Harris v. Commissioner , 43 B.T.A. 711 ( 1941 )

V. V. HARRIS, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.

Harris v. Commissioner

Docket No. 99027.

United States Board of Tax Appeals

43 B.T.A. 711; 1941 BTA LEXIS 1461;

February 26, 1941, Promulgated

---

">*1461 Suit to foreclose a mortgage upon property owned by a corporation was instituted in a state court. The corporation distributed its cash to its stockholders as a liquidating dividend. Subsequently a deficiency judgment was rendered against the corporation, but no effort was ever made to compel repayment of the liquidating dividends. Petitioner computed his loss upon the corporate stock by deducting the amount of the liquidating dividends from its cost. Held that the loss was properly computed, though it may be deducted from gross income only to the extent provided by the section of the revenue act dealing with capital gains and losses. White v. United States,305 U.S. 281">305 U.S. 281.

Charles H. Garnett, Esq., for the petitioner.

Wilford H. Payne, Esq., for the respondent.

---

MELLOTT

">*711 The Commissioner made several adjustments to the net income shown by petitioner's return for the year 1935 and determined a deficiency in income tax in the amount of $2,580.66. The sole error charged in the petition is the disallowance of $30,234.06 as an ordinary loss and the allowance, in lieu thereof, of $9,956.74 as a capital loss, in connection">*1462 with 649 shares of the capital stock of the Main Street Arcade Co. owned by petitioner. In an amended petition it is alleged that the total cost of the stock, $32,220, should be allowed as an ordinary loss.

FINDINGS OF FACT.

Petitioner is an individual residing at Oklahoma City, Oklahoma.

On January 31, 1924, petitioner purchased 409 shares of the capital stock of Main Street Arcade Co., a corporation, hereinafter referred to as the Arcade Co. or the corporation, for a consideration of $22,620. On September 20, 1926, he purchased 240 shares of the capital stock of the same corporation for a consideration of $9,600. The total cost to petitioner of the 649 shares was $32,220.

The total issued capital stock of the Arcade Co. consisted of 1,500 shares of the par value of $100. Charles H. Taylor owned 722 of said shares, and during the year 1935 he was president, petitioner was vice president, and V. W. Boyte was secretary of the company. Petitioner, Taylor, and John H. Wright constituted its board of directors.

The principal asset of the Arcade Co. was a business building known as the Main Street Arcade Building and the ground on which it was situated, located on West">*1463 Main Street in Oklahoma City. The only other assets of the corporation consisted of small items and a few accounts for rents.

">*712 On June 7, 1927, the Arcade Co. executed a promissory note in the principal sum of $90,000, payable in semiannual installments of $2,500 each, beginning on the first day of January 1928, the balance of the principal sum being due and payable on the first day of July 1937. The note provided for the payment of interest on the principal sum at the rate of 5 1/2 percent per annum until maturity, payable semiannually, both principal and interest to bear interest at the rate of 10 percent per annum after maturity until paid. The note was secured by a mortgage on the real estate referred to above. The note and mortgage were duly endorsed and transferred to the Prudential Insurance Co. of America.

The Arcade Co. defaulted in the performance of the terms and conditions of the note and failed to pay the principal installments which became due on July 1, 1932, and January 1, 1933, and the principal and interest installments which became due on July 1, 1933, January 1, 1934, July 1, 1934, and January 1, 1935, though it paid the sum of $1,538.01 on">*1464 the interest installment which became due on July 1, 1933.

On May 2, 1935, the Prudential Insurance Co. instituted an action in the appropriate District Court of the State of Oklahoma, praying judgment against the Arcade Co. in the sum of $78,815.30, with interest thereon at the rate of 10 percent per annum from May 1, 1935, until paid, $9,000 attorney fees, and the costs of the suit; asking that the mortgage be adjudged to be a valid lien; that if the judgment be not paid within six months, an order of sale issue; and that the premises be sold and the proceeds be applied to the payment of the judgment and costs.

On May 11, 1935, a receiver for the mortgaged property was appointed by the court to take and receive the rents during the period of the litigation.

On July 12, 1935, a judgment was entered in favor of the Prudential Insurance Co. for $78,815.30, with interest thereon at the rate of 10 percent per annum from May 1, 1935, until paid, $750 attorney fees, and the costs of suit. In the journal entry of judgment it was directed that in the event the judgment with interest, attorney fees, and costs be not paid and satisfied in full within six months from the date thereof, ">*1465 an order of sale issue to the sheriff commanding him to advertise and sell the mortgaged property according to law, and that the proceeds arising from such sale, after payment of costs, be applied in satisfaction of the judgment, interest, and attorney fees. It was further provided that, in the event the said premises upon sale should not bring a sum sufficient to satisfy the judgment in full, the plaintiff in said action should then have execution against the defendant, Main Street Arcade Co., for any deficiency that might remain.

">*713 On January 13, 1936, an order of sale was issued to the sheriff and on February 17, 1936, the property was sold to the plaintiff insurance company for $57,000, which amount was credited on the judgment. The sheriff's sale was confirmed by order of the court on February 21, 1936.

On February 28, 1936, the receiver filed his report, showing that the sum of $3,608.37 then remained in his possession as the proceeds of his receivership. He claimed and was allowed a fee of $450 and was ordered to pay the balance in his possession, $3,158.37, to the plaintiff in the action and to file a receipt for that amount in court, which he did.

The">*1466 judgment, interest, attorney fees, and costs aggregated $85,971.71. After crediting upon the judgment the proceeds of the sheriff's sale and the funds turned over to the plaintiff in the action by the receiver, there was a net dificiency judgment of $25,813.34. No part of that amount has been paid.

The minutes of a special meeting of the directors of the Arcade Co. held on May 7, 1935, in the office of petitioner disclose the following:

The Prudential Life Insurance Company filed a suit to foreclose its mortgage on the Main Street Arcade property and the directors met to consider the matter. After full discussion they were of the opinion that the indebtedness against the property is fully equal to its value and no director was disposed to put up any money individually to protect the property from foreclosure.

John H. Wright was asked to represent the company in the foreclosure proceedings and endeavor to delay the final sale of the property with the hope that there might be a considerable advance in real estate before that time.

The directors decided to declare a liquidating dividend. After some discussion a liquidating dividend of 2.56% was declared and the secretary">*1467 was directed to issue and mail checks for same.

On May 10, 1935, a distribution was made to the stockholders of $2.56 per share or a total of $3,840. On December 6, 1935, another distribution was made to the stockholders in the aggregate amount of $750, representing 50 cents per share. No formal action was taken by the directors with respect to the distribution of the $750, but it was made by the secretary on instructions from the officers and directors.

Of the distributions referred to in the preceding paragraph, petitioner received $1,661.44 on May 11, 1935, and $324.50 on December 10, 1935, or an aggregate amount of $1,985.94. No other distributions were made at any time by the corporation with respect to its stock.

No demand had ever been made upon petitioner by the Arcade Co. or the Prudential Insurance Co. prior to the hearing (May 14, 1940) that he repay any portion of the amounts distributed to him or apply any amount upon the deficiency judgment rendered in favor of the insurance company against the Arcade Co. and no part of said amount was ever repaid or applied upon the judgment.

">*714 After the two distributions referred to in the preceding paragraphs">*1468 were made, the Arcade Co. was left without any assets except such interest as it had in the property which was the subject of the foreclosure proceedings. Under date of October 16, 1936, the Arcade Co. was notified that by reason of its failure to comply with the provisions of the Oklahoma Corporation License Act its charter or other instrument of organization was canceled and forfeited.

The balance sheet of the corporation at January 1, 1935, discloses total assets of $253,508.97 and a deficit of $11,485.25. Its liabilities on that date, other than capital stock, amounted to $114,993.25. Its balance sheet at January 1, 1936, discloses total assets of $249,741.26 and a deficit of $13,903.74. Its liabilities, other than capital stock, were $118,235. On each of the balance sheets the building was carried at $162,089.37 and the land at $85,500, and on each bills payable were carried at $67,500. The only other liability shown on the balance sheets was a reserve for depreciation, the amount in 1935 being $47,493.25 and in 1936 $50,735.

In 1934 the Arcade Co. received total rents of $8,443.46 and its operating expenses amounted to $7,299.76, resulting in a net profit of $1,143.70. ">*1469 In 1935 it received rents of $8,781.75 and its total operating expenses amounted to $7,038.36, leaving a net profit of $1,743.39.

The value of the corporation's real estate was substantially the same - between $60,000 and $65,000 - during the years 1933, 1934, and 1935.

OPINION.

MELLOTT: Petitioner contends that his stock in the Arcade Co. became worthless during the calendar year 1935, as a result of which he sustained a loss, deductible in full as an ordinary loss, in an amount equal to the cost of the stock. In his income tax return he deducted, as an ordinary loss, the difference between the cost of the stock ($32,220) and the aggregate of the liquidating dividends ($1,985.94) or $30,234.06. The respondent determined that the loss was a capital loss, deductible only to the extent authorized by subparagraphs (a) and (d) of section 117 of the Revenue Act of 1934. ^{1941 BTA LEXIS 1461">*1470 ">*715 In the original petition it is alleged the respondent erroneously determined that the loss was a capital loss. In an amended petition it is alleged that petitioner "is entitled as a matter of law to deduct the full sum of his cost * * * as a loss due to said stock having become worthless * * *"; that "when the Prudential Life Insurance Company began proceedings to foreclose its mortgage on the Main Street Arcade Building, which was the only asset of value the corporation had, and the fact became apparent that said mortgagee intended to enforce its mortgage lien by foreclosure and a sale of that property, it was then established that the * * * company was insolvent and its stock worthless, for that its indebtedness then greatly exceeded the actual or any reasonably possible value of all of its assets; that all dividends distributed by the * * * company to its stockholders after that date were liquidating dividends, for that they were necessarily paid out of the corporation's capital; and that the amount of such dividends received by the petitioner were not his property, but were so received in trust for creditors of the corporation, for by operation of law he became a">*1471 trustee, and the amount of such dividends a trust fund in his hands, for the benefit of the creditors of the corporation."}

Respondent denies that he erred in determining the deficiency in tax. In an amended answer he alleges that if the loss is not a capital loss resulting from the liquidation of the corporation then petitioner is entitled to no deduction from gross income for the year 1935 on account of his investment in the stock because it did not become worthless during that year.

It is doubtful if the mere institution of the suit to foreclose the mortgage and the appointment of a receiver to collect the rents constituted an "identifiable event" (United States v. White Dental Manufacturing Co.,274 U.S. 398">274 U.S. 398) establishing worthlessness of the stock of the corporation which owned the real estate. Cf. Peter Doelger Brewing Co.,22 B.T.A. 1176">22 B.T.A. 1176; William H. Redfield,34 B.T.A. 967">34 B.T.A. 967; Olds & Whipple v. Commissioner, 75 Fed.(2d) 272. The corporation itself sustained no deductible loss until the property was sold. ">*1472 Helvering v. Hammel,311 U.S. 504">311 U.S. 504. This did not occur until 1936. It is not contended that there was any abandonment of the property by the corporation. Collateral Mortgage & Investment Co.,37 B.T.A. 630">37 B.T.A. 630. Indeed the contrary appears. The corporation directed its attorneys to represent it "in the foreclosure proceedings and endeavor to delay the final sale of the property with the hope that there might be a considerable advance in real estate before that time." Had the hoped for advance occurred, it is possible that no less would ever have been sustained by the corporation.

">*716 But our question is not whether the corporation sustained a loss in 1935. It is: Did petitioner's stock become worthless during that year? The test to be applied is a practical rather than a legal one (Lucas v. American Code Co.,280 U.S. 445">280 U.S. 445) and petitioner has the burden of proof.

In support of his contention that the dividends received by him were not his property but were received in trust for creditors of the corporation, petitioner cites several Oklahoma cases applying the rule enunciated by Justice Story in Woods v. Dummer,">*1473 3 Mason, 308; 30 Fed.Cases 435, and by the Supreme Court in Sanger v. Upton,91 U.S. 56">91 U.S. 56. It is thus stated by the Supreme Court of Oklahoma:

Equity regards the property of a corporation as held in trust for the payment of the debts of the corporation, and recognizes the right of creditors to pursue it into whosesoever possession it may be transferred, unless it has passed into the hands of a bona fide purchaser. * * * if the fund has been distributed among the stockholders * * * leaving debts of the corporation unpaid, the established rule in equity is that such holders take the fund charged with the trust in favor of creditors, which a court of equity will enforce * * *. Kramer v. Eysenbach,186 Okla. 234">186 Okla. 234, 96 Pac.(2d) 1049.

The rule is sound and will be applied in proper cases. Thus in Benjamin E. May,35 B.T.A. 84">35 B.T.A. 84, it was held that stockholders receiving the assets of a corporation upon its liquidation were liable, as transferees, for its unpaid income taxes. In ">*1474 O. B. Barker,3 B.T.A. 1180">3 B.T.A. 1180, it was held that a taxpayer need not include in his gross income the portion of a liquidating dividend which he had been compelled to pay out on account of taxes assessed against the liquidating corporation. A similar conclusion was reached in E. F. Cremin,5 B.T.A. 1164">5 B.T.A. 1164; J. G. Tomlinson,7 B.T.A. 961">7 B.T.A. 961, and Edward F. Harkness,31 B.T.A. 1100">31 B.T.A. 1100. In Carey Van Fleet,2 B.T.A. 825">2 B.T.A. 825, it was held that a lawyer, keeping his books and making his return of income upon a cash basis, need not include in gross income his portion of a fee collected by the partnership of which he was a member where the firm had acknowledged that it was not entitled to the fee at the time it was paid.

It will be noted that in each of the cited cases the taxpayer either had paid out the amount which had been received or, as in the Van Fleet case, had acknowledged that the amount was being held in trust. This petitioner, however, received the $1,985.94 "under a claim of right and without any restriction as to its disposition." ">*1475 Burnet v. Sanford & Brooks Co.,282 U.S. 359">282 U.S. 359. He commingled it with his other property, still retains it (or in any event was still retaining it at the date of the hearing), and has always treated it as belonging to him. In his return of income for the year in ">*717 which it was received he considered it to be a partial return of his capital investment in the stock of the corporation, computing his loss to be the difference between the cost of the stock and the aggregate of the dividends. In his petition he alleges that the corporation had no earnings or surplus from which ordinary dividends could be declared and that the amount distributed consisted of the cash on hand and collections on notes and accounts. It may be that the corporation itself or its creditors could, in an appropriate action, compel petitioner to pay over the amount distributed to him; but no attempt has been made to do so. Petitioner touched the whole question only very generally at the hearing. His testimony was directed primarily to the value of the real estate. Under cross-examination, however, he admitted that between $1,900 and $2,000 was received by him; that the entire amount">*1476 was retained; and that so far as he knew he would never be required to pay over any portion of it to anyone. We know of no reason why we should not consider the payments precisely as they were considered by the corporation and its stockholders - as liquidating dividends. Incidentally it may be pointed out that only if we do so can petitioner be allowed any deduction from gross income during the taxable year; for in our opinion the evidence indicates that the stock had as much value in 1935 as it had in 1934; and, if it were not worthless at the beginning of 1935, it is questionable if it became entirely worthless earlier than 1936.

In our opinion petitioner correctly computed the amount of his loss upon the Arcade Co. stock in his return of income for the calendar year 1935. He erred, however, in failing to treat it as a capital loss. White v. United States,305 U.S. 281">305 U.S. 281; Helvering v. Weaver Co.,305 U.S. 293">305 U.S. 293; Martin General Agency v. Commissioner, 101 Fed.(2d) 165; ">*1477 Inter-State Grocery Co.,39 B.T.A. 182">39 B.T.A. 182. The Commissioner committed no error in determining the deficiency.

Reviewed by the Board.

Decision will be entered for the respondent.

HILL

HILL, DISSENTING: I respectfully dissent from the conclusion reached in the majority opinion. The evidence establishes, I think, that petitioner's loss was sustained in the taxable year 1935, not as a result of the liquidation of the corporation, as the majority holds, but from the fact that petitioner's investment in the corporation's stock became wholly worthless in that year when suit was instituted to foreclose the mortgage and sell the real estate which constituted the sole asset of substantial value owned by the corporation.

">*718 It is true that the corporation was wholly insolvent, the value of its assets being far less than the amount of its liabilities, in the years immediately preceding the taxable year, and its stock therefore had no liquidating value either in 1934 or 1935. Nevertheless, it can not be said that petitioner sustained his loss prior to the taxable year merely because the stock had no liquidating value. Undoubtedly the stock had">*1478 a substantial potential value up to the time the foreclosure proceeding was instituted. Cf. Sterling Morton,38 B.T.A. 1270">38 B.T.A. 1270; affd., 112 Fed.(2d) 320.

The corporation's only business was the operation of the Arcade Building in Oklahoma City. It had no other source of income, but it had been able to meet all semiannual installments of principal and interest due on its mortgage indebtedness up to July 1, 1932, and it also had paid $1,538.01 on the interest installment due July 1, 1933. Its net earnings for 1935 increased materially over its net earnings for 1934. At the beginning of the taxable year the corporation was actively engaged in carrying on its business, and there was a reasonable hope and expectation that if it could continue in possession of its property and operate its business, its profits might further increase to the benefit of the stockholders. Also, there was the hope that real estate values would increase so that ultimately the value of its assets might exceed its liabilities and its stock would have a liquidating as well as potential value. However, ehen the foreclosure proceeding was instituted on May 2, 1935, these hopes and">*1479 expectations were definitely terminated. Under the conditions existing, the corporation's real estate could not be sold for enough to satisfy the mortgage debt; in fact, the mortgagee obtained a deficiency judgment in excess of $25,000. The filing of the foreclosure suit, in my opinion, was the "identifiable event" which established worthlessness lessness of the corporation's stock and the incidence of petitioner's loss.

Since petitioner's loss resulted from the stock having become worthless less in 1935, the amount is allowable in full as an ordinary loss, and is not subject to the limitations of section 117 of the Revenue Act of 1934. I am impelled to this conclusion for the further reason that the so-called liquidating dividends were not such in fact. So much appears to be admitted, at least by inference, in the majority opinion. It is true that the distributions made by the corporation in 1935 were designated by the directors as liquidating dividends, but the name by which they were called is immaterial; we must look to the facts to determine their true nature. The distributions were necessarily made out of capital, since the corporation was wholly insolvent. Its capital">*1480 in such circumstance ">*719 constituted a trust fund for the benefit of its creditors, and could not be legally distributed to the stockholders in liquidation or otherwise. See section 9763, Oklahoma Statutes, 1931. And upon distribution the funds did not become the property of the stockholders but in their hands an involuntary or constructive trust by operation of law, payable upon demand to the beneficial owner, the insurance company creditor. This doctrine is so well established and so universally applied that citation of authorities in addition to those referred to in the majority opinion is not deemed necessary here.

The fact that prior to the hearing of this case the insurance company had not made any demand for repayment to it of the funds distributed is wholly immaterial. Under the Oklahoma statute the right of a creditor to demand repayment of such funds is not barred by limitations, and may be made at any time. In view of the apparent emphasis laid by the majority opinion on the fact that prior to the hearing of this proceeding no demand had ever been made upon petitioner by the Arcade Co. or the insurance company to repay any portion of the amounts distributed">*1481 to him, it is interesting to note that on brief conusel for petitioner states that "Since the trial, and no doubt because of facts developed at the trial, the Prudential Insurance Company has demanded of petitioner and other stockholders, the amounts they received in those dividend distributions in 1935. Petitioner's counsel knows of no defense to that demand."

In the majority opinion the trust fund doctrine is recognized as a sound rule, and that it should be applied in proper cases. In that connection, the following dicisions of this Board, among others, are cited. In Benjamin E. May,35 B.T.A. 84">35 B.T.A. 84, it was held that stockholders receiving the assets of a corporation upon liquidation were liable as transferees for its unpaid income taxes, a fund left for payment of creditors having been dissipated. In O. B. Barker,3 B.T.A. 1180">3 B.T.A. 1180, it was held that a taxpayer was not subject to tax on that portion of a liquidating dividend paid on taxes assessed against the corporation. To the same effect see ">*1482 E. F. Cremin,5 B.T.A. 1164">5 B.T.A. 1164; J. G. Tomlinson,7 B.T.A. 961">7 B.T.A. 961; and Edward S. Harkness,31 B.T.A. 1100">31 B.T.A. 1100. The cited cases are sought to be distinguished on the ground that in each of them the taxpayer had actually paid out the amount received, while in the instant proceeding the petitioner received the amount of the so-called liquidating dividends under a claim of right and without restriction as to its disposition; further that petitioner commingled the amount so received with his other property, still retained it at the date of the hearing, and has always treated it as belonging to him. With a single exception, precisely the same statements ">*720 may be made in respect of each of the cases above cited. In each of them, so far as disclosed by the reports, the taxpayer received the corporate distribution under a claim of right and without restriction as to its disposition, commingled the fund with his other property, treated it as belonging to him, and retained it until compelled to pay it over in discharge of tax liability of the corporation.

The only material ground upon which the cases referred to may be distinguished from the">*1483 case at bar lies in the fact that up to the date of the hearing, no demand had been made on this petitioner, to pay over to the corporation or its creditor the amounts received as liquidating dividends. Must the application of the trust fund doctrine in favor of the taxpayer, then, be held to depend solely upon the fortuitous circumstance of repayment of the fund to a creditor prior to hearing of the tax proceeding before the Board? Would the rule have been applied differently in the majority opinion if it had been made to appear that the amounts received by petitioner had been repaid to the insurance company, or a demand therefor had been made prior to the hearing? And does it follow that because such repayment or demand was not so made, notwithstanding liability therefor still existed, that the so-called liquidating dividends received by petitioner must be regarded for tax purposes as his property? The rule has never been so interpreted in its application against taxpayers in the numerous decisions of this Board involving transferee liability for corporate taxes, of which ">*1484 Benjamin e. 35 B.T.A. 84">May, supra, is an example. Uniformly we have held in such cases that liquidating dividends did not constitute property of the tranferee, but trust funds to the extent of the unpaid taxes, and no inquiry was made, it being obviously immaterial, whether such distributions were received under claim of right and without restriction as to disposition, whether or not commingled with other funds, or whether or not treated by the transferees as belonging to them. And it is apparent, of course, from the nature of such proceedings that the recipients had not prior thereto parted with the funds in payment of criditors' claims or tax liability of the corporations. In the absence of any elements of estoppel, I can find no sound reason for applying the doctrine differently in the present case, in favor of the taxpayer, than it is applied generally in transferee cases in favor of the Government.

In my opinion, the decision here should be for petitioner.

---

Footnotes

• 1. SEC. 117. CAPITAL GAINS AND LOSSES.

  (a) GENERAL RULE. - In the case of a taxpayer, other than a corporation, only the following percentages of the gain or loss recognized upon the sale or exchange of a capital asset shall be taken into account in computing net income:

  * * *

  40 per centum if the capital asset has been held for more than 5 years but not for more than 10 years;

  30 per centum if the capital asset has been held for more than 10 years.

  * * *

  (d) LIMITATION ON CAPITAL LOSSES. - Losses from sales or exchanges of capital assets shall be allowed only to the extent of $2,000 plus the gains from such sales or exchanges. * * * ↩