author: Teammell : GeatjpneR and Phillips,

text:
    Appeal of James S. McCandless.

    Docket No. 2782.
    Decided April 23, 1926.
    Upon the evidence, held, that the transfer of stock by the taxpayer in 1921 did not constitute a tona -fide sale and no deductible loss was sustained on account thereof. The return for 1921, including a deduction on that account, was false and fraudulent and willfully so made.

      Urban E. Wild, Esq., ArtJkt/r S. Hoppe, Esq., E. B. Gameron, O. P. A., and A. R. Beohtold, G. P. A., for the petitioner.

      A. 0alder Mackay, Esq., Ward Loveless, Esq., John D. Foley, Esq., and W. Frank Gibbs, Esq., for the Commissioner.
    This is an appeal from the determination of a deficiency in income tax in the amount of $7,363.16 for the year 1921, and an added penalty of $3,681.58 for alleged fraud, or a total deficiency of $11,044.74.
    FINDINGS OF FACT.
    1. The taxpayer is a citizen of the United States and a resident of Honolulu, Territory of Hawaii.
    2. The California-Hawaiian Development Co. is a corporation which was organized under the laws of the State of California on or about September 27, 1911. This company, hereinafter called the corporation, was organized by the taxpayer and several associates, among whom was C. G. Bockus, for the purpose of acquiring from the Sierra Nevada Development Co., an Arizona corporation, certain mining properties located in Placer County, Calif. The corporation was incorporated with a capital stock of 3,000,000 shares having a par value of $1 each. Sometime in 1909 the taxpayer had purchased shares of stock in the Sierra Nevada Development Co. at the price of $7.50 for shares having a par value of $10 each. These shares were exchanged in 1911 for shares of stock in the corporation at the ratio of 1 for 20, thus making the cost to the taxpayer of such shares in the corporation 37½ cents each. Subsequent to the organization of the corporation, the taxpayer bought other shares of stock therein at prices varying from 50 to 10 cents per share.
    3. C. G. Bockus was a resident of Honolulu for many years prior to March, 1922, when he left Honolulu for San Francisco, Calif., where he has since continued to reside. He had been one of the organizers and for some time was the secretary of the corporation. He was a licensed dealer in stocks, bonds, and general securities in the Territory of Hawaii. There had been a number of sales of stock of the corporation in 1920 and 1921. Bockus had procured purchasers for some of it and knew of the sales. He was on terms of intimate friendship and association with the taxpayer and had many business dealings with him over a period of 25 years. The taxpayer treated him practically as a member of his family.
    4. On or about December 10,1921, Bockus, after having heard that the taxpayer desired to sell some of his stock through another broker, called at the office of the taxpayer and asked, “ Why not let me do it ?” stating that he thought he could sell some shares of the stock of the corporation as he had a similar transaction. Bockus stated to the taxpayer that he had already made a similar arrangement with the taxpayer’s brother, John A. McCandless, from whom he understood the taxpayer was “ undertaking a similar sale through a broker known as Guy H. Buttolph.” Bockus offered to purchase some of the taxpayer’s shares at 5 cents per share. At that time no agreement was reached between the parties. The taxpayer subsequently made inquiry among stockholders in Honolulu and ascertained from them that, in their opinion, it had a value of about 5 cents per share. Thereafter, on or about December 21,1921, Bockus again called upon the taxpayer and at that time he again offered to take shares in the corporation from the taxpayer for 5 cents per share and give his promissory note therefor. During neither of the conversations was mention made by Bockus of any particular number of shares. The taxpayer thereupon delivered to Bockus 159,344 shares of stock of the corporation and took his note on the basis of 5 cents a share. These shares were among those acquired by the taxpayer after the organization of the corporation and were represented by four certificates numbered, respectively, 15, 263, 312, and 395. The certificates were indorsed and delivered by the taxpayer to Bockus and, at the request of Bockus, transferred to him on the books of the corporation and replaced by certificate No. 695, dated December 30, 1921, and made out in his name for the 159,344 shares. Certificate No. 695 was thereafter held by Bockus in his possession until he delivered it to the trustee of his estate in bankruptcy, as hereinafter set forth. The taxpayer received from Bockus a promissory note for $7,967.20, dated December 22, 1921, payable on demand. Bockus was in “ straightened circumstances.” At that time the taxpayer, on account of his confidential relationship with Bockus, knew in a way his financial condition. On June 30,1925, the day before it was filed in evidence in this appeal, documentary stamps in the amount of $1.60 were placed on the note and canceled. The taxpayer never made demand on Bockus for payment of the note, nor was any amount ever paid on the note, nor was any interest ever paid thereon. The transaction was entered into and carried out by the taxpayer in the manner set forth, for the purpose of taking a deduction on his income-tax return. The taxpayer stated that one reason he desired to dispose of the stock was that it had been quite a burden to him. Some time in 1922, and prior to the adjudication of Bockus as a bankrupt, but after the transfer to him of the stock, the taxpayer paid an assessment of one-half per cent per share levied upon the shares of stock of the corporation transferred to Bockus. The taxpayer also, on February 11, 1924,' paid another assessment which was levied in December, 1923, on the stock transferred to Bockus. Bockus continued to hold certificate No. 695 in his possession until after he was adjudged an involuntary bankrupt on December 28, 1922. He did not list these 159,344 shares of stock among his assets in the schedule in bankruptcy, nor did he list the promissory note given by him to the taxpayer as a liability. On demand, he delivered the certificate, indorsed in blank by him, to the trustee in bankruptcy about the month of October, 1924. The taxpayer, having knowledge of the bankruptcy proceedings, did not file a claim with the trustee for the amount of the note received by him from Bockus, but stated that he would have been willing to destroy the note if it were not for the question raised by the Commissioner with respect to his tax liability which was coming up. The certificate, from the time of its delivery by Bockus, has been held by said trustee as a part of the assets of the estate in bankruptcy. After the transfer of the stock as above set out, Bockus sold other securities to the taxpayer, and, acting as broker, sold other securities for him. The taxpayer paid Bockus his regular commissions in cash on such deals and paid cash for the securities purchased, and no part of the amount due Bockus was credited on the note. The securities sold to the taxpayer had been bought by Bockus with his own money.
    5. The taxpayer purchased no shares of the stock of the corporation within a year prior to the sale described in the preceding paragraph and has purchased no shares of such stock since that time, either from Bockus or any other person.
    6. The certificates of stock acquired by the taxpayer and transferred to Bockus were numbered and issued and cost the amounts set forth in the following schedule:

    During the period from December 26, 1914, to June 28, 1921, the taxpayer paid assessments amounting to 11 cents per share, or a total of $17,527.84, on the 159,344 shares. The total cost of these shares to the taxpayer was $63,791.04. The cost of certificate No. 15, which was purchased on November 14, 1911, was less than its Marcli 1, 1913, value.
    7. The transfer of stock to Bockus referred to in paragraph 4 was not a sale in good faith, but was resorted to by the taxpayer for the purpose of establishing the appearance of a sale without consummating it in actuality. The taxpayer filed a return for the year 1921 in which a loss was claimed on account of that alleged sale, which claim was false, was known to the taxpayer to be false, and was made with intent to evade tax.

       Publication of this decision was withheld pending the action of the Board on the taxpayer’s application for rehearing. — Repokteb.

   OPINION.

Teammell :

The taxpayer, in his income-tax return for 1921, took as a deduction a loss in the amount of $67,721.20 on account of a sale of 159,344 shares of stock to Bockus. The Commissioner disallowed any loss on that account, upon the ground that there was in fact no sale of the stock referred to. The taxpayer at the hearing conceded that the amount of the loss claimed was erroneous and that, if he was entitled to any loss, the amount thereof was $58,823.84, because the cost of the stock transferred, and which the taxpayer claims that he sold, was less than the cost which he asserted in his return.

The Commissioner asserts that the transfer of the stock by the taxpayer to Bockus in 1921 was nothing more than a pretended sale, not an actual bona fide sale, and that the transaction was entered into for the purpose of evading the payment of tax. The taxpayer admits that the transaction was entered into because he desired to take a loss for the purpose of deducting the same in his return for the year 1921. If the transaction amounted to an actual sale of the stock, the admission by the taxpayer that it was consummated for the purpose of realizing a loss during that taxable year, in order that he might deduct the same in his income-tax return, is perfectly legitimate and sets forth an intention which is legal and which gives rise to no fraud or illegal intent.

A taxpayer is not entitled, under the statute, to take a loss merely because stock or securities during a taxable year shrink in value, unless the loss is actually realized by a sale or other disposition of such property. It is perfectly legal and proper for a taxpayer to sell such assets at a price representing their reduced value and thus to sustain a deductible loss which is allowed him by the statute. United States v. Isham, 17 Wall. 496; Appeal of The Pennsylvania Co., etc., 2 B. T. A. 48; Appeal of Benjamin T. Britt, 2 B. T. A. 53; Appeal of Harold B. Clark, 2 B. T. A. 555.

The question now resolves itself into a question of fact, and that is, whether the taxpayer actually sold the stock in question during the taxable year, or whether the transfer of the stock to Bockus was carried out for the purpose of taking a deduction on account of a loss which had not in fact been sustained. In order to determine whether there was an actual sale or merely a pretended one, it is necessary to look at all facts and circumstances in the case and to consider and weigh all the evidence.

The taxpayer testified that he sold the stock to Bockus, and Bockus testified that he bought it. The taxpayer and Bockus, however, testified to other facts, and we have the testimony of other witnesses. There were facts and circumstances in connection with and surrounding the transaction which can not be ignored. Facts which are not denied by the taxpayer or Bockus must be taken into consideration and a decision can not be made alone upon 'Categorical statements of the parties. In the light of all the testimony, we are convinced that the taxpayer did not make a sale to Bockus of the stock in question in 1921, and that the taxpayer’s return for that year, in which he claims a deduction on that account, was willfully false and fraudulent. The facts and circumstances which lead us to this conclusion may be briefly stated.

Bockus, having learned that the taxpayer desired to dispose of some of his stock and that he was undertaking to sell it through another broker, approached the taxpayer and asked him, “ Why not let me do it?” The taxpayer and Bockus were on terms of intimate friendship and were closely associated in business affairs. The taxpayer testified that he treated Bockus as practically belonging to the family. They had many business dealings together. The taxpayer bought securities from Bockus and Bockus acted as the taxpayer’s selling agent and sold whatever securities the taxpayer had to sell. During 1920 and 1921 Bockus had sold other stock of the same corporation. Bockus was in a bad financial condition. The taxpayer knew, at least in a general way, of the financial condition of Bockus. He testified that he knew that Bockus was “ hard up,” although he did not know of any contemplated bankruptcy proceedings. Bockus himself may not have known that his creditors intended to institute such proceedings. About a year after Bockus received the stock and after he had executed to the taxpayer his promissory note in exchange therefor, Bockus was declared an involuntary bankrupt. He did not list the note of the taxpayer as an indebtedness and did not include the stock as an asset, nor did he list it among his assets when he was notified in 1923 that an assessment had been levied on the stock. If he had overlooked the stock in 1922 when the bankruptcy proceedings were instituted, his mind must have been refreshed when the stock was called to his attention by the assessment thereon. The taxpayer, knowing of the bankruptcy proceedings, did not file a claim against the bankrupt, but testified that he would have been willing to destroy the note, except for the question of tax liability which was coming up. Prior to the adjudication in bankruptcy an assessment of one-half cent per share was levied by the corporation upon the stock transferred to Bockus. This assessment was paid by the taxpayer in order to prevent the stock from being sold to satisfy the assessment. On February 11, 1924, another assessment .which had been levied on the stock held by Bockus was paid by the taxpayer. This was after Bockus had been declared bankrupt. Neither of the assessments have since been paid by Bockus. The taxpayer testified that one of the reasons that he desired to sell the stock was that it was a burden to him; yet he continued after the transaction to bear the burden of paying assessments thereon. After the transfer of the stock to Bockus, and while the taxpayer held Bockus’ note payable on demand, Bockus sold other securities to the taxpayer. These securities had been purchased by Bockus with his own funds and the taxpayer paid to Bockus the consideration therefor in cash. Bockus also sold some securities for the taxpayer and the taxpayer paid him his commission in cash. No part of the money due to Bockus as the result of these transactions was credited or applied on the note held by the taxpayer. The note was payable on demand, and, notwithstanding these transactions, the taxpayer did not make demand and has never made demand for any part of the principal or any interest on the note. From all the testimony in the case, we are of the opinion that the transfer of the stock by the taxpayer to Bockus in 1921 was not an actual tona -fide sale, and that the return filed for that year, in which a deduction was claimed on account of such transaction, was willfully false and fraudulent.

Order of red&termination will te entered on 30 days’ notice, under Rule 50.

GeatjpneR and Phillips,

dissenting: As the only two members of the Board who heard all of the testimony in this appeal, we feel it incumbent on us to express our opinion that the satisfactory evidence in this appeal does not justify the decision of the Board. It is true that certain incidents disclosed by the record may be considered as raising suspicions, but, on the other hand, these same incidents are susceptible of a different interpretation. From the conclusions formed by us, after hearing all of the testimony and seeing the witnesses on the stand, we do not believe the evidence sufficient to support a finding that the sale from the taxpayer to Bockus was not tona fide, or that the taxpayer was guilty of fraud.

The Commissioner relied upon the testimony of two revenue agents for the purpose of impeaching the testimony of Bockus. We are agreed that it is too evasive and too contradictory to be worthy of belief. As we observed their conduct on the witness stand, we were impressed with the belief that they were overanxious to convict the taxpayer and too willing to make damaging deductions from small incidents. But apparently some weight has been given their testimony in the prevailing opinion, which refers to the testimony of “ other witnesses ” than McCandless and Bockus.

Regarding the sale, the evidence shows beyond a doubt that the stock was assigned and the note was given in December, 1921, that the price was fair, that Bockus took the stock into his possession, had it transferred to his own name, and held the certificate therefor in his own possession and control until he was required to surrender it to the trustee of his estate in bankruptcy. There is no evidence that Bockus held the stock in the capacity of trustee or agent for the taxpayer. On the contrary, we have absolute denials of such relationship from both the parties. There is no evidence to show that the taxpayer exercised or attempted to assert any control over or right to possession of the stock after its delivery by him to Bockus. The fact that Bockus had frequently acted as broker in the purchase or sale of securities for the taxpayer raises no presumption that in this case he was not operating on his own account. Nor do the incidents of Bockus going into involuntary bankruptcy, without setting forth the stock in question in the schedule filed by him, or of the taxpayer failing to file a claim in bankruptcy on the note held by him, raise any presumption of the relationship of trustee and trustor between them. The individual actions of Bockus should not be permitted to reflect on the actions and attitude of the taxpayer, unless collusion was proven, which it was not.

Bockus was declared an involuntary bankrupt on the petition of creditors in Honolulu, while he resided in San Francisco. The schedule was prepared in Honolulu and sent to Bockus, and he signed it as thus prepared. Other assets and liabilities were omitted from the schedule, including Bockus’ home in Honolulu and debts due from him secured by mortgage thereon. Many creditors fail to file claims in bankruptcy where the futility of collection is apparent, and there is no reason to distinguish the taxpayer from other creditors. It must be borne in mind that the taxpayer was traveling about the United States on matters wholly unrelated to his business in Honolulu during all of the period over which the so-called suspicious circumstances were spread, and he was paying little or no attention to his affairs at home. This circumstance might more readily account for his failure to demand payment of the note from Bockus than as assumed evidence of Bockus being agent for the taxpayer.

The payment by the taxpayer of the assessment on all of the stock owned by Bockus was not, in our opinion, evidence of other than a generous and over-indulgent attitude on the part of the taxpayer toward the man he considered as a friend. Apparently, these loans were made as a matter of course, without any thought of the status of the stock ownership. The taxpayer loaned money to others, who never had purchased any stock from him, with which to pay these same assessments. It may be that Bockus was unworthy of this friendship, but his conduct, unless in collusion with the taxpayer, should not influence the decision of this appeal.

Stress is laid upon the financial condition of Bockus. All of the evidence in the appeal is to the effect that, in December, 1921, when the transaction took place, Bockus was solvent, although pressed for cash to use in his business. It was not until a year later that bankruptcy proceedings were instituted, and this came about by reason of the failure of a company in which Bockus was financially interested.

We believe that from the evidence the transaction between the parties was a sale and that the taxpayer is entitled to the deduction claimed. We further believe that there is no evidence to warrant any finding of fraud.


source: Caselaw Access Project

author: Littleton:

license: Public Domain

text:
    Knutson Hardware Co., Petitioner, v. Commissioner of Internal Revenue, Respondent.
    Docket No. 4384.
    Decided October 4, 1926.

      Roy P. Will cox, Esq., for the petitioner.

      John W. Fisher, Esq., for the respondent.
   Littleton:

This proceeding involves a deficiency of $1,880.14 for the calendar year 1920. Petitioner assigns the following errors by the Commissioner:

(1) Failure to include in invested capital promissory notes amounting to $9,800 paid in for stock.

(2) Refusal to compute the income upon the accrual basis.

(3) Failure to include $2,197 paid for wood in the merchandise account.

(4) Refusal to allow a deduction of $780 for Wisconsin state taxes paid during the year.

(5) Disallowance of alleged worthless accounts totaling $692.29.

FINDINGS OF FACT.

Petitioner is a Wisconsin corporation engaged in the sale of hardware and implements at retail at Blair. It also purchased and sold wood. The Commissioner concedes that petitioner’s books and records were maintained upon the accrual instead of the cash basis, as used by him, and that the Wisconsin personal property taxes for 1920 were a proper accrual during that year.

Such books and records as the petitioner maintained were kept upon the accrual basis. The Commissioner’s agent who examined them concluded that the -income should be determined upon the basis of cash received and disbursed, and that only $3,000, representing promissory notes paid in for stock, should be included in invested capital. J. A. Knutson individually owned Liberty bonds of the value of $500, which appeared upon the petitioner’s books as being its property, and these bonds were erroneously included by the Commissioner in petitioner’s invested capital.

Petitioner was organized in 1920 to take over the individual business of the former owner. It issued certain of its capital stock to J. O. Knutson for which he gave his interest-bearing promissory note payable on demand for $7,600; and likewise the corporation sold and issued to I. K. Knutson certain shares of stock in exchange for his interest-bearing promissory note dated January 2, 1920, for $2,200, payable on demand. The makers of these notes were solvent and the notes were worth their face value. They should be included in invested capital.

During 1920 certain of the petitioner’s customers paid their accounts in firewood, the total amount of wood so purchased during the year being as follows:

165½ cords green wood at $6.00_ $993
172 cords dry wood at $7.00- 1,204
Total-2,197

All of this wood was sold during the year 1920 and the proceeds thereof were entered upon the petitioner’s records as receipts from merchandise sold during the year. The amount of $2,197 should be included in purchases during the year.

During 1920 petitioner had upon its books numerous small accounts receivable, ranging from $1 to $43, totaling $692.29. These accounts were worthless on December 31,1920. They were charged off by the petitioner and the total thereof was a proper deduction from gross income for 1920.

Order of redetermination will ~be entered on 15 days' notice, under Rule 50.


author: Littleton :

text:
    Metropolitan Business College, Petitioner, v. Commissioner of Internal Revenue, Respondent.
    Docket No. 5717.
    Decided October 4, 1926.
    Petitioner was not a personal service corporation during 1918 and 1919.

      Forest D. Bieflcin, Esq., for the petitioner.

      L. G. Mitchell, Esq., for the respondent.
    This proceeding involves deficiencies in income and profits tax for 1918 and 1919 in the amounts of $8,051.06 and $5,478.23, respectively, arising from the denial of the petitioner’s claim that it should be classified as a personal service corporation.
    FINDINGS OF FACT.
    The petitioner is an Illinois corporation, organized in 1897 for the purpose of operating business schools, with principal office at Chicago. It succeeded the business college which had been conducted by O. M. Powers.
    From incorporation Powers was the sole owner, except for two qualifying shares of stock, until 1903, when the school was reorganized and some of the stock ivas sold to teachers who had been with the school for a number of years.
    During the taxable years petitioner operated 13 schools, the central school being located in the downtown district of Chicago. There were 9 branches in the City of Chicago, the one farthest from the central school being about 11 miles distant. Branches were also maintained in the towns of Elgin, Aurora and. Joliet, Ill., about 40 miles from the central school.
    Elementary instruction in business and commercial subjects was given. During 1918 and 1919, 50 teachers were employed, and 5,000 students were enrolled. Solicitors were employed, many of whom were teachers who solicited enrollment on Saturdays and at such other times as they were not engaged in the classroom.
    The capital stock of the corporation during 1918 and 1919 consisted of 1,000 shares of the par value of $100 each. Its tangible property consisted of desks, typewriters, and the usual school equipment necessary in conducting a school offering business courses. With the exception of 10 shares of stock owned by Edwin B. Powers, a son, and 20 shares owned by Eva A. Powers, a daughter of O. M. Powers, acquired by them as an inheritance from their mother, the petitioner’s stock was owned by persons actively engaged in the conduct of petitioner’s affairs.
    O. M. Powers held the office of president and owned 81 per cent of the stock. J. A. Stevens, the vice president, owned 11 ½ per cent of the stock, and C. W. Reynolds, the treasurer, owned 4.7 per cent of the stock. These men regularly devoted themselves to the affairs of the petitioner and allied enterprises. Prior to 1918 these men had acquired all of the stock of Orr’s Business College, situated in Chicago, and during 1918 and 1919 operated that institution as one of a chain of 14 schools in Chicago and suburban localities. The petitioner had an investment of $8,169.04 in Orr’s Business College.
    Powers and Stevens had written several textbooks on commercial and business subjects. Prior to 1918 the Metropolitan Textbook Co., a corporation, was organized for the purpose of publishing these books, and in 1918 and 1919 all of the stock of the textbook company was owned by Powers, Stevens and Reynolds. The petitioner also had an investment of $7,796.71 in the textbook company and derived a substantial income from sales of textbooks published by that company.
    During the taxable years the stock in the three associated companies was owned as follows:

      Suitable space was engaged for each branch school, necessary equipment was secured, teachers were employed, and in every particular the courses were identical with those at the central school, and such changes as were made in the course of study by the principal stockholders were put into effect in the branch schools. A head teacher was employed at each branch school, but no authority was given to him to change the course of instruction as specified. The business came to each of the branch schools just as it did to the parent school prior to the establishment of the branches. The publicity and advertising in connection with the branches was the same as that’ for the central school, always emphasizing the fact that the principal stockholders, and particularly Powers, were at the head of the school, and that the courses of instruction were those specified by Powers.
    Typewriters were furnished to students without charge, but necessary stationery and supplies were sold to them at prices in excess of cost.
    The following are the gross receipts of the three affiliated corporations for the years in question :

    The item of rentals consists of amounts received under subleases. In negotiating for space for some of the schools, it was necessary to lease more space than was actually necessary at the time, either to provide for expansion, or in order to obtain the space needed. This surplus space was re-rented at a profit. The entire amount so received is included in the above-mentioned item and does not take into consideration the amount paid by the petitioner for the same space. In two of the schools, namely, Garfield Park and Lake View, long-term leases were entered into for considerably more space than was required, in order to secure the particular location desired. A leasehold account ivas entered upon the ledger for these two schools. These accounts were debited with the amount of rent and incidental expenses paid and credited with the amount of rent received for the portion of the property sublet. The space available for subletting by other branches was not large enough to justify the opening of a special account, and in such instances the rent account was charged with the rent and incidental expenses paid and credited with amounts received from such tenants, the balance representing the net cost of rent in those particular schools.
    The following shows the assets and liabilities at the end of each of the years 1918 and 1919:

    The Lake View and the Garfield leaseholds shown in the above assets represent the balance of these accounts at the close of each year. At the time these leases were secured, an entry was made upon the books debiting leasehold account and crediting surplus. These leases are being exhausted ratably over the terms thereof.
    The South Side investment of $8,410.40 at the end of the year 1918 and $8,965.65 at the end of the year 1919 represents money advanced by petitioner to Orr’s Business College.
    The bills receivable of $6,203.92 at the end of the year 1918 and $6,342.84 at the end of the year 1919 consist principally of notes of the Metropolitan Textbook Co. Prior to 1912 petitioner published its own textbooks. In 1912 the textbook company was organized and it purchased the machinery, plates, copyrights, books on hand, etc., from the Metropolitan Business College, paying a portion of the purchase price in cash and giving its interest-bearing notes for the balance.
    Powers, the president, devoted all of his time to the affairs of the school and received a salary of $5,000 per annum. Stevens devoted all of his time to the corporation and received a. salary of $5,000 per annum. Reynolds, treasurer, devoted about one-half of his time to the business of the petitioner and received a salary of $1,000 for the year 1918 and no salary for the year 1919. He was also paid a salary each year by the Metropolitan Textbook Co., to which he devoted one-half of his time, of $3,500 per annum.
   OPINION.

Littleton :

The question presented is whether the Commissioner erred in holding that the petitioner was not entitled to be classified as a personal service corporation during the years in question within the meaning of section 200 of the Revenue Act of 1918.

The petitioner contends that this case comes squarely within the decision of the Board in the Appeal of Bryant & Stratton Commercial School, Inc., 1 B. T. A. 32, and that its income was not materially produced by capital, but was ascribable primarily to the activities of the principal stockholders. Whether a corporation is entitled to be classified as a personal service corporation must in each instance be decided on the facts established. In the opinion of the Board, the facts in this case clearly distinguish it from the Bryant & Stratton appeal. The record shows that in 1919 petitioner received $157,889.65 as tuition and expended for advertising, catalogues and soliciting $32,485.23. The amount expended for advertising was 50 per cent greater than the net income of $21,-979.82 for the year. The percentage of tuition paid out for advertising in the Bryant & Stratton appeal was less than 9 per cent, whereas in this proceeding such expenditure is shown to have been approximately 21 per cent.

This comparison brings out one of the striking differences between the two institutions. During the year 1919 the Bryant & Stratton School received a gross income from the sale of books and stationery of $3,846.45. This gross income represented a slight advance over cost to cover maintenance of the department. In the instant case, the gross income from books and stationery was $6,441.91, of which more than 50 per cent represented net profit. A large portion of this profit arose from selling books written by Powers and Stevens and published by the Metropolitan Textbook Co., all of the stock of which was owned by the principal stockholders of the. petitioner. In addition to this net profit from the sale of the books, the petitioner received $495.38 from its investments in the textbook company. Of the three principal officers of the petitioner, Reynolds had the chief responsibility and was the active man in conducting the affairs ‘of the textbook company. During 1918 he was paid a salary of $1,000 by petitioner and in 1919 it paid him no salary. However, he was paid a salary of $3,500 each year by the textbook company. He was actively engaged in the affairs of both corporations and devoted about one-half of his time to each. The two corporations were owned by the same three men who were in a position to adjust their salaries between the two corporations as they might desire. The result of the arrangements was that the textbook company paid all of Reynolds’ salary in 1919 for his combined services. The petitioner thus profited to the extent of about $1,750 from its relation with the textbook company.

The Bryant & Stratton School, upon the decision of whose appeal the petitioner relies, chose to sell stationery and books to its students merely as a matter of convenience and without any net profit. The petitioner elected to make a substantial investment in the company organized to publish its officers’ books and to make a profit from its dealings in those books. The profits from sales of stationery and books and in the investment in the textbook company aggregated approximately 25 per cent of the total net income of $21,979.82 for 1919, and the percentage was approximately the same for 1918. At the beginning of 1918, petitioner held notes aggregating $7,796.71 in the textbook company, which notes, less comparatively small payments, were held throughout 1918 and 1919 and produced revenue in both years.

At the end of the year 1918, petitioner carried in its balance sheet as an asset described as “South Side Investment, $8,410.40.” This item represented advances to Orr’s Business College, and was carried through the years 1918 and 1919. Orr’s Business College was a separate corporation and the investment was made for the purpose of profit. It also carried upon its balance sheet as an asset an item, described as “Lake View Leasehold,” at $7,000, and another item, described as “ Garfield Leasehold,” at a value of $9,000. It was the petitioner’s custom to lease more space than was necessary for its own purposes and to sublet the extra space. In the matter of investments, outside the primary functions of giving business instructions, the proceeding differs from the case cited in that petitioner had approximately $32,000 in such investments as compared with none in the case relied upon.

We are of opinion that capital was a material income-producing factor, and that the petitioner is not therefore entitled to classification as a personal service corporation under section 200 of the Revenue Act of 1918.

Order of redetermination will be entered on IS days’ notice, wider Rule 50.

Trammell concurs in the result only.


author: Tettssell:

text:
    Appeal of Illinois Terminal Co. (formerly Illinois Terminal Railroad Co.)
    Docket No. 2763.
    Decided October 4, 1926.
    Compensation of railroad company during period of Federal control. — Tbe reasonable compensation of a railroad company, for tbe use of its properties during -tbe period of Federal control, awarded to a taxpayer keeping its accounts on tbe accrual basis, was income for eaeb of tbe accounting periods for wbicb tbe compensation was allowed, although not received until a later date.

      E. F. Wetteroth, <7. P. A., for the petitioner.

      P. S. Orewe, Esq., for the Commissioner.

      Tliis is an appeal from the determination of deficiencies in income and profits tax for the years 1918, 1919 and 1920, in the amount of $65,878.19. The question involved is whether money paid by the United States to the taxpayer, in the year 1922, for the use of the taxpayer’s propei’ty during the period January 1, 1918, to March 1, 1920, was income for that period or for the year in which it was paid. The appeal was submitted on the pleadings and stipulations by the parties.
    FINDINGS OF FACT.
    The taxpayer is an Illinois corporation with its principal place of business at Elton.
    During the period of Federal control of carriers, which extended from January 1, 1918, to March 1, 1920, the Government took charge of the taxpayer’s property. No agreement was entered into between the taxpayer and the Government with respect to the compensation the taxpayer was to receive for the use of its property during the period of Federal control. No compensation was actually received by the taxpayer from the Government until more than two years after the' close of the Federal control period, and no compensation was entered by the taxpayer upon its books during that period. The taxpayer kept its books on the accrual basis.
    After the close of the period of Federal control, the taxpayer filed a claim with the United States Railroad Administration for compensation for the use of its property by the Government during the period of Federal control, and in September, 1922, it was awarded compensation therefor in the amount of $390,818.05.
    The taxpayer included in its income-tax return for the year 1922 the amount of $390,818.05, received in that year from the Government for the use of its property during the period of Federal control, and paid a tax thereon of $48,852.26. The amount of $390,818.05 so included in its return for the year 1922 represents income for two years and two months on the basis of a “ standard return ” of $180,377.56 per year.
    The Commissioner prorated the $390,818.05 referred to to the years 1918, 1919 and 1920, and determined that there are additional taxes due for those years as follows:
    1918-$35,119. 24
    1919- 28,970.43
    1920_ 1-, 788. 52
    Total- 65, 878.19
   OPINION.

Tettssell:

The taxpayer is a corporation owning certain railroad properties which it had operated for a number of years prior to 1918. Between January 1, 1918, and March 1, 1920, these properties were in the possession and use of the United States. During all the times here considered it has had the established practice of keeping its books in accordance with the methods of accrual accounting, and has made reports on that basis to the Interstate Commerce Commission and income and profits tax returns under the several revenue acts. The issue here presented is, What was this taxpayer’s income and liability to income and profits taxes during the calendar years 1918, 1919 and 1920?

As of the date of January 1, 1918, the Government of the United States took over “ the possession, use, control, and operation ” of the taxpayer’s property and retained such possession, use, and operation until March 1, 1920, when the said property was restored to the possession, use, and control of the taxpayer. The period from January 1, 1918, to February 28, 1920, has been designated as the period of Federal control, and during that time “the Government operated [the taxpayer’s property] not as lessee, but under a right in the nature of eminent domain.” North Carolina R. R. Co. v. Lee, 260 U. S. 16; Missouri Pacific R. R. Co. v. Ault, 256 U. S. 554. The Government having thus exercised its right of taking the use and operation of this taxpayer’s property and appropriating the same to the public uses, such .act immediately set in motion the guarantee contained in the Fifth Amendment of the Constitution which provides:

Nor shall private property be taken for public use, without just compensation.

Immediately upon the taking over by this exercise of the right of eminent domain, Congress, on March 21, 1918, enacted the Federal Control Act, 40 Stat. 451, defining the position of the United States in relation to the “ possession, use, control, and operation ” of the railroad systems and providing for the immediate adjustment and payment of the just compensation required by the Constitution. The relevant portions of said Act are as follows:

Sec. 1. * * * That the President, having in time of war taken over the possession, use, control, and operation (called herein Federal control) of certain railroads and systems of transportation (called herein carriers), is hereby authorized to agree with and to guarantee to any such carrier making operating returns to the Interstate Commerce Commission, that during the period of such Federal control it shall receive as just compensation an annual sum, payable ■from time to time in reasonable installments, for each year and pro rata for any fractional year of such Federal control, not exceeding a sum equivalent as nearly as may be to its average annual railway operating income for the three years ended June thirtieth, nineteen hundred and seventeen.
*******
Every such agreement shall provide that any Federal taxes under the Act of October third, nineteen hundred and seventeen, or Acts in addition thereto of in amendment thereof, commonly called war taxes, assessed for the period of Federal control beginning January first, nineteen hundred and eighteen, or any part of such period, shall be paid by the carrier out of its own funds, or shall be charged against or deducted from the just compensation; * * *.
*******
Sec. 2. That if no such agreement is made, or pending the execution of an agreement, the President may nevertheless pay to any carrier while under Federal control an annual amount, payable in reasonable installments, not exceeding ninety per centum of the estimated annual amount of just compensation, remitting such carrier, in case where no agreement is made, to its legal rights for any balance claimed to the remedies provided in section three hereof. Any amount thereafter found due such carrier above the amount paid shall bear interest at the rate of six per centum per annum. The acceptance of any benefits under this section shall constitute an acceptance by the carrier of all the provisions of this Act and shall obligate the carrier to pay to the United States, with interest at the rate of six per centum per annum from a date or dates fixed in proceedings under section three, the amount by which the sums received under this section exceed the sum found due in such proceedings.
Sec. 3. That all claims for just compensation not adjusted (as provided in section one) shall, on the application of the President or of any carrier, be submitted to boards, each consisting of three referees to be appointed by the Interstate Commerce Commission, * * *. Said boards shall give full hearings to such carriers and to the United States; shall consider all the facts and circumstances, and shall report as soon as practicable in each case to the President the just compensation, calculated on an amvual basis and otherwise in such form as to be convenient and available for the making of such agreement as is authorized in section one. * * *
*******
Sec. 14. That the Federal control of railroads and transportation systems herein and heretofore provided for shall continue for and during the period of the war and for a reasonable time thereafter, which shall not exceed one year and nine months next following the date of the proclamation by the President of the exchange of ratifications of the treaty of peace * * *.
*******
Sec. 16. That this Act is expressly declared to be emergency legislation enacted to meet conditions growing out of war * * *, (italics ours.)

By this Act, Congress provided both the methods of ascertainment and the time and manner of payment to this taxpayer of the just compensation guaranteed to it by the Constitution. In respect to this Act the report of the Senate Committee on Interstate Commerce stated that the Act would—

Determine finally and completely all rights as between the Government and the owners [of the transportation systems], thus avoiding the delays incident to litigation and giving strength and stability to the security market and rendering assistance to our future war financing. (Italics ours.)

The same Senate Committee report also contains the following:

Section 1 further provides that ordinary taxes, National and State, shall as now, be paid out of operating revenue; but wan• tames accruing under the Act of October S, 1911, cure to be paid by the companies out of their own funds or charged against the standard return. In other words, the holders of railroad securities are by section 1 (like holders of other securities) to bear their oum just portion of the war burden * * *.
The standard return thus provided for will, if accepted by the various operating companies, be disposed of substantially as hitherto; that is, for the payment of their fixed charges (and war taxes which remain a burden upon the standard return), for dividends, and if any balance remains for so-called surplus. (Italics ours.)

Respecting the same Act, the report oí the House Committee on Interstate and Foreign Commerce, recommending H. R. 9685, which carried the general plan of the statute as finally enacted, said:

Section 1 is a fundamentally important section; for it sets the outside limits of the expected agreements. Its sole function is to provide a basis of such just and proper agreements as may eliminate litigation. This section authorizes the President to make agreements with the operating carriers under which they shall receive in lieu of their constitutional rights the average of their railway operating income for the three years ended June 30, 1917, plus an additional income at some reasonable rate to be fixed by the President upon the cost of additions to their property made during the last six months of 1917. This additional return is allowed for the sake of equality, as it is stated that a comparatively few of the carriers have during this six months period invested more than $200,000,000 in property now applied to public use. Ordinary taxes, Federal and State, are to be paid as hitherto out of operating income. But war taxes are (m effect) payable out of the standard return; the owners of railroad securities, Mice the oioners of other securities, are thus left to carry their share of the war tax burden. (Italics ours.)

The Federal Control Act, some of the provisions of which are shown above, clearly sets forth and defines the situation created by the taking over of the transportation systems, and the relations between the Government and the owners of such systems and the provisions of that Act have been universally accepted, both by the carrier corporations and by the courts and the people of the United States, as finally determining and settling all the problems growing out of the situation created when the President, in the exercise of his war authority, took over the transportation systems of the country.

In unmistakable language the said Act determined that the Government took over and appropriated to the public use, not the properties of the carrier companies, but only “ the possession, use, control, and operation ” of such properties. And in section 14 of the Act it is specifically stated that such possession and operation was taken only for a limited period, and the jhst compensation required by the Constitution was fixed upon a definite annual basis. Having under consideration a somewhat analogous situation, the Court of Claims, in Johnson v. United States (1866), 2 Ct. Cls. 391, said:

Tbe measure of the damages [for the temporary occupation of lands by the government] must be limited to the value of this temporary occupancy [at the time of entry], as though the claimant had leased and the government had rented the premises regard being paid to the nature of the occupancy and to the fact that the government had the option of discounting- the implied tenancy on any day or of retaining it indefinitely.

It thus appears that while, during the possession and control of property taken by virtue of the exercise of the right of eminent domain, and for a temporary period, the Government does not occupy the position of a lessee, the just compensation required by the Constitution is in effect in the nature of rent and may be properly measured by the value of the use and operation of such properties at the time of the entry; and, therefore, Congress enacted that the just compensation should, in the absence of special circumstances or conditions, be measured by the amount of the net average operating income accruing to the carrier corporations during the three annual accounting periods last preceding the taking over of control and operation by the Government, and that such just compensation should be paid to the carrier corporations “ in reasonable installments, for each year and fro rata for any fractional year ” during which Federal control might continue. The language of the Act is too explicit to permit of any doubt that the just compensation provided for was intended to be and was income to the carrier corporations annually during the period of Federal control.

While the Federal Control Act can not be interpreted in any sense as a revenue or taxing statute, it is obvious throughout the entire body of the Act that Congress had constantly in mind the effect which Federal operation of the transportation systems might have upon the revenues of the United States and did not for a moment overlook the urgent necessity of the Government for the raising of extraordinary revenue by the means of income and profits taxes already levied, or which might thereafter be levied, to meet the necessities of the Government during the period of the then existing war; and in the framing of the Federal Control Act Congress undertook to, and in our opinion successfully did, make such provisions that the carrier corporations should, out of their gains and profits, including just compensation for the use of their properties, contribute to the revenues of the Government their just proportionate share of the extraordinary tax levies, and that such contributions from the carrier corporations should be made as of the same periods of time during which other taxpayers were carrying the burden of excess-profits and war-profits taxation.

During the entire period of Federal control of the transportation systems the Revenue Act of 1918 was in force and effect, and section 212 (b) of that Act provided that:

The net income [of all taxpayers] sliall be computed upon the basis of the taxpayer’s annual accounting period (fiscal year or calendar year, as the case may be) in accordance with the method of accounting regularly employed in keeping the books of such taxpayer; « * * 0r if the method employed does not clearly reflect the income, the computation shall be made upon such basis and in such manner as in the opinion of the Commissioner does clearly reflect the income.

This taxpayer kept its books upon what is known as the accrual system of accounting, and, while there may not be any fixed and unchangeable rules of accounting methods, it has become the settled practice of accrual accounting that all items of gross income, as well as all items of deductible expense and loss, shall be set up in the accounting system as accrued income, whether received or not, or as expenses and losses, whether paid or not. In the recent case of United States v. Anderson, 269 U. S. 422, where there was under consideration the subject of the accrual of operating expenses, including deductible taxes, Mr. Justice Stone, speaking for the court and referring to section 13(d) of the Revenue Act of 1916, which provided for the making of income-tax returns in accordance with the taxpayer’s method of accounting, said (p. 440):

A consideration of tbe difficulties involved in tbe preparation of an income account on a strict basis of receipts and disbursements for a business of any complexity, wbicb bad been experienced in tbe application of tbe Acts of 1009 aud 1913 and wbicb made it necessary to authorize, by departmental regulation, a method of preparing returns not in terms provided for by those statutes, indicates with no uncertainty tbe purpose of §§ 12 (a) and 13 (d) of tbe Act of 1916. It was to enable taxpayers to keep their books and make their returns according to scientific accounting principles, by charging against income earned during tbe taxable period, tbe expenses incurred in and properly attributable to tbe process of earning income during that period; and indeed, to require tbe tax return to be made on that basis, if tbe taxpayer failed or was unable to make tbe return on a strict receipts and disbursements basis.

The converse of the principle thus stated requires that the gross income from which accrued deductions are to be taken must include all the items of income properly accruable during the period for which the deductions are to be taken, and that a taxpayer’s net income is not clearly shown unless all the items of income are first set up and included in the amount from which the accrued deductions are subtracted.

In the instant case, the Government provided for the payment to the taxpayer, during the years from January 1, 1918, to March 1, 1920, as just compensation for the use and occupation of its properties, of an amount equivalent to the so-called standard return, or such greater amount as might have been agreed upon, and that such payments should be made annually in convenient installments during all of that period. These payments were provided for in order that the amount so determined might become the annual income of the taxpayer and might also bear their proportion of the tax revenues payable to the Government during that period. The full amount of just compensation, as measured by the so-called standard return, was known both to the Government and to the taxpayer during all of the years 1918, 1919 and 1920, and all of that amount definitely accrued by virtue of the Federal Control Act of March 21, 1918, and that amount, or in the absence of agreement not less than 90 per cent thereof, was payable to the taxpayer in convenient installments throughout that period. This taxpayer, in common with all others, owed to the people of the United States the duty of contributing annually its fair proportion of the burden of war taxation, and it should not in good conscience now be permitted to claim that, because it then declined to enter into a contract with the Railroad Administration, or to receive payments of 90 per cent of the amount provided for by the standard return, it should escape its just proportion of war taxes.

Applying the reasoning of the Anderson case, supra, to the agreed facts of the case at bar, it appears that this taxpayer had a consistent practice of keeping its books of account upon an accrual basis, and that under such system of accounting all its gross income from whatever source should have been entered upon its books. Finding that a part of such gross income was omitted from the taxpayer’s books of account for the years 1918, 1919 and 1920, we must hold that such books of account must now be treated in the same manner as they would be had such items of gross income been properly accrued and entered upon the books. Having now before us for review the income and profits-tax returns for the years 1918, 1919 and 1920, when all differences as to the true amount of the accrued income for those years have been adjusted, the true income and profits-tax liability for the several periods must be computed upon the basis of the accrual during those periods of the true amount of income as finally settled.

We are, therefore, of the opinion that the income and profits-tax liability of this taxpayer for the years 1918, 1919 and 1920, should be computed, after having added to the gross income for the years 1918 and 1919 the sum of $180,377.56, respectively, and for the year 1920 the sum of $30,062.93, and that the deficiencies be computed upon the amount of resulting net income for each of said years at the rates of tax prescribed for each year, respectively, and subject to such adjustments of invested capital as heretofore determined by the Board to be authorized by law.

Order of redetermination will be entered on 15 davs' notice, vmder Rule 50.

GReen, Marquette, Milliken, Morris, Smith and Sternhagen dissent.


author: Smith :

text:
    Appeal of United States Fidelity & Guaranty Co.
    Docket No. 4263.
    Decided October 4, 1926.
    1. The net addition to reserve funds which an insurance company is entitled to deduct from gross income, under section 234 (a) (10) of the Revenue Act of 1918, is the excess of the reserve funds required by statute law of any State in which it transacts business at the close of the taxable year over the corresponding reserve at the beginning of the taxable year, and it is immaterial that the highest reserve funds required by statute at the close of the year is in a different State from the highest reserve fund required by statute at the beginning of the year.
    2. A taxpayer appealing to this Board from a deficiency in income and profits tax found by the Commissioner and entitled to a credit for taxes under the provisions of section 238 of the Revenue Act of 1918, is not barred from claiming such benefit before this Board on the ground that it did not furnish the proof of payment required by article 611 of Regulations 45, requiring it to file with the Commissioner Form 1118.

      J. Kemp Bartlett, Esq., for the petitioner.

      George G. Witter, Esq., for the Commissioner.
    The petitioner appeals from a deficiency in income and profits tax for the year 1919 in the amount of $24,723.40, only a part of which amount is in controversy. The points in issue are: (1) The right of the petitioner to deduct from gross income $1,083.98 for net addition to reserve funds over the amount allowed by the Commissioner; (2) the right of the petitioner to receive a credit under section 238 of the Revenue Act of 1918 of $4,873.60, representing an income tax paid to the Canadian Government during the year 1919; and (3) the right of the petitioner to deduct from gross income $202.12, taxes paid to the Department of Insurance of the Dominion of Canada, which amount it failed to deduct from gross income in its income-tax return for 1919.
    FINDINGS OF FACT.
    The petitioner is a Maryland corporation domiciled at Baltimore. Under the provisions of the Excise Tax Act of August 5, 1909, the Income Tax Law of 1913, and subsequent income tax laws, it has made returns of net income to the Federal Government. Under the provisions of the Revenue Act of 1918, it filed a return of its income for the year 1919 with the collector at Baltimore, such return checking with its return made for the same year to the Surety Bonds Division of the Treasury Department of the United States and with the Insurance Department of the State of Maryland. In such return it claimed as a deduction from gross income a net addition to reserve funds represented by the increase in reserve funds at the close of 1919 required by the Insurance Department of the State of Maryland oyer the amount of such reserve funds at the beginning of the year. For years prior to 1919, and also for years subsequent to 1919, the petitioner’s returns to the collector have been audited upon the basis of the published reports of insurance companies of the State of Maryland. For the year 1919, the Commissioner audited the petitioner’s return upon the basis of the petitioner’s return .to the Insurance Department of the State of New York. The net addition to reserve funds required by the Insurance Department of the State of New York, and also by the statutes of the State of New York, was $1,088.98 less than the amount shown by its return to the Insurance Department of the State of Maryland. The reason for this discrepancy is that the petitioner during the year 1919 reinsured certain of its risks with reinsurance companies which were not admitted to do business in the State of New York. With respect to such reinsurances, the Insurance Department of the State of Maryland permitted the deduction from the premiums received of the amounts paid to the reinsurance companies and required the reserve to be computed on only the balance of the premiums received; the Insurance Department of the State of New York did not permit the deduction of such premiums paid to non-admitted reinsurance companies and computed the reserve upon the total premiums collected from the insured. The result was that the premium reserve shown by the printed report of the Insurance Department of the State of New York was higher at both the beginning and the close of the year 1919 than the reserves shown by the Maryland insurance report. The difference between the required reserve shown by the New York report was $1,088.98 less than the difference shown by the Maryland insurance report, and it is this difference which the Commissioner disallowed the petitioner to deduct from gross income in the audit of its return for the year 1919.
    In its income-tax return for the year 1919, the petitioner claimed a credit against a tax due the United States of $5,075.72, representing taxes or assessments paid to the Department of Insurance of the Dominion of Canada. The petitioner did not, however, comply with the provisions of article 611 of Regulations 45 of the Treasury Department, and failed to file with its return or with the Commissioner Form 1118. For lack of proof of . the character of the tax claimed as a credit and of the date of payment the Commissioner disallowed the credit.
    Under the Special War Revenue Act of 1915 of the Dominion of Canada, “ every company, other than a life insurance company, a company transacting marine insurance, a fraternal benefit society and a purely mutual company, licensed or registered or otherwise authorized to transact in Canada or in any province thereof the business of insurance shall pay to the Minister for the Consolidated Revenue Fund a tax of one per cent upon the net premiums received by it in Canada on and after the first day of January one thousand nine hundred and fifteen.” Under this law the petitioner paid to the Department of Insurance of the Dominion of Canada, during the calendar year 1919, $4,873.60, representing one per cent of the net premiums of the company collected in Canada. During the same calendar year it also paid to the Department of Insurance of the Dominion of Canada $202.12, which was an assessment made against, it by the Dominion of Canada towards the support of the Department of Insurance.
    The total income tax and assessment paid to the Dominion of Canada during the year 1919 was $5,075.72, no part of which was deducted from gross income by the petitioner in its income-tax return made to the collector at Baltimore for the year 1919, but all of which was claimed as a credit against the income and profits tax shown to be due by that return. The petitioner now admits that it was in error in claiming a credit of the $202.12 paid to the Dominion of Canada as an assessment for the support of the Department of Insurance of the Dominion. It claims, however, a credit of the income tax paid to the Dominion of Canada in the amount of $4,873.60, and the deduction from gross income of the $202.12 paid as an assessment.
   OPINION.

Smith :

The petitioner complains that the Commissioner failed to audit its income and profits-tax return for the year 1919 from the published report of the Department of Insurance of the State of Maryland, which report was used in auditing its returns for years prior to 1919 and for subsequent years; that if the Commissioner had audited its return by the Maryland report, it would have been entitled to a deduction from gross income of $1,083.98 addition to reserve funds more than the amount allowed by the Commissioner.

The taxing statute permits the petitioner to deduct from gross income “the net addition required by law to be made within the taxable year to reserve funds * * Section 234(a) (10) (a), Revenue Act of 1918. The reserve funds referred to by the statute are the reserve funds required by the statutes of the State or States in which theinsurance company transacts business. United States v. Boston Insurance Co., 269 U. S. 197. It appears from the evidence that the statutes of the State of New York required the petitioner to maintain larger reserves at January 1, 1919, and at December 31, 1919, than did the statutes of the State of Maryland. The petitioner was clearly entitled to take the deduction from gross income of the excess amount of such reserves at December 81, 1919, over the highest amount required as a reserve by statutes of any other State in which it transacted business at January 1, 1919. It is immaterial whether the highest reserve required at the beginning and close of 1919 was of Maryland or some other State. We are not informed as to the amount of the reserves required by States other than New York and Maryland. It is clear, however, that the net addition to reserves, as between the States of New York and Maryland, was not in excess of the difference between the reserves required to be held by the statutes of the State of New York on January 1, 1919, and December 31, 1919, since at both dates the reserves were in excess of those of Maryland. The petitioner, following the Maryland insurance report, claimed a deduction from gross income for the year 1919 of a net addition to reserve funds greater than the proof before us indicates it was entitled to claim. The position of the Commissioner upon this point must therefore be sustained.

With respect to the second and third points in issue, no question is raised by the Commissioner but that the one per cent net premium tax paid to the Department of Insurance of the Dominion of Canada is an income tax within the purview of section 238 of the Revenue Act of 1918. The Commissioner contends, however, that the petitioner did not comply with article 611 of Regulations 45, and that it has never filed Form 1118; that such regulation is a reasonable regulation, and that the petitioner has come forward with its proof too late and that the credit for the $4,873.60 should be denied.

The term “ deficiency ” is defined by the Revenue Acts of 1924 and 1926 as “ the amount by which the tax imposed by this title exceeds the amount shown as the tax by the taxpayer upon his return; * * Section 273. Whether the amount shown as the tax upon the return, or the amount admitted by the petitioner to be due and collectible, is the starting point in the computation of a deficiency, has been determined by this Board in Appeal of John Moir, 3 B. T. A. 21. Upon the authority of that decision the Board assumes jurisdiction to determine the point in issue, raised in this appeal.

We are of the opinion that in any case a taxpayer appealing to this Board from a deficiency found by the Commissioner is not too late in submitting evidence to the Board. The petitioner has proven before this Board its right to a credit against income and profits tax due of $4,873.60. The deficiency found by the Commissioner must therefore be reduced in that amount.

The petitioner erroneously claimed a credit against the tax due the United States of $202.12. This tax, however, was paid and was an ordinary and necessary expense of the petitioner in the conduct of its business in 1919. In the redetermination of the deficiency the petitioner should be given the benefit of such deduction from gross income.

Order of redetermination will be entered on 15 days' notice, under Bule 60.

Tkammell concurs in the result only.


author: Love :

text:
    Appeal of Isabel Anderson.
    Docket No. 1394.
    Decided October 4, 1926.
    1. Net value of rights to purchase stock in addition to stock held, and in proportion to such stock so held, enters into computation of cost of original stock purchase, in determining amount of gain or loss in sale thereof.
    2. Taxes paid at source on tax-free covenant bonds are not taxable income.

      Allison R. Brown, G. P. A., for the petitioner.

      M. N. Fisher, Esq., for the Commissioner.
    This appeal is from the determination of deficiencies in income tax for the years 1919 and 1920, in the respective amounts of $11,557.68 and $183.99.
    The deficiencies arose by reason of the fact that the Commissioner used the amount of the proceeds of the sale of certain rights incident to stock held by the petitioner to reduce the amount of loss accruing on the sale of said stock, and further ruled that a 2 per cent tax paid by the obligor on tax-free covenant bonds constituted additional income.
    FINDINGS OF FACT.
    The petitioner is an individual residing in Washington, D. C. In 1903 she had purchased 5,796 shares of stock of the Pennsylvania Railroad Co. In 1903 she sold 386 shares, and again in 1908 she purchased 245 shares. On March 1, 1913, she owned 5,655 shares the cost of which, as shown upon her books, was $338⅛767.60. The market value of the said stock on March 1, 1913, was $338,593.13. The .cost of the several purchases are shown in computations, as indicated herein.
    At several dates, from 1903 to June 1, 1913, there were issued and delivered to petitioner certificates which entitled her to purchase additional stock at favorable prices, which certificates were assignable. She received and sold these certificates as follows:
    In 1908 she received and sold certificates entitling her to purchase one new share at $60 for each three shares held by her. She sold the certificates for___$8,694. 00
    In 1909 she received and sold certificates entitling- her to purchase one new share at $50 for each four shares held by her. She sold the certificates for_ 22, 726. 98
    In 1911 she received and sold certificates entitling her to purchase one new share at $50 for each ten shares held by her. She sold the certificates for_ 5, 891. 50
    In 1913 she received and sold certificates entitling her to purchase one new share at $50 for each ten shares held by her. She sold the certificates in June, 1913, for_ 3, 053.80
    Making a total amount received for all the certificates of_ 40, 366.28
    In 1919 the petitioner sold the stock for $226,096.13, and claimed a loss of $112,497, the difference between the March 1, 1913, value, as shown upon the books, and the selling price. The Commissioner determined that the book cost of $338,767.60 was not the true cost and that the actual cost was $321,000.42, which was less than the March 1, 1913, value, and allowed a loss of $94,904.29. The Commissioner arrived at such cost as follows:
    1901, 1902, 1903:
    5,796 shares cost-$347, 539. 89
    1903:
    1 share cost, old_ 59. 962
    ⅜ share cost new at $60--- 20.00
    1⅜ shares cost_,_ 79. 962
    1 share, old and new, average_ 59.9715
    1908:
    245 shares cost $16,170. $66 per share. Old shares, 5,410 (386 were sold in 1903) $59.9715 a share_ 324,445.815
    245 at $06- 16,170. 00
    340, 615. 815
    $340,615,815 divided by 5,655_ 60.232
    1909:
    1 share old, cost_ 60. 232
    ½ share, new, at $50_ 12. 50
    1⅛ shares cost_ 72. 732
    1 share, old and new, average_ 58.186
    1911:
    1 share adjusted_:_ 58.186
    A share, new, at $50- 5.00
    1A shares, old and new- 63.186
    1 share, old and new, average_ 57.441
    March 1, 1913 value_ 59.875

      1913:
    1 share adjusted_ $57.441
    ⅛ new share, at $50- 5. 00
    1⅜ shares, old and new_ 62.441
    1 share adjusted_,- 56. 764
    5,655 shares at $56.764 a share_ 321,000. 42
    Selling price in 1919_ 226,096.13
    Loss_- 94, 904.29
    In calculating the petitioner’s income for the year in question, the Commissioner included $822.59, which was the amount of 2 per cent tax withheld at source and paid by the obligor on tax-free covenant bonds owned by the petitioner.
   OPINION.

Love :

In this appeal there is no controversy between the petitioner and the Commissioner as to the facts and amounts entering into the computation of loss resulting from the stock sale in question. The sole issue is whether or not the cost of the stock sho'uld be affected by the subsequent sale of certain rights to purchase additional stock. The petitioner’s cost, as shown by her books, is in excess of the March 1,1913, value, so in computing the loss resulting from the sale in 1919 she merely subtracted the sale price from the March 1, 1918, value. The Commissioner, on the other hand, contends that the March 1, 1913, value, as shown on the books, should be reduced by reason of the fact that at various times she sold certain rights, which she had acquired by virtue of the ownership of the stock, to purchase additional stock, for which she received substantial s'ums, the amounts of which are not in dispute. The Commissioner reduced the cost in the manner set forth in the findings of fact, which resulted in decreasing the loss in 1919.

The Supreme Court has definitely approved this plan or formula for determining the cost and gain or loss where rights to purchase stock are received and then sold by the recipient.

In the case of Safe Deposit & Trust Co. v. Miles, 273 Fed. 822, the petitioner had been issued certificates of right to purchase stock — one new share for each old share held — the price to be paid for the new being $150 per share, while the old stock had cost $710 per share. The District Court which decided the case, in a written opinion, held:

The plaintiff, in the right of every share it held, and which had cost it, as just mentioned, $710, could, by paying $150 a share more, get another, so that it would have two, which in the aggregate would have cost it $860, or $430 apiece. There would be no way of distinguishing between the old and the new. If the latter was something which had not before existed, almost the same might as truthfully be said of the former. Its characteristics had undergone a great change. Before the issue of the new stock, it represented one twenty-thousandth of the capital of the company; afterwards it stood for but one forty-thousandth. Moreover, if the plaintiff had in person taken the new stock, and had had its old and new consolidated into one certificate, and had subsequently sold a part of its holdings, it could not say that that with which it parted was out of the old, or out of the new, or partly out of both. In determining the cost of its shares for the calculation of the profit or loss upon resale, it would be necessary to assume that they had one and all cost the holder an equal amount, which in the case of the plaintiff here was $430 a share.
It certainly could make no difference that without waiting until the stock was issued, and then selling, it sold the right to the new stock, and made it part of the consideration that the buyer should assume for it the payment of the $150 per share exacted by the company. All that would have to be borne in mind in comparing the two ways of reaching the same end is that, if the right was sold, the price really received for the new share was $150 more than the sum paid to the seller, which in the case at bar was $358.48. That was equivalent to $508.48 for a fully paid for share, and the $78.48 by which it exceeded the $430, which the share cost the plaintiff, was the gain or profit it made out of the transaction.
That is the whole story. If $78.48 be multiplied by 35, the number of shares or rights sold by the plaintiff, the product will be $2,746.80, and upon that it was properly taxable, and upon nothing more. It still retains 35 shares. When, if ever, they, or any of them, are sold, there must be returned as profit, in the year in which the price is received for them, the amount, if any, by which that price exceeds $430. It is, of course, immaterial that, if the plaintiff had chosen at the time it parted with the rights to the other 35, to sell any of those it still held, it would have made a taxable profit of nearly $80 a share upon those so disposed of. * * *

The case went to the Supreme Court under the style of Miles v. Safe Deposit & Trust Co., 259 U. S. 247, and that court affirmed the decision of the lower court.

The Commissioner’s computations are in harmony with this decision, and since no evidence was presented controverting in any way the correctness of the computations of the Commissioner, the amount of the loss as determined by him will not be disturbed.

In respect to the other question, the determination of the Commissioner is disapproved. Taxes paid at the source on tax-free covenant bonds are not additional income and should not be included as such. Pitney v. Duffy, 291 Fed. 621; 2 Fed. (2d) 230; certiorari denied, 267 U. S. 595.

Order of redetermination will be entered on 15 days’ notice, under Rule 50.