*903 1. In 1933 six small banks, almost all of the stock of which was held by a bank holding company, transferred all of their assets to petitioner, a larger bank also controlled by the holding company, pursuant to a plan of reorganization looking to the operation of the transferor banks as branches of petitioner, the transferee bank. Preliminary to the transfers all of the banks charged off their books not only worthless debts but also debts which had value but might be subject to criticism by banking authorities. Petitioner assumed the liabilities of the transferor banks, which liabilities were equal to the assets remaining on their books after said charge-offs. After said transfers, petitioner did not carry as assets upon its books the assets thus charged off by the transferors. In 1933 tax returns all of these charge-offs were taken as deductions, but the net losses of the banks were greater than the deductions thus claimed. Recoveries were made by petitioner on such debts in 1934. Held, recoveries on debts charged off by petitioner are not income subject to tax, but recoveries on debts charged off by transferor banks are income to petitioner subject to tax.
2. Petitioner*904 in its 1934 tax return deducted as worthless debts certain of the debts charged off by it and by transferors in 1933 but determined by petitioner to be worthless in 1934. Held, deductions of debts charged off by transferors in 1933 not to be allowed, but deductions of debts charged off by petitioner in 1933 should be allowed.
*72 This proceeding involves a deficiency in income tax liability of petitioner determined by respondent for the year 1934 in the sum of $2,896.54, and a claim for refund of taxes paid for that year in the sum of $3,076.94, denied by respondent. The parties have stipulated that "the taxes in controversy are income taxes for the year 1934 and in the amount of $5,833.23."
The parties hereto have filed two stipulations of fact and a number of exhibits in our record, which we include in our findings by reference. For specific details, where material, we refer to these stipulations and exhibits. In addition, oral testimony was given at the hearing herein. Our findings of fact set out below include*905 the findings based upon such oral testimony and also a recitation of those facts contained in the stipulations which are necessary for an understanding of the issues presented by this proceeding.
FINDINGS OF FACT.
The petitioner is a banking corporation, with its principal place of business in Seattle, Washington. Most of the stock of petitioner was *73 owned by the Marine Bancorporation during the years 1933 and 1934. In the year 1933, and prior to the transfers hereinafter described, the Marine Bancorporation was the owner of 94.5 percent of the capital stock of the Central National Bank of Commerce, 91 percent of the capital stock of the Washington National Bank of Commerce, 93 percent of the capital stock of the Capital National Bank, 94 percent of the capital stock of the Grays Harbor National Bank, 94 percent of the capital stock of the Bank of Elma, and 88 percent of the capital stock of the Montesano State Bank. These banks were smaller than petitioner and had their place of business in Seattle or its vicinity.
In the early part of 1933 the Marine Bancorporation evolved a plan of reorganization with regard to petitioner and the other banks above enumerated, *906 whereby the assets of the six smaller banks were to be transferred to petitioner, subject to all their liabilities, and thereafter the business of the six smaller banks was to be carried on by petitioner through branches which would take the place of such smaller banks.
Pursuant to the plan of reorganization, the Central National Bank of Commerce and the Washington National Bank of Commerce transferred all of their assets to petitioner on April 1, 1933, the Capital National Bank and the Grays Harbor National Bank transferred all their assets to petitioner on September 1, 1933, and the Bank of Elma and the Montesano State Bank transferred all their assets to petitioner on December 1, 1933. Immediately after each of such transfers, the Marine Bancorporation was the owner of over 99 percent of the capital stock of petitioner. Petitioner, at the time of such transfers, assumed the liabilities of each of the banks making such transfers in an amount equal to the value of the "ledger" assets remaining upon the books of such transferor banks at the time of the transfers.
Immediately prior to the transfers set out above, each of the transferor banks, pursuant to the general plan of*907 reorganization, went over its accounts and notes receivable and charged off its books all of such debts which it owned which were either worthless or which, while not worthless, might be considered as subject to criticism by either state or national bank examiners, such as loans made to companies in which some officer of the bank might be interested, or real estate loans not justified by 1933 appraisals, or real estate loans in excess of 50 percent of the value of the security. The total amount of the debts thus charged off on the books of the transferor banks prior to the transfers in question were in the following amounts:
| Central National Bank of Commerce | $30,074.90 |
| Washington National Bank of Commerce | 18,839.49 |
| Capital National Bank | 32,054.59 |
| Grays Harbor National Bank | 169,544.37 |
| Bank of Elma | 54,505.98 |
| Montesano State Bank | $120,664.03 |
*74 Each of the transferor banks claimed deduction for worthless debts in the amounts set forth above in its original 1933 income tax return. In 1936, however, each of the six transferor banks filed an amended return for the year 1933 in which deductions for worthless debts were claimed in a lesser amount as follows: *908
| Central National Bank of Commerce | |
| Washington National Bank of Commerce | $157.79 |
| Capital National Bank | 2,464.13 |
| Grays Harbor National Bank | 55,675.13 |
| Bank of Elma | 10,027.99 |
| Montesano State Bank | 14,418.84 |
The amended returns explained that the difference between the amount of such deductions claimed therein and those claimed in the original returns for 1933 represented loans partially or fully secured, and therefore, not deductible items. It was further explained that these items were charged off by way of capital adjustments and were deducted in the original returns by mistake.
At the time of the reorganization and transfers described above, petitioner charged off its books notes and accounts receivable which it owned in the amount of $531,597.63 and claimed as a deduction for worthless debts those amounts in its original 1933 income tax return. In an amended return submitted for 1933 petitioner claimed as such a deduction the sum of $366,269.97. A similar explanation was made with regard to the discrepancy between the amount of the deduction claimed in the amended return and that claimed in the original return.
With the exception of the Central National*909 Bank of Commerce, each of the transferor banks sustained a net loss in the year 1933 in an amount greater than the bad debts claimed as a deduction in its original return. Petitioner also sustained a net loss for that year in an amount greater than the bad debts claimed as a deduction in its original return for the year 1933. The taxable gain of the Central National Bank of Commerce for 1933 amounted to $1,333.03 after excluding $30,074.90 of bad debts which had been claimed on its original return for the year 1933. Petitioner made recoveries on such debts in 1934 in the sum of $3,110.33.
After the transfers had been made to petitioner in 1933 pursuant to the reorganization, all as above described, the accounts which had been charged off the books of the transferor banks and the accounts which had been charged off the books of petitioner were carried as nonledger assets of the petitioner, that is, they were charged off the general ledger of petitioner or the transferor banks, and after the transfers and the reorganization, were carried by petitioner as nonledger accounts in the form of cards which were periodically checked by officers of the bank, but which did not appear in*910 the asset account *75 of the bank. Many of these accounts, while not carried as assets of the bank, were considered of value.
In 1934 petitioner made recoveries in the amount of $11,835.16 on accounts charged off by it in 1933 and claimed as deductions for bad debts in its original 1933 income tax return, and also made recoveries in the amount of $26,230.90 on debts charged off by the transferor banks and claimed by them as deductions for worthless debts in their income tax returns for 1933. In 1934 petitioner reported as income all of such recoveries except recoveries in the amount of $4,935.48 which were had on account of debts which petitioner had received from the Montesano State Bank.
In its income tax return for 1934 petitioner claimed as a deduction bad debts in a total amount of $4,357.44 made up of 16 items, 4 of which in a total amount of $525 had been charged off by petitioner, and 12 of which in a total amount of $3,832.44 had been charged off by the transferor banks in 1933, after which charge-offs and transfers they had been carried as nonledger accounts by petitioner. Deductions for these debts had been claimed in the original income tax return of petitioner*911 and the transferor banks in 1933. They were ascertained by petitioner to be worthless in 1934, but no charge-off was made as to these debts upon the books of petitioner in the year 1934.
Petitioner has stipulated that recoveries made by it in 1934 in the amount of $1,132.24 are taxable.
OPINION.
KERN: The primary question presented by this proceeding is whether the recoveries of debts charged off as worthless in previous years by a bank on its own initiative constitute taxable income in the year of their recovery by such bank, even though the prior charge-off accomplished no reduction in tax liability in the year in which they were charged off.
It is now well settled that where amounts previously deducted from income for losses, expenses, bad debts, taxes, etc., which effect an offset of taxable income, are recovered in subsequent years, such recoveries "should be reported as a part of gross income for the year in which * * * recovered." Estate of William H. Block,39 B.T.A. 338">39 B.T.A. 338; Dixie Margarine Co.,38 B.T.A. 471">38 B.T.A. 471. The converse of this proposition is also true - that if such amounts so deducted did not effect an offset of taxable income*912 for the year in which deducted, then recoveries in subsequent years should not be included in gross income in the years of recovery. Central Loan & Investment Co.,39 B.T.A. 981">39 B.T.A. 981. Therefore, regardless of whether the debts were *76 charged off, in the instant proceeding, on the bank's own initiative or on the order of a bank examiner, if the charge-off accomplished no reduction in tax liability in the year in which they were charged off, the recoveries of such debts in a subsequent year would not constitute income in the year of their recovery.
As pointed out in Central Loan & Investment Co., supra, this conclusion accords with the views expressed by the General Counsel of the Bureau of Internal Revenue in G.C.M. 18525 (C.B. 1937-1, p. 80) and G.C.M. 20854 (1939 Int. Rev. Bul. No. 9, p. 2).
A question is involved in this proceeding which was not present in the Central Loan & Investment Co. case, in that here a large part of the debts upon which recoveries were made by petitioner had been charged off in a prior year from the books of other corporations which were then the owners of the debts and deducted by*913 them without offsetting any tax liability on their part. The debts were later transferred to petitioner. Will our conclusion be the same as to the recoveries made on these debts thus transferred to petitioner prior to the taxable year?
Respondent contends that all of the debts involved herein were acquired by purchase from the banks whose assets were taken over by petitioner; that the purchase price was allocated by petitioner solely to the sound or ledger assets, which included the debts of unquestioned value, and not to the debts of questionable value which had been charged off as worthless by the transferor banks and which were not carried as assets on petitioner's ledger; and that, therefore, the nonledger assets cost petitioner nothing and could have no basis in the accounts of petitioner. It follows, respondent argues, that the recoveries made by petitioner upon the debts which were not carried as assets upon petitioner's ledger must be considered as income.
Petitioner contends that these debts were acquired by petitioner in the course of a reorganization and not by purchase, regardless of how the transaction was treated on the books of petitioner. In 1933 the Marine*914 Bancorporation owned from 88 percent to 94.5 percent of the stock of certain small banks located in the vicinity of Seattle. In that year it was decided by the Marine Bancorporation that the business of these banks should be carried on as branches of petitioner. Pursuant to a plan of reorganization, and in order to accomplish this purpose, these banks transferred all of their assets to petitioner in 1933 subject to their liabilities. Immediately after each of these transfers the Marine Bancorporation was the owner of over 99 percent of the stock of petitioner. Therefore, petitioner contends, these transactions constituted a reorganization within the meaning of section 112(i)(1)(B) of the Revenue Act of 1932 (section 112(g)(1) *77 (C), Act of 1934), and the basis of the accounts to petitioner was the same as to the transferors; that is, cost.
We agree with petitioner that these transactions do constitute a reorganization within the definition of the statute set out in section 112(i)(1)(B) of the Act of 1932. However, that particular section is only a definition and does not provide that in all transactions which may be classified as reorganizations no gain or loss shall*915 be recognized. Section 112(a) states the general rule that upon the sale or exchange of property the gain or loss shall be recognized "except as hereinafter provided in this section." Subsections (b) to (h) inclusive of section 112 set out the exceptions to which subsection (a) refers. These subsections are not applicable to a reorganization such as the one consummated in the instant proceeding. Therefore, we must conclude that gain or loss shall be recognized in the transactions resulting in the reorganization involved here. Those transactions may be briefly stated as follows: The small transferor banks charged off prior to the reorganization certain of their assets. They then transferred all of their assets to petitioner, and in return, petitioner assumed all of their liabilities. The liabilities thus assumed equaled the amount of assets remaining on the books of the small transferor banks and were set up by petitioner on its books as the purchase price allocated to the assets which remained on the books of the transferor banks at the time of transfer and which, after the transfer, were carried on the books of petitioner. *916 Petitioner did not carry as assets on its books the items which had been charged off by the transferor banks. Since these transfers were made in connection with a reorganization (even though not a tax-free reorganization) and immediately after the transfers a control in the property transferred remained in the same persons (i.e., the Marine Bancorporation), section 113(a)(7) of the Act of 1934 is applicable. Cf. Piedmont Financial Co., Inc.,26 B.T.A. 1221">26 B.T.A. 1221. The pertinent provisions of that section are as follows:
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. * * *
Applying that section to the facts of the instant proceeding, it becomes necessary to determine whether a gain or loss was recognized*917 to the transferors upon such transfers. We are of the opinion that there was a loss to the transferors upon such transfers. The transferors received from the petitioner an assumption of their liabilities equivalent to the value of their ledger assets which, we must conclude *78 from the evidence, were worth the amount at which they were carried on the books of the transferors. In return petitioner acquired all of the assets of the transferors, including the nonledger assets which had been charged off the books of the transferors. As to these nonledger assets there is evidence that the transferor banks and petitioner considered them to be of some value, but there is no evidence as to what that value was. The transferor banks, by charging off these assets prior to the transfers and deducting them as bad debts in their income tax returns, treated them as of no value, and petitioner, after the transfers, treated them in the same way by not carrying them as assets on its books and allocating the liabilities assumed as the purchase price of the ledger assets. We are of the opinion that whatever value the nonledger assets had was lost to the transferors at the time of the transfers*918 and, therefore, the basis of such assets to them at that time was zero. It follows, pursuant to section 113(a)(7), that the basis of such assets to petitioner, the transferee, would also be zero. Since petitioner acquired by purchase accounts which had as to it a basis of zero, any collections made by petitioner on such accounts would constitute income. Cf. Chatham & Phenix National Bank,1 B.T.A. 460">1 B.T.A. 460; Madison & Kedzie State Bank,1 B.T.A. 922">1 B.T.A. 922. On this issue our decision is for respondent.
One more question remains for our decision. In 1933 petitioner and three of the smaller transferor banks deducted as bad debts some 16 items in a total amount of $4,357.44 which had been charged off in that year, but which had not been ascertained to be worthless in 1933. As set out in our findings, 4 of these items were charged off by petitioner while 12 were charged off by the transferor banks and then transferred to petitioner. The deduction of these items did not effect an offset against the taxable income of the banks to which these debts were owed. In that year the petitioner acquired all of the debts in connection with the reorganization which we*919 have already described. In 1934 petitioner ascertained these debts to be worthless and claimed them as a deduction in that year. They were not charged off the books of petitioner in 1934, since they had been charged off the books of petitioner and its transferors in 1933. Since we have just decided that the debts which were charged off by the transferor banks in 1933 and then transferred to petitioner had a basis in the hands of petitioner of zero, it is obvious that the 12 items thus transferred to petitioner in 1933 can not be deducted by it under any circumstances because no loss has been sustained by it. However, the 4 items which were at all times the property of petitioner are properly deductible under the rule of George H. Fraser,6 B.T.A. 997">6 B.T.A. 997, and Georgia Engineering Co.,21 B.T.A. 532">21 B.T.A. 532.
Reviewed by the Board.
Decision will be entered under Rule 50.
*79 LEECH, dissenting on the last issue: The tax effect involved in the decision of this issue is slight. However, the rule laid down seems to me to be important enough to warrant comment.
The four debts in question under this issue were charged off the books of the taxpayer*920 in 1933. Deductions were claimed therefor as worthless debts in its return for that year. This resulted in an addition in that amount to its net loss for such year, which would have been carried over to 1934 had it not been for the elimination of the right to carry over net losses, by the Revenue Act of 1934, section 117. The debts were ascertained to be worthless in 1934 but no charge-off then occurred - since, of course, they had already been charged off once and were never thereafter restored to petitioner's asset account.
The majority holds the amount of these debts was deductible for 1934 under the rule of George H. Fraser,6 B.T.A. 997">6 B.T.A. 997, and Georgia Engineering Co.,21 B.T.A. 532">21 B.T.A. 532.
It is possible both those cases are distinguishable from this case. But, in any event, I disagree with the conclusions of the Board in both of them and with that of the majority here. The opinions in the two cited cases stem from Mason Machine Works Co.,3 B.T.A. 745">3 B.T.A. 745. In that case the Board found as a fact that a constructive charge-off occurred during the taxable year. Neither in the present case nor in the Fraser and Georgia Engineering*921 Co. cases, supra, was there a charge-off of any kind.
The controlling statutory provision, section 23(k) of the Revenue Act of 1934, allows as deductions "debts ascertained to be worthless and charged off within the taxable year * * *." The meaning thus expressed is clear and unambiguous. I think Congress meant exactly that it said. To entitle a taxpayer to the reduction there authorized, he must perform two affirmative acts - and they must both occur "within the taxable year." To hold otherwise seems to me requires a rather flagrant violation of the statutory bounds of our jurisdiction and a trespass upon the constitutionally exclusive legislative function of Congress.
The Circuit Court of Appeals for the Second Circuit, in deciding Ludlow Value Manufacturing Co. v. Durey, 62 Fed.(2d) 508, after our decisions in the Fraser and Georgia Engineering Co. cases, concisely states my position here:
Presumably so much of those debts as were charged off in 1915 and 1916 were ascertained to be worthless in those years, else they would not then have been written off, but we merely suggest that. The important fact is that, having previously been*922 charged off, they could not be written off again in 1918. Darling v. Commissioner (C.C.A.) 49 F.(2d) 111; Avery v. Commissioner (C.C.A.) 22 F.(2d) 6, 55 A.L.R. 1277">55 A.L.R. 1277;Stephenson v. Commissioner (C.C.A.) 43 F.(2d) 348. To permit that would leave a taxpayer free to charge off bad debts whenever they were ascertained to be worthless and the exigencies *80 of his business required by entry and to let him take the deduction then or in a later year as he preferred. This would give him the opportunity to wait before claiming the deduction until there should be a year in which his income would be sufficient to allow him the maximum benefit, instead of taking it as the statute required in the year when the debts were both ascertained to be worthless and charged off. * * * [Emphasis supplied.]