had been charged off earlier in the year by the transferors and had a zero basis in the hands of the transferee. In the course of its opinion holding that recoveries made by the transferee on the notes charged off by the transferors constituted income, the court said:

However, when such a loan becomes worthless, the amount thereof is loss of capital, but the income tax laws permit the bank to recoup its capital by deducting from the profits or income the amount of the loss. Thus the bank does not pay a tax on all its income, but on the amount of income less the loss on the worthless debt. The debt itself then loses its nature as capital, but represents that portion of the income which is not taxed, and the capital is the money taken from the profits or income. If the loan, after being deducted from income, is paid, then the lender is receiving profit or income-otherwise the lender would double its capital on one transaction. In other words, the profits or income used to pay back the capital when the debt is charged off is represented by the worthless loan, so that when such loan is paid the profits are replaced.

Thus, if the recoveries in question had been made by the smaller banks, they would of necessity been included in the returns as income.

While the loans were not capital assets in the hands of the smaller banks, upon sale to petitioner, such loans became capital assets in petitioner's bands.

In Commissioner v. First State Bank of Stratford, 168 Fed. (2d) 1004, the taxpayer declared and paid a dividend in kind consisting of notes which it had in previous years charged off as worthless and deducted as bad debts. Recoveries were made on the notes later during the same year by the stockholders. The question was whether the recoveries thus made were income to the bank. The court, in holding that the recoveries represented income taxable to the bank, cited and quoted from the National Bank of Commerce case with approval, and remarked that the notes were assets of the bank in the sense that they represented potential income to the extent of the deduction previously allowed in taxes, but "were not capital assets for income tax purposes"; that in assigning the notes without recourse, "the bank assigned its vested right to receive the income that the notes represented" and that the property distributed as a dividend represented income and not a capital asset.

Petitioner seeks to distinguish the National Bank of Commerce and First State Bank of Stratford cases upon the ground that the payments there were made by the debtors and therefore the income was not received out of a sale to a third party. We are unable to agree with the view. The notes here ceased to be capital assets for tax purposes when they took on a zero basis as the result of deductions taken and allowed for charge-offs as bad debts.

Considering the matter realistically, as we must, petitioner recovered a portion of the amount that had previously reduced ordinary taxable income and the amount can not effectively offset the advantage so obtained without according it like treatment. As the court said

in Rice Drug Co. v. Commissioner, 175 Fed. (2d) 681, affirming 10 T. C. 642: "The 'recovery of bad debts' envisages the whole cycle of a claim becoming worthless and later being recovered by the same taxpayer, or perhaps one standing in his shoes, with the usual attending accounting and legal consequences." A sale of the right to receive income to other than the debtor did not alter the character of the asset from which the income was derived. To hold otherwise would place form above substance, contrary to the well established rule. The substance of the transaction was a recoupment of ordinary income which had escaped taxation by bad debt deductions.

In the Hilton case the note was a capital asset when sold, contrary to the situation here.

The reasoning of the National Bank of Commerce of Seattle and First State Bank of Stratford cases controls the question. Accordingly, we sustain the respondent on this issue.

To reflect adjustments agreed to in the stipulation,

Decision will be entered under Rule 50.

JAMES F. BOYLE, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.

Docket No. 21624. Promulgated June 30, 1950.

Petitioner's share of payments received from a corporation by him and the two other principal stockholders in exchange for a portion of the stock, being made for no corporate reason and not affecting petitioner's ultimate proportional interest in the company, held on facts essentially equivalent to the distribution of a taxable dividend. Section 115 (g), Internal Revenue Code.

Llewelyn A. Luce, Esq., and Clyde D. Yeomans, C. P. A., for the petitioner.

John E. Mahoney, Esq., and Francis X. Gallagher, Esq., for the respondent.

A deficiency of $137,561.21 in income and victory tax for calendar year 1943 is challenged on the ground that respondent erred in treating as "essentially equivalent to the distribution of a taxable dividend," under section 115 (g), Internal Revenue Code, amounts received by petitioner in exchange for stock and reported by him as long term capital gain.

The case was heard on a stipulation of facts and other evidence.

FINDINGS OF FACT.

The stipulated facts are hereby found.

Petitioner filed Federal income tax returns for 1942 and 1943 with the collector of internal revenue for the fifth district of New Jersey.

Petitioner, an engineer, began manufacturing and selling airships and inflatable rubber products upon graduation from college, and invented several products which later proved useful to this country's war effort, including inflatable rubber boats, Mae West life jackets, a pontoon bridge, barrage balloons, and airplane emergency flotation gear. In 1929 he organized Air Cruisers, Inc., a Delaware corporation hereinafter called the company.

Prior to his death in July, 1943, Earl F. Glover was the company's business manager and financial head, serving as president and treasurer. Thomas P. Vaughan succeeded Glover as treasurer. Petitioner was secretary, chief engineer, production manager, and sales engineer; and upon Glover's death he became president. Carter Tiffany, vice president, was active principally in signing notes for the company.

Gross sales rose from practically zero in 1939 to about $10,000,000 in 1942. In its returns for 1943 and 1944, the company reported gross sales of $10,746,221.31 and $7,037,067.71, respectively. During the years in question the company was engaged in manufacturing and selling the inflatable products already mentioned, and about 95 per cent of its sales were to the United States Government.

The company's authorized capital stock was increased on June 27, 1929, from 10,000 to 15,000 shares of no par value common. The company has never declared cash or stock dividends. No more than 10,705 shares were ever issued and outstanding. The stock as of the dates indicated was held as follows:

Petitioner's original 3,095 shares were received in exchange for his inventions and services in organizing the company. By the transaction of May 11, 1943, which involved the first transfer of stock recorded on the company's books since 1939, Bissell and Muffling's aggregate of 1,520 shares were acquired by petitioner (507), Glover (506), and Tiffany (507), at $20 per share. Petitioner paid $10,140 for his 507 shares. The 1,520 shares were acquired because of the advantages in offering all the stock for sale. Due to disagreements with Glover on management policy, Tiffany had been trying to sell his stock since

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1941. In that year he offered to sell out to petitioner and Glover for $75,000. Subsequently he negotiated with two other individuals and one corporation, but all negotiations failed because the prospective purchasers wanted 100 per cent of the outstanding stock. Most of Tiffany's negotiations were based upon a sale of the entire stock. When the opportunity arose to buy the 1,520 shares from Bissell and Muffling, Tiffany was authorized to negotiate and buy the stock for the joint account of petitioner, Glover, and Tiffany.

Petitioner, in directing the company's production, depended on Glover for efficient business management. Upon Glover's death on July 16, 1943, the company's financial management fell to Vaughan, who had been Glover's assistant. Tiffany disagreed with Vaughan as he had with Glover and continued his efforts to sell the stock. He offered 100 per cent of the stock in the company to Pharis Tire & Rubber Co.

Glover's will appointed Harry A. Gerrish, the company's attorney, as executor. Caveats protesting probate of the will were filed by Glover's divorced wife and son on August 6, 1943, and September 7, 1943, respectively. The former filed a petition for appointment of an administrator pendente lite on August 12, 1943. Passaic County Surrogate's Court, New Jersey, on March 30, 1944, dismissed the caveats and authorized Gerrish to administer the estate.

During the negotiations with Pharis Tire & Rubber Co., in 1943, Gerrish took the position that because of the caveats, neither he nor anyone else could convey title to the Glover stock. Pharis refused to wait until the estate was settled, or to buy on condition that Gerrish qualify as executor. In October, 1943, an instrument was drafted providing for the sale of an undisclosed amount of stock to Pharis. At the last minute petitioner refused to sign because he was dissatisfied with the terms, and the deal fell through.

Tiffany and petitioner proposed a transfer of some of their stock to the company. In late November, 1943, Gerrish informed Tiffany that, if offered for sale, the company would buy Tiffany's stock at its book value. Tiffany agreed to accept that figure. At a special meeting of stockholders on December 13, 1943, presided over by Tiffany and attended only by him and petitioner, Vaughan was elected director to succeed Glover. The minutes disclose the following action:

The Chairman then stated that the further purpose of the meeting was to consider and take action upon a proposal made by Mr. Tiffany and Mr. Boyle, offering 6504 shares of their capital stock to the corporation for sale.

A general discussion was had during which the balance sheet of the corporation as of November 30, 1943, was analyzed and Mr. Clyde D. Yeomans, accountant for the corporation, stated that the book value of the stock was $62.67 per share,

Upon motion, duly made, seconded and unanimously adopted, it was resolved as follows:

WHEREAS, Mr. Carter Tiffany and Mr. James F. Boyle have offered 6504 shares of the capital stock of Air Cruisers, Inc., to the corporation at its book value and

WHEREAS, the surplus of the corporation is larger than the sum required to purchase the said stock,

NOW, THEREFORE, BE IT RESOLVED, that the Board of Directors be and it is hereby authorized and directed to accept said offer and to purchase said shares from the said Carter Tiffany and James F. Boyle, for the sum of $62.67 per share.

At a special meeting of the Board of Directors on December 13, 1943, attended by petitioner, Tiffany, and Vaughan, comprising the entire board, it was

RESOLVED that the offer of Mr. Carter Tiffany and Mr. James F. Boyle be, and the same is hereby accepted and that this corporation purchase 6504 shares of its stock for the sum of $62.67 per share

At the same meeting of the Board of Directors, officers of the company were elected as follows:

On December 13, 1943, petitioner and Tiffany endorsed to the company 3,302 and 3,202 shares, for which they received $206,936.34 and $200,669.34, respectively. The 6,504 shares were held by the company as treasury stock until its dissolution.

Petitioner retained 300 shares. Gerrish expected to function as executor of Glover's estate, and believed that petitioner's technical knowledge was required for the company to complete work under its contracts.

Tiffany executed an instrument which gave Gerrish a ten-year option to purchase 300 shares for 10 cents each, and a proxy and power of attorney to vote the stock during the option period. The instrument, which was dated December 1, 1943, recited that certificates evidencing ownership of the 300 shares were simultaneously deposited with a trustee who was directed to deliver them to Gerrish upon receipt of the purchase price. Gerrish exercised the option in 1944. Tiffany considered the 300 shares as compensation to Gerrish for services in connection with disposing of the 3,202 shares to the company. Gerrish considered that the 300 shares were a gratuity from Tiffany.

As of December 18, 1943, Vaughan and Gerrish each acquired half of the stock (50 shares) from the remaining minority stockholder, Morris. As of May 16, 1944, 150 of the 300 shares covered by the