Merchants Nat. Bank of Mobile v. Commissioner of Internal Revenue
199 F.2d 657, 42 A.F.T.R. (P-H) 749, 1952 U.S. App. LEXIS 4097 (1952)
Rule of Law:
When a national bank acquires stock from a liquidating affiliate and holds it as an investment awaiting market improvement, any loss upon its subsequent sale is a capital loss due to statutory prohibitions against banks engaging in stock sales. Recoveries on debts previously charged off as worthless and deducted from ordinary income are taxable as ordinary income under the tax benefit rule, irrespective of whether the recovery is through direct collection or sale to a third party.
Facts:
- In 1934, the Petitioner, a national bank, owned all the stock of Merchants Securities Corporation, which dealt in securities.
- Effective May 19, 1934, liquidation of Merchants Securities Corporation began due to the Banking Act of 1933, which prohibited such affiliations.
- Merchants Securities Corporation owned all the capital stock of Dorgan-McPhillips Packing Corporation, which it held for sale in its ordinary course of business.
- On March 31, 1937, upon completion of Merchants Securities Corporation's liquidation, the bank acquired the Dorgan-McPhillips Packing Corporation stock at an appraised value of $43,770.17 and held it for eventual sale, awaiting a more favorable market.
- The bank made no effort to sell the Dorgan-McPhillips Packing Corporation stock between 1937 and 1943.
- In 1941 and 1943, the bank held notes of Alabama Naval Stores Company, with an unpaid balance of $49,025.00, which it charged off as worthless at the direction of national bank examiners.
- In 1943, the bank sold the Dorgan-McPhillips Packing Corporation stock for $2,380.65, resulting in a loss of $41,389.52.
- In 1944, the bank sold the previously charged-off Alabama Naval Stores Company notes to a third party for $18,460.58.
Procedural Posture:
- The Commissioner of Internal Revenue issued deficiency assessments against the petitioner for its income taxes for the years 1943 and 1944.
- The Tax Court sustained the Commissioner's deficiency assessments.
- The petitioner filed a petition to review the decision of the Tax Court.
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Issue:
1. Does stock acquired by a national bank from a liquidating affiliate, which was originally held by the affiliate for sale in the ordinary course of its business but is subsequently held by the bank for years awaiting market improvement, constitute a capital asset for purposes of determining loss on its eventual sale? 2. Do recoveries on notes previously charged off as worthless and deducted from ordinary income constitute ordinary income or long-term capital gain for tax purposes, even when the notes are sold to a third party?
Opinions:
Majority - STRUM, Circuit Judge
1. No, the loss on the sale of the Dorgan-McPhillips Packing Corporation stock was a long-term capital loss, not an ordinary loss, because the stock was held by the bank as a capital asset. National banks are forbidden by law to engage in the business of selling stocks (12 U.S.C.A. § 378) and could only acquire such stock as an 'investment' (12 U.S.C.A. § 24). There was no evidence that the bank held the stock 'primarily' for sale in the ordinary course of its business. Instead, holding the stock for six years awaiting market improvement strongly indicated that the bank regarded it as a capital investment. The Commissioner's prior ruling to a different bank, even if similar, was factually distinguishable and therefore inapplicable; moreover, the Commissioner retains the power to overrule or modify a subordinate's ruling. 2. No, the recoveries on the Alabama Naval Stores Company notes constituted ordinary income, not a long-term capital gain. The rule is well-settled that when a deduction for worthless debts is taken and allowed, subsequent recoveries on those debts constitute taxable income for that year to the extent a tax benefit was received from the prior deduction. When the notes were initially charged off and the bank received a tax benefit by deducting the amount from its ordinary income, the notes were no longer considered capital assets for income tax purposes. To allow a capital gain treatment on the recovery would afford an unintended tax advantage. The court affirmed this principle citing Commissioner v. First State Bank of Stratford and Nat’l Bank of Commerce of Seattle v. Commissioner of Internal Revenue, emphasizing that the controlling factor is the original deduction from ordinary income, and the method of recovery (sale to a third party versus collection from the maker) does not alter this classification.
Analysis:
This case clarifies the tax treatment of assets held by national banks under specific circumstances, reinforcing the statutory limitations on a bank's ability to engage in activities like stock dealing. It emphasizes that a bank's conduct and legal restrictions define whether an asset is a capital asset or inventory, even if acquired from an affiliate whose primary business was trading. Crucially, the decision solidifies the application of the tax benefit rule, ensuring that recoveries on previously deducted worthless debts are consistently taxed as ordinary income, thereby preventing taxpayers from gaining an unwarranted double tax advantage. The ruling also underscores the Commissioner's authority to interpret and apply tax law, even in light of prior informal or subordinate rulings, particularly when factual distinctions exist.
