
    H. N. MILLER, MARCELLA MILLER, ROY FRANK VARNADO, LEXIA I. VARNADO, DAVID S. BUELL, MARGIE NELL BUELL, RAY E. LEE, KATHLEEN B. LEE, JOHN EARLE NEFF, JR., BARBARA LOUISE NEFF, BEN H. POWELL, JR., AND MARIAN R. POWELL v. THE UNITED STATES
    [No. 212-59.
    Decided May 15, 1964]
    
      
      W. Morgan Humber for plaintiffs. Powell, Rauhut, Mc-Ginnis, Reavley <db Loehridge were on the briefs.
    
      Joseph P. Spellman, with whom was Assistant Attorney Generad Louis F. Oherdorfer, for defendant. Edward S. Smith, Lyle M. Turner, and Philip R. Miller were on the brief.
    Before JoNes, Chief Judge, Whitaker, Laramore, Dureee and Davis, Judges.
    
   Per Curiam :

This case was referred pursuant to Rule 45 (since April 1,1964, Rule 57) to Wilson Cowen, a trial commissioner of this court, with directions to make findings of fact and recommendations for conclusions of. law. The commissioner has done so in a report filed April 26, 1962. Exceptions to the commissioner’s report and briefs were filed by both parties and the case was submitted to the court on oral argument of counsel. Plaintiff filed a post argument submission to which defendant filed an opposition. Upon consideration thereof, since the court is in agreement with the findings and recommendations of the trial commissioner, as hereinafter set forth, it hereby adopts the same as the basis for its judgment in this case. Plaintiffs are therefore entitled to recover and judgment is entered for them with the amounts of recovery to be determined pursuant to Rule 47(c)(2).

OPINION OP COMMISSIONER

This suit was brought by the plaintiffs to recover Federal income taxes paid by them for the calendar year 1955. Two of the plaintiffs also seek to recover taxes paid with respect to the calendar years 1953, 1954, and 1956. The amounts claimed by each plaintiff for the years stated are set forth in finding 2.

Austin Mutual Life Insurance Company (hereinafter called Austin Mutual) was organized in 1921 and under applicable Texas statutes was authorized to issue ordinary mutual assessment life insurance policies up to a maximum amount of $5,000 for each person insured.

Austin Mutual Insurance Agency (hereinafter called Agency Partnership) was a partnership which at relevant times was composed of plaintiffs H. N. Miller, Roy Frank Yarnado, Margie Nell Buell, Ray E. Lee, John Earle Neff, Jr., Ben H. Powell, and two other individuals not parties to this action. The interest of each partner as of March 30, 1955, is detailed in finding 10.

The sole asset of Agency Partnership, aside from certain physical assets such as desks, chairs, etc., was a management contract with Austin Mutual. Pursuant to the bylaws of Austin Mutual, a portion of the premiums collected from the policyholders of Austin Mutual, known as the general or expense fund, were paid to and became property of the partners of Agency Partnership in consideration of their operating the business of Austin Mutual in accordance with the terms of the management contract, and this provided the partnership with its only source of income. Under the constitution and bylaws of Austin Mutual its officers, all partners of Agency Partnership, were to have complete charge of the management and control of the company and had life tenure. During the years prior to September 30, 1954, Agency Partnership’s bylaw arrangement with Austin Mutual was very profitable as attested by the amounts plaintiffs paid for their respective interests in the Agency Partnership, despite the fact that the book value of the partnership assets was far less than each plaintiff paid for his interest.

Austin Life Insurance Company (hereinafter called Austin Life) is the third business organization involved in this case. It was and is a legal reserve stock life insurance corporation authorized to issue life, health, and accident insurance, and was organized under the laws of Texas in 1946 by the same persons who were the managers of Austin Mutual and partners of Agency Partnership. F. W. Woolsey, not a party to this action, became controlling stockholder of Austin Life upon its incorporation and it was he who determined the composition of the remaining stockholders. The other partners of Agency Partnership also acquired interests in Austin Life, their holdings being substantially but not exactly proportional to their participation in the partnership. There was no instance in which anyone ever acquired or disposed of an interest in Agency Partnership without simultaneously acquiring or disposing of an interest in Austin Life.

During the years in which Austin Mutual, Agency Partnership and Austin Life were in existence concurrently, they all used the same office, all had the same employees, all used the same furniture, fixtures and office equipment, and all had the same management. Title to the furniture, fixtures and equipment was held by Agency Partnership. Subsequent to its incorporation, the officers of Austin Life were substantially the same persons as officers in Austin Mutual. Because few policyholders of Austin Mutual ever attended the annual membership meetings, there was no instance in which any management decision of the company was initiated by anyone other than the managers.

With improved economic conditions during and particularly after World War II, Austin Mutual found it difficult to sell new policies because people preferred legal reserve life insurance. Also, by 1946 the average age of its policyholders was high and rising. During the early 1940’s, one of its employees made calculations showing that the mortuary fund would be insufficient to meet expected death claims within 15 years thereafter. In mid-1950, a consulting actuary confirmed the inadequacy of the mortuary fund to meet anticipated death claims and recommended that Austin Mutual’s policies be converted to legal reserve term life insurance. The alternatives to this course of action were (1) to make additional assessments against policyholders to pay death claims arising in the future or (2) to continue to operate the company as in the past and permit it to become formally insolvent in a period of 10 or 15 years. The first of these alternatives was unacceptable to the management, because it was feared that increased assessments would drive the better-risk policyholders to other companies and thus worsen the financial condition of Austin Mutual, and the second alternative was equally unacceptable because it was felt that such a course of action would be harmful to the business of Austin Life.

Therefore, on July 29,1954, the board of directors of Austin Mutual adopted a plan for converting the mutual assessment policies into legal reserve term life insurance policies to be issued in the form of certificates of assumption by Austin Life. This action was taken in spite of disagreement voiced by some members of Agency Partnership as late as the spring of 1954. The conditions under which the mutual assessment life insurance policies could be converted to legal reserve life insurance were regulated by Texas law, and the following steps were taken in compliance with the Insurance Code of Texas:

(1) Before it was submitted to the membership, the plan had to receive the approval of the State Board of Insurance Commissioners, and such approval was given on July 29, 1954;

(2) written notice, including a copy of the proposed plan, was given to the policyholders for the required period in advance of a meeting held on September 30, 1954;

(3) the plan was ratified by a majority of the votes cast by the policyholders at the meeting. Members could vote in person, by mail or by proxy, and out of about 15,000 policyholders, 2,044 voted by mail, 2,168 cast votes by proxy, and 25 voted in person. The plan was approved by a vote of 3,945 to 292;

(4) after the results of the policyholders’ meeting were certified to the Board of Insurance Commissioners, the board approved the reinsurance plan on November 29,1954, finding that it complied with the Insurance Code of Texas.

Effective as of October 1, 1954, the mortuary fund of Austin Mutual was transferred to and became the property of Austin Life, which issued certificates of assumption, providing the former policyholders of Austin Mutual legal reserve term life insurance policies in lieu of the mutual assessment policies; premiums were payable at the same rates as stipulated in the old policies.

No former policyholder was required to accept a certificate of assumption. Instead he had the right to return it within 60 days and receive a cash payment equal to his proportionate share of the mortuary fund of Austin Mutual.

Because of the deficiency in the mortuary fund transferred to it from Austin Mutual, Austin Life was required to add about $10,000 out of its surplus to the legal reserves for the certificates of assumption.

On December 81, 1954, the furniture, fixtures, and office equipment previously used by the three business concerns were sold for cash by Agency Partnership to Austin Life at the depreciated book value of $18,209.74, an amount which was somewhat larger than the market value of the property. No other assets or property of Agency Partnership were sold or transferred to Austin Life.

On March 31, 1955, Agency Partnership was formally dissolved, and its remaining assets, consisting of cash, were distributed pro rata to the partners. As shown in finding 34, each of the plaintiffs received less than the amount he had paid for his share in the partnership.

Agency Partnership kept its books and filed its income tax returns on fiscal years beginning April 1 and ending March 31. Since the partnership’s fiscal year began before December 31,1954, the provisions of the 1939 Internal Beve-nue Code are applicable for the determination of plaintiffs’ gain or loss. The pertinent provision is 26 U.S.C. (I.E.C. 1939) § 113(a)(13) (1952 Ed.) and Treasury Regulation 118, § 39.113(a) (13)-2, which, was issued pursuant thereto and provided as follows:

READJUSTMENT OF PARTNERSHIP INTERESTS. (a) When a partner retires from a partnership, or the partnership is dissolved, the partner realizes a gain or loss measured by the difference between the price received for his interest and the sum of the adjusted cost or other basis to him of his interest in the partnership plus the amount of his share in any undistributed partnership net income earned since he became a partner on which the income tax has been paid. * * *

The losses sustained by plaintiffs, computed in accordance with the applicable statutes and regulation, are shown in finding 34.

Conceding that the 1939 code applies for the purpose stated above, defendant has urged three separate defenses as a bar to plaintiffs’ recovery herein.

As its first and principal defense, defendant asserts that Agency Partnership dominated and controlled Austin Mutual ; that by the simple expedient of amending the bylaws of Austin Mutual, plaintiffs indirectly transferred to Austin Life an income-producing asset — the right to participate in the premiums formerly paid to Austin Mutual; that Austin Life was also controlled by plaintiffs, and that since plaintiffs merely shifted their investment in the partnership from one pocket to another, they sustained no loss. Defendant relies on such cases as Fritz v. Commissioner, 76 F. 2d 460, Anderson v. United States, 232 F. 2d 794, and similar cases which deal generally with situations in which the members of a partnership purported to sell partnership assets at a loss to a successor business organization in which they had similar but not necessarily identical ownership.

The weakness in defendant’s argument is that it ignores too many of the controlling facts. Plaintiffs did not control but they owned interests in Austin Life which were substantially proportionate to their interests in Agency Partnership ; the partnership’s only asset that produced income was its management contract with Austin Mutual; the partnership, in which plaintiffs did not own a controlling interest, directed the day-to-day operations of Austin Mutual, and the partners, as officers of Austin Mutual, initiated the plan for converting the mutual assessment policies to legal reserve term life policies to be issued by Austin Life. However, with the exception of the furniture sold by the partnership to Austin Life, plaintiffs did not, either as officers of Austin Mutual or as members of Agency Partnership, transfer or sell any assets or property, directly or indirectly, to Austin Life. The complex transaction by which the mutual assessment policies were converted was accomplished in compliance with the Insurance Code of the State of Texas and under the supervision of the State Board of Insurance Commissioners. The inescapable fact is that the reinsurance plan would not and could not have been adopted except for the favorable vote of the policyholders of Austin Mutual. There is no suggestion in the record, much less any tangible evidence, that the plaintiffs influenced or controlled the votes of the policyholders. It was their action rather than that of plaintiffs or of the partnership which effected the transfer of Austin Mutual’s assets to Austin Life.

When the reinsurance agreement was ratified by the policyholders and approved by the State Board of Insurance Commissioners, the management contract with Austin Mutual was not transferred to Austin Life. Instead, its value was reduced to zero, because the partnership’s sole source of income was eliminated. It is the loss of that intangible asset which is the root of this law suit.

With reference to taxable transactions involving related taxpayers, this court in Long v. United States, 156 Ct. Cl. 197, 203, 298 F. 2d 450, 453, stated :

In determining whether or not the form used was one of substance, and not a sham, this court has closely scrutinized those transactions in which a common ownership factor was present. Our approach has been to ascertain whether the transaction was “one that could have reasonably been made between parties dealing at arm’s length,” and if it were, a business loss would be deductible. George E. Warren Corp. v. United States, 135 Ct. Cl. 305, 312 (1956).

Tested by that standard, the plaintiffs have demonstrated by undisputed evidence that they sustained a bona fide loss and that their participation in the events which culminated in the issuance of the certificates of assumption by Austin Life may not be equated to the simulated transactions at issue in the cases cited by defendant.

For its second defense, the defendant contends that the losses claimed by plaintiffs may not be recognized because of the provisions of section 351(a) of the 1954 code, 26 U.S.C. (I.R.C. 1954) § 351(a) (1958 Ed.).

As pointed out above, the only property transferred by Agency Partnership to Austin Life was the office equipment sold to Austin Life at a price somewhat above market value. No loss was sustained and none is claimed by reason of the sale of that property; the transaction has no bearing on the issues here.

It is too clear for argument that section 351(a) has no application to the facts of this case, for the plain requirements of that statute are not met. No property was transferred by Agency Partnership or by plaintiffs to Austin Life solely in exchange for stock or securities.

In its third defense, defendant contends that the losses claimed by plaintiff resulted from the sale or exchange of property between related taxpayers and, as such, must be disallowed under the provisions of 26 U.S.C. (I.R.C. 1954) §267 (1958 Ed.).

Much of what has been said above in respect to defendant’s principal defense demonstrates the inapplicability of section 267 because no loss arose nor is any claimed as a result of any sale or exchange of property from plaintiffs to Austin Life. Aside from the immaterial sale of the office equipment at a price above market value, neither plaintiffs nor the partnership sold to or exchanged any property with Austin Life. The management contract was never transferred to Austin Life. Except for the office equipment, the only transfer of property to the corporation (Austin Life), i.e., the right to collect premiums from the policyholders and the mortuary fund of Austin Mutual, was accomplished by the vote of the policyholders pursuant to applicable Texas law. In fact, any property thus transferred was done by each policyholder at his own option, since each had the right to reject the certificates of assumption and withdraw his portion of the mortuary fund.

Thus, the essential elements of a “sale or exchange” — a transfer of property by the taxpayer to the transferee and consideration in cash or in kind moving from the transferee to the taxpayer — are totally lacking in this instance and, in their absence, section 267 can have no application.

The final question to be decided is whether the full amount of the losses incurred by plaintiffs may be deducted as ordinary losses, as plaintiffs contend, or whether they are to be treated as capital losses, as defendant contends. Plaintiffs agree that it is now well established that an interest in a partnership is a capital asset. Commissioner v. Smith, 173 F. 2d 470; Long v. Commissioner, 173 F. 2d 471. Plaintiffs also admit that when a partner retires from a continuing partnership and takes out his share in cash, a sale or exchange of his partnership interest occurs. Smith v. Commissioner, 5 T.C. 323. However, plaintiffs insist that since the 1939 code contained no provision that liquidations of partnership should be treated as sales or exchanges of partnership interests and that since the asset which produced the loss involved herein was never sold or exchanged, their losses should be treated as ordinary losses.

Defendant calls attention to Ad. Auriema, Inc. v. Commissioner, 8 T.C.M. 778, a memorandum decision of the Tax Court, decided December 7, 1943. This is the only case directly in point cited by either party and specifically covers the treatment of a loss in a partnership interest upon the voluntary liquidation of an entire partnership. There the court stated that a partnership interest is a capital asset and that since the loss claimed did not fall within any of the excluded categories of “property held” as defined in 26 U.S.C. (I.R.C. 1939) § 117 (1952 Ed.), the loss was a capital loss.

Although there appears to be a paucity of decisions on the precise question, there are other authorities which treat losses resulting from distributions upon the liquidation of partnerships in the same way. 6 Mertens, Law of Federal Income Taxation, Section 35.54 states:

§ 35.54. DISTRIBUTIONS IN LIQUIDATION OF PAETNEESHIP OE PAETNEE’S INTEEEST. The tax consequences with respect to a partner who, along with the other members of the firm, receives a distribution of money or property, or a combination of the two, upon the liquidation of the partnership business are essentially the same as in the case of a similar distribution to a retiring member of a continuing partnership. * * *
*****
When a partner receives a distribution of cash, either as his share of the proceeds of a liquidated partnership business, or in settlement of his interest upon his retirement from a continuing partnership, he realizes gain or loss in the difference between the amount received and the adjusted cost of his partnership interest increased by the amount of his share of any undistributed partnership net earnings since he became a partner.

Also, Rev. Rul. 56-5, 1956-1 Cum. Bull. 630, states in part:

The disposition of a partnership interest, even though it be by liquidation thereof, is a capital transaction. Any gain or loss realized upon the partial or complete liquidation of a partnership interest is capital in nature.

It should also be pointed out that Treasury Eegulation 118, Sec. 39.113 (a) (13)-2(a), upon which plaintiffs rely, utilizes the same standard for determining the realized gain or loss to a partner upon the dissolution of a partnership as is applied when a partner retires from a continuing partnership.

Accordingly, it is concluded that defendant’s contention is supported by the weight of authority and that the losses realized by plaintiffs were capital losses.

For the reasons and upon the basis stated in the foregoing opinion, plaintiffs are entitled to recover. The amounts to be recovered are to be determined pursuant to Eule 47 (c) (2).

FINDINGS OF FACT

1. Plaintiffs are H. N. Miller and Marcella Miller, husband and wife, 3254 Goldfinch Street, San Diego, California; Eoy Frank Vamado and Lexia I. Varnado, husband and wife, 2212 Hartford Eoad, Austin, Texas; David S. Buell and Margie Nell Buell, husband and wife, 7030 Azalea Lane, Dallas, Texas; Eay E. Lee and Kathleen B. Lee, husband and wife, 1410 Northwood Eoad, Austin, Texas; John Earle Neff, Jr., and Barbara Louise Neff, husband and wife, 3406 Foothill Parkway, Austin, Texas; Ben H. Powell, P.O. Box 63, Austin, Texas (who died on December 3, 1960, and is now represented by his executors, Ben EL Powell, Jr., and Marian E. Powell); and Marian E. Powell, wife of Ben H. Powell, joined pro forma by him, P.O. Box 63, Austin, Texas. Plaintiffs Marcella Miller, Lexia I. Vamado, David S. Buell, Kathleen B. Lee and Barbara Louise Neff are parties to this action only by virtue of having filed joint Federal income tax returns with their spouses. Although Ben H. Powell and Marian E. Powell filed separate Federal income tax returns for the year 1955, Marian E. Powell is a party by virtue of her having a community property interest in her husband’s assets.

2. This suit was instituted by the plaintiffs to recover individual Federal income taxes paid by them with respect to the calendar year 1955 in the total amount of $34,125.80, plus statutory interest (and also, in the case of plaintiffs Buell, with respect to the calendar years 1953, 1954, and 1956), as follows:

A. For the year 1955:
H. N. Miller, et ux-$5, 890.65
R. F. Varnado, et ux- 4, 925.90
D. S. Buell, et ux_ 2,004.69
R. B. Lee, et ux_ 7, 051.36
J. B. Neff, Jr., et ux_ 302.28
Ben H. Powell_ 5,264.82
Marian R. Powell- 5, 310.57
B. For the years 1953, 1954, and 1956, plaintiffs Buell seek to recover, by virtue of carryback and carry-forward from the year 1955, the amounts of $599.80, $720.47, and $2,055.26, respectively.

3. There are three business organizations involved in this suit: Austin Mutual Life Insurance Company (Austin Mutual) ; Austin Mutual Insurance Agency (Agency Partnership) ; and Austin Life Insurance Company (Austin Life).

4. Austin Mutual was organized in 1921 under the laws of the State of Tesas as a mutual assessment life insurance company. Under the applicable state statutes, it was authorized to issue ordinary life insurance policies up to a maximum amount of $5,000 per each insured. It was not required to compute or maintain any actuarially determined reserves with which to meet policy claims, as the policies were subject to assessment for that purpose if the need arose. However, Texas law did require that such an organization segregate into a claim or mortuary fund a minimum of 60 percent of the premiums collected from policyholders. This fund was to be the sole source of meeting policy claims and was to bear, to a limited extent, some of the expenses of defending against contested claims.

Article 14.25 of Chapter 14 of the Insurance Code of Texas (and comparable provisions of earlier Texas statutes) provides as follows:

Assessments when collected shall be divided into at least two (2) funds. One (1) of these shall be the mortuary or relief fund, by whatever name it may be called in the different associations, from which claims under certificates shall be paid, and to a limited extent the cost of defending contested claims, and nothing else; and the other funds shall be the expense funds from which expenses may be paid. At least sixty (60%) percent of assessments collected except the membership fee, must be placed in the mortuary or relief fund. The mortuary or relief funds may be invested only in such securities as are a legal investment for the reserve funds of stock life insurance companies.
Such association shall provide in its by-laws for the portion of its assessments to be allotted to the mortuary or relief fund and may provide for the payment out of said mortuary or relief funds of attorney’s fees and necessary expenses arising out of the defense, settlement, or payment of contested claims. Any such payments out of the mortuary or relief fund for other than claims shall be subject to approval of the Board of Insurance Commissioners.
A separate record shall be kept of the mortuary or relief funds of each group, club or class and the mortuary or relief funds of one group, club or class shall not be used to pay the claims or obligations of any other group, club, or class.

5. In practice, during the years immediately prior to 1954, Austin Mutual set aside in its mortuary fund 60 percent of the premiums collected. It also put into a contingency reserve fund, also designed to meet claims, another 5-15 percent of the premiums collected.

6. Pursuant to the bylaws of Austin Mutual, the remaining 25-85 percent of the premiums collected from the policyholders of Austin Mutual were paid to, and became the property of, the partners of Agency Partnership in consideration of their operating the business of Austin Mutual in accordance with the terms of a contract existing between Austin Mutual and Agency Partnership. Out of this portion of the premiums collected, which was known as the general or expense fund, the partners were to pay the expenses of operating the business of Austin Mutual and were to retain any balance for themselves. The pertinent bylaw of Austin Mutual, as amended December 17, 1945, reads as follows:

ARTICLE XVII. A fund to be known as the General, or Expense Fund shall be created from premium income and reinstatement fees and all other income which is credited neither to the Mortuary Fund nor to the Contingent Reserve Fund, as is provided for in Article XVI and Article XVI-A, respectively; and all monies in such General, or Expense Fund, after transferring to the Mortuary Fund an amount equivalent to claims occurring in their first policy year, are and shall, as compensation for conducting the affairs of the Company, be the sole property of and retained by Woolsey, Roberts, et al., a partnership presently composed of F. W. Woolsey, J. E. Roberts, Ben H. Powell, A. J. Wirtz and H. W. Bishop and their assigns, it being provided that the members of the said partnership may be changed from time to time and that the partnership name may be changed, it being intended that the name will be changed to Austin Mutual Insurance Agency on or about January 1,1946. However, it shall be the duty of the said Partnership to pay out of the said General, or Expense Fund all agents’ commissions and fees, office salaries, legal expenses, general underwriting expenses, necessary traveling expenses, insurance department fees and licenses, rent, advertising, printing and stationery, postage, express, telegraph and telephone, premiums required on surety bonds on officers and employees, and all other expenses incident to the management and conduct of the business of the Company, except payment of claims as provided in Article XVI hereof, and expenditures authorized to be made from the Contingent Reserve Fund as set forth in Article XVI-A hereof.
Title to all property purchased out of the General, or Expense Fund shall vest in the said Partnership.

7. Under the constitution and bylaws of Austin Mutual, its officers, who had life tenure, were to have complete charge of the management and control of the company. There was no significant change in the nature or character of the general fund from 1929 to 1955.

8. Agency Partnership, which had been in existence for many years prior to 1946, had as its sole function the management of the affairs of Austin Mutual. During all of the years prior to September 30, 1954, its bylaw arrangement with Austin Mutual (see finding 6) was a very profitable one for the partners and provided the partnership with its only source of income.

9. Plaintiffs H. N. Miller, R. F. Vamado, Mrs. Buell, R. E. Lee, and J. E. Neff, Jr., were not members of Agency Partnership when it was first organized (under the name of “Woolsey, Roberts, et al”) but became members at various times subsequently through the purchase of interests from retiring partners. Plaintiff Ben H. Powell was a member of Agency Partnership at the time it was organized and later acquired a larger interest by purchase.

10.On March 30, 1955, plaintiffs H. N. Miller, K. F. Var-nado, Mrs. Buell, E. E. Lee, J. E. Neff, Jr., and B. N. Powell were partners in Agency Partnership, owning in the aggregate 41 y3 percent interest in that firm. F. W. Woolsey and Kitty Mae Wirtz, who are not parties to this action, were also partners and owned a majority interest in the partnership.

Plaintiff partners’ respective interests in Agency Partnership as of March 30, 1955, were as follows:

Percent
H. N. Miller_ 6.224
R. F. Varnado_ 6.224
Mrs. Buell_10.067
R. E. Lee_ 8.266
J. E. Neff, Jr_ . 552
B. H. Powell_10.000

11.The aggregate amounts paid by the plaintiff partners for their interests in Agency Partnership, acquired on various dates between 1935 and March of 1954, were as follows :

H. N. Miller— $18,157. 66
R. P. Varnado. 18,157. 66
Mrs. Buell_ 27, 985. S3
R. E. Lee_ 22, 627. 93
J. E. Neff, Jr_. 1, 511.49
B. H. Powell— 17,133. 33

12.The price paid by plaintiff Varnado for his aggregate interest in Agency Partnership, acquired in 1946, 1953, and 1954, was far in excess of his resulting pro rata share in the tangible partnership assets. The partnership had no intangible assets other than the bylaw arrangement with Austin Mutual for the conduct of the latter’s business, but he was willing to pay the agreed price because he was buying a right to receive a portion of the profits of Agency Partnership derived from the premiums being paid by the policyholders of Austin Mutual. He did not anticipate that the management would take any steps to alter the bylaw arrangement which was responsible for the partnership’s profits. Also, one of the reasons inducing him to make the purchases in. 1953 and 1954 was the fact that the purchases were made substantially on credit.

13. Agency Partnership kept its books and filed its United States Partnership Returns of Income for fiscal years beginning April 1, and ending March 31. The last such return filed was for the fiscal year beginning April 1, 1954, and ending March 31,1955.

14. The capital account of Agency Partnership was, at the beginning of fiscal year April 1, 1954-M'arch 31, 1955, $3,186.47. Approximately $3,000 was left in the capital account of Agency Partnership after the final distribution of profits to the partners each year, and approximately the same amount was in the capital account of Agency Partnership when plaintiffs purchased their interests in the partnership.

15. Austin Life was and is a legal reserve stock life insurance corporation organized under the laws of Texas in 1946 by the same persons who were the managers of Austin Mutual and the partners of Agency Partnership. It was chartered to write life, health and accident insurance. Initially, because of its relatively small capitalization ($25,000 capital and $5,000 contributed surplus), Austin Life was limited as to the size and type of life insurance policies which it could write; the limitation being a $1,000 ordinary life insurance policy with double indemnity per each policyholder. Subsequently, with increased capitalization to $100,000, resulting partly from additional stock subscriptions, all such limitations were removed.

16. Upon the incorporation of Austin Life, Mr. Woolsey became the controlling stockholder and determined who would be permitted to subscribe to its stock and in what amounts. The other partners in Agency Partnership also acquired interests in Austin Life, there being a substantial overlap, but not an exact identity, between their shareholdings in the corporation and their participations in the partnership.

At all times since 1946, Austin Life has been actively engaged in the life insurance business and its capital, surplus and volume of insurance in force have fairly consistently increased since that time (without regard to the substitution transaction with Austin Mutual hereinafter described). Austin Life paid no dividends to its stockholders until the year 1955, after the dissolution of Agency Partnership, at which time it began paying regular quarterly dividends. There was no significant change in the annual volume of new business being written by the company at that time. Stock dividends in the amount of $40,000 and $100,000 were declared in the years 1956 and 1958, respectively.

17. During the years in which Austin Mutual, Agency Partnership and Austin Life were in existence concurrently, they all operated out of the same office, all had the same employees, all used the same furniture, fixtures and office equipment, and all had the same management. Record title to these physical assets stood in the name of Agency Partnership until December of 1954. The principal officers of Austin Mutual and the directors of Austin Mutual, except for the medical director, were the partners in Agency Partnership, and they also held stock in Austin Life. During this same period of time, there was no instance in which anyone ever acquired or disposed of an interest in Agency Partnership without simultaneously acquiring or disposing of an interest in Austin Life. The officers of Austin Mutual were elected for life, and there was no such officer who was not also a partner in Agency Partnership. From 1946 to March 31,1955, the officers of Austin Mutual and the officers of Austin Life were substantially the same.

Few of the policyholders of Austin Mutual ever attended the annual membership meetings, and there was no instance in which any management decision of that company was initiated by anyone other than its managers.

18. The type of insurance policies issued by Austin Mutual were relatively low cost policies and consequently sales were high during the 1930’s. During and immediately after World War II, however, Austin Mutual found that it was unable to sell very many new policies, partly because of the lack of available sales personnel interested in selling such policies and partly because, with improved economic conditions after the War, people were interested in and. able to purchase relatively higher cost legal reserve policies. As of 1946, therefore, the average age of Austin Mutual’s policyholders was high and was rising. Sales of mutual assessment life insurance policies were not increasing in Texas at that time.

19. During the early 1940’s one of Austin Mutual’s employees, who had had some actuarial training, was requested to and did make calculations with respect to the adequacy of the mortuary fund to meet expected death claims in future years. The calculations showed that the mortuary fund would not be sufficient for that purpose in view of the fact that sales of new policies had fallen off so appreciably and that something would have to be done within the next 15 years in order to prevent the complete insolvency of Austin Mutual. Plaintiff Varnado and the management of Austin Mutual were aware of the results of this study.

20. In mid-1952, the management of Austin Mutual arranged to have formal studies made by a consulting actuary with respect to the adequacy of the mortuary fund to meet expected death claims in the future. The consultant was asked to investigate the financial feasibility of converting or reinsuring the outstanding mutual assessment ordinary life insurance policies of Austin Mutual and giving the policyholders legal reserve policies instead of the ones they had.

It was immediately apparent to the consulting actuary that, because of the insufficiency of the mortuary fund, converting the existing policies into whole life legal reserve ordinary life insurance policies at the same premium level was out of the question. Moreover, the mortuary fund was deficient by approximately $1,000,000 of the amount required to offer legal reserve term life insurance to age 65 to the existing policyholders under age 50, and to offer 15-year legal reserve term life insurance to all other policyholders.

21. The consulting actuary recommended to the management of Austin Mutual in late 1952 or early 1953 that, given the amount then in the mortuary fund and assuming the continued collection of the same level of premiums, the outstanding insurance coverage could be changed from mutual assessment ordinary life insurance to legal reserve term life insurance to age 60 in the case of policyholders then under age 50 and to 10-year legal reserve term life insurance for all other policyholders. The new contracts would be convertible to ordinary whole life policies or 20-year payment life policies without further proof of insurability, or would be renewable upon the expiration of the specified term. A policyholder exercising the right of conversion or renewal would be required to pay a substantially higher premium than he had been paying for his original Austin Mutual policy.

22. The alternatives available to the management of Austin Mutual to thus changing the outstanding insurance coverage to a legal reserve basis were (1) to make additional assessments against the existing policyholders in order to pay death claims arising in the future or (2) to continue to operate Austin Mutual as had been done in the past and allow it to become formally insolvent in a matter of 10 to 15 years and thus terminate any liability under the policies. Both of these alternatives were unacceptable to the management because it was anticipated that the former course of action would drive away the better-risk policyholders, who could get coverage in other companies (and thus make the financial situation of Austin Mutual even worse than it was), while the latter course of action would, it was felt, cause severe repercussions in the business of Austin Life in view of the similarity of the names, management and offices of the two companies.

23. Accordingly, a majority of the board of directors of Austin Mutual, at a duly called meeting held on July 29, 1954, adopted the plan of substituting legal reserve term life insurance for the mutual assessment ordinary life insurance as recommended by the consulting actuary (see finding 21). Upon obtaining the approval of the Texas Insurance Commission, Austin Life was caused by the management to propose the plan of substitution to the policyholders of Austin Mutual. The policyholders of Austin Mutual approved the plan by a vote of 3,945 to 292 at a duly called meeting held on September 30, 1954, for that purpose. Out of the approximately 15,000 policyholders of Austin Mutual at that time, 2,044 cast votes by mail, 2,168 cast votes by proxy, and 25 cast votes in person. Effective October 1, 1954, therefore, the mortuary fund of Austin Mutual attributable to the life insurance class of policyholders was transferred to and became the property of Austin Life and Austin Life issued certificates of assumption (i.e., nonassessable legal reserve term life insurance policies) to the former life insurance policyholders of Austin Mutual. Austin Life was required to add some $8,000-10,000 out of its surplus to the legal reserves behind the certificates of assumption because of a deficiency in that amount in the mortuary fund transferred to Austin Life. Each of the above-described actions was taken pursuant to and in conformity with the Insurance Code of Texas.

24. The new certificates of assumption issued by Austin Life provided that the former Austin Mutual policyholders would pay to Austin Life premiums at the same rates that they had theretofore paid to Austin Mutual.

25. The agreement entered into between Austin Mutual and Austin Life on July 29, 1954, for the purpose of effectuating the plan of substitution provided for the establishment of a contingent participation and reserve account on the books of Austin Life. To that account would be credited or charged: (1) the annual profit or loss on mortality (the difference between the actual death claims and those which were actuarially anticipated when the amount of the premium was determined) derived from the certificates of assumption and policies issued by Austin Life pursuant to the conversion right accorded the former policyholders of Austin Mutual, to the extent of 12y2 percent of the total premiums received from those certificates and policies during the year; (2) reserves (behind the certificates of assumption and policies issued by Austin Life pursuant to the right of conversion) which were released by lapses during the year, to the extent of 8/100ths of 1 percent of the total amount of insurance in force under such certificates of assumption and policies issued by Austin Life at the beginning of each accounting period (the limitation was 2/100ths of 1 percent for the period October 1, 1954 to December 31, 1954); and (3) any losses incurred by Austin Life with respect to mortgages acquired from Austin Mutual in connection with the substitution transaction.

If, at the end of 10 years from the date on which the plan of substitution went into effect (which would be September 30, 1964), any credit balance in the contingent participation and reserve account to the extent of 2*4 percent of the total premiums paid under the certificates of assumption and policies issued by Austin Life pursuant to the right of conversion during the 10-year period was to be withdrawn and placed into a mortality contingency fund for another 15 years to cover death claims in excess of those actuarially anticipated. If, at the end of the original 10-year period, the credit balance in the contingent participation and reserve account exceeded the amount so withdrawn and placed into the mortality contingency fund, the excess was to be pro rated among the holders of the certificates of assumption and policies issued by Austin Life pursuant to the right of conversion as of September 80, 1964, in the form of additional paid-up, five-year legal reserve term life insurance. Any credit balance in the mortality contingency fund at the end of the additional 15-year period was to become the property of Austin Life.

26. The profit or loss on mortality and other items referred to in finding 25 have no reference to, and the contingent participation and reserve account and the mortality contingency fund are not concerned with, any earnings on the reserves in excess of the assumed rate of return of 314 percent.

27. No former policyholder of Austin Mutual was required to accept the certificates of assumption, but could elect to return the certificate to Austin Life within 60 days from the effective date of the agreement between the two companies (September 30, 1954) and receive instead an amount of money equal to his proportionate share of the mortuary fund of Austin Mutual.

28. The consulting actuary recommended to the management against the inclusion of the provision for the contingent participation and reserve account in the plan of substitution on the ground that the risk of possible loss which Austin Life was assuming under the plan did not warrant participation on the part of the policyholders in any profits which might arise. He felt that there was a very real risk that a great number of Austin Mutual policyholders, particularly those in good health, would reject the certificates of assumption, while those with impaired health would accept them. Thus, the mortality calculations upon which the plan of substitution was based might be completely distorted by the anti-selection against the certificates of assumption. He also felt that a possibility existed that the holders of the certificates of assumption who were in good health might seek coverage elsewhere at the expiration of their term policies when they would be confronted with an increase in the rate of premium for renewal.

29. As late as the spring of 1954, there was disagreement among the members of Agency Partnership as to the desirability of adopting the plan of substitution as opposed to the continued operation of Austin Mutual on the same basis as theretofore and the continued receipt by Agency Partnership of 25-35 percent of the premiums paid by the policyholders each year. At that time there was no assurance that the plan of substitution recommended by the consulting actuary or any other comparable device would be adopted by the members of Agency Partnership.

30. After September 30, 1954, the mortuary fund of Austin Mutual was limited to the portion previously attributable to its health and accident class of policyholders. Austin Mutual wrote no more life insurance, and the gross income of Agency Partnership was limited to that arising from the premiums derived from Austin Mutual’s health and accident business. On and after October 1, 1954, as a result of the plan of substitution, the right to whatever net profits which might arise under the certificates of assumption, with the exceptions shown in finding 25, inured to the benefit of Austin Life.

31. Between September 30, 1954, and March 30, 1955, the small health and accident insurance business theretofore carried on by Agency Partnership in behalf of Austin Mutual was handled in the name of the partnership by the office employees of Austin Life under a service agreement providing for an allocation of the direct expenses attributable to the two companies and a division of the indirect expenses on the basis of a premium income ratio.

32. As of December 31, 1954, the furniture, fixtures, and office equipment theretofore used by all three business organizations but owned of record by Agency Partnership, were sold for cash to Austin Life at the depreciated book value of $18,209.74. The sale was made on that basis pursuant to an agreement made by Austin Life and Agency Partnership. Since some of the assets had been purchased 10 years or more prior to 1954, the market value was probably somewhat less than the depreciated book value.

33. On March 30, 1955, Agency Partnership entered into a contract with the Austin Accident Insurance Agency, whereby the former transferred to the latter the health and accident business previously conducted by Agency Partnership for Austin Mutual. In consideration for the transfer, Austin Accident Insurance Agency agreed to assume all obligations with respect to such health and accident business. Austin Accident Insurance Agency was a partnership composed of persons other than the members of Agency Partnership and consisted of a number of employees of Austin Life who were selected by Agency Partnership for the purpose of managing the health and accident business.

34. Effective March 31, 1955, Agency Partnership was formally terminated and dissolved and its remaining assets, which consisted solely of cash, were distributed to each of the partners proportionately. The statutory certificate of termination was filed with the County Clerk of Travis County, Texas, on that date. Each of the plaintiff partners received a cash distribution upon dissolution of less than what he had paid for his partnership interest.

Immediately before the final distribution on March 31, 1955, the respective plaintiff partners’ shares of the undistributed partnership net income earned since they became partners were as follows:

H. N. Miller_$192.19
R. IT. Varnado_ 192.19
Mrs. Buell_ 310.85
R. E. Lee_ 255. 24
J. E. Neff, Jr_ 17.04
B. H. Powell_ 308.78

The amounts distributed to each of the plaintiff partners in the final distribution on March 31,1955, were as follows:

H. N. Miller_ S90.51
R. F. Varnado_ 390. 51
Mrs. Buell_ 631. 63
B. E. Lee_ 518. 63
J. E. Neff, Jr_ 34. 64
B. H. Powell_ 627.43

The amounts by which the final distributions to plaintiff partners were less than their cost basis for their respective interests in the partnership (reduced by each partner’s share in the undistributed profits) were:

H. N. Miller-. 17, 959. 34
B. E. Varnado. 17,959.34
Mrs. Buell-27,664.55
B. E. Lee-22,364.54
J. E. Neff, Jr_. 1,493. 89
B. H. Powell-16,814. 68

35. For the fiscal year ended March 31, 1955, and prior years, Agency Partnership filed partnership returns of income in which were reported, as the distributed income of each individual partner, his respective share of the net profits of Agency Partnership and the partners paid individual Federal income taxes accordingly. For the period 1946 through 1955, no deduction was made, or chargeoff accomplished, for the sums invested by the plaintiff partners to purchase their interests in Agency Partnership.

36. Since October 1, 1954, the gross incomes of plaintiff partners, including salaries and/or dividends, earned in the insurance business have not decreased below the gross incomes earned by such partners prior to the date the reinsurance agreement became effective. However, plaintiff partners have not recouped or charged off their original investments in Agency Partnership.

37. In their Federal income tax returns for the year 1955, the plaintiff partners claimed as deductions from their respective ordinary incomes the full amounts of their claimed losses as set forth in finding 34. The Commissioner of Internal Revenue disallowed the claimed deductions in full upon, audit of the returns and tliereaf ter timely assessed and collected the resulting income tax deficiencies, plus interest. The Commissioner of Internal Revenue also assessed and collected from plaintiffs David S. Buell and Margie Nell Buell deficiencies in accordance with, the Commissioner’s determination that no part of the loss claimed by them should be allowed as a net operating loss carryback or carry-forward to 1953,1954, or 1956.

38. All of the plaintiffs timely filed claims for refund of the aforesaid Federal income taxes in the same amounts and on the same grounds as are claimed and alleged in the petition (see finding 2). The Commissioner sent notices of dis-allowance of such claims by registered mail to plaintiffs Buell on January 20,1959, and to the other plaintiffs on December 8,1958.

Plaintiffs thereafter complied with all'procedural requisites to the maintenance of this action and allege they are entitled to claim the amounts shown in finding 34 as deductions from ordinary income, or in the alternative, as long-term capital losses.

39. The parties agreed that the trial of this action would be limited in the first instance to the issues of law and fact relating to the right of the plaintiffs to recover.

CONCLUSION OF LAW

Upon the foregoing findings of fact, which are made a part of the judgment herein, the court concludes as a matter of law that plaintiffs are entitled to recover and judgment will be entered to that effect. The amounts to be recovered will be determined pursuant to Rule 47(c) (2). 
      
       The plaintiff partners owned an aggregate of 41% percent of the interests in the firm. See finding 10.
     
      
       Art. 14.61 § 1(a), Vernon’s Texas Statutes (1951).
     
      
       § 351(a) provides:
      § 351. Transfer to corporation controlled by transferor.
      (a) General rule.
      No gain or loss shall be recognized if property is transferred to a corporation by one or more persons solely in exchange for stock or securities in such corporation and immediately after the exchange such person or persons are in control (as defined in section 368(c)) of the corporation. For purposes of this section, stock or securities issued for services shall not be considered as issued in return for property.
     
      
       § 267 provides in pertinent part:
      (a) Deductions disallowed.
      No deduction shall be allowed — ■
      (1) Losses.
      In respect of losses from sales or exchanges of property * » * directly or indirectly between persons specified within any one of the paragraphs of subsection (b).
      (b) Relationships. The persons referred to in subsection (a) are:
      (1) * * *
      (2) An individual and a corporation more than 50 percent in value of the outstanding stock of which is owned, directly or indirectly, by or for such individual.
     
      
       53 Columbia Law Review 976.
     