Non-Negotiable Promissory Notes Are Not Capital Assets

By memorandum dated October 14, 1963, and bearing the symbols T:R:I-JCF-2, the Director, Tax Rulings Division, sent us a proposed ruling in the above case and invited our concurrence or comment. Representatives of this office also discussed various aspects thereof with Messrs. Driscoll, Utter, and Frasco of the Tax Rulings Division on December 17, 1963. The proposed ruling involves the question of whether or not any of the gain which an assignee of certain corporate notes would realize, in the event of a complete redemption and retirement thereof, should be treated as a capital gain.

Taxpayer’s counsel set out the basic facts giving rise to such question in an initial request letter of July 26, 1963, which was thereafter supplemented by two additional letters, dated August 13, 1963 and October 3, 1963. The proposed ruling letter summarizes substantially all of the most pertinent facts thereby developed in the following manner:

The administrative file also includes a direct representation on * * * behalf to the effect that he is not related to * * * in any manner other than through the relationship necessarily resulting from their common interest in * * * as hereinabove set forth. It further appears to be entirely proper to assume, for the purpose of considering the specific question presented by taxpayer’s counsel, that in the case of both * * * original issue of all the corporate notes initially made payable to * * * as well as the taxpayer’s subsequent purchase thereof at a time when the unpaid principal amounted to * * * there was a fully genuine, arms-length transaction which not only had a bona fide business purpose but was also entirely free from any element of personal accommodation, collateral reciprocity or the like.

The proposed ruling letter and the supporting memorandum associated therewith take the position that the nonnegotiable demand notes issued by * * * are not capital assets in the hands of * * * with the result that any and all amounts received on the contemplated redemption thereof will necessarily constitute ordinary income to him. This view is primarily founded upon certain statements contained in Judge Laramore’s opinion in the case of Wilkinson v. United States, 304 F.2d 469 (Ct. Cl. 1962) which we are unable to deem proper for application to the type of factual situation involved in the subject case. As a matter of fact, we believe that the result reached in the Wilkinson case turned on certain special features of the income under consideration therein which seriously undermine its value as a precedent for any general application in the subject field and that there are also certain unique aspects of the cited opinion therein which call for the exercise of extreme caution in seeking any judicial application of the particular statements quoted in the supporting statement where the factual situation involved is not substantially identical therewith.

It should be carefully noted that Judge Laramore’s opinion in the Wilkinson case was concurred in by Judge Durfee only and that it became the majority opinion with respect to the issues here pertinent solely because of the special concurrences of Chief Judge Jones and Mr. Justice Reed. Neither of these special concurrences accepted the views of Judge Laramore on which the proposed ruling appears to be at least primarily founded.

It is by no means clear from a reading of Judge Laramore’s so- called majority opinion in its entirety that he would have treated either the indirect collection or the sale of the choses in action under consideration therein as resulting in the receipt of ordinary income if he had not believed that the respective amounts thereby received or otherwise realized by the assignee-taxpayer were not primarily attributable to the rendition of personal services by both such assignee and the assignor in a common business enterprise. We are not prepared to maintain that Judge Laramore’s opinion is entirely clear in this respect but there can be no doubt that the final paragraph of the most pertinent discussion therein expressly emphasizes the fact that the accretion in the value of the contract right giving rise to the assignee’s receipt of income “was due mainly as the result of [such] taxpayer’s own efforts and the performance of his personal services.”

In our opinion, the general citation of Arnfeld v. United States, 143 Ct. Cls. 277, 163 F. Supp. 865 (1958) and Commissioner v. Phillips, 275 F.2d 33 (4th Cir. 1960) lend no substantial support to the position taken in the proposed ruling. Each of these cases can be readily distinguished from the subject case because of involving the sale of contractual right to receive ordinary income within a very short time prior to a date when the seller’s continued retention of such contractual right would have clearly resulted in his receipt of ordinary income. In both of these instances, the tax liability at issue was also that of the original owner of the basic contract right involved rather than that of any subsequent assignee thereof. Moreover, the total consideration received for the transfer was, in each case, only very little short of being equal to the full face amount of this basic contract right, so that there was ample justification for treating such consideration as essentially nothing more than a mere substitute for the aforesaid right to receive ordinary income in the future. See Commissioner v. P.G. Lake, Inc., 356 U.S. 260 (1958) on which each of these cited opinions (in the Arnfeld and Phillips cases) relied heavily.

The aforesaid “majority opinion” in the Wilkinson case, supra, contains certain references to Cotlow v. Commissioner, 228 F.2d 186 (2nd Cir. 1955) tending to suggest that this latter decision would support a broad general rule to the effect that any contractual obligation involving a payment for personal services, or the like, which would have been a non-capital asset in the hands of the original owner of the right to receive such income necessarily continues to have this same non-capital character in the hands of any subsequent assignee thereof. An examination of this Cotlow case does not bear out such suggestion, however, because it merely held that an individual who made a regular practice of purchasing rights to future insurance renewal commissions, and then proceeded to collect such commissions, was not entitled to report his profit thereon as a capital gain.

As a matter of fact, we read the court’s opinion in Cotlow v. Commissioner, supra, as saying that the holding hereinabove described was founded entirely upon the single undisputed showing that the collections Mr. Cotlow had made did not involve any sale or exchange of the renewal commissions or contract rights under consideration therein. This is of course, the precise point dealt with in section 1232(a)(1) of the 1954 Code. Subject to certain much more limited exceptions than those contained in the corresponding provisions of the 1939 Code, all of which are clearly inapplicable in the present case, such statute expressly provides that “in the case of bonds, debentures, notes, or certificates or other evidences of indebtedness, WHICH ARE CAPITAL ASSETS IN THE HANDS OF THE TAXPAYER, and which are issued by any corporation,” all amounts received on the retirement thereof “shall be considered as amounts received in exchange therefor.” (Emphasis supplied.)

Such statutory reference to evidences of indebtedness “which are capital assets in the hands of the taxpayer” naturally calls for consideration of section 1221 of the 1954 Code, which defines the term “capital asset” for the purposes of Subtitle A of the Code and provides, in part, that such term

The aforesaid provision for the exclusion from capital assets of any accounts or notes receivable which were acquired for services rendered was wholly new in the 1954 Code. It is, therefore, especially significant that the legislative history of both this provision and the closely related provision hereinabove quoted from section 1232(a)(1) thereof rather definitely suggests that this new exclusion was not intended to be applicable to any such accounts or notes which do not continue to be held up through redemption by a party who has acquired them in the manner specified in section 1221(4). See H. Rept. 1337, 83d Cong., at pp. 82, A-273, A-274 and A- 276 (1954) as well as S. Rept. 1622, 83d Cong., at pp. 111, 431 and 433.

With the sole possible exception of the aforesaid opinion on which Judges Laramore and Durfee agreed in the Wilkinson case, supra, we have been unable to find any precedent or authority for refusing to treat a wholly unconditional contractual obligation for the payment of money as a capital asset in the hands of a bona fide assignee thereof, merely because the original owner of such obligation initially acquired it by way of consideration for services.

The Supreme Court’s opinion in Commissioner v. P.G. Lake, Inc., supra, refers with apparent approval to G.C.M. 24649, C.B. 1946-1, 66, which discusses the proper tax treatment to be accorded to various assignments of declared dividends, and other rights to expected income from property or for services, where the original holder of the particular right in question has thereby effectively elected to anticipate his normal realization thereof. Immediately after first reaching the conclusion that the consideration received by an earner-assignor represents ordinary income in all the various different types of situations therein mentioned, such discussion includes the following statements:

As the foregoing quotation clearly suggests, the nature of the income which the purchaser-assignee of a given promise to pay a fixed or determinable amount of money will realize upon the final redemption thereof by the original obligor cannot properly be determined by reference to the character which such money would have had in the hands of the initial earner-assignor. In our opinion, each case arising in this area should be decided on the basis of its own facts, with due consideration being given to the inherent character which the particular money in question will have in the hands of the assignee at the time when he receives the same. See 3B Mertens, Law of Federal Income Taxation, secs. 22.12, 22.20, 22.32, 22.36, and 22.94 (Rev. ed. 1956) along with Rev. Rul. 60-284, C.B. 1960-2, 464 and Jaglom v. Commissioner, 303 F.2d 847 (2nd Cir. 1962).

In a given case, for example, the assignee should clearly be deemed to have realized ordinary income to the full extent that the amount ultimately collected from the obligor exceeds the consideration paid for the assignment, if the assignee makes a regular practice of buying and selling comparable obligations for the purpose of realizing a profit from this kind of business activities. For equally obvious reasons, we think that the entire amount which any assignee of an interest-bearing obligation succeeds in collecting with respect to interest accruing after the date of the assignment should certainly be treated as ordinary income.

We have found nothing in the subject file which any way tends to indicate that * * * has ever made a regular practice of buying and selling corporate obligations for profit. Assuming, therefore, that he has never been engaged in any such business and further assuming that the amount of the gain he will now realize on his original investment in the * * * notes now held by him can be readily segregated from the interest which will have accrued during the period of his ownership thereof, we believe such amount should be treated as received in exchange for assets constituting capital assets within the purview of section 1221 and 1232(a)(1) of the 1954 Code.

Before concluding these comments we would again like to stress that as a practical matter it would not be possible to reach the legal issue dealt with in the proposed ruling letter without first assuming that each of the various steps involved in the initial issuance, subsequent transfer, and proposed redemption of the * * * notes will have had a bona fide business purpose. In other words, it would not be possible, in our opinion, to draft any valid summary of the basic facts under consideration herein without including an express assumption to the effect that the real substance coincides with the outward form for each and every one of said transactions.

As hereinabove suggested, proceeding to issue any substantive ruling whatever at this time would thus seem to be tantamount to inferring that every pertinent factual aspect of this case has been fully and properly developed by * * * counsel. At the same time, however, it is reasonably obvious that there are a great many potentially relevant subjects, like the manner in which * * * and * * * have dealt with both * * * and each other during the last few years, which the administrative file, as presently constituted, does not even purport to develop in any specific terms. No information whatever appears to have been made available, for example, as to why the * * * notes were not initially issued in negotiable form or as to the extent, if any, to which this feature of such notes affected * * * purchase price for them. This same situation likewise seems to obtain about the extent to which the respective amounts of the various salary notes heretofore issued to * * * and his former wife have been treated as unallowable deductions under section 267 of the 1954 Code. And, by the same token, an unsettled status must certainly be assigned to the closely related question of whether * * * is now in a financial position to pay off the full principal amount of all its outstanding salary notes, together with the very substantial amounts of interest now due thereon, and accordingly contemplates redeeming at least the * * * notes on the same terms and at the same time as the * * * notes.

* * * position as the owner of a 60 percent interest in all the outstanding common stock of * * * would appear to provide him with ample opportunity to manipulate its corporate affairs to his own personal tax advantage. Under such circumstances, the question of whether or not the redemption of the * * * notes, when considered in the light of all his prior dealings with such controlled corporation, would actually involve sufficient manipulation to justify according special adverse tax treatment thereto would appear to be at least one of the major factors that would have to be considered in any final resolution of the question dealt with in the proposed ruling letter. Since a determination of the proper weight to be accorded this factor seems to be at least primarily one of fact, you may therefore wish to reconsider whether or not it would be advisable to withhold the issuance of any ruling whatever at this time in reliance upon Rev. Proc. 62-32, C.B. 1962-2, 527.

The administrative file is returned herewith.

Dear * * *

This is in reply to your letter of July 26, 1963, in which a ruling is requested on behalf of * * * with respect to a proposed redemption of certain promissory notes issued by * * *.

Briefly stated, the pertinent facts submitted in your letter are as follows:

* * * organized on * * * under the laws of the State of * * * is engaged in the business of exploiting certain patents covering a device designed to * * *. It maintains its books and records on the basis of a fiscal year ending July 31st. Its authorized capital stock consists of * * * shares of 5 percent cumulative preferred stock and * * * shares of common stock. * * * owns * * * shares of the preferred stock and * * * shares of the common stock. The remaining shares of the corporation are owned by * * *.

On August 1, 1958, the corporation retained * * * at its General Counsel and Secretary-Treasurer at a salary of * * * per annum. On July 31, 1959 the corporation gave * * * a nonnegotiable demand note for * * * bearing interest at 6 percent for the compensation owing to him. For the fiscal year ending July 31, 1960, * * * was paid only * * * of the total compensation to which he was entitled; and received three non-negotiable demand notes bearing interest at 6 percent for the balance of his compensation. On December 31, 1960, the corporation gave * * * another nonnegotiable demand note in the amount of * * * representing further compensation for services rendered by him after July 31, 1960. Therefore, as of December 31, 1960, * * * held notes issued by the Corporation in the aggregate amount of * * *. On January 9, 1961, * * * paid him * * * leaving a balance due of * * *.

Because of a disagreement with * * * resigned as Secretary- Treasurer of the Corporation on March 15, 1961, and ceased to serve as its general counsel. Since the corporation did not have a cash balance which would enable it to pay the nonnegotiable demand notes issued to * * *, he entered into negotiations with * * * with respect to the purchase of such notes. On June 28, 1961 * * * purchased the notes from * * * for * * * is now in a financial position to pay the balance due on the notes and proposes to redeem the notes by paying * * * to * * *.

In view of the foregoing, a ruling is requested that the gain to be realized by * * * on the proposed redemption of the notes will be taxable to * * * as long-term capital gain pursuant to the provisions of section 1232 of the Internal Revenue Code.

Section 1232(a)(1) of the 1954 Code provides, in pertinent part, that amounts received by the holder upon the retirement of bonds, debentures, notes, or certificates or other evidences of indebtedness issued by any corporation, government or political subdivision thereof, which are capital assets in the hands of the taxpayer shall be considered as amounts received in exchange therefor.

Section 1221 of the 1954 Code which defines a capital asset for Federal income tax purposes, reenacts section 117(a) of the 1939 Code with one change, the addition of paragraph 4 thereof. Paragraph 4 of section 1221 specifically excludes from the term “capital assets” accounts or notes receivable acquired in the ordinary course of trade or business for services rendered.

It is the position of the service that the nonnegotiable demand notes issued by the * * * are not capital assets in the hands of * * *. If * * * had retained the notes he would have received income for personal services taxable as ordinary income. The sale of the notes to * * * did not alter the inherent characteristics of the income so as to remove it from the realm of ordinary income when it is ultimately received.

See Ernest I. Wilkinson and Alice L. Wilkinson v. United States, (Ct. Cl. 1962) 304 F.2d 469. As to similar rationale in cases involving sales of insurance policies and annuity contracts see Arnfeld v. United States (Ct. Cl. 1958) 163 F.Supp. 865, cert. den. 359 U.S. 943; and Commissioner v. Phillips, (C.A. 4th 1960), 275 F.2d 33, rev’g 30 T.C. 866.

The primary issue present for our consideration involves the determination of whether the nonnegotiable promissory notes issued by * * * are capital assets in the hands of * * *. We have taken the position that the sale of notes issued by a corporation for services rendered by an employee which under section 1221(4) of the Code do not qualify as capital assets, do not change their character by reason of sale to a third party. We contend that in selling his notes to * * * the seller, * * * sold his right to receive ordinary income and that a sale of a right to receive in the future ordinary income already accrued produces ordinary income rather than a capital gain.

The Courts have consistently held that the capital gain limitation “has always been narrowly construed”, and that it applies to a “conversion of capital investments”, and not to a conversion of future income. In the case of Corn Products Refining Company v. Commissioner, 350 U. S. 46, involving commodity futures, the Supreme Court has stated that the “preferential” treatment of capital gains “is an exception from the normal tax requirements of the Internal Revenue Code”, and that “the definition of a capital asset must be narrowly applied and its exclusions interpreted broadly”.

In our proposed ruling letter we have cited the case of Wilkinson v. United States, 304 F.2d 469, as one of the authorities for holding that the notes in the hands of * * * are not capital assets and the provisions of section 1232 have no application when the notes are paid off by the corporation. In the Wilkinson case the taxpayer, after purchasing part of Captain Raymond T. Bonnin’s contract right to receive legal fees, later sold part of these rights. The Court held that the taxpayer who purchased assignment of contract rights to amounts which might become due to assignor for services rendered and who sold this right at a profit was taxable on profit as on ordinary income, rather than as on capital gain. The Court stated at page 473, in part, as follows:

Recognizing the possibility of a tax loophole arising from such transactions the Court stated at page 474, in part, as follows:

The facts in the cases involving the sale of insurance and annuity contracts differ to the extent that such sales constituted the sale of capital assets. The Service has taken the position in such transactions that the sale cannot be held to convert what would in time constitute ordinary income into capital gain. In the * * * case the Court stated that it is illogical to assume that Congress intended to permit, even through the medium of a bona fide sale, the conversion of what is the equivalent of ordinary income into a capital gain.

Should your office conclude otherwise, your comments and views are requested as to whether the proceeds to be paid by the corporation will constitute a dividend to * * *. It should be noted that the taxpayer and his representatives are entitled to a conference in the event of an adverse ruling. As indicated in the conference reports contained in the administrative file, previous conferences held on this case were with respect to the issue of whether a ruling should be made by the National Office in view of the facts involved herein.