*6 Decision will be entered under Rule 50.
Petitioner advanced money to a corporation under an agreement relating to the reorganization and refinancing of the corporation. Held, the transaction gave rise to an indebtedness constituting a basis for a deduction from gross income as a worthless debt; held, further, the debt became partially worthless in 1940.
*478 This proceeding involves a deficiency in income tax for the year 1940, determined by the Commissioner in the amount of $ 6,695.34. Certain minor adjustments in the notice of deficiency are not contested by the petitioner. The sole issue is whether the sum of $ 10,000, or some part *479 thereof, subscribed by petitioner under a subscription agreement, is deductible as a bad debt under the provisions of section 23 (k) of the Internal Revenue Code.
Some of the facts were stipulated by the parties and are found as stipulated. Other material facts were found from the evidence.
FINDINGS OF FACT.
Petitioner resides at Clapboard Ridge Road, Greenwich, *7 Connecticut, and has his office and place of business at 230 Park Avenue, New York, New York. He filed his income tax return for the calendar year 1940 with the collector of internal revenue for the third New York district and reported on the cash receipts basis. During 1940 petitioner was president of the Simmons Co., a manufacturing corporation.
Fishers Island Corporation, hereinafter referred to as the corporation, was organized in 1925, under the laws of the State of New York. At that time it acquired from Fishers Island Farms, Inc., approximately 1,754 acres of land on Fishers Island, for which it gave 15,000 shares of its common stock and $ 1,500,000 of its noninterest bearing A debentures. Upon being advised that it was essential to have a club with recreational facilities for the success of the development, the corporation formed the Fishers Island Club for recreational facilities as the best means of promoting sales of its property and drawing people there. It operated the club until 1935.
Between 1925 and June 30, 1934, the corporation sold approximately 595 acres of home site property for a sum in excess of $ 2,500,000. The purchasers of the above sites have invested*8 an additional amount of approximately $ 3,600,000 in developing their properties.
The corporation expended in construction of a club house, sports and bathing facilities, light and water systems, landscaping, and interest charges sums totaling approximately $ 3,130,000. This amount, together with its operating deficits, had been financed partly by the sale of home sites, partly from a first mortgage on realty, and by bank loans. As of June 30, 1934, in addition to other assets, it had approximately 454 acres of land available for home sites, which at that time were classified for sale at over $ 3,000,000. The outstanding liabilities of the corporation amounted to approximately $ 2,927,077.
The corporation's B debentures had been purchased by club members, who had received as a bonus a total of 4,488 shares of the corporation's capital stock. These shares, coupled with the 15,000 shares held by Fishers Island Farms, Inc., totaling 19,488 shares, represented all of the stock outstanding.
Petitioner joined Fishers Island Club in 1928. At that time he purchased from the corporation a B debenture for $ 2,500, which he later exchanged as part payment for a home site on the island. *9 Up *480 to 1934 he had invested in his summer home on the island approximately $ 125,000. His summer home was situated about 1 1/2 miles from the Fishers Island Club. Petitioner stayed at his Fishers Island property a few weeks and additional week ends during the summers from 1929 to 1942. His wife and family spent the summers there. He and his family frequently used the recreational facilities of the club.
The corporation formulated a plan of reorganization and recapitalization dated October 1, 1934, and a proposed subscription agreement pursuant to that plan. These plans were formulated because Fishers Island Farms, Inc., had advised the corporation that the "Farms" could make no further advancements to the corporation; because the first mortgage of $ 292,000 on the properties of the corporation was past due; and because the banks holding the demand notes of the corporation were unwilling to continue the notes as unsecured loans without a readjustment of the corporation's debt.
The subscription agreement provided for an extention of the first mortgage for a period of five years from January 1, 1935, upon the deposit by the corporation of a sum sufficient to cover interest*10 at the rate of 5 percent for five years and estimated taxes in the amount of $ 45,000. The New York Trust Co. and the Chase National Bank agreed to extend their loans to the corporation, aggregating $ 270,000, for a period of five years from January 1, 1935, upon the payment to them of five years' interest in advance. After the liquidation of the first mortgage the banks were to be repaid out of the proceeds from the sale of home sites and net earnings of the corporation.
It was necessary that $ 250,000 be subscribed for the contract to be effective. The corporation's specific agreement with the subscribers reads as follows:
2. I. The Corporation agrees with the Subscribers
(a) that it will repay all amounts subscribed and paid in to it without interest, after payment of the first mortgage, out of the net proceeds of the acreage of the Corporation available for homesites, net earnings of the Corporation, and the interest reserve upon the mortgage which may be in excess of amounts required for the purpose by reason of the reduction of the principal of the mortgage; one-half of such monies available to be applicable to the reductions of subscriptions and one-half to be applicable*11 to paying down the bank loans.
(b) The Corporation will not place a lien upon the property other than the first mortgage (or mortgage to be created to refund the same) without the approval of (i) seventy-five per cent. in amount of the subscribers and of (ii) the Banks, respectively, until (i) the subscriptions are repaid and (ii) the Bank debt is paid in full, respectively.
Fishers Island Farms, Inc., which had guaranteed the first mortgage and the bank loans of the corporation, was to be relieved of liability on its guaranty and it in turn agreed to deliver to the corporation 1,090 shares of the latter's stock for use in exchanging the same *481 for B debentures; to deliver to the corporation for cancellation A debentures in the amount of $ 1,500,000; to turn over 9,750 shares of the corporation's stock for delivery to subscribers; and to subordinate the indebtedness of the corporation to it in the sum of $ 320,000. The "Farms" also waived interest thereon for a five-year period beginning January 1, 1935.
Petitioner and others executed the agreement and thereafter the plan was declared operative. Petitioner paid $ 10,000 about March 25, 1935, to the New York Trust Co. as *12 escrow depositary pursuant to the plan and agreement. In acknowledgment he received a letter from the escrow depositary as follows:
We acknowledge receipt from you the sum of $ 10,000. being payment in full of your subscription under and pursuant to a Subscription Agreement dated October 1, 1934 between Fishers Island Corporation, Fishers Island Farms, Inc. and the several subscribers thereto.
The foregoing receipt was the only evidence of the payment received by petitioner. He did not receive any bond, debenture, note or certificate, or other evidence of indebtedness for the sum paid.
Both the petitioner and the corporation regarded the transaction as a loan and it was consistently so treated by them.
In May 1935 the petitioner received a certificate for 390 shares of the corporation's capital stock without further payment, in accordance with the plan and agreement. The stock was transferred to the subscribers by Fishers Island Farms, Inc., and was received by the subscribers in lieu of interest on their subscriptions and to give them an interest in and control of the corporation in order to make the repayment of the loan more likely.
The sum of $ 10,000 paid by petitioner under*13 the subscription agreement was a loan made by him to the corporation.
After its reorganization the following shift of stock control of the corporation took place:
| Before | After | ||
| reorganization | Change | reorganization | |
| Shares | Shares | Shares | |
| Bonus stock held by original purchasers | |||
| of B debentures | 4,488 | 0 | 4,488 |
| Held by Fishers Island Farms, Inc | 15,000 | (10,840) | 4,160 |
| Received in exchange for B debentures | None | 1,090 | 1,090 |
| Received by subscribers to tax and | |||
| interest fund | None | 9,750 | 9,750 |
| 19,488 | None | 19,488 |
Pursuant to the plan the board of directors reclassified 454.68 acres of home site land and reduced the schedule of selling prices from a total of $ 3,105,610 to $ 1,128,475.
Petitioner became a member of the newly formed Fishers Island Club, Inc., which thereafter operated the club facilities under the lease from the corporation.
*482 During the period between 1935 and November 1, 1939, the corporation succeeded in selling only 6.74 acres of land for a gross price of $ 22,360, the proceeds of which were applied in reduction of the mortgage debt.
The December 30, 1939, balance sheet of Fishers Island Corporation reflected the following assets*14 and liabilities:
| ASSETS | |||||
| Cash | $ 1,103.82 | ||||
| Cash on deposit with escrow | 13,726.72 | ||||
| Cash on deposit: Mortgage special account | 48.88 | ||||
| Cash on deposit with trustee: for mortgage | 2,504.67 | ||||
| Notes, accounts, and accrued interest receivable | $ 83,726.45 | ||||
| Less: Reserve | 54,076.48 | ||||
| 29,649.97 | |||||
| Due from Fishers Island Club: Open account | 11,055.43 | ||||
| Due from Fishers Island Club: 4% demand notes | 3,000.00 | ||||
| Tax lien certificates | 870.75 | ||||
| Reorganization expense chargeable to Fishers Island Utilities Co | 2,000.00 | ||||
| Acreage plotted for sale | $ 1,152,166.29 | ||||
| Less: Reserve | 179,055.55 | ||||
| 973,110.74 | |||||
| Fixed assets and acreage not plotted for sale: | |||||
| Club land, bldgs., | Gross value | Less reserve | Net value | ||
| and equip | $ 1,547,192.21 | $ 522,733.55 | $ 1,024,458.66 | ||
| Land and plans for 2d | |||||
| golf course | 238,719.87 | 238,719.87 | |||
| Peninsula land | 52,330.63 | 52,330.63 | |||
| Dwellings | 57,078.99 | 39,276.72 | 17,802.27 | ||
| Other bldgs. and | |||||
| equipment | 115,279.14 | 83,335.74 | 31,943.40 | ||
| Electric system | 132,000.41 | 43,276.39 | 88,724.02 | ||
| Telephone system | 86,253.79 | 31,106.61 | 55,147.18 | ||
| Water system | 433,759.06 | 113,323.30 | 320,435.76 | ||
| 2,662,614.10 | 833,052.31 | ||||
| Total fixed assets and acreage not plotted for sale | $ 1,829,561.79 | ||||
| Deferred charges: | |||||
| Materials and Supplies on Hand | $ 2,320.51 | ||||
| Prepaid insurance | 5,802.63 | ||||
| Misc. prepaid expenses | 33.33 | ||||
| Total deferred assets | 8,156.47 | ||||
| Total assets | 2,874,789.24 | ||||
| LIABILITIES AND CAPITAL | |||||
| Accounts payable | $ 3,992.86 | ||||
| Accrued property taxes | 11,501.49 | ||||
| Accrued interest on mortgage payable | 3,650.00 | ||||
| Accrued interest on bank loans | 115.86 | ||||
| Collateral notes | 9,200.00 | ||||
| Rentals paid in advance | $ 175.00 | ||||
| Class B debentures | 5,000.00 | ||||
| First mortgage on real estate, due Jan. 1, 1940 | 273,833.25 | ||||
| Due to subscribers to interest and tax fund, due Jan. 1, 1940 | 250,000.00 | ||||
| Notes payable to banks, due Jan. 1, 1940 | 270,000.00 | ||||
| Notes payable to Fishers Island Farms, due Jan. 1, 1940 | 320,000.00 | ||||
| Estimated liability on roads and utilities per contracts | 61,200.00 | ||||
| Reserve for restoration of insured properties | 2,504.67 | ||||
| Reserve for renewals and replacements | 1,000.00 | ||||
| Capital stock: | |||||
| Authorized 22,500 shares without par value at | |||||
| stated value of $ 50 per share: | |||||
| Issued, 22,500 shares | $ 1,125,000 | ||||
| In treasury, 3,113 shares | 155,650 | ||||
| 969,350.00 | |||||
| Capital surplus: | |||||
| At Jan. 1, 1939 | 784,204.22 | ||||
| Deduct: Net loss as at Dec. 30, 1939 | 90,938.11 | ||||
| 693,366.11 | |||||
| Total capital stock and surplus | 1,662,616.11 | ||||
| Total liabilities and capital | 2,874,789.24 |
*15 *483 At a special meeting of the stockholders of Fishers Island Corporation held December 30, 1939, at which owners of a majority of the stock were present or represented, it was pointed out that the five-year plan was about to expire and that no extension thereof appeared possible; that the corporation's principal liabilities would all mature on January 1, 1940; and that the corporation did not have sufficient cash resources available for the payment thereof. It was stated that, for the protection of all concerned, the property ought to be turned over to the court if, as, and when the board of directors should determine. A motion to that effect was adopted. The chairman stated that he was willing to try to save bankruptcy proceedings and would like to feel that all present would attend a further meeting if required.
On January 23, 1940, the corporation filed a voluntary petition in bankruptcy in the Federal District Court for the Eastern District of New York. The corporation listed its assets at $ 827,650.82 and liabilities of $ 1,207,716.62, of which unsecured claims totaled $ 909,970.06, and included $ 250,000 repayable to the subscribers under the subscription agreement. *16 Petitioner filed a claim with the trustee in bankruptcy in the amount of $ 10,000 based upon his subscription. Other subscribers, including Samuel A. Salvage, filed similar claims in the amount of their respective subscriptions. All of the claims were admitted.
On or about November 25, 1940, the Federal District Court having jurisdiction ordered the principal assets of the corporation to be sold:
* * * for the sum of $ 300,000, payable $ 100,000 in cash or good certified check and $ 200,000 by taking such property subject to the existing first mortgage, *484 of which $ 100,000 cash payment, $ 75,000 will be payable to the mortgagee under said mortgage for principal and interest in order to bring about a reduction of said mortgage to the amount stated and the balance of which, amounting to $ 25,000 will be payable to said trustee.
In October 1941 the trustee in bankruptcy moved to reconsider and reject all claims based on the subscription agreement on the ground that (a) repayment under the agreement was limited to certain sources for which no funds were at any time available, (b) said claims did not represent an indebtedness of the corporation, but represented a contribution*17 to its capital by the subscribers, and (c) that the claims should be withdrawn under the arrangement made with the manager of the new syndicate.
Petitioner did not oppose this motion because he had already charged off the debt as worthless and thought there was no possibility of getting anything from the bankruptcy. Samuel A. Salvage did oppose the motion and his claim was allowed. The claims of other subscribers who did not oppose the motion were expunged.
On March 2, 1943, by an order of distribution of said bankrupt estate, a first and final dividend of $ 449.75 was paid upon Samuel Salvage's claim in the amount of $ 5,000, being 8.73 percent thereof.
During the taxable year 1940 petitioner's debt became partially worthless to the extent of 91.27 percent of its face value.
In his income tax return for 1940 the petitioner deducted the sum of $ 10,000 as a bad debt. In the deficiency notice disallowing such deduction the Commissioner held that the $ 10,000 advanced by petitioner to the Fishers Island Club was a contribution to the so-called "Interest and Tax Fund" and was not allowable as a bad debt deduction under the provisions of section 23 (k) of the Internal Revenue Code.
*18 OPINION.
The respondent denied the petitioner a bad debt deduction on the ground that Fishers Island Corporation's liability to repay was contingent upon the existence of designated funds and that, since such funds were never available for the purpose of repayment, a deductible debt never existed. We do not believe that argument is tenable, in view of the circumstances herein. The subscription agreement was entered into by the petitioner in the light of a plan for the reorganization and recapitalization of the corporation. It was agreed that the existing creditors of the corporation would extend or subordinate the obligations held by them, and it was reasonably hoped that during such time the corporation could dispose of sufficient of its realty to pay its obligations. The secured creditor was to be repaid from the first money received from the sale of the property which secured that loan. The parties contemplated that the subscribers and the banks would be repaid equally from the *485 sale proceeds over and above the amount necessary to satisfy the mortgagee, and from the first net earnings of the corporation and any balance which might be left in the interest and tax reserve*19 fund. The parties must have been aware that the plan of repayment might not be successful. If it had been their intention that the petitioner was to be repaid only in the event the plan succeeded and that no obligation to repay would arise if the plan failed, the parties would certainly have made specific provision in the agreement for such an eventuality. The problem is not unlike that presented to the Court of Claims in Birdsboro Steel Foundry & Machine Co. v. United States, 3 Fed. Supp. 640.
The language in the agreement stating the sources from which funds would be available for repayment was not intended to limit, nor does it have the effect of limiting, the general liability of the corporation to repay. The language, it seems to us, is in the nature of a security provision describing the manner in which the parties anticipated that the loan would be repaid and indicating that certain funds would be held for that purpose, and was not a condition upon which the general liability of the corporation was contingent. This view finds support from the action of the referee in bankruptcy in allowing the claim of Samuel A. Salvage, who, as a subscriber, *20 contested a motion to expunge his claim and succeeded in obtaining his pro rata share in the distribution to the unsecured creditors. The parties at all times regarded their relationship as that of debtor and creditor, and we think the obligation to repay petitioner was absolute.
What we have just said disposes of respondent's alternative argument that the subscription agreement was in the nature of an investment rather than a loan. It seems clear that the shares received by the subscribers were in lieu of interest and to give them a control of the corporation in order that the repayment of the loan might be better assured. There is no warrant for allocating any portion of the $ 10,000 to the shares acquired.
To establish the value at the end of 1939, petitioner introduced a balance sheet which reflected assets considerably in excess of liabilities. From this and other evidence, we have concluded that the company had valuable assets to which a creditor standing in petitioner's position might look. Further, the major obligations of the corporation, including that to petitioner, in accordance with the terms of the plan, did not mature until January 1, 1940.
The identifiable event*21 signifying the loss by petitioner and indicating the probable amount thereof was the order of the Federal District Court on November 25, 1940, directing the sale of the bankrupt's principal assets for the sum of $ 25,000 over and above the claim of the secured creditors.
*486 It was thus apparent at the end of 1940 that petitioner's claim would in no event be paid in its entirety. At best, he could hope to recover only a very small percentage of the sum loaned. The right to a partial charge-off was thus established. But at the end of 1940 petitioner's claim had not been expunged by the referee and it was not until October of the following year that the referee disallowed the claim on motion of the trustee. Salvage, who persisted in his claim, received a dividend of 8.73 percent and petitioner would have received substantially the same dividend if he had pursued his remedy. In the circumstances the deduction is allowable in 1940 to the extent of 91.27 percent of its face amount as a partial bad debt.
Decision will be entered under Rule 50.