20 T.C. 580 (1953)

When a solvent taxpayer’s valid debt to a controlled corporation is canceled, the canceled debt constitutes taxable income, and bookkeeping entries are presumed correct unless proven otherwise.

Summary

Wilson v. Commissioner addresses the tax implications of a debt cancellation between a shareholder (Wilson) and his controlled corporation (Wil-Tex Oil Corporation). The Tax Court held that the cancellation of a valid debt owed by Wilson to Wil-Tex constituted taxable dividend income to Wilson. The court emphasized the importance of adhering to established bookkeeping entries, finding that Wilson failed to demonstrate that the initial debt entry was erroneous. Furthermore, the court determined the cancellation was not part of the stock sale consideration and should be taxed as ordinary income.

Facts

Wilson transferred assets to Wil-Tex Oil Corporation. An initial book entry showed Wilson owing Wil-Tex $42,104.87. This was later reduced to $33,950 after Wilson transferred a building, warehouse equity, and cash to Wil-Tex. In 1948, Wil-Tex canceled the $33,950 debt. Wilson later sold his Wil-Tex stock to Panhandle Producing and Refining Company.

Procedural History

The Commissioner of Internal Revenue determined that the cancellation of the debt constituted taxable dividend income to Wilson. Wilson petitioned the Tax Court, contesting the Commissioner’s determination.

Issue(s)

1. Whether the $33,950 debt cancellation by Wil-Tex Oil Corporation resulted in taxable income to Wilson.

2. Whether, if taxable, the income from the debt cancellation should be treated as ordinary income or capital gain.

Holding

1. Yes, because the bookkeeping entries were presumed correct, and Wilson did not provide sufficient evidence to prove otherwise. Furthermore, Wilson was solvent at the time of the cancellation.

2. Ordinary income, because the debt cancellation was separate from the sale of stock and did not factor into the sale price calculation.

Court’s Reasoning

The court relied on the presumption that book entries are correct unless proven otherwise, citing National Contracting Co., 25 B.T.A. 407. Wilson argued the initial debt entry was a mistake, but the court found this unpersuasive given the involvement of legal counsel and experienced bookkeepers. The court noted that Wilson benefited from the debt arrangement in 1947 by avoiding capital gains taxes. The court cited Commissioner v. Jacobson, 336 U.S. 28, in holding that the cancellation of a valid debt results in income to the debtor. The court emphasized that the cancellation occurred before the stock sale and did not factor into the stock’s sale price, thus it could not be treated as capital gain.

Practical Implications

Wilson v. Commissioner underscores the importance of accurate record-keeping and the tax consequences of transactions between shareholders and controlled corporations. Attorneys should advise clients to carefully document and characterize such transactions, as the IRS and courts will generally rely on the taxpayer’s own books and records. This case also illustrates that taxpayers cannot retroactively recharacterize transactions to minimize taxes after the fact. Furthermore, debt cancellations, even within controlled entities, will be scrutinized and often treated as taxable income to the debtor. Later cases cite this case in determining if a distribution is a dividend versus capital gain treatment.