author: Van Fossan :

text:
    Boston Elevated Railway Company, Petitioner, v. Commissioner of Internal Revenue, Respondent.
    Docket Nos. 76751, 77244.
    Promulgated March 22, 1938.

      Charles W. Mulcahy, Esq., and Ward Loveless, Esq., for the petitioner.

      Bruce A. Low, Esq., Warren W. Cole, Esq., and L. H. Rushbrooh, Esq., for the respondent.
   OPINION.

Van Fossan :

The first and controlling issue is whether, under the above facts, petitioner should, as contended by it, return its income in the normal way, usual to corporations, by listing all items of gross income and deducting therefrom the deductions allowed by statute, paying tax on the net income so determined, or should, as contended by respondent, return as gross income the amount of the dividends paid to its stockholders, plus the Federal tax thereon and minus certain deductions, paying tax on the net of such computation, as provided in article 70 of Regulations 74 and Regulations 77, entitled “Income to lessor corporation from leased property.”

The basic predicate of article 70 of Regulations 74 and Regulations 77 is “where a corporation has leased its property in consideration that the lessee shall pay in lieu of other rental an amount equivalent to a certain rate of dividend on the lessor’s capital stock * * * such payments shall be considered rental payments and shall be returned by the lessor corporation as income”, etc. Here the Commissioner ruled that “the taking over of the properties of the Boston Elevated Railway Company was, in effect, a direct lease of these properties and assets to the Commonwealth of Massachusetts in consideration for the payment of a fixed annual rental * * * in the form of dividends on the capital stock * * Obviously petitioner had not leased its property to the commonwealth in the ordinary sense of that term. Was the Commissioner correct in holding that the relationship, “in effect”, was that of lease?

The commonwealth, through its legislative body, established an elaborate system whereby the railway properties of petitioner were to be kept in operation for the benefit of the public. The Public Control Act, designed to carry out the plan, provided for the appointment of a board of trustees to assume that duty and take charge of petitioner’s property. Their function was to “manage and operate” the petitioner’s railway and other properties. The petitioner consented to the plan.

The board was given the broad and unusual powers to regulate and fix rates and also to cooperate with the treasurer and receiver-general of the commonwealth in equalizing the cost of service with operating receipts, by means of assessments against the cities and towns served by the company’s lines. Thus, it acted in a dual capacity — as a manager and as a rate-fixing board. But it is in relation to the former capacity that questions of income must be decided.

In so far as the taxable income received by petitioner is concerned, the board of trustees acted in the capacity of a managing agent. The board conducted the petitioner’s affairs just as a corporation, individual, or any other entity designated for that purpose might have done. In this respect it served as a substitute to carry on the functions normally performed by the petitioner itself.

In section 2 of the Public Control Act the status of the board of trustees was specifically set forth. The trustees and their agents and employees were “deemed to be acting as the agents of the company and not of the Commonwealth.” In its acts involved in the operation of the railway system and hence in the production of income, the board thus was designated as the agent of the petitioner. The issue is not confused nor is it controlled by the fact that the trustees also represented the people of the commonwealth and that in one sense the properties were operated by the commonwealth. See Helvering v. Powers, 293 U. S. 214. The consideration of their undertaking and managing of the petitioner’s affairs was the continuation of the operation of the railway as a public utility for the benefit of the citizens who were dependent on its lines for transportation, but, by the express terms of the act creating the board of trustees and defining their duties and powers, the corporate entity of the petitioner was preserved. The property remained in private ownership. Helvering v. Powers, supra. All business transactions were carried on in the name of the corporation, including making contracts, paying bills, receiving and banking operating revenues, and all other acts normal to the conduct of its business. By specific provision of the act the compensation of the trustees was paid by the company.

In various cases, the Public Control Act has been construed by different courts on points directly related to the issue before us. In Boston Elevated Railway Co. v. Melley, 24 Fed. (2d) 758, the petitioner asked for a refund of capital stock tax on the ground that under the leased road theory it was not taxable. There, the court (in 1928) said:

The rather complicated arrangement under which the public tools: over the management and operation of the Boston Elevated Railway Company under Sp. Acts 1918, c. 159, has been fully and authoritatively described (see Opinion of the Justices to the Senate, 231 Mass. 607, 122 N. E. 763; Boston v. Treasurer of the Commonwealth, 237 Mass. 403, 130 N. E. 390; Id., 260 U. S. 309, 43 S. Ct 129, 67 L. Ed. 274; Opinion of the Attorneys General of Massachusetts 1919, p. 20; Opinions of the Justices to the Legislature (Mass.) 159 N. E. 55, 70, November 22, 1927; Boston Elevated Railway v. Malley, (D. C. 288 F. 864) ; and it is not necessary to restate it here. The gist of it is that the company, in return for payments and guaranties by the commonwealth, abdicated its right to manage its property and affairs in favor of public trustees appointed by the Governor. The business was still conducted in the name of the compauy, and all contracts for labor and supplies relating to the operation of its railway were made in its name. It continued to be liable in contract and in tort, as it had previously been. The special act expressly provided that the trustees “shall be deemed to be acting as agents of the company and not of the commonwealth.”
The basic facts leave but slight ground for the plaintiff’s contention. An elaborate and ingenious argument has been made on its behalf based largely upon the use of the words “lease” and “take over” by the Supreme Judicial Court in describing the relations between the company and the commonwealth. 231 Mass. 607, 609, 122 N. E. 763. See, too, Opinion of the Justices of November 22, 1927 (Mass.) 159 N. E. 55. With respect to this terminology, Judge Peters observed: “It is not profitable to discuss whether the term ‘lease’ is properly descriptive of the legislative contract.” Boston Elevated Railway v. Malley (D. C.) 288 F. 864, 870. It is the essential character of the arrangement as gathered from the special act and the opinions and decisions above cited, rather than the expressions used to describe it, upon which the present question turns. * * *

In Boston Elevated Railway Co. v. White (not reported), the precise issue here presented was decided in favor of the petitioner by the United States District Court for the District of Massachusetts and no appeal was taken from that decision. In that case the petitioner sued for a refund of Federal income tax paid for the year 1930 on the leased road basis. There, the court (in 1934) said:

The defendant contends that the relation between the plaintiff and the Public Trustees of the Boston Elevated Railway Company was in effect that of lessor and lessee for the purpose of the Federal income tax. Assuming, for the purposes of this case, but by no means deciding that this is so, the tax was not legally collectable.
The Treasury Regulation providing that where a corporation leases its property in consideration that the lessee shall pay in lieu of other rental an amount equivalent to a certain rate of dividend on the lessor’s capital stock, such payments shall be considered rental payments and shall be returned by the lessor corporation as income, notwithstanding the fact that the dividends are paid by the lessee directly to the stockholders of the lessor, is not applicable. The dividends received by the stockholders in the case at bar were in no sense received from the Public Trustees or from the Commonwealth. The amount of such dividends paid by the plaintiff cannot be regarded as income received by it.

We are of the opinion that respondent was in error in his holding that the taking over of these properties “was, in effect, a direct lease of these properties” to the Commonwealth.

It may be added that nothing has come to our attention that leads us to believe that the employment of the fiction that the relationship between the petitioner and the commonwealth was that of lessor and lessee would more accurately reflect petitioner’s income. In this respect the instant case bears some resemblance to Cleveland Railway Co., 10 B. T. A. 310; affirmed in part, 36 Fed. (2d) 347, albeit in that case the position of the parties and their respective contentions were exactly reversed.

In the Cleveland Railway Co. case, consequent on financial difficulties experienced by the railway system, a plan of operation known as the “Taylor plan” was adopted, under which transportation was to be furnished at cost of service. This cost of service included “operating and maintenance costs fixed by the City of Cleveland on a car-mile basis, interest on bonded and floating indebtedness and a return to the stockholders of 6 per cent on the outstanding capital stock. In fixing a return of 6 per cent it was provided that this would be paid in quarterly amounts and would not be dependent upon the earnings of the petitioner, but regardless of the amount earned, the return to the stockholders could not exceed 6 per cent.” A fund of $500,000 known as the “interest fund” was established by the company, into which all earnings in excess of certain stated expenses were to go, and out of which certain payments were to be made, the fund being calculated to serve as a barometer to determine when and how the rate of fare was to be changed.

For several years the Cleveland Co. filed returns in the form and manner normal to corporations but in the taxable years returned as its net income the amount of money paid as the 6 percent return to its stockholders plus the certain taxes of the previous year. The Commissioner treated the gross amount received from car riders, less the usual statutory deductions, as the taxable income of the company and determined deficiencies accordingly. At the hearing the Commissioner contended that the taxpayer’s net income should be determined in the ordinary way, namely, by treating as receipts all gross income and deducting therefrom those deductions allowed by statute, and that the remainder should be taxed as income, irrespective of whether the net income so determined exceeded or was less than the 6 percent permitted and guaranteed to its stockholders.

Discussing petitioner’s contention that the net income of a given year may not reflect the exact status of the taxpayer, the Board held that “when viewed in the light of the statute * * * the petitioner’s position is untenable.” We said further, the fact “that the petitioner would not object to being taxed on more income than is earned in the dean years’ does not make taxable income that which is not taxable income under the statute.” Specifically, we held “that the contentions of the petitioner for a limitation of its taxable income to a-6 per cent return on its outstanding capital stock, without regard to the income earned, as defined by statute, must be denied.”

In the case at bar the parties are in exactly the opposite positions. The taxpayer is contending for the right to return its income in the normal manner. The Commissioner is urging the unusual. Under the facts here present, we believe petitioner is right.

The second issue presents the question whether the-payment of $1,775,388.80 made to the petitioner by the commonwealth in 1932 was an advance or loan or was a part of the petitioner’s gross income.

The Public Control Act provided that a reserve fund of $1,000,000 should be set up for the purpose of making good any deficiency in the petitioner’s income and, conversely, if its income were more than sufficient to meet the cost of service, the excess should be added to the reserve fund. The act as amended also provided that if the reserve fund was insufficient to meet any deficiency the commonwealth would pay over to the company the necessary amount to meet it. On June 30, 1932, the cost of service exceeded the petitioner’s income by $1,775,338.80. The reserve fund had been exhausted and on July 15, 1932, the commonwealth paid that amount to the petitioner. The petitioner contends that the amount so paid was an advance or loan to it which it was required to repay under section 11, which reads as follows:

If as of the last day of any June thereafter during the period of public operation the reserve fund shall exceed the amount originally established, the trustees shall apply the excess so far as necessary to reimbursing the commonwealth for any amounts which it may have paid to the company under the provisions hereof.

The respondent maintains that the sum so paid is properly includible in the petitioner’s gross income.

The petitioner’s books reflect its position that the payment by the commonwealth was an advance or loan and that payments to the commonwealth were designated and treated as “repayments.”

The petitioner relies on the principle set forth in Island Petroleum Co. v. Commissioner, 57 Fed. (2d) 992; certiorari denied, 287 U. S. 646; affirming 17 B. T. A. 1. In that case the petitioner paid to several corporations certain amounts which were to be repaid from the proceeds of the operation of those companies and which the petitioner would lose only if the operation were ultimately unsuccessful. Such payments were held to be loans. The court there said:

In the event of success it was to receive back the amount it had advanced plus its portion of the net profits. The advances were, therefore, loans which the Texas corporations would repay if successful. If they were unsuccessful, they would have nothing to pay with and the loss would fall upon petitioner.
It is immaterial that there was no express agreement on the part of the Texas corporations to repay the moneys advanced. Not only was such agreement implied in the agreement that only the net profits of the various enterprises were to be divided among the stockholders, but a promise to repay moneys laid out and expended for the use and benefit of another and at his request is implied in law. * * * Here the expenditures were made for the use and benefit of the Texas corporations and upon an agreement made in their behalf. And it makes no difference in the result, if we construe the agreement as requiring repayment by the Texas corporations only in the event that their operations should prove successful. A loan is no less a loan because its repayment is made contingent.

It is well settled that when a taxpayer makes expenditures under an agreement that he will be reimbursed therefor, such expenditures are in the nature of advancements and are not deductible as business expenses. Glendinning, McLeish & Co., 24 B. T. A. 518; affd., 61 Fed. (2d) 950; Henry F. Cochrane, 28 B. T. A. 202; George M. Cohan, 11 B. T. A. 743; George F. Baker, Jr., Executor, 28 B. T. A. 104; affd., 80 Fed. (2d) 813. By parity of reasoning payments so conditioned would not be income to the recipient.

The terms employed by the statute characterize definitely the nature of the payment and repayments to and from the commonwealth and the petitioner. When the reserve fund exceeds the $1,000,000 originally established, the excess shall be applied to “reimburse” the commonwealth, (sec. 11, Public Control Act) and the special trust fund remaining after the retirement of the second preferred stock shall be used to “repay” to the commonwealth all amounts previously assessed but not “repaid” under the Public Control Act (sec. 23, Acts 1921).

It is thus apparent that by the very language of the acts which form the agreement between the petitioner and the commonwealth both parties thereto understood and agreed that the payments back and forth through the reserve fund were advances and repayments as the profitable or unprofitable operation of the railway dictated. The sum of $1,175,338.80, therefore, was not income taxable to the petitioner in 1932.

The cases cited by the respondent involve no obligation of repayment and, therefore, are not in point.

The determination of the second issue automatically disposes of the third issue. No deduction of the item of $1,409,253.35 is allowable.

The fourth issue relates to the deductibility of an item paid by the petitioner to its preferred stockholders. The sum of $156,206.11 was paid as interest on the amounts due to stockholders in payment for their preferred stock, from July 1, 1931, the effective date of the act, to August 18,1931, the date fixed by the trustees for the surrender and cancellation of the stock under section 9 of chapter 333, Acts 1931.

That section states unequivocally that after the effective date of the act “dividends upon all classes of preferred stock of the company shall cease.” The act, in effect, changed the status of preferred stockholders on July 1, 1931, from shareholders in the petitioner corporation to creditors of it. After that date they had the right only to surrender their stock and to receive therefor various amounts fixed by the statute, together with dividends on their stock to July 1, 1931. The trustees were given a reasonable time in which to redeem the stock certificates and pay the debt so created by the act.

In obvious recognition of the character of the payments so to be made, the act makes a sharp and clear distinction between the stock prior to July 1, 1931, and the right of the stockholders to payment therefor, by providing that “interest at the rate of 5 per cent per annum from the date dividends cease” shall be paid to the petitioner’s former stockholders. It imposed upon the petitioner the definite corporate liability to pay a fixed rate of interest on such principal indebtedness remaining unpaid after that date. The conclusion is inescapable that the $156,206.11 paid as interest thereon is an allowable deduction for the year 1931.

A brief resume of the facts relating to the establishment and treatment of the special trust fund is necessary for a clear understanding of the question raised by the fifth issue.

Under the provisions of chapter 740, Statutes 1911, the petitioner and West End were consolidated, to take effect June 10, 1922. The form of the acquisition of the West End assets by the petitioner was deemed a purchase and sale. The petitioner purchased the property, privileges, and franchises of West End in exchange for its own capital stock equal at par to the par value of the outstanding West End stock. West End thereupon distributed the petitioner’s stock so received to its stockholders in accordance with their ownership of common and preferred stock.

In addition, the petitioner purchased the real estate of West End, not required in the railway business, for slightly over $1,500,000. The act required that the proceeds of the sale not to exceed $1,500,000 should be set aside by petitioner as a special trust fund the income of which should be used to retire the petitioner’s second preferred stock issued to West End and distributed by it to its stockholders. The special trust fund was established to insure the redemption and retirement of such stock and after that should be accomplished (or its conversion into common stock, an alternative offered by the statute) the petitioner could use the fund and its accumulations for any purpose for which its stocks and bonds could legally be used. The act further provided that on June 10,1922, the petitioner should assume all of West End liabilities and indebtedness and succeed to all of its rights.

Pursuant to the act, the nonbusiness real estate was purchased for $1,500,000 cash and the special trust fund was set up on July 18, 1913. The fund was held by the petitioner as trustee until June 10, 1922, when, with accumulations from income amounting to $707,342.17, it was taken over as property of the petitioner under the terms of the statute. Appropriate entries reflecting such acts were made on the petitioner’s books.

Chapter 333, Acts 1931, changed the method of retirement of petitioner’s second preferred stock held by former West End stockholders by authorizing the issuance of bonds, not exceeding $30,000,000 in amount, to cover the retirement of all existing preferred stocks of the petitioner. The only effect of this act in this respect was to release the special trust fund from the prior restriction and limitation of its use to the retirement of the second preferred stock.

Chapter 333 also voided, for the year 1931 only, the use of the reserve fund and payments from and to the commonwealth as established pursuant to sections 5, 8, and 9 of the Public Control Act. It likewise compelled the petitioner to repay to the commonwealth from the special trust fund the amount of $1,409,253.35 previously advanced by the commonwealth (secs. 22 and 23).

After the payment of the $1,409,253.35 on August 19, 1931, there remained in the special trust fund $823,753.95, which the respondent contends thereupon became income to the petitioner. That balance was divided and reassigned to the petitioner’s other accounts to which the items properly related. Of the balance of $823,753.95 but $83,844.59 represented profit earned in the taxable year, which amount, it was stipulated, has already been considered in computing the petitioner’s income on the “operating road” basis. In so far as the remainder of the fund represented accumulated profits of the fund they were earned in years prior to the taxable year, and accordingly should not be included in income for the taxable year. Earnings become income when they are received, not when they are distributed. Cleveland Railway Co. v. Commissioner, 36 Fed. (2d) 347. The removal of the restriction on the use of the fund in 1931 did not have the effect of converting accumulated profits from prior years, on which presumptively the tax had been paid, into income of the taxable year. Except as to the $83,844.59 earned in the taxable year, the fund represented a capital asset of petitioner. The smn of $83,844.59 representing profit derived from the. use of the fund in 1931 was a proper item of income and has been so treated.

In the last issue respondent avers affirmatively that, in the event the Board determines that petitioner should report its income on the normal corporate basis as an operating company, such income should be returned on the basis of a fiscal year ended June 30 of each year. On this issue respondent has the burden of proof.

We find no evidence that leads ns to conclude that petitioner’s income will not be accurately reflected if reported on a calendar year basis. Petitioner made its return on the basis of the calendar year. It may be called to attention that the parties have stipulated, without apparent difficulty, the precise amount of petitioner’s income under both the “operating road” and “leased road” theories and both on the calendar year basis. In any event, the proof of record falls far short of sustaining respondent’s contention. Such evidence as we have and all reasonable inferences tend to support petitioner on the issue.

Reviewed by the Board.

Decision will be entered v/nder Rule SO.

Leech, Arnold, and Disnet concur only in the result.

       Art. 70. Income to lessor corporation from leased property. — Where a corporation has leased its property in consideration that the lessee shall pay in lieu of other rental an amount equivalent to a certain rate of dividend on the lessor’s capital stock or the interest on the lessor’s outstanding indebtedness, together with taxes, insurance, or other fixed charges, such payments shall be considered rental payments and shall be returned by the lessor corporation as income, notwithstanding the fact that the dividends and interest are paid .by the lessee directly.to the shareholders and bondholders of the lessor. The fact that a corporation has conveyed or let its property and has parted with its management and control, or has ceased to engage in the business for which it was originally organized, will not relieve it from liability to the tax. While the payments made by the lessee directly to the bondholders or shareholders of the lessor are rentals as to both the lessee and lessor (rentals paid in one case and rentals received in the other), to the bondholders and the shareholders such amounts are interest and dividend payments received as from the lessor and as such shall be accounted for in their returns. [Article 70 of Regulations 77 is identical.]


source: Caselaw Access Project

author: Murdock: Habeon,

license: Public Domain

text:
    C. H. Spitzner & Son, Inc., Petitioner, v. Commissioner of Internal Revenue, Respondent.
    Docket No. 80744.
    Promulgated. March 22, 1938.

      J. Marvin Haynes, Esq., for the petitioner.

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

Murdock:

Section 104 is entitled “Accumulation of Surplus to Evade Surtaxes.” The provisions of the section impose a tax of 50 percent of the net income of the corporation. That tax is in addition to the tax imposed by section 13, and the net income includes divi-(lends and interest oil certain obligations of the United States, which items are not normally taxed to corporations but are subject to tax in the hands of an individual owner. The following quotations are from paragraphs (a) and (b) of the section:

(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, * * *
(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.

The Commissioner has held that the petitioner is liable under section 104. In such cases he sometimes makes a categorical determination under (b). Here he has not made a categorical determination that the petitioner is a mere holding or investment company, or that its gains or profits have been permitted to accumulate beyond the reasonable needs of the business. Nevertheless, we shall consider whether or not (b) applies. The facts show conclusively that the petitioner was not a mere holding or investment company. It regularly carried on a business. It did nothing else. The character of the business was quite different from that of a mere holding or investment company. Furthermore, the fact that the gains or profits were not permitted to accumulate beyond the reasonable needs of the business is clear from the record. The Commissioner has made his determination on the basis of conditions as they existed at the close of the taxable year. The books of the corporation at the close of 1932 showed a surplus of $318.12. The corporation, in computing that surplus, valued its securities and fixed assets at market. The Commissioner does not contend that the values used by the petitioner were other than the correct fair market values of the assets in question. It had followed the practice of inventorying those assets at market during its entire existence, and for all purposes other than the computation of its taxable net income. However, it was not allowed to use inventories of those assets in computing its taxable net income and it did not use the inventories for that purpose, but used cost. Sec. 22 (c); ^Regulation 77, art. 105. The Commissioner, by using the cost of the securities and the cost less depreciation of the fixed assets, has computed a surplus of somewhat more than $2,00(3,000 at the close of 1932. It is unnecessary, for the purpose of paragraph (b), to determine whether or not a surplus of that amount was “beyond the reasonable needs of the business”, since no such surplus was available for the needs of the business. The paragraph sets up a practical test rather than a theoretical one. Was there an accumulation “beyond the reasonable needs of the business ?” The assets would be useful to tbe business only to tbe extent of their actual market values. The fact that they cost a greater amount would not benefit tbe business. Thus the surplus based upon cost, as computed by the Commissioner, was not available for the reasonable needs of the business. It did not actually exist and could not have been used in the business. Business men and bankers, worthy of those names, would not have regarded it as a surplus. The accumulation of surplus which the petitioner actually had for use in the business amounted to only $318.12. That small surplus did not represent an accumulation of gains or profits beyond the reasonable needs of the business within the meaning of paragraph (b).

Nevertheless the Commissioner has determined that section 104 applies. He has wiped out the net loss for the year by adding dividends and a relatively small amount of interest from Government obligations, which are only taxable to the petitioner in case section 104 applies. The Board must decide whether or not the petitioner was formed or availed of in 1932 for the purpose of preventing the imposition of the surtax upon its shareholders through the medium of permitting its gains or profits to accumulate instead of being divided or distributed. The determination of the Commissioner is presumed to be correct, and the petitioner was required “to show its hand.” United Business Corporation of America v. Commissioner, 62 Fed. (2d) 754; certiorari denied, 290 U. S. 635. It has made what appears to be a complete disclosure of the facts. The test is the state of mind of those persons responsible for the formation and operation of the petitioner. United Business Corporation of America v. Commissioner, supra. Even though the effect of the formation and operation of the corporation may have been to avoid surtaxes, still section 104 does not apply unless the purpose, the intention of the participants, was to prevent the imposition of surtaxes upon themselves by permitting the gains and profits of the corporation to accumulate instead of distributing them. Cecil B. De Mille, 31 B. T. A. 1161; affd., 90 Fed. (2d) 12; certiorari denied, 302 U. S. 713.

Counsel for the respondent argue in brief that this corporation was formed for the purpose mentioned in section 104 (a). In order to reach that conclusion they have to argue that the testimony of the principal witness should be disbelieved. They point to the fact that the two partners paid in dividend-bearing securities, and to certain other circumstances. Self-serving declarations of interested witnesses are not necessarily determinative. Yet such testimony can not be waved aside merely because of its character. If it comes from witnesses who are impressive, if it is reasonable, if it is not inconsistent with other evidence) in the case, and if it is corroborated by other evidence, it is important evidence. The reasons for the incorporation. of this petitioner at the close of 1920 are clear from the testimony of Kienbusch, and they were wholly unrelated to a purpose of preventing the imposition of a surtax upon shareholders.

Kienbusch had been active in the business for a number of years. He had become an equal partner with Spitzner. A large part of the responsibility for the successful conduct of the business rested upon him. His entire fortune of about $1,000,000 was risked in the business as long as the partnership continued. He wanted to limit his liability from the business. He was apprehensive about the health of his partner. That partner had contributed about two-thirds of the capital of the partnership. Kienbusch realized that in case of Spitzner’s death his personal representatives, in a proper administration of his estate, would probably withdraw his property from the hazardous business of the partnership. Kienbusch, having all of these things in mind, sought to organize the corporation. Spitzner opposed the change, largely for sentimental reasons, but finally succumbed to his partner’s persistent urging. The petitioner was formed and thus the purposes which Kienbusch had in mind were accomplished, i. e., to limit his liability and to remove the danger of liquidation which might result from the death of Spitzner. Kienbusch testified that tax benefits were not considered or discussed and the evidence corroborates his statement. Therefore, we have no hesitation in concluding that section 104 may not be invoked by reason of the purpose leading to the formation of the petitioner.

A somewhat more difficult question is whether the petitioner was mailed of during the year 1982 for the purpose described in section 104. Although the petitioner sustained a loss from the operation of its business in that year, it had gains and profits in the form of dividends and interest from its securities, and it permitted those to accumulate, instead of dividing or distributing them. Had the individual stockholders owned those securities during 1932, those gains would have been subject to surtaxes in their hands and, obviously, the intervention of the corporation prevented the imposition of surtaxes upon the shareholders. But the same would be true of any corporation which received any dividends. Yet Congress did not intend to impose the severe penalty of section 104 upon all such corporations. For example, the provisions of that section were never intended to apply to a corporation which limited its activities to some branch of agriculture, manufacture, or merchandising and made normal distributions. United Business Corporation of America, 19 B. T. A. 809; affd., 62 Fed. (2d) 754. However, the stockholders of that kind of a corporation might bring their corporation under the lash of section 104 by diverting it from its normal business activities and intentionally using it during any taxable year for the purpose of preventing the imposition of surtax upon themselves through the medium of permitting its gains and profits to accumulate instead of being divided. The question here narrows to this, Does the fact that the petitioner accumulated its tax exempt gains from dividends and interest, instead of distributing them, show a purpose on the part of its shareholders to prevent the imposition of the surtax upon themselves ?

The incorporators of the petitioner believed, when they organized it, that it would need capital of at least $4,000,000 to successfully conduct its tobacco business. Kienbusch contributed as much as he could. Although their interests in the partnership had been equal, and although Kienbusch wanted his interest in the corporation to be as near a 50 percent interest as he could make it, nevertheless Spitzner also contributed over $100,000 to the business just before the formation of the corporation. The property contributed by Kienbusch had previously been held as collateral for a loan used in the business. Earnings of the first year were capitalized in order to give the corporation $4,000,000 capital. These and other circumstances indicate that the stockholders believed that $4,000,000 was needed in the business. That amount was used during 1922. The actual capital available for use in the business in 1932 was still approximately $4,000,000.

The business of the corporation in 1932 was not what it had been in 1922. It had fallen off very badly. But the petitioner never slackened its efforts to make a success of the tobacco business. Kien-busch, in his testimony, gave what he regarded as the principal reasons for the decline in sales and profits. The factors upon which he blamed the slump were of a temporary character, and he expressed confidence that the business would recover, would again have gross sales of $3,000,000, and would again need all of its available funds. The opinions which he expressed as to the future possibilities and needs of the business were honestly held by him and were not unreasonable. The respondent says he was an “incorrigible optimist.” He may have been, but, if so, his optimism rather negatives the purpose described in section 104. All of the assets, including all gains and profits accumulated up to the end of 1982, woxdd bo necessary and desirable for the successful conduct of the business in case it should again expand to a volume equivalent’ to that of 1922.

Certainly there was good reason for the failure of the corporation to declare any dividend in 1932. Operations were conducted at a loss in that year and in prior years. The value of the assets had materially declined. The officers hoped and expected to continue in business. Capital available for business purposes would have been impaired by any distribution at that time. The financial standing of the petitioner during the trying times through which it was passing was precarious. The addition of any avoidable strain would have been unwise. The failure to declare dividends in 1932 may not fairly be taken as an indication of a purpose on the part of the shareholders to avoid surtaxes.

The amount of the investment of this corporation in securities had grown tremendously from its early days up to the period here involved. But the reason for that change is also satisfactorily explained in this record. As the business of the corporation declined, a smaller and smaller portion of its capital was used for operating purposes. Common sense required that the inactive funds be employed as profitably as they might be. So it is not surprising that they were invested in income producing securities. The corporation had to be ready at all times to take full advantage of a good crop and of any increased demand for its products due to a return of better times. The investments were generally in high grade, listed securities. The assets were thus retained in as liquid form as could be, ready for prompt use in the business either as collateral or by conversion into cash when, as, and if the part of that business which had been lost was recovered.

The books of the corporation at the close of 1931 showed a surplus of $179,868.92, and at the close of prior years showed surpluses in much larger amounts. The question of whether or not the corporation was availed of in those years to avoid surtaxes on the shareholders is not the question for decision here. Nevertheless, the situation in those years may be scrutinized in an effort to determine whether or not a purpose of the kind described in section 104 existed in the year 1932. A large part of the book surplus shown in prior years represented the write-up resulting from the annual inventory of securities at market. The surplus in some of those years may have been beyond the reasonable needs of the business. However, the Commissioner never attempted to apply section 104, or its counterpart in earlier acts, to the income of this petitioner for any of those years. Dividends in substantial amounts were paid in most of those years. . The large book surplus of these years had disappeared prior to 1932. Although the facts relating to those prior years do not show that the corporation was never availed of for the purpose of preventing the imposition of the surtax, that circumstance is not important, since the conclusion can not be drawn from those facts that the shareholders in 1932 had a purpose to avail of the petitioner to avoid surtaxes.

The two principal stockholders of the petitioner had been indebted to it at times for small amounts of money. When so indebted, they were charged with and they paid interest on the indebtednesses. But for the most part and in much larger amounts the corporation was indebted to those stockholders for advances made by them to meet the needs of the business. Interest was paid on those advances. Thus, this is not a case where the principal stockholders have withdrawn funds of the corporation through loans so that they might have the use of the accumulations and, at the same time, save surtaxes by not receiving the dividends and interest directly.

Kienbusch, the treasurer, was indebted to the corporation in the amount .of $18,000 at the close of 1932. This loan to him was necessitated by conditions in his own finances brought on by the depression. He did not like to be indebted to the corporation and sought legal advice to learn whether or not the corporation might declare a dividend sufficient to enable him to discharge this indebtedness. He was advised that, inasmuch as the books of the corporation showed insufficient surplus, a dividend could not be paid and any distribution would impair capital, rendering the officers and directors liable civilly and criminally for their action. These circumstances have some tendency to negative a purpose to avoid surtaxes.

The explanation of the investments of this petitioner in the stock and securities of other tobacco companies and of its loans to those companies leads inescapably to the conclusion that those investments and loans were incidental to and reasonably necessary in the successful conduct of the tobacco business of the petitioner. Most of the purchases were made by the partnership before the organization of the petitioner. They not only led to sales of tobacco to those particular companies, but they led indirectly to sales to other companies. Some of them were made in the hope of sales and profits which never materialized. But it may not be inferred from that unfortunate circumstance that the investments were unrelated to the business of the petitioner or that they indicate a purpose to evade surtaxes. The loans and the purchases were made to assist customers financially, to promote sales, or for both purposes.

The parties have filed rather lengthy briefs which indicate that they have carefully considered the mass of detailed facts and figures in this record. This discussion would be unduly prolonged were it to include comments on every point made by the parties. But our failure to mention any particular point in this opinion may not be taken as an indication that some point or argument made has not been carefully considered. It does seem proper, however, to make special mention of three of the cases cited by the respondent. The Board held in Rands, Inc., 34 B. T. A. 1094, and in Nipoch Corporation, 36 B. T. A. 662, that the corporation there was availed of within the year for the purpose described in the statute, despite the fact that in each case the corporation would not have had any surplus had its securities been valued at market. The differences between those cases and the present case are marked. Each of those corporations was a mere holding or investment company. Neither had any business like that of the petitioner in this case. The activities of those corporations up to and including the taxable year involved were indicative of purposes on the part of the shareholders to avail of the corporations to prevent the imposition of the surtax upon the shareholders. Here the activities of the petitioner for a similar period indicate an absence of such a purpose. Purpose is the test, and those cases are not authority one way or the other for decision of the present proceeding. The facts in the case of National Grocery Co., 35 B. T. A. 163, in some respects parallel the facts in the present case. However, the decision of the Board in that case was reversed, 92 Fed. (2d) 931, and, to the extent that the facts are parallel, that case now supports the contention of the petitioner in this case.

Reviewed by the Board.

Decision will te entered for the petitioner.

Habeon,

dissenting: I respectfully dissent from the majority opinion. Certain agreed facts, together with detailed schedules of the financial history of the petitioner corporation from 1922 to 1932, inclusive, have been filed in this proceeding and provide the ground for the dissenting opinion.

The petitioner reported, for the year 1932, no income tax liability. It had realized a net loss from its tobacco business in 1932 in the amount of $56,089.29. It had received net income from investments in the amount of $255,043.43, but it appears that, dividends being deductible under section 23 (p) of the Revenue Act of 1932 and interest on obligations of the United States being not taxable, these were not in-cludable in taxable net income under ordinary circumstances. The Commissioner, pursuant to the provisions of section 104 (c), has determined that the petitioner had a net income for the year 1932 since, under subsection (c), dividends and interest would be includable in the net income of a corporation which came within the other provisions of section 104. In his notice of deficiency the Commissioner states:

After careful consideration of your Federal income tax return and all other available information, the Bureau holds that your corporation is subject to taxation under the provisions of section 104 of the Revenue Act of 1982.

From the notice of deficiency it is evident that the Commissioner based his determination upon the conclusion that the petitioner had run afoul of the provisions of section 104 generally, although the determination was not based upon section 104 (b) specifically. After the hearing in this proceeding the respondent asked that this Board find as a fact that the petitioner had violated section 104 (b); namely, that its gains and profits were permitted to accumulate beyond the reasonable needs of tbe business in .(he taxable year. The respondent contends that petitioner was formed for the purpose of escaping surtax on its shareholders; that the petitioner was availed of to escape surtax of its shareholders; and that gains and profits of petitioner were permitted to accumulate beyond the reasonable needs of its business. There is, therefore, the question in this proceeding whether the facts show that in the taxable year 1932 the petitioner permitted its gains or profits to accumulate beyond the reasonable needs of the business. This question is a fact question. If the facts show such circumstance as is covered by subsection (b), the statute regards this as prima facie evidence of a purpose to escape surtax and the burden is upon the petitioner to introduce evidence to overcome such prima facie evidence. The majority view concludes that the evidence does not show a state of mind in the two chief stockholders of petitioner to operate their corporation so as to prevent the imposition of surtaxes upon themselves. It is always difficult to obtain the admission of the interdicted purpose, but the facts relating to the financial history of the corporation in question, the fair needs of the business, and the conduct of its officers may disclose the interdicted purpose.

There are several questions, one of which is, Were the gains and profits of petitioner permitted to accumulate beyond the reasonable needs of the business in 1932 and does the evidence show that petitioner has overcome the prima facie evidence of a purpose to escape surtax? It is the view of this dissenting opinion that the evidence shows that the gains and profits of petitioner were permitted to accumulate beyond the reasonable needs of its tobacco business and that there is not sufficient evidence to overcome the prima facie evidence of a purpose to escape surtax. The following discussion of the evidence is believed to support this conclusion.

At the close of 1932 the petitioner had the following assets, excluding investments in securities: Cash, $434,102.75; notes and loans receivable, $186,481.11; accounts receivable, $206,826.40; inventories, $258,994.82; advances to agents and farmers, $29,061.70; investments in stock of tobacco companies, $676,803. Its only current liability was accounts payable in the amount of $219,952.16. Petitioner had followed a practice of “writing down” the asset values of investments to the current market prices at the end of the fiscal year, so that at the end of 1932 securities and mortgages which had a cost value of $4,936,586.26, had a book value of $2,237,068. On the basis of the book value of the petitioner’s investments, petitioner showed a surplus of only $318.12. There is no evidence, other than the book value adopted by petitioner, of the value of securities in the taxable year. It has not been found as a fact that the value of the securities in 1932 was the book value. It is petitioner’s contention that no dividend could have been declared in 1932 because there was no substantial surplus upon its books, so that to have paid a dividend would have impaired capital. It is a question of fact whether payment of a dividend in the taxable yéar would have impaired capital. In effect petitioner argues that its earnings were “impounded” on account of the shrinkage of its security values at the end of the taxable year. This argument of petitioner must be weighed against the financial record of the company, which shows that in over 10 years the petitioner accumulated $2,577,759.63 from dividends, net income from operations of the tobacco business, and net profit from the sales of securities. This amount is a net amount excluding a total of $660,000 dividends declared and paid by petitioner over the 10-year period. It appears that these accumulated earnings were invested from year to year in the purchase of more dividend-producing securities, for the cost value of petitioner’s investments increased over the 10 years in the amount of $3,663,483.15. The following schedule shows this.

19%2-198%, inclusive.
Dividends from investments_$2, 389,116.93
Net income from operations, less losses_ 671,419. 61
Net profit from the sales of securities, less losses- 177,223. 09
Total_ 3,237,759.63
Less: Dividends paid hy petitioner_ 660,000.00
Net earnings and gains_ 2, 577,759.63
Cost of investments, end of 1932_ 4, 936, 586.26
Cost of investments, end of 1922_ 1,273,103.11
Increase in investments, 10 years_ 3,663,483.15

The following schedule from comparative balance sheets of petitioner, excluding a stock dividend paid in 1922 in the amount of $290,000, shows that the petitioner had an earned surplus at the end of 1932 in the amount of $2,107,845.88.

From this we believe that the amount of $318.12 which petitioner contends was its true surplus, was not the true surplus available for dividends, but that the actual earned surplus available for dividends was $2,107,845.88. The securities and fixed assets which petitioner “wrote-down” were owned by petitioner at the end of the taxable year and no actual reduction in'earned surplus was effected during the taxable year, for the assets were not disposed of. Cf. R. & L., Inc., 33 B. T. A. 857; affd., 84 Fed. (2d) 721; certiorari denied, 299 U. S. 588; A. D. Saenger, Inc. v. Commissioner, 84 Fed. (2d) 23, affirming 33 B. T. A. 135; certiorari denied, 299 U. S. 578; Rands, Inc., 34 B. T. A. 1094; Nipoch Corporation, 36 B. T. A. 662.

The net income of petitioner for 1932 was $198,954.14. From this fact it is extremely doubtful that petitioner would have had to sell any securities to pay dividends in 1932, as petitioner contends. This income was derived from dividends and interest on investments totaling $255,043.43, from which is deducted the year’s loss from the tobacco business of $56,089.29. Since the investments which produced the income represent in themselves accumulated earnings and gains of prior years, it is obvious that the earnings for the taxable year were earnings from accumulated surplus. It is also apparent that the petitioner corporation from the time of its organization in 1922 did not require in its tobacco business any of the earned surplus or any of the invested capital which it kept in dividend and interest-bearing securities, the cost value of which steadily increased from year to year. There is no evidence that petitioner sold any substantial amount of its securities so as to put its earned surplus in liquid, usable form. A smaller and smaller portion of its capital was used each year for operating expenses and the amount of capital invested in securities increased. It is this evident nonuse of capital invested so largely in securities that gives rise to respondent’s claim that petitioner was a holding company and gives importance to the circumstance that the two chief stockholders, Spitzner and Kienbusch, contributed to the partnership, just prior to the incorporation of petitioner, stocks and bonds of values of $109,750 and $606,133.04, respectively, increasing investments in securities and real estate to $1,546,236, compared to the amount of about $500,000 which the partnership previously carried. Kienbusch’s contribution represented his entire wealth with the exception of property valued at about $120,000. These contributions relieved the two individuals of surtax liabilities on income from dividends thereafter paid to and accumulated by petitioner. Cf. Keck Investment Co., 29 B. T. A. 143; affd., 77 Fed. (2d) 244; certiorari denied, 296 U. S. 633.

Petitioner claims that the transfer of securities to it by its two chief stockholders, at the end of 1921, was necessary to provide additional capital for the tobacco business. The evidence shows that in 1922, when petitioner did its largest business, the cost of sales of tobacco was in the sum of $2,423,590, which is approximately only two-thirds of the capital of petitioner. Thus, in 1922 there was no evident need for capital in excess of $3,710,000, which would have been the capital of petitioner if the chief stockholders had not made a contribution of securities in the amount of $608,133. Further, the record shows that in 1922 petitioner had more liquid capital than it needed in carrying on the tobacco business in the year of its largest business. Petitioner at the end of 1922 had loaned $800,000 to a concern, S. Rupin, Inc., a corporation in which petitioner owned 50 percent of the outstanding stock. The explanation of loans to tobacco concerns is that such loans were effective in developing and maintaining petitioner’s business. However, the record shows that from 1922 to 1932 petitioner made no sales of tobacco to S. Rupin, Inc. Therefore, it is a fair conclusion that the Rupin loan was not made to develop petitioner’s business, but as investment in an associated company of a surplus of capital which petitioner did not need in its own tobacco business. It also indicates that petitioner did not need the additional income-producing capital at the date of the formation of petitioner out of the assets of the chief stockholders. The transfer of income-producing securities to a corporation, without proof of the need of such additional assets in the conduct of business, is proof of a purpose on the part of the transferors to use the corporation to avoid payment of surtaxes on their own income. Cf. United Business Corporation of American v. Commissioner, 62 Fed. (2d) 754; certiorari denied, 290 U. S. 635. Further, in the period 1922 to 1932 the petitioner loaned funds to one of its chief stockholders, Kienbusch, in the years when petitioner paid no dividends, which is further indication that the petitioner was accumulating earnings and gains beyond its reasonable needs.

The following schedule shows the steady increase of investments in stocks and bonds from accumulated earnings and gains:

The explanation given by one of petitioner’s chief stockholders for the steady accumulation of earnings is that it was conserving its working capital for use at such time as improved and increased tobacco business would require; that it was hoped and expected that the petitioner’s tobacco business would eventually return to an annual volume of $3,000,000, which would require working capital of about $4,000,000. This explanation is also an argument advanced against the respondent’s contention that the petitioner corporation had become a holding company even though it engaged in a tobacco business.

Whether or not the managers of petitioner were optimists, it is evident that a volume of business at $3,000,000 a year was not normal. In one year only, 1922, did gross sales reach that amount. Since the question involved relates to what working capital is necessary for the reasonable needs of the business, the year 1922 is not the normal year to take to test what amount of capital the reasonable needs of the tobacco business requires. The following schedule shows the size of petitioner’s business during its life.

In the year 1922, when petitioner’s volume of business amounted to $3,000,000, the working capital of the business was $3,490,557.08. From 1927 to 1932 the business of petitioner has never required working capital in excess of $1,900,000. The following table shows the actual working capital in use in each year. It is computed from petitioner’s comparative balance sheets by excluding from total assets the book values of the investments in securities and mortgages.

From the above, it seems evident that petitioner’s normal business did not require maintaining a surplus of earnings that would assure a working capital of $4,000,000 a year. There is little substance in the argument of petitioner that it was accumulating earnings to meet the anticipated needs of its business. The petitioner had substantially no liabilities. In the 10-year period there is no evidence of efforts to increase business to a size that would require use of the large accumulation of earnings. Cf. Almours Securities, Inc,, 35 B. T. A. 61; aff'd., 91 Fed. (2d) 427; certiorari denied, 302 U. S. 765. In the taxable year 1932 there was a substantial accumulation of earnings that had been turned back into income-producing securities, which had increased during 10 years to a cost value of $4,936,586. The petitioner was in a liquid position. No evidence having been introduced to prove the value of securities at less than cost, it should be held that petitioner had an earned surplus of $2,107,845.88. The evidence does not show that there were reasonable needs for any further accumulation of earnings by preserving the entire net earnings of the taxable year. Cf. R. & L., Inc., supra. The earnings for 1932 could as well have been distributed as held for future investment or distribution. Petitioner’s turnover of business has been far below its invested capital.

It should be found as a fact that petitioner permitted its gains to accumulate beyond the reasonable needs of the business in 1932. It should further be held that petitioner has not introduced evidence to overcome the prima facie evidence of a purpose to avoid surtax. The analysis of the surplus account of petitioner gives strong support to respondent’s contention that it had become a holding company. In every year since 1924 net income received from investments has far exceeded net income from operations, and capital used in operations has steadily been less than capital converted into investments. The following schedule shows this fact and greatly weakens petitioner’s argument that the conduct of its operations was solely to further the tobacco business.

Year 1922. 1923. 1924. 1925. 1925 1927. 1928. 1929. 1930. 1931. 1932. Total. Net income from tobacco operations $351,336.38 250,238.59 (loss) 12,082.41 (loss) 46,652.77 45,201.67 59,433.95 101,801.49 87,407.46 (loss) 73,175.77 (loss) 35,999.49 (loss) 56,089.29 671,419.61 Net income other than operations $53,873.81 64,261.13 119,274.83 167,233.44 270,793.73 255,360.59 366.475.61 307,879.41 289,661.33 239.269.62 255,043.43 2,389,116.93 Net income $405,209.99 314,499.72 107,192.42 120,580.67 315,995.40 314,784.54 468,277.10 395,286.87 216,485.56 203.270.13 198.954.14 3,060,536.54 Dividends paid $60,000 80,000 40,000 40,000 80,000 120,000 120,000 80,000 40,000 660,000

Petitioner claims that because of the shrinkage in values of its assets it had no surplus out of which to pay dividends in 1932 and that to do so would have been in violation of section 58 of the New York State Stock Corporation Law and section 164 of the Penal Law. Petitioner relies on certain advice given him by an attorney. This attorney appeared as a witness. His testimony, on cross-examination, shows that his opinion was given without examining the books of the corporation and without knowledge of whether payment of a dividend would have impaired capital. He admitted that, where there is a close corporation and no creditors (the petitioner had only $220,000 current liabilities and $484,000 in cash), and the stockholders agree to the distribution, it is inconceivable that there could be “injury” from payment of a dividend and hence no penalty under the New York statute for distributing dividends. There is no evidence in this proceeding that the security assets of petitioner were in fact of the book value in 1932 ascribed to them by petitioner in its own “write-down” of values. Nor is there any evidence that the value of the security investments was less than cost. The surplus of $318.12 for 1932 is a result of bookkeeping and creates nothing. As stated in Sitterding v. Commissioner, 80 Fed. (2d) 939, “mere bookkeeping entries cannot preclude the government from collecting its revenues, nor are such entries conclusive upon the taxpayer.” It is exceedingly doubtful whether payment of a dividend would have impaired capital and consequently doubt that there was any statutory bar against payment of a dividend by petitioner in 1929. In an issue of this kind, claimed shrinkage of values in assets as a bar to paying dividends is a fact to be proved, and that fact apparently has not been proved here.

In conclusion, it is the opinion of this dissenting view that the penalty prescribed by section 104 should be imposed upon the petitioner.


author: Akxjndell:

text:
    Palmer, Stacy-Merrill, Inc., a Delaware Corporation, Petitioner, v. Commissioner of Internal Revenue, Respondent.
    Docket No. 87997.
    Promulgated March 25, 1938.

      Tom 8. Patterson, Esq., for the petitioner.

      B. M. Coon, Esq., for the respondent.
   OPINION.

Akxjndell:

Section 23 (b), supra, which petitioner pleads, provides that in computing net income for income tax purposes there shall be allowed deductions from gross income of all interest paid or accrued within the taxable year on indebtedness. The petitioner contends that the circumstances under which it issued its preferred stock, together with the commitments it undertook at the time, created debts which it was bound to pay through redemption in cash, and not mere investments in its capital. In this view it argues that the dividends paid on the preferred stock amounted to interest on debts. The respondent contends for a strict construction of the preferred stock certificates, as held in Elko Lamoille Power Co. v. Commissioner, 50 Fed. (2d) 595 (affirming 21 B. T. A. 291); Angelus Building & Investment Co. v. Commissioner, 57 Fed. (2d) 130 (affirming 20 B. T. A. 667); Finance & Investment Corporation v. Burnet, 57 Fed. (2d) 444 (affirming 19 B. T. A. 643); and Greensboro News Co., 31 B. T. A. 812.

If the disbursements here involved were made solely on petitioner’s obligations under its preferred stock certificates, then the respondent’s contention would prevail, since the issuance of preferred stock certificates, without more, can not create debts against a corporation even though a time fixed for their retirement is agreed upon. Fletcher, Cyclopedia Corporations, permanent ed., vol. 11, sec. 5294. Booth v. Union Fibre Co., 137 Minn. 7; 162 N. W. 677. On the other hand, corporation stock certificates are no exception to the general rule of construction for written instruments, which places intent of the parties above mere form. Burt v. Rattle, 31 Ohio St. 116; Heller v. National Marine Bank, 89 Md. 602; 43 Atl. 800; Savannah R. E. L. & B. Co. v. Silverberg, 108 Ga. 281; 33 S. E. 908; Ellsworth v. Lyons, 181 Fed. 55. In the case at bar the holders of the stock certificates were not investors in any sense of that word. They were sellers who accepted the stock at the time of the transfer of their properties only on condition that the stock would be redeemed in cash and the dividends paid on dates certain, without regard to petitioner’s earnings. In other words, the sale consideration included not alone the stock issued to the sellers, but in addition the purchaser’s agreement to redeem all of the stock for cash at fixed times. Obviously, cash payments at times certain formed the essence of the sales agreements, and created indebtedness which could be discharged only by cash payments. This interpretation of the transactions finds undisputed support in the testimony of the Fruit Co.’s president, who negotiated them. He stated that the intention was to make possible ultimate cash payments to the sellers, not available when the sales took place but without which they would not sell, and, further, that the sellers rejected the proposal to accept payment in corporation stock, either common or preferred, as investments, insisting that they desired no interest in the buying corporation. This testimony was not disputed.

In all cases cited by the respondent the facts are clearly distinguishable from these at bar, and in none of them were there contracts which created debts independent of the stocks involved. However, in Jones Syndicate v. Commissioner, 23 Fed. (2d) 833, such an agreement was present, and the court there sustained the loan theory. Elko Lamoille Power Co. v. Commissioner, supra, cited by the respondent, by implication at least, approved the loan theory announced in the Jones Syndicate case by distinguishing its facts in language which we quote from the opinion, as follows:

* * * There were other stipulations not here applicable. The preferred stock was a direct obligation with a definite date for payment. In the instant case the preferred stock could, at the option of the corporation, be redeemed within three years at 110. In the Jones Syndicate there was an express provision to pay at five years. It was in effect a bond payable in five years.

The petitioner has cited numerous authorities to support its version of the transactions, but in view of the conclusions we have reached it is unnecessary to review them in detail here. The Fruit Co. purchased assets which the petitioner took over, issuing to the seller its preferred stock, agreeing in the same transaction to redeem all of the stock in determined installments on dates certain over a period of 20 years, and to pay dividends on the stock at the rate of 6 percent, payable quarterly. This created an indebtedness which could only be discharged by payment in money. The stock was accepted by the sellers not as an investment, but as security for the consideration which was to be liquidated in 20 installments, the sellers in the meantime to receive 6 percent on the deferred installments. The record convinces us that the petitioner’s outstanding issue of preferred stock should be regarded as debts, and not an investment in its capital stock; also that the dividends provided for in the stock certificates were intended to represent compensation for deferred payments on the indebtedness thus created. Proctor Shop, Inc., 30 B. T. A. 721; affd., 82 Fed. (2d) 792. In these circumstances the disputed disbursements amounted to interest on indebtedness, and we so hold. There being no deficiency in tax, there is no basis for assertion of the ad valorem negligence penalty.

Decision will he entered for the petitioner.


author: Black:

text:
    Chemical Bank & Trust Company and John G. Saxe, as Executors of the Estate of Frank J. Saxe, Deceased, Petitioners, v. Commissioner of Internal Revenue, Respondent.
    Docket No. 79276.
    Promulgated March 29, 1938.

      Harry W. Forbes, Esq., for the petitioners.

      J. R. Johnston, Esq., for the respondent.
   OPINION.

Black:

We shall take up and dispose of the issues in the order that we have stated them. Issue (1) relates to two annuity contracts which decedent had purchased in his lifetime from the Mutual Life Insurance Co. of New York for lump sum payments. These annuities were payable to decedent as long as he should live, and at his death if his wife survived him the annuities were payable to her as long as she should live. Decedent’s wife did survive him, and respondent included in decedent’s gross estate the amount which he determined to be the value, at the date of decedent’s death, of the annuities which were payable to her. The annuity contracts when purchased were irrevocable. The decedent had no right to change the beneficiary and no control or interest in the contracts other than his right to receive the annuities during his life. This right ceased a.t his death. The interest which his wife, Mary L. Saxe, had was a right to receive the annuities after his death if she survived him. That right she obtained absolutely at the time the contracts were made. It was not a right over which the testator had any power of revocation or control during his lifetime, and at his death nothing-passed from the dead to the living. May v. Heiner, 281 U. S. 238; Burnet v. Northern Trust Co., 283 U. S. 782; Morsman v. Burnet, 283 U. S. 783; McCormick v. Burnet, 283 U. S. 784.

These annuity contracts are different from the ones which we had before us in Guaranty Trust Co. of New York, Executor, 16 B. T. A. 314. In that case the annuity contracts were revocable at the pleasure of Mrs. Roxy M. Smith, who purchased them. In our opinion in that case we pointed out this fact in the following language:

* * * Tlie contracts had at all times a cash surrender or commuted value and the decedent could have canceled them at any time and received the amount thereof, and she could have changed the beneficiary and made it payable to whom she pleased.

In other words, the annuity contracts were essentially equivalent to revocable trusts.

The situation is different in the instant case. Here the annuity contracts had no cash surrender value and decedent had no power to revoke them. They were in all essential respects equivalent to irrevocable trusts, and the Supreme Court decisions relating to conveyances to irrevocable trusts which we have cited above aré applicable.

We sustain petitioners’ assignment of error as to issue (1).

Issue (2). — Respecting this issue, the parties are not so far apart. The petitioners returned in the estate tax return $14,815.40 for this item, and respondent increased this amount to $20,000. The subject of valuation is the $20,000 death refund provided for in the investment annuity contract of July 1, 1929.

Petitioners’ contention regarding this issue in substance is as follows : That the contract in question was a combined annuity and life insurance contract and that the $20,000 death refund which was payable at decedent’s death was an insurance payment and is governed by the provisions of section 302 (g) of the Revenue Act of 1926, which reads as follows:

Seo. 302. Tbe value of the gross estate of the decedent shall be determined by including the value at the time of his death of all property, real or personal, tangible or intangible, wherever situated.
*******
(g) To the extent of the amount receivable by the executor as insurance under policies taken out by the decedent upon his own life; and to the extent of the excess over $40,000 of the amount receivable by all other beneficiaries as insurance under policies taken out by decedent upon his own life.

Petitioners contend that the right of the executors to receive the $20,000 death refund was postponed until the death of decedent’s widow, Mary L. Saxe, and therefore the right of the executors to receive this sum had only a present value of $14,815.40 at the date of decedent’s death, and that it is this latter amount and not $20,000 which should be included as a part of decedent’s gross estate.

It is petitioners’ further contention that the right of Mary L. Saxe to receive interest at the rate of 3 per centum per annum on this $20,000 death refund during the remainder of her life had a present value at the date of the death of decedent of $5,185, based upon the life expectancy of Mary L. Saxe, and that this sum represents the commuted value of insurance payable under the terms of the contract and therefore is exempt as being a part of the $40,000 of life insurance, payable to beneficiaries other than the decedent’s estate, which is exempted under section 302 (g) of the Revenue Act of 1926.

If the contract in question were an insurance policy, the contention of petitioners would seem to be correct, but it was not an insurance policy. It was an annuity contract, with death refund benefits. The contract itself was designated on its face as an “Investment Annuity.” Nowhere in the contract is it designated as an insurance policy. The contract in the instant case seems to be in all essential respects the same as the contract which we recently had before us in Old Colony Trust Co., et al., Executors, 37 B. T. A. 435. In that case we held that the contract under which the payments were made was not a policy of life insurance and was not exempt from estate tax within the provisions of section 302 (g) of the Revenue Act of 1926. We so hold in the instant case.

It should be pointed out that the annuity contract which we are now considering under issue (2) is different from the contracts which we considered under issue (1). The contracts there considered were irrevocable, whereas the contract which we are now considering was revocable and at any time prior to his death the decedent could have changed the beneficiary, hence the contract was in the same category as a revocable trust. This much the petitioners concede, but they contend that the part which was payable to decedent’s wife, Mary L. Saxe, represented insurance benefits and hence is exempt under the $40,000 life insurance exemption provision of section 302 (g) of the Revenue Act of 1926.

For reasons already stated, we overrule this contention and sustain the Commissioner in including in decedent’s gross estate the full value of the death refund payment, which was $20,000.

Issue (3). — This issue involves the inclusion by respondent in decedent’s gross estate of the value of property conveyed by him in trust on August 10,1928, more than five years prior to his death. In this trust decedent reserved for himself the income for life, with remainder over of the corpus to his wife and other relatives. The trust was irrevocable. In his deficiency notice respondent included the value of this trust property on the ground that decedent died subsequent to the passage of the Revenue Act of 1932, effective June 6, 1932, and therefore the property is includable as part of the decedent’s gross estate pursuant to the provisions of section 803 (a) of that act, and articles 15 and 18 of Estate Tax Regulations 80, promulgated thereunder.

Respondent at the hearing amended his answer and affirmatively alleged that decedent executed the deed of trust in contemplation of death. However respondent offered no evidence in support of his affirmative allegations, and relies in support of this contention upon other evidence in the record. This of course he has a right to do, but we do not think the facts sustain him in this contention.

Petitioners at the hearing offered the testimony of John G. Saxe, one of the executors of the estate, who had known the decedent for many years. Saxe testified that at the time decedent executed the deed of trust in question he was 74 years of age and in good health. He said that decedent came of a long lived family, his mother having lived beyond the age of 90 years. The witness testified that several years before her death decedent’s mother lost the use of her mental faculties and never regained them, though remaining in good physical health until a short time before her death. He said that decedent told him that the reason he executed the deed of trust on August 10, 1928, was to place a part of his property in the hands of a competent trustee so that if, like his mother, he should lose his mental faculties in his declining years there would be somebody competent to look after his affairs and care for him and his wife during the period of his disability. Ho testimony was offered to contradict the testimony of this witness and we therefore accept as true his explanation of the dominant reason for decedent’s execution of the trust deed in question. These reasons we think were associated with life rather than death. The purpose of the transfer was not testamentary. Cf. United States v. Wells, 283 U. S. 102.

Decedent had made a testamentary disposition of his property by a will dated February 19, 1924, which was more than 4 years prior to the execution of the trust deed in question. It is true that decedent executed a codicil to his will 3 days after the execution of the deed of trust, but this codicil made no reference whatever to the property conveyed in the deed of trust. It was simply a correction of the spelling of a name contained hi his will of February 19, 1924, and the addition of a clause that the provisions for his wife contained in his will were in lieu of dower. This codicil, we think, is not of any controlling importance to any issue which we have here to decide.

We hold on the evidence that the deed of trust dated August 10, 1928, was not executed in contemplation of death. Respondent contends however that, even if we hold against him on the issue of contemplation of death, nevertheless the value of the trust corpus is includable as a part of decedent’s gross estate because he reserved to himself for life the income from the property and died after the effective date of the provisions of section 803 (a) of the Revenue Act of 1932. It is true that decedent died December 15, 1933, which was after the effective date of said section, but we have held that this section has no retroactive application to irrevocable transfers which were made prior to its enactment and prior to the enactment of the joint resolution of March 3, 1931, amending section 302 (c) of the Revenue Act of 1926. See Mildred Kienbusch et al., Executors, 34 B. T. A. 1248; Dwight Whiting et al., Trustees, 35 B. T. A. 100; Pearl W. Dahl, Executrix, 35 B. T. A. 282; E. Pennington Pearson, Executor, 36 B. T. A. 5; Welch v. Hassett, 90 Fed. (2d) 833, certiorari granted, 302 U. S. 674.

The Supreme Court recently handed down decisions in Hassett v. Welch, 303 U. S. 303, and Helvering v. Marshall, 303 U. S. 303, in which it held that the joint resolution of March 3, 1931, and section 80S (a) of the 1932 Act, amending section 302 (c) of the 1926 Act, apply only to transfers with reservation of life income made after the dates of their respective adoption. Section 302 (h) of the 1926 Act does not authorize retroactive application of section 302 (c) of that act as amended.

The trust involved here was executed August 10, 1928, and, as we have stated, was irrevocable and made complete disposition of the corpus and was not executed ip contemplation of death. Hence we hold, following the decisions of the Supreme Court just above cited, that respondent was in error in including as a part of decedent’s gross estate the value of the property conveyed in the trust instrument of August 10, 1928.

On this issue we sustain petitioners.

Decision will Toe entered under Rule 50.


text:
    Sol Greisler and Mrs. Sol Greisler (Husband and Wife), Petitioners, v. Commissioner of Internal Revenue, Respondent. Bernard Greisler, Petitioner, v. Commissioner of Internal Revenue, Respondent.
    Docket Nos. 89403, 89404.
    Promulgated March 29, 1938.

      Max Heller, Esq., for the petitioners.

      J. W. Smith, Esq., for the- respondent.
   OPINION.

Black:

In Docket No. 89403 the Commissioner determined a deficiency of $611.47 for the year 1934 against Sol Greisler and his wife, and in Docket No. 89404 he determined a deficiency of $725.42 for the year 1934 against Bernard,Greisler.

The sole issue in each proceeding is whether a loss incurred by petitioners on the foreclosure of a mortgage on property which they owned was an ordinary loss and allowable as a deduction to the full extent thereof as provided in section 23 (e) (2) of the Revenue Act of 1934, or whether such loss was a capital loss and limited to $2,000 as provided by section 117 (d) of the Revenue Act of 1934. The parties stipulated that if the Board should hold that the loss was an ordinary loss and deductible in full under the provisions of section 23 (e) (2) of the Revenue Act of 1934, then the Board should enter an order in each proceeding of no deficiency, but if the Board should hold the loss was a capital loss and limited to $2,000 by the provisions of section 117 (d) of the Revenue Act of 1934, then the deficiencies are in the amounts determined by the Commissioner and decisions should be entered accordingly.

The facts were all stipulated, and the facts as stipulated are adopted as our findings of fact. They may be briefly summarized as follows.

Petitioners reside at Philadelphia, Pennsylvania, and filed their income tax returns with the collector of internal revenue for the first Pennsylvania district, Philadelphia, Pennsylvania.

Petitioners Sol Greisler and Bernard Greisler on July 2, 1934, jointly owned premises located at 252-254 South Ninth Street, Philadelphia, Pennsylvania. The property was held subject to an outstanding first mortgage of $80,000 given by a former owner of the premises. The property was acquired on March 22,1927. On July 2, 1934, the mortgagee instituted foreclosure proceedings against petitioners on his first mortgage, which proceedings were prosecuted to a successful conclusion within the taxable year. The property was acquired by the mortgagee on October 1, 1934, by a sheriff’s deed without right of redemption in the petitioners, pursuant to sheriff’s sale, for $49,050. By reason of the foreclosure proceedings petitioner Sol Greisler sustained a loss of $14,252.75 and petitioner Bernard Greisler sustained a loss of $16,493.80.

Section 23 (e) (2) of the Revenue Act of 1934 reads as follows:

In computing net income there shall be allowed as deductions:
(e) Losses bt Individuals. — -In the case of an individual, losses sustained during the taxable year and not compensated for by insurance or otherwise—
* * * * * * $
(2) If incurred in any transaction entered into for profit, though not connected with a trade or business.

Section 117 (d) of the Revenue Act of 1934 reads as follows:

(d) Limitation on Capital Losses. — Losses from sales or exchanges of capital assets shall be allowed only to the extent of $2,000 plus the gains from such sales or exchanges. * * *

There is no dispute between the parties that the property owned by petitioners upon which foreclosure was had in 1934 was a capital asset within the meaning of section 117 (b) of the Revenue Act of 1934. That provision of the statute defines what are capital assets but need not be quoted here because there is no controversy over that point. But it will be noted that the limitation on capital losses provided by section 117 (d) does not apply except to sales or exchanges of capital assets which have been made by the owners. For example, if a taxpayer owns a promissory note which has been held for a sufficient length of time to make it a capital asset within the meaning of section 117 (b) of the Revenue Act of 1934, and such note becomes worthless in the taxable year and is charged off, the loss is deductible in its entirety under section 23 (k) of the Revenue Act of 1934, because there has been no sale or exchange of the note by its owner and the limitation provided by section 117 (d) does not apply. Cf. R. W. Hale, 32 B. T. A. 356.

Petitioners contend that they made no sale or exchange of the property in 1934, but that on the contrary there was a foreclosure proceeding by which they lost their property and received nothing in exchange. Petitioners point out that the property was sold under a foreclosure of a first mortgage for $80,000 on which they were not personally liable and that they previously purchased the property subject to this first mortgage, and hence when the property was sold to satisfy the mortgage and brought less than the face value of the mortgage the petitioners received nothing — not even an acquittance of a debt, for they owed no debt, having purchased the property subject to the first mortgage and not assuming it.

We think petitioners must be sustained in this contention under the Board’s decision in Commonwealth, Inc., 36 B. T. A. 850. In that case the owner of realty, subject to a mortgage, deeded the property to the mortgagee without consideration and thereby sustained a loss. On these facts we held that the loss so sustained was an ordinary loss, deductible in full under the provisions of the Revenue Act of 1934, and was not a capital loss subject to the limitation under section 117 (d) of the Revenue Act of 1934.

In Commonwealth, Inc., supra, among other things, we said:

* * * The purported release of liability under the mortgage was of no benefit to the petitioner for it had no liability under the mortgage. Neither the petitioner nor its grantor assumed the mortgage liability, but took title subject to it. Hence, there was no personal liability on the part of the petitioner. Hulin v. Veatch, 148 Or. 119, 35 Pac. (2d) 253; Metropolitan Bank v. St. Louis Dispatch Co., 149 U. S. 436; Fulton Gold Corporation, 31 B. T. A. 519. Inasmuch as there was in fact no consideration to the petitioner, the transfer of title was not a sale or exchange. The execution of the deed marked the close of a transaction whereby petitioner abandoned its title. Cf. A. J. Schwarzler Co., 3 B. T. A. 535, Greenleaf Textile Corporation, 26 B. T. A. 737, holding that a taxpayer does not sustain a deductible loss of the value of real estate while retaining title to it.

While the facts of the instant case differ somewhat from those of the Commonwealth, Inc., case, in that in Commonwealth, Inc., there was a voluntary conveyance of the property to the mortgagee, whereas in the instant case there was a foreclosure of the mortgage and a conveyance to the purchaser by a sheriff’s deed, we think the principle governing the two cases is the same.

In the instant case, just as in the Commonwealth case, the petitioners received nothing in exchange for their property, not even an acquittance of a liability under the first mortgage, because, as in the Commonwealth case, petitioners had purchased the property subject to the first mortgage and had not assumed any personal liability thereon. Petitioners neither sold nor exchanged anything. They lost their property through the operation of the law of foreclosure. The sale by the sheriff effected a transfer of title to the property, but it did not constitute a sale or exchange by petitioners.

We therefore hold, following Commonwealth, Inc., supra, that petitioners are entitled to deduct the losses admittedly incurred, in their entirety and not limited by the provisions of section 111 (d) of the Revenue Act of 1934.

It was stipulated that, under such disposal of the issue, there is no deficiency against petitioners.

Decision will be entered for petitioners.


author: Tyson: Murdock,

text:
    The Rogers Recreation Company of Connecticut, Petitioner, v. Commissioner of Internal Revenue, Respondent.
    Docket No. 83233.
    Promulgated March 29, 1938.

      Dennis P. O’Connor, Esq., and A. F. Hall, C. P. A., for the petitioner.

      F. L. Van Haaften, Esq., L. H. RushbrooJc, Esq., and George H. Mitchell. Esq., for the respondent.
   OPINION.

Tyson:

While the record in this proceeding does not establish definitely the financial condition of the St. Louis Co. at any time, it is clear that it was a losing venture, particularly after the first three years of its existence. It is evident that in 1929 the St. Louis Co.’s capital stock was worth a great deal less than par and in that year the petitioner disposed of the 450 shares of such stock, which had cost it $45,000 in 1924, in exchange for 500 shares of its own capital stock, having a total par value of $25,000, which were canceled and retired. That constituted a closed transaction, and whether it resulted in a realized and deductible loss in 1929 is not an issue in this proceeding. The petitioner did claim a deduction of $20,000 on its 1929 return on account of that transaction and the respondent disallowed that deduction in his deficiency notice dated November 17, 1931. The petitioner acquiesced in that determination and paid the additional tax for 1929.

On November 24, 1931, and in pursuance of a plan designed to enable the petitioner to secure a deduction of $44,000 as a loss sustained in 1931, the $45,000 par value stock of the St. Louis Co. was transferred to petitioner by Eogers (who with his wife owned the majority of petitioner’s capital stock) in exchange for $25,000 par value of petitioner’s stock. In further pursuance of that plan, said St. Louis Co. stock was transferred by petitioner to Eogers for $1,000 in December 1931. The purpose of the plan was to eliminate the effect of the closed transaction of 1929 and thereby restore to petitioner a cost basis of $45,000, as of 1924, for determining a loss of $44,000 upon a disposition of the St. Louis Co. stock in December 1931. However, that purpose was not effectuated, for the 1929 transaction was completed and became a closed transaction in that year for income tax purposes. If the petitioner’s acquisition of the St. Louis Co. stock in November 1931 and its disposition thereof in December 1931 had been bona fide transactions the cost of such stock to petitioner in November 1931 would have been the basis for determining the amount of the loss sustained upon the disposition thereof in December 1931. The petitioner does not prove that the 450 shares of St. Louis Co. stock cost it anything in November 1931, for the reason that there is no evidence as to the value of that time of petitioner’s capital stock which was given in exchange for the 450 shares of St. Louis Co. stock.

In December 1931 the stock of the St. Louis Co. “was not worth hardly anything.” There is no proof that it was any more valuable in the preceding month of November 1931, or that there was any material change in the affairs of the St. Louis Co. between those dates. From this record it is clear that the stock of the St. Louis Co. had little, if any, value in November as well as in December of 1931.

Thus it is clear that, in fact, the transactions in November and December of 1931 involving the 450 shares of ‘St. Louis Co. stock which had little, if any, value in either month, were merely transfers in form and lacked substance and were not bona fide transactions resulting in any deductible loss. The respondent’s disallowance of the claimed deduction of $44,000 as a loss is approved. Cf. Wishon-Watson Co. v. Commissioner, 66 Fed. (2d) 52; Rubay Co., 9 B. T. A. 133; John M. Burdine Realty Co., 20 B. T. A. 54; Sydney M. Shoenberg, 30 B. T. A. 659; affd., 77 Fed. (2d) 446; certiorari denied, 296 U. S. 586.

The petitioner’s tax return for 1931 failed to disclose the transfer of November 1931, which should have been reported as the date of acquisition for the purpose of claiming the amount, if any, of a loss on the St. Louis Co. stock in 1931, thus concealing the true facts from the respondent, and, further, the return falsely reported that this stock had been acquired in 1924 at a cost of $45,000, leaving the necessary inference that it had been owned by petitioner continuously thereafter until the purported sale to Rogers for $1,000 in December 1931. The return was false and fraudulent and made with intent to evade tax, and we have so found as a fact. Cf. Sol H. Goldberg, 36 B. T. A. 44; Victor A. Dorsey, 33 B. T. A. 295; Charles E. Mitchell, 32 B. T. A. 1093; affirmed in part, 89 Fed. (2d) 873; D. C. Clarke, 22 B. T. A. 314; M. Rea Gano, 19 B. T. A. 518; Chas. F. Long,. 12 B. T. A. 488.

The deficiency in controversy being due, at least in part, to fraud with intent to evade tax, the respondent’s determination of the 50 percent addition to the deficiency, pursuant to section 293 (b) of the Revenue Act of 1928, is approved and, consequently, under section 276 (a) of the Revenue Act of 1928, the assessment and collection of the deficiency is not barred by the statute of limitations.

Reviewed by the Board.

Decision will be entered for the respondent.

Murdock,

dissenting: I do not think that the evidence of a fraudulent intent is clear and convincing.

Melloit agrees with the above.