Corbett v. Commissioner

MERRITT J. CORBETT, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.

Corbett v. Commissioner

Docket No. 18733.

United States Board of Tax Appeals

15 B.T.A. 698; 1929 BTA LEXIS 2808;

March 1, 1929, Promulgated

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1. Held that petitioner is entitled to deduction from gross income of the year 1921 the cost to him of railroad bonds which were ascertained to be worthless in the year 1921.

2. Notes and a bond received by petitioner and others in exchange for stock held to have had a readily realizable market value in 1921.

John E. Hughes, Esq., and William Cogger, Esq., for the petitioner.

W. Frank Gibbs, Esq., for the respondent.

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SIEFKIN

This is a proceeding for the redetermination of deficiencies in income taxes for the calendar years 1920 and 1921 in the amounts of $2,333.84 and $24,482.20, respectively.

The petition contains the following allegations of error:

(1) The respondent erred in disallowing a loss on the sale of 1,600 shares of Tonopah Belmont sold in 1920.

(2) The respondent erred by disallowing in 1921 the loss on bonds of the Colorado, Wyoming & Eastern Railroad Co.

(3) The respondent erred by increasing the petitioner's income for the year 1921 by $13,859.10, an alleged profit on the sale of stock of the Melville-Corbett Co. sold in 1921 by the M. J. Corbett Co. of St. Mary's, Pa., in which company the petitioner was a partner.

(4) The respondent erred by increasing the petitioner's income for the year 1921 by $54,349.40, an alleged profit on the sale of stock of the Melville-Corbett Co., which stock was owned individually by the petitioner.

At the hearing the petitioner abandoned assignment of error (1) and leave was granted petitioner to amend the assignment of error (2) to allege as an alternate contention that the respondent erred by refusing to allow the petitioner to deduct in 1921 the sum of $25,000 for a bad debt due from the Colorado, Wyoming & Eastern Railroad Co.

FINDINGS OF FACT.

The petitioner is an individual residing at Bellaire, Fla.

In 1918 petitioner acquired $10,000 par value of the general mortgage bonds of the Colorado, Wyoming & Eastern Railway Co. in exchange for American Hide & Leather Co. bonds which had cost him $10,000. The sale of bonds of the American Hide & Leather Co. for the year 1918 on the New York stock exchange, as shown in the "Financial Chronicle" for that year, ranged from a low price of 98 1/4 to 102.

In 1919 the petitioner purchased another $10,000 par value Colorado, Wyoming & Eastern Railway Co. bonds for $8,000 cash and later, in the same year, he purchased another $5,000 par value of said bonds for $4,250.

The railroad on which the bonds were issued was built to get coal out of a mixed coal deposit that was supposed to be a 60-foot vein. The coal property was later ascertained to be less valuable than at first thought. In 1921 the mine caught fire and the whole property became practically worthless. The railroad then ceased to function. The petitioner ascertained these facts in 1921.

The railroad was originally named the Wyoming, Laramie & Hahn's Peak Railroad Co. Its properties were sold under foreclosure proceedings in 1914 and turned over to the Colorado, Wyoming & Eastern Railway Co. In 1920 there were several liens against this railroad. Under one of these, a first mortgage given by the Laramie & Hahn's Peak Railroad Co. to the American Trust Co. of Boston, there were outstanding $240,000 principal amount of bonds. Under a mortgage, called the first refunding mortgage, of the Colorado, Wyoming & Eastern Railway Co. there were outstanding $550,000 principal amount of bonds. The general mortgage under which the Equitable Trust Co. of New York and Lyman Rhoades were trustees, was given to secure an issue of $1,600,000 principal amount of bonds. It was a part of these bonds which the petitioner held. The two other mortgages had priority over the general mortgage. No interest was ever paid upon the general mortgage bonds which had been outstanding since July 1, 1914. In 1921 the railroad defaulted upon the interest payment of both of the other issues of bonds.

For the year 1918 the railroad had had a deficit of $11,971.37. For the year 1919 there was a surplus of $11,608.04, but it was the opinion of the directors of the railroad that if the property had been properly maintained the apparent surplus would have been wiped out. For the year 1920 the company had a deficit, after paying interest, of $37,718.75. In the year 1921 the deficit of the railroad, after charging interest on the first two bonds as if it had been paid, was $8,757.62. In the year 1921 the railroad went into the hands of a receiver. The railroad company published no annual reports and made no financial statements of any kind. Except for its officers and directors, none of the security holders knew about the actual condition of the company.

Under date of November 14, 1921, the trustees under the general mortgage issued a notice to the petitioner and the bondholders, which stated in part:

The Trustees under the General Mortgage securing your bonds have, under the authority conferred by the mortgage, declared the principal of all of the outstanding bonds to be due and payable, which declaration automatically makes the accrued interest due and payable, and have made demand upon the Company for the payment of the total sum. It is anticipated that the Company will be entirely unable to make any such payment, and in such case, the Trustees, under the authority granted by the General Mortgage, expect to commence foreclosure proceedings in the Federal District Court for the District of Wyoming, and to ask for the appointment of a receiver. It is expected that this action will immediately be followed by the filing of bills to foreclose by both Guaranty Trust Company of New York, Trustees under the First and Refunding Mortgage, and American Trust Company of Boston, Trustee under the mortgage of Laramie, Hahn's Peak & Pacific Railway Company.

The trustees under the General Mortgage are, of course, willing to follow and abide by the request or instructions of the holders of a sufficient amount of the bonds pursuant to the provisions of the General Mortgage. Although it has been represented to the Trustees that it is doubtful whether this receivership and foreclosure will, in the normal course of things, realize anything for the General Mortgage bonds, the Trustees feel that in the absence of such instructions or request, the proper course for them to pursue is as outlined above in order that the rights and interests of the parties may be adjudicated by a court of competent jurisdiction, and it may be determined what amount, if any, is distributable on account of the General Mortgage bonds.

On December 1, 1923, the United States District Court for the District of Wyoming entered a decree of foreclosure of the mortgages and on April 11, 1924, at the foreclosure sale the property of the railroad sold for $201,000. The date of confirmation of the sale was April 18, 1924. The properties and assets which might be subjected to the general mortgage only were sold for $1,000, which was insufficient to pay the various costs and expenses of the sale. The trustee had no appraisal of the properties of the railroad in 1921 or later.

The petitioner kept no books of account. His return for the year 1921 was filed upon the cash receipts and disbursements basis.

The bonds were worthless in the year 1921 and were ascertained to be so by the petitioner in that year.

On October 13, 1921, an agreement was entered into among M. J. Corbett, Corbett, M. J. Corbett & Co., a copartnership, and Corbett & Stuart, a corporation, parties of the first part, the Miner-Edgar Co., a New York corporation, party of the second part, and the Melville-Corbett Co., a Pennsylvania corporation, party of the third part. This contract provides in part as follows:

Whereas M. J. Corbett owns 200 shares, M. J. Corbett & Company 150 shares and Corbett & Stuart 150 shares, making a total of 500 shares of the common stock of the Melville-Corbett Company, a Pennsylvania corporation, and

Whereas the Miner-Edgar Company owns all the other shares of the common stock of the Melville-Corbett Company issued and now outstanding, to-wit: 500 shares, and

Whereas The Miner-Edgar Company wishes to acquire by purchase the 500 shares of said stock of the Melville-Corbett Company owned by the parties of the first part,

Now, Therefore, in consideration of the premises, the mutual promises herein contained and other valuable considerations, the parties hereto agree as follows:

First: The Sellers agree to deliver to the Buyer on November 1, 1921, at 10:00 o'clock in the forenoon at the offices of Moore, Hall, Swan & Cunningham, 27 William Street, Borough of Manhattan, New York City, 500 shares of the common stock of the Melville-Corbett Company duly endorsed for transfer to The Miner-Edgar Company or to any nominee the Buyer may select, but subject to a pledging thereof as hereinafter provided.

Second: The Buyer agrees to pay therefor $10,000.00 in cash on delivery of the stock as provided in Paragraph "FIRST," and to execute and deliver its notes and the securities as follows:

(A) Three promissory notes made by the Buyer and endorsed by the Melville-Corbett Company to be dated November 1, 1921, with interest at 6 per cent, of $5,000.00 each payable in two months, four months and six months, respectively, at the Nassau National Bank of Brooklyn, Brooklyn, N.Y., and to secure the principal and interest of said notes, the Buyer agrees to pledge as security the 500 shares of common stock of the Melville-Corbett Company which is being sold under this agreement.

(B) A bond secured by a mortgage on the real estate and plant of the Melville-Corbett Company located at Saint Marys, Pennsylvania, to be dated November 1, 1921, with interest at 6%, payable semiannually, for $80,000.00 to mature $8,000.00 on May 1, 1927, and $8,000.00 six months thereafter and at the expiration of each of the eight succeeding periods of six months until the mortgage be satisfied with the option in the obligor or mortgagor on thirty days' notice, to satisfy the whole or any part of said mortgage provided that every such payment less than the entire debt shall be not less than $4,000.00 or shall be some multiple thereof, The Buyer agrees to execute and deliver to the Sellers its bond in the penal sum of $160,000.00 conditioned for the payment of said indebtedness on the terms herein stated and the party of the third part on its part covenants and agrees to duly execute, acknowledge and deliver to the Sellers a mortgage which shall convey and be a first lien upon its entire real estate and plant aforesaid as collateral security for the payment of said bond. It is mutually covenanted, understood and agreed that said bond and mortgage shall contain covenants that during the continuance of said mortgage, the obligor or mortgagor will pay all legal taxes and assessments, will keep all buildings, tools, machinery and equipment in good and substantial repair, will keep the buildings on the premises insured against loss by fire for the benefit of the mortgagee, will not pull down or remove any of the buildings or any part thereof or any engines, fixed or movable machinery or tools or the like appurtenant to the business to be carried on at said plant without the written consent of the mortgagee, unless all articles removed shall be replaced by others of equal value, together with a covenant that if the plant is shut down continuously and does not operate for a period of more than six months that then and in every such event, the obligor or mortgagor will pay to the mortgagee $1,000.00 per month for each month or fraction thereof in excess of said six months that the plants is shut down and does not operate, it being expressly understood and agreed that all amounts so paid shall be applied as a payment on the mortgage debr. It is also further expressly understood and agreed that said bond and mortgage shall contain such other clauses and covenants as are usual in plant mortgages.

(C) Ten notes made by the Buyer and endorsed by the Melville-Corbett Company with interest at 6%, payable semi-annually, dated November 1, 1921, each for $8,300.00, aggregating $83,000.00, payable at the Nassau National Bank of Brooklyn, Brooklyn, New York, as follows:

One note shall be payable on May 1, 1922, and one at the expiration of each subsequent six months period until all are paid. The notes shall be subject to a condition that if there be a default in any note for a period exceeding three months then all of said notes shall become due and payable at the election of the holders thereof. All said notes shall be secured by bonds of the Miner-Edgar Company of the par value of $100,000.00 known as first mortgage and refunding bonds of a total authorized issue of $1,500,000.00 bearing interest at the rate of 7%. As each note of $8,300.00 and interest is retired, there shall be released from the bonds so pledged and surrendered to the obligor bonds of the par value of $8,000.00, provided there has been no default in the payment of interest on the notes remaining unpaid or the mortgage indebtedness.

The contract was executed according to its terms. The three notes for $5,000 each were worth their face value. At or about the date of delivery of the $80,000 bond secured by the mortgage, petitioner attempted to sell it. Petitioner discussed the matter with the president of a bank in St. Mary's, Pa., and then tried to sell it to the A. Curie Chemical Co. This company refused to buy it. Petitioner also offered it to other people who also refused to buy it. No part of the principal amount of the bond has been paid except $4,000, which was paid at the time the first installment of $8,000 was due, which was May 1, 1927. Interest on the bond was paid up till May 1, 1927, but since that time none has been paid. The petitioner turned over the bond to a bank in Binghamton, N.Y., which marketed it.

The obligor on this bond, which was secured by the mortgage, was the Melville-Corbett Co. The plant of the Melville-Corbett Co. has not been run for two years. It was built primarily to produce acetone for the English Government during the World War. After the war was over the acetone business was gone. Acetone is now being supplied in other ways so that this plant now has very little value. In 1921, however, the Melville-Corbett Co. had an alcoholic refinery plant and a formaldehyde plant and other equipment in connection with it. The plant was upon leased ground.

The equipment of the formaldehyde plant has for years been disconnected and stored and was not covered in the mortgage. Since some time after May 1, 1927, this mortgage has been in the hands of attorneys for purpose of foreclosure.

The ten notes of $8,300 each, the first of which was payable November 1, 1922, were made by the Miner-Edgar Co., which was the purchaser under the contract. The credit of the Miner-Edgar Co. was not good.

As shown by the contract above, the petitioner owned 200 shares of the stock of the Melville-Corbett Co. In addition to this the petitioner owned a 34 per cent interest in M. J. Corbett & Co., which was a partnership.

The petitioner's return for 1921 showed that a profit of $54,349.40 was derived from the sale of his stock in the Melville-Corbett Co.; that a loss of $25,000 was sustained upon the Colorado, Wyoming & Eastern Railroad Co. bonds; and that a $4,000 loss was sustained upon stock or bonds of the Binghamton Cold Storage & Ice Co., making a net gain from sale of stocks and bonds of $25,349.40.

The respondent disallowed the claimed loss of $29,000 and increased the income of petitioner from the M. J. Corbett Co., the partnership in which petitioner owned a 34 per cent interest, by an amount of $13,859.10.

OPINION.

SIEFKIN: The first question for decision is whether petitioner is entitled to a deduction for the year 1921 for an alleged loss on bonds of the Colorado, Wyoming & Eastern Railway Co. In 1918 petitioner acquired $10,000 par value of the bonds for American Hide & Leather Co., bonds of a value of $9,825. We may assume, then, that the Colorado, Wyoming & Eastern Railway Co. bonds were of this value. Petitioner in 1919 bought a total of $15,000 par value of the same bonds for $12,250. The total cost of the bonds was, therefore, $22,075.

Section 214(a) of the Revenue Act of 1921 provides:

That in computing net income there shall be allowed as deductions:

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(7) Debts ascertained to be worthless and charged off within the taxable year * * *

We have found, as a fact, based upon the facts found and upon the testimony of witnesses who were familiar with the affairs of the railroad, that these bonds were worthless in 1921 and that the petitioner ascertained them to be so in that year. Petitioner kept no books of account and, therefore, could not charge them off. The petitioner is entitled to a deduction of $22,075 for the year 1921.

The remaining question for decision relates to the profit upon the disposition of stock. The petitioner does not question the cost of the stock as determined by the respondent. On October 13, 1921, the petitioner, M. J. Corbett & Co., a partnership in which petitioner held a 34 per cent interest, and Corbett & Stuart, a corporation, all agreed in one instrument to transfer stock in the Melville-Corbett Co. to the Miner-Edgar Co. Petitioner held 200 shares, M. J. Corbett & Co. held 150 shares, and Corbett & Stuart held 150 shares. The total consideration received by the three parties consisted of $10,000 cash, three notes for $5,000 each, ten notes for $8,300 each, and a bond for $80,000 secured by a mortgage.

The petitioner, on his return, showed a profit of $54,349.40 as his profits upon the sale of his 200 shares of stock of the Melville-Corbett Co. The respondent accepted this figure as correct and also increased petitioner's income from the partnership by $13,589.10. The petitioner now claims that the inclusion of both the $54,349.40 item and the $13,589.10 item in income was error. This claim arises from the contention of the petitioner that neither the bond for $80,000 nor the ten notes for $8,300 had a readily realizable market value at the time received. Petitioner concedes that the three notes for $5,000 each were worth their face value.

Section 202(e) of the Revenue Act of 1921 provides:

Where property is exchanged for other property which has no readily realizable market value, together with money or other property which has a readily realizable market value, then the money or the fair merket value of the property having such readily realizable market value received in exchange shall be applied against and reduce the basis, provided in this section, of the property exchanged, and if in excess of such basis, shall be taxable to the extent of the excess; * * *

The petitioner testified that the ten notes for $8,300 each had very little, if any, market value. However, this is a conclusion of the witness and we can not accept it as a fact. The petitioner did not disclose his reasons for reaching such a conclusion. Nor do we believe that the petitioner has shown that the bond secured by the mortgage had no readily realizable market value. It will be observed from the contract set forth in our findings of fact that both the Melville-Corbett Co., and the Edgar-Miner Co., assume to be responsible to the petitioner and the other sellers of the stock for the payment of the bond. The Edgar-Miner Co. agreed to execute a penal bond to secure the payment.

The holding of the respondent with regard to the profit upon the sale of stock will not be disturbed.

Judgment will be entered under Rule 50.