First Kentucky Company v. Gray, 14595.

• Decision Date: 21 November 1962
• Docket Number: No. 14595.,14595.
• Parties: FIRST KENTUCKY COMPANY, Plaintiff-Appellant, v. William M. GRAY, District Director of Internal Revenue for Kentucky, Defendant-Appellee.
• Court: U.S. Court of Appeals — Sixth Circuit

309 F.2d 845 (1962)

FIRST KENTUCKY COMPANY, Plaintiff-Appellant, v. William M. GRAY, District Director of Internal Revenue for Kentucky, Defendant-Appellee.

No. 14595.

United States Court of Appeals Sixth Circuit.

November 21, 1962.

James W. Stites, Jr., Louisville, Ky. (James W. Stites, Louisville, Ky., on the brief; Stites, Peabody & Helm, Louisville, Ky., of counsel), for appellant.

John A. Bailey, Dept. of Justice, Washington, D. C. (Louis F. Oberdorfer, Asst. Atty. Gen., Lee A. Jackson, Meyer Rothwacks, Attys., Dept. of Justice, Washington, D. C., William B. Jones, U. S. Atty., on the brief), for appellee.

Before O'SULLIVAN, Circuit Judge, and BOYD and THORNTON, District Judges.

BOYD, District Judge.

The appellant is a Kentucky corporation engaged in the business of making investments. It instituted this suit in the District Court for refund of $21,007.98, income taxes paid under protest, plus interest. The payment of these taxes was made by appellant as a result of a deficiency assessment for the year 1954 by the Commissioner of Internal Revenue on the theory that accrued interest in default was part of the sale price of railroad bonds sold "flat" by the appellant, which part should have been declared by appellant as ordinary income for tax purposes. The appellant kept its books on a calendar year and cash basis method of accounting and in its return had treated the proceeds from all sales of bonds herein, which exceeded the adjusted basis on the bonds, as long term capital gain. The District Court ruled in essence that a part of the proceeds from the sales aforesaid was allocable to interest accrued during the period taxpayer held the bonds and was taxable as ordinary income, after determining on a proportionate basis that part of the sales proceeds which represented accrued interest. First Kentucky Company v. Gray, 190 F.Supp. 824, D.C.1960. The method of computing the proportionment is demonstrated in Shattuck v. Commissioner, 25 T.C. 416. From that part of the District Court judgment adverse to it the taxpayer has brought this appeal.

In the years 1939, 1940 and 1941, appellant purchased Missouri Pacific Railroad First and Refunding First Mortgage 5% Bonds of various series. Some of said bonds, $8,000.00 in principal amount, were sold in 1944 and are not here involved. The face value of the bonds with which we are concerned was $325,000.00 and the price paid for them by the appellant was $57,491.40. At the time of the purchase the railroad company was undergoing reorganization, which was begun in 1933, pursuant to provisions of Section 77 of the Bankruptcy Act.

In 1942 the Trustee in reorganization began to make certain distributions of accrued interest. Certain of these payments were received by appellant and used to reduce its tax basis as return of capital, since the interest paid had accrued before appellant's ownership of the bonds. When its basis on the various bonds was reduced to zero, the cash distributions were reported by the taxpayer as ordinary income. The propriety of this procedure is not in issue on this appeal.

The appellant sold the bonds in question "flat" and considerably above par at the then quoted market price of $387,577.40, the sales transactions taking place on November 17, 18, and 19, 1954. On November 9, 1954, the Interstate Commerce Commission had approved and certified to the District Court the fourth plan of reorganization of the railroad company in the aforesaid bankruptcy proceeding. This plan as finally modified was approved by the District Court on February 25, 1955, In re Missouri Pacific Railroad Company, 129 F. Supp. 392, and was later affirmed by the Court of Appeals for the Eighth Circuit on September 14, 1955, Missouri Pacific Railroad Company 5¼% Secured Bondholders Committee v. Thompson, 225 F. 2d 761.

On November 5, 1954, pursuant to the proposed fourth plan, but before the sale of the bonds herein by the taxpayer, the District Court entered an order authorizing payment of accrued interest on the bonds under the following caption — "ORDER. Authorizing Trustee to Pay All Interest Matured at December 31, 1954, on Missouri Pacific Railroad Company First and Refunding Mortgage Bonds." In this order, however, the Court provided as terms, conditions, and reservations, that in the event the fourth plan of reorganization should fail of adoption or be modified, certain credits would be effected according to any changes necessitated. Approximately one month after the sales of the bonds herein by the taxpayer, these payments of accrued interest were made in accordance with the order aforesaid.

The appellant contends that the profits realized from the sales of the bonds "flat" were capital gains and reportable as such for tax purposes. The reasoning behind this contention is grounded in the general understanding of that term "flat sale." Under its generally accepted meaning, there is no allocation for sale purposes between principal and interest. Thus, reasons the appellant, there should be none for tax purposes, and, although the bonds herein were sold above par, the appellee was not justified in allocating part of the sales proceeds to interest, taxable as ordinary income. This insistence we reject in the light of the "flat purchase rule" as announced by this court in McDonald v. Commissioner of Internal Revenue, 217 F.2d 475 (C.A.6) 1954,¹ and in view of the recent decisions by the Courts of Appeals of the Second and Fifth Circuits in Jaglom v. Commissioner of Internal Revenue, 303 F.2d 847 (C.A.2) 1962, and United States of America v. Langston, 308 F.2d 729 (C.A.5), both cases upholding allocation as between principal and interest, for tax purposes, in above-par "flat" sales of Missouri Pacific bonds. We feel that had the appellant held the bonds here involved until actual payment of the defaulted interest, the proceeds without question would have been taxable as income. See Fisher v. Commissioner of Internal Revenue, 209 F.2d 513 (C.A.6), 1954, cert. denied 347 U.S. 1014, 74 S.Ct. 868, 98 L.Ed. 1136. Appellant disagrees with this conclusion, although the taxpayers in Jaglom and Langston apparently did not. Appellant cites as authority Sections 354 and 356 of the 1954 Internal Revenue Code in support of his argument that the payments made by the Trustee in reorganization would not have constitued income had appellant retained the bonds. However, those sections deal with treatment of gain on exchange of securities in the course of...