author: Tyson : HaRRON,

text:
    George O. Knapp, Petitioner, v. Commissioner of Internal Revenue, Respondent.
    Docket No. 91699.
    Promulgated December 19, 1939.

      Farnsworth L. Jennings, Esq., for the petitioner.

      George B. Sherriff, Esq., for the respondent.
   OPINION.

Tyson :

This case involves the amount of $6,000 distributed under a retirement pay or pension trust, which amount had been previously assigned by petitioner, as shown in our findings of fact, to the benevolent fund. The only question presented is whether this amount so distributed by the service annuity trust is taxable to petitioner, the assignor. The applicable statute is set put in the margin.

■ Petitioner contends that, having irrevocably assigned to the trustees of the benevolent fund all of the annual pension receivable by him during his lifetime in the future for services performed in the past, he has transferred all of his right in the retirement pay, or pension, that such right is a property right, that the income receivable therefrom was not conditioned upon the performance of any further services by the petitioner, and that he is not taxable upon the amount paid to his assignee. He further contends that, since the payments in 1934 were from the income or corpus of a trust, his assignment effected the transfer therefore of his beneficial interest in the trust, and that the income therefrom paid to his assignee is not taxable to him.

The respondent contends that the retirement pay, or pension, which petitioner was entitled to receive as a retired employee of the company was taxable to Mm under section 165 of the Revenue Act of 1934 and, if not, that it was nevertheless taxable to him as earned income within the meaning of the applicable statute, regardless of the fact that it was irrevocably assigned by petitioner to a benevolent trust for the uses and purposes of the trust.

No contention is made by respondent that the amount here involved should be included in the income of petitioner because of the application of either section 166 or 167 of the Revenue Act of 1934 to the trust by which petitioner created the benevolent fund.

There is no question raised as to the validity of the assignment or its enforceability as between the parties. So, regarding the assignment as valid between the parties, the question remains whether the assignor is taxable on the amount paid the assignee.

Under the service annuity system of the company, the retirement pay, or pension, to a retired employee was based on services theretofore performed and varied in amount according to the length of service of the employee and the salary paid him during the last five years of his employment. Such retirement pay, or pension, is to be regarded as additional compensation for past services within the meaning of the applicable statute. Cf. Lucas v. One Fibre Brush Co., 281 U. S. 115; Fisher v. Commissioner, 59 Fed. (2d) 192; Noel v. Parrott, 15 Fed. (2d) 669; certiorari denied, 273 U. S. 754; Botchford v. Commissioner, 81 Fed. (2d) 914, affirming 29 B. T. A. 656; Levey v. Helvering, 68 Fed. (2d) 401; James H. Anderson, 31 B. T. A. 197, affirmed per curiam, 79 Fed. (2d) 979; George S. Williams, 36 B. T. A. 974.

The question of whether compensation for personal services can be so assigned as to relieve the “earner”’ from income tax thereon has often been before this Board and the courts, and the decisions are not all in harmony and are somewhat difficult of classification. It is, however, settled that income to be earned in the future as compensation for personal services can not be assigned by an anticipatory agreement so as to relieve the assignor of the tax, Lucas v. Earl, 281 U. S. 111, and that a member of a partnership can not assign future earnings to a nonpartner and thereby escape the tax. Burnet v. Leininger, 285 U. S. 136. But where the income assigned is to be received as compensation for services rendered entirely in the past by the assignor and the right to receive it has become fixed and determined in him before assignment, it has been generally held that the assignor is relieved from tax thereon because his assignment is that of a property interest. Hall v. Burnet, 54 Fed. (2d) 443; certiorari denied, 285 U. S. 552; Commissioner v. Ross, 83 Fed. (2d) 18, affirming 30 B. T. A. 496; cf. Nelson v. Ferguson, 56 Fed. (2d) 121; certiorari denied, 286 U. S. 565; Helvering v. Seatree, 72 Fed. (2d) 67; Shanley v. Bowers, 81 Fed. (2d) 13; Byrnes v. Commissioner, 89 Fed. (2d) 243; Julius E. Lilienfeld, 35 B. T. A. 391; and Fontaine Fox, 37 B. T. A. 271.

By the instrument of May 8, 1912, the company established a fund to be used solely for the payment of retirement benefits, or pensions, to its retired employees for their long and faithful services. After his retirement on October 1, 1913, petitioner was duly placed on the service annuity roll and thereby became entitled to an annual retirement pay, or pension, during his lifetime to be paid from the fund and later additions made thereto, including those made under the instrument of December 31, 1929, by which the Peoples Gas Light & Coke Co. service annuity trust was created by the company for the purpose of giving employees “better assurance as to the payment of service annuity allowances granted, or to be granted.” Petitioner’s right to receive the pension during his lifetime thus became fixed and definite and constituted such a property right as was subject to the assignment he made to the benevolent fund.

Accordingly, under the authorities last above cited, we are of the opinion that the irrevocable assignment of January 21, 1920, by petitioner to the trustees of the benevolent fund of all the retirement pay, or pension, which would have otherwise been thereafter receivable by him from the company constituted an assignment of a property interest which had become fixed and determined in petitioner prior to the time the assignment was made and that the retirement pay, or pension, here involved and received by petitioner’s assignee was in no degree dependent upon continued activity of the petitioner to produce it. See Bowery v. Commissioner, 70 Fed. (2d) 713; Rossmoore v. Commissioner, 76 Fed. (2d) 520; Matchette v. Helvering, 81 Fed. (2d) 73; Shanley v. Bowers, supra; and Commissioner v. Ross, sufra; Horst v. Commissioner, 107 Fed. (2d) 906.

The decision in Gerald A. Eubank, 39 B. T. A. 583, is not controlling here, for the facts there involved are clearly distinguishable from the facts in the instant case. There, the taxpayer assigned merely a contingent right to receive presently unmatured, unascer-tainable renewal commissions which the insurance company would not become obligated to pay until the policyholders had made future premium payments, none of which might ever be made, and, further, the insurance company retained the right to offset against renewal commissions as they became payable any then existing debt of the assignor to the company. There, the subject matter of the assignment was a chose in action the rights under which were entirely contingent upon the happening of uncertain future events in the respects mentioned. In the instant case, the taxpayer assigned a presently existing absolute right to pension payments from a fund created for that sole purpose and neither the assignor’s right nor the obligation of the trustees of that fund to pay such pension was contingent upon the happening of any future events.

Having held, as we have, that the assignment of the petitioner to the trustees of the benevolent fund was that of a property interest, it follows that, as further contended by petitioner, it was also an assignment of his beneficial interest in the trust created by the company and thus comes within the rule announced in the following cases: Blair v. Commissioner, 300 U. S. 5; Byrnes v. Commissioner, supra; and Ellen S. Booth, 36 B. T. A. 141.

We think that the contention of respondent that section 165 of the Revenue Act of 1934 applies here is not sound. As we view that section, it was the intention of Congress to thereby tax to the dis-tributee of a pension fund the amount actually distributed or made available to him during the taxable year. Here, petitioner, after the assignment of his right to retirement pay, or pension, was no longer entitled to any distribution and no amount was actually distributed or made available to him during the taxable year. The amount of the retirement pay, or pension, here involved was actually available only to petitioner’s assignee, the trustees of the benevolent fund, who had the legal right to it and to whom it was actually distributed.

We conclude that the respondent erred in including in petitioner’s income the amount of $6,000 here involved.

Reviewed by the Board.

Decision will be entered wnder Rule 50.

DisNey dissents.

HaRRON,

dissenting: The income in question, paid from an employees’ trust fund which was contributed wholly by an employer, is retirement pay, and is additional compensation for personal services actually rendered. A pension payment is a form of compensation for personal services, and it is not different from salary or wages, as a type of income. The issue involves taxation of a particular type of income, namely, earned income, or compensation for personal services. The question is, whether the pension payment for 1934 is taxable to petitioner, despite his prior assignment thereof, under the provisions of either or all of the following sections: section 22 (a), defining gross income; section 25 (a) (5), defining earned income ; or section 165.

The majority opinion says, in effect, that the rule of Lucas v. Earl, 281 U. S. 111, does not apply to this case. However, it is submitted that the doctrine of the Earl case is that, because of the special quality of earned income, it must vest in the earner, for purposes of income tax, and the earner may not prevent the vesting of earnings in him by assignment thereof in anticipation of the payment of the earned compensation. It is believed that the Supreme Court has categorically stated the rule to be that Congress has the right to and intended to tax earned income to the earner, and that the earner may not escape taxation upon earned income. Such appears to be the meaning of the following statement in the Earl case:

There is no doubt that the statute could tax salaries to those who earned them and provide that the tax could not be escaped by anticipatory arrangements and contracts however skillfully devised to prevent the salary when paid from vesting even for a second in the man who earned it. [Italics supplied.]

The words “when paid” seem to make it clear that the time relation of the effort to prevent the vesting of earned income in the earner and the rendering of services for compensation is not material; i. e., it is immaterial whether, at the date of assignment of future compensation, the earner-assignor has or has not completed the rendering of his personal services. It is in the nature of compensation. for personal services, that the compensation is earned by the work of the individual, and is payable to the worker. He may not, by his agility, escape taxation on compensation by executing an assignment at any time. That appears to be the absolute rule. If it is not the rule, every worker can escape taxation on compensation for personal services by the adroitness of assigning compensation before it is paid, as soon as he completes his work. The Supreme Court appears to have placed, already, a bar to the above procedure, by stating that the earner of income can not prevent compensation from vesting in him “when paid.” The test is not whether earned income is “beneficially received.” The earner may elect to never receive the compensation, but when it is paid, it vests in him for the purposes of Federal income tax. If the foregoing is a correct statement of the meaning of the rule in the Earl case, it is applicable here, and petitioner is taxable on the pension paid in 1934 to his assignee.

Congress has clearly indicated that pension payments are to be taxed under the same rule as other earned income by enacting section 165, and that the amount of a pension payment is taxable to the earner when it is “made available” to him. Petitioner retired from the employ of the company in 1913. Thereafter, his name appeared on the company’s “Service Annuity Roll” and he was entitled to receive pension annually for life. Presumably petitioner received, personally, pension payments from 1913 up to the date of the assignment in 1920 to the Knapp benevolent fund. Congress enacted for the first time the provision applying to employees’ pensions in the Revenue Act of 1921. Bee section 219 (f) of the Revenue Acts of 1921, 1924, and 192.6 and section 165 of the Revenue Acts of 1928, 1932, and 1934. Under these sections of the various acts petitioner was taxable on pension payments distributed or made available to him. After the , assignment in 1920, the pension payments were “made available” to petitioner when they became payable. Only the names of former employees could appear on the company’s “Service Annuity Roll.” The name of the Knapp benevolent fund could not appear on that roll as an employee, and it could receive payment of the pension under the assignment only through petitioner, because of his existence and his status as a former employee. When pension became payable it was “made available” to petitioner because of the services he had rendered and because he lived. The pension was none the less “available” to petitioner even though he elected to have it paid to his assignee. Section 165 is applicable. The 1934 payment is taxable to petitioner under that section and under the rule of Lucas v. Earl, supra, because the pension vested in petitioner when it was paid, despite his prior assignment thereof.

Congress has allowed deduction from gross income for gifts made to certain charitable uses under section 23 (o) (5). But the amount of the deduction is limited to 15 percent of the taxpayer’s net income as computed without the benefit of the subsection. Petitioner’s assignment' of his pension pay was a gift or contribution to the Knapp benevolent fund. The result reached by the majority opinion in this case would defeat and make meaningless the limitation imposed on the amount of the deduction under section 23 (o) (5) where the amount involved is more than 15 percent of net income. Also, Congress has allowed an exemption from income tax of 10 percent of earned income under section 25 (a) (4), providing an earned income credit. The limitation imposed on the amount of the credit would be defeated, under the majority view, where income of the type involved in this case amounted to more than 10 percent of total earned income.

The case of Julius E. Lilienfeld, 35 B. T. A. 391, is distinguishable from this case. The income assigned there was royalties, a type of income clearly different from compensation for personal services and not within the rule of the Earl case.

For the reasons stated, I respectfully dissent from the majority opinion.

SteRNHágeN and Opper agree with this dissent.

       Revenue Act of 1934.—
      SEC. 22. GROSS INCOME.
      (a) General Definition. — “Gross Income” Includes gains, profits, and income derived from salaries, wages, or compensation for personal service, of whatever kind, and in whatever form paid, or from professions, vocations, trades, businesses, commerce, or sales, or dealings in property, whether real or personal, growing out of the ownership or use of or interest in such property ; * * *

       SEC. 165. EMPLOYEES’ TRUSTS.
      A trust created by an employer as a part of a stock bonus,, pension, or profit-sharing plan for the exclusive benefit of some or all of bis employees, to wbieb contributions are made by such employer, or employees, or both, for the purpose of distributing to such employees the earnings and principal of the fund accumulated by the trust in accordance with such plan, shall not be taxable under section 16Í, but the amount actually distributed or made available to any distributee shall be taxable to him in the year in which so distributed or made available to the extent that it exceeds the amounts paid in by him. * * *


source: Caselaw Access Project

author: MurdoCk: OppeR,

license: Public Domain

text:
    Corporate Investment Company, Petitioner, v. Commissioner of Internal Revenue, Respondent.
    Docket No. 78363.
    Promulgated December 20, 1939.

      J. G. Komer, Jr., Esq., Frank J. Widernan, Esq., and Richard, S. Doyle, Esq., for the petitioner.

      Frank D.

      'Strader, Esq., W. Herdman Sehwatka, Esq., and Edward L. Updike, Esq., for the respondent.

       He apparently has thought, in determining the tax liability of Munroe, that the ease of Fremont C. Peck et al., Executors, 31 B. T. A. 87; affd., 77 Fed. (2d) 857; certiorari denied, 298 U. S. 625, was not in point. There, some securities were loaned to a corporation under a contract somewhat like the one involved in the present case. The corporation had power to sell the securities, but was required to pay to the lender at the end of the period the amount of the dividends which it received on the stock. Although the lender was on the cash basis and did not receive the dividends, nevertheless, she was required to include them in her income for the years in which they were received by the borrower.

   OPINION.

MurdoCk:

The two issues raised by the respondent will be discussed first, since they may have some bearing upon the main issue. The case of General Utilities & Operating Co. v. Helvering, 296 U. S. 200, is controlling on the question of whether the distribution of the Loew and Chase stocks resulted in deductible losses. The dividend resolution in that case provided for a dividend of a certain amount payable in a named stock at a declared valuation. The Court held that no sale of the stock resulted and the stock was not used to discharge an indebtedness. Here the dividend resolution was strikingly similar and no deductible losses resulted. The Commissioner erred in allowing the deductions claimed on the return for losses on the two stocks distributed. Cf. First Savings Bank of Ogden v. Burnet, 53 Fed. (2d) 919; Commissioner v. Columbia Pacific Shipping Co., 77 Fed. (2d) 759.

The respondent has failed to show error in his allowance of the deduction of $45,106.98 claimed by the petitioner as accrued interest and a charge of one-fifth on income due to Munroe under the contracts of September 13, 1922, and March 5, 1923. The respondent concedes that an accrual and a charge in accordance with the terms of the agreements are proper deductions for 1929, but argues that the correct figure is $14,010.79, not $45,106.98. The amount accrued and deducted for 1929 was computed in the same way that similar amounts were computed for all prior years. The evidence fails to show that the computation of the accrual for 1929 was not made in accordance with the intent of the contracting parties as expressed' in their contracts. The contention of the respondent seems to be that no interest and no charge of one-fifth is properly accruable on income of prior years. The contract itself and the consistent interpretation of it by the parties are to the contrary. The deduction was properly allowed.

The most important issue for decision is whether the petitioner is subject to tax under section 104 as a corporation “formed or availed of for the purpose of preventing the imposition of the surtax upon its shareholders through the medium of permitting its gains and profits to accumulate instead of being divided or distributed.” The decision of that issue must depend, in the final analysis, upon the facts in this particular case. It is, therefore, not surprising that the cases cited by the parties are only of general interest and require no detailed discussion. Both parties seem satisfied that all relevant facts are contained in the rather lengthy record. We have carefully considered all of that record, although not all of it has been set forth in detail in the findings of fact.

The test of “purpose” necessarily depends upon the state of mind of the person or persons responsible for the formation and operation of the corporation. United Business Corporation of America, 19 B. T. A. 809; affd., 62 Fed. (2d) 754; certiorari denied, 290 U. S. 635. Even though the effect of the formation and operation of a corporation may have been to avoid surtax upon the stockholders, still section 104 does not apply unless the parties in control had .the intent and purpose described in that section. Cecil B. deMille Productions, Inc., 31 B. T. A. 1161; affd., 90 Fed. (2d) 12; certiorari denied, 302 U. S. 713; 61 H. Spitzner & Son, Inc., 37 B. T. A. 511; B. L. Blaffer & Co., 37 B. T. A. 851; affd., 103 Fed. (2d) 487; Mellbank Corporation, 38 B. T. A. 1108. Here Munroe created the corporation and completely dominated its operation, so that the real question is, What was his purpose in the formation and operation of the petitioner? He has testified that he did not have the purpose described in section 104, either in the formation or the operation of the petitioner. However, he is an interested witness and we have considered, not only his categorical denial of the existence of the proscribed purpose, but also all other evidence which might show that his purpose was, in truth, different from what he says it was.

There is a clear preponderance of evidence to show that the petitioner was not “formed” to avoid surtaxes upon Munroe through the means described in section 104. His primary purpose in forming the petitioner was to profit from the purchase of installment paper. Although he might have had additional purposes, and although some surtaxes may have been avoided eventually, nevertheless, this record indicates no purpose in the formation of the corporation which would bring it within section 104.

The only argument made by the respondent upon this point is that Munroe, a -very astute and active man in avoiding taxes, obviously intended from the very beginning to utilize the two contracts, dated September 13, 1922, and March 5, 1923, to avoid tax not only upon himself (since he was on the cash basis and was to receive nothing for ten years, he reported no income) but also upon the corporation, which was using an accrual method whereby it could currently accrue and deduct items eventually payable to Munroe. He does not contend that the agreements were invalid, that Munroe was required by statute to report any items due him under the contracts, or that the petitioner was not entitled under the statutes to accrue and deduct amounts in accordance with the agreements. Yet he attempts to find, in the fact that the contracts were so effective in saving and delaying tax, a purpose to avoid surtax upon Munroe through the medium of having the corporation accumulate its gains and profits instead of distributing them.

One sufficient answer to his argument is at once apparent. The moment the petitioner received anything under the contracts, it became indebted in a like amount to Munroe. It also had to accrue fees and charges on the receipts as amounts due Munroe. The Commissioner recognizes the propriety of these accounts. Thus the amounts due Munroe always were increasing more rapidly than the receipts under the contracts were being accumulated, and those receipts were not increasing the accumulated “gains and profits” of the petitioner or any fund from which dividends of the petitioner could come. The petitioner was permitted to use funds accumulated under the contracts to transact other business from which it might derive gains and profits of its own. But if it had had no business transactions, aside from receipts under the contracts, it would have had no accumulation of gains and profits to distribute as dividends and no surtaxes upon its shareholder could have been avoided. The large surplus which it accumulated was not the result of receipts under the contracts, but came from wholly different transactions. Although the contracts may have avoided or delayed tax on Munroe, they do not bring section 104 into play, since their use did not serve to avoid surtax on Munroe through the medium of permitting the gains and profits of this petitioner to accumulate instead of being distributed as taxable dividends to Munroe. Munroe may have been tax conscious and his contracts may have been cleverly drawn to save him from tax, but still this petitioner is not subject to tax under section 104 unless the facts are within the provisions of that section, which Congress has made so definite and specific.

Although the foregoing discussion disposes- of the only argument presented by the respondent on the purpose of formation, nevertheless we have considered the evidence from other angles. The history of the corporation during a reasonable period immediately following its incorporation shows that it was using large amounts in the purchase of installment paper but was not successful in accumulating sufficient working- capital of -its own. It had a paid-in capital of only $6,000 and, at the beginning of 1926, it had accumulated a surplus of only $18,175.30. It began to have greater financial success in 1926, about the time that it ceased purchasing installment notes. But Munroe did not foresee that situation when he formed the petitioner. The evidence does not supply any sound basis for a finding that the purpose in forming this petitioner was such as to bring it within section 104.

The respondent next argues that the petitioner was “availed of” during the period 1922 to 1928, inclusive, for the purpose described in section 104 and the section applies, since Munroe did not include in his gross income for 1929 all of the net income of the corporation. He does not argue that the failure of the petitioner to distribute in 1929 the surplus accumulated in prior years is important. The words' of the statute, the legislative history of section 104 and its antecedents, and the general scheme of the revenue acts taxing income upon an annual basis show that Congress intended to apply section 104 in case a corporation was “availed of” within the taxable year through .the medium of permitting its gains and profits of that year to accumulate, but did not intend to tax a corporation under section 104 merely because it had been availed of in other years or because it did not distribute a surplus accumulated in prior years. The income tax acts have always taxed income upon an annual basis and many terms which could refer to a different period are generally understood to refer to an annual period without any express statement to that effect appearing in the acts. Income, gross income, net income, and dividends are examples. Although some terms, particularly those relating to deductions, are expressly qualified so that they can refer only to the taxable year, nevertheless, where a term is used and is not expressly defined as relating to the taxable year, it is generally so understood. Thus the natural meaning to ascribe to the words “gains and profits” in section 104 is the gains and profits of the taxable year.

Furthermore, the use of the words “to accumulate” instead of some such phrase as “to remain accumulated” is significant. Earnings of prior years may remain accumulated during the year but are not permitted “to accumulate” during that year. If Congress had intended to penalize the corporation for accumulating a surplus in prior years or for failing to distribute such a surplus in the taxable year, it would hardly have measured the penalty by the earnings of the current year or relieved the corporation from the penalty upon condition that the earnings of the current year were distributed to or reported by the stockholders. See subsection (d), which permits the corporation to escape the tax if the stockholders report the net income of the corporation for the particular year as a part of their gross income. The thought back of this “escape clause” was that the penalty should not be imposed upon the corporation if the stockholders, like partners, reported the earnings of that particular year. See Committee Reports on section 220, of the Revenue Act of 1921. The Senate Finance Committee said, when it approved of the counterpart of (d) as section 220 (e) of the Revenue Act of 1926, that there could be no avoidance of surtax on earnings if the stockholders reported their shares of the net income “and the reason for the imposition of the 50 per cent tax on the corporation no longer exists.” S. Rept. 52, p. 22, 69th Cong., 1st sess. Thus it appears that Congress was thinking in terms of current income and current gains and profits when it enacted the provisions of section 104. The Bureau has always interpreted similar provisions as referring to “gains and profits” of and “availed of” in the current taxable year. O. D. 188, 1 C. B. 182; I. T. 1572, C. B. II — 1, 139. The decisions of the Board are to the same effect. United Business Corporation of America, 33 B. T. A. 83; remanded, C. C. A., 2d Cir., Aug. 31, 1936; Almours Seciurities, Inc., 35 B. T. A. 61; affd., 91 Fed. (2d) 427 (C. C. A., 5th Cir.); certiorari denied, 302 U. S. 765; Dill Manufacturing Co., 39 B. T. A. 1023. Consequently, a detailed discussion of events of prior years is not necessary here, even though those events might show that the corporation was or was not availed of prior to 1928 for the proscribed purpose. They are important only in so far as they may tend to show a purpose, or lack of purpose, in 1929.

The argument of the respondent on the question of whether the petitioner was “availed of” in 1929 is relatively short. He attempts to show that the “gains and profits” for the purpose of section 104 were $977,909.39; the distributions were limited to $350,000 so that Munroe would escape tax; no liability for the 1927 tax or interest thereon was accrued or accruable in 1929; and the contracts of 1922 and 1923 with Munroe, the losses realized by him upon stock transfers to the petitioner in 1929, and the loans to Munroe, show a purpose to avoid tax, as does the “repeat” attempt to avoid tax through the reorganization of 1930 contemplated in 1929.

The claim of the Commissioner, made in his brief, that the correct amount of “gains and profits” for 1929 was $977,909.35 is not supported by the pleadings or the proof but, on the contrary, is shown by the proof to be erroneous. He includes in that total the amount received during the year under the contracts of 1922 and 1923, contrary to his action in determining the deficiency, and he disregards the increase in the amounts due Munroe which he has heretofore allowed to offset those receipts in computing the deficiency. The words “gains and profits” are not defined in the statute. However, it is obvious that in this case they are not greater than the net income as defined in section 104 (c). The later amount, as determined by the Commissioner in the notice of deficiency, was $671,817.78. The pleadings and proof show that the only proper increase in that figure is $63,402.50, the amount disallowed as loss on the Loew and Chase stocks. Thus the correct amount of net income as defined in section 104 (c) is $735,220.28. The petitioner contends that this figure must be reduced by several items in order to arrive at “gains and profits” within the meaning of those words as used in section 104. The first item is the income taxes for the year 1929 under section 13 as finally determined, and the Commissioner agrees that those taxes are a proper adjustment in arriving at “gains and profits.” The correct amount of those taxes under this opinion will be about $73,700.

The petitioner also contends that the shrinkage in value of its securities should be deducted from “net income.” The Board, however, has held to the contrary. Rands, Inc., 34 B. T. A. 1094. The other two items which the petitioner would use to reduce “net income” in arriving at “gains and profits” are interest of about $120,000 and lawyers’ fees in the amoirnt of $16,666.66. The interest is the amount which accrued during 1929 on the large deficiency for 1927. The lawyers’ fees were incurred in 1929 in connection with the 1927 tax controversy. Both of those items, although not entered on the books as expenses of 1929, were actually incurred as expenses in that year and were later paid. Perhaps they should have been accrued on the books as expenses of 1929. Lucas v. American Code Co., 280 U. S. 445. The petitioner contends only that they are items which must be considered in determining how much of the earnings of 1929 were permitted to accumulate instead of being distributed. It may be argued that there is as much justification for reducing “net income” by those, two items in order to arrive at “gains and profits” as there is for reducing “net income” by the income taxes for 1929. The taxes for 1929 under section 13 have a direct relation to the year 1929 and will have to be paid. The Commissioner apparently recognizes that earnings, to the extent of the taxes, will not be permitted to accumulate, but will Be used to pay the taxes, even though they may serve to swell the boob surplus at the end of the year. The situation is exactly the same in relation to the interest on the deficiency for 1927 and the attorneys’ fees. All three of the items were incurred during 1929 but not accrued on the books. The interest and attorneys’ fees were actually paid in 1930, whereas the taxes have not been fully paid at this time. The amounts necessary to pay those items were accumulated only temporarily. It is difficult to see any distinction unfavorable to this petitioner between the taxes for 1929 and the interest for 1929 on the unpaid deficiency for 1927. The “gains and profits” for 1929 were either $524,853.62, or $661,520.28, depending upon whether or not the interest and attorneys’ fees are proper adjustments to “net income” in order to arrive at “gains and profits.”

It may be pertinent to determine the amount of the “gains and profits” actually permitted “to accumulate” during 1929. The distribution of the dividend eliminated $413,402.50 from surplus and that amount of the “gains and profits” for the year was not permitted “to accumulate.” The basis and book value of the Loew and Chase stocks was $409,902.50, and the distribution of those stocks eliminated that amount from the assets of the petitioner, despite the fact that the distribution was described as a dividend of $350,000, and the petitioner is not entitled to deduct any loss under section 23. But not all of the “gains and profits” for the year were distributed. The amount permitted to accumulate was either $111,451.12, or $248,-117.78, depending upon the treatment to be accorded the interest and attorneys’ fees above described. The fact that these “gains and profits” were permitted to accumulate raises the issue but is not determinative of that issue. The important question is, Was there any intention on the part of the corporation and its controlling stockholder, Munroe, to avail of the corporation in 1929 for the purpose of preventing the imposition of the surtax upon Munroe through the medium of permitting those “gains and .profits” of the corporation to accumulate instead of being divided or distributed? It is appropriate, in order to answer that question, to consider the amount of “gains and profits” which Munroe thought the petitioner had towards, the close of 1929 and what he proposed to do with these “gains and profits.”

Munroe had an estimate made at that time to determine what amount would be available for distribution and would not be needed to pay expenses incurred during the year. The estimate was honestly made and convinced Munroe that about $350,000 would be accumulated unless it was distributed. This figure was arrived at by eliminating one-tenth of the gain from the Laclede sale, which the Commissioner had insisted was income of 1927 rather than income of 1929 as shown on the books. That left earnings of about $560,000. It was known that the petitioner had agreed to pay the large deficiency for 1927, interest would have to be paid on that deficiency, and the interest accruing during 1929 would amount to about $120,000. It was also known that lawyers? fees in the amount of $16,666.66 had been incurred in 1929 in connection with the tax controversy and would have to be paid. The taxes for 1929 were estimated at about $61,000. Munroe believed that all of those obligations were proper charges against 1929 earnings in determining the amount of those earnings available for distribution. It was estimated that the securities of the petitioner had depreciated in value to the extent of about $90,000. Munroe thought that allowance would have to be made for that shrinkage in determining the amount of 1929 earnings available for distribution as a dividend. He concluded that a distribution of $350,000 would be proper, would represent a complete distribution of the “gains and profits” for the year, would permit none of those “gains and profits” to accumulate, and, therefore, would relieve the corporation from all possibility of tax liability' under section 104. It now appears, as shown in the preceding paragraph, that the correct amount of “gains and profits” was somewhat in excess of-his estimate. The fact that his estimate later turned out to be erroneous is not so important as the fact that it was honestly made in an effort to distribute the earnings of the petitioner as Munroe saw them. The errors which were made were not inexcusable ones. ■ The evidence as a whole indicates that Munroe did not whnt to take any chances on the application of section 104, but intended to distribute all of the available “gains and profits” of the petitioner for 1929 and to permit none of those “gains and profits” to accumulate. Such an intent is inconsistent with a purpose to avail of the petitioner to avoid surtax upon Munroe through the medium of permitting fits “gains and profits” to accumulate.

Munroe filed a return for himself showing a loss and if he had had the matter in mind, he would have thought that his return could absorb tax-free even larger distributions from the petitioner. But apparently he was not thinking so much of the' tax significance of the distribution to himself as he was of its importance to the corporation. The record does not support the respondent’s claim that the amount of the dividend was fixed so that Munroe would not have any tax to pay. The figures used in the estimate, as well as other evidence in the record, corroborate Munroe’s testimony that he had no purpose to avail of the petitioner in 1929 to avoid surtaxes upon himself through the medium of permitting its gains and profits to accumulate instead of being distributed. Furthermore, a “large portion of its earnings for the year in question” were distributed, a fact which also negatives intent to avoid surtaxes and brings the petitioner within Article 542 of Regulations 74, to the effect that the presumption of section 104 (c) is thus overcome.

The importance of the 1922 and 1923 contracts has been discussed already and merits no further mention. The fact that Munroe in 1929 discharged indebtedness to the petitioner by transfer of securities and thereby sustained deductible losses seems to have little or no significance for present purposes. The reorganization, which occurred in 1930, does not have any bearing whatsoever -upon the present question, even though the Board has held that it was a nontaxable reorganization. C. A. Munroe, supra. The loans to Munroe in 1929 and those made in prior years do not show a purpose within section 104. They did not weaken the financial position of the petitioner and they were not disguised dividends of the earnings of the corporation. Cf. Helvering v. National Grocery Co., 304 U. S. 282; United Business Corporation, supra; William C. deMille Productions, Inc., 30 B. T. A. 826; A. D. Saenger, Inc., 33 B. T. A. 135; affd., 84 Fed. (2d) 23; cer-tiorari denied, 299 U. S. 577. Munroe gave his notes for the amount of the loans, paid the interest in full, and paid the principal. There is every indication that he at all times intended to pay them. Cf. Charleston Lumber Co. v. United States, 20 Fed. Supp. 83; United States v. Tway Coal Sales Co., 75 Fed. (2d) 336. The petitioner had substantial income from the loans to Munroe, particularly in the year 1929. Furthermore, Munroe made loans to the petitioner and the latter was indebted to him for a large amount under the contracts. We can not find in the loan situation any purpose to avoid surtax upon Munroe by permitting the gains and profits of 1929 to accumulate.

The petitioner made its greatest profit from the sale of the Laclede stock in 1927. It attempted-to spread the tax from that transaction over a period of ten years by taking Munroe’s notes for the purchase price. It was not, however, a scheme to avoid taxes. Neither does it demonstrate any purpose within section 104 applicable to the year 1929. The Commissioner has refused to consider any of that gain as gain for 1929.

Both parties gave considerable time and thought to the trial and briefing of this case. All of the evidence and all arguments presented have been carefully considered in an effort to determine correctly whether section 104 applies. This opinion would be entirely too long were it to contain a detailed discussion of all of the many points argued. We have concluded upon the entire record that section 104 does not apply.

Beviewed by the Board.

Decision will be entered under Rule SO.

OppeR,

dissenting: While the section which is being resisted is penal in its nature, the evil Congress intended to restrict by its enactment is clearly recognizable, and one may assume that the application of the statute was intended so that it would be effective for the purposes for which it was designed. See Foster v. United States, 303 U. S. 118. What was within the manifest intention of the legislative body should be considered as much a part of legislation as what is included in its express terms. Helvering v. New York Trust Co., 292 U. S. 455. And this rulé does not yield to any effort to make the statute bear less heavily upon those subject to its operation.' Helvering v. Stockholms Enskilda Bank, 293 U. S. 84.

This is not to say that a technical construction of the section will fail to sustain respondent’s position in this case, but merely that overlooking the main purpose of the provision so that we permit ourselves to be lost in a maze of detail will more easily result in an erroneous conclusion. The purpose of section 104 clearly was to penalize the intentional avoidance of surtaxes upon individuals by the intervention of corporations. Congressional Becord, vol. 50, part VI, p. 5319. That precise result has been accomplished by the use of this petitioner. Since the conclusion that the section does not reach this case is at war with its evident purpose, only an unmistakable prohibition in the language of the act itself should preclude its application.

Petitioner’s sole stockholder succeeded from 1922 to 1929 in escaping all individual income tax on the earnings of the securities he transferred to petitioner. This was the direct result of the plan disclosed by the present facts. It is not unreasonable to assume that a result so clear and inevitable was also a purpose, at least in the absence of countervailing proof. R. L. Blaffer & Co., 37 B. T. A. 851; affd., 103 Fed. (2d) 487 (C. C. A., 5th Cir.) ; certiorari denied, 308 U. S. 576. He was enabled to accomplish this purpose by three elements in the plan: First, the creation of petitioner; second, the terms of the security transfers; and third, the failure to mesh the corporation’s’accrual method with the individual’s cash basis. Because all three parts of the plan were necessary to enable the shareholder to escape surtax, it does not follow that the corporation was not formed for that inhibited purpose. Its formation was as much an integral and essential part of the scheme as either of the other elements. And because that was not its only purpose it does not follow that the impact of the section is averted. R. L. Blaffer & Co., supra.

Petitioner must, therefore, it seems to me, be regarded as having been formed for the purpose of avoiding the imposition of surtax upon its shareholder, a result which so far brings the situation meticulously within the most technical reading of the first portion of the section. The majority opinion does not take a contrary view, but rejects the conclusion that this was to be done by permitting the gains and profits of petitioner to accumulate instead of being divided or distributed. That depends upon'how we define the words “gains and profits” as used in section 104. There is no express limitation to “net” gains and profits. Whether the provision must be restricted to such net gains in the ordinary and natural application of the section need not be considered. Clearly petitioner here bad gains and profits before it set off against them the corresponding accrued liabilities to its shareholder. It seems obvious that Congress could not have intended the term “gains and profits”, whether net or gross, to mean those resulting from an artificial calculation pursuant to a clever device for frustrating the fundamental purpose of the very provision in which the term appears. Cf. Gregory v. Helvering, 293 U. S. 465. It requires no more penetration than it did in that case to conclude that the organization of petitioner and its accrual of these “expenses” was a mere “disguise for concealing its real character and the sole object and accomplishment of which was the consummation of a preconceived plan * * *. To hold otherwise would be to exalt artifice above reality and to deprive the statutory provision in question of all serious purpose.” (Pp. 469, 470.)

But for the ingenious terms of the contracts there would have been no such accrued “expenses.” Without the accruals there would clearly have been gains and profits in the strictest sense. The contracts pursuant to which petitioner made book entries purporting to offset these gains and profits with “debts” to the shareholder were an integral part of the very scheme by which the shareholder was to avoid surtax. Moreover, these gains and profits were permitted — in fact, under the plan of petitioner’s organization, were required— to be accumulated instead of being divided or distributed. That the ultimate division or distribution — the payment for contributed capital — would be in the bookkeeping form of compensation rather than dividends can not change the actuality of the gains and profits, or the fact of their accumulation. See Foster v. United States, supra. Viewed from the standpoint of reality, this corporation was formed, whether or not it was also availed of, for the very purpose which the intent and a fair construction of the language of section 104 will easily cover. We should not permit a long and roundabout path to lead to a different place from the one to which the straight path would take us. Minnesota Tea Go. v. HeVoering, 302 U. S. 609.

I am of the opinion that respondent properly sought to apply section 104 to this petitioner.

Smith, SteRnhagen, Turner, Arnold, and Harron agree with this dissent.

       See see. 10 of the Revenue Act of 1916, as amended by sec. 1206 (2) of the Revenue Act of 1917 ; sec. 104 (c) of the House BiU of the Revenue Act of 1928.

       See Helvering v. Mitchell, 303 U. S. 391, 405.

         Mead Corporation, 38 B. T. A. 687, 700.

       Petitioner is obviously giving expression to a misconception when it says in its brief: “But there is no proof in this case of minimizing taxes. Thé record shows that with the exception of a small profit in 1923 ($5,264.95) the company had net losses for the first five years of its existence (Exhibit 38). During that same period Munroe’s net income was less than the losses sustained by the corporation (Exhibit 39). It follows, therefore, that if he had made the transactions which were made by the corporation and sustained the same losses, all his income for those years would have been wiped out, and he would have had large net losses to carry forward.”
      The “net losses” to which petitioner refers were those taken for income tax purposes. They were evidently arrived at by deducting from gross income the accrued “liabilities” consisting not only of all of the income received on the securities contributed by Munroe, but of 20 per cent thereof in addition, or of 7 per cent interest on the proceeds of sales. Naturally these accruals could not have been deducted by Monroe if he had been receiving the income and reporting it for tax purposes. And of course the larger the income from these securities and the smaller the petitioner’s income from other sources, the greater would be its net loss, since the receipt of income from that source required it to accrue as a “liability” a greater amount than the income received.
      For example, petitioner’s tax return for the calendar year 1925 shows a gross income of $179,442.17. Of this $114,346.30 is income from interest and dividends and only $14,554.84 is gross profit from its operations. The balance represents capital gains. Against this, in addition to the offsetting deduction for dividends from domestic corporations, it deducted $141,892.99 as “interest.” It was thus enabled to show a “net loss”, but its dividend and interest income was eight times as great as its operating income. If the bulk of this came from the securities contributed by Munroe or their proceeds, which seems certain, it is manifest that Munroe’s net income for 1925 of $32,024.06 would have been augmented three or four times over for surtax purposes if he had retained the securities instead of transferring them to petitioner.

       See Revenue Act, 1928, section 22 (a), where “gains” and “profits” are used in the definition of gross income. Cf. G. B. R. Oil Co., 40 B. T. A. 738 dealing with the term “earnings and profits.”

       See Reynard Corporation, 37 B. T. A. 652, 662.


author: Disney: Turnee,

text:
    Delaware Terminal Corporation, Petitioner, v. Commissioner of Internal Revenue, Respondent.
    Docket No. 86105.
    Promulgated December 20, 1939.

      Hugh Sabterlee, Esq., and I. Herman Slier, Esq., for the petitioner.

      H. D. Thomas, Esq., for the respondent.
   OPINION.

Disney:

In his determination of the deficiency the respondent adjusted the return of petitioner by including therein certain items as taxable income under the provisions of section 104 (c) of the Revenue Act of 1932 and held the resulting net income to be taxable under the provisions of section 104 (a). He contends that the petitioner is and at all times has been a mere holding or investment company, that it permitted its gains or profits during the taxable year to accumulate beyond the reasonable needs of its business, thereby establishing prima facie evidence of a purpose to avoid the surtax. The statutory presumption “does no more than make the taxpayer show his hand”, United Business Corporation of America v. Commissioner, 62 Fed. (2d) 754, and the tax may not be imposed unless the purpose was to prevent the imposition of surtax upon the shareholders of the taxpayer. Cecil B. deMille, 31 B. T. A. 1161; affd., 90 Fed. (2d) 12; certiorari denied, 302 U. S. 713; C. H. Spitzner & Son, Inc., 37 B. T. A. 511. We think we should make findings as to the facts which under section 104 (b) of the Eevenue Act of 1932 constitute prima facie evidence of purpose to escape surtax. Was petitioner a mere holding or investment company ?

The petitioner acquired all of the common stock of Terminal by an exchange of all of its stock for all of the stock of Terminal, and promptly thereafter received a dividend in the amount of $370,000 on Terminal’s stock. The dividend was paid in cash and securities of other corporations. Except for casual sales, petitioner continued to hold the securities.

The dominant purpose for petitioner’s existence in 1932 appears to have been to act as what may be characterized as a financing company for Terminal, and during the taxable year petitioner is not shown to have done anything more than hold the stock of Terminal and receive a dividend therefrom. We should not, we think, consider alone what was done in the taxable year, any more than we should consider alone the charter powers of the corporation. Both elements, and any other evidence material to the point, should be considered. The charter powers were broad, and petitioner had potentialities of acts outside those of a mere holding company, yet, when considered with the obvious object of the petitioner to protect Terminal and its subsidiaries by holding its finances ready for its rescue in case of financial storm and to conceal from some creditors at least the true financial status of Terminal, we come to the conclusion and hold that petitioner was a mere holding company.

Did petitioner permit its gains to accumulate beyond the reasonable needs of its business? The question is one of fact, and the answer can not be found without considering the business needs of Terminal and its subsidiaries.

The record discloses a consistent policy of Terminal to expand its activities and distribute a large part of its earnings to stockholders as dividends. The expansion continued through 1931, during which year 5 new shops were opened for business; 35 shops were opened during the preceding 7 years. Negotiations were conducted at various times for an extension of Terminal’s activities into other fields of the barber business. Terminal and its subsidiaries had built up a surplus of about $950,000 by the close of 1931 and it does not appear that respondent ever questioned the reasonableness of the accumulation for business needs. From 1924 to 1931 investments in improvements and fixtures increased about $500,000 and the investments of earnings in securities increased only about $112,000. During that period about 60 percent of the consolidated net income was paid out in dividends. Dividends were paid in 1932, when Terminal operated at a loss.

In 1932 Terminal’s officers were alarmed about the financial effect that a continuation of the depression would have upon the corporation’s business. There was considerable justification for their pessimism. It was known that net earnings had decreased from $309,000 in 1929 to $146,000 in 1931, and to a net loss' in 1932, notwithstanding the existence of ten more shops in operation; that landlords were not inclined to decrease rents, which was a very heavy item of expense; that there was no absolute certainty that wages being paid barbers, a large portion of the total expense, could be changed to a straight commission basis and, among other things, that Terminal would not be called upon to redeem, in greater volume, preferred stock held by its employees. The annual expense of Terminal was very heavy. Considering the New York corporation only, it had been $1,625,402.54 in 1930, $1,514,184.28 in 1931, and $1,217,978.05 in 1932. The total direct expense of Terminal and its affiliates, consolidated, was much higher. The net amount of money accumulated in the hands of petitioner (after deduction of approximately $50,000 in a dividend almost immectiately paid out) was approximately $320,000. We think that a company which in the course of three years had seen its net earnings decrease from over $300,000 to a small net loss, and decrease by approximately $150,000 during the last year, might very reasonably desire to accumulate funds of $320,000, that amount being a little more than twice the amount of the decrease in the earnings for the past year, and approximately the same amount as the decrease in three years. Had the company’s financial situation continued in the same trend for two years more, the $320,000 would, approximately speaking, have been necessary to repair the situation. Without pointing to other facts disclosing a need for a substantial surplus, we find that Terminal did not at any time accumulate earnings beyond its reasonable business needs. There was no accumulation of earnings current in the taxable year, for it operated at a loss.

What then were the business needs of petitioner ? It was organized to hold funds of Terminal in such a manner as to make them available for reorganization purposes in the event the depression forced Terminal into receivership or bankruptcy proceedings, and other business hazards existing at that time. Under the circumstances, petitioner’s need for accumulating the income for probable future business purposes was equal to Terminal’s requirements prior to the payment. Distribution of all or most of the fund by petitioner as a dividend would have defeated the purposes for its creation and prevented petitioner from protecting the value of the stock it held of Terminal.

The statute does not compel a business to remain static, William C. deMille Productions, Inc., 30 B. T. A. 826, and “a corporation certainly must have the untrammeled right, within reasonable limits, to financially protect itself and its shareholders.” Dill Manufacturing Co., 39 B. T. A. 1023. Terminal’s officers had these objects in mind when the fund was distributed and petitioner accumulated the earnings to perpetuate the plan. Whether creditors of Terminal could have reached the fund to satisfy their claims is not decisive of the question.

The business of Terminal constituted the life work of Schusser. He, and other directors of the corporation, desired to protect the business from the uncertainties of the depression. The amount needed for that protection could not be determined with mathematical certainty. Those most interested in the plan determined upon a specified sum for accumulation and from the facts of record we are, we think, warranted in holding it to not be beyond the reasonable needs of the business.

However, even though we hold that petitioner was a mere holding company, and take such fact and consideration as prima facie evidence of purpose to escape surtax, the respondent can not prevail if there is satisfactory proof that petitioner was not organized or availed of for the prohibited purpose, for “The test is the state of mind of those persons responsible for the formation and operation of the petitioner.” C. H. Spitmer & Son, Inc., supra. We think petitioner has met its burden of establishing that it was not organized or availed of during the taxable year for the purpose of preventing the imposition of surtax upon its shareholders.

No useful purpose would be served by a restatement of all of the evidence on the point. First as to purpose of formation of petitioner: The plan was to form a corporation under the laws of a state other than New York to act as a reservoir for part of the surplus Terminal had accumulated over a period of many years, and to take title to the stock of Terminal’s subsidiaries and its securities to eliminate double taxation. Petitioner was organized and received some of the accumulated earnings of Terminal as a protection to it against business hazards its officers thought existed or might result from the depression. If Terminal had not made the distribution the Commissioner could not have succeeded in applying the provisions of section 104 to its earnings, since the result of operations for the year was a loss, the first one in its history. Petitioner never acquired the stock of Terminal’s subsidiaries, on account of circumstances arising after its formation. In holding the money and securities petitioner was carrying out one of the purposes of its creation, that of protecting Terminal against business hazards. The respondent argues that Terminal would have received the same protection by a distribution directly to its old stockholders, citing Helvering v. National Grocery Co., 304 U. S. 282, and that therefore formation and use of petitioner was unnecessary, demonstrating petitioner to be a mere holding company. That case involved a corporation with a single stockholder. Terminal had nine stockholders, who did not always agree, as is shown by the ouster of Schusser as president. Obviously, segregation of the fund in the hands of petitioner gave Terminal more protection than would have been possible by a pro rata distribution to stockholders as a dividend.

Schusser testified that he did not approve the formation of petitioner for the purpose of preventing the imposition of surtaxes and that during the course of his discussions of the subject with other stockholders of Terminal, the question of Federal taxes was never mentioned. Counsel who handled all of the legal affairs of Terminal for several years prior to and after 1932 under the supervision of Wolff, including the organization of petitioner, testified that in his discussions with Terminal’s stockholders regarding the organization of petitioner nothing was ever said to indicate intent to form petitioner for the prohibited purpose. Terminal’s accountant, who suggested to Wolff as early as March 1931 that a corporation such as petitioner would eliminate blew York taxes on dividends paid by Terminal’s subsidiaries, testified that Wolff did not at any time disclose a purpose to organize petitioner to prevent the imposition of surtax. While testimony of this nature is not determinative of the question, it is important because of its consistency with other evidence. C. H. Spitzner & Son, Inc., supra.

We incline to the view that some of the arguments urged by petitioner as indicative of purpose other than that of avoiding surtax have little weight. Thus an idea of necessity of money for investment in the Thomas System of shops, which was dropped not later than 1930, can not candidly be said to have had any influence on the formation of petitioner in September 1932; there is little or no definite evidence that the idea of investing in the system of Charles of the Kitz, dropped in 1929, revived in 1930 and again dropped, was a factor in mind in the formation of petitioner; and of course the desire to secure rent reductions by presenting less favorable balance sheets to landlords could have been effectuated by distribution of dividends of Terminal to stockholders, equally as effectively as concealing the funds in a new corporation. Yet, when the whole situation is reviewed, we think it plain that the purpose was riot to escape surtax, but rather to escape creditors, landlords, and others, who might, in the depressed times then existent, have seriously threatened the solvency of Terminal, the net income of which in three years had decreased from over $800,000 to a net loss. We can not say that the fears of the parties were so unjustified as to indicate a purpose which is categorically denied. Purpose to escape creditors is one thing; purpose to escape surtax is another. Even if it were admitted that there was a positive plan to convey in fraud of certain creditors, purpose to evade surtax would not follow. Considering all of the evidence on the record, we conclude and hold that the purpose in. the formation of petitioner was not to escape surtax, as interdicted by the language of section 104, Revenue Act of 1932.

Neither are we of the opinion that petitioner was availed of for the prohibited purpose. The charter powers of petitioner were broad enough to finance and otherwise assist Terminal in the manner contemplated by its organizers. It received, by way of a dividend, a fund for that purpose and, with the exception of a comparatively small amount subsequently paid out as a dividend, held it for the remainder of the taxable year subject to such use. Any other use of the money would have been inconsistent with the purpose for which the fund was created. The intent was to preserve the fund, not dissipate or distribute all of it so that it would not be available for Terminal’s activities. The failure of petitioner to use part or all of the money to assist Terminal out of financial difficulties was due to the ability of Terminal to adjust its affairs without outside help. There was reason in 1932 for Terminal’s officers to be alarmed about the effect the depression would continue to have upon its affairs and the need for accumulating the earnings must be judged by conditions existing at that time and reasonably expected to occur in the future, rather than from what actually happened during future years.

We think petitioner has shown that it was not formed or availed of during the taxable year for the purpose of preventing the imposition of surtax upon its shareholders by accumulating its gains and profits instead of dividing or distributing them, and we so hold.

Reviewed by the Board.

Decision will be entered for the fetitioner.

Turnee,

dissenting: In my opinion, the petitioner was both formed and availed of for the purpose of preventing the imposition of surtax upon its shareholders. During the period of its existence up to the time of the formation of the petitioner, Terminal had accumulated a surplus in excess of twice its capital stock liability. It is claimed that this surplus was required by the reasonable needs of its business, the explanation being that due to the depression it might be forced through a reorganization in bankruptcy unless its entire surplus, including the $870,000 distributed to the petitioner, should be retained within reach. On the other hand, it is explained that it was necessary for Terminal to outwardly divorce itself from the said $370,000 before it could convincingly contend with its lessors that it was in sufficiently straitened circumstances to merit the reduction of rents under the various leases. To me the stories do not ring true and are not at all convincing. It is true that Terminal’s net income for 1931 was approximately half of what it had been in 1930 and for several years preceding, but its net income for 1932 was still equal to approximately half of its capital stock liability. It is also true that Terminal sustained a net loss in 1932, but that net loss amounted to only $5,606.02, and, according to the record, that is the only year up to 1937 that it did not earn a net income and in practically every year a very creditable net income for a corporation of its size. Furthermore, after making the distribution to petitioner, Terminal still had at the end of 1932 a surplus of $363,890.20 to stand between it and bankruptcy, the only indication of which so far as the record shows, was the $5,606.02 loss in 1932. In my opinion, the only convincing reason advanced for making the distribution from surplus was that Terminal desired to put itself in a better position to argue for the reduction of rentals. If, however, it distributed such a portion of its accumulated surplus to its stockholders, those stockholders, Schusser in the main, would have been required to pay substantial surtaxes, and, in order to accomplish a reduction of its surplus and at the same time prevent the imposition of surtax on its stockholders, Terminal and its stockholders caused the petitioner to be organized.

For the reasons stated, I respectfully note my dissent.

       (a) If any corporation, however created or organized, is formed or availed of for the purpose of preventing the imposition of the surtax upon its shareholders through the medium of permitting its gains and profits to accumulate instead of being divided or distributed, there shall be levied, collected, and paid for each taxable year upon the net income of such corporation a tax equal to 50 per centum of the amount thereof, which shall be in addition to the tax imposed by section 13 and shall be computed, collected, and paid upon the same basis and in the same manner and subject to the same provisions of law, including penalties, as that tax.

       (b) The fact that any corporation is a mere holding or investment company, or that the gains or profits are permitted to accumulate beyond the reasonable needs of the business, shall be prima facie evidence of a purpose to escape the surtax.


author: Black :

text:
    Sultana Oil Corporation, a Delaware Corporation, Petitioner, v. Commissioner of Internal Revenue, Respondent.
    Docket Nos. 90078, 90079.
    Promulgated December 20, 1939.

      Eugene 'P. Loche, Esq., for the petitioner.

      William A. Schmitt, Esq., for the respondent.
   OPINION.

Black :

Docket No. 90078 involves a deficiency of $2,045.88 in income tax determined by the Commissioner against the petitioner for the year 1934. Part of the deficiency is not contested and has been paid. The remainder is contested by appropriate assignments of error.

Docket No. 90079 involves a deficiency in income tax of $6,851.59 determined against the petitioner as transferee of Sultana Oil Corporation of Louisiana, a dissolved corporation. Part of this deficiency the petitioner does not contest and has paid. The remainder is contested by appropriate assignments of error.

The proceedings have been consolidated and have been submitted upon a stipulation of facts. We adopt the stipulation of facts as our findings of fact and ‘will state only such parts of the facts as seem necessary to an understanding of the issues which are submitted to us for decision.

The petitioner (in both cases, No. 90078 and No. 90079) is a Delaware corporation. It began to transact business on December 1, 1934, and transacted business during the month of December 1934 and during the year 1935 in the State of Louisiana, having its principal office at Shreveport. The Sultana Oil Corporation, a Louisiana corporation, engaged in business in that state prior to December 1,1934, and as of November 30, 1934, transferred its assets to petitioner and was dissolved. Docket No. 90078 involves the income tax liability of petitioner for the short tax period beginning December 1,1934 and ending December 31, 1934. Docket No. 90079 involves the income tax liability of petitioner as transferee of the assets of the said Louisiana corporation for the tax periods ended July 31, 1934, and July 31, 1935 (the latter period, however, actually ending on dissolution of the Louisiana corporation on November 30,1934). The petitioner admits liability under the applicable revenue acts as transferee of the assets of the Louisiana corporation for all amounts which shall be finally determined to be due and owing within the said two tax periods ended July 31, 1934, and July 31,1935, respectively.

We shall first take up and decide the issues involved in Docket No. 90078, income tax liability of the Sultana Oil Corporation of Delaware for the period beginning December 1, 1934, and ending December 31, 1934. In order that we may have a clear understanding of the issues to be decided in that docket the parties have stipulated the following facts:

During the month of December, 1934, and the year 3935, petitioner was engaged in the business of operating and developing oil lands, the drilling of wells and the production of oil generally, as was its predecessor corporation, Sultana Oil Corporation of Louisiana. For the period ended December 31, 1934, the petitioner expended for what is commonly known as intangible drilling and development costs (wages, fuel, supplies, etc.) the sum of $9,438.46. The petitioner elected prior to making its return for the tax period in question, in accordance with Treasury Department regulations, to treat such intangible drilling and development costs as expense deductible within the year in lieu of capitalizing the same. In computing petitioner’s net income for the period ended December 31, 1934, the above mentioned sum of $9,438.46, representing intangible drilling and development costs was deducted from the gross income of the petitioner as an expense, and such deduction has been allowed by respondent in computing petitioner’s income.
During the period ended December 31, 1934, the gross income of the petitioner from oil wells was $31,623.85. The net income before deduction of said sum of $9,438.46 representing intangible drilling and development costs, was $24,317.57. 50% of said amount is $12,158.78. 27%% of said gross income is $8,696.55. In computing petitioner’s net income for the period ended December 31, 1934, the above mentioned sum of $8,696.55 was deducted from gross income as allowance for percentage depletion under Section 114 (b) (3) of the Revenue Act of 1934. Respondent has disallowed such deduction. The difference between the respondent and petitioner in computation of net taxable income for the mentioned period is $8,696.55 and is attributable to the claim of respondent that if the said sum of $9,438.46 representing intangible drilling and development costs is to be deducted from income as expense, then no allowance is to be permitted for percentage depletion under said Section 114 (b) (3). If said sum of $9,438.46 representing intangible drilling and development costs is deducted from gross income in arriving at the 50% of net income limitation on percentage depletion provided by said Section 114 (b) (3), then 50% of net income is $7,439.55 and this figure, instead of the said figure of $8,696.55, would be the correct amount for percentage depletion allowance. The only issues involved in the proceeding for the said tax period are (1) whether the Commissioner erred in failing to allow percentage depletion under Section 114(b) (3), and (2) if he did, whether the said amount of $9,438.46 representing intangible drilling and development costs is deductible from gross income in arriving at the 50% of net income limitation on percentage depletion under said Section 114 (b) (3).

As to issue (1) above we hold that the Commissioner erred in failing to allow petitioner any percentage depletion at all. He seems to have acted upon the assumption in this instance that when once he had allowed petitioner a deduction for intangible drilling costs in determining petitioner’s net income, then no percentage depletion was allowable at all. The respondent’s action in this respect finds no support in the decided cases and, in so far as we can see, finds no support in his own regulations.

Article 23 (m) — 16 of Regulations 86 provides that all expenditures for wages, fuel, repairs, supplies, etc., incident to and necessary for the drilling of wells and the preparation of wells for the production of oil or gas, may at the option of the taxpayer, he deducted from gross income as an expense or charged to capital account.

The facts in the instant case disclose that petitioner has elected to deduct these intangible development costs as an expense and not capitalize them. This it had the right to do under the above cited regulation. The taking of this deduction does not deprive petitioner of the right to percentage depletion.

Article 23 (m) — 4 of Regulations 86 provides for “Computation of depletion based on a percentage of income in the case of oil and gas wells.” This article cites article 23 (m)-l (h) of Regulations 86, which requires that, in determining net income from the property for the purpose of applying the 50 percent limitation applicable to percentage depletion, gross income shall be reduced by, among other things “overhead and operating expenses, development costs properly charged to expense, * * * etc.”

Petitioner at the hearing contended that this latter provision of the regulation was invalid and that petitioner was entitled to have percentage depletion without the $9,438.46 expended for intangible drilling and development costs being deducted from gross income in arriving at the 50 percent of net income limitation on percentage depletion under section 114 (b) (3).

Petitioner relies upon Wilshire Oil Co., 35 B. T. A. 450; affd. (C. C. A., 9th Cir.), 95 Fed. (2d) 971. Since the instant case was submitted the Supreme Court of the United States has reversed the Wilshire Oil Oo. case and has held that for the purpose of limitation on percentage depletion to 50 percent of net income from oil property, such net income must be reduced by development expenditures deducted in computing taxable net income. See Helvering v. Wilshire Oil Co., 308 U. S. 90. Therefore we hold (1) that the Commissioner erred in failing to allow petitioner a deduction for percentage depletion under section 114 (b) (3), and (2) that in accordance with the Supreme Court’s decision in the Wilshire Oil Co. case, the $9,438.46, representing intangible drilling and development costs is deductible from gross income in arriving at the 50 percent of net income limitation on percentage depletion under section 114 (b) (3).

¿Sultana OH Corporation of Louisiana, Fiscal Year Ended July 31, 1931.

We shall next consider the tax liability of the Sultana Oil Corporation of Louisiana for the fiscal year ended July 31, 1934. In order that we may clearly decide the issues presented for this period, the parties have stipulated as follows:

For the taxable period ended July 31, 1934, the Sultana Oil Corporation of Louisiana (transferor) expended for what is commonly known as intangible drilling and development costs the sum of $17,736.84. The taxpayer (Louisiana corporation, transferor) elected prior to making its return for the tax period in question, in accordance with Treasury Department regulations, to treat such intangible drilling and development costs as expense deductible within the year in lieu of capitalizing the same. In computing said corporation’s net income for the period ended July 31,1934, the above mentioned sum of $17,736.84 representing intangible drilling and development costs was deducted from gross income of the taxpayer as an expense. But said deduction has been disallowed by respondent in computing that taxpayer’s net income.
During the period ended July 31, 1934, the gross income of that taxpayer from oil wells was $72,924.25. The net income before deduction of said sum of $17,736.84 representing intangible drilling and development costs was $55,710.51. 50% of said amount is $27,855.25. 27%% of said gross income is $20,054.16. In computing said corporation’s net taxable income for the period ended July 31, 1934, the above mentioned sum of $20,054.16 was deducted as allowable depletion under Section 114 (b) (3) of the Revenue Act of 1932, and said deduction has been allowed by respondent in computing the taxpayer’s net income. The difference between respondent and petitioner in computation of net taxable income for the period ended July 31, 1934, is $17,736.84, representing intangible drilling and development costs, and is attributable to the claim of respondent that such intangible drilling and development costs are not duductible from income if allowance of said sum of $20,054.16 is permitted for depletion under said Section 114 (b)(3). If the said sum of $17,736.84 representing intangible drilling and development costs is deducted from gross income in arriving at the 50% of net income limitation on percentage depletion provided by said Section 114 (b) (3) then 50% of net income is $18,736.84 and this figure, instead of the said figure of $20,054.16, would be the correct amount for percentage depletion allowance. The only issues involved in the proceeding for the said tax period are (1) whether the Commissioner erred in failing to allow deduction of intangible drilling and development costs from gross income and (2) if he did, whether the said amount of $17,736.84 representing intangible drilling and development costs is deductible from gross income in arriving at the 50% of net income limitation on percentage depletion under said Section 114 (b) (3).

For reasons stated in our discussion of the tax liability of the Sultana Oil Corporation of Delaware, above, we hold (1) that the Commissioner erred in failing to allow deduction of intangible drilling and development costs of $17,736.84 from gross income; and (2) that the said amount of $17,736.84 representing intangible drilling and development costs is deductible from gross income in arriving at the 50 percent of net income limitation on percentage depletion under said section 114 (b) (3).

Sultana Oil Corporation of Louisiana, Fiscal Ymr Ended July SI, 19S5.

In order that we may have an understanding of the issues to be decided in determining the income tax liability of the Sultana Oil Corporation of Louisiana for the fiscal year ended July 31, 1935, the parties have stipulated as follows:

ITor the taxable period ended July 31, 1935, Sultana Oil Corporation of Louisiana (transferor) expended for what is commonly known as intangible drilling and development costs tlie sum of $26,083.42. The taxpayer (Louisiana corporation, transferor) elected prior to making its return for the tax period in question, in accordance with Treasury Department regulations, to treat such intangible drilling and development costs as expense deductible within the year in lieu of capitalizing same. In computing said corporation’s net income for the period ended July 31,1935, the above mentioned sum of $26)083.42 representing intangible drilling and development costs, was deducted from gross income of the taxpayer as an expense, and said deduction has been allowed by respondent in computing that taxpayer’s net income.
During the period ended July 31, 1935, the gross income of that taxpayer from oil wells was $49,542.90. The net income before deduction of said sum of $26,083.42 representing intangible drilling and development costs, was $39,314.58. 50% of said amount is $19,657.29. 27%% of said gross income is $13,624.29. In computing said corporation’s net income for the period ended July 31, 1935, the above mentioned sum of $13,624.29 was deducted from gross income as allowance for percentage depletion under Section 114 (b) (3) of the Revenue Act of 1934. Respondent has disallowed such deduction. The difference between petitioner and respondent in computation of net taxable income for the above mentioned period is $13,624.29 and is attributable to the claim of respondent that no percentage depletion allowance under Section 114 (b) (3) is to be permitted if deduction for intangible drilling and development costs is permitted. If said sum of $26,083.42 representing intangible drilling and development costs is deducted from gross income in arriving at the 50% of net income limitation on percentage depletion provided by said Section 114 (b) (3) then 50% of net income is $6,615.58, and this figure, instead of the said figure of $13,624.29, would be the correct amount for percentage depletion allowance. The only issues involved in the proceeding for said tax period are (1) whether the Commissioner erred in failing to allow percentage depletion under Section 114 (b) (3), and (2) if he did, whether the said amount of $26,083.42 representing intangible drilling and development costs is deductible from gross income in arriving at the 50% of net income limitation on percentage depletion under said Section 114 (b) (3).

For the reasons stated in our discussion under the Sultana Q.il Corporation of Delaware, above, we hold (1) that the Commissioner erred in failing to allow percentage depletion under section 114 (b) (3); and (2) that the said sum of $26,083.42 representing intangible drilling and development costs is deductible from gross income in arriving at the 50 percent of net income limitation on percentage depletion under said section 114 (b) (3).

Decision wül be entered wnder Bule 50.