Huey & Philip Hardware Co. v. Commissioner

HUEY & PHILP HARDWARE COMPANY, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT. Huey & Philip Hardware Co. v. Commissioner Docket No. 92801. United States Board of Tax Appeals 40 B.T.A. 781; 1939 BTA LEXIS 799; October 24, 1939, Promulgated *799 Petitioner and a realty corporation, owning and holding real estate which petitioner rented and used in its business, had substantially the same stockholders and officers, though there were some differences and the two corporations were operated as separate entities. , petitioner had loaned the realty company money in prior years and in 1934 took its demand promissory note secured by a second mortgage in settlement of its indebtedness. In November 1935, the realty company being in default, petitioner instituted foreclosure proceedings and petitioner purchased the property at foreclosure sale subject to the first mortgages which were held against it by outside parties. Petitioner credited the bid price on the note which it held against the realty company. The realty company, being without further assets, dissolved. Petitioner during the taxable year ascertained the balance of its indebtedness against the realty company to be worthless and charged it off. After receiving a deed for the properties purchased at foreclosure sale, petitioner conveyed them to two newly organized corporations in consideration of cash and deferred payment notes secured by a second mortgage and subject*800 ot the first mortgage liens against the properties. Held there was no plan of reorganization in contemplation when petitioner purchased the properties at foreclosure sale and the sale was not a part of any plan of reorganization and must be given its usual consequences, and petitioner is entitled to the deduction which it claims as a debt ascertained to be worthless and charged off during the taxable year. Alvin H. Lane, Esq., for the petitioner. J. L. Backstrom, Esq., for the respondent. BLACK *781 The Commissioner has determined a deficiency of $6,435.33 in petitioner's income tax liability for the calendar year of 1935. This deficiency results from four adjustments made by the Commissioner in auditing petitioner's income tax return for the year 1935. Three *782 of these adjustments add to petitioner's income and one reduces it. The major adjustment consists of a disallowance of $53,741.15 deducted by the petitioner as a debt ascertained to be worthless and charged off during the taxable year. In disallowing this bad debt diduction, the Commissioner stated in his deficiency notice: The decrease in the amount of $53,741.15*801 represents a so-called bad debt resulting from advances made by you to Huey and Philp Realty Company, a corporation whose outstanding capital stock was principally owned by your stockholders. After careful consideration of the evidence presented, it is held that the transaction through which all of the assets of Huey and Philp Realty Company were acquired by you was, in substance, a reorganization resulting in no gain or loss, under provisions of section 112 of the Revenue Act of 1934. It is also held that the fair market value of the properties acquired by you was at least $302,502.91, the amount of the indebtedness against the properties. The amount of the so-called bad debt deduction is, therefore, disallowed. By an appropriate assignment of error in its petition, the petitioner contests the foregoing action of the Commissioner. At the hearing, counsel for petitioner stated that petitioner no longer claimed a deduction of $53,741.15 as a bad debt charged off, but $49,504.72 instead, the reason for the reduction in the amount claimed being that the larger figure included interest on the indebtedness which petitioner had never taken into taxable income and which it, therefore, *802 conceded it had no right to deduct as a bad debt. FINDINGS OF FACT. 1. Petitioner herein, the Huey & Philp Hardware Co., sometimes hereinafter referred to as the hardware company, is a Texas corporation, originally organized about 68 years ago as a partnership, but for the past 40 years or longer it has been incorporated under the laws of the State of Texas, having as its authorized purpose "To purchase and sell goods, wares and merchandise and agricultural and farm products." In September 1926 its authorized capital stock was $1,000,000, and its net assets were substantially in excess of $1,100,000. 2. For some years prior to 1927, the hardware company had been leasing a building for its office and principal warehouse. In 1926, however, condemnation by the city of Dallas of a portion of this building necessitated the acquisition of new quarters. The directors decided to build a warehouse, but did not wish to add mortgage indebtedness on the building to the indebtedness owed by the hardware company in the operation of its business, and for this reason, decided to incorporate a separate and distinct company to own the building and lease it to the hardware company. *783 *803 3. On November 20, 1926, pursuant to authority granted by the stockholders of the Huey & Philp Hardware Co. on September 28, 1926, and by the directors of the hardware company on October 26, 1926, the Huey & Philp Realty Co., sometimes hereinafter referred to as the realty company, was granted a charter by the State of Texas and authorized to engage in the business of owning and operating real property and other things incident thereto. It was capitalized at $100,000, which capital stock was paid for out of the surplus of the hardware company, and stock in the realty company was issued to the persons who were record stockholders of the hardware company, as of the date of the incorporation of the realty company, in the ratio of one share of $10 par value in the realty company for each share of $100 par value in the hardware company then owned by such persons. The property which was used to pay up the capital stock of the realty company was a part of block 60 in the city of Dallas, theretofore owned by the hardware company and valued for incorporation purposes at $100,000. 4. At the time the realty company was organized, the same persons were stockholders of both companies, and*804 in the same proportions. By November 1935, however, this was no longer true. Out of 109 persons who owned stock in both companies in the aggregate (i.e., they either owned stock in both companies, or in one or the other) 12 persons had stock in one company, but no stock in the other, and 11 persons had stock in both companies, but not in the same proportions. A complete list of the stockholders and number of shares owned by each of both the hardware company and the realty company was incorporated in the record by agreement and is made a part of these findings of fact by reference. The companies were managed as entirely separate entities, each had its own stockholders' meetings and elected its own directors and officers, and they dealt with each other as separate entities. 5. In December 1926 the realty company borrowed $100,000 from the Praetorians, a life insurance company, giving a mortgage on its property in block 60 as security, and used the proceeds of this loan to purchase the property situated in block 220 of the city of Dallas, upon which it subsequently erected the office and warehouse building used by the hardware company as its principal office. This property in*805 block 220 was purchased in 1926 at a total cost of $96,483.62. 6. In 1927 the realty company borrowed $135,000 from the Minnesota Mutual Life Insurance Co., giving a first mortgage on the property in block 220 as security therefor, and used a portion of the proceeds of the loan to erect the first unit of its warehouse and office building on that property at a cost of $124,477.36. This was a straight 10-year loan. In 1930 a second unit was added to the warehouse at a cost of $57,719.27, and at that time an additional $25,000 was borrowed *784 from the Minnesota Mutual Life Insurance Co. The $25,000 loan was payable at the rate of $5,000 per annum, and on November 5, 1935, $5,000 of that loan was still owed to the insurance company, so that on November 5, 1935, the realty company owed ot the insurance company $140,000 as a first lien against the block 220 property. 7. In 1930 the property in block 60 was remodeled at an expense of approximately $42,000, $25,000 of which was secured from the Praetorians as an additional loan, to be repaid at the rate of $5,000 per annum, and the balance of which was advanced by the hardware company to the realty company. Certain payments*806 were made by the realty company from time to time on its indebtedness to the Praetorians. On November 5, 1935, the first mortgage indebtedness owed by the realty company to the Praetorians on the property in block 60 was $88,761.76. 8. In 1930 the hardware company began lending money to the realty company to enable the latter to build the second unit of the hardware building and to remodel the property in block 60. Some money for those purposes was borrowed by the realty company from banks in Dallas, and these bank loans were eventually paid by the hardware company as a further loan to the realty company. By June 1934 the total indebtedness owed by the realty company to the hardware company had grown to approximately $70,000, and on June 10, 1934, at the instance of the hardware company, the realty company executed its demand note for $70,000, bearing 6 percent interest, payable to the hardware company, and on the same date executed a second mortgage deed of trust lien on all of its properties as security therefor. 9. By October 1935 it had become the opinion of the board of directors of the hardware company that they had no substantial equity as security for their second*807 lien note. Accordingly, they directed the trustee to post notices to foreclose their mortgage, and directed their agent who attended the sale to offer a bid of $20,000 for the properties, subject to the first liens, with further instructions that if any third party should show up at the sale and offer more than $20,000 as a cash bid he should let such higher bidder purchase the properties. 10. P. H. Speaker, the trustee designated in the deed of trust executed June 10, 1934, by the Huey & Philp Realty Co., as security for its promissory note in the sum of $70,000 payable to the order of Huey & Philp Hardware Co., more than 21 days prior to November 5, 1935, prepared and signed notices in proper legal form advertising that he would sell the property described in said deed of trust and belonging to the Huey & Philp Realty Co., on November 5, 1935, between the hours of 10 a.m. and 4 p.m., and posted three of said notices, one at the courthouse door in Dallas, Dallas County, Texas, *785 one elsewhere within the city limits of Dallas, and the third notice out in Dallas County, which notices were prepared and posted in full accordance with the statutes of the State of Texas governing*808 such foreclosure sales. On Tuesday, November 5, 1935, about 2:15 p.m., the said trustee, P. H. Speaker, and Alvin H. Lane, attorney and agent for the Huey & Philp Hardware Co. went to the courthouse door of Dallas County, and there Speaker read his notice of sale in a distinct tone of voice, loud enough to be heard by any third party who might be standing in that vicinity, and offered said property for sale. When Speaker called for bids, Lane, on behalf of the Huey & Philp Hardware Co., submitted a bid against both tracts of property, subject to the first liens which existed against each of them in the sum of $20,000. Speaker then called for any other bids, and when no other bids were made, he announced that the property was sold to the Huey & Philp Hardware Co. for $20,000, and subject to the first mortgages against the property. Thereafter, and upon the same day, P. H. Speaker, as trustee, executed his trustee's deed conveying said property to the Huey & Philp Hardware Co., which deed is recorded in volume 1929, page 226, of the deed records of Dallas County, Texas. This deed contained, among other things, the following: Now, THEREFORE, in consideration of the premises*809 and of the said Twenty Thousand ($20,000.00) Dollars, to me in hand paid by the said Huey & Philp Hardware Company, the receipt of which is hereby acknowledged and confessed, I, the said P. H. Speaker, Trustee as aforesaid, do by these presents bargain, grant, sell and convey to the said Huey & Philp Hardware Company the above described tract of land, together with all and singular the rights, members and appurtenances to the same in any manner belonging. This conveyance, however, is made subject to mortgages which are outstanding against the first tract, consisting of six contiguous tracts of land as above described, in favor of Minnesota Mutual Life Insurance Company, and subject to mortgage in favor of The Praetorians on the second tract, consisting of two tracts of land hereinabove described, it being expressly understood that the grantee herein does not assume the payment of any of said mortgages. The $20,000 paid by petitioner at foreclosure sale for these several tracts of land, plus the amounts of the first mortgages which were held against them, represented their fair market value at that time. 11. Following the foreclosure in November 1935 the realty company was stripped*810 of assets. Its stockholders, at a special meeting, in December 1935 authorized its dissolution, which was accomplished on the records of the Secretary of State of Texas on January 4, 1936. The hardware company ascertained the balance of $49,504.72 owed by the realty company to it after crediting the $20,000 bid upon the $70,000 note to be worthless and charged it off on its books as an *786 uncollectible bad debt. The charge-off was duly entered on the hardware company's books during the year 1935. 12. Subsequent to the purchase by the hardware company of the above described real estate at foreclosure sale, it organized two corporation - the Magna Realty Co. and Griffin Realty Co. - the capital stock of which was subscribed by and issued to the petitioner. Petitioner transferred to the Magna Realty Co. the six tracts of land which were under a mortgage to the Minnesota Mutual Life Insurance Co. The consideration for this transfer was $850 in cash and $9,150 in deferred payments secured by a second mortgage and was made subject to the first mortgage lien held by the Minnesota Mutual Life Insurance Co. The two tracts of land and buildings thereon which were under mortgage*811 to the Praetorians were transferred to the Griffin Realty Co. The consideration of this transfer was $850 in cash and $9,150 deferred payments secured by a second mortgage and was made subject to the first lien held by the Praetorians. 13. The foreclosure sale in November 1935 was not preceded by any discussion between the two companies of any plan for reorganization of the realty company. No reorganization of the realty company in any way was ever discussed, and neither it nor its stockholders secured or were granted any character of interest in the hardware company by reason of the foreclosure sale or in any corporation subsequently organized to hold title to the real estate acquired by the hardware company at the foreclosure sale. OPINION. BLACK: The only issue involved in this proceeding is whether petitioner is entitled to a deduction for a bad debt which it alleges it ascertained to be worthless and charged off during the taxable year. There is no issue as to the amount of the debt or that it was charged off during the taxable year. Petitioner originally claimed $53,741.15 as the amount of the bad debt, but now concedes that this figure should be reduced to $49,504.72. *812 The respondent has denied the deduction on two grounds: First, that the purchase of the real estate at foreclosure sale by the hardware company and its subsequent transfer to two newly organized corporations, the Magna Realty Co. and Griffin Realty Co., was all part of a plan for the reorganization of the realty company and that all the above named corporations were parties to such reorganization and that petitioner is, therefore, not entitled to the deduction which it claims; second, that even if there were no reorganization of the realty company, nevertheless the fair market value of the property in question was far in excess of what petitioner paid for it at the foreclosure sale and petitioner, therefore, did not ascertain its debt against the realty company to be worthless, as it claims. *787 We shall take up respondent's first ground for disallowing the deduction. It is respondent's contention that petitioner sustained no loss within the purview of section 112(b)(3) of the Revenue Act of 1934. It is respondent's contention that the $70,000 demand note executed by the Huey & Philp Realty Co. to petitioner (described in our findings of fact) was a "security" within*813 the meaning of section 112(b)(3) of the Revenue Act of 1934. Section 112(b)(3) of the Revenue Act of 1934 provides: * * * 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. The reorganization provisions of the Revenue Act of 1934 relied upon by the respondent are printed in the margin. 1 *814 The respondent cites the following authorities in support of his contention that there was a reorganization: ; certiorari denied, ; ; ; certiorari denied, ; ; ; ; ; . To these authorities may be added . We shall not attempt to review each of the above authorities but we have read and carefully considered them. In substance they hold that, where the bondholders of a corporation which has defaulted in its bonds form a protective committee and agree upon a plan to purchase the property of the defaulting corporation at a foreclosure sale and transfer it to a new corporation organized as a part of the plan of reorganization, in*815 exchange in whole or in part for the new corporation's stock or bonds or debentures, such transactions constitute a reorganization and gain or loss is to be recognized only to the extent provided in section 112. *788 In the first place, we doubt if the $70,000 demand note of petitioner against the realty company dated June 10, 1934, secured by a second mortgage and foreclosed upon in November 1935, can be held to be a "security" within the meaning of section 112(b)(3), cited above. Cf. . . But even if we assume that the $70,000 demand note in question was a "security" within the meaning of the quoted statute, in order for the transactions in question to be within the nonrecognition provisions of the statute in question, and the authorities above cited, petitioner must have purchased the property at foreclosure sale and transferred it to the newly organized corporations in exchange for their capital stock or securities, all as a part of a plan of reorganization previously agreed upon. In the instant case there is no evidence of*816 any plan to reorganize the realty company. On the contrary, certain of petitioner's officers who were in control of its affairs at the time of the foreclosure sale testified that there was no plan of reorganization; that the hardware company simply realized that it had a loss on the realty company and under the then set-up, the loss would in all probability continue to increase; and that the hardware company decided to foreclose its second lien and purchase the property at $20,000 if no one bid the property in at a higher price than that and take its loss by charging off the remainder of its debt as a bad debt. These officers testified that at the time of the foreclosure sale, there had been no plans made to organize two new corporations and transfer the purchased property to them; that these plans were agreed upon and consummated after the foreclosure sale. There is no evidence in the record to the contrary, such as minutes of the corporations or letters to stockholders outlining a plan of reorganization. Therefore, we conclude from the evidence that the real estate in question was not purchased by petitioner at foreclosure sale as part of a plan to reorganize the realty company, *817 but was simply a sale and must be so treated. As a further reason for coming to this conclusion, aside from the reasons which we have already stated, petitioner apparently did not exchange the property purchased at the foreclosure sale for the stock of the two newly organized corporations. Apparently each of these two newly organized corporations was organized with a capital stock of $1,000 paid in cash by petitioner. Subsequently the real estate on which the Minnesota Mutual Life Insurance Co. held a first mortgage lien was conveyed to the Magna Realty Co. for $850 in cash and $9,150 deferred payments secured by a second mortgage and subject to the first mortgage held by the Minnesota Mutual Life Insurance Co. In the same manner and for *789 the same consideration, petitioner conveyed to the Griffin Realty Co. the real estate upon which the Praetorians held a first mortgage lien. It is not necessary for us to decide whether the conveyance to the two newly organized corporations by petitioner of the real estate purchased by it at foreclosure sale was one in which gain or loss is recognized or is one in which gain or loss is postponed, either because of the reorganization*818 provisions of section 112 of the Revenue Act of 1934 or of section 112(b)(5) of the same act. Apparently there was neither gain nor loss to petitioner in these transactions with the two newly organized corporations in any event, because it appears to have conveyed the properties to the newly organized corporations for exactly what it paid for them at the foreclosure sale. But we have not that question before us. As we have already stated, the only question which we have before us to decide is whether or not petitioner is entitled to the deduction of a debt which it alleges it ascertained to be worthless in the taxable year and charged off. In line with what we have said above, we hold that it is so entitled unless it is precluded from doing so by reason of the second reason assigned by the Commissioner in his deficiency notice. , the statute which authorizes a taxpayer to take a deduction for a debt ascertained to be worthless and charged off in the taxable year is section 23(k) and is so familiar that it need not be quoted. Article 23(k)-3 of Regulations 86, dealing with the phase of the question which we have here to decide, is in part printed in the margin. 2 *819 The petitioner contends that, under the doctrine promulgated by the Supreme Court of the United States in , the sale price at foreclosure is conclusive proof as to the fair market value of the property at the time of sale, and that no independent inquiry as to fair market value of the property at such time is permissible. We do not think the Supreme Court went as far in the Midland Mutual Life Insurance Co. case as petitioner contends, but we do not think it is necessary for us to decide how far it went in this respect. *790 At the hearing, evidence was admitted from both parties as to the fair market value of the property in question. Upon a weighing of that evidence we have found that the fair market value of the property in question at the time of sale was the $20,000 which petitioner bid for it, plus the amounts of the outstanding first mortgages against it. We consider that it is unnecessary to discuss this evidence in detail. It is simply an ordinary instance where witnesses differ in their opinion as to value and it is unnecessary to believe that any of them testified in bad*820 faith. We simply conclude that the usual presumption that the bid price at the duly advertised public sale represented the fair market value of the property at that time, coupled with petitioner's evidence at the hearing as to value, discharges its burden of proof in that respect and justifies our above finding as to its fair market value. Therefore, petitioner's basis for gain or loss on the future sale or exchange of the property was the purchase price paid for it at the foreclosure sale. Petitioner will, of course, not be entitled to have any of the $49,504.72 that is charged off as a bad debt carried forward as a part of its cost basis of the property, as would have been the case if we had held that the transactions showed a reorganization and petitioner could not take its bad debt deduction because of section 112(b)(3). Petitioner is now getting a deduction for this $49,504.72 bad debt loss and as a matter of course can not use it as a part of the cost of the real property purchased at the foreclosure sale for the purpose of determining gain or loss or depreciation on the property in the future. We, therefore, hold that petitioner is entitled to a deduction of $49,504.72*821 as a debt ascertained to be worthless and charged off during the taxable year. Decision will be entered under Rule 50. Footnotes 1. SEC. 112. (g) DEFINITION OF REORGANIZATION. - As used in this section and section 113 - (1) The term "reorganization" means * * * (B) the acquisition by one corporation in exchange solely for all or a part of its voting stock: of at least 80 per centum of the voting stock and at least 80 per centum of the total number of shares of all other classes of stock of another corporation; or of substantially all the properties of another corporation, or (C) a transfer by a corporation of all or a part of its assets to another corporation if immediately after the transfer the transferor or its stockholders or both are in control of the corporation to which the assets are transferred. * * * (2) The term "a party to a reorganization" includes a corporation resulting from a reorganization and includes both corporations in the case of a reorganization resulting from the acquisition by one corporation of stock or properties of another * * * (h) DEFINITION OF CONTROL. - As used in this section the term "control" means the ownership of at least 80 per centum of the voting stock and at least 80 per centum of the total number of shares of all other classes of stock of the corporation. ↩ 2. * * * If mortgaged or pledged property is lawfully sold (whether to the creditor or another purchaser) for less than the amount of the debt, and the mortgagee or pledgee ascertains that the portion of the indebtedness remaining unsatisfied after such sale is wholly or partially uncollectible, and charges it off, he may deduct such amount (to the extent that it constitutes capital or represents an item the income from which has been returned by him) as a bad debt for the taxable year in which it is ascertained to be wholly or partially worthless and charged off. In addition, if the creditor buys in the mortgaged or pledged property, loss or gain is realized measured by the difference between the amount of those obligations of the debtor which are applied to the purchase or bid price of the property (to the extent that such obligations constitute capital or represent an item the income from which has been returned by him) and the fair market value of the property. The fair market value of the property shall be presumed to be the amount for which it is bid in by the taxpayer in the absence of clear and convincing proof to the contrary. * * * ↩