Manning v. Commissioner

Charles N. Manning, Petitioner, v. Commissioner of Internal Revenue, Respondent

Manning v. Commissioner

Docket No. 1282

United States Tax Court

3 T.C. 853; 1944 U.S. Tax Ct. LEXIS 118;

May 17, 1944, Promulgated

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Decision will be entered under Rule 50.

1. Petitioner was a shareholder of three joint stock land banks which were organized pursuant to the Federal Farm Loan Act and were authorized to lend money on farm properties, to issue farm mortgage bonds, and to own farm properties, Government securities, and other assets incidental to their business. The banks reached the peak of their operations in 1929, but thereafter economic conditions became such that there was a substantial shrinkage in the value of farm securities and a considerable increase in defaults on debts owed to the banks. On May 12, 1933, the Emergency Farm Mortgage Act was enacted, which prohibited joint stock land banks from making new farm loans or issuing new farm mortgage bonds except in the refinancing of loans already made. The act did not require the liquidation of any of these banks, nor did it specify any period within which the banks were to be liquidated. Subsequent to 1937, the stockholders of the respective banks adopted plans of liquidation which provided for distributions in liquidation to the stockholders within a period not exceeding three years from the year in which the first distribution in liquidation was made. After the enactment of the Emergency Farm Mortgage Act, and until the adoption of the plans of liquidation by the stockholders of the respective banks, the banks continued to hold farm mortgage loans, acquired farms by foreclosure, invested in Government securities, and refunded their bonded indebtedness. Held that the plans of voluntary liquidation adopted by the stockholders of each bank were bona fide plans of liquidation; that the distributions received by petitioner were received under those plans of liquidation and were amounts distributed in complete liquidation under section 115 (c) of the Internal Revenue Code, so that they are taxable as long term capital gains.

2. Attorneys' fees and legal expenses in connection with litigation in a prior year involving a claimed tax liability of petitioner, held deductible as nonbusiness expenses, under section 121 of the Revenue Act of 1942.

Donald V. Hunter, Esq., and W. A. Hifner, Jr., C. P. A., for the petitioner.

John H. Pigg, Esq., for the respondent.

Harron, Judge.

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HARRON

Respondent determined deficiencies in income tax for the calendar years 1939, 1940, and 1941 as follows:

1939	$ 1,126.48
1940	20,580.73
1941	602.83

Some of respondent's adjustments have been conceded by petitioner. The principal issue for determination is whether certain distributions received by petitioner from three joint stock land banks were received in complete liquidation of the corporations under section 115 (c) of the Internal Revenue Code so as to entitle petitioner to have the gains derived therefrom treated as long term capital gains. There is also the question as to whether attorneys' fees and legal expenses paid by petitioner in 1939 for services in connection with certain litigation before the Board of Tax Appeals and the Circuit Court of Appeals for the Sixth Circuit are deductible as a nontrade or nonbusiness expense under section 23 (a) (2) of the code, as amended by section 121 of the Revenue Act of 1942.

Most of the facts have been stipulated. Petitioner resides in Lexington, Kentucky, and filed his returns for the taxable years with the collector for the district of Kentucky.

FINDINGS OF FACT.

During the years 1939, 1940, and 1941 petitioner was president of the Security Trust Co., Lexington, Kentucky, and, until April 1941, was also president of the Kentucky Joint Stock Land Bank of Lexington, Kentucky, hereinafter referred to as the Kentucky bank. During this period he owned shares of stock of the Kentucky bank, the Dallas Joint Stock Land Bank, Dallas, Texas, hereinafter called the Dallas bank, and the North Carolina Joint Stock Land Bank of Durham, North Carolina, hereinafter called the North Carolina bank. Petitioner's stock in these banks was acquired as follows:

Kentucky Bank
	Number
Date acquired	of shares	Cost
1926 to 1936	214 3/4	$ 21,537.82
1937 to 1938	17 1/4	2,692.50
Nov. 25, 1939	24	7,915.50
1939 to 1940	9	1,768.68
Total	265	33,914.50
Dallas Bank
1936	54	$ 3,823.50
North Carolina Bank
June 7, 1940	51	$ 5,030.37

The Kentucky bank was organized April 4, 1922, pursuant to the Federal Farm Loan Act of July 17, 1916, for the purpose of engaging in the business of lending money on farm mortgage security, issuing farm loan bonds, receiving deposits of public money from the Government of the United States, acting as financial agent for the Government, and generally transacting all business which joint stock land banks may transact under the Federal Farm Loan Act. Its initial capitalization was $ 250,000, consisting of 2,500 shares of the par value of $ 100 each. The capitalization was subsequently increased to 6,500 shares of the same par value. The capital was obtained by the sale of the stock to private individuals and private corporations. All of such stock was sold at $ 120 per share, the $ 20 premium being credited to paid-in surplus as follows:

		Paid-in	Paid-in
Year	Shares	capital	surplus
1922	2,500	$ 250,000	$ 50,000
1923	3,000	300,000	60,000
1926	500	50,000	10,000
1927	500	50,000	10,000
Total	6,500	650,000	130,000

The capital of the bank remained in these amounts until the final liquidation of the bank.

The Kentucky bank, like other joint stock land banks, was a privately organized institution, and none of its stock was ever owned by the United States. The bank's directors were elected each year by the stockholders and these directors elected the officers of the bank and controlled its policies. The loans of these banks were similar to those of the Federal land banks in that they were made on an amortization basis for maturities of not less than five years nor more than forty years and were secured by first mortgages on farm lands. The borrower from a joint stock land bank dealt directly with the bank. For the purpose of obtaining funds with which to make loans, the Kentucky bank was authorized to issue bonds, designated as farm loan bonds, in an amount not in excess of fifteen times its capital and surplus. These bonds were required to be secured by first mortgages on farms or United States Government bonds, not less, in an aggregate amount, than the sum of the issued bonds, and to bear a rate of interest not to exceed 5 percent per annum. It was authorized to charge a rate of interest on farm loans not to exceed by more than one percent per annum the rate of interest established for its last series of farm loan bonds. The Kentucky bank paid 5 percent interest on its bonds and charged 6 percent interest on its loans. The bonds and income derived therefrom were exempt from Federal, state, municipal, and local taxation, but the Government assumed no liability for the payment of either principal or interest. Upon default of any obligation, any joint stock land bank was subject to being declared insolvent and placed in the hands of a receiver by the Federal Farm Loan Board. No such bank was to go into voluntary liquidation without the written consent of the Federal Farm Loan Board, which had general supervisory authority over a joint stock land banks until May 27, 1933, when its functions were taken over by the Farm Credit Administration.

From the time of its organization in 1922 until May 12, 1933, the principal sources of income of the Kentucky bank consisted of interest on farm loans, interest on Government securities and profits from the sale of such securities, and income from the operations of farm properties acquired by foreclosure and from the sale of such properties.

The Kentucky bank reached the peak of its operations in 1929, and at the end of that year its gross mortgage loans amounted to $ 12,140,400, on which payments of principal of $ 789,605.89 had been made and defaults in principal amounted to $ 2,897.64, leaving net loans outstanding of $ 11,347,896.47. The unmatured farm mortgage bonds of the bank then outstanding amounted to $ 11,193.500. After 1929 economic conditions became such that there was a substantial shrinkage in the value of farm properties and a considerable increase in the defaults in the debts owed to the Kentucky bank and to land banks generally throughout the United States. This condition resulted in the enactment of the Emergency Farm Mortgage Act of 1933, approved May 12, 1933, the preamble of which reads as follows:

To relieve the existing national economic emergency by increasing agricultural purchasing power, to raise revenue for extraordinary expenses incurred by reason of such emergency, to provide emergency relief with respect to agricultural indebtedness, to provide for the orderly liquidation of joint-stock land banks, and for other purposes.

The Emergency Farm Mortgage Act of 1933 provided in section 29 thereof as follows:

After the date of enactment of this Act, no joint-stock land bank shall issue any tax-exempt bonds or make any farm loans except such as are necessary and incidental to the refinancing of existing loans or bond issues or to the sale of any real estate now owned or hereafter acquired by such bank.

Subsequent to the enactment of the Emergency Farm Mortgage Act of 1933, the Kentucky bank did not issue any new farm mortgage bonds, nor did it make any new farm mortgage loans except such as were necessary and incidental to the refinancing of existing loans or bond issues or to the sale of real estate then owned or thereafter acquired through foreclosures.

Sections 30 and 31 of the Emergency Farm Mortgage Act of 1933 authorized, but did not make compulsory upon any joint stock land bank, the borrowing of funds from the Reconstruction Finance Corporation and from the Farm Loan Commissioner "to provide for orderly liquidation" and "for emergency purposes." The Kentucky bank neither applied for nor received any loan or loans under these sections of the act.

During the period from May 12, 1933, to November 1938, the Kentucky bank continued to own the then unpaid mortgage loans theretofore made by it. In addition it acquired farms by foreclosures in cases of default on mortgage loans, which it operated until sold, taking mortgages from the vendees in connection with such sales. It also from time to time invested available funds in Government securities. Beginning in 1929, and until February 1935, the Kentucky bank purchased on the open market, or by tenders, at less than par, such of its outstanding farm mortgage bonds as were tendered to it by its bondholders, at prices which its directors approved. Subsequent to February 1935, when its bonds attained a market value equal to par, it borrowed money from commercial banks, on collateral loans at interest rates of from 1 percent to 2 percent, and used the proceeds of such loans to retire certain of its outstanding farm mortgage bonds as they matured or became subject to call. With the approval of the Farm Credit Administration, the Kentucky bank in 1935 issued its five-year 3 percent refunding bonds in the total amount of $ 3,360,000, which bonds were to be used by the Kentucky bank as collateral on loans made to it by commercial banks for the purpose of taking up certain of its then outstanding farm mortgage bonds, or which were to be exchanged, par for par, for certain of its then outstanding farm mortgage bonds which had been called for payment as of May 1, 1935. Of the $ 3,360,000 refunding bonds so issued, $ 2,470,000 thereof were in 1935 used as collateral with commercial banks on 2 percent loans made in connection with the retirement of its called farm mortgage bonds. None of these refunding bonds was exchanged for the outstanding farm mortgage bonds.

These activities of the Kentucky bank during the period from 1933 through 1938 resulted in year-end earned surpluses as follows:

1933	$ 145,266.84
1934	313,938.40
1935	728,908.32
1936	$ 881,205.38
1937	1,450,226.61
1938	1,627,261.33

During the period 1933 to 1938 the Kentucky bank purchased and canceled its outstanding farm mortgage bonds as follows:

Bond Purchases
Year	Purchased	Cost	Discount
On hand --
1/1/33	$ 696,500	$ 373,332.50	$ 323,167.50
1933	2,306,500	1,644,600.00	661,900.00
1934	2,176,500	2,062,434.06	114,065.94
1935	3,369,000	3,369,000.00	None
1936	264,500	264,500.00	None
1937	181,000	181,000.00	None
1938	None	None	None
Total	8,994,000	7,894,866.56	1,099,133.44

Bond Cancellation
Year	Canceled	Cost	Discount
1933	$ 1,569,000	$ 1,076,032.50	$ 492,967.50
1934	2,544,000	2,145,151.88	398,848.12
1935	4,385,500	4,178,182.18	207,317.82
1936	270,500	270,500.00	None
1937	225,000	225,000.00	None
1938	None	None	None
Total	8,994,000	7,894,866.56	1,099,133.44

Dividend distributions were made to the stockholders of the Kentucky bank in each of the years 1923 through 1928, amounting in the aggregate to $ 277,000. No further dividends were paid and no other distributions were made to the shareholders until June 1, 1939, when the first liquidating distribution of $ 35 per share was made to each shareholder.

Prior to and including the year 1932, there were published by the Federal Farm Loan Bureau, as of December 31 of each year, certain reports described thereon as follows:

Statements of Condition of Federal Land Banks

Joint Stock Land Banks

Federal Intermediate Credit Banks

Compiled from Reports to the Federal Farm Loan Board as of December 31, * * *

A similarly described report, as of December 31, 1933, was published by the Farm Credit Administration. Thereafter, the annual reports relating to the financial condition of joint stock land banks were published by that Federal agency. In the reports subsequent to December 31, 1933, no reference is made to Federal Land Banks and Federal Intermediate Credit Banks. The report as of December 31, 1934, was described thereon, as follows:

Statements of Condition of Joint Stock Land Banks

Compiled from Reports of the Banks as of December 31, 1934

Beginning with the report as of December 31, 1935, all such subsequent annual reports (for the years 1935 to 1941, inclusive) were described thereon as follows:

Joint Stock Land Banks

Progress in Liquidation Including Statements of Condition as of December 31, * * *

Compiled from Reports Submitted by the Banks to the Farm Credit Administration

In the above described report of December 31, 1934, and in each of the mentioned subsequent reports, the following statement appears:

Orderly Liquidation. -- With regard to these banks, the Emergency Farm Mortgage Act of 1933, approved May 12, 1933, provided that "After the date of enactment of this act, no joint stock land bank shall issue any tax-exempt bonds or make any farm loans except as are necessary and incidental to the refinancing of existing loans or bond issues or to the sale of any real estate now owned or hereafter acquired by such banks." This act in effect prohibits joint stock land banks from acquiring new business and restricts them to the orderly liquidation of their existing assets. * * *

Each of these reports contained a paragraph entitled "Status of Banks," of which that appearing in the report of December 31, 1935, is typical. It reads in part as follows:

Status of Banks. -- Forty-four joint stock land banks are in operation, one is in voluntary liquidation, and three are in process of liquidation through receivership.

As of December 31 of the years 1933 to 1939, inclusive, the Kentucky bank had (A) total assets, including (B) net outstanding unmatured farm mortgage loans; and (C) total liabilities, including (D) outstanding unmatured farm loan bonds, as follows:

	Assets		Liabilities
	A	B	C 1	D 2
Dec. 31 --
				Outstanding
		Outstanding	Total	unmatured
	Total assets	unmatured	liabilities	farm loan
		farm loans		bonds
1933	$ 7,826,394.35	$ 6,967,121.02	$ 6,895,995.76	$ 5,991,000
1934	5,243,800.97	4,277,655.70	4,145,135.59	3,814,500
1935	3,940,298.10	3,394,706.73	2,385,611.83	387,000
1936	3,454,237.11	2,971,274.08	1,766,112.20	178,000
1937	3,160,762.89	2,559,724.12	902,143.20	0
1938	2,494,333.38	2,190,750.99	87,072.05	0
1939	1,640,941.99	1,068,899.64	9,045.55	0

On December 31, 1940, the Kentucky bank had only $ 52,999.58 of assets remaining, all of which was cash. Its liabilities on that date amounted to $ 50,516.74.

There was submitted to the board of directors of the Kentucky bank at its monthly meeting of July 12, 1933, the report of the bank's executive committee, including a "printed plan of tender of the bonds issued by the Bank to the holders of same" which report, "on motion made and unanimously carried * * * was approved." A copy of said printed plan or letter dated July 3, 1933, was mailed by the Kentucky bank to each of its bondholders on or about that date. This printed plan or letter stated as follows:

Under the terms of the Emergency Farm Mortgage Act of 1933, Joint Stock Land Banks are required to liquidate. The hope that Congress would recognize some moral obligation of the Government to the holders of Joint Stock Land Bank Bonds on account of the characterization "Instrumentalities of the United States Government" has ended in disappointment. The banks are forbidden to issue any additional bonds or to make additional loans except for the purpose of refunding old obligations.

PRINCIPAL PROVISIONS OF ACT

The following provisions of the Act deal with the liquidation of Joint Stock Land Banks:

* * * *

OBSTACLES TO LIQUIDATION

While it is the expressed purpose of the Act to require liquidation of the Joint Stock Land Banks, various obstacles have been imposed by the authorities in the States in which this Bank operates to the collection of debts due to the Bank, viz:

* * * *

NECESSITY FOR IMPARTIAL PLAN OF LIQUIDATION

The present situation of the Bank as revealed from the circumstances has influenced the management to give its consideration to a plan of liquidation. It would, obviously, be unfair for the Bank to allocate its prime liquid assets to the payment of bonds selected by it without giving an opportunity to all its bondholders known to it to offer their bonds for cancellation. To do so would be to prefer certain bondholders and to leave the slower and less desirable assets as security for the remaining bonds, upon which dividends in liquidation might be long deferred and separated by wide intervals of time. The Bank, therefore, has decided, if tenders of its bonds are received at prices justified by the present situation and future prospects of the Bank, to apply its cash and United States bonds according to the plan on the following page.

The plan provided that bondholders of the Kentucky bank who desired to dispose of their bonds should tender them to the Kentucky bank at such prices as the bondholders might be willing to accept and preference would be given to the bonds tendered at the lowest figures.

At a special meeting of the board of directors of the Kentucky bank held on September 20, 1933, and at other meetings of the board of directors held during the years 1934 to 1937, inclusive, there were considered and adopted various means and plans for borrowing from commercial banks and otherwise for the purpose of "providing funds with which to purchase outstanding bonds of the Bank, pay interest on outstanding bonds and/or other corporate purposes designed to facilitate the liquidation of the Bank * * *."

Under date of February 16, 1935, E. S. Dabney, as vice president and manager of the Kentucky bank, addressed a letter to the Collector of Internal Revenue, Louisville, Kentucky, which read in part as follows:

We are in receipt of a letter from your office * * * relative 1933 capital stock return. You enclose blank Form 707 (capital stock tax return) for 1933, requesting that we execute this and return it to your office without further delay, together with an affidavit setting forth the reason why we failed to file the return within the time prescribed by law.

In view of the fact that this Bank, as are all Joint Stock Land Banks, is required to liquidate as provided by the Emergency Farm Mortgage Act of 1933 and is now in liquidation and no earnings of the Bank, if any there be, are distributable to the shareholders, and for the further fact that the Bank is organized under the Federal Farm Loan Act and by reason thereof is entitled to certain exemptions from payment of taxes, we have understood that it was not necessary for us to file the return in question.

A capital stock tax return for the year ended June 30, 1933, disclosing no tax due, was filed by the Kentucky bank on June 12, 1935.

On July 3, 1935, the Kentucky bank filed a capital stock tax return for the year ended June 30, 1934, on the face of which the following statement appeared:

The Kentucky Joint Stock Land Bank, being a joint stock land bank organized under Federal Farm Loan Act and now in liquidation under said Act as amended and having been ruled exempt from this tax, no computation of same is made.

On the same date, July 3, 1935, the Kentucky bank filed a capital stock tax return for the year ended June 30, 1935, on the face of which the identical statement, as above, appeared.

The Kentucky bank filed an income tax return for the year 1933, disclosing thereon a net loss of $ 148,167.96. The question as to the main kind of business in which it was engaged was answered, on page 4 of said return, as follows: "Farm Loans -- Principal in Liquidation."

At the monthly meeting of the board of directors of the Kentucky bank held on November 9, 1938, the officers of the bank submitted a "Plan of Liquidation" of the bank and suggested that a special stockholders' meeting be called for the purpose of considering such a plan, and a resolution to that effect was adopted. At a special meeting of the stockholders held on November 29, 1938, the "Plan of Liquidation" proposed by the board of directors at the meeting of November 9, 1938, was duly adopted by a vote of 4,957 shares out of a total of 6,500 shares of outstanding stock. On December 3, 1938, the "Plan of Liquidation" so proposed by the directors and approved by the stockholders received the approval of the Farm Credit Administration, such approval taking the form of an order signed by the Land Bank Commissioner.

The plan of liquidation adopted by the stockholders of the Kentucky bank, and approved by the Farm Credit Administration, specifically provided for the following steps:

Item I: Collection or Disposition of Assets

Item II: Provisions for Payment of Obligations of the Land Bank

Item III: Publication of Notice of Dissolution of the Land Bank

Item IV: Provision for Conveyance of Residuum of Title or Interest in Real Estate

Item V: Distribution to Shareholders -- Period of Liquidation

Item VI: Surrender of Charter

Item VII: General Authorization to Officers and Directors

Item VIII: Provision for Submission of Plan to Shareholders of Land Bank and to the Farm Credit Administration

"Item V -- Distribution to Shareholders" of the "Plan of Liquidation" of the Kentucky bank provided as follows:

After the payment, or provision for the payment, by the Land Bank of its obligations in the manner hereinabove set forth, liquidating dividends shall be paid to the shareholders of the Land Bank, equally and ratably according to the number of shares held by them, respectively, from time to time, as the Directors of the Land Bank may prescribe, subject always, however, to the prior approval of the Farm Credit Administration; provided that no such liquidating dividends shall be authorized or paid until after January 1, 1939, and that all such liquidating dividends shall be fully paid on or before December 30, 1942. At or before the time of the payment of each of said liquidating dividends the shareholders shall present to the Land Bank their certificates of stock, upon which shall be endorsed a notation of the liquidating dividends paid thereon, after which said certificates of stock shall be returned by the Land Bank to the respective owners thereof; provided, however, that upon the payment of the last of said liquidating dividends the shareholders shall surrender to the Land Bank their certificates of stock, which, immediately upon being delivered to the Land Bank, shall be cancelled by it. If any shareholder or shareholders shall fail to surrender their certificates of stock to the Land Bank at the time of the payment of the last of said liquidating dividends, on or before December 30, 1942, the Land Bank, on or before December 30, 1942, shall deposit in a special account in Security Trust Company of Lexington, Kentucky, the amounts due said shareholders on their unpresented certificates of stock, with instructions and directions to said Security Trust Company to complete the payment to said shareholders, respectively, for said certificates of stocks as and when said certificates may be presented for payment and thereupon cancel said surrendered certificates. Should any of said certificates of stock not be presented for payment on or before December 30, 1942, the Land Bank, upon depositing in said Security Trust Company the amounts due thereon for the credit of said shareholders owning said certificates, shall be relieved entirely of all responsibility and liability in connection therewith.

It is the intent and purpose of this plan of voluntary liquidation of the Land Bank to provide for its "complete liquidation" within the meaning of this term as expressed in Section 115 of the Revenue Act of 1938 of the United States, and in order to complete the liquidation of the Land Bank within a period of three years from the close of the taxable year during which is to be made the first of the series of distributions under this plan (the first of said series of distributions to be made during the year 1939), it is specified herein that the final liquidation shall be completed before or during the year 1942. If, after this plan of liquidation of the Land Bank shall have been adopted, it shall appear that the "complete liquidation" of the Land Bank, within the meaning of said Section 115 of the Revenue Act of 1938, must be effectuated sooner than the time herein specified, then and in that event the period herein provided for the liquidation of the Land Bank shall be deemed to be, and is hereby, reduced to such extent as to effectuate said liquidation within the time specified in said Section 115 for a "complete liquidation."

The "Plan of Liquidation" so adopted November 29, 1938, was the only plan of liquidation of the Kentucky bank which was ever submitted to or voted upon by its stockholders, and no steps to place the corporation in involuntary liquidation were ever taken by the Farm Credit Administration.

Following the approval by the Farm Credit Administration of the above described plan of liquidation, the officers and directors of the Kentucky bank caused its then remaining assets, other than cash, to be reduced to cash and its then remaining indebtedness to be paid, and the balance was distributed to the shareholders as liquidating dividends upon the dates and in the amounts, as follows:

	Amount per	Total amount
Dates of distribution	share	distributed
June 1, 1939	$ 35.00	$ 227,500.00
Nov. 25, 1939	100.00	650,000.00
Jan. 25, 1940	100.00	650,000.00
Apr. 15, 1940	90.00	585,000.00
May  15, 1940	35.00	227,500.00
Apr. 23, 1941	4.97 1/2	32,337.50
Total		2,372,337.50
Return per share		364.97 1/2

As the foregoing distributions were made, the amounts thereof were endorsed or noted on the stock certificates, and upon the final distribution, on April 23, 1941, the stock certificates of the shareholders were surrendered to the Kentucky bank and were canceled. By reason of these distributions in liquidation, petitioner realized total capital gains as follows:

1939	$ 7,453.43
1940	53,307.57
1941	1,202.87

The last meeting of the board of directors of the Kentucky bank was held on April 9, 1941, and the last meeting of the stockholders of said bank was held on April 10, 1941. The charter of the Kentucky bank was surrendered to the Farm Credit Administration following the payment of the final liquidating dividend, on April 23, 1941.

The liquidation of the Kentucky bank commenced on December 3, 1938, when its plan of liquidation was approved by the Farm Credit Administration.

The Dallas bank was organized July 3, 1919, pursuant to the provisions of the Federal Farm Loan Act of July 17, 1916. Its charter and bylaws were identical as regards powers and general organization with that of the Kentucky bank, except that the area in which the Dallas bank was authorized to make mortgage loans was the States of Texas and Oklahoma. The stock of the Dallas bank was at all times owned by individuals and private corporations. These stockholders elected the directors of the bank, who in turn elected its officers and controlled its policies.

The Dallas bank during the years 1930, 1931, and 1932 was the owner, in each of the years, of farm mortgage loans, U. S. Government securities, purchase money mortgages, real estate contracts, notes receivable, accrued interest, real estate, and sheriff's certificates, as well as miscellaneous assets. Its principal liabilities consisted of farm loan bonds and interest payable. The unmatured principal of loans outstanding, which reached a peak of $ 42,888,116 on December 31, 1928, had fallen to $ 32,933,982 by April 30, 1933, of which 54.1 percent was delinquent.

The Dallas bank, after enactment of the Emergency Farm Mortgage Act of May 12, 1933, did not issue any farm loan bonds or make any new farm mortgage loans except such as were necessary and incidental to the refinancing of existing loans or bond issues or to the sale of real estate then owned or thereafter acquired through foreclosures. In the period after May 12, 1933, the Dallas bank continued to own assets of the same kind as it owned on May 12, 1933, but in varying quantities, and retired its bonded debt as farm loans were liquidated.

(a) At December 31, 1935, the bank had 3,235 6 percent mortgage loans outstanding. It owned 610 farms, sheriff's certificates, etc. All of the bank's farm loan bonds outstanding bore interest at the rate of 5 percent.

(b) At December 31, 1936, the bank had 2,813 6 percent mortgage loans outstanding and owned 597 farms, sheriff's certificates, etc. During 1936 the bank called at par $ 5,432,000 of its 5 percent bonds and issued $ 1,000,000 of refunding bonds bearing interest at the rate of 3 percent.

(c) At December 31, 1937, the bank had 2,529 6 percent mortgage loans outstanding and owned 465 farms, sheriff's certificates, etc. During 1937 the bank called at par $ 12,646,000 of its 5 percent bonds and issued $ 11,700,000 of refunding bonds bearing interest at the rate of 3 percent.

(d) At December 31, 1938, the bank had 2,252 6 percent mortgage loans outstanding. It owned 402 farms, sheriff's certificates, etc. During 1938, the bank called at par $ 1,354,000 of its 3 percent and 5 percent bonds.

(e) At December 31, 1939, the bank had 503 6 percent mortgage loans outstanding and owned 341 farms, sheriff's certificates, etc. From January 1 to December 31, 1939, gross assets and bonds decreased $ 2,943,566 and $ 3,029,000, respectively, and during 1939 the bank called at par $ 2,824,000 of its 3 percent bonds.

The net worth of the Dallas bank for the years 1930 through 1939 was as follows:

	Capital stock
Year	and paid-in	Earned sur	Total
	surplus	plus 1
1930	$ 2,589,000	$ 959,207.29	$ 3,548,207.29
1931	2,449,000	1,283,449.27	3,732,449.27
1932	2,449,000	724,099.53	3,173,099.53
1933	2,449,000	763,000.00	3,212,000.00
1934	2,449,000	781,223.00	3,230,223.00
1935	2,449,000	616,467.13	3,065,467.13
1936	2,439,000	331,820.85	2,770,820.85
1937	2,439,000	2,807,168.58	5,246,168.58
1938	2,439,000	3,139,070.64	5,578,070.64
1939	2,439,000	3,318,037.63	5,757,037.63

No distributions of any kind were made to stockholders of the Dallas bank during the years 1933 through 1939 except a dividend of 1 percent which was authorized in 1931, but was not paid until 1936, to stockholders of record as of March 20, 1932.

At a meeting on March 27, 1940, by a vote of over two-thirds of the stock of the Dallas bank, there was adopted a "Plan of Liquidation." This plan of liquidation was identical with that adopted by the Kentucky bank as to the steps to be taken in liquidation, except that the period for distribution to the shareholders was limited to December 31, 1943. This plan of liquidation was approved without change by the Administrator of the Farm Credit Administration on May 2, 1940, and following such approval distributions in liquidation were made to Dallas bank stockholders in the years involved as follows:

Year	Amount per share
1940	$ 100.00
1941	25.00
1942	40.00

On December 27, 1943, the final distribution in liquidation under the plan was made. By reason of these distributions, petitioner realized total capital gains during the years 1940 and 1941 in the respective amounts of $ 1,576.50 and $ 1,350.

There were no distributions by the Dallas bank in 1940 prior to approval of the plan of liquidation, and this plan of liquidation was the only plan of liquidation ever voted upon by the stockholders of the Dallas bank or approved by the Farm Credit Administration. No steps were ever taken by the Farm Credit Administration to place the Dallas bank in involuntary liquidation.

The liquidation of the Dallas bank commenced on May 2, 1940, when its plan of liquidation was approved by the Farm Credit Administration.

The North Carolina bank was organized July 5, 1922, pursuant to the provisions of the Federal Farm Loan Act of July 17, 1916. The charter and bylaws of this bank were identical with that of the Kentucky bank, except that the area in which the North Carolina bank was authorized to make farm mortgage loans was North Carolina and Virginia. The stock of the North Carolina bank was at all times owned by individuals and private corporations. These stockholders elected the directors of the bank, who in turn elected its officers and controlled its policies.

During the years 1930 to 1932, inclusive, the North Carolina bank was the owner of farm mortgage loans, United States Government securities, notes receivable, accounts receivable, delinquent installments on mortgage notes, accrued interest, real estate, and sheriff's certificates, as well as cash in substantial amounts. Its principal liabilities consisted of its farm mortgage loan bonds and accrued interest on these bonds. The unmatured principal of loans outstanding and owned by the North Carolina bank reached a peak of $ 14,364,489 on January 31, 1929, but had fallen to $ 8,351,874 by April 30, 1933, of which 55.4 percent was delinquent. The amount of bonded debt was greatest on April 30, 1928, amounting to $ 13,700,000. The amount was reduced to $ 11,253,000 on April 30, 1933, and notes payable of $ 126,895 were outstanding.

The North Carolina bank, after enactment of the Emergency Farm Mortgage Act of May 12, 1933, did not issue any farm loan bonds or make any new farm mortgage loans except such as were necessary and incidental to the refinancing of existing loans or bond issues, or to the sale of real estate then owned or thereafter acquired through foreclosure. During the years 1933 to 1941, inclusive, the North Carolina bank continued to own assets similar to those held prior to May 12, 1933, in diminishing amounts as regards the farm loan mortgages, and its liabilities on its farm loan bonds were substantially reduced.

(a) At December 31, 1935, the bank had 1,912 6 percent mortgage loans outstanding and owned 501 farms. Its outstanding farm loan bonds bore interest at 5 percent.

(b) At December 31, 1936, the bank had 1,700 6 percent farm mortgage loans outstanding and owned 393 farms.

(c) At December 31, 1937, the bank had 1,565 6 percent mortgage loans outstanding and owned 267 farms. During 1937 the bank called at par $ 729,500 of its 5 percent bonds.

(d) At December 31, 1938, the bank had 1,463 6 percent mortgage loans outstanding and owned 172 farms. During 1938 gross assets and bonds decreased $ 1,194,122 and $ 2,578,000, respectively, while notes payable increased $ 1,422,000. During the year 1938 the bank called at par $ 5,551,000 of its 5 percent farm loan bonds and issued $ 3,075,000 of refunding bonds bearing interest at 1 1/2, 2, and 3 percent.

(e) At December 31, 1939, the bank had 1,368 6 percent mortgage loans outstanding and owned 150 farms. During 1939 the bank called at par $ 192,000 of its 2 percent bonds and issued $ 150,000 of refunding bonds bearing interest at three-fourths of 1 percent.

(f) At December 31, 1940, the bank had 774 6 percent mortgage loans outstanding and owned 114 farms.

(g) At December 31, 1941, the bank had 206 6 percent mortgage loans outstanding. In addition it held 234 purchase money mortgages and real estate sales contracts. It owned 21 farms. During 1941, the bank called at par $ 2,250,000 of its 1, 1 1/4, 1 3/8, and 1 1/2 percent bonds and issued $ 2,100,000 of refunding bonds bearing interest ranging from 3/8 of 1 percent to 1 percent. It also redeemed $ 200,000 of its 6 percent bonds which matured during this year.

The net worth and accumulated earnings of the North Carolina bank for the years 1930 through 1941 (excluding a liquidating dividend in 1941) were as follows:

	Capital stock	Earned
Year	and paid-in	surplus 1	Total
	surplus
1930	$ 815,615	$ 338,058.24	$ 1,153,673.24
1931	815,615	365,677.81	1,181,292.81
1932	815,615	294,527.96	1,110,142.96
1933	815,615	475,317.98	1,290,932.98
1934	815,615	330,902.17	1,146,517.17
1935	815,615	317,235.66	1,132,850.66
1936	815,615	273,210.76	1,088,825.76
1937	815,615	468,918.65	1,284,533.65
1938	815,615	527,870.28	1,343,485.28
1939	815,615	631,484.57	1,447,099.57
1940	815,615	674,018.25	1,489,633.25
1941	815,615	684,365.61	1,499,980.61

On August 8, 1941, the stockholders of the North Carolina bank, by a vote of more than two-thirds of its outstanding capital stock, adopted a plan of liquidation. This plan of liquidation was substantially identical, as to provisions and procedure to be followed, with the plan of liquidation adopted by the Kentucky bank, except that it called for the payment of the final liquidating dividend on or before December 31, 1944. This plan of liquidation was approved by the Farm Credit Administration on August 8, 1941, and was the only plan of liquidation ever voted upon by the stockholders of the North Carolina bank or approved by the Farm Credit Administration. No steps were ever taken by the Farm Credit Administration to place the North Carolina bank in involuntary liquidation.

No distributions were made by the North Carolina bank to its stockholders from May 12, 1933, until December 22, 1941. Distribution among its stockholders of all the assets of the North Carolina bank remaining after payment of its debts was made as follows:

Date	Amount per share
Dec. 22, 1941	$ 115.00
Dec. 24, 1942	91.50

The charter of the North Carolina bank was surrendered early in 1943. By reason of the distribution in 1941, petitioner realized a total capital gain in that year of $ 834.63.

The liquidation of the North Carolina bank commenced on August 8, 1941, when its plan of liquidation was approved by the Farm Credit Administration.

The plans of voluntary liquidation which were adopted by the respective stockholders of the Kentucky, Dallas, and North Carolina banks in 1938, 1940, and 1941, were bona fide plans of liquidation. The distributions received by petitioner in the taxable years were made under those plans, and they were amounts distributed in complete liquidation of the banks.

Issue II.

In addition to his compensation as president of the Security Trust Co. of Lexington, Kentucky, and of the Kentucky bank, the petitioner derived income in 1928 from investments in real estate and in securities. Among the securities owned by petitioner in 1928 were 4,525 shares of the common stock of the Fayette Home Telephone Co., hereinafter referred to as the Fayette Co., and stock of the Woodford Telephone Co. The petitioner received dividends on the stock of the Fayette Co. in each of the years 1927, 1928, and 1929.

Petitioner, together with a majority of the other stockholders of the Fayette Co., contracted in 1928 to sell all of his stock in the Fayette Co. to S. E. Stern for an agreed consideration of approximately $ 30 per share. This sale was consummated on April 1, 1929, as a result of which the petitioner received on or about that date the sum of $ 132,356.25 by reason of his ownership of 4,525 shares of Fayette Co. stock. Petitioner in this connection realized a gain of $ 109,093.75, which he duly reported in his income tax return for 1929. In its income tax return for the year 1929 the Fayette Co. did not include any income from the transactions heretofore set forth. Thereafter, respondent determined that the Fayette Co. sold its assets in 1929 at a profit to it of $ 2,282,422.56, and on December 28, 1930, sent, by registered mail, a notice of deficiency to the Fayette Co., wherein that company was notified of a determined deficiency of $ 251,066.48 for the year 1929 which had been made the subject of a jeopardy assessment. No petition was filed with the Board of Tax Appeals for a redetermination of this deficiency. By separate notices of deficiency dated February 7, 1933, the respondent determined that petitioner, together with other former stockholders of the Fayette Co., was a transferee of the assets of the Fayette Co. and liable for the deficiency for the year 1929 to the extent of the sum of $ 132,356.25, so received by him, together with interest.

Petitioner contested the respondent's effort to enforce transferee liability against him, being successful in the Board of Tax Appeals and later in the United States Circuit Court of Appeals for the Sixth Circuit. Litigation was terminated in May 1939 by the decision of the Circuit Court of Appeals. During 1939 petitioner paid to counsel who represented him in the above described litigation attorneys' fees of $ 3,000 and legal expense of $ 11.48, which amounts were claimed as deductions on petitioner's income tax return for the year 1939. This deduction was disallowed by the respondent both as to the attorneys' fees and as to the legal expense.

Petitioner in 1939 owned income-producing stocks and bonds having a value in excess of $ 132,356.25. The only property owned by petitioner during the year 1939 the income from which was not subject to Federal income tax consisted of certain United States Treasury notes in the face amount of $ 3,000.

OPINION.

Petitioner realized gains from the distributions by the three banks during the taxable years. There is no dispute over the amount of the gains realized. The controversy relates only to the question of whether the gains are short term taxable gains, taxable to the extent of 100 percent thereof, as respondent has determined, or whether they are long term capital gains, less than 100 percent of which are to be taken into account in computing net income. The question arises under section 115 (c) of the Internal Revenue Code, ¹ which was in effect during the taxable years.

Under section 115 (c) the general provision is that gains recognized from corporate distributions in liquidation are to be considered as short term capital gains, but an exception is made with respect to amounts distributed in "complete liquidation" which is defined. Petitioner claims the benefit of the exception. Respondent contends that the distributions were not made in complete liquidation as defined.

Respondent takes the view that, under the facts, the adoption by the stockholders of the respective banks of plans of voluntary liquidation in the years 1938, 1940, and 1941 are not material or determinative of the question. He takes the view that the banks were in liquidation after May 12, 1933, when the Emergency Farm Mortgage Act of 1933 was enacted, and that the distributions in question were made in pursuance of a liquidation, in each instance, which began in 1933. We understand this argument to mean that the respondent contends that the distributions in question were not made "in accordance with a bona fide plan of liquidation and under which the transfer of the property under the liquidation is to be completed within a time specified in the plan," etc., within the meaning of section 115 (c). Respondent contends that the plans of voluntary liquidation adopted by the stockholders of the banks can not be said to be bona fide plans of liquidation, within the meaning of the statute, if in fact the liquidation was begun in 1933. Respondent urges that the question presented under the particular facts should be considered with regard to the rules that are often given attention where a tax avoidance motive is present, such as the rules that questions of taxation should be determined by viewing what was actually done rather than the declared purpose of the participants, citing Weiss v. Stearn, 265 U.S. 242">265 U.S. 242; and that where there is doubt about a taxpayer's right to a privilege or exemption, the statute must be construed in favor of the Government, citing Bank of Commerce v. State of Tennessee, 161 U.S. 134">161 U.S. 134. Respondent also contends that the exception provided in section 115 (c) was intended to apply only to liquidations which began after December 31, 1937, and was not intended to apply to liquidations which were in progress prior to January 1, 1938. The fact on which respondent places chief reliance is that after the enactment of the Emergency Farm Mortgage Act of 1933 the banks could not issue any tax-exempt bonds or make any farm loans except such as were necessary in the refinancing of existing loans. He relies upon the statements of the purpose of the Emergency Farm Mortgage Act which have been set forth in the findings of fact to the effect that the effect of the act was to restrict the joint stock land banks to an orderly liquidation of their assets. Respondent says that all of the banks in question were "in process of liquidation" from May 12, 1933, until the date of payment of the final liquidating distributions to the stockholders.

Upon due consideration of respondent's argument, we can not agree that the plans of liquidation adopted by the stockholders of the banks in question were not bona fide. We agree that all of the facts are to be considered and that the formal steps taken by the stockholders should not be isolated from the background, but we must conclude that the over-all view of the facts brings us to a result other than that reached by the respondent.

The banks in question were chartered pursuant to the Federal Farm Loan Act, sec. 811, Title 12, U. S. C. A., p. 843. Under that act they were restricted as to the kind of business they could transact and were subject to regulation by the Farm Credit Administration, but they were nevertheless "privately owned corporations organized for profit to the stockholders." Federal Land Bank v. Priddy, 295 U.S. 229">295 U.S. 229; Bankers Farm Mortgage Co., 1 T. C. 406; Dallas Joint Stock Land Bank v. State, 133 S. W. (2d) 827. Under Federal statute, sec. 822, Title 12, U. S. C. A., p. 850, provision is made for the voluntary liquidation of joint stock land banks, under which each bank is given the right to go into liquidation at any time provided it has made provision, with the approval of the Federal Farm Loan Board, for the payment of its liabilities and has been authorized to liquidate by vote of two-thirds of its stockholders. Andrews v. St. Louis Joint Stock Land Bank, 107 Fed. (2d) 462, 467. The above provision for voluntary liquidation is found in section 16 of the Federal Farm Loan Act of July 17, 1916, as amended by the Act of May 29, 1920, ch. 215, 41 Stat. 691, and the Emergency Farm Mortgage Act of 1933 did not amend or affect the provisions of section 16 of the Federal Farm Loan Act of 1916, as amended. Also, the Emergency Farm Mortgage Act did not direct or require liquidation of any joint stock land bank at any specified time, but left the matter of liquidation to the judgment and discretion of the stockholders of those banks, except in cases of insolvency. The Emergency Farm Mortgage Act permitted the joint stock land banks to continue limited operations and to hold their assets even though they were prohibited from issuing new farm mortgage bonds or making new farm loans and were eventually to be liquidated. In so far as the Federal statutes relating to the joint stock land banks are pertinent to the question presented here, it can not be concluded that under the 1933 Emergency Act there was a mandate to the stockholders of the banks to immediately liquidate which excluded and made inconsistent with the terms of that act the voluntary liquidation of the banks by a two-thirds vote of the stockholders. Our conclusion is that the action of the stockholders of the banks in question in adopting plans of voluntary liquidation was consistent with and in accord with the applicable Federal statutes. We do not understand respondent to make a very strong argument to the contrary.

As we see the problem, the real question is whether the adoption of the plans of voluntary liquidation by the stockholders of the respective banks in 1938, 1940, and 1941 shows a lack of bona fides when considered with the procedures followed during the respective intervals between May 12, 1933, and the dates of adoption of the plans. The facts have been set forth fully and we do not repeat them. We only conclude that there was no lack of bona fides. We think the officers and directors of the banks were exercising their honest judgment in putting the affairs of the banks in order and in endeavoring to operate them profitably during an extremely difficult period. Their efforts were devoted to a program of operations which would facilitate orderly liquidation and dissolution of the banks at some future time. Cf. W. E. Guild, 19 B. T. A. 1186. Such efforts continued over a period of from 5 to 7 years, and they proved profitable to the banks, and upon liquidation were profitable to the stockholders, including petitioner. Under the facts, it is held that the respective plans of voluntary liquidation adopted by the stockholders of the several banks involved were bona fide.

Our views as expressed above mean, of course, that we reject respondent's view that the plans of voluntary liquidation should be disregarded in determining the question at issue. We conclude that they are entitled to full recognition under all of the facts. That being so, respondent's contentions fall. Both the terms of the plans of voluntary liquidation and the carrying out of the provisions of the plans are within the provisions of section 115 (c). It was clearly provided in the plans of voluntary liquidation that the liquidations, in so far as it involved the transfer of the assets of the banks to the stockholders in cancellation of their stock, were to be completed within a three-year period, and actually they were completed within that period. Also, it is clear that there were no plans for the transfer of the assets of the banks to the stockholders in cancellation of their stock, and no such transfers were made to the stockholders, at any time prior to the adoption of the plans of voluntary liquidation. Thus the amounts distributed as liquidating dividends come squarely within section 115. It is held that the distributions received by petitioner in the taxable years were "amounts distributed in complete liquidation" within the provisions of section 115 (c). Respondent's determination is reversed.

Issue II.

Petitioner claims deduction under section 23 (a) (2) of the Internal Revenue Code, as amended by section 121 of the Revenue Act of 1942, of the sum of $ 3,011.48, as a nonbusiness expense. These expenditures in 1939 were incident to litigation before the United States Board of Tax Appeals in 1936, and to an appeal which was taken from the decision of the Board. Respondent contends that the expenditures are not deductible under the above provision of the statute because the subject matter of the litigation did not bear a reasonable and proximate relation to the production or collection of income, or to the management, conservation, or maintenance of property held for that purpose. Respondent relies upon John W. Willmott, 2 T. C. 321.

The subject matter of the litigation appears in the report on the proceeding entitled Southern Bell Telephone & Telegraph Co., 34 B. T. A. 540, in which proceeding petitioner, along with others, was a petitioner. Respondent had determined a deficiency in the income tax of the Fayette Co. for the year 1929 in the sum of $ 256,623.89, and proposed to assess the same proportionately against all of the petitioners as transferees of the assets of the Fayette Co., under section 311 of the Revenue Act of 1928. The total outstanding common stock of the Fayette Co. was 101,240 shares, and it appears that petitioner owned 4,525 shares thereof. It was the respondent's theory in that case that, disregarding the form and the steps of the transaction under which petitioner and the others sold their stock, there had been a transfer by Fayette Co. of its assets to the petitioners, and a sale of the assets by petitioner and the others to a third party. The Board of Tax Appeals rejected respondent's theory, holding that the several petitioners were not liable as transferees. That holding made, the Board of Tax Appeals did not consider other issues including the issue whether the Fayette Co. realized any gain upon the transfer of its assets in 1929.

The question in the proceeding before the Board of Tax Appeals was dependent, inter alia, upon whether the stockholders of the Fayette Co. had sold their stock or whether they had sold the assets of the company. Petitioner, in this proceeding, argues that in the earlier litigation before the Board of Tax Appeals he was endeavoring to establish a valid sale of his stock and his right to retain the proceeds of the sale, which included a profit of roughly $ 109,000. In the Willmott case we said that "Attorney's fees and expenses of litigation are deductible under section 121 of the Revenue Act of 1942 only when the subject matter of the litigation bears a reasonable and proximate relation to the production or collection of income or to the management, conservation, or maintenance of property held for that purpose." We examined the transaction between the taxpayer and his wife, the transfer by him of a one-half interest in property to the wife, to determine whether the original transaction was proximately related to the production or collection of income. We concluded that it was not, and that "any litigation arising out of the transaction involving its tax consequences would also not be related" to the production or collection of income. We held that the fees and expenses paid in connection with the litigation were not deductible under section 121.

However, following the same approach here, we think a different result must be reached. The original transaction was the sale of the Fayette Co. stock, and petitioner entered into that transaction for profit and realized profit. Expenditures in litigation relating to that transaction would have come within section 121 as expenditures in connection with the collection of income. In Walter S. Heller, 2 T. C. 371, 375, upon which petitioner relies, we pointed out that Congress intended the term "income" to embrace income from the disposition of property. Applying the reasoning which was employed in the Willmott case, we must say here that since the original transaction was proximately related to the production or collection of income, any litigation arising out of that transaction involving its tax consequences would also proximately relate to the production or collection of income, and, therefore, fees and expenses paid in connection with such litigation would be deductible under section 121.

Accordingly, under the authority of the Willmott and Heller cases, petitioner is sustained and it is held that the expenditures are deductible under section 121.

Decision will be entered under Rule 50.

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Footnotes

• 1. The amounts shown in column C above, represent the aggregate actual liabilities, as shown by the Kentucky bank's balance sheets, as distinguished from capital stock, surplus reserves, deferred income advance payments on farm loans, and interest thereon, etc.↩

• 2. The amounts shown in column D above represent the aggregate of unmatured farm loan bonds as shown by balance sheets of Kentucky bank, less the amounts of such bonds purchased by the bank and on hand -- but uncanceled↩

• 1. Earned surplus consists of items listed as "Surplus Earned," "Legal Reserve," "Other Reserves," and "Undivided Profits."↩

• 1. Earned surplus consists of items listed as "Surplus Earned," "Legal Reserve," "Other Reserves," and "Undivided Profits."↩

• 1. SEC. 115. DISTRIBUTIONS BY CORPORATIONS.

  * * * *

  (c) Distributions in Liquidation. -- Amounts distributed in complete liquidation of a corporation shall be treated as in full payment in exchange for the stock, and amounts distributed in partial liquidation of a corporation shall be treated as in part or full payment in exchange for the stock. The gain or loss to the distributee resulting from such exchange shall be determined under section 111, but shall be recognized only to the extent provided in section 112. Despite the provisions of section 117↩, the gain so recognized shall be considered as a short-term capital gain, except in the case of amounts distributed in complete liquidation. For the purpose of the preceding sentence, "complete liquidation" includes any one of a series of distributions made by a corporation in complete cancellation or redemption of all of its stock in accordance with a bona fide plan of liquidation and under which the transfer of the property under the liquidation is to be completed within a time specified in the plan, not exceeding, from the close of the taxable year during which is made the first of the series of distributions under the plan, (1) three years, if the first of such series of distributions is made in a taxable year beginning after December 31, 1937, * * *