*85 Decisions will be entered under Rule 50.
Held, the cancellation of interest indebtedness by the shareholder-creditor of Hartland Corp. did not result in the receipt of income by the corporation notwithstanding the deduction of such interest as it accrued in prior years. Such cancellation constituted, rather, a capital contribution to the corporation. Held, further, Hartland Corp. must be denied a deduction for accrued rentals payable in favor of its controlling shareholder which remained unpaid as of the close of the 2 1/2-month period following the taxable year. A document evidencing the rental indebtedness issued by the corporation to its shareholder was not a negotiable note and thus did not constitute payment for purposes of sec. 267, I.R.C. 1954, since it was not required to be included in the gross income of the cash basis shareholder.
*1580 Respondent has determined that petitioner is liable as transferee for the following deficiencies in the income tax of Hartland Hospital, transferor:
| Taxable period | Deficiency |
| May 1, 1963, to Apr. 30, 1964 | $ 7,788.00 |
| May 1, 1964, to Jan. 2, 1965 | 17,364.00 |
*1581 Petitioner does not contest its liability as transferee, but challenges the alleged deficiencies of Hartland Hospital asserted by respondent. The issues presented for decision are: (1) Whether cancellation of accrued interest by a creditor-shareholder of Hartland Hospital, transferor, constituted income to Hartland Hospital; and (2) whether Hartland Hospital is entitled to a deduction for rent due to its principal shareholder in excess of amounts allowed by respondent under section 267(a)(2), I.R.C. 1954. 1
FINDINGS OF FACT
*88 Some of the facts were stipulated. The stipulation of facts and exhibits attached thereto are incorporated herein by this reference.
Petitioner, Hartland Associates, is a partnership organized under the laws of California on June 1, 1964. Petitioner's principal place of business was Baldwin Park, Calif., at the time it filed its petitions in this case.
Hartland Hospital (hereinafter referred to as Hartland), a California corporation, was organized on January 26, 1956, for the purpose of operating a hospital for profit. It filed Federal income tax returns for the taxable year ending April 30, 1964, and its short taxable year May 1, 1964, through January 2, 1965, on an accrual method of accounting with the district director of internal revenue, Los Angeles, Calif.
Hartland was liquidated and its assets distributed to its then sole shareholder, petitioner, in January 1965. Petitioner assumed the liabilities of Hartland at such time. Petitioner furnished no consideration, other than its surrender of Hartland stock and assumption of Hartland's liabilites, in exchange for its receipt of the corporate assets. The net value of the assets transferred to petitioner at such time exceeded*89 the deficiencies in income tax which have been determined by respondent in this case plus interest thereon as provided by law.
Prior to February 1, 1963, the land and building occupied by Hartland and the equipment used in its business were owned by Baldwin Co., a partnership. Baldwin Co. leased the real estate and equipment to Hartland for a monthly rental of $ 10,000. The stock of Hartland was owned in part by the members of the Baldwin Co. partnership.
On February 20, 1963, Jack L. Rau (hereinafter referred to as Rau) entered into an "Agreement for Purchase and Sale of Promissory Notes" under which Rau agreed to purchase certain outstanding promissory notes of Hartland for a total consideration of $ 65,000 from the owners and holders of such notes. The balance owing at that time *1582 under the promissory notes amounted to $ 65,000 plus accrued interest. The agreement further provided:
V. The performance of this agreement is expressly conditioned upon both of the following events:A. The acquisition by Jack L. Rau and Marjorie D. Rau of the real property upon which Hartland Hospital is located, from the Baldwin Co. * * *
B. The acquisition by Jack L. Rau of all of the *90 outstanding stock of Hartland Corporation * * *
During the month of February 1963, Rau purchased the promissory notes described in the above agreement. Unpaid interest which had accrued upon these notes prior to February 1, 1963, amounted to $ 18,391. About the same time, Rau, who had formerly been a minority shareholder of Hartland, acquired the remaining stock of Hartland, thus becoming the sole shareholder of Hartland. At this time, due to competition from a nearby hospital built in 1961, Hartland's financial position was rather poor. Rau, after becoming controlling shareholder of Hartland, advanced funds to Hartland to enable the hospital to meet its operating expenses.
On June 1, 1963, Rau forgave the interest owed to him by Hartland, including the entire interest obligation which had accrued on the notes prior to February 1, 1963. This transaction is evidenced by a handwritten letter bearing Rau's signature, dated June 1, 1963, which reads:
Board of Directors of Hartland Hospital, a corporation
Gentlemen:
I hereby gratuitously waive all interest accrued to me on notes due me from Hartland Hospital amounting to $ 65,000.00 to date hereof.
(S) Jack L. Rau
The cancellation*91 of interest was reflected in the general journal of Hartland as follows:
| 4/30/64 | Accrued interest | $ 18,662.14 | |
| Capital surplus | $ 18,391.30 | ||
| Interest expense | 270.84 |
Interest in the sum of $ 18,391 which accrued prior to February 1, 1963, had been deducted by Hartland for Federal income tax purposes in the taxable year during which such expense accrued. Said sum had thus been deducted in full prior to the taxable year commencing May 1, 1963.
The Commissioner, in determining the deficiencies of Hartland for the taxable years in question, increased its income by the amount of the canceled interest on the ground that such cancellation constituted income to Hartland.
In 1963, Rau purchased from Baldwin Co. the real estate and equipment *1583 of Hartland subject to the existing lease between Baldwin Co. and Hartland. As a result of the purchase, Rau succeeded to the rights of Baldwin Co. as a lessor of the property. For the taxable year ending April 30, 1964, Hartland deducted as rent expenses accrued in such year the sum of $ 121,894. Such deduction was in part attributable to rentals which had accrued in favor of Rau under the aforesaid lease covering real*92 estate and equipment. As of April 30, 1964, Hartland's accrued rent payable account reflected unpaid rent in the sum of $ 78,785.07. An additional $ 10,000 was paid to Rau during the 2 1/2-month period following April 30, 1964. Thus, as shown in Hartland's records, accrued rent payable to Rau during the 1963-64 fiscal year which remained unpaid as of June 15, 1964, amounted to $ 68,785.07.
In June 1964, Rau and Hartland entered into an agreement respecting the payment of the delinquent rent obligation to Rau. The agreement was evidenced by a letter, dated June 25, 1964, which read:
Mr. Jack L. Rau
1118 -- 19th Street
Santa Monica, Calif.
Dear Sir:
The undersigned acknowledges that it is indebted to you in the sum of $ 64,758.00 accrued and delinquent rent.
You have agreed that the undersigned may pay said sum at the rate of $ 1,000.00 or more per month, without interest, provided, however, that during any month in which the gross profit of the undersigned is less than $ 5,000.00, the payment to you in the following month shall be $ 500.00 or more.
Said payments shall commence August 1, 1964 and you reserve the right to declare the entire balance immediately due and*93 payable in the event of a default under the terms hereof.
Please acknowledge the terms hereof on a copy of this letter for our records.
Very truly yours,
Hartland Hospital
(S) A. W. Cutter, M.D.
By (S) Ann C. Amatore,
Secretary.
Agreed and Accepted:
(S) Jack L. Rau
Rau thus agreed to accept payment of the delinquent rent, commencing August 1, 1964, at the rate of either $ 1,000 or $ 500 per month, depending upon the gross income of Hartland. For accounting purposes, the issuance of the above letter was not treated as payment of Hartland's rent obligation; the accrued rent payable account continued to show a balance of $ 84,285 representing the accrued rent payable to Rau as of June 30, 1964. Such balance was reduced as installment payments were made to Rau in succeeding months under the terms of the above agreement.
*1584 Rau reported income, for Federal income tax purposes, on the cash basis. He thus did not include in gross income rental income, which had accrued in his favor, until such time as payment was actually received.
Prior to September 1965, Rau was indebted to the Union Bank for some $ 350,000. Such indebtedness was secured by collateral. In 1965, the collateral*94 declined substantially in value causing Union Bank to request additional collateral. In September 1965, pursuant to such request, Rau assigned as additional collateral for the indebtedness a second trust deed, the unpaid balance of which was approximately $ 325,000 at such time. In addition, he transferred to Union Bank, by written assignment, his rights to the accrued rent owing from Hartland as evidenced by the aforementioned letter dated June 25, 1964. Following such transaction, Union Bank notified petitioner, the distributee of Hartland's assets following its (Hartland's) liquidation in January 1965, of Union Bank's newly acquired right to collect the accrued rent payable to Rau under the letter of June 25, 1964. This notification consisted of a form letter with certain typewritten insertions and read in part as follows:
September 29, 1965
Hartland Assoc.
Attn: Ann Amatory
14148 Francisquito Ave.
Baldwin Park, CaliforniaWe hold for collection your Accured [sic] &DelinquentRent dated 6/25/64 in the amount of $ 69,280.00 with interest at none % in favor of Jack L. Rau payable $ 1000.00 or more on the 1st. of each month, starting 10-1-65*95 .
* * * *
As of your last payment, each year a detailed statement will be mailed to you showing the principal and interest applied to your note and the balance due. At the same time, a new supply of envelopes will be enclosed for the new year.
* * * *
Sincerely,
(S) Fred Gindy,
Collection Department[Typewritten insertions are underlined.]
Respondent has disallowed Hartland's claimed rental expense deduction (of $ 121,894) to the extent of $ 68,785, representing amounts which remained unpaid as of the close of the 2 1/2-month period following April 30, 1964. The stated ground for such disallowance is the provisions of section 267.
Following Rau's acquisition of Hartland in 1963, its financial condition continued to worsen. In an effort to avert the failure of Hartland, Rau sought to increase its patronage by encouraging a group of doctors, who had previously divided their business among Hartland and *1585 other hospitals, to refer a greater percentage of their patients to Hartland. As an inducement to do so, Rau offered to transfer an interest in the hospital to the doctors. Petitioner was organized for this purpose on June 1, 1964, with a capitalization of $ 200,000. *96 Petitioner thereafter acquired from Rau the land, building, and equipment of Hartland formerly owned by Rau. Petitioner also acquired from Rau 88 percent of the Hartland stock, representing Rau's entire interest in Hartland at that time. The remaining 12 percent had been sold at an earlier date to several of the organizers of petitioner. In exchange for this property and stock, Rau received approximately $ 140,000 in cash, a promissory note in the sum of some $ 334,000 secured by a second trust deed on the land, and a promissory note for the accrued rentals owed to Rau by Hartland. Petitioner was the sole shareholder of Hartland in January of 1965.
OPINION
The first issue to be decided is whether the cancellation by Rau, a creditor-shareholder of Hartland, of Hartland's interest indebtedness constituted taxable income to Hartland.
Section 61(a)(12), I.R.C. 1954, requires the inclusion in gross income of "Income from discharge of indebtedness." It is clear, however, that income resulting from such discharge is not in all cases taxable to the debtor. Where the cancellation is "gratuitous," that is, "a release of something for nothing," cancellation of a debt is regarded as a gift*97 2 and is thus excluded from gross income under section 102. Helvering v. Amer. Dental Co., 318 U.S. 322">318 U.S. 322 (1943); George Hall Corporation, 2 T.C. 146">2 T.C. 146 (1943); Utilities & Industries Corporation, 41 T.C. 888 (1964), affd. on this ground but reversed on others sub nom. South Bay Corporation v. Commissioner, 345 F. 2d 698 (C.A. 2, 1965). Likewise, the gratuitous cancellation by a shareholder of a corporate indebtedness is regarded as a capital contribution rather than income to the corporation. Sec. 1.61-12 (a), Income Tax Regs.; Autostrop Safety Razor Co., 28 B.T.A. 621">28 B.T.A. 621 (1933), affirmed on this point 74 F. 2d 226 (C.A. 2, 1934); Lidgerwood Mfg. Co. v. Commissioner, 229 F. 2d 241 (C.A. 2, 1956), affirming 22 T.C. 1152">22 T.C. 1152 (1954), certiorari denied 351 U.S. 951">351 U.S. 951 (1956); Carroll-McCreary Co. v. Commissioner, 124 F. 2d 303 (C.A. 2, 1941); Bratton v. Commissioner, 217 F. 2d 486*98 (C.A. 6, 1954). Such cancellations are excludable from gross income under section 118.
The nontaxability of the gratuitous cancellation of an indebtedness applies equally to the principal and interest portions of the indebtedness. Helvering v. Amer. Dental Co., supra;George Hall Corporation, *1586 ;Commissioner v. Auto Strop Safety Razor Co., Inc., 74 F. 2d 226 (C.A. 2, 1934), affirming on this point 28 B.T.A. 621">28 B.T.A. 621 (1933); McConway & Torley Corporation, 2 T.C. 593">2 T.C. 593 (1943). It is of little consequence in determining the result of the cancellation of interest indebtedness that the interest had been deducted by the debtor*99 in prior years. The imposition of tax liability on the basis of prior tax benefits has been uniformly rejected by the courts in the case of the gratuitous forgiveness of a debt. 3Reynolds v. Boos, 188 F. 2d 322 (C.A. 8, 1951), citing Helvering v. Amer. Dental Co., supra;Commissioner v. Auto Strop Safety Razor Co., supra.Sections 102 and 118, which govern taxability of such cancellations, will not be overriden by the abstract notion of tax benefit. 4Reynolds v. Boos, supra.
*100 Applying the foregoing principles to the instant controversy, we concur with petitioner that the cancellation herein did not give rise to income. The gratuitous discharge of the overdue interest obligation of Hartland constituted, rather, a contribution to capital by Rau, its controlling shareholder. Notwithstanding respondent's contrary assertion, it appears quite clear from the record before us that the cancellation of interest was, in fact, gratuitous in that consideration did not pass between the corporation and Rau in return for the cancellation. The plain inference from the record is that Rau, who had at that time recently acquired a controlling interest in the corporation, intended , in discharging the outstanding interest indebtedness in the sum of $ 18,391, to thereby improve the deteriorating financial condition of the corporation. Requiring the payment of consideration would thus have frustrated the very purpose of such cancellation. Furthermore, petitioner has produced the contemporaneous handwritten letter of Rau, dated June 1, 1963, expressly stating that the unpaid interest "is hereby gratuitously [waived]." (Emphasis added.) While Rau was unable to recall *101 the execution of this letter, as respondent points out upon brief, its authenticity is unquestioned and its meaning quite clear. Petitioner's assertion respecting the absence of consideration, which might otherwise invite the particular scrutiny of the Court, is less so the object of concern where, as in the case before us, the cancellation is made by a controlling shareholder in favor of its ailing corporation. *1587 There is no evidence in the record to support his bare allegation that consideration passed between Rau and the corporation. On the state of the record, in view of the above-described circumstances, as well as the documentary evidence before us, we hold that the cancellation was, in fact, gratuitous. We thus consider any gain realized as a result of such cancellation properly excludable from gross income under section 118.
The next issue concerns respondent's denial of a deduction for rentals, accrued but allegedly unpaid, as of the close of the 2 1/2-month period following Hartland's taxable year ended April 30, 1964.
Section 267(a)(2)5 provides for the disallowance of certain accrued but unpaid expenses otherwise deductible under sections 162 or 212 where*102 the taxpayer bears a specified relationship with the person to whom payment is to be made. Under this section, accrued expenses payable to a related person are deductible only if "paid" within the taxable year or the 21/2-month period following the close thereof. Respondent has disallowed, under section 267, the portion of the claimed rental deduction attributable to rentals which had accrued in favor of Rau during Hartland's taxable year ended April 30, 1964, but which, respondent claims, remained unpaid as of July 15, 1964. The sole question presented is whether Hartland had "paid" its accrued rent, within the meaning of section 267, prior to July 15, 1964. Petitioner's contention in this regard is that the letter issued to Rau by Hartland on June 25, 1964, acknowledging the indebtedness for unpaid rent and setting forth a schedule of payment in installments, constituted payment within section 267(a)(2) of such rent. Petitioner maintains that the letter, which it characterizes as a promissory note, satisfied the payment requirement of the Code, citing Musselman Hub-Brake Co. v. Commissioner, 139 F. 2d 65 (C.A. 6, 1943); Celina Manufacturing Co. v. Commissioner, 142 F. 2d 449*103 (C.A. 6, 1944); Anthony P. Miller, Inc., v. Commissioner, 164 F. 2d 268 (C.A. 3, 1947); Akron Welding & *1588 ., 10 T.C. 715">10 T.C. 715 (1948); and Heatbath Corporation, 14 T.C. 332 (1950).
*104 The petitioner correctly states that issuance of a promissory note may constitute payment for purposes of section 267. For reasons hereinafter stated, this proposition must, in our opinion, be limited to the issuance of a negotiable note, as against either a nonnegotiable note or mere contractual obligation. 6 The term "paid" of section 267 comprehends transactions which, as in the case of cash payments, result in the receipt of income by a cash basis taxpayer. Sec. 1.267(a)-1(b)(1)(iii), Income Tax Regs.; Musselman Hub-Brake Co. v. Commissioner, supra.This principle follows from the general purpose of section 267 which is to deny a deduction to an accrual method taxpayer for amounts which, because of the absence of actual payment, are not includable in the income of the cash basis taxpayer in whose favor such amount is accrued. In determining whether the payment requirement has been met, therefore, the focal point of inquiry is the includability of the payment in question in the income of a cash basis taxpayer.
*105 As a general rule, negotiable promissory notes issued as payment to a cash basis taxpayer result in the receipt of income. Joseph Marcello, Jr., 43 T.C. 168 (1964), remanded on other grounds 380 F. 2d 499 (C.A. 5, 1967); Alvin B. Lowe, 44 T.C. 363">44 T.C. 363, 372 (1965), acq. 1 C.B. 2">1966-1 C.B. 2; Wolfson v. Reinecke, 72 F. 2d 59 (C.A. 7, 1934). Such obligations are regarded as the "equivalent of cash" because, like money, they are freely and easily negotiable so that they pass from hand to hand in commerce. Nina J. Ennis, 17 T.C. 465">17 T.C. 465, 470 (1951). On the other hand, a mere contractual obligation to make payments in the future is not treated as a cash equivalent and hence is not includable in income of a cash basis taxpayer until payment thereunder is actually received. Dudley T. Humphrey, 32 B.T.A. 280">32 B.T.A. 280 (1935); Bedell v. Commission, 30 F.2d 622">30 F.2d 622 (C.A. 2, 1929), affirming 9 B.T.A. 270">9 B.T.A. 270 (1927); Harold W. Johnston, 14 T.C. 560">14 T.C. 560 (1950).*106 Similarly, because they lack negotiability, nonnegotiable notes are not normally the equivalent of cash. Nina J. Ennis, supra;Denver & Rio Grande Western Railroad Co. v. United States, 318 F. 2d 922 (Ct. Cl. 1963).
Petitioner, without discussing the negotiability of the letter in question, asserts categorically that such letter, though not in the usual form, constituted a promissory note. It is the negotiable aspect of such instrument which, as we have stated above, is crucial to the outcome of this case. The mere fact that Rau may have considered the instrument a negotiable note, which is not entirely clear from the *1589 record, would not alone accord it negotiable status as petitioner implies. Ornbaun v. First Nat. Bank of Cloverdale, 215 Cal. 72">215 Cal. 72, 8 P. 2d 470 (1932); Westlake Mercantile Finance Corporation v. Merritt, 204 Cal. 673">204 Cal. 673, 269 P. 620">269 P. 620 (1928). Looking to the face of the instrument in question, we think it quite clear that such instrument is nonnegotiable under California law, which provides:
§ 3082. Form*107 and requisites.
An instrument to be negotiable must conform to the following requirements:
(1) It must be in writing and signed by the maker or drawer;
(2) Must contain an unconditional promise or order to pay a sum certain in money;
(3) Must be payable on demand, or at a fixed or determinable future time;
(4) Must be payable to order or to bearer; * * *
* * * *
[Cal. Civ Code, sec. 3082, p. 448 (West 1954).]
The instrument in the instant case contains no express promise to pay as required by section 3082(2) above. Although such promise to pay may be inferred from the acknowledgement of a debt for the purpose of characterizing the instrument as a promissory note, the law of California seems to require, for negotiability, more than a mere implied promise to pay. Patterson v. Chapman, 179 Cal. 203">179 Cal. 203, 176 P.37 (1918); 11 Am. Jur. 2d secs. 139, 140; 127 A.L.R. 654">127 A.L.R. 654. Moreover, it is clear that the absence of the required words of negotiability (see sec. 3082(4) above), deprives the instrument in question of negotiability. An indispensible element of the negotiable instrument under the statute is that it be "payable to order*108 or bearer." Failing this explicit requirement, the instrument in question must be characterized as nonnegotiable under California law. Guggenhime & Co. v. Lamantia, 207 Cal. 96">207 Cal. 96, 276 P. 995">276 P. 995 (1929).
Accordingly, the letter in question, which constituted either a contract for future payment or a nonnegotiable promissory note, was not required to be included in the income of Rau for the taxable year 1964. Indeed, Rau did not in fact report amounts represented by such letter on his Federal income tax return for such year. By the same token, such letter cannot, we think, be regarded as payment within the meaning of section 267.
Moreover, to the extent that the parties' subjective intent to liquidate the indebtedness by the issuance of a promissory note plays a role in determining the effect of such payment, see Musselman Hub-Brake Co. v. Commissioner, supra at 69; Akron Welding & Spring Co., supra at 721, the facts of the instant case further reinforce our conclusion. Hartland upon issuance of the letter made no entries upon its books of account indicating the payment *109 of its rental obligations to Rau at such time. The accrued rent payable account continued to *1590 show after June 25, 1964, a balance in excess of $ 68,785.07 which included the amounts represented by the letter of June 25. Common accounting procedures would have required the debiting of this account and crediting of a note payable account had Hartland regarded the issuance of the letter as full payment of its outstanding rent obligation. Nor did Rau, the principal shareholder and an officer of Hartland, regard the letter as payment, as evidenced by his failure to include the amount thereof in gross income upon its receipt. Moreover, the language of the letter, which conveys the impression of an agreement rather than a negotiable evidence of indebtedness, is significant in ascertaining the intent of the parties to the transaction. It appears that the purpose of such document was primarily to set forth the terms of payment and secondarily evidence the existing indebtedness owed by Hartland to Rau, rather than to create a negotiable instrument.
Accordingly, we uphold the Commissioner's partial denial of the rental deduction to Hartland for the taxable years at issue.
Decisions*110 will be entered under Rule 50.
Footnotes
1. All statutory references are to the Internal Revenue Code of 1954, unless otherwise specified.↩
2. As to the payment of gift tax, see Stephen F. Heringer, 21 T.C. 607 (1954), modified 235 F. 2d 149 (C.A. 9, 1956), certiorari denied 352 U.S. 927">352 U.S. 927↩ (1956).
3. The prior tax benefit may be of importance in determining the effect of a nongratuitous cancellation of interest or salary previously deducted by the debtor. In such cases, the recovery by reason of cancellation of amounts previously deducted has been held to result in income to the extent of any prior tax benefit. Helvering v. Jane Holding Corporation, 109 F. 2d 933↩ (C.A. 8, 1940).
4. It is to be noted that as regards the issue under consideration the shoe is often on the other foot. The Commissioner has prevailed in his denial of a deduction for bad debt loss on the ground that such loss constituted a capital contribution. Carl C. Harris, 19 B.T.A. 895 (1930). Similarly, the Commissioner has successfully denied a deduction to a shareholder for a corporation's nonpayment of accrued salary which the shareholder had included in prior years. Leo Perlman, 27 T.C. 755 (1957), affd. 252 F. 2d 890↩ (C.A. 2, 1958).
5. SEC. 267. LOSSES, EXPENSES, AND INTEREST WITH RESPECT TO TRANSACTIONS BETWEEN RELATED TAXPAYERS.
(a) Deductions Disallowed. -- No deduction shall be allowed --
* * * *
(2) Unpaid expenses and interest. -- In respect of expenses, otherwise deductible under section 162 or 212, or of interest, otherwise deductible under section 163, --
(A) If within the period consisting of the taxable year of the taxpayer and 2 1/2-months after the close thereof (i) such expenses or interest are not paid, and (ii) the amount thereof is not includible in the gross income of the person to whom the payment is to be made; and
(B) If, by reason of the method of accounting of the person to whom the payment is to be made, the amount thereof is not, unless paid, includible in the gross income of such person for the taxable year in which or with which the taxable year of the taxpayer ends; and
(C) If, at the close of the taxable year of the taxpayer or at any time within 2 1/2-months thereafter, both the taxpayer and the person to whom the payment is to be made are persons specified within any one of the paragraphs of subsection (b).↩
6. It is to be noted that the cases cited by petitioner all involve the issuance of a negotiable promissory note.↩