Summary
In Texas Gas Distributing Co. v. Commissioner, 3 T.C. 57, 61, decided January 18, 1944, the Tax Court states the rule as follows: "Where an insolvent debtor turns over all or part of his property to his creditors in full or partial satisfaction of his debts, if the debtor remains insolvent he realizes no taxable gain.
Summary of this case from Commissioner v. Capento Securities Corp.Opinion
Docket No. 112785.
1944-01-18
TEXAS GAS DISTRIBUTING COMPANY, BY H. HARPER MCKEE, TRUSTEE, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.
C. F. Rothenburg, Esq., for the petitioner. P. J. Cavanaugh, Esq., for the respondent.
1. On December 31, 1940, petitioner owed a note for $400,000 and other current obligations of $108,649. The fair market value of its assets was $235,000. On that day, pursuant to a prior agreement, it sold its entire assets to A. M. Russ, who assumed the current indebtedness, acquired the note, delivered it marked ‘Cancelled‘ to petitioner, and paid petitioner $14,610 in cash. The petitioner's assets were acquired by it at a cost of $455,155.82. Petitioner was insolvent at the time of the sale and transfer of its property to Russ. Held, that due to the insolvency of petitioner no taxable gain, except the $14,610 paid in cash, was derived by it from the transaction.
2. Under the same conditions, a bookkeeping entry made during the taxable year, transferring credit balances in reserve accounts to petitioner's surplus, did not result in taxable gain. C. F. Rothenburg, Esq., for the petitioner. P. J. Cavanaugh, Esq., for the respondent.
The respondent determined deficiencies of $9,232.11 and $5,177.71 in the petitioner's income tax and excess profits tax, respectively, for the taxable year ended June 30, 1941.
The issues are (1) the correct amount of taxable gain or loss upon the sale of the petitioner's assets; and
(2) the inclusion in the petitioner's income of $3,438.59 representing reserve amounts closed out to surplus on December 31, 1940.
FINDINGS OF FACT.
Certain facts were stipulated and as so stipulated are adopted as findings of fact. The portions thereof material to the issues are as follows:
The petitioner is a Texas corporation organized on November 15, 1935, for the purpose of selling and distributing natural gas. Its capital stock consisted of ten shares of common stock with a par value of $100 per share, owned in equal proportions by Albert D. Brokaw, A. Faison Dixon, and H. Harper McKee. In June 1936 the petitioner's capital stock was increased to $5,844, consisting of 5,844 shares of common stock with a par value of $1 per share.
The petitioner kept its books on the accrual basis of accounting, with its fiscal year ending June 30. It filed its income and excess profits tax returns for its fiscal year ended June 30, 1941, with the collector of internal revenue for the second district of New York.
On May 29, 1941, the petitioner was dissolved pursuant to the laws of the State of Texas. Under the laws of that state the existence of the petitioner was continued for three years after its dissolution for the purpose of enabling those charged with the duty to settle its affairs.
On November 21, 1935, pursuant to court authorization, the petitioner purchased from the receiver then in charge of the operations of the Texas Gas Utilities Co., hereinafter called Utilities, the natural gas distribution facilities in the towns of Del Rio and Eagle Pass, Texas, and adjacent towns and territory, for the sum of $400,000, represented by a note payable to Utilities due on or before April 1, 1945. At the time of the purchase of the assets, the petitioner also agreed to purchase from Utilities all of the petitioner's requirements of gas. Upon consummation of the plan the petitioner's stockholders deposited all outstanding stock of the Texas Gas Distributing Co. under a voting trust agreement and voting trust certificates representing such stock were issued pro rata to the holders of Utilities' first mortgage bonds due September 1, 1951. George W. Shrimpton, Dugold Gordon, and Harry L. Tower were appointed as voting trustees and served continuously thereafter.
For its fiscal years ended June 30, 1936, to June 30, 1940, inclusive, and at December 31, 1940, the petitioner's balance sheets showed a net surplus and deficits as follows:
+-----------------------------------------------------------+ ¦Year¦Surplus ¦Deficit ¦Year ¦Surplus¦Deficit ¦ +----+----------+---------+--------------+-------+----------¦ ¦1936¦$16,671.63¦ ¦1939 ¦ ¦$40,578.39¦ +----+----------+---------+--------------+-------+----------¦ ¦1937¦ ¦$4,629.24¦1940 ¦ ¦53,630.63 ¦ +----+----------+---------+--------------+-------+----------¦ ¦1938¦ ¦25,574.95¦1940 (Dec. 31)¦ ¦58,254.44 ¦ +-----------------------------------------------------------+
On November 2, 1940, a written agreement was entered into between the petitioner and A. M. Russ of San Antonio, Texas, for the sale of the petitioner's assets upon the terms and conditions as set forth therein. The contract recited that the petitioner owned and operated systems of gas distributions in Del Rio, Eagle Pass, Uvalde, La Pryor, Crystal City, and Carrizo Springs, Texas, subject to a trust mortgage securing a note for $400,000 due on April 1, 1945. The purchaser agreed to buy and the seller to sell all of the petitioner's property whatsoever, including cash, accounts receivable, materials, and supplies. The assets were to be assigned and conveyed subject to the lien securing the $400,000 note and to all other liabilities of the petitioner as reflected on its balance sheet of December 31, 1940.
The purchase price of such properties and assets of the petitioner was $14,610 in cash. The purchaser agreed to acquire the note of $400,000, and upon the consummation of the terms of the contract to cancel and deliver the note to the petitioner.
The contract of November 2, 1940, was amended by supplement thereto bearing the same date and not materially affecting the issue. The cash payment of $14,610 mentioned in the agreement was deposited on November 9, 1940, in escrow with the Frost National Bank, San Antonio, Texas.
On December 31, 1940, the sale was consummated pursuant to the agreement of November 2, 1940, and the assets of the petitioner were transferred to the purchaser. At the same time, pursuant to the terms of the agreement, the petitioner received a check for the cash consideration of $14,610 and its note in the principal amount of $400,000 marked ‘Cancelled‘ by the purchaser's nominee, the Texas Gas Distributing Corporation. On December 31, 1940, the cost of the petitioner's assets sold amounted to $455,155.82 and the total amount of its liabilities amounted to $508,649. Subsequent to the consummation of the sale the petitioner's sole assets were the sum of $14,610, the amount of the cash received from Russ. Its capital stock was in the sum of $5,844. There were no other liabilities.
In its income and excess profits tax returns for the fiscal year ended June 30, 1941, the petitioner reported a net gain from the sale of its properties in the amount of $14,610. In the notice of deficiency the Commissioner determined a taxable gain in the amount of $68,103.18, computed by him as follows:
+----------------------------------------+ ¦Cash received ¦$14,610.00¦ +-----------------------------+----------¦ ¦Liabilities assumed by vendee¦508,649.00¦ +-----------------------------+----------¦ ¦ ¦523,259.00¦ +-----------------------------+----------¦ ¦Cost of assets sold ¦455,155.82¦ +-----------------------------+----------¦ ¦Gain ¦68,103.18 ¦ +----------------------------------------+
He increased petitioner's taxable income by $53,493.18 on account of such item.
In the notice of deficiency the Commissioner also increased the petitioner's taxable income by the sum of $3,438.59 representing the following reserve accounts with credit balances closed out to surplus on December 31, 1940:
+-----------------------------------------------------------------------------+ ¦Reserve for uncollectible accounts-consumers ¦$2,126.07¦ +-------------------------------------------------------------------+---------¦ ¦Reserve against merchandise, installment and miscellaneous ¦794.16 ¦ ¦receivables as of Nov. 30, 1935 ¦ ¦ +-------------------------------------------------------------------+---------¦ ¦Reserve against merchandise receivables since Dec.1, 1935 ¦518.36 ¦ +-------------------------------------------------------------------+---------¦ ¦Total ¦3,438.59 ¦ +-----------------------------------------------------------------------------+
Such amounts were not reported in income for the taxable year. They were claimed as deductions from gross income in the petitioner's income tax returns for prior years. In so far as such amounts were concerned, the Commissioner made no change therein. The petitioner reported the following amounts of gross income, deductions, and net income or loss for prior years:
+----------------------------------------------------------------+ ¦ ¦ ¦ ¦Net income or¦ +--------------------------+------------+----------+-------------¦ ¦Fiscal year ended June 30-¦Gross income¦Deductions¦(loss) ¦ +--------------------------+------------+----------+-------------¦ ¦1936 ¦$38,339.27 ¦$37,838.13¦$501.14 ¦ +--------------------------+------------+----------+-------------¦ ¦1937 ¦47,299.02 ¦62,917.01 ¦(15,617.99) ¦ +--------------------------+------------+----------+-------------¦ ¦1938 ¦37,904.79 ¦58,881.70 ¦(20,976.91) ¦ +--------------------------+------------+----------+-------------¦ ¦1939 ¦41,844.75 ¦56,724.20 ¦(14,879.45) ¦ +--------------------------+------------+----------+-------------¦ ¦1940 ¦49,606.00 ¦62,425.95 ¦(12,819.95) ¦ +----------------------------------------------------------------+
The record discloses the following additional facts:
The properties purchased by the petitioner from Utilities in November 1935 were appraised at $335,700 at that time. Their true value was that amount.
Between April and November 1940 Russ negotiated with Utilities for the purchase of the $400,000 note of the petitioner. Russ offered $200,000. An expert of Utilities appraised the note at $235,000. Russ finally made an offer of $221,000, which was accepted. He was given an option to buy the note at that figure. He exercised the option and paid the purchase price by certified check on December 31, 1940. The fair market value of the petitioner's assets transferred to Russ was $235,000 on December 31, 1940.
The petitioner was insolvent during 1940 and on December 31, of that year.
OPINION.
VAN FOSSAN, Judge:
In the first issue the petitioner contends that it was insolvent at the time of the sale of all of its assets to Russ and that hence the transaction which relieved it of its liabilities, the $400,000 note and $108,649 in accounts payable, freed no assets usable by the petitioner for other purposes. Petitioner concedes that the cash received represents income and so treated it. The respondent applies the conventional rule of computing gain or loss, arguing that the gain from the sale of capital assets by a corporation is unaffected by its financial condition.
This case well illustrates the difference between a realistic and a theoretical treatment of a tax problem. To be taxable, income, whether resulting from ordinary business transactions or from the sale of capital assets, must be ‘derived‘ by the taxpayer. It does not result from a speculative calculation based on a rule of thumb, with no regard to the reality of the situation.
Briefly the facts are these: Before the sale to Russ the petitioner owed approximately $108,000 of debts. It also was liable for the payment of its $400,000 note owed to Utilities. Its entire assets had a fair market value of $235,000. Thus its liabilities exceeded its assets by $173,000, and consequently it was hopelessly insolvent.
After the sale it had $14,610 in cash and no liabilities except outstanding capital stock of the par value of $5,844. We are not concerned with the motives that prompted Russ to pay the $14,610 or with the reasons why Utilities exchanged its $400,000 note for Russ's certified check for $221,000. From the transaction the petitioner emerged with no property except the $14,610 in cash and with no debts. It returned as income the amount of money so received and paid the tax on it. About $11,000 was left for distribution to the stockholders.
The respondent calculates his proposed deficiency by using the cost basis of the assets sold and the full face value of the obligations from which the petitioner was released. His method of computing the tax, together with the deficiency arising from the second issue, resulted in a deficiency in tax of over $14,000.
The deficiency was based largely on the one transaction completed under the contract of November 2, 1940. There was no accumulation of profit in past years or any other such intervening factor indicating a gain on which the collection of tax had been deferred. During its entire existence, with the exception of a small profit in 1936, the petitioner had consistently operated at a loss. Its operating deficit gradually mounted to over $58,000 on December 31, 1940. By its highly advantageous deal with Russ it succeeded in wiping out all its liabilities, except its capital stock, and obtaining a substantial cash payment, which it treated as income.
As above noted, the petitioner contends that since it was insolvent the transaction resulted in the freeing of no assets whatever except the cash received and that, therefore, except for the cash, it derived no taxable gain from the sale. We think this position is fundamentally sound. The petitioner had obligations aggregating $508,000. These were discharged by the means of the sale to Russ, who assumed the normal business debts and agreed to and did secure the cancellation of the $400,000 note. The petitioner paid for such extinguishment of its debts the sum of $235,000, representing the fair market value of its entire assets. For a full discussion of the law in cases of comparable facts see Dallas Transfer & Terminal Warehouse Co. v. Commissioner, 70 Fed.(2d) 95; Highland Farms Corporation, 42 B.T.A. 1314; Rufus S. Cole, 42 B.T.A. 1110; Springfield Industrial Building Co., 38 B.T.A. 1445; Madison Railways Co., 36 B.T.A. 1106; Lakeland Grocery Co., 36 B.T.A. 289.
The principles enunciated by these cases are these: Where an insolvent debtor turns over all or part of his property to his creditors in full or partial satisfaction of his debts, if the debtor remains insolvent he realizes no taxable gain. On the other hand, where an insolvent debtor, by reason of the transaction in question, becomes solvent he realizes taxable gain in the amount of the assets freed from the claims of creditors, i.e., to the extent by which the transaction renders him solvent.
Here the petitioner, while formerly insolvent, emerged from the transaction with $14,610 in cash and no liabilities except to its stockholders. Therefore, it became solvent to the extent of that sum. Under the doctrine set forth in the Lakeland Grocery Co. case, supra, it was taxable on that sum. It made a proper return thereof. Petitioner owed no further tax on the transaction.
The second issue requires little discussion. The same principle which guided us in the decision of the first issue applies here. The bookkeeping entries transferring certain reserve accounts to surplus created no income taxable to the insolvent petitioner. They were made before the petitioner's assets were assigned to Russ. After the books were so changed the petitioner was still insolvent. Thus no asset, potentially or actually, was freed for the petitioner's use. The closing out of the credit balances in such reserve accounts to surplus in 1940 did not result in taxable income.
Decision will be entered under Rule 50.