*1905 1. AFFILIATION. - Whether three companies were affiliated in 1921, 1922, and 1923 could not be determined in those years as the ownership of two was in litigation not terminated until 1924. For two of the companies no returns were filed during the litigation and the third company filed a separate return in each year reporting such income as was not involved in litigation and advising the Commissioner of the peculiar conditions in respect to all three companies. Upon termination of the litigation, consolidated returns were filed for all of the three years. Held, that the filing for 1922 of a separate return by one company did not, under these facts, constitute the exercise by these companies of the option provided by section 240(a) of the Revenue Act of 1921.
2. INCOME. - One of the petitioner corporations contracted in 1920 for the sale and conveyance of most of its assets and business. This contract, after the first payment of $100,000 was made, was repudiated by the purchaser, who, as a result of suit brought against him, settled the controversy, petitioner retaining its property and the payment already made, and receiving in addition, payment of $755,000. The amount*1906 paid was measured by the losses incurred in operation of the properties for the purchaser following the execution of the contract. Held, that the items of $755,000 paid and $100,000 retained under the contract of settlement represented income to petitioner. Burnet v. Sanford & Brooks Co.,282 U.S. 359">282 U.S. 359. Held, further, that these amounts should be included in income for 1924, in which year the litigation under which they were secured was terminated. Lucas v. American Code Co.,280 U.S. 445">280 U.S. 445.
*228 By these appeals, consolidated for hearing, redetermination is sought of a deficiency in income tax of $29,317.30 as to the Dexter Sulphite Pulp and Paper Company for 1923, and a deficiency of $1,732.49 as to the Howland Bag and Paper Company for 1922.
Errors assigned by the two petitioners are (1) failure to determine the tax liabilities of petitioners on the basis of consolidated returns as affiliated with the Dexter & Northern Railroad*1907 Company in 1921, 1922, and 1923; (2) the inclusion by respondent in income of the Dexter Sulphite Pulp and Paper Company for 1923 of $755,000 paid that petitioner in settlement of suit against William Randolph Hearst for breach of contract to purchase the assets of that company, the amount paid being the estimated losses in operation following the execution of the contract; and (3) the inclusion by respondent in income of this petitioner for 1923 of $100,000 paid by Hearst in 1920 on account of the contract to acquire the corporate assets and retained by this petitioner under the settlement above referred to.
Additional errors assigned upon respondent's action in failing to allow for 1923 to the Dexter Sulphite Pulp and Paper Company deductions of $921.25 and $3,630.83, and including in its income for that year an item of $308.82, were withdrawn and abandoned by petitioners at the hearing.
FINDINGS OF FACT.
The Dexter Sulphite Pulp and Paper Company, hereinafter called the Dexter Company, is a New York corporation organized in 1888 and engaged since organization in the manufacture and sale of paper and paper sulphite. The Howland Bag and Paper Company, hereinafter called*1908 the Howland Company, is a New York corporation organized in 1904, and engaged since that time in the manufacture and sale of paper bags. The business is carried on in the plant of the Dexter Company, it being a subsidiary organized to use a product of that company. The Dexter & Northern Railroad Company, hereinafter referred to as the Railroad Company, is a New York corporation organized in 1908. It was organized to construct and hold title to a short line of railroad to connect the factories and warehouses of *229 the Dexter Company plant and to connect such plant with the main line railroad. The operation of this railroad has been its business since organization. It is purely a plant facility and was organized as a separate corporation in order that it might have power to condemn its right of way, such power not being possessed by the Dexter Company.
All three of the corporations named above were affiliated within the purview of the Revenue Act of 1921, throughout the years 1921, 1922, and 1923.
On May 1, 1920, the Dexter Company and James E. and Clarence W. Campbell, owners of its capital stock, entered into a written agreement with William Randolph Hearst, providing*1909 for a sale to Hearst of the property and business of the Dexter Company, including all of the capital stock of the Howland and Railroad Companies. This agreement provided for a total consideration of $3,500,000 to be paid by Hearst, $100,000 at the time of the execution of the agreement and the balance in stipulated deferred payments, and further provided that formal transfer of title to the assets was to be made on or before July 1, 1920. The sale and transfer was not to include the Dexter Company franchise nor certain investment securities which it owned.
The $100,000 cash payment provided for was made upon the execution of the contract and was entered on the books of the Dexter Company as a payment on account of the sale of the capital assets and was not included in income of that year.
Following the execution of the contract with Hearst, an accountant employed by the latter took charge of the accounting system of the companies. No formal transfer of the properties was made, but the two Campbells continued to run the business as if owned by Hearst, making reports to him of operations.
Prior to the execution of the contract with Hearst, the Dexter Company had made certain*1910 special grades of paper and had a large and well established business with many customers. The acquisition of the plant by Hearst was for the purpose of changing the operation to produce only newsprint paper to supply his various newspapers, and following the execution of the agreement, the Dexter Company notified all of its customers that it had sold its properties and no further orders would be accepted by it for paper and their future requirements would have to be supplied elsewhere. The operation of the plant following the execution of the contract was by readjustment to make newspring paper and the manufacture of such paper.
On February 25, 1921, Hearst, by letter repudiated the contract and refused to accept formal conveyance of the properties. Thereupon the Dexter Company instituted suit against Hearst for breach *230 of contract and the latter countered with a like suit against it, this litigation continuing through 1921, 1922, and 1923. The trial of the suit by the Dexter Company began in December, 1923, and continued until the day before Christmas, when court recessed for the holidays, and thereupon the Hearst attorneys approached the attorneys for the Dexter*1911 Company in respect to a settlement, the negotiations being carried on for several days and a settlement being finally effected on January 5, 1924, by the terms of which the Dexter Company retained the assets covered by the contract and Hearst agreed to pay to it $755,000 as reimbursement of the losses sustained from May 1, 1920, to December 31, 1923, resulting from Hearst's possession and operation of the properties from the day of the execution of the contract to February 25, 1921, when he repudiated it. Under this settlement the Dexter Company, in addition to the $755,000 provided for, retained the $100,000 cash paid in 1920 upon the execution of the contract.
The $755,000 provided to be paid in settlement was paid by Hearst executing and delivering to the Dexter Company's attorney shortly after January 5, 1924, deferred payment notes in that amount. These notes were entered on the Dexter Company's books as of December 31, 1923, and included in 1923 income by the accountants employed by that company.
Following the repudiation by Hearst on February 25, 1921, of the contract of May 1, 1920, the Dexter Company had proceeded to readapt its plant to its former manufacture of paper*1912 and attempted to regain its former business and customers, but the latter it found difficult to do, and its operations resulted in a net loss by the Howland Company for 1921 of $130,103.37 and net losses for 1921 and 1922 by the Railroad Company of $4,175.05 and $2,494.09. The net income of the Dexter & Northern Railroad Company for the year 1923 was $1,068.74.
At the time of the effecting of the settlement of the litigation with Hearst, the combined losses of these three corporations from operations for the period from January 1, 1920, to December 31, 1923, were computed to be $816,905.52.
Upon the repudiation on February 25, 1921, by Hearst, of the contract for acquisition of the Dexter Company's assets, counsel for the Dexter Company and a representative of that company came to Washington, it being just prior to the time for filing returns for 1920, and explained to the Commissioner the peculiar condition in which the companies were placed by the repudiation of the contract and the pending litigation, it being impossible to determine until the conclusion of the litigation who was the owner of the assets in question, these assets including the stock of the Howland *231 *1913 and Railroad Companies. It was explained that the ownership of the income of these companies could not then be determined but the companies did not wish to take the chance of delaying a report of income and the probable assessment of penalties for such delay. Following the result of this conference, a tentative return was filed by the Dexter Company for 1920, reporting only income from its investment securities which were not included in the sale to Hearst. No returns were filed for the Howland and Railroad Companies.
On June 10, 1921, there was a second conference by the representatives of the Dexter Company with the chief of the Rules and Regulations Section in the office of the Commissioner, and following this, a letter was written as follows:
JULY 6, 1921.
HARRY C. ARMSTRONG, ESQ.,
Chief, Rules & Regulations Section,Income Tax Bureau, Washington, D.C.
DEAR SIR: Absence from home has prevented my writing you sooner according to understanding, in regard to the call of myself and Mr. C. E. Scoville, of the firm of Haskins & Sells, certified public accountants, on June 10, 1921, in relation to the tax against the Dexter Sulphite Pulp & Paper Company from May 1, 1920 to*1914 and including December 31, 1920.
Under contract the Dexter Sulphite Pulp & Paper Company sold its property, including mill &c., but not its franchises, to William Randolph Hearst of New York City, and delivered possession on May 1, 1920. This sale included all of the capital stock of the Hwland Bag & Paper Company and the Dexter & Northern Railroad Corporation, affiliated with the Dexter Sulphite Pulp & Paper Company, and the control and possession of these properties. Hearst remained in possession until February 28, 1921, when he repudiated the contract of purchase, and the Dexter Sulphite Pulp & Paper Company under a clause of the agreement for its security, resumed possession to protect itself in the payments secured by the contract with Hearst.
The Dexter Sulphite Pulp & Paper Company acting under an extension, will later file a tax return for the period from January 1, 1920 to May 1, 1920. The profits from May 1, 1920 to December 31, 1920, amount to several hundred thousand dollars, and the Dexter Sulphite Pulp & Paper Company is not responsible for the filing of a tax return covering such profits. Its only concern therewith is that it desires to protect the assets involved*1915 from possible penalties and fines from the failure of William R. Hearst to file a tax return covering the profits over the period from May 1, 1920 to December 31, 1920. It is interested in this omission and failure by Hearst for the reason that if it shall be determined that the contract of sale to Hearst is invalid, the property will revert to said Dexter Sulphite Pulp & Paper Company, subject to said tax. If the Dexter Sulphite Pulp & Paper Company is unable to collect on the contract from Hearst because of his insolvency, or for any other reason, although the contract is valid, then and in that case the tax from May 1st to December 31st, 1920, will have to be borne by the Dexter Sulphite Pulp & Paper Company.
The Dexter Sulphite Pulp & Paper Company made every effort by furnishing the information and otherwise to secure the filing of a return by Hearst, but without avail.
*232 While you did not think it necessary to write a letter that in your opinion under the circumstances the Dexter Sulphite Pulp & Paper Company was not in a position to be penalized for the period from May 1, 1920 to December 31, 1920, you kindly assured us that in your opinion we were not subject*1916 to penalties or fines, and that they were not likely to be assessed against the properties or assets so far as the Dexter Sulphite Pulp & Paper Company were interested in them, and that it was probable no action would be taken during the current year by the Government to enforce them on account of the condition of the calendar, thus giving an opportunity to have the rights between Hearst and the Dexter Sulphite Pulp & Paper Company first adjudged.
I am writing this letter not for the purpose of binding the Government to any agreement, but so that the substance of our interview may be on record, when and if the matter is necessarily the subject of further consultation with a view to settlement.
Thanking you in advance for an acknowledgment, I remain
Very truly yours,
(Signed) ELON R. BROWN, Counsel,
DEXTER SULPHITE PULP & PAPER COMPANY.
Receipt of this letter was acknowledged as follows:
TREASURY DEPARTMENT,
OFFICE OF COMMISSIONER OF INTERNAL REVENUE,
WASHINGTON, July 9, 1921.
IT:R:RR
CSF
Mr. ELON BROWN,
104 Stone Street, Watertown, N.Y.
SIR: Receipt is acknowledged of your letter of July 6, 1921, relative to the tax assessed against the Dexter*1917 Sulphite Pulp & Paper Company, for the period May 1, 1920, to December 31, 1920.
As suggested by you, this letter will be filed pending any further action on your part.
Respectifully,
(Signed) E. H. BATSON,
Deputy Commissioner.
By H. C. ARMSTRONG,
Chief of Section.
Following the receipt of this acknowledgment, a consolidated return for 1920 was filed for the Dexter Company, the Howland Company, and the Railroad Company, reporting income of all three from January 1, to May 1, 1920, and only the income from the securities which the Dexter Company was to retain under the Hearst contract after that date.
In 1922, when the time arrived for filing returns for 1921, the litigation with Hearst had not been settled and the representative of the Dexter Company advised the Commissioner of this fact and that the status of the business was the same as when the return for the prior year had been filed. Thereupon, the Dexter Company filed a return for 1921 including the income from its securities not *233 contracted to Hearst and no returns were filed for the Howland or Railroad Companies. In 1923 when the time arrived for filing returns for 1922, the same condition*1918 existed as had for the two preceding years and the same action was taken as in the prior year.
Upon the settlement of the litigation with Hearst on January 5, 1924, the Dexter Company employed accountants to audit and "unscramble" the books and readjust them to their business prior to the transaction with Hearst, and following this, filed on March 15, 1924, a tentative consolidated return for all three companies for 1923, and on September 15, 1924, a complete consolidated return. On December 13, 1924, on conclusion of the accounting work, amended consolidated returns for all three petitioners were filed for 1920, 1921, 1922, and 1923. There was included in income of the Dexter Company in the final consolidated return filed for 1923, both the $755,000 payment made by Hearst in 1924, in settlement of the litigation and the $100,000 paid by him on May 1, 1920, and retained by the Dexter Company under the settlement referred to.
The amended consolidated return for 1920 filed on December 13, 1924, was approved by the Commissioner. No question was raised by the Commissioner as to the consolidated return filed on that date for 1921, but in determining the deficiencies here in question*1919 for 1922 and 1923, the Commissioner denied the right of these petitioners to file returns on a consolidated basis for those years and the deficiencies here appealed from he computed upon the basis of separate returns.
OPINION.
TRUSSELL: Section 240(a) of the Revenue Act of 1921 provides:
That corporations which are affiliated within the meaning of this section may, for any taxable year beginning on or after January 1, 1922, make separate returns or, under regulations prescribed by the Commissioner with the approval of the Secretary, make a consolidated return of net income for the purpose of this title, in which case the taxes thereunder shall be computed and determined upon the basis of such return. If return is made on either of such bases, all returns thereafter made shall be upon the same basis unless permission to change the basis is granted by the Commissioner.
With respect to the first issue it appears that the additional taxes proposed for assessment arise from a determination by respondent that the three companies here involved were in fact not affiliated during the years in question. The respondent now admits affiliation, but contends that the deficiencies are*1920 correct for the reason that the filing of a separate return for 1922 by the Dexter Company was the exercise by petitioners of the option provided by the above quoted section - that they thereby elected to return income on a separate basis and consequently there was no authority for the filing in 1924 of amended returns for each year upon a consolidated basis.
*234 It is contended by petitioners that the filing of individual returns for 1922 and 1923 by the Dexter Company did not constitute, under the peculiar facts existing, an election to change the basis theretofore consistently used in reporting income upon a consolidated basis. It is insisted that not until 1924 could it be determined as to whether affiliation in fact existed in each of the years in question.
The record shows that during the calendar year 1920 the Dexter Company and the two Campbells, who own its capital stock, entered into a contract with William Randolph Hearst, for the sale to the latter of all of the business and of the assets of the corporation will the exception of certain investment securities and including the stock of the Howland and Railroad Companies, this contract providing for formal*1921 transfer of the assets on or before July 1 of that year. The $100,000 provided by the contract to be paid in cash was paid by Hearst upon execution of the contract. From this date the properties in question were considered by the Dexter Company and the Campbells to be the property of Hearst and operation of them in his interest and for his purposes was entered upon, the plant being turned over to the manufacture of newsprint paper, which before that time it had not made, and the regular business in which the Dexter Company and the Howland Company had theretofore been engaged was discontinued. Some months thereafter, but prior to the time for filing returns for the calendar year 1920, the contract in question was repudiated by Hearst and suit brought against him by the Dexter Company.
It was with these conditions existing that the time arrived for filing returns for 1920 and the Dexter Company could not determine whether or not it was in fact affiliated with the Howland and Railroad Companies for the period following the execution of the contract. It was contended in a court proceeding that these properties belonged to Hearst, which fact was denied by the latter, and the actual*1922 ownership could not be determined until the conclusion of this litigation. These conditions were explained to respondent and a consolidated return was filed for the period in 1920 prior to the execution of the contract with Hearst and a separate return was filed by the Dexter Company for the period in that year following the execution of that contract, this return merely reporting the income from the investment securities not included in the sale to Hearst. This litigation was in progress for more than two years and the status of these corporations was not possible of determination in each year at the time for filing returns for the prior year, and in each case the Dexter Company again advised respondent of the conditions existing and its inability to determine what the facts were, *235 and filed for itself a return reporting income from investment securities alone, no returns being filed for the Howland and Railroad Companies. It will be noted that the Dexter Company even filed a separate return for 1921, for which year petitioners had no option to file any but a consolidated return if they were in fact affiliated, as is now admitted.
There appears to be no dispute between*1923 the parties as to the facts except in regard to the year in which the settlement of the litigation with Hearst was finally completed, respondent contending that this settlement was in December, 1923, and petitioners that it was in January, 1924. On this question we have sustained petitioners' contention and we find that following this settlement, which provided for the Dexter Company to retain the $100,000 cash payment made and the assets covered by the contract, and Hearst to pay a large amount in damages, petitioners filed in 1924 amended returns for the calendar years 1920, 1921, 1922, and 1923, upon a consolidated basis.
The question presented is whether or not under these facts, the filing in 1923 by the Dexter Company of a separate return for 1922 constituted an exercise of the election provided by section 240(a) of the Revenue Act of 1921 to file upon either a separate or consolidated basis. In , the court said: "'Election', says Dyer, 'is the internal, free and spontaneous separation of one thing from another, existing in the mind and will.' 3 Dyer, 281. *1924 That designed selection can not occur if the party be ignorant of his rights. He can not deliberately select one of two or more remedies if he know of but one to which he is entitled. * * * In order to constitute a valid election, the act must be done with a full knowledge of the circumstances of the case, and the right to which the person put to his election was entitled." In , the court said: "An election which involves no freedom of choice is known as 'Hobson's choice' which is defined as a choice without an alternative." One of the most frequently quoted definitions of election is that by Mr. Justice Holmes in ; , during his service on the bench in Massachusetts, that "Election exists when the party has two alternative and inconsistent rights, and it is determined by a manifestion of choice."
It appears to us to be idle to say that these taxpayers have made a free and deliberate choice of one of the two bases upon which the revenue act permitted corporations actually affiliated to make a return, when under existing conditions it was impossible for*1925 them to even determine the fact of affiliation, or, in other words, impossible to determine whether or not they were entitled to exercise the option provided by the statute.
*236 Under such conditions we think that the filing of the individual return for 1922 by the Dexter Company was not an exercise by petitioners of the option provided by section 240(a) of the Revenue Act of 1921 and that when their affiliated status was determined in 1924 for the several years in question, they then, for the first time, could determine their right to file either consolidated or separate returns for these years and that the amended returns on a consolidated basis as then filed were in the proper exercise of the right granted by the cited section. Cf. ; ; .
With respect to the second issue, petitioners contend that the $755,000 paid under the settlement of the suit against William Randolph Hearst did not constitute income to the Dexter Company, or, if income, that it did not pertain to the calendar year 1923, but to the year 1924, in which*1926 the settlement was effected.
Petitioners' first contention can not be sustained. In , this question was presented under a situation in many respects similar to the one here existing, the court holding that the damages recovered, measured by the losses incurred, constituted income. Petitioner's second contention is sustained by our finding that the termination of this litigation was in the calendar year 1924. There was no basis prior to that year for accrual of any amount on account of the Hearst liability, finally admitted and liquidated by the settlement. The $755,000 in question represented income for the year 1924. Cf. .
In respect to the third issue, it is noted that the $100,000 paid by Hearst in 1920 was retained by the Dexter Company under the settlement effected in 1924. The right of the Dexter Company to retain this amount, as part of the compensation for the damage sustained, accrued under the contract of settlement, and we hold that this amount should be included in income for the calendar year 1924.
Reviewed by the Board.
Judgment*1927 will be entered pursuant to Rule 50.
TRAMMELL and MURDOCK dissent.