*1207 1. When a solvent taxpayer settles a debt for less than the full amount, the saving as a general rule is income.
2. The value of the taxpayer's assets held, upon the evidence, not to establish insolvency.
3. In the settlement of a secured debt for less than its amount, it is not the release of the pledged property from the lien that constitutes the realization of income, it is the obliteration of the debt itself.
4. The basis for determining gain on the sale of preferred stock received with common in a tax-free exchange held to be an allocable part of the cost of the original shares given up in the exchange, since the evidence shows that both preferred and common had value when received.
5. Under a contract made in 1936 to sell 25,000 shares on prescribed terms, the shares to be delivered as payment was made for each share, 12,500 shares were delivered in 1936 and 12,500 in 1937, within the contract period. Held, the sale of the last 12,500 was in 1937 and the gain therefrom is not within 1936 income.
*1235 The*1208 Commissioner determined deficiencies for 1936 of $9,902.53 in the income tax of W. R. Whitthorne and a penalty of $495.12, and of $44,854.91 in the income tax of Sherwood Swan and a penalty of $2,242.74. Petitioners assail the determinations (1) of gain in the settlement of debts in 1936; (2) of gain in the sale of shares received in a tax-free exchange; and (3) of a delinquency penalty for failure to file income tax returns in time.
FINDINGS OF FACT.
Minnie L. Whitthorne and Eva Whitthorne are executrices of the estate of W. W. Whitthorne, who died July 25, 1940. W. R. Whitthorne and Sherwood Swan (called petitioners), residents of Oakland, California, filed their returns in the first district of California. They were associated in business enterprises for many years. Each had acquired at a cost of $50,000 one-half of the outstanding 1,000 shares of Sherwood Swan & Co., Ltd. (old company), which operated a market in oakland.
In March 1930 petitioners were indebted to Harrison S. Robinson on their joint and several promissory note for $35,000, secured by 1,000 old company shares. They were indebted to David S. Wasserman on their joint purchase money note for $100,000, *1209 secured by 1,000 shares of Wasserman-Gattmann Co., one-half being owned by each. To the Central National Bank of Oakland they owed $250,000 on their joint and several note secured by 6,000 shares of the Hale Bros. Stores, Inc. To the Bank of America they owed $100,000 on their joint and several note secured by 2,071 shares of the Hale Bros. Realty Co. To the Central National Bank Swan alone owed an unsecured debt of $20,000; and to the Bank of America he owed *1236 an unsecured debt of $65,000 and a debt of $10,000 secured by a mortgage on a ranch.
Pursuant to an agreement between petitioners and the note holders on March 12, 1930, the two banks paid off petitioners' note to Robinson, later being reimbursed therefor. Petitioners' shares of the old company which were pledged to Robinson were then released, and 500 were pledged with each bank as security for $100,000 of petitioners' debts to it, The banks agreed not to
* * * look to the securities thus pledged to us in equal amounts for more than the $100,000 each, * * *.
* * * it was not intended, however, to forgive the indebtedness due by the individuals in excess of this amount.
On December 15, 1936, petitioners*1210 on their joint and several demand note borrowed $175,000 from the Anglo-California National Bank of San Francisco. The Central National Bank was in receivership, and on the same date petitioners made an agreement with the receiver under which they paid him $75,000 and gave their noninterest-bearing promissory note for $20,000, payable $4,000 a year, in full compromise settlement of:
| Note signed by - | Face of note | Balance due |
| Both | $100,000.00 | $13,080.32 |
| Do | 15,000.00 | 15,000.00 |
| Do | 85,000.00 | 85,000.00 |
| Do | 66,000.00 | 1.00 |
| Swan | 25,664.67 | 25,664.67 |
| Both | 73,369.05 | 73,369.05 |
| Total | 365,033.72 | 212,115.04 |
Accrued interest was due on the notes, and $5,664.67 and $21,369.05, respectively, of the face amounts of the last two notes represented unpaid interest on the original loans. The aggregate original loans represented by the notes were $185,081.32, of which petitioners were jointly indebted for $165,081.32 and Swan was individually indebted for $20,000. The notes were secured by 500 old company shares and by 2,000 shares of Swan's, a corporation, 1,725 shares of Wasserman-Gattmann, and a $50,000 insurance policy on the life of Swan. The 2,000 shares*1211 of Swan's, the 1,725 shares of Wasserman-Gattmann, and the insurance policy were, in a petition for approval of the compromise offer filed with the court in the Central National Bank receivership proceeding, described as worthless. The settlement was approved by the court, and the 500 old company shares were released from pledge.
On December 16, 1936, petitioners were indebted to the Bank of America on notes aggregating $196,073.14, secured by 500 old company shares, 2,071 shares of the Hale Bros. Realty Co., 2,000 shares of *1237 Swan's, a corporation, and 1,725 shares of the Wassermann-Gattmann Co. Of these notes, $89,066.33 was the aggregate principal amount of joint notes of petitioners and $65,000 was the principal of a separate note of Swan. On that date a sale of the pledges was held, at which petitioners bid in the 500 old company shares for $100,000 and the Bank of America bid in the remaining securities for $96,073.14. The 2,071 Hale shares were worth $34,564.69 and the other shares were worthless. Petitioners paid the bank $100,000. The 500 old company shares were released from pledge, and, with the other 500 shares released by the Central National Bank, *1212 were placed with the trust department of the Anglo-California Bank.
On December 16, 1936, petitioners' liabilities were as follows:
| Whitthorne | Swan | |
| Joint note to Central Co., $20,000 | $10,000.00 | $10,000.00 |
| Note to Bank of America, secured by | ||
| mortgage on Swan's ranch | 10,000.00 | |
| Joint notes to Anglo-California Bank, | ||
| $175,000 and $5,000 | 90,000.00 | 90,000.00 |
| Note due David S. Wasserman | 5,000.00 | |
| Accounts payable | 1,500.00 | 15,571.60 |
| Unpaid taxes | 764.35 | |
| Total | 101,500.00 | 131,335.95 |
On the same date each owned 500 old company shares. Whitthorne owned nothing else. Swan owned in addition a claim of $9,835.12 against the old company and the mortgaged ranch, which had a value of $6,000. After the settlement of petitioners' indebtedness to the banks, Whitthorne's assets exceeded his liabilities by at least $35,040.66 and Swan's assets exceeded his liabilities by at least $80,009.13.
Pursuant to an agreement with the Anglo-California Bank under which the $175,000 loan had been made to petitioners, the 1,000 old company shares were surrendered by the bank's trust department, and in a tax-free exchange the Sherwood Swan Co. Ltd. (new company), *1213 issued therefor 30,000 class A shares of a par value of $10 each and 45,000 common shares of no par value, representing its entire capital stock. Each petitioner exchanged his 500 old company shares for one-half of the new shares. On November 18, 1936, petitioners and Robert N. Miller & Co. had made a contract contemplating this reorganization. Miller & Co. had agreed to purchase 25,000 class A shares for $175,000, or at $7 each; to deposit $25,000 and securities of a value of $35,000 with the bank as trustee as security for payment of the price; and to pay $24,500 to the trustee within 3 days after shares should be available for delivery. Thereupon Miller & Co. became entitled to the delivery of 3,500 shares. The remainder of the purchase price was payable in installments within a 90-day period, the purchaser being entitled upon each payment to delivery of one *1238 share for each $7 paid. It agreed to pay the trustee, in addition to the $175,000 recited price:
* * * an amount equal to the accrued dividends on each of the 25,000 shares from December 1, 1936, to the date of actual delivery thereof to [it].
In case Miller & Co. should fail to make full payment within*1214 the 90-day period, the trustee was directed to apply the $25,000 and the proceeds of the sale of the securities deposited as collateral to petitioners' note due the bank, and then to deliver to Miller & Co. that number of class A shares necessary to make the total number delivered to it equal to one share for each $10 paid by it or applied by the trustee on the purchase price under the agreement. During 1936 Miller & Co. deposited the collateral, paid the following installments, and received as payment the following number of shares:
| Payment | Shares | |
| Dec. 23 | $49,000 | 7,000 |
| Dec. 26 | 21,000 | 3,000 |
| Dec. 30 | 17,500 | 2,500 |
| Total | 87,500 | 12,500 |
Additional installments completed payment of the purchase price by February 9, 1937; the remaining 12,500 shares were delivered as payments were made, and after final payment the trustee delivered the 2,500 class A and 22,500 common shares remaining with him to each petitioner. There has been no sale of common shares, but in 1937 Whitthorne transferred 4,500 to Swan, who agreed to relieve Whitthorne of liability on their joint $20,000 note due the Central National Bank.
On December 31, 1936, the new company had assets*1215 of a book value of $858,332.19. It had liabilities of $370,661.74; a capital stock account of $390,000, of which $300,000 was allocated to the 30,000 class A shares and $90,000 to the 45,000 common shares, and a book surplus of $97,670.45. Land was carried among the assets at a book value of $618,674.83. In 1934, 1935, and 1936, the old company's net income and dividends were as follows:
| 1934 | 1935 | 1936 | |
| Net income | $64,025.26 | $65,834.77 | $70,052.26 |
| Dividends | 12,000.00 | 32,000.00 | 11,000.00 |
The class A shares of the new company are entitled to cumulative preferential annual dividends of 60 cents a share and to a further participating dividend equal to any dividend declared or paid on the common shares for the same period after the common shares *1239 shall have received a dividend of 60 cents for that period. Holders of class A shares are entitled to one vote a share, and upon liquidation shall be preferred as to assets to the extent of $10 a share plus accumulated and unpaid dividends.
Petitioners were granted an extension of time, expiring on June 1, 1937, for filing their income tax returns for 1936. An accountant employed by them completed*1216 preparation of the returns on May 29, 1937. The returns, properly signed and sworn to, were delivered to the collector. Swan's return is stamped by the collector as filed on June 2, 1937.
The Commissioner determined that for 1936 Whitthorne received income of $35,040.66 and Swan income of $80,009.14 in the settlement with the Central National Bank and the Bank of America. He adopted the profit reported by them of $66,317.50 on the sale of shares in Sherwood Swan & Co., Ltd., and included 30 percent thereof, or $19,895.25 in the income of each. He determined penalties for failure to file their income tax returns within the time prescribed by law.
OPINION.
STERNHAGEN: 1. The taxpayers were in 1936 jointly indebted to Central Bank for $165,081.32 and Swan separately owed that bank $20,000. They compromised this aggregate indebtedness of $185,081.32 1 for $75,000 cash and a new joint note of $20,000, thus relieving themselves of an aggregate of $90,081.32, of which $70,081.32 was attributable to the joint note of $165,081.32 and $20,000 was attributable to Swan's separate individual note. The Commissioner determined that Whitthorne's income included the released $35,040.66, *1217 one-half the joint note, and Swan's income included the released $55,040.66, one-half the joint note and all of his separate note.
The taxpayers were jointly indebted to the Bank of America for $89,066.33 and Swan separately owed that bank $65,000. This aggregate debt was settled by the payment of $100,000 cash and the taking by the debtor of the shares of the Hale Bros. Realty Co., Wasserman-Gattmann Co., and Swan's. The shares of the last two corporations were worthless and the shares of the Hale Bros. Realty Co. were recognized as having a value of $34,564.69. The Commissioner determined that Whitthorne realized no income in the settlement of this indebtedness and that Swan's income included the $24,968.47 difference between his share ($109,553.16) of the *1240 aggregate of $154,066.33 owed and his share ($50,000) of the amount of cash and the value ($34,564.69) of the Hale shares paid by Swan*1218 in the settlement.
When a taxpayer settles a debt for less than the full amount, the saving, as a general rule, is income. ; ; . The petitioners try to bring themselves within the line of cases holding that income is not realized if the debtor is insolvent before and after the settlement. Swan claims to have had a net insolvency of $10,500.83 and Whitthorne a net worth of $3,500. In each instance, their shares in the corporation are treated as worth $105,000, arrived at by using a value of $200,000 for the corporation's land. The evidence does not, in our opinion, establish insolvency of either petitioner.
The value of the petitioners' shares is not properly fixed by the value of the land on which the corporation operates the market. Other factors must be considered. In view of all the evidence, the opinions of the witnesses as to the value of the land can not be adopted. The earnings of 1935 were over $65,000 and of 1936 over $70,000. The dividends for 1935 were $32,000 and for 1936 were*1219 $11,000. The new financing was based upon a recognition of the book value of the market property. The wholesale price of the class A shares to the dealer was $7 and to the public $10. The common shares had commensurate rights which gave them substantial value. It is not necessary to find a definitive value for the corporations' shares, but it is clear that they were worth more than enough to show that as assets in the hands of petitioners they preclude a finding of insolvency and do not affect the gain realized in the settlement of their debts.
The petitioners argue a new conception of the doctrine of realization of income in connection with a debt settlement. They say the essence of the realization is not the settlement of the debts alone, but the freeing of assets, and that such freeing of assets occurred in 1930 when the pledge of the shares was limited by the banks to $100,000. This can not be adopted as the theory of the rule. A solvent taxpayer realizes a gain by a reduction of his debt irrespective of whether the debt is secured by a pledge or mortgage. The freeing of assets which has been regarded in the decisions as a significant fact is not the release of the pledged*1220 security from lien, but the effect of enabling the debtor to use all his assets freed from the incubus of the debt. The obliteration of the offsetting liability for debt is what constitutes the gain. If in 1930 the creditor banks had not only agreed to limit the use of the pledged shares to security for $100,000 of the debt, but had also renounced all claim on the *1241 debtor for more than $100,000, the forgiveness would have been a gain, not because the lien was limited, but because the excess amount of the debt was discharged without payment. Having been realized in 1930 it would have been taxable then and not later. But it was not until 1936 that the debt was finally settled; so the resulting gain is properly taxable then.
The petitioners also make a point that the measure of the gain, according to their theory, is not the value of the assets freed, but the cost of them to the petitioners, which was $50,000 to each. The point, however, falls with the theory. Since the release of the pledged shares from the lien is not the occasion of the gain, their particular value or cost is not determinative of the gain. The relevancy of their value when the debt is discharged*1221 is only as a factor in considering whether the extent of petitioners' assets demonstrates insolvency; and this, as has been stated, is not true.
The Commissioner's determinations of taxable gain resulting from the settlement of debts to the Central National Bank of Oakland and Bank of America are sustained.
2. The petitioners claim that in the computation of gain resulting from the sale of the new shares the basis has been erroneously distributed between the class A preferred and the common shares. The original 1,000 old company shares cost them $100,000. The petitioners exchanged their old shares for new and agreed with Miller & Co. to sell 25,000 class A shares to it for $175,000 on prescribed terms. They say that in computing the gain from this transaction the basis of $100,000 must all be assigned to the class A shares because the common shares were worthless. By such a computation the basis of the shares sold would be increased and the gain correspondingly reduced, and the unsold common shares would be left with no basis, and any future sale price would be entirely gain. The Commissioner adopted for the distribution of the basis between the two classes of shares the*1222 ratio which petitioners used on their returns, viz., 50.84 percent for the preferred and 49.16 percent for the common. This is, in our opinion, the best the petitioners can demand on the evidence.
The corporation's balance sheet showed a surplus of $97,670.45 after assigning $390,000 to capital stock. The assets included the $618,674.83 book value of the market property. Net income each year was about $65,000. This was more than enough to have enabled the corporation to pay dividends equal to the first 60 cents on the preferred and the corresponding first 60 cents on the common. Additional dividends were to be equal on the two classes of shares. Other rights of the shareholders were very much alike, except the liquidation preference of the class A. The fact that the common *1242 shares were not actually sold is no indication of a lack of market or of value, when the preferred were so promptly sold at $10 a share on the open market. The basis used by the Commissioner is sustained.
3. The petitioners contend that in 1936 they sold only 12,500 of the class A shares and that their tax may not be measured by a profit from the sale of 25,000 shares. *1223 In this we think they are correct. The contract with Miller & Co. was not a sale of the entire 25,000 shares. In fact only 12,500 were delivered in 1936 and, since this was well within the 90-day period, there was no duty of the dealer to take any more in that year. It fulfilled its contract in 1937 by taking the remaining 12,500 and paying for them in that year. It can not be said that the latter were sold in 1936 or that petitioners in that year derived the profit from their sale. They had made a contract to sell, but there is no evidence that this was intended to be an immediate sale. It is error to treat it as such. ; ; ; certiorari denied, ; .
The gain in 1936 should be reduced to that applicable to a sale of 12,500 shares.
4. The Commissioner determined a penalty of 5 percent under section 291, Revenue Act of 1936, for failure of petitioners to file their returns on time. The evidence does not*1224 establish that the delay was due to reasonable cause and not to willful neglect, and the penalty is therefore sustained.
Decision will be entered under Rule 50.
Footnotes
1. The balance due on the face amount of the notes was $212,115.04, but the Commissioner's determination treats the excess as interest and omits it from the computation. Likewise the excess of the face amount of the Bank of America notes is omitted from the computation. ↩