*176 Decisions will be entered under Rule 50.
1. P and D were partners whose proportionate share of the profits and losses of the partnership were 75 percent and 25 percent respectively. Held, the partners, anticipating a substantial operating loss, properly incorporated their business and effectively transferred all of the partnership assets to the corporation.
2. The corporation then properly elected to be taxed as a small business corporation under subchap. S, I.R.C. 1954. Shortly thereafter the corporation transferred to P and his wife land with a value that exceeded P and his wife's basis in the stock of the corporation. Held, in acquiring the land, P and his wife received a return of capital in the amount of their basis in the stock of the corporation under sec. 301(c)(2), I.R.C. 1954, respectively. Held, further, the shareholders, in deducting the amount of their prorata share of the losses of the corporation, were limited by the amount of their basis in stock of the corporation plus their basis in corporate indebtedness owed to them under sec. 1374(c)(2), I.R.C. 1954.
3. Held, further, P and his wife, as cash basis taxpayers, could not deduct as a bad debt*177 the amount of an unpaid note executed by them in the settlement of their obligation as sureties on a contract entered into by the partnership and which was later transferred to the corporation.
*508 In these consolidated cases, the respondent determined deficiencies in income tax for the taxable years 1959 through 1963 as follows: *509
| Donald M. and Freda | H. E. and Annie | |
| Taxable year | M. Perry | Mae Perry |
| 1959 | $ 1,155.60 | $ 8,018.86 |
| 1960 | 1,201.64 | 31,168.83 |
| 1961 | 2,439.47 | 5,189.98 |
| 1962 | 361.21 | 954.40 |
| 1963 | 35.78 |
The issues for our determination are:
(1) Whether Perry Electric Co., Inc. (hereinafter sometimes referred to as the corporation), was properly incorporated, and if so, whether Perry Electric Co. (hereinafter sometimes*180 referred to as the partnership) transferred all its assets, liabilities, and operations to the corporation.
(2) The amount of petitioners' basis in corporate stock and corporate indebtedness which limits the portion of the operating loss of the corporation that is deductible by petitioners under section 1374(c), I.R.C. 1954. 1
(3) Whether certain petitioners were entitled to a bad debt deduction under section 166 during 1963.
FINDINGS OF FACT
Some of the facts have been stipulated. The stipulation of facts and exhibits attached thereto are incorporated herein by this reference.
Petitioners are H. E. Perry and his wife Annie Mae, their son Donald M. Perry and his wife Freda M. Perry. They all reside in Decatur, Ala., and for the taxable years in question they filed their income tax returns with the district director of internal revenue at Birmingham, Ala. For a number of years H. E. Perry (hereinafter sometimes referred*181 to as Perry) operated an electrical contracting business in northern Alabama. In 1960 he formed a partnership known as the Perry Electric Co. with his son Donald M. Perry (hereinafter sometimes referred to as Donald), in which the profits and losses were shared 75 percent to Perry and 25 percent to Donald.
Issue 1. Incorporation and Transfer of the Partnership Business to the CorporationOn November 15, 1961, the partnership was awarded a contract by the United States through the U.S. Army Engineering District, Mobile Corps of Engineers (hereinafter sometimes referred to as the Corps of Engineers). The contract called for construction by the partnership of an electrical substation at the Redstone Arsenal in Huntsville, Ala. The contract was known as contract No. DA-01-076-ENG-5328 (hereinafter sometimes referred to as contract No. 5328). Pursuant to normal *510 requirements of contracting with the United States, the partnership entered into a payment bond contract with Maryland Casualty Co. (hereinafter sometimes referred to as the bonding company) in the amount of $ 184,768.63, and a performance bond of $ 369,537.25, the total contract price.
On November 6, 1961, prior*182 to the signing of contract No. 5328, Perry recognized that he had made a mistake in his bid, and so informed the Corps of Engineers by telegraph. However, subsequent negotiation by conference, telephone, and letter did not result in any change from the original bid and accordingly the contract was signed on November 15, 1961.
Early in 1962 it became apparent that a large loss would result in completing contract No. 5328. In attempting to limit their personal liabilities with respect to this anticipated loss, the partners, Perry and Donald, consulted their attorney who advised them to incorporate the partnership. Pursuant to this advice, papers were prepared and signed by Perry, Donald, and Annie Mae on June 22, 1962, to incorporate the partnership.
The name of this new corporation became Perry Electric Co., Inc. The incorporation papers were properly filed in the office of the probate judge of Morgan County, Ala., on June 25, 1962. The 100 shares of common stock of the corporation were assigned a share value of $ 100 a share and the declaration of incorporation listed the following as sucscribers for shares of stock:
| Name | Shares | Amount |
| H. E. Perry | 38 | $ 3,800 |
| Annie Mae Perry | 37 | 3,700 |
| Donald M. Perry | 25 | 2,500 |
| Total | 100 | 10,000 |
*183 The declaration of incorporation also stated that Perry, Donald, and Annie Mae were chosen as directors and also as president, vice president, and secretary-treasurer, respectively. These positions were to be maintained by the various parties for the first year or until their successors are elected.
On June 22, 1962, an agreement between the partnership and the corporation was entered into providing for the transfer and assignment of all assets and liabilities of the partnership to the corporation. This agreement stated:
STATE OF ALABAMA
COUNTY OF MORGAN
AGREEMENT
Whereas, H. E. Perry and Donald M. Perry are partners operating under the partnership name of Perry Electric Company, and
*511 Whereas, they desire to incorporate under the name of Perry Electric Company, Inc., and
Whereas, H. E. Perry, Donald M. Perry and Annie Mae Perry, have formed a corporation to carry on the work, business and transaction heretofore carried on by the partnership, and
Whereas, it is the desire and intention of all the partners of Perry Electric Company and all the officers and stock holders of Perry Electric Company, Inc., viz: H. E. Perry, Donald M. Perry and Annie Mae Perry to enter into*184 an agreement transferring the assets of the partnership to the corporation and assumption by the corporation of all liabilities of the partnership, it is agreed as follows, witnesseth:
This Agreement entered into this 22nd day of June, 1962, by and between H. E. Perry and Donald M. Perry, all the partners in the business and partnership known as Perry Electric Company, and Perry Electric Company, Inc., a corporation, composed of H. E. Perry, Donald M. Perry and Annie Mae Perry.
1. For and in consideration of the premises and the mutual agreements herein, Perry Electric Company, a partnership, composed of H. E. Perry and Donald M. Perry, agrees to transfer and assign, and does hereby transfer and assign all of it's assets of whatever kind and nature and all of it's liabilities of whatever kind and nature to Perry Electric Company, Inc., a corporation.
2. Perry Electric Company, Inc., a corporation, incorporated by H. E. Perry, Donald M. Perry and Annie Mae Perry, who are the owners of all the shares of stock and are the officers of said Corporation, does hereby agree to accept and does hereby accept all of the assets, whatever kind and nature of Perry Electric Company and partnership*185 and does hereby assume all liabilities of whatever kind and nature of said partnership.
In Witness Whereof, we have hereunto set our hands and signatures this day of , 1962.
Perry Electric Company, a partnership
Witness:
By/Partner
By (S) Donald M. Perry/Partner
Perry Electric Company, Inc., a corporation
ByH. E. Perry, President
By (S) Donald M. PerryDonald M. Perry, Vice-president
By (S) Annie Mae PerryAnnie Mae Perry, Secretary-treasurer
This agreement was undated, it was not witnessed, and was only signed by Donald and Annie Mae Perry (hereinafter sometimes referred to as Annie Mae). Donald signed as partner and as vice president of the corporation, while Annie Mae signed as secretary-treasurer of the corporation. Perry did not sign the document in either his capacity as partner or as president of the corporation. Also, at the time of incorporation, the business signs of the partnership were not changed nor were the creditors of the partnership informed of the incorporation.
Subsequently, the partnership filed a final partnership income tax return for the period January 1, 1962, through June 30, 1962, which *512 *186 was signed by Perry. The corporation made the election to be taxed under section 1372 of the Internal Revenue Code of 1954. The corporation filed income tax returns, Form 1120-S, U.S. Small Business Corporation Return of Income, for the period July 1, 1962, through December 31, 1962, and for the calendar year ended December 31, 1963, and these were signed by Perry.
On September 18, 1962, the partnership, the corporation, and the United States entered into modification No. 5, supplemental agreement to contract No. DA-01-076-ENG-5328 (hereinafter sometimes referred to as the modification agreement). The modification agreement provided, in part, as follows:
This Agreement, entered into as of 18 September 1962, by and between the Perry Electric Company, a partnership consisting of H. E. Perry and Donald M. Perry (hereinafter referred to as the "Transferor"); the Perry Electric Company, Inc., a corporation duly organized and existing under the laws of the State of Alabama with its principal office in the City of Decatur, Alabama (hereinafter referred to as the "Transferee"); and the UNITED STATES OF AMERICA (hereinafter referred to as the "Government").
WITNESSETH:
Whereas, the Government, *187 represented by the Contracting Officer of the Department of the Army, Corps of Engineers, has entered into Contract No. DA-01-076-ENG-5328, dated 15 November 1961 covering Construction of Electrical Expansion for N.A.S.A., at Redstone Arsenal, Alabama; and
Whereas, as of 22 June 1962, the Transferor assigned, conveyed, and transferred to the Transferee all the assets of the Transferor by virtue of an agreement, conveyance and transfer between the Transferor and Transferee; and
Whereas, the Transferee, by virtue of said assignment, conveyance and transfer, has acquired all the assets of the Transferor; and
Whereas, by virtue of said assignment, conveyance and transfer, the Transferee has assumed all the duties, obligations and liabilities of the Transferor under the Contract; and
Whereas, the Transferee is in a position fully to perform the contract, and such duties and obligations as may exist under the Contract; and
Whereas, it is consistent with the Government's interest to recognize the Transferee as the successor party to the Contract; and
Whereas, there has been filed with the Government evidence of said assignment, conveyance and transfer; and
Whereas, there has been filed with*188 the Government a certificate dated 22 June 1962, signed by the Secretary of State of the State of Alabama as to the incorporation of the Perry Electric Company, Inc.;
Now, Therefore, in consideration of the premises, the parties hereto agree as follows:
1. The Transferor hereby confirms said assignment, conveyance and transfer to the Transferee, and does hereby release and discharge the Government from, and does hereby waive, any and all claims, demands, and rights against the Government which it now or may hereafter have in connection with the Contract.
2. The Transferee hereby assumes, agrees to be bound by, and undertakes to perform each and every one of the terms, covenants, and conditions contained in the Contract. The Transferee further assumes all obligations and liabilities of, and all claims and demands against, the Transferor under the Contract, in all respects as if the Transferee were the original party to the Contract.
*513 3. The Transferee hereby ratifies and confirms all actions heretofore taken by the Transferor with respect to the Contract with the same force and effect as if the action had been taken by the Transferee.
4. The Government hereby recognizes the*189 Transferee as the Transferor's successor in interest in and to the Contract. The Transferee hereby becomes entitled to all right, title, and interest of the Transferor in and to the Contract in all respects as if the Transferee were the original party to the Contract. The term "Contractor" as used in the Contract shall be deemed to refer to the Transferee rather than to the Transferor.
* * * *
8. The Transferor hereby guarantees payment of all liabilities and the performance of all obligations which the Transferee (i) assumes under this Agreement, or (ii) may hereafter undertake under the Contract as it may hereafter be amended or modified; and the Transferor hereby waives notice of and consents to any such amendment or modification.
This modification agreement was signed by Colonel D. A. Raymond of the Corps of Engineers, the District Engineer contracting officer, on behalf of the United States of America. This agreement was also signed by Perry as a partner on behalf of the partnership and as president of the corporation, and also by Annie Mae as secretary of the corporation.
In a letter dated September 26, 1962, Maryland Casualty Co. consented to the modification agreement in*190 the following language:
The Maryland Casualty Company, by its Attorney In Fact, consents to the supplemental agreement executed 18 September 1962 by and between Contracting Officer of the United States of America and Perry Electric Company, A Partnership and Perry Electric Company, Inc., A Corporation which supplemental agreement transfers Contract No. DA-01-076-ENG-5328 (Contract being Construction of electrical expansion for N.S.S.A. [sic], at Redstone Arsenal, Alabama) from Perry Electric Company, A Partnership to Perry Electric Company, Inc., A Corporation.
Nothing herein contained shall increase the penalty or penalties of the bond executed, including any modifications.
This letter was signed by Maryland Casualty Co.'s "Attorney in Fact."
Issue 2. Basis in Stock and Corporate IndebtednessThe assets and liabilities of the partnership on June 30, 1962, were as follows:
| ASSETS | ||
| Cash | ($ 1,171.32) | |
| Accounts receivable | 139,884.46 | |
| Notes receivable | 27,268.97 | |
| Inventory | 9,292.25 | |
| Equipment and buildings | $ 94,769.86 | |
| Less: accumulated depr | 48,696.64 | |
| 46,073.22 | ||
| Land | 46,666.67 | |
| Total assets | 268,014.25 | |
| LIABILITIES | ||
| Payroll taxes | $ 4,913.44 | |
| Accounts payable | 153,489.61 | |
| Note payable -- real estate | 80,130.00 | |
| Capital: | ||
| H. E. Perry | 26,574.50 | |
| Donald M. Perry | 2,906.70 | |
| Total liabilities | 268,014.25 |
*191 *514 The above assets did not reflect the amount of $ 22,949.31 of land improvements which had been erroneously charged as an expense rather than capitalized.
The accountant employed by the partnership entered on the books of the corporation only the following assets and liabilities of the partnership:
| ASSETS | |
| State National Bank | ($ 1,927.65) |
| First National Bank | 756.33 |
| Retainage | 34,385.24 |
| Job equipment | 16,097.43 |
| Trucks and auto | 32,137.30 |
| Office furniture and equipment | 2,660.26 |
| Inventory | 9,292.25 |
| Accounts receivable -- regular | 105,499.22 |
| 198,900.38 | |
| LIABILITIES | |
| Social security taxes | $ 1,068.85 |
| Federal withholding tax | 2,115.31 |
| State unemployment insurance tax | 1,372.13 |
| Alabama withholding tax | 357.15 |
| Notes payable -- State National Bank | 40,000.00 |
| Reserve for depreciation | 42,131.62 |
| Accounts payable | 153,489.61 |
| Capital stock | 10,000.00 |
| 250,534.67 | |
| Excess of liabilities over assets | 51,634.29 |
This accountant, who was deceased at the time of the trial, was an independent certified public accountant who had practiced in northern Alabama for a number of years.
On September 26, 1962, Perry and his wife Annie Mae conveyed to a newly*192 formed corporation, Perry Landings, Inc., a tract of land containing approximately 31 acres. Until this transfer the legal title to this real estate, since its acquisition, had been in the name of Perry and Annie Mae. However, this real estate had been considered a partnership asset which was included in the assets schedule of the balance sheet of the partnership as of June 30, 1962. With the aforementioned adjustment for land improvements, the real estate had a basis in the hands of the partnership of $ 47,544.67.
*515 For the period July 1 through December 31, 1962, Perry Electric Co., Inc., sustained a net operating loss of $ 165,863.05, and for the taxable year 1963 it sustained a net operating loss of $ 16,900.18. These net operating losses were a direct result of the completion of contract No. 5328. On December 31, 1963, the corporation owed Perry and Annie Mae $ 10,184.49.
Issue 3. Bad DebtIn connection with contract No. 5328, the corporation incurred debts for materials and supplies for which it was unable to pay. The bonding company, as surety of the contract, paid to the creditors of the corporation a total of $ 170,112.15 during 1963, and was thereafter*193 reimbursed from undisclosed sources to the extent of $ 32,112.15.
On February 14, 1963, the bonding company filed a bill for exoneration of surety in the Circuit Court of Morgan County, Ala., in equity. This complaint brought an action against Perry as an individual, the corporation, Perry Landings, Inc., Donald as an individual, and the partnership. The suit was settled by an agreement. The settlement document was executed on September 25, 1963, and provided that Perry, Annie Mae, and Perry Landings, Inc., execute a promissory note in favor of the bonding company in the amount of $ 138,000, plus interest of 5 percent per annum. Payment on this promissory note was to be secured by mortgages on five different parcels of land, but Perry Landings, Inc.'s liability was limited to only $ 25,000 plus interest. The note was duly executed and provided that payment would be made in the amount of $ 1,000 principal plus interest on the first day of January 1964, with similar amounts of principal and interest to be paid on the first day of each consecutive month thereafter. No payments were made by Perry, or Annie Mae and Perry Landings, Inc., on this note during any of the years presently*194 before us.
Respondent's DeterminationThe jointly filed individual income tax returns of Perry and Annie Mae for the taxable years 1959, 1960, and 1961 were audited by respondent in 1962, and as a result of this audit additional taxes were found to be due for the years 1960 and 1961. Perry and Annie Mae agreed to these additions and also to the additions to the tax under section 6653(a) of the Internal Revenue Code of 1954. In August 1963, petitioners filed applications for tentative carryback adjustments as a result of the net operating loss reported by Perry Electric Co., Inc., for the year 1962. These tentative allowances were made by respondent and resulted in refunds to the petitioners in the following amounts for the following years:
| 1959 | 1960 | 1961 | |
| H. E. and Annie Mae Perry | $ 8,018.86 | $ 42,525.43 | $ 5,189.98 |
| Donald and Freda M. Perry | 1,155.60 | 1,201.64 | 2,439.47 |
*516 In the notices of deficiency dated October 10, 1967, respondent determined deficiencies against petitioners with the following explanation:
It is determined that you did not sustain a net operating loss during the taxable year ended December 31, 1962 as shown hereinafter. It is further*195 determined that you are not entitled to net operating loss deductions in the taxable years ended December 31, 1959, 1960 and 1961 as a result of a net operating loss carryback from the taxable year ended December 31, 1962. Therefore, * * * allowances made * * * pursuant to the provisions of section 6411 of the Internal Revenue Code of 1954, based on your claim for a net operating loss carryback from the taxable year ended December 31, 1962 to the taxable years ended December 31, 1959, 1960, and 1961 have been determined to be excessive.
Respondent, in a further explanation of adjustments attached to the deficiency notices, determined that petitioners had additional ordinary income in 1962 in the total amount of $ 51,634.29. Respondent determined this to be the amount by which the liabilities transferred to the corporation exceeded the basis of the assets so transferred. Respondent further determined that this income should be apportioned among the petitioners and recognized in 1962, and that the amount recognized be added to the basis of petitioners' stock in the corporation. Therefore, for the same year, respondent's determination allowed petitioners to deduct the net operating*196 loss up to their respective bases in the stock pursuant to the corporation's election under section 1372.
Furthermore, with respect to Perry and Annie Mae for the taxable year ended December 31, 1963, respondent determined that the bad debt deduction which they claimed on their 1963 tax return in the amount of $ 138,000 was unallowable. In addition, respondent limited Perry and Annie Mae's deduction for the net operating loss on the electing small business corporation to $ 10,184.49, the amount of indebtedness of the corporation owed to Perry and Annie Mae as of December 31, 1963.
OPINION
Issue 1. Incorporation and Transfer of the Partnership Business to the CorporationThe first issue is whether the corporation was properly formed and whether the business of the partnership was effectively transferred to it. Petitioners argue the negative and reason that the losses were actually sustained by the partnership, the same organization in which the partners had successfully done business for the past several years. However, respondent argues that all the requirements have been met for special treatment under sections 1371-1378 (subchap. S) and therefore petitioners should be allowed*197 only to deduct their prorata *517 share of the net operating losses as limited by section 1374(c)(2). 2
*198 In support of the contention that the corporation was not properly organized, petitioners rely upon the following facts to show that the petitioners never really intended to incorporate the partnership: The stockholders held only one meeting during the years presently before us and failed to elect any directors although directors had been previously chosen in the declaration of incorporation. The partnership never informed its creditors that there was a change to corporate form. The corporation changed neither the names on the business signs nor its method of operation in any material respect from those of the partnership. However, we cannot agree that Perry and Donald's intention was not to incorporate, and we conclude that the corporation did come into being especially in light of other acts hereafter set forth.
Petitioners have stipulated that in an effort to limit their personal liability, the partners (Perry and Donald) consulted an attorney who advised them to incorporate the business. We believe that the partners' firm intention was to follow the advice of their attorney, whatever that might entail.
Perry, Donald, and Annie Mae executed and properly filed all the*199 papers necessary to incorporate the business. Also, a final income tax return for the partnership was signed and filed for the short period January 1 to June 30, 1962, as were corporate tax returns for the corporation.
In addition, the proper elections were filed under section 1372 in order that the income from the business would not be taxed as a corporation. Petitioners must have considered that the partnership had been incorporated for Federal income tax purposes. Moreover, shortly thereafter, Perry and the Corps of Engineers executed an agreement to transfer contract No. 5328 from the partnership to the corporation. This modification agreement specifically stated:
"Perry Electric Company, Inc., a corporation duly organized and existing under the laws of the State of Alabama." Accordingly, we find *518 that the facts show that Perry and Donald did intend to and did incorporate the partnership.
Furthermore, under Alabama statutory law, title 10, section 21(11) provides:
When a body corporate. -- When the certificate of incorporation has been made and filed for record as provided, the incorporators, their successors and assigns, shall constitute a body corporate under the*200 name set forth in the certificate of incorporation, but subject to dissolution as provided for in this chapter.
This was done.
As the above facts show that all the appropriate papers were filed, we conclude that the above statute was followed and that Perry Electric Co., Inc., was a corporation properly incorporated under the laws of the State of Alabama.
In the alternative, petitioners argue that even if the corporation were properly formed, the partnership never intended to transfer the assets, liabilities, and operations to the corporation and accordingly the assets were still the partnership's and not the corporation's; accordingly, the contract was performed and the net operating loss was sustained by the partnership and not the corporation. Petitioners base this argument on the contention that there was no contract transferring the business as the written agreement had been signed only by Donald and Annie Mae, but not by Perry in his capacity as either a partner or as president of the corporation.
On brief, even petitioners concede that:
[a] signature is not always essential to the binding force of an agreement, and whether a writing constitutes a binding contract even *201 though it is not signed or whether the signing of the instrument is a condition precedent to its becoming a binding contract usually depends on the intention of the parties. [Citing 17 C.J.S., sec. 62 (pp. 731, 732).]
In addition, Alabama follows the rule that "The object of a signature is to show mutuality or assent, but these facts may be shown in other ways, as, for example, by the acts or conduct of the parties." 17 C.J.S., sec. 62. See Whatley v. Reese, 128 Ala. 500">128 Ala. 500, 29 So. 606">29 So. 606 (1900); and Paterson & Edey Lbr. Co. v. Carolina-Portland Cement Co., 215 Ala. 621">215 Ala. 621, 112 So. 245">112 So. 245 (1927). The issue is a question of fact as to whether Perry's conduct indicates his assent to the contract even though the writing was not signed by him.
We believe that Perry's acts subsequent to June 22, 1962, clearly indicate that he and Donald intended that the "instrument was a binding contract even though it was not signed" by Perry and that his conduct evidenced his assent to the agreement.
The facts show that the parties acted as if the contract were sufficient. The corporation filed tax returns that*202 reflected the operations *519 of the business and these tax returns were signed by Perry. Moreover, Perry signed, as partner and as president of the corporation, a modification agreement with the Corps of Engineers which made specific reference to the fact that on June 22, 1962, the partnership "assigned, conveyed, and transferred to the Transferee [corporation]" and "the Transferee [corporation], by virtue of said assignment, conveyance and transfer, has acquired" all assets, liabilities, and operations of the partnership. We conclude that Perry did in fact assent to the contract and that this contract was legally sufficient to transfer the assets to the corporation.
Issue 2. Basis in Stock and Corporate IndebtednessPetitioners' next argument is that even if the corporation were properly organized and the assets, liabilities, and operations were transferred to the corporation, the petitioners should be allowed to deduct their prorata share of net operating losses sustained up to their basis in the stock of the corporation plus their basis in any corporate indebtedness owed to them, because the corporation properly elected to be taxed under subchapter S of the Internal*203 Revenue Code of 1954. We find no fault with this theory as it is supported by sections 1374(b)3 and 1374(c)(2). See also Richard Lee Plowden, 48 T.C. 666">48 T.C. 666 (1967).
Accordingly, since the parties are unable to agree on the proper figure, we must determine the total amount of their basis in the stock of the corporation on December 31, 1962, the date fixed by section 1374(c)(2). Petitioners argue for a figure of $ 52,430.51, the total*204 of $ 29,481.20 (the amount in the capital account of the partnership at the date of incorporation) 4 plus $ 22,949.31, the costs of improvements made to land which had been erroneously charged to the purchases account. We agree with petitioners that these figures should be taken into consideration, since we have concluded that all assets and liabilities of the partnership were transferred to the corporation by the June 22, 1962, agreement. However, we believe petitioners' reasoning does *520 not go far enough. It fails to recognize events subsequent to the transfer of assets, but prior to December 31, 1962.
On September*205 26, 1962, the corporation transferred land to Perry and Annie Mae, which had a total basis of $ 47,544.67.
However, at the date of transfer, Perry and Annie Mae only had a total adjusted basis in their stock of $ 39,322.88. 5*206 Since the corporation did not have any current or accumulated earnings and profits on December 31, 1962, we find that Perry and Annie Mae realized a return of capital in the amount of their total adjusted basis in the stock under section 301(c). 6 The parties have stipulated and we find that the fair market value of this property was the same as its adjusted basis on the date the property was distributed to Perry and Annie Mae.
Donald's adjusted basis in the stock of the corporation on December 31, 1962, the close of the taxable year of the corporation, was $ 13,107.63 7 while Perry and Annie Mae each had an adjusted basis of zero 8 at this date. Under section 1374(c)(2), petitioners are limited by these amounts in determining their prorata share of the net operating loss of the corporation for the taxable year ending December 31, 1962. Richard Lee Plowden, supra. The facts are clear that Donald's prorata share of the loss exceeded his adjusted basis and he will be able to deduct the full amount of his basis in the stock under section 1374(c). *207 However, his basis in the stock will be reduced by this amount as required under section 1376(b)(1). 9
With respect to the taxable year ended December 31, 1963, the corporation sustained a net operating loss of $ 16,900.18. *208 Again, section 1374(c)(2) limits petitioners' deductions for their prorata share of *521 the operating loss to an amount equal to petitioners' adjusted basis in all their stock and in any corporate indebtedness owed to them. Byrne v. Commissioner, 361 F. 2d 939, 942, affirming 45 T.C. 151">45 T.C. 151. As explained above, petitioners' adjusted basis in their stock was zero at the beginning of the taxable year 1963. Furthermore, there is no evidence of anything which occurred in 1963 that would have increased Donald's adjusted basis, nor is there any evidence that he had an adjusted basis in any liability which might be owed to him from the corporation. Therefore, we hold that Donald cannot deduct his prorata share of the corporation's net loss sustained in 1963. See Richard Lee Plowden, supra.
However, with respect to Perry and Annie Mae, the facts show that on December 31, 1963, their adjusted basis in corporate indebtedness to them was $ 10,184.49. Pursuant to section 1374(c)(2), Perry and Annie Mae may deduct their prorata share of the net operating loss sustained by the corporation but only*209 to the extent of this amount.
Issue 3. Bad DebtThe remaining issue is whether Perry and Annie Mae can deduct as a bad debt, under section 166, 10 the amount of a note executed by them in 1963, but not paid until 1964, a year which is not before us. The note was given to the bonding company in settlement of the obligation owed by the corporation on which Perry and Annie Mae were secondarily liable.
Petitioners' argument is that under section 166, Perry and Annie Mae should be allowed to deduct in 1963 all or a portion of the note. They apparently contend that this is an allowable bad debt deduction because the note given was secured by their real property and there was no prospect of recovering any amount from the corporation. The $ 138,000 note was signed by them in fulfillment of Perry's obligation to indemnify the bonding company*210 for any loss to it which was caused by the partnership (and later by the corporation) under contract No. 5328.
The rule is well established that when a cash basis taxpayer gives a note to satisfy an obligation, a deductible expense does not arise under the income tax laws until the note is paid. Helvering v. Price, 309 U.S. 409">309 U.S. 409; Eckert v. Burnet, 283 U.S. 140">283 U.S. 140, 141; Baltimore Dairy Lunch v. United States, 231 F.2d 870">231 F. 2d 870, 875. Furthermore, the rule has been applied to section 166, bad debt deductions. The courts have not *522 allowed a cash basis taxpayer a deduction for the amount of an unpaid note given to a creditor to evidence taxpayer's intention to fulfill his obligation as guarantor for a third party. This is true even though the note is secured by the taxpayer's property and there is no prospect of the taxpayer-guarantor recovering from the primary obligor. Frank Kuhn, 34 B.T.A. 274">34 B.T.A. 274; Elmer A. Clark, 14 B.T.A. 65">14 B.T.A. 65; Eckert v. Burnet, supra.
As the parties have stipulated *211 that no payments 11 were made on this note until January 1964, we cannot agree that Perry and Annie Mae should be allowed to deduct the amount of the note as a bad debt in the taxable year 1963.
Decisions will be entered under Rule 50.
Footnotes
1. All statutory references are to the Internal Revenue Code of 1954 unless otherwise indicated.↩
2. SEC. 1374. CORPORATION NET OPERATING LOSS ALLOWED TO SHAREHOLDERS.
(c) Determination of Shareholder's Portion. --
* * * *
(2) Limitation. -- A shareholder's portion of the net operating loss of an electing small business corporation for any taxable year shall not exceed the sum of --
(A) the adjusted basis (determined without regard to any adjustment under section 1376 for the taxable year) of the shareholder's stock in the electing small business corporation, determined as of the close of the taxable year of the corporation (or, in respect of stock sold or otherwise disposed of during such taxable year, as of the day before the day of such sale or other disposition), and
(B) the adjusted basis (determined without regard to any adjustment under section 1376 for the taxable year) of any indebtedness of the corporation to the shareholder, determined as of the close of the taxable year of the corporation (or, if the shareholder is not a shareholder as of the close of such taxable year, as of the close of the last day in such taxable year on which the shareholder was a shareholder in the corporation).↩
3. SEC. 1374(b)↩. Allowance of Deduction. -- Each person who is a shareholder of an electing small business corporation at any time during a taxable year of the corporation in which it has a net operating loss shall be allowed as a deduction from gross income, for his taxable year in which or with which the taxable year of the corporation ends (or for the final taxable year of a shareholder who dies before the end of the corporation's taxable year), an amount equal to his portion of the corporation's net operating loss (as determined under subsection (c)).
4. It should be noted that the use of the capital account is proper to determine petitioners' basis in their stock, as this is only a shortcut method of expressing the fact that under sec. 358 the basis of stock of distributee is his basis in the assets transferred minus the liabilities assumed by the corporation. We believe for purposes of this opinion the capital account represented this.↩
5. The proportion of the partnership owned by Perry was 75 percent, therefore, the basis in the stock attributable to this partnership interest was equal to 75 percent of $ 52,430.51 or $ 39,322.88. The above facts show that upon incorporation Perry only obtained 38 percent of the stock of the corporation while Annie Mae acquired 37 percent of the stock in some undisclosed manner. For purposes of this opinion, we shall consider Perry to have made a gift of this stock to Annie Mae, and that her basis in this stock was the same as her donor's.↩
6. SEC. 301. DISTRIBUTIONS OF PROPERTY.
(c) Amount Taxable. -- In the case of a distribution to which subsection (a) applies --
(1) Amount constituting dividend. -- That portion of the distribution which is a dividend (as defined in section 316) shall be included in gross income.
(2) Amount applied against basis. -- That portion of the distribution which is not a dividend shall be applied against and reduce the adjusted basis of the stock.↩
7. The proportion of the partnership owned by Donald was 25 percent, therefore his basis in the stock was equal to 25 percent of $ 52,430.51 or $ 13,107.63.↩
8. Their bases were reduced because of the distribution of real estate to them handled under sec. 301(c)(2)↩.
9. SEC. 1376. ADJUSTMENT TO BASIS OF STOCK OF, AND INDEBTEDNESS OWING SHAREHOLDERS.
(b) Reduction in Basis of Stock and Indebtedness for Shareholder's Portion of Corporation Net Operating Loss. --
(1) Reduction in basis of stock. -- The basis of a shareholder's stock in an electing small business corporation shall be reduced (but not below zero) by an amount equal to the amount of his portion of the corporation's net operating loss for any taxable year attributable to such stock (as determined under section 1374(c)↩).
10. SEC. 166. BAD DEBTS.
(a) General Rule. --
(1) Wholly worthless debts. -- There shall be allowed as a deduction any debt which becomes worthless within the taxable year.↩
11. Although there is no evidence to establish whether Perry and Annie Mae operated on the cash receipts and disbursements basis or on the accrual basis, we assume that Perry and Annie Mae were cash basis taxpayers. See Stanley C. Warrick, 20 B.T.A. 220">20 B.T.A. 220↩.