*1055 Respondent's allowance to petitioner in a prior year of an excessive deduction for damage and use due to certain liens created by the defaulting vendee against stock which petitioner had previously sold in an installment sale and reacquired in that year, held, not to justify charging petitioner with income in the tax year on account of its discharge of the liens in that year for a smaller amount than the earlier deduction.
*874 Petitioner challenges the determination of a deficiency of $239,672.42 in its income tax for the calendar year 1936. The issue involved is whether petitioner, having computed its taxable income for 1932, including a profit on the reacquisition of stock in that year, by deducting as damage and use the amount of liens to which the stock had been subjected by the defaulting purchaser, is taxable in 1936 on the difference between the amount so deducted in 1932 and the smaller amount paid by petitioner in 1936 to remove the liens.
*875 FINDINGS OF FACT.
The facts are stipulated and as*1056 so stipulated are hereby adopted as our findings.
This proceeding was brought by the executors in behalf of the estate of George H. Flinn, who died March 29, 1929, a resident of Pittsburgh, Pennsylvania. The return for the period here involved was filed with the collector for the Twenty-third District of Pennsylvania. Petitioner kept its books and filed its income tax returns on the basis of cash receipts and disbursements.
Among the assets of the estate were 5,000 shares of the capital stock of American Reduction Co., being all the outstanding stock of that company, and 4,150 shares of the capital stock of Detroit Reduction Co. out of a total of 4,500 shares outstanding. These shares were appraised for Federal estate tax purposes at $1,450,000 and $400,000, respectively.
By contract of sale dated June 20, 1929, petitioner transferred to one Gillespie title to the 4,150 shares of Detroit Reduction Co. stock for a consideration of $650,000, payable $150,000 in cash and the balance, without interest, in yearly installments of $100,000 each within 30 days from the end of each fiscal year of the company, if earned. On the date the contract was entered into petitioner delivered*1057 to Gillespie 1,855 shares and retained the remaining 2,295 shares in its name as security for the latter's performance of the contract.
The contract was treated as an installment sale by respondent and returned as such by petitioner. The following table shows the total payments made by Gillespie and the amount of profit returned by petitioner on such payments:
| Year | Payments | Profits reported |
| 1929 | $150,000 | $57,692.31 |
| 1930 | 40,000 | 15,384.62 |
| 1931 | 13,000 | 5,000.00 |
| Total | 203,000 | 78,076.93 |
Gillespie made no other payments under the contract, having defaulted in 1930 and 1931 and continued in default thereafter. He gave petitioner two notes, aggregating $97,000, on account of the deferred payments, but he failed to pay the notes. In addition to the notes, the unpaid deferred payments amounted to $350,000.
By contract of sale dated July 12, 1929, petitioner transferred to Gillespie title to its 5,000 shares of American Reduction Co. stock for a consideration of $1,250,000, payable as follows: $475,000 in cash; an assignment to petitioner, under Gillespie's personal guarantee *876 of payment, of a bond and mortgage of the American Reduction Co. *1058 in the amount of $275,000 payable in one year with 6 percent interest and secured by all the assets of the company; $100,000 in cash within 10 days; and the remaining $400,000 in yearly installments of $100,000 each payable within 30 days from the end of the second and each subsequent fiscal year of the company, if earned. The contract further provided that any money paid by the company to the city of Pittsburgh on an existing claim against the company should be credited on the deferred payments. On the date of the contract petitioner delivered to Gillespie 2,450 shares and retained 2,550 shares in its name as security. This sale was not an installment sale, was not returned as such, and a loss was sustained thereon.
Under this contract Gillespie paid the initial cash payment of $475,000 and the first deferred payment of $100,000. The mortgage of $275,000 was not paid when due, and Gillespie defaulted in his guarantee. By virtue of a settlement between the company and the city of Pittsburgh, Gillespie was given a credit of $390,000 on the deferred payments, so that he was in default about $10,000 on the deferred payments, in addition to his default in the mortgage of $275,000.
*1059 On June 22, 1931, a modification of the two agreements with Gillespie, in view of his defaults, was entered into, by which it was agreed that one-half of the salary paid by Detroit Reduction Co., all the salary paid by the American Reduction Co., and all dividends of both companies to which Gillespie might be entitled should be paid to petitioner to apply on the contracts of sale, and the voting rights of 51 percent of the stock of both companies and other powers were given to petitioner for its protection. This agreement also provided that the Detroit Reduction Co., out of the first available funds, would pay a debt it owed petitioner in the sum of $90,000.
After delivery of the stocks to Gillespie as aforesaid, he pledged 2,000 shares of American Reduction Co. and 1,500 shares of Detroit Reduction Co., as well as his equity in the balance of the stocks, to secure collateral trust notes issued by him in the sum of $130,000. The Detroit Trust Co. became trustee of this pledge for the benefit of the holders of the notes. The holders of the notes were the Fidelity Trust Co. and the First Wayne National Bank, both of Detroit, each of which held one-half of the face amount of*1060 Gillespie's notes, or $65,000. During his management of the companies Gillespie caused the American Reduction Co. to borrow $100,000 and Detroit Reduction Co. to borrow $180,000 from the First Wayne National Bank. These sums, for which the companies gave their respective notes, were used for Gillespie's individual benefit.
After Gillespie's continued defaults, petitioner, by bill of sale from Gillespie dated January 15, 1932, repossessed the stocks of both *877 companies subject to the rights and interests of the trustee of the pledge to secure Gillespie's collateral trust notes. At the time of the repossession Gillespie and the Reduction companies owed petitioner and the various banks the following sums:
| I. Due petitioner: | ||
| a. Bond and mortgage of American Reduction Co | $275,000 | |
| b. Two notes of Gillespie | 97,000 | |
| c. Deferred payments from Gillespie on purchase of Detroit Reduction stock | 350,000 | |
| d. Two notes made by Detroit Reduction Co | 90,000 | |
| 812,000 | ||
| II. Claims by banks against Detroit Reduction Co. or its stock: | ||
| a. Fidelity Trust Co., notes of Gillespie | $65,000 | |
| b. First Wayne National Bank, notes of Gillespie | 65,000 | |
| c. First Wayne National Bank, note of Detroit Reduction Co | 180,000 | |
| 310,000 | ||
| III. Claim by bank against American Reduction Co.: | ||
| First Wayne National Bank, note of AmericanReduction Co | 100,000 | |
| Total | 1,222,000 |
*1061 In addition Gillespie owed the banks $200,000 not specifically secured by Detroit Reduction Co.'s stock.
Following the repossession and pursuant to tentative agreements made prior thereto by petitioner and the banks, an agreement was entered into on February 10, 1932, between petitioner and the First Wayne National Bank and the Detroit Trust Co., which recited the obligations of $1,222,000 owing by Gillespie and the Reduction companies and provided that the parties would not collect from the Reduction companies except as specified in the contract; that the Detroit Trust Co. should continue to retain the stock held by it on Gillespie's collateral trust notes as security for the $410,000 obligations due the banks; and that the earnings and assets of the Reduction companies should be applied as follows: $150,000 to petitioner to reduce the American Reduction Co. bond and mortgage to $125,000; $25,000 to the First Wayne National Bank to apply on the $100,000 note of the American Reduction Co.; and then, after paying interest on the interest-bearing obligations, 492/877 of the earnings and assets should be paid to petitioner and 385/877 thereof to the banks until all the obligations*1062 due the banks were satisfied, after which the stocks held by the banks should be delivered to petitioner. A supplemental agreement, dated the same day, provided that after receiving the stock and having been paid all the obligations due it, petitioner would hold one-third of the stock of each company in trust for the banks; that *878 petitioner might sell all the stock within six months after payment of all the obligations to it and the banks, in which event the banks would be paid from the proceeds of sale the unpaid portion of Gillespie's obligations to the banks, which then amounted to $200,000; and that, in the event such a sale was not made in six months, one-third of the stock of each company would be delivered to the banks. This supplemental agreement was executed by petitioner in recognition of the right of the banks to pursue Gillespie's equity in the stocks pledged with the banks for the recovery of their claims against Gillespie in the amount of $200,000, although the stocks themselves had not been pledged as collateral for such debts.
The taxable profit to petitioner on the repossession of the stock in 1932 was computed in 1935 by the internal revenue agent*1063 and acquiesced in by petitioner, which paid the tax in accordance therewith as follows:
| 1. Market value of American Reduction Co. stock as of January 15, 1932 | $502,416.71 | |
| (In computing this, allowance was made for the $100,000 note due the bank by this company.) | ||
| 2. Profit on repossession of Detroit Reduction Co. stock: Cash paid | $203,000.00 | |
| Previously reported | 78,076.93 | 124,923.07 |
| 627,339.78 |
The report of the internal revenue agent stated that "it is evident that the stocks repossessed * * * were subject to the following liens:
"1. Obligation of John Gillespie and of the Reduction Companies to the Banks * * * $410,000
"2. Other obligations of John Gillespie to the Banks in the amount of $200,000, which the Executors could pay either in cash or by delivering to the banks one-third of the respective Reduction Companies' stock."
Pursuant to Regulations 77, article 351, it was held that these liens represented damages sustained by petitioner which should be deducted in computing the profit on repossession. The following amounts were therefore deducted from the profit of $627,339.78:
| 1. Obligations due banks | $310,000.00 |
| 2. One-third of the American Reduction Co. stock | 167,472.24 |
| 3. One-third of the Detroit Reduction Co. stock | 133,333.33 |
| 610,805.57 |
*1064 These deductions resulted in a net profit of $16,534.21.
On December 28, 1936, petitioner and the receivers of the Detroit banks effected a settlement whereby petitioner paid the receivers $245,000 in cash, the two agreements of February 10, 1932, were canceled, Gillespie's collateral trust notes of $130,000 were canceled, the *879 $180,000 note of Detroit Reduction Co. to First Wayne National Bank was assigned to petitioner, a mutual release of all claims was executed, and the stocks held by the banks were surrendered to petitioner free of all claims. After the agreements of February 10, 1932, and prior to the settlement of December 28, 1936, there had been paid from the earnings of the two Reduction companies $240,000 to petitioner, thereby discharging in full the two notes of $90,000 of the Detroit Reduction Co. and reducing the obligation of the American Reduction Co. under its bond and mortgage from $275,000 to $125,000; and there had been paid $100,000 from the earnings of the companies to the First Wayne National Bank in full payment of the note of the American can Reduction Co. At the time of the settlement therefore there were obligations owing to petitioner*1065 of $572,000, and to the banks of approximately $610,000 which could be discharged either by payment of $510,000 in cash or of $310,000 in cash and the balance by delivering stock valued at about $300,000.
In determining the deficiency involved herein respondent determined that petitioner derived a net taxable profit of $365,805.57 in 1936 by reason of the fact that in computing its profit on repossession in 1932 it had been allowed as a deduction the sum of $610,805.57, representing the liabilities due the banks, which liabilities were liquidated in the taxable year by petitioner's payment of only $245,000. He also increased the amount of dividends reported by $2,700, which adjustment is not in dispute here.
OPINION.
OPPER: The present controversy arises as the ultimate result of a sale by petitioner on the installment basis. Upon default of the purchaser in 1932 the securities sold were reacquired, subject, however, to certain liens and charges incurred by the vendee and by the corporation which he controlled by holding the securities. At the same time agreements between petitioner and the several lienors modified their respective interests. Although containing more complications*1066 than need be detailed, the essence of these contracts was to apportion the earnings of the securities in accordance with the respective interests of the parties; and to arrange for future payments to the creditors to provide eventually for the discharge of their advances.
In addition to the stock of Detroit Reduction Co. which was the subject matter of the sale on the installment basis, petitioner had sold to the same vendee stock of American Reduction Co. which, however, was not an installment sale. But this stock was reacquired at the same time, liens and charges existed against it in favor of the same creditors, and the same agreements between the latter and *880 petitioner referred to both. In determining petitioner's income for that year, including its gain from the retransfer of all the property, respondent permitted it to decuct the total of the adjusted claims as "damage and use."
In 1936, the year before us, petitioner made a final settlement with the lienors under which, by a cash payment of very much less than their adjusted total, all claims against both blocks of stock were withdrawn. The deficiency arises from respondent's assertion that petitioner is chargeable*1067 with income in the year of settlement to the extent of the difference between the amount actually paid to remove the liens and the deduction allowed in the prior year. This deduction had resulted from a purported application of respondent's regulation relating to installment sales of personalty which at the time provided as follows:
* * *
If for any reason the purchaser defaults in any of his payments, and the vendor returning income on the installment basis repossesses the property, the entire amount received in installment payments and retained by the vendor, less the sum of the profits previously returned as income and an amount representing proper allowance for damage and use, if any, will be income of the vendor for the year in which the property is repossessed, and the property repossessed must be carried on the books of the vendor at its original cost, less proper allowance for damage and use, if any.
* * *
[Regulations 77, art. 351.]
If this regulation comprehended a case like this where there had been a casual sale, and the "damage and use" took the form of liens rather than physical deterioration, still we think the action of respondent's agent in dealing with*1068 petitioner's 1932 income was so erroneous an interpretation of the regulation as not to be supportable on any ground.
The regulation treats the damage and use allowance not as a general deduction from gross income, but specifically and narrowly as an offset against the income resulting from the retransfer of the subject of an installment sale. Presumably the theory is that a vendor resuming ownership is as well off as he was before the sale and in addition has been enriched by the vendee's purchase money, which constitutes taxable income; 1 except that the vendor is to be accorded a set-off for damage and use to the extent that the property has been diminished in value by the use to which the vendee may have put it meanwhile. The justification for the allowance of damage *881 and use must be that since, under the regulation, the taxpayer's income from reacquisition is computed on the cash he has received and without regard to the market value of the transferred property, the gain is illusory unless it is diminished by the counteracting damage caused by the vendee's use. But no recognition is given to a possibly minus result of that operation, and authorization to apply*1069 a net loss on reacquisition as a general deduction from gross income is lacking.
Here the regulation could properly be employed only in computing gain on the transfer of the Detroit stock since only that had been sold on the installment basis; and no more than a minor portion of petitioner's 1932 income was profit on its reacquisition which was subject to tax under the regulation. It follows that the permissible allowance for damage and use under the regulatory scheme was limited by this related item of income. No greater allowance could have been made, since no greater income appeared against which the allowance could act as an offset. If this had been the extent of respondent's treatment, the tax benefit to petitioner in 1932 from the damage and*1070 use allowance would have been no more than the part of the income which it canceled. And when, in 1936, almost twice this amount was paid out in removal of the liens, it is evident that the net result would have left the petitioner with no tax advantage from the two transactions. Hence, the necessity of treating the 1936 transaction as giving rise ot taxable income 2 would not have existed. Central Loan & Investment Co.,39 B.T.A. 981">39 B.T.A. 981. See National Bank of Commerce of Seattle,40 B.T.A. 72">40 B.T.A. 72; affd. (C.C.A., 9th Cir.), 115 Fed.(2d) 875.
*1071 It is evident that the deduction permitted in 1932 was due in large part to inclusion in the computation of a much greater gain on the receipt of the American stock. But for this there was no warrant, since those securities were not the subject of an installment sale and altogether different principles for computing gain and allowing for loss of value were applicable. 3 The two transactions were not susceptible of joint treatment and respondent's action can acquire no authority from association of the two.
It follows that any addition made to petitioner's tax liability for the year in dispute would have as its only justification an error in *882 respondent's calculation of the proper tax for an earlier year. This Board is committed to the position that the principle requiring adjustment in a later year on account of subsequent developments which result in an unwarranted tax benefit, does not apply under these circumstances. *1072 American Light & Traction Co.,42 B.T.A. 1121">42 B.T.A. 1121. Respondent's determination must accordingly be disapproved.
Reviewed by the Board.
Decision will be entered under Rule 50.
Footnotes
1. "* * * And when property is sold to be paid for in installments, and only part of what is paid is returned as gain, but the property is gotten back without any refund, so that all that was received turns out to be gain, the addition is made to income in the year the additional gain appears to be such." [Sneed v. Commissioner (C.C.A., 5th Cir.), 119 Fed.(2d) 767, affirming 40 B.T.A. 1136">40 B.T.A. 1136↩.]
2. Estate of William H. Block,39 B.T.A. 338">39 B.T.A. 338; affd. (C.C.A., 7th Cir.), 111 Fed.(2d) 60; certiorari denied, 311 U.S. 658">311 U.S. 658; Commissioner v. Liberty Bank & Trust Co. (C.C.A., 6th Cir.), 59 Fed.(2d) 320; Beacon Auto Stores, Inc.,42 B.T.A. 703">42 B.T.A. 703; Helvering v. Jane Holding Corporation (C.C.A., 8th Cir.), 109 Fed.(2d) 933; certiorari denied, 310 U.S. 653">310 U.S. 653; Houbigant, Inc.,31 B.T.A. 954">31 B.T.A. 954; affd. (C.C.A., 2d Cir.), 80 Fed.(2d) 1012; certiorari denied, 298 U.S, 669; Jamaica Water Supply Co.,42 B.T.A. 359">42 B.T.A. 359; Hartford Hat & Cap Co.,7 B.T.A. 714">7 B.T.A. 714; South Dakota Concrete Products Co.,26 B.T.A. 1429">26 B.T.A. 1429. See E. B. Elliott Co.,45 B.T.A. 82">45 B.T.A. 82↩.
3. Regulations 77, art. 354; G.C.M. 1387, C.B. VI-1, p. 48; G.C.M. 952↩, C.B. VI-1, p. 191.