author: Black:

text:
    Artesian Water Company, Petitioner, v. Commissioner of Internal Revenue, Respondent.
    Docket No. 100824.
    Promulgated January 22, 1941.

      George G. Witter, Esq., for the petitioner.

      E. A. Tonyes, Esq., for the respondent.
   OPINION.

Black:

The petitioner in its return for the taxable year reported gross income of $171,493.42, from which it claimed deductions amounting to $119,805.17, leaving a taxable net income of $54,101.14, upon which it paid the normal income tax for the year.

The petitioner paid no surtax upon its undistributed profits for the year but in its return claimed an exemption from that obligation. It stated its claim for exemption as follows:

Exemption from undistributed profits surtax is claimed on the following grounds: Attention is respectfully directed to Section 14 of the Revenue Act of 1936, part (d) (2) of which reads:
(d) Exempt from surtax. The following corporations shall not he subject to the surtax imposed by this Section:
(2) Domestic corporations which for any portion of the taxable year are in bankruptcy under the laws of the United States, or are insolvent and in receivership in any Court of the United States, or of any State, Territory, or the District of Columbia.
The word “insolvent” was apparently used in its dual sense by Congress. The Senate Finance Committee Report on the Revenue Bill of 1936 of June 1, 1936, on page 15, in discussing Section 14 (d) (2), said:
The Finance Committee Bill also avoids the possibility of tax avoidance by collusive receiverships by limiting the provision to cases in which the corporation is in bankruptcy under the Federal bankruptcy laws, and to cases in which it is insolvent, i. e., its liabilities are in excess of its assets or it is unable to pay the claims of creditors as they mature — and in receivership in Federal or State Courts.
The taxpayer was certainly unable to pay the claims of its creditors as they matured. That is, it was unable to pay them in the usual course of business out of quick assets without selling its capital assets. 32 Corpus Juris 806 states that the word “insolvency” has two meanings:
In its general and popular meaning, the term denotes the state of one whose entire property and assets, when converted into money without unreasonable haste or sacrifice, are insufficient to pay his debts: But it is frequently used in the more restricted sense to express the inability of a person to pay his debts as they become due in the ordinary course of business.
Creditors claims, referred to above, which the corporation was unable to pay at maturity, consist of balance due the Pacific Mutual Life Insurance Company on account of money borrowed on November 12, 1929, and represented by two notes, one for $35,000 and one for $175,000. The note for $35,000 carried with it a specific agreement prohibiting the payment of dividends until said note was paid. During 1936 the sum of $26,750 was paid on this note leaving a balance of $8,250 which balance was paid during 1937, whereupon the note and collateral agreement were cancelled.
Similarly, during 1937 payments totaling $74,750 were made on the note for $175,000, making a grand total of payments made of $83,000.
The corporation owns subdivision land and oil producing property. The oil land is under lease to Shell Oil Company. The corporation secured its note to the Pacific Mutual Life Insurance Company by a mortgage on its properties, and gave as collateral security an assignment of the oil lease “together with all rents due, or to become due thereunder.” The mortgagee notified Shell Oil Co. of the pledge of the lease and rents and instructed Shell Oil Co. to continue to pay the rents and royalties due under the lease to the corporation until further notice. The note and mortgage became due November 30, 1934, and is still past due. It has not been extended or renewed, and will outlaw November 30, 1938.
The corporation has never been in a position to pay oft the mortgage out of current assets. Prom the foregoing, it is apparent, therefore, the corporation was insolvent and in receivership during the taxable year 1937, and is exempt from the surtax under Section 14.

The respondent in his audit disallowed petitioner’s claim for exemption as an insolvent corporation, but, in recognition of its agreement not to declare dividends so long as the $85,000 note remained unpaid, allowed it a credit from the adjusted base in amount of $8,250, under authority of section 26 (c) (1) of the Revenue Act of 1936.

Petitioner, in its brief, states that the points which it relies upon are as follows:

1. The petitioner was in receivership and insolvent in the taxable year.
2. The California codes prohibited the declaration of dividends by the petitioner during the taxable year.

We shall take these points up in their order. As to point 1, it is clear that petitioner was in receivership, but it is also equally clear that this receivership was not occasioned by any insolvency of petitioner. It was due to an altogether different cause. Petitioner concedes that the receivership was not instituted by its creditor, the insurance company, nor was it prolonged by any insistence on the part of the insurance company. Petitioner does contend, however, that in the taxable year 1937 it was insolvent within the meaning of the applicable statute, and that, when the two conditions exist simultaneously, namely, insolvency and receivership, then the exemption provided by section 14 (d) (2) applies. Petitioner, in support of its contention tliat it was insolvent during the taxable year within the meaning of the act, quotes from Dutcher v. Wright, 94 U. S. 553:

Insolvency, in the sense of the Bankrupt Act, means that the party whose business affairs are in question is unable to pay his debts as they become due, in the ordinary course of his daily transactions; and a creditor may be said to have reasonable cause to believe his debtor to be insolvent when such a state of facts is brought to his notice respecting the affairs and pecuniary condition of his debtor as would lead a prudent man to the conclusion that the debtor is unable to meet his obligations as they mature, in the ordinary course of his business. Buchanan v. Smith, 16 Wal., 308, 21 L. Ed., 286; Toof v. Martin, 13 Wal. 1, 40, 20 L. Ed., 481. * * *

That the word “insolvent” as used in section 14 (d) (2) was intended by Congress to carry the meaning used in the above language by the Supreme Court, petitioner contends is evidenced by Senate Finance Committee Keport of June 1,1936, on the Revenue Bill of 1936, where on page 15, in discussing section 14 (d) (2), it is said:

The Finance Committee Bill also avoids the possibility of tax avoidance by collusive Receiverships by limiting the provision to cases in which the corporation is in bankruptcy under the Federal bankruptcy laws, and to cases in which it is insolvent, i. e., its liabilities are in excess of its assets or it is unable to pay the claims of creditors as they mature — and in receivership in Federal or State Courts.

We accept as correct the contention which petitioner makes as to the meaning of the word “insolvent” as used in section 14 (d) (2). We do not think, however, that the evidence shows that petitioner was “insolvent” within the meaning of the act and the foregoing definition at any time during the taxable year. In a balance sheet attached to its income tax return for the taxable year, its total assets are listed at a value of $1,162,789.84; its total liabilities, exclusive of capital stock and surplus, are listed at $144,255.21. It had net income in 1937 of $54,101.14.

While it did not finish paying all of its indebtedness to the insurance company in 1937, it paid $83,000 of it in that year and, as has already been stated, this creditor had nothing whatever to do with instituting the receivership and took no part in prolonging it. Under these circumstances we can not hold that petitioner was an insolvent corporation in receivership during the taxable year. It was not exempt under section 14 (d) (2). On this point we sustain respondent.

As to point 2, raised in petitioner’s brief, it is equally clear that the respondent must prevail. The question of whether or not state laws and/or charter provisions of a corporation create contractual relations recognizable in determining Federal income tax questions has been the subject of diverse decisions in different courts, notably in Northwest Steel Rolling Mills, Inc. v. Commissioner, 110 Fed. (2d) 286, where the Circuit Court of Appeals for the Ninth Circuit sustained the position herein contended for by the petitioner; and in Crane-Johnson Co. v. Commissioner, 105 Fed. (2d) 740, wherein the Circuit Court of Appeals for the Eighth Circuit held to the opposite view. To settle this conflict in Circuit Court opinions, the Supreme Court granted certiorari in both cases, and in rendering its decisions sustained the Eighth Circuit Court’s views in Crane-Johnson Co. v. Commissioner, 311 U. S. 54, and reversed the Ninth Circuit Court’s decision in Helvering v. Northwest Steel Rolling Mills, Inc., 311 U. S. 46. Following the Supreme Court’s decision in these two cases, we sustain respondent as to point 2.

We have disposed of the two points raised by petitioner in its original brief. The petitioner, in its reply brief, has raised a third point which in substance is this: Petitioner had assigned prior to May 1, 1936, as additional security for the payment of its $175,000 note due the insurance company, the oil royalties which it was to receive from the Shell Oil Co., and while this assignment did not expressly limit petitioner in the payment of dividends so long as any of the $175,000 note remained unpaid, nevertheless there was an implied restriction on the payment of dividends imposed by the agreement, and petitioner is entitled thereby to a credit under section 26 (c) (1), supra.

There is nothing to show that the assignment of the Shell Co. oil royalties by petitioner to its creditor, the Pacific Mutual Insurance Co., as further security for the payment of its $175,000 note, in any manner expressly restricted petitioner in the payment of dividends. This assignment is not in evidence and we do not know what written provisions it contained, but the witness who testified in regard to it did not say that the assignment dealt “expressly with the payment of dividends.” Petitioner does not so contend in its brief. It simply contends that because petitioner had assigned these oil royalties to its creditor, as additional security for the payment of its notes, it was by necessary implication prohibited from the payment of any dividends during the effective period of the assignment. We think this contention must be denied. Cf. Belle-Vue Manufacturing Co., 43 B. T. A. 12.

Petitioner does not make any claim that it is entitled to a credit under the provisions of section 26 (c) (2). On account, however, of the close connection between paragraphs (1) and (2) of section 26 (c) of the Revenue Act of 1936, perhaps we should say a word as to the applicability of section 26 (c) (2) to the facts of the instant case. We have considered the evidence carefully and we find no contract in evidence which would seem to fall within the provisions of section 26 (c) (2).

Our decision in G. B. R. Oil Corporation, 40 B. T. A. 738, which was under section 26 (c) (2), is not applicable to the facts in the instant case. In that case the taxpayer, to secure the loans with which to purchase certain oil leases and oil royalties, executed and delivered to the bank from which it was borrowing the money appropriate deeds of trust and also by separate instruments in writing assigned its interests in the properties to the bank in trust and authorized the bank to receive and collect all sums of money derived from the properties and to apply same on its indebtedness to the bank. Under those circumstances, we held that the taxpayer in computing its adjusted net income was entitled to a credit under section 26 (c) (2) of the amount paid on its indebtedness during the taxable year in compliance with the contract.

In the instant case, there was no requirement that the oil royalties received from the Shell Co. should be paid to petitioner’s creditor, the insurance company, as there was in G. B. R. Oil Corporation, supra. On the contrary, the oil royalties were to be paid to petitioner and were in fact paid to it. The insurance company had a mortgage on these oil royalty receipts, it is true, and it is undoubtedly true that a considerable portion of them was used as payments on petitioner’s indebtedness to the insurance company, but it seems to us that this falls short of meeting the requirements of section 26 (c) (2). Cf. Nocona Cotton Seed Oil Co., 42 B. T. A. 1172.

For reasons above stated we think the facts in the instant case are distinguishable from those which were present in G. B. R. Oil Corporation, supra.

Decision will he entered for respondent.

       SBC. 26. CREDITS OE CORPORATIONS.
      *******
      (c) Contracts Restricting Payment op Dividends.—
      (1) Prohibition on payment op dividends. — An amount equal to the excess ol the adjusted net income over the aggregate of the amounts which can be distributed within the taxable year as dividends without violating a provision of a written contract executed by the corporation prior to May 1, 1636, which provision' expressly deals with the payment of dividends. If a corporation would be entitled to a credit under this paragraph because of a contract provision and also to one or more credits because of other contract provisions, only the largest of such credits shall be allowed, and for such purpose if two or more credits are equal in amount only one shall be taken into account.


source: Caselaw Access Project

author: Steknhagen:

license: Public Domain

text:
    Warner G. Baird and Julia Dole Baird, Petitioners, v. Commissioner of Internal Revenue, Respondent.
    Docket No. 97439.
   MEMORANDUM SUR DECISION UNDER RULE 50 AND DENIAL OE MOTION TO VACATE, ETC.

Steknhagen:

After alternative computations filed by both parties, a hearing was had under Rule 50. As petitioner states in his explanation of the discrepancy between the two computations, the respondent has increased the income by $4,083.20, representing interest on United States Liberty and Treasury bonds. Were it not for this item, the computations of both parties would be the same and show no deficiency.

Dated January 22, 1941.

This, addition of $4,083.20 is unauthorized and unjustified. The item was not covered in the deficiency notice, the original petition, the original answer, or the trial. On July 15, 1940, two months after the trial, the respondent filed a motion for leave to file an amended answer for the purpose of raising the issue as to the item in question. The petitioner objected to the proposed amendment, and after due consideration the motion was denied, and the amended answer was not filed.

The findings of fact and opinion were promulgated October 15, 1940, and respondent’s computation, which is said to be “in compliance with the Board’s opinion determining the issues in this proceeding,” was filed January 3, 1941. This computation, however, despite the absence of the item from the pleadings and the denial of the motion to amend the pleadings to raise the issue, adds the item to the income and as a result determines a deficiency. This is said to be supported by the Board’s findings of fact. It is plain, however, that- the facts, if they could be read to include such a finding, were not the result of a litigated issue but are, as to this item, only incidental to the facts necessary to determine the issues properly litigated. There is no justification for the introduction of the item through the back door of the deficiency notice, and the attempt to do so in the face of the Board’s express ruling to the contrary must be condemned as improper practice. Davison v. Commissioner, 60 Fed. (2d) 50; State Consolidated Oil Co. v. Commissioner, 66 Fed. (2d) 648; Fifth Street Building v. Commissioner, 77 Fed. (2d) 605; Helvering v. Edison Securities Corporation, 78 Fed. (2d) 85; Morrisdale Coal Co. v. Commissioner, 97 Fed. (2d) 272, 288; Commissioner v. Sussman, 102 Fed. (2d) 919.

The petitioners’ computation filed January 16, 1941, is in accordance with the Board’s report and is the proper basis of the decision.

The respondent, on January 15, 194Í, also filed a motion for leave to file out of time a motion to vacate, etc., in order to bring the decision within the rule of Electro-Chemical Engraving Co. v. Commissioner, 311 U. S. 513 and Commissioner v. Hammel, 311 U. S. 504. These opinions of the Supreme Court have been duly considered and are found to be distinguishable and to require no modification of the Board’s opinion in the present proceeding.

       This decision was not promulgated as a printed pamphlet.


author: Disney:

text:
    Campbell Transportation Company, Petitioner, v. Commissioner of Internal Revenue, Respondent.
    Docket Nos. 100296, 100297.
    Promulgated January 23, 1941.

      John A. McCann, Esq., and William B. Hanson, C. P. A., for the petitioner.

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

Disney:

The question here presented is whether the petitioner is entitled to credit under section 26 (c) (2) of the Revenue Act of 1936, for the amount of $33,880 set aside by the petitioner during 1936 and paid to the lessor on December 30, 1936 (though not due until March 1, 1937), as rental, and $8,747.57 set aside and paid in 1936 upon amortized life insurance premiums on the life of its general manager; and $6,120 rental set aside during 1937 and paid February 25, 1937, $42,328.77 set aside as rental during 1937 and paid December 30, 1937, on account of rental due March 1, 1938, and $9,514 annual premium on the life insurance policy. In other words, the question is whether the contract, consisting of lease, declaration of trust, and acceptance thereof, constitutes a contract expressly dealing with the disposition of earnings and profits of the taxable years and requiring them to be paid or irrevocably set aside, within the taxable years, in discharge of a debt.

In these proceedings there is no dispute about the fact that the amounts were set aside, and were paid, nor that the contract was executed prior to the date required by statute.

The petitioner, citing Tyler v. United States, 281 U. S. 497, argues,' in effect, that as an “eminently practical” matter of taxation it was, regardless of the absence from the contract of express words required by the statute, required to set aside and pay the rental on the dates due in order to keep its river equipment; that such river equipment was its source of income; that such income and the retention of the equipment depended on the making of the payments as due under the lease; that such payments were due on February 25 and August 25 of each year; that the only way “in all reasonable possibility” that the February 25 payment could be made was to accrue and set aside part of it before the close of the preceding calendar year (the petitioner being upon the calendar year basis) because its income from January 1 to February 25 was clearly insufficient for the payment; that it could not sell its equipment without violating the terms of the lease; and that it could not pay its earnings out in -dividends. Petitioner points out that in G. B. R. Oil Corporation, 40 B. T. A. 738, the express words “earnings and profits” are found not to be requisite and contends that, as in that case it was said that “the language of the assignments was certainly broad enough to include the taxable year 1936 and the parties have so construed the contract”, so here the provision as to payment of rentals was broad enough to require the setting aside of current earnings to pay them, and that the parties here so construed the instant contract.

We are unable to agree with this contention. In the G. B. R. Oil Corporation case the language was considered sufficiently broad for the reason that all of the company’s receipts from the property purchased, comprising the petitioner’s total income, with the exception of $154, were required to be paid to the creditor. Obviously “all receipts” were properly considered to cover “earnings and profits.” Here there is no requirement that any receipts, earnings, or profits be devoted to the payment of rentals under the lease, but we find merely an ordinary provision for payment of rentals. The petitioner had other assets with which the rentals might have been paid and perhaps, at least in part, were paid. It had large assets on January 1, 1936, prior to the contract here involved, including cash of $44,603.86, more than the $33,880 set aside during 1936 and paid on December 30, 1936, and on December 31, 1936, still had $13,630.69. It is obvious that the $33,880 may have been paid, not with earnings or profits of 1936, but with such cash or with other assets on hand January 1, 1936, and not covered by the agreement here considered, and that the same is true of the payments on rental made in 1937. Moreover, there was under the agreement no requirement that any payment here involved (except possibly insurance hereinafter discussed) be made or amount irrevocably set aside during 1936; for, although the 2)4 percent interest due August 25, 1936, amounted to about $13,500, it is stipulated that the $33,880 paid December 30, 1936, was not due and payable until March 1, 1937. The mere fact of payment or setting aside of funds does not satisfy the terms, and we think the intent, of the statute. Unless it was required by the contract to be paid or irrevocably set aside, the petitioner would be free to elect whether to so treat its earnings or to pay dividends. Such is not the situation contemplated by the statute, which concerns itself, as we said in the G. B. R. Oil Corporation case, with contracts which “inevitably require in their performance a drawing on current earnings.” (Italics supplied.) The use of the word “irrevocably” indicates that no election was intended to be within the taxpayer’s power. We think it clear that here there was no such inevitable drain upon the current earnings or profits as to apply the statute, as to rental payments in 1936. That a payment was required to be made February 25, 1937, is not sufficient. Petitioner says its income in the interim was not sufficient to make the payment. If that were material, as we think it plainly is not, there is no evidence to that effect. The income during that period may have been much more than the payment to be met. The same thought applies to the payment which was due March 1,1938, but accumulated and paid December 30, 1937.

As to the payments to provide life insurance upon the life of petitioner’s general manager, under the agreement, we think the same general thought above expressed clearly applies — the contract did not require such expense to be from the earnings or profits of the years here involved, but only that they be, in some maimer, paid. As to whether there was “a debt” to the extent (one-half) that the insurance was payable to the petitioner itself, and not the lessee, may well be questioned, but is not necessary of decision here, under our conclusion above. Moreover, since the agreement provided for payment of the amount of the insurance premiums only “as and when demanded”, it seems clear that there is no contractual requirement that the amounts be paid in the taxable years here involved, and that the statute therefore does not apply. We can discern no requirement that petitioner’s earnings and profits during the taxable years be devoted to payment of insurance. Like the rental payments, the insurance was not payable from any particular fund. The petitioner’s undivided profits of $68,020.43 on hand January 1,1936, prior to the agreement here involved, as well as other assets then appearing, may have been applied either to insurance or rentals; certainly it could have been so utilized — which takes away the requirement or necessity of using current earnings or profits. During 1936 it appears that $50,000 was paid into surplus, since that amount of “paid in or capital surplus” appears on January 1,1937, where none had appeared before. Moreover upon that date there was $133,659.17 earned surplus and undivided profits, as well as other assets above referred to. Payment therefrom in 1937 would not have been from current earnings or profits. This serves to emphasize the fact that throughout the taxable years here involved, though the petitioner was under a duty to make certain payments, there was neither express nor implied requirement that they be made from the earnings or profits of the taxable years. The creditor could not, we think, have prevented distribution of dividends. Its right was merely to payment, however made. Under all of the facts appearing herein, in our opinion there was not, in the contract involved, that requirement of use or irrevocable reservation of current earnings and profits which, within the intendment of the statute, forms the basis for the credit claimed. Therefore,

Decision will he entered for the respondent.

       SEC. 26. CREDITS OE CORPORATIONS.
      In the case of a corporation the following credits shall be allowed to the extent provided in the various sections imposing tax—
      * * * * * * *
      (c) Contracts Restricting Payment of Dividends.—
      .#**#**
      (2) Disposition of profits of taxable teak. — An amount equal to the portion of the earnings and profits of the taxable year which is required (by a provision of a written contract executed by the corporation prior to May 1, 1936, which provision expressly deals with the disposition of earnings and profits of the taxable year) to be paid within the taxable year in discharge of a debt, or to be irrevocably set aside within the taxable year for the discharge of a debt; to the extent that such amount has been so paid or set aside. Eor the purposes of this paragraph, a requirement to pay or set aside an amount equal to a percentage of earnings and profits shall be considered a requirement to pay or set aside such percentage of earnings and profits. As used in this paragraph, the word “debt” does not include a debt incurred after April 30,1936.


text:
    Valley Lumber Company of Lodi, Petitioner, v. Commissioner of Internal Revenue, Respondent.
    Docket No. 100421.
    Promulgated January 23, 1941.

      Frank O. Scott, O. P. A., for the petitioner.

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

Steknhagen:

The Commissioner determined a deficiency for 1936 of $967.36 in income tax and $28.36 in excess profits tax. He disallowed a dividends paid credit of so much of the amounts of dividends declared and credited to shareholders’ accounts as was not withdrawn by them. The facts are found as stipulated.

The petitioner was a close corporation, with eight shareholders. Its accounts and return were on an accrual basis. In 1936 it declared two dividends, one on September 5 and the other on December 24, both payable at once. All the shareholders had accounts on the corporation’s books and none was indebted to the corporation. The amounts of the dividends were immediately credited to the shareholders’ accounts. The amount of the first dividend was almost entirely withdrawn by the shareholders, and the Commissioner has allowed the credit of the amount withdrawn. The second dividend remained undrawn in the several accounts for the remainder of the year, and the Commissioner has disallowed all of it as a credit. Six of the shareholders included the entire amount of both dividends in their 1936 income; one included the September dividend and not the December dividend, and one filed no return.

The dividends paid credit is that provided by the Revenue Act of 1936, section 27, prescribed by section 14 (a) (2) as a factor in the computation of “undistributed net income”, which is the subject of the “surtax on undistributed profits” imposed by section 14 (b). The credit is for “dividends paid” and it is so purely a term in the scheme of the undistributed profits surtax that it may not be lifted from its context in a search for a general meaning. It is not a factor of general income and does not determine the ordinary income tax, so there is no use importing supposed analogies to items like interest and salaries, cf. Schoenheit v. Lucas, 44 Fed. (2d) 476, involving questions as to deduction by the payer and inclusion in income by the recipient, cf. Massachusetts Mutual Life Insurance Co. v. United States, 288 U. S. 269, Hart v. Commissioner, 54 Fed. (2d) 848. As to such items it has been said that the taxing statute is asymmetrical, Cox Motor Sales Co., 42 B. T. A. 192. If there is a reciprocal treatment of an amount for income tax purposes, so that what one is held to receive another is held to pay and vice versa, it is not because of a commanding rule, but because this is a form of logic which is often engaging but never compelling. The important concern, irrespective of logic or symmetry, is to promote the manifest purpose of the statute.

The purpose of the undistributed profits tax, like that of the prior personal holding company tax, is set forth in Foley Securities Corporation v. Commissioner, 106 Fed. (2d) 731, and Sanford Corporation v. Commissioner, 106 Fed. (2d) 882; certiorari denied, 309 U. S. 659. See also Credit Alliance Corporation, 42 B. T. A. 1020; Centennial Oil Co. v. Thomas, 109 Fed. (2d) 359; certiorari denied, 309 U. S. 690. It is to promote equalization of taxation and prevent a failure of tax upon shareholders by the method of withholding distributions of earnings. H. Rept. No. 2475, 74th Cong., 2d sess.; S. Kept. No. 2156. A reciprocal recognition of a distribution is therefore important, for, if as to the shareholder there is a clear recognition that a dividend has been received within his taxable income so that there is no failure of tax (cf. Brooks v. Commissioner, 35 Fed. (2d) 178), the purpose of the statute has been served and there is every reason to give the corporation the credit for a dividend paid. This is not to say that the matter is dependent on the individual shareholder’s personal treatment of the dividend as within or without his taxable income, but rather that it is dependent on whether the receipt is objectively cognizable, see Valley Tractor & Equipment Co., 42 B. T. A. 311.

Eecent decisions relating to the dividends paid credit do not require the denial of the credit here. Atlantic Land Co., 43 B. T. A. 74, is entirely similar, and it was held there that the credit was allowable in the year 1936, when the dividend was declared and placed to the shareholders’ credit in their accounts on the corporation’s books without restriction as to withdrawal. Sanford Corporation v. Commissioner, supra, in which the credit was held to have been properly disallowed, involved, not an unrestricted and withdrawable book credit to the shareholder within the taxable year, but a mere declaration on the last day of the year, unbeknown to the sole shareholder, and an entry to his credit at an uncertain time, perhaps in the following year. Because of his absence he was unable to draw the amount in the taxable year. He could not receive it and be taxed, Avery v. Commissioner, 292 U. S. 210, and the corporation made no kind of distribution which could be called a dividend paid. The corporation and not the shareholder continued throughout the taxable year to have full command and control of the dividend fund, the purpose of the statute to encourage placing earnings at the disposition of shareholders was not fulfilled, and reason for the dividends paid credit was lacking. In Cox Motor Sales Co., 42 B. T. A. 192, the dividends paid credit was disallowed because, although a dividend “of all profits” was declared in the taxable year and a credit was entered on the accounts of the shareholders, it was not thereby made subject to the complete control of the shareholders and removed from the control of the corporation; the shareholders would not have had complete control until the final accounting in the following year, cf. C. E. Gullett, 31 B. T. A. 1067.

In Valley Tractor & Equipment Co., supra, the corporation in the taxable year issued checks for the dividend. The shareholders did not cash the checks, but the amounts were within their taxable income. The dividend was held to have been paid and the credit allowed. The difference between that case and this is that there the bank was the repository of the funds which the shareholders controlled and here the corporation continued to hold the funds wholly subject to the shareholders’ unrestricted demand and control. This difference does not justify a distinction in the recognition of payment.

In Pacific Grape Products Co., 42 B. T. A. 914, the corporation in the taxable year issued checks for the dividend, but, because it was clearly understood with most of the shareholders that their checks would be turned back, they were held to be without substance as payment and hence the credit was denied. However, as to the small amount of the checks which were not turned back by a few shareholders within the taxable year, the cáse was indistinguishable from Valley Tractor de Equipment Co., supra, and credit was properly allowed.

There is a provision in Regulations 94, article 27 (b), which purports to cover this case.

If a corporation, instead, of paying the dividend directly to the shareholder, credits the account of the shareholder on the books of the corporation with the amount of the dividend, the credit for a dividend paid will not be allowed unless it be shown to the satisfaction- of the Commissioner that such crediting constituted payment of the dividend to the shareholder within the taxable year.

This article leaves the problem where it finds it. It says merely that dividends credited to shareholders’ accounts are not to be regarded as paid unless the Commissioner is satisfied that they constitute payment. When a book credit is unrestricted and thoroughly subject to the demand and control of the shareholder, it is the equivalent of cash and does constitute payment of the dividend for the purpose of the dividends paid credit.

Decision will he entered under Rule 50.

       The Surtax on Undistributed Profits, Harvard Law Review, vol. 30, p. 332; The Corporate Undistributed Profits Tax, Columbia Law Review, vol. 36, p. 1321.

       Cf. In re Interborough Consolidated Corporation, 288 Fed. 334, 341, 344.


author: HaReon:

text:
    Lafayette Hotel Co., Petitioner, v. Commissioner of Internal Revenue, Respondent.
    Docket No. 101160.
    Promulgated January 24, 1941.

      Olmton M. Earbison, Esq., for the petitioner.

      Stanley B. Pierson, Esq., for the respondent.
   OPINION.

HaReon:

Petitioner claims credits under the terms of section 26 (c) (2) of the Revenue Act of 1936, for purposes of computing the surtax on its undistributed profits. In orden to obtain such credit under the pertinent statutory provision it must be shown as fact that the corporation not only paid or irrevocably set aside part of the earnings and profits of the taxable year, but that it was required, to do so by a provision of a written contract executed before May 1, 1936, which provision expressly deals with the disposition of earnings and profits of the taxable year, and that the payment or setting aside of earnings was in discharge of a debt. As used in section 26 (c) (2), the word “debt” does not include a debt incurred after April 30,1936.

The petitioner, in 1920, executed a mortgage trust agreement to secure an issue of bonds which were delivered to the trustee to hold until such tune as holders of petitioner’s first preferred convertible stock exercised an option to convert that stock into bonds, the trustee being authorized to make such exchange at any time within 25 years from April 20, 1920. Without reference to whether or not in any given year any of the bonds had been issued by the trustee in exchange for stock, the trust agreement provided that petitioner should make sinking fund payments of $5,000 a year, commencing with July 1,1925. From 1932 on, petitioner did not make the sinking fund payments, so that on July 1, 1936, $25,000 was due the trustee. On July 1, 1936, no bonds had been issued in exchange for stock. Petitioner was not required to make the sinking fund payments from its earnings and profits each year. In fact, in 1932,1934, and 1935 petitioner’s business yielded substantial net earnings and profits, but petitioner did not pay or set aside any portion thereof for the sinking fund.

Petitioner contends that in 1936 and 1937 it was in substance and by contract required to use part of its net earnings for sinking fund payments which were due, and that its financial condition was such that it did pay out of net earnings in 1936 and 1937, respectively, $20,000 and $10,000 to the trustee for the sinking fund. To support these contentions petitioner argues that, because its book account entitled capital surplus showed deficits at the end of 1935, 1936, and 1937 in the respective amounts of $155,945.06, $155,020.68, and $108,916.29, its financial condition was such that the amounts paid to the trustee in 1936 and 1937 must be held to have been paid from current earnings in each year. Petitioner argues further that a provision in the terms of the bonds in question, set forth in the trust agreement of 1920, must be construed as requiring, in 1936 and 1937, that the earnings in each year must be applied to the sinking fund payments said to be in default. Eeference to that provision will be made hereafter. Neither contention of petitioner can be approved under the record in this case.

Petitioner reported net income for 1936 and 1937 in the respective amounts of $53,737.84 and $75,094.60, which respondent adjusted to $51,912.41 and $74,136.87, respectively. Respondent refused to allow credits for $20,000 and $10,000 under section 26 (c) (2). Respondent contends that the provision in the mortgage deed of trust under which petitioner claims the credits fails to meet the requirements of section 26 (c) (2) for a written contract, because it does not reauire a portion of earnings in the taxable years to be used for annual sinking fund payments, and because no debt was incurred prior to April 30, 1936, at which time no bonds had been exchanged for convertible stock. Respondent relies on Haffenreffer Brewing Co., 41 B. T. A. 443; affd., 116 Fed. (2d) 465; and Spaulding Bakeries, Inc., 42 B. T. A. 430, as authority for the proposition that an obligation to set aside funds to retire preferred stock is not an obligation to retire indebtedness, since the stockholder relation is not one of a debtor and creditor.

Admittedly petitioner was not required to set aside earnings each year for sinking fund payments, by any provision to that effect in the mortgage deed of trust. Petitioner argues, however, that defaults in the payments made all annual profits subject to the lien of the mortgage given to secure bonds, when, as, and if issued, and that the rule of G. B. R. Oil Corporation, 40 B. T. A. 738, is applicable here. Paragraph 5 of the mortgage deed of trust provides that, in the event of breach of any obligations imposed by the trust on petitioner, all subsequently accruing rents and profits shall pass under the lien of the mortgage, “provided any proceedings are instituted in a court of competent jurisdiction for the enforcement of the lien created by this mortgage, or for the appointment of a receiver or for both of said purposes.” The trustee at no time instituted such proceedings as are referred to above. By the end of 1936 petitioner had substantially cured defaults in sinking fund payments and, so far as the record shows, no proceedings to enforce the lien of a mortgage against petitioner’s earnings ever were instituted by the trustee. Since no bonds’were issued by the trustee prior to July 2,1936, there is considerable doubt whether at that date the trustee, under the mortgage deed of trust securing the bonds, had any equitable lien on the earnings from petitioner’s property which was covered by the mortgage. It is concluded that paragraph 6 of the trust was not put into operation in the taxable years so as to require, as under a written contract, the application of petitioner’s earnings in the taxable years in payment of the sinking fund installments. The G. B. R. Oil Corporation case is distinguishable on the facts, the circumstances which were present in that case not being present here. If we regard the mortgage deed of trust as the kind of written contract referred to in section 26 (c) (2), for argument, we find no provision therein which inevitably required petitioner to set aside earnings in the taxable years in payment of a debt incurred prior to April 30,1936. Belle-Vue Manufacturing Co., 13 B. T. A. 12. It has been pointed out previously that the per-: tinent statutory provision is to be construed precisely as it is written. Moloney Electric Co., 42 B. T. A. 78, 85. Section 26 (c) refers primarily to “Contracts Restricting Payment of Dividends.” Petitioner during the taxable years and in prior years paid dividends each year, and, as far as the record shows, at no time regarded the terms of the mortgage deed of trust as a contract restricting payment of dividends. Petitioner’s contentions call for a strained construction. See Helvering v. Northwest Steel Rolling Mills, Inc., 311 U. S. 46; Oregon City Manufacturing Co., 43 B. T. A. 212.

Petitioner’s contentions fail for two other reasons. The record does not prove conclusively that the $20,000 paid to the trustee in 1936, and the $10,000 paid in 1937 were paid from the earnings and profits of each respective year. Also, it can not be held that the payments in the taxable years were paid in discharge of a debt incurred prior to April 30,1936.

Petitioner’s argument that its financial condition was such as to require payment of the sinking fund installments from earnings is without merit. Reliance is placed entirely upon a book deficit in the capital surplus account at the end of each taxable year and upon book entries at the end of each taxable year charging, for the sinking fund payments which were made, the profit and loss account and crediting an account entitled “Earnings Appropriated to Comply with Contract, for Bond Retirement.” Direct evidence on the source of the payments made in the taxable years is limited. The complete financial condition of petitioner, as would be shown by the profit and loss account and a balance sheet, is not in evidence. The capital account, standing alone in the record, is not conclusive, and it is difficult to understand. The capital deficit was accumulated from 1928 to 1933, and thereafter it was gradually reduced. From 1928 through 1933 annual dividends in very large amounts were paid each year, even as the capital deficit increased. For the years 1934 and 1935 net profits exceeded paradoxically dividends and other items paid by the respective amounts of $24,104.54 and $16,795.25. In 1936 net profits exceeded dividends and other items paid by $924.38. It is possible that the total sinking fund payments of $30,000 made in 1936 and 1937 were from surplus accumulated in the capital surplus account in the years 1934 and 1935, and the record does not indicate the contrary. The evidence does not disclose that petitioner’s financial situation in the taxable years and in the immediately preceding years was such as to demand a construction of the mortgage trust deed as requiring that earnings in the taxable years be paid into the sinking fund. Belle-Vue Manufacturing Co., supra. And further, it has been pointed out in Brockway Glass Co., 43 B. T. A. 267, that section 26 (c) (2) allows a credit only for an amount equal to earnings and profits of the taxable year which is required to be paid within the taxable year in discharge of a debt, among other things. If petitioner’s contention was sound, in general, which it is not, arguendo, the provision in the 1920 mortgage deed of trust provides for a payment of $5,000 per annum only. Under the rule of the Brockway Glass Co. case petitioner could not validly claim credits in the taxable year for amounts in excess of $5,000 in each year. And, further, petitioner must prove that the sum paid in each taxable year was in fact paid from- earnings and profits of the taxable year, and, as indicated above, petitioner has failed to so prove beyond doubt.

The convertible first preferred stock was entitled to 6 percent per annum dividends, cumulative, and payable from surplus or net profits. This stock was convertible at any time into bonds, and within 25 years with respect to the bonds referred to in the 1920 mortgage deed of trust. Since no bonds were issued in exchange for stock prior to July 2, 1936, and April 30, 1936, it would appear that any sinking fund created prior to July 2, 1936, must be regarded as a fund for the retirement of outstanding preferred stock. It was possible that no exchanges of stock for bonds would ever be made, and if such proved to be true, the petitioner’s agreement to create a sinking fund would represent no more than an agreement to create a fund to retire •stock rather than to pay an indebtedness. There is no evidence here to show that the terms and conditions under which the first preferred cumulative convertible stock was issued were such as to make the shares of stock evidence of indebtedness rather than preferred stock, in fact. Haffenreffer Brewing Co., supra; Spaulding Bakeries, Inc., supra. Here, as in the cited cases, the preferred’ stock did not by its terms have a definite maturity date. The 25-year conversion period was first agreed to in the 1920 mortgage deed of trust and it is a limitation upon the trustee thereunder after which time the trustee may not issue the particular bonds referred to in that trust deed in exchange for stock. See also, May Hosiery Mills, Inc., 42 B. T. A. 646. When preferred stockholders exercised the option to exchange stock for bonds, no doubt a debtor-creditor relationship arose, but no exchanges were made until after July 2, 1936. The Commissioner has ruled in his regulations that “An indebtedness evidenced by bonds or other similar obligations issued by a corporation is incurred as of the date such obligations are issued * * Art. 26-2 (c), Regulations 94. This appears to be a reasonable regulation. Here, there was no bonded debt until July 2, 1936, and thereafter, and whatever part of the sinking fund payments made in 1936 and 1937 can be allocated to the retirement of bonds issued in the taxable years can not be said to represent payments in discharge of a debt incurred prior to April 30,1936, within the terms of section 26 (c) (2).

Petitioner fails on all contentions made and taken together; but petitioner fails primarily because it can not be held that under the. terms of a written contract executed by it prior to May 1, 1936,, expressly dealing with the disposition of earnings and profits, it was. required to pay or set aside earnings in each taxable year for the discharge of a debt within the particular terms of section 26 (c) (2).

Decision wül be entered for the respondent.

       SBC. 26. CREDITS OB’ CORPORATIONS.
      *******
      (c) Contracts Restricting Payment of Dividends.—
      *******
      (2) Disposition of profits of taxable teak. — An amount equal to the portion of the earnings and profits of the taxable year which is required (by a provision of a written contract executed by the corporation prior to May 1, 1936, which provision expressly deals with the disposition of earnings and profits of the taxable year) to be paid within the taxable year in discharge of a debt, or to be irrevocably set aside within the taxable year fon the discharge of a debt; to the extent that such amount has been so paid or set aside. For the purposes -of this paragraph, a requirement to pay or set aside an amount equal to a percentage of earnings and profits shaU be considered a requirement to pay or set aside such percentage of earnings and profits. As used in this paragraph, the word “debt” does not include a debt incurred after April 30, 1936.


author: Mellott :

text:
    Estate of Charles Schmalstig, Deceased, Julius M. Schmalstig and Charles F. Blum, Executors, Petitioners, v. Commissioner of Internal Revenue, Respondent.
    Docket No. 103584.
    Promulgated January 28, 1941.

      Murray Seasongood, Esq., Harry Stickney, Esq., and Bert H. Long, Esq., for the petitioners.

      E. M. Woolf, Esq., for the respondent.
   opinion.

Mellott :

Respondent has filed a motion to dismiss the instant proceeding for lack of jurisdiction. Petitioner insists that the motion should be denied. After oral argument the parties were given leave to file briefs in support of their contentions and have done so.

The petition alleges that the petitioners are the duly qualified, appointed, and acting executors of the estate of Charles Schmalstig, who died August 4, 1935, a resident of Cincinnati, Ohio, leaving an estate of approximately $2,000,000; that they filed an estate tax return for the estate of the decedent with the collector of internal revenue at Cincinnati on or about July 30, 1936, paying the tax shown to be due thereon, aggregating $350,139.92, in installments, between July 30, 1936, and January 9, 1937; that in computing the amount of the tax certain deductions to which they were entitled were inadvertently not taken into consideration; and that there is an overpayment of estate taxes in the sum of $34,817.44.

It is further alleged that under date of June 3, 1939, and within three years from the payment of the estate taxes petitioners filed a claim for refund in the amount set out above. Attached to the petition and marked Exhibit A is a letter which it is alleged constitutes a “notice of deficiency” and which appears to have been mailed to the petitioners on April 2, 1940, by registered mail. The letter is as follows:

TREASURY DEPARTMENT
Washington
Office of Commissioner Apr. 2, 1940 of Internal Revenue MT-ET-3029-lst Ohio Estate of Charles Schmalstig
Date of death — August 4, 1935
Julius M. Schmalstig, et al., Executors 1727 Northcutt Ave. Cincinnati, Ohio
Gentlemen:
Reference is made to the claim filed by you on June 3, 1939, for refund of $34,817.44, Federal estate tax paid under the Revenue Act of 1934.
The claim is based on the contention that additional amounts should be allowed as deductions from the decedent’s gross estate. An examination of the evidence at hand shows a deficiency of $4,034.76, computed as follows:
DEDUCTIONS.
Returned Determined Adjusted
Miscellaneous Administration Expenses:
Item 1-$300.00 $0.00 $494.07
Executors’ commissions_ 40,747.46 .40,747.46 42,733. 00
Attorneys’ fees_ 20,373. 73 20, 373. 73 42,500.00
Debts of decedent:
Item 8-75.00 0.00 75.00
Charitable, public, and similar gifts and 2, 600.00 0.00 2,600.00
SUMMARY
Gross estate- $2,032,147.69
Deductions, 1926 Act- 208,160. 61
Net estate, 1926 Act- $1,823,987.08
Net estate, 1932 Act- $1,873,987.08
Gross tax, 1926 Act-$117,658. 84
Credit for State estate, inheritance, legacy, or succession taxes_ 83, 361.31
Net tax, 1926 Act_ $34,297.53
Total gross taxes, 1926 and 1932 Acts-$437,535.99
Gross tax, 1926 Act_ 117,658.84
Additional tax--- $319,877.15
Total net tax- $354,174. 68
Amount assessed on return — _ 350,139.92
Deficiency. $4,034.76
The amount of the additional deductions allowed in connection with the several items, as indicated in the above set-up, is offset by the reduction in the amount previously allowed as a credit for State estate, inheritance, legacy, or succession taxes, by reason of refunds made by the State out of the amounts previously paid. The deficiency of $4,034.76 has not been assessed. Inasmuch as there is no overassessment of tax, the claim for refund filed by you on June 3,1939, is rejected in its entirety.
Respectfully,
Guy T. Helvering,
Commissioner,
By:
[Signed] adelbert oheisty Adeebebt Christy,
Acting Deputy Commissioner.

The petition was filed with the Board under date of June 24, 1940, and within due time thereafter the motion to dismiss was filed.

The sole issue is: Is the letter a notice of deficiency? The applicable statutes are section 307 of the Revenue Act of 1926 and section 308 (a) of the same act as amended by section 501 of the Revenue Act of 1934. (See also sections 870 and 871, Internal Revenue Code.)

Petitioners contend that the form of the notice is immaterial; that the letter clearly shows that the Commissioner determined a deficiency in tax; that he obviously intended the letter to be a “notice of such deficiency”; and that the Board has jurisdiction to redetermine the deficiency. They cite the following cases: Fanny Newman, 6 B. T. A. 373; Austin Co., 8 B. T. A. 628; affd., 35 Fed. (2d) 910; certiorari denied, 281 U. S. 735; Commissioner v. Leasing & Building Co., 46 Fed. (2d) 2; Oswego Falls Corporation, 26 B. T. A. 60; affd., 71 Fed. (2d) 673; McDonnell v. United States, 59 Fed. (2d) 290; United States v. Chemical Foundation, 272 U. S. 1; Ventura Consolidated Oil Fields v. Rogan, 86 Fed. (2d) 149; certiorari denied, 300 U. S. 672; and Gebelein, Inc., 37 B. T. A. 605.

In the Newman case the letter stated: “In view of the decision of the United States Supreme Court [in a cited case] * * * the Burean has redetermined the tax in this estate * * (Italics ours.) It was pointed out in the opinion that the language employed in the notice was “most specific in terms” and indicated that the Department proposed to collect a tax on the theory that the entire value of the community property must be included in the decedent’s gross estate. Austin Go. involved primarily the power of the Commissioner to determine a deficiency after the tax had been paid, a portion of it had been refunded, and subsequent investigation convinced the Commissioner that he had refunded more than should have been refunded. In that case it was plain that the Commissioner was endeavoring to collect an additional tax. The Leasing & Building Co. case merely applied to a waiver prepared by the Commissioner the general rule of law that doubt resulting from the use of ambiguous language is to be resolved against the one responsible for its use. In Oswego Falls Corporation the Board declined to bold that it is necessary for the Commissioner personally to sign a notice of deficiency. In the McDonnell case the Court of Claims held that the facts before it showed the “Commissioner fully complied with the requirements of section 274 (of the Revenue Act of 1926.).” It was pointed out that he had given the taxpayer notice of a proposed deficiency, allowing him thirty days in which to file a protest; that protest had been filed, setting forth that the tax was $4,386.15 instead of $4,549.03 as proposed in the thirty-day letter; that the protest had been considered and allowed and thereafter “the Commissioner sent the plaintiff a written notice of his final determination of a deficiency for 1917 in the amount of $4,386.15”; and that the Commissioner was not required specifically to advise the taxpayer of his right to institute a proceeding before the Board.

United States v. Chemical Foundation, supra, is relied upon by petitioners as justifying a presumption that the Commissioner has performed his duty by mailing a statutory notice of deficiency before the claim for additional tax should become barred by the statute of limitations. Gebelem, Inc., merely holds that a notice not sent by registered mail may not be regarded as an authorized notice of deficiency. See also William M. Greve, 37 B. T. A. 450.

In Ventura Consolidated Oil Fields v. Rogan, supra, the court referred to some of the well established rules applicable to a statutory notice of deficiency — that the deficiency letter (notice) need be in no particular form; that it suffices to authorize an assessment after 60 days (now 90 days) if it fairly advises the taxpayer that the Commissioner has determined a deficiency; and that it need not notify the taxpayer of his right to appeal to the Board, since he is presumed to know that. Nevertheless the court held that the letter which the Commissioner had sent to the taxpayer in that case, even though it contained “the necessary elements of a deficiency as required by * * * [the cases cited earlier in its opinion]”, was not a valid notice of deficiency, not because of what it lacked, but because of the additional matter it included. It was pointed out that the letter “* * * was coupled with a blank form closing agreement for a final settlement of tax liability, and was expressly sent only in reference to such closing agreement and in reference to the confei’ence had earlier between representatives of the taxpayer and the government. It was, in substance, only an invitation to the taxpayer to offer to compromise the disputed taxes in an agreed determination to be made the basis of a settlement.”

Petitioners’ first contention is correct. The form of .the notice is immaterial. It need not advise the taxpayer of his right to invoke the jurisdiction of this Board, though it usually does do so; and it is sufficient if it fairly advises the taxpayer that there is a deficiency in; respect of the tax. Nothing short of such a notice (Cornelius Cotton Mills, 4 B. T. A. 255; Will County Title Co., 38 B. T. A. 1396), sent by registered mail (Gebelein, Inc., supra, and William M. Greve, supra) gives a taxpayer the right to petition this Board for a redetermination of the deficiency. A thirty-day letter does not do so (Frost Superior Fence Co., 1 B. T. A. 1096; Mohawk Glove Corporation, 2 B. T. A. 1247; Fidelity Title & Trust Co. et al., Executors, 10 B. T. A. 482; affd., 64 Fed. (2d) 52) nor does a preliminary letter from the Income Tax Unit of the Bureau (Fidelity Insurance Agency, 1 B. T. A. 86) or from the collector. (Franklin H. Moyer, 1 B. T. A. 75; Roy Nichols, 14 B. T. A. 1347; American Bag Co., 16 B. T. A. 774.) But the sufficiency of the notice must be determined from the language used. It is idle to speculate that the Commissioner must have intended to give petitioners a notice of deficiency before the bar of the statute had fallen. Nor is there such ambiguity in the language of the letter, as will be pointed out later, that it should be construed to be a notice of deficiency under the rule of Commissioner v. Leasing & Building Co., supra.

Ventura Consolidated Oil Fields v. Rogan, supra, though referring to the rule that an ambiguous document is to be “construed against the draftsman”, really supports respondent’s position more than petitioners’. It seems to hold that a deficiency notice under the statute should be no more and no less than a notice that the Commissioner has determined the taxpayer has an additional tax liability, which is to be made the basis of an assessment in the manner prescribed by law. The Supreme Court denied certiorari, 300 U. S. 672, and the case has been cited with approval in Lehigh Portland Cement Co. v. United States (Ct. Cls.), 30 Fed. Supp. 217, and in United States v. National City Bank of New York, 32 Fed. Supp. 890. The Circuit Court of Appeals for the Seventh Circuit expressed somewhat the same view in Tyson v. Commissioner, 66 Fed. (2d) 160, in which, it will be noted, substantially the same form of letter was used as that now before us, including a similar computation.

We do not agree with petitioners’ contention that the Commissioner intended the letter set out above to be, or that it was, a statutory notice of deficiency. It begins by making reference to the claim filed by petitioners on June 3, 1939, for refund of Federal estate tax paid under the Eevenue Act of 1934. It concludes by rejecting, in its entirety, “the claim for refund filed by you on June 3, 1939.” This clearly indicates that the claim for refund was the subject of the letter and the disallowance of such claim — no more and no less — was its object. The fact that it contained a computation showing, as one of the reasons for disallowing the claim for refund, an underpayment of tax characterized as a “deficiency”, does not change it from a notice of rejection of a claim for refund to a notice of deficiency in tax. Cf. Tyson v. Commissioner, supra; J. M. Richardson Lyeth, Jr., 41 B. T. A. 186.

Petitioners make a point of the fact that the letter was sent by registered mail — one of the essentials for a valid notice of deficiency, which will start the running of the statute of limitations. Gebelein, Inc., supra; Tyson v. Commissioner, supra. In this comiection it is appropriate to point out that under section 3772 of the Internal Revenue Code no suit for refund shall be begun “after the expiration of two years from the date of mailing by registered mail by the Commissioner to the taxpayer of a notice of the disallowance of the part of the claim to which such suit or proceeding relates.” The Commissioner apparently had this statute in mind when he mailed the letter to petitioners rejecting their claim for refund “in its entirety.” In any event, the mere use of a registered letter does not necessarily support petitioners’ contention that the Commissioner intended it to be a notice of deficiency.

Being of the opinion that no notice of deficiency has been sent to petitioners, the motion must be, and it is, granted and the proceeding is

Dismissed.

Reviewed by the Board.

       Sec. 307. As used in this title in respect of a tax imposed by this title the term “deficiency” means—
      (1) The amount by which the tax imposed by this title exceeds the amount shown as the tax by the executor upon his return; but the amount so shown on the return shall first be increased by the amounts previously assessed (or collected without assessment) as a deficiency, and decreased by the amounts previously abated, refunded, or otherwise repaid in respect of such tax; or
      (2) If no amount is shown as the tax by the executor upon his return, or if no return is made by the executor, then the amount by which the tax exceeds the amounts previously assessed (or collected without assessment) as a deficiency; but such amount previously assessed, or collected -without assessment, shall first be decreased by the amounts previously abated, refunded, or otherwise repaid in respect of such tax.
      Sac. 308. (a) If the Commissioner determines that there is a deficiency in respect of the tax imposed by this title, the Commissioner is authorized to send notice of such deficiency to the executor by registered mail. Within 60 days after such notice is mailed (not counting Sunday as the sixtieth day), the executor may file a petition with the Board of Tax Appeals for a redetermination of the deficiency. Except as otherwise provided in subdivision (d) or (f) of this section or in section 312 or 1001, no assessment of a deficiency in respect of the tax imposed by this title and no distraint or proceeding in court for its collection shall be made, begun, or prosecuted until such notice has been mailed to the executor, nor until the expiration of such 60-day period, nor, if a petition has been filed with the Board, until the decision of the Board has become final. Notwithstanding the provisions of section 3224 of the Revised Statutes the malting of such assessment or the beginning of such proceeding or distraint during the time such prohibition is in force may be enjoined by a proceeding in the proper court.
      SEC. 501. PERIOD FOR PETITION TO BOARD UNDER PRIOR ACTS.
      Section 274 (a) of the Revenue Act of 1926, section 308 (a) of the Revenue Act of 1926, section 513 (a) of the Revenue Act of 1932, and section 272 (a) of the Revenue Act of 1928 and the Revenue Act of 1932 (relating to the period during which a taxpayer may petition the Board of Tax Appeals for redetermination of a deficiency), are amended by striking out “60 days" and inserting in lieu thereof “90 days”; by striking out “not counting Sunday as the sixtieth day” and inserting 'in lieu thereof “not counting Sunday or a legal holiday in the District of Columbia as tire ninetieth day” ; and by striking out “60-day” and inserting in lieu thereof “90-day”. The amendments made by this section shall apply only in respect of notices mailed after 30 days after the date of the enactment of this Act.


text:
    William D. P. Jarvis, an Infant, by Amilius Jarvis, Jr., Guardian, Petitioner, v. Commissioner of Internal Revenue, Respondent.
    Docket No. 99227.
    Promulgated January 29, 1941.

      Paul P. Cohen, Esq., for the petitioner.

      Henry C. Clark, Esq., for the respondent.
   OPINION.

Steknhagen:

1. Petitioner contends that the later 1935 dividends were traceable in part to Acheson Corporation’s capital and paid-in surplus because its accumulated earnings had been exhausted by prior distributions. The circumstances of the 1934 distribution were as follows: "

The Acheson Corporation was organized in 1915, with a capital stock of $1,000,000, represented by 10,000 shares, all of which were issued to Edward G. Acheson. It began with a paid-in surplus of $911,499.66. Petitioner insists that the distribution of $f¿6fijlfl0 in June 1934 served to reduce by $1,060,000 the accumulated earnings, so that distributions of $63,000 cash and of $990,000 in shares of the Graphite Corporation on or before May 14, 1935, completely exhausted the total of undistributed profits which, had accumulated since inception. The 1934 distribution, however, was not a dividend. It was paid by the corporation to redeem 1,000 shares of its own $100 par value stock and represented payment of $1,160 per share, the agreed price. During the remainder of 1935 the corporation declared dividends of $435,150. Between May 14 and December 27, 1935, date of the last dividend, the corporation’s earnings amounted to only $349,183.56. Petitioner takes the position that “the cash distributions "during that period totalling $435,150 were taxable as dividends to the stockholders of Acheson Corporation only to the extent of $349.188.56 being 82,74 jper cent thereof.” ((Thus stated, the facts are exactly comparable with those in Foster v. United States, 303 U. S. 118, except that here the existence of the corporation, and hence of its accumulated earnings, began in L915, and the date of March 1, 1913, has no relevance. Were it not for that difference of fact there would be nothing to do but hold the 1935^cLi.stí-'ibutions .taxable, as the Foster case so clearly did.

But the difference is crucial. The 1913 date lay at every point in the Court’s consideration of the Foster case. It permeates the entire reasoning of the opinion, and therefore the decision must-be limited to cases involving pre-1913 earnings. It was said that the "pHoFstock purchase was "properly chargeable to capital account consisting of pre-1913 earnings and left post-1913 earnings unimpaired and available for distribution as a dividend in the later year. A tax on such a dividend was what Congress plainly intended to impose and it was not to be defeated by the bookkeeping device of charging it to pre-1913 earnings, which by earlier judicial decision had been held to be nontaxable capital. Cf. Helvering v. Canfield, 291 U. S. 163.

The present case involves no opportunity to escape a tax by a bookkeeping device. No doubt in this case all earnings and profits are taxable when distributed, no matter by what method or what label and no matter what the accounting, Helvering v. Canfield, supra. The Acheson Corporation has but one “capital account” and that account consists of the original amount received for its capital stock, comprising both the par value and the paid-in surplus, August Horrmann, 34 B. T. A. 1178, 1186-7; Arthur C. Stifel, 29 B. T. A. 1145, 1150. Any distributions properly chargeable to those funds are distributions of capital and not dividends, provided that distributions are first charged against earnings or profits and more particularly the most recently accumulated earnings or profits, as section 115 of the Revenue Act of 1934 prescribes, Foley Securities Corporation v. Commissioner, 106 Fed. (2d) 731. There is no pre-1913 source of tax-free distributions.

In so far as John B. Stewart, 29 B. T. A. 809; Harter v. Helvering, 79 Fed. (2d) 12, and August Horrmarm, supra, recognize the later distribution as attributable to pre-1913 earnings, they are at variance with the Foster decision and must be regarded as to that extent overruled. But they are not overruled in so far as the dividend is attributed to post-1913 earnings. The 1934 transaction was a stock purchase by the corporation and pro tanto a liquidation — a reduction of capital by one-tenth. Thus of the $1,160,000 paid out by the corporation, $100,000 is properly chargeable to capital stock account, $91,149.97 (as petitioner now admits) to paid-in surplus, and the rest of the $1,160,000 to accumulated earnings and profits. Presumably the distribution of the last named earnings and profits was properly taxed in 1934 to the recipients. There is nothing in the statute to justify the belief that Congress intended to treat the 1935 distribution as from the same source and hence taxable again. Section 115 quite clearly indicates the contrary. How much was left in earned surplus immediately after the distribution in 1934 does not appear (although it does appear that on January 1, 1935, the earnings were $388,152.67). The corporation had further earnings in 1935; and it is not disputed that the 1935 distributions must in each instance be applied to the most recently accumulated earnings and treated by the shareholders as taxable dividends. After earnings and profits are thus exhausted, the remaining distributions must be regarded as properly chargeable to capital account and received by the shareholder~noFasli~dividend, but as return of capital, with resulting gain or loss, depending on his basis. In this way the shareholders are taxed at one time or another upon all dividends — that is, distributions out of earnings or profits — and only j after juch earnings añd~pro^s~have .been exhaustedJs.a shareholder^ recognized as recovering his capital.

2. In his computation of The earned surplus distributed in June 1934, petitioner adopts the figure which results from the .write-off., in 1926 of the $600,914.21 principal and interest of the debt owed to it by the Oildag Co. Respondent contends that the 1926 write-off was improper, that the surplus in 1934 was that much greater, and was therefore not exhausted by the 1934 distribution. The ground for respondent’s position is that the advances made by the Acheson Corporation to Oildag from 1916 to 1926 were not loans, but were contributions to capital which served to increase the cost of the Acheson Corporation’s investment in Oildag’s shares, and as such were not susceptible of a surplus adjustment until the shares were finally disposed of.

The evidence shows that during the period of the advances, although the Oildag venture was not fruitful, both the parties and all concerned regarded the advances as loans and accounted for them as such. There is nothing from which it could be reasonably inferred that beneath the outward signs of a debt was a conception of additional contributions to Oildag’s capital. Bona ftdes is not in doubt. Certainly the corporation had the right to create such debts. The fact that the lender was a shareholder of the borrower is not enough to stamp the advances as contributions, Daniel Gimbel, 36 B. T. A. 539; Harry T. Nicolai, 42 B. T. A. 899.

The evidence, as shown by the findings, establishes that in 1926 the judgment of the directors that the amount was uncollectible was well founded. The Acheson Corporation properly charged it off and thus reduced its surplus. In this proceeding affecting 1935 it is not necessary to determine whether the entire debt was first ascertained to be worthless in 1926, as it would be if the issue were the corporation’s right to a deduction in 1926. The issue here would be the same, irrespective of a write-off by the corporation each year of its advances. We are to say whether the surplus at the time of the stock purchase in 1934 used up earnings; and if the advances to Oildag were properly charged off in any prior year, the effect is to reduce the distributable earnings, and, as shown by the findings, to use them up. Since the $600,914.21 was a worthless credit long before 1934, it was properly eliminated from surplus and should not be restored for present purposes.

This is just as true of so much of the amount as represented interest ($131,452.52) as it is of the principal ($469,461.69), for the interest debt was as worthless as the principal. Even if, as respondent suggests, the interest debt was not in 1926 the proper subj'ect of a tax deduction, that would not require its inclusion in the surplus of 1934.

It is held that the 1934 -expenditure of $1,160,000 must be treated as using up $100,000 of capital stock, $91,149.97 of paid-in surplus, and the rest, earnings and profits. The 1935 dividends are to be applied against the most recently accumulated earnings and profits, and after all earnings and profits are thus used up the rest of the 1935 dividends is chargeable to capital account and not taxable as a dividend to the distributee shareholder.

Reviewed by the Board.

Decision will be entered wider Bule 50.


author: Mellott:

text:
    The Hustad Company, a Corporation, Petitioner, v. Commissioner of Internal Revenue, Respondent.
    Docket No. 99336.
    Promulgated January 29, 1941.

      Benjamin H. Flesher, Esq., for the petitioner.

      H. A. Melville, Esq., for the respondent.
   OPINION.

Mellott:

The sole issue is: Did the respondent err in denying petitioner a dividend paid credit of $9,000? The applicable statute is section 27 (a) of the Revenue Act of 1936. It is part of the act imposing a surtax on corporations in an amount measured by the undistributed net income (section 14) which is defined (section 14 (a) (2)) as the adjusted net income minus the dividends paid credit (section 27 (a), supra) and the credit provided in section 26 (c) relating to contracts restricting the payment of dividends.

Petitioner insists that the dividend was paid during the fiscal year. Quoting article 42-2 of Regulations 94, dealing with income not reduced to possession and requiring the taxpayer to include in gross income amounts credited or set apart to him “without any substantial limitation or restriction as to the time or manner of payment or condition upon which payment is to be made”, it urges that its stockholders constructively received the amounts credited to their accounts. Though it does not say so in so many words, inferentially it argues it made a constructive payment of the same amounts. The force of this argument is weakened by the fact that petitioner’s active officers, owners of two-thirds of its stock, did not include the amounts in their gross income. While the respondent places considerable stress upon this circumstance, we think it is relatively unimportant. Constructive receipt by a stockholder does not imply, as a correlative, constructive payment by the corporation, Cox Motor Sales Co., 42 B. T. A. 192, even if we are justified in assuming, contrary to the language of the statute, that Congress intended to grant the credit if a constructive payment be shown. Cf. Sanford Corporation v. Commissioner, 106 Fed. (2d) 882; Massachusetts Mutual Life Insurance Co. v. United States, 288 U. S. 269.

In the recent proceeding of Atlantic Land Co., 43 B. T. A. 74, a corporation on December 30, 1936, declared a dividend payable on that day and credited the amount thereof upon its books to accounts carried in the names of its stockholders without any restrictions as to withdrawals. It was held that the object of the statute had been satisfied and that the corporation should be given the dividends paid credit. Valley Tractor & Equipment Co., 42 B. T. A. 311, was cited, it being pointed out that the “only difference between the situation in the two cases is the fact that no checks were issued” in the Atlantic Land Co. case, though checks had been issued in the cited case, which were not cashed until several months later.

The Department in its regulations (art. 27-1 (b), Regulations 94) recognizes that a corporation may become entitled to the dividend paid credit by crediting the account of the shareholder on the books of the corporation with the amount of the dividend. It states that such credit “will not be allowed unless it is shown to the satisfaction of the Commissioner that such crediting constituted payment of the dividend to the shareholder within the taxable year.” It has been said that this provision “leaves the problem where it finds it” Valley Lumber Co. of Lodi, 43 B. T. A. 423, and it manifestly furnishes but slight aid in solving the present problem. The question is, not whether crediting the amounts of the dividend to the accounts of the stockholders may constitute the payment of a dividend, but whether the crediting to the accounts of the stockholders in the manner and under the circumstances shown in this record constituted payment of a dividend. We are of the opinion that it did not.

It will be noted that the resolution does not make the amount of the dividend available to the stockholders at any time they should see fit to withdraw it. While the respective amounts were “to be credited to the drawing accounts”, charges could not be made against them unless “in the opinion of the directors the finances of the company warranted payment in full or partial settlement.” The companj' was no doubt solvent; but its cash position was such that it probably would have been necessary for it to borrow additional funds in order to make the payment. This may have been one of the reasons for requiring subsequent action of the board of directors as a condition precedent to withdrawing the amounts credited. But there is another equally cogent reason why the credit can not be allowed. The evidence clearly indicates that petitioner’s officers did not intend that a dividend should be “paid during the taxable year.” Its president, testifying as a witness, said: “We like to keep the money in our business as much as we can, and we use that money to keep our credit in good condition, and we don’t want to use any more money than we can get along with.- Our business is not a very big business, and we need all the cash we can [sic], therefore, we draw it as we need it.” In answer to the question: “In other words, because of the cash position of' the company, you neither actually pay salary nor dividends, except to the extent that the officers need the money?” the witness responded: “Well, if you take it that way, I think that is about what it would be, yes.” The same thought was again expressed by the witness when he stated that he had told the revenue agent “that we try to keep our salaries and commissions in the corporation as long as we can to take care of our business.” This was probably a sound business practice; but it must be kept in mind that Congress, in enacting the undistributed profits tax, deliberately chose to fix the rate corporations should pay “in accordance with the proportion of net income undistributed.” It limited the credit, which may be allowed under section 21 (a), supra, to “dividends paid during the taxable year”, and we can do no less.

Petitioner has failed to show that it paid any dividend during the taxable year and the Commissioner’s determination of a deficiency must be, and it is, approved.

Decision will ~be entered for the respondent.

       SEC. 27. CORPORATION CREDIT FOR DIVIDENDS PAID.
      (a) Dividends Paid Credit in General. — For the purposes of this title, the dividends paid credit shall be the amount of dividends paid! during the taxable year.

       Report of Committee on Ways and Means, 74th Cong., 2d sess.


author: Opper:

text:
    WarrEn Telephone Company, Petitioner, v. Commissioner of Internal Revenue, Respondent.
    Docket No. 98115.
    Promulgated January 30, 1941.

      E. E. Eoppe, Esq., for the petitioner.

      W. W. Kerr, Esq., and E. M. Woolf, Esq., for the respondent.
   OPINION.

Opper:

Petitioner contests a part of the deficiency determined by respondent with respect to normal tax on the ground of his erroneous refusal to permit it to deduct an item of $18,000 which it refunded to its subscribers in the taxable year; and with respect to the surtax on undistributed profits on the ground that it was entitled to a credit up to the full amount of its undistributed income pursuant to the provisions of section 26 (c) (1), Revenue Act of 1936.

Respondent apparently agrees that the $18,000 item raises an issue identical with one previously decided by an unpublished Board decision in petitioner’s favor and from which an appeal to the Circuit Court of Appeals for the Sixth Circuit was dismissed on November 10, 1939. Petitioner contends that the point is therefore res judicata in its favor. Since the contrary is not argued by respondent in his brief, we regard it as conceded. Accordingly this item is determined in favor of petitioner on the ground of its prior adjudication and without reexamination on the merits in this proceeding.

The issue with respect to the undistributed profits tax credit, in so far as it involves the concept of petitioner’s corporate charter as a contract incorporating state statutes prohibiting the payment of dividends by deficit corporations, is determined in favor of respondent upon the authority of Helvering v. Northwest Steel Rolling Mills, Inc., 311 U. S. 46, and Crane-Johnson Co. v. Helvering, 311 U. S. 54.

Petitioner seeks to bring itself within 26 (c) (1) for the further reason that its bond indenture, a written contract, contained a provision that petitioner would not declare or pay any dividends “except out of net earnings”; and also that there was at the time outstanding an order of the state Public Utilities Commission directing that petitioner “cease and desist from declaring, distributing and paying dividends * * * until and as the same are available from its corporate net operating income.” This, argues petitioner, prevented it from paying dividends because of a requirement of the same indenture that there be “proper observance of all the covenants hereof”, one of which was “that it will comply with all lawful statutes, acts and regulations.”

Without attempting to consider what would be the result if either the indenture or the commission’s order unconditionally forbade the declaration of dividends, cf. G. B. R. Oil Corporation, 40 B. T. A. 738, it will suffice here to note that both indenture and order limit their scope to the availability of corporate net operating income or net earnings. No suggestion is made that there were no such earnings, after deduction of all current items of expense, or that these were insufficient to declare the entire amount of dividends necessary for petitioner to obtain the dividends paid credit. Indeed, that it had such earnings is apparent from the stipulated facts and the normal tax to which it was concededly subject. See Long Beach Improvement Co., 5 B. T. A. 590. If they were not “available” the most that could be suggested is that deficits inherited from prior years, perhaps the result of unauthorized dividend declarations in the past, had to be offset before there could arise an earned surplus. No doubt this situation effectually circumscribed petitioner’s action in declaring any dividend. But it seems to us this clearly resulted, not from the terms of the relevant documents but from the same fundamental situation that existed in the Northwest and Crane-Johnson cases, supra, namely, that accepted principles of corporation lawT as embodied in the state statutes preclude the payment of dividends in the absence of a corporate surplus. This was no more the result here than it was in those cases of any provision of a written contract expressly dealing with the declaration of dividends.

Bespondent’s determination, in so far as it disallowed the deduction under section 26 (c) (1) is approved.

Beviewed by the Board.

Decision will be entered wider Rule 50.

       There is no reason to assume that indenture or order was concerned with an accumulated deficit. The indenture requires payment only of current items, such as interest; and the purpose of the order appears with sufficient clarity from the citation which preceded it. It is there charged that “the commission has cause to believe and finds that the directors and officers of the said Warren Telephone Company are preparing to and will, unless prevented, declare and pay further unearned dividends.”


author: Sternhagen :

text:
    The First National Bank, Philipsburg, Pennsylvania, Petitioner, v. Commissioner of Internal Revenue, Respondent.
    Docket No. 101772.
    Promulgated January 30, 1941.

      Lawrence Cake, Esq., for the petitioner.

      Paul E. Waring, Esq., for the respondent.
   OPINION.

Sternhagen :

The Commissioner determined deficiencies of $1,719.77 in income tas and $888.52 in excess profits tax for 1936, and $226.82 in income tax for 1937. The petitioner seeks a reduction of the profit from the sale of securities through an increase in the basis. The principal facts are stipulated and are found as agreed.

The petitioner in 1933 loaned $5,766.17 to Shirey on his note with interest and took 150 shares of General Refractories Co. as collateral. The note was defaulted and in 1935 petitioner took the collateral, which was then worth $2,250. Petitioner charged this amount to its securities account and charged the remaining $3,216.17 to profit and loss. On its return for 1935 petitioner showed a net loss of $55,356.99, in which was included the charge-off, $3,216.17 representing the Shirey loan. In 1936 the General Refractories Co. shares were sold for $6,713.86. Similarly the petitioner in 1934 loaned $18,000 to Miller and took various shares as collateral. The collateral fwasl .forfeited in 1935, when fit was worth $7,926.75. Petitioner charged off $10,073.25 in that year and this amount was reflected in the aforesaid net loss on its tax return. The shares were sold in 1936 and 1937 for $23,825.05 and $4,764.90.

The taxpayer contends that in determining the gain or loss from the sale of the collateral shares, the basis is the original amount loaned, that being the true cost, and not the value of the shares when it acquired ownership of them. It puts aside the fact that its net loss in 1935 reflected the charge-off of the unpaid portion of the loans as of no significance because its net loss was sufficiently greater to absorb any tax benefit from the deduction.

The contention must be rejected. When the loans became worthless to any extent above the value of the collateral, the petitioner properly charged off the worthless amount and deducted it- on its return. It simultaneously took the collateral at fair market value into its asset accounts, thereby applying it pro tanto to a satisfaction of the loans. Thus the value of the shares immediately became their basis, as if they had been purchased for that amount. The subsequent sale or disposition resulted in gain or loss computed upon that basis. The fact that the 1935 charge-off served only to enlarge the petitioner’s net loss and gave it no immediate reduction of taxes because it had no taxable income, has no significance as a factor of the computation in the later year. Herbert N. Fell, 18 B. T. A. 81. See also Paul and Mertens, Law of Federal Income Taxation, vol. 3, §§ 28.77, 28.78.

Decision will be entered for the respondent.


author: Hill:

text:
    Chaparral Oil Company, Petitioner, v. Commissioner of Internal Revenue, Respondent.
    Docket No. 97552.
    Promulgated January 30, 1941.

      Harold E. Rorschach, Esq., for the petitioner.

      Stanley B. Anderson, Esq., for the respondent.
   OPINION.

Hill:

Petitioner offered the testimony (by deposition or in person) of five witnesses, all of whom were graduate geologists of long practical experience and were members of the American Association of Petroleum Geologists and the Tulsa Geological Society. Some were also members of other technical organizations. One of these witnesses was a geologist for petitioner, who examined the royalty interest in 1935 and accumulated the data made available by the wells which had been drilled at that time in and around the oil producing area including wells on every side of the leased land and additional data secured from the Kansas Geological Society, which are accepted generally by geologists as authoritative. This data furnished the control for the construction of a development and geological contour map of the oil producing area and of the royalty interest in question as of December 31, 1935. Such a map was drawn by petitioner’s geologist, coordinating and demonstrating such controlling data, and was admitted in evidence. He testified to the correctness of the data and to the accuracy of the map constructed therefrom. He also testified that, on the basis of the data secured as a result of the investigation of the royalty interest in 1935, he condemned the royalty interest as worthless and recommended that petitioner charge it off on its books as a loss in that year; that petitioner did so charge it off and took a deduction of such loss in its income tax return for that year, filed March 15, 1936.

Another of such witnesses checked the above described map with information secured independently thereof and testified that it accurately demonstrated the geological structure involved as indicated by known data.

Two of such witnesses based their testimony on the data disclosed by the map, without personal knowledge of such data. The fifth of such witnesses was the chief geologist of the northern division of the Sinclair Prairie Oil Co. He testified, from his own knowledge without reference to the map, as to facts known in 1935 which influenced the Sinclair Co. to decline to renew its lease which expired March 2, 1936.

Concisely stated, the testimony of the geologists was to the effect (1) that a property located on the edge of an oil and gas field will not produce in commercial quantities where it lies structurally below the water line surrounding the field; (2) that a sufficient number of wells had been drilled at the end of 1935 to permit the mapping of the producing oil and gas area and of the property covered by petitioner’s royalty interest; and (3) that it was shown by the new developments in the field during 1935 that the west side of the land in which petitioner held its royalty interest is situated about a quarter of a mile to the east of the structure which had trapped the commercial oil pool; that it is on the syncline bordering the east side of the oil producing area and lies below the water line thereof.

Four of such witnesses testified categorically that in their opinion, based on the data reflected on the map, it was demonstrated in 1935 that the property here involved would not produce oil and gas in commercial quantities. The geologist for the Sinclair Co. testified in effect that the reason that company declined to renew its lease on the property was that developments in 1935 demonstrated that the structural axis of the oil pool was west of the previously conceived line thereof, thus showing the leased property to be on the east edge of the pool, and, further, that wells on the east side of the pool were flowing an alarming quantity of water and that there was a dry well on the adjoining section to the east of the leasehold. He also testified that the Sinclair Co. did not have sufficient faith in the property to drill it; that his company tries to “farm out” a lease when it looks so bad geologically that it does not want to drill it itself — just a last desperate effort to get something out of a lease.

While petitioner charged off its investment as a loss during the taxable year, it still retained title to its royalty interest. That fact alone, however, is not sufficient ground to justify denial of the deduction claimed. A. H. Fell, 7 B. T. A. 263; B. G. Adams, 5 B. T. A. 113.

The rule properly applicable under the present circumstances is well stated, we think, in the following extract quoted from G. C. M. 3890, C. B. VII-1, p. 168:

Whether an oil and gas lease and/or royalty right comprehend a present interest or estate in the realty itself or in the oil and gas in place * * * they bear a value in direct relation to the presence of oil and gas in the land in commercial quantities. Where there is no oil or gas in the land the oil and gas lease and royalty right relate to a nonexistent subject matter and have absolutely no value. It would appear that the right to extract oil and gas, or to share in the same when produced, becomes worthless when the subject matter of the right is found to be nonexistent. It is believed that formal disposal of the valueless interest by sale or relinquishment should not be required as a prerequisite to allowance of a loss. A careful prospect of the entire field which demonstrates that the same is barren of oil in commercial quantities may establish the absolute worthlessness of the investment in an oil and gas lease or royalty right.

In the light of the new developments in the field during 1935, which clearly established that the land in which petitioner owned a royalty interest was structurally below the water line and thus shut off from any reasonable hope of commercial production, and upon the advice of its consulting geologist, petitioner charged off its investment as worthless in the taxable year. The fact that in the following year, through an unexpected and fortuitous circumstance, it realized rent of $600 and received a small royalty from oil produced, is not in our opinion persuasive evidence that petitioner’s royalty interest had not become worthless, for tax purposes, in 1935. Undoubtedly the well drilled by the Shell Co. in 1931 was purely a speculative venture, and its abandonment in 1938, after the production of oil sufficient to repay only a small part of the cost of drilling, demonstrates the practical worthlessness in 1935 of petitioner’s interest.

In such circumstances, it is not necessary for a taxpayer to establish complete and total loss beyond the possibility of any recoupment. In United States v. White Dental Manufacturing Co., 274 U. S. 398, the taxpayer had an aggregate investment of more than $130,000 in a German subsidiary corporation. In March 1918 a sequestrator appointed by the German Government took over the property of the subsidiary. The taxpayer thereupon charged off as a loss the amount of its investment in the German corporation and in its income tax return for 1918 deducted the amount from gross income. The deduction was disallowed by the Commissioner, solely on the ground that the loss was not evidenced by a closed and completed transaction. In 1922 the taxpayer recovered $6,000 of its investment, which it returned as income. The taxpayer also filed a claim with the Mixed Claims Commission, which in 1924 was allowed to the extent of $70,000. The Supreme Court held that the taxpayer was entitled to the deduction claimed in 1918, saying:

The statute obviously does not contemplate and the regulations * * * forbid the deduction of losses resulting from the mere fluctuation in value of property owned by the taxpayer * * *. But with equal certainty they do contemplate the deduction from gross income of losses, which are fixed by identifiable events, * * * a loss may become complete enough for deduction without the taxpayer’s establishing that there is no possibility of an eventual recoupment. It would require a high degree of optimism to discern in the seizure of enemy property by the German government in 1918 more than a remote hope of ultimate salvage from the wreck of the war. The taxing act does not require the taxpayer to be an incorrigible optimist.

In Royal Packing Co. v. Commissioner (C. C. A., 9th Cir.), 22 Fed. (2d) 536, the court said:

* * * The taxpayer was not entitled to the deduction merely because the stock may have subsequently become worthless or because, in the light only of subsequent developments, it may appear to have been inherently worthless during the year in question. Nor can the deduction be claimed for a mere shrinkage in value. A loss may be said to be actually sustained in a given year if, within that year, it reasonably appears that such stock has, in fact, become worthless. It is not requisite that there be a. charge-ofC on the books of the taxpayer, and the ultimate fact of worthlessness may be shown by circumstances, as in other eases where that question is in issue. But the burden is on the taxpayer to establish the fact by reasonably convincing evidence. * * *

In Morton v. Commissioner, 112 Fed. (2d) 320, the court quotes with approval from Lucas v. American Code Co., 280 U. S. 445, as follows:

Generally speaking, the income tax law is concerned only with realized loss, * * *. Exception is made, however, in the case of losses which are so reasonably certain in fact and ascertainable in amount as to justify their deduction, in certain circumstances, before they are absolutely realized. * * * The general requirement that losses be deducted in the year in which they are sustained calls for a practical not a legal test.1 '

The court in the Morton case also quotes with approval from DeLoss v. Commissioner, 28 Fed. (2d) 803, as follows:

True, it was not possible to say beyond imaginable peradventure that these assets might not be snatched at by some impressionable buyer, who did not share their owners’ estimate of their value. But any such expectation was plainly illusory * * *. So far as human foresight could go, the shares were worthless * * *. [Citing United States v. White Dental Manufacturing Co., supra; Royal Packing Co. v. Commissioner, supra.]

In Keeney v. Commissioner, 116 Fed. (2d) 401, the court said:

* * * Nor can he postpone his claim of loss until only an “incorrigible optimist” would fail to know that the stock had become worthless at an earlier date. A finding of worthlessness depends on all the facts of the particular case reasonably leading to that conclusion. * * *

On the basis of facts and circumstances in evidence we hold that petitioner sustained a loss in 1935 in the amount of the cost of its royalty interest and consequently was entitled to take a deduction therefor in its income tax return for that year.

We hold that respondent was in error in disallowing the deduction claimed by petitioner.

Eeviewed by the Board.

Decision will be entered umder Rule 50.

Tubker, Arnold, Disney, and Kern dissent.