First Kentucky Company v. Gray

• Decision Date: 11 August 1960
• Docket Number: Civ. No. 3677.
• Citation: 190 F. Supp. 824
• Parties: FIRST KENTUCKY COMPANY, Plaintiff, v. William M. GRAY, District Director of Internal Revenue for Kentucky, Defendant.
• Court: U.S. District Court — Western District of Kentucky

190 F. Supp. 824

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

Civ. No. 3677.

United States District Court W. D. Kentucky, Louisville Division.

August 11, 1960.

James W. Stites, Louisville, Ky., for plaintiff.

William B. Jones, U. S. Atty., Louisville, Ky., for defendant.

BROOKS, Chief Judge.

This action is submitted on the record which includes a stipulation of facts. The briefs of the parties have been considered.

At the time the plaintiff-taxpayer purchased the Missouri Pacific Railroad Company bonds involved in this case a considerable amount of accrued interest was in default. The bonds were quoted for sale at a "flat" price, which means a sale for one specified sum without distinction as between principal and interest, and were purchased and subsequently sold by the taxpayer at a "flat" price. At the time of sale a substantial amount of interest amounting to $95,131.24 which had accrued subsequent to purchase was in default although an amount equal to the interest which had accrued prior to the dates the bonds were purchased had been paid to the taxpayer by the Trustee of the debtor corporation. These payments of interest that had accrued prior to the dates of acquisition were first applied as a reduction to taxpayer's basis for the bonds until the basis was reduced to zero, and thereafter all amounts received as interest were reported as ordinary income. The interest so reported as ordinary income amounted to $52,797.25.

When the bonds were sold the taxpayer treated the excess of the total proceeds of the sale of the bonds over their adjusted bases as long-term capital gain. The Commissioner determined that the full amount of the defaulted interest accrued since the dates the bonds were purchased was ordinary income to the taxpayer. A deficiency was assessed and paid by the taxpayer followed by an unsuccessful claim for refund and the filing of this action.

When bonds in default are purchased "flat" the amount of interest accrued and unpaid at the time of acquisition is a capital asset and when paid represents a return of capital and not a receipt of interest to be treated as taxable income. Receipt of interest accruing after the date of purchase of bonds in default is taxable income. See McDonald v. Commissioner, 6 Cir., 217 F.2d 475; National City Lines v. United States, 3 Cir., 197 F.2d 754; Commissioner v. Carman, 2 Cir., 189 F.2d 363; Clyde C. Pierce Corporation v. Commissioner, 5 Cir., 120 F.2d 206; Estate of Rickaby, 27 T.C. 886; Tobey, 26 T.C. 610; Shattuck v. Commissioner, 25 T.C. 416; Adrian and James, Inc., 4 T.C. 708; R. O. Holton & Co. v. Commissioner, 44 B.T.A. 202; Hewitt v. Commissioner, 30 B.T.A. 962.

The proper application of this rule requires the parties to treat all interest received which had accrued prior to the dates the bonds were purchased as a return of capital and to treat all interest received which had accrued subsequent to the date the bonds were acquired as taxable income. It therefore follows that the taxpayer erroneously reported the sum of $52,797.25 as ordinary income instead of treating this amount as a return of capital. And it also follows that such...