*673 1. Held, petitioner was not entitled to deduct as a business expense money paid to accountants in connection with a dispute over income taxes for prior years.
2. Pursuant to a plan of reorganization under section 77B of the Bankruptcy Act, the first mortgage bondholders of X Corporation were given first mortgage bonds and stock in a new corporation and the second mortgage noteholders were given second mortgage bonds of the new corporation. Additional stock in the new corporation was issued for cash. Petitioner sought to deduct either as a bad debt or a loss the amount paid for his undivided interest in the second mortgage note of the old corporation which he exchanged for new second mortgage bonds. In his return petitioner included in income gain on the exchange of certain first mortgage bonds and deducted a loss on the exchange of others. Held, the transfer of assets to the new corporation constituted a reorganization within the meaning of section 112(g)(1)(B) of the Revenue Act of 1936, as amended by the Revenue Act of 1939, and the exchange of petitioner's first mortgage bonds and his interest in the second mortgage note for new bonds and stock constituted a nontaxable*674 exchange under section 112(b)(3) of the 1936 Act upon which no gain or loss might be recognized.
3. Held, further, petitioner is not entitled to take a bad debt deduction on the exchange.
*584 The respondent determined a deficiency of $16,970.14 in petitioner's income tax for the year 1936. The questions presented are:
1. Whether the petitioner is entitled to deduct as a business expense money paid to accountants in connection with a controversy over his 1932 and 1933 Federal income taxes.
2. Whether the petitioner is entitled to deduct as a bad debt or as a loss the amount paid by him for an undivided interest in a second mortgage note of the Taft Realty Co. second mortgage note of the Taft Realty Co.
*585 FINDINGS OF FACT.
Petitioner is an individual with his principal office at One East 57th Street, New York, New York. He keeps his books on a cash receipts and disbursements basis. He filed his income tax return for the year 1936 with the collector of internal revenue for the district*675 of Connecticut.
Petitioner, together with his two sisters, inherited an undivided interest in several large estates. The estates consisted of a large amount of real estate in Chicago and Pittsburgh and personal property in the form of notes, bonds, and mortgages. During 1936 petitioner, together with his two sisters and father, maintained an office for the purpose of managing the property. They also employed a staff of three persons who kept a record of the transactions, consisting of lending money, renting property, collecting rent, and generally managing the property. During the same year petitioner maintained an active interest in the affairs of the estate but did not regularly attend business.
Prior to petitioner's becoming of age in December 1934, his father, Louis E. Stoddard, Sr., acted as guardian and looked after petitioner's business affairs. In a previous proceeding before this Board petitioner was found to have been in business in the years 1932 and 1933 through his father as guardian.
In his return for the year 1936 petitioner deducted as a business expense $522.63 paid by him to accountants for services in handling a controversy over his 1932 and 1933 Federal*676 income taxes. Respondent refused to allow the deduction.
In 1925 petitioner obtained for $43,333.34 an undivided 13/45 interest in a $350,000 7 percent second mortgage note of the Taft Realty Co., payable in 1955. The mortgage covered all of the property of the Taft Realty Co., which consisted of the Taft Hotel, the Taft Apartments, and the Shubert Theatre and the furnishings and equipment contained therein. The hotel was built in 1912 and is situated on the corner of College and Chapel Streets in New Haven, Connecticut, a town of approximately 161,000 population. It has approximately 77 feet frontage on Chapel Street and 215 feet on College Street. It is the leading hotel in New Haven and is 12 stories high, constructed of brick, steel, and concrete and contains 348 rooms, a lobby on the first floor, a ballroom on the top floor, and the usual hotel appurtenances. In 1936 the hotel was in shabby condition and was poorly managed.
The apartment building which adjoins the hotel on College Street was built in 1914. It is six stories high, of brick, stone, and steel construction, and contains 115 rooms. It is situated on a plot of land approximately 122 feet by 184 feet. The*677 theatre is in the apartment *586 building. It seats 1,400 persons and is used for legitimate plays. It is not adapted to the showing of moving pictures.
In addition to the second mortgage, the real and personal properties were subject to a first mortgage given to secure an issue of $1,400,000 of 6 percent first mortgage bonds. The principal and interest of the first mortgage bonds were guaranteed by Louis E. Stoddard, Sr. Petitioner and his sisters together held $112,000 face amount of the first mortgage bonds. Interest on the second mortgage note was paid through October 15, 1932. The first mortgage bonds have been in default since October 31, 1933.
Late in 1935 the first mortgage bondholders started foreclosure proceedings in the Connecticut State courts. The liabilities of the Taft Realty Co. at that time were as follows:
| First mortgage 6 percent bonds due 1940 | $1,175,900.00 |
| Defaulted interest on first mortgage bonds | 158,746.50 |
| Second mortgage 7 percent note due 1955 | 350,000.00 |
| Defaulted interest on second mortgage note | 22,881.33 |
| Third mortgage notes - J. C. LaVin Co | 80,000.00 |
| Notes payable, New Haven Bank, N.B.A. | 19,000.00 |
| City taxes payable and interest thereon | 7,067.74 |
| Accounts payable | 500.00 |
*678 The capital stock outstanding was of no par value and was carried on the books as of August 31, 1935, at $666,728.57.
In 1936, upon ascertaining that there might be a deficiency claim against him on his guarantee, Stoddard, Sr., who owned all of the stock of the Taft Realty Co. except certain qualifying shares, induced it to file a voluntary petition for reorganization under section 77B of the National Bankruptcy Act in the, united States District Court for the District of Connecticut. Subsequent to the approval of the petition for reorganization the state foreclosure proceeding was dismissed. The plan of reorganization of the Taft Realty Co. which was confirmed by the court and subsequently carried out was substantially as follows:
A new corporation called the Taft Realty Corporation was formed and took over all the assets of the Taft Realty Co. For each $100 of the old first mortgage bonds plus interest coupons maturing October 1, 1933, and subsequently, the holders were given $100 in first mortgage bonds of the new corporation with interest at 3 percent cumulative from November 1, 1938, plus a voting trust certificate, representing one share of stock in the new corporation. *679 The voting trust certificates given to the first mortgage bondholders represented 11,759 shares of stock or five-twelfths of all the stock. The holders of the undivided interests in the $350,000 second mortgage note were given 4 percent income second mortgage bonds in the principal amount of $150,000. Five thousand dollars additional second mortgage bonds were given to the New Haven Bank in exchange for its $19,000 note. *587 The new first mortgage bonds mature September 1, 1951, and the new second mortgage bonds mature September 1, 1956.
Voting trust certificates, representing the remaining seven-twelfths, or 16,463 shares of the new corporation stock, were issued in exchange for $150,000 of new money which Stoddard, Sr., had undertaken to raise. The petitioner furnished $42,500 of the new money and received voting trust certificates representing 4,664 shares. His sisters furnished $67,500 and a friend of Stoddard, Sr., furnished the remaining $40,000. A part of the new money was used for improvement of the property.
All 28,222 shares of the $5 par common stock of the new corporation were issued to voting trustees under a voting trust agreement, which is to continue*680 in effect for 15 years from the date of issuance, or until all of the new first mortgage bonds have been paid or called for redemption and payment provided for, whichever is sooner.
Pursuant to the plan of reorganization, petitioner surrendered his interest in the old second mortgage note and received new second mortgage bonds in the face amount of $43,333.34. Subsequently, on September 15, 1936, he charged off the old second mortgage note on his books and entered the new second mortgage bonds at no cost. In 1937 he received $405.52 in interest on the second mortgage bonds. In 1938 he received $1,515.82 in such interest, and in 1939, $95.34.
At the time the reorganization proceedings were instituted the Taft Realty Co. was operating at a loss. The land and buildings were carried on its books at $2,158,505.13. The properties were assessed for real estate tax purposes at a value of $1,712,730. The furnishings and equipment were carried on the books of the old corporation at a value of $313,721.59. The land, buildings, furniture, and equipment were all entered on the books of the new corporation at an appraised value of $1,619,000.
During the fiscal years ending August 31, 1937, 1938, *681 and 1939 the new company, after deducting depreciation, showed incomes of $9,877.51, $20,056.28, and $8,504.83, respectively. Interest on the mortgage bonds amounts to $35,277 annually. The interest on the first mortgage bonds was paid in full in the fiscal years ending August 31, 1937, 1938, and 1939, even though after depreciation charges there was not sufficient income for the payment of such interest. The interest was not paid in full for the fiscal year ending August 31, 1940.
The price range of the old first mortgage bonds during the years prior to the 77B reorganization was as follows:
| Year | High | Low |
| 1931 | 85 | 71 |
| 1932 | 53 1/2 | 50 1/2 |
| 1933 | 35 | 13 1/2 |
| 1934 | 20 | 15 |
| 1935 | 25 | 18 |
| 1936 | 34 | 24 |
*588 The last sale of the old bonds was on August 29, 1936, at 32. The first sale of the new first mortgage bonds was on September 4, 1936, at 31 1/2.
In his 1936 Federal income tax return petitioner deducted as a bad debt the cost of his interest in the second mortgage note of the Taft Realty Co. He also reported a deductible capital loss of $5 and a taxable capital gain of $2,712.03 on the exchange of first mortgage bonds of the Taft Realty Co. *682 which he had acquired at various times. Respondent determined that the transaction whereby the obligations of the Taft Realty Co. were exchanged for those of the Taft Realty Corporation constituted a nontaxable exchange within the meaning of the Revenue Act of 1936. Accordingly, the deductions were disallowed and the gain excluded from income.
OPINION.
VAN FOSSAN: The first question presented is whether or not petitioner is entitled to deduct as an ordinary and necessary business expense the payments made to accountants for services rendered in connection with a controversy over petitioner's 1932 and 1933 Federal income taxes.
Petitioner's argument that the decision of this Board in Louis E. Stoddard, Jr., Docket No. 92977, memorandum opinion entered December 14, 1939, is res judicata as to this issue must be rejected. A finding that petitioner was engaged in business during the year 1934 does not establish that he was engaged in business during the year 1936. Moreover, such a holding would not dispose of the issue. There remains the question of the nature of the expense.
As to the nature of the expense the proof is insufficient to enable us to hold that the*683 tax controversy which gave rise to the expenditure arose from business transactions. For aught that appears it may have arisen from petitioner's personal, as contrasted with his business, relationships.
The second issue arises from respondent's determination that the transaction in which the first mortgage bonds and the second mortgage notes of the Taft Realty Co. were exchanged for first mortgage bonds, second mortgage bonds and stock of the Taft Realty Corporation was a nontaxable exchange upon which ne gain or loss may be recognized. The applicable statutory provisions are contained in sections 112:b):3) 1 and 112:g):1) of the Revenue Act of 1936, *589 as amended by section 213:g):1) of the Revenue Act of 1939; 2 and section 112:g):2) and :h), Revenue Act of 1936. 3
*684 Petitioner exchanged his interest in the first mortgage bonds of the old corporation for bonds and stock of the new corporation and he exchanged his interest in the old second mortgage note for new second mortgage bonds. These exchanges were within the scope of section 112:b):3). Hence, no gain or loss may be recognized if there was a reorganization to which both corporations were parties.
One of the statutory definitions of a reorganization is the acquisition by one corporation of substantially all the properties of another solely in exchange for all or a part of its voting stock. In the case at bar Taft Realty Corporation acquired all the properties of Taft Realty Co. by virtue of an exchange of its voting stock and bonds for bonds of the old company. The fact that the new company's stock was issued to the old bondholders rather than to the old corporation is immaterial. Helvering v.New Haven & Shore Line R.R. Co., 121 Fed.:2d) 985.
In ; affd., 128 Fed.:2d) 885, this Board held that the issuance of debentures of the new corporation in exchange for debentures of the old corporation constituted an assumption of indebtedness. *685 We are of the opinion that the issuance of the first and second mortgage bonds in the case at bar likewise constituted an assumption of indebtedness. The bonds were issued in recognition of the indebtedness of the old corporation. The indebtedness antedated the reorganization and did not arise out of it. Cf. . Since the bonds are eliminated from consideration, the property was acquired solely for voting stock, *590 within the meaning of the first part of section 112:g):1):b) of the 1936 Act, as amended.
An essential factor which distinguishes a reorganization from a sale is the existence of a continuity of interest. ; . The Supreme Court has recently held that the continuity of interest requirement is satisfied where a proprietory interest in the new corporation is retained by the creditors of the insolvent old corporation. *686 . Cf. In the case at bar the continuity of interest requirement was satisfied by issuance of stock to the first mortgage bondholders. We are not convinced by petitioner's argument that a different result should be reached by reason of the fact that the shares of stock were issued to voting trustees. We deem this fact immaterial. See Helvering v.New Haven & Shore Line R.R. Co., supra.
In keeping with the above, we hold that the second mortgage bonds were acquired in a nontaxable reorganization.
The record shows that petitioner charged off his interest in the second mortgage note of the old corporation subsequent to the exchange. He claims a deduction either as a bad debt or as a loss. Since the exchange was nontaxable, no gain or loss may be recognized, nor may petitioner take a bad debt deduction on account of the same. ; *687 .
It also follows that in determining the deficiency respondent correctly excluded from petitioner's income the gain reported on the exchange of a part of petitioner's first mortgage bonds and correctly disallowed the loss claimed on the exchange of the remainder of petitioner's first mortgage bonds.
Reviewed by the Board.
Decision will be entered for the respondent.
KERN dissents on the second issue.
Footnotes
1. SEC. 112. RECOGNITION OF GAIN OR LOSS.
* * *
(b) EXCHANGES SOLELY IN KIND. -
* * *
(3) STOCK FOR STOCK ON REORGANIZATION. - No gain or loss shall be recognized if stock or sedurities in a corporation a party to a reorganization are, in pursuance of the plan of reorganization, exchanged solely for stock or securities in such corporation or in another corporation a party to the reorganization. ↩
2. (g) DEFINITION OF REORGANIZATION UNDER PRIOR ACTS. -
(1) Section 112(g)(1) of the Revenue Acts of 1938, 1936, and 1934 are amended to
"(1) The term 'reorganization' means (A) a statutory merger or consolidation, or (B) the acquisition by one corporation, in exchange solely for all or a part of its voting stock, of substantially all the properties of another corporaton, but in determining whether the exchange is solely for voting stock the assumption by the acquiring corporation of a liability of the other, or the fact that property acquired is subject to a liability, shall be disregarded; or the acquisition by one corporation in exchange solely for all or a part of its voting stock of at least 80 per centum of the voting stock and at least 80 per centum of the total number of shares of all other classes of stock of another corporation, or (C) a transfer by a corporation of all or a part of its assets to another corporation if immediately after the tranfer the transferor or its shareholders or both are in control of the corporation to which the assets are transferred, or (D) a recapitalization, or (E) a mere change in identity, form, or place of organization, however effected."
(See , upholding the constitutionality of the retroactive application of section 213(g).)↩
3. (g)(2) The term "a party to a reorganization" includes a corporation resulting from a reorganization and includes both corporations in the case of a reorganization resulting from the acquisition by one corporation of stock or properties of another.
(h) DEFINITION OF CONTROL. - As used in this section the term "control" means the ownership of stock possessing at least 80 per centum of the total combined voting power of all classes of stock entitled to vote and at least 80 per centum of the total number of shares of all other classes of stock of the corporation. ↩