Before LUMBARD, Chief Judge, and WATERMAN and HAYS, Circuit Judges.
The sole question to be decided is whether that portion of the proceeds from the "flat" sale of defaulted bond which is allocable to interest accrued while the taxpayers held the bonds is taxable as ordinary income or capital gain. We hold that it is ordinary income.
On March 15, 1950 the taxpayer purchased $50,000 face amount of Missouri Pacific Railroad Company 5% bonds upon which interest of $20,000, accrued from March 1, 1942 to March 1, 1950, was in default. These bonds were purchased "flat," i. e., without allocation of the purchase price between interest and principal, for $50,101.25 including commissions. The Missouri Pacific had been in bankruptcy since 1933. While the taxpayers held these bonds they received $17,500 on account of the interest that had accrued prior to their purchase of the bonds which they correctly treated as a return of capital. Since they were on the cash method of accounting and did not receive any payments on account of the interest which accrued while they held the bonds, they did not report any taxable interest income.
On November 5, 1954 the district court approved a request by the trustee in bankruptcy to pay all the defaulted interest. The Court of Appeals issued a temporary stay order, but vacated it on December 10, 1954, and on December 16, 1954 all of the interest in default was paid.
Meanwhile, on December 13, 1954, after the last hurdle to payment of all back interest had been cleared but before actual payment, the taxpayers sold their bonds "flat" for $59,747.50. On their 1954 federal income tax return the taxpayers reported $27,146.25 of long-term capital gain from this sale, computed as follows:
Less: Payments received on
account of interest accrued
at time of purchase 17,500.00
Taxpayers' basis 32,601.25
Long-term capital gain $27,146.25
The Commissioner asserted a deficiency on the ground that part of the proceeds was ordinary income because it represented interest.*fn1 The Tax Court upheld the Commissioner's contention and fixed the amount of ordinary income at ...