Wilson v. Commissioner , 27 T.C. 976 ( 1957 )

Sam E. Wilson, Jr., Petitioner, v. Commissioner of Internal Revenue, Respondent. Ada Rogers Wilson, Petitioner, v. Commissioner of Internal Revenue, Respondent

Wilson v. Commissioner

Docket Nos. 35639, 35640

United States Tax Court

27 T.C. 976; 1957 U.S. Tax Ct. LEXIS 239;

March 20, 1957, Filed

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Decisions will be entered for the respondent.

During the year 1947 and through February 10, 1948, petitioner, the owner of all but a nominal number of shares of stock of Wil-Tex, owed Wil-Tex $ 33,950. On February 10, 1948, petitioner entered into a contract with Panhandle to sell all of the shares of Wil-Tex for $ 4,000,000, less net liabilities of Wil-Tex, net liabilities being defined as liabilities less current assets as shown by balance sheet of February 28, 1948. The closing date was to be March 10, 1948. Later, the closing date was by mutual agreement advanced to April 10, 1948, with the net liabilities to be determined at the close of business on March 31, 1948. Sometime after February 10, 1948, and before February 29, 1948, Wil-Tex canceled its debt against petitioner without the payment by him of any consideration and he being solvent at the time. The cancellation was recorded by Wil-Tex and by petitioner as a dividend. Petitioners, on their separate returns filed on a community property basis, returned the dividend as ordinary income. Petitioners now contend that they erred in doing so and should have reported the $ 33,950 as long-term capital gain. Held , that the cancellation was not a prepayment of part of the purchase price of the stock by Panhandle and was not long-term capital gain to petitioners; that the cancellation was a dividend and income to the petitioners and not to Panhandle; and that the cancellation was not a distribution from a depletion reserve under section 115 (d), I. R. C. 1939, and Regulations 111, section 29.115-6.

Robert B. Payne, Esq., and J. A. Martin, Esq., for the petitioners.

M. Clifton Maxwell, Esq., for the respondent.

Black, Judge.

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BLACK

Our Findings of Fact and Opinion in these proceedings were originally promulgated on May 28, 1953. See Sam E. Wilson, Jr., 20 T. C. 505. We found that an account receivable on the books of Wil-Tex Oil Corporation (hereinafter called Wil-Tex) and a corresponding account payable on the books of the petitioner, Sam E. Wilson, Jr. (hereinafter referred to as petitioner or Wilson), who owned all but a nominal number of the shares of Wil-Tex stock, in the amount of $ 33,950, was a valid debt and that when it was canceled by Wil-Tex under date of January 31, 1948, without Wilson's paying anything on the debt, it represented income to the petitioner. We also held, as a matter of law, that the $ 33,950 was ordinary income rather than additional long-term capital gain resulting from the sale to the Panhandle Producing & Refining Company (hereinafter referred to as Panhandle) of Wil-Tex stock owned by the petitioner on April 8, 1948.

The United States Court of Appeals for the Fifth Circuit reviewed our holding on the "ordinary income v. capital gain" issue at the instance of the petitioner. The petitioner argued that, although the debt was recorded as canceled under date of January 31, 1948, it was actually canceled subsequent to February 10, 1948, and that since the petitioner entered into the contract with Panhandle on February 10, 1948, to sell the Wil-Tex stock for a price that was based on a formula specified in the agreement, the cancellation represented a part of the purchase price paid to the petitioner or, in the alternative, was dividend income to Panhandle. In reversing us, the Court of Appeals held that it was necessary to determine whether the cancellation occurred before or after February 10, 1948, before it would consider the petitioner's argument. It reversed and remanded the case to resolve the fact issue and also to consider the petitioner's argument, which was not presented or argued here previously, that in the admitted condition of Wil-Tex's depletion or depreciation reserve, the cancellation fell within the provisions of Treasury Regulations 111, section 29.115-6, causing it to be taxed as a long-term capital gain from the sale or other disposition of property as provided in section 29.111-1 of Treasury Regulations 111.

At the hearing on remand a stipulation of facts was filed which is incorporated herein by reference. In the stipulation of facts it was agreed that:

2. The entire record made before the Tax Court in the original trial of these cases, including the testimony and exhibits, is hereby incorporated herein by reference as if it were attached hereto and made a part hereof.

Some additional oral testimony was received at the hearing on remand. We summarize the stipulated facts and make additional findings of fact based on the oral testimony at the hearing, as follows.

FINDINGS OF FACT.

Petitioners Sam E. Wilson, Jr., and Ada Rogers Wilson are husband and wife residing in Corpus Christi, Texas. Their Federal income tax returns for the calendar year 1948 were filed separately, on a community property basis, with the then collector of internal revenue for the first district of Texas.

Petitioners kept their books and records on an accrual basis during the years 1946 to 1948, inclusive.

On February 10, 1948, the petitioner owned all but a nominal number of shares of stock of Wil-Tex. On that date the petitioner was indebted to Wil-Tex in the amount of $ 33,950. An account receivable for that amount was reflected on the books of Wil-Tex. A corresponding account payable was reflected on the books of Wilson.

On February 10, 1948, an agreement was entered into between Wilson and Panhandle whereby Wilson agreed to sell and Panhandle agreed to buy all of the Wil-Tex stock. The agreement provided that:

The consideration to be paid by the undersigned [Panhandle] for said stock is the sum of Four Million Dollars ($ 4,000,000) less the net liabilities of Wil-Tex at the close of business on February 28, 1948. By "net liabilities" is meant the total liabilities of Wil-Tex other than the capital stock and surplus, less the aggregate amount of the current assets of Wil-Tex, all as shown by the balance sheet of Wil-Tex at the close of business on February 28, 1948.

The agreement was conditioned as follows:

It is understood that the undersigned is negotiating for a loan from Massachusetts Mutual Life Insurance Company in an amount equal to the consideration required to be paid by the undersigned hereunder for said 2500 shares of stock, and it is contemplated that such loan will be secured by the pledge of said stock and by the giving of other security by the undersigned. This agreement is made subject to the ability of the undersigned to consummate such loan prior to the closing date, and it is understood and agreed that if the undersigned is unable to secure said loan it shall be relieved from all obligation hereunder.

The agreement also provided that:

You covenant and agree that Wil-Tex will operate its properties from the date hereof to the closing date in a reasonable and prudent manner and that it will not incur any indebtedness during said period other than in the ordinary course of its business.

The agreement provided that the sale was to be consummated on March 10, 1948. On March 18, 1948, the closing date was, by mutual agreement, advanced to April 10, 1948, with the net liabilities, as previously defined, to be determined at the close of business on March 31, 1948, rather than February 28, 1948. The sale was consummated and the price was computed as follows:

Sale of 2,500 shares capital stock -- consideration		$ 4,000,000.00
Current assets:
Corpus Christi National Bank	$ 759.56
City National Bank	3,189.87
City National Bank -- collateral account	874.53
Accounts receivable	147,640.92
Oil and distillate in storage	2,210.86
Advance deposits	5.00
Prepaid insurance and bonds	1,720.28
Deferred State, county, and school taxes	11,925.00
Total current assets		168,326.02
Total		$ 4,168,326.02
Current liabilities and long-term liabilities:
Accounts payable	$ 81,895.69
Accrued taxes	16,847.16
Accrued interest payable	1,374.67
Mortgage notes payable	1,766,707.09
Total liabilities		$ 1,866,824.61
Net value of stock, 7 a. m. Apr. 1, 1948		$ 2,301,501.41
Less accounts receivable -- Sinclair		13,331.35
Sales price		$ 2,288,170.06

The sales price shown above, less the value of the nominal shares held by others and the expenses of sale, was returned by petitioners as long-term capital gain from the sale of capital assets. The whole amount of gain represented long-term capital gain since Wilson had a zero basis for the stock. The Commissioner in his deficiency notice made no change in the long-term capital gain reported by petitioner from the sale of his stock in Wil-Tex.

On the balance sheets prepared from the books of Wil-Tex, the account receivable due from petitioner prior to its cancellation by Wil-Tex was shown under the classification of "Other Assets." The account "Prepaid Insurance and Bonds" and the account "Deferred State, County & School Taxes" were also shown on the February 28, 1947, balance sheet and subsequent balance sheets as "Other Assets." The latter two accounts are shown above in the computation of the sales price as current assets.

The $ 33,950 account receivable due by Wilson to Wil-Tex is not shown in the computation of the sales price of the stock because it had been canceled prior to March 31, 1948, the date when the net sales price of the stock was computed in accordance with the agreement of the parties.

It is stipulated that sometime after February 10, 1948, and before February 29, 1948, Wil-Tex voucher No. 1-75, dated January 31, 1948, was prepared and the debt in question canceled thereby by the following journal entry:

Dr.: Surplus Account	$ 33,950
Cr.: Accounts Receivable, Sam E. Wilson, Jr. -- Producing Properties
Transfer Account	33,950

Explanation

To clear account as shown of Sam E. Wilson, Jr., to Surplus Account.

At about the same time voucher No. 1-67A, dated January 31, 1948, of Wilson was prepared as follows:

Dr.: Accounts payable, Wil-Tex Oil Corporation, "Producing Properties
Transfer Account"	$ 33,950
Cr.: Dividends Earned "Wil-Tex Oil Corporation"	33,950

Explanation

To clear account of Wil-Tex Oil Corporation "Producing Properties Transfer" as this account cleared in form of Dividend to Sam E. Wilson, Jr.

The returns of both Wil-Tex and petitioners reflected the $ 33,950 as a dividend. Exhibit C attached to the return of Wil-Tex showed a dividend for the fiscal year ending February 29, 1948, of $ 33,950. Schedule M of the return showed a cash dividend by Wil-Tex of $ 33,950 for this same fiscal year. The amount of $ 33,950 was reported as community dividend income on each of the petitioner's returns for 1948.

For all taxable years up to and including the taxable year ending February 28, 1947, Wil-Tex had a substantial deficit in earnings or profits. At the end of the fiscal year February 29, 1948, Wil-Tex had a depletion reserve of $ 290,921.52, of which $ 226,003.88 was based upon cost depletion, and $ 64,917.64 was based on percentage depletion. For the single taxable year ending February 29, 1948, Wil-Tex had earnings or profits, not taking into consideration the $ 33,950 transaction in litigation herein nor so much of the depletion reserve as was based on cost depletion, of $ 237,017.20. For all taxable years up to and including the taxable year ending February 29, 1948, and without taking into consideration the $ 33,950 transaction in litigation herein, Wil-Tex had a deficit in earnings or profits substantially in excess of $ 33,950.

OPINION.

The petitioners returned the $ 33,950 in question as dividend income, that being the manner in which the cancellation of the account receivable was reflected on both the books of Wil-Tex and of Wilson. Petitioners now contend that they erred in treating the $ 33,950 as a dividend.

It may at this juncture be observed that the adjustments made by the Commissioner to the net community income reported by petitioners on their returns, which resulted in the deficiencies, are not in issue. Petitioners did not assign error as to them. What petitioners now assign as error in the present proceeding is as follows:

The Commissioner erred in failing to treat as long term capital gain a certain amount of $ 33,950.00 which Petitioners erroneously included in their gross ordinary community income as a dividend from Wil-Tex Oil Corporation.

As to the foregoing assignment of error, the petitioners have the right to make it. Even though they did include the $ 33,950 as a dividend in their income tax returns, they are not estopped from now alleging that they erred in so doing. However, it seems clear to us, notwithstanding the date of cancellation of the debt was not January 31, 1948, as recorded on the books, that petitioners did not err in treating the transaction as a dividend. It is perfectly clear that Wilson was indebted to Wil-Tex in the sum of $ 33,950 and that Wil-Tex, at Wilson's instance, canceled this indebtedness without the payment to it by Wilson of any sum whatsoever. It is also clear that Panhandle had nothing to do with the cancellation of the debt. Wilson was entirely solvent and fully able to pay the debt at the time it was canceled. These facts, we think, make the transaction result in a taxable dividend to petitioners, as we shall endeavor to point out more fully hereafter in this Opinion.

Petitioner's contention that the cancellation of the debt was not the payment of a dividend to Wilson, as urged on brief, is based upon several different grounds which we will hereafter discuss separately.

First, petitioner contends that the cancellation of the debt only served to reduce the consideration which Panhandle had previously agreed to pay for the stock, and therefore that it did not result in any benefit to him. This contention is necessarily based on the assumption that, within the meaning of the contract, the account receivable due to Wil-Tex from Wilson was a current asset at the time the net sales price of the stock was to be fixed. If it was not, it would not affect the sales price of the Wil-Tex stock.

The contract with Panhandle fixed the consideration for the Wil-Tex stock at $ 4,000,000, less net liabilities, and net liabilities were defined as "the total liabilities of Wil-Tex other than the capital stock and surplus, less the aggregate amount of the current assets of Wil-Tex, all as shown by the balance sheet of Wil-Tex at the close of business on February 28, 1948." This date was subsequently changed by agreement to March 31, 1948. By that time the $ 33,950 account was no longer on the books; it had been canceled. It is doubtless true, as petitioners argue, that a business concern actively carrying on a business would have its accounts receivable classed as current assets. This is illustrated by the fact that, when the sale by Wilson to Panhandle of his stock in Wil-Tex was consummated on April 10, 1948, and the net sales price of the Wil-Tex stock was computed in accordance with the formula which the parties had agreed upon on February 10, 1948, among the current assets of Wil-Tex on March 31, 1948, were accounts receivable of $ 147,640.92. But the account which Wilson owed Wil-Tex at the time the contract was signed was not a part of that $ 147,640.92. That much is certainly clear. According to the stipulation now filed it had been canceled at some time prior to February 29, 1948, and was no longer on the books of Wil-Tex. Therefore, assuming that the $ 33,950 account was a current asset at all times that it was carried on the books of Wil-Tex, it seems to us that that fact, under the circumstances present in the instant case, can make no difference. We still think the cancellation represented ordinary income to the petitioners and not long-term capital gain.

The petitioner argues that his gain was fixed on February 10, 1948, and that the gain accrued to him on that date and that the subsequent cancellation was only a prepayment of part of the purchase price of the stock by Panhandle. In order to accept the petitioner's argument it would be necessary for us to hold that Panhandle agreed to pay $ 4,000,000, less net liabilities as shown by a balance sheet at the close of business on February 10, 1948, and that any reduction in current assets would be prepayments by Panhandle. We cannot make such a holding because the contract specifically provides otherwise. February 28, 1948, was to be the date for the determination of net liabilities (subsequently advanced to March 31, 1948). The consideration that Panhandle agreed to pay was based on the current assets as of March 31, 1948, not February 10, 1948. Panhandle, we have no doubt, recorded its cost basis for the stock as $ 4,000,000, less net liabilities on March 31, 1948; not the $ 4,000,000, less net liabilities on February 10, 1948. Wil-Tex was doing business between February 10, 1948, and March 31, 1948, and its current assets and liabilities undoubtedly fluctuated. Any reduction in current assets and/or increase in liabilities was not in any sense tantamount to a prepayment by Panhandle of the price it agreed to pay the petitioner for the stock. Petitioner's argument that the cancellation of the debt by Wil-Tex amounted to such a prepayment of part of the purchase price of the stock and therefore resulted in long-term capital gain to Wilson rather than ordinary income is rejected.

The petitioner next argues that the cancellation, if a dividend, was ordinary income to Panhandle, the purchaser, and part of the purchase price to Wilson, the seller, since Panhandle, and not he, received the economic benefit of it. We held in our prior decision in this cause that the cancellation represented a dividend and was ordinary income to the petitioner. Despite our additional finding that the cancellation occurred subsequent to February 10, 1948, and prior to February 29, 1948, our former holding must stand.

The dividend is "inexorably someone's income." DeGuire v. Higgins, 159 F. 2d 921, 923 (C. A. 2, 1947); and that "someone" is the beneficial owner of the shares upon which the dividend was paid. Moore v. Commissioner, 124 F. 2d 991 (C. A. 7, 1941). The petitioner argues that beneficial ownership of the stock passed to Panhandle on February 10, 1948. As we stated previously, his argument ignores the contract. The contract did not provide for a security device or for title to remain in the vendor merely to secure the unpaid portion of the purchase price. Cf. Moore v. Commissioner, supra;DeGuire v. Higgins, supra;Northern Trust Co. of Chicago v. United States, 193 F. 2d 127 (C. A. 7, 1951); Estate of Arthur L. Hobson, 17 T. C. 854 (1951). Here, title and all of the incidents of ownership remained with the petitioner until the closing date. The only thing that petitioner was required to do was to see that Wil-Tex operated its properties in a reasonable and prudent manner until the closing date. This undoubtedly was to protect the oil properties which were the principal assets of Wil-Tex, for which Panhandle was paying the purchase price agreed upon in the contract. The manner of determining the purchase price was fixed, but the purchase price itself was not determined or determinable on February 10, 1948.

It seems to us that the essential factor in this whole matter is that at the time of entering into the contract of sale on February 10, 1948, petitioner was indebted to Wil-Tex on open account in the amount of $ 33,950. Nothing at all was said in the contract concerning this indebtedness. However, the evidence makes it clear that petitioner wanted the account off the books of Wil-Tex before the sale to Panhandle was consummated. In order to accomplish this, the account was canceled in the manner shown in our Findings of Fact.

Since, therefore, the cancellation did not benefit Panhandle and that corporation had nothing whatever to do with it, but rather was of benefit to Wilson and was at his instance, we uphold the respondent's contention. The argument that Wilson might have accomplished the same over-all result by leaving the $ 33,950 account on the books of Wil-Tex unpaid and thus increase the sales price of his Wil-Tex stock to Panhandle and return the gain as long-term capital gain instead of as ordinary income and then later pay the account to Wil-Tex, we think is without significance. We are governed by what was done, rather than what might have been done. Cf. Merrill C. Gilmore, 25 T. C. 1321 (1956).

The petitioner's final argument is that in the admitted state of Wil-Tex's depletion reserve, the cancellation fell within the provisions of Treasury Regulations 111, section 29.115-6, causing it to be taxed as a gain from the sale or other disposition of property as provided in section 29.111-1. The pertinent parts of the Internal Revenue Code of 1939 and Regulations 111 are printed in the margin. ¹

It has been stipulated as follows:

For the single taxable year ending February 29, 1948, Wil-Tex had earnings or profits, not taking into consideration the $ 33,950.00 transaction in litigation herein nor so much of the depletion reserve as was based on cost depletion, of $ 237,017.20. * * *

The Code itself is clear. Section 115 (a) defines a dividend as a distribution by a corporation "(2) out of the earnings or profits of the taxable year (computed as of the close of the taxable year without diminution by reason of any distributions made during the taxable year), without regard to the amount of the earnings and profits at the time the distribution was made." Section 115 (b) creates a presumption that the distribution is from the most recent earnings and profits. Since there were current earnings and profits of $ 237,017.20, the distribution of $ 33,950 is a dividend; see Stanley V. Waldheim, 25 T.C. 839">25 T. C. 839, 849 (1956); William G. Maguire, 21 T. C. 853, 854 (1954), reversed on another issue 222 F. 2d 472 (C. A. 7, 1955). Section 115 (d), therefore, would not apply because it refers to a distribution that is not a "dividend."

Regulations 111, section 29.115-6, promulgated pursuant to section 115 (d) of the 1939 Code provide that distributions from depletion reserves based on cost shall be applied against the basis of the stock and if in excess of such basis shall be treated as a capital gain. This section also provides that "[no] distribution, however, can be made from such a reserve until all the earnings or profits of the corporation have first been distributed." Petitioner contends that, despite the clear wording of the Code itself, the distribution is from a depletion reserve because all the earnings and profits means the total earnings and profits for all years, including the current year, and that all earnings and profits have been distributed since there is a deficit for all years rather than earnings and profits. In view of the clarity of the Code provisions we cannot approve such a construction. Such a construction would render the definition -- a dividend is a distribution from current earnings and profits -- meaningless for any corporation which had a depreciation or depletion reserve and also had a net deficit for all years.

The petitioner contends that there were no current earnings and profits when you consider the depletion reserve. That is not so. When the reserve is credited, earnings and profits are charged with a like amount. Therefore, the amount in the reserve has been considered in determining all earnings and profits, viz, earnings and profits prior to depletion charges have been reduced by the depletion charges or by the same amount of the reserve account.

The petitioner also argues that if section 115 of the 1939 Code is construed contrary to his contention, it is unconstitutional because it taxes a return of capital as ordinary income. There is no merit to this argument. Petitioner had a zero basis for the Wil-Tex stock; therefore, the amount he realized because of his ownership or disposition of this stock would be income to him. See Merchants Loan & Trust Co. v. Smietanka, 255 U.S. 509">255 U.S. 509 (1921). He had no capital to be returned. Since it is income, Congress has the power to tax it and to set the rate, and Congress has done so.

Accordingly,

Decisions will be entered for the respondent.

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Footnotes

• 1. Internal Revenue Code of 1939.

  SEC. 115. DISTRIBUTIONS BY CORPORATIONS.

  (a) Definition of Dividend. -- The term "dividend" * * * means any distribution made by a corporation to its shareholders, whether in money or in other property, (1) out of its earnings or profits accumulated after February 28, 1913, or (2) out of the earnings or profits of the taxable year (computed as of the close of the taxable year without diminution by reason of any distributions made during the taxable year), without regard to the amount of the earnings and profits at the time the distribution was made. * * *

  * * * *

  (b) Source of Distributions. -- For the purpose of this chapter every distribution is made out of earnings or profits to the extent thereof, and from the most recently accumulated earnings and profits. Any earnings or profits accumulated, or increase in value of property accrued, before March 1, 1913, may be distributed exempt from tax, after the earnings and profits accumulated after February 28, 1913, have been distributed, but any such tax-free distribution shall be applied against and reduce the adjusted basis of the stock provided in section 113. The preceding sentence shall not apply to a distribution which is a dividend within the meaning of the last sentence of subsection (a).

  * * * *

  (d) Other Distributions from Capital. -- If any distribution made by a corporation to its shareholders is not out of increase in value of property accrued before March 1, 1913, and is not a dividend, then the amount of such distribution shall be applied against and reduce the adjusted basis of the stock provided in section 113, and if in excess of such basis, such excess shall be taxable in the same manner as a gain from the sale or exchange of property. This subsection shall not apply to a distribution in partial or complete liquidation or to a distribution which, under subsection (f) (1), is not treated as a dividend, whether or not otherwise a dividend.

  Regulations 111.

  Sec. 29.115-6. Distributions from Depletion or Depreciation Reserves. -- A reserve set up out of gross income by a corporation and maintained for the purpose of making good any loss of capital assets on account of depletion or depreciation is not a part of surplus out of which ordinary dividends may be paid. A distribution made from a depletion or a depreciation reserve based upon the cost or other basis of the property will not be considered as having been paid out of earnings or profits, but the amount thereof shall be applied against and reduce the cost or other basis of the stock upon which declared. If such a distribution is in excess of the basis, the excess shall be taxed as a gain from the sale or other disposition of property as provided in section 29.111-1↩. * * * No distribution, however, can be made from such a reserve until all the earnings or profits of the corporation have first been distributed.