*1116 1. Corporation B was the lessee of certain real property under a 99-year lease. B subleased the property to C, its subsidiary, which built a hotel thereon, financing the building in part by issuance of first mortgage bonds which B guaranteed. B assigned its interest in the 99-year lease to A, C subleased the property to D, which assigned its interest to E. E furnished the hotel and operated the property. After several years of operation it became evident that fixed charges could not be met and a reorganization was proposed. A new corporation, N, was formed, with $100,000 authorized capital consisting of 1,000 shares of $100 par value of common voting stock. Pursuant to a plan of reorganization A conveyed the 99-year lease, worth $25,000, and paid $25,000 cash to N, receiving therefor 50 percent of the stock of N. B paid $25,000 and caused C to convey its interest in the property to N, receiving therefor $25,000 of the stock of N. D paid $25,000 and caused E to convey its interest in the property to N, receiving therefor $25,000 of the stock of N. All property, other than the 99-year lease conveyed by A and the cash, had no value in excess of liabilities against such property. *1117 Held, that N was a party to a reorganization as defined by section 112(g) of the Revenue Act of 1934, so that its basis for purposes of depreciation is that of its transferors under section 113(a)(7) of the Revenue Act of 1934; held, further, that the basis may not be reduced by liabilities of the transferors assumed by N.
2. Held, that N's rate of depreciation was properly fixed by respondent at 2 percent.
3. B received a dividend from N in 1936. Held, that the proportion of this dividend which was attributable to earnings and profits of N must be computed by deducting from gross income of N depreciation at the rate of 2 percent upon the basis of the transferors of the property as determined in the first issue.
4. Held, that B properly ascertained to be worthless and charged off a bad debt representing its investment in certain debentures of corporation X.
5. Held, that B failed to sustain the burden of proving that certain stock of X held by B became worthless in the taxable year.
*440 Respondent determined deficiencies in income tax of the Roosevelt Investment Corporation, petitioner in Docket No. 101453, for the years 1935 and 1936 in the amounts of $1,679.52 and $2,768.47, respectively. He determined a deficiency in that petitioner's excess profits tax for *441 the year 1936 in the amount of $252.04. Respondent determined a deficiency in income tax of the First Realty Corporation, petitioner in Docket No. 101558, for the year 1936 in the sum of $1,840.40. The proceedings were consolidated for hearing.
The first issue is whether the basis of the property transferred to the Roosevelt Investment Corporation is cost to the transferor corporations, or actual cost to the transferee. The second issue concerns the rate of depreciation on the property transferred to the Roosevelt Investment Corporation. The third issue is whether respondent correctly determined the proportion of a dividend of the Roosevelt Investment Corporation received by the First Realty Corporation which was paid out of earnings and profits of the payor corporation. The fourth issue involves a bad debt deduction claimed by*1119 the First Realty Corporation. The final issue is whether the First Realty Corporation is entitled to a loss deduction due to stock becoming worthless.
FINDINGS OF FACT.
The Roosevelt Investment Corporation, hereinafter referred to as Roosevelt Investment, is a corporation existing under the laws of the State of Washington, with its principal place of business at Seattle, Washington. The First Realty Corporation, hereinafter referred to as First Realty, was organized under the laws of the State of Washington and has its principal place of business in Seattle, Washington. The returns of both petitioners for the taxable periods here involved were filed with the collector for the district of Washington.
On August 2, 1929, Nellie Carman, the owner in fee of certain real property, leased that property to First Realty for a term of 99 years, with ground rentals at a base of $1,500 a month, gradually increasing to $3,500 a month. The lease agreement provided that the lessee should pay all taxes, assessments, and other charges against the property. The agreement also contained the following provisions:
* * * It is expressly understood and agreed, however, between the parties*1120 hereto that any assignment of this lease by the lessee or its successors or assigns while the lessee, its successors or assigns, are not in default, shall release the assignor from the performance of the covenants of this lease subsequent to the date of such assignment and from any further liability thereafter arising under this lease, provided that such assignment shall be made in strict accordance with and subject to the provisions and conditions hereinbefore expressed relating to the assignment of this instrument.
* * *
In the event the lessor shall terminate this lease and shall reenter and take possession of said premises and the buildings and improvements situated thereon by reason of any default herein specified, nevertheless the lessor agrees that at any time within twelve (12) months subsequent to the date of any such re-entry *442 but not thereafter, the lessee may reinstate this lease by paying to the lessor all rent in default, with interest thereon at the rate of 8 per cent (8%) per annum from the date that such rental became due and by the payment of all sums owing to the lessor by the lessee according to the provisions of this lease, with interest thereon*1121 at the rate of eight per cent (8%) per annum from the date that such sums became due, and by the payment of all taxes, assessments, liens and charges, if any, and interest thereon at eight per cent (8%) per annum, and by the complete performance of all of the obligations imposed upon the lessee by the terms and provisions of this lease, and by the payment to the lessor of all costs and expenses incurred by the lessor in taking possession of the premises on account of such default, together with a reasonable attorney's fee for the services of attorneys employed by the lessor in enforcing the provisions of this lease and taking possession of said premises, and by the payment of all cost and expense on account of loss of rentals. * * *
On March 7, 1930, First Realty subleased this property to the First Realty Hotel Corporation, hereinafter referred to as First Hotel, for 98 years from March 1, 1930. This lease provided for a rental of $500 a month in excess of the rents specified in the 99-year lease from Nellie Carman to First Realty. First Hotel was a wholly owned subsidiary of First Realty. Parent and subsidiary had the same officers and directors, shared the same offices, and*1122 used the same books and bank account. The affairs of both companies were handled simultaneously.
On March 7, 1930, First Hotel subleased the property to the Maltby-Thurston Hotels, Inc., hereinafter referred to as Maltby-Thurston, for 35 years beginning January 1, 1931. This lease provided for a graduated monthly rental beginning at $4,250 and increasing to $4,775, the last 16 years of the lease being at the rate of $4,600 a month.
On March 15, 1930, First Hotel mortgaged its leasehold estate to the Peoples Bank & Trust Co. as trustee, to secure an issue of $235,000 of 6 1/2 percent bonds. The bond issue was guaranteed as to principal and interest by First Realty. The deed of trust provided that the bonds should mature annually according to serial number from April 1, 1932, to April 1, 1940. From the proceeds of the bond issue and additional funds loaned to it by First Realty, First Hotel erected a hotel building known as the Roosevelt Hotel, at a total cost of $535,184.06.
On December 20, 1930, Maltby-Thurston assigned its 35-year leasehold estate to the Roosevelt Hotel Co., hereinafter referred to as the operating company, a subsidiary of Maltby-Thurston. The operating*1123 company made leasehold improvements and installed cafe equipment and furniture and fixtures at a total cost of $159,496.39. The operating company continued to operate the property until acquisition of the property by petitioner Roosevelt Investment in 1935.
Under date of January 1, 1931, the operating company conveyed the furniture in the hotel to First Hotel, which gave the operating company an option to repurchase the furniture for the sum of $1 upon completion of the 35-year lease. On February 2, 1932, the operating *443 company gave First Hotel a chattel mortgage on additional furnishings and equipment to secure payments under the lease.
Under date of July 28, 1931, First Realty assigned its 99-year lease from Nellie Carman to the Realty Investment Corporation, hereinafter referred to as Realty Investment, subject to the 98-year and 35-year subleases and the mortgage of $235,000. Realty Investment was incorporated under the laws of the State of Nevada in August 1929.
The hotel was never operated at a profit. All parties junior to the fee owner of the property found it impossible to meet their obligations. It became necessary to adjust the mortgage securing*1124 the $235,000 bond issue and on July 1, 1932, a supplemental deed of trust was executed by First Hotel, mortgagor, First Realty, guarantor, and the Peoples Bank & Trust Co., mortgagee. This supplemental agreement provided for the deposit of all earnings of the hotel in a designated depository to be allocated as specified in the agreement. The interest rate on the bonds remained at 6 1/2 percent.
On September 1, 1932, Realty Investment and First Hotel entered into a lease modification agreement by which the monthly payments from First Hotel to Realty Investment were reduced.
By the year 1935 the 99-year lease and the two subleases were in default, the bonds, unpaid in the principal amount of $225,000, were in default, the purveyors to the hotel were unpaid, and the hotel equipment and furniture contracts were in default. The condition of the hotel was such that there was no hope of continuing on the basis of obligations then in force. It became imperative that there by a reorganization, since the equities of all parties were subject to immediate loss.
For months prior to July 1935 William Edris, representing Realty Investment, Henry Broderick, representing First Hotel, and*1125 S. W. Thurston, representing the Maltby-Thurston interests, negotiated with a view to reorganizing the financial and operating structure of the hotel property. The Seattle Trust Co., successor to the Peoples Bank & Trust Co., as trustee for the bondholders, also participated in these negotiations.
Under date of May 1, 1935, the Seattle Trust Co., as trustee, sent a letter to the holders of the bonds outlining the proposal of Realty Investment, First Realty, First Hotel, and Maltby-Thurston for a readjustment of the financial and operating structure of the hotel property. The proposal was outlined as follows:
(a) That the principal and accrued interest of outstanding bonds be reduced from $225,000 to 141,187.50, or from 100% to 62.75% of face value. That interest on this remaining balance be reduced from the rate of 5 1/2% which has prevailed for the past few years, to 3%, beginning April 1, 1935.
(b) That the lease ownership be vested in a new operating company which has agreed to procure a reduction of the permanent fixed ground rental to $1,850.00 per month, upon payment by it of $25,000 to the fee owner.
*444 (c) That the furniture is to be released from the*1126 trust deed, but in lieu thereof it will be charged with the obligation of remaining as an operating unit in the hotel so long as the loan is unpaid.
(d) That the first mortgage securing your bonds will continue to be a first lien upon the leasehold, as amended by the rent reduction agreement, and with the further proviso that the mortgage is to be also given priority over the rights of Realty Investment Corporation, which heretofore has claimed priority and the right to receive ground rentals.
(e) That an immediate cash payment be made to bondholders sufficient to pay then 18.725% of the adjusted face value of the bonds. In other words, the holder of each $1,000 bond would agree to adjust the face value to $627.50, of which amount he would immediately receive in cash the sum of $117.50, leaving an adjusted face value of $510.00.
(f) The remainder of the adjusted principal amount is agreed to be paid in thirty equal semi-annual principal installments, together with interest at the rate of 3% per annum. The semi-annual principal payments, amounting to $3,825.00, are to be used in purchasing and retiring bonds at the best price obtainable, or by call at the adjusted face value. *1127 The new company, in lieu of the cash principal payments, may purchase and tender for cancellation an equal amount of bonds at their adjusted face value. It no bonds are tendered for cancellation the semi-annual payments will be used to retire the bonds are tendered the adjusted face value by lot. Interest is to be always paid in cash.
In consideration of the proposed adjustment in the face value of outstanding bonds, present holders will obtain the benefit of a permanent adjustment in ground rent to $1,850 per month and the subordination of the claimed prior rights of the Realty Investment Corporation in the property. Expressed in another manner, bondholders are scaling their principal in return for what appears to be a sounder security and more complete protection for the remaining principal amount involved. Instead of being subject to a maximum $4,000 per month ground rent, which rental it is apparently impossible to meet, the same would be fixed at $1,850 per month. On the basis of past experience this appears to be a figure at which the hotel can continue operation on a profitable basis and retire the existing bond issue on the adjusted basis proposed. In addition, the*1128 guarantee of the First Realty Corporation will remain and it will likewise be under the obligation of making the semi-annual payments for the retirement of bonds at their adjusted face value, as above provided.
It appears that no adjustment in ground rent may be obtained without the payment of a substantial sum to the present fee owner. It is also necessary to satisfy certain creditors of the operating company in order to avoid receivership of the Roosevelt Hotel Company and the continuity of management which is essential to the success of the entire operation. To accomplish this the sum of at least $39,000, plus some additional working capital must be immediately raised. Accordingly, it is proposed that the operating corporation be formed with a paid in capital of $75,000, which it is proposed will be disbursed in the following manner:
| To the fee owner in consideration of modifying the existing ground lease to a permanent fixed ground rental of $1,850.00 per month | $25,000.00 |
| To satisfy the creditors of the operating company to avoid receivership | 14,000.00 |
| Down payment to the bondholders as a first payment on the liquidation of their bonds at 62.75% | 26,437.50 |
| Working Capital | 9,562.50 |
| TOTAL | $75,000.00 |
*1129 *445 The trustee then stated:
To make this program effective, a Supplemental Deed of Trust has been drafted and will be executed by the undersigned trustee under its authority contained in the original Deed of Trust, upon being so instructed by holders of 75% or more of the outstanding bonds. It is the opinion of the trustee that a reorganization is essential, or that receivership and foreclosure proceedings be instituted in the immediate future. It is further the belief of the trustee that the reorganization plan outlined herein is preferable and will probably result in a larger recovery than by resorting to legal action.
Roosevelt Investment was incorporated July 3, 1935, under the laws of the State of Washington, with an authorized capital stock of $100,000, consisting of 1,000 shares of $100 par value common stock.
After much negotiation among Edris, Broderick, and Thurston, representing their respective interests, they determined that the 99-year lease, which was held by Realty Investment, had a value of $25,000, while the equities of First Hotel and the operating company were of no value. The parties decided that Realty Investment should subscribe for 50 percent*1130 of the new corporation's shares and that First Hotel and the operating company should each subscribe for 25 percent.
In accordance with the plan of reorganization the following transactions took place on July 25, 1935:
The 99-year lease was modified to provide for a fixed monthly rental of $1,850 and a shorter period of redemption available to the lessee. The sum of $25,000 was deposited with the trustee of the fee owner as security for performance of the conditions of the lease as modified.
The operating company quitclaimed all of its interest in the 35-year lease to First Hotel, and all rights and obligations arising thereunder were released and extinguished. First Hotel quitclaimed its interest in the 98-year lease to Realty Investment, and all rights and obligations arising thereunder were released and extinguished. Realty Investment assigned the 99-year lease to Roosevelt Investment. Roosevelt Investment assumed the conditions of the 99-year lease as modified and agreed that it title should be subordinate to the lien of the mortgage securing the bonds.
First Hotel, First Realty, Realty Investment, Roosevelt Investment, and the Seattle Trust Co., trustee, entered*1131 into a second supplemental deed of trust in which the maturity date of the bonds secured by the $235,000 mortgage on the hotel property was extended to April 1, 1950, the principal of the bonds was reduced to $141,187.50, past due interest for periods prior to April 1, 1935, was canceled, and interest was reduced to 3 percent per year. The furniture was released from the mortgage lien in the hands of the trustee. It was agreed that, contemporaneously with the execution of the second supplemental deed of trust, the First Hotel, First *446 Realty, or Roosevelt Investment should pay the trustee the sum of $26,437.50 to be distributed to the bondholders pro rata so that each $1,000 bond as adjusted would have an unpaid face value of $510 in accordance with the plan. Roosevelt Investment assumed the liabilities of the original deed of trust as modified by the second supplemental deed of trust, thus assuming a liability of principal in the amount of $141,187.50 and interest at 3 percent. It paid thereon the sum of $26,437.50 in accordance with the agreement above indicated.
First Hotel and the operating company conveyed their interests in the hotel property other than their*1132 leaseholds to Roosevelt Investment. Prior to the conveyance of these interests the operating company had outstanding liabilities of $54,240.82. Roosevelt Investment assumed the operating company's liabilities to the extent of $24,750.25.
The equity of First Hotel in the hotel property which it conveyed to Roosevelt Investment had no value in excess of First Hotel's indebtedness assumed by Roosevelt Investment. The equity of the operating company in the hotel property conveyed to Roosevelt Investment had no value in excess of the operating company's liability assumed by Roosevelt Investment.
The stock of Roosevelt Investment was subscribed for on its books as follows:
| Realty Investment | 250 shares |
| Wm. Edris | 250 shares |
| First Realty | 250 shares |
| Maltby-Thurston | 250 shares |
The original certificates of capital stock of Roosevelt Investment were issued July 29, 1935, as follows:
| Certificate No. | Issued to | Shares |
| 1 | Realty Investment Corporation | 250 |
| 2 | Wm. Edris | 250 |
| 3 | First Realty Corporation | 250 |
| 4 | Maltby-Thurston Hotels, Inc | 125 |
| 5 | Pacific Coast Investment Co | 62 1/2 |
| 6 | H. E. Dupar, Trustee | 15 |
| 7 | do | 15 1/2 |
| 8 | do | 16 |
| 9 | do | 16 |
| Total | 1,000 |
*1133 The subscription of Realty Investment for 250 shares as shown above was paid for in full by the assignment to Roosevelt Investment of the 99-year lease hereinabove described at the value of $25,000. The Edris subscription was actually made for and on behalf of Realty Investment and the amount thereof, $25,000, was *447 paid by it. Edris held mere legal title to the stock, Realty Investment being the true owner. First Realty and Maltby-Thurston each paid $25,000 cash to Roosevelt Investment on their respective stock subscriptions. In addition to such payments, First Realty agreed to cause its subsidiary, First Hotel, to transfer to Roosevelt Investment all right, title, and interest of First Hotel in and to the Roosevelt Hotel furniture, furnishings, and fixtures, and Maltby-Thurston agreed to release any interest which it or any of its subsidiaries may have by virtue of any lease on the Roosevelt Hotel property, but subject to claims of general creditors as itemized in a submitted list thereof.
First Realty's stock subscription was made and paid by it on behalf of First Hotel. The latter's indebtedness of over $300,000 to First Realty was credited with $75,000 as the*1134 purchase price of the stock from First Hotel.
An original issue stamp tax was paid upon the entire 250 shares subscribed for by Maltby-Thurston. An additional transfer tax was paid on the shares which were issued to the Pacific Coast Investment Co. and Dupar, trustee. Maltby-Thurston, Pacific Coast Investment Co., and Hillcrest Investment Co. were the stockholders of the operating company. H. E. Dupar was trustee of the shares of the operating company held by the Hillcrest Investment Co.
Immediately after the exchange of property by Realty Investment, First Hotel, and the operating company for Roosevelt Investment stock, the transferor corporations or their shareholders owned all of the voting and all other classes of stock of Roosevelt Investment. The transfers of property for stock of Roosevelt Investment were pursuant to a plan of reorganization.
At a special meeting of the shareholders of the operating company held on December 30, 1935, at which all the capital stock was voted, the following shares of the operating company were represented:
| Maltby-Thurston | 7,500 shares |
| Hillcrest Investment Co | 1,250 shares |
| Pacific Coast Investment Co | 1,250 shares |
*1135 The holders of all the shares of the operating company voted and by vote of more than two-thirds of all the outstanding shares adopted a resolution to dissolve the company.
In its income and excess profits tax returns for 1935 and 1936 Roosevelt Investment claimed depreciation on the hotel building at the rate of 2 percent a year. The present rate of depreciation on Roosevelt Investment's books is 2 percent and a reserve is maintained at that rate.
*448 First Realty received a dividend in the amount of $14,250 from Roosevelt Investment in the year 1936.
First Realty had a 99-year lease on a corner property in the university district of Seattle which was owned by the University Improvement Co., hereinafter referred to as Improvement. The businessmen of the district were willing to back the construction and operation of a hotel on the property owned by Improvement in the event that Evro Becket, owner of a majority of the stock of Improvement, would consent to supervise its construction and become part of the hotel organization. Becket agreed and, after supervising the construction of the hotel, became a director of the organization operating the hotel.
The University*1136 Community Hotel Corporation, hereinafter referred to as Community, was incorporated under the laws of the State of Washington on January 28, 1930, and became lessee of the land upon which it was proposed to build the hotel. Under the supervision of Becket the hotel building, which was known as the Edmond Meany Hotel, was erected in 1931 at a cost of $489,805.84. The building was financed by the issue of first mortgage bonds, subscription to capital stock of Community, and the issue of debentures.
A portion of the kitchen of the hotel was erected on an adjoining lot not covered by the lease from Improvement. This lot was owned by Elmer S. Deibler, and Community leased the land from him under terms of a lease dated August 1, 1932.
The first mortgage bonds were issued under date of December 1, 1930, in the principal amount of $340,000 and bore interest at the rate of 6 percent a year. The bonds were secured by a mortgage on the leasehold estate and upon all the furniture and furnishings in the building with the exception of kitchen and dining room equipment. The authorized common stock of Community was in the amount of $300,000, of which at least $266,100 was subscribed and*1137 paid for. Shares subscribed for on which subscriptions remained unpaid totaled 339 shares. First Realty purchased 250 shares of $100 par value common stock of Community for the sum of $25,000. It became necessary to raise additional funds to finish and furnish the hotel, and 7 percent unsecured debentures aggregating $50,350 par value were issued. These debentures were dated October 1, 1931, and had a maturity date of October 1, 1941. First Realty purchased Community debentures having a par value of $13,900 for the sum of $12,510.
The Edmond Meany Hotel opened for business on November 11, 1931, and Becket became its managing director. Becket remained in charge of the hotel during all the years material herein. From the beginning the hotel was in financial difficulty. In 1932 the unsecured creditors and debenture holders of Community exerted pressure on *449 the corporation and obtained a chattel mortgage on the furniture and equipment in the hotel to the extent of $130,000, subject to the prior lien of the first mortgage bondholders.
Liens had arisen for services and materials furnished in connection with the construction of the hotel building and on February 19, 1934, judgment*1138 of foreclosure of these liens was entered in favor of the architect and a material supply company, the architect recovering judgment for $12,369.50 and $1,000 attorneys' fees, interest, and costs, and the supply company recovering judgment for $1,592 and $350 attorneys' fees, interest, and costs. No foreclosure sale was ever made pursuant to the judgment of foreclosure of these liens. The liens were satisfied by purchase of the judgment claims by Becket for 50 cents on the dollar.
Community never paid any ground rent to Improvement and on December 31, 1936, owed Improvement the sum of $70,722.32 for rentals and cash advances. Community never paid interest on the 7 percent debentures and on December 31, 1936, unpaid interest on the debentures amounted to $18,503.73. Only $400 was ever paid on the chattel mortgage of $130,000.
As of December 31, 1936, Community owed Deibler the sum of $2,281.16 for unpaid rent on the property upon which the kitchen of the hotel is situated. On December 29, 1936, Deibler instituted suit in the Superior Court of the State of Washington for King County, praying for cancellation of the lease, judgment for accrued rental, and appointment of a receiver.
*1139 Only five-sixths of the interest due on the first mortgage bonds on December 1, 1933, was paid. All of the bonds were in default as to interest since that date.
In May 1936 the trustee for the bondholders informed Becket that if there were not a reorganization acceptable to the trustee, the trustee would be forced to foreclose the mortgage. From May until November 1936 the parties in interest carried on negotiations contemplating a reorganization. In November 1936 the trustee sent a letter to the bondholders containing the following:
The undersigned trustee for first mortgage bonds of the University Community Hotel Corporation (Edmond Meany Hotel) has for sometime been negotiating with the management in an endeavor to formulate an acceptable plan for the reorganization of the indebtedness of the borrowing corporation.
The trustee hopes that such a plan will be available for submission to holders of first mortgage bonds, and other creditors, within the next thirty days. Such a reorganization will, in all probability, be effected through the medium of Section 77B of the Federal Bankruptcy Act, in which event it will be necessary to ask for the immediate deposit of bonds.
*1140 It is not contemplated that the reorganization will involve a reduction of the principal amount of outstanding first mortgage bonds, and the trustee has provided legal representation for first mortgage bondholders in all negotiations, that their interests may be fully protected.
*450 Pending completion of the proposed reorganization plan for submission to creditors, no interest will be paid. For this reason coupons should not be presented for payment on December 1, 1936.
Community had a total deficit as of December 31, 1936, of $292,635.79. Of this amount the sum of $48,502.35 was incurred in the year 1936. The petition in Federal court for reorganization of the hotel was delayed until after the audit of the hotel's books for the year 1936, so that the trustee for the bondholders might examine the hotel's financial statement before acceding to the plan.
On February 11, 1937, Community filed a petition in bankruptcy for corporate reorganization of Community. The reorganization plan was carried through to completion in 1938. A special master determined Community to be insolvent and recommended that the suggested reorganization plan be accepted by the court. Pursuant*1141 to the plan of reorganization, a new corporoation known as Edmond Meany Hotel, Inc., was organized. The land owned by Improvement, the leasehold estate of Community, and all furniture and equipment were transferred by their former owners to the new corporation, which assumed liabilities of the old corporation with regard to principal of the first mortgage bonds. Interest on the bonds was reduced from 6 percent to 3 percent and their maturity date was extended. The bondholders waived their claim for unpaid interest in arrears prior to December 1, 1936, and received approximately 27 percent of the prior preferred stock and 22 percent of the common stock of the new corporation.
Lienors or their assignees who had foreclosed claims in 1934 received promissory notes for about 40 percent of their claims, payable in 10 equal annual installments at 3 percent a year.
In partial consideration for its conveyance of the property upon which the hotel is situated to the new corporation, Improvement received 90,000 shares of prior preferred stock of the new corporation having a par value of $1 per share.
Debenture holders received 25,175 shares of preferred stock of $1 par value in exchange*1142 for their holdings. First Realty received 6,950 shares of this stock for its debentures in 1938. The preferred stock of the new corporation received by First Realty was of no value. The plan of reorganization provided that:
The holders of the preferred stock shall not be entitled to receive any dividends until the outstanding First Mortgage Bonds have been reduced to the aggregate principal amount of Two Hundred Thousand Dollars ($200,000.00), and then only after the payment of interest to the First Mortgage Bondholders at the rate of five per cent. (5%) per annum and all other sums required to be paid by the terms of the Mortgage or Deed of Trust, and after all dividends payable in each calendar year at the rate of four cents (4??) per share have been paid to the holders of the prior preferred stock. Thereafter, the holders *451 of the preferred stock shall be entitled to receive dividends in an amount not exceeding a total of three cents (3??) per share per year. Such dividends shall be non-cumulative and, if not earned during any calendar year, there shall no obligation to pay the same. The holders of the preferred stock shall be entitled to preference on the liquidation*1143 of the New Company, either voluntary or involuntary, at the rate of One Dollar ($1.00) per share, after payment has been made to the holders of the prior preferred stock as hereinbefore provided, but before any distribution is made to the holders of the common stock.
The holders of the preferred stock shall not be entitled to vote at any time under any circumstances. * * *
The new corporation issued 150,000 shares of $1 par value common stock. This stock was placed in a voting trust for a period of 10 years or until the bond issue should be reduced to $200,000. No dividends are payable on this stock until the entire bond issue has been paid off and then only after payment of a 4-cent dividend per share on prior preferred and a 3-cent dividend per share on preferred. In 1938, at the completion of the reorganization, First Realty received 3,250 shares of common stock of the new corporation for its 250 shares $100of par value stock of the old company. The common stock of the new corporation received by First Realty was of no value.
In 1936 the board of directors of First Realty decided to revalue all the assets of First Realty with the view of reducing its capital. The board*1144 directed the chairman of the board, the president, the vice president and the secretary of First Realty each to make an independent appraisal of the corporate assets. All of these officers were experienced in real estate matters. Each officer valued the debentures and stock of Community held by First Realty at $1.
At a meeting of the board of directors of First Realty held September 22, 1936, the board adopted the valuation of corporate assets as appraised by the officers. Also at a meeting of its shareholders held November 17, 1936, such valuation was approved and adopted.
The cost of the debentures, $12,510, and the cost of the shares of Community stock, $25,000, were written off on the books of First Realty as of December 31, 1936. As of that date capital surplus was charged with the difference between the cost of the debentures and common stock of Community and the sum of $1.
On the income and excess profits tax return of First Realty for the year 1936 the debentures and common stock of Community held by First Realty were included in schedule M, "Reconciliation of Net Income and Analysis of Changes in Surplus", as debits to surplus:
| Write-down of assets | $203,175.09 |
| Write off receivables from subsidiaries | 138,653.16 |
| Total | 341,828.25 |
*1145 *452 No deduction was taken on this return for a bad debt with regard to the debentures of Community nor for a loss with regard to common stock of Community. The return showed a net loss.
In the taxable year 1936 First Realty ascertained as worthless and charged off as a bad debt the sum of $12,510, the amount of its investment in debentures of Community.
OPINION.
HILL: The first issue is whether the basis to Roosevelt Investment for purposes of depreciation is the adjusted cost basis of the corporations which transferred their properties to Roosevelt Investment or the actual cost to the transferee. Petitioner Roosevelt Investment contends that the properties were transferred to it solely in exchange for stock and that the transaction in which it acquired the properties was either a tax-free exchange under section 112(b)(5) of the Revenue Act of 1934 or a statutory reorganization under section 112(g)(1)(C) of the Revenue Act of 1934. It maintains that, since the properties were acquired pursuant to a reorganization within the meaning of section 112(g)(1)(C), the basis remains the same as in the hands of the transferors. Respondent argues that the securities received*1146 from Roosevelt Investment by the transferors were not "substantially in proportion" to the transferors' interests in the property prior to the exchange and contends that such disproportion disqualifies Roosevelt Investment from the benefits of section 112(b)(5). He contends that the continuity of interest necessary for the application of section 112(g)(1)(C) was not present, so that section 113(a)(7) is not applicable.
We first inquire whether petitioner Roosevelt Investment acquired the hotel property in the course of a reorganization as defined by section 112(g)(1)(C) of the Revenue Act of 1934. 1 In order to qualify under this section there must be a continuity of interest in the transferors. Pinellas Ice & Cold Storage Co. v. Commissioner,287 U.S. 462">287 U.S. 462; Le Tulle v. Scofield,308 U.S. 415">308 U.S. 415. Immediately after the transfer the transferors or their shareholders must be in control of the transferee. Control within the meaning of the reoganization provisions is defined by section 112(h) of the Revenue Act of 1934 as the ownership of at least 80 percent of the voting stock and 80 percent of all other classes of stock of the corporation. *1147
*453 In the instant case Realty Investment transferred a lease valued at $25,000 and $25,000 in cash to petitioner Roosevelt Investment in exchange for 50 percent of all of Roosevelt Investment's common voting stock. No stock other than common was issued by the new corporation. First Realty subscribed in behalf of First Hotel for 25 percent of the new corporation's shares, paying $25,000 cash therefor and causing First Hotel to transfer its interest in the hotel property to the new corporation. Maltby-Thurston subscribed for the remaining 25 percent of the new corporation's stock, paying $25,000 cash and causing the operating company to transfer its interest in the hotel property to the new corporation. Immediately after the transfer the control of the*1148 new corporation was in the hands of the transferors. Realty Investment then owned 50 percent of Roosevelt Investment's entire capital stock, First Hotel or its sole shareholder, First Realty, owned 25 percent, and Maltby-Thurston and the other stockholders of the operating company owned 25 percent of the shares of Roosevelt Investment. Realty Investment, First Hotel, and the operating company were the transferor corporations and they or their stockholders were in control of the new corporation by virtue of ownership by them or their shareholders of 100 percent of all shares, voting and otherwise, of Roosevelt Investment.
We have found as a fact that Edris subscribed for stock of the new corporation in behalf of Realty Investment and the cash thus paid must be deemed to be that of Realty Investment. Respondent has argued at length regarding alleged disproportion of interests transferred to Roosevelt Investment to value of stock received. It is sufficient answer to this argument for purposes of discussion here that the proportionate interest required under section 112(b)(5) is not required for a statutory reorganization under section 112(g)(1)(C). The transfer under consideration*1149 was pursuant to a reorganization, and, by virtue of coming within the terms of section 112(g)(1)(C), Roosevelt Investment's basis for purpose of computing depreciation is that of its transferors, increased by the gain or decreased by the loss recognized to the transferors upon the transfer. Sec. 113(a)(7). 2
*1150 *454 No gain or loss was recognized on the transfer of the various properties to the new corporation in exchange for the new corporation's stock. Sec. 112(b)(4), Revenue Act of 1934. Although a liability of the operating company and a portion of the mortgage indebtedness of First Hotel and First Realty were assumed by Roosevelt Investment, such assumption is not to be considered as "other property or money" received by the taxpayer within the meaning of section 112(c), (d), or (e) of the Revenue Act of 1934 and does not prevent the exchange from being within the provisions of section 112(b)(4) of the Revenue Act of 1934. Sec. 213(f)(1) and (2), Revenue Act of 1939.
Respondent next contends that, even though the transfer was in the course of a reorganization, the basis in the hands of Roosevelt Investment must be reduced in the amount of indebtedness of which the transferors were relieved at the time of the transfer. We see no reasonable ground for this contention. Respondent has cited no authority in behalf of his argument and given no valid reason for the adjustment of the basis in the manner which he suggests. The statutory provisions for adjustment of basis will*1151 be found only in section 113(b) of the Revenue Act of 1934 and, after giving effect to gain or loss recognized on the transfer, no adjustment to basis other than as authorized by section 113(b) may be made. While section 113(a)(6) of the Internal Revenue Code, relating to basis of tax-free exchanges in general, has been amended by section 213(d) of the Revenue Act of 1939, so that for all taxable years beginning after December 31, 1938, assumption or taking subject to liabilities will affect the basis in the hands of the transferee, that section can not be applied retroactively. Moreover, section 113(a)(6) is specifically not applicable when the transferee corporation acquires property by issuance of its securities. Accordingly, we hold for petitioner on this issue. Upon our disposition of the issue we need not consider petitioner's argument that the transfer was in the course of a tax-free exchange under section 112(b)(5) of the Revenue Act of 1934.
The second issue, which involves the rate of depreciation on the hotel building, must be decided for respondent. Petitioner has failed to give convincing proof that respondent erred in determining that the proper rate of depreciation*1152 is 2 percent. Respondent's determination of a 2 percent depreciation rate is supported by the fact that Roosevelt Investment deducted depreciation on the hotel building on its 1935 and 1936 returns and carried a reserve for depreciation on the hotel on its books at that rate. Testimony adduced at the hearing did not demonstrate that the 2 percent rate of depreciation was unreasonable nor that the proper rate should be other than 2 percent.
*455 The third issue is whether or not respondent erred in determining the proportion of the dividend from Roosevelt Investment received by First Realty which was attributable to earnings and profits. Petitioner First Realty contends that a large proportion of the dividend represents return of capital, which consequently is not taxable to the recipient. The disposition of this question is directly dependent upon our determination of the first and second issues. We have held that the basis of Roosevelt Investment was that of its transferors and have upheld respondent's determination of rate. The amount of dividend paid by Roosevelt Investment which was attributable to earnings and profits will be determined upon recomputation under*1153 Rule 50.
The fourth issue is whether or not First Realty is entitled to a bad debt deduction for the year 1936 for the amount of its investment in debentures of Community. Petitioner First Realty contends that its board of directors directed a revaluation of the assets of the corporation, which resulted in the ascertainment that the debentures were worthless. Petitioner contends further that the debentures were ascertained to be worthless and charged off in the taxable year. Respondent claims that there was no true ascertainment of worthlessness and that nothing constituting a charge-off occurred in the taxable year. He stresses the fact that the alleged bad debt was not claimed as a deduction on the return.
We are of the opinion that petitioner First Realty properly ascertained the debentures to be worthless and charged them off in the taxable year. The fact that they might have been worthless before that year will not necessarily deny the deduction. Commissioner v. MacDonald Engineering Co., 102 Fed.(2d) 942. The test is that of a reasonable man having a knowledge of the facts available to the taxpayer. *1154 Avery v. Commissioner, 22 Fed.(2d) 6.
In the taxable year certain officers of First Realty experienced in real estate matters made independent valuations of the assets of the corporation. Each of these officers valued the debentures and stock of Community at nominal value. The new valuations were adopted by the board of directors and shareholders of First Realty during the taxable year and the debentures and stock of Community were reduced on the books of the corporation as of December 31, 1936, to a nominal value of $1. The revaluation of the assets amounted to an ascertainment of worthlessness and the reduction on the books amounted to a charge-off under the statute. See Commissioner v. MacDonald Engineering Co., supra, at p. 945.
The fact that the deduction was not claimed in the First Realty return is not material since the return showed a net loss. Nor is the fact that the debentures were later exchanged for worthless securities pursuant to the reorganization important. Coon Valley State Bank,*456 13 B.T.A. 132">13 B.T.A. 132. We hold that respondent erred in disallowing First Realty's claimed bad debt deduction in*1155 the sum of $12,510 representing its investment in debentures of Community.
The final issue is whether or not petitioner First Realty may deduct the sum of $25,000 representing its investment in common stock of Community. Petitioner claims that a number of identifiable events, such as the trustee's ultimatum to Community to reorganize and the suit by Deibler to cancel the lease on property on which the hotel kitchen is situated, show that the stock actually became worthless in the taxable year. Respondent argues that there has been no proof that the stock became worthless in the taxable year and contends that during the year the stock actually increased in value due to the reorganization plan.
We are of the opinion that the petitioner has failed to prove an essential fact necessary for a finding by us that the stock became worthless in the taxable year, namely, that the stock had value at the beginning of the taxable year. Frank C. Rand,40 B.T.A. 233">40 B.T.A. 233. Unless the stock had value at some time in the taxable year there could be no loss sustained due to the stock becoming worthless in that year. For failure of petitioner First Realty to sustain the burden*1156 of proof in this matter we uphold respondent on this issue.
Decision will be entered under Rule 50.
Footnotes
1. SEC. 112. RECOGNITION OF GAIN OR LOSS.
* * *
(g) DEFINITION OF REORGANIZATION. - As used in this section and section 113 -
(1) The term "reorganization" means * * * (C) a transfer by a corporation of all or a part of its assets to another corporation if immediately after the transfer the transferor or its stockholders or both are in control of the corporation to which the assets are transferred, * * * ↩
2. SEC. 113. ADJUSTED BASIS FOR DETERMINING GAIN OR LOSS.
(a) BASIS (UNADJUSTED) OF PROPERTY. - The basis of property shall be the cost of such property; except that -
* * *
(7) TRANSFER TO CORPORATION WHERE CONTROL OF PROPERTY REMAINS IN SAME PERSONS. - If the property was acquired after December 31, 1917, by a corporation in connection with a reorganization, and immediately after the transfer an interest or control in such property of 50 per centum or more remained in the same persons or any of them, then the basis shall be the same as it would be in the hands of the transferor, increased in the amount of gain or decreased in the amount of loss recognized to the transferor upon such transfer under the law applicable to the year in which the transfer was made. This paragraph shall not apply if the property acquired consists of stock or securities in a corporation a party to the reorganization, unless acquired by the issuance of stock or securities of the transferee as the consideration in whole or in part for the transfer. ↩