Hughes v. Commissioner , 32 B.T.A. 1248 ( 1935 )

E. A. HUGHES, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.

Hughes v. Commissioner

Docket No. 67335.

United States Board of Tax Appeals

32 B.T.A. 1248; 1935 BTA LEXIS 827;

August 23, 1935, Promulgated

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">*827 1. Payments made under terms of a sales contract by the purchaser of corporation stocks and bonds to the seller to reimburse the latter for Federal income taxes incurred on his profits in the transaction are taxable income to the seller in the year received, and not the year of the sale.

2. On the evidence, the basis used by the respondent in determining the gain from the sale of certain stock is approved.

William Mitchell, Esq., for the petitioner.

Shelby S. Faulkner, Esq., for the respondent.

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TURNER

">*1249 This proceeding relates to an income tax deficiency amounting to $27,862.48 for the year 1928. The petition, as amended, sets forth five assignments of error. Two of these the petitioner abandoned at the hearing, and the respondent admitted error in respect of another. The two remaining assignments of error relied upon by the petitioner are stated in the pleadings as follows:

Respondent erred in adding to petitioner's income for the calendar year 1928, $207,383.85 received by the petitioner in 1929 as representing a part of the sale price of the stock of the Hughes Electric Company and Knife River Coal Mining Company and taxable">*828 in the year 1928 when the sale was made, and not in the calendar year 1929 when the amount was included by petitioner in his income.

Respondent erred in taking as the base value of petitioner's Knife River Coal Mining Company stock and bonds the sum of One Hundred Twelve Thousand One Hundred Eight and 54/100 ($112,108.54), representing the value of the property of that company in 1924, instead of the sum of Two Hundred Twenty-four Thousand Three Hundred Seventy-five and 54/100 Dollars ($224,375.54), representing the original cost of said property to the petitioner and his associates.

FINDINGS OF FACT.

At the beginning of the year 1918, the petitioner and one C. B. Little owned, as copartners, a coal mining business with properties located near Beulah, North Dakota. In June 1918 they organized a corporation known as the Beulah Coal Mining Co., hereinafter referred to as the Beulah Co., to which they conveyed the partnership assets and some cash in payment of its capital stock. All of the corporation's stock, except nominal holdings, was transferred to petitioner and Little in equal shares.

The Beulah Co. was active until about October 2, 1922, at which time it was closed">*829 down by petitioner and Little, who, on that date, procured a charter for the Knife River Coal Mining Co., hereinafter referred to as the corporation, which was intended to succeed the Buelah Co. in the mining operations. Instead of carrying out that plan, however, Little took a lease from Beulah Co. of its properties, which he and the petitioner operated as copartners under the firm name of "Knife River Coal Mining Company." They opened a partnership property account in a set of books under said firm title, in which they took up all of the assets of the Beulah Co.

In the prior operations the petitioner and Little had advanced to the Beulah Co. from their personal funds various amounts which remained unpaid when operations of the company were discontinued. They also assumed outstanding debts of that company, which, together with the cash advances, amounted in the aggregate to $224,375.10.

Included in the Beulah Co. obligations was $50,000 par value of its bonds which the petitioner and Little had acquired. They ">*1250 instituted foreclosure proceedings under the bonds and at the sale thereunder, held in July 1923, acquired title to all of the company's assets for a bid">*830 price of $35,000. Thereafter the Beulah Co. had no assets.

As of December 31, 1923, the petitioner and Little transferred their partnership operations and assets to the Knife River Coal Mining Co., the corporation. On the books of the corporation the assets which had belonged to the Beulah Co. were shown at a value of $112,108.54. This result was accomplished by entering charges against the Beulah Co. in the amount of $224,375.10, against which $112,108.54 was credited on account of assets received, and then balancing the account by a charge against surplus.

For the partnership assets so received and other assets, which were given a book value of $260,035 as of December 31, 1923, the corporation issued to the petitioner and Little, in equal parts, $170,000 of its bonds and 604 shares of its capital stock having a par value of $60,400. It also assumed liability for certain of their debts aggregating $44,481.

The transfer by the petitioner and Little of the assets in question for the stock of the Knife River Coal Mining Co. was accepted and approved by resolution of the stockholders of that corporation on January 15, 1924.

">*831 In their tax returns for 1924 the petitioner and Little each claimed bad debt deductions in connection with their transactions with the Beulah Co. The Commissioner of Internal Revenue denied these claims and the issue came before the Board through appeals taken by the petitioner and Little. In our opinion in those cases () we sustained the contention of the respondent.

The petitioner had disposed of all of his Knife River Coal Mining Co. bonds prior to 1928.

In addition to their holdings already considered, the petitioner and Little owned stock in a corporation known as the Hughes Electric Co. On January 19, 1928, they sold their holdings in both corporations to the United Public Service Co. for a named price of $4,505,499.69. In making up the gross price, the parties attributed to each share of Knife River Coal Mining Co. stock a price of $891.53, and to the Hughes Electric Co. stock a price of $150.22 per share.

In addition to the cash consideration mentioned, the sales contract contained a provision reading as follows:

(6) The Buyer agrees to pay, as and when the same becomes due and payable, all Federal Income Taxes not">*832 exceeding Three Hundred Fifty Thousand ">*1251 Dollars ($350,000), payable by the vendors of the stock hereby sold upon any profit realized by them on such sale, (but not in any event in excess of 12 1/2% of such profit, and not including in any such profit, any additional taxable profit which may result to them from this paragraph (6)), the said taxes to be computed as far as possible under the capital gain provisions of the Federal Income Tax Law, and so far as is possible under any provisions more favorable to the taxpayer. Said taxes up to the sum of Three Hundred Fifty Thousand Dollars ($350,000) shall be paid in the following amounts, and in the following orders:

1. To the payment of taxes, payable by E. A. Hughes, until the net amount received by him hereunder for his stock shall equal Two Million, One Hundred Thousand Dollars ($2,100,000).

2. The balance of said Three Hundred Fifty Thousand Dollars ($350,000), if any, to the payment of taxes of the other vendors of stock pro rata in proportion to their respective taxes.

The Sellers expressly agree to cooperate with the Buyer as far as possible in reducing their tax liability and to this end agree to sign any">*833 and all documents necessary to secure a reduction of any tax liability or to secure a review of the same.

In his income tax return for 1928 the petitioner reported capital net gain from the sale of the said corporation stocks and a tax of $188,384.21. He reported a further capital net gain amounting to $198,494.90 on this transaction in his return for 1929, on which he paid a tax of $24,811.86.

Pursuant to the provisions of its contract aforesaid, the United Public Service Co. paid to petitioner and his associates, in 1929, the sum of $350,000 in reimbursement for Federal income taxes paid. Of the sum received, the petitioner retained $207,383.85, which he reported as income in his return for the year 1929. The respondent has held that this sum must be regarded as part of the petitioner's income in 1928.

The petitioner keeps his books and accounts on a cash receipts and disbursements basis.

In computing the petitioner's profit on the sale of the Knife River Coal Mining Co. stock the respondent included in the cost basis of the stock and bonds of that company the sum of $112,108.54 as the base, to the petitioner and Little, of the assets which had formerly belonged to">*834 the Beulah Co.

OPINION.

TURNER: The first assignment of error is based on the inclusion in 1928 income of the sum of $207,383.85, received by the petitioner in 1929 as a reimbursement by the United Public Service Co. of income taxes paid by the petitioner on profits realized from the sale to that company of stock in the Hughes Electric Co. and the ">*1252 Knife River Coal Mining Co. In his notice of deficiency, the respondent explained his action in this respect as follows:

(1) While it appears that the amount received representing a reimbursement of income taxes due and payable on the profit from the sale of stock was reported in the 1929 return, it is clear from a reading of the contract that it represents a part of the sale price of the stock and is taxable in the year the sale was made. The tax assessed and paid for 1929 on such profit is therefore subject to credit or refund.

The petitioner makes no point that the payments in issue were not a part of the price received for the stock of the two companies previously mentioned, but does contend that, since the payments were not actually received until the year 1929 and his books of account were kept and his income">*835 reported on the cash receipts and disbursements basis, such payments constituted income in 1929, when received, and not in 1928, when the sale was made.

We had this specific question before us in the case of . Shaffer was a member of a partnership which sold its assets to a corporation in 1919. The contract of sale contained a provision with reference to the payment of the income tax on any profit derived from the sale, substantially similar to the provision contained in the contract of sale in this case. The tax became due and was paid in 1920. We there held that the tax so paid in 1920 did not constitute income to Shaffer and his partner in 1919, the year of the sale, on the ground that the obligation to pay the tax had no fair market value at the time the sale was consummated. We said:

At the time of the receipt of the promise to pay the taxes in May 1919, it could not be determined whether any amount would ever be paid. The taxes to be paid were those on the income of the partners, including certain surtaxes for the calendar year 1919. They were extensively engaged in many enterprises, certain transactions giving rise to">*836 gains and others to losses. On the one hand the net result of such operations might be losses, resulting therefore in no tax liability for the year, while again such operations might have resulted in such large profits as to produce a much greater tax than the amount finally paid by the vendee. In view of the highly speculative and contingent nature of the right acquired from the vendee, we do not think it can be said to have had a fair market value at the time of its receipt.

Some of the members of the Board were of the opinion in , that the amount paid by the purchaser as income taxes for the vendor did not constitute income in the year of the sale, in view of the fact that the vendor was on a cash basis. This view is supported by our decisions in ; ; and ; affd., .

">*1253 Under either theory the result is the same. In section 202(a) of the Revenue Act of 1928, it is provided that gain from the sale of property is the excess of "the amount realized" over the basis. It">*837 is a matter of fact that the money did not become due and was not paid until the year following the sale. It is equally true that even though the obligation to pay the income tax for which the vendee might become liable was a valid and binding obligation, which arose at the time of the sale, the facts show that the ultimate liability of the purchaser was so highly speculative and contingent that it could not be said that the amount which subsequently became due and payable in the following year was realized, within the meaning of the statute, in the year of the sale. . Cf. , affirming ; ; affd., ; ; ; and . On this issue the petitioner is sustained.

On the remaining assignment of error the petitioner contends that the decision in ">*838 , establishes the cost base for his stock in the Knife River Coal Mining Co. He contends that our findings were that he and Little acquired the stock and bonds of that company in a tax free exchange, and, starting from that premise, argues that in effect we held that $224,375.10, the full amount of the advances made by him and Little to the Beulah Co., constituted a part of the cost basis of his Knife River Coal Mining Co. stock and bonds. Relying on that decision, he takes the position that the issue now under discussion is res judicata.

It seems obvious that the petitioner has erroneously interpreted the issues and decision in In that case there was no issue which called for a finding as to the basis for determining the gain or loss from a subsequent sale or disposition of Knife River Coal Mining Co. stock, and we made no such finding. The only issue raised by the pleadings, in so far as there might be any applicability to this case, was one of bad debts. The petitioner sought to deduct from income the difference between sums advanced to the Beulah Co. during its existence and the">*839 value at which the assets which had formerly belonged to the Beulah Co. were paid in for stock of the Knife River Coal Mining Co. Our holding was that the petitioner and Little were not entitled to the bad debt deduction claimed, since they had failed to show that they had lost in 1924 any part of the advances which had been made to the Beulah Co. in prior years. It was pointed out that, if the Beulah Co. ">*1254 obligations had become worthless, that worthlessness had occurred prior to 1924. On petition for review, filed by Little, the United States Circuit Court of Appeals for the Eighth Circuit, in , affirmed the decision of the Board holding that losses claimed by the petitioner and Little in respect of their advances to the Beulah Co. were sustained in 1923, prior to the acquisition of the assets by the Knife River Coal Mining Co. in 1924. Clearly the claim of res judicata is not sustained.

The evidence in the record before us does not show that the basis for determining petitioner's gain from the sale of his Knife River Coal Mining Co. stock was greater than that determined by the respondent.

Decision">*840 will be entered under Rule 50.