*1338 1. Where there is a bona fide sale of a chose in action (in this case a debt due to the petitioner for money loaned) for a consideration, and the debt is not in fact worthless, the taxpayer sustained a deductible loss in the amount of the difference between the amount of the debt assigned and the amount of the consideration received.
2. In a prior year the taxpayer exchanged a note receivable of one corporation for the cancellation of his indebtedness to another corporation and an account receivable payable in monthly installments, with interest upon the unpaid balance. Of each monthly payment a portion was deemed to constitute interest on the balance of the account then payable and the balance a payment of the principal of the account. In 1928 the petitioner received $24,000 in monthly installments. Held, that the payments received represented in part a realization of taxable income and in part a return of capital and should be taxed accordingly.
*624 The Commissioner determined a*1339 deficiency of $27,766.81 in the petitioner's income tax for 1928. The petition sets forth the following allegations of error:
(a) The respondent erred in refusing to allow the petitioner to deduct for the year 1928 a loss of $221,688.33 arising from the sale of an indebtedness of Evergreen Mining Company in 1928 for $100.
(b) The respondent erred in including $24,000 interest in line 3 of the return and in not allowing in lieu thereof the item of $3,533.61 as such interest, together with $1,634.02 as profit by way of gain in realization of discount.
FINDINGS OF FACT.
The petitioner is a resident of Duluth, Minnesota.
*625 In 1923 the petitioner, D. R. McLennan (trading as the Empire Securities Company), and Robert M. Adams Company, a copartnership (hereinafter for convenience referred to as Adams), formed a syndicate for the development of certain iron ore mining properties, known as the Evergreen properties, in the Cuyuna Range near Duluth, Minnesota. These properties were acquired by the Evergreen Mining Company and the Minnesota Sintering Company, both Delaware corporations. The stock of each company, consisting of 1,000 shares of no par value, was owned*1340 as follows:
| Shares | |
| Ward Ames, Jr | 427 1/2 |
| D. R. McLennan | 427 1/2 |
| Robert M. Adams Co | 145 |
Pursuant to their agreement for the development of the mining properties, the petitioner and his associates made large cash advances by way of loans to the two companies. Between October 1, 1923, and July 1, 1927, petitioner loaned the companies $709,190.17.
In the spring of 1927, Adams, being in default of its agreed advances, the petitioner, being unwilling to continue the large advances he was making, and McLennan, wanting to continue the enterprise, entered into a new agreement, which in substance provided that: (1) Adams should be relieved from all further payments; (2) petitioner should make additional payments sufficient to bring his total investment up to $750,722.76; and (3) that the indebtedness of the mining companies to the three contributors should be divided into various classes in the following order of priority:
Class A - New advances by McLennan
Class B - Preferences to be given McLennan
Class C - Existing advances of the various parties made subsequent to the default of Robert M. Adams Company
Class D - Certain other preferences to McLennan
*1341 Class E - Existing advances of the three parties made prior to the default of Robert M. Adams Company
Simple interest at 6 per cent accrued on each class of indebtedness from specified times.
Pursuant to this agreement, the petitioner and his associates transferred their stock in the Minnesota Sintering Company to the Evergreen Mining Company, which, under the agreement, was thereafter controlled and operated by McLennan. The classified indebtedness referred to above was thereafter carried on its books as an obligation of the Evergreen Mining Company, and the Minnesota Sintering Company was operated as a subsidiary. The classified indebtedness, in its order of preference, was as follows on the dates indicated:
| Amount of indebtedness | |||
| Class | Creditor | November, 1927 | November, 1928 |
| A | McLennan | $174,000.00 | $443,576.66 |
| B | do | 174,000.00 | 443,576.66 |
| C | Petitioner | 307,146.10 | 307,146.10 |
| C | McLennan | 133,146.10 | |
| D | do | 174,000.00 | 307,146.10 |
| E | do | 269,576.66 | |
| E | Adams | 46,692.28 | 46,692.28 |
| E | Petitioner | 443,576.66 | 221,788.33 |
| E | John R. Washburn | 221,788.33 | |
| Total | 1,722,137.80 | 1,991,714.46 |
*626 The summarized balance sheet*1342 of the Evergreen Mining Company as of December 31, 1927, is as follows:
| Assets | |
| Current assets | $1,251.46 |
| Ore and sinter at market | 36,219.00 |
| Prepaid royalties | 228,051.69 |
| Mine development | 891,100.39 |
| Other assets, including railroad tracks, fixtures, equipment, power line, warehouse supplies, etc | 47,465.22 |
| Interest accured on advances to Minnesota Sintering Company | 12,140.35 |
| Operating deficit 1925-1926 | 298,564.13 |
| Deficit for 1927 | 83,543.89 |
| Prepaid insurance | 2,652.32 |
| Net advance to Minnesota Sintering Company | 272,582.54 |
| Total | 1,873,570.99 |
| Liabilities | |
| Current liabilities | $40,166.57 |
| Account payable Estate of Roger R. Hill | 1,793.60 |
| Note payable First National Bank, Crosby | 3,000.00 |
| Interest accrued on classified indebtedness | 96,473.02 |
| Classified indebtedness | 1,732,137.80 |
| Total | 1,873,570.99 |
In the fall of 1927, the petitioner and his associates inspected the Evergreen properties. The overburden had been removed at a cost of nearly $700,000 and the properties were ready for mining operations, the ore then being at the surface. The sintering plant had a capacity of:
85,000 tons of ore in 1927
115,000 tons of ore in 1928
200,000*1343 tons of ore in 1929
300,000 tons of ore in 1930
Prior to 1928 the production was only 15,000 to 20,000 tons of ore per year. The first big order for ore was received in December, 1927, from the American Radiator Company for 85,000 tons a year for three years. Prior to that time, the plant had not put through enough ore to pay expenses. Operating losses were incurred in 1925, 1926, 1927, and 1928, during which time the development continued by stripping the land, building railroad tracks, and adding to the equipment of the sintering plant. The company made operating profits, before interest charges on the classified indebtedness, in 1929 and 1930. The mining companies met their current obligations *627 in 1927 and 1928 and their credit was good in both years. Neither company had started dissolution proceedings, no receiver had been appointed, no foreclosure proceedings started, no assignment for the benefit of creditors had been made, and neither company was in any way liquidated at the close of 1927. At that time, the estimated ore reserve was sufficient for operations for 40 years at a production of 200,000 tons per year, which would have been a profitable basis*1344 of operation.
In December, 1927, the petitioner sold to John R. Washburn for $500 one half of the Class E indebtedness owed to him by the Evergreen Mining Company and on his income tax return for the taxable year 1927 claimed a loss of $221,288.33 arising from the sale of $221,788.33 of the Class E indebtedness for $500. The Commissioner allowed the claimed deduction.
In December 1928, the petitioner sold the remaining one half of the Class E indebtedness of the Evergreen Mining Company for the sum of $100, and upon his income tax return for the taxable year 1928 claimed a loss of $221,688.33 upon the sale of $221,788.33 of the Class E indebtedness for $100. The Commissioner has disallowed the claimed deduction. In the statement attached to the deficiency notice is the following explanation:
The loss claimed for the year 1928 has been disallowed for the reason that the entire account under the class E indebtedness became worthless in 1927 and the sale of one-half of this account in 1928 for a nominal sum does not have the effect of transferring the right to the deduction from 1927 to 1928.
In each of the taxable years 1927 and 1928, the petitioner reported large gains*1345 from the sale of securities.
Prior to the year 1926 the petitioner, with his business partner, Julius H. Barnes, had promoted the Klearflax Linen Looms Company, a corporation engaged in the development and manufacture of rugs and carpets from flax straw. Up to some date in 1926 the petitioner had advanced to this company $165,819.75, which was on that date represented by a note of the company bearing interest at 6 per cent. Unpaid interest on September 3, 1926, amounted to $50,765.51.
In 1926 the petitioner and Barnes were operating a grain commission business through Barnes-Ames Company and each owned approximately one-half of the capital stock of that company. On September 3, 1926, the petitioner was indebted to the Barnes-Ames Company in the amount of $110,121.18.
A stipulation of the parties reads in part as follows:
* * * On or about September 3, 1926, the petitioner sold the Klearflax Linen Looms Company note to Barnes-Ames Company, receiving in payment therefor the cancellation of petitioner's debit balance on the books of Barnes-Ames *628 Company in the sum of $110,121.18, and an unsecured account receivable against Barnes-Ames Company, in the amount of*1346 $106,464.08 bearing interest at 5%, for the balance of the principal and accrued interest on the note, payable to the petitioner $2,000 per month, beginning September 1, 1926, of which payment a portion was deemed to constitute interest on the balance of the account then payable and the balance a payment of the principal of the account.
That for the purpose of settlement of income taxes for the year 1929, the Income Tax Unit and the petitioner have agreed that the value of said unsecured account receivable as of September 3, 1926 was its face amount less a discount of $8,500., and that of a payment of $24,000. made by Barnes-Ames Company to the petitioner in 1929, $2,406.32 represented interest on the balance of the account, $1,719.71 represented realization of the discount, and the balance of $19,873.97 represented a return of the principal and, therefore, did not constitute taxable income. This settlement for the year 1929 was made upon the basis of auditors' computations of the profit of the petitioner on the sale of said Klearflax Linen Looms Company note, which are annexed hereto and marked Exhibits 8 and 9.
For the taxable year 1928 the taxpayer received from Barnes-Ames*1347 Company, pursuant to his agreement with it, the sum of $24,000., all of which he included in Item 3(c) of his income tax return for the year 1928, as interest received upon said note of Klearflax Linen Looms Company. That upon the basis on which the taxes for 1929 were settled the amount received by the petitioner in 1928 as interest from said unsecured account receivable was $3,533.61, and the amount received in realization of discount was $1,634.02. [Sic.]
The petitioner kept no books of account, but reported his income on the basis of cash receipts and disbursements.
OPINION.
SMITH: The first issue is the deductibility of the claimed loss upon the sale of the balance of petitioner's Class E indebtedness in the amount of $221,788.33 for $100. A similar sale was made in 1927, and a similar deduction allowed. The respondent has disallowed the deduction claimed in 1928 on the ground that the debt was worthless in 1927. The bona fides of neither the 1927 nor 1928 sale is questioned, and the fact that the sales were made to offset gains upon the sales of securities does not make the transaction illegal or warrant the disallowance of the claimed deduction if the taxpayer*1348 has in fact sustained a loss upon the sale of his assets. Cf. ; .
The record shows that the mining properties were in the process of development up to and including 1927, that most of the indebtedness was incurred for development purposes, which was largely a matter of stripping the overburden of soil from the ore, which then being exposed could be mined more easily and economically. The company had spent nearly $700,000 in this development and its *629 sintering plant was equipped for profitable production and sale of iron ore. The petitioner was familiar with the physical condition of the properties and the financial condition of both companies at the close of 1927. The first large order had just been received and there was a sufficient ore reserve for profitable operations for many years. The mining and sintering companies, the latter as subsidiary of the former, were actively engaged in business and there was no liquidation of either in 1927 or 1928. At the close of 1927, the balance sheet of the Evergreen Mining Company reflected all of the classified indebtedness due*1349 the petitioner and his associates, and the operating deficits of prior years, but aside from the capital expenditures for development it did not reflect the value of the leasehold or the value of the ore reserve, which had become more valuable by reason of the development work.
At the close of 1927 the petitioner held a valid claim against the Evergreen Mining Company, which claim was recognized and carried upon the books of the company as an account payable, pursuant to the agreement for the classification of the indebtedness due the petitioner and his associates for money advanced by them. This is not a case in which the petitioner ascertained the debt to be partially worthless in 1927 and partially worthless in 1928, and claimed deductions in these years for the progressive worthlessness of the debt (cf. ), but one in which a loss is claimed upon the sale of a chose in action. The respondent argues that the "provision in the revenue laws provides for deductions [for losses] in the case of sales for an actual, and not a nominal, consideration. One hundred dollars for a debt of $221,788.33 is not and cannot be*1350 regarded as evidence of an actual sale. It speaks for itself and proclaims itself a nominal and not a real consideration." We can not agree with this argument. The evidence by no means shows that the Class E indebtedness of the Evergreen Mining Company was worthless in 1927, or in 1928, the year before us. On brief, the respondent admits that the balance sheet of the company at December 31, 1927, gave the Class E Indebtedness some book value. Such Class E indebtedness owed to the petitioner in 1928 represented a cost to him in cash of $221,788.33. The stipulation shows that he sold it within that year for $100. The respondent does not question that the sale was an arm's length transaction. His only contention is that the indebtedness was worthless in 1927 and that the only purpose of the sale in 1928 was to establish a loss which would be a legal deduction from the gross income of 1928. A bona fide sale made for that purpose is not forbidden by the statute. The respondent erred in disallowing the claimed deduction in 1928. Cf. *1351 ; Harry*630 ; affd., ; certiorari denied, ; ; ; ;; .
The second issue is the determination of the amount of taxable income realized by the petitioner in 1928 from the receipt of payments aggregating $24,000 from the Barnes-Ames Company. The petitioner reported his income on the cash receipts and disbursements basis. Prior to some date in 1926, the petitioner had loaned the Klearflax Linen Looms Company $165,819.75, which was evidenced by a note bearing interest at 6 per cent per annum and on which the unpaid interest amounted to $50,765.51 on September 3, 1926. On the same date petitioner owed the Barnes-Ames Company the amount of $110,121.18. It was agreed between petitioner and the Barnes-Ames Company that the note should be canceled and that the Barnes-Ames Company should stand indebted to the*1352 petitioner in the amount of $106,464.08, which is the exact difference between the face value of the note plus the accrued interest thereon and the $110,121.18 owed by the petitioner to the Barnes-Ames Company. The Barnes-Ames Company was to make payment of the $106,464.08 at the rate of $2,000 per month beginning September 1, 1926, and the company was to pay interest to the petitioner on the account at the rate of 5 per cent per annum. The stipulation is to the effect that of each $2,000 payment to the petitioner "a portion was deemed to constitute interest on the balance of the account then payable and the balance a payment of the principal of the account." The petitioner contends that the value of the account to the petitioner on or about September 3, 1926, was $106,464.08 less $8,500, and that the only portion of the $24,000 received in 1928 which constitutes taxable income is the portion representing interest upon the unpaid balance as of the date of each payment and the accrued discount. This was the basis upon which the petitioner's tax liability for the year 1929 was settled and it is agreed that if this is a proper basis of settlement for the year 1928 the only taxable*1353 income received by the petitioner from the $24,000 in 1928 is $3,533.61 representing interest and $1,634.02 representing realization of the discount.
The respondent contends, however, that this was not a correct settlement; that there was no realization of income by the petitioner in 1926, when he turned in his note receivable from the Barnes-Ames Company in consideration of the cancellation of his indebtedness to it, and a credit upon its books in his favor of $106,464.08 to be paid at the rate of $2,000 per month with interest at 5 per cent per annum.
*631 The record is silent as to whether the petitioner accounted for any profit in his 1926 return from the exchange of his note of the Barnes-Ames Company for a cancellation of his indebtedness to that company plus an open account receivable. Presumably not, for the petitioner in his 1928 return reported the entire $24,000 received in 1928 as taxable income. The petitioner was on a cash receipts and disbursements basis. The case of , was one involving an exchange of property for other property and cash in deferred payments. The question there was whether the petitioner, *1354 being on the cash receipts and disbursements basis, had any taxable income from the exchange transaction. We there stated:
* * * So far as we have been able to ascertain, a promise to pay evidenced solely by an open account has never been regarded as income to one reporting on a cash basis by the Bureau of Internal Revenue. Certainly this is true in the absence of any showing that the amount was immediately available to the taxpayer. The Board has further held that income was not constructively received by the mailing of a check, , or the entry on the books of a corporation of the amount of salary due when in fact money was not available to make payment, . * * *
* * *
* * * While no categorical answer is available and the facts in each case must be closely scrutinized, we believe that in the case of one reporting income on the receipts and disbursements basis only cash or its equivalent constitutes income. * * *
Clearly, the total profit to be realized by the petitioner from the payments to be received by him from the Barnes-Ames Company was $50,765.51 plus interest at the rate of 5*1355 per cent per annum upon deferred payments. In his brief the respondent contends that as soon as the petitioner began to receive the deferred payments of $2,000 per month he began to realize part of his profit in the proportion that the amount of gross profit bore to the principal sum, that is, as $50,765.51 is to $106,464.08; that each monthly payment of $2,000 included interest at 5 per cent per annum on the principal yet unpaid plus a realization of profit of 50,765.51/106,464.08 of the payment after deducting the above interest plus a return of principal consisting of the balance of the payment.
We are of the opinion that the respondent is correct in treating a portion of each payment of $2,000 as consisting of one month's accrued interest upon the balance owing for the monthly payment and that the balance of the payment represents in part a realization of profit and in part a return of capital.
Reviewed by the Board.
Judgment will be entered under Rule 50.