Cole v. Commissioner , 42 B.T.A. 1110 ( 1940 )

RUFUS S. COLE, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.

Cole v. Commissioner

Docket No. 96589.

United States Board of Tax Appeals

42 B.T.A. 1110; 1940 BTA LEXIS 901;

October 30, 1940, Promulgated

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On January 30, 1935, a creditor canceled petitioner's note, with the result that petitioner's status changed from insolvency to solvency. Under rule of Lakeland Grocery Co.,36 B.T.A. 289, petitioner realized taxable gain in the amount of the value of assets freed from claims of creditors. The amount of such gain depends upon whether or not petitioner's equity in life insurance policies is includable in assets. Held, that the equity in insurance is not includable in assets because it is exempt from claims of creditors under local law. sec. 55(a), Insurance Law of New York; In re Messinger, 29 Fed.(2d) 158. Petitioner is taxable only on gain in the amount of the assets actually freed from claims of creditors.

Benjamin P. DeWitt, Esq., and Sidney Pepper, Esq., for the petitioner.

Allen T. Akin, Esq., for the respondent.

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HARRON

Respondent determined a deficiency of $13,701.55 in income tax for the year 1935. The sole question is whether respondent erred in adding to petitioner's income the amount of certain indebtedness which was canceled by one of petitioner's creditors in the taxable year. Other adjustments made by respondent to petitioner's income are not in issue.

FINDINGS OF FACT.

Petitioner is a resident of New York. From January 1, 1924, to January 23, 1935, petitioner was employed in various executive capacities by the Hupp Motor Car Corporation, a Virginia corporation, hereinafter referred to as Hupp.

In November 1929 petitioner became heavily indebted to brokers, and Hupp advanced $101,830 to him to enable him to satisfy these debts. Petitioner delivered to Hupp his demand note for $101,830, dated November 18, 1929, and bearing interest at 6 percent, and also deposited with Hupp certain securities as collateral. Petitioner made regular monthly payments to Hupp to reduce the amount of his note, and after several years Hupp waived any further interest. On December 31, 1931, the note was renewed for $76,770.32. On January 30, 1935, the balance due on this note was $62,487.12.

In August 1934 petitioner was elected a director of Hupp. On August 23, 1934, petitioner and Hupp entered into an agreement under the terms of which Hupp agreed to employ petitioner for a period of at least eighteen months as general sales manager at a salary of $25,000 per year and to pay him a percentage of net profits of Hupp in excess of $1,000,000 and also granted him an option to purchase 25,000 shares of Hupp common capital stock at $2.50 per share.

On January 23, 1935, petitioner was discharged by Hupp.

On January 30, 1935, Hupp agreed to cancel petitioner's note if petitioner would resign as director and sever all connections with the corporation. On that date Hupp, as first party, and petitioner, as second party, entered into an agreement which provided in part as follows:

In consideration of the mutual covenants of the parties hereto, it is hereby agreed as follows:

First Party cancels and delivers the note of Second Party, dated December 31, 1931, in the sum of Seventy-six Thousand Seven Hundred Seventy and 32/100 Dollars ($76,770.32), on which there is now due a balance of approximately Sixty-three Thousand Dollars ($63,000.00), and in addition thereto delivers to Second Party the collateral which was deposited with First Party at the time of the execution of said note.

Second Party hereby cancels his agreement with First Party, dated the 23rd day of August, 1934, by the terms of which Second Party was granted certain options and rights in the net profits of First Party.

Second Party hereby releases First Party from any and all claims and demands of any nature or description whatsoever, and First Party hereby releases Second Party from any claims and demands of any nature or description whatsoever, it being the intention of the parties hereto that each is hereby giving to the other a general acquittance of any and all claims which either may have against the other.

Thereupon, petitioner executed a written resignation as director and delivered it to Hupp, and Hupp delivered to petitioner his canceled note and the securities which he had deposited with Hupp as collateral.

Immediately prior to the delivery to him of his canceled note petitioner had the following assets: Cash in bank, $2,044.93; Hupp stock, $4,506.02; securities deposited as collateral, $2,700; equity in a house, $793. Petitioner owned, on January 30, 1935, a net equity of $19,515.62 in ten life insurance policies in the aggregate face amount of $133,745.71. The wife of petitioner, Edna L. Cole, was the named beneficiary of all the policies. Petitioner had the right reserved to change the named beneficiary in each policy. In April of 1939 the Bankers Trust Co. held all the policies as assignee and at the date of the hearing in this case it had possession of all of the policies as assignee. The above ten policies represent all the insurance on petitioner's life existing on January 30, 1935. None of the policies were effected and none of the premiums were paid with intent to defraud creditors.

Immediately prior to the delivery to him of his canceled note petitioner had the following liabilities: Note owing to Hupp, $62,487.12; miscellaneous, $5,526.38; total, $68,013.50.

Immediately prior to January 30, 1935, the date of petitioner's receipt of his canceled note, petitioner's assets aggregated $10,043,95; and his liabilities aggregated $68,013.50. Immediately after the receipt of his canceled note petitioner was solvent with an excess of total assets over total liabilities in the amount of $4,517.57 (assets of $10,043.95 less liabilities of $5,526.38).

OPINION.

HARRON: The sole question is whether the cancellation of petitioner's indebtedness to Hupp resulted in taxable income under section 22(a) of the Revenue Act of 1934, the pertinent provisions of which are set forth in the margin. ¹

Respondent determined that the entire amount of the indebtedness canceled was taxable income under section 22(a). In his brief petitioner contends that, since he was insolvent immediately prior to the cancellation of the indebtedness, the cancellation did not result in taxable income, and relies on Dallas Transfer & Terminal Warehouse Co. v. Commissioner, 70 Fed.(2d) 95, and Burnet v. Campbell Co., 50 Fed.(2d) 488.

In our opinion the Board's decision in Lakeland Grocery Co.,36 B.T.A. 289, is controlling here. In the Lakeland case the taxpayer was insolvent immediately prior to the cancellation of his indebtedness by his creditors but solvent immediately after the cancellation, with an excess of total assets over total liabilities. After considering, inter alia, the same cases relied on by petitioner in his brief here, the Board held that the cancellation of the indebtedness resulted in taxable income to the extent of the excess of total assets over total liabilities immediately after the cancellation. The Board stated in part as follows:

* * * The petitioner's net assets were increased from zero to $39,596.93 as a result of the cancellation of indebtedness by its creditors, and to that extent it had assets which ceased to be offset by any liability. The decisions that the increase in clear assets so brought about constitutes taxable "gain" or "income" (United Statesv. Kirby Lumber Co., supra, and Helvering v. American Chicle Co.,291 U.S. 426) are applicable to the facts of the instant case, as the cancellation of the petitioner's debts had the effect of making its assets greater than they were before that transaction occurred. It is true that "gain" or "profit" is essential to the existence of taxable "income" (cf. Dallas Transfer & Terminal Warehouse Co., supra ), and we believe that "gain", as commonly understood, was realized here when the petitioner, who was hopelessly insolvent, received by the action of its creditors an increment to its assets clear and free of any claims of the creditors.

The rule of the Lakeland case is applicable here in so far as the cancellation of the indebtedness by Hupp released petitioner's assets which were subject to claims of creditors. The evidence shows that certain assets of petitioner, aggregating $10,043.95, were released from claims of Hupp, a creditor, and thereafter petitioner's net assets free from liabilities were in the amount of $4,517.57. Such increase in clear assets, resulting from the cancellation of petitioner's indebtedness constitutes taxable "gain" or "income" to petitioner. Lakeland Grocery Co., supra.

In determining the amount in which petitioner's net assets were increased as a result of the cancellation of petitioner's indebtedness by his creditor, i.e., the amount of petitioner's assets which ceased to be offset by claims of creditors, there should be, and has been, omitted from the value of petitioner's assets the value of his equity in ten life insurance policies. Under the applicable law of New, york, which was in effect prior to the date of petitioner's original note to Hupp and at the time of the cancellation of the note, such equity in insurance was free from claims of creditors. See section 55(a) of the Insurance Law of New York. ² In determining whether or not petitioner was solvent or insolvent after cancellation of the debt his exempt property should not be considered. Underleak v. Scott,117 Minn. 136; 134 N.W. 731. Section 55(a) of the New Ork Insurance Law has been held to include within its exemption the cash surrender value of insurance policies, notwithstanding that the insured reserved the right to change the beneficiary. See In re Messinger, 29 Fed.(2d) 158, where section 55(a) was held to allow "exemption" from assets of a bankrupt insured of insurance similar to that involved here, where the claims of creditors arose after March 31, 1927, the effective date of section 55(a). Accordingly, the value of petitioner's assets was $10,043.95 on January 30, 1935, exclusive of the value of his equity in the insurance policies.

Petitioner does not contend directly that the cancellation resulted in a gift, but he does contend that the agreement between Hupp and petitioner, relating to petitioner's employment by Hupp as general sales manager and to other matters, dated August 23, 1934, was invalid and that his indebtedness to Hupp was not canceled in consideration of the cancellation of the agreement of August 23, 1934. We deem it unnecessary to consider these express contentions, because the evidence clearly shows that the cancellation of petitioner's indebtedness to Hupp was for a consideration, and, thus, did not result in a gift to petitioner. As was pointed out by the Board in Reginald Denny,33 B.T.A. 738, 742, "It is elementary that if there i a consideration for a transfer if is not a gift. Noel v. Parrott, 15 Fed.(2d) 669." In this case, as in the Denny case, there was a consideration which removed the transaction from the category of a gift. It consisted of petitioner's agreement to resign as a director of Hupp. Hupp was extremely desirous of terminating petitioner's entire participation in Hupp's management, as well as his employment. As stated by petitioner in his brief. "as director, he [petitioner] had steadfastly opposed policies" of the individual then in control of Hupp, and "had embarrassed and incurred the enmity" of that individual, "not only by opposing his policies at meetings of the board of directors of the corporation but also by sending on December 11, 1934, a letter to the Securities and Exchange Commission and an identical letter to the New York Stock Exchange informing those bodies of acts * * * which petitioner believed improper."

It is held that the cancellation of petitioner's indebtedness to Hupp resulted in taxable income in the amount of $4,517.57. Lakeland Grocery Co., supra.

Decision will be entered under Rule 50.

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Footnotes

• 1. SEC. 22. GROSS INCOME.

  (a) GENERAL DEFINITION. - "Gross income" includes gains, profits, and income derived from salaries, wages, or compensation for personal service, of whatever kind and in whatever form paid, or from professions, vocations, trades, businesses, commerce, or sales, or dealings in property, whether real or personal, growing out of the ownership or use of or@ interest in such property; also from interest, rent, dividends, securities, or the transaction of any business carried on for gain or profit, or gains or profits and income derived from any source whatever. ↩

• 2. SEC. 55(a). Rights of creditors and beneficiaries under policies of life insurance. - If a policy of insurance whether heretofore or hereafter issued, is effected by any person on his own life or on another life, in favor of a person other than himself, or, except in cases of transfer with intent to defraud creditors, if a policy of life insurance is assigned or in any way made payable to any such person, the lawful beneficiary or assignee thereof, other than the insured or the person so effecting such insurance, or his executors or administrators, shall be entitled to its proceeds and avails against the creditors and representatives of the insured and of the person effecting the same, whether or not the right to change the beneficiary is reserved or permitted, and whether or not the policy is made payable to the person whose life is insured if the beneficiary or assignee shall predecease such person; Provided, that, subject to the statute of limitations, the amount of any premiums for said insurance paid with intent to defraud creditors, with interest thereon, shall inure to their benefit from the proceeds of the policy; but the company issuing the policy shall be discharged of all liability thereon by payment of its proceeds in accordance with its terms, unless before such payment the company shall have written notice, by or in behalf of a creditor, of a claim to recover for transfer made or premiums paid with intent to defraud creditors with specification of the amount claimed. [L 1927 C 468↩ Eff. Mar. 31, 1927.]