Hegra Note Corporation v. CIR

• Decision Date: 21 December 1967
• Docket Number: No. 24115.,24115.
• Citation: 387 F.2d 515
• Parties: HEGRA NOTE CORPORATION, Petitioner, v. COMMISSIONER OF INTERNAL REVENUE, Respondent.
• Court: U.S. Court of Appeals — Fifth Circuit

387 F.2d 515 (1967)

HEGRA NOTE CORPORATION, Petitioner, v. COMMISSIONER OF INTERNAL REVENUE, Respondent.

No. 24115.

United States Court of Appeals Fifth Circuit.

December 21, 1967.

E. Michael Masinter, Atlanta, Ga., for petitioner.

Lester R. Uretz, Chief Counsel, Aaron D. Trub, Atty., IRS, Mitchell Rogovin, Asst. Atty. Gen., Lee A. Jackson, Harry Marselli, Crombie J. D. Garrett, Robert J. Campbell, Attys., Dept. of Justice, Washington, D. C., for respondent.

Before TUTTLE, GEWIN and AINSWORTH, Circuit Judges.

TUTTLE, Circuit Judge:

This is an appeal from a decision of the Tax Court determining a deficiency in the taxpayers 1961 income tax. It draws in question the correctness of the Tax Court's holding that taxpayer's transfer of seven installment notes of the hotel corporation which it had acquired to an insurance company in exchange for certain rights in 154,000 shares of stock of the insurance company was such a disposition of the notes as to necessitate the recognition as long term capital gain under Section 453(d) (1) of the Internal Revenue Code of 1954, measured by the difference between taxpayer's basis in the installment notes and their fair market value, and whether the court was correct in finding the value of the said notes to equal 66% of their face.

The facts leading up to the transaction here in issue are complicated and involved. However, it is not necessary that they be recited because they have no bearing on the precise issue which was decided by the Tax Court and presented to us for review.

On June 29, 1960, the then holders of these seven installment notes of the Henry Grady Hotel Corporation, incorporated Hegra Note Corporation. Upon incorporation the seven installment notes, with an aggregate face value of $385,000, and an adjusted basis of $64,593.10 were the taxpayer's sole assets. They were transferred to Hegra in return for its entire capital stock. Prior to this incorporation, the incorporators had been in negotiations with Kennesaw Life and Accident Insurance Company, and an agreement had been tentatively worked out under which the seven notes (the first was to become due and payable on January 15, 1961 and was for the principal amount of $30,000; the latter six were for $59,166.66 each, due successfully one year thereafter, all bearing interest at 5% from date) would be exchanged for 154,000 shares of the common stock of Kennesaw, provided the insurance commissioner of the state of Georgia would permit Kennesaw to carry these notes as "admitted assets," thus enabling the insurance company to increase the amount of insurance it could write.

In order to obtain this approval, the president of Kennesaw wrote the insurance commissioner expressing his opinion of the worth of the notes in the following language:

"The Henry Grady Hotel Corporation operates the well known Henry Grady Hotel at the Corner of Peachtree and Cain Streets in Atlanta. This has been for thirty years one of the City of Atlanta\'s best known and successful hotels. Except for a period during the depth of the depression, it has been a highly successful and profitable operation.

* * * * * *

"These notes represent approximately 40% of the purchase price for all of the stock of the Henry Grady Hotel Company, the balance having been previously paid in cash. Since the purchasers invested over $500,000 in the Henry Grady stock and the purchasers are men of substance and I think there is every reason to believe that the Henry Grady Hotel Corporation notes will be paid as they mature * * *."

The insurance commissioner, in effect, granted conditional approval for the exchange. In his letter he said, "The notes appear to be a good credit risk," and he stated that if the 154,000 shares when issued to Hegra Note Corporation should, rather than be delivered to it, be held in escrow until the notes were paid, the whole face amount of the notes could be taken into "admitted assets" of the company. The commissioner also required that there be a clause in the agreement providing that in the event of default in a principal or interest payment exceeding sixty days, the transaction would be rescinded; Kennesaw would return all unpaid notes, together with stock representing the principal amount thus far paid on the basis of $2.50 per share; Kennesaw would then cancel the remaining escrow shares and retain all principal and interest payments made. At the time of this transaction, the Kennesaw stock was inactively traded on the local over-the-counter market. On May 13, 1960, it was quoted at 2 3/8 bid, 2 7/8 asked, while on June 29, 1960, the price was 2 bid, 2¼ asked. On the date of its incorporation, Hegra entered into a contract with Kennesaw along the lines required by the insurance commissioner, and under the terms of which it transferred and assigned the notes outright to Kennesaw, in return for Kennesaw's issuing the 154,000 shares of stock and placing them in escrow subject to the above agreement.

The Henry Grady Hotel Corporation, the maker of the notes, made the January 15, 1961, principal payment and all interest payments up to that date, but defaulted on the January 15, 1962, principal and interest payments. On January 19, 1962, the Hotel company filed a voluntary petition in bankruptcy in the federal district court under Chapter XI of the Bankruptcy Act. Kennesaw gave written notice of default to the taxpayer on February 2nd. Subsequent to this notice of default, the notes were sold for $30,000 to the Fulton National Bank, as trustee under the wills of Cecil Cannon and Fred B. Wilson (former stockholders in the old Henry Grady Hotel Company.) Thereupon Kennesaw, giving credit for the $30,000 and the $30,000 sales price, delivered 25,000 shares of its stock to the taxpayer and cancelled the rest of the stock.

The taxpayer reported its transaction with Kennesaw on its 1961 income tax return as a nontaxable exchange under Section 368(a) (1) (C) of the Internal Revenue Code of 1954. In doing so the taxpayer apparently overlooked the provisions of Section 453 (d) (5) that made the non-recognition provisions of the statute inapplicable as to life insurance companies. The commissioner thereupon determined a deficiency of $80,101.72 in this return, basing his determination on Section 453(d) of the Internal Revenue Code.¹

In the Tax Court proceedings then commenced by the taxpayer, it took the position that gain cannot be recognized under Section 453(d), it being a cash basis taxpayer and it not having received the equivalent of cash in the exchange. We think this contention is completely answered in the case of Nuckolls v. United States, (10 Cir.) 76 F.2d 357, where that c...