*874 1. The cancellation by court decree of bonds of a corporation whose assets have decreased in value to such an extent that the corporation is insolvent, held, to result in no taxable gain.
2. A corporation which has in earlier years taken deductions for interest paid on its bonds but which is insolvent at the time a recovery of such interest is applied to the debt upon cancellation of the bonds, held, to realize no taxable gain upon any part of the cancellation.
3. Damages against a bank-mortgagee awarded to a corporation for injuries resulting from a course of conduct pursued by the bank's president against the corporation, held a restoration of lost capital and not taxable income.
4. Punitive damages, held, not to constitute taxable income.
5. Attorneys' fees contingent upon the outcome of litigation, held, deductible by a taxpayer on an accrual basis in the year in which judgment of the trial court became final.
*1314 The Commissioner determined deficiencies of $19,841.17 in income*875 tax and $7,214.97 in excess profits tax of petitioner for 1935. Petitioner contests the inclusion in income of (1) gain from the cancellation *1315 of bonds of petitioner, and (2) awards for actual and punitive damages, and (3) the failure to allow a deduction for attorneys' fees.
FINDINGS OF FACT.
The Harry K. Johnson trust was formed in 1927, with Harry K. Johnson as trustee. Johnson and his wife together had invested from $30,000 to $40,000 in the trust and owned a one-half interest in it. Johnson's brother-in-law, Victor C. Smith, who had invested about $60,000 in the trust, owned the other half. The trust purchased in Johnson's name 7,800 acres of land in Harris County, Texas, situated along an interurban electric railroad, the Houston North Shore Railroad, which was constructed by Johnson and operated between Houston and Baytown, Texas. The trust laid out the townsite of Highlands and developed the property, which was situated principally in Highlands, constructing 25 miles of shell roads and more than 150 cottages. The trust had water mains and electric lighting and gas facilities installed. It planted 1,050 acres of strawberries at a cost of $110,000. In*876 the latter part of 1928 and in 1929 Highlands had a population of about 1,500. It was incorporated in 1929. The trust sold real estate in Highlands to purchasers most of whom were employed by the Humble Oil & Refining Co. at its plant in Baytown.
In the latter part of 1928 and early 1929 the trust was in need of capital for development purposes and to pay off obligations. It owed W. D. Haden & Co. a balance of $27,186 for shells. Negotiations with Fidelity Trust Co. were undertaken by the trust through a Houston law firm. J. S. Cullinan, the majority stockholder and controlling executive of Fidelity inspected the properties of the trust, as did another man employed by Fidelity for that purpose.
On February 11, 1929, petitioner, which had been incorporated for the purpose of securing the loan from Fidelity, entered into a contract with Fidelity providing for the issuance by petitioner of $200,000 principal amount of 10-year first mortgage 7 percent sinking fund gold bonds, dated January 1, 1929. The bonds were to be secured by personal notes, vendor's lien notes and contracts of sale of town lots in Highlands and Highland Farm lands having an aggregate face value of $275,000, *877 and by 1,300 acres of farm lands, 750 acres of timber lands and various other properties formerly owned by the Harry K. Johnson trust. Under the contract Fidelity was to pay petitioner 97 percent of the par value of the bonds and was to receive 1,000 shares of petitioner's no par value capital stock. Fidelity was to receive $21,000 from the strawberry crop on the 1,050 acres planted by the Harry K. Johnson trust.
Petitioner issued an aggregate of 10,000 shares of stock to Johnson and his wife and Smith. Smith turned over 500 shares to Fidelity*1316 and Johnson and his wife together turned over an equal amount. The properties pledged to secure the loan were appraised at approximately $623,000 by Fidelity. This was their fair market value on February 11, 1929. Included in the $275,000 face amount of notes pledged under the contract by petitioner was a potential or unrealized profit of $153,516.10. Petitioner used the $194,000 received from Fidelity to pay off its obligations.
On April 11, 1929, in a "personal" letter to Johnson, the president of Fidelity submitted a bill in the amount of $5,000, which purported to be for legal services rendered to the Harry K. Johnson*878 trust and to petitioner. Johnson refused to pay the bill on the ground that no legal services had been contracted for and none had been rendered. The president of Fidelity then began informing purchasers of petitioner's land orally and in writing that petitioner was failing to turn over to Fidelity its collections on sales and that the purchasers would not receive deeds and would lose their money. Petitioner's collections, which had amounted to from $4,000 to $5,000 a month, dwindled rapidly. Purchasers of petitioner's property began to leave and the population of Highlands decreased from 40 to 50 percent. The loss of population in the outlying districts was greater. Johnson agreed to resign as president of petitioner and at his suggestion a representative of W. D. Haden & Co. took his place.
On Friday, April 13, 1929, a disastrous rainstorm washed away petitioner's strawberry beds, causing a loss of $138,000.
Petitioner, at the time of its formation, assumed the $27,186 debt owing from the Harry K. Johnson trust to W. D. Haden & Co. for shells. Johnson put up 5,250 shares of petitioner's stock to secure the $27,186 debt. In 1931 W. D. Haden & Co. advanced about $29,000*879 to petitioner in cash, which petitioner paid to Fidelity in an effort to keep Fidelity from foreclosing. In January 1932 W. D. Haden & Co. took certain second mortgages from petitioner in payment of the $29,000. In that year W. D. Haden & Co. also wrote off the $27,186 as a bad debt and charged off as worthless the stock pledged with it by Johnson, but it kept the stock. In 1934 the Harry K. Johnson trust went through bankruptcy and in 1935 W. D. Haden & Co. sold back the 5,250 shares of stock to Johnson at $6 a share, receiving in payment his notes. None of the interest or principal has been paid on the notes.
On January 1, 1932, Fidelity notified petitioner that it was going to begin foreclosure proceedings and on March 1, 1932, it filed suit against petitioner in the District Court of Harris County. Petitioner filed an answer and cross-action denying that it had defaulted and alleging, in the alternative, that if it had defaulted then the breach was caused by the acts of the plaintiff, that heavy damages and losses had resulted to petitioner, that the obligations and mortgage *1317 sued on were usurious, and that the president of Fidelity had commenced and pursued*880 a course of slander against Johnson.
In suing Fidelity for $400,000 actual damages and $100,000 punitive damages, petitioner alleged as a basis for its claim for $400,000 actual damages that there was a plan "to injure" petitioner, that the false statements "were made for the purpose of wrecking the enterprise, and depriving the Highland Corporation of these properties, and for the purpose of preventing it from carrying on its enterprise, and paying the money borrowed, so that the property might be foreclosed and bought by the Fidelity Co. or its associates and those conspiring with it; or otherwise seized." As a basis for its claim for $100,000 punitive damages petitioner alleged that there was a "plan and conspiracy" carried out "in an attempt to wreck the Highland Corporation and prevent it from carrying out its enterprise, and to seize the proceeds of the enterprise legitimately belonging to it, and which it would have obtained if it had not been for the wrongful acts complained of", and that "all of this was done wilfully, maliciously and greedily and with animosity and with the deliberate and malicious effort to destroy the business of the Highland Corporation and prevent*881 it from completing the enterprise with success."
The case was tried before a jury. The trial began July 3, 1933. On August 5, 1933, the jury found that the transaction of petitioner with Fidelity was a loan of $194,000, that the 1,000 shares of petitioner had a reasonable fair cash value of $40,000 on February 11, 1929, that Fidelity had slandered petitioner's title to its lands and had prevented realization by petitioner on its assets and interfered with the orderly conduct of its business, that $90,000 was reasonable compensation to petitioner for damages, and that petitioner was entitled to $10,000 as exemplary damages.
On November 23, 1933, the court decreed that the obligation evidenced by the bonds sued on was usurious, that all payments made and received thereon, whether as interest or principal, be credited on the principal, and that such obligation, originally $200,000, was subject to credits, as follows:
| Money paid to Fidelity and used by it to retire and purchase bonds for the sinking fund | $51,900.00 |
| Money collected by Fidelity on notes and contracts pledged under the mortgage | 3,907.56 |
| Interest paid on bonds more than two years prior to the bringing of the suit | 20,410.83 |
| Double $12,903.40 interest paid within two years before suit was brought | 25,806.80 |
| Value of 1,000 shares Highland Farms stock | 40,000.00 |
| Three percent of the face value of the loan retained by Fidelity | 6,000.00 |
| Total credit | 148,025.19 |
*882 *1318 After deducting the total credit to petitioner of $148,025.19 from the $200,000 loan, the court decreed (there being an error of $70 in subtraction in the decree) that there was a credit of $51,904.81 in favor of Fidelity. The court also decreed that Fidelity recover of petitioner expenses of $1,044.24 and $5,000 for services as trustee; that petitioner recover from Fidelity the $90,000 awarded by the jury as actual damages and $10,000 as exemplary damages; that from the aggregate of these sums should be deducted the $57,949.05 credits due Fidelity, and that petitioner should recover of Fidelity the residue, $42,050.95, together with interest at 6 percent from the date of judgment. The court further decreed that the mortgage be canceled and that plaintiff deliver to petitioner all the notes, claims, and contracts pledged under the mortgage. The judgment of the trial court became final on May 15, 1935.
Deduction of the $33,314.23 interest paid by petitioner to plaintiff under the mortgage was allowed to the petitioner on its income tax returns for the years in which the interest was paid.
Under a contract dated April 21, 1933, petitioner had agreed with its attorneys*883 in the foreclosure proceedings that they should receive a contingent fee of one-third of any credits obtained by petitioner against the amounts sued for by Fidelity and one-third of any amount not so credited but recovered by petitioner from Fidelity. Under this contract the petitioner's attorneys claimed $71,000 plus interest from the date of judgment, a total of approximately $76,000. Under the court decree a check for $46,180 was given to Johnson, who was acting as petitioner's president, and petitioner's attorneys were given a check for $36,000 by Johnson as part of their fee. The balance of the $46,180, $10,180, Johnson deposited in a bank and petitioner used it to defray expenses of the suit, $1,000 being paid for franchise tax. Petitioner was obligated to its attorneys for the balance of the fee then due in the amount of approximately $30,000.
After the conclusion of the mortgage foreclosure proceedings in 1935 the value of petitioner's total assets was less than $25,000. Out of the $275,000 face amount of notes pledged by petitioner under the mortgage only $15,000 or $16,000 was collectible. Petitioner was insolvent in 1935.
In 1935 some stock was put in Johnson's*884 name, his stock having been foreclosed. As acting president of petitioner he tried to revive the sale of petitioner's real estate and petitioner's other activities. He endeavored, without success, to obtain loans from Federal lending agencies. Many foreclosures of properties formerly sold by petitioner took place.
Petitioner was on an accrual basis of accounting in 1935.
In September 1938 petitioner's attorneys brought suit for the $40,000 which they claimed was still owing to them and on December *1319 1, 1938, they agreed to accept a sheriff's title to certain lands of petitioner in settlement of their claims.
OPINION.
KERN: 1. The Commissioner added to income $87,844.63 "gain from cancellation and redemption of mortgage bonds", computed by deducting from the $200,000 face value of the bonds issued by petitioner the aggregate of (1) $6,000 discount on issuance, (2) $51,900 representing bonds retired at par by Fidelity with money supplied by petitioner, less $1,557 discount applicable to such retired bonds, (3) $3,907.56 representing funds collected by Fidelity on notes and contracts pledged by petitioner under the mortgage and used to redeem the bonds, and*885 (4) $51,904.81 of the damage award used to redeem the bonds.
The evidence discloses that, although the court decree of November 23, 1933, adjudged the obligation evidenced by the bonds usurious, the court recognized petitioner's obligation to pay the full $200,000 face value of the bonds to the extent of applying as credits against the obligation the amounts which are deducted from the face value of the bonds in the deficiency notice and, in addition thereto, $20,410.83 as a return of interest paid more than two years prior to the bringing of the suit, $25,806.80 as double the amount of interest paid within two years before the suit was brought, and $40,000 as the value of Highland Farms stock which Fidelity received when the loan was made.
The Commissioner's determination is difficult to explain in that he property credits the $51,904.81 portion of the damage award as a payment against the $200,000 face value of the bonds, but omits the amount credited for interest and for the Highland Farms stock, although all of the items were applied in satisfaction of the bonds by the same decree. Since the total of amounts paid and applied by the court in satisfaction of Fidelity's claim*886 under the bonds equals their face value of $200,000 (apart from a mathematical error of $70 in the decree's computation), we can perceive no justification for the determination that gain resulted from the cancellation and retirement of the bonds. For purposes of decision we confine ourselves to the issues presented and argued by the parties.
Petitioner meets the issue of whether gain was derived from cancellation and redemption of its bonds by contending that it realized no taxable gain because there was a shrinkage in the value of its assets from $623,000 to less than $25,000 and the transaction as a whole was a loss. In this it relies on . In that case the taxpayer's subsidiary lost in its business money which the taxpayer had borrowed and was bound to repay in a foreign currency. The taxpayer repaid the loan in *1320 the foreign currency, which had depreciated between the time of the loan and repayment, and no taxable gain was held to result, since the transaction as a whole was a loss. That case, however, has been considerably limited in scope by *887 , wherein the recovery in 1920 by a judgment of compensation for work done at a loss in earlier years was held to constitute taxable income for 1920, although the whole transaction resulted in a loss. Cf. .
But petitioner, as distinguished from the taxpayer in the Sanford & Brooks Co. case, was insolvent during the taxable year and it has been held that an insolvent taxpayer which discharges its obligations by payment of less than the amount owed realizes no taxable gain where it is still insolvent after the transaction. ; ; ; ; ; ; *888 . Cf. ; ; ; .
The facts show that in 1935 petitioner's assets, aside from the $46,180 check received under the state court decree, were worth less than $25,000. Petitioner paid $36,000 of the $46,180 to its attorneys in 1935 and used the balance to defray expenses of the suit. Petitioner still owed its attorneys $35,000 under its contract with them and, since its assets did not equal its liabilities, it was insolvent. From the cancellation of its bonds, therefore, it appears that petitioner derived no taxable gain.
A further question arises, however, from the fact that petitioner on its income tax returns for earlier years has been allowed deductions aggregating $33,314.23 for interest paid to Fidelity. In numerous cases it has been held that a taxpayer must include in taxable income amounts recovered in the taxable year where deductions in respect of such amounts have been taken in prior years. *889 ; affirmed per curiam,; certiorari denied, ; ; ; ; ; affd., ; ; ; ; ; *1321 on appeal, C.C.A., 6th Cir.; ; ; Jamaica Water supply .
Despite the fact that petitioner has been allowed deductions in earlier years for the interest paid to Fidelity, the income to petitioner, if any, was received solely in the form of a cancellation of indebtedness, and this fact*890 adequately distinguishes the instant proceeding from the cases above cited. The arguments which have prompted holdings that the taxpayer realizes no taxable gain from the cancellation of indebtedness where he is insolvent after the transaction is over are equally applicable here, even though the cancellation resulted from the application to the indebtedness of interest payments made in prior years. Petitioner, being insolvent, was unable to realize income from the cancellation of its bonds however accomplished, since when the transaction was all over it still did not have sufficient assets to meet its liabilities and there were not "made available" any "assets previously offset by the obligation of bonds now extinct." See . The addition to income of $87,844.63 "gain from cancellation and redemption of mortgage bonds" was error.
2. The Commissioner also added to income $98,188.09 "income from collection of damage awards", computed by adding $42,050.95 damages received in cash, $4,232.33 interest on the award, and $57,949.05 damages applied against the retirement of bonds and trustee's expense, and deducting from*891 the total of $104,232.33 trustee's expense of $1,044.24 for taxes and $5,000 trustee's fee.
The petitioner's cross-action in the state court for actual damages alleged that there was a plan to injure petitioner and to wreck the enterprise. The facts disclose no separate claim for loss of profits, although such a loss is mentioned in the complaint and the damages awarded by the court do not appear, in view of the facts presented in the case and the verdict of the jury on the special issues submitted to it, to have been intended as a restoration of lost profits but rather of lost capital caused by the course of injurious conduct pursued by the president of Fidelity against petitioner. , and other cases cited by respondent involving recovery of lost profits are, therefore, distinguishable.
The situation in the instant case is akin to that found in , wherein an amount received by a bank in settlement of an action for injury inflicted on its business by a Federal Reserve bank which had employed agents*892 to cash checks at the taxpayer bank in such manner as to attract unfavorable public comment and interfere with *1322 the taxpayer's business was held not to constitute taxable gain. The Circuit Court in that case observed:
The fund involved must be considered in the light of the claim from which it was realized and which is reflected in the petition filed in its action against the Reserve Bank. We find nothing therein to indicate, with the certainty required in the statement of a cause of action, that petitioner sought reparation for profits which petitioner's [Reserve Bank] misconduct prevented it from earning in 1925. * * *
We think that the gravamen of petitioner's action against the Reserve Bank was the injury inflicted to its banking business generally, and that the true measure of damages was compensation to be determined by ascertaining how much less valuable its business was by reason of the wrongful acts of the Reserve Bank. * * *
The facts show that the value of the property pledged by petitioner to secure the bonds at the time of issuance was $623,000 and that petitioner's total assets in 1935 were less than $25,000, a loss of almost $600,000. Deducting*893 therefrom the $138,000 loss due to the storm of April 13, 1929, which destroyed petitioner's strawberry crop, the $100,000 damages received under the state court's decree restored only one-sixth of petitioner's loss of capital between 1929 and 1935. Lost profits could have been at most but an incidental ground for the award. We must conclude that the damages in the instant case were a compensatory payment constituting return of capital investment. ;; ; affd., ; ; ; ; . Cf. ; . The respondent was in error, therefore, in including the $90,000 actual damages in petitioner's taxable income.
*894 The punitive damages of $10,000 present a different problem. They were awarded neither for loss of capital nor for loss of profits, but as a penalty. In , an amount received by a taxpayer in settlement of a suit against a fiduciary for an accounting of profits earned by a corporation organized and controlled by the fiduciary for business operations adverse to the taxpayer's interest was held to be a penalty imposed by law upon a faithless fiduciary and not taxable income. A penalty imposed by law does not meet the test of taxable income set forth in , as "'the gain derived from capital, from labor, or from both combined,' provided it be understood to include profit gained through a sale or conversion of capital assets." The respondent erred in adding the $10,000 punitive damages to petitioner's taxable income.
*1323 3. A claim for an additional deduction of $35,435.06 for attorneys' fees was first presented in the petition. Respondent contends that in 1935 the balance due petitioner's attorneys had not become fixed or determined and that*895 petitioner's president took the position that the attorneys were not entitled to receive anything more than the $36,000 they had already been paid.
Petitioner was on an accrual basis of accounting in 1935 and its liability under the contract of April 21, 1933, with its attorneys was fixed and definite in 1935. The $71,000 fee claimed by the attorneys had been earned in 1935, when the judgment of the trial court became final. In that year all the events had occurred which fixed the fee and determined the liability of petitioner to pay it. The fact that payment did not take place until 1938, when the attorneys brought suit for $40,000 and a settlement was reached, does not alter the fact that the fee which had been contingent upon the outcome of the litigation constituted an accrued expense in 1935 and was deductible in that year. ; ; . On this issue also the respondent's determination was in error.
Because of an additional deduction granted for legal fees,
Decision will be entered under Rule*896 50.