the bank and the trust fund for the taxable year, and their treatment in petitioner's tax returns and by the respondent, the following facts are found as stipulated: 9. That, during the calendar year 1935, there was received into the "Trust Fund" interest, on certain of the assets segregated thereto, of $10,288.03; there was received $407.31 collected on debts which were a part of the segregated assets and which had been considered to have been worthless in a prior year and charged off therein; there was received $2,483.96 realized from liquidation of certain of the segregated assets consisting of securities, which had a gain or loss basis to the bank at the time segregated of $5,650.00; and there was also received $12,852.12 realized from liquidation of certain segregated assets, other than securities, which had a gain or loss basis to the bank at the time segregated of $9,700.70. During the same year, it was determined that certain notes, which were a part of the assets segregated*823 to the "Trust Fund" were worthless and uncollectible in the amount of $21,345.04, and same were charged off in 1935. The amount charged off is based upon the cost of the assets to the bank at the time segregated. 10. That, the net profit reported from the operation of the reorganized bank during the calendar year 1935 amounted to $2,951.79, which included capital gains of $6,107.93. This net profit was increased by the respondent $1,459.39 through certain adjustments not in dispute, and by disallowance of $767.28 for prepaid insurance which is disputed, or a total increase of $2,226.67. *861 11. That, the petitioner considered the reorganized bank and the "Trust Fund" to constitute a single entity, and duly filed its Federal income and excess profits tax return for the calendar year 1935, including therein income and deductions from the operation of the reorganized bank. Petitioner also included therein as its income the interest of $10,288.03 received into the "Trust Fund," the amount of $407.31 collected into the "Trust Fund" on notes previously considered to be worthless, and $3,151.42 as "capital gains" on the segregated assets (other than securities) which were*824 liquidated in 1935, such amount of $3,151.42 being the difference between the amount received into the "Trust Fund" on liquidation thereof and the gain or loss basis to the bank of such liquidated assets at the time segregated. Petitioner in such return also claimed as deductions $21,345.04 for bad debts on account of notes, hereinbefore mentioned, and $3,166.04 for "capital losses" on securities segregated to the "Trust Fund" which were liquidated in 1935, such amount of $3,166.04 being the difference between the amounts received into the "Trust Fund" on liquidation thereof and the cost thereof to the bank before segregation, or the par thereof, whichever was lower. 12. That, in addition to the adjustments set forth in paragraph 10 above, the respondent did not allow to petitioner the deductions claimed for the "Trust Fund", "bad debts" and "capital losses," and eliminated from petitioner's gross income the "Trust Fund," "bad debt recoveries" and "capital gains." In this manner the respondent determined petitioner's taxable net income to be $15,466.49, as against the returned net loss of $7,712.53. * * * 15. That, in accordance with the * * * Depositors' Agreement * * *, *825 the net profits accruing from the operation of the reorganized bank for the calendar year 1935 were credited to the "Trust Fund." 16. That, on October 25, 1935, petitioner paid $1,150.82, representing payment of premiums for three years on burglary and robbery insurance. Of this amount, the respondent allowed $383.54 as a deduction applicable to the year 1935, and disallowed the balance of $767.28 as applicable to the remaining years of 1936 and 1937 covered by the policy. 17. The books and records of the reorganized bank and the "Trust Fund" were kept on a cash receipts and disbursements basis and the return was filed on that basis. OPINION. OPPER: Petitioner, closed in 1932 because of insolvency, was reopened pursuant to Michigan law 1 by virtue of a judicially approved agreement by the depositors to accept the proceeds of liquidation of certain segregated assets and the earnings of the bank for five years in satisfaction of approximately half of their deposits. These assets, of a book value equal to the allocated deposits, were held in what was designated a "Trust Fund", but the bank retained full ownership powers over their liquidation and reserved the right with*826 the consent of the state commissioner of banking to substitute for the segregated assets any of the retained assets which might become doubtful or undesirable. Any losses of the bank were to be charged against the so-called trust fund. At the end of the five-year liquidation *862 period the fund was to be paid to the depositors up to the full amount of their deposits, together with 3 percent per annum interest, the excess, if any, to be retained by the bank. As it finally developed in 1938, at the end of the five-year period the depositors were paid less than 50 percent of their allocated deposits. A table summarizing the figures for the taxable year 1935 as given in the stipulation appears in the margin. 2 *827 We begin with the assumption that the bank and "trust fund" are taxable together as one entity 3 because that position is agreed to by both parties 4 and therefore is not in issue. 5 The dispute arises by reason of the treatment accorded by respondent to the various items of income and deduction. Principally these consist of income earned by the bank, income received from assets held in the trust fund, and losses incurred on bad debts, and from the sale of capital assets, held in the trust fund. Respondent has taxed petitioner on the two income items and refused to allow the deductions. Petitioner contends that it should be given the benefit of the loss deduction or, alternatively, be freed from liability to tax on the income items. In either event there would be no income subject to tax. 6 *828 *863 Respondent suggests a third possibility, namely, that current income is taxable on an annual basis whether earned by the bank itself or by the assets in the trust fund, but that capital losses and bad debts of the trust fund must be held in abeyance for treatment as part of the completed transaction in the year when the entire arrangement is concluded. There may be other possible methods of dealing with the petitioner's tax status, but none occurs to us, except that suggested by respondent, which would have the effect of charging petitioner with any taxable income in the instant proceeding. That being so, we expressly refrain from attempting to determine which treatment is properly applicable, if that advanced by the respondent is not. Once it is conceded that the trust fund is the property of the bank and is to be taxed along with the bank's income in the same way as any of its other property, some special circumstance must exist to justify a departure from the statutory direction that capital losses and bad debts may be deducted in the year when they materialize. Revenue Act of 1934, sec. 23(f) and (k). The only grounds advanced for such an exception here are, *829 first, that petitioner's loss has been "compensated for" 7 by the depositor's agreement to accept the assets in settlement of their deposit liabilities 8 and, second, that to permit deductions to this petitioner would result in a failure properly to reflect its income. 9 *830 As to the first ground urged by respondent, it was not the segregated assets alone which secured petitioner's relief from liability, but these assets together with its agreement to devote its own income and that from the trust assets to the depositors. Thus, any benefit secured by it from the segregated assets was not the amount of the deposit liabilities forgiven, but this amount less the income it might earn during the operative period. If, as in the instant case, there is in a given year a net capital loss of say $21,000 and net income from bank and trust assets combined of $15,000, the decrease taking place as of the end of the tax year in the amount available to depositors is the difference between the two, namely, $6,000. This is the amount which, if no later change occurs, will represent liability forgiven. *864 If petitioner is charged with this amount in the current year, either as "compensation" for a loss or as income received, and also with its actual income of $15,000, the total is and necessarily must be exactly equal to the capital loss, since petitioner's cost basis of the assets in the trust fund was the same as the deposit liabilities originally allocated*831 thereto. Even if the "compensation" theory could be applied to such a case as this, a point which we do not decide, it follows that any "compensation" derived by petitioner in the tax year falls short of the loss suffered by it by exactly the amount of its current income, with the consequence that the income is offset by the remaining loss. Respondent's second contention is in turn based on the suggestion to which we have already referred, that the results of the liquidation must be known before it can be determined whether or not petitioner has actually suffered a loss. In the first place, it is by no means clear that each annual period can not be considered by itself so that income for each period may be properly computed without regard to the ultimate effect of the liquidation. The petitioner's current income and the loss on assets sold in the tax year are known. The doubtful item, if there be one, is the amount of indebtedness which will ultimately be forgiven. Whether or not under some other circumstances a bank situated as was petitioner might obtain taxable income from the scaling down of its deposit liability we do not consider it necessary to determine, for in this*832 instance the amount of liabilities forgiven was so indefinite that at most it could be charged to petitioner only to the extent that the transactions concluded prior to the end of the tax year resulted in such forgiveness. And even if we add to petitioner's income the amount of indebtedness the release of which arises out of the transactions of that year, no income results since, as we have seen, the extent of the forgiveness exactly equals and must, on these facts, always exactly equal the difference between the capital losses and the income received. On the other hand, the hypothesis that petitioner's income can not properly be reflected until the liquidation is completed, seems to us to require postponement to the year of final liquidation not only of the capital items but also of current income. Petitioner's income, the segregated assets, and the release of liability were all the subjects of one executory contract. At the time the agreement was made the amount of future income was "uncertain and indeterminable." But until the entire transaction was closed that uncertain and indeterminable quantity was, as we have seen, as much a necessary factor in calculating the effect*833 of the entire transaction upon petitioner's situation as was the amount which would ultimately be realized from the assets themselves, the uncertain and indeterminable character of which causes respondent to urge postponement. Thus when respondent *865 contends that the loss on these assets must be deferred until the end of the liquidating period he inferentially, it seems to us, advances the same argument for postponing consideration of current income, in which event, of course, there would still be no taxable income attributable to petitioner for the year before us. All of this results, perhaps, only by reason of the present facts that the deposit liability equaled the basis of the segregated assets, that there are capital losses on these assets greater than net income, and that all net income goes to the creditors, thereby reducing any amount required to be treated as forgiveness. But we do not purport to be passing upon other cases where the facts may be different. In the light of this disposition of the proceeding it is not necessary to consider petitioner's alternative argument that the income is not taxable to it because of its assignment to the creditors; nor its*834 further assertion that the Act of March 1, 1879, 10 referring to the taxation of insolvent banks either in its original form or as amended by the Revenue Act of 1938, requires petitioner's income to be exempted from tax. For the same reason such doubts as may exist of our jurisdiction under that statute, 11 need not now be resolved. While it may be unfortunate that so many open questions should*835 remain after the decision of a proceeding regarded by both parties as a test case, we do not feel justified in attempting to decide controversial issues of law which seem to us immaterial upon the present record. Decision will be entered for the petitioner. Footnotes 1. Act No. 8, Public Acts of 1932. ↩ 2. See following table: Reorganized bank Segregated assets Combined GROSS INCOME: Interest Received $50,401.66 $10,288.03 $60,689.69 Collected on Bad Debts previously charged off 407.31 407.31 Miscellaneous Income 6,851.07 6,851.07 Capital Gains 6,107.93 3,151.42 9,259.35 Commr.'s increase in income (not disputed) 1,459.39 1,459.39 Commr.'s increase in income - deduction disallowed for insurance paid (disputed) 767.28 767.28 Total 65,587.33 $13,846.76 $79,434.09 DEDUCTIONS: Expenses 60,408.87 60,408.87 Capital Losses (disallowed) 3,166.04 3,166.04 Bad Debts (disallowed) 21,345.04 21,345.04 Total 24,511.08 84,919.95 Net Income↩ (credited to Trust Fund) 5,178.46 (Loss) $10,664.32 (Loss) $5,485.86 Commissioner added interest received on segregated assets 10,288.03 Net Income of Bank per 90-Day Letter 15,466.49 3. See G.C.M. 12000, XII-2 C.B. 62↩. 4. * * * both the petitioner and the Commissioner regard the "Trust Fund" here involved to be not a separate taxable entity from the bank. * * * (p. 15, respondent's brief.) * * * throughout the liquidation period the bank retained such complete control of the segregated assets, both by its liquidation thereof with "the same authority it would have if such trusteed assets were fully owned by it" (depositors' agreement, par. 11), and through its power of substitution of its retained assets therefor, that it must be considered as remaining in substance the owner thereof. * * * (P. 6, petitioner's brief.) ↩ 5. It may be noted that if the trust fund were taxable as a separate entity there would apparently be no basis for excluding the deductions, in which event the taxable income could be no more than $5,178.46 instead of the $15,466.49 claimed in the deficiency letter. See footnote 2, supra.↩ 6. See footnote 2, supra.↩ 7. Revenue Act of 1934, sec. 23(f). ↩ 8. Respondent's brief states: "Moreover the facts show (Stip., par. 13) that the bank has been fully compensated for the segregated assets, they having cost the bank $939,931.06 and the bank was relieved of liability for deposits of the same amount in consideration of the assets being set aside for liquidation in payment of such deposit." A similar statement appears in the deficiency letter: However, in regard to losses on segregated assets it seems clear that there is involved in connection with the segregated assets but one composite executory transaction, that your bank has been recompensed for losses on the segregated assets to the extent of claims relinquished by depositors, and that as a result thereof there are offsets which would eliminate otherwise allowable deductions. This office accordingly holds that as loss or disposition of the segregated assets is so utterly indefinite and indeterminable no loss is allowable in advance of their final liquidation. ↩ 9. Revenue Act of 1934, sec. 41. ↩ 10. Sec. 22. That whenever and after any bank has ceased to do business by reason of insolvency or bankruptcy, no tax shall be assessed or collected, or paid into the Treasury of the United States, on account of such bank, which shall diminish the assets thereof necessary for the full payment of all its depositors; and such tax shall be abated from such national banks as are found by the Comptroller of the Currency to be insolvent; and the Commissioner of Internal Revenue, when the facts shall so appear to him, is authorized to remit so much of said tax against insolvent State and savings banks as shall be found to affect the claims of their depositors. * * * ↩ 11. See West Town State Bank,32 B.T.A. 531↩, minority opinion, and cf. sec. 818(3), Revenue Act of 1938.