Ganey, Smith and Freedman, Circuit Judges.
The Commissioner of Internal Revenue seeks a review of the Tax Court's decision allowing the taxpayer*fn1 an ordinary deduction of $544,000 as a business bad debt for the year 1960. The issues posed are: (1) Was the taxpayer's leasing of coal lands to a corporation a business within the meaning of the Internal Revenue Code of 1954? And if so, (2) Was his pledging of a future award for the repayment of loans made by the corporation proximately related to that leasing business within the meaning of § 166(d)(2) of that Code?
The underlying facts are not in dispute. In 1953, taxpayer purchased tracts of coal and surface lands and coal mining structures and equipment located thereon in Lackawanna County, Pennsylvania. From that time to September 30, 1957, he engaged in the business of mining and selling coal from these lands as a sole proprietorship under the name Moffat Coal Company. In 1954, the Pennsylvania Turnpike Commission, by right of eminent domain, acquired title and possession of certain portions of that land, estimated to be worth over a million dollars.
In 1955, the taxpayer raised $3,000,000 by borrowing (a) $2,500,000 from a bank secured by a first mortgage on the lands and coal mining structures and equipment, and a security interest in the proceeds to be received by the taxpayer from the condemnation award, and (b) $500,000 from the Glen Alden Coal Company secured by a second mortgage on the same properties set forth under (a) above. In 1956, the Glen Alden Coal Company transferred the second mortgage to taxpayer's son and daughter for $400,000.
In 1957, to reward and retain the services of eighteen key employees by giving them an interest in the business, the taxpayer decided to form a corporation to take over the active operation of mining and selling the coal. On September 30, 1957, he formed the Moffat Coal Company, Inc., and transferred to it all of the structures, equipment, inventories and accounts receivable, but retained title to the lands and the coal reserves thereunder. The value of the assets transferred over the debts relating to that business was $880,000. The corporation issued 88,000 shares of stock in exchange for these assets, 58,000 of which were issued to the taxpayer and the remaining 30,000 were distributed among the eighteen key employees. Each of these employees executed a promissory note to the taxpayer in the amount of $10 for each share of stock received. At all times relevant hereto, the taxpayer was the majority stockholder and chairman of the board of the corporation.
On September 30, 1957, the taxpayer leased the coal lands to the corporation for a term of 51 years, plus such additional time as would be required to remove all the merchantable coal thereunder. In return the corporation agreed to pay all the taxes assessed against the land and a royalty of 50 cents for each ton of coal mined and shipped. The Royalty rate of 50 cents per ton was common in the area at that time. One month later the lease was amended to provide that the royalty would not be payable for any period in which the corporation was unable to meet all of its maturing obligations.
In December of 1957, the corporation borrowed $300,000 on a line of credit from the bank.
On January 2, 1958, taxpayer and his son and daughter organized a partnership under the name of Moffat & Company. The son and daughter contributed the second mortgage to the partnership in return for each receiving a 20% interest in the firm. The taxpayer conveyed to the partnership his title to the coal lands subject to the first and second mortgages. In return he received a 60% interest in the partnership.
From the time of its incorporation to the end of 1959, the corporation paid $832,790 in royalties.
During 1960, the corporation was unable to make payment on a series of loans, the balance of which amounted to $800,000, given by the bank. On February 4, 1960, the taxpayer gave his check for $200,000 to the corporation. The latter in turn paid its check in that amount to the bank. The amount was entered in the corporate books as a loan payable to the taxpayer and he was given a demand note. Similar treatment was accorded several other payments made later by him to the corporation in the aggregate of $180,000. Still later in that year, upon demand from the bank, the taxpayer paid the balance of $420,000 on the loans.*fn2 In this year the partnership, after receiving demand from the local taxing authorities, remitted $422,319 in taxes which the corporation had failed to pay over the years.
No dividend had ever been paid by the corporation and its stock became worthless in 1960. No payments were ever made on any of the notes given by the eighteen key employees and in 1961 they were canceled by the taxpayer and the shares of stock were returned to him.
The total of the payments made by the taxpayer to the bank on behalf of the corporation amounting to $800,000 was claimed by him in his income tax return for 1960 as a deduction for a business bad debt. The Commissioner of Internal Revenue disallowed the entire deduction on the determination that the debt was non-business in ...