operations. On June 21, 1935, Southern received a $1,000 liquidating dividend on the 1,000 shares of National stock. The $20,000 note given by Southern to Josey for the 1,000 shares of National stock was an interest-bearing note and interest was paid thereon until March 4, 1936, after which date Southern did not pay any interest on the note. On or about March 1, 1936, Southern asked Josey to surrender the note in exchange for the stock, but Josey was unable to do so at that time for the reason that the note was pledged by him as collateral with a bank. As soon as the financial affairs of Josey permitted, he got the bank to release the note as collateral and thereupon, on February 1, 1938, Southern notified Josey of its intention to exercise the option contained in the original agreement between the parties, whereupon Southern delivered and transferred to Josey the 1,000 shares of National stock originally purchased from him on September 4, 1929, and on the same date, and as a part of the same transaction, Josey canceled and delivered back to Southern the $20,000 note originally given by Southern as purchase price of the stock. The 1,000 shares of the capital stock of National were worthless at the time Southern received its $20,000 note back from the seller of the stock. Southern, on its income tax return for the taxable year ended December 31, 1938, returned as income the amount of $1,900 representing the liquidating dividends which it had received and which had been credited to cost of the 1,000 shares of National stock in 1933 and 1935. Respondent in his deficiency notice determined that an additional amount of $20,000 should be returned as income from the cancellation of the Josey note originally given by Southern as purchase price of the 1,000 shares of the National stock. For the taxable years 1934 to 1936, inclusive, Southern's Federal income tax returns show net losses as follows: 1934 1936_ $2,646, 215. 40 21, 853. 61 For the taxable year 1937 Southern's Federal income tax return showed net income $4,029.19, with respect to which a tax was paid in the amount of $683.43. For the taxable years 1931, 1932, and 1933 Southern was included in the consolidated returns of its parent, Jesse H. Jones Co. Such consolidated returns for 1931 showed no net income, and for 1932 they showed a net loss of $1,396,600.08. No sub. stantial adjustments were made by respondent for the years 1931 to 1936, inclusive. Southern realized no taxable gain on the redelivery to Josey in 1938 of the 1,000 shares of National stock in exchange for its $20,000 note, except the $1,900 representing liquidating dividends, which it duly reported as income. Issue No. 2.-Another of the adjustments to net income of Southern for the year 1938 was an addition thereto of $75,000 which the respondent called "(e) Capital loss" and explained as follows: (e) The amount of $75,000 claimed by you as a bad debt and deducted from gross income in your return is disallowed since it represents a payment made by you within the taxable year upon your own obligation voluntarily assumed. In 1928, 1929, 1930, and 1931 Southern owned the capital stock of the Fort Worth Properties Corporation. In 1928 the Fort Worth Properties Corporation owned certain land in Fort Worth, Texas, upon which Southern was constructing what was later known as the Fort Worth Electric Building and Theatre. * On October 12, 1928, a written contract was entered into between J. W. Colvin of Houston, Texas, as first party, and Jesse H. Jones of Houston, as second party. Jones was acting on behalf of Southern "and/or those affiliated companies owning and building the Electric Building in Fort Worth, Texas This contract was later modified by written agreements dated February 9 and July 3, 1929. Pursuant to these three agreements: (1) A new corporation, named Fort Worth Electric Building Co., hereinafter sometimes referred to as the Electric Co., was organized under the laws of the State of Texas; (2) Fort Worth Properties Corporation paid in the entire capital stock of the Electric Co.; (3) Southern during 1929 sold the Fort Worth Electric Building and Theatre to the Electric Co. for $1,500,000 first mortgage bonds of the Electric Co., on which Southern realized $1,380,000 cash during 1929, after paying $120,000 commission to an investment broker; (4) Fort Worth Properties Corporation sold part of the land on which the Fort Worth Electric Building and Theatre was built to the Electric Co. for $500,000 par value series A bonds and $100,000 par value series B bonds of the Electric Co., and it leased the remainder of the land on which the Fort Worth Electric Building and Theatre was built to the Electric Co. for $30,000 per annum; and (5) Colvin for a cash consideration of $200,000 paid to Fort Worth Properties Corporation, received, together with other considerations, the entire capital stock of the Electric Co., $150,000 par value series A bonds, and $100,000 par value series B bonds of the Electric Co., and an option to acquire for $600,000 the fee to that part of the land under the Fort Worth Electric Building and Theatre which was leased by the Electric Co. Thereafter Colvin became dissatisfied with what he had received and a controversy arose between Southern and Colvin, with the result that on February 28, 1931, Southern, Fort Worth Properties Corporation, and Colvin entered into a written agreement, hereinafter Sometimes referred to as the three-party agreement, supplemented by O written agreements of the same date between Southern and Colvin. hereinafter sometimes referred to as Exhibit A and Exhibit B, re spectively. Pursuant to these agreements: (1) Fort Worth Proper ties Corporation, which owned $350,000 par value series A bonds of the Electric Co., transferred $200,000 par value thereof to Colvin, who transferred to Fort Worth Properties Corporation all the capita stock of the Electric Co., $100,000 series B bonds of the latter com pany, and one-half interest in a theatre lease and certain equipment and (2) Fort Worth Properties Corporation canceled $150,000 par value series A bonds and the $100,000 par value series B bonds of the Electric Co. which it received back from Colvin. Paragraphs eighth and ninth of the three-party agreement were as follows: Eighth Southern, for value received, agrees to execute to and with Colvin agreements for the purchase of Series A bonds and to establish and maintain a line of credit for Colvin, his heirs or estate,-such agreements to be executed in the form of those hereto attached marked "Exhibit A" and "Exhibit B", respectively. Ninth Colvin and Jesse H. Jones, acting for himself and companies or corporations owned or controlled by him, executed a certain agreement dated October 12, 1928, and a supplement or amendment thereto dated February 9, 1929, and a further supplement or amendment dated on or about July 3, 1929,-all having reference or being related to dealing with the properties of Electric Company, reference being here made for all purposes to said original contract of October 12, 1928, and any and all amendments or supplements thereto irrespective of whether same are hereinabove mentioned or identified. Part of the consideration for the execution of this instrument is the cancellation and full release of said contract of October 12, 1928, and any and all amendments or supplements thereto; hence, Colvin hereby agrees that said original contract, and the amendments or supplements thereto are hereby fully discharged, canceled, rescinded and set aside and all parties thereto are fully, finally and unconditionally released and discharged from any and all liability thereunder, and Colvin hereby waives and releases all claims for losses or damages and all causes of action, if any, of any and every kind or character which he has, had or may have against Jesse H. Jones and/or any of those corporations for which Jesse H. Jones was acting in making said original contract of October 12, 1928, and all amendments or supplements thereto. Exhibit A referred to in the three-party agreement was an agreement reciting that Colvin was the owner of $350,000 of series A bonds of the Electric Co. and that Southern agreed to purchase such bonds, $15,000 par value on or before March 2, 1932, an additional $15,000 every year thereafter until and including March 2, 1945, and the balance on or before March 2, 1946. It was also provided that these purchases could be made in advance of Southern's obligation to purchase. Exhibit B referred to in the three-party agreement was an agreement wherein Southern agreed to establish and maintain for a period of five years an unconditional line of credit for "Colvin, his heirs or (364) MAIN PROPERTIES, INC. 371 Estate, and/or any companies or corporations owned or controlled by him" up to $150,000, on condition that any loan made be secured by a pledge of series A bonds of the Electric Co. in a par value amount of one and one-third times the amount of any loan made. In April 1931 Colvin transferred to Fort Worth Properties Corporation $100,000 par value series A bonds of the Electric Co. in consideration of his release from liability for his one-half of losses on the theatre lease. This transfer left Colvin with $250,000 series A bonds. On June 10, 1931, Texas Investors, Inc., a corporation controlled by Colvin, obtained from the National Bank of Commerce of Houston, Texas, hereinafter sometimes referred to as the bank, the sum of $150,000, executing a note endorsed by Colvin, guaranteed by Southern, and secured by Colvin's series A bonds in the face amount of $200,000. The series A bonds of the Electric Co., if not worthless on February 28, 1931, were worthless in 1934 or prior thereto. On June 5, 1934, all of the properties of the Electric Co. were sold at public auction, pursuant to foreclosure decree to the first mortgage bondholders' committee, for $300,000, and immediately thereafter the first mortgage bondholders transferred the assets to a new corporation, Electric Properties, Inc., for all the capital stock of the new corporation. Since the first mortgage bonds amounted to $1,500,000, there were no assets to be applied against the series A bonds. Likewise, Fort Worth Properties Corporation was insolvent in 1934 or prior thereto. Southern, during the years 1932, 1933, and 1934 and prior to November 25, 1935, purchased the $15,000 par value series A bonds per year it had agreed to purchase in accordance with Exhibit A referred to above, and $7,500 of the amount paid was applied on the $150,000 note referred to above, leaving a balance due on November 25, 1935, of $142,500 and leaving $190,000 face amount of series A bonds in the possession of the bank. On May 11, 1932, Metropolitan Properties Corporation, a corporation controlled by Colvin, had entered into an agreement with Southern in regard to Southern's liability to Metropolitan Properties Corporation under an operating agreement entered into prior to 1932, and thereafter on November 25, 1935, a final settlement of such liability was agreed upon. As a part of the consideration for this final settlement contract and on the same date, four agreements in the form of four letters were entered into. The body of the first letter, dated November 25, 1935, from Southern to Texas Investors, Inc., was as follows: This is to evidence our agreement that the undersigned has this day purchased from you for $145,775.00 all of the Second Mortgage Series A Bonds of Fort Worth Electric Building Company pledged as collateral to secure your note at The National Bank of Commerce of Houston maturing December 1, 1935, for the principal sum of $142,500. Of the consideration aforesaid $13,275.00 has this day been paid to you by the undersigned and $10,000 applied by you on your note at said Bank, the balance on your note having been renewed for ninety (90) days from the date hereof. You agree upon the interest being paid in advance upon said bank note by Southern Loan & Investment Company to renew the same from time to time for the convenience of Southern Loan & Investment Company over a period of the next eighteen months on or before the expiration of which time full payment for the purchase price of said bonds will be made to you by the undersigned and paid by you to the Bank in liquidation of your note. The body of the second letter, dated November 25, 1935, from Southern to the bank was as follows: The undersigned at present is a guarantor of an obligation held by you in the amount of $142,500.00 executed by Texas Investors, Inc. and endorsed by J. W. Colvin of Houston, Texas. This will authorize you to release J. W. Colvin and Texas Investors, Inc. from any personal liability on said note or any renewal or extension thereof without effecting in any way the liability of the undersigned on its present guarantee to you. The body of the third letter, dated November 25, 1935, from Jesse H. Jones & Co. to the bank was as follows: Southern Loan & Investment Company has this day authorized you to release from personal liability J. W. Colvin and Texas Investors, Inc. on a certain note in the amount of $142,500 held by you and executed by Texas Investors, Inc. and endorsed by J. W. Colvin. This is to advise you that we concur in the request made upon you by Southern Loan & Investment Company and hereby agree that our guarantees made to you in regard to direct or indirect liabilities of Southern Loan & Investment Company shall not be affected or the collateral securing the same shall not be affected in any respect by your action in complying with the request of Southern Loan & Investment Company. The body of the fourth letter, dated November 25, 1935, from the bank to Colvin and Texas Investors, Inc., was as follows: Because of the $10,000 payment on the principal of the note of Texas Investors, Inc. held by us in the amount of $142,500, we are accepting renewal note of Texas Investors, Inc. due in 90 days for the balance, without Mr. Colvin's personal guarantee. We agree to accept the collateral of and promises made by Southern Loan & Investment Company in lieu of the personal liability of either of you and in the event said note, or any renewal or extension thereof, is not paid in full we will not hold you or either of you personally responsible. On August 1, 1936, Jesse H. Jones & Co. executed and delivered to the bank a guaranty of the note in question. On November 25, 1935, the note at the bank was reduced to $132,500 as a result of the $10,000 payment. In 1936 Southern paid $17,500 to the bank, reducing the |