author: Littleton:

text:
    Appeal of California Brewing Association.
    Docket No. 3903.
    Decided October 30, 1926.
    Upon the evidence, held, that petitioner, an unincorporated association, was affiliated with several other corporations during 1918 and 1919.

      W. W. Spalding, Esq., and M. Cerf, C. P. A., for the petitioner.

      Percy 8. Crewe, Esq., for the Commissioner.
    In this appeal the petitioner contests the correctness of the Commissioner’s determinations of deficiencies in income and profits taxes for the calendar years 1918 and 1919 in the amounts of $57,890.23 and $23,624.99, respectively. The issues involved are:
    (1) Was the petitioner affiliated with seven other corporations, within the meaning of section 240 of the Revenue Act of 1918?
    (2) Should the value of certain plant assets alleged to have been paid in by the five other corporations be included in the petitioner’s invested capital?
    (3) Is the petitioner entitled to deductions for wear and tear and obsolescence of such assets?

      (4) Should the petitioner be allowed to deduct as an ordinary and necessary expense an amount contributed to the State Brewing Association?
    FINDINGS OF FACT.
    The petitioner was organized on January 30, 191V, by the following corporations:
    National Brewing Oo.
    Acme Brewing Oo.
    Union Brewing & Malting Co.
    Claus Wreden Brewing Oo.
    Broadway Brewing Co.
    San Francisco Brandi of Henry Winehart Brewing Oo.
    These corporations are hereinafter referred to as “ units ” or “ members ” of the Association.
    Prior to January 30, 191V, each of the units was an independent corporation not associated with any of the other units, and was engaged in the manufacture and sale of beer on its own account. Shortly before the date above mentioned, it was decided by the officers of each of the units that, owing to the curtailment of sales by prohibition, it would be the part of wisdom for the units to coim bine their businesses into one central organization, in which each would have an interest based on its sales of beer for the preceding year. This decision resulted in the organization of the California Brewing Association. The law of California permits the organization of an association solely of corporate units and the petitioner is such an organization. The corporate units themselves are its members. They also compose it. It was no part of the plan of organization that any individual or partnership should be included in the organization.
    No articles of association or by-laws were adopted by or for the Association. Instead, the structure of the Association and its management, as well as the rights, duties, obligations and interests of the Association and its members inter sese, were defined by the contract to which the Association and the units and their stockholders were signatory parties. No shares of stock or certificates of beneficial interest were issued by the Association. Bather was it a part of the plan of organization that the rights and obligations of the owners of the Association should be evidenced by the several contracts hereinafter mentioned.
    The Association functioned much the same as a corporation. There was a board of directors which selected the active officers and fixed their compensation. The directors were in control of the business and the affairs of the Association and determined its policies. They had supervision of all of the assets and determined when distributions of earnings should be made. In fact they had all of the powers of boards of directors of corporations of similar size. Each of the smaller units selected one member of the board of directors of the Association, while the larger units were permitted to select two members.
    The first contract of January 30, 1917, between the several units and the Association, provided for the purchase by the Association from the units of their businesses, good will, trade-marks, trade names, raw materials, goods in process, finished product, supplies, machinery and equipment, movables and immovables, for which the Association issued to the units certain class A, B, and 0 obligations, the amounts of which are not material here. By this contract the units also granted to the Association a leasehold estate in the land and buildings formerly used in the manufacture of beer. Each of the units agreed that it would not at any time engage in the brewing business in the City or County of San Francisco. Paragraph XII provided that, after the satisfaction of its obligations, the Association should pay monthly to each unit a pro rata portion of its surplus earnings, these distributions to be on the barrelage basis, i. e., that each unit should receive such proportionate part of the surplus earnings as its sales of beer, in terms of barrels for the period from December 1, 1915, to November 80, 1916, was of the total number of barrels sold by all members of the Association for that period. The purpose of this provision was to define the proportionate interest of each member in the profits of the Association. Further reference to distributions on the barrelage basis are contained in paragraphs XVIII and XTX of the contract, which provide:
    As further consideration to the first party it is agreed in the event the business shall cease to continue, or the Association shall be dissolved, either voluntarily or otherwise, or the Association shall decide to distribute any funds or property owned by it, the first party shall receive such pro rata portion of all moneys of the Association on hand, and such pro rata portion of the proceeds of all funds derived by the Association from the sales of all property, after paying all the outstanding indebtedness of the Association, as is provided in paragraph Nil hereof.
    And as further consideration to the first party it is agreed that during the existence of the Association the first party shall be paid by the Association from time to time, in addition to all the foregoing considerations, the same pro rata portion of all the net earnings, dividends and profits of the Association as may accrue from time to time, as is fixed by paragraph Nil hereof to be paid to the first party. The Association shall require its directors to make such pro rata payments to the first party, promptly from time to time as the business of the Association shall justify.
    The grant to the Association of the leasehold in the real estate of the units is contained in paragraph V of this first contract of January 30,1917, which reads:
    And the first party does give and grant to the Association the exclusive right and privilege of using all buildings and lands now used as a plant by the first party, so long as the same may bo desired by the Association, not exceeding forty-nine (49) years.
    The consideration for the grant of a leasehold in the several plants was the interest of the general grantors, the units, in the Association.
    On the same day, January 30,1917, the second contract — or option agreement, as it is termed in the record — was made between the units and the Association, and provided in part as follows:
    That for value received, the first party does hereby give and grant unto the Association, the exclusive right and privilege of using for purposes of the Association, as long as the Association may require the same, not exceeding forty-nine (49) years, those certain buildings and lands now used as a plant by the first party, in the City and County of San Francisco, State of California, and particularly described in Exhibit “A” hereto attached expressly referred to and made a part hereof. And the Association shall have the right and privilege, during the term hereof, of operating the same as a plant, dismantling, closing down, or leasing the same. The rental derived from which in the event of such leasing shall be paid into the Building and Beal Estate fund hereinafter created and disposed of as heroin provided.
    This contract further gave the Association the option and right to purchase at any time within 49 years the plant assets at a price to be fixed by an appraisal to be made within 30 days thereafter by a reputable appraisal company to be selected by the Association. The sole office of the appraisal, stated by the parties in the contract, was the determination of the purchase price to be paid for the plants by the Association upon the exercise of the option. This option agreement further provided for the creation of a building and real estate fund in which certain funds were to be deposited, out of which payments were to be made to the units of the purchase prices of the several plants. The legal or record title was retained by the units.
    The third and final contract between the Association and the various units was dated March 21, 1918, and after reciting the steps theretofore taken, viz, the grant of the leaseholds and the giving of the options to purchase, stated that the appraisal of the. plants had been made in accordance with the option agreement of January 30, 1917, as follows:
    And, whereas, such appraisal has been made of all said buildings and lands of each of the parties of the second part, by the American Appraisal Company, a .true and correct copy of which said appraisal of such buildings and lands of each of the parties of the second part, is as follows:
    Those of the Union Beewing & Malting Co., appraised as follows:
    Land_§30,000.00
    Wells_ 720. 90
    Buildings_ 95, 837.91
    Total_ 126,564.81

      Those of the Claus Wreden Brewing Company, . Washington Brewery, appraised as follows:
    Land_$32,500.00
    Wells-
    Buildings_ 45,346. 89
    Total_ 77,846. 89
    Those of the National Brewing Company, appraised as follows:
    Land_$51,000.00
    Wells_ 1,070.00
    Buildings_ 166,305.43
    Total_ 218,375.43
    Those of the Broadway Brewing Company, appraised as follows:
    Land_$15,000.00
    Wells_ 1,190. 00
    Buildings_ 22,380.53
    Total_■ 38, 570.53
    Two of the unit corporations held their plant properties under leases which are not involved in this proceeding. After the above-quoted references to the appraisal, the contract provided:
    Whereas, it is desired by all the parties hereto, that said option agreement be converted into an agreement of purchase and sale, and that in lieu of said option agreement, this agreement shall be substituted and supersede said option agreement.
    The contract then provided for the creation of a building and real estate fund in which there should be deposited (a) proceeds of sales of any of the plant assets, (b) rentals received by the Association from the leasing of any of the plants, (c) interest accumulated on loans of any part of the monies of the building and real estate fund, and (d) monthly contributions to the fund by the Association of 2½ per cent to 5 per cent, as the directors may decide, of the total collections of the Association — after which appears the following provision upon which the Commissioner predicated his holding that the plant assets were the property of the units during the taxable years here involved:
    As soon as said Building and Beal Estate Fund shall amount to the sum of $461,357.66, derived from such sources, then the Association shall purchase, and pay from said fund, for all the buildings and real estate of each of the parties of the second part, described herein, the respective sums, at which the property of each of said parties has been appraised, as herein set forth; said sums to be paid to each of said parties of the second part, at such time, contemporaneously, regardless of the fact that any of said buildings or other portions of said property have been destroyed or damaged from any cause whatsoever.
    The intention of the parties to the contract was that the words “shall purchase” should be equivalent to the words “shall acquire the record title.” The contemporaneous construction of the contract by the parties was that the ownership of the plant assets passed to the Association not later than March, 1918, and that the Association could do as it might desire with those assets without the consent of the former owners. The brewing of beer at several of the plants was discontinued by the Association and the equipment permitted to deteriorate. When additional equipment and machinery was needed at the National Brewery plant, where the brewing of beer was continued by the Association, the employees of the Association moved the equipment and machinery needed from other breweries to the National plant. In effecting such removal considerable damage was done to the plants from which the equipment and machinery were taken. Several of the plants were leased by the Association and the rentals were collected and retained by it. No charge was made on the books against the Association or any of the units, no credit was given to any of the units, and no adjustment was made on account of any of these transactions. Two of the plants were sold by the Association and the purchase price in each case was paid to and retained by the Association. In completing these sales, the units were used merely for the purpose of transferring the record title.
    It was stipulated by the parties that the actual cash value of the plant assets at January 30, 1917, was $461,357.66, and that the net value of these assets after deducting mortgages was $337,930.62. Subject to depreciation suffered during the intervening period, this value was maintained down to 1918. The stipulation further provides:
    It is further stipulated that the amount of obsolescence sustained on said plants, during 1918, was $106,638.27. By this stipulation, the Commissioner does not concede that the ownership of said plants, or any of them, was at any time, in the California Brewing Association.
    Prior to making the contracts hereinbefore mentioned, each of the units was in control of its own properties and its own business affairs. By the contracts, however, the units divested themselves of any control whatsoever over the properties and businesses formerly owned and conducted by them. They were left without property or business, and thus became inactive except to receive and disburse their proportionate shares of the profits of the Association. Contracts in each instance were signed by all of the stockholders of each unit. Thereafter the Association became the original source of all earnings and profits and of all distributions to stockholders. There was a complete merger of the business activities of the units into the Association. No other interest was identified with it.
    The smaller units selected one and the larger units two members as directors of the Association. The individuals so selected became the nominees of the Association and the stockholders. To enable them to act as such nominees the representatives were given control of the stock of the units during the taxable years here involved.
    The Remar Company, a corporation, was organized in 1918 to manufacture yeast and other materials used by bakeries. Its principal place of business was in Oakland, Calif. It became active in the summer of 1918. Its stock was divided into two classes, pra ferred and common, both of which had voting rights, and the petitioner and its unit corporations owned 68.651 per cent of preferred stock and 86.11 per cent of common stock. Of the remainder, 26.828 per cent of the preferred and 61.545 per cent of the common was owned by officers of the petitioner or the units and members of their families, interests that were closely affiliated with the petitioner. The latter stockholders acquired their stock with the understanding that the Remar Company was to be one of the group of corporations to be controlled by the Association, and this understanding was observed at all times. In point of fact, the Remar Company was always regarded as a branch of the Association and operated as the interest of the Association required.
    In 1918, the Association contributed $6,002.10 to the State Brewers Association and deducted that amount from gross income in its return as an ordinary and necessary expense. This deduction was disallowed by the Commissioner. The State Brewers Association was organized in 1918 for the purpose of bringing the brewers of the State together periodically in conventions for the discussion of their business problems, “to establish trade practices favorable to the industry, to deal with labor collectively and to deal with labor matters specifically such as handling cases of arbitration, disputes between members of the Association and the unions, and to use its influence, collectively, for the elimination of the objectionable features that attached themselves to the brewing business.” Rone of the activities of the petitioner during the taxable years had to do with lobbying or other efforts relating to legislation.
   OPINION.

Littleton:

The first question relates to the disallowance of the deduction of $6,002.10 for 1918 representing a contribution by petitioner to the State Brewers Association. From the evidence submitted, we are of the opinion that this was a proper business expense and should be allowed as a deduction from gross income.

The second issue is whether the petitioner, an unincorporated association, was, during the years 1918 and 1919, affiliated with the seven corporations mentioned in the findings of fact. The six brewing companies together composed the California Brewing Association, which they organized under the laws of California and to which they transferred their entire businesses and assets. The Reinar Company was organized in 1918 by the group. The petitioner, a voluntary association of corporations, was taxable as a corporation under the provisions of the Revenue Act of 1918. These powers, duties, rights and liabilities were defined by the contracts herein-before referred to. The petitioner had no capital stock. The Commissioner held that it did not control the stock of the units which composed it, and that the stock of the other corporations was not controlled by the same or closely affiliated interests.

Section 240 of the Revenue Act of 1918 contemplates that corporations and associations may be affiliated and speaks of the control of stock, which is evidence of the proprietary interest in a corporation or an association entitling the holder to vote at stockholders’ meetings, to receive profits by way of dividends and the assets upon liquidation. When we look for the equivalent of stock in this case, we are immediately confronted with the fact that the six brewing companies composed the Association and, apart from them collectively, it had no existence. Therefore, it seems to us that we have at the threshold of the consideration of the question the patent fact that the question in reality is whether the Association shall be regarded as having been affiliated with itself, for the units were the Association, and we should hesitate before saying that the component parts of an organization must, for tax purposes, be separated from itself. The petitioner and the units which composed it constituted a single business enterprise or unit. Each of the units sold and conveyed to the Association its business and transferred all stock on hand, raw materials, goods in process, finished product and all equipment, together with the management and control of the entire plants and assets of every character and discontinued operations. Thereafter the Association determined which plant or plants should be operated, with the result that three plants were closed and later sold and the proceeds became the property of the Association. Upon the formation of the Association no profits thereafter accrued to the units or to the stockholders of the units, except through the Association. Instead of sharing in the profits through the ownership of stock in the Association, the units and their stockholders received distributions from the profits of the Association under the provisions of the contracts hereinbefore mentioned.

The important point in this proceeding is the manner in which one corporation or association may control the stock of another, so as to be affiliated within the meaning of the statute. A corporation can function only through agents, and control by these agents is its control. The statute states “where one corporation controls the stock of another,” but a corporation can not function and can not control the stock of another except through its agents. No other means of control is possible.

It was provided in the contracts between the various units and the petitioner that the units should have the right to select, in some instances, one, and in others, two members of the board of directors of the Association. When so selected they were the representatives of not only the units'but also of the stockholders of the units who were parties to the contracts. They were selected as the representatives of the stockholders and there was no provision for their removal by anyone during their terms of office. The board of directors of the Association controlled the stock that it represented, the selection of the directors being for that purpose. The purpose of the membership representation on the board of directors of the Association was to place the control of the units and the stock, so far as the Association was concerned, with the members who were elected to the board of directors. The directors were first the agents of the Association having the management and control of its affairs — their allegiance was to it, whatever act it performed was through them. When they controlled, being the agents of the Association, the Association controlled. The control here was through interests closely affiliated with the Association.

Under the evidence presented, we are of the opinion that the stock of the Remar Company was owned or controlled by the same or closely affiliated interests. The net income and invested capital of the six brewing companies, the Remar Company and the petitioner for the years 1918 and 1919 should therefore be computed upon the basis of consolidated returns. The amount of obsolescence sustained on the plants for 1918 has been stipulated and the fact of exhaustion, wear and tear is not in question.

In view of our decision upon the question of affiliation, it is not necessary to decide whether real estate of the value of $461,000 should be included in the invested capital .of the Association or the units.

Judgment will he entered on 15 days’ notice, under Rule 50.

GResn and Morris dissent.

Phillips concurs in the result only.

Milliken did not participate.


source: Caselaw Access Project

author:
Trammell:
      Phillips,

license: Public Domain

text:
    Appeal of W. J. Hunt.
    Docket No. 5791.
    Decided October 30, 1926.

      Held,, on the evidence, that the dividend received by the petitioner was a cash dividend and not a stock dividend.

      A. Lee Rawlings, G. P. A., for the petitioner.

      Thomas P. Dudley, Jr., Esg., for the Commissioner.
    This is an appeal from the determination of a deficiency in income tax for 1918 in the amount of $2,219.62. The deficiency arises from the action of the Commissioner in increasing the income reported by the petitioner on account of amounts claimed by the petitioner to be stock dividends.
    FINDINGS OF FACT.
    The petitioner is a resident of Norfolk, Va. On January 1, 1918, he owned 275½ shares of the capital stock of the Merchants Bakery, Inc., of Norfolk. The par value of this stock was $100 per share. On January 2, the petitioner acquired 148 additional shares of stock of the same company, as hereinafter set out.
    At a meeting of the board of directors of the above-named company, held on December 1, 1917, a resolution was adopted wherein the board recommended to the stockholders that the capital stock of the corporation be increased from $65,000 to $100,000, the maximum allowed by the charter, and that the additional issue of $35,000 of capital stock be offered to the stockholders at par in proportion to their respective holdings, and, if any of the stockholders did not take their allotment, then the amount so refused should be offered to the stockholders in proportion to their respective holdings.
    The stockholders of the Merchants Bakery, Inc., on December 1, 1917, and during the taxable year, were W. J. Hunt, F. H. Hobbs, B. Randolph Hicks, T. G. Hobbs and Walter Dickson.
    At a special meeting of the stockholders of the Merchants Bakery, Inc., called on December 1, 1917, the recommendation of the board of directors submitted on the same date was by resolution adopted by the stockholders, and the capital stock was increased to $100,000 in accordance with the recommendations made by the board of directors, which resolution was unanimously adopted.
    On December 24, 1917, at a meeting of the board of directors of the Merchants Bakery, Inc., the following resolution was unanimously adopted:
    Resolved: that tke business of the company showed that its operation had been so prosperous in the year 3917 as to justify the payment of an extra dividend. Now, Therefore, Be it resolved that an extra dividend of $60 per share is hereby declared payable on the stock outstanding as of January 1,1917.

      Subsequent to the adoption of the resolutions by the board of directors and the stockholders at the meeting held on December 1, 1917, but prior to the declaration of the dividend on December 24, 1917, it was agreed between all the stockholders, including those who were members of the board of directors, that they would take stock and pay for it with the money distributed by the corporation to the extent of $35,000, and that the checks received from the corporation should be deposited to the credit of the individual stockholders whose checks in payment for stock would be simultaneously deposited. When the contemplated dividend was declared the corporation had a surplus on hand at the date of the resolution, December 24, 1917, in excess of $39,000.
    At the meeting of the directors on December 24, 1917, the stockholders delivered to the treasurer of the corporation their personal checks aggregating $35,000 as follows:
    W. J. Hunt_$14, 800
    S'. H. Hobbs_ 11,300
    B. Eandolpb Hicks_ 5,700
    T. G. Hobbs_ 2,900
    Walter Dickson_ 800
    35,000
    The above checks were given in payment for stock on December 24, 1917, but were not to be presented for payment until the corporation’s checks representing the pro rata share of each stockholder of the dividend were deposited. Some of the stockholders who signed the above checks had no money in the banks upon which they were drawn; others were for amounts in excess of the respective balances of their personal bank accounts, and by agreement were held by Merchants Bakery, Inc., until January 2, 1918, when the checks of the corporation were made out in favor of all of the stockholders in amounts aggregating $39,000 as follows:
    W. J. Hunt_$16, 530
    JT. H. Hobbs_ 12, 570
    E. Eandolpb Hicks- 6,360
    T. G. Hobbs_ 3,240
    Walter Dickson_ 300
    39,000
    The treasurer of the Merchants Bakery, Inc., deposited the checks issued to the stockholders by the company in amounts aggregating $39,000 in the bank to the personal credit of the stockholders and simultaneously deposited the stockholders’ checks which he held aggregating $35,000, which checks had been endorsed by the respective stockholders. Prior to such deposit on January 2, 1918, the cash of the company in the bank was $10,600.

      On the same day, January 2, 1918, the stockholders received their additional- stock in the corporation.
   OPINION.

Trammell:

The question involved in this appeal is whether the dividend paid by the Merchants Bakery, Inc., is a stock dividend or a cash dividend.

It is contended by the petitioner that his distributive share of the dividend declared by the company was a stock dividend to the extent of the amount which equaled the amount of the check drawn by him, which was not to be paid until the check of the corporation representing a dividend was deposited, and that only the amount of the cash received in excess of the check deposited by him represented a cash dividend.

The taxpayer relies in support of his contention upon the cases of United States v. Mellon, 281 Fed. 645; United States v. Davison, 1 Fed. (2d) 465; and Appeal of Theresa Zellerbach, 2 B. T. A. 1076.

Whether, in any case, a dividend is a stock or cash dividend is a question of fact and the question must be decided upon the peculiar facts in each case. While the Board will look through form to substance in order to arrive at what actually occurred, it is sometimes difficult to determine what is mere form and what is in fact substance. The form which a transaction takes frequently determines what the transaction is.

In the case of Eisner v. Macomber, 252 U. S. 189, the United States Supreme Court defined what a stock dividend is. In that case it was argued by the Government that there was no essential difference between a stock dividend and a transaction whereby the corporation declared a dividend in cash with the privilege of purchasing stock with that cash. In support of its contention that there was no essential difference between the two transactions, the Government cited the case of Tax Commissioner v. Putnam, 227 Mass. 522; 116 N. E. 904. In that case the court stated as follows:

In essence the thing which has been done is to distribute a symbol representing an accumulation of profits, which instead of being paid out in cash is invested in the business, thus augmenting its durable assets. In this aspect of the case the substance of the transaction is no different from what it would be if a cash dividend had been declared with the privilege of subscription to an equivalent amount of new shareá.

That court reasoned upon the theory that, since a dividend declared in cash with the privilege of purchasing stock was taxable, a dividend declared and paid in stock was also taxable.

The Supreme Court, however, did not accept this reasoning of the Massachusetts court, and in reply to that argument said (252 U. S. 217):

We cannot accept this reasoning. Evidently, in order to give a sufficiently broad sweep to the new taxing provision, it was deemed necessary to take the symbol for the substance, accumulation for distribution, capital accretion for its opposite; while a case where money is paid into the hand of the stockholder with an option to buy new shares with it, followed by acceptance of the option, was regarded as identical in substance with a case where the stockholder receives no money and has no option. The Massachusetts court was not under an obligation, like the one which binds us, of applying a constitutional amendment in the light of other constitutional provisions that stand in the way of extending it by construction.

In this connection Mr. Justice Brandéis, in his dissenting opinion, used the following language (252 U. S. 225):

It is conceded that if the stock dividend paid to Mrs. Macomber had been made by the more complicated method pursued by the Standard Oil Company of Kentucky, that is, issuing rights to take new stock pro rata and paying to each stockholder simultaneously a dividend in cash sufficient in amount to enable him to pay for this pro rata of new stock to be purchased- — the dividends so paid to him would have been taxable as income whether he retained the cash or whether he returned it to the corporation in payment for his pro rata of new stock.

The Supreme Court did not consider that the receipt of cash by a stockholder and the purchase of stock with that cash was the equivalent in substance to the receipt of dividends in stock directly. The reasoning of the Massachusetts court to this effect was expressly rejected.

The Supreme Court further said (252 U. S. 211):

We are considering the taxability of bona fide stock dividends only.

The court further said, in answering the argument of the Government that stock dividends were taxable (252 U. S. 213):

It [the Government] contends that the tax may be laid when earnings “ are received by the stockholder,” whereas he has received none; that the profits are “ distributed by means of a stock dividend,” although a stock dividend distributes no profits; * * * that the “ profits are segregated from his former capital, and he has a separate certificate representing his invested profits or gains,” whereas there has been no segregation of profits, nor has he any separate certificate representing a personal gain, since the certificates, new and old, are alike in what they represent — a capital interest in the entire concerns of the corporation.

In this case, however, there was a segregation of the profits of the corporation. The corporation issued its check to the stockholders for their proportionate share of the corporate earnings. Each stockholder endorsed the check and turned it back to an officer of the corporation who deposited to the stockholder’s credit, whereupon the checks given by the stockholders for stock were presented and paid. The fact that the stockholders, in accordance with an agreement entered into among themselves, purchased stock from the corporation with a portion of the money received, is to our mind not controlling. It does not mean that the stockholder did not receive from the corporation his proportionate part of the earnings. His proportionate part of the profits of the corporation became separated from the corporate funds and in every substantial sense of the word was income derived and separated from capital. What a stockholder does with his part of the earnings of the corporation when those earnings have become separated from corporate funds and become the property of the stockholder, seems to us to be not material in the consideration of the case.

In the Appeal of Edward Langenbach, 2 B. T. A. 777, the Board used the following language:

In United States v. Phellis, 257 U. S. 156 and Rockefeller v. United States, 257 U. S. 176, the court considered situations where the stockholders received, not cash, hut stock in a new corporation holding some of the same assets which the old stock had theretofore represented; and the stockholder was held taxable upon the value of the stock thus received as a dividend, notwithstanding that the new stock was part of a reorganization. In those cases the stockholders urged that they were merely receiving new symbols of ownership of the same interest tlicir right in which had never changed and never come to realization; but this the court declined to adopt. Here the corporation declared and the stockholder received a cash dividend, which, were it not for his voluntary contract, he had under his complete dominion. At the moment of its receipt he realized income, and what he did with it thereafter, irrespective of how soon, can not change its character at that time.

In this case the petitioner actually received the check of the corporation representing his distributive share of the profits which the corporation had accumulated and he bought stock in the corporation with the funds received. It seems to us that such a situation involves the principle and the reasoning upon which the Massachusetts court, in the case of Tax Commissioner v. Putnam, supra, held that a stock dividend was taxable, which reasoning and analogy the United States Supreme Court expressly rejected in the case of Eisner v. Macomber, supra.

It seems to us that there is a material difference between a transaction whereby a corporation actually distributes its profits in the way of a dividend to its stockholders and then receives back a portion thereof as a subscription price for stock, and a transaction where a corporation does not in fact segregate and distribute any of its profits but merely distributes a symbol representing the proportionate ownership in all profits of the corporation.

In the Appeal of Eugene E. Paul, 2 B. T. A. 150, the Board used the following language:

Upon tbe declaration of a dividend the right of the stockholders becomes fixed and the dividend becomes segregated from the stock and exists independently o£ it; the acquisition of new stock of the corporation with the dividend checks constitutes a purchase of the stock and the dividend was consequently realized as income at the time the checks were received.

It was urged by the petitioner that he and all the other stockholders had an oral agreement to the effect that they would take the dividend in cash but would apply it on the purchase of new stock. It does not appear, however, that this was the action of the corporation or that any such agreement was entered into by the corporation. Without such an agreement on the part of the corporation itself, the stockholders were not legally bound to subscribe for the new stock, nor were they under any legal duty to apply the checks in payment for new stock. The agreement among the stockholders can not alter the action of the corporation in declaring a cash dividend. Agreements made by stockholders as such are not to be treated as the contract of the corporation unless the corporation formally ratifies or adopts them. De La Vergne Co. v. German Savings Institution, 175 U. S. 40; Moore & Handley Hardware Co. v. Towers Hardware Co., 87 Ala. 206; 6 So. 41.

By the overwhelming weight of authority, when the power to do particular acts or general authority to manage the affairs of the corporation is vested in the directors or trustees, it is vested in them not as individuals, but as a board, and as a general rule they can act so as to bind the corporation, assuming that there is no ratification or estoppel, only when they act as a board and at a legal meeting. Kansas City Hay-Press Co. v. Devol, 72 Fed. 717; Ames v. Goldfield Merger Mines Co., 227 Fed. 292.

The members of the governing body of a corporation are agents of the corporation only as a board and not individually. Hence it follows that they have no authority to act save when assembled at a board meeting. The separate action individually of the persons composing such governing body is not the action of the constituted body of men clothed with corporate power. Commercial Brewing Co. v. McCormick, 225 Mass. 504; 114 17. E. 812; Citizens' Securities Co. v. Hammel, 14 Cal. App. 564; 112 Pac. 731.

In this case, even if it be conceded that the individual members of the board of directors could have legally bound the corporation, it is not alleged by any witness that the agreement referred to was other than an agreement between the stockholders, those who were to receive the dividends, and it related to what they would do with their dividends and not to the manner in which the corporation would distribute the dividends. There is no evidence that the directors as such undertook to act for the corporation. The resolution declaring the dividend did not recognize any such agreement as having been made. It is true that the corporation may have acted and very likely did act upon the assumption that the stockholders, in accordance with the agreement among themselves, would purchase stock with their dividends, but this is not sufficient to change what was declared by the corporation to be a cash dividend to a stock dividend. The stockholders were not legally bound to take stock.

We are not unmindful of the line of decisions holding that corporations are liable on contracts made by certain directors or stockholders not based on formal action of the board of directors, but an analysis of the leading decisions to that effect indicates that they were based on estoppel on the part of the corporation on account of the fact that it had received benefits under the contracts, because of implied authority of such individuals, because the corporation ratified the action, or for other reasons which do not exist in this case.

It is also a general rule of law that a corporation is a distinct legal entity separate and apart from the individual stockholders who compose it and is not affected by any personal rights, obligations or transactions of the stockholders. McCaskill Co. v. United States, 216 U. S. 504; Eisner v. Macomber, supra.

When the dividend was declared by the corporation the surjdus out of which it was declared became segregated from its other assets and the corporation became the debtor of the stockholder and the stockholder became the creditor of the corporation. United States v. Guinzburg, 278 Fed. 363; Staats v. Biograph Co., 236 Fed. 454; Plant v. Walsh, 280 Fed. 722.

The corporation as a debtor then held the dividends for the stockholder, and he or his representatives could maintain an action for the recovery thereof. Wheeler v. Northwestern Sleigh Co., 39 Fed. 347; Hooper v. Sage, 112 N. Y. 530; 20 N. E. 350; Bright v. Lord, 51 Ind. 272; 19 Am. Rep. 732.

The dividend which was declared in this case, according to the resolution by which it was declared, was a cash dividend. The fact that the recipients of that dividend agreed to apply it to the purchase of stock is not sufficient to change the nature of the transaction. It is not material what the recipients of the dividend agreed to do with it when it was received. A violation of the agreement of the stockholders to purchase stock with that dividend would not have given the corporation a right to sue for the application of that money to the purchase of stock.

In the case of Hyde v. Holmes, 198 Mass. 287; 84 N E. 318, the dividends were paid in cash with an option given to use same in the purchase of stock, and the stock was increased on the same day in the same amount as the cash dividends. It was held to be a cash dividend.

In the case of Cox v. Gaulbert's Trustee, 148 Ky. 407; 147 S. W. 25, the dividends were declared payable in cash. An increase was authorized in the capital stock equal in amount to the dividend. Though called a cash dividend, it was intended and understood to be paid in new stock. It was held to be in effect a cash dividend.

In the case of Ballantine v. Young, 79 N. J. Eq. 70; 81 Atl. 119, the case was stated by the court as follows:

On April 28, 1909, the surplus [of the Central Trust Company] had increased to $15,579,696.65. In June, 1909, its capital stock, by appropriate action on the part of the directors and stockholders, was increased to $3,000,000. The stockholders were given the right to subscribe at par for the new issue of $2,000,000; that is, each stockholder might subscribe for two new shares for every old one he held. * * *
The first question is, Who is entitled to the dividend of the Central Trust Company issued under the circumstances above described, the life tenants or the remaindermen?

The court said (81 Atl. 120);

It seems to me plain that the dividend is a cash dividend, and not a so-called stock dividend. There is nothing, either in the substance or form of the transaction, that indicates that it was other than what it purports to be. Gray v. Hemenway, 206 Mass. 126, 92 N. E. 31, 138 Am. St. Hep. 377. It is true that the company at the time it declared the dividend gave an option to subscribe to the new stock, and that its officers anticipated that the new stock would be paid for with the cash dividend; but it did not attempt to compel the subscription. The stockholder could do as he pleased. * * * and (3) it was evidently made for the special-purpose of enabling the stockholders to avail themselves of the new subscription.

In the case of Davis v. Jackson, 152 Mass. 58; 25 N. E. 21, the facts were as follows:

On April 26, 1889, at a stockholders’ meeting, it was voted that the capital stock be increased by 1000 shares, of $100 each, and that the stockholders be entitled to subscribe in proportion to the number of their shares, if they paid within 30 days. This vote allowed the stockholders to take one new share for every four held by them. At a meeting of the directors, held on the same day, at the close of the stockholders’ meeting, an extra dividend of $25 a share was declared. This dividend was exactly sufficient to enable the stockholders to pay for their new stock if they were so minded. But they were not bound to take the stock; and if they preferred to keep the money, and to sell their rights to subscribe for stock, they could do so, as some of them did in fact. * * * The earnings of the company were sufficient to pay the dividend, but if they were used to pay the dividend then it was necessary to raise about an equal amount to pay for additions which had been made to the capital, and which had increased its value at least 25 per cent, above the par value of the old stock. The directors would testify, if material, that they discussed the question of a stock dividend, and understood that it was not permitted by law, and declared the extra dividend as a substitute.
The argument for the remainderman is that the transactions of the company, viewed as a whole, are in substance a stock dividend. It is tacitly assumed that the company had appropriated its earnings to the improvements which the stock represented before the dividend was declared, and then the conclusion is drawn that the dividend represented those improvements. But, in the opinion of a majority of the court, it is evident that, if we look at either extreme of the facts, the life-tenants ought to prevail. The dividend was declared as a cash dividend, and it represented what, originally at least, were earnings of the company.

In the case of Newport Trust Co. v. VanRensselaer, 32 R. I. 231; 78 Atl. 1009, it was held, following the decision in the case of Davis v. Jackson, supra:

The earnings of the corporation were sufficient to pay the dividends; hut, if used for that purpose, it would be necessary to raise money to pay for additions which had been made to the capital. Held, that the transaction was a cash dividend, and passed to the life tenant as income. Said the court: “ The argument for the remainderman is that the transactions of the company, viewed as a whole, are in substance a stock dividend. It is tacitly assumed that the .company had appropriated its earnings to the improvements which the stock represented before the dividend was declared, and then the conclusion is drawn that the dividend represented these improvements. But in the opinion of a majority of the court it is evident that, if we look at either extreme of the facts, the life tenants ought to prevail. The dividend was declared as a cash dividend, and it represented what originally at least were earnings of the company. * * * If the plaintiff trustees had seen fit to keep the money and to sell their rights, they could have done so, and neither the corporation, nor the cestui que trust could have complained. Of course, the trustee could not affect the respective rights of the defendants by their determination. If they had kept the dividend, it would have been a bold claim on the part of the remaindermen that it was theirs because the corporation was in debt for additions to capital. * * * A dividend of cash representing profits is none the less to be taken as income, because the stockholder is at liberty to invest it at par in stock which is worth more than par, if he is also at liberty to sell the right to subscribe for the stock.” See, also, Thompson on Corporations, §2208; Minot v. Paine, 99 Mass. 101, 96 Am. Dec. 705; Adams v. Adams, 139 Mass. 452, 1 N. E. 746.

When the dividend in this case was declared it took the form of a cash dividend. The resolution made no reference to anything else. The resolution represented the action of the corporation and there was no evidence that it did not correctly reflect the corporate action. If we concede that the corporation had knowledge of the agreement among its stockholders and relied upon that agreement in declaring the cash dividend, it does not alter the situation. If the stockholders had not desired to take stock, the corporation could not have relied on the agreement to compel them to do so. It seems to us that under the facts the stockholders had an option to take and retain the cash or to purchase stock with it.

In our opinion, the facts in the case of United States v. Mellon, 281 Fed. 645, and United States v. Davison, 1 Fed. (2d) 465, are distinguishable from the facts in this case, and hence the decisions of the courts in those cases are not determinative of the issue here. Based on the facts in the instant proceeding, we are of opinion that the dividend in question was a cash dividend.

Judgment will be entered for the Commissioner.

Phillips,

dissenting: On December 1, 1917, resolutions were duly adopted by the directors and by the stockholders of the Merchants Bakery, Inc., increasing the capital stock from $65,000 to $100,000, the additional stock to be offered to stockholders at par. Subsequently the stockholders, who were also the directors, agreed that they would subscribe for all of such stock, payment to be made from a dividend to be declared by the corporation. On December 24, 1917, the directors declared a dividend of $60 per share, a total of $39,000.* At the same meeting at which the dividend was declared the stockholders delivered to the treasurer of the company their checks aggregating $35,000. Hone of the stockholders had funds on deposit sufficent to pay such checks, and it was agreed that they should be deposited for collection at the same time the corporation deposited the dividend checks. On January 2, 1918, the treasurer of the company deposited the dividend checks to the credit of the stockholders. These checks totaled $39,000. At that time the company had only $10,600 cash on hand or on deposit, but at the same time the treasurer deposited to the credit of the company the checks of the stockholders for $35,000, the checks serving to offset each other, except as to $4,000 admittedly paid as a dividend.

In my opinion this appeal falls squarely within the decision of the Circuit Court of Appeals in United States v. Mellon, 281 Fed. 645; 2 Am. Fed. Tax Rep. 1726, and the decision of this Board in Appeal of Theresa Zellerbach, 2 B. T. A. 1076. While in form a cash dividend, it is apparent that the company was in no position to pay sucli a dividend, and that the stockholders did not at any time expect to receive any cash dividend, other than $4,000. Except as to such $4,000, there was never any distribution of the corporation’s assets among its stockholders, and at the close of the transaction the stockholders had nothing more than at the beginning.

It is said that the stockholders had the right to take cash and either retain it or use it to purchase stock. If this is so, there can be no doubt the dividend was taxable, but this is not my understanding of the situation. Before any dividend was declared all of the stockholders had agreed that stock and not cash was to be taken. These stockholders were also the directors. Furthermore, at the same meeting of the directors at which the dividend was declared, checks were delivered to the treasurer for the stock and he was authorized to deposit the dividend checks in such manner that the stockholders’ checks would be paid from the dividend checks. To say that in such circumstances the stockholders had the right to receive their dividends in cash, or that the agreement was not binding because it was not made with the corporation, would seem to be to mistake the facts. The agreement was not only recognized at the directors’ meeting at which the dividend was declared, but was carried out at that same meeting by the delivery of checks to the treasurer, such checks to be collected from the dividend checks. All of the parties recognized the existence of such an agreement and acted upon it, and it is not within the authority of the taxing power, a third party, to disregard an agreement which the parties have so recognized.

It is unnecessary to determine whether a corporation is bound by an agreement made by all of its stockholders who are also all of its directors. Nor need we determine whether the corporation could ratify and enforce a contract made between others for its benefit. In the instant appeal the declaration of the dividend and the subscription for the stock were all part of the same transaction to which both the corporation and the stockholders were parties.

While the transaction took the form of the declaration of a dividend and an exchange of checks, there never was any right upon the part of this taxpayer at any time to receive such dividends in cash, and no tax liability accrued. Eisner v. Macomber, 252 U. S. 189. For the reasons stated I can not agree with the result which has been reached.

Smith concurs.


text:
    Appeal of Stuart W. Webb.
    Docket No. 5591.
    Decided October 30, 1926.
    1. The taxpayer’s distributive share of the income of a partnership of which he was a member, from April 1, 1919, to December 81, 1919, determined.
    2. Under the Revenue Act of 1918, the basis, in this ease the cost, for determining the gain derived or loss sustained upon the sale in 1919 of certain shares of stock, should not be reduced by the amount of a tax-free distribution made in March, 1917. Appeal of Oarolme S. McLean, 4 B. T. A. 487.
    3. The taxpayer kept his books and rendered his returns on a cash receipts and disbursements basis, but now claims that his income for the taxable year 1919 should be computed upon the accrual basis, for the reason that the Massachusetts income tax levied upon the income for the year 1919 accrued on December 31 of that year and constituted a proper deduction from gross income for the purpose of Federal tax upon the accrual basis, and that a computation of his income upon the cash receipts and disbursements basis did not clearly reflect his income. Held, that the Massachusetts income tax did not accrue within the year in which the income upon which it was levied was earned, and it can not be said that the method of accounting employed by the taxpayer in keeping his books did not clearly reflect income.

      James W. Mudge, Esq., for the petitioner.

      M. N. Fisher, Esq., for the Commissioner.

      This appeal is from the determination of a deficiency of $34,012.69 for the calendar year 1919. It is claimed that (1) the taxpayer’s distributive share of the profits of the partnership of Bond & Goodwin from April 1,1919, to December 31,1919, was $27,036.27, instead of $60,121.33, as determined by the Commissioner; (2) in determining the profit from the sale in 1919 of certain shares of stock, the Commissioner erred in reducing the cost of said stock by the amount of the dividend paid in March, 1917, out of earnings accumulated prior to March 1, 1913; (3) a computation of the tax for 1919 upon the cash receipts and disbursements basis did not clearly reflect income, for the reason that taxpayer was not thereby permitted to take a deduction from gross income in the amount of the Massachusetts income tax levied in 1920 upon the income for 1919.
    FINDINGS OP PACT.
    The taxpayer is a resident of Boston, Mass.
    During the period from April 1 to December 31, 1919, he was a member of the firm of Bond & Goodwin, a partnership, engaged in the sale of securities. His share of the profits of the partnership during the period from April 1, 1919, to December 31, 1919, was 15 per cent of the amount by which the sale price of securities exceeded the book value thereof on April 1, 1919. The Commissioner determined that the taxpayer’s distributive share from this partnership for 1919 was $60,121.33. His distributive share of the partnership profits for the period April 1 to December 31,1919, was $27,036.27.
    In March, 1917, the taxpayer purchased 68-6/13 shares of the stock of the Clinton Wire Cloth Co., a Massachusetts corporation, at $554.50 a share, said shares having a par value of $100 each. These shares were purchased through Estabrook & Company, acting as agents for the taxpayer and others, the date of purchase and the entire number of shares purchased for all of the interested individuals being as follows: March 2, 1917, 3,961 shares; March 9, 1917, 33 shares.
    At a meeting of the directors of the Clinton Wire Cloth Co. held March 10, 1917, a cash dividend of $392 a share was declared from the surplus of the corporation accumulated prior to March 1, 1913, payable to stockholders of record at the close of business on that date. This dividend was paid on March 12, 1917, and was received by Estabrook & Company, acting as agents for the taxpayer and other individuals for whom Estabrook & Company had purchased the stock, and was applied as part payment on the purchase price of such stock.
    At a meeting of the directors of the Clinton Wire Cloth Co. held March 14, 1917, a stock dividend of 150 per cent was declared against a transfer from surplus to the capital account of $600,000, the taxpayer’s holdings of stock being thereby increased to 171-2/13, having a cost per share based upon the $554.50 a share cost of the 68-6/13 shares originally purchased, of $221.80. During the year 1919 he sold the aforementioned 171-2/13 shares at $148 a share.
    The cash dividend of $392 a share declared on March 10, 1917, was paid from the surplus of the corporation accumulated prior to March 1, 1913, and not from paid-in capital. It was not the proceeds of the sale by the corporation of any of its plant or operating assets. Ho stock of the corporation was surrendered in connection with or in consideration of the declaration or payment of the dividend. Ho endorsement of full or partial distribution in liquidation was made upon any of the shares of the corporation’s stock in connection with or on consideration of the declaration or payment of the dividend. The corporation continued uninterruptedly in the conduct of the business for which it was organized for several years subsequent to the declaration and payment of the cash dividend.
    In determining the profit or loss upon the sale of the stock in 1919, the Commissioner reduced the cost thereof by the amount of the tax-free distribution in March, 1917, of $392 a share. This computation resulted in a profit of $14,205.77, instead of a loss of $12,631.15 as claimed by the taxpayer.
    The taxpayer kept his books and rendered his returns for 1919 and prior years upon the cash receipts and disbursements basis. During 1919 and for many years prior thereto he was a resident of the Commonwealth of Massachusetts and was subject to the Massachusetts income tax. The Massachusetts income tax was payable in October of each year and was measured by the income received during the preceding year.
    During the years 1917 to 1921, inclusive, the taxpayer’s income was inconstant and was subject to extreme fluctuation. The Massachusetts State income tax paid in the years 1917 to 1921, inclusive, and the tax based upon the income during the same years, referred to below as accrued, was as follows:

    The taxpayer’s net taxable income for the years 1917 to 1921, inclusive, computed on the cash basis, and on the accrual basis, including the accrual of the Massachusetts income tax in the year in which the income was earned, compare as follows:

    The Federal income tax due for the years 1917 to 1921, inclusive, computed upon the income shown in the preceding tabulation on the cash basis and on the accrual basis, compare as follows:

    In the administration of the Massachusetts income tax law, the taxing authorities of the Commonwealth permit the accrual of the tax in the year in which the income on the basis of which the tax is computed accrues, which is the year preceding the year in which the tax is assessed and becomes payable.
   OPINION.

Littleton:

As to the first issue, the parties have stipulated that the taxpayer’s distributive share of the income of the partnership of Bond & Goodwin for the period from April 1 to December 31, 1919, was $33,085.06, less than that determined by the Commissioner. In the computation of the deficiency for the taxable year, the income should therefore be reduced by this amount.

The second issue is governed by the decision of the Board in the Appeal of Caroline S. McLean, 4 B. T. A. 487, decided July 29,1926, in which it was held that the basis — in that appeal the March 1, 1913, value of shares of stock — should not be reduced by the amount of a tax-free distribution made thereon in 1917, in determining the gain derived from the sale of the stock in 1919.

General Acts of the Commonwealth of Massachusetts, 1916, chapter 269, imposing a tax upon income received from certain forms of intangible property, provides in section 1 as follows:

There shall be levied in the year nineteen hundred and seventeen, and in each year thereafter, a tax upon incomes as hereinafter set forth.

Section 2 provides:

Income of the following classes received by any inhabitant of this commonwealth during the calendar year prior to the assessment of the tax shall be taxed at the rate of * * *.

See also section 5, containing the same language relating to the tax upon annuities, professions, employments, trade or business.

Section 1 provides:

Persons who customarily estimate their income and expenditure on a basis other than that of actual cash receipts and disbursements may, with the approval of the tax commissioner, compute upon a similar basis their income taxable under this act. * * *

Section 8 relating to estates of deceased persons provides in part as follows:

The income received by persons since deceased shall be taxed to their estates. The income received by estates of deceased persons who last dwelt in this commonwealth shall be subject to the taxes assessed by this act, to the extent that the persons to whom such income is payable or for whose benefit it is accumulated are inhabitants of this commonwealth, which shall be assessed to the executor or administrator, and before the appointment of an executor or an administrator such taxes shall be assessed in general terms to the estate of the deceased, and the executor or administrator subsequently appointed shall be liable for the tax so assessed as though assessed to him. * * *

Section 12 provides “ Every individual inhabitant of the commonwealth, including every partnership, association or trust, whose annual income from all sources exceeds two thousand dollars shall annually make a return of his entire income * * with certain exceptions not material here. This section further provides as follows:

The return shall he made on or before the first day of March in each year, and shall relate to the income received during the calendar year ending on the preceding thirty-first day of December.
The return required by this section shall be filed by every person who is at any time between the first day of January and the thirtieth day of June in any year an inhabitant of the commonwealth, if such person has in the preceding year received income taxable hereunder: * * * Every person who is an inhabitant of the commonwealth at any time between the first day of January and the thirtieth day of June, both inclusive, in any year, shall be subject to the taxes imposed by this act.

Under tbe foregoing provisions of the statute, an individual taxpayer is not liable for the tax until he has been an inhabitant of the Commonwealth during some portion of the first six months of the year following the year in which the income was earned. This condition must occur before any liability for the tax comes into existence. At the close of December 31 in any year, there is no liability for the tax. In the opinion of the Board, the Massachusetts income tax is a tax for the year in which it is assessed and becomes payable, in this case for the year 1920, and is measured by the income for the preceding calendar year.

The statute of the Commonwealth of Massachusetts levying the tax upon persons who are inhabitants of the Commonwealth in the year succeeding that in which the income was received appears conclusive on this point.

It is unnecessary, in view of our conclusion as to the accrual of the tax, to discuss the question of whether the method of accounting employed by the taxpayer correctly reflected his income, since the Massachusetts tax was the only item upon which the taxpayer relied in support of his claim that his income for 1919 should be computed upon the accrual basis.

Judgment will he entered on 15 days' notice, wider Bule 50.


text:
    Appeals of Toxaway Tanning Co.
    Docket Nos. 5084, 5694.
    Decided November 9, 1926.
    1. Petitioner was engaged in tbe business of tanning bides and producing finished leather. A number of years prior to the taxable years it constructed 322 tanning vats which, when completed, had a useful life of 60 years. Seld, that the cost of constructing and tanning the vats was a capital expenditure and that such cost, less depreciation at 2 per cent per annum, should be included in invested capital for the taxable years.
    2. The evidence submitted does not warrant the conclusion that petitioner is entitled to include in invested capital for the years 1911 and 1918 any amount with respect to the cost of tanning liquor in its vats at the beginning of these years.
    3. Loss from fire determined.

      Charles D. Hamel, Esq., Albert L. Hopkins, Esq., L. Dana Latham, Esq., and B. 8. Womhle, Esq., for the petitioner.

      John D. Foley, Esq., for the Commissioner.
    These appeals involve deficiencies in income and profits taxes for 1917 and 1918 in the amounts of $21,029.93 and $81,334.62, respectively, arising from the Commissioner’s reduction of officers’ salaries voted and accrued for 1917, the failure of the Commissioner to restore and include in petitioner’s invested capital for 1917 and 1918 the cost, less' depreciation, of tanning 322 tanning vats constructed during the period from 1904 through 1914, the failure to include in invested capital for 1917 and 1918 the cost of tanning liquor in vats on December 31, 1917, and December 31, 1918, and the failure to allow the full amount of a loss from destruction and damage by fire in 1918 to certain of its capital assets.

      FINDINGS OF FACT.
    The petitioner, a Forth Carolina corporation, was organized in 1902 to engage in the business of tanning hides and selling finished leather. Its principal product was heavy bolting and sole leather. Its tannery was located at Busman. Its selling organization maintains its headquarters in New York City and it has warehouses at New York, Boston and Chicago.
    Prior to 1912, and from that date through 1919, the petitioner’s officers were as follows:
    Morris Dworetzky, president and sales manager.
    Joseph S. Silversteen, vice president and general manager.
    Joseph F. Schain, secretary.
    Morris Osmansky, treasurer.
    Joseph Rosenthal, assistant treasurer and assistant secretary.
    Dworetzky had been in the leather business forty-five years. He had direct charge of all sales and exercised specific supervision over the New York and Boston selling department. He also had charge of the buying of raw hides and visited the tannery several times during each year. Silversteen was a practical tanner of more than thirty years’ experience. He had full charge of the operations of the tannery and superintended the construction of all properties, tanning of the hides, the buying of tanning bark and the employment of labor, tie also made frequent trips to New York in connection with the business. The other officers mentioned above had been with the company for more than fifteen years. They performed all duties incident to their respective offices and devoted their entire time thereto.
    The petitioner voted and paid its officers’ salaries for 1917 in the amount of $88,000, as follows:
    Morris Dworetzky-$24, 000
    Joseph S. Silversteen- 26,000
    Morris Osmansky- 14, 000
    Joseph F. Schain_ 12, 000
    Joseph Rosenthal_ 12, 000
    88, 000
    The officers’ salaries paid for the years 1914 to 1917, inclusive, were as follows:
    1914-$110, 000
    1915- 120,000
    1916_ 128, 000
    1917- 88,000

      The earnings before payment of salaries for the years above stated were as follows:
    1914-$158,416.41
    1915-'_ 209, 527. 95
    1916 - 284,720.70
    1917- 153, 794. 68
    During the year 1917 the petitioner paid a cash dividend of 40 per cent. Its sales during that year were in excess of $1,000,000. In addition it tanned hides and sold them for Swift & Co., on commission, in an amount in excess of $790,000. During the year 1917 it added to its surplus, after payment of officers’ salaries and all other charges, $192,615.43. Its average interest-bearing indebtedness for 1917 was $407,000.
    It had been the custom of the petitioner, from the time it was organized to and including 1917, to determine its officers’ salariés for each year during the summer thereof. During July or August of each year, after the taking of the semi-annual inventory, the directors of the corporation met in New York and voted the officers their salaries for that year, but the resolutions fixing such salaries were not formally entered of record until the annual meeting of the stockholders and directors in February of the succeeding year. The amounts of salaries fixed in July or August were always entered on the books prior to the close of the books for that year, and the books were always closed prior to the annual directors’ meeting at which the resolutions relating to salaries voted during the preceding summer were formally entered of record.
    For 1918 and subsequent years, salaries voted for each year and the formal resolutions relating thereto were entered of record during the year. The change at that time was due to advice that income-tax procedure required formal record of the directors’ action during the year of its occurrence.
    Salaries voted for each year were customarily paid during the following year. This practice had its origin during the early years of the petitioner’s existence and was based upon a desire to retain the funds for corporate use as long as possible. Salaries in the amount of $128,000, voted for 1916 in July of that year and recorded on the minute book at the annual directors’ meeting February 6, 1917, were paid during the calendar year 1917. Salaries for 1917 in the amount of $88,000, voted in July, 1917, and formally recorded in the minute book at the annual directors’ meeting February 7,1918, were paid during 1918. The Commissioner allowed a deduction for officers’ salaries for 1917 of only $12,000.
    During the years 1917,1918, and 1919, the .petitioner had in operation 322 tanning vats. In the tanning process the raw hides were placed in those vats and covered with a tanning liquor. In the construction of each vat an excavation of the proper size is first made in the ground, a box of brick-concrete walls is then constructed in the excavation and lined with pine timbers. The completed vat was 8 feet by 9 feet and 6 feet in depth. When the vat was completed the cracks were caulked with a Navy spun oakum.
    Before the vat was ready for use it was necessary to tan the wooden lining in order to prevent it from withdrawing from the hides in process of tanning the liquor intended to tan the hides. The tanning of a Amt preparatory to its use in the business was a standard process. Each vat was first filled with a tanning liquor of 30 degrees strength, prepared in a manner similar to the preparation of the liquor used for tanning the hides. In the course of a few days, one-fifth of the liquor with which the vat was filled was absorbed by the dry wooden lining. The vat was then refilled with liquor and so maintained for a period of from thirty to forty days until the wooden lining was completely saturated or tanned. The important element in this tanning liquor was the tannin. In the process an amount of liquor of 30 degrees strength, equivalent to 1 ⅛ times the cubic contents of each vat, was used. Fifty per cent of the tannin in this 30 degrees solution was actually absorbed in the tanning process. Before the remaining liquor could be used for other purposes it had to be filtered and purified. In the process of purification one-half of the remaining liquor was lost. When the tanning process was completed the liquor was withdrawn, the vat thoroughly scraped and the cracks re-caulked. The vat was then ready for use for the tanning of hides.
    The 322 vats in use during 1917, 1918, and 1919, were constructed as follows:
    Vear. Number of vats.
    1904_ 72
    1907_106
    1912_120
    1914_ 24
    Total_ 322
    The cost of constructing these vats was charged to expense in the year of construction. The vat, when tanned as above described, has a useful life of at least 50 years.
    The actual cost of tanning each vat can not be shown from the petitioner’s books, due to the fact that the cost was merged with other expense items, but the amount of tannin used for tanning each vat, the market price per pound of such tannin at the dates of construction, and the labor required is readily determinable and was established by evidence. Eqch vat, being of standard size, had a cubic content of 432 cubic feet. Each cubic foot of this liquor weighed 64½ pounds, or a total for each vat of 27,792 pounds of tanning liquor. In the process of tanning each vat, one-fifth of the volume of the liquor was absorbed and the vat was re-filled, making a total of 33,350 pounds of tanning liquor used. Each pound of this tanning liquor contained 4½ per cent of tannin. The 33,350 pounds of liquor contained 1,500% pounds of tannin. Of this amount one-half was actually absorbed by the wooden lining. One-half of the balance was lost in the necessary process of purification. Each vat, therefore, required and used 1,125 pounds of tannin in the tanning process. The only item that varied was the cost per pound of the tannin and the labor. The total cost of tanning the 322 vats was $33,885.78. This cost included only items entering into the cost of actually tanning the vats, and was as follows:
    1904.
    72 vats, 1,125 lbs. of tannin to the vat at 6 cents per lb-$4, 860. 00
    Labor, re-eaulking and cleansing at $5.75 per vat- 414.00
    Total_ 5,274. 00
    1907.
    106 vats, 1,125 lbs. of tannin to each vat at 8½ cents per lb- 9, 375.00
    Labor, re-caulking and cleansing each vat at $8.13 per vat_ 961. 78
    Total_ 10,236.78
    1912.
    120 vats, 1,125 lbs. of tannin per vat at 10 cents per lb_ 13, 500.00
    Labor, re-caulking and cleaning each vat at $10.60 per vat_ 1, 207. 20
    Total_ 14, 707.20
    1914.
    24 vats, 1,125 lbs. of tannin per vat at 12½ cents per lb_ 3, 375. 00
    Labor, re-caulking and cleaning each vat at $12.20 per vat_ 292. 80
    Total_ 3, 667.80
    Before the raw hides could be placed in the vats for tanning, each vat had to be filled with liquor to a depth of 4½ feet. The strength of the liquor in the different vats varied according to the stage of the tanning process. In the process a certain amount of the tannin in the liquors was absorbed by the hides. It was necessary to replace the tannin absorbed so that the liquors were constantly maintained at their original strength. From the date of organization through the taxable years the petitioner charged to expense the cost not only of the original liquors with which the vats were filled but the cost of the additions necessary to maintain the liquors at their original strength.

      The liquors in the 322 vats during 1917, 1918, and 1919 varied from 30 to 73 degrees, depending upon the particular stage of the tanning process. The average strength of the tanning liquors in all the vats was 46 degrees. Each vat contained 324 cubic feet of liquor. The weight of this liquor in each vat at 46 degrees was 22,168 pounds, and each vat contained 1,551.76 pounds of tannin. The cost of the liquors in the vats on December 31, 1916, was 13 cents per pound of tannin, or a total cost of $64,956.67. The cost of the liquors in the vats on December 31, 1917, was 13½ cents per pound of tannin, making the total cost $67,456.
    The plant was practically destroyed by fire on October 11, 1918. The tanning liquors in all of the vats were completely destroyed. The cost thereof on October 11, 1918, at 14½ cents a pound, was $72,451. The petitioner received $19,706.54 in settlement from the insurance company for the tanning liquors destroyed. This entire amount was received in 1918 and was included in taxable income for that year.
    A pump and ringer purchased during the year 1917, at a cost of $1,056.25, was destroyed by fire. The cost of this item was charged by the petitioner to expense. The Commissioner disallowed this deduction in 1917 and restored the cost to capital account. The amount received from the insurance company in 1918 on account of the destruction of this machinery was included by the petitioner in its income for that year. The useful life of the pump and ringer was 15 years.
    On the date of the fire the petitioner had in its vats in process of tanning in excess of 36,000 hides, which had cost $641,565.77. This amount did not include any part of the tanning, manufacturing or selling costs. These hides were in various stages of tanning at the date of the fire. They were of a heavy grade, of high quality, and were intended when tanned for use for soles and belting. Such leather must have great tensile strength and must not be off color. The fire heated the hides and the tanning liquors in which they were submerged to a high temperature. The heat destroyed the gelatine which forms the core of each hide, with the result that the tanning liquor could not penetrate the hide and transfer it into finished leather. Particles of iron, a great amount of nails, and other foreign substances fell into the liquors during the fire and turned them black and the hides off color. Some of the hides were more seriously damaged than others, owing to the stage of process in tanning.
    The petitioner was engaged at the time of the fire in the production of material contributing to the prosecution of the war. Quantity production was essential. It estimated the damage to its hides in process, in its claim to the insurance company, to be $300,000. It was impossible to determine at the time of the fire the exact amount of the damage to the hides in process. The actual damage could only be determind after the tanning process had been completed and the hides disposed of or offered for sale. The petitioner did not carry insurance to the full value of the assets destroyed, and because of its failure to do so received but 58 cents on the dollar of damage determined by the insurance company to have been sustained. ' The insurance company determined the petitioner’s damage to its hides in process to be $140,505.09. The petitioner received from the insurance company for damage to hides in process $84,185.23. The settlement was not satisfactory to the petitioner and was accepted only because of the pressing necessity of resuming its war production. The entire amount of this insurance was received during the year 1918 and was included in taxable income for that year.
    The petitioner’s closing inventory, December 31, 1918, for hides in process was reduced by the amount of $140,505.09, leaving a balance for the cost of raw hides in process of $501,151.68. The Commissioner allowed the petitioner a loss from damage to the hides in process occasioned by the fire of only $140,505.09.
    Immediately after its settlement with the insurance company, the petitioner proceeded to rebuild its plant and complete the tanning of the hides in process. It was necessary to do this, as otherwise the hides would have been unusable and the loss total.
    The damaged hides when tanned were sold during 1919 and years following. It was then that the extent of the damage was realized. The hides were off color, brittle, pocketed, and without their usual tensile strength. A portion was sold as low as 15 cents a pound at the time when undamaged hides were selling for as much as 75 cents a pound. The petitioner received for the damaged hides $560,874.07. Eliminating manufacturing cost, which was $212,-650.11, the petitioner received from the raw hides $348,223.96. The cost of the raw hides in process at the date of the fire was $641,-565.77. Deducting $348,223.96, the amount received for the hides, from the cost, the damage to hides in process from the fire would be $293,341.81. Of this loss, the Commissioner allowed $140,505.09. The petitioner is entitled to an additional deduction from income for 1918 for this loss of $152,836.72. The insurance of $84,185.23 need not be considered in determining this loss, since the entire amount thereof was included by the petitioner in its income for 1918.
   OPINION.

Littleton:

These appeals were consolidated for hearing and decision. The Commissioner in his answer objected to the jurisdiction of the Board with regard to the year 1917. On a statement of the facts involved the Commissioner’s objection to the Board’s jurisdiction was overruled by the division hearing this case. That ruling is approved. The Commissioner’s answer also set up a counter-claim for the year 1918, but such counter-claim was abandoned and no proof in support thereof was introduced.

The issues involved are as follows:

1. The disallowance for 1917 of all but $12,000 of $88,000 claimed for officers’ salaries.

2. The failure to restore to and include in the invested capital for 1917 and 1918 the cost, less depreciation, of tanning 322 vats constructed in 1904, 1907, 1912, and 1914.

3. Failure to include in invested capital for the years 1917 and 1918 the cost on December 31, 1916, and December 31, 1917, respectively, of tanning liquors in vats on those dates.

4. Failure to allow the full amount of loss from the destruction and damage by fire in 1918 to certain capital assets.

5. The reduction of invested capital for 1917, 1918, and 1919, by the amount of prior years’ income and profits taxes.

The first question is whether the petitioner is entitled to a deduction for 1917 for the full amount of the $88,000 officers’ salaries voted and accrued during 1917 for that year. The record discloses that it had been the consistent policy of the directors for many years prior to 1917 to agree upon the officers’ salaries for each year at a meeting held in ÍTew York during the summer of that year. At that meeting, which occurred immediately subsequent to the semiannual inventory, after the profits for the first six months’ operations had been determined, all of the officers and directors were present. Officers’ salaries in the amount of $128,000 for 1916 were agreed upon in the summer of 1916. The same was true for prior years. The salaries voted during the summer of 1917 for that year were entered on the books of the company and credited to the officers’ accounts before the close of that calendar year. This was also in accordance with the regular custom of the corporation. These salaries were corporate liabilities in 1917. Four of the five directors testified as to the action taken in regard to the salaries and the amounts agreed upon, and the record discloses that the salaries accrued for 1917 were decided upon and voted in July, 1917, although no minutes were made showing such action and no entries made on the books until the close of the year.

The question was raised as to whether the salaries of the officers for the year 1917 were reasonable. We believe from all of the evidence that this objection is not well taken. The sales for 1917 exceeded $1,000,000. In addition the petitioner tanned and sold raw hides on commission for Swift & Co. in an amount aggregating in excess of $790,000. During the same year it added to its surplus, after payment of officers’ salaries and other charges, $192,615.43, and paid its stockholders a cash dividend of 40 per cent. Each of the officers was actively engaged in the administration of the company’s affairs during 1917 and from its organization in 1902. In our opinion the salaries for 1917 were reasonable and should be allowed. The Parisian, 2 B. T. A. 415.

The next question is whether invested capital for 1917 and 1918 should be increased by the cost, less depreciation, of tanning its 322 tanning vats. The tanning of the wooden lining of each of the vats was as essential as the lining itself. Hides could not be tanned until the lining itself had first been tanned. When the lining was once saturated with tannin the vat was ready for use and there was nothing further to be done. The lining had a useful life equal to that of the vat. Each vat when tanned had a useful life of at least 50 years. The Commissioner did not contend that this cost .was not a capital expenditure. His objection was that the specific costs could not be definitely determined from the petitioner’s books, that the cost of tanning the vats was charged to expense and included with other such items and for that reason it would be impossible to make a separation on the books of the petitioner.

The cost of tanning a vat was standard. The 322 vats were 8 feet by 9 feet by 6 feet in depth. Each vat had a content of 432 cubic feet and absorbed one-fifth of its cubical contents in the process of tanning. A liquor of 46 degrees strength was used in the process. Each cubic foot of this liquor weighed 64½ pounds. Four and one-half per cent in weight of each pound of this liquor was tannin. The total tannin required for each vat was 1,500¾ pounds; one-half of this amount was actually absorbed by the wooden lining; one-half of the remainder was lost in the necessary process of filtration and purification of the residue. The tanning of each vat, therefore, consumed 1,125 pounds of tannin. The cost of tannin per pound in 1904,1907, 1912, and 1914 was disclosed by the petitioner’s books. The dimensions of the vats and the cost per pound of tanning being given, it is but a mathematical process to determine the cost of tanning a vat. The cost of farming the 322 tanning vats was $33,884.78. The useful life of each vat was 50 years. The proper deduction for depreciation was 2 per cent. The addition to petitioner’s invested capital for 1917 and 1918 was cost, less depreciation at 2 per cent from the date of construction. The deduction for exhaustion, wear and tear of the vats for 1917 and 1918 should be computed at the rate of 2 per cent.

The third issue is whether the petitioner is entitled to include in its invested capital for 1917 the cost of tanning liquor in its vats at December 31, 1916, and for 1918 the cost of such liquor at December 31, 1917. Upon the construction of the vats and before the process of tanning hides could be commenced, it was necessary to fill each vat with liquor to a depth of 4½ feet and constantly to maintain this liquor at an average strength of 46 degrees Barko-meter. The cost of the original liquor placed in the 322 vats is not shown. In the process of tanning the hides, a portion of the tannin, which is the essential element, is absorbed from day to day, and additional tannin must be added to maintain the liquor at the required strength. The cost of the tannin fluctuates from time to time. It is contended that “the taxpayer’s investment in tanning liquor is the cost of the original liquor plus all additions thereto to maintain the required strength, less the cost of the liquor actually absorbed by the hides,” and that “it is clear therefore that on a given date all the liquor in the vats constitutes the capital item in question.” The Board can not agree with this contention. It may be that the cost of the liquor with which the vats were originally filled was a capital expenditure, since the liquor was as essential as the vats or any other item of a major character, and since it was necessary to maintain the liquor throughout at a uniform strength, but the cost of tannin subsequently added from time to time during the year made necessary by the constant absorption thereof by the hides was an ordinary and necessary manufacturing expense within such year.

The method contended for by the petitioner would permit it to include in invested capital for the year the cost not only of the liquor originally placed in the vats, but also any increase in the cost of tannin used for replacement purposes, such increase in cost being deducted as an expense of manufacture.

We have no evidence as to the cost of the liquor with which the vats were originally filled, and it is not necessary therefore to consider whether any amount should be restored to invested capital on this account. It is our opinion that the Commissioner correctly denied the claim that the cost of the liquor in the vats on December 31, 1916, and December 31, 1917, should be included in invested capital for 1917 and 1918, respectively.

The fourth issue concerns the amount which the petitioner is entitled to deduct from income for 1918 as losses sustained by it from fire during that year. Its plant was destroyed by fire on October 11, 1918. The plant was partially covered by insurance and for every dollar of damage done, as determined by the insurance company, the petitioner received 58 cents. It was under-insured 42 per cent. At the time of the fire the petitioner was engaged in war production. The settlement with the insurance company was not satisfactory to the petitioner but was accepted in order that it might rebuild its plant and resume work. The entire amount of the insurance was received by the petitioner during the year 1918 and was included in taxable income for that year.

The tanning liquor in the vats on October 11, 1918, was completely destroyed by fire. The cost thereof, which had been charged to expense, was $74,451. The petitioner received in 1918 insurance of $19,706.54 for the destruction of this liquor and included the same in income for 1918 and claimed a loss of $72,451. The Commissioner declined to allow the deduction of any portion of the claimed loss.

For the reason stated in connection with the preceding issue relating to the capitalization of the cost of tanning liquor, it is the opinion of the Board that the Commissioner correctly denied the deduction of the cost of the liquor destroyed by fire as a loss sustained within the year. When the petitioner received $19,706.54 from the insurance company, it was in the same position as if it had incurred an expense for liquor of $54,744.46. The petitioner had already deducted from income, and we think properly, the cost of the liquor destroyed, and it may not again reduce its income by the same amount or in the amount of the difference between the insurance received and the cost of the liquor destroyed.

A pump ringer costing $1,056.25 was purchased by the petitioner in 1917, which cost was charged to expense during the year 1917. The deduction was disallowed by the Commissioner and the cost restored to capital. This article was totally destroyed by the fire. Some insurance was recovered but was included in income for 1918. The petitioner is entitled to a deduction from income for 1918 of the total cost of this article, amounting to $1,056.25, less one year’s depreciation at 6% per cent, since the useful life of the article was 15 years.

The petitioner had on hand at the date of the fire, in process of tanning, hides which had cost it $641,565.77. This amount did not. include manufacturing or selling cost. The hides were badly damaged by heat and discolored as a result of pieces of iron, nails and other debris falling into the vats. The exact amount of the damage done could not be determined at that time. It was necessary to complete the tanning process and then dispose of the hides, if possible, in order definitely to determine the extent of the damage. As soon as the settlement was made with the insurance company, the tanning of the hides was resumed and was completed, in 1919.

On December 31, 1918, petitioner reduced its inventory of hides in process by $140,505.09, leaving a net cost of hides in process of $501,151.68. This figure included the cost of the raw hides exclusive of the cost of manufacture. The total cost of tanning the hides damaged by the fire was $212,650.11, which was also carried in the inventory. The damaged hides were subsequently sold for $560,874.07. The Commissioner allowed $140,505.09 as a deduction from income for 1918 for damage to hides in process; From the evidence we are of opinion that the damage to hides in process was $293,341.81. The petitioner is therefore entitled to a deduction from income for the year 1918 of this loss. The petitioner received from the insurance company on account of the damage $84,185.23. This was included in 1918 taxable income and need not be considered in determining the loss.

The fifth issue involved in this appeal is whether invested capital for the years 1917, 1918, and 1919 should be determined without reduction thereof on account of prior year’s income and profits taxes. We approve the Commissioner’s computation of invested capital in this regard. Appeal of Russel Wheel & Foundry Co., 3 B. T. A. 1168.

Judgment mill he entered on 15 days' notice, wider Rule 50.