author: Black:

text:
    Susan H. Mathews, as Executrix of the Last Will and Testament of W. B. Mathews, Deceased, Petitioner, v. Commissioner of Internal Revenue, Respondent.
    Docket No. 43208.
    Promulgated December 11, 1935.

      W. H. Wadsworth, Esq., for the petitioner.

      T. M. Mather, Esq., for the respondent.
   OPINION.

Black:

This proceeding involves the redetermination of the following deficiencies in income tax:

1924 $85.17
1925 221. 71
1926 114. 80
1927 673. 42

The petitioner assigns as error the inclusion in his distributive shares of the income of certain partnerships of which he was a member certain amounts received by him which he asserts were exempt from income tax.

The facts were stipulated and are adopted as our findings of fact. Only so much thereof will be stated here as seems necessary to a proper understanding of this opinion.

The petitioner, W. B. Mathews, was an individual who resided in Los Angeles, California, during the taxable years and died on December 9, 1981. His executrix has been substituted in his stead. In W. B. Mathews, 13 B. T. A. 1133, the Board passed upon the tax liability of this same taxpayer for the year 1923. The first part of the stipulation filed herein is almost a literal copy of the findings of fact in that proceeding, the only exceptions being years and dates. The petitioner served during all the years before us under the agreement of August 4, 1922. The remaining part of the stipulation not found in W. B. Mathews, supra, is as follows:

During the taxable years the petitioner was a member of the law partnerships designated as Bordwell and Mathews, Bordwell, Mathews and Wadsworth #1 and Bordwell, Mathews and Wadsworth #2. The partnership of Bordwell and Mathews was formed on January 1, 1914, and consisted of Walter Bordwell and W. B. Mathews, and the partnership of Bordwell, Mathews and Wadsworth #1 was formed on January 1, 1925, and consisted of Walter Bordwell, W. B. Mathews and W. H. Wadsworth, and the partnership of Bordwell, Mathews and Wadsworth #2 was formed on September 23, 1926, and consisted of Walter Bordwell, W. B. Mathews and W. H. Wadsworth.
Walter Bordwell died on the 23rd day of September, 1926. There was no written or oral agreement for the continuation of the partnerships of Bordwell and Mathews and Bordwell, Mathews and Wadsworth #1, and the partnerships were dissolved immediately upon the death of Walter Bordwell. All of said partnerships were formed to engage in the practice of law, and all compensation from any source whatsoever individually received by the members of the partnership for legal services rendered was income of said firms.
Of the said salary of the petitioner, W. B. Mathews, the Bureau included as income of the firm of Bordwell and Mathews, $12,000.00 for 1924, of which his distributive share was 50% and the distributive share of Walter Bordwell 50% ; as income of the firm of Bordwell, Mathews and Wadsworth #1, $12,000.00 for 1925, of which petitioner, W. B. Matthews’ distributive share was 40%, Walter Bordwell’s distributive share 40% and W. H. Wadsworth’s distributive share 20% ; as income of the firm of Bordwell, Mathews and Wadsworth #1, $10,000.00 for 1926, of which petitioner, W. B. Mathews’ distributive share was 40%, Walter Bordwell’s distributive share 40% and W. H. Wadsworth’s distributive share 20%; as income of the firm of Bordwell, Mathews and Wadsworth #2, $2,000.00 for 1926, of which petitioner, W. B. Mathews’ distributive share was 60% and W. H. Wadsworth’s distributive share was 40%; and $12,000.00 for 1927, of which petitioner, W. B. Mathews’ distributive share was 60% for the first nine months and 55% for the remaining three months of that year, and W. H. Wadsworth’s distributive share was 40% for the first nine months and 45% for the remaining three months of that year. The Bureau included W. B. Mathews’ distributive share, as indicated above, as income from partnerships as shown in the income notice. The petitioner, W. B. Mathews, included no part of said salary in his returns. The same state of facts is true as to Walter Bordwell for the taxable years and also as to W. H. Wadsworth for the year 1927.
During the taxable years petitioner gave no bond and toot no oath of office.
During the taxable years the partnership of which petitioner, W. B. Mathews, was a member, received compensation for services rendered from municipal corporations of the State of California for the preparation of bond proceedings and rendition of opinions covering the validity of municipal bonds, as follows:
(a)1924 — Bordwell and Mathews
City of Long Beach-$2, 025. 00
City of Santa Barbara_ 250. 00
City of Inglewood_ 75. 00
City of El Segundo_ 150. 00
City of Whittier_ 187. 50
$2, 687. 50
(b)1925 — Bordwell, Mathews and Wadsworth #1
City of Long Beach_ $250. 00
East Bay Municipal Utility District_ 250. 00
$500. 00
(c) 1926 — Bordwell, Mathews and Wadsworth #1 City of Long Beach- $350. 00
(d) 1927 — Bordwell, Mathews and Wadsworth #2 City of Long Beach_$1, 325. 00
In the deficiency notice there was included as income from partnerships his distributive share of the amounts set forth above on the basis shown on pages 11 and 12. The petitioner included no part of said fees as income in his return.
The cities of Long Beach, Santa Barbara, Inglewood, El Segundo, Whittier and the East Bay Municipal Utility District, are municipal corporations of the State of California.
It is further stipulated and agreed that the City of Los Angeles, California, during the taxable years, was a city of a population of several hundred thousand resident inhabitants; that during said taxable years, said City of Los Angeles maintained and operated a municipal sewerage system for the disposal of sewage from said city into the Pacific Ocean; that during said taxable years said City of Los Angeles maintained and operated a municipal fire department for the combating and preventing of fires within said city; that said City of Los Angelos during all the taxable years, maintained a system of public streets and highways.

The petitioner asserts that the income which he derived from his contract of August 4, 1922, with the Board of Public Service Commissioners for the City of Los Angeles, herein referred to as the board, is exempt from income tax, and that this exemption followed it as it passed through the several partnership firms to the members thereof. He makes the same contention with reference to the amounts received by the firms of which he was a member from the cities of Long Beach, Santa Barbara, Inglewood, Whittier, and El Segundo, and from the East Bay Municipal Utility District.

Whether petitioners compensation as attorney for the board for the year 1924 is exempt depends solely on whether he was during that year an officer or employee of a political subdivision of the State of California, irrespective of what function the board performed during that year. Section 1211 of the Revenue Act of 1926 governs. This section reads as follows:

Any taxes imposed by the Revenue Act of 1924 or prior revenue Acts upon any individual in respect of amounts received by him as compensation for personal services as an officer or employee of any State- or political subdivision thereof (except to the extent that such compensation is paid by the United States Government directly or indirectly), shall, subject to the statutory period of limitations properly applicable thereto, be abated, credited, or refunded.

It seems clear that the city of Los Angeles is a political subdivision of the State of California and that petitioner was not an officer. The primary question is whether petitioner was during the years before us an employee of the Department of Public Service and therefore an employee of the City of Los Angeles. The question whether the compensation of the petitioner for the year 1923 was exempt was decided in W. B. Mathews, supra. In our opinion in that case, after quoting from Metcalf & Eddy v. Mitchell, 269 U. S. 514, we said:

The facts in the instant case are substantially different from those in Metcalf & Eddy case, supra. Here the services rendered by the petitioner for the Department of Public Service were at all times subject to the control of the Board of Public Commissioners and the City Attorney. The latter’s name appeared on all the pleadings filed by the petitioner on behalf of the city and its subdivisions. The petitioner’s employment was continuous and his compensation was on a definite monthly basis. He devoted practically no time to other matters. His office space, supplies and necessary help were all furnished him by the city. * * *

We there held that the petitioner was an employee of a political subdivision of the State of California. We think our former opinion" is correct. With respect to his outside legal activities, it is stipulated : “ During the taxable years, the petitioner devoted at least 90 to 95 per cent of his time to the fulfillment of his duties as special counsel. While he had connection with a private law firm, he gave practically no attention to it. He visited his private law office infrequently and would be away from it sometimes for several months, although he might be in the City of Los Angeles all during that time.” It would be unreasonable to hold that this slight outside service converted one who was in fact an employee into something else. We hold that during the years before us he was an employee of the Board of Public Service of the City of Los Angeles, California. G. Ridgely Sappington, 25 B. T. A. 1385; Robert P. Bay, 28 B. T. A. 1169. This being the case, his compensation for the year 1924 is not subject to Federal income tax under section 1211 of the Revenue Act of 1926 (applicable to 1924 and prior years).

When we come to consider whether petitioner’s compensation is exempt for the years 1925, 1926, and 1927, we are confronted by an entirely different situation. Leland Powers, Executor, 26 B. T. A. 1381, affirmed by the Supreme Court, 293 U. S. 214. Section 1211 is no longer applicable. In the absence of any statutory provision.exempting the compensation of employees of a political subdivision of a state for the years 1925, 1926, and 1927, we must look to the decisions of the courts. In Fox Film Corporation v. Doyal, 286 U. S. 123, the Supreme Court said:

The principle of immunity from state taxation of instrumentalities of the Federal Government, and of the corresponding immunity of state instrumen-talities from Federal taxation — essential to the maintenance of our dual system — has its inherent limitations. It is aimed at the protection of the operations of government (McCulloch v. Maryland, 4 Wheat. 316, 436), and the immunity does not extend “ to anything lying outside or beyond governmental functions and their exertions.” Indian Motocycle Co. v. United States, 283 U. S. 570, 576, 579. Where the immunity exists, it is absolute, resting upon an “ entire absence of power ” (Johnson v. Maryland, 254 U. S. 51, 55, 56) but it does not exist “ where no direct burden is laid upon the governmental instrumentality, and there is only a remote, if any, influence upon the exercise of the functions of government.” Willcuts v. Bunn, 282 U. S. 216, 225.

The petitioner, as an employee of the Department of Public Service, served the board in connection with its function of furnishing the city of Los Angeles and its inhabitants with water and electric current. It is insisted that talcing into consideration the size and the necessities of that city, a function which elsewhere may be properly termed proprietary, becomes governmental when exercised by that city. To this we are unable to agree.

We have had occasion to consider the question whether a municipality in furnishing water to its inhabitants was exercising a governmental function and have held that it was not. C. S. Denman, 27 B. T. A. 256; Edward J. Miller, 28 B. T. A. 229; Citizens Water Works, Inc., 33 B. T. A. 201. It may be pointed out that the Supreme Court of California follows the general trend of decisions, holding that the furnishing of water to a city is proprietary and not governmental in its nature. Davoust v. City of Alameda, 149 Cal. 69; 84 Pac. 760; Marin Water & Power Co. v. Town of Sausalito, 168 Cal. 587; 143 Pac. 767; City of South Pasadena v. Pasadena Land & Water Co., 152 Cal. 579; 93 Pac. 490; In re Bonds of Orosi Public Utility District, 196 Cal. 43; 235 Pac. 1004. The same rule, we think, applies to the furnishing of electric current. Cf. Helvering v. Powers, 293 U. S. 214. In Los Angeles Gas & Electric Co. v. City of Los Angeles, 241 Fed. 912, the question was whether the city .could remove the. poles of a private company and install those of the city owned system. It was argued that the lighting of the streets was necessary from a police standpoint, in fact an exercise of the police power. The court held against such contention. This case was affirmed in Los Angeles v. Los Angeles Gas & Electric Corporation, 251 U. S. 32, where the Supreme Court, among other things, said:

The court reasoned and concluded that what the city did was done not in its governmental capacity — an exertion of the police power — but in its “ proprietary or quasi-private capacity ” and that therefore the city was subordinate in right to the corporation, the latter being an earlier and lawful occupant of the field. The difference in the capacities is recognized and the difference in attendant powers pointed out in decisions of this court. Vilas v. Manila, 220 U. S. 345; Russell v. Sebastian, 233 U. S. 195; South Carolina v. United States, 199 U. S. 437; New Orleans Gas Co. v. Drainage Commission, 197 U. S. 453; Vicksburg v. Vicksburg Waterworks Co., 206 U. S. 496, 508.

These cases, we think, dispose of the claim that exemption arises from the fact that a part of the electric current and water was used for street lighting and for other municipal purposes.

In Helvering v. Powers, supra, the Supreme Court said:

If the business itself, by reason of its character, is not immune, although undertaken by the state, from a federal excise tax upon its operations, upon what ground can it be said that the compensation of those who conduct the enterprise for the state is exempt from a federal income tax? Their compensation, whether paid out of the returns from the business or otherwise, can have no quality, so far as the federal taxing power is concerned superior to that of the enterprise in which the compensated service is rendered.
We conclude that the Congress had the constitutional authority to lay the tax.

On the strength of these cited authorities, we think that none of the compensation received by petitioner’s decedent as an employee of the Board of Public Service of the City of Los Angeles for the years 1925,1926, and 1927 was immune from taxation.

We have been .given no information as to what relation the firms of which the petitioner was a member bore to the cities of Long Beach, Inglewood, Santa Barbara, El Segundo, and Whittier, and to the East Bay Municipal Utility District. Certainly the members of the respective firms were not officers of these several municipalities or any of them and the stipulation discloses no sufficient facts to justify us in holding that the respective firms were employees of the several municipalities named or any of them. The respondent is affirmed in including in petitioner’s taxable income the amount which he received from these cities. Cf. E. A. Simpson, 28 B. T. A. 556; Register v. Commissioner, 69 Fed. (2d) 607.

Petitioner is only contending that $6,000 of the $12,000 salary received by W. B. Mathews from the Department of Public Service of the City of Los Angeles in 1924 is exempt from taxation to petitioner’s decedent. This fact is shown by assignment of error (b) in the petition, which reads as follows:

(b) The failure of the respondent to find that $6,000 of income received through the partnership of Bordwell & Mathews, and reported by petitioner in the return filed for the calendar year 1924, was in fact income not subject to the income tax, and the failure of respondent to eliminate such $6,000 from taxable income.

It appears that the Commissioner has included the other $6,000 of the $12,000 salary received by W. B. Mathews, in the income tax return of Walter Bordwell, a member of the partnership of Bord-well & Mathews, and the correctness of his action in so doing is before us in another proceeding, Docket No. 42919, Security Trust & Savings Bank and Mary E. Bordwell as coexecutors of the estate of Walter Bordwell, deceased. The latter proceeding has not been consolidated with the instant case and will, therefore, be decided separately.

Under the facts stipulated and the authorities above cited, we sustain petitioner’s assignment of error (b) and hold that the $6,000 in question was exempt from taxation under section 1211, Revenue Act of 1926.

Having determined that the petitioner’s salary for the years 1925, 1926, and 1921 was taxable, the Commissioner is affirmed as to those years.

Reviewed by the Board.

Decision will be entered under Rule SO.


source: Caselaw Access Project

author: Seawell:

license: Public Domain

text:
    Henry K. Chapin, Petitioner, v. Commissioner of Internal Revenue, Respondent.
    Docket No. 59994.
    Promulgated December 11, 1935.

      Samuel B. Kraus, Esq., for the petitioner.

      G. R. Marshall, Esq., for the respondent.
   OPINION.

Seawell:

Respondent determined a deficiency in income tax of petitioner for the year 1927 in the amount of $19,746.56.

The deficiency arises, in part, by reason of the respondent’s determination that the petitioner realized taxable gain of $151,146.91 on the sale of a parcel of land based upon a fair market value of $100 per share for stock received as part of the consideration for the property, and further gain of $28,582.85 realized from a sale later in the year of a portion of the stock so received, computed on a cost basis of $100 per share. In his return for 1927 the petitioner placed no fair market value on the stock, and, since the cash received in the sale was less than his cost basis, reported no gain. As to the stock subsequently sold, he reported gain computed by deducting from the selling price the unrecovered cost basis of the land, increased by the amount of an assessment. The question is the fair market value, if any, of the shares of stock at the time received, the contention of the respondent being that it had a fair market value of $100 per share, as determined by him, and the claim of the petitioner being that the stock had no fair market value at that time.

The case was submitted upon a stipulation covering substantially all the facts and the tetsimony of one witness called by petitioner.

Petitioner is an individual, residing in Chicago, Illinois. In 1916 he purchased for investment at a total cost of $73,853.09 a parcel of real estate in Chicago fronting on Lincoln Park at No. 2430 Lake View Avenue, this realty being hereinafter referred to as the Lake View Site.

On or about November 19, 1926, petitioner and eight other men agreed orally to organize a corporation to acquire said Lake View Site and construct a cooperative apartment building thereon under a plan hereinafter appearing. Accordingly, on November 19, 1926, a corporation was organized under the laws of the State of Illinois by petitioner and the eight others, under the name of 2430 Lake View Avenue Corporation (the name was changed on December 24, 1926, to 2430 Lake View Avenue Building Corporation, hereinafter sometimes referred to as the building corporation). The authorized capital stock of the corporation was $550,000, represented by 5,500 shares of stock of the par value of $100 per share. There were nine stockholders, including petitioner, when the corporation was organized, but immediately thereafter another joined in the agreement with reference to the cooperative apartment and became the tenth stockholder, the ten being sometimes referred to hereinafter as the original stockholders. The entire authorized capital stock of the building corporation was subscribed for by the original stockholders at par. The petitioner received 1,750 shares thereof together witli $50,000 in cash, all in the year 1927, for the conveyance by him to the building corporation o.f the Lake View Site. This transaction was entered on the books of the building corporation at a cost to it of $225,000. The remaining 3,750 shares of the stock were issued in equal blocks of 416% shares to each of the nine other original stockholders, as it had been subscribed. Under the plan adopted (at first orally, later embraced in the bylaws) the ownership of 323-9/17 shares of stock of the building corporation was a prerequisite to owning a proprietary lease in the apartment building. Each of the original stockholders held and retained such number of shares, designated as qualifying shares, in addition to shares not so designated. The original stockholders agreed, and it was later incorporated in the bylaws of the building corporation, that the stock in excess of qualifying shares held by each should be held for resale on the holders’ own account, and that the stock should be sold only in blocks of 323-9/17 shares, contributed by all the stockholders proportionately out of their several holdings of stock above qualifying shares.

About the end of November 1927 an 18-story apartment building, containing 17 apartments, with space for laundry and storage room for each apartment on the basement floor, was completed on the Lake View Site at a cost of $1,113,940.88. It stood in an almost unbroken line of the finest and most desirable skyscraper hotel and apartment buildings existing in Chicago.” Money borrowed from a bank was used to pay part of the cost of construction and became an indebtedness thereafter assumed or paid proportionately by leaseholders. Apartments were allotted to each of the original stockholders. The entire fourth floor was allotted to petitioner, with usual basement space, The other nine original stockholders were each allotted a duplex apartment, that is, one half of two contiguous floors, one above the other, with basement space. This allotment of space to the original stockholders was agreed upon when the building corporation was organized.

Pursuant to authority granted by resolution of the board of directors of the building corporation on November 18, 1927, the ten original stockholders sold and transferred to Iver Lawson and E. A. Cudahy 323-9/17 shares each of the stock of the building corporation ; and the proper officers of the corporation, under like authority, leased to Lawson the south apartment on the seventh and eighth floors, together with basement space, and to Cudahy the south apartment on the ninth and tenth floors, together with basement space. These leases commenced December 1, 1927, and the term extends to April 30, 2026. This is the term provided in the bylaws and in a form of lease prescribed November 18, 1927, by the building corporation for all leases. The lease to the original stockholders contains the same term. Laivson and Cudahy each paid for the transfer of the stock and the granting of the “ proprietary leases ” the sum of $55,000 in cash to the former owners of the stock, and each assumed all the obligations contained in his proprietary lease contract, including payment of his pro rata share of the outstanding indebtedness of the corporation, of which $44,117.65 was apportioned to each apartment. Lawson paid the indebtedness apportioned to his apartment on December 1, 1927, and Cudahy paid that apportioned to his apartment on February 3, 1928. Of the $110,000 paid for stock in cash by Lawson and Cudahy, each of the original stockholders was credited with and received during 1927 an amount bearing the same relation to $110,000 as the stock of the original stockholders in excess of 323-9/17 qualifying shares of each bore to all such excess stock, and upon Lawson and Cudahy receiving their leases the original stockholders were relieved from all liability with respect to the two apartments taken by Lawson and Cudahy. The number of petitioner’s shares sold to Lawson and Cudahy was 408.3264, for which petitioner received $69,415.49. On June 22, 1928, qualifying shares were sold to one Frank E. Wilhelm, with a proprietary lease of an apartment, for the same consideration as paid by Lawson and Cudahy each.

Upon the foregoing and all pertinent facts of the case, respondent contends that the shares of stock of the building corporation had a fair market value of $100 per share when acquired by petitioner, and that that value was petitioner’s basis upon his sale of 408.3264 shares to Lawson and Cudahy. Petitioner’s contention on the contrary, as expressed by his counsel, is “ that in the very nature of things, and due to the fact that the value, if any, is bound up with so many speculative features, that no fair market value can be attributed to the stock.” Summed up more specifically in the brief, it is contended that absence of fair market value of the stock is shown by the plan of the original stockholders to operate a residential apartment house on a mutual and cooperative basis for the exclusive use of the stockholders and without profit or remuneration to the corporation, under which plan “ the sale, assignment, transfer or conveyance, either voluntarily or involuntarily, of any shares of stock of the corporation without the written approval of a majority of the Board of Directors shall not entitle the purchaser or assignee of said stock to receive a stockholder’s proprietary lease of any apartment in the building ”; that the total value of an interest in the corporation lies entirely in the use of an apartment — the lease— and none of it inheres in the stock itself, which stock can reap no profit, receive no dividend, and, under the restrictions of the bylaws, is itself not salable; that there were no contemporaneous sales of stock, solely as such without lease rights, from which to judge the fair market value of stock alone; and that a witness for petitioner testified that, in his opinion, the stock, by reasons of such restrictions, had no fair market value, standing alone as such, which testimony was not contradicted by any other witness at the hearing.

The reasons assigned by petitioner are not convincing, and seem insufficient to overcome the presumption which favors respondent’s determination, or to outweigh the evidence of fair market value produced on the trial. Before the corporation was formed those to compose the original stockholders entered into an agreement to accept at par all the stock to be apportioned among them. This was done and the price paid, not merely to give each of the ten original stockholders 323-9/17 shares of stock and a 99-year proprietary lease, but to insure the intrinsic value of the stock and lease by withholding sales to undesirable persons. Petitioner received 1,426-72/153 shares of stock in addition to his qualifying 323-9/17 shares, and each of the other original shareholders received 93-21/153 shares in addition to his qualifying 323-9/17 shares. These shares of stock in excess of 323-9/17 shares were paid for by the original stockholders, except petitioner, at $100 per share, but could not be availed of by them to secure a proprietary lease in the apartment building. No shareholder except petitioner held sufficient additional shares to make up a block of qualifying shares if he had been permitted to sell them. The agreement among the original stockholders also provided that the surplus shares were to be sold only conjunctively and proportionately to the shares each held. In this way petitioner was doubly insured against the encroachment of undesirables, for he held a veto power. Of course petitioner and the other stockholders at all times held the power to abrogate all restrictions on the sale of stock or leases. The restrictions were relaxed in a later year and two temporary leases, with option to convert them into proprietary leases, were sold.

When the usual power of unrestricted alienation is separated from ownership of property, the value of the property, as a trading commodity, is usually lessened; but not necessarily destroyed. Frederick A. Koch, Jr., Executor, 28 B. T. A. 363. Power of alienation, or its absence, would not affect the value of property in the hands of one who did not wish to sell. Restrictive agreements not to sell corporate stock do not necessarily deprive the stock of fair market value. T. W. Henritze, 28 B. T. A. 1173.

The sale of the stock of the building corporation in this case was restricted only to a class. All persons who were approved by the board of directors of the corporation as proper tenants of the apartments could buy stock from the stockholders and with the prescribed number of shares could secure a proprietary lease. The restriction as to the class of purchasers could have been removed, or modified, by the stockholders and directors. It appears only inferentially that the increase in the price of the stock (about 70 percent above par) in the hands of the stockholders may have affected the sale of stock supporting the leases for the remaining apartments.

In affirming a decision of the Board involving a comparable question of law, the Circuit Court of Appeals for the Tenth Circuit, in Newman v. Commissioner, 40 Fed. (2d) 225; certiorari denied, 282 U. S. 858, said:

Where a person agrees to receive, as consideration for the exchange of property, either a joint interest in property which cannot be sold without the consent of all the joint owners or an individual interest in a whole in which others have individual interests and which, by agreement, cannot be sold without the consent of all the parties in interest, we are of the opinion that the test to be applied in determining whether taxable income has been derived is not whether the property has a market value and is convertible into cash by such person, but whether it has a market value and is convertible into cash by those who, under the agreement of the parties, are vested with the power of sale. In other words, where a person voluntarily exchanges his property for other property under conditions that vest the power to sell the property received jointly in him and other persons, he receives taxable income to the extent of the profit derived from the transaction, if the property received has a market value and is salable by those in whom the power of sale is vested under his voluntary agreement.

It may be true that stock of the corporation separated entirely from the right to any use of an apartment would have no fair market value, but the stock of the building corporation was not intended to be so separated. ISTo one would buy as an investment the stock so separated. But the facts show that the requisite amount of stock in the hands of one who wished a tenancy in the building and who had been accepted as a tenant was very valuable and was salable at a fair market value. The fact that two of the apartments have not been leased and the requisite stock to support such leases has not been sold at the price at which the owners held the stock does not disclose that the stock was not of the fair market value of $100 a share. The building, one of the finest in Chicago in an area of other fine hotels and apartments, cost more than a million dollars; it had 17 apartments with 12 to 14 rooms in each apartment; the yearly rental value of each apartment was $12,000; a 99-year lease of an apartment in 1927 was of the value of $120,000. These values were given by petitioner’s witness, whose testimony, however, as to the fair market value of the stock had reference to stock irretrievably separated from the possibility of a lease, a situation not present here, and is of doubtful value to us on that account in deciding the issue before us.

While ownership of 323-9/17 shares of stock was necessary to the acquisition of a lease, that was not all that was required to obtain and hold a lease. Under the bylaws and the form of lease contract required many burdens were placed upon the lessee. In addition to a nominal $1 a year rent, he was required to assume and pay his part of the existing mortgage debt on the property, at that time amounting to $44,111.65 for each tenant, and to pay his proportionate part of maintenance cost, general taxes, water rates, insurance premiums, repairs, interest on mortgages which might be given from time to time in the discretion of the directors, cost of financing mortgages, payment of liens, reserves set up in the discretion of the directors to meet any unexpected or extraordinary expense, and much other expense provided for in the contract of lease.

We sustain the respondent in his determination of the fair market value of the stock of the building corporation when acquired by petitioner, and as to the basis for gain on the sale of the stock when a portion of it was sold in 1927 by petitioner.

It was stipulated at the hearing that the original stockholders paid commissions to brokers for negotiating the sales to Lawson and Cudahy in the sum of $2,973.52, a pro rata portion of which, according to stock ownership, was allocated to and paid by petitioner. This amount will be considered in a recomputation under Hule 50.

Decision will be entered under Rule 50.


author: McMahon :

text:
    Blue Line Holding Company, a Corporation, and George B. Coleman and Sue Coleman, Trustees of the Blue Line Holding Company, a Corporation, Petitioners, v. Commissioner of Internal Revenue, Respondent.
    Docket No. 74725.
    Promulgated December 11, 1935.

      H. B. Jones, Esq., for the petitioners.

      P. A. Bayer, Esq., for the respondent.
   OPINION.

McMahon :

This is a proceeding for the redetermination of a deficiency in income tax for the calendar year 1931 in the sum of $3,615.92.

It is alleged that the respondent erred in adding to income as profit on the sale of assets an amount of $32,542.22. At the hearing the issue was narrowed to the single question of whether the sale was made by the petitioner or whether the assets had theretofore been transferred by petitioner to its■ stockholders and the sale made by them.

The Blue Line Holding Co., hereinafter referred to as the petitioner, was, until March 14,1932, a corporation organized and existing under the laws of the State of Washington. On or about that date it was duly disincorporated by proceedings in the Superior Court for King County of the State of Washington. At that time George B. Coleman and Sue Coleman were and thereafter continued to be the trustees of the corporation, and as such were and are empowered under the laws of the State of Washington to manage, continue and wind up the affairs of the corporation. These individuals are residents of Seattle, Washington.

George B. Coleman and Sue Coleman, husband and wife, were the owners of all the stock of the petitioner.

Two brothers, E. Royce and B. Boyce, of Portland, Oregon, were desirous of purchasing the taxicab business operated by the petitioner in Seattle. Besides operating taxicabs, the petitioner operated a gasoline station having as an adjunct a shop for repairs, tires, accessories, etc. This station and lot were under lease to the petitioner. The Boyces approached George B. Coleman and negotiations were carried on for two or three months prior to March 13,1931.

On March 13, 1931, George B. Coleman and Sue Coleman, as parties of the first part individually, and as owners of all the stock of the petitioner and of the Boyal Blue Cab Co., entered into an agreement with E. Boyce and B. Boyce, parties of the second part, Avhereby they agreed to sell to the parties of the second part, or a corporation to be organized by them, to be known as the Boyal Blue Taxicab Co., all the assets of such corporation, including 39 automobiles, except cash, deposit on insurance, and assets receivable to March 1, 1931. In payment therefor the parties of the second part agreed to pay $75,000, of which $40,000 was to be in cash. Such parties agreed to assume and pay the installment payments on the taxicabs purchased under conditional sale contracts. The remainder of the purchase price was to be paid in two equal payments, represented by notes. It was agreed therein that all the stock of the new corporation to be organized by the parties of the second part should be placed in escrow with a bank as collateral for payment of the notes. Parties of the first part agreed to dissolve the petitioner and the Boyal Blue Cab Co. It was further agreed that George Coleman should be employed as manager of the new corporation for one year.

On March 20, 1931, George B. Coleman and Sue Coleman, as parties of the first part, the petitioner, party of the second part, and E. Boyce and B. Boyce, as parties of the third part, entered into a supplemental agreement providing in part as follows:

Whereas, parties of the first part are not in a position at this time to make and execute a transfer, with the consent of the lessor, of rented premises located in Seattle and now occupied by second party as lessee, and possibly not in a position at this time to make formal assignments or transfers of taxi licenses, etc., and parties of the third part have not at this date organized a proposed corporation, mentioned in said contract and to be called “ Boyal Blue Taxicab Co.”;
Now, Therefore, by This Supplemental Agbeement, It Is Agree©:
1. Parties of the first and second parts have this day made, executed and delivered to parties of the third part a bill of sale of a portion of the properties described in said contract, and have delivered possession of all of said taxicabs and all other of said properties, except possession has not been delivered of said leased premises, nor have third parties executed the notes for the deferred payments of said purchase price nor placed in escrow, as collateral security for the payment of said notes, the stock of said proposed new company.
2. It Is Further Agreed that within fifteen (15) days from this date, the parties of the first and second parts will do and perform all other things requisite or necessary to fully do and perform the conditions of said contract on their part to be done and performed, including the transfer and assignment of the lease of said leased premises, with the consent of the lessor, and the parties of the third part will, within said period of time, perform all other acts and things by them to be done and performed as provided in said contract.
3. Parties of the first and second parts hereby agree and consent that parties of the third part may organize a corporation under the laws of this state, to be called “ Boyal Blue Taxicab Co.”, and agree to file with the Secretary of State a written consent to said effect, and parties of the third part hereby agree, within a period of five (5) days from this date, to organize said corporation.
4. Second party hereby adopts, ratifies, confirms and approves said contract of March 13, 1931, inasmuch as it is the owner of the property affected by said contract.

Although the above supplemental agreement refers to a bill of sale, there was no bill of sale to the Boyces or the corporation to be organized by them prior to April 1, 1931. On that date, by a bill of sale, the petitioner and George B. and Sue Coleman, as parties of the first part, in consideration of the sum of $10 “ and other good and valuable consideration, to them in hand paid by Boyal Blue Cab Company, * * * party of the second part ”, purported to sell and transfer to the party of the second part certain listed personal property, including 12 taxicabs, it being the intention of the parties of the first part to convey generally the physical properties located at 2104 Second Avenue or wherever found and used in the conduct of the business of first parties at said location. * * * and subject to the provisions of that certain agreement entered into on the 13th day of March, 1931 * * This bill of sale was signed for the petitioner by G. B. Coleman, president, and Sue Coleman, secretary, and was also signed by G. B. Coleman and Sue Coleman as stockholders of petitioner.

The $40,000 down payment was made by a cashier’s bank check, dated April 9, 1931, payable to the petitioner. Such check was endorsed for the petitioner by G. B. Coleman, president, and thereafter by G. B. Coleman individually. It was cashed on April 14, 1931. The check was received by George B. Coleman, who cashed it and appropriated the money to his own use.

The Boyal Blue Cab Co. and the Boyce brothers, as individuals, executed two promissory notes, each dated April 11, 1931, and each in the principal sum of $10,746.20, with interest at 6 percent, one being payable October 1, 1931, and the other April 1, 1932, to the order of G. B. Coleman. These notes were received by Coleman, who did not turn them over to the petitioner but kept them personally. When the notes were paid, the proceeds were placed in his own personal account. On April 16, 1932, G. B. Coleman acknowledged receipt of the amount due under the note, the maturity date of. which was April 1, 1932, and authorized the escrow agent to release the stock to the Boyal Blue Cab Co. He thereby released such company from any and all claims he might have against it, except for salary. The remainder of the purchase price of $75,000 was made up of contracts payable assumed by the purchaser. These amounted to $13,507.60.

By instrument dated April 11, 1931, E. Boyce transferred in escrow to a bank of Seattle, as collateral security for the payment of the promissory notes, 396 shares of the capital stock of the Boyal Blue Cab Co. owned by him. It was therein recited that the Boyal Blue Cab Co. jointly with E. Boyce and B. Boyce had delivered to George B. Coleman two notes as a part of the purchase price of taxicabs and equipment purchased by the Boyal Blue Cab Co. from the petitioner and George B. Coleman and Sue Coleman, his wife, as stockholders thereof. In such escrow agreement, E. Boyce agreed that in the event of the nonpayment of the notes or interest, the bank had authority to deliver the stock to George B. Coleman for foreclosure.

There is nothing in the books of petitioner to show the disposition of its assets by way of dividend or otherwise, or that petitioner received the purchase price of $75,000 or any part of it.

In the income tax returns of George B. Coleman and Sue Coleman for 1931 there is no showing of a distribution to them of assets of petitioner as a dividend or otherwise.

In the income tax return of petitioner for 1931 there was no showing of the disposition by petitioner of its assets except that in the balance sheet forming a part of the return the assets shown at the end of the year are considerably less than the assets shown at the beginning of the year. Petitioner returned no profit in such return upon the disposition of its assets.

In the notice of deficiency the respondent treated the sale as a sale by petitioner of its assets and included in its taxable income a gain of $32,542.22 upon the sale. In determining the cost thereof to the petitioner the respondent accepted the cost balances appearing in the petitioner’s ledger, less the reserve for depreciation shown therein.

Upon the foregoing facts, which we find, the sole question presented for our determination is whether the profit of $32,542.22 determined by respondent to have been derived from the sale of the assets in 1931 to the Boyce brothers or a corporation organized by them was income to the petitioner. There is no issue raised as to the amount of profit, but the petitioner contends that the sale was not made by it, but by its stockholders, to whom it had previously transferred its assets. Respondent held that the sale was made by petitioner and that the gain is taxable to petitioner.

The respondent’s holding that the profit was income to the petitioner has the support of a presumption of correctness and the petitioner has the burden of proving it to be wrong. Welch v. Helvering, 290 U. S. 111.

Assuming its burden, the petitioner attempted to show a transfer of the assets from it to its two stockholders and from them to the ultimate purchaser. Witnesses for the petitioner testified, in substance, that such was the plan and that it was adopted in order to save tax; that a meeting of the two stockholders was held at or about April 1, 1931, at which an arrangement was made between the petitioner and its stockholders with regard to the transfer of the assets; that this arrangement was recorded in the minutes of a special meeting of the board of trustees; that such minutes contained a resolution by the trustees declaring a dividend in an amount of $30,000 and providing that the dividend should be paid by the transfer of certain specified items of personal property to the two stockholders; that a bill of sale was drawn transferring the assets from the petitioner to the two stockholders; and that both the bill of sale and the minutes are lost and can not be found.

However, under all the facts and circumstances, the testimony of these witnesses is not adequate to establish petitioner’s contention. There is nothing in the record from which we can determine the provisions of the bill of sale or the minutes. No witness has informed us as to the language or details of the alleged arrangement, minutes or bill of sale. All we have in this respect are the opinions or conclusions of the witnesses to the effect that such arrangement and minutes furnished the basis for a transfer or distribution of the assets to the stockholders, and that a purported bill of sale accomplished a sale or distribution. These are the vital questions which we are called upon to decide in the instant proceeding and we can not permit the witnesses’ opinions or conclusions to be substituted for our decision. Furthermore, the respondent challenges the existence of such minutes and bill of sale, and there is evidence in the record which, tends to support his position in this respect. There is no basis in the evidence as a whole for findings of fact or conclusions of law, made in the exercise of our independent judgment, to the effect that the parties accomplished a sale or distribution of any of the assets in question from the petitioner to its stockholders, the Colemans.

On the other hand, we know that on March 13, 1931, the date the agreement to sell was executed, the Colemans were stockholders of the petitioner and not owners of its property, they signing such agreement as stockholders rather than owners of assets; that in the supplemental agreement of March 20, 1931, the petitioner was made a party and confirmed the agreement of March 13, 1931, “ inasmuch as it is the owner of the property affected- by said contract ”; that the bill of sale dated April 1, 1931, by which the assets were transferred to the Boyce’s corporation, the Boyal Blue Cab Co., was executed by the petitioner; that the Colemans, in signing such bill of sale, signed only in their capacities as officers of the petitioner and as stockholders thereof, and not in their capacities as individuals; that the check representing the initial payment in the purchase of the assets was made payable to the petitioner; that in the escrow agreement it was recited that the assets were purchased from the petitioner and the Colemans as stockholders thereof; that some of the assets of the petitioner, notably the lease, were never transferred by the petitioner to the stockholders; and that neither the individual income tax returns of the Colemans nor the return of the petitioner for 1931 showed a distribution or sale of the assets of petitioner to its stockholders. Vital things, about which there is no dispute, which the parties actually did and omitted to do in regard to the transaction are more persuasive than conflicting parol evidence. They support respondent’s determination.

It may be added that in our opinion the fact that the bill of sale was executed by the corporation is open to the inference that the purchaser would not accept title to the assets from the stockholders as individuals.

While the petitioner does not make the contention that it derived no income for the reason that it never actually received the proceeds of the sale (such proceeds having been retained by its stockholder, Coleman, personally), it may not be amiss to state that the fact that the petitioner did not take action to recover the proceeds from its stockholder does not relieve it of liability for the tax. See Garrison Bros. State Bank v. Commissioner, 67 Fed. (2d) 486, affirming Garrison Bros. State Bank, 25 B. T. A. 673. Furthermore, there is no evidence to establish that Coleman did not account to the corporation for the moneys paid for the assets.

We note that in the agreement to sell, dated March 13, 1931, the assets to be transferred are referred to as those of the petitioner and also of the Rojal Blue Cab Co. However, the petitioner makes no contention that for this reason the profit was not all income to it, and the facts do not justify our disturbing the respondent’s determination upon this ground.

After considering all of the evidence in the record, we are constrained to hold that the petitioner has not overcome the presumption in favor of the correctness of the respondent’s determination.

Decision will be entered for the respondent.


author: Mtjrdock :

text:
    George A. Lembcke, Petitioner, v. Commissioner of Internal Revenue, Respondent.
    Docket No. 75365.
    Promulgated December 11, 1935.

      Allen G. Gartner, Esq., for the petitioner.

      O. A. Ray, Esq., for the respondent.
   OPINION.

Mtjrdock :

The Commissioner has applied section 115(g) of the Revenue Act of 1928, which provides:

If a corporation cancels or redeems its stock (whether or not such stock was issued as a stock dividend) at such time and in such manner as to make the distribution and cancellation or redemption in whole-\or in part essentially equivalent to the distribution of a taxable dividend, the amount so distributed in redemption or cancellation of the stock, to the extent that it represents a distribution of earnings or profits accumulated after February 28, 1913, shall be treated as a taxable dividend.

The petitioner concedes that if the distribution in question was at such time and in such manner as to. make it essentially equivalent to the distribution of a taxable dividend, then the amount distributed represented in its entirety a distribution of earnings or profits accumulated after February 28, 1913. He contends, however, that sections 113 (c) and (h) apply, that is, that the distribution and redemption of the preferred stock was in partial liquidation of the corporation, since the term “ amounts distributed in partial liquidation ” is defined in subsection (h) as a distribution by a corporation in complete cancellation or redemption of a part of its stock. Undoubtedly the distribution in question was in complete cancellation or redemption of the 215% shares of stock owned by the petitioner. Subsection (c) provides that amounts distributed in partial liquidation of a corporation shall be treated as in part or full payment in exchange for the stock. The parties have agreed that if the petitioner’s contention is correct, the gain determined under section 111 was $8,788.09 and all of it is recognized for tax purposes. The respondent does not contend that it would not be taxable as capital gain.

The Commissioner has determined that the distribution was at such time and in such manner as to make it essentially equivalent to the distribution of a taxable dividend. It was, therefore, encum-bent upon the petitioner to produce sufficient evidence to overcome the presumption of correctness which attaches to the Commissioner’s determination. He sketched, by his evidence, the history of the corporation in so far as changes in its capital structure were concerned. The details of the issuance and redemption of the particular stock in question appeared as a part of that evidence. Thus far there is no dispute between the parties.

The only witness for the petitioner was Oscar M. Bernuth. He had been interested in the business of the corporation since 1898 and was president of the corporation during the period most important to this proceeding. Fie gave several reasons for the increase in the capital stock which took place in 1927 and also for the increase in capital stock and the change from common to preferred stock which was made in 1929. Some of his reasons are not clear or persuasive, particularly when viewed in the light of other evidence in the case. However, two of his reasons are not without force. The corporation was forced by the necessities of its business to borrow a considerable amount of money from banks on its short term unsecured paper. The banks making these loans preferred that the corporation should have a larger capitalization and felt that the credit which they extended to the corporation would be better secured if such an increase were made. The witness stated that this was one of the reasons for the increase in 1927 and also one of the reasons for the increase in 1929. Another reason which he gave us was that the petitioner had expressed a desire to retire from active participation in the business and in anticipation of this retirement, which actually took place in 1931, had requested that a larger portion of the investment of the stockholders in the corporation be placed in preferred stock. These two reasons can not be disregarded. They indicate that the stock dividends of 1927 and 1929 were declared for legitimate business purposes rather than to disguise the later distribution of cash dividends. The redemption in 1931 was no part of a plan to distribute cash dividends in avoidance of tax. The redemption was at par. The amount distributed was relatively small. Neither the time nor the manner of the redemption indicates an ordinary dividend. Cf. Annie Watts Hill, 27 B. T. A. 73; affd., 66 Fed. (2d) 45. It was a true partial liquidation.

Decision will be entered vrnder Rule 50.


author: Sea well:

text:
    American Arch Company and Subsidiary, American Arch Company, Inc., Petitioners, v. Commissioner of Internal Revenue, Respondent.
    Docket No. 77269.
    Promulgated December 12, 1935.

      George A. Price and H. W. Muller, for the petitioners.

      R. N. McMillan, Esq., and Wilford H. Payne, Esq., for the respondent.
   opinion.

Sea well:

All of the evidence in these proceedings is embodied in a stipulation of facts, which is incorporated herein by reference as our findings of fact.

The American Arch Co., the petitioner herein, was organized in 1917 under the laws of Delaware, and the American Arch Co., Inc.. was organized in 1920. Thereafter the corporations filed consolidated returns each year to and including 1921, in which they reported net income on the accrual basis.

For the fiscal years ended February 28, 1918, and February 28, 1919, the 10-month period ended December 31,1919, and the calendar years 1920 and 1921, the petitioner claimed depreciation on certain patents owned by it on the basis of a useful life of 19% years. As a result of a suit brought sometime prior to 1922 involving infringement of the patents, the petitioner determined that the patents had a useful life of only 17 years, and in its income tax return for 1921 it accordingly claimed depreciation on the patents on the basis of a life of 17 years. The return for 1921, showing a tax liability of $239,970.72, was accompanied by amended returns for the four preceding taxable periods, in which depreciation on the patents was recomputed on the basis of a 17-year life. The petitioner requested that the overpayments of tax in the amount of $128,160.21, as disclosed by the amended returns, be applied as a credit against its income tax liability for 1921.

In 1926, prior to any action by the respondent on the petitioner’s claim for credit, the petitioner, upon the presentation of a writ of distraint by the collector, paid the remaining portion of $128,160.21 of its 1921 income tax liability, plus interest and penalty in the amount of $26,913.64, a total of $155,073.85. The petitioner, in pursuance of its contention that it should not be required to pay the tax and interest demanded by the collector for 1921, in view of the fact that it expected its claim for overpayment of tax for the years 1917 to 1920, inclusive, would eventually be allowed by the Commissioner, then set up on its books an account receivable under the title “ Claim for United States Government Tax Refund ” in the amount of $155,073.85. As the result of such entry, the petitioner failed to claim a deduction in its 1926 return for the interest and penalty paid in the amount of $26,913.64.

The income tax liability for the petitioner for 1921 was redetermined by the Board on February 16, 1931, based upon an agreement on the amount of the deficiency. In May 1931 the respondent completed his consideration of the petitioner’s claim for credit for the years 1917 to 1920, inclusive, and determined that its taxes were overpaid for those years in the aggregate amount of $121,128.73, and that the petitioner was also entitled to interest thereon in the amount of $74,709.16, a total of $195,837.89, which was paid in 1931.

Upon receipt of the overpayment the petitioner credited $155,-073.85 of the amount to the account previously set up under the title “ Claim for United States Government Tax Refund ” and reported the amount of $40,127.05 as income for 1931. The respondent treated all of the payment of $74,709.16 as taxable income in 1931 and increased the income reported by petitioner by $34,582.11. This action resulted in the determination of a deficiency of $3,229.64 in income tax for 1931. The petitioner concedes that it understated the amount of taxable interest for 1931 by $7,668.47, thereby reducing the amount of interest in controversy to $26,913.64, a sum equal to the interest and penalty paid in 1926. The taxability of such amount as interest received in 1931 is the only question before us.

Although it is stipulated that the item of $26,913.64 was paid by the petitioner in 1926 as penalty and interest, the amount of each not appearing, in the briefs filed on behalf of the parties the amount is referred to as a payment of interest. Since under our view of the case the point is not material, we will assume that the whole sum constituted interest on unpaid income tax for 1921.

The petitioner is not contesting the right of the Government to impose a tax on interest paid on an income tax refund. Such interest has been held to be taxable. American Viscose Corporation, 19 B. T. A. 937; affd., 56 Fed. (2d) 1033; certiorari denied, 287 U. S. 615. It does contend, however, that, on account of the pending claim for overpayment of taxes for prior years, no deficiency in payment of tax for 1921 ever existed, with the result that there was no indebtedness for tax upon which an interest charge could properly be made. It regards the payment of $155,073.85 made under protest in 1926 as an advance or in the nature of collateral pending final action on its credit claim, thus creating a right to offset the amount of interest paid in 1931 on the tax refund by the alleged interest paid in 1926.

The effect of the petitioner’s argument is that payment of an unpaid balance of tax liability for a taxable year may be held in suspense, without interest, until final determination of a pending application for credit for an alleged overpayment of taxes for prior years. It cites no authority for such a privilege, and we know of none. The applicable statute provides for the times when the tax, as shown by the return, is due and payable, and liability for interest if the tax is not paid on the specific dates. Sec. 250 (a), Revenue Act of 1921. Section 252 contains authority for the application of excess tax payments for years prior to 1921 against tax due under any other return, when an examination of any return discloses an overpayment of tax, but makes no provision for suspending interest charges on overdue tax during the period a claim for credit is pending. Here there was no acknowledgment of liability for overpaid taxes until 1931, and interest on unpaid tax for 1921 and interest on overpayments of tax for prior years were not accruing at the same time. The petitioner’s right to interest on the amount of the refund did not exist before the claim was allowed. Sec. 1324 (a), Revenue Act of 1921.

Deductions from gross income are a matter of legislative grace and may not be taken unless plainly authorized. New Colonial Ice Co. v. Helvering, 292 U. S. 435; Helvering v. Inter-Mountain Life Insurance Co., 294 U. S. 686. The statute allows as a deduction “All interest paid or accrued within the taxable year on indebtedness.” Sec. 23 (b), Revenue Act of 1928. The interest sought to be offset against interest received in 1931, was not “ paid or accrued ” in the taxable year, but prior thereto. Income taxes are imposed on the basis of annual periods and deductions allowable in the computation of taxable net income in only one period may not be withheld and taken in a subsequent year. Burnet v. Thompson Oil & Gas Co., 283 U. S. 301. The failure of petitioner to deduct the interest in its 1926 return does not of itself warrant allowance of the amount in the taxable year. To do so would permit the petitioner to choose the year in which to take the deduction and distort income for that year. Its remedy is a review of its correct taxable liability for 1926. United States v. Ludey, 274 U. S. 295.

The failure of the Commissioner to observe during the course of his audit of petitioner’s 1926 return that no deduction had been taken for the interest and to adjust petitioners’ tax liability accordingly does not permit us to sanction an erroneous computation of tax for a later year. Niles Bement Pond Co. v. United States, 281 U. S. 357. The rule is equally applicable where the error works in favor of the taxpayer. MacMillan Co., 4 B. T. A. 251.

The action of the respondent in not reducing the interest payment in question by $26,913.64, representing the amount of penalty and interest paid by the petitioner in 1926, was not error.

Decision will he entered for the respondent.


author: Arundell :

text:
    The Equitable Life Assurance Society of the United States, Petitioner, v. Commissioner of Internal Revenue, Respondent.
    Docket Nos. 31110, 33241, 57867.
    Promulgated December 12, 1935.

      G. E. Loche, Esq., for the petitioner, John W. Townsend, as amicus curiae.

      Ghester A. Gwinn, Esq., for the respondent. .
   OPINION.

Arundell :

Respondent determined deficiencies in petitioner’s income tax of $60,920.07 for 1924, $64,365.42 for 1925, $157,006.23 for 1926, and $10,129.93 for 1928. The question for decision is 'whether certain so-called reserves maintained by the petitioner are reserves required by law within the meaning of section 245(a) (2) of the Revenue Acts of 1924 and 1926 and section 203 (a) (2) of the Revenue Act of 1928. All other issues raised by the pleadings have either been withdrawn or settled by stipulation. Full effect will be given to the stipulation in the recomputations under Rule 50. The proceedings were consolidated for hearing and decision.

The petitioner, a New York corporation with its principal office at 393 Seventh Avenue, New York City, was organized in 1859 and ever since has been engaged in the life insurance business. In the taxable years, it transacted business in every state of the United States except Texas.

In and prior to the taxable years, the petitioner issued cancellable and noncancellable accident and health policies insuring the holders thereof, in consideration for the payment of specified premiums, against loss from bodily injuries effected through external, violent and accidental means, and against disability from disease. The policies provided for the payment of sums certain in the case of loss of life, limb or sight by accident, for the payment of specified weekly indemnities during the continuance of disabilities caused by accident or disease, and for the reimbursement of the insured, up to specified limits, for surgical and hospital expenses.

Additional reserve on noncancellable accident and health policies.— In a noncancellable accident and health policy, although the risk insured against increases with the age of the insured and the claim costs of later years of the policy are, therefore, greater than those of the earlier years, the annual premium is uniform throughout the life of the policy. It follows that in each of the earlier years of a non-cancellable policy the net annual premium exceeds the prospective claim costs, while in each of the later years the prospective claim cost exceeds the net annual premium.

This reserve is maintained and used for the purpose of supplementing the net annual premiums of such policies in their later years, to the extent that their prospective claim costs of such years exceed their net annual premiums.

The reserve is the amount, which, supplemented in each future year by the excess of the year’s net premium over the year’s prospective claim cost of every noncancellable policy in its earlier years, all accumulated with Sy2 percent compound interest, it is necessary to maintain to meet in future years the excess of prospective claim costs over annual net premiums in respect to all noncancellable policies in their later years.

Viewed as a fund, the reserve on December 31 of any year is:

(a) The fund maintained by petitioner for that reserve on December 31 of the preceding year; plus
(b) The excess of the current year’s net premiums over the current year’s prospective claim costs for policies in their earlier years; less
(c) The excess of the current year’s prospective claim costs over the current year’s net premiums for policies in their later years; plus
(d) The year’s interest increment, at the rate of 3% percent.

The maintenance of this reserve with annual interest increments was required in the taxable years by sections 52, 84, 86, 93 and 95 of the Insurance Law of New York; by express rulings of the Superintendent of Insurance of the State of New York pursuant to the authority conferred on him by the statutes; by sections 10501 and 10502 of the Oklahoma Statutes, 1931; and by sections 4139 and 4181 of the General Statutes of Connecticut, Revision of 1930.

The amount of the reserve held by the petitioner as so required by state laws, at the beginning and end of each of the taxable years, was as follows:

The respondent, in making his determination as to each of the taxable years, has not allowed a deduction of 4 percent of the mean of the reserve held at the beginning and end of the taxable year.

Respondent now concedes, on brief, that this reserve is “ includi-ble in the reserve funds required by law to be used in determining the deduction of ‘ 4 per centum of the mean of the reserve funds required by law and held at the beginning and end of the taxable year.’ ” Believing this concession to be proper and in line with the decisions in McCoach v. Insurance Co. of North America, 244 U. S. 585; Maryland Casualty Co. v. United States, 251 U. S. 342; United States v. Boston Insurance Co., 269 U. S. 197; New York Life Insurance Co. v. Edwards, 271 U. S. 109; Minnesota Mutual Life Insurance Co. v. United States, 66 Ct. Cls. 481; Massachusetts Mutual Life Insurance Co. v. United States, 56 Fed. (2d) 897; Helvering v. Inter-Mountain Life Insurance Co., 294 U. S. 686; Continental Assurance Co. v. United States, 8 Fed. Supp. 474; and Midland Mutual Life Insurance Co., 19 B. T. A. 765, we deem it unnecessary to pursue the question further. The net income determined by the respondent for the taxable years will be reduced by the amounts of $39,276.44 for 1924, $49,576.20 for 1925, $47,393.12 for 1926, and $50,616.74 for 1928.

Reserve for unpaid and unresisted accident and, health claims.— The purpose of this reserve is to maintain and accumulate funds to provide for the payment of benefits expected to arise from disabilities which have already commenced.

On December 31 of any year this reserve is the amount prospectively determined which it is necessary to maintain to cover:

(1) the present value, at 3)4 percent interest, of the total benefits which will probably accrue in the future years as a result of disabilities which commenced prior to the current year; plus
(2) the amount of unpaid benefits which have accrued as a result of disabilities which commenced prior to the current year; plus
(3) the present value, at B /^ percent interest, of the total benefits which will probably accrue in future years as a result of disabilities which commenced during the current year; plus
(4) the amount of unpaid benefits which have accrued as a result of disabilities which commenced during the current year.

Viewed as a fund, the reserve on December 31 of any year is:

(a) the fund maintained by petitioner for the reserve on December 31 of the preceding year, less the funds spent during the year on benefits arising from disabilities which commenced prior to the current year; plus
(b) the excess of funds held to meet the year’s claim costs over amounts paid on benefits which arose from disabilities commencing during the. year; plus
(c) the year’s interest increment, at the rate of 4/4 percent.

Any deficiency in the amount maintained for the reserve on December 31 of the preceding year plus the current year’s interest increment for the reserve, below the sum of items (1) and (2) of the prospective valuation plus benefits paid during the year as a result of disabilities which commenced prior to the current year, is taken from petitioner’s surplus funds and entered in its annual statement as a loss item for the year. Any surplus of the amount of the reserve held on December 31 of the preceding year plus its current year’s interest increment, over the sum of said items (1) and (2) plus the said benefits paid during the year as a result of disabilities which commenced prior to the current year, is added to the petitioner’s surplus funds and entered in its annual statement as a profit item for the year.

Ten percent of the reserve at the beginning or end of any taxable year is held for the payment of benefits which have accrued and are unpaid, in respect to disabilities which have already commenced, and the remainder is held for the payment of benefits which will become due in the future, if the policyholders survive and remain disabled. The petitioner concedes that this 10 percent is not a reserve required by law, within the meaning of the applicable taxing statutes; and, therefore, we have only to consider whether the remaining 90 percent is such a reserve.

The maintenance of this reserve with annual interest increments was required in the taxable years by sections 52, 84, 86, 93 and 95 of the Insurance Law of New York; sections 10501 and 10502 of the Oklahoma Statutes, 1931; sections 4139 and 4181 of the General Statutes of Connecticut, Revision of 1930; and by the express ruling of the Commissioner of Insurance of Indiana made on January 22, 1923, pursuant to the statutes of that state. It was also required by the express rulings of the Superintendent of Insurance of New York dated July 21, 1925, and December 18, 1926, made pursuant to authority conferred by section 93 of the New York Insurance Law.

The amount of the reserve held by the petitioner, as so required by state laws, at the beginning and end of each of the taxable years, was as follows:

Respondent, in making his determination as to each of the taxable years, has allowed a deduction of 4 percent of the mean of the reserve held at the beginning and end of the taxable year, amounting to $15,201.42 for 1924, $15,466.14 for 1925, $31,758.82 for 1926, and $70,881.94 for 1928. He now contends that this reserve is not a reserve required by law within the meaning of the taxing statutes, and that the allowance of the aforesaid deductions is erroneous; and he lays claim to the increased deficiencies that may result from the correction of his alleged error.

The meaning of the term “ reserve funds required by law ”, as employed by Congress in the several taxing acts, has been considered in a number of decided cases involving either fire, marine, casualty, or life insurance companies, under the revenue acts in force prior and subsequent to the Revenue Act of 1921. That act made a material change in the provisions relating to the taxation of insurance companies. Under prior revenue acts, insurance companies were allowed to deduct from income the net additions to the reserve funds required by law, while in the 1921 and all later acts the deduction provided for is “ an amount equal to 4 per centum of the mean of the reserve funds required by law and held at the beginning and end of the taxable year.” The decisions in these cases, except that in Helvering v. Inter-Mountain Life Insurance Co., supra, which came later, have been analyzed, discussed and interpreted in a lengthy opinion by the Court of Claims in Continental Assurance Co. v. United States, supra, cited and approved by the Supreme Court in the Inter-Mountain case. We can add little to what was there said by the Court of Claims; and to go over the same ground here would unnecessarily burden and extend this opinion. Interpreting the cases set out in the margin, the Court of Claims said:

Properly interpreted we think these last mentioned cases establish the principle that the term “reserve” has a special meaning in the law of insurance and means a sum of money variously computed or estimated which, with accretions from interest, is set aside, “reserved,” as a fund with which to mature or liquidate, either by payment or reinsurance with other companies, future un-accrued and contingent claims. Also, that reserves for matured accrued claims which are payable in cash or subject to certain options cannot be included in the “ reserve required by law ” within the meaning of the taxing act.

Summing up, the court stated:

After a careful study of the nature and purpose of reserves maintained by life insurance companies in the light of all the decisions which have been rendered upon the subject and the plan of taxation of such companies as provided in the federal taxing acts, we conclude: (1) That accrued liabilities are not the subject of the “ reserve fund ” deductions granted by Congress in any of the revenue acts; (2) that the “reserve” contemplated in the Federal statutes is “ that fund which when added to the present value of future net premiums is equal to the present value of future death claims ”; that is, the mathematical equivalent of tire obligation incurred by the company to pay the sum insured at the death of the policyholder or upon the surrender and cancellation of the policy; (3) that the “ reserve ” contemplated in the federal statutes is calculated upon the basis of a selected table of mortality plus an assumed rate of interest; and that reserves not so calculated, whether required by state law or by state officer, are not “ reserve funds required by law ” within the meaning of the federal statutes; and (4) that the “ reserve fund ” required by law within the meaning of the federal statutes does not include “ solvency ” reserves required to be maintained by state law or state officer to keep the company in sound financial condition.

In the Inter-Mountain case, the Supreme Court, in considering the identical question before the Court of Claims in the Continental Assurance Co. case — whether funds held for payment of matured unsur-rendered and unpaid coupons attached to 20-payment life policies, which were payable in cash or subject to certain options, constituted “ reserve funds required by law ”• — stated as follows;

The word “ reserve ” has many meanings. Accounts creating reserves are set up in almost every line of business and funds evidenced- by the book entries are held for many and widely different purposes. As the Act does not permit corporations other than insurance companies to make deductions of the kind here under consideration, “ reserve funds ” may not reasonably be deemed to include values that do not directly pertain to insurance. In life insurance the reserve means the amount, accumulated by the company out of premium payments, which is attributable to- and represents the value of the life insurance elements of the policy contracts. The premiums include enough, over and above what is needed to maintain proper insurance reserves, to provide for the discharge of coupon liability according to the terms of the policy. The coupon values are the equivalent of cash and may be used to pay premiums on the face amount of the policy, to procure additional insurance, to lessen the number of annual premiums or otherwise to obtain insurance protection. The amounts so applied cease to exist as coupon liabilities and automatically become a part of the life insurance reserves. These differ essentially írom coupon liability. Life insurance matures only upon the death of the insured and the life reserve is based upon that contingency, whereas liability on the matured coupons depends upon no contingency. It follows that the insurance reserves alone constitute the base on which the deduction is to be computed. Reserves against matured coupons are excluded.

The funds set aside to meet the probabilities covered by this reserve are “ accumulated by the company out of premium payments.” The reserve, at any valuation date, to the extent of 90 percent thereof, represents the present value, at 3% percent interest, of benefits expected, upon the basis of selected tables of probabilities, to be paid in the future to policyholders who have already been disabled by accident or disease. It is, therefore, a reserve “ calculated upon the basis of * * * selected table[s] of * * * [probabilities] plus an assumed rate of interest ”, and “ represents the value of the * * * [disability] insurance elements of the policy contracts.” And, since the contingencies insured against are those which maj'- arise in the future, though the accidents or illnesses which may give rise thereto have already occurred, the reserve, to the extent indicated,, is strictly “ a fund with which to mature or liquidate, either by payment or reinsurance with other companies, future un-accrued and contingent claims.” We have here then a true insurance reserve fund required by law.

The respondent’s present position is predicated upon the proposition that contemporaneously with the occurrence of accident or inception of disease, the petitioner becomes obligated to pay all benefits which the policyholder may receive in the future because of such accident or disease, and that this obligation constitutes a present loss or liability and the reserve is, therefore, a “ solvency ” reserve. This discloses a confusion of the possible future loss insured against with the actual accident or illness which may cause that loss to happen. Accident and illness in and of themselves give rise to no liability on the part of the petitioner. What is insured against, as clearly indicated by the policy contracts is loss of life, limb, sight or time by accident, disability caused by disease, and the incurrence of hospital and surgical expenses. In other words, the petitioner’s liability in respect to airy accident or disease is determined, both in fact and in amount, by future events; it is wholly contingent upon loss of life, limb, sight or time, or the incurrence by the policyholder of hospital and surgical expenses; and if none of these things occur, the petitioner has incurred no liability whatsoever in respect to that particular accident or illness.

The respondent casually suggests that this reserve is maintained to meet the very contingencies for which the petitioner’s true insurance reserves were created, and, therefore, the former is but a duplication of the latter. Here again we have confusion. The petitioner maintains only two insurance reserves in respect to its accident and health policies — the reserve first discussed in this opinion and the one now under consideration. That, as to cancellable policies, there can be no duplication in the two reserves is obvious, for the first is maintained only in respect to noncancellable policies; and that there can be no duplication in respect to noncancellable policies is clear when the purposes of the two reserves are understood. The additional reserve on noncancellable accident and health policies relates to benefits that may become due from disabilities commencing in the future, that is, arising from accidents which may happen or maladies which may begin in the future. The reserve for unpaid and unresisted accident and health claims, on the other hand, is held to provide for future benefits that may become due from disabilities which have commenced in the past, that is, arising from accidents which have already happened or maladies which have already started. As we understand the situation, in valuing the first of these reserves there are excluded all policies under which benefits have accrued and will accrue in the future because of accidents which have happened or maladies which have begun in the past, and that it is in respect to these policies only that the second of these reserves is maintained. The two reserves are, therefore, necessarily mutually exclusive.

In view of the foregoing, we hold that the reserve under consideration is a reserve fund required by law within the meaning of the applicable taxing statutes; that, to the extent of 90 percent thereof, the deductions allowed by the respondent in respect to this reserve are correct and proper; and that the remaining 10 percent of said deductions were improperly allowed. The net income determined by the respondent for the taxable years will be increased by the amounts of $1,520.14 for 1924, $1,546.61 for 1925, $3,175.88 for 1926, and $7,088.19 for 1928, and the respondent’s claim for increased deficiencies, if any, will be allowed to that extent.

Reserve for dividends left with the company to accumulate at interest and accrued interest thereon. — In the taxable years and prior thereto, petitioner’s policyholders were privileged in accordance with the terms of their policies to leave dividends on their policies with the petitioner to accumulate at interest. Upon the maturity of any of its policies credited with such dividend accumulations, the petitioner was obligated to pay the amount of the dividend accumulation so credited, in addition to the face amount of the policy, to the policy beneficiary.

Under the terms of his policy any of the petitioner’s policyholders could utilize his dividend accumulations, left with the petitioner, to convert his policy to a paid-up policy of the same face amount whenever the reserve on the face amount of his policy together with the reserve on any dividend additions thereto, plus the amount of the dividend accumulation equaled the single net premium required for such a paid-up policy.

The purpose of this reserve was to maintain a fund equal to the amount of the dividends left with petitioner to accumulate at interest and accrued interest thereon, and to supplement the fund with the annual increments of interest at a guaranteed rate.

The maintenance of this reserve with such annual increments of interest was required in the taxable years by sections 52, 84, 86 and 95 of the Insurance Law of New York; sections 10501 and 10502 of Oklahoma Statutes, 1931; sections 4139 and 4181 of the General Statutes of Connecticut, Revisión of 1930; and by express ruling of the Commissioner of Insurance of Indiana made on January 22, 1923, pursuant to the statutes of that state.

The amount of the reserve held by the petitioner, as so required by state laws, at the beginning and end of each of the taxable years, was as follows:

The respondent, in making his determination as to each of the taxable years, has not allowed a deduction of 4 percent of the mean of the reserve held at the beginning and end of the taxable year.

In Midland Mutual Life Insurance Co., supra, it was expressly held by this Board that a reserve maintained for the same purposes as the reserve here under consideration is not a reserve fund required by law. In Continental Assurance Co. v. United States, supra, and Helvering v. Inter-Mountain Life Insurance Co., supra, it was held that funds reserved against matured and unpaid coupons attached to 20-payment life policies are not reserve funds required by law, but constitute solvency reserves to meet existing liabilities of the companies. In these cases, the matured coupons were payable in cash or could be applied in substantially the same way as the dividends payable under petitioner’s policies. We are unable to see any distinction between a reserve for matured coupons payable and a reserve for declared dividends payable. The payment of neither the coupons nor the dividends is dependent upon any contingency. Both reserves are liability or solvency, and not insurance, reserves. The respondent very properly denied any deduction in the taxable years in respect to this reserve.

Judgment will be entered wider Rule 50.

         McCoach v. Insurance Co. of North America, supra; Maryland Casualty Co. v. United States, supra; United States v. Boston Insurance Co., supra; New York Life Insurance Co. v. Edwards, supra; Minnesota Mutual Life Insurance Co. v. United States, supra; Massachusetts Mutual Life Insurance Co. v. United States, supra; Helvering v. Inter-Mountain Life Insurance Co., supra; Continental Assurance Co. v. United States, supra; and Midland Mutual Life Insurance Co., supra.