District Bond Co. v. Commissioner ( 1939 )

DISTRICT BOND COMPANY, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.

MAE RECOR MACPHERSON, PETITIONER v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.

District Bond Co. v. Commissioner

Docket Nos. 88970, 92083, 94486.

United States Board of Tax Appeals

39 B.T.A. 739; 1939 BTA LEXIS 988;

April 11, 1939, Promulgated

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1. Held, bonds issued under the California Municipal Improvement District Act of 1915 were obligations of a political subdivision of the State of California, and interest received thereon by petitioners during the years 1934-1936 was not subject to Federal income tax; held, further, bonds issued under the California Street Opening Bond Act of 1911 were not obligations of a political subdivision of the state, and interest received thereon during 1934-1936 was subject to tax.

2. Petitioner accrued on its books, but did not report in its Federal income tax return, for 1934, interest on tax-exempt bonds issued under the California Acquisition and Improvement Act of 1925, which interest obligation became worthless in 1935 and was charged off in that year by petitioner. Held, petitioner is not entitled to a loss deduction of such amount, since it represents merely the loss of a gain which has not been reflected in taxable income.

Dana Latham, Esq., and I. Blair Evans, Esq., for the petitioners.

Alva C. Baird, Esq., for the respondent.

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HILL

These proceedings, duly consolidated, are for the redetermination of deficiencies in income tax as follows:

Petitioner	Docket No.	Year	Deficiency
District Bond Co	88970	1934	$5,292.93
Do	88970	1935	3,168.46
Do	94486	1936	201.15
Mae Recor MacPherson	92083	1934	239.63
Do	92083	1935	355.71

The issues raised by the pleadings are (1) whether or not interest received by petitioners in the taxable years on certain bonds issued by various California municipalities under various California improvement acts is includable in gross income for tax purposes; and (2) whether or not respondent erred in disallowing certain deductions claimed by petitioner in Docket Nos. 88970 and 94486. The proceedings were submitted on the pleadings and stipulation of facts, which we adopt in full as our findings of fact and set forth below in part deemed material to a discussion of the issues presented.

FINDINGS OF FACT.

Docket Nos. 88970 and 94486.

Petitioner is a California corporation, with its principal office at Los Angeles. During the calendar years 1932 to 1936, inclusive, petitioner kept its books of account and filed its Federal income tax returns on an accrual basis.

For the years 1934, 1935, and 1936 respondent included in petitioner's taxable income amounts representing interest accrued on its books in each of the respective years upon bonds issued by various California municipalities under various California improvement acts, which amounts petitioner had omitted from its returns on the theory that they were exempt from Federal income tax, as follows:

Act	1934	1935	1936
California Improvement Act of 1911	$21,089.12	$7,698.25	$13,393.27
California County Improvement Act of 1921	7,908.42	1,347.20	5,129.34
California Acquisition and Improvement Act of 1925	9,226.49	5,773.67	4,559.41
California Municipal Improvement District Act of 1915	1,581.68	577.37	712.41
California Road District Improvement Act of 1907	790.84		142.48
California Improvement Bond Act of 1915	4,745.05	1,732.11	1,709.78
California Street Opening Bond Act of 1911	7,381.19	2,117.02	2,849.63
Total	52,722.79	19,245.62	28,496.32

The bonds held by petitioner during the taxable years, issued under the California Municipal Improvement District Act of 1915, contained the following provisions:

Under and by virtue of an Act of the Legislature of the State of California * * * Municipal Improvement District No. 27 of the City of Los Angeles, * * * by its governing body, the Mayor and Council of said City, promises out of the fund hereinafter described, to pay to the bearer, on the first day of October, 1957, the sum of $1,000 with interest * * *. The principal and interest of this bond are payable exclusively out of taxes levied upon the taxable property in said Municipal Improvement District No. 27 * * * and neither the City of Los Angeles nor any officer thereof is holden for the payment thereof otherwise. It is hereby certified that all requirements of the constitution and laws of the State of California * * * have been fully complied with by the proper officers in the issuing of this bond; that this issue of bonds has been authorized by a two-thirds vote of the duly qualified voters of said district * * * and that provision has been made for the collection of an annual tax upon the taxable property of said district sufficient to pay the interest on this bond and the issue of which it forms a part, as said interest falls due, and also provision to constitute a sinking fund for the payment of the principal thereof.

The bonds held by petitioner during the taxable years, issued under the California Street Opening Bond Act of 1911, contained the following provisions:

Under and by virtue of and pursuant to the provisions of (title of this Act) I (the city treasurer) out of the fund for the above designated improvement bonds series , will pay to bearer the sum of dollars, with interest * * *. This bond is issued to represent an assessment for in the city of , as the same is more fully described in the assessment thereof. Its amount is the amount assessed in said assessment against the lot or parcel of land numbered thereon * * * and which remains unpaid; but until paid, with accrued interest, is a first lien upon the property affected thereby * * *.

This bond is payable exclusively from said fund, and neither the city of , nor any officer thereof, is to be holden otherwise for its principal or interest. * * * Should default be made in the annual payment upon the principal, or in any payment of interest, the holder of this bond is entitled to declare the whole unpaid amount to be due and payable, and to have said lot or parcel of land advertised and sold forthwith in the manner provided by law. In case of such default, there shall be immediately added to such defaulted amount, five per cent (5%) of the amount thereof, and on the first day of each month following such default there shall be added a further penalty of one per cent to such defaulted amount. The city shall be entitled to one-half of the penalty first imposed, namely, two and one-half per cent and the other two and one-half percent and all subsequent penalties shall be paid to the holder of the bond along with and as part of such defaulted payment.

All of the bonds issued under the various California improvement acts above referred to, the interest on which is here in controversy, were issued by California municipalities in accordance with the provisions of the statute applicable to each type of bond, and were issued to provide funds for public purposes, such as the opening and widening of public highways, and other public works authorized by the various acts.

In determining petitioner's taxable income for the year 1935, respondent disallowed as a deduction the amount of $2,636.90, claimed by petitioner as a bad debt deduction on account of the ascertainment of the total worthlessness during 1935, of certain interest coupons accrued on its books in prior years, representing interest on bonds issued by the County of San Diego and the City of Oceanside under the California Acquisition and Improvement Act of 1925. Respondent disallowed such deduction for the reason only that the amount had not theretofore been reported as taxable income.

For the year 1932 petitioner accrued on its books interest on the bonds above referred to in the amount of $1,318.45, for 1933 it accrued a like amount, and for 1934 it accrued the sum of $1,795.27. The sum of $1,318.45 so accrued by petitioner for each of the years 1932 and 1933 was not included in determining taxable income for either year by petitioner in its return or by respondent upon audit of the return.

Included in the bond interest item of $52,722.79, added by respondent to petitioner's taxable income for 1934, is the item of $1,795.27 above mentioned as accrued by petitioner for the year 1934.

The coupons on the particular acquisition and improvement bonds here in question, accrued by petitioner on its books for the years 1932, 1933, and 1934, became uncollectible and totally worthless during the year 1935, and were so ascertained and charged off on its books by petitioner in determining its taxable income for that year. Respondent has allowed petitioner a deduction from gross income for 1935 in the amount of $1,795.27 representing the interest accrued by petitioner on such bonds in 1934. In this connection there was no fraud, negligence, or failure to disclose pertinent facts involved on the part of petitioner for any of the years here involved, including the calendar years 1932 and 1933.

Docket No. 92083.

Petitioner is an individual, residing in San Gabriel, California. For the years 1934 and 1935 respondent increased petitioner's taxable income from Trust No. 5221, First Trust and Savings Bank of Pasadena, Pasadena, California, trustee, in the amounts of $2,736.77 and $3,692.27, respectively, representing interest received by such trustee on bonds issued by various California municipalities under various California improvement acts, which amounts were omitted from petitioner's income tax returns on the theory that they were exempt from Federal income tax, as follows:

Act	1934	1935
California Improvement Act of 1911	$847.20	$859.56
California County Improvement Act of 1921	312.83	152.79
California Acquisition and Improvement Act of 1925	925.65	2,099.21
California Municipal Improvement District Act of 1915	63.54	64.47
California Road District Improvement Act of 1907	42.57
California Improvement Bond Act of 1915	250.15	277.28
California Street Opening Bond Act of 1911	294.83	238.96
Total	2,736.77	3,692.27

The interest involved herein as set out above was received by Trust No. 5221 in part from bonds in which it owned "Assignments of Undivided Ownership" and in part from bonds "owned direct", but the parties are in agreement that for the purposes of these proceedings it may be assumed that all of such bonds were "owned direct" by the trust during the taxable years.

All of the bonds here in question were issued under the various California improvement acts by various California municipalities in accordance with the statute applicable to each type of bond, and were issued in order to provide funds for public purposes, such as opening and widening of public highways and other public works authorized by the various improvement acts.

For the year 1935 respondent increased petitioner's taxable income from Trust No. 2441, First Trust & Savings Bank of Pasadena, Pasadena, California, trustee, in the amount of $945, representing interest received by the trust on "Assignments of Undivided Interests" in said bonds issued by various California municipalities under various California improvement acts, no part of which amount was included by petitioner as taxable income in her return on the ground that such interest was exempt from Federal income tax, as follows:

Act	1935
California Improvement Act of 1911	$378.00
California County Improvement Act of 1921	67.19
California Acquisition and Improvement Act of 1925	284.16
California Municipal Improvement District Act of 1915	28.35
California Improvement Bond Act of 1915	82.22
California Street Opening Bond Act of 1911	105.08
Total	945.00

OPINION.

HILL: The principal issue for decision, involved in all three of the present proceedings, is whether or not interest on bonds issued by various California municipalities under the various California improvement acts set out in our findings of fact above is exempt from Federal income tax. We have heretofore considered and decided this question in respect of five of the seven California improvement acts involved.

In , we held that interest on bonds issued under the California Improvement Act of 1911 and the California County Improvement Act of 1921 was subject to the tax, while interest on bonds issued under the California Acquisition and Improvement Act of 1925 and the California Improvement Bond Act of 1915 was held not subject to such tax. Also, in , we held that interest on bonds issued under the California Road District Improvement Act of 1907 was exempt from the Federal income tax.

On authority of the cited decisions and for the reasons therein stated, we approve respondent's action in including in the taxable income of the present petitioners interest received by them on bonds issued under the California Improvement Act of 1911 and the California County Improvement Act of 1921; on the same authority we hold that respondent erred, and accordingly disapprove his action, in including in the taxable income of petitioners interest received on bonds issued under the California Acquisition and Improvement Act of 1925, the California Road District Improvement Act of 1907, and the California Improvement Bond Act of 1915.

This leaves for consideration here only the question of the taxability of interest on bonds issued under the California Municipal Improvement District Act of 1915, approved April 20, 1915, California Stats. 1915, p. 99; Deering's General Laws of California, Act No. 5184, and the California Street Opening Bond Act of 1911, approved April 27, 1911, California Stats. 1911, p. 1192; Deering's General Laws of California, Act No. 855.

Section 22(b)(4) of the Revenue Acts of 1934 and 1936 provides, among other things, that interest upon obligations of a state, or any political subdivision thereof, shall not be included in gross income and shall be exempt from income tax. The question presented here, then, is whether or not the bonds in controversy constituted obligations of the State of California, or its political subdivisions. The parties have stipulated that all of the bonds under consideration were issued by California municipalities under the various California improvement acts referred to, in accordance with the provisions of the act applicable to each type of bond, and were issued to provide funds for public purposes. Our further discussion will, therefore, proceed upon the hypothesis that the terms of the bonds were in accordance with the provisions of the statute applicable to each type, and reference will be made only to the terms of the bonds, which, so far as material to the question under consideration, are set out at length hereinabove.

Following the reasoning of the decisions above cited, we hold that petitioners' bonds issued under the California Municipal Improvement District Act of 1915 were direct obligations of a political subdivision of the State of California, and so exempt from tax. These bonds contained the affirmative and unconditional promise of Municipal Improvement District No. 27 of the City of Los Angeles, by its governing body, the mayor and the council of that city, to pay to the bearer on a date specified the principal sum of each bond, together with interest as therein provided. The bonds recited that provision had been made for the collection of an annual tax upon the taxable property of the improvement district sufficient to pay the interest and constitute a sinking fund for payment of the principal. These bonds were nonetheless obligations of Municipal Improvement District No. 27 because principal and interest were payable exclusively out of taxes levied upon the taxable property of the district. Cf. ; affd., ; , affirming . Respondent's action in including in petitioners' taxable income the interest received on bonds issued under the California Municipal Improvement District Act of 1915 is reversed.

The bonds of petitioners issued under the California Street Opening Bond Act of 1911 were materially different from those last above discussed. They resemble more closely, both in form and substance, the bonds issued under the California Improvement Act of 1911 and California County Improvement Act of 1921, interest on which, as we have before pointed out, was held in the Bekins case, supra, to be subject to tax.

These bonds were issued to represent unpaid assessments against the benefited property, and until paid with accrued interest were a first lien on the property affected. The bondholder was required to look to the property for payment, and in case of default was entitled to declare the whole unpaid amount due and payable, and to have the land advertised and sold forthwith in the manner provided by law. Certain specified penalties were to be added to the amount in default and paid to the holder of the bond along with and as a part of the defaulted payment.

Under the California Street Opening Bond Act of 1911, as under the California Improvement Act of 1911, considered in the Bekins case, the bondholder's sole remedy was against the property benefited, neither the city nor any of its officials being holden for payment. Such bonds, therefore, did not represent obligations of the city, and we hold respondent did not err in including in petitioners' gross income the interest received by them in the taxable years from such bonds.

The second issue submitted for decision involves a deduction from gross income for 1935 claimed by petitioner in Docket No. 88970 and disallowed by respondent in the following circumstances: For the years 1932 and 1933 petitioner accrued on its books interest in the amount of $2,636.90 on bonds issued under the California Acquisition and Improvement Act of 1925, which was exempt from Federal income tax. Such amount was not included in determining taxable income for either year by petitioner or respondent. Petitioner also accrued on its books for 1934 interest on similar bonds in the sum of $1,795.27 which was not reported by petitioner in its return as taxable income but was included in income by respondent in computing the deficiency for 1934. The coupons on the particular bonds representing the interest referred to and here in controversy became wholly worthless in 1935 and were charged off its books by petitioner.

Respondent allowed the deduction of the $1,795.27 as a bad debt for 1935 because such amount has been included in taxable income for 1934. But respondent disallowed the deduction of $2,636.90 accrued for 1932 and 1933 from income for 1935 for the reason that such amount had not theretofore been included in taxable income. Respondent's action on this issue must be approved. We have long adhered to the rule that a taxpayer can not take as a deduction the loss of a gain which has not been reflected in income. ; ; ; ; affd., ; ; ; .

Petitioner insists that the deduction should be allowed in the instant case, notwithstanding the rule above referred to, for the reason that the amount in controversy was accrued by petitioner on its books and, it is argued, thus passed through the "tax mill." We can not agree with this argument. So far as concerns tax liability, a taxpayer on an accrual basis who accrues an income item on his books but does not include the amount in taxable income is in no different position than the taxpayer on a cash basis who does not include a similar item in income because it has not been received. To allow the deduction in either of such events would result in reducing the amount of the taxable income received or accrued from other sources by an amount representing not a loss of capital or of actual income, but merely a loss of anticipated earnings. For a further discussion of this point, see .

The parties have stipulated that if we should hold that the interest accrued by petitioner in Docket No. 88970 on the bonds issued under the California Acquisition and Improvement Act of 1925 was not subject to the Federal income tax, and should further hold that a loss on account of accruals thereof in prior years was not deductible from petitioner's income for 1935, then the income as computed by respondent for 1935 should be increased by the amount of $1,795.27. Having so held, the income computed by respondent may be increased, as stipulated, to the extent that the deficiency originally determined by respondent is not thereby increased, since respondent has made no claim for an increased deficiency.

The issues hereinabove discussed and decided have been stipulated by the parties to be the only issues submitted for decision. Accordingly, all other issues raised by the pleadings are assumed to have been abandoned, and respondent's action thereon stands approved.

Decisions will be entered under Rule 50.