Suffolk & Berks v. Commissioner , 40 B.T.A. 1121 ( 1939 )

MARGUERITE HYDE SUFFOLK & BERKS, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.

Suffolk & Berks v. Commissioner

Docket Nos. 81417, 93257.

United States Board of Tax Appeals

40 B.T.A. 1121; 1939 BTA LEXIS 748;

December 15, 1939, Promulgated

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1. Pursuant to court decree and for the purpose of restoring an impairment of corpus which resulted from overdistribution in prior years to life tenants of an estate of which the petitioner was one, the trustees retained and added to corpus in 1932 and 1934 certain amounts of the petitioner's share of the income of the estate currently distributable for such years. Held, that the amounts so retained were taxable to the petitioner in the respective years.

2. Held, that the estate, which kept its books on the accrual basis, was not required to include as income unpaid rent for 1934 where it was uncollectible in that year and there was little or no likelihood of its collection in the future.

3. Held, that additional real and personal property taxes for 1934 paid by the estate subsequent to that year and which were deductible for 1934 served to reduce the petitioner's share of the estate net income currently distributable for such year.

Calvin F. Selfridge, Esq., for the petitioner.

Gerald W. Brooks, Esq., for the respondent.

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TURNER

These proceedings, which were consolidated for hearing, involve deficiencies in income tax of $5,918.71 and $12,788.96 for 1932 and 1934, respectively. All issues raised by the petitioner have been abandoned except the correctness of the respondent's action in determining (1) that income in the amount of $39,591.46 received in each of the years 1932 and 1934 by the trustees of the estate of Levi Z. Leiter, deceased, of which the petitioner was a beneficiary, and added by them to the corpus of the trust pursuant to court decree constituted income of the estate distributable to the income beneficiaries thereof for the respective years; (2) that rental in the amount of $20,000 for 1934 on certain real estate owned by the estate which has never been paid constituted income of the estate distributable to the income beneficiaries for that year; and (3) that an amount of $16,592.55 representing real estate and personal property taxes of the estate for 1934 was not an allowable deduction in ascertaining the income distributable to the beneficiaries for that year.

By amended answers the respondent has asked that the deficiencies determined for 1932 and 1934 be increased by $921.83 and $76.44, respectively. The claim for the increased deficiencies rests on four affirmative allegations contained in the amended answers. Of the four issues so raised, one was abandoned by the respondent at the hearing, while the three remaining have now been conceded by the petitioner.

FINDINGS OF FACT.

The petitioner is a nonresident alien individual, whose principal business address in the United States is Chicago, Illinois. She filed her income tax returns for the calendar years 1932 and 1934, respectively, with the collector of internal revenue for the first district of Illinois in Chicago, Illinois.

The petitioner is a daughter of Levi Z. Leiter, who died testate on June 9, 1904, a resident of Washington, D.C. He was survived by his widow and four children, who were his only heirs at law. By the will of Levi Z. Leiter, sometimes referred to as the decedent, his residuary estate was devised and bequeathed in trust to his wife, his son, two of his daughters, and to another person, to pay one-third of the income therefrom to his widow for her life, and the balance in equal parts, except as modified by accounting for interest on advances, to his four children and the children of a deceased child in the event of the death of a child, the children of a deceased child to take per stirpes. It was further provided that on the death of the last surviving child of the decedent the corpus of the estate should be distributed per stirpes to the surviving issue of the children of decedent.

At the time of his death the decedent had, among other properties, large real estate holdings in Chicago and in the State of Wyoming, which became part of his residuary estate.

Respecting the management of his residuary estate and the method for determining income for purposes of distribution, the will of the decedent provided as follows:

It is My Will that such trustees shall collect and receive and that they may give acquittance for all the rents, issues and profits, interest and dividends of the said trust estate, and that they shall pay therefrom all the expenses of management thereof, including taxes, and assessments of every sort, insurance and repairs, and to pay to my said wife in each and every year during her life for her own use, absolutely, one-third (1-3) of the entire net income of said trust property as above provided. Upon her decease, and during the continuance thereafter of the trust hereby created, the portion of said net income theretofore paid to her shall become a part of the general income of said estate held under this trust, and subject to the distribution directed to be made thereof.

And said trustees are given full power and authority to lease any of the real estate or to sell and convey any of the real or personal estate held by them as trustees as aforesaid, and also to borrow money and secure the repayment thereof by mortgage or trust deed on any of the real estate held by them, for either of the following purposes, to wit: for the purpose of paying any encumbrance which may be upon any of the property held in trust under my will, or to make improvements upon any of the propery so held in trust by them. * * *

I also authorize and empower my said trustees and their successors to use and apply such portions of the net income derived from said trust estate, as they may deem best, either in the payment of mortgages or encumbrances upon the same, or any part thereof, or in making improvements upon any of the property so held in trust by them under my will.

After and subject to the said payment or proper provision for the said payment of one-third (1-3) of the said net annual income to my wife as aforesaid, during her life, and before the distribution of the balance of tw0-thirds of said net annual income among my children as hereinafter provided, there shall be added to said balance of two-thirds (2-3) of the said net annual income an amount equal to four (4) per cent. interest on the respective advances made by me to each of my said children as hereinafter referred to in the Fifth Paragraph of this my last will, which said interest on said advances shall be treated by my said trustees as so much additional income received by them from said trust estate, and the amount thereof shall be by my said trustees divided into four (4) equal parts or shares; * * * it being my intention to make equal the amounts which my said children shall severally receive from my said estate. * * * And I give to each of my said four children * * * the share of the said net income so set apart for each of them respectively; and I direct my said trustees to pay over in each year, during the continuance of the trust hereby created, to each of my said children, * * * the share of said net income to which each may be entitled hereunder, * * * at such times and in such instalments as the one so entitled may require so far as the amount of the several shares of said net income may with reasonable convenience be so ascertained and paid. * * *

On May 4, 1923, the petitioner herein, in her individual capacity and as trustee under the will of her father, instituted a proceeding against her brother, Joseph Leiter, individually and as trustee under the will, and all of the persons interested in the trust, in the Superior Court of Cook County, Illinois, wherein she sought, among other things, the removal of Joseph Leiter as a trustee, an accounting of the affairs of the estate, and the construction of the provisions of the will necessary to be construed in connection with the accounting. One of the grounds of complaint was the conduct of Joseph Leiter and others as trustees with respect to the development of the Wyoming real estate and the management of the Chicago real estate.

The decedent's widow died on some undisclosed date prior to January 14, 1928.

On January 14, 1928, a decree was entered by the court wherein it was held that Joseph Leiter should not be removed as trustee. The court directed, however, that an accounting be taken before a master in chancery between the trustees and the trust estate for the period from March 7, 1913, to January 14, 1928; that such account should show how much, if any, of certain expenditures made with respect to the real estate holdings in Wyoming and Chicago was chargeable to corpus of the estate and how much, if any, was chargeable to income; and that recommendation be made of a method or plan for restoring or reimbursing in full to corpus within a period not to exceed 15 years all amounts found to be due. The decree was affirmed by the Appellate Court of Illinois for the First District. (.)

Thereafter the accounting so directed was had. Upon receipt and consideration of the report of the master in chancery the Superior Court, on May 14, 1931, approved the same and entered its decree, which contained the following provisions:

The court finds that of the amount paid out and expended by the Trustees of the Estate of Levi Z. Leiter, deceased, on December 31, 1929, on the properties of the trust estate located in the State of Wyoming, $158,468.98, - which amount has heretofore been paid out of the corpus of said estate, - should be charged to income; that since December 31, 1929, $30,000 of said amount has been paid from the income of the Estate into the corpus of said estate, and that the balance, namely: $128,468.98 should be amortized and repaid from income to corpus in installments over a period of nine years beginning January 1, 1931.

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The court further finds that on December 31, 1929 there had been expended in connection with improvements, repairs and operation of the * * * [Chicago properties] not heretofore charged to either corpus or income, the sum of $920,144.11; that of said sum so expended $214,529.06 is properly chargeable to corpus and $705,615.05 is properly chargeable to income; that subsequent to December 31, 1929 $55,000 of said $705,615.05 properly chargeable to income, as aforesaid, has been repaid from income to corpus, and that there should be paid from the income to the corpus of said trust estate the balance of said sum, namely, $650,615.05; that $422,746.82 of said amount should be paid immediately, and $227,868.23 of said amount should be amortized and repaid from income to corpus over a period of nine years commencing January 1, 1931.

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WHEREFORE, the premises considered, it is hereby ORDERED, ADJUDGED and DECREED:

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That the Trustees do forthwith make the charges and credits to corpus and income and forthwith pay from income to corpus said sum of $422,746.82, all as hereinbefore found by the Court, and that said Trustees amortize and pay over from income to corpus the balance of the amount hereinbefore found to be properly payable from income to corpus, namely; the sum of $356,337.21 in equal annual installments over a period of nine years beginning on the 1st day of January, 1931, and that said amortization be effected by charging against the share of each income beneficiary, and crediting and paying over to corpus, such proportion of each annual installment, as the distributable share of such income beneficiary bears to the total distributive income of said trust estate, and that upon said charges and credits and payments being made, the said Trustees and all former Trustees shall be released from any further liability to said estate by reason of any charges or credits heretofore made by them to corpus and income; that the right to have the payments necessary to carry out the amortization directed by this decree is hereby imposed against those who are now, or may hereafter become, entitled to the income, and upon the income to which they are, or may be, so entitled, and in favor of those who are now, or may hereafter become, entitled to the corpus of the estate and the trustees and their successors are directed to make the payments from the income to the corpus of the estate accordingly.

Pursuant to the court decree the trustees for each of the years 1932 and 1934 charged $39,591.46 against the income of the trust estate and credited such amounts to corpus. The balances of the income remaining after such charges were in the respective years credited in properly allocated amounts to the various beneficiaries including the petitioner.

In her income tax returns for 1932 and 1934 the petitioner did not report any part of the above amounts charged against income and credited to corpus under the decree. In determining the deficiencies the respondent increased the net income of the trust by said amounts of $39,591.46 and increased the petitioner's distributable share thereof by $13,608.63 for 1932 and $12,396.68 for 1934.

In October 1910 the estate of Levi Z. Leiter was the owner in fee of two lots sometimes referred to as the Quinlan property, situated on the east side of Clark Street between Randolph and Washington Streets in Chicago, Illinois. Adjacent to this property were three lots owned in fee by the estate of A. L. Trude. Under date of October 29, 1910, the foregoing properties were leased by separate leases to one Heyworth for a period of 198 years from May 1, 1911, at an annual net rental to each estate of $18,000 for the first five years, $20,000 per year for the next 94 years and $22,000 per year for the balance of the term, the lessee to pay all taxes on the properties. The lease from the Leiter estate provided that the lessee would erect a building on the properties of not less than 16 stories in height, including a theatre building, the whole to cost not less than $600,000, of which a minimum of $450,000 was to be expended for office building. It was further provided that the building should be ready for occupancy by May 1, 1914. Provision was also made for insurance by the lessee against loss or damage to the buildings or improvements by fire; for termination of the lease and repossession of the property in case of default in payment of the rent; that no building erected on the premises was to be removed or so altered as to diminish its value without the consent of the lessors and that upon termination of the lease, whether by lapse of time or by forfeiture, all buildings, fixtures, or improvements then existing upon the premises should become the absolute property of the lessors. Shortly after the date of the lease the lessee constructed on the lots of the two estates a building 23 stories in height. The entrance, the front main corridors, and the elevators are on the side of the building which occupies the lots owned by the Trude estate, while the boilers and the theatre entrance are on the side of the building which occupies the lots owned by the Leiter estate. The part of the building standing on lots owned by the Leiter estate could not be operated as a building apart from the rest of the structure and it would not be feasible financially to attempt to convert such part into a separate building.

In August 1926, with the consent of the fee owners, Heyworth conveyed the leasehold estates to an Illinois corporation known as the City Hall Square Building Corporation, which thereafter in 1926 conveyed the building and leasehold estates to a trustee as security for the payment of $1,750,000 principal amount of bonds issued by it in that year. In 1931 the corporation defaulted in payment of its bonds and a committee for bondholders was organized. This committee formed a new corporation, known as Town Center Building Corporation, which ultimately acquired through foreclosure or assignment the building and leasehold estates.

On or about March 1, 1933, the ground lessors served notices of default. In May 1933 negotiations between the committee and the ground lessors resulted in an agreement between them and the Town Center Building Corporation, which provided, among other things, that further steps to effect the forfeiture of the ground leases would not be taken by the ground lessors before May 31, 1938, unless a receiver was appointed in proceedings other than for the collection of taxes, provided all the net income from the operation of the property, except an operating balance, was applied toward payment of delinquent taxes and ground rent, and provided further that the lessee should have the right to operate the property for one year commencing June 1, 1933, and if the net income from the operation of the property in that year was $95,000 or more, the lessee should have the right to continue to operate the property for the succeeding one year period, and if the net income from the operation of the property for the succeeding one year period was equivalent to one year's ground rent and taxes, then the lessee should have the right to operate the property for another year and so on until May 31, 1938. It was also provided that if the defaults under the ground leases did not exceed $100,000 on June 1, 1938, the arrangement should continue for two years thereafter. The agreement also created a special committee of three persons, one member to be appointed by each of the ground lessors and the third member by the lessee, which special committee should have the right to operate the property if the net income was less than the amounts referred to above. The net income from the operation of the property for the year ending May 31, 1934, was less than $95,000. Thereafter an agent for the Town Center Building Corporation operated the property under the supervision of the special committee.

The balance sheet of the Town Center Building Corporation as of June 30, 1933, shows assets and liabilities as follows:

Assets
Cash (including amounts due from agents and on deposit with trustee under the bond issue), building supplies, and furniture	$26,670.36
Notes and accounts receivable from subtenants (less reserve)	39,558.55
Building and equipment (less reserve)	1,724,661.06
Total	1,790,889.97
Liabilities
Accrued real estate taxes	$194,985.08
Accrued ground rent	16,666.67
Accrued bond interest	267,480.23
Balance due on coal burner purchase contract	1,120.00
	480,251.98
First mortgage bonds	1,617,500.00
Total	2,097,751.98

The said balance sheet also stated that there was an operating deficit of $307,862.01 for the period from August 1, 1931, to June 30, 1933.

At June 1, 1933, the Town Center Building Corporation had a cash balance of $85,567.11. Its real estate taxes as far back as 1928 were still unpaid and at June 30, 1933, amounted to $194,985.08, as shown in the above statement of assets and liabilities. Its gross and net operating receipts beginning with the fiscal year ended May 31, 1934, through the six-month period ended November 30, 1937, were as follows:

	6-1-33 to 5-31-34	6-1-34 to 5-31-35	6-1-35 to 5-31-36	6-1-36 to 5-31-37	6-1-37 to 11-30-37	Total
Receipts from operation	$152,803.59	$159,934.95	$160,299.53	$171,984.20	$95,270.02	$740,292.29
Operating expenses (including insurance but excluding taxes and ground rent)	75,048.26	80,443.44	87,269.69	89,118.14	40,834.12	372,713.65
Net receipts from operations	77,755.33	79,491.51	73,029.84	82,866.06	54,435.90	367,578.64

The ground rent and tax requirements for the period shown in the above tabulation, with the exception of the six-month period ended November 30, 1937, were as follows:

	Year ended -
	5-31-34	5-31-35	5-31-36	5-31-37
Ground rent	$40,000.00	$40,000.00	$40,000.00	$40,000.00
Real estate taxes	41,721.39	42,013.94	49,640.24	50,360.08
Total	81,721.39	82,013.94	89,640.24	90,360.08

During the period from June 1, 1933, to November 30, 1937, there was available for the payment of ground rent, real estate taxes, and other items of expense, exclusive of those covered above as operating expenses, $85,567.11, being the cash on hand at the beginning of the period; $367,578.64 representing net operating receipts for the period; $122.44, the amount of profit realized on the sale of tax warrants received as rent; and $11.77 representing a fire loss adjustment, or a total of $453,279.96. During that period $330,870.10 was paid on real estate taxes and interest; $37,587.70 was disbursed in satisfaction of legal fees, personal property taxes, foreclosure expenses and miscellaneous expenditures for a stoker and new elevator cars, and for painting and repairing, leaving a balance on hand at November 30, 1937, of $84,822.16. The record indicates that taxes and the interest thereon for 1928 and subsequent years up to and including the year 1934 were paid in full. With respect to the year 1935, $40,282.92 was expended on taxes and interest, the balance, if any, for that year not being disclosed. ^{*766 the lessors, the disbursements summarized above for the period from June 1, 1933, to November 30, 1937, were made in part by the lessee and in part by the special committee which began supervision of operations at May 31, 1934. The lessee, during the period from June 1, 1933, to May 31, 1934, paid out of the net operating receipts toward delinquent taxes for the years 1928 to 1930 a total of $73,000. It turned over to the special committee in that year for further application to taxes and ground rent, cash in the amount of $61,124.71, and tax warrants in the amount of $4,940.56. The special committee completed the payment of taxes due for the years 1928 to 1930, with interest thereon, bringing the total payments on real estate taxes during the year ended May 31, 1934, to $121,700.61. Thereafter the lessee turned over to the special committee, out of net operating receipts, for application on taxes and ground rent the amount of $77,860.84 for the year June 1, 1934, to May 31, 1935; $75,882.52 for the year June 1, 1935, to May 31, 1936; $80,385.39 for the year June 1, 1936, to May 31, 1937; and $51,541.53 for the period June 1, 1937, to November 30, 1937. From the amounts so received, the special committee made the remaining payments on real estate taxes and interest, bringing the total payments to $330,870.10, as shown above. It also made out of the amounts so received certain disbursements covering legal fees, commissions, repairs to elevators, buildings, etc., which were included in the total of $37,587.70 shown for such disbursements in the preceding paragraph. Neither the lessee nor the special committee made any payments on ground rent during the period from June 1, 1933, to November 30, 1937.}

On or about August 23, 1934, holders of certain undeposited bonds filed a petition in the United States District Court for the Northern District of Illinois, seeking the reorganization of the City Hall Square Building Corporation and the Town Center Building Corporation under the provisions of section 77-B of the Bankruptcy Act. The ground lessors refused to consent to the proposed reorganization and indicated that they would take the position that the appointment of a trustee in the proceedings would give them the right, under their agreement with the Town Center Building Corporation, to immediately terminate the ground leases. Under the circumstances the proceeding was not pressed, and on January 8, 1938, the committee for the bondholders notified the bondholders that it was convinced that there was no possibility of effecting a reorganization of the security back of their investment evidenced by the City Hall Square Building and leasehold estates first mortgage bonds. It further notified them that the deposit agreement had been terminated and that the depositaries had been directed to return the deposited bonds to the holders of certificates of deposit and to distribute among them certificates of the shares of stock of the Town Center Building Corporation.

From and after June 1, 1933, the Leiter estate received no payment on ground rent until July 12, 1938, when $1,000 was received. Subsequent to June 30, 1938, the said estate served on the Town Center Building Corporation and on E. M. Kimball, successor trustee of the bond issue on the building, notice of default under the lease to the City Hall Square Building Corporation.

The Leiter estate keeps its books on the accrual basis and in the year 1934 it accrued $20,000 on its books as the 1934 rental on the Quinlan property but charged the amount to an account, designated "Reserve for Incollected Rents", to which all rents not collected by the estate at the end of the year are charged if there is doubt as to their collection. As a result the $20,000 was not included in the amount of rents reported by the estate in its 1934 return and no part of the amount was reported by the petitioner in her return for that year. In an audit of the estate's return for 1934 the respondent included the $20,000 in rental income. In determining the deficiency herein for 1934 respondent included as income to petitioner 31.3115 percent of the $20,000, or $6,262.30.

The facts as to the final issue are stipulated by the parties as follows:

The Leiter estate in its return for 1934 claimed a deduction of $178,201.21 for accrued taxes. Respondent disallowed $61,391.56 thereof and allowed $116,809.65, representing the amount of the accrued taxes paid in 1935 and 1936. The detail is shown on Exhibit C attached to said report (See Exhibit B attached to the petition, Docket No. 93257). Additional real estate and personal property taxes for the year 1934 in the amount of $16,592.55 have since been paid by the Leiter estate to the County Collector of Cook County, Illinois. Said taxes paid over and above the taxes allowed reduced the petitioner's distributable share of the income of the Leiter estate $5,195.38 (being 31.3115 percent of said $16,592.55).

OPINION.

TURNER: The petitioner contends that no part of the income of the Leiter estate added to the corpus of the estate in 1932 and 1934, pursuant to court decree, constituted income distributable or taxable to her in the respective years. The respondent's position is that the petitioner is taxable on her proportionate share of such income on the ground that said income was distributable to her under the terms of the will, and the court decree did not effect a departure from the terms thereof.

Section 162 of the Revenue Acts of 1932 and 1934 provides as follows:

SEC. 162. NET INCOME.

The net income of the estate or trust shall be computed in the same manner and on the same basis as in the case of an individual, except that -

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(b) There shall be allowed as an additional deduction in computing the net income of the estate or trust the amount of the income of the estate or trust for its taxable year which is to be distributed currently by the fiduciary to the beneficiaries, * * * but the amount so allowed as a deduction shall be included in computing the net income of the beneficiaries whether distributed to them or not. * * *

Under the will of the decedent the trustees were directed to pay out of the trust income the expenses of managing the trust estate and were authorized and empowered to use and apply such protions of net income derived from the trust estate as they deemed best, either in payment of mortgages or incumbrances upon the property or in making any inprovements thereon. The remainder of the income was currently distributable to the named beneficiaries. A number of years prior to the years here in question the trustees expended substantial sums with respect to real estate owned by the trust and located in Chicago and Wyoming. The petitioner in 1923 instituted proceedings in the Superior Court of Cook County, Illinois, for the removal of her brother as trustee, for an accounting of the affairs of the estate, and a construction of the provisions of the will with respect to the development and management of the parcels of real estate mentioned. As a result of this proceeding, the court on May 14, 1931, entered its decree construing the will and fixing the amounts of such expenditures properly chargeable to income and the amounts chargeable to corpus. There is no contention by either party to this proceeding that the amounts chargeable to income and the amounts chargeable to corpus were incorrectly determined. The court found that a portion of the amount which had been expended from corpus with respect to the two parcels of real estate and should have been expended from income, had been repaid from income to corpus, and further found that there still remained unpaid the total amount of $779,084.03, of which $422,746.82 should be paid immediately and the remainder, amounting to $356,337.21, should be amortized avd repaid from income to corpus in equal installments over a period of nine years commencing January 1, 1931. The court further directed that such amortization be effected "by charging against the share of each income beneficiary, and crediting and paying over to corpus, such proportion of each annual installment as the distributable share of such income beneficiary bears to the total distributive income of said trust estate * * *; that the right to have the payments necessary to carry out the amortization directed by this decree is hereby imposed against those who are now, or may hereafter become, entitled to the income, and upon the income to which they are, or may be, so entitled, and in favor of those who are now, or may hereafter become, entitled to the corpus of the estate * * *."

There is no showing or claim that the income beneficiaries did not previously receive distributions of income which they would not have received if the expenditures in respect of the Chicago and Wyoming properties had been charged as they should have been, and we accordingly conclude that, to the extent the decree so charged the distributive shares of the income beneficiaries, they did receive distributions from the estate in excess of the income to which they were entitled. The court by its decree directed that corpus should be reimbursed for the amounts so expended which should, under the terms of the will, have been expended from income. It directed that this reimbursement should be effected by direct charge against the current distributable share of the income of each income beneficiary, stating specifically that the charge was "imposed against those who are now, or may hereafter become, entitled to the income, and upon the income to which they are, or may be, so entitled, and in favor of those who are now, or may hereafter become, entitled to the corpus of the estate." The situation here is similar to that considered by us in . In that case the trustees of an estate created by will made an excessive distribution to the life tenant during the year 1920. In 1921 the error was discovered and for the purpose of correcting the error the trustees withheld in that year from distribution to the life tenant an amount equal to the excessive distribution in 1920. Subsequently the court approved the 1921 account of the trustees in which the withholding described was reflected. Finding that the will under which the estate was created provided for the payment of the income of the estate to the life tenant in quarterly installments, we held that the entire income of the estate for 1921, undiminished in any amount whatsoever, was distributable to the life tenant and should have been included in computing her taxable net income for 1921. Our holding in that case is applicable here, and the respondent's action on this issue is sustained. Compare , wherein we concluded that the facts did not justify the conclusion that the withholding from the income of the beneficiary was in settlement of an obligation on her part to replace the impaired capital. In this case the court, by its decree, specifically made the obligation a direct charge on the shares of income currently distributable to the beneficiaries. Compare , in which it was held that where during a given taxable year an income beneficiary of a trust was actually paid an amount in excess of the amount to which he was entitled, he was taxable in such year only on the amount that was properly receivable by him in that year.

With respect to the item of $20,000 representing the rent due the Leiter estate on the Quinlan property for 1934, we do not have a case where the taxpayer had previously reported an item as income and is now claiming as a bad debt deduction the amount previously accrued and reported as income. The respondent has determined that the omission by the estate of the said item from gross income was erroneous and has increased rents in that amount, thereby determining that the petitioner's income should be increased pro rata. Such an increase by the respondent of the rental income of the estate is claimed as error in the petition.

Where an account has been properly accrued and later becomes uncollectible, the taxpayer's remedy is by way of a deduction and the requirements of the specific statutory provision must be met, and it may not be claimed that the item so accrued should not have been included in income in the first instance. . With respect to inclusion in income in the first instance, however, it has been held that where the facts are such that the item in question is not collectible when due and its collection in the future is highly improbable, the taxpayer, even though on the accrual basis, is not required to report such income in his return. ; Oregon; ; ; . From these cases, however, it is apparent that a taxpayer is justified in failing to accrue an income item which has become due only where the facts are such as to show that it is uncollectible when due and there is little or no likelihood of collection in the future.

In the instant case the petitioner called as a witness one of the officers of the real estate firm which acted as agent for the building to establish by opinion testimony the uncollectibility of the rent item at the time it became due and at all times subsequent thereto. The petitioner also relies on the financial condition of the lessee. The respondent claims that the rent item was properly accruable in 1934 and that the record is not sufficient to sustain the allowance of a deduction for a bad debt. He supports this contention by pointing to the right of the estate to declare a forfeiture of the lease and to repossess the real estate on which the lessee, or its assignor, had constructed the office building previously described. While we are not impressed with the argument of petitioner that the half of the building standing on the Leiter property had no value, neither do we think it follows, as argued by the respondent, that the existence of the right of the lessors to declare a forfeiture of the lease and to repossess the property, including the building thereon, establishes a value in or the collectibility of the claim for rent. Obviously the building on the Trude and Leiter properties did have value. It consistently in all of the years shown by the record produced income in excess of its operating expenses, maintenance charges, and taxes. The petitioner bases its claim of no value on the testimony of the witness previously mentioned and on the fact that the entrance to the building was located on the Trude property and that the part of the building located on the Leiter property probably could not be cut off from that portion located on the Trude property and operated profitably as a separate building. Obviously there was no thought or intention of such action. The Trude and Leiter estates had leased their properties to the same interest undoubtedly with the understanding that the building to be erected on both properties should be a single operating unit. The estates had proceeded jointly with their efforts to collect rent during the period described by the record and there is nothing to indicate or suggest that there was any likelihood that they would not continue to operate jointly if the leases should be forfeited. On the other hand, a forfeiture of the leases would merely result in the reacquisition by the lessors of real estate which had been enhanced in value by the erection of a building and not only would not effect the payment of rent past due but would in this instance eliminate all possibilities of subsequent collection of the rent items. The question as to whether gain is realized by a lessor upon repossession of its property where the lessee has erected a valuable building thereon is an entirely different question.

For the answer to the issue here we must look to the condition of the lessee corporation at the time of accrual and its prospects for the future. Prior to 1933 the lessee had apparently paid ground rents in full. It had become delinquent, however, with respect to real estate taxes and the interest on its bonds. At June 30, 1933, it owed real estate taxes as far back as 1928 and in the amount of $194,985.08, and by that time was in arrears with respect to ground rent in the amount of $16,666.67. There was accrued and unpaid bond interest in the amount of $267,480.23 and the books disclosed an operating deficit of $307,862.01. The existence of unpaid interest, although substantial in amount, is of no concern here. Regardless of whether or not under other circumstances the claim of the bondholders for the unpaid interest might be on a parity with the claim for ground rents, the claim of the bondholders was secured only by the lease and the building, and the existence of the right in the lessors to forfeit the lease and to take over the property, including the building, clearly put the lessors in the position of being preferred with respect to their claims for ground rent over the claims of the bondholders for unpaid interest. The bondholders recognized that fact in 1934, when they abandoned efforts to reorganize under the Bankruptcy Act. Apparently unpaid real estate taxes had accrued to such an extent that by June 1, 1933, it was necessary to devote all of the income over and above operating expenses and necessary maintenance charges to the payment of such taxes until they were paid. The facts show that the building was not producing over and above operating expenses and maintenance costs an amount sufficient to meet the current requirements for real estate taxes and ground rents. Accordingly, in order to avoid a loss of the property for taxes, it was necessary to apply such amounts as might otherwise be available for the payment of ground rents to the payment of taxes which had become due but were unpaid. If it was reasonable to assume that the profits would increase to the extent that an excess over current requirements might be realized in the future, there would be no merit in the claim of the petitioner here. Prior to the taxable year, the lessors had agreed in May 1933 to permit the lessee to continue for the fiscal year ending May 31, 1934, even though it was delinquent in the payment of its ground rent, and to continue operations thereafter if the net income from operations for that period was $95,000 or more, which amount would have been sufficient to meet current needs for taxes and ground rents and leave a small balance over. The profits realized were not sufficient in amount to equal current requirements, however, and a special committee composed of representatives of the two lessors and the lessee took over supervision of operations. At no time up to June 1, 1938, had the building produced an amount sufficient to meet its current requirements. The lessors had received nothing with respect to ground rents since June 30, 1933, and on that date, as we have noted, there was already outstanding an unpaid balance of $16,666.67. It is true that by that time real estate taxes and the interest thereon had been paid in full up to and including the year 1934 and a substantial portion, if not all, of the taxes for 1935 had been paid, but in the meantime an additional $160,000 in ground rents had become due and remained unpaid. There had been an increase in operating profits, but there had been also a gradual increase in real estate taxes, and on June 30, 1938, one month after the operation of the building under supervision of the special committee was to come to an end, the Leiter estate, and presumably the Trude estate, served notice of default on the lessee. In face of such notice of default, the only payment shown on delinquent ground rent was the amount of $1,000 paid to the Leiter estate on July 12, 1938.

Taking into consideration the financial condition of the lessee in 1934, when the rent here in question became due, and the prospective receipts from operation of the building for the future, as corroborated by the actual figures covering operations for some three years thereafter, it is our opinion, under decisions previously cited, that the claim of petitioner, that ground rents which became due and payable in 1934 should not be included in the income of the Leiter estate, should be sustained.

The remaining issue involves the deductibility by the Leiter estate in 1934 of $16,592.55 representing real estate and personal property taxes of the estate for that year. The portion of the stipulation relating to this issue is set out verbatim in the last paragraph of our findings of fact. An examination of the exhibits mentioned in that paragraph discloses that in 1934 the estate accrued real estate taxes in the amount of $178,201.21 and deducted that amount in its return for that year, but respondent allowed only $116,809.65 of the deduction taken, the latter amount representing the total of such real estate taxes for 1934 as were paid by the estate in November 1935 and May 1936. According to the stipulation the estate, subsequent to such payments, has made payment of additional real estate and personal property taxes for 1934 in the amount of $16,592.55. This amount the petitioner contends was deductible by the estate in determining the net income distributable to the income beneficiaries. Despite the fact that the respondent has stipulated that "Said taxes paid over and above the taxes allowed reduce the petitioner's share of the income of the Leiter estate $5,195.38 (being 31.3115% of said $16,592.55)", and the fact that it is specifically determined in the deficiency notice for the 1934 deficiency that the Leiter estate keeps its books on the accrual basis, the respondent, on brief, urges that we should find that the amount is not deductible because of failure of the petitioner to prove a number of other facts not touched upon in the stipulation. Suffice to say that, since the respondent determined that the estate kept its books on the accrual basis and all the evidence of record relating to the point is to the same effect and since the parties have stipulated that the taxes of $16,592.55 were for 1934 and that their payment reduced the petitioner's distributable share of the estate income by $5,195.88 (31.3115 percent of said amount of taxes), we think the evidence of record is sufficient to sustain the conclusion that the amount of taxes in controversy was deductible by the estate in 1934 in determining its net income distributable to the beneficiaries and that the petitioner's share of such income as determined by the respondent is to be reduced by $5,195.38. Accordingly the petitioner is sustained on this issue.

Decision will be entered under Rule 50.

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Footnotes

• 1. In the stipulation of the parties the tax requirements are shown for fiscal years as set forth in the statement contained in the preceding paragraph, while tax payments are shown for calendar years. The amount of $41,721.39 shown in the statement as the tax requirement for the fiscal year ended May 31, 1934, is not so shown in the stipulation but is the amount shown as the 1934 taxes subsequently paid. The respondent in his proposed findings of fact requested that we make the above finding as to tax requirements for the fiscal year 1934 and the petitioner acquiesced in that request. ↩