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IDI MANAGEMENT, INC., AND SUBSIDIARIES, Petitioner v. COMMISSIONER OF INTERNAL REVENUE, RespondentIDI Management, Inc. v. CommissionerDocket No. 6830-74.
United States Tax Court T.C. Memo 1977-369; 1977 Tax Ct. Memo LEXIS 71; 36 T.C.M. (CCH) 1482; T.C.M. (RIA) 770369;October 25, 1977, Filed William R. Seaman andRonald E. Heinlen Conley G. Wilkerson TANNENWALDMEMORANDUM FINDINGS OF FACT AND OPINION
TANNENWALD,
Judge : Respondent determined the following deficiencies in petitioner's Federal income tax:Year Deficiency 1963 $ 75,297.04 1964 1,837.35 1965 226,925.69 1966 552,921.68 1967 644,722.01 1968 1,587,827.91 1969 514,598.33 1970 403,146.00 By amended petition, petitioner claims that the net operating losses for its 1971 and 1972 taxable years are available for carryback to some of the years for which the respondent has asserted deficiencies.
The issues before us concern four longterm construction contracts executed by petitioner, a taxpayer reporting income therefrom on the completed contract basis. More particularly, we are asked to decide whether, in the year of contract completion, petitioner properly accrued in income the fair market value rather*74 than the face value of debt obligations arising from such contracts. Resolution of this issue will affect the disposition of other issues relating to bad debt deductions by petitioner in respect of the partial worthlessness of such obligations in the year of completion and in subsequent years.
FINDINGS OF FACT
Some of the facts have been stipulated by the parties and are found accordingly.
Petitioner, IDI Management, Inc. (IDI), is an Ohio corporation and had its principal place of business in Cincinnati, Ohio, at the time of the filing of the petition herein. At all times material herein, petitioner was engaged, directly and through subsidiary corporations, in the business of designing, engineering, constructing, and selling individual plant process units and complete facilities for the manufacture of agricultural chemicals used primarily for fertilizer. Petitioner and its subsidiaries filed consolidated Federal income tax returns for the 1963-1970 calendar years with the district director of internal revenue, Cincinnati, Ohio. Both petitioner and one of its subsidiaries, whose transactions are involved herein, used the accrual method of accounting.They accounted for long-term*75 construction on their own books and records by percentage of completion and they used the completed contract method of accounting for tax purposes. Reference herein to petitioner shall be deemed to refer to the subsidiary as well as IDI.
On November 1, 1966, petitioner executed a long-term construction contract (#1157), effective as of June 27, 1966, pursuant to which it agreed to design and construct an addition to a fertilizer plant for St. Paul Ammonia Products, Inc. (St. Paul), at a contract price of $9,662,340. The contract called for an initial $1,000,000 payment, monthly progress payments thereafter, and final payments due on acceptance and 60 days later. Subsequently, the parties to the contract mutually agreed to eliminate a substantial portion of the expansion work called for by the contract when it appeared that St. Paul's plan of financing would not be completed as scheduled. Petitioner could not abandon the contract when St. Paul was unable to obtain financing because highly specialized construction materials had already been ordered and cancellation of such orders involved substantial costs.
By October 27, 1967, St. Paul had made progress payments of only $219,639.91. *76 On that date, petitioner and St. Paul entered into a settlement agreement recognizing interest owing petitioner on past due progress payments in the amount of $248,240.34 and fixing the remaining portion of the contract price at $5,086,202.41, subject to certain additional charges which were finally determined in 1969 to be $266,690.91. Pursuant to this agreement, St. Paul delivered to petitioner: (a) an unsubordinated 7 percent demand promissory note dated October 27, 1967 for $248,240.34; (b) 490,000 shares of St. Paul common stock to be applied against the contract price at the rate of $1.00 per share, and (c) 7 percent subordinated demand construction notes in a total face amount of $4,596,202.41. In November, 1967, St. Paul paid the note for $248,240.34.
At a special meeting of the shareholders of St. Paul on October 26, 1967, a general plan of refinancing of the company was approved. The plan included the foregoing settlement agreement with petitioner to be executed the following day; it recognized that the construction debt to petitioner as well as $4,700,000 of its 5-1/2 percent debentures were past due; and, it authorized $7,500,000 of new bank debt to which the construction*77 notes issued to petitioner would be subordinated. The purpose of the new debt was to pay the past due debentures and to provide new working capital. The refinancing was implemented in November, 1967. No part of the bank loan proceeds was available for payment to the petitioner other than the $248,240.34 used to pay the demand note mentioned above. To facilitate the refinancing, petitioner gave up its right under Minnesota law to file a mechanic's lien against the newly constructed plant and agreed to hold the new bank creditors harmless against any outstanding mechanic's liens, or any that might be filed in the future, in respect of facilities constructed by petitioner pursuant to its contract with St. Paul.
Petitioner completed the long-term construction contract for St. Paul in 1968.
In respect of past due interest on the construction notes, St. Paul issued to petitioner the following 7 percent interest-bearing demand promissory notes:
Date Face Amount 2/1/68 $ 84,620.16 5/1/68 80,792.10 8/1/68 84,013.48 11/1/68 85,495.60 2/1/69 87,003.48 5/1/69 85,651.82 Total $507,576.64 At a special meeting of the shareholders of St. Paul on November 28, 1969, a*78 plan of recapitalization was adopted whereby common stock of St. Paul would be issued in exchange for various outstanding debts and securities of St. Paul.
The effectiveness of the plan was conditioned upon the acceptance of the plan on or before February 2, 1970, by holders of 95 percent of the principal amount of St. Paul's 6 percent convertible subordinated debentures, 95 percent of the principal amount of its interim notes, and 100 percent of the construction notes (held by petitioner) with the right of St. Paul to reduce the required percentages to 75 percent. By February 2, 1970, St. Paul had received consents representing over 80 percent of the required amounts and its board of directors decided to proceed with the implementation of the plan. Pursuant to the plan, petitioner surrendered its $4,596,202.41 of St. Paul's construction notes and its $507,576.64 of St. Paul promissory notes issued in respect of past due interest in exchange for 4,203,779 shares of St. Paul common stock and a new $900,000, 7 percent subordinated construction note.
At the same meeting on November 28, 1969, the St. Paul shareholders authorized the borrowing of $2,500,000 from Manufacturers Hanover*79 Trust Company (Hanover) for the construction of a 275-ton-per-day nitric acid plant. Under the terms of the new loan, Hanover would have a first mortgage lien on all assets of St. Paul, all stock or securities of St. Paul, and certain other securities owned by Continental Nitrogen and Chemicals, Inc. (Continental). *80 stock at any time material herein.
On January 6, 1967, and February 1, 1967, petitioner entered into two contracts (#1143 and #6257) with the Oklahoma Ordnance Works Authority (O.O.W.A.), an Oklahoma public trust, for the construction of a facility containing ammonia, nitric acid, and ammonium nitrate plants, related buildings, and equipment for a total price of $7,500,000. The contract price was payable partly in cash ($3,000,000) and partly in industrial revenue bonds to be issued by O.O.W.A. ($4,500,000), but such bonds were subject to a participation by O.O.W.A.. As of February 1, 1967, O.O.W.A. entered into a lease with Cherokee Nitrogen Company (Cherokee) (a wholly-owned subsidiary of Continental, the major shareholder of St. Paul prior to its recapitalization), pursuant to which Cherokee would operate the facilities constructed for O.O.W.A. by petitioner.
As of July 1, 1967, petitioner entered into a long-term construction contract (#6274) with Cherokee for additional facilities to be built at the O.O.W.A. fertilizer plant, leased by Cherokee, for a price of $4,075,000. The contract price was subsequently reduced to $4,000,000. The facilities to be constructed were*81 also subject to the lease from O.O.W.A. to Cherokee.
In 1968, petitioner completed its two contracts with O.O.W.A. (#1143 and #6257) as well as its contract with Cherokee (#6274). As provided by contract, O.O.W.A. paid petitioner $3,000,000 in cash and gave to petitioner $4,500,000 Series A, 6 percent Industrial Development Subordinated Revenue Bonds issued by O.O.W.A. in satisfaction of the $7,500,000 contract price. In order to make the cash payment, O.O.W.A. borrowed $2,500,000 from the First National Bank and Trust Company of Tulsa and $500,000 from The Oklahoma Industrial Finance Authority. As security for such loans, O.O.W.A. executed an indenture of mortgage, a security agreement, and an assignment of rents (due from Cherokee) in favor of each of the lenders with the First National Bank and Trust Company of Tulsa having first priority.
The O.O.W.A. bonds delivered to petitioner were due July 15, 1977. Although they carried interest from date of issue, payment of interest was postponed until October 15, 1971. The bonds were subject to a $400,000 Participation Certificate giving O.O.W.A. a right to 4/45ths of the proceeds, whether principal or interest. They were secured*82 solely by the lease to Cherokee, a trust indenture, and a third mortgage of the plant leased to Cherokee, *83 of the Cherokee contract debt. On or about July 30, 1971, petitioner accepted an additional 10,000 shares of the $10 par value Cherokee common stock in satisfaction of the remaining $500,000 of the Cherokee debt.
As of December 31, 1968, and December 31, 1969, the fair market values of the various debt obligations held by petitioner as a result of its contracts with St. Paul, O.O.W.A., and Cherokee were as follows:
12/31/68 Fair Obligation Face Value Market Value St. Paul 7% subordinated $4,596,202.41 $2,000,000.00 Construction Notes O.O.W.A. Series A, 6% 4,500,000.00 2,600,000.00 Industrial Development Subordinated Revenue Bond Account Receivable from 4,000,000.00 2,500,000.00 Cherokee Total $13,096,202.41 $7,100,000.00 12/31/69 Fair St. Paul 7% $900,000.00 $360,000.00 Subordinated Construction Note Receivable due from 266,690.57 106,676.23 St. Paul Interest due from 244,536.18 97,814.47 St. Paul Total $1,411,226.75 $564,490.70 As of November 28, 1969, and*84 December 31, 1969, the fair market value of 4,203,779 shares of St. Paul common stock was $840,755.80.
The 60,000 shares of Cherokee common stock that petitioner received in 1971 had a fair market value of $920,000 at the time of receipt.
From 1967 to 1970, the nitrogen fertilizer industry experienced a serious imbalance in supply and demand. Although consumption increased, production increased at a higher rate due to production efficiencies effected primarily by new plant facilities in the Gulf Coast and southern regions of the country. Because of this increased supply as well as the sensitivity of demand to other market conditions, industry prices dropped sharply during this period. New production facilities enabled companies to market ammonia products at prices equal to or below St. Paul's and Cherokee's production costs. Both companies suffered during this period. St. Paul, which had been in existence for some years, curtailed its production of ammonia in 1967-1968 and purchased its ammonia needs in the market.Cherokee, which had only come into being in 1967, was experiencing a difficult start.
St. Paul's June 30 fiscal year-end balance sheets for 1966 through 1973*85 were as follows:
ST. PAUL AMMONIA PRODUCTS, INC. Balance Sheets as of June 30
Assets 1966 1967 1968 1969 Current Assets: Cash and equivalent: $ 1,653,224 $ 257,528 $ 320,575 $ 594,052 Receivables: Trade Accounts 1,482,122 2,010,818 2,526,362 2,858,905 Other 8,467 802,966 708,088 114,466 2,813,784 3,234,450 2,973,371 Less allowance for discounts, price adjustments and doubtful n/a 28,461 143,127 104,778 receivables Net receivables 1,490,589 2,785,324 3,091,323 2,868,593 Inventories: Finished products Finished and in process 93,386 868,453 1,152,043 825,593 Raw materials and 212,867 197,840 190,031 225,555 chemicals Parts and supplies 432,665 471,199 460,753 248,088 Total Inventories 743,918 1,537,492 1,802,827 1,299,236 Prepaid expenses 54,941 63,045 66,132 157,005 Total current assets 3,942,672 4,643,388 5,280,857 4,918,886 Investment in 5.0%-owned 135,000 85,000 70,000 company Plant and equipment, at cost: Land 257,911 253,728 261,658 261,658 Plant and equipment 14,872,631 20,734,235 20,998,132 12,202,515 Specialized repair parts Office and agency 208,571 254,768 254,168 257,699 buildings Office fixtures and other 103,645 123,544 311,019 341,958 equipment Construction in progress 66,374 1,416,984 15,442,758 21,371,275 21,891,351 14,480,814 Less allowance for 6,900,642 7,675,198 10,817,175 4,714,319 depreciation Net plant and equipment 8,542,116 12,696,077 11,074,176 9,766,495 Deferred turnaround, debenture, loan and other expenses and 61,004 34,672 20,027 290,098 other assets $12,545,792 $18,509,137 $16,460,060 $15,045,479
*87Assets 1970 1971 1972 1973 Current Assets: Cash and equivalent: $ 536,992 $ 414,523 $ 637,079 $ 1,343,509 Receivables: Trade Accounts 2,413,532 3,016,314 2,724,862 3,1 91,767 Other 48,708 57,671 75,383 52,038 2,462,240 3,073,985 2,800,245 3,243,805 Less allowance for discounts, price adjustments and doubtful 200,000 162,000 117,350 106,000 receivables Net receivables 2,262,240 2,911,985 2,682,895 3,137,805 Inventories: Finished products Finished and in process 625,825 1,570,259 2,202,241 465,648 Raw materials and 153,749 177,386 139,624 145,212 chemicals Parts and supplies 144,125 633,027 643,135 388,875 Total Inventories 923,699 2,380,672 2,985,000 999,735 Prepaid expenses 104,726 670,870 779,605 809,214 Total current assets 3,827,657 6,378,050 7,084,579 6,290,263 Investment in 5.0%-owned 61,000 69,000 25,922 company Plant and equipment, at cost: Land 264,575 645,575 639,007 638,207 Plant and equipment 12,483,294 19,316,356 19,522,318 20,720,606 Specialized repair parts 424,590 Office and agency 266,665 533,678 535,274 512,468 buildings Office fixtures and other 318,881 707,946 726,724 695,051 equipment Construction in progress 1,948,465 137,998 189,022 69,664 15,281,880 21,341,553 21,612,345 23,060,586 Less allowance for 5,722,806 7,286,413 8,598,349 10,134,613 depreciation Net plant and equipment 9,559,074 14,055,140 13,013,996 12,925,973 Deferred turnaround, debenture, loan and other expenses and 72,015 33,166 280,359 319,935 other assets $13,519,746 $20,535,356 $20,378,934 $19,562,093 ST. PAUL AMMONIA PRODUCTS, INC. Balance Sheets as of June 30 (All footnotes not included) *88
LIABILITIES 1966 1967 1968 1969 Current liabilities Demand notes payable to $ $ $ 4,680,823 $ 5,103,779 construction company Notes payable to banks 170,000 6,547,585 9,451,458 Current maturities of 2,625,721 9,922,152 32,353 1,031,424 long term debt Accounts payable 475,872 792,077 1,224,017 2,277,877 Accrued liabilities 285,253 326,987 525,495 452,163 Advance deposits on bulk product sales Federal and State incomes 320,370 121,393 taxes, estimated Total current liabilities 3,715,216 11,332,809 13,010,273 18,316,701 Long term debt 3,660,254 1,421,779 1,564,450 646,253 Deferred income taxes 802,000 1,167,000 Stockholders equity: Preferred stock 2,000,000 2,000,000 2,000,000 2,000,000 Common stock 32,813 33,938 46,188 46,188 Additional paid-in 959,138 1,093,013 1,570,763 1,570,763 capital Accumulated earnings 1,376,371 1,460,598 (1,731,614) (7,534,426) (deficit) Less treasury stock Total stockholders equity 4,368,322 4,587,549 1,885,337 (3,917,475) $12,545,792 $18,509,137 $16,460,060 $15,045,479
*89LIABILITIES 1970 1971 1972 1973 Current liabilities Demand notes payable to $ 900,000 $ $ $ construction company Notes payable to banks 9,951,137 10,256,689 11,726,905 12,792,944 Current maturities of 348,708 1,113,218 1,372,543 1,352,724 long term debt Accounts payable 2,587,432 2,539,672 1,843,430 1,978,905 Accrued liabilities 1,235,628 683,111 863,929 833,084 Advance deposits on bulk 456,478 26,446 product sales Federal and State incomes taxes, estimated Total current liabilities 15,022,905 14,592,690 16,263,203 16,904,121 Long term debt 214,622 5,110,737 4,461,878 3,292,229 Deferred income taxes Stockholders equity: Preferred stock 3,679,900 4,326,200 4,995,200 Common stock 200,022 200,131 208,131 200,131 Additional paid-in 1,320,213 1,333,554 1,333,554 1,333,554 capital Accumulated earnings (3,246,016) (4,381,656) (6,188,429) (7,226,267) (deficit) Less treasury stock (16,875) (16,875) Total stockholders equity (1,717,781) 831,929 (345,419) (714,257) $13,519,746 $20,535,356 $20,378,914 $19,562,343 During fiscal 1966 through 1973, St. Paul had the following net income (or loss):
1966 $456,964 1967 84,227 1968 (3,192,212) 1969 (5,802,812) 1970 (3,246,016) 1971 (1,135,640) 1972 (1,806,773) 1973 (1,037,838) *90 As of December 31, 1968, St. Paul's balance sheet showed a small excess of assets over liabilities.
1967 1968 1969 Net income (loss) $ 84,227 [3,192,212) [5,802,812) Add charges not requiring funds (depreciation, amortization, etc.) 1,165,888 2,041,728 2,795,561 Funds from operations (deficit) 1,250,115 (1,150,484) (3,007,251) Add proceeds of debt or other 5,168,548 1,248,628 3,438,061 securities Total funds available 6,418,663 98,144 430,810 Less: Additions to plant and equipment 5,928,517 522,182 1,458,743 Funds available for debt retirement 490,146 (424,038) (1,027,933) Bank loans 170,000 6,436,353 9,451,458 Amount owing IDI Management 5,168,548 4,680,823 5,103,779 1970 1971 Net income (loss) [3,246,016) [1,135,640) Add charges not requiring funds (depreciation, amortization, etc.) 1,031,421 1,564,587 Funds from operations (deficit) (2,214,595) 428,947 Add proceeds of debt or other 5,445,710 10,539,041 securities Total funds available 3,231,115 9,681,154 Less: Additions to plant and equipment 535,442 6,088,759 Funds available for debt retirement 2,695,673 4,450,289 Bank loans 9,951,137 10,256,689 Amount owing IDI Management 900,000 Cherokee, whose financial condition was important to IDI not only because of the Cherokee account receivable but also because the O.O.W.A. bonds held*92 by IDI were payable out of Cherokee's lease payments to O.O.W.A.,
ASSETS 1968 1969 1970 Current Assets: Cash $ 123,727 $ 248,540 $ 153,927 Receivables Net trade accounts receivable 801,986 1,042,634 459,978 Insurance claims receivable Other receivables 7,358 13,403 23,471 Total receivables 809,344 1,056,037 483,449 Inventories Finished and in process 673,376 541,787 530,389 Spare parts 100,000 251,751 276,478 Total Inventories 773,376 793,538 806,867 Prepaid expenses 31,461 143,406 88,977 Total Current Assets 1,737,908 2,241,521 1,533,220 Funds reserved for construction: Cash Insurance Claims receivable Property plant & equipment at cost 11,462,082 11,654,301 12,114,030 Less accumulated depreciation 694,783 1,741,982 2,820,214 Net property plant, equipment 10,767,299 9,912,319 9,293,816 Advance to affiliated company Deferred charges and other costs less amortization: Plant and product development costs Start -up and maintenance expense 150,886 119,428 133,021 Other Total deferred charges & other costs 150,886 119,428 133,021 Costs in excess of net tangible assets of acquired business (not amortized) 47,169 66,348 66,348 $12,703,262 $12,339,616 $11,026,405
*94ASSETS 1971 1972 1973 Current Assets: Cash $ 108,762 $ 98,300 $ 207,097 Receivables Net trade accounts receivable 513,211 759,967 483,773 Insurance claims receivable 544,191 Other receivables 18,006 6,480 6,549 Total receivables 531,217 766,447 1,034,513 Inventories Finished and in process 1,295,904 588,028 110,472 Spare parts 324,555 335,249 353,924 Total Inventories 1,620,459 923,277 464,396 Prepaid expenses 31,158 31,293 29,426 Total Current Assets 2,291,596 1,819,317 1,735,432 Funds reserved for construction: Cash 97,302 Insurance Claims receivable 1,119,234 1,216,536 Property plant & equipment at cost 12,488,796 12,566,740 11,836,832 Less accumulated depreciation 3,764,052 4,729,715 5,204,952 Net property plant, equipment 8,724,744 7,837,025 6,631,910 Advance to affiliated company 82,182 Deferred charges and other costs less amortization: Plant and product development costs 56,781 Start -up and maintenance expense 117,851 90,236 28,802 Other 8,309 Total deferred charges & other costs 117,851 90,236 93,892 Costs in excess of net tangible assets of acquired business (not amortized) 66,348 66,348 66,348 $11,200,539 $9,812,926 $9,826,300 CHEROKEE NITROGEN COMPANY Balance Sheets as of June 30 (All footnotes not included)
Liabilities 1968 1969 1970 Current Liabilities: $ $ $ Current instalments of long term debt: IDI Management, Inc. Other 2,000,000 1,222,090 812,707 Notes payable: Banks 1,193,378 1,134,455 Continental Nitrogen and Chemicals Oklahoma Natural Gas Co. Accounts Payable IDI Management, Inc. 37,808 21,429 Other 457,402 673,573 894,229 Accrued Expenses 51,632 58,327 49,425 Total current liabilities 2,509,034 3,185,176 2,912,245 Construction liabilities Long term debt including capitalized lease rentals IDI Management, Inc. 4,000,000 8,850,630 9,209,142 Other 8, 001,724 2,123,992 1,162,993 12,001,724 10,974,622 10,372,135 Less current instalments 2,000,000 1,222,090 812,707 Total Long Term Debt excluding current instalments 10,001,724 9,752,532 9,559,428 Shareholders equity: Common Stock $10 par value 100,000 100,000 100,000 Additional paid in capital 300,000 664,000 664,000 Accumulated earnings (deficit) (207,496) (1,362,092) (2,209,268) Total Shareholders equity 192,504 (598,092) (1,445,268) $12,703,262 $12,339,616 $11,206,405
*96Liabilities 1971 1972 1973 Current Liabilities: $ $ Current instalments of long term debt: IDI Management, Inc. 340,290 769,750 Other 506,667 206,104 53,253 Notes payable: Banks 2,096,322 1,165,230 435,008 Continental Nitrogen and Chemicals 12,000 10,500 Oklahoma Natural Gas Co. 93,000 93,000 39,000 Accounts Payable IDI Management, Inc. 95,321 49,891 48,046 Other 542,942 401,621 274,757 Accrued Expenses 60,921 48,104 66,024 Total current liabilities 3,407,173 2,314,740 1,685,838 Construction liabilities 216,541 Long term debt including capitalized lease rentals n(2) IDI Management, Inc. 6,403,130 6,733,130 6,792,750 Other 795,119 523,982 368,896 7,198,249 7,257,112 7,161,646 Less current instalments 506,667 546,394 823,003 Total Long Term Debt excluding current instalments 6,691,582 6,710,718 6,338,643 Shareholders equity: Common Stock $10 par value 700,000 700,000 700,000 Additional paid in capital 854,732 854,732 854,732 Accumulated earnings (deficit) (452,948) (767,264) 30,546 Total Shareholders equity 1,101,784 787,468 1,585,278 $11,200,539 $9,812,926 $9,826,300 During fiscal 1968 through 1973, Cherokee showed the following net income (or loss):
*981971 1972 1973 Net income (loss) $ (452,948) $ (314,316) 224,100 Add charges not requiring funds (depreciation, amort- ization, etc.) 1,324,633 1,391,213 1,015,761 Funds from operations 871,685 1,076,897 1,239,871 Add proceeds of debt or other securities 21,673 1,005,271 Less: Addition to plant and equipment 374,766 77,944 1,292,931 Additional start-up costs and deferred items 74,147 58,958 100,500 Funds available for debt retirement 422,772 961,668 851,711 Bank loans and other Notes 2,096,322 1,165,230 435,008 Owing IDI Management Indirectly through Capitalized Lease Agreement 5,500,000 5,500,000 5,500,000 Directly - construction Notes Accrued Interest 903,130 1,233,130 1,292,750 Total 6,403,130 6,733,130 6,792,750 *99 At the end of 1968, Continental, owning a controlling stock interest in both St. Paul and Cherokee, contemplated a rearrangement of the capital structures of these two companies as well as a third company in which Continental had a controlling interest. This plan, known as "MidAmerica Financing," contemplated the infusion of some $19,000,000 into the three companies from which St. Paul and Cherokee would satisfy their obligations to IDI. By the end of 1968, however, there was no assurance that the MidAmerica Financing could have been completed.
Because outside financial interests, who were considering participation in MidAmerica Financing, wanted an independent appraisal of the three companies' economic prospects, Arthur D. Little, Inc., was retained by Continental to investigate their economic outlook. The report dated January, 1969, determined that the supplydemand problem in the nitrogen industry could correct itself by 1971 causing nitrogen prices to recover. Moreover, the report concluded that St. Paul and Cherokee were favorably situated and, with the infusion of new capital, could turn around by 1970.MidAmerica Financing fell through prior to December 31, 1969.
*100 In December, 1969, St. Paul's bank creditors advised the company that, because their existing loans were in jeopardy, they were prepared to foreclose.St. Paul's management persuaded the banks to wait at least six months because their net yield from a foreclosure would not be great. The banks consented to St. Paul's continuing operations at least until June 30, 1970.
In February, 1970, St. Paul began negotiating for the purchase of an ammonia plant from the Apple River Chemical Company (Apple River Plant), the company from which St. Paul had been buying ammonia. The management of St. Paul saw this acquisition as affording an opportunity to help put the company back on its feet and to ward off foreclosure. The sale was consummated in November, 1970. St. Paul's senior bank creditors were aware of the negotiations but, because any debt that would have been necessary for such purchase would be subordinate to their claims, the purchase did not concern them.
The banks never pursued their plan of foreclosure. St. Paul continued to operate and by 1974 was showing a profit.
Cherokee, too, remained in operation throughout the years in question and, by 1973, was operating at a profit.
*101 On December 31, 1968, petitioner wrotedown the value of the St. Paul notes, the O.O.W.A. bonds, and the Cherokee account receivable in the aggregate amount of $6,220,000 and reported the balance as gross income for that year in respect of its completed contracts, *102 Throughout the years in question, petitioner attempted to avoid becoming too financially involved as an investor in the companies for which it constructed facilities lest it discourage other customers for construction contracts by putting itself in a competitive position with such customers.
Other than as previously indicated, the record does not show that petitioner received any payment in respect of the St. Paul obligations or the Cherokee account receivable during the years in question, although it made demands therefor.
OPINION
Taxable year 1968 The first issue herein involves the amount of income petitioner is required to report for 1968, when it completed its contracts with St. Paul, O.O.W.A., and Cherokee and the fair market values of their obligations to petitioner were significantly less than their face values. Respondent contends that petitioner may not limit the amount includible in income to the fair market values of such obligations because the completed contract method of accounting requires the accrual of the gross contract price (or the face value of the debtor's obligations) in the year the contract is completed. Because this argument was first raised*103 in an amended pleading by respondent, he concedes that he bears the burden of proof in respect of the amount includible in petitioner's income for 1968 from the St. Paul, O.O.W.A., and Cherokee contracts. *104 us.
Initially, we note that there is no express statutory directive in respect of the face versus fair market value controversy herein. Moreover, prior to 1976, respondent's regulations offered no guidance. In
T.D. 7397 ,1 C.B. 115">1976-1 C.B. 115 , however, respondent amended his regulations concerning accounting for long-term contracts andsection 1.451-3(d)(1), Income Tax Regs. , now provides:under the completed contract method, gross income derived from long-term contracts must be reported by including the gross contract price of each contract in gross income for the taxable year in which such contract is completed * * *.
The regulations then go on to carve out exceptions for "disputed" claims.
Respondent, however, has not argued that his 1976 regulation should be literally applied and has acknowledged that there is a further exception which recognizes that an item need not be included in income by a taxpayer utilizing the completed contract method of accounting, to the extent*105 that it is "contingent and uncertain" (see
National Contracting Co. v. Commissioner, 37 B.T.A. 689">37 B.T.A. 689105 F.2d 488">105 F.2d 488 (8th Cir.) 1939)), a phrase which has been redefined as "reasonable uncertainty about the ultimate payment." SeeHudson v. Commissioner, 11 T.C. 1042">11 T.C. 1042Hudson Engineering Corp. v. Commissioner, 183 F.2d 180">183 F.2d 180Jones Lumber Co. v. Commissioner, 404 F. 2d 764, 767 (6th Cir. 1968)T.C. Memo. 1967-81 , and relied upon by this Court inSteele v. Commissioner, T.C. Memo 1969-177">T.C. Memo. 1969-177We also do not agree with petitioner that this Court has heretofore twice approved the use of fair market value by a completed-contract-basis taxpayer in accounting for debt obligations. In the first case,
Hudson v. Commissioner, supra , one of the taxpayers was an engineering company (Engineering) that reported income on the completed contract basis. One contract negotiated by Engineering involved the construction of a processing plant for a fee of $120,000. The company commissioning the processing plant sustained net losses through the year in which the contract was completed; moreover, payment of Engineering's fee was subordinated to a substantial amount of other debt which was secured by a mortgage of all of the debtor company's properties.Engineering received no payment in the year of completion and reported no income in respect of the fee*108 to which it was entitled. Respondent valued the fee at $50,000 for the year of completion and determined that such value was properly includible in Engineering's income. This Court upheld that determination on the ground that Engineering failed to show sufficient uncertainty as to payment of $50,000 to warrant exclusion of that amount as income. See11 T.C. at 1050 . Although we noted that respondent's valuation indicated thathe thought there was sufficient uncertainty as to the payment of such amount to excuse the accrual thereof, the issue of the includibility of the remaining $70,000 was simply not before the Court. Consequently,Hudson does not stand for the the proposition that, had the respondent determined that all of the $120,000 fee should have been included in income, this Court would not have sustained that determination.In the second case,
American Electric Co., Ltd. v. Commissioner, T.C. Memo. 1966-76Steele v. Commissioner, supra , where a homebuilder accepted second mortgages as part payment for homes that he sold and, under the completed contract method of accounting, reported only the fair market values of such mortgages as income in the year of completion. The Court sustained respondent's determination that the taxpayer was required to include in income the face values of such mortgages because they were neither contingent nor uncertain as to collectibility.The receipt of third-party obligations in satisfaction of a debt is quite different from the receipt of obligations of the debtor itself, as is the case herein. In the former situation, the obligations constitute property and a standard of fair market value is an appropriate*110 standard to apply. In the latter situation, the taxpayer is simply receiving evidence of his debtor's
continuing obligation in a different form; the right of the creditor to receive full payment of the debtor's obligation remains and, in the case of an accrual or a completed-contract-basis taxpayer, the existence of that right is the critical determinant subject only, in a situation such as involved herein, to the question of collectibility.American Electric Co., Ltd., supra , we spoke both in terms*111 of fair market value and proof by the taxpayer of "contingencies or reasonable uncertainties extant in the year of completion in order for taxability of the full amount to be postponed." But even leaving aside the significant element of a third-party obligation, our language does not necessarily make fair market value the test of certainty under any and all circumstances. At most, that case stands for the proposition that we applied a dual test and came to the conclusion that the taxpayer satisfied both criteria.As we see it, the issue herein is a factual one, namely, whether the difference between the face and fair market values of the obligations involved represents an amount sufficiently uncertain as to payment so as to justify petitioner's exclusion of such amount from income.
Georgia School-Book Depository, Inc. v. Commissioner, 1 T.C. 463">1 T.C. 463, 469 (1943)Harmont Plaza, Inc. v. Commissioner, 64 T.C. 632">64 T.C. 632549 F. 2d 414 (6th Cir. 1977) .As of December 31, 1968, both St. Paul and Cherokee faced serious financial difficulty. St. Paul had been forced to curtail its costly production of amonia. In 1967, subsequent to its execution of the construction contract with petitioner, St. Paul had to borrow $7,500,000 to service its past due debentures and to provide working capital. The borrowing came about as part of a general plan of refinancing, including its settlement agreement with petitioner whereby petitioner was to receive stock and notes for its contract rather than cash. Moreover, the notes were subordinated to the new $7,500,000 loan and petitioner surrendered its right to file a mechanic's lien against the facilities*113 it constructed. All indications in the record are that petitioner had little choice but to accept the settlement agreement. The contract was not yet completed. Yet, construction could not be halted because the necessary construction materials, which were highly specialized, had been ordered and were in the fabrication process. Cancellation of such orders involved steep penalties.Progress payments were delinquent, although petitioner made demands therefor. Petitioner's treasurer testified that petitioner believed its only hope of realizing any payment was for St. Paul to remain in business and this, in turn, required the borrowing of new capital to which petitioner would have to subordinate its claims.
By the end of 1968, St. Paul's situation had worsened rather than improved. Its current liabilities (including its obligations to petitioner) were more than two times its current assets. Although its balance sheet, as of the end of 1968, showed total assets in excess of total liabilities, the assets included the carrying of its plant and equipment at cost. A fair inference from the record is that, given the general state of the industry at the end of 1968 owing in large measure*114 to new entrants with larger, more efficient plants, liquidation of these fixed assets would yield far less than book value. In any event, under the circumstances, we think it was incumbent upon the respondent, who bore the burden of proof, to challenge such inference with evidence to the contrary. This he has not done. Therefore, although St. Paul did not show "balance sheet insolvency" at the close of 1968, it clearly did not have current assets with which to pay petitioner's subordinated claims, and there is real doubt as to whether its total assets could have satisfied any, let alone all, of such claims. *115 As for Cherokee, upon whose financial success petitioner depended for payment of both the O.O.W.A. bonds and the account receivable from Cherokee, the company was insolvent as of December 31, 1968, *116 determined. Both the testimonial and documentary evidence on this point indicate that collectibility was a key ingredient in determining fair market value, and the ultimate conclusion was that the only market for such obligations would be among speculators or "venture capital investors."
We think fair market value can represent a number of things. It can represent a discounted value of a right to receive a sum certain in the future as to which there is no doubt about collection. Or, it can represent more of a "gamble," e.g., the price one is willing to pay for the "chance" to receive a greater sum in the future. Respondent argues that where fair market value is 50 percent or more of a maximum return, "as a matter of practical economics," there must be reasonable prospects of realizing a greater amount.
When there is some doubt as to the collectibility of an obligation, which respondent concedes there is here, we agree that such doubt is an element reflected in fair market value. Just as we have rejected petitioner's contention that fair market value is necessarily determinative of collectibility (see p. 34,
supra ), so do we reject respondent's contention that when fair*117 market value is a certain percentage of face value, ipso facto, there must be insufficient doubt to prevent the inclusion of face value in income. The factors underlying the valuation must be examined. This is particularly true in a situation, such as is involved herein, where respondent, who had the burden of proof, offered no evidence of "marketability" as distinguished from "fair market value". SeeUnderhill v. Commissioner, 45 T.C. 489">45 T.C. 489The respondent attempts to negate the possibility of a reasonable expectation, as of the end of 1968, that the difference between the face and fair market values of the obligations was uncollectible by pointing to the proposed MidAmerica Financing as well as the Arthur D. Little, Inc., report predicting a turnaround in the fertilizer industry. From the limited evidence we have before us concerning the MidAmerica Financing, we cannot conclude that it was more than a slight possibility already factored into the fair market valuation. *118 the fact that it was commissioned by Continental in order to attract new capital. Moreover, any specific profit projections for St. Paul and Cherokee presupposed the acquisition of new capital. Because the new capital was anticipated from MidAmerica Financing and because we have already found that the possibility of such financing was slight, the profit picture painted by the report is of questionable reliability herein.
We have also had the benefit of testimony from an audit partner in the independent accounting firm certifying petitioner's 1968 financial statement. He testified that he agreed with petitioner's write-down of income for 1968; in fact, he testified that he had sufficient doubts as to the collectibility of the balance, i.e., the writtendown amount of the obligations, and, for that reason, the auditor's opinion as to that amount was qualified to show that*119 the obligations in their entirety were questionable assets. The accountant's judgment was based upon the fact that both companies had current liabilities in excess of current assets, both were experiencing losses, both showed insufficient cash flow with which to service their respective debts, and both had significant other debts to which their obligations to petitioner were subordinated. Petitioner's treasurer also testified that, in both 1968 and 1969, he regarded the debts from St. Paul and Cherokee as being uncollectible. By way of contrast, respondent produced no witnesses to testify affirmatively on the issue, even though he had the burden of proof.
Based upon the entire record before us, we conclude that respondent has failed to sustain his burden of proof that there was not a reasonable uncertainty as to the ultimate payment of the portion of the disputed obligations in excess of their December 31, 1968, fair market values and that petitioner may exclude such excess from its income for 1968. *120
Portland Manufacturing Co. v. Commissioner, 56 T.C. 58">56 T.C. 58supra), including respondent's passing contention on brief that the manner of petitioner's chargeoff for 1968 does not satisfy the requirements of section 166(a)(2), a contention which we would, in any event, consider to be of doubtful validity.Taxable year 1969 Petitioner next claims entitlement to a partial bad debt deduction for 1969 in respect of St. Paul's obligations outstanding on December 31 of that year.
Face Value St. Paul 7% Construction Notes $4,596,202.41 St. Paul 7% Promissory Notes 507,576.64 Account Receivable from St. Paul 266,690.57 Interest due from St. Paul 244,536.18 At the close of 1969, a plan of recapitalization of St. Paul had been approved by its shareholders and was in the process of being submitted for approval by the necessary percentage of holders of debt obligations (see pp. 7-8,
supra) . Prior to that time, petitioner had agreed to surrender the St. Paul construction and promissory notes in exchange for 4,203,779 shares of St. Paul common stock and a new 7-percent $900,000 note of St. Paul. The parties have stipulated that as of December 31, 1969, the fair market value of the stock was $840,775.80 and*122 the fair market value of the note was $360,000. While the state of the record is not crystal clear, we think it a fair inference that the parties are in agreement that these values should be used in measuring the petitioner's partially worthless bad debt deduction, if we hold that any such deduction is allowable.The December 31, 1969 fair market values of the account receivable from St. Paul and the interest due from St. Paul were $106,676.23 and $97,814.47, respectively. supra):
Charge-off Notes receivable $5,061,741.26 (Both construction and promissory) Account receivable 266,690.51 Interest due 244,536.18 TOTAL $5,572,967.95 *123 Such total charge-off exceeds the deductions claimed herein.
In his notice of deficiency, respondent disallowed any deduction in respect of the St. Paul obligations on the ground that St. Paul was a continuing business and neither its debts nor its stock could be considered worthless.
To the extent that the issue of partial worthlessness is thus posed, petitioner has the burden of proof. However, by amended pleading, respondent asserts that no deduction in respect of the St. Paul notes that were ultimately exchanged, pursuant to the plan of recapitalization, for 4,203,779 shares of St. Paul common stock should be allowed on the additional ground that such recapitalization qualified as a corporate reorganization under section 368(a)(1)(E) and that the notes exchanged by petitioner for stock pursuant thereto constituted "securities" within the meaning of section 354(a). Alternatively, respondent's amended pleading argues for the disallowance of any deduction in respect of such exchange because any "loss" thereon represented a contribution of capital to St. Paul. Respondent concedes that the issues raised in his amended answer constitute new matters as to which he bears the burden*124 of proof.
We begin by rejecting respondent's fleeting pitch that petitioner is not entitled to any bad debt deduction in respect of the St. Paul construction and promissory notes for the reason that such notes were, according to respondent, "tantamount to a stock interest or at least a right to subscribe, or to receive stock in St. Paul" and therefore constituted "securities" for which a deduction is allowed under section 165 only in the year of total worthlessness. Respondent's position is not within the scope of the deficiency notice, was not pleaded, was not raised at trial, and is raised on brief only as an afterthought to his argument as to the applicability of the reorganization provisions. It cannot be gainsaid that, prior to the end of 1969, petitioner had agreed to accept St. Paul stock,
provided the various other conditions of the recapitalization plan, including the necessary acceptance of other creditors, was forthcoming. Thus, at most, it had a conditional right to stock which would come to fruition only upon the happening of a number of other events beyond the control of either St. Paul or petitioner. Under the foregoing circumstances, assuming that this issue*125 is properly before the Court (as to which we have serious doubts), we are satisfied that the notes in question should be treated as what they appear to be on their face, i.e., debt, and that section 166 applies.We must now decide whether petitioner has satisfied the requirements of section 166(a)(2)
section 1.166-1(e), Income Tax Regs. ) was "worthless." This is a question of fact.Respondent correctly notes that section 166(a)(2) confers--
a discretion upon the respondent, which, although not boundless, requires respondent's determination as to deductibility*126 to be upheld unless found to be plainly arbitrary or unreasonable * * *. In attempting to make the required showing it is the taxpayer's burden to introduce evidence which establishes that in the year the partial worthlessness was claimed, the amount of such worthlessness could be predicted with "reasonable certainty." * * * [
Sika Chemical Corp. v. Commissioner, 64 T.C. 856">64 T.C. 856538 F.2d 320">538 F.2d 320 (3rd Cir., 1976).]Although the respondent is given greater discretion in the area of partially worthless debts than in the area of wholly worthless debts, such discretion does not include the power to disregard soundly exercised business judgment.
Portland Manufacturing Co. v. Commissioner, supra. subordinated debt to petitioner was approximately $5,107,000. Thus, from the balance sheet figures alone, St. Paul was unable to satisfy any of its debts to petitioner.Petitioner has introduced evidence that matters were far more serious than the books would indicate. Its senior bank creditors threatened foreclosure on December 31, 1969. At that time, St. Paul determined that immediate liquidation would yield total proceeds of only $4,230,000, including $2,000,000 for its fixed assets. Of these proceeds, St. Paul expected only $2,080,000 would be available for its senior bank creditors whom they owed some $9.5 million, leaving petitioner with nothing. Respondent has offered no challenge to the figures presented. If insolvency alone dictated the degree of an obligation's worthlessness, which it does not (see
Trinco Industries, Inc. v. Commissioner, 22 T.C. 959">22 T.C. 959By the same token, we do not accept respondent's contention that the ability of St. Paul to continue as an operating entity automatically precludes any partial worthlessness of its obligations. See
Sika Chemical Corp. v. Commissioner, supra. Riss v. Commissioner, 478 F.2d 1160">478 F.2d 1160Steadman v. Commissioner, 50 T.C. 369">50 T.C. 369424 F.2d 1">424 F.2d 1 (6th Cir. 1970). Moreover, the situation at the close of 1969 was such that St. Paul's prospects of remaining in business were, to say the least, doubtful. Respondent also argues that the plan of recapitalization adopted by St. Paul in November of 1969 and the determination of St. Paul's management to keep the company afloat preclude partial worthlessness. Neither of these factors, however, would seem to have been comforting to petitioner on December 31, 1969, when St. Paul's bank creditors came knocking at its door. Nor do St. Paul's 1970 negotiations for, and eventual purchase of, a new ammonia plant change the outlook as of December 31, 1969, particularly*129 where it appears that such plant was acquired as a "sink or swim" type effort. In addition, both petitioner's own treasurer and its independent accountant testified that they agreed to a write-down of the St. Paul obligations to their estimate of the December 31, 1969, fair market values.Based upon the record as a whole, we conclude that petitioner has carried its heavy burden of proving that St. Paul's obligations to it were partially worthless as of December 31, 1969, to the extent that their face values exceeded their fair market values (after deducting that portion of the face values which we have held was not required to be included in petitioner's income in 1968) and that respondent's denial of such partial worthlessness was unreasonable. *130 In so finding, we reject respondent's position that the partial worthlessness of that portion of the St. Paul obligations exchangeable for stock pursuant to the plan of recapitalization was in fact a loss suffered on the actual exchange in February, 1970, pursuant to a plan of recapitalization constituting a corporate reorganization within the meaning of section 368(a)(1)(E) others exchanged stock or securities for stock. However, *131 petitioner's exchange of notes for stock in February 1970 does not necessarily preclude a partial bad debt deduction for the year ending December 31, 1969.
The worthlessness (or partial worthlessness) of a debt and the sale or exchange of such debt are separate and distinct events, provided for separately by the Code. If partial worthlessness is factually established as happening prior to a sale or exchange, two identifiable tax events have occurred. Cf.
Levine v. Commissioner, 31 T.C. 1121">31 T.C. 1121Mitchell v. Commissioner, 187 F.2d 706">187 F.2d 70613 T.C. 368">13 T.C. 368 (1949).Levine v. Commissioner, supra. supra ), other factors contributed significantly to our conclusion that the claimed partial worthlessness of St. Paul's obligations in fact existed as of the end of 1969. These other factors have previously been set forth.See pp. 55-58,supra. In evaluating those factors, we have taken into account the effect of the plan of recapitalization that was in the wind. This is all that is required; the fact of the subsequent exchange does not per se preclude the charge-off and the consequent allowable deduction.In view of our conclusion that petitioner's charge-off should not be integrated with the subsequent exchange, we need not determine whether, as respondent contends, the St. Paul construction notes were securities for purposes of section 354 (an issue fraught with ramifications in the area of reorganizations generally) or whether as part of such exchange petitioner made a contribution to the capital of St. Paul and suffered no loss. *133
Taxable year 1971 The last issue is the amount of petitioner's net operating loss for 1971 which petitioner claims is available for carry-back to the years in issue.On its 1971 return, petitioner claimed a net operating loss of $659,156, of which $580,000 is now in dispute.The amount in dispute relates to a partially worthless bad debt deduction claimed by petitioner in an amended petition in respect of its acceptance, pursuant to the three-party agreement among petitioner, Cherokee, and O.O.W.A., of $1,000,000 in Series B, O.O.W.A. bonds and 60,000 shares of Cherokee stock in satisfaction of the $4,000,000 account receivable from Cherokee (written down by petitioner to $2,500,000 prior to 1971 by virtue of our previous holdings herein (see pp. 47-48,
supra )) which petitioner claims was a compromise with its debtor.Respondent argues that any loss which petitioner suffered on the exchange of $3,000,000 of its account receivable for 60,000 shares of Cherokee stock is not recognizable for tax purposes under section 354(a) because the three-party agreement was in reality a plan of recapitalization of Cherokee which constituted a corporate reorganization within the meaning*134 of section 368(a)(1)(E) and, further, because the account receivable was a "security" which petitioner exchanged for stock. Alternatively, respondent argues that no deduction is warranted because petitioner voluntarily canceled the debt in exchange for stock or because the difference between what petitioner gave up and what it received constituted a contribution to the capital of Cherokee.
Unlike the partial worthlessness claimed in respect of the St. Paul obligations at the end of 1969 and prior to the exchange thereof for St. Paul stock, the partial worthlessness claimed by petitioner in respect of the Cherokee account receivable for 1971 is part and parcel of the exchange thereof for Cherokee stock. Whether petitioner realized a loss as a result of such exchange depends upon whether it was a compromise with Cherokee and whether the difference between petitioner's basis in the account receivable and the value of the stock it accepted in satisfaction thereof was worthless. See, generally, 5 Mertens, Law of Federal Income Taxation, sec. 30.36 (1975 rev.). If the transaction with the debtor is more in the nature of a voluntary forgiveness of all or part of the indebtedness, there*135 can be no worthlessness within the meaning of the bad debt provisions. Cf.
Lidgerwood Mfg. Co. v. Commissioner, 22 T.C. 1152">22 T.C. 1152229 F.2d 241">229 F.2d 241 (2d Cir. 1956).Unfortunately, the record before us is simply insufficient to determine the collectibility of the $580,000 difference between the written-down amount of the account receivable ($2,500,000) and the aggregate value of the O.O.W.A. bonds and Cherokee stock ($1,000,000 + $920,000) as of the time of the exchange. *136 Even assuming arguendo, however, that petitioner did realize a loss as a result of any partial worthlessness of the Cherokee account receivable, there is a further difficulty with any deduction thereof. Respondent has taken the position that the Cherokee account receivable was a "security" in petitioner's hands and that the exchange of such security for Cherokee stock constituted a recapitalization within the meaning of section 368(a) (1)(E) so that no gain or loss is recognized under section 354. Irrespective of whether said account receivable was a security for purposes of section 354, we think the nonrecognition rules of section 351 effectively preclude any deduction in respect of the exchange. *137 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 atfer the exchange such person or persons are in control (as defined in section 368(c)) of the corporation. For purposes of this section, stock or securities issued for services shall not be considered as issued in return for property.
Control, under section 368(c) means
the ownership of stock possessing at least 80 percent of the total combined voting power of all classes of stock entitled to vote and at least 80 percent of the total number of shares of all other classes of stock of the corporation.
From Cherokee's balance sheets, it is apparent that Cherokee had but one class of $10 par common stock. Prior to the issuance of shares to petitioner, 10,000 shares were outstanding. In April, 1971, petitioner exchanged $2,500,000 of the account receivable for 50,000 newly-issued shares of Cherokee and came into control of 83.33 percent of Cherokee's stock. Several months later, petitioner exchanged $500,000 of the account receivable for an additional 10,000 shares giving it 85.71 percent of the stock.*138 Viewed either together or separately, the exchanges satisfied the control test of section 368(c).
The critical question, as far as the instant case is concerned, is whether the Cherokee account receivable which was exchanged for Cherokee stock constituted "property" within the meaning of section 351, a term which is broadly construed. See
DuPont deNemours & Co. v. United States, 471 F.2d 1211">471 F.2d 1211H.B. Zachry Co. v. Commissioner, 49 T.C. 73">49 T.C. 73Duncan v. Commissioner, 9 T.C. 468">9 T.C. 468Although section 351 does not apply to "stock or securities issued for services," we are satisfied that the Cherokee stock received by petitioner does not fit the mold of this exception. In the first place, the agreements out of which the account receivable arose speak in terms of "acquisition by purchase" and "purchase and sale" of "facilities." Granted that the construction of such facilities involved the rendition of services, the fact of the matter is such services were*139 directed at the creation of the facilities -- property in which petitioner had an interest prior to the transfer to Cherokee. Compare
James v. Commissioner, 53 T.C. 63">53 T.C. 63Roberts Co. v. Commissioner, 5 T.C. 1">5 T.C. 1Duncan v. Commissioner, supra ; see also Bittker and Eustice, Federal Income Taxation of Corporations and Shareholders, par. 3.03 (1971).By the operation of section 351, petitioner recognizes no loss on its transfer and carries over its adjusted basis in the obligation surrendered to the stock received. Section 358.
*140
Decision will be entered under Rule 155 .Footnotes
1. Prior to the issuance of stock pursuant to the plan of recapitalization, Continental was the shareholder owning the most common stock of St. Paul.↩
2. Cherokee accounted for such lease as a purchase and financing. ↩
3. The amount of the rentals Cherokee was to pay O.O.W.A. under the lease was calculated to be sufficient to amortize the principal and interest owing on the two mortgages and the O.O.W.A. revenue bonds over the term of the lease.↩
1. This receivable is shown as $266,690.91, $266,690.57, and $266,690.51 at various parts of the record. We deem the differences to be immaterial herein.↩
1. Source: Certified financial statements of Peat, Marwick, Mitchell & Co. ↩
4. Cash restricted for application against Demand Notes payable to bank totalled $177,778 in 1968; $466,476 in 1969; $489,256 in 1970; $398,952 in 1971; $637,079 in 1972 $1,269,915 in 1973. ↩
2. Advance on preliminary engineering study for proposed construction. ↩
3. Certification of financial statement by Peat, Marwick, Mitchell & Co. "subject to the continued availability of current borrowing on Demand Notes or the ability of the Company to obtain permanent financing of such indebtedness." ↩
5. Certain items in the 1972 certified financial statement were "reclassified to conform with the 1973 presentation" of the balance sheet in the 1973 Annual Report to stockholders. In 1972 lawsuits were filed against the Company alleging violations of the Minnesota Pollution Control Agency (MPCA) seeking injunctive relief and compensation for damages of $1,000,000 together with punitive damages. The Company estimated $1-2 million costs will be required over a period of years to comply with present standards.↩
1. Source: Certified financial statements prepared by Peat, Marwick, Mitchell & Co. ↩
2. estated is the Company's 1968 Annual Report as $5,168,548 Demand Notes payable to construction company and $4,753,804 Current maturities of long term debt.↩
3. Refelcts Plan of Recapitalization under which $4,203,779 Construction Notes hold by IDI Management Inc., $806,990 Convertible Debentures, $2,000,000 Preferred Stock and $434,940 accrued interest was exchanged for a total of 6,153,347 Common Shares and $7,445,709 contributed to capital. ↩
4. Sowly created Comvertible Proferred Stock issued in payment of notes payable to banks and a construction company $1,735,931, prepaid interest to 6/30/72 on notes payable to banks $544,100, purchase obligation $500,000 and $900,000 Demand Note payable to construction company. ↩
5. Reflects issuance of Convertable Preferred Stock in payment of interest of $646,300 in 1972 and $669,000 in 1973.↩
4. The following summarizes the unaudited balance sheets as of December 31, 1968 and 1969:
Assets 12/31/68 Does not reflect $2,081,718 loss on closing ammonia plant during the second fiscal quarter.
12/31/69 Current assets $ 5,034,280 $ 3,711,797 Net plant and equipment 11,035,082 9,476,440 Other assets 200,546 Intangible assets 97,959 185,390 Total assets $16,167,321 $13,574,173 Liabilities Current liabilities $14,387,760 $18,084,984 Long term debt 1,577,719 739,500 Stockholders equity (deficit) 201,842 (5,250,311) Total liabilities $16,167,321 $13,574,173 1. Source: Certified financial statements prepared by Peat, Marwick, Mitchell & Co. ↩
2. Reflects effect of Plan of Recapitalization approved by stockholders under which $806,990 Convertible Debentures, $4,203,779 Construction Notes due IDI Management, and $434,940 accrued interest was exchanged for common stock of the Company. ↩
3. Reflects issuance of $3,679,000 Preferred stock in payment of obligations and accrued interest including $900,000 demand Note payable to IDI Management.↩
5. See footnote
3, supra↩ .1. Source: Audited financial statements prepared by Peat Marwick, Mitchell & Co.↩
1. Source: Audited financial statements prepared by Peat, Marwick, Mitchell & Co. ↩
2. Reflects treatment of lease of plant facilities from Oklahoma Ordnance Works Authority as a purchase. ↩
3. Reflects cancellation by parent of $364,000 Notes Payable to it, and treated as contribution to paid-in capital. ↩
6. On January 17, 1973 a fire and explosion caused substantial damage to plant facilities. As a result, portions of the facilities were inoperative for a period of time during 1973.↩
4. Reflects issuance of 60,000 shares of common stock to IDI Management, Inc. in satisfaction of $3,000,000 indebtedness. ↩
5. Reflects charge to paid-in capital of accumulated deficit as of July 1, 1970 of $2,209,268. ↩
1. Exclusive of extraordinary items (insurance recovery and income tax reduction due to net operating loss carry forward).↩
6. The following summarizes the unaudited balance sheets as of December 31, 1968 and December 31, 1969:
↩ Assets 12/31/68 12/31/69 Current assets $ 1,625,967 $ 1,934,743 Net plant and equipment 10,296,520 9,575,945 Intangible assets 171,007 192,212 Total assets $12,093,494 $11,702,900 Liabilities Current liabilities $ 2,384,897 $ 3,245,529 Long term debt 10,000,000 9,106,903 Net equity deficit (loss) (291,403) (649,532) Total liabilities $12,093,494 $11,702,900 5. Source: Certified financial statements prepared by Peat, Marwick, Mitchell & Co.↩
1. Capitalized lease obligation collateralizing bank loan ↩
4. Includes $88,512 other notes ↩
3. Extraordinary items ↩
2. Reflects issuance of 60,000 shares of Cherokee common stock in satisfaction of $3,000,000 obligations owing IDI Management
Consists of: Series A Industrial Development Revenue Bonds $4,500,000
Series B Industrial Development Revenue Bonds 1,000,000 ↩
7.
↩ Obligation Face Value St. Paul Construction Notes $4,596,202.41 O.O.W.A. Bonds 4,500,000.00 Cherokee Account Receivable 4,000,000.00 Total $13,096,202.41 Less Write-Down 6,220,000.00 Income Reported $ 6,876,202.41 8. The aggregate fair market values of such obligations as of December 31, 1968, has now been stipulated at $7,100,000 (p. 13,
supra↩ ).9. The deduction for worthlessness represented the decline in estimated fair market value as follows:
Difference Between Face Value and IDI's Estimate of 12/31/69 Item Fair Market Value Cherokee account receivable $1,500,000.00 ($4,000,000.) St. Paul construction and 5,061,741.26 promissory notes ($4,596,202.41 and $507,576.64) Accrued interest due from St. Paul 244,536.18 ($244,536.18) St. Paul account receivable 266,690.51 ($266,690.51) Total $7,072,967.95 Less 1968 Write-off Excluded from Income (6,220,000.00) Claimed Partial Bad $ 852,967.95 Debt Deduction for 1969 The fair market value of these obligations on December 31, 1969 has now been stipulated as noted on p. 13,
supra↩ .10. In its 1968 return, petitioner accrued as income only amounts representing the estimated fair market values of the obligations in question. In his notice of deficiency, respondent challenged those amounts on the ground that petitioner failed to establish that the fair market values of the obligations were less than their face values. The parties have since stipulated the fair market values of the obligations as of the close of 1968 and they are substantially below their face values. (See p. 13,
supra.↩ ) By amendment to his answer to the amended petition, respondent alleged that, under the completed contract method of accounting the obligations were includible in petitioner's income in their "full face amount" rather than their fair market values.11. The partial bad debt deduction for 1968 is raised by petitioner as an alternative to its position that it need not accrue the face values of the obligations as income for such year.↩
12. See also
Steele v. Commissioner, T.C. Memo. 1969-177American Electric Co., Ltd. v. Commissioner, T.C. Memo. 1966-76Jones Lumber Co. v. Commissioner, 404 F.2d 764">404 F.2d 764T.C. Memo. 1967-81 ("reasonable doubt as to its collectibility" and "doubtful collectibility")Harmont Plaza, Inc. v. Commissioner, 64 T.C. 632">64 T.C. 632549 F.2d 414">549 F.2d 414↩ (6th Cir. 1977) ("doubtful collectibility").13. Unless otherwise stated all section references are to the Internal Revenue Code of 1954, as amended and in effect during the taxable years in issue.↩
14. Neither party asks us to decide whether the time for determining reasonable uncertainty should be the date of the receipt of such obligations by petitioner rather than the end of its fiscal year. Under the circumstances herein, we doubt that our conclusion would differ if the former date were used.↩
14. Petitioner's argument that the only difference in tax treatment of an item by an accrual basis, as contrasted with a cash basis, taxpayer is timing and not substantive tax treatment is an oversimplified generalization.For example, an accrual basis taxpayer reports an account receivable when it accrues, and his right to a deduction, when he receives a lesser amount in payment in a later year, is subject to his ability to prove that the amount sought to be deducted is worthless. On the other hand, a cash basis taxpayer reports only the amount which is in fact paid in a later year and is never put to the proof required for a deduction.↩
15. This inquiry may be akin to but not necessarily the same as in evaluating a partially worthless bad debt. See
Corn Exchange Bank v. United States, 37 F.2d 34">37 F.2d 34supra↩ .16. As of December 31, 1968, total assets exceeded total liabilities by a scant $201,842. Fixed assets were carried at a cost less depreciation in the amount of $11,035,082.We have no specific evidence of the fair market value of such assets. Because of general industry conditions, and the inability of St. Paul's production facilities to operate profitably in the face of competition from newer facilities, it is not unreasonable to infer that book value exceeded fair market value by an amount at least equal to $201,842 plus the $2,596,202.41 that petitioner claims is uncertain as to payment in respect of the St. Paul obligations (face less fair market value). See p. 56,
infra,↩ concerning evidence of December 31, 1969, liquidation values of St. Paul's fixed assets.17. Such insolvency is reflected in Cherokee's balance sheet as of December 31, 1968. Respondent offered no evidence that the balance sheet figures did not reflect an actual excess of liabilities over the fair market value of Cherokee's assets. Indeed we think it fair to infer, as we did in the case of St. Paul, that such was actually the case.↩
18. Indeed, St. Paul's earlier attempts to finance the construction of facilities by petitioner had been unsuccessful even before its rather pronounced financial descent. The unavailability of such financing triggered the need for petitioner to accept stock and notes under the 1967 settlement agreement.↩
19. An adjustment to income is necessary to reflect the fair market values as stipulated by the parties.↩
20. Petitioner also argued conditionally for an additional partial bad debt deduction in respect of Cherokee's obligation to the extent that its basis therein exceeded the December 31, 1969 fair market value. Because of our determination for 1968 that petitioner may report only the fair market value of the obligation in issue as income, petitioner need only report $2,500,000 of the $4,000,000 Cherokee account receivable as income in that year. The maximum write-off claimed by petitioner for this receivable for both 1968 and 1969 is $1,500,000. Hence, no bad debt issue remains for 1969 in respect of the Cherokee obligation.↩
21. Although not clearly indicated in the record, we infer that the promissory notes, account receivable, and interest were taken into income by petitioner during or before its 1969 taxable year. See
section 1.166-1(e), Income Tax Regs.↩ In this connection, we note that respondent has not argued that these amounts were not so reported.22. This amount represents the sum of $4,596,202.41 and $507,576.64, or $5,103,779.05 less $42,037.79 representing petitioner's valuation of the shares of St. Paul stock which it would receive if the plan of recapitalization was consummated. The last figure has now been stipulated at $840,775.80, and the $900,000 construction note, which petitioner determined to be valueless at the time of the charge-off, has now been stipulated at $360,000.↩
23. Section 166(a)(2), as in effect for the taxable year in question, provides:
When satisfied that a debt is recoverable only in part, the Secretary or his delegate may allow such debt, in an amount not in excess of the part charged off within the taxable year, as a deduction.↩
24. See also
Harrington v. Commissioner, T.C. Memo. 1972-181↩24. Petitioner is entitled to deduct an amount calculated as follows:
Face Value of St. Paul Obligations = $4,596,202.41 266,690.57 244,536.18 $5,107,429.16 Amount Reported as Income (see footnote 21, supra↩ )$2,000,000.00 (construction notes) 507,576.64 (promissory notes) 266,690.57 (account receivable) 244,536.18 (interest) $3,018,803.39 Less 12/31/69 Fair Market Value $1,200,755.80 (construction and promissory notes) 106,676.23 (account receivable) 97,814.47 (interest) ($1,405,246.50) Partial Bad Debt Deduction = $1,613,556.89 25. Section 368(a)(1)(E) provides:
(a) Reorganization.--
(1) In general.--For purposes of parts I and II and this part, the term "reorganization" means- * * *
(E) a recapitalization * * * ↩
26. Section 354(a) provides:
(a) General Rule.--
(1) In general.--No gain or loss shall be recognized if stock or securities in a corporation a party to a reorganization are, in pursuance of the plan of reorganization, exchanged solely for stock or securities in such corporation * * *.↩
27. This Court's original position in
Mitchell was that a charge-off of a partially worthless debt followed by a sale of the debt to a third party within one taxable year triggered only capital loss on the sale and no bad debt deduction. The court of appeals reversed and stated that if two such separate events occur within one taxable year, the partial bad debt deduction need not be denied. The opinion of the court of appeals has met with subsequent acceptance by this Court. SeeLevine v. Commissioner, 31 T.C. 1121">31 T.C. 112128. Cf.
Ardela, Inc. v. Commissioner, T.C. Memo. 1969-83↩29. As a result of our decision that the petitioner was entitled to a partially worthless bad debt deduction, separate and apart from the recapitalization, its basis in the obligations of St. Paul surrendered in the February 1970 exchange was reduced to the point where no gain or loss would be realized on the exchange, whether taxable or nontaxable.↩
30. Petitioner actually accepted 50,000 shares of Cherokee stock and O.O.W.A. bonds in partial ($3,500,000) settlement of the account receivable on or about April 15, 1971, and accepted an additional 10,000 shares of Cherokee stock on or about July 30, 1971, in settlement of the remaining balance ($500,000). ↩
31. We recognize that our conclusion differs from that which we reached in respect of the worthlessness of the St. Paul obligations in 1969 (as to which petitioner also had the burden of proof). Such difference merely reflects diverse elements which must be taken into account in a case such as this and evaluated by a trial court. Compare pp. 55-58,
supra, where we were able to find partial worthlessness in light of detailed independent appraisals of the debts disputed therein, threatened foreclosure by senior creditors, balance sheets reflecting insolvency at the relevant time estimates of value for assets carried on such balance sheets, etc. See and compare pp. 47-48,supra,↩ where the record did not permit us to find that respondent carried his burden of proving that the collectibility of certain obligations at the end of 1968 was not uncertain.32. To be sure, respondent did not specifically argue the applicability of section 351, but his contribution to capital argument can be construed as encompassing this issue. Moreoever, the respondent's failure to advance a particular legal theory does not preclude our application of such theory to resolve an issue in his favor. See
Smith v. Commissioner, 56 T.C. 263">56 T.C. 26333. The reason for eliminating stock issued for services from section 351 was to prevent compensation for services from escaping taxation upon receipt. See H. Rept. No. 1337 to accompany H.R. 8300, 83d Cong., 2d Sess., A117 (1954).↩
Document Info
Docket Number： Docket No. 6830-74.
Citation Numbers： 36 T.C.M. 1482, 1977 Tax Ct. Memo LEXIS 71, 1977 T.C. Memo. 369
Filed Date： 10/25/1977
Precedential Status： Non-Precedential
Modified Date： 11/21/2020