Opinion
Docket No. 4292.
1946-04-25
RECORD REALTY COMPANY, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.
Harvey H. Berger, C.P.A., for the petitioner. William F. Robinson, Esq., for the respondent.
Petitioner's only asset, apartment house property, was mortgaged to secure bonds. Petitioner defaulted in the payment of interest on the bonds and principal. The indenture trustee instituted foreclosure proceedings and a state court entered a decree for foreclosure. That decree was permanently stayed by a Federal District Court, which approved a plan of reorganization of petitioner under section 77-B of the Bankruptcy Act. The approved plan of reorganization resulted in extension of the bonds and the mortgage for 10 years and cancellation of part of petitioner's indebtedness for accrued interest, inter alia. Expenses of the reorganization were less than the amount of the canceled indebtedness. Held, that the expenses of the indebtedness and could not, therefore, be amortized over the 10-year period of the extension of the bonds, as petitioner contends. Horn & Hardart Baking Co., 19 B.T.A. 704; S. & L. Building Corporation, 19 B.T.A. 788, distinguished. Harvey H. Berger, C.P.A., for the petitioner. William F. Robinson, Esq., for the respondent.
The respondent determined that there is a deficiency in income tax liability for the year 1941 in the amount of $736.69. The deficiency results from several adjustments, but only one remains in dispute, the disallowance of a deduction of $1,815.99 which is a pro rata part of expenses in the total sum of $10,934.31. The expenses were incurred in promulgating and consummating a plan of reorganization pursuant to proceedings under section 77-B of the Bankruptcy Act, as amended.
Petitioner filed its return with the collector for the district of Michigan.
The proceeding has been submitted on stipulated facts together with joint exhibits.
FINDINGS OF FACT.
Petitioner is a Michigan corporation, organized in 1935. On February 17, 1936, petitioner acquired the title, under a deed, to an apartment house and the realty, the property being known as Roselawn or Roselan Apartments, located in the city of Highland Park, near Detroit. In 1927 first mortgage 6 1/2 percent bonds had been issued against the property in the principal amount of $375,000, which were secured by a trust mortgage. James I. D. Straus was the trustee under the trust indenture. The maturity date of the bonds was March 1, 1937. Petitioner's only asset consists of the above property and the furniture and fixtures in the apartment building. Petitioner acquired the above property subject to the first mortgage and a second mortgage.
The original mortgagors defaulted in the payment of principal and interest and on other obligations under the trust indenture in 1931. The defaults continued. James I. D. Straus instituted proceedings at some time prior to October 9, 1935, to foreclose the mortgage, as he had a right to do under the trust. On October 9, 1935, the Circuit Court for Wayne County, Michigan, entered a decree for foreclosure. The decree recited that $466,604.69 was due for principal, interest, and income tax payments, and other amounts for fees of the trustee and the costs of the foreclosure, making a total of $470,604.69. The decree provided that unless the amounts due were paid the mortgaged property should be sold at public auction.
At the time petitioner acquired the property and assumed the mortgage there was in default all interest due from March 1, 1931. The total amount of bonds outstanding was $364,000, $11,000 of bonds having been paid in 1930. Certain sinking fund payments having been made in the amount of $3,848.41, the balance owing on the principal of outstanding bonds was $360,151.59.
In 1931, after the first defaults, the management of the property was put in the Standard Management Co., and the net income was turned over to the indenture trustee under an assignment of rents. The indenture trustee had the right to receive rents in the event of a default under the trust indenture, and he exercised that right in 1931. Since 1931 the management has been by Standard Management Co., and rents have gone to the indenture trustee under an assignment of rents.
On April 14, 1937, petitioner filed a voluntary petition for a reorganization in the United States District Court in the Eastern District of Michigan, for the purpose of effecting a reorganization under section 77-B of the Bankruptcy Act, as amended. In the petition Record Realty Co. declared that as a result of the depression the earnings of apartment buildings in the city of Highland Park had been greatly impaired; that it (Record Realty) had not been earning sufficient moneys to discharge its matured obligations under the mortgage, in addition to its operating expenses, taxes, and interest on the mortgage indebtedness; that by reason thereof, Record Realty was in danger of losing its property unless the payments called for by the mortgage and bonds and coupons could be adjusted by a reorganization; and that Record Realty was insolvent and unable to meet its debts as they matured. It was stated also, that the debtor, Record Realty, had held conferences with the bondholders' protective committee representing the bondholders under the first trust; that a plan of reorganization involving a readjustment of the principal and interest had been prepared, and had been approved by the Michigan Public Trust Commission; that the rents were being paid to James I. D. Straus, trustee under an assignment of rents. The debtor asked that its petition be approved and that it be permitted to remain in possession of the premises.
On April 14, 1937, the District Court approved the debtor's petition under section 77-B, and ordered that the Standard Management Co. should continue to operate and manage the property, that it should use the net income, after operation expenses, to pay the costs of mailing notices in the 77-B proceedings, and to pay taxes; and that it should deliver the remainder of the net income to Straus, as trustee, for the purposes of the mortgage; and that all money received should be deposited in the Detroit Bank of Detroit in an account entitled ‘Roselawn Apartments Bond Issue Trust Account.‘ The order of the District Court enjoined all stockholders, creditors, and persons from levying upon the property or in any way interfering with the possession of the debtor, and from bringing any new suits against the debtor. The order of the court continued petitioner in possession, subject to the managing arrangement.
On May 10, 1937, the District Court confirmed the above order and continued the arrangements set forth above.
In conjunction with the debtor's petition, a plan of reorganization was filed on October 22, 1937, in the District Court by petitioner, as the debtor, and by the bondholders' protective committee. The District Court entered its order confirming the plan of reorganization on March 15, 1939.
The plan provided that the assignment of rents should continue; that Equitable Trust Co. of Detroit should be appointed successor trustee under the trust indenture; that the debtor owed no other debts than those secured by the trust mortgage; that reorganization expenses, other than fees of the debtor's attorneys and unpaid fees of the original indenture trustee and his attorney, incurred prior to the institution of the 77-B proceedings, as fixed by the court, should be paid in cash; that when the plan was consummated the bonds, properly stamped, would be returned to the bondholders without expense to them for any committee fees or other charges.
The plan recited that there was an unpaid principal amount of bonds of $360; 151.59, after giving effect to certain ‘frozen‘ sinking fund payments. It provided that a cash payment of $51.59 should be made in order to bring the unpaid principal to even figures of $360,100. It provided, further, that $36,000 of bonds would be canceled, with all accrued interest, in exchange for the debtor's (petitioner's) unsecured note bearing interest at 4 percent, payable March 1, 1947. The cancellation of $36,000 of bonds would reduce the unpaid principal amount of the bonds to $324,100. The plan provided that the maturity date of the outstanding bonds should be extended to March 1, 1947, a period of 10 years; that normal interest from September 1, 1936, should be reduced from 6 1/2 percent to 4 percent per annum for the entire extended period; that, instead of computing past due interest from March 1, 1931, to September 1, 1936, at the rate of 6 1/2 percent, the interest for such period should be computed on a straight interest basis of 1 percent; that past due interest so computed would amount to $39,616.67, and that all interest and interest on interest and all income tax thereon in excess of 2 percent for such period should be canceled; that one-fifth of the sum of $39,616.67 should be paid in cash, leaving $31,600 unpaid; that the $31,600 should be deemed secured by the trust mortgage; and that the time of payment, without interest or income tax thereon, should be extended to March 1, 1947. The cancellation of $36,000 of bonds, referred to above, reduced the deferred recomputed interest from $31,600 to $28,440.
The plan made other provisions which need not be set forth.
The plan was approved, with slight modifications, and was put into effect August 2, 1937.
On March 16, 1939, James I. D. Straus resigned as indenture trustee, and Equitable Trust Co. was appointed successor trustee by order of the District Court on April 17, 1939. In this order the District Court permanently stayed the decree of the Circuit Court of Wayne County entered October 9, 1935, and directed Equitable Trust Co., as successor trustee, to become substituted as plaintiff in those proceedings and to enter its appearance therein. The order of the District Court stated: ‘ * * * it being hereby determined that the bonds and coupons covered by said decree have not, are not, and will not be, affected by said Decree, but as and to the extent contemplated by Debtor's Plan of Reorganization confirmed herein, shall be secured by said trust Court's order also required the holders of the Roselan Apartment bonds to present them to Equitable Trust Co.
On March 15, 1939, the District Court entered its order confirming and approving the plan of reorganization. In this order the court found that the debtor, petitioner, was insolvent. The court found that the creditors affected by the reorganization were the holders of the outstanding bonds and coupons attached, excepting the $36,000 of bonds referred to above, and the holders of the $36,000 of bonds who were to receive the debtor's note in lieu of the bonds. The court determined that the debtor, as reorganized, was to pay taxes to become due without requiring proof under the proceeding, but that nothing was to give priority to taxes or any lien therefor superior to the trust mortgage nor over the chattel mortgage (covering furniture and fixtures), nor priority over the superior rights of the trustee and bondholders under the assignment of rents contained in the trust mortgage; that the cancellation of $36,000 of bonds and the giving of an unsecured promissory note therefor, due on March 1, 1947, was approved; and that all amounts ‘to be paid by the Debtor for services and expenses incident to the reorganization under said Plan, and all sums owing to the Trustee under said trust mortgage, and to the attorney for the said Trustee, for unpaid fees and expenses thereunder prior to and after the institution of the proceedings herein, are to be fixed by the court herein and to be paid in full in cash.‘ The court also approved an option given to the indenture trustee, to last for two years, until March 1, 1941, to purchase $20,000 of bonds at 37 percent of the par value.
On December 30, 1940, the District Court entered an order approving the indenture trustee's report and account and approving and allowing expenses, fees, and fees of attorneys. On the same date the final decree of the District Court was entered approving the report of the debtor on the consummation of the plan of reorganization, declaring the plan fully carried out, and discharging Record Realty Co. from all of its debts except as provided in the plan of reorganization.
In connection with promulgating and consummating the plan of reorganization, expenses were incurred in the total amount of $10,934.31, of which $479.70 was paid by James I. D. Straus, as original indenture trustee, and $10,454.61 was paid by Equitable Trust Co., successor indenture trustee. These amounts were paid out of the cash income of the Roselan Apartments, out of funds in the possession or control of the trustee. All of the expenses were incurred and paid prior to 1941. The expenses consisted of fees of the attorneys for the bondholders' protective committee; expenses of the committee, printing costs, fees of the indenture trustees, etc.
Petitioner keeps its books and reports its income on the accrual method of accounting. Petitioner carried the above $10,934.31 of expenses on its books as deferred charges with the view of amortizing them over the extended life of the bond issue. In accordance with this plan, petitioner deducted $1,815.99 in its return for 1941 as ‘Amortization of Refinancing Expense.‘ Respondent disallowed the deduction on the ground that ‘disbursements made in connection with the receivership are not deductible.‘
OPINION.
HARRON, Judge:
The question is whether expenses in the total sum of $10,934.31, which were incurred in preparing and consummating the bondholders' and debtor's plan of reorganization and in filing and carrying through petitioner's voluntary petition for a reorganization under section 77-B of the Bankruptcy Act, as amended, are the type of capital expenses which may be spread over a fixed period and deducted in annual, proportional amounts, over such period. Petitioner contends that, for tax deduction purposes, it is entitled to spread the expenses over the extended period of the bond indebtedness, which ends on March 1, 1947. Under such plan of amortization of the expenses, petitioner claims that it is entitled to deduct $1,815.99 in the taxable year.
In support of its general contention, petitioner contends that the expenditures in question were paid by or for petitioner and that the expenses were incurred ‘in refinancing a mortgage bond issue.‘ Under petitioner's description of the expenses as expenses of refinancing its bonds, petitioner argues that there should be applied to these expenses in this case the rule expressed in Horn & Hardart Baking Co., 19 B.T.A. 704, 706, under issue 2 of that case, where it was held that commissions paid to a firm of investment brokers for selling bonds of the taxpayer were capital expenses rather than currently deductible business expenses, and that such expenses should be spread over the life of the bonds. Petitioner, in its supplemental brief, also cites S. & L. Building Corporation, 19 B.T.A. 788, 795, 796; affd., 288 U.S. 406, on another point, and relies upon the holding made in that case under issue 1.
The facts and the contentions of the parties have been clarified by the filing of a supplemental stipulation of facts, together with additional joint exhibits, and supplemental briefs.
Respondent recognizes that no receiver was appointed in the 77-B proceedings, but that petitioner was left in possession of its property, subject to an existing arrangement under which the property was managed by a management company and subject to an assignment of rents to the indenture trustee. From this it appears, and there is no evidence to the contrary, that petitioner reported the rents from the property in its income tax returns during the years in which the 77-B proceedings were pending. This is noted to make it clear that, as we understand the situation, there was no filing of a return by a receiver to report the income earned by the property during that period (see 415 South Taylor Building Corporation, 2 T.C. 184), so that, if any deductions are allowable under petitioner's theory, petitioner is the proper person to claim the deductions because it was reporting the income therefrom in returns which it was required to file. See H. W. Clark Co., 1 T.C. 891.
Respondent contends, on supplemental brief, that the expenses in question were not expenses of refinancing the mortgage debt of petitioners, as it contends, but were expenses of a reorganization; that such expenses of reorganization are in the same class as expenses of organization; and that, since organization expenses are capital expenses which can not be amortized ratably over a definite period, the reorganization expenses, likewise, can not be amortized ratably over a definite period. Respondent cites Hershey Manufacturing Co., 14 B.T.A. 867, 877
(and cases cited therein); Surety Finance Co. of Tacoma, 27 B.T.A. 616, 620; affd., 77 Fed.(2d) 221; and Morris Plan Bank of Cleveland, 31 B.T.A. 253, 255, as the authorities which provide the rule to be applied here. He contends that Horn & Hardart Baking Co., supra, is distinguishable, and does not control the question presented. He argues that the rule expressed in Julia Stow Lovejoy, 18 B.T.A. 1179, which was relied upon by the Board of Tax Appeals in the Horn & Hardart Baking Co. case, is not applicable nor controlling here; that the Lovejoy case is distinguishable; and that the voluntary filing of a petition for reorganization under section 77-B was not primarily to obtain a new loan or an extension of the foreclosed mortgage, but was simply a proceeding authorized by statute and utilized by petitioner to save its investment and its property. Respondent argues, further, that the expenses in question were paid exclusively for and on behalf of the bondholders, and not the petitioner; that petitioner had lost control of the property and held a bare legal title; and that the expenses were paid out of a trust fund held by the indenture trustee, and so it is open to question whether the expenses were paid by or for petitioner.
Hershey' Manufacturing Co., 14 B.T.A. 867, was affirmed in part and modified on the issue for which it is cited by respondent, 43 Fed. (2d) 298, 300; but no further action was taken by the parties on the point which was remanded, and the Board of Tax Appeals respectfully declined to follow the Circuit Court's view, but applied the rule stated in the Hershey case before the Board, in Surety Finance Co. of Tacoma, supra, at p. 620.
The pertinent facts, in our opinion, include the following: At the time petitioner acquired the fee title to Roselan Apartments on February 17, 1936, the mortgage bonds were in default and the Circuit Court of Wayne County had entered a decree for foreclosure on October 9, 1935. The due date of the bonds was March 1, 1937. On April 14, 1937, petitioner filed a voluntary petition for reorganization under section 77-B in the District Court. The only creditors affected were the holders of the bonds. The plan of reorganization provided for extension of the foreclosed mortgage and of the bonds for a 10-year period to March 1, 1947. When the plan of reorganization of petitioner was approved, the mortgage was reinstated and extended, the maturity date of $324,100 of bonds was extended, unpaid past-due interest was canceled in part, and the rate of future interest was reduced. While the principal amount of the bonds was reduced, to the extend of $36,000, petitioner's indebtedness was not thereby eliminated in that amount because it gave its note for $36,000, but the cancellation of past-due interest in excess of $39,616.67 represented elimination of part of the petitioner's indebtedness in an amount which has not been stated in this record.
The record does not show the amount of accrued and unpaid interest on the bonds. The interest, at 6 1/2 percent, on $360,000, principal, is $23,400 per annum. The unpaid interest for the period of 5 years and 6 months from March 1, 1931, to September 1, 1936, would be $128,700. The difference between $128,700 and $39,616.67 is $89,083.33, and the interest canceled may have been in about that amount.
As petitioner contends, Horn & Hardart Baking Co., supra, does stand for the proposition that the costs of placing a mortgage should be amortized over the life of the mortgage. In the instant case, however, the reinstating of the mortgage and the extension of the maturity date of the bonds were not the only results attained through the expenditure of the sum here involved. The bond indebtedness, which was secured by the mortgage, was reduced by $36,000, and petitioner's indebtedness on past due interest, which was also secured by the mortgage, was canceled in part. The exact amount canceled is not shown by the record. Also, the obligation of petitioner for future interest was reduced from 6 1/2 percent to 4 percent. Also, petitioner was given to a 10-year extension of time within which to pay the uncanceled past due interest in the amount of $28,440. The cancellation of part of the past due interest, which may have been as large as $89,000 (even figure), was an important result of the proceedings under section 77-B of the Bankruptcy Act, as amended. It appears that petitioner could not have continued to carry the property unless part of its accrued and unpaid obligations has been canceled. Petitioner could not have kept title to the property unless its defaults under the trust mortgage had been cured under the plan of reorganization under the 77-B proceedings. A decree for foreclosure of the mortgage had been entered and the property would have been sold at public auction unless the decree for foreclosure had not been permanently stayed by the District Court under the 77-B proceedings.
Therefore, we think petitioner oversimplifies the question in contending that the expenses in question are in a class with title fee expense, and such, which have been referred to as ‘mortgage fees.‘ Petitioner overlooks the fact that the expenses in question, in the total amount of $10,934.31, were offset by the amount of the canceled indebtedness consisting of interest, which was, apparently, in excess of $10,934.31.
The expenses were paid in cash out of current receipts from rents under orders of the District Court which released, in all, $10,934.31 of receipts from rents from the claims of the bondholders and the priorities of the trust indenture. If the District Court's orders had not directed that such total amount of receipts from rents could be used to defray the costs of the reorganization, that amount could have gone to bondholders in some way to be applied to their claims. The entire plan of canceling part of petitioner's indebtedness and of extending the payment of the uncanceled part of the debt had to take into consideration the earnings of the property, the available cash on hand, and the assignment of rents to the trustee. Under the most practical view, the savings in dollars to petitioner by the cancellation of part of its debt was a net amount over and above the expenses of carrying out the plan and getting the plan approved; and the offsetting of the expenses against a larger sum representing canceled debt left no amount of the expenses to be amortized over future years. It is so held.
The reorganization under section 77-B was completed in 1940. Petitioner reports its income on the accrual basis of accounting. Whatever may be necessary with respect to making any possible adjustments as a result of the 77-B reorganization, such adjustments must be made for the year of 1940. The taxable year before us is 1941. Under the holding made above, no part of the expenses in question can be deducted in 1941.
Decision will be entered for the respondent.