*1475 1. INCOME - INTEREST. Corporate notes were received in 1920 in an amount equal to the preexisting indebtedness of a partnership and the interest accrued thereon. The notes in the aggregate were worth not more than the principal of the debt and the amount of the notes representing interest was not entered on the creditor's books as income in 1920. Held that the interest was income in 1922 when the notes were paid.
2. Id. PROFIT ON SALE OF BONDS. Partnership agreed to buy new issues of corporate bonds and stock at specified prices. The agreement was reduced to writing in which the method of payment was specified. In this contract the payment to be made upon delivery of each bond was less than the agreed cost and also less than the value of the bond, and the payment to be made upon delivery of each share of stock was greater than the agreed cost and also greater than the value of the stock. The bonds were received and sold by the partnership in 1922. Held that the proper basis for determining the profit realized in 1922 is the actual cost of the bonds rather than the amount set out in the contract specifying the method of payment, and, the tax having been reported*1476 on that basis, there is no deficiency for 1922 attributable to the bond transaction.
*764 The respondent has determined a deficiency for 1922 in the amount of $8,937.11. The petitioners seek a redetermination, claiming (1) that an item of $104,721.43 interest collected by a certain partnership was income to the partnership in 1920 and therefore the petitioners' share thereof, $57,596.79, should not be included in income *765 for 1922; (2) an item of $153,000 was profit to the said partnership in 1926, since it was properly profit on a transaction in certain notes and not profit on bonds sold in 1922, and therefore the petitioners' share thereof, $84,150, should not be included in income for 1922; (3) if the respective costs to the partnership of said bonds and notes can not be allocated satisfactorily, then no profit to the partnership and the partners should be reported until 1926, when all transactions were completed, and consequently*1477 no profit should be reported by the petitioners in 1922 arising out of the partnership income from this source.
FINDINGS OF FACT.
The decedent, William A. Paine, was, from 1880 until his death in 1929, a partner in the firm of Paine, Webber and Company, hereinafter sometimes referred to, for convenience, as the partnership, which firm was engaged in the business of investment banking and brokerage, with principal office at Boston, Massachusetts. During the taxable year the decedent held an interest of 55 per cent in the partnership and was entitled to a distributive share of 55 per cent of its profits. The partnership kept its books by the double-entry system.
Prior to October, 1916, the partnership had become interested in the development of hydroelectric properties on the Chippewa River in the State of Wisconsin. As part of this development the partnership desired to obtain control of a dam site property known as the Jim Falls site, on the Chippewa River, which site was owned by the Davis Falls Land Company, a corporation. However, prior to October 15, 1916, Kelsey, Brewer & Company, a partnership, had obtained from the Davis Falls Land Company, an option on the Jim*1478 Falls site. On October 15, 1916, John H. Blodgett, a partner in Paine, Webber and Company, acquired and afterward held an interest of 41 1/4 per cent in Kelsey, Brewer & Company, for Paine, Webber and Company. On October 25, 1916, Kelsey, Brewer & Company and the Davis Falls Land Company entered into a written option agreement whereby Kelsey, Brewer & Company acquired the right to purchase the Jim Falls dam site and this right was exercised on January 25, 1917, the purchase being effected for a consideration of $605,000, payable $200,000 on February 1, 1918; $200,000 on February 1, 1919; and $205,000 on February 1, 1920, with interest at the rate of 6 per cent per annum from October 25, 1916, payable annually. As the payments thus required to be made became due, the funds therefor were advanced by Paine, Webber and Company in exchange for the demand notes of Kelsey, Brewer & Company, all of which were interest-bearing, some at the rate of 7 *766 per cent per annum and others at the rate of 8 per cent per annum. On June 12, 1918, Kelsey, Brewer & Company assigned to Paine, Webber and Company its interest in the said dam site and also in 4,750 shares of the common stock of*1479 the Eastern Wisconsin Electric Company, as security for advances previously made or to be made, and they agreed to execute and deliver demand notes bearing interest at the rate of 7 per cent per annum for further advances. Kelsey, Brewer & Company owned various utility stocks and the utility companies were indebted to them in a large sum on management contracts. The security was retained until 1928.
On January 2, 1919, the interest of John H. Blodgett in Kelsey, Brewer & Company, held by him for Paine, Webber and Company, was increased, with respect specifically to the Jim Falls dam site, to 75 per cent.
On January 20, 1920, Kelsey, Brewer & Company was dissolved and all of its assets were assigned to William A. Paine (the decedent) and Joseph Brewer as liquidating trustees.
The total advances by Paine, Webber and Company, to August 6, 1920, to or for the account of Kelsey, Brewer & Company, amounted to $711,179.16, all evidenced by demand notes of that aggregate face amount. At that time, and for several years prior thereto, Kelsey, Brewer & Company were and they had been without funds available for the discharge of their indebtedness, both as to principal and interest, *1480 to Paine, Webber and Company.
On August 5, 1920, the liquidating trustees of Kelsey, Brewer & Company agreed to transfer to the Chippewa Power Company, a newly organized Wisconsin corporation, all of the interest of Kelsey, Brewer & Company in the Jim Falls dam site property in consideration of the issuance to them of all of the common stock of the Chippewa Power Company save five shares held for qualifying purposes, the assumption by the Chippewa Power Company of all of the indebtedness of Kelsey, Brewer & Company to Paine, Webber and Company (including interest thereon) and of any indebtedness of Kelsey, Brewer & Company to Davis Falls Land Company, and the reimbursement of Kelsey, Brewer & Company for its expenditures in connection with the Jim Falls dam site property.
This agreement was carried out by the parties. The Chippewa Power Company issued all of its remaining common stock, 1,995 shares, to said liquidating trustees, who in turn distributed 1,500 thereof, or 75 per cent of the total issue, to Paine, Webber and Company, and the remainder to Joseph H. Brewer and Charles McPherson. The Chippewa Power Company assumed the indebtedness of Kelsey, Brewer & Company to Paine, *1481 Webber and Company, which stood on September 28, 1920, at an amount of $711,179.16 *767 principal and $104,721.43 accrued interest, of which $900.59 was thereupon charged upon the books to the open account of the Chippewa Power Company, and for the balance the Chippewa Power Company gave to Paine, Webber and Company demand notes aggregating $815,000 face amount and bearing interest at the rate of 7 per cent per annum. The Jim Falls dam site property was transferred to the Chippewa Power Company subject to the previous deed of trust. The demand notes in the face amount of $815,000 were entered upon the books of Paine, Webber and Company in an amount of $710,278.57; the balance of the face amount, $104,721.43, was not entered upon their books until 1922. The usual method of accounting followed by Paine, Webber and Company was to enter notes in the full amount of their face value and notes given for interest were usually credited to income in the year the notes were received. The interest in the amount of $104,721.43 was not accrued on the books as income in 1920 because Paine, Webber and Company in that year regarded the collectibility of the amount as doubtful. The value*1482 of $710,278.57 assigned to the notes on the books of Paine, Webber and Company equaled their fair market value when received and the Chippewa Power Company was, in 1920, without funds available for payment of said notes.
During 1921 Paine, Webber and Company advanced $110,975 to the Chippewa Power Company, receiving therefor demand notes of the power company bearing interest at the rate of 7 per cent per annum. These notes were entered upon the partnership books at their full face value. In 1921 the partnership also received notes of the power company in an aggregate of $60,025 for interest accrued on the outstanding indebtedness of the power company. These notes were not accrued on the partnership books as income in 1921, the year received, but in 1922, the year in which the notes were paid. In determining the income of the partnership for 1921 the respondent included the item of $60,025 as income from interest accrued.
In 1922 business conditions improved and a public financing of the power project became feasible. During the spring of 1922 negotiations were opened looking to the improvement of the property of the Chippewa Power Company by the construction of a power house*1483 and the leasing of the entire property to the Wisconsin-Minnesota Light & Power Company, a Wisconsin corporation. An oral understanding was arrived at in the latter part of May, 1922, in whicn the money necessary for constructing the plant and for reorganizing the financial structure of Chippewa Power Company was to be furnished by the partnership through the purchase of $1,800,000 par value of 6 per cent mortgage bonds of the power company at 90 per cent of the par value and of $1,000,000 par value of 7 per cent *768 cumulative preferred stock of the power company at 85 per cent of the par value.
On May 31, 1922, a lease agreement was entered into between the Wisconsin-Minnesota Light & Power Company and Chippewa Power Company, providing for the construction by the latter of a power plant and transmission line and for the lease of the entire property to the former for a period of 30 years from the time when construction was completed, at a rental of $245,000 per annum for the first 7 years, $255,000 for the next 10 years, and $265,000 for the remaining 13 years, with option of purchase at a fixed consideration.
The oral understanding between the power company and the*1484 partnership referred to above was never reduced to writing, due to the advice of counsel respecting the requirements of Wisconsin State law. An agreement in writing between the Chippewa Power Company and Paine, Webber and Company was executed on June 1, 1922, providing, so far as material to the issue here, as follows:
JUNE 1ST, 1922.
CHIPPEWA POWER COMPANY,
82 Devonshire Street,
Boston, Mass.
GENTLEMEN: We understand that your Company is about to issue (a) $1,800,000 face value of 6% First Mortgage Bonds, to be secured by a mortgage to The National Shawmut Bank of Boston and Ralph W. Hill, Trustees, covering all property now owned and hereafter acquired by your Company, said mortgage and bonds to be in substantially the form set forth in copy hereto attached and marked "Schedule A," and (b) $1,000,000 par value of 7% cumulative preferred stock, said stock to have such preferences and provisions as may be permitted by law and as shall be satisfactory to us.
We further understand that prior to the execution and delivery of said mortgage your Company will make a lease of all its property for the term of thirty years from the completion of the first unit of the*1485 hydroelectric development referred to in said lease, which lease shall be substantially in the form set forth in the copy hereto annexed and marked "Schedule B." and that your Company will at the same time enter into a contract with some responsible contractor for the construction of the hydro-electric development referred to in said lease.
Subject to the performance on the part of your Company of the matters above recited and to the fulfillment of the conditions hereinafter set forth, we agree to purchase the bonds and preferred stock above mentioned for the sum of $2,467,000 plus accrued interest and dividends, upon the following conditions:
* * *
2. You are to deliver to us at our office in Boston, Massachusetts, on August 1, 1922, or on such earlier date as we may untually agree upon, the bonds which are the subject of this agreement, in either temporary or permanent form, and at that time and place we will make payment to you for the bonds as follows:
For each $1,000 face value of bonds we will pay $815 plus accrued interest upon the face amount of the bond at 6% per annum for the period from June *769 1, 1922, to the date of delivery of our interim receipt, *1486 if an interim receipt shall previously have been delivered on account of such bond, plus interest at the rate of 3% per annum on 96% of the face amount of the bond from the date of issue of our interim receipt to the date of delivery of the bond to us; or, if no interim receipt shall have been issued on account of such bond, then accrued interest at the rate of 6% per annum upon the face amount of the bond from June 1, 1922, to the date of delivery of the bond to us.
All amounts paid to your Company up to an aggregate equal to the principal and interest then due and unpaid upon the then outstanding indebtedness of your Company as listed in the schedule hereto attached and marked "Schedule C" shall be forthwith applied in payment of such due and unpaid principal and interest. As soon as said indebtedness shall have been paid in full, your Company is to cause any mortgage indenture securing the same to be discharged of record.
Any balance of the proceeds of the sale of said bonds to us shall be deposited by us in a special account to be opened by us in our Banking Department, to be entitled "Chippewa Power Company Construction Account."
3. You are to deliver to us at our*1487 office in Boston, Massachusetts, from time to time on such date or dates (not later than January 1, 1924) as you may have been able to comply with all the conditions of this agreement and as you may require the funds, certificates, in either permanent or temporary form, for the stock which is the subject of this agreement, and upon such deliveries we are to pay you for them at par and accrued dividend. All amounts so paid to your Company shall be deposited by us for account of your Company in said Chippewa Power Company Construction Account.
* * *
5. We agree to advance the Company such amounts in cash from time to time as it may require to pay for the cost of construction of said hydro-electric development to the extent that the proceeds of the bonds and preferred stock already sold and paid for hereunder may be insufficient therefor. The Company shall give us therefor its 7% unsecured demand notes to a face amount equal to the amount of such advances.
* * *
8. Unless your Company shall be able to tender delivery to us of said bonds and stock subject to all the conditions hereof, on or before the final dates above prescribed for such deliveries respectively, we*1488 shall have the right to terminate this agreement, in which case all our obligations to you hereunder shall cease, but you shall be under obligation to reimburse us for all legal and other expenses which we may have incurred in the matter and for all interest which we shall be obliged to pay to our customers upon our interim receipts, a reasonable time thereafter to be allowed us for getting in said receipts.
Your acceptance signed below shall constitute this a valid contract between us.
Yours very truly,
PAINE, WEBBER AND COMPANY,
By A. P. EVERTS.
Accepted:
CHIPPEWA POWER COMPANY,
By MORRIS F. LACROIX.
Secty. & Treas.
*770 The $1,800,000 par value first mortgage bonds of the power company were issued to the partnership on June 28, 1922, and were all sold to the public on or before June 30, 1922. Upon the books of the partnership the power company was credited, for the bonds, an amount of $1,467,000, being at the rate of $815 per $1,000 par value in accordance with the contract, plus an amount of $6,899.94 representing accrued interest upon the bonds when delivered to the partnership. The proceeds of the sales of the bonds received by the partnership*1489 aggregated $1,767,682.44. By a separate journal entry the book cost of the bonds was increased to $1,626,899.94, the increase of $153,000 being carried to an account opened for the purpose and headed "Chippewa Power Company, Preferred, Reserve," with the explanation that the entry was for the purpose of recording the purchase price as 90 instead of 81 1/2. This amount of $153,000 was not carried into income on the partnership books until 1926, when this reserve account was closed out. The credit to the account of Chippewa Power Company was offset against demand notes of the power company in an aggregate of $986,000, held by the partnership and comprising the aggregations of $815,000, $60,025, and $110,975 hereinbefore described. The amount of the open account of the power company, $183,247.74, which was inclusive of the item of $900.59 carried to it in 1920, was also offset against the credit, and the remainder of the credit was made available for the construction of the planned hydroelectric plant.
In July, 1922, the Railroad Commission of Wisconsin, upon its own initiative, instituted an investigation into the reasonableness of the terms and conditions of the lease agreement*1490 of May 31, 1922, with the Wisconsin-Minnesota Light and Power Company. Resulting from this situation it was considered impracticable to issue the preferred stock as provided in the agreement of June 1, 1922, and the contract was modified by oral agreement, the partnership continuing the advances of cash during 1922 and 1923, to an amount of $1,000,000, and accepting therefor 7 per cent demand notes of the Chippewa Power Company. A stock dividend of 150 per cent upon the common stock was distributed in 1923, of which the partnership received 2,250 shares of additional common stock of the Chippewa Power Company. It was part of the oral understanding that the demand notes should be convertible at face value into preferred stock at par value if and when issued. However, the preferred stock was never issued during the period from organization until the partnership parted with control of the power company in 1926. Further advances to enable completion of the development were made by the partnership in 1923 and 1924, aggregating $250,000, for *771 which 7 per cent demand notes of the power company were accepted. The hydroelectric plant was completed by the end of 1923, and operation*1491 and rental payments under the lease agreement were begun. In November, 1925, the Wisconsin Supreme Court decided that the Chippewa Power Company was not a public utility, whereupon the State Railway Commission found it was without jurisdiction to continue further with its proceedings relative to the lease agreement and its action was terminated. Closely following thereafter an agreement was entered into, on December 1, 1925, with parties who had acquired control of the Wisconsin-Minnesota Light and Power Company looking to the exercise of the option of purchase provided in the lease agreement, and in 1926 the purchase was accomplished through the medium of the transfer of the capital stock of the Chippewa Power Company. In this deal the partnership, among other things, sold out its entire holdings of the common stock at par value and within 1926 was paid in full the face value of the demand notes of the power company and the accrued interest thereon. Previous to the transfer of the stock a dividend at the rate of 23.27 per cent was paid out of undivided profits.
The decedent was entitled, as a partner in Paine, Webber and Company, to receive 55 per cent of the net profits of*1492 all partnership transactions relating to the Jim Falls dam site and the Chippewa Power Company.
The return for 1922 executed and filed by the decedent, William A. Paine, reported net income in the amount of $421,655.42 and a tax liability of $203,656.84, which tax was duly assessed and paid. Included in the income reported on the return was an item of $57,596.79, being the decedent's distributive share of the item of $104,721.43 interest reported by the partnership as realized in 1922, and an item of $77,430.37, being the decedent's distributive share of the book profit of $140,782.50 reported by the partnership as having been realized in 1922 from the sale of the said bonds.
In determining the deficiency the respondent accepted as a proper income item the decedent's distributive share of interest, $57,596.79, and has increased his distributive share of the profit from sale of bonds to $161,580.37, thus increasing income from this source by $84,150, being 55 per cent of $153,000.
While these proceedings were pending, the original petitioner, William A. Paine, died testate. Francis Ward Paine, Robert H. Gross, Morris F. LaCroix, Stephen Paine and Isaiah R. Clark were, on*1493 October 17, 1929, duly appointed executors of his estate, and such executors have been substituted petitioners in the place of William A. Paine.
*772 OPINION.
ARUNDELL: Petitioners contend that the interest item of $104,721.43 became taxable income in 1920, when the notes of the Chippewa Power Company were received, rather than in 1922, when the notes were liquidated. They urge that under the laws of both Wisconsin and Massachusetts the presumption is that a negotiable promissory note of a third person is given in satisfaction of a preexisting debt, rather than as mere evidence of the debt. See ; ; ; ; . Whatever the rule may be as between the maker and holder of the notes, it is not necessarily controlling in deciding the question of when income is realized. . But granting that the rule urged is correct, the notes would be income in the year of their receipt only to the extent of their value. *1494 ; . The evidence in this case is to the effect that the accounting practice of the partnership was to enter interest notes as income in the year of receipt, but in this instance they were not so entered because of the doubt as to their collectibility. The maker of the notes was without funds to pay them, and the value of the group of notes, covering both principal and interest, was not more than the amount of the principal. Under these circumstances we think it was proper not to record or report the interest notes as income in 1920 and that it was proper to include in income for 1922 the amount received in payment of them.
Whether the item of $153,000 was taxable income in 1922 depends upon whether the cost of the Chippewa Power Company bonds to the partnership was $900 per $1000 bond, as contended by petitioners, or $815 as contended by respondent. Petitioners contend, (1) that the oral agreement of May, 1922, fixed the price at $900 and that that agreement was not superseded by the written agreement, and (2) that, if the written agreement controls the transaction, if fixed a lump-sum*1495 consideration for both bonds and stock and an equitable apportionment should be made, based on the relative values of the two classes of securities. Respondent argues that the written contract provides for a cost price of $815 for each bond, and as a matter of fact that was all that the partnership paid for the bonds.
Our view of the matter is that the written contract should be construed as providing for a lump sum to be paid for the bonds and stock and that the agreement to pay specified sums upon the delivery of each bond and each certificate of stock was merely a method of payment. The evidence is clear that such was the intent of the parties to the agreement, and, in so far as the bonds were concerned, *773 it was carried out in that manner and so recorded on the partnership books. Due to unforeseen circumstances the preferred stock could not be issued, but in lieu thereof the Chippewa Company issued its notes, which, the evidence shows, were of the same value in relation to the bonds as the stock originally contemplated. It is clearly established that the bonds were worth at least 90 and the stock not more than 85. In the face of this evidence it seems obvious*1496 that to hold that the cost of the bonds to the partnership was at the rate of 81 1/2, as contended by respondent, would be to do violence to the intent and the agreement of the parties. Petitioners do not contend that the $153,000 was never income. On the contrary, they admit that it was, but they say that it was realized in 1926, when the transaction between the partnership and the Chippewa Company was brought to a conclusion. We are not called upon to determine whether it was income in 1926, but we are satisfied that it was not income in 1922. Even if it be conceded that the figures of $815 and $100 set out in the written agreement were designed to represent "cost" of the bonds and stock, respectively, we could not say, in the light of the evidence, that they were bona fide figures. Tax liability may not be fixed or evaded by means of inserting fictitious prices in contracts. Had the agreement provided, for example, that the partnership was to pay a sum considerably in excess of the face amount of the bonds, we clearly could not say, in view of the relation of the partnership and corporation and the evidence as to values, that a bona fide loss had been sustained upon the sale*1497 within a day or two at less than the face amount of the bonds.
We accordingly hold that the interest item of $104,721.43 was properly included in income in 1922, and that the amount of $153,000 income from the sale of bonds was not realized by the partnership in 1922.
Decision will be entered under Rule 50.