Society Brand Clothes, Inc. v. Commissioner , 18 T.C. 304 ( 1952 )

Society Brand Clothes, Inc., Petitioner, v. Commissioner of Internal Revenue, Respondent

Society Brand Clothes, Inc. v. Commissioner

Docket No. 28122

United States Tax Court

18 T.C. 304; 1952 U.S. Tax Ct. LEXIS 198;

May 13, 1952, Promulgated

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">*198 Decision will be entered under Rule 50.

1. In connection with the settlement of an indebtedness in January 1934, petitioner received 24,000 shares of its own stock which, in the settlement made, were subject to a 10-year option. During January 1934, shares of the stock, unrestricted by any option, were sold at prices between $ 1 1/8 and $ 2 1/2 per share. Under the terms of the option the stock was sold in December 1943. Held, the evidence shows that the stock, encumbered as it was by a 10-year option which compelled petitioner to hold the stock during the term of the option, had no fair market value at the time it was received in 1934. Held, further, the cost basis to the petitioner of these 24,000 shares was the remaining balance of its debt against its debtor which it canceled under terms agreed upon in the receipt of the stock and this basis should be used in the computation of the gain when the stock was sold during the fiscal year 1944.

2. Petitioner acquired in 1919 good will from its predecessor, a partnership. Held, for computing equity invested capital the fair market value of the good will was $ 1,000,000.

3. In a recapitalization petitioner distributed">*199 debenture bonds in exchange for its outstanding preferred stock and accumulated dividends due thereon. A part of this distribution was charged to earnings for the taxable year. Held, the entire face value of the debentures represented indebtedness of petitioner and is properly includible in petitioner's borrowed invested capital as computed under section 719 of the Code.

4. Petitioner, a corporation on the accrual basis, held a 10-year promissory note of its wholly owned subsidiary. The note provided for 5 per cent interest, but it was executed with the mutual understanding that no interest would be charged or paid until some future date to be determined by agreement of the parties to the note. Such an agreement was made subsequent to the year 1944, but was in no sense retroactive to cover 1944 and prior years. Held, petitioner is not required to accrue interest on the note as income during the year 1944.

Ben W. Heineman, Esq., Max Swiren, Esq., and Joseph D. Block, Esq., for the petitioner.

William Schwerdtfeger, Esq., for the respondent.

Black, Judge. Murdock, Le Mire, and Raum, JJ., concur in the result. Arundell, J., dissents on the first">*200 point.

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BLACK

">*305 Respondent has determined deficiencies in petitioner's income, declared value excess-profits, and excess profits taxes for the fiscal years ended October 31, 1944, and October 31, 1945, as follows:

		Declared	Excess
Year ended October 31	Income	value excess-profits	profits
	tax	tax	tax
1944	$ 21,576.68	$ 1,531.05	$ 83,237.63
1945	None	None	14,274.51

Certain adjustments made by respondent in his deficiency notice are not contested by petitioner. The assignments of error raise four issues. The first and fourth issues relate to adjustments which increased petitioner's net income for the fiscal year ended October 31, 1944. The second and third issues relate to the computation of petitioner's excess profits credit based on invested capital. The issues are:

1. What is the amount of the long term capital gain realized by petitioner upon the transfer of 24,000 shares of its treasury stock to Raye H. Decker pursuant to the exercise of an option by her during the taxable year ended October 31, 1944.

2. What is the cost to petitioner of the good will transferred to it in 1919 as property paid in for stock for the purpose of computing its">*201 equity invested capital for the taxable years 1944 and 1945 under section 718 (a) (2) of the Internal Revenue Code.

3. (a) Whether the sum of $ 171,680, being the excess of the face amount of debentures over the par value of preferred stock retired in exchange therefor during the taxable year 1944, was a distribution out of the earnings and profits of such taxable year so as not to result in a reduction of petitioner's equity invested capital for 1944 under section 718 (b) (2) of the Internal Revenue Code.

(b) If the above question is determined in favor of the petitioner, whether such sum of $ 171,680 was properly included in petitioner's borrowed capital for the taxable years 1944 and 1945 under section 719 of the Internal Revenue Code.

4. Whether the sum of $ 8,750 should be included in petitioner's income for the taxable year 1944 as interest on a certain promissory note of Harris & Frank Co., Los Angeles, California.

In his brief respondent concedes that petitioner's equity invested capital should not be reduced in the amount of $ 171,680 for the taxable year 1944. Issue 3 (a) is, therefore, determined in favor of the petitioner; however, Issue 3 (b) remains for our decision.

">*202 ">*306 The stipulated facts are so found and are incorporated herein by this reference.

FINDINGS OF FACT.

The petitioner, Society Brand Clothes, Inc. (formerly known as Alfred Decker & Cohn, Inc.), is a corporation duly organized and existing under the laws of the State of Illinois, with its principal office in Chicago, Illinois. The tax returns for the two fiscal years here involved were filed with the collector for the first district of Illinois. Petitioner was an accrual basis taxpayer.

Issue 1 -- Capital Gain from Sale of 24,000 Shares of Stock.

As of December 31, 1933, Alfred Decker, founder, president, and stockholder of petitioner was indebted to petitioner in the amount of $ 188,566.74. Of this amount, $ 18,860.41 constituted accrued interest which had been reported by petitioner as income for Federal tax purposes. In addition to this indebtedness, petitioner was liable as guarantor upon a personal debt of Alfred Decker in the amount of $ 15,075. This debt was owed to the Continental Illinois National Bank and Trust Company of Chicago and it was secured by 10,000 shares of the common stock of petitioner owned by Alfred Decker.

A plan for the settlement of his indebtedness">*203 to petitioner was proposed by Alfred Decker and submitted to petitioner's shareholders at a meeting held on January 15, 1934. At the time of this meeting, petitioner had 237 preferred stockholders, 718 common stockholders, and 91 stockholders who held both preferred and common stock. The preferred and common stock issued and outstanding were entitled to one vote per share. At the meeting on January 15, 1934, the holders of 2,973 shares of preferred stock out of 4,425 shares of preferred stock issued and outstanding and the holders of 68,882 shares of common stock out of 88,960 shares of common stock issued and outstanding were present in person or by proxy. The shareholders adopted a resolution authorizing and directing the acceptance of the plan of settlement with certain modifications. In accordance with the resolution adopted at the meeting of the shareholders an agreement dated January 19, 1934, for the settlement of Alfred Decker's indebtedness to petitioner was entered into by and between petitioner and Alfred Decker and his wife, Raye H. Decker. Pursuant to the foregoing agreement, Alfred Decker's indebtedness to petitioner was reduced to $ 145,086.74 by the acceptance">*204 by petitioner of certain collateral upon the following basis:

Miscellaneous collateral at estimated market value	$ 12,000
123 shares of petitioner's preferred stock at $ 100 per share	12,300
1,918 shares of petitioner's common stock at $ 10 per share	19,180
	$ 43,480

">*307 Also, pursuant to and as a part of this settlement agreement, petitioner on or about January 23, 1934, paid Alfred Decker's indebtedness to the Continental Illinois National Bank and Trust Company of Chicago in the amount of $ 15,075, thereby discharging its liability as guarantor. Thereupon, petitioner, on its books, increased Alfred Decker's indebtedness to it to $ 160,161.74. The 10,000 shares of petitioner's common stock which had been pledged by Alfred Decker to secure the indebtedness to the Continental Bank were thereby acquired by petitioner subject to the option agreement hereinafter mentioned.

In the resolution of the stockholders dated January 15, 1934, adopting the settlement proposed by Alfred Decker, it was provided:

AND BE IT FURTHER RESOLVED, that in order to consummate the foregoing settlement and in compromise and satisfaction of any obligation of this Corporation to purchase">*205 said 10,000 shares of Common Stock referred to in said letter of December 29, 1933, the Vice President and Treasurer of the Corporation are hereby authorized, empowered and directed, concurrently with the consummation of the settlement herein authorized, to purchase and acquire said 10,000 shares of Common Stock and pay therefor the sum of $ 15,075.00.

The terms of the option were set forth in a written agreement between petitioner and Raye Decker executed on January 23, 1934. It was provided therein (after referring to the 14,000 shares acquired at or about the same time from Raye Decker):

2. The Company has likewise acquired an additional 10,000 shares of its common capital stock through the purchase of the same for $ 15,075.00, as a part of a plan for compromising and collecting the obligation of Alfred Decker to the Company, * * *

In accordance with the settlement agreement, on January 23, 1934, petitioner released and discharged Alfred Decker from all liability upon his entire indebtedness to petitioner, and, as consideration for such release and discharge, Raye Decker assigned and delivered to petitioner on January 23, 1934, 14,000 shares of the common stock of petitioner subject">*206 to a 10-year option to her and her assigns to repurchase the same. Under the option agreement Raye Decker was given the right to repurchase the 14,000 shares of common stock of petitioner at the following prices:

On or before January 1, 1937 at $ 11 per share

On or before January 1, 1940 at $ 12 per share

On or before January 1, 1944 at $ 13 per share

The agreement expressly provided that in the event that petitioner shall, on or before January 1, 1944, receive from Raye Decker an amount equal to $ 160,161.74, with interest thereon at the rate of 4 per cent per annum from December 31, 1933, less certain credits hereinafter referred to, then petitioner shall forthwith deliver to her the 24,000 shares of common stock consisting of the 14,000 shares delivered to petitioner by Raye Decker and the 10,000 shares of common stock acquired by petitioner as aforesaid by the payment of Alfred Decker's ">*308 indebtedness to the Continental Illinois National Bank and Trust Company of Chicago.

As a part of the settlement plan, Alfred Decker assigned his unpledged assets to a trustee for the benefit of his creditors, including the petitioner. Both the settlement agreement and the option">*207 agreement provided that any amounts received by petitioner from its participation in the unpledged assets, and any amounts realized by petitioner upon the miscellaneous collateral taken in from Alfred Decker in excess of its estimated market value of $ 12,000 shall be deducted from the total amount required to be paid by Raye Decker and her assigns upon the exercise of her option. From February 23, 1934 to December 31, 1943, petitioner credited the option price with the sum of $ 26,723.19 received from these two sources.

On or about December 22, 1943, Raye Decker and her assigns exercised the option by the payment to petitioner of $ 195,260.66, and the 24,000 shares of common stock were thereupon delivered to her and her assigns.

From the time that it received the 24,000 shares of common stock subject to the option, on January 23, 1934, until the exercise of the option on December 22, 1943, petitioner was required by the terms of the option agreement to hold, and held, such shares in its treasury. During this entire period, petitioner in all of its audit reports, published financial statements, and annual reports to shareholders referred to the 24,000 shares of common stock in its">*208 treasury as "under option to Mrs. Raye H. Decker." The option agreement prohibited petitioner from transferring the 24,000 shares held in its treasury and petitioner at no time during the option period made any effort to sell, pledge or otherwise deal with those shares. No one expressed to petitioner an interest to purchase such shares.

The 24,000 shares of common stock received by petitioner in the foregoing transactions, restricted as they were by the option held by Raye H. Decker, had no ascertainable fair market value at the time they were received. The 24,000 shares of common stock were received by petitioner as part of the settlement, which settlement was in full discharge of the indebtedness of Alfred Decker.

The stipulated facts contain the following:

Summary of Transactions Pertaining to Indebtedness of Alfred Decker as Shown by Books of Society Brand Clothes, Inc., Formerly Alfred Decker & Cohn, Inc.

Indebtedness as of December 31, 1933:
Amount of principal	$ 169,706.33
Amount of accrued interest	18,860.41
Total		$ 188,566.74
Paid to Continental Illinois Bank and Trust Co., 1-31-1934		15,075.00
Total		$ 203,641.74
Settled as follows:
1-31-34 Miscellaneous collateral	$ 12,000.00
1-31-34 123 shares Alfred Decker &
Cohn, preferred	12,300.00
1-31-34 1,918 shares Alfred Decker &
Cohn, common	19,180.00
		43,480.00
Total [Difference]		$ 160,161.74

">*209 ">*309 The above account as shown on petitioner's books showed "Balance due as at 12-31-43 $ 133,438.55." This figure of $ 133,438.55 was arrived at by subtracting from the total of $ 160,161.74 shown to be due January 31, 1934, the total credits of $ 26,723.19 posted to the account between the dates of February 28, 1934, and December 31, 1943.

The exercise of the option to acquire the 24,000 shares of common stock exercised by Raye Decker on December 31, 1943, is reflected on petitioner's books as follows:

Exercise of option:
Cash received 12-31-43 from Mrs. Decker was applied as follows --
Account * * * common stock under option	$ 160,161.74
Less * * * special reserve	26,723.19
	133,438.55
Cash received 12-31-43	195,260.66
Balance transferred to account 238, capital surplus	$ 61,822.11

For its taxable year ended October 31, 1934, petitioner filed an income tax return showing a net loss of $ 187,560.95, and no deduction of any loss on the Alfred Decker indebtedness was made for tax purposes. Petitioner neither obtained nor could have obtained a tax benefit on account of this indebtedness, either in the taxable year 1934 or in any other year.

The taxable">*210 long term capital gain realized by petitioner upon the transfer of the 24,000 shares of its common stock to Raye Decker in its fiscal year 1944 was $ 61,822.11.

Issue 2 -- Value of Good Will Paid in for Stock.

In 1902, Alfred Decker, Abe Cohn, and Adolphus G. Peine commenced business as a partnership under the firm name and style of Alfred Decker & Cohn for the manufacture and sale of men's clothing exclusively at wholesale. For the period from October 31, 1903, through October 26, 1919, its annual sales increased from $ 68,168 to $ 8,641,811, its net tangible assets increased from $ 15,830 to $ 1,612,166, and its annual net profits increased from $ 6,738 to $ 467,624. The growth in the partnership net tangible assets resulted entirely from earnings.

">*310 By October 1919, the partnership had built up a substantial amount of good will. It had attained a reputation in the men's clothing manufacturing industry as a leader in style, particularly in young men's clothing. For a considerable period the partnership had been an active national advertiser and also cooperated closely with retail dealers in popularizing the trade names "Society Brand Clothes" and "Alfred Decker & ">*211 Cohn." The result was that these trade names became well known throughout the entire country and were particularly well established with a large number of the most substantial and representative retail clothing houses. The partnership sold its products throughout the United States, and also in foreign countries. One of the partners, Adolphus G. Peine, was regarded at that time as an outstanding designer of men's clothing and the partnership advertising publicized his association with the firm.

On October 10, 1919, petitioner was incorporated under the laws of the State of Illinois under its former name of Alfred Decker & Cohn, Inc. By a bill of sale dated October 27, 1919, the former partners, Alfred Decker, Abe Cohn and Adolphus G. Peine, transferred to petitioner all of the partnership assets, including all the intangibles, the name and good will of the business. Petitioner paid to the partners therefor the sum of $ 540,750.66 in cash, plus 100,000 shares of the petitioner's common stock, and petitioner assumed all of the partnership liabilities.

On September 6, 1919, the three partners entered into a contract with A. G. Becker & Co., a Chicago brokerage firm, whereby they agreed">*212 that, upon the formation of petitioner and the transfer of the partnership assets to it, they would cause petitioner to sell to the brokerage company the 25,000 shares of its preferred stock for $ 2,500,000, and upon the payment of such sum by A. G. Becker & Co., the three partners were to transfer 20,000 shares of the common stock (to be issued to them) to the brokers without additional consideration.

The partnership's good will was entered on petitioner's books at $ 1 as a matter of conservative accounting practice and not in any way as a reflection of the value of the good will. On its returns for the taxable years here in question petitioner valued the good will at $ 1,400,000 as property paid in as invested capital. The Commissioner has allowed only $ 850,000.

Trading in petitioner's common stock on the Chicago Stock Exchange commenced on October 16, 1919, on an unlisted basis. The issue was listed on November 3, 1919, and listed trading commenced on that date and continued thereafter. On October 16, 1919, the stock sold at a low of $ 38.50 and at a high of $ 42; from October 17, 1919, to the end of the unlisted trading on October 29, 1919, sales were made at prices ranging">*213 from a low of $ 43 to a high of $ 49; ">*311 on October 27, 1919, the date on which all of the partnership assets were transferred to petitioner the sales price of the common stock on the Chicago Stock Exchange was $ 45; and from November 3, 1919, the date of the first listed trading through December 29, 1919, the stock sold within a range of $ 43 to $ 46, with most of the sales occurring at a price of $ 45. The volume of trading from October 16 to December 29, 1919, amounted to 4,059 shares.

For the fiscal years indicated below the net profits of Alfred Decker & Cohn (partnership) were as follows:

Fiscal year ending in	Net profits
1915	$ 139,344.85
1916	351,137.73
1917	354,480.31
1918	528,456.08
1919	467,624.43

The net profits as indicted are unadjusted for compensation due to the partners and for income taxes due by a corporation. The net profits for the partnership during the fiscal period ending in 1919 were earned as follows:

Period	Amount
November 1, 1918-April 26, 1919	$ 355,683.70
April 26, 1919-October 26, 1919	111,940.73
Total for fiscal period	$ 467,624.43

It was stipulated that the net assets of the partnership, exclusive of good will, ">*214 trademarks, and other intangibles, were $ 1,612,166.92 as of the close of business on October 26, 1919.

Petitioner's initial capitalization consisted of 25,000 shares of $ 100 par value 7 per cent cumulative preferred stock, and 100,000 shares of no par value common stock. All of the common stock was issued to the former partners in return for the partnership assets, including all the intangibles, the name and good will of the business. All of the preferred stock was sold to investment bankers who resold it publicly at $ 98 per share. The investment bankers offered one share of petitioner's common stock at $ 30 per share with each three shares of preferred stock purchased. The 8,333 shares of common stock sold by the investment bankers in this manner had been acquired by them from the former partners.

The fair market value of the good will transferred to petitioner on October 27, 1919, as property paid in for stock was $ 1,000,000.

Issue 3 -- Equity Invested Capital, Borrowed Capital.

On February 3, 1944, petitioner issued debentures in the face amount of $ 600,880 in exchange for its preferred stock and dividend ">*312 arrearages thereon. The total par value of the preferred">*215 stock was $ 429,200. Cash in the amount of $ 42,560 was also distributed to the preferred stockholders.

The earned surplus account of petitioner for the fiscal year ending in 1944, as shown by its books of account and tax return, Form 1120, is as follows:

Balance October 31, 1943		$ 414,138.74
Additions to surplus:
Net profit for fiscal year 1944	$ 185,217.79
Special credit to income -- adjustment of prior
year's income taxes	84,468.22
Discount on debentures retired	2,190.00
		271,876.01
		686,014.75
Deductions from surplus:
Excess of face value of debentures over par
value of preferred stock	171,680.00
Cash paid on exchange of debentures for
preferred stock	42,560.00
Dividends paid	42,759.00
		256,999.00
Balance October 31, 1944		$ 429,015.75

The sum of $ 171,680, being the excess of the face amount of debentures over the par value of preferred stock retired, was a distribution out of petitioner's earnings and profits of the fiscal year ending in 1944, and petitioner's equity invested capital for that fiscal year is not to be reduced therefor.

The accumulated unpaid dividends upon the shares of preferred">*216 stock outstanding amounted to $ 79.92 per share as of October 31, 1943, or an aggregate of $ 343,016.64. Each share of stock, together with all accumulated unpaid dividends thereon, was surrendered to the petitioner in exchange for debentures of the principal amount of $ 140 and the sum of $ 10 in cash. It was explained to the stockholders that the following entry would reflect the exchange:

To give effect to the conversion of shares of Preferred Stock into Debentures and cash, the accounts of the Corporation will be adjusted by (1) establishing an obligation in the sum of $ 600,880 representing the aggregate principal amount of the Debentures, (2) charging off the capital account allocable to the shares of the Preferred Stock, being the aggregate par value thereof in the sum of $ 429,200, (3) charging the earned surplus with the sum of $ 171,680, being the sum by which the principal amount of the Debentures exceeds the aggregate par value of the shares of Preferred Stock, and (4) charging to earned surplus the cash distribution of $ 42,920 made to the holders of the shares of Preferred Stock at the rate of $ 10.00 per share.

">*313 The debentures were a general obligation ">*217 of the petitioner, junior and subordinate and subject to all other indebtedness then existing or thereafter created.

On petitioner's excess profits tax returns for the fiscal years ending in 1944 and 1945, petitioner included in its average borrowed capital the amount of outstanding debentures in the sum of $ 600,880, less certain relatively small amounts representing debentures retired during such taxable years.

The full face amount of the outstanding debentures, including the $ 171,680, is to be included in petitioner's borrowed capital for the taxable years ending in 1944 and 1945, in accordance with the provisions of section 719 of the Code.

Issue 4 -- Accrual of Interest.

Harris & Frank Co., a Delaware corporation, was a wholly owned subsidiary of petitioner from 1927 until April 1947. During this period Harris & Frank Co. operated a men's retail clothing store in Los Angeles, California. Both Harris & Frank Co. and petitioner kept their books and filed their Federal income tax returns on an accrual basis, and the fiscal year of each company ended on October 31.

In the fiscal year 1940, Harris & Frank Co. owed petitioner a sum in excess of $ 175,000 for merchandise on a ">*218 noninterest bearing account payable. This account was carried on the books of Harris & Frank Co. as a current liability, and as an account receivable on the books of petitioner. At this time the current liabilities of the subsidiary exceeded its current assets, and its deficits exceeded its capital stock account. The company was encountering credit difficulties, and this problem was discussed by the president of Harris & Frank Co. and the officers of petitioner. They reached an agreement whereby in order to improve the credit rating of the debtor the current account payable owing to petitioner would be converted into a long term liability to the extent of $ 175,000. Pursuant thereto, Harris & Frank Co. executed and delivered to petitioner on October 28, 1940, a 10-year note in that amount providing for the payment of interest at the rate of 5 per cent per annum. It was orally agreed between the two companies acting through their respective officers that liability for interest would not commence and that no interest would be due and payable until such time as the two companies should agree that the financial condition of Harris & Frank Co. would permit it to commence the payment">*219 of interest.

For the fiscal years 1940 through 1944, Harris & Frank Co. paid no interest on the note to petitioner, did not accrue such interest on ">*314 its books as an expense or a liability, and took no deduction for interest on this note for Federal income tax purposes. Nor was interest for such fiscal years accrued or paid by Harris & Frank Co. at any time thereafter. The audit reports of Harris & Frank Co. for these fiscal years showed the principal amount of the note as a liability but did not show interest on the note as an expense or a liability. For the fiscal years 1940 through 1944, petitioner did not receive interest on this note, did not accrue such interest on its books as income or as an asset, and did not include such interest as income for Federal income tax purposes. Nor was interest for such fiscal years accrued or received by petitioner at any time thereafter. The audit reports of petitioner for these fiscal years show the principal amount of the note as an asset but do not show interest on the note as income or as an asset.

In June or July of 1945, officers of Harris & Frank Co. and petitioner reached an agreement that the financial condition of Harris">*220 & Frank Co. was such as to permit the commencement of interest payments on the note as of the beginning of the 1945 fiscal year. The first payment of interest on the note was received by petitioner on August 31, 1945, being the sum of $ 6,562.53, covering the period from November 1, 1944, to July 31, 1945. Interest subsequent to this period was regularly paid and received.

The sum of $ 8,750 should not be included in petitioner's income for the taxable year 1944, as no interest was due and payable to petitioner for that year on the promissory note of Harris & Frank Co.

OPINION.

As has been mentioned in our preliminary statement, four issues are presented in this proceeding.

The first issue relates to the transaction whereby petitioner sold 24,000 shares of its treasury common stock in December 1943, to Raye Decker for $ 195,260.66 under the terms of an option. On its tax returns for the taxable year petitioner reported no income from the transaction, but on brief it concedes that a taxable long term capital gain of $ 61,822.11 was realized. ¹ In the deficiency notice respondent determined that petitioner realized a long term capital gain of ">*315 $ 192,908.85, but in his ">*221 brief respondent computes the long term capital gain to be $ 166,185.66. ²

Hence, the question is whether the long term capital gain which resulted from the sale of the stock in 1944 amounted to $ 61,822.11 or $ 166,185.66, and this question, in turn, ">*222 depends upon whether the basis of the capital asset is $ 133,438.55 as contended by petitioner, or $ 29,075 as determined and contended by respondent.

We think petitioner's contention must be sustained. It seems to us that the acquiring of the 24,000 shares of petitioner's common stock, the granting of the 10-year option to Raye Decker and the release of Alfred Decker from the indebtedness which he owed petitioner, including the $ 15,075 which petitioner paid the Continental Bank when it took over the 10,000 shares of stock, must all be treated as one integrated transaction. If the shares of stock, encumbered as they were by the 10-year option, had an ascertainable fair market value at the time they were received in the cancelation of Alfred Decker's indebtedness to petitioner, then the transaction was one by which petitioner collected its debt against Alfred Decker to the extent of the fair market value of the stock and the cost basis of the stock to petitioner thereafter was its fair market value at the time it was received. If, however, the 24,000 shares of stock, encumbered as they were by the 10-year option, had no fair market value at the time they were received, then it ">*223 could not be ascertained how much of petitioner's indebtedness against Alfred Decker was collected by receipt of the stock and cost basis of the stock to petitioner was the net amount of the indebtedness of Alfred Decker which was ultimately canceled in the transaction after allowances had been made for all other collections on the account. See Gould Securities Co. v. United States, 96 F.2d 780.

In the Gould Securities Co. case one corporation, Gould Storage Battery Company, owed the Gould Coupler Company, predecessor of the Gould Securities Co. on open account a debt which with interest amounted to $ 1,200,000. On February 15, 1915, the Battery Company issued 12,000 shares of preferred stock having a par value of $ 100 and a dividend rate of 6 per cent, all of which the Coupler Company took in exchange for the debt which the Battery Company owed it. Thereafter the Coupler Company, in the year when the 12,000 preferred shares in the Battery Company became worthless, claimed that ">*316 the 12,000 shares of Battery Company preferred stock which it received in cancelation of its indebtedness had no fair market value at the time it was received">*224 from Battery and hence the cost basis of the 12,000 shares of preferred stock to Coupler was the amount of $ 1,200,000. The Government on its part contended that the cost basis to Coupler was not $ 1,200,000 as it claimed but instead was only $ 815,535.39 which the Commissioner determined to be the fair market value of the 12,000 shares of Battery when Coupler Company acquired them on February 28, 1915. In dealing with the issue thus raised between the parties the court said:

It is undisputed that, if the cost basis to be given the preferred shares is $ 1,200,000, the admitted cost to the appellee of what it exchanged for them, the judgment below was right. And it is also undisputed that, if the shares had a fair market value when acquired in the amount for which the government contends, the appellee may not recover anything in this suit. And so the first issue on this appeal is whether or not these shares had a fair market value when they were acquired by the taxpayer. If that goes against the government, it is not only the first but it is the decisive issue.

It needs no citation of authorities, of course, for the principle that respondent's determination in the instant case">*225 that the stock had a fair market value at the time it was received is presumed to be correct. However, there is much evidence in the record, both from petitioner's witnesses and respondent's witnesses, as to the fair market value of the shares of petitioner's common stock at the time it was received by petitioner, encumbered as it was by a 10-year option to Raye Decker to acquire. We shall not undertake in this opinion to discuss this testimony in any great detail. The substance of it is that at the time petitioner acquired these shares from Raye Decker and the Continental Bank early in 1934, the country was slowly emerging from the great depression; common stocks of the strongest and best known corporations in the United States were selling at bargain prices and there was but very little demand for common stock of corporations like petitioner which, at that time, were incurring heavy annual losses and were piling up accumulated unpaid dividends on preferred stock.

Both petitioner's and respondent's expert witnesses seemed to agree that the fair market value of petitioner's common stock at that time was $ 1 per share, unrestricted by any option. Shares of petitioner's common stock, ">*226 unrestricted by any option, were sold on the Chicago Stock Exchange at prices between $ 1 1/8 and $ 2 1/2 per share during the month of January 1934, when the settlement agreement was entered into. However, all agreed that these prices were for a comparatively small number of shares and that the number of shares here involved could not have been marketed for a greater amount than $ 1 per share. The $ 1 per share fair market value was with reference to shares unencumbered by any option. The shares here involved were definitely ">*317 encumbered by a 10-year option as has been explained in our Findings of Fact. As we interpret the testimony of the expert witnesses, these shares, encumbered as they were by the 10-year option, had no fair market value at the time they were received or, at least, only a nominal value. During the course of the testimony of one of respondent's expert witnesses, Richard S. Cutler, the following questions were asked by respondent's counsel:

Q. My question, Mr. Cutler, is whether or not you have in your mind determined what the value of, we will say, 24,000 shares of the common stock of Alfred Decker and Cohn would be subject to this option?

* * * *

">*227 The Witness: In that case, where you could not possibly hope to get delivery of the stock for ten years, it would have almost a nominal value, five cents a share, or something of that.

Q. Do you think it could be sold for that?

A. I think you probably could have gotten a speculator to put up five cents a share in that case.

Upon the strength of this testimony and other testimony in the record we have made a finding of fact under Issue 1 as follows: "The 24,000 shares of common stock received by petitioner in the foregoing transactions, restricted as they were by the option held by Raye H. Decker, had no ascertainable fair market value at the time they were received." In thus making the foregoing finding of fact we do not mean to hold that as a matter of law the restriction of the sale of stock by an option necessarily destroys its fair market value. We think whether the fair market value of stock has been destroyed by an option will depend upon what kind of stock it is and upon the kind of option which has been granted and other relevant facts and circumstances of the particular case. All that we mean to hold in the instant case is that under the evidence we have here, when petitioner">*228 received the 24,000 shares of its common stock in part settlement of the indebtedness which it held against Alfred Decker, encumbered as it was by the 10-year option described in our Findings of Fact, it had no fair market value at the time it was received. This being true, we think petitioner is correct in its contention that the cost basis of these shares to petitioner under section 113 (a), I. R. C.³ would be the remaining portion of its debt to Alfred Decker. See Gould Securities Co. v. United States, supra.In that case the court concludes its opinion with the following paragraph:

Since these shares did not then have a fair market value, no profit or loss from the standpoint of taxation was realized when they were taken in exchange for the debt in 1915. Burnet v. Logan, 283 U.S. 404">283 U.S. 404, * * *; Helvering v. ">*318 Tex-Penn Oil Co., 300 U.S. 481">300 U.S. 481, * * *. When they became worthless in 1924, therefore, the loss sustained was the amount of the advances which the taxpayer had cancelled in exchange for the stock. United States v. Tillinghast, * * * 69 F.2d 718.

">*229 If the rule as to fixing the basis for taxpayers' loss in Gould Securities Co. case is as stated in that case, we fail to see why the same rule would not apply in fixing petitioner's gain in the instant case. Certainly, in the usual case, the basis for gain is the same as the basis for loss and we know of no reason why that rule should not apply here. We think it does apply.

On this issue we sustain petitioner.

Issue 2 -- Value of Good Will Paid in for Stock.

The second issue to be decided in this proceeding is the value of good will acquired by petitioner from its shareholders in 1919.

In computing its equity invested capital under the provisions of section 718, I. R. C., the taxpayer may include property contributed or paid in for stock or as paid-in surplus. Ordinarily such property shall be included in an amount equal to its basis (unadjusted) for determining loss upon sale or exchange, but if the property was acquired by a corporation from a shareholder as paid-in surplus or from any other person as a contribution to capital prior to January 1, 1921, the basis is the fair market value of the property at the time it was paid in. Regulations 112, section 35.718-1.

">*230 Petitioner used a value of $ 1,400,000 for good will in the preparation of its excess profits tax returns. In computing petitioner's equity invested capital for the deficiency notice respondent used a value of $ 850,000 for the good will. Petitioner, on brief, for the first time contended that the fair market value of the good will was $ 3,428,583.74. However, it seems clear to us that the good will of Alfred Decker & Cohn partnership at the time of transfer to Alfred Decker & Cohn, Inc., had no such value as petitioner now seeks to place upon it in its brief.

It was on October 27, 1919, that petitioner acquired all the business properties, including good will, of the partnership, Alfred Decker & Cohn. Petitioner was organized to succeed the partnership, and prior to October 27, 1919, petitioner was not engaged in business. Trading in petitioner's common stock, nevertheless, was commenced on October 16, 1919, on the Chicago Stock Exchange. At the time the partnership assets were transferred to petitioner its shares of common stock were selling on the Exchange at $ 45. However, petitioner's common stock was being marketed by brokers during this same period at $ 30 per share, ">*231 along with shares of petitioner's preferred stock. Under these circumstances, the fair market value of the good will is ">*319 to be determined primarily from the past earnings record of petitioner's predecessor, the general conditions of the men's clothing business at that time, and the prospective future earnings of the petitioner. ⁴ In arriving at the fair market value of the good will acquired by petitioner from its predecessor in business we have considered the stipulated facts, the exhibits, the testimony of witnesses, in fact, all the evidence, and we have determined a fair market value of $ 1,000,000.

Issue 3 (b) -- Borrowed Invested Capital.

As to Issue 3 (a), respondent concedes that petitioner's equity invested capital should not be reduced in the amount of $ 171,680 for the fiscal year ending in 1944, as was proposed in the deficiency notice. Since ">*232 petitioner's earnings and profits for the taxable year exceeded the amount of the distribution (excess of the principal amount of the debentures over the par value of the preferred stock), it is presumed that the distribution is made from earnings and profits of the taxable year. See section 718 (b) of the Code and Regulations 112, section 35.718-5.

At the hearing respondent filed an amended answer raising Issue 3 (b). In our Findings of Fact we have described the recapitalization of petitioner which took place on February 3, 1944. The issue for us to decide is whether petitioner's borrowed invested capital is to be computed by including the debentures therein at their face value, or at the par value of the preferred stock surrendered to petitioner in exchange for the debentures.

Section 719 (a) (1) of the Code provides that borrowed capital shall include, among other things, "The amount of the outstanding indebtedness (not including interest) of the taxpayer which is evidenced by a bond, note, bill of exchange, debenture, certificate of indebtedness, mortgage, or deed of trust." Respondent contends that the sum of $ 171,680 here involved is neither borrowed, nor invested, nor capital. ">*233 As authority in support of his contention respondent relies on McKinney Manufacturing Co., 10 T.C. 135, and Columbia, Newberry & Laurens Railroad Co., 14 T.C. 154. These cases hold, relying on section 719 (a) (1) of the Code, that where script or certificates of indebtedness have been issued in lieu of interest the securities retain their character as interest and are not to be included in the taxpayer's borrowed capital under section 719 (a) (1). Respondent contends that those decisions are controlling here for if that rule is applicable with regard to interest, then it follows that debentures issued in lieu of accumulated dividends on preferred stock retain ">*320 their original character as dividends. The extension of the rule established by those two cases relating to accrued interest to the fact situation presented in the instant proceeding we do not think is warranted. Prior to the issuance of script, done in the earlier case, or certificates of indebtedness, done in the latter case, the amount of interest was not includible in the amount of the taxpayers' invested capital. ⁵ Through the expedient of issuing">*234 script and certificates of indebtedness the taxpayers hoped to increase their invested capital by qualifying under the provisions of section 719 (a) (1) of the Code their liability for interest as borrowed capital. In accordance with legislative intent the cases cited by respondent hold that the corporate taxpayer may not convert its liability for interest into borrowed capital for the purpose of computing its excess profits credit. The statute expressly excludes it.

In the instant proceeding, as a consequence of issuing the securities, petitioner is deemed to have distributed out of its earnings and profits for the taxable year ending in 1944, the sum of $ 171,680, Issue 3 (a), and for all subsequent taxable years petitioner's equity invested capital will be reduced accordingly from what it otherwise would have been, save for the distribution of the $ 171,680. To the extent of $ 171,680, therefore, petitioner converted equity invested capital into borrowed">*235 capital. There is no statutory prohibition against this practice, ⁶ in fact, petitioner converted preferred stock of the par value of $ 429,200 (equity invested capital) into debentures (borrowed capital) by this same recapitalization. Respondent would have us distinguish the face value of debentures arising from the redemption of the canceled preferred stock and the face value of debentures arising from the satisfaction of the accumulated dividends due on the preferred stock, yet in the absence of the recapitalization the earned surplus used to satisfy the accumulated dividends on the preferred stock and the par value of its preferred stock were both includible alike in petitioner's equity invested capital.

Respondent is not sustained as to Issue 3 (b).

Issue 4 -- Accrued Interest.

The fourth issue presents a question involving interest income from a promissory note held by petitioner. Respondent contends that petitioner, an accrual">*236 basis taxpayer, must include in income the interest due and payable to petitioner as provided under the terms of a note for $ 175,000. The 10-year note was executed by petitioner's wholly owned subsidiary in 1940. According to the note interest was due and ">*321 payable at the rate of 5 per cent. Petitioner has established, however, that there was a mutual agreement that no interest was to be charged or paid on the note until an undetermined future date to be determined subsequently upon the agreement between the parties to the note that the subsidiary was financially able to pay the interest. The books and the tax returns of both petitioner and the subsidiary were set up on a consistent basis and in accordance with the oral agreement of the promisor and the promisee.

There is no material difference in the issue presented here and the one in Combs Lumber Co., 41 B. T. A. 339. There the taxpayer held demand promissory notes which were executed by the taxpayer's stockholders with the mutual understanding that no interest would be paid or charged thereon, and we held that the taxpayer was not required to accrue interest on the notes as income. ">*237 In so holding we said, "The important factor in this case is succinctly stated in Spring City Foundry Co. v. Commissioner, 292 U.S. 182">292 U.S. 182, 292 U.S. 182">184, wherein we said: 'When the right to receive an amount becomes fixed, the right accrues'."

As to this final issue we think respondent erred in determining that petitioner earned interest income during the fiscal year ending in 1944 in the amount of $ 8,750 on the note of its subsidiary.

Decision will be entered under Rule 50.

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Footnotes

• 1. Instead of including the amount of $ 61,822.11 in its net income for the fiscal year, petitioner credited its capital surplus by that amount. The credit to capital surplus, which petitioner now concedes to be the amount of the gain, was computed by petitioner as follows:

  ↩

  Cash received from Mrs. Decker	$ 195,260.66
  Unpaid balance of indebtedness of Alfred Decker	133,438.55
  Difference -- credited to capital surplus	61,822.11

• 2. Respondent computes the long term capital gain as follows:

  ↩

  Proceeds from sale of 24,000 shares of stock		$ 195,260.66
  Basis of 10,000 shares (cost)	$ 15,075.00
  Basis of 14,000 shares (fair market value)	14,000.00
  Cost basis for the 24,000 shares of stock		29,075.00
  Long term capital gain realized		166,185.66

• 3. SEC. 113. ADJUSTED BASIS FOR DETERMINING GAIN OR LOSS.

  (a) Basis (Unadjusted) of Property. -- The basis of property shall be the cost of such property; * * *↩

• 4. See Regulations 112, section 35.718-1 for a discussion of the various factors which may be considered in determining fair market value.↩

• 5. Invested capital is defined in section 715 of the Code.↩

• 6. See: Tribune Publishing Co., 17 T.C. 1228↩.