Commissioner of Internal Revenue v. First State Bank

• Decision Date: 25 June 1948
• Docket Number: No. 12183.,12183.
• Citation: 168 F.2d 1004
• Parties: COMMISSIONER OF INTERNAL REVENUE v. FIRST STATE BANK OF STRATFORD.
• Court: U.S. Court of Appeals — Fifth Circuit

168 F.2d 1004 (1948)

COMMISSIONER OF INTERNAL REVENUE v. FIRST STATE BANK OF STRATFORD.

No. 12183.

Circuit Court of Appeals, Fifth Circuit.

June 25, 1948.

Melva M. Graney, George A. Stinson and Lee A. Jackson, Sp. Assts. to the Atty. Gen., Theron L. Caudle, Asst. Atty. Gen. and Charles Oliphant, Chief Counsel, Bureau of Internal Revenue, and John M. Morawski, Sp. Atty., Bureau of Internal Revenue, both of Washington, D. C., for petitioner.

Dorothy Ann Kinney and Walter G. Russell, both of Amarillo, Tex., for respondent.

Before SIBLEY, HUTCHESON, HOLMES, McCORD, WALLER, and LEE, Circuit Judges.

HOLMES, Circuit Judge.

The Commissioner is seeking the correction of errors alleged to have been made by the Tax Court in its decision in this case. The question for decision is whether certain recoveries on notes in 1942 were income to the taxpayer, the respondent on review.

On October 17, 1942, the First State Bank of Stratford declared a dividend in kind, which consisted of certain notes that had been charged off as wholly worthless, and deducted as bad debts in its income-tax returns for years previous to 1942. These notes did not appear on the bank's books. They had been kept in a case by themselves, but were brought to the directors' meeting on the above date, when the possibility of their collection was discussed. It then appeared that collections on the notes were currently being made, about $25,000 already having been collected. The payment of a dividend by the bank was next considered. Attention was called to the matter of increased taxes and the advisability of deferring a cash dividend until more would be known about the new income-tax law soon to be enacted. It was pointed out that the bank had a number of charged-off accounts of doubtful value, also real estate carried on the books at the nominal sum of one dollar. The advisability of paying a dividend in these properties was fully considered, and the following resolution adopted:

"Whereas, This bank is the owner of several thousand dollars of charged off notes, some of which may be collected in future, and the balance of which are of doubtful value.

"Now, Therefore, Be it resolved that the following charged off notes be assigned to the stockholders of this bank without recourse on it, said notes being paid as a dividend in kind and without any value being placed thereon by this bank." (A list and description of the notes followed.)

After the meeting the directors, as stockholders, further discussed the matter. It was suggested, with approval, that W. N. Price take charge of the notes for the stockholders. Within the next few days, the notes included in the dividend were endorsed to W. N. Price without recourse on the bank. Amounts thereafter collected in 1942 on the dividend notes were deposited in the bank in an account designated "W. N. Price, Special." In attempting collection of these notes, Price, who worked in the bank, did nothing that he did not do in collecting notes owed to the bank, except at various times he worked after banking hours. No system of bookkeeping for the notes was set up by the stockholders in 1942. The debtors were not notified of the assignment of their debts to the stockholders. The notes when paid were marked paid with a stamp on which appeared the bank's name, but not the stockholders.'

After October 17, 1942, and prior to January 1, 1943, collections amounting to $11,662.71 were made on these dividend notes, of which the sum of $10,548.20 was determined by the Commissioner to be taxable income of the respondent on the theory that to this extent the distribution of the dividend in kind merely represented an assignment of anticipated income, because a tax benefit had been received for it in prior years. The Tax Court reversed the Commissioner's determination, and held that the amounts so collected were not taxable to the respondent as income.

The taxpayer relies upon General Utilities & Operating Co. v. Helvering, 296 U.S. 200, 56 S.Ct. 185, 80 L.Ed. 154, as authority that a corporation does not realize income by its distribution of a dividend in kind. It contends that collections made on notes subsequent to their distribution as a dividend in kind are not taxable to the corporation that distributed the dividend but to their legal owners, who in this instance are the stockholders. The Commissioner argues that, having recovered its capital investment in the notes through the allowance of bad-debt deductions, the taxpayer in declaring and distributing the dividend in 1942 made an anticipatory assignment of the bank's right to collect the income represented by the notes, and was taxable on the amounts collected.

The Commissioner cites Helvering v. Horst, 311 U.S. 112, 61 S.Ct. 144, 85 L.Ed. 75, 131 A.L.R. 655, and Helvering v. Eubank, 311 U.S. 122, 61 S.Ct. 149, 85 L.Ed. 81, as to the realization and enjoyment of taxable income. After stating the issues before it, the Tax Court in its opinion said: "We have here, on its face, a dividend in kind which under the settled law indicated in the General Utilities & Operating Co. case, supra, is no ground for realization of taxable income; and our problem therefore is: Does the fact of previous charge-off, as worthless, of the notes involved, distinguish that case? We do not think so. Though it is true that the National Bank of Commerce of Seattle case 115 F.2d 875 * * *, states * * * that after the loans there involved were charged off and deducted from income, they `were no longer a capital asset but represented income,' yet it was held that when they were transferred to another bank, in a nontaxable reorganization, recoveries thereafter made were income, within the broad meaning of section 22(a), Internal Revenue Code 26 U.S.C.A.Int.Rev.Code, § 22(a), * * * the transferee having the same basis of zero which the transferor had after the charge-off and deduction from income. Here, instead of transfer in a reorganization, we find a transfer in a dividend in kind, and the National Bank of Commerce case seems to us recognition of the principle that despite their nature as representing income after deduction by the transferor bank, such loans nevertheless are subject to transfer as property and may constitute income to the transferee. The Horst and Eubank cases, supra, do not help the respondent. That line of authority involves transfers of rights to income, without consideration, where it was denied that the transferor was freed from tax. Here it can not be said that there was assignment of the notes for no consideration. Distribution of a dividend in kind to stockholders is not gift, and is not without consideration — which appears inherent in the original cost of the stock upon which the dividend in kind is received. We think the logic of the Horst and similar cases is not applicable here." 8 T.C. 831.

We think we are bound under the Dobson rule by the decision of the Tax Court as to the reality and good faith of the dividend declaration, and as to the finding that the stockholders were owners of the notes after the assignment; but the facts are undisputed that these notes had been charged off as worthless, and that income-tax deductions had been taken for them by the respondent in prior years. Therefore, an issue of law is presented as to whether or not for all purposes of income-tax accounting, these notes ceased to be capital assets of the bank and became purely potential income, which when assigned to and collected by the stockholders was required to be included in respondent's gross income. Another way of stating the question of law is: Does the fact that the notes were distributed as a dividend in kind preclude the treatment of the transaction as a assignment of anticipatory income? The ultimate legal question is: What are the tax consequences of a dividend in kind that admittedly was intended to effect and did effect an anticipatory assignment of future corporate income?

It is well settled that, when a deduction for income-tax purposes is taken and allowed for debts deemed worthless, recoveries on the debts in a later year constitute taxable income for that year to the extent that a tax benefit was received from the deduction taken in a prior year.¹ Thus, when the tax benefit for a bad debt is obtained, the debt loses its nature as capital, and becomes representative of that portion of the taxpayer's income which was not taxed.² As stated in the just-cited case:

"The profits or income used to pay back the capital when the debt is charged off is represented by the worthless loan, so that when such loan is paid the profits are replaced."

A dividend to a shareholder by a corporation in any medium other than money is a dividend in kind, and in a formal sense the notes here represented such a dividend. Ordinarily no gain or loss is realized by a corporation from the mere distribution of its assets in kind in partial or complete liquidation, however they may have appreciated or depreciated in value since their acquisition;³ but the rule is deemed to be otherwise where the dividend in kind is not in liquidation and consists of bad debts on account of the worthlessness of which a deduction was allowed for a prior taxable year. Whether or not the respondent corporation made an assignment of anticipatory income upon the distribution of its dividend in kind depends upon the nature of the property distributed in relation to the capital structure of the corporation. In this case, the charged-off debts no longer represented an asset except in the sense that any vested right to receive income is an asset; the notes had a basis of zero, and were no longer reflected in the capital structure of the corporation. They merely represented potential income to the extent of the tax deduction previously allowed.

The Tax Court distinguished the Horst and Eubank cases⁴ because in them the anticipatory assignments were without consideration, which is not true as to a dividend in...