Opinion
Docket No. 24389.
1952-05-22
ESTATE OF CLARENCE E. LEHR, DECEASED, MRS. SARAH JANE WIANT AND MRS. RENA E. GORDON, EXECUTRIXES, PETITIONERS, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.
Edgar W. Pugh, Esq., for the petitioners. Robert E. Johnson, Esq., for the respondent.
A certain note held by petitioners' decedent constituted a capital asset and was sold to, rather than discounted at, a bank with the result that the loss sustained in the sale is deductible only as a capital loss. Edgar W. Pugh, Esq., for the petitioners. Robert E. Johnson, Esq., for the respondent.
The respondent determined a deficiency of $9,331.55 in income tax for the year 1946. The issue is whether a loss of $12,471.58, sustained upon the disposition of a note, is deductible as an ordinary or a capital loss. The return of the decedent was filed with the collector for the district of Michigan.
FINDINGS OF FACT.
The facts set forth in a stipulation are so found.
Petitioners are the duly qualified executrixes of the estate of Clarence E. Lehr, who died January 31, 1948.
In 1939 the Blair Distilling Company, a Michigan corporation, hereinafter called the corporation, of which the decedent was president was engaged in the business of distilling whiskey, and although it was not producing the product at that time, it owned about 40,000 barrels of whiskey which were hypothecated with the Louisville Trust Company, a banking institution hereinafter referred to as the bank. In 1939 Martin Solomon and David Karp, who were whiskey brokers, entered into an agreement with the corporation to manage and operate its distillery and to purchase its output for an agreed price. The corporation commended to produce whiskey in January 1940 at the rate of about 50 barrels a day. Production was at about the same rate throughout 1941. Solomon and Karp were unable to pay for the whiskey. The bank loaned them $15 or $16 a barrel and the decedent put up the difference. The decedent first acquired common stock of the distilling company about July 1935. In November 1940 Solomon purchased a total of 40,000 shares of common stock of the corporation from the decedent. He gave decedent notes for the stock and used the stock as collateral for payment of the notes.
Solomon was elected a director of the corporation on January 20, 1941. On February 6, 1941, the board of directors of the corporation authorized the issuance of 100,000 shares of its preferred stock, each of a par value of $1, to the decedent, for which the decedent gave the corporation his note for $10,000 and the corporation canceled its indebtedness to him in the amount of $90,000 for advances made in connection with the purchase of whiskey by Solomon and Karp. No other preferred stock was outstanding. About that time the decedent reacquired the common stock held by Solomon at the price he had previously sold it to him. On March 30, 1942, he held 270,648 shares of the 400,000 shares of outstanding common stock, each of a par value of $1, and 100,000 shares of preferred stock.
Thereafter the corporation lacked funds to continue operation and about May 1942 a decision was made to liquidate its affairs, in connection with which Solomon and Karp offered to buy the corporation's assets for about $350,000.
About July 1, 1942, Solomon and Karp entered into a contract with the corporation to purchase all of its assets for the net price of approximately $350,000, which amount the buyers expected to be able to raise by borrowing from the decedent, banks, and other sources. After ascertaining that they could not borrow the full amount, Solomon and Karp agreed to sell to Joseph E. Seagram & Sons, Inc., all of the assets to be received from the corporation in the sale, except real estate of a value of about $145,000 which they leased to Seagram and H. McKenna, Inc., for a term of 11 years from July 1, 1942, at an annual rental of $30,000, payable semiannually. The arrangement with Seagram to purchase assets and a semiannual payment of rent in advance, reduced the amount of money Solomon and Karp were required to borrow to $145,000.
On July 1, 1942, decedent loaned Solomon and Karp $145,000, for which they gave him their note on the same day reading as follows:
On or before January 1, 1953, we promise to pay to the order of CLARENCE E. LEHR the sum of One Hundred and Forty-Five Thousand Dollars, with interest at the rate of one and one-fourth per cent (1 1/4%) per annum, payable as follows:
Five Thousand Dollars ($5,000.00) and accrued interest on the 1st day of January and July each year after the date hereof to and including July 1, 1947, and Nine Thousand Dollars ($9,000.00) and accrued interest on the 1st day of each January and July thereafter to and including July 1, 1952, and Five Thousand Dollars ($5,000.00) and accrued interest on January 1, 1953; provided that interest in each instance is to be accrued on only the unpaid balance.
This note is negotiable and is payable as to principal and interest at the office of the Louisville Trust Company in Louisville, Kentucky.
The money borrowed from the decedent was used by Solomon and Karp on July 15, 1942, to pay part of the purchase price of about $350,000 for all of the assets of the corporation.
On June 30, 1942, Solomon, Karp, decedent and the bank entered into an agreement in which, after reciting that Solomon and Karp had assigned to the bank the obligations of Seagram and McKenna to them under the lease for rent and that they had executed and delivered to the decedent their promissory note in the principal amount of $145,000, the bank agreed upon receipt of rent payable under the lease to disburse it in equal amounts to the other parties until the decedent received the amount of $50,000, and thereafter one-fifth thereof each to Solomon and Karp and three-fifths to the decedent until the decedent received the additional amount of $95,000. All payments to the decedent were to be credited upon the note for $145,000. Solomon and Karp agreed to pay directly to the decedent the accrued interest on the note. The instrument contained other provisions reading as follows:
3. The rights of the parties in and to this agreement are for the benefit of and shall run to their successors and assigns, and any party hereto shall have the right to assign his interest herein independently of any other party hereto.
4. The party of the third part shall be under no obligation to bring any action to enforce the collection of any moneys due under the indenture herein referred to, but shall do so upon being indemnified as to any costs or expense to be incurred by it.
The lease and the assignment thereof were recorded. The bank notified the lessees of the assignment of the lease to it and advised them that the only change necessitated by the assignment was to make rental payments directly to the assignee instead of to the lessors. Thereafter the bank received the rent payable under the lease and distributed the collections in accordance with the terms of the agreement of June 30, 1942.
The lease was assigned to the bank by Solomon and Karp to facilitate collection of rent under the lease and to secure their payment of the note held by decedent. The bank received no consideration from any of the parties for the service it performed in collecting the rent and disbursing the proceeds, and it paid no consideration for the assignment of the lease to it. It was not an unusual service for the bank to perform for its customers in connection with transactions involving substantially the same amount.
The decedent received in liquidation of the corporation dividends in cash, the amount of which representing gain he reported in his return for 1942.
On December 18, 1942, the decedent endorsed the $145,000 note to the bank to secure payment of a note given to the bank on the same day in the amount of $50,000 for a loan. The note continued as collateral with the bank whenever it renewed the decedent's loan.
The bank collected all of the rents payable by the lessees under the lease. From January 7, 1943, through July 3, 1946, a total of $40,000 was credited by the bank on the note for $145,000 from rental collections made from the lessees. The rental received by Solomon and Karp each year was reported by them as income.
In June 1946 the decedent expressed to Solomon a desire to receive the balance payable on the note for $145,000 and offered him a substantial discount if he would pay the unpaid amount of the note. Decedent informed him that he had discussed the matter with the bank but felt that he should first offer the discount privilege to the makers. Solomon informed decedent that he would try to raise the money and that he did not think he would be able to do so. The bank was interested in acquiring the note for an amount that would yield it a return of 5 per cent to its maturity.
On July 9, 1946, when the unpaid balance on the note was $105,000, decedent endorsed the instrument to the bank without recourse. On the same day, as part of the transaction, the bank typed and the decedent signed the following on the agreement of June 30, 1942:
The Louisville Trust Company having this day purchased the note referred to in this agreement, I now assign and set over to the Louisville Trust Company all of my rights under the terms of this agreement, and under the assignment of the Indenture of Lease referred to in this agreement.
On that date the bank entered the note in its books as a note receivable in the amount of $105,000, credited the decedent's checking account with $92,528.42 and entered the difference of $12,471.58 between that amount and $105,000 in its books as unearned discount, and otherwise recorded that it would ‘earn $17,190.33 on this loan to maturity‘ and that the additional amount of $4,718.75 would be credited to the account for interest to be paid by the makers. The bank's auditor prepared a memorandum in regard to the transaction in which he wrote that ‘We are today purchasing this note from Clarence E. Lehr for $92,528.42.‘ The amount of $12,471.58 is equal to a yield to the bank of 5 per cent per annum on the note to its maturity, aside from interest payable by the makers, and a pro rata amount thereof was reported by the bank as income each year as payments were made on this note. At that time all of the interest due on the note had been paid to decedent by the makers.
On July 10, 1946, the bank charged to decedent's checking account the amount of $30,000, representing the amount outstanding on a note issued to it by the decedent.
The note held by the decedent was acquired by the bank in the regular course of its business. It did not at any time during the course of doing business with the decedent from 1936 to 1948 acquire another note from decedent in excess of $100,000.
Solomon and Karp paid by credits made by the bank from collections of rent $5,000 on the principal of the note January 6, 1947, and $9,000 each 6 months thereafter through July 1951, when the unpaid face amount of the note was $19,000.
In his return for 1946 the decedent listed ‘Executive‘ as his occupation, and reported the following amounts as gross income:
+-------------------------------------+ ¦Detroit Racing Association¦$20,000.00¦ +--------------------------+----------¦ ¦Dividends ¦8,160.00 ¦ +--------------------------+----------¦ ¦Interest ¦3,908.07 ¦ +--------------------------+----------¦ ¦Rents and royalties ¦4,217.85 ¦ +--------------------------+----------¦ ¦Horse racing and baseball ¦32,930.00 ¦ +-------------------------------------+
He deducted in the return $1,000 for net short term loss sustained in sales of securities, the actual loss reported being $11,179.27, and $12,471.58 for ‘Notes discounted.‘
In his determination of the deficiency respondent disallowed the deduction of $12,471.58 upon the ground that it represented a loss sustained ‘on the discount‘ of the note and was a capital loss deductible only under section 117 of the Code and therefore not an allowable deduction under the provisions of section 23 of the Code.
The note was a capital asset held by the decedent and was sold by him to the bank.
OPINION.
JOHNSON, Judge:
The petitioners assigned as error in their petition the action of respondent in treating the note in the unpaid amount of $105,000 as a capital asset and the ‘loss‘ sustained in the ‘discounting‘ thereof as a capital loss. They contend upon brief that the charge of $12,471.58 by the bank represents discount and is deductible as an ordinary and necessary business or nonbusiness expense under the provisions of section 23(a)(1) and (2) of the Code, or, in the alternative, as a business or nonbusiness loss or as a bad debt.
Section 23(g)(1) of the Code provides that : ‘Losses from sales or exchange of capital assets shall be allowed only to the extent provided in section 117.‘
Section 117 provides as follows to the extent material here:
(a) DEFINITIONS.— As used in this chapter
(1) CAPITAL ASSETS.— The term ‘capital assets‘ means property held by the taxpayer (whether or not connected with his trade or business), but does not include * * * property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business * * *
(d) LIMITATION ON CAPITAL LOSSES
(2) OTHER TAXPAYERS.— In the case of a taxpayer, other than a corporation, losses from sales or exchanges of capital assets shall be allowed only to the extent of the gains from such sales or exchanges, plus the net income of the taxpayer of $1,000, whichever is smaller. * * *
Petitioners argue, without citation of authority, that Congress never contemplated that section 117 should be interpreted so as to deny because of a technicality an economic loss otherwise allowable. The well established rule is that deductions from gross income are subject to the will of Congress and may not be allowed without a showing by the taxpayer of clear legislative authority. New Colonial Ice Co. v. Helvering, 292 U.S. 435; White v. United States, 305 U.S. 281; Interstate Transit Lines v. Commissioner, 319 U.S. 590. Congress has provided that where a capital asset, as defined in the statute is sold or exchanged, the deduction for any loss is deductible only under section 117. The respondent having determined that section 117 applies to the transaction, petitioners had the burden of proving that the note was not a capital asset or that it was not sold or exchanged within the meaning of the statute.
The note was property held by the decedent. Petitioners, however, seek to show otherwise by contending that decedent never intended to make a capital investment; that the loan was made to Solomon and Karp to provide them with funds to purchase assets of the corporation in a liquidation proceeding; that the loan was the only satisfactory method of selling corporate assets to the borrowers; that the note could not be disposed of at a profit; that the reason for making the loan was to enable the decedent to get out of a business in which he was engaged and that as the note was acquired to accomplish a business purpose, the note was held primarily for sale to customers in the ordinary course of decedent's trade or business within the meaning of Hercules Motors Corporation, 40 B.T.A. 999.
There is implied in the contentions of petitioners that the liquidation of the corporation was a business of the decedent. Without a contention or proof that the corporation was a sham, it must be regarded as an entity separate and distinct from the decedent for tax purposes even though he held a majority of its stock and had from time to time made advances to it. Moline Properties, Inc. v. Commissioner, 319 U.S. 436; Burnet v. Commonwealth Improvement Co., 287 U.S. 415. Petitioners do not otherwise characterize the decedent's alleged business. None, in the conduct of which the note was acquired, is established by the evidence. In any event, section 117 is applicable to all property held by the taxpayer regardless of whether or not connected with his trade or business.
Assuming that the note was held in connection with a trade or business and that the property was acquired in the ordinary course thereof and not to be held as an investment, to come within the exception claimed it would be necessary to establish that it was held primarily for sale to customers in the ordinary course of the trade or business. Rockford Varnish Co., 9 T.C. 171; W. T. Thrift, Sr., 15 T.C. 366. Here the note was held for 4 years, and no proof was made that it was ever offered for sale during that period.
In Hercules Motors Corporation, supra, the trade acceptances reached the taxpayer as a necessary incident to the sale of its products and it was necessary that the corporation dispose of them. The activities of the corporation in the sale of other acceptances were sufficient to meet the exception to the statute concerning sale to customers. In Joe B. Fortson, 47 B.T.A. 158, and Harry Dunitz, 7 T.C. 672, affd. 167 F.2d 223, cases cited by petitioners, we reached a like conclusion from the evidence.
The record made by petitioners does not establish that the note was held primarily for sale to customers in the ordinary conduct of a trade or business. Accordingly, we hold that the note was property held by the decedent within the meaning of section 117. Rockford Varnish Co., supra; Conrad N. Hilton, 13 T.C. 623.
The gist of the contention of petitioners on the disposition of the note is that it was discounted by and not sold to the bank; hence there was no sale of the property.
The term ‘sale‘ in section 117 should be given its ordinary meaning. Helvering v. Flaccus Oak Leather Co. 313 U.S. 247; Hale v. Helvering, 85 F.2d 819; John H. S. Lee, 42 B.T.A. 920, affd. 119 F.2d 946. In Gruver v. Commissioner, 142 F.2d 363, the court said that:
* * * The legislative purpose is served if the term ‘sale‘ is not given a strict interpretation but is held to include kindred transactions of exchange, for in one case as in the other gains are earned in the ordinary course of business. * * *
* * * If no price is set for either property, it is said to be an exchange; but if each is valued and the difference is paid in money, it is a sale. * * *
In Iowa v. McFarland, 110 U.S. 471, the Court said that:
A sale, in the ordinary sense of the word, is a transfer of property for a fixed price in money or its equivalent. * * *
Definitions appearing in Hale v. Helvering, supra, and Rogers v. Commissioner, 103 F.2d 790, cases involving questions like the one here, are to the same effect.
The term ‘discount‘ was defined in Fleckner v. United States Bank, 21 U.S. 338, as follows:
* * * Nothing can be clearer, than that by the language of the commercial world, and the settled practice of banks, a discount by a bank means, ex vi termini, a deduction or drawback made upon its advances or loans of money, upon negotiable paper, or other evidences of debt, payable at a future day, which are transferred to the bank. We must suppose that the legislative used the language in this its appropriate sense; and if we depart from this settled construction, there is none other which can be adopted, which would not defeat the great objects for which the charter was granted, and make it, as to the stockholders, a mere mockery. If, therefore, the discounting of a promissory note, according to the usage of banks, be a purchase, within the meaning of the 9th rule above stated (upon which serious doubts may well be entertained), it is a purchase by way of discount, * * *
The definition was quoted with approval by the same Court in National Bank v. Johnson, 104 U.S. 271, with the following comment:
Discount, as we have seen, is the difference between the price and the amount of the debt, the evidence of which is transferred. That difference represents interest charged, being at some rate, according to which the price paid, if invested until the maturity of the debt, will just produce its amount. And the advance, therefore, upon every note discounted, without reference to its character as business or accommodation paper, is properly denominated a loan, for interest is predicable only of loans, being the price paid for the use of money.
Other definitions cited by the petitioners are to the same general effect.
Here there was no loan made by the bank to the decedent with a deduction from the amount thereof for interest paid in advance. The bank determined the consideration it paid to petitioner by deducting from the unpaid balance of $105,000 on the note, an amount computed as discount at the rate of 5 per cent, and entered the amount of $12,471.58 so computed in its books as unearned discount, and credited decedent's checking account with the net proceeds of $92,528.42. The bank's treatment of the amount in controversy on its books and returns as discount is not controlling, for book entries must give way to facts, Doyle v. Mitchell Bros. Co., 247 U.S. 179, and the conclusion here depends upon the substance of the transaction, rather than form inconsistent therewith. Conrad N. Hilton, 13 T.C. 623, 630. That the bank, notwithstanding the contrary entries it made on its books, and the decedent considered that they were parties to a sale is indicated by the use of the word ‘purchased‘ in the endorsement which was typed by the bank on the agreement of June 30, 1942, and signed by the decedent, and other records of the bank. Other evidence of a sale and not a loan to petitioner by the bank involving a charge by the bank for discount is decedent's endorsement of the note, without recourse, which endorsement relieved him of liability on the obligation as an endorser. Thereafter the bank, as holder of the note, was required to look to the makers and collateral for payment of all of the unpaid principal and interest, they not having been relieved of any of their liability in the transaction between the bank and the decedent.
Prior to July 9, 1946, the note was in the possession of the bank with power to receive rentals payable by lessees for application of a specified portion thereof to the principal of the note and distribution of the remainder to the makers. Its service in that regard was that of a collection agent for all of the parties in interest. The acquisition of the note from the decedent was a transaction separate and distinct from that agency and one in which it acted for itself and in which the makers had no economic interest, for their liability, as we have pointed out, continued without change.
Other cases cited by petitioners are distinguishable. In John H. S. Lee, supra, the amount was paid on behalf of the maker of the note. In John H. Watson, Jr., 27 B.T.A. 463, United States bonds were paid on maturity by the United States. In Hale v. Helvering, supra, there was a compromise with the maker of the notes. Here the transaction giving rise to this proceeding was between decedent and a third party, the bank. In Sol Greisler, 37 B.T.A. 542, affd. 102 F.2d 787, there was a conveyance of worthless equities in real property in foreclosure proceedings and the circuit court said: ‘One cannot sell what has wholly disappeared.‘ Decedent here had property of high value which he transferred in a transaction negotiated at arm's length.
We conclude that the note was a capital asset and was sold by the decedent to the bank, as determined by respondent. In view of the conclusion reached it is unnecessary to consider other contentions made by the petitioners. Accordingly,
Decision will be entered for the respondent.