The opinion of the court was delivered by: MCVICAR
The above two actions against the Collector of Internal Revenue of this district are for the recovery of income taxes alleged to have been erroneously collected from the plaintiffs by the defendant. Both actions involve additional assessments made by reason of disallowance of bad debt deductions claimed in the taxpayers' 1936 income tax returns. In each case the obligation which gave rise to the bad debt deductions were obligations of Carbo-Oxygen Company which became partially worthless in the year 1936. Plaintiff, Sarah N. Benedum, held the Company's first mortgage bonds and the plaintiff, M. L. Benedum, held the Company's promissory notes secured by its first mortgage bonds, bonds acquired by purchase and a claim derived from payment as endorser of a Carbo-Oxygen Company note.
During some time prior to 1936, Carbo-Oxygen Company had been in financial difficulties. On December 31, 1934, it defaulted in the payment of interest then due on its first mortgage bonds, and in 1935 a receiver was appointed for the Company by this Court in proceedings instituted for the foreclosure of the mortgage given to secure its bonds. On May 1, 1936, Carbo-Oxygen Company, as debtor, filed its petition in this Court for a reorganization under Section 77B of the Bankruptcy Act, 11 U.S.C.A. § 207. On July 14, 1936 by final decree in said proceedings, this Court approved a Plan of Reorganization which the debtor had submitted with its petition and fixed August 1, 1936 as the effective date of the plan. Pursuant to the terms of said plan all assets of Carbo-Oxygen Company were transferred to a new Company, viz., Carbo-Oxygen Company, Inc. The preferred and common stocks of the new company were turned over to the trustee in the reorganization proceedings for delivery to the stockholders and creditors of the old company upon surrender of their stocks and claims. Both plaintiffs surrendered their obligations of the old company and in exchange therefor received the stocks of the new company in accordance with the Plan of Reorganization.
The facts are fully stated in the Findings of Fact made by the Court, which includes the stipulated facts made by the parties.
Are plaintiffs entitled to a bad debt deduction in their 1936 income tax returns by reason of the decrease in value of their Carbo-Oxygen Company indebtedness as determined in the Carbo-Oxygen Company reorganization proceedings?
The Revenue Act of 1936, 26 U.S.C.A.Int.Rev.Acts, pages 813, 828, provides:
'23(k) Bad Debts. Debts ascertained to be worthless and charged off within the taxable year (or, in the discretion of the Commissioner, a reasonable addition to a reserve for bad debts); and when satisfied that a debt is recoverable only in part, the Commissioner may allow such debt, in an amount not in excess of the part charged off within the taxable year, as a deduction.'
In McClain v. Commissioner of Internal Revenue (Helvering, Commissioner v. Thomson), 311 U.S. 527, 61 S. Ct. 373, 85 L. Ed. 319, the Supreme Court decided that Section 23(k) of the Revenue Act of 1934 was limited by Section 117 of said Act and that consequently losses resulting on the exchange of bonds must be treated as capital losses. See Bunker Hill and Sullivan Mining Co. v. Commissioner of Internal Revenue, 1 T.C. 1057.
Losses on loan and endorser liability of M. L. Benedum are deductible as debts determined to be partially worthless.
To the extent that plaintiffs' claims are represented by losses sustained upon exchange of securities of an insolvent corporation in connection with its reorganization such losses are recognized as bad debt deductions under the provisions of Section 112(l) of the Internal Revenue Code, 26 U.S.C.A. § 112(l).
Section 121 of the Revenue Act of 1943 amended the Internal Revenue Code by adding subsections, 112(b) and 112(l). These added provisions are as follows:
'112(b)(10) Gain or loss not recognized on reorganization of corporations in certain receivership and bankruptcy proceedings. No gain or loss shall be recognized if property of a corporation (other than a railroad corporation, as defined in section 77m of the National Bankruptcy Act, as amended) is transferred, in a taxable year of such corporation beginning after December 31, 1933, in pursuance of an order of the court having jurisdiction of such corporation --
'(A) in a receivership, foreclosure, or similar proceeding, or
'(B) in a proceeding under section 77B or Chapter X of the National Bankruptcy Act, as amended, to another corporation organized or made use of to effectuate a plan of reorganization approved by the court in such proceeding, in exchange solely for stock or securities in such other corporation.'
'112(l) Exchange by security holders in connection with certain corporation reorganizations.
'(1) General rule. No gain or loss shall be recognized upon an exchange consisting of the relinquishment or extinguishment of stock or securities in a corporation the plan of reorganization of which is approved by the court in a proceeding described in subsection (b)(10), in consideration of the acquisition solely of stock or securities in a corporation organized or made use of to effectuate such plan of reorganization.
'(A) to the extent that it was recognized or not recognized in the final determination of the tax of such person for such taxable year, if such tax was finally determined prior to the ninetieth day after the date of the enactment of the Revenue Act of 1943; or
'(B) in cases to which subparagraph (A) is not applicable, to the extent that it would be recognized or not recognized under the latest treatment of such exchange by such person prior to December 15, 1943, in connection with his tax liability for such taxable year.'
Subsection (B), Regulations 111, Sec. 29, 112(1)-2(b), provides in part:
'For the purposes of this section, such position must have been formally maintained by the taxpayer in his return, or amended by the taxpayer in his return, or amended return for the taxable year, in a claim for refund in a proceeding before a court or the Tax Court or the Board of Tax Appeals, or in some formal action taken in connection with the determination or proposed determination of his tax liability for such taxable year.'
It is clear under the stipulated facts, that the position taken by both plaintiffs is within the requirements of Section 112(l)(2)(B) and the applicable ...