*1026 1. On the facts held, that there was no such ascertainment of partial worthlessness of debt as is required by section 23(k), Revenue Act of 1936, to warrant deduction for bad debt.
2. held, that there was an exchange of property for stock of a corporation within the provisions of section 112(b)(5) and that no loss sustained thereby can be recognized.
*1131 Respondent determined deficiencies in income tax of petitioners for the year 1936 in the following amounts:
| Leslie H. Reed | $717.31 |
| Charles C. and Lillian H. Reed | 937.03 |
| Lewis G. Larus | 2,378.99 |
| Charles D. Larus, Jr | 2,090.33 |
| John H. Reed | 359.39 |
The proceedings were consolidated for hearing.
The sole issue before the Board is whether or not petitioners are entitled to deductions for partial bad debts in the taxable year.
FINDINGS OF FACT.
All of petitioners are residents of the State of Virginia. The income tax returns of petitioners for the taxable year were filed with the collector of internal revenue at Richmond, Virginia. *1027 At all times material herein petitioners kept no records or books of account other than their check books. All of petitioners filed their income tax returns on the cash receipts and disbursements basis.
The Georgia Land & Livestock Co., hereinafter referred to as the Land Co., was organized in 1916. The Land Co. owned approximately 128,000 acres of land in McIntosh and Liberty Counties, Georgia, and issued about $1,400,000 first mortgage bonds which were secured by the 128,000 acres of land. The Land Co. also issued slightly less than $200,000 of 7 percent notes. The Land Co. bonds and notes were all sold at par. Petitioners purchased bonds and notes of the Land Co. for cash at par.
In 1921 the Land Co. sold a tract of 35,450 acres of the land securing the Land Co.'s first mortgage bonds to James I. Miller. Miller purchased this tract, hereinafter referred to as the property, for a total price of $1,222,000, payable $100,000 in cash and $1,122,000 in six notes of $187,000 each, secured by a first mortgage on the property. Two of the Miller notes were to mature in two years; each of the others was to mature successively in three, four, five, and six years after issue.
*1028 In order to release the property from the lien in favor of the Land Co. bondholders it was necessary to retire a certain amount of the outstanding bonds and other indebtedness of the Land Co. A corporation known as "The Investment Company", hereinafter referred to as Investment, which had been organized in Virginia in 1919 for another purpose, was employed to facilitate the sale of the property to Miller. The Land Co. transferred the six $187,000 notes of Miller to Investment. Investment then deposited the Miller notes with a *1132 trustee of a collateral trust agreement under which Investment issued to the Land Co. collateral trust gold notes to the amount of the Miller notes which were security for this issue. These Investment notes were used in payment of the Land Co.'s obligation which then encumbered the property. Since the notes of Investment were of even denomination, the exchanges were usually adjusted to the nearest $100, the Land Co. paying or receiving the difference in cash.
The obligation of the Land Co. to the petitioners and the Investment notes issued in payment were as follows:
| Bonds, notes, | Interest | Total | Investment | |
| cash advances | due | indebtedness | notes, received | |
| Leslie H. Reed | $12,725 | $3,191.52 | $15,916.52 | $15,900 |
| Charles C. Reed | 25,700 | 6,394.79 | 32,094.69 | 32,100 |
| Lewis G. Larus | 32,075 | 7,463.44 | 39,538.44 | 39,600 |
| Charles D. Larus, Jr | 25,700 | 5,975.43 | 31,675.43 | 31,700 |
| John H. Reed | 6,200 | 1,479.58 | 7,679.58 | 7,700 |
*1029 At the time the property was sold to Miller, Miller was considered a very wealthy man and his notes were sold at par. Miller made payments on his notes prior to 1924, thereby reducing his indebtedness to $764,400. The collateral notes of Investment were correspondingly reduced to the sum of $764,400. In the closing months of 1923 Miller became involved in financial difficulties and subsequently was declared a bankrupt in 1932.
On February 15, 1924, the holders of the collateral trust gold notes of Investment formed a committee, hereinafter referred to as the noteholders' committee, and named petitioner Charles C. Reed chairman. In accordance with the provisions of a deposit agreement dated February 15, 1924, an aggregate of $762,900 of the collateral notes of Investment outstanding was deposited with the First National Bank of Richmond as depositary of the noteholders' committee. The remaining $1,500 in collateral notes outstanding could not be located.
In the year 1925 Miller, through a previously formed creditors' committee, leased the property to the Twin Tree Lumber Co. The lease was for 10 years and gave the Lumber Co. the right to cut timber from the property. The*1030 Lumber Co. paid $100,000 in cash, built a mill on the property and commenced cutting timber, but failed after a year's operation. The property lay idle for another year and then was leased to a second company, which took over the former lease of the Twin Tree Lumber Co., completing cutting in April 1935.
The money received from the timber lease was paid to the American Trust Co., trustee, and was applied on the Miller notes. The funds were in turn paid to the Richmond bank as depositary.
The charter of Investment was revoked by the State of Virginia in 1926 for the nonpayment of franchise and registration taxes. Also in *1133 1926 a bank to which Miller had given a second mortgage on the property foreclosed and obtained legal title thereto, subject to the first mortgage.
After the timber cutting lease expired in 1935, James Mullen, counsel to the noteholders' committee, began to negotiate for the sale or other disposition of the property. R. L. Cooper was authorized to act as agent in selling the property for the noteholders' committee. R. A. Bruce, an expert timber cruiser, was also working with the noteholders' committee in attempting to dispose of the property.
*1031 After several attempts to sell the property, an option was given to the Union Bag & Paper Co., hereinafter referred to as the Bag Co., to purchase the property at a price of $5 an acre. The Bag Co. investigated and had the property "cruised" and in the middle of December 1935 notified Cooper that it did not desire to exercise the option. However, late in 1935, Cooper informed Mullen that he was of the opinion that the Bag Co. would be willing to lease the property for a long term on the basis of $3 an acre.
In a letter dated January 6, 1936, the Bag Co. offered to lease the property for 99 years at a valuation of $3 per acre and to make an immediate cash payment of $10,000 returnable by application against future rent. Under date of January 9, 1936, Cooper advised Mullen by wire that a prospect to whom he had hoped to sell the property at $4 an acre was not interested, thereby leaving the Bag Co. the sole prospect.
During the negotiations for the sale of the property it was brought to the attention of the noteholders' committee that the timber on the property had been improperly logged, with consequent injury to the value of the property, and that similar land in the vicinity*1032 of the property was being sold for less than $3 an acre. Early in January 1936 Mullen sent Bruce to investigate the property and the values of surrounding land. Bruce inspected the property and investigated disposition of similar properties in the vicinity. He returned prior to January 14, 1936, and reported to Mullen and petitioner Charles C. Reed, sole surviving member of the noteholders' committee, that the timber growth had been injured by improper logging methods and burning by natives of the country to improve pasturage. Bruce gave his opinion that the property was worth no more than $3 an acre. He reported that surrounding land of similar timber growth could be purchased for $3 or less an acre.
On the 12th, 13th, and 14th of January 1936, a meeting of the noteholders of Investment was called, at which all of the petitioners were present. After informing the noteholders of the negotiations and of the report of Bruce, petitioner Charles C. Reed requested authority to dispose of the property at $3 an acre. He further informed the *1134 noteholders that they could not expect to receive more than that sum per acre.
Under date of January 14, 1936, a letter signed*1033 by Mullen in behalf of petitioner Charles C. Reed was mailed to all of the noteholders. This letter recited the history of the noteholders' committee, the opinion of the committee concerning the condition of the property, and the offer of the Bag Co. to lease the property on the basis of $3 an acre. The letter advocated the acceptance of the offer.
After Miller's payments the par value of the notes outstanding in the hands of petitioners was as follows:
| Leslie H. Reed | $10,600 |
| Charles C. Reed | 20,100 |
| Lewis G. Larus | 19,200 |
| Charles D. Larus, Jr | 16,300 |
| John H. Reed | 4,200 |
Prior to January 1, 1936, the outstanding indebtedness had been reduced by cash distributions from the proceeds of the timber lease in the amount of $48.755 per hundred dollars. As of December 31, 1935, the noteholders' committee had cash on hand in the sum of $28,881.47, out of which a further distribution of $3 per hundred dollars was made to the noteholders on September 1, 1936.
After the meeting of the noteholders on January 14, 1936, negotiations were continued with the Bag Co. for lease of the property. Under date of March 3, 1936, the Bag Co. through its attorney, sent Mullen*1034 a proposed agreement for the lease of the property for 99 years at an annual rental of 5 percent of a valuation of $3 per acre on an estimated 32,082 acres of land, the Bag Co. to pay all taxes thereon during the term of the lease and also to pay annually 5 cents per acre into the forestry management fund to be expended by it for protection against fire and for sound forestry methods. The proposed agreement also gave the Bag Co. the option to purchase the land at the price of $3 per acre. This proposed lease agreement was not accepted by the noteholders' committee because the committee claimed that there was a larger acreage than 32,082.
In the further negotiations regarding the lease the bank that held the legal title to the property subject to the Miller mortgage, realizing that its equity therein had no value, advised the noteholders' committee that it desired to divest itself of title to the property and to have no further connection therewith. In April 1936 Mullen, acting for the noteholders' committee, initiated the incorporation of the Sutherland Bluff Realty Co., hereinafter referred to as Sutherland, for the purpose of having it acquire title to the property. Sutherland's*1035 charter was issued on May 21, 1936. Shares of stock of Sutherland were issued in a total amount of $100,000. The bank in question sold and *1135 conveyed the property, subject to the first mortgage, to Sutherland for the sum of $50. Sutherland leased the property to the Bag Co. on the basis of $100,000 valuation for the land.
In order that Sutherland might have clear title to the property it was necessary to remove the first mortgage lien. To effect this result the noteholders' committee exchanged the Investment collateral notes for the Miller notes held by the American Trust Co. as trustee. The collateral notes and the collateral agreement were thereupon canceled. The noteholders' committee delivered the six Miller notes, upon which all payments received from the leases had been credited, to the depositary for the committee. The committee then informed the depositary that it should deliver the notes as Sutherland might direct. The depositary, at the direction of Sutherland, delivered the notes to the trustee of the Miller first mortgage, which executed a release to Sutherland.
In exchange for removing the first mortgage lien by surrender of the collateral notes, *1036 the noteholders' committee received from Sutherland $1,000 in cash and $95,000 in nonassessable stock of Sutherland. One month after this transaction the committee purchased for cash the remaining $5,000 of Sutherland stock, so that it might fully control the corporation. The stock of Sutherland was then distributed proportionately among the noteholders, including petitioners. At the time of the noteholders' meeting on the 12th, 13th, and 14th of January 1936, the organization of Sutherland was not contemplated.
All of the petitioners, except Leslie H. Reed, claimed deductions for bad debts on their 1936 Federal income tax returns in respect of the Investment notes. The amounts so deducted represented a loss equal to the remaining face value of the notes after crediting thereon all cash payments and the par value of the Sutherland stock received. Petitioner Leslie H. Reed computed his loss in the same way and deducted the amount thereof as a capital loss on his income tax return for the year 1936. In determining the deficiencies herein the respondent disallowed each of such deductions.
OPINION.
HILL: Petitioner Leslie H. Reed claims in his petition the right to a bad*1037 debt deduction for the loss sustained in respect of the Investment notes held by him and that he erroneously claimed a deduction therefor as a capital loss in his income tax return. This petitioner also claims overpayment of tax which, he contends, would result from an allowance of a deduction of his loss as a bad debt.
The single issue for our determination is whether or not petitioners are entitled to deductions for debts ascertained to be partially worthless and charged off in the taxable year. Petitioners contend that they *1136 reasonably determined in 1936 that the collateral notes of Investment held by them were partially worthless and charged off the amounts of such worthlessness in their Federal income tax returns for that year. Respondent argues that the notes were exchanged for stock of Sutherland in the course of a tax-free exchange under which no loss can be recognized. He contends that, in any event, Investment ceased to exist in 1936, so that in the taxable year there was no debtor from which the debt was owing. He asserts that in the absence of a debtor there can be no debt and consequently no bad debt deduction. Finally, respondent maintains that, even*1038 if we should hold that petitioners are entitled to bad debt deductions, those parts of the deductions which represent collateral notes received by petitioners for accrued interest are not deductible because that interest had not been properly returned as income by petitioners.
Section 23(k) of the Revenue Act of 1936 allows a deduction "in an amount not in excess of the part charged off" where a taxpayer has ascertained the debt to be partially worthless. No deduction for a partial bad debt need be taken even though the taxpayer has ascertained it to be partially worthless in a specific amount. He can either charge off the amount he has ascertained to be bad and take a partial bad debt deduction, or wait until some other event fixes the amount of his loss. This is entirely at the taxpayer's option. .
The record discloses that in January 1936 petitioners were advised of facts which rendered inescapable the conclusion that the debts represented by the Investment notes were partially worthless. The evidence does not disclose that prior to the acquisition of the Sutherland stock by petitioners there was an ascertainment*1039 of loss in any specified amount for bad debt or otherwise. The only evidence as to the amount of loss ascertained by petitioners is found in the computed loss taken as a deduction in their income tax returns. The computation of this loss was not made with respect to a debt wholly or partially worthless. It was not made with respect to debt at all. Such computation of loss was made on the basis of the value of the stock received in exchange for the cancellation of the debt remaining after crediting cash payments and of the release of the mortgage securing such debts. The deductions taken in the returns represented capital losses sustained in exchange of property for stock of a corporation notwithstanding they were claimed in the returns as deductions for bad debts. Prior to such exchange there was no such ascertainment and charge-off in respect of total or partial worthlessness of debt as is required by section 23(k) to warrant a deduction for bad debt. Upon the consummation of the exchange there remained no indebtedness of Investment or Miller to petitioners and, hence, no basis for a bad debt charge-off. We hold, *1137 therefore, that petitioners are not entitled to*1040 deductions for bad debts.
The parties to the proceedings have not presented or raised the question of whether the loss sustained was deductible as a capital loss, but, since it is our view that the loss was a capital loss instead of a loss for bad debt, we think such question inheres. It is apparent that whatever loss petitioners may have sustained resulted from and was determined by the exchange of their notes and the security back of them for stock of Sutherland. However, the petitioners insist that no such exchange was accomplished because the notes were not transferred to Sutherland. The facts show that the Investment notes were exchanged for the Miller notes, which in turn were delivered to the depositary for the noteholders' committee. The depositary was instructed to deliver the Miller notes as Sutherland might direct. Sutherland directed the delivery to the trustee of the Miller mortgage. From the trustee, Sutherland received a release of that mortgage, thereby becoming the owner of the property free from any lien. The result was exactly the same as if the Investment notes had been transferred to Sutherland. We fail to perceive any reason why the transaction should*1041 not be viewed as a whole and held to be an exchange, even though neither the Investment notes nor the Miller notes were directly exchanged for the stock of Sutherland. Cf. . All of the issued stock of Sutherland was received by the noteholders, including petitioners, in proportion to their respective interests in the property exchanged for the stock and, therefore, immediately after the exchange the noteholders were in control of Sutherland. We hold that it was an exchange within the meaning of section 112(b)(5), Revenue Act of 1936, 1 and that no loss can be recognized.
*1042 Decision will be entered for respondent.
Footnotes
1. SEC. 112. RECOGNITION OF GAIN OR LOSS.
* * *
(b) EXCHANGES SOLELY IN KIND. -
(5) TRANSFER TO CORPORATION CONTROLLED BY TRANSFEROR. - No gain or loss shall be recognized if property is transferred to a corporation by one or more persons solely in exchange for stock or securities in such corporation, and immediately after the exchange such person or persons are in control of the corporation; but in the case of an exchange by two or more persons this paragraph shall apply only if the amount of the stock and securities received by each is substantially in proportion to his interest in the property prior to the exchange. ↩