Rivers v. Commissioner , 49 T.C. 663 ( 1968 )

E. D. Rivers, Jr., and Marie Bie Rivers, Petitioners v. Commissioner of Internal Revenue, Respondent

Rivers v. Commissioner

Docket No. 6990-65

United States Tax Court

49 T.C. 663; 1968 U.S. Tax Ct. LEXIS 160;

March 22, 1968, Filed

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Decision will be entered under Rule 50.

1. Held, where petitioner received stock and notes in exchange for assets transferred to controlled corporations pursuant to sec. 112(b)(5), I.R.C. 1939, and where the payout period on the notes was 20 years, in equal monthly installments, each monthly note payment consisted of return of principal, interest, and gain. Darby Investment Corporation, 37 T.C. 839 (1962), affd. 315 F. 2d 551 (C.A. 6, 1963).

2. Held, that portion of each monthly note payment attributable to gain was taxable as ordinary income in the absence of a "sale or exchange."

Hubert E. Ulmer, for the petitioners.

David S. Meisel, for the respondent.

Withey, Judge.

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WITHEY

The respondent determined deficiencies in petitioners' income tax for the years and in the amounts as follows:

Year	Deficiency
1958	$ 6,963.48
1959	8,194.35
1960	8,603.56

The issues for determination are as follows:

(1) Whether petitioners realized gain upon receipt of monthly principal payments on promissory notes issued to them in 1951, pursuant to a nontaxable exchange;

(2) If so, whether such gain constituted a proportionate share of each monthly note payment; and

(3) If so, whether the gain attributable to each monthly note payment was taxable as ordinary income or as capital gain.

FINDINGS OF FACT

All of the facts have been stipulated and are so found.

Petitioners, husband and wife, were residents of the State of Florida on the date the petition herein was filed. They filed joint income tax returns for 1958, 1959, and 1960 with the district director of internal revenue, Jacksonville, Fla. E. D. Rivers, the husband, will be referred to hereinafter as petitioner.

On April 1, 1951, petitioner transferred certain assets to WEAS, Inc. (hereinafter WEAS), in exchange for the corporation's capital stock and a note, in a transaction which was nontaxable under section 112(b)(5) of the Internal Revenue Code of 1939. ^*162 The tangible or physical assets transferred were set up on the corporate books of WEAS at a value of $ 90,154.73, which was the adjusted basis of those assets in the hands of petitioner. The corporation used that basis for the purpose of computing depreciation of those assets. The remaining assets, in which petitioner had a zero basis, were set up on the corporate books at their "stated value" of $ 159,845.27.

As security for the note received by petitioner from WEAS, petitioner received from that corporation a bill of sale to secure debt which covered all the personal property he had transferred and a "Deed to Secure Debt" which covered the real property transferred. Both security instruments secured an indebtedness of $ 240,000 as evidenced by the note. The note issued by WEAS was in the face amount of $ 240,000 and was payable at the rate of $ 1,000 per month, with interest at the rate of 6 percent per annum on the unpaid balance. It was not issued with interest coupons nor in registered form and was not put into registered form by March 1, 1954. The fair market value of the note on April 1, 1951, was equal to its face amount.

Petitioner's adjusted basis in the capital stock of WEAS was $ 10,000 on the date of the transfer. His adjusted basis in the note was $ 80,154.73 on the date of the transfer.

WEAS began making payments to petitioner on the note on May 1, 1951. Petitioner received 8 principal payments of $ 1,000 each in 1951 and 12 principal payments of $ 1,000 each in each month of the years 1952 through 1960, inclusive. In addition, in each of the years in which payments on the note were made, payments of interest were also made to petitioner.

On April 1, 1951, petitioner also transferred certain assets to WJIV, Inc. (hereinafter WJIV), in exchange for the corporation's capital stock and a note in a transaction which was nontaxable under section 112(b)(5). The tangible or physical assets transferred were set up on the corporate books of WJIV at a value of $ 53,075.48, which was the adjusted basis of those assets in the hands of petitioner. The corporation used that basis for the purpose of computing depreciation on those assets. The remaining assets, in which petitioner had a zero basis, were set up on the corporate books at their "stated value" of $ 76,924.52.

As security for the note received by petitioner from WJIV, petitioner received from that corporation a bill of sale to secure debt which covered all the personal property transferred and a "Deed to Secure Debt" which covered the real property transferred. Both security instruments secured an indebtedness of $ 120,000 as evidenced by the note. The note issued by WJIV was issued in the face amount of $ 120,000 *164 the rate of 4 percent per annum on the unpaid balance. It was not issued with interest coupons nor in registered form and was not put into registered form by March 1, 1954. The fair market value of the note on April 1, 1951, was equal to its face amount.

Petitioner's adjusted basis in the capital stock of WJIV was $ 10,000 on the date of the transfer. His adjusted basis in the note issued by WJIV was $ 43,075.48 on the date of the transfer.

WJIV began making payments to petitioner on the note on May 1, 1951. Petitioner received 8 principal payments of $ 500 each in 1951 and 12 principal payments of $ 500 in each month of the years 1952 through 1960, inclusive. In addition, in each of the years in which payments on the note were made, payments of interest were also made to petitioner.

Petitioner and his wife did not include any portion of the principal payments received on the WEAS and WJIV notes on their income for Federal tax purposes for the taxable years 1951 through 1960.

OPINION

The first question presented is whether petitioner received taxable income during the years in question upon receipt of the payments on the notes issued in 1951. The parties concede that the 1951 transactions, from which the promissory notes arose, were nontaxable transfers pursuant to section 112(b)(5) of the 1939 Code, *168 the statutory predecessor to section 351 of the 1954 Code. Pursuant to section 113(a)(6), petitioner's basis in the stock and notes received from the transferee corporations, WEAS and WJIV, was the same as the basis of petitioner's property transferred to those corporations, i.e., $ 90,154.73 as to WEAS and $ 53,075.48 as to WJIV. After allocating $ 10,000 to the stock of each corporation, petitioner's basis in the WEAS note was $ 80,154.73 and his basis in the WJIV note was $ 43,075.48, although the face amount of the WEAS note was $ 240,000 and the face amount of the WJIV note was $ 120,000. *166 upon the receipt of the note payments because the nontaxable transfer, pursuant to which the notes were acquired, did not permit the transferee corporation to take a stepped-up basis. We agree with petitioner that where property is acquired by a corporation in a transaction to which section 112(b)(5) applies, the basis of the property in the hands of the corporation is the same as it was in the hands of the transferor. Sec. 113(a) (8). However, to conclude from that fact that petitioner will never receive taxable income upon payment of the notes received in such a transaction is without legal foundation. Under both the 1939 and 1954 Codes, gain is defined as the excess of the amount realized from the sale or other disposition of property over its adjusted basis. Sec. 111(a), I.R.C. 1939; sec. 1001(a), I.R.C. 1954. The "amount realized," where no money is received, is by definition the fair market value of the property received, sec. 111(b), I.R.C. 1939; sec. 1001(b), I.R.C. 1954, and since in this case no money was received by petitioner at the time of the transfer in 1951, the "amount realized" was the fair market value of the stock and notes received, i.e., their face amount. Section 112(b)(5) reflects the well-established intent of Congress to foster tax-free business reorganizations of the very type which occurred in this case by postponing recognition of gain. However, there is no suggestion in that Code section, or any other, that Congress intended to thereby eliminate all tax to a transferor in such a transaction. The fact that section 113(a)(6) specifically provided a basis for the property received by the transferor in such a transaction convinces us of the error in petitioner's argument. It follows that since the bases of petitioner's notes were less than their fair market value, petitioner derived taxable income on the receipt of the note payments. We must therefore decide whether petitioner was required to pay a tax on the gain only after he had fully recovered his basis or, on the other hand, whether some portion of each monthly payment was taxable as gain.

Respondent contends, as he has in the past, Victor B. Gilbert, 6 T.C. 10">6 T.C. 10, 13 (1946), that receipt by petitioner of the monthly note payments, beginning in May 1951, was attributable entirely to recovery of petitioner's basis in the notes, with the result that by sometime in 1958, the first tax year in question, petitioner had recovered the entire basis in each note. From this respondent contends that the entire portion of all subsequent note payments were attributable solely to income. In Darby Investment Corporation, 37 T.C. 839">37 T.C. 839 (1962), affd. 315 F.2d 551">315 F.2d 551 (C.A. 6, 1963), we recognized the long-standing principle that:

where evidences of indebtedness such as negotiable bonds, notes, and mortgages payable in installments with interest are purchased at discount, and where when purchased they have an ascertainable fair market value less than the amount due and payable thereon, the payments each include, after deduction of interest, realized discount income in proportion to the difference between the taxpayer's cost and the principal balance due upon the face of such instruments at the date of taxpayer's purchase thereof. William A. Tombari, 35 T.C. 250">35 T.C. 250; Phillips v. Frank, 185 F. Supp. 349">185 F. Supp. 349 (W.D. Wash.); Victor B. Gilbert, 6 T.C. 10">6 T.C. 10; Vancoh Realty Co., 33 B.T.A. 918">33 B.T.A. 918; Shafpa Realty Corporation, 8 B.T.A. 283">8 B.T.A. 283; Florence L. Klein, et al., 6 B.T.A. 617">6 B.T.A. 617.

It is therefore established in the discount note cases that where the cost basis of a note is less than the amount due and payable thereon, the difference, or discount, is to be allocated to each installment payment reported as discount income. In the instant case, while the notes were not purchased at a discount, there also exists a disparity between the holder's basis and the amounts to be received on the note. For this reason, we think it follows that each principal payment in retirement of the notes, after deduction of interest, must be allocated in part to return of petitioner's basis and in part to the receipt of income. ^{Alderson v. Healy, an unreported case ( D. Mont. 1965, 15 A.F.T.R. 2d 536; 65-1 U.S.T.C. par. 9239), and Orange Securities Corp. v. Commissioner, 131 F.2d 662">131 F.2d 662 (C.A. 5, 1942), affirming 45 B.T.A. 24">45 B.T.A. 24 (1941).}

While we agree with respondent that such treatment of the note payments would best protect the Federal revenue, we do not think a doctrine of quasi-estoppel is applicable here. That doctrine, as relied upon in the cited cases, merely imposes upon the taxpayer the duty of taking a consistent position with regard to similar facts and transactions in different years where inconsistency would work to the benefit of the taxpayer and to the detriment of the tax revenue. In the instant case, however, petitioner has taken consistent positions. While he has never reported as income any portion of the monthly note payments, excepting interest, he continues to take the position that because of the nonrecognition provisions of section 112(b)(5) and the transferred, rather than stepped-up, basis required to be taken by the transferee corporation under section 113(a)(8), he has derived no income from the receipt of the monthly payments on the notes. While we consider petitioner's arguments on this point frivolous and completely lacking in judicial authority, we think it clear that his position has at all times been consistent and therefore application of a doctrine of quasi-estoppel is not warranted.

There remains for our determination the question whether the income portion of each monthly note payment received by petitioner during the years in question, 1958 through 1960, constituted ordinary income or capital gain. Assuming, without deciding, that the notes constituted capital assets in the hands of petitioner, it was still necessary that the collections thereon constituted a "sale or exchange" in order for petitioner to be entitled to capital gains treatment on the gain portion thereof. Sec. 117(a), I.R.C. 1939; sec. 1222, I.R.C. 1954. It is now well settled that if gain arises from the sale or exchange of a claim or chose in action, capital gains treatment results, whereas if the gain arises from the mere collection of a claim or chose in action, the gain is taxed as ordinary income. Fairbanks v. United States, 306 U.S. 436 (1939); Mace Osenbach, 17 T.C. 797">17 T.C. 797 (1951), affd. 198 F.2d 235">198 F.2d 235 (C.A. 4, 1952); John H. S. Lee, 42 B.T.A. 920 (1940), affd. 119 F.2d 946">119 F.2d 946 (C.A. 7, 1940); R. W. Hale, 32 B.T.A. 356">32 B.T.A. 356. (1935), affd. 85 F.2d 819">85 F.2d 819 (C.A. D.C. 1936); John H. Watson, Jr., 27 B.T.A. 463">27 B.T.A. 463 (1932). In spite of the foregoing authority, petitioner contends that if gain resulted from the collection on the notes, that gain must be taxed at capital gains rates, relying on section 117(o). That section, as added to the 1939 Code by section 328(a) of the Revenue Act of 1951, ch. 521, 65 Stat. 452, provided as follows:

SEC. 117(o). Gain From Sale of Certain Property Between Spouses or Between an Individual and a Controlled Corporation. --

(1) Treatment of gain as ordinary income. -- In the case of a sale or exchange, directly or indirectly, of property described in paragraph (2) --

* * * *

(B) between an individual and a corporation more than 80 per centum in value of the outstanding stock of which is owned by such individual, his spouse, and his minor children and minor grandchildren;

any gain recognized to the transferor from the sale or exchange of such property shall be considered as gain from the sale or exchange of property which is neither a capital asset nor property described in subsection (j). [Emphasis supplied.]

(2) Subsection applicable only to sales or exchanges of depreciable property. -- This subsection shall apply only in the case of a sale or exchange of property by a transferor which in the hands of the transferee is property of a character which is subject to the allowance for depreciation provided in section 23(1).

Section 328(b) of the Revenue Act of 1951 provided that the foregoing provisions "shall be applicable with respect to taxable years ending after April 30, 1951, but shall apply only with respect to sales or exchanges made after May 3, 1951." From this, petitioner concludes that:

such a transaction as the petitioners entered into [on April 1, 1951] would have had any gain treated as ordinary income if it had been entered into after May 3, 1951. This was thirty-three (33) days after petitioners' transaction. From this, it can be concluded that such transactions could only have resulted in capital gains if entered into on or before May 3, 1951.

Petitioner has failed to cite any judicial authority for this novel argument for the obvious reason that none exists. By its very language, section 117(o) applied to the situation where gain was "recognized to the transferor from the sale or exchange of * * * property." As we have indicated above, since the notes in question arose out of a transaction governed by section 112(b)(5), any gain which may have been realized at the time of the transfer was not "recognized." Thus, the specific language of section 117(o) precludes its application to a situation like that which exists in the instant case. We think section 117(o) was intended to apply rather to gains which were "recognized" at the time of the sale or exchange, as, for instance, where a transferor received, in addition to stock or securities, "other property or money." Sec. 112(c), I.R.C. 1939; sec. 351(b), I.R.C. 1954.

Neither do we think the sale or exchange requirement is met under the special sections found in both the 1939 and 1954 Codes relating to the retirement of notes and other evidences of indebtedness by corporations. Sec. 117(f), I.R.C. 1939; sec. 1232(a), I.R.C. 1954. While those Code sections provide the "exchange" element to the payment of corporate indebtedness, in order for section 117(f)^*176 to apply, the notes must have been issued "with interest coupons or in registered form." Similarly, for section 1232(a)

Since petitioner has failed to prove the existence of a sale or exchange upon the collection of the notes, and since we have concluded that section 117(o) cannot apply to the facts in this case, we must hold that the income portion of each note payment received by petitioner during the years in question was taxable as ordinary income and not as capital gain.

Decision will be entered under Rule 50.

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Footnotes

• 1. All statutory references are to the Internal Revenue Code of 1939 unless otherwise stated.

• 2. Although the parties have stipulated that the WJIV note was issued in the face amount of $ 116,000, "since some payments had already been made on the $ 120,000 obligation," the face amount of the note placed in evidence is $ 120,000.↩

• 3. SEC. 112(b). Exchanges Solely in Kind. --

  (5) Transfer to corporation controlled by transferor. -- No gain or loss shall be recognized if property is transferred to a corporation by one or more persons solely in exchange for stock or securities in such corporation, and immediately after the exchange such person or persons are in control of the corporation * * *

• 4. Petitioner has failed to suggest that the fair market value of each note was less than its face amount and we find no evidence in the record to support such a finding.↩

• 5. See fn. 4, supra↩.

• 6. To illustrate, the $ 1,000 monthly payment received from the WEAS note must, after deduction for interest, be allocated $ 80,154.73/$ 240,000, or approximately one-third to the return of petitioner's basis and $ 159,845.27/240,000, or approximately two-thirds to income.↩

• 7. I.R.C. 1939.

  SEC. 117. CAPITAL GAINS AND LOSSES.

  (f) Retirement of Bonds, Etc. -- For the purposes of this chapter, amounts received by the holder upon the retirement of bonds, debentures, notes, or certificates or other evidences of indebtedness issued by any corporation (including those issued by a government or political subdivision thereof), with interest coupons or in registered form, shall be considered as amounts received in exchange therefor.↩

• 8. I.R.C. 1954.

  SEC. 1232. BONDS AND OTHER EVIDENCES OF INDEBTEDNESS.

  (a) General Rule. -- For purposes of this subtitle, in the case of bonds, debentures, notes, or certificates or other evidences of indebtedness, which are capital assets in the hands of the taxpayer, and which are issued by any corporation, or government or political subdivision thereof --

  (1) Retirement. -- Amounts received by the holder on retirement of such bonds or other evidences of indebtedness shall be considered as amounts received in exchange therefor (except that in the case of bonds or other evidences of indebtedness issued before January 1, 1955, this paragraph shall apply only to those issued with interest coupons or in registered form, or to those in such form on March 1, 1954).↩