*57 Decision will be entered under Rule 50.
Where the purchaser of a $ 175,000 note received as a part of the entire transaction a payment of $ 75,000 on the note, arranged for by the seller, and the purchaser intended to buy only $ 100,000 of the note, held, there was in substance a payment of $ 75,000 on the note by the maker to the seller; held, further, there was a bona fide sale of a capital asset to the extent of $ 100,000; held, further, a prior settlement agreement by the Commissioner of Internal Revenue and the taxpayer providing for the treatment of future payments on the note as ordinary income does not estop petitioners from claiming the income from a bona fide sale is a capital gain.
*623 This proceeding involves a deficiency of $ 67,759.58 in income tax for the year 1944. The deficiency results from three adjustments in petitioners' net income. By appropriate assignment of error petitioners contest only adjustment (a), which was explained by respondent in a statement attached to the deficiency notice as follows:
(a) It is held that the transaction reported in your return as a sale of a debenture note issued by Lubbock Hilton Hotel Company, Inc. and from which a long term capital gain was reported actually resulted in ordinary income computed as follows:
| Amount received | $ 175,000 |
| Less cost 30% | 52,500 |
| Taxable ordinary income | 122,500 |
The sole issue, therefore, is whether the income realized by petitioners on the disposition of a note in 1944 is taxable as ordinary income or as a capital gain.
*624 FINDINGS OF FACT.
The facts stipulated are so found.
Petitioner Conrad N. Hilton is an individual, residing in Los Angeles, California, and petitioner Sari G. Hilton is his wife, who resides in New York, New York. A joint income tax return for the year 1944 was filed with the collector of internal revenue for the first district of Texas.
*59 On October 1, 1937, petitioner Conrad N. Hilton (hereinafter called Hilton) exchanged a previously acquired judgment of approximately $ 240,000 against the Lubbock Hilton Hotel Co. (hereinafter sometimes referred to as the hotel) for a debenture note of the hotel in the amount of $ 250,000, with interest at 5 per cent to September 1, 1938, and interest at 7 per cent thereafter until paid. This note provided, inter alia, that:
The Company hereby covenants with the payee that all of its net income after payment of all operating expenses, insurance, taxes, principal, and interest on the mortgage obligations of the Company, and any other fixed charges, and the interest on this debenture, shall be applied on the first day of each month to the payment of principal of this debenture.
Hilton owned all the stock, except for three qualifying shares, of the Lubbock Hilton Hotel Co.
Upon audit of Hilton's 1936 to 1939 income tax returns the respondent determined aggregate deficiencies of $ 176,916.89, of which amount $ 151,590.97 was applicable to the year 1937. Included in additions to income as determined by the respondent for the year 1937 was the amount of $ 244,503.63, explained *60 as follows:
It is held that the value of the debenture note of Lubbock Hilton Hotel Company, Inc. received at no cost to you in 1937 constituted income taxable to you in the year of receipt of the note.
Hilton filed a petition with the Board of Tax Appeals (now the Tax Court), assigning error with respect to the respondent's determination, which was given Docket No. 107218. Hilton contended in his petition that the judgment exchanged for the note had a cost basis to him of $ 189,650 and in any event had a reasonable market value at that time of only $ 150,000, and that the receipt of the note did not constitute income, as it was not a payment of the judgment, but merely additional evidence of the debt. The respondent answered the petition, denying that he had erred as alleged. Conferences were held between representatives of Hilton and respondent in which the issues covering Hilton's tax liability for the years 1936 to 1939, inclusive, were discussed. As the result of these conferences, an agreement was entered into whereby Hilton's tax liability was settled for the years 1936 to 1939. The entire agreement, omitting formal parts, was as follows:
*625 1. The undersigned *61 taxpayer, in consideration of the settlement of his case, Docket No. 107218, for the years 1936 to 1939, before the United States Board of Tax Appeals, on the basis of a total deficiency in tax of $ 13,225.53 plus interest as provided by law, hereby agrees:
(a) That he will report as taxable income for each of the years, beginning with 1940 and subsequent thereto, 70% of the yearly payments received by him on the principal of the $ 250,000 debenture note, which he acquired from the Lubbock Hilton Hotel Company in the year 1937, until said principal is fully paid.
(b) That he will agree to the taxation of said income as ordinary income subject to normal and surtax rates applicable to the years in which said payments are received.
2. The taxpayer as an integral part of this agreement has concurrently herewith executed a stipulation to conform with the provisions of paragraph 1 hereof.
3. This agreement, together with all instruments thereunder, constitutes an entire basis of settlement, subject to acceptance by the Commissioner of Internal Revenue, and in the event of his failure to accept any provision thereof, no part of this agreement shall have any force or effect.
4. The*62 undersigned further agrees in behalf of himself, his administrators and executors, that this document may be introduced in evidence without objection in any proceeding involving tax liability to the Federal Government, whether said proceeding is before the executive or the judicial branches of the Federal Government.
Sept. 23, 1941(Date)
ACCEPTED
A stipulation of the deficiency for the years 1936 to 1939, inclusive, was duly filed with the United States Board of Tax Appeals, which entered its decision on October 28, 1941, in accordance therewith.
During the years 1936 to 1943 the hotel made payments to Hilton on the principal of the debenture note, reducing the balance to $ 175,000 by March 16, 1944. In accordance with the terms of the 1941 agreement, Hilton reported 30 per cent of the payments which were thereafter made in his Federal income tax returns as a return of cost and 70 per cent as ordinary income. The hotel had no regular plan for making payments on the note; payments depended upon its financial condition and Hilton's need for money. If Hilton needed money, he would ask the hotel to send him some.
Sometime in February 1944 Hilton was in need of additional funds*63 for use in purchasing the Stevens Hotel in Chicago. In discussing his financial statement with his accountant, Hilton was advised that if the note could be sold the profit over the agreed basis would be taxed as a capital gain, whereas if he waited for payments on the note the income would be treated as ordinary income in accordance with the settlement agreement.
On March 13, 1944, Hilton wrote a letter to Sam D. Young (hereinafter referred to as Young), president of the El Paso National *626 Bank, enclosing a balance sheet of the Lubbock Hilton Hotel Co. and asking Young if the bank would like to buy this $ 250,000 debenture note which had been reduced to $ 175,000. The letter stated in part that "the company is in a position to pay you $ 50,000 and to reduce it at the rate of $ 5,000 per month." The enclosed balance sheet was dated January 31, 1944, and showed cash, $ 46,910.52, treasury notes of $ 20,056, accounts receivable of $ 23,852.77, of which Hilton owed $ 19,667.26, and current liabilities of $ 32,096.19. Upon receiving this letter, Young telephoned Hilton, telling him that, since the bank could only lend 10 per cent of its capital stock, its legal limit was $ 100,000*64 and, therefore, the note would have to be reduced by $ 75,000 before it could be purchased by the bank. Hilton replied that he thought the hotel company could so reduce the indebtedness and that $ 75,000 of the note could be made a demand obligation. Accordingly, Young agreed that the bank would purchase the note if these conditions were fulfilled. On March 14 Hilton wrote Young a letter, received on March 16, in which he stated that the hotel was in a position to pay $ 75,000 on this note and $ 5,000 per month thereafter. Hilton stated that, should Young desire the note in regular bankable form rather than debenture form, it would be agreeable with the hotel to so issue the note. On March 16 Hilton wrote Young a letter, received March 18, enclosing the note, endorsed to the El Paso National Bank, which he said he was selling this date. The original $ 250,000 note received by Young was not in current form. This caused Young, in his own words, "to raise a howl." It was not the practice of the bank to take past due notes or debentures. The note was sent by Young to Thornton Hardie, Hilton's and the bank's attorney (hereinafter called Hardie) for preparation of a renewal. The*65 original note was not purchased by Young.
Hardie, upon receipt of instructions from Young, prepared a $ 175,000 debenture note of Lubbock Hilton Hotel Co. to Conrad N. Hilton, dated March 26, 1944, a $ 75,000 demand note from the hotel to the El Paso National Bank, dated April 1, 1944, and a $ 100,000 note from the Lubbock Hilton Hotel Co., to the El Paso National Bank, due in one year, payable at the rate of $ 5,000 a month, and dated April 1, 1944, together with minutes of a board of directors' meeting of the Lubbock Hilton Hotel Co., held March 25, 1944, which minutes, omitting unnecessary parts, were as follows:
* * * *
A quorum being present, the meeting was called to order, and Vernon Herndon moved the adoption of the following resolution:
"Be It Resolved by the Board of Directors of Lubbock Hilton Hotel Company, Inc., that whereas, this corporation is indebted to C. N. Hilton for a principal balance of $ 175,000.00 on a debenture signed by it, payable to the order of Conrad N. Hilton, said debenture being in the original principal amount of $ 250,000.00, and being dated the 1st day of October, 1937:
*627 "Now, Therefore, Be It Resolved that this corporation extend and *66 renew said indebtedness by agreement with C. N. Hilton so that the balance of $ 175,000.00 shall become due and payable one year after the date of such debenture, and shall bear interest from date at the rate of 5% per annum, the renewal note to have the same terms and conditions as the original note, except that it shall be payable at El Paso National Bank, El Paso, Texas, and shall be due one year after its date, with the same right of prepayment as set forth in the original note. It shall be signed by Lubbock Hilton Hotel Company, Inc., acting by either of its vice-presidents and its secretary or assistant secretary.
"And Whereas, it is contemplated that subsequent to the execution and delivery of said note to Conrad N. Hilton he may sell said note to El Paso National Bank, of El Paso, Texas.
"Now, Therefore, Be It Further Resolved that in the event said note shall be sold to El Paso National Bank, of El Paso, Texas, the president and secretary of this corporation may further extend and renew said indebtedness by agreement with El Paso National Bank, upon such terms and conditions as may be satisfactory to the president of this corporation and to the El Paso National Bank, and *67 any note or notes given to so extend and renew said indebtedness shall be signed by this corporation, acting by its president and its secretary."
Said motion was seconded by Ralph Wike, and thereupon all of the Directors present having voted in favor of said motion, same was declared carried, and the resolution was duly adopted.
* * * *
Insofar as the minutes state that Hilton may sell the note to the El Paso National Bank, Hilton claimed they were in error as he had already sold the note to the bank. Actually the bank did not purchase the note until April 5. The notes prepared by Hardie were sent to Hilton for his signature.
On March 27 Hilton wrote Young that the hotel was converting defense bonds in preparation for the payment of the $ 75,000 note when Young desired it. Hilton suggested that it would be paid around the 5th to 10th of April. Young acknowledged the letter, saying that it would be satisfactory to make the $ 75,000 payment on the note by the 10th of April as suggested and that the bank would give Hilton credit for the full sum just as soon as the papers were in shape. On March 30 Hilton wrote Young that he had returned the notes to Hardie and Hilton would notify*68 the hotel to remit the $ 75,000 on April 10. On April 5 Conrad N. Hilton's account at the El Paso National Bank was credited with $ 175,243.05, $ 175,000 being for "note of Lubbock Hilton Hotel Company, Inc., dated 3/26/44 in favor of Conrad N. Hilton properly endorsed with recourse $ 175,000.00, Accrued interest from 3/26/44 to 4/5/44, $ 243.05." On April 5 Young wrote a letter, the body of which is as follows:
We are enclosing duplicate deposit tickets for $ 175,243.05 covering principal and accrued interest from March 26, 1944 to April 5, 1944 on the note of Lubbock-Hilton Hotel Company, Inc., endorsed by you with recourse, which we purchased from you as of this date. The note, which we have just purchased, was given you in renewal of an original note dated October 1, 1937 for $ 250,000 *628 bearing a credit endorsement of $ 175,000 as of December 31, 1943. This original note, marked "Renewed by note dated March 26, 1944," is enclosed herewith. It is entirely possible that you will need this note for reference later on so it is suggested that you keep it securely in your files.
The $ 175,000 was a typographical error and should read $ 75,000.
Young would not have made*69 out the deposit slip on April 5 if Hilton had died between March 18 and April 5. The renewal note in proper form for $ 175,000 was purchased by the bank; however, it was intended by the parties that as a part of the transaction $ 75,000 of this was to be paid by the hotel by April 10. The entire transaction, cleared of its legal refinements, was a purchase by the bank of $ 100,000 of the note that Hilton held. The new $ 175,000 note, which was a renewal of the original $ 250,000 note, was recorded in the Lubbock Hilton Hotel Co. account on the bank's books on April 6, 1944. This note had actually been accepted on April 5. On April 7, 1944, the account shows a payment of $ 175,000 which indicates the exchange made that date of the $ 175,000 note for the demand note of $ 75,000 and the installment note of $ 100,000. Both the $ 75,000 and the $ 100,000 notes were payable to the bank and endorsed by Hilton as guarantor. When Hilton received the proceeds of the note he paid his account of $ 19,667.26 to the hotel and instructed the hotel to pay the $ 75,000 demand note. On April 10 the hotel sent a check for $ 75,156.20 to the bank, $ 75,000 for the note and $ 156.20 covering interest*70 from March 26 to April 10. The Lubbock Hilton Hotel Co. account on the bank's books showed a balance of $ 100,000 due as of April 12, 1944. The hotel was not financially able to pay during the year 1944 the entire amount of $ 175,000 balance due on the $ 250,000 debenture note. During the year 1944 the hotel paid $ 45,000 of its liability to the El Paso National Bank. However, this resulted in a strain on the hotel's assets which necessitated its borrowing $ 25,000 from the El Paso Hilton Hotel Co. during 1944.
During the year 1944 and during prior years Hilton was engaged in the hotel business. He was not engaged in the business of buying and selling notes, nor had he ever been engaged in such business.
Hilton reported the transaction as a sale of a capital asset. Respondent determined that this was not a sale, but, instead, payment of the note by the hotel, and that Hilton had gain from the transaction of $ 122,500, which was all taxable as ordinary income.
The transaction in question represented a bona fide sale of a capital asset to the extent of $ 100,000. As to the remaining $ 75,000, it was in substance a payment on the note. The El Paso National Bank was actually purchasing*71 only $ 100,000 of the note and was merely acting as a conduit for the remaining $ 75,000, which was a payment by the hotel to Hilton.
*629 OPINION.
The question in this proceeding is whether the income realized on the disposition of a $ 175,000 note in 1944 is taxable as ordinary income or as a capital gain. Petitioners contend that Hilton made a bona fide sale of the note and, therefore, the transaction is within the purview of section 117 of the Internal Revenue Code, the pertinent provisions of which are printed in the margin. 1 In support of their contention petitioners cite Stanley D. Beard, 4 T. C. 756; W. P. Hobby, 2 T. C. 980, and Clara M. Tully Trust, 1 T. C. 611.
*72 The respondent contends that the amount received by Hilton on the disposition of the note was in substance a payment of the note by the hotel and, therefore, does not represent the proceeds of a sale. In support of his contention respondent cites Commissioner v. Court Holding Co., 324 U.S. 331">324 U.S. 331; Griffiths v. Commissioner, 308 U.S. 355">308 U.S. 355; Higgins v. Smith, 308 U.S. 473">308 U.S. 473; Minnesota Tea Co. v. Helvering, 302 U.S. 609">302 U.S. 609; and Lee v. Commissioner, 119 Fed. (2d) 946, affirming 42 B. T. A. 920. Respondent also contends that petitioners are estopped from asserting that the amount received over the agreed basis should be taxed as a long term capital gain. The foundation of this contention is the agreement between Hilton and respondent in which Hilton's 1936 to 1939 tax liability was settled.
The cases cited by petitioners are cases wherein the taxpayers, who were holders of preferred stock which had been called for redemption, made unrestricted bona fide sales to third persons in order that the petitioners*73 might have a long term capital gain and a lesser tax liability than would have resulted if they had waited for redemption. We held in those cases that a bona fide unrestricted sale to third persons for the sole purpose of reducing petitioners' tax liability was a business purpose, and the petitioners were entitled to claim the tax benefit resulting from the sale of a capital asset. The note in Hilton's hands represented a capital asset. Rockford Varnish Co., 9 T. C. 171. Therefore, if the transaction herein represented a bona fide sale, the *630 income therefrom is taxable as a long term capital gain under the provisions of section 117 of the code. Stanley D. Beard, supra;W. P. Hobby, supra; and Clara M. Tully Trust, supra.If, however, the transaction represented a payment of the note by the hotel, the income therefrom can not be treated as a capital gain, notwithstanding the fact that Hilton labeled the transaction a sale. Cf. Lee v. Commissioner, supra.
Respondent argues that the payment of $ 175,000 to Hilton by the*74 bank really represented a payment of the note by the hotel. He contends that in substance the hotel borrowed the money and the bank was used as a conduit to pay Hilton. This contention can not stand, as the evidence shows there was no intention on the bank's part to lend money to the hotel. The transaction was between Hilton, as the holder of the note, and the bank, as the purchaser. Any consideration the bank gave the hotel's ability to pay was the usual consideration any purchaser gives the financial responsibility of the maker, but this consideration does not transform an otherwise bona fide purchase into a loan to the maker.
The cases cited by respondent are cases in which meaningless steps were taken to obtain a tax benefit and support respondent's assertion that "the incidence of taxation depends upon the substance of the transaction." Commissioner v. Court Holding Co., supra. A mask of legal formalisms can not change what actually transpired.
Whether petitioner is entitled to the benefit of section 117 depends upon the substance of the transaction -- whether there was a bona fide sale of all or any part of the note. On March 13, 1944, *75 Hilton began negotiations for the sale of the hotel's note, on which there was then due a balance of $ 175,000. He desired to sell the entire note. Hilton's desire to sell the note was twofold: He needed additional cash for the purchase of the Stevens Hotel in Chicago and the sale of the note was one way to get it, and also he was informed that if he sold the note any income realized could be treated as capital gain, whereas if he waited for payments on the note the income would be treated as ordinary income in accordance with the settlement agreement involving his 1936 to 1939 taxes. If there was a bona fide sale by Hilton, it must be recognized despite the fact that one of his motives was tax saving. In Clara M. Tully Trust, supra, we stated: "It has been said many times by the courts that if a method to minimize taxes is carried out by legal means and is bona fide and not a mere sham, it is not subject to censure." See also Stanley D. Beard, supra.Examining the transaction in an attempt to ascertain its real character, we find that during the entire course of the negotiations it was understood by Young, who was *76 purchasing the note from Hilton for the El Paso National Bank, that the note would be reduced to $ 100,000 by a $ 75,000 payment by the hotel. This was necessary because the bank's legal *631 limit for loans was $ 100,000. We are not troubled by the fact that Hilton received a credit from the bank of $ 175,000 prior to the bank's receiving the $ 75,000 from the hotel, for there was an understanding that there would be only $ 100,000 owing on the note when the entire transaction was completed. Hilton acted in a dual capacity during the negotiations for the sale of the note -- as the holder of the note, and as the agent of the hotel. As owner of all but three shares of the Lubbock Hilton Hotel Co., he made it plain to Young that the hotel was ready and able to pay $ 75,000 of the note. The purchase of the note included the forthcoming payment of $ 75,000 by the hotel as part of the transaction. There was no bona fide sale of the $ 75,000 portion of the note, but rather a payment of $ 75,000 by the hotel to Hilton, with the bank acting as a conduit. We hold that as to the $ 75,000, Hilton received in substance a payment on the note by the hotel. The devious route taken by*77 Hilton to obtain payment of the note has the same tax effect as if he had followed a direct route. See Minnesota Tea Co. v. Helvering, supra.We also hold that Hilton made a bona fide sale of $ 100,000 of the note and, therefore, as to this amount section 117 of the code controls. Stanley D. Beard, supra;W. P. Hobby, supra; and Clara M. Tully Trust, supra.
There remains but one other point for us to consider, the question of estoppel raised by respondent. Respondent contends that where the deficiencies of prior years are settled by an agreement providing for taxing in subsequent years as ordinary income the excess payments received on a nonnegotiable note over an agreed basis, petitioner is estopped in the taxable year from contending that such excess payments should be taxed as long term capital gains.
The settlement agreement is set out in our findings of fact, and we can see no basis for respondent's contention that this agreement estops petitioner from claiming the benefit of section 117. The agreement provides that 70 per cent of the payments on*78 the note shall be treated as ordinary income. There is nothing in the agreement that provides for the treatment of the proceeds of a sale as ordinary income. In reaching the settlement there were concessions by both parties. If it had been intended that a sale of the note was to be treated in the same manner as payments on the note, it would have been a simple matter to have drawn the agreement to include a sale or disposition of the note. Petitioners are not estopped from claiming the benefit of section 117 as to that portion of the transaction which was actually a sale.
The settlement agreement for the years 1936 to 1939, inclusive, provides that as to any payments on the note, 30 per cent shall constitute a return of cost and 70 per cent shall be reported as ordinary income and, therefore, the $ 75,000 payment must be so treated. It is apparent from a reading of the settlement agreement that it was intended that the $ 250,000 note should have a basis of $ 75,000 or 30 per *632 cent of the value of the note; therefore, as to the $ 100,000 which represented a bona fide sale there is a long term capital gain of $ 70,000.
Decision will be entered under Rule 50.
Footnotes
1. SEC. 117. CAPITAL GAINS AND LOSSES.
(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 stock in trade of the taxpayer or other property of a kind which would properly be included in the inventory of the taxpayer if on hand at the close of the taxable year, or property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business, or property, used in the trade or business, of a character which is subject to the allowance for depreciation provided in section 23 (l), or an obligation of the United States or any of its possessions, or of a State or Territory, or any political subdivision thereof, or of the District of Columbia, issued on or after March 1, 1941, on a discount basis and payable without interest at a fixed maturity date not exceeding one year from the date of issue, or real property used in the trade or business of the taxpayer;
* * * *
(4) Long-term capital gain. -- The term "long-term capital gain" means gain from the sale or exchange of a capital asset held for more than 6 months, if and to the extent such gain is taken into account in computing net income.↩