Opinion
Docket No. 35570.
1952-08-5
CONCORD LUMBER CO., INC., PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.
Eugene J. Steiner, Esq., for the petitioner. Charles M. Greenspan, Esq., for the respondent.
1. Where a creditor joins with the other creditors of his debtor in an agreement to accept preferred stock of the debtor in lieu of the claim held by the creditor against the debtor for the purpose or subordinating the claims of all to an outstanding mortgage on the debtor's principal asset and with no intention of extinguishing the debt, held, the transaction is not a sale or exchange under section 117 of the Internal Revenue Code.
2. Bad debt deduction disallowed for failure of proof of worthlessness.
3. The respondent's determination of reasonable compensation upheld.
4. New York State franchise tax held to be a nonaccruable item where the liability on which the tax is based is contested. Eugene J. Steiner, Esq., for the petitioner. Charles M. Greenspan, Esq., for the respondent.
The respondent determined a deficiency of $657.53 in petitioner's income tax and a deficiency of $3,503.71 in its excess profits tax for the taxable year ended June 30, 1945. The deficiencies resulted from the respondent's determination that the petitioner was not entitled to deduct from its gross income for the taxable year an accrual of $38.95 for New York State franchise tax, nor the amount of $1,000 of $3,900 claimed as compensation of Esther Jacobson, an officer-stockholder of the petitioner, nor the amount of $5,494.26 owed to the petitioner by the Schenectady Homes Corporation and claimed as a bad debt deduction.
The questions presented are as follows:
1. Whether petitioner is entitled to deduct from its gross income for the taxable year as a bad debt a claim of $5,494.26 held against the Schenectady Homes Corporation.
2. Whether the compensation paid by petitioner to Esther Jacobson, its president, during the fiscal year ended June 30, 1945, was excessive to the extent of $1,000.
3. Whether petitioner is entitled to accrue during the taxable year more than $855.50 as a deduction for New York State franchise tax.
FINDINGS OF FACT.
The petitioner, with principal offices in Albany, New York, was organized in 1935 under the laws of the State of New York and was engaged in the wholesale lumber and millwork business. It filed its Federal income and declared value excess-profits tax return for the fiscal year ended June 30, 1945, with the collector of internal revenue for the fourteenth district of New York on an accrual basis.
The Schenectady Homes Corporation, whose principal stockholder was Leon Marrano, began the construction in 1940 or 1941 of 24 double houses known as Mohawk Gardens in Schenectady, New York. The petitioner supplied Schenectady Homes Corporation with building materials. By June 28, 1943, Mohawk Gardens was substantially completed and ready for occupancy. However, it appeared that there then were or would be a large amount of unpaid debts, including a debt of $5,494.26 owing to petitioner.
As a result of the unstable financial condition of Schenectady Homes Corporation, approximately four creditors' meetings were held in 1943. These meetings resulted in an agreement between the petitioner, the other creditors and the Schenectady Homes Corporation, entered into on June 28, 1943, reciting that it was desirable and to the interests of all parties to complete Mohawk Gardens with all reasonable dispatch in order to place it upon a revenue-producing basis at the earliest possible time, and it was to the advantage of all the parties that a mortgage then held by the Bowery Savings Bank on the property be converted to Federal Housing mortgages. The agreement provided that a creditors' committee be appointed to operate Mohawk Gardens and a building committee composed of creditors be constituted to complete the project. The agreement was to continue in full force and effect until the debts of all the creditors should have been paid in full. To implement the agreement Leon Marrano was required to assign all of his stock in Schenectady Homes Corporation to the creditors' committee.
On October 13, 1943, the petitioner and other creditors entered into an agreement which supplemented and amended the agreement dated June 28, 1943, which remained in effect. This latter agreement provided in part that the claims of all the creditors were to be transferred to the creditors' committee by the execution of this agreement and that the creditors agreed to accept in lieu thereof preferred or common stock or any other certificate showing the interest of each creditor in Schenectady Homes Corporation, and that such preferred or common stock or other certificate should be subject only to the first mortgage, interest and amortization thereof, taxes, water rates, insurance charges, and other usual operation and maintenance costs. It also provided that any certificates of satisfaction required by the committee should be furnished by the creditors. This agreement further stated:
SIXTH: That for all purposes the claims of creditors shall be extinguished and satisfied upon the issuance or transfer of preferred or common stock or some such other certificate of interest as may be decided upon by the committee, which stock or certificate shall be retired by the method of payment herein provided for the payment of claims, and upon retirement thereof shall be transferred by said stock or certificate holder or by the committee, if the same shall have been retained by the committee to Leon Marrano. Said certificates shall be non-transferable and non-negotiable.
Pursuant to the agreement of October 13, 1943, the incorporation certificate of Schenectady Homes Corporation was amended and preferred stock issued. By registered mail the petitioner received preferred stock in Schenectady Homes Corporation of a face value of $5,494.26, being the amount of the indebtedness owed by Schenectady Homes Corporation to the petitioner. The petitioner sold the stock early in 1946 for over $3,000.
For its fiscal year ended June 30, 1945, the petitioner was using both the direct charge-off method and, in addition, the reserve for bad debts. The Schenectady Homes Corporation debt of $5,494.26 was charged directly to bad debts and also to the reserve.
On its Federal income tax and declared value excess-profits tax return for the fiscal year ended June 30, 1945, the petitioner deducted as item 1, page 1, entitled ‘Loss: Returns and allowances,‘ the sum of $7,270.30, which included the Schenectady Homes Corporation indebtedness of $5,494.26, and under item 29(c) as shown by Schedule K of the return, entitled ‘Other Deductions—Provision for Bad Debts,‘ the sum of $2,436.22.
The petitioner did not intend to accept the preferred stock received by it in 1943 in payment of the debt owed it by Schenectady Homes Corporation. The agreement of October 13, 1943, was entered into by the petitioner and the other creditors for the purpose of subordinating their claims and postponing the amortization payments on the mortgage held by the Bowery Savings Bank.
Esther Jacobson was president of the petitioner during the fiscal year ended June 30, 1945. She received a salary of $3,900 for the fiscal year ended June 30, 1945. During the taxable year David Jacobson was petitioner's treasurer and received a salary of $7,800, and Bernard Jacobson was petitioner's vice president and received a salary of $3,900. The three, mother, father, and son, owned all of the stock of petitioner, Esther Jacobson being the largest stockholder. It was the habit of the three to discuss business matters at the close of the business day at home. In these discussions Esther Jacobson had a voice in decisions relating to collections, employment, purchases, and sales. Esther Jacobson was a mother and also a housewife. She devoted most of her time to the household. She seldom spent her day at the office of petitioner. However, when both Bernard and David Jacobson were away, Esther ran the business. The petitioner is on an accrual basis.
Ultimate Findings of Fact.
1. The agreement entered into by the petitioner, the other creditors and Schenectady Homes Corporation on October 13, 1943, was for the purpose of subordinating the creditors' claims to the mortgage on Mohawk Gardens, and the preferred stock received pursuant to that agreement by the petitioner did not extinguish the debt of $5,494.26 due and owing to the petitioner. The debt did not become worthless in the taxable year.
2. The sum of $2,900 allowed by the respondent represents reasonable compensation for the services rendered petitioner by Esther Jacobson during the taxable year.
3. Petitioner is not entitled to deduct from its gross income for the taxable year any increase in its New York State franchise tax liability resulting from this litigation.
OPINION.
HILL, Judge:
We have found as a fact that the petitioner was using both a reserve for bad debts and a direct charge-off items deemed to be uncollectible. However, in spite of this unorthodox system of accounting and its possible tax effects, the respondent bases his determination in this case upon a disallowance of the $5,494.26 item owed to the petitioner by Schenectady Homes Corporation. The respondent treats this as a bad debt directly charged off and in his notice of deficiency raises no objection to the reserve system which the petitioner claims it had been using since 1941.
In its petition the petitioner alleges that ‘The Commissioner of Internal Revenue has erroneously disallowed a bad debt deduction in the amount of $5,494.26,‘,”’ but upon trial the petitioner's proof, while hardly clear, tended to establish that it was using both the direct charge-off method for bad debts and the reserve method. The respondent by his answer denies the allegation of petitioner.
The issue before this Court has been narrowly drawn by the pleadings. Our determination is limited to the deductibility of $5,494.26, treated as a business bad debt under the provisions of section 23(k)(1) of the Internal Revenue Code and not as a reasonable addition to a reserve for bad debts under that section.
SEC. 23. DEDUCTIONS FROM GROSS INCOME.In computing net income there shall be allowed as deductions:(k) BAD DEBTS.—(1) GENERAL RULE.— Debts which become worthless within the taxable year; or (in the discretion of the Commissioner) a reasonable addition to a reserve for bad debts; and when satisfied that a debt is recovered only in part, the Commissioner may allow such debt, in an amount not in excess of the part charged off within the taxable year, as a deduction. * * *
The respondent bases his opposition to the petitioner upon this issue on the following facts. The debtor, Schenectady Homes Corporation, found itself in financial difficulties. The creditors of that Corporation, including the petitioner, entered into an agreement whereby the creditors took over Mohawk Gardens, the principal asset of Schenectady, were to complete and operate that asset and pay off the creditors. The original agreement was amended October 13, 1943. This latter agreement provided that the creditors should release their individual claims and take in lieu thereof preferred stock of Schenectady, and further provided in paragraph SIXTH as follows:
SIXTH: That for all purposes the claims of creditors shall be extinguished and satisfied upon the issuance or transfer of preferred or common stock or some such other certificate of interest as may be decided upon by the committee, which stock or certificate shall be retired by the method of payment herein provided for the payment of claims, and upon retirement thereof shall be transferred by said stock or certificate holder or by the committee, if the same shall have been retained by the committee to Leon Marrano. Said certificates shall be non-transferrable and non-negotiable.
The respondent treats the transaction growing out of the amended agreement as one by which the debt owed by Schenectady to the petitioner was extinguished upon receipt of capital stock in Schenectady. The respondent thus treats the transaction as a sale or exchange and argues that the petitioner's loss, if any, should be treated under section 117 of the Internal Revenue Code. We disagree with the respondent. In form the transaction was an exchange of a claim for preferred stock. However, the substance of the transaction was a subordination agreement. Questions of taxation are determined by what was actually done rather than the declared purpose of those affected. Weiss v. Stern, 265 U.S. 242; Commissioner v. Court Holding Co., 324 U.S. 331.
The amended agreement provided that payment of the creditors' claims should be made and that upon such payment the stock issued in lieu of the claims should be surrendered to the creditors' committee, which in turn was bound to turn the stock over to Leon Marrano, together with the capital stock which he had surrendered to the creditors' committee in order to implement the original agreement.
However, all this does not aid the petitioner for its proof is such that we are unable to find that the debt became worthless within the taxable year in question. The record discloses that the stock held by the petitioner was sold in 1947 for over $3,000, but as to the condition of Schenectady Homes Corporation, or the successor of the creditors' committee in operating that corporation's chief asset, in the petitioner's taxable year 1945, we have no information. True, the petitioner did offer testimony as to attempted sales of the preferred stock in 1943, 1944 and 1945, but this testimony tends to establish that the debt was worthless in 1943, or at least is as strong towards establishing that fact for 1943 as for 1945. The petitioner's evidence does not point to any event in the taxable year 1945 tending to crystallize the difficulty of Schenectady Homes Corporation into worthlessness of the claims owed by that Corporation to its creditors. Since this is so, the petitioner has failed in its burden of proof, and we hold for the respondent on this issue.
The respondent contests the reasonableness of the compensation paid by the petitioner to its president, Esther Jacobson, and disallowed $1,000 of the claimed compensation deduction, deciding that $2,900 was reasonable compensation for her services. The issue thus presented is affected by the fact that the petitioner is a close family corporation. The officers and family members are the same. The petitioner's record with respect to the payment of dividends and a comparison between the amount of compensation paid and the net earnings are also factors to be considered, as is the amount of time spent and the type of services rendered by Esther Jacobson. Bernard Jacobson, vice president of the petitioner, devoted his whole day and constant efforts to the petitioner's welfare. Esther Jacobson's services were limited to after-hours' discussions of policy and occasional attendance at the office when her son and her husband were out of town, yet Esther Jacobson's salary was the same as Bernard's for the year in question. From this and a consideration of the other factors mentioned and upon the evidence as a whole, we conclude that the determination of respondent is a reasonable one and that the petitioner has not brought forth evidence sufficient in strength to offset that ruling. We therefore hold that $2,900 was reasonable compensation for Esther Jacobson's services to petitioner in the taxable year.
The petitioner argues that if we hold against it, as we have, on issues 1 and 2, it is entitled to accrue as taxes the amount of New York State franchise tax due for the taxable year based on its net income as determined in this proceeding. We can not sustain this position. Even if this additional tax should be asserted and paid, the deductibility as an expense for the year in question does not follow. Curran Realty Co., 15 T.C. 341. The liability on which the petitioner's claim is based is contested, as this proceeding proves beyond dispute. The item is not so certain in prospect as to warrant an accrual for the year in question. It cannot be an accruable item for the taxable year in question in any event and must accordingly be disallowed.
Decision will be entered for the respondent.