author: Keen:

text:
    Wilkerson Daily Corporation, Ltd., Petitioner, v. Commissioner of Internal Revenue, Respondent.
    Docket No. 96048.
    Promulgated November 22, 1940.

      A. Galder Maehay, Esq., Thomas B. Dempsey., Esq., and Noel Singer, G. P. A., for the petitioner.

      E. A. Tonjes, Esq., for the respondent.
   opinion.

Keen:

Petitioner here attacks respondent’s determination of a surtax upon the taxpayer based upon section 102 (a) of the Eevenue Act of 1934 (48 Stat. 680, ch. 277). Respondent does not claim that the taxpayer was formed for the purpose of preventing the imposition of a surtax on its shareholders, but merely that in the taxable fiscal year of 1936 it was availed of for that purpose.

In the instant proceeding respondent relies upon subsection (b) of section 102, supra, which provides:

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

It is an admitted fact in this proceeding that gains were permitted to accumulate during the taxable year; but that they were beyond the reasonable needs of the business is contested by the taxpayer. In support of his contention on this point respondent has cited several cases, among them Helvering v. National Grocery Co., 304 U. S. 282. In that case, in finding against the taxpayer, the Court said: “That there was no need of accumulating any part of the year’s earnings for the purpose of financing the business was shown by the balance sheet.”

In the instant ease a balance sheet would provide no basis for adjudging the necessity of a surplus. But the Court, in the National Grocery case, went on to say that no conceivable expansion could have utilized so large a surplus. It is possible, however, in the instant case, that the establishment of a New York daily and an annual could have completely exhausted the surplus, but these ideas were never carried into effect and were, apparently, abandoned.

In United States v. Tway Coal Sales Co., 75 Fed. (2d) 336, cited by the respondent, the court declared that “It is the accumulation of surplus plus its interdicted purpose that brings the statute into operation, and its size in relation to business needs is but a circumstance out of which a presumption of improper purpose arises, though such purpose may be shown by pertinent evidence with or without the presumption as an aid.” This view has been accepted as correct by the Board and its application to the instant facts tests the validity of the respondent’s contentions. The petitioner corporation certainly can not be judged by the same business standards as could a grocery store chain. What would clearly be an unreasonable surplus in the former case might be far from unreasonable in the latter. In William C. de Mille Productions, Inc., 30 B. T. A. 826, the Board, when confronted with this question, said: “The word ‘reasonable’ is a relative term. What would be reasonable in one situation or for one business might be clearly unreasonable in another.”

Viewing the reasonableness of petitioner’s surplus in this light, and accepting as true the contention of Wilkerson, the sole witness introduced at the hearing, that petitioner’s business was at best a gamble and one in which any year might bring unforeseen lack of patronage, we would then have to arrive at the conclusion that the surplus set up by the petitioner during the taxable year was not necessarily unreasonable. The purpose of accumulating the surplus was set forth by Wilkerson at the hearing and respondent introduced no witnesses to testify to the contrary.

Wilkerson testified that it was in order to avoid the effect of lockouts and to establish independent good will that he purchased the Bel Air property, where he might conduct business at the dinner table. His entry into the restaurant business, he testified, was also to enable petitioner to do business on a social basis. But, interestingly enough, the profits from the restaurants did not go to the petitioner, but to Wilkerson. It was his venture, not the petitioner’s. Wilkerson testified also that he thought it would lend necessary prestige if petitioner could purchase an office building of its own, which would require a large amount of capital. And, in addition to this, Wilkerson said that petitioner was also trying to garner a sufficient surplus to enable it to operate for a whole year without income in the event of disastrous boycotts. This, it was estimated, would require a reserve of at least $200,000. Further, Wilkerson said petitioner contemplated the organization of a New York corporation as a wholly owned subsidiary to publish a separate daily journal, and in 1935 passed resolutions authorizing the organization thereof. This was estimated to require an additional forty to sixty thousand dollars; and the further cost of the projected annual motion picture publication would be in the neighborhood of $60,000 per issue, according to Wilkerson.

Whether it be thought a prudent business venture to contemplate expansion or the doing of business on a large scale “front” is not for the Board to determine. It must be assumed that a business shall have the right to grow, William C. de Mille Productions, Inc., supra; and such growth is at the discretion of the corporation. However, in our instant case there appears no rational answer to the sudden abandonment of all the allegedly contemplated expansions. Only one, the failure to build an office building, is satisfactorily explained. If petitioner actually intended the expansions set forth by Wilkerson, it is peculiar that it allowed its surplus on hand to be so diverted to the use of its sole stockholder that it could not make those expansions. Nor has it carried any of them into effect to date, except for the change in office address.

Respondent insists that further facts exist which controvert Wilkerson’s statements as to the corporation’s purposes and intentions. He points to the extensive borrowing of Wilkerson in the taxable year from the funds of the taxpayer. In the National Grocery Co. case, supra, the Court affirmed a principle laid down in United Business Corporation of America, 19 B. T. A. 809; affd., 62 Fed. (2d) 754, to the effect that certain loans were incompatible with a purpose to strengthen the financial position of the petitioner and were entirely in accord with a desire to get the equivalent of the dividends under another guise. In the United Business Corporation case, supra, money was loaned to an individual who held all the capital stock except for three qualifying shares. The Board there found as a matter of fact that the borrower was worth approximately three-quarters of a million dollars in addition to his interest in the corporation in the taxable year, and had the financial ability to meet his obligations to the corporaton. He had the use of the corporation’s funds in an amount greatly in excess of its surplus and made only a very small payment on account of interest. In the instant case, while the facts are not identical, they are, to say the least, related. The bulk of the loans to Wilkerson went for three main purposes— buying in the stock held by Sonn, financing the purchase of a private home, and paying current personal bills. Any benefit which accrued to the taxpayer from Wilkerson’s uses of these funds seems in the main to be incidental. Certainly nothing was gained by the corporation by loaning money to Wilkerson to pay his personal debts. This was entirely beneficial to Wilkerson himself. Nor does the situation seem materially different in the case of the purchase of Sonn’s stock. The acquisition of the stock gave an absolutely controlling hand to Wilkerson and at the same time quieted the voice of a man who was hypercritical of Wilkerson’s management and financial manipulations. Sonn was never a serious threat from the standpoint of disrupting the management of the corporation. He owned too small a block of stock. The minutes of the petitioner which have been put in evidence clearly indicate that Sonn’s voice was most ineffectual. Consequently, it is difficult to see how the petitioner rather than Wilkerson himself received the benefit from the purchase of Sonn’s stock. As for the third item — the funds used for the purchase of the residence — undoubtedly, as Wilkerson testified, it thereby became possible to establish valuable “over the table” contacts, which may ultimately have proved beneficial to the petitioner. But it seems a strain on a practical imagination to abide by Wilkerson’s statement that the only reason for the purchase of the home was as a place for business contacts. The approximate cost of the residence was $160,000, which figure seems greatly out of proportion to the expected return on such an investment, if it can be thought to have been purchased solely as a business investment, inasmuch as the continued maintenance would run to an extremely high figure. Also, there seem to have been other places in which to talk business “over the table.” Wilkerson owned the Vendóme and the Trocadero restaurants, which were admittedly patronized almost exclusively by the very people with whom petitioner sought to do business. The inescapable conclusion, in the eyes of the Board, is that the purchase of the residence was for the primary benefit of Wilkerson himself.

The amounts of the loans to Wilkerson are interestingly in proportion to his interest in the accumulated surplus in the years 1985 and 1936. In these years he had title to 80 percent of the outstanding stock (including the 15 shares held by the bank), and consequently, an interest in that proportion in any surplus which might be distributed in the form of dividends. The following shows the amount of loan, the surplus accumulated, and Wilkerson’s contingent 80 percent interest in that surplus for the years 1935 and 1936:

The close similarity between what Wilkerson borrowed and what he would have received as his share of the dividends (subject, of course, to his wife’s claim under their settlement agreement), while not determinative of the fact that it was Wilkerson’s desire to get the equivalent of his dividends under another guise, certainly casts affirmative weight in that direction.

As respondent points out, Wilkerson actually held no bankable assets sufficient to entice a prudent disinterested corporation to make such large personal loans. If the petitioner was storing up a nest egg for future use in case of emergency, it stands to reason that it would require some form of security which could be readily liquidated. So far as the record indicates, the only security Wilkerson could offer was his interest in the two restaurants and in the private dwelling for the purchase of which he was borrowing. Wilkerson himself pointed out that the restaurants were indirectly beneficial to the business, and, consequently, it stands to reason that the corporation would be loath to see them sold. It is of no consequence that Wilkerson was willing to pay a higher rate of interest than the banks or other interested parties. In the United Business Corporation case, supra, the borrower guaranteed to pay interest. As a matter of fact, he did not currently meet those interest payments. In the instant case the most convenient method of meeting interest payments on the loan would have been for Wilkerson to award himself a greater salary in the years subsequent to 1935. And this he did; whether for this purpose or because he calculated that he actually merited such increase. The evidence shows that by March 1938 Wilkerson had fully repaid the petitioner. The evidence, moreover, clearly shows that petitioner had declared dividends between July 31, 1936, and March 1938, sufficient to aid Wilkerson materially in offsetting the amounts he still owed on those dates. Added to this factor are the salary increases Wilkerson awarded himself, by means of which he paid off the balance. The entire picture, viwed in this light, indicates that the petitioner, at Wilkerson’s direction, must have forthwith abandoned any alleged beneficial purpose for the accumulation of surplus. To conclude otherwise would necessitate overlooking a material inconsistency in petitioner’s management.

Following the principle announced in United Business Corporation, National Grocery Co., and Tway Coal Sales Co., supra, we find that the petitioner’s loans to Wilkerson did not constitute real investments by the former, and that the circumstances negative any real business purpose for the accumulation by petitioner of a surplus in the amount shown. After a careful consideration of the evidence adduced herein, we have concluded that respondent did not err in his determination that petitioner was subject to surtax under section 102 of the Eevenue Act of 1934, set out above.

Reviewed by the Board.

Decision will be entered wider Bule SO.

Ahundell, Mukdook, Black, and Leech dissent.

       SEC. 102. SuRTAX ON CORPORATIONS IMPROPERLY ACCUMULATING SURPLUS.
      (a) Imposition op Tax. — There shall be levied, collected, and paid for each taxable year upon the adjusted net income of every corporation (other than a personal holding company as defined in section 351) if such corporation, however created or organized, is formed or availed of for the purpose of preventing the imposition of the surtax upon its shareholders or the shareholders of any other corporation, through the medium of permitting gains and profits to accumulate instead of being divided or distributed, a surtax equal to the sum of the following:
      (1) 25 per centum of the amount of the adjusted net income not in excess of $100,000, plus
      (2) 35 per centum of the amount of the adjusted net income in excess of $100,000.


source: Caselaw Access Project

author: SxeRNhagen :

license: Public Domain

text:
    Olean Times Publishing Company, Petitioner, v. Commissioner of Internal Revenue, Respondent.
    Docket No. 96728.
    Promulgated November 22, 1940.

      Earl G. Tedder, Esq., for the petitioner.

      Loren P. Oakes, Esq., for the respondent.
   OPINION.

SxeRNhagen :

In 1937 all petitioner’s shares were owned by five persons. Over 97 percent of its gross income was dividends, and over 1 percent was interest. Literally, therefore, it is a personal holding-company as defined in the Kevenue Act of 1937, section 352 (which is the same as Internal Kevenue Code, section 501).

Petitioner argues that its charter gave it no power to hold corporate shares and that it could not become a holding company under New York law. But the definition of the revenue act clearly sets forth its own factors and does not import the New York law. The fact is that tlie petitioner owned the shares of the Times-Herald Co. and we do not adjudicate the propriety of that ownership. The statutory criterion of a “personal holding company” is not the corporation’s ownership of other shares or the colloquial term “holding company.” It is the existence of the factors set forth in the terms of the legislation.

Petitioner argues that it is not within the intendment of the statute, and points to statements made in the course of the consideration of the bill to show that Congress intended to reach wealthy men who were “incorporating their pocketbooks” to reduce their taxes. But the express language is too clear to admit of this consideration even if it were permissible to suppose that the tax was intended to be limited to corporations of the rich.

Petitioner argues that it didn’t really receive the dividend of $13,200 because it had to pay $12,000 for the preferred shares in order to enable the corporation to pay the dividend. The two events were, however, legally separate, as they were deliberately intended to be. So they must be recognized for present purposes.

Petitioner filed no personal holding company return, and hence the penalty of 25 percent imposed by the Revenue Act of 1936, section 291, is mandatory. Reasonable cause is only effective to avoid the penalty if the return is delayed — not when the return is omitted entirely, Alex Holmstrom, 35 B. T. A. 1092; dismissed, 94 Fed. (2d) 747; National Contracting Co. v. Commissioner, 105 Fed. (2d) 488. This is true as to a personal holding company return even though an income tax return has been filed, Collateral Mortgage & Investment Co., 37 B. T. A. 630; Rotorite Corporation, 40 B. T. A. 1304 (on review C. C. A., 7th Cir.); Lone Pine Lawn Corporation, 41 B. T. A. 638 (on review C. C. A., 2d Cir.).

The determination of the deficiency is sustained and a penalty of 25 percent is properly to be added.

Decision will be entered under Rule 50.


author: Black :

text:
    Estate of Lucele Gruy, Joseph Gruy, Independent Executor, Petitioner, v. Commissioner of Internal Revenue, Respondent.
    Docket No. 95901.
    Promulgated November 22, 1940.

      E. H. Suhr, Esq., for tbe petitioner.

      J. E. Marshall, Esq., for the respondent.
   OPINION.

Black :

The first issue arises from the inclusion by the respondent in petitioner’s income for the year 1935 of $7,889.46 representing one-half of the income from community property of the decedent and her husband, Joseph Gruy. There is no dispute as to the amount of income involved. In support of his determination, the respondent contends that the income in question was received during the period of administration or settlement of the estate and is taxable to petitioner under section 161 (a) (3) of the [Revenue Act of 1934.

The petitioner concedes that the separate estate of Lueile Gruy was in process of administration in 1935, that there were debts of the separate estate still unpaid, and that the Federal estate tax was still in dispute and was not settled until a subsequent year. He contends, however, that, as an independent executor under the will of Lueile Gruy, he paid all of the debts of the community estate in 1933 and distributed to himself, as legatee and devisee under the will, all the interest of Lueile Gruy in the community property owned by herself and her husband, Joseph Gruy, at the time of her death.

The record discloses that after 1933 Joseph Gruy treated all the community property as his own; that he paid the taxes on such property and all expenses incident to it from his own funds; that he consistently deposited tbe income from such property in Ms personal bank account, used it as Ms own individual income, and included it in his personal income tax return for the taxable year before us. Moreover, no community income was included in the fiduciary income tax return for the estate of Lucile Gruy for the year 1935. Obviously after 1933, Joseph Gruy regarded himself as owner in possession of the community property formerly belonging to Ms deceased wife and himself and he dealt with it as such.

The case then turns on whether there was such a distribution of the community estate of decedent in 1933 as to take it out of the estate of Lucile Gruy and out of the control of the executor of the estate. If the community property remained under administration in 1935 and the income in question was received by Joseph Gruy in Ms fiduciary capacity as independent executor of the estate of Lucile Gruy, it is taxable to the estate, as respondent contends. Barbour v. Commissioner, 89 Fed. (2d) 474.

The estate of Lucile Gruy consisted of both her separate and community property. While all of such property was included in her general estate, the separate and community property were kept separate for the purposes of administration. At the death of Lucile Gruy, her husband, as surviving member of the community, was invested with full control of all the community property. Wilthrow v. Adams, 23 S. W. 437; Lovejoy v. Cockrell, 63 S. W. (2d) 1009.

Under the terms of the will he became independent executor of all the decedent’s estate, including the community property. As independent executor he was required to file a complete inventory and ap-praisement of all the property in the decedent’s estate. Having filed such inventory and appraisement, he had the right to administer the community property for the payment of community debts without any supervision by the Probate Court. Levy v. W. L. Moody & Co., 87 S. W. 205. He could do whatever the court could do if the estate were under its entire control. Griggs v. Brewster, 62 S. W. (2d) 980. He had the power to close administration or surrender all or any portion of the property to the heirs or devisees without the formality of judicial sanction. Parks v. Knox, 130 S. W. 203.

Joseph Gruy, as independent executor, paid all the community debts against the estate in 1933. His acts thereafter were the acts of an owner and not administrator of the community property. We hold that the community property from which the income in question was derived was distributed to Joseph Gruy as legatee under the will prior to 1935 and that none of it was in process of administration in that year. As to this issue petitioner is sustained.

In our opimon, it is immaterial whether or not the separate estate was indebted to the community estate in the year 1935 as respondent contends. The only evidence of such indebtedness is the statement in the deed of April 25, 1935, to Ernest Cotulla and wife. No such indebtedness appears in the inventory and appraisement. But even if the statement in the deed were correct, it would only mean that there was a partial distribution of community property in 1933, and would not affect our decision as to the property distributed. The income from such property after it was distributed belonged to Joseph Gruy, who was then the owner thereof. Nor is the fact that the estate tax was in dispute in 1935 controlling. Under the laws of Texas, property of a decedent vests immediately upon his death in the devisee, subject to the payment of the debts of the testator. Roberts v. Carlisle, 4 S. W. (2d) 144; Dakan v. Dakan, 83 S. W. (2d) 620; Weiner v. Zweib, 128 S. W. 699; Patton v. Smith, 221 S. W. 1034. See Vernon’s Annotated Civil Statutes, art. 3314. The distributee would, therefore, be liable for such debts to the extent of the amount distributed to him, Kauffman v. Wooters, 13 S. W. 549, but the distribution would be valid and have the effect under Texas law of taking the property distributed out of administration. Parks v. Knox, supra.

The Commissioner, in his adjustment of petitioner’s income for 1935, allowed as additional deductions: (h) Taxes, $290.61; (i) insurance, $466.35; (j) repairs, $100.32. In explanation of these additional deductions he stated in his deficiency notice, as follows:

(h), (i), and (j) These amounts, which represent one-half of the following community deductions claimed by the surviving spouse, Joseph G-ruy, are held to be allowable deductions on your return. [Here are set out by the Commissioner the figures we have given above.]

Manifestly, if the community property was distributed to Joseph Gruy prior to the taxable year, the expenditures named above were made by him individually and the deductions are his and no part of them are deductible by the estate. We do not understand that petitioner contends otherwise. In a recomputation under Rule 50 the above named deductions should be disallowed.

The second issue involves the claim for a credit in the amount of $926.67 representing income taxes paid by the independent executor, Joseph Gruy, from funds of the estate of decedent on income returned by Joseph Gruy as natural guardian for Dagmar Gruy, Viggo Gruy, and Joseph Gruy, Jr., all minor children of Lucile Gruy and Joseph Gruy. Dagmar Gruy, Viggo Gruy, and Joseph Gruy, Jr., were the beneficiaries of the separate estate of Lucile Gruy. As independent executor of that estate, Joseph Gruy had the right to make distribution to these beneficiaries of sufficient funds to pay their income tax. Patton v. Smith, supra; Parks v. Knox, supra, and as natural guardian of the minor children, Joseph Gruy had the right to make a return of their income and to pay the tax from the funds so distributed, and we must regard such acts as within the scope of his power. But having distributed to the minors or their natural guardian the funds to pay their income tax, the petitioner may not now claim a credit on its tax for the amount so paid.

We do not have the cases of the minor children before us and, therefore, do not pass upon the question as to whether they owed any income tax for the year 1935. Assuming, however, that the natural guardian erroneously filed a return for the minor children, we fail to see how the amount so paid can be allowed as a credit to petitioner. The minor children, by their natural guardian, are not parties- to this proceeding. Unquestionably they have a right to apply for a refund of the amounts paid, but such action has no relation to this petitioner, which is a different taxpayer.

If an overpayment in taxes exists and the same taxpayer has an outstanding liability, the Commissioner is required before making any refund to apply the overpayment against the liability or allow a credit. Cf. Blair v. United States ex rel. Union Pacific Railroad Co., 6 Fed. (2d) 484. But he has no authority of his own motion to credit one taxpayer’s overpayment against another’s liability. Cf. Hart Glass Manufacturing Co. v. United States, 48 Fed. (2d) 435; certiorari denied, 286 U. S. 556. He may allow such a credit with the consent of the parties, cf. Daube v. United States, 59 Fed. (2d) 842; affd., 289 U. S. 367, but he can refuse to do so because of the fact that the parties are separate and distinct taxpayers. Charles V. Parker, 17 B. T. A. 608.

On the record before us, petitioner’s claim for credit is denied. Charles V. Parker, supra.

Decision will be entered imder Rule SO.

       SEC. 161. IMPOSITION OP TAX.
      (a) Application oír Tax. — The taxes Imposed by this title upon individuals shall apply to the income of estates or of any kind of property held in trust, including—

      (3) Income received by estates of deceased persons during the period of administration or settlement of the estate.


author: Disney:

text:
    Skenandoa Rayon Corporation, Petitioner, v. Commissioner of Internal Revenue, Respondent.
    Docket No. 99519.
    Promulgated November 26, 1940.

      Horace B. Lamb, Esq., for the petitioner.

      Harold D. Thomas, Esq., for the respondent.

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

   OPINION.

Disney:

There are left for our consideration only two questions: (1) Whether the petitioner is entitled to dividends paid credit, and (2) whether it is entitled to deduction of attorneys’ fees as ordinary and necessary expenses. Other issues have been eliminated and will be reflected in decision under Rule 50.

1. There is little, if any, dispute about the facts on the question as to whether the petitioner is entitled to dividends paid credit under section 27 of the Revenue Act of 1936. In sum, the pertinent facts may be stated as follows: Being in arrears for several years upon payment of dividends upon its $7 cumulative preferred stock, the arrears amounting to $45.50 per share in the taxable year, and having earned in the taxable year substantial amounts which were, however, desired for use in operating and expanding the business, the petitioner, with the primary object of relieving itself from the burden of the arrears in dividends on the preferred stock, entered into a recapitalization. The effect of the recapitalization was that the holders of the preferred stock surrendered same with the understanding that they were also surrendering their rights to accumulated undeclared and unpaid dividends, all in consideration of the receipt of 1.4 shares of a new issue of new preferred stock (which differed from the old in some respects and incident rights), plus $5.50 per share in cash, for each share of the old preferred. Out of 5,632 shares of preferred stock so held, all stockholders, except the holders of 79 shares, participated, surrendered their old stock, and received the new stock; that is, the holders of 5,553 old shares received 7,774.2 shares of the new preferred stock, and $5.50 per share in cash for each of the 5,553 shares. The holders of 79 shares refused to take stock and received $45.50 cash per share, and contention as to them has been abandoned by the respondent. The old preferred stock was of no par value, but was by amendment of certificate of incorporation converted into class A preferred stock of $100 par value (which will, however, be hereinafter referred to as the old stock). The petitioner contends that when the holders of the old preferred stock (as changed) received 1.4 shares and $5.50 cash for each of the old shares, they in effect received a dividend of $40 for the .4 share received and $5.50 in cash, or a total dividend of $45.50, in the same way as did the nonparticipating holders of the 79 shares, amounting to $222,120; that such constituted a “dividend paid” within the language of section 27 (a) of the Revenue Act of 1936, and the petitioner is therefore entitled to dividends paid credit in the amount of $222,120. The earnings of the taxable year were more than that amount. Although the respondent contends that, considering the fact of deficits in earlier years and their absorption by the application of capital thereto, there were in fact and in effect not sufficient earnings against which to charge the alleged dividend in the taxable year, it is not necessary, in view of the conclusion to which we have come, to consider that phase of the matter.

The petitioner must show that under section 27 of the Revenue Act of 1936 there was a dividend and that it was paid, and, under subsection (h) of the statute, that it was a “taxable dividend.” There was in fact no payment in this case, but the petitioner contends that the effect is the same as if a dividend had been paid. Although attention was upon brief paid to the question of stock dividend, that question is not before us, since at trial it was stated by petitioner’s counsel that there was no contention that a stock dividend was paid, and evidence was not adduced to show the fair market value of such stock dividend. We therefore confine ourselves to the question as to whether the transaction which took place should be given the effect of a cash dividend, taxable and paid. The petitioner’s idea is, in effect, that, since the primary object of the recapitalization was to eliminate the arrears in unpaid accumulated dividends upon the preferred stock, and since the petitioner had the current earnings with which to pay them, the stockholders simply surrendered their rights to $45.50 per share dividends in consideration of the .4 per share of new stock which was a capitalization of $40 of earnings and $5.50 cash; and that therefore they in effect received a dividend of $45.50. The respondent allowed the dividends paid credit in the amount of $5.50 per share, but disallowed it as to the $40. He contends in substance that the transaction was what it was called in, the plan, a recapitalization, and therefore a reorganization under the definition laid down in section 112 (g) (1) (D): that sections 112 (b) (2) and (3) and (c) (1) of the Revenue Act of 1936 apply; that under the provisions thereof there was no recognition of gain or loss upon the exchange of stock for stock in the same corporation, except upon the cash received; that therefore under section 27 (h) of the Revenue Act of 1936 the distribution was not a “taxable dividend”; and that therefore dividends paid credit can not be allowed.

That the transaction was a recapitalization can not be denied in view of the repeated use of that expression throughout the documents by which the plan is evidenced. Thus, in the letter to the stockholders proposing the plan it is stated that the board of directors has given consideration to the desirability of presenting to the stockholders “a plan of recapitalization of the Corporation * * and in effect the same expression is again more than once used. Likewise it can hardly be denied and in fact is not denied that there was an “exchange”, for in the same letter and in the same paragraph just referred to the “plan of recapitalization of the Corporation” was stated as: The preferred stock “may be exchanged for a new Cumulative Prior Preferred Stock, 5% Convertible Series and an adjustment of the unpaid dividends on the present Convertible Preferred Stock may be effected.” The expression “exchange” is thereafter repeatedly used. It thus appears to be incontrovertible that at least within the language of section 112 (b) (2) and (3) “preferred stock in a corporation is exchanged * * * for preferred stock in the same corporation”, and that under section 112 (c) (1), since the exchange was not solely for stock, $5.50 in cash being received upon each share, gain or loss was limited to recognition of the cash received. The respondent further relies upon the language of section 115 (h) of the Revenue Act of 1936, pointing out that a distribution by a corporation “ox its stock or securities * * * shall not be considered a distribution of earnings or profits * * * if no gain to such distributee from the receipt of such stock or securities was recognized by law, * * that therefore section 112 (b) (2) and (3), having provided that there shall be no such recognition of gain to the distributee, the distribution can not be considered one from earnings or profits and therefore is not a dividend within the definition of section 115 (a) providing that a dividend “means any distribution made by a corporation * * * out of its earnings or profits accumulated after February 28, 1913, or ⅜ * * out of earnings or profits of the taxable year * *

To all of this the petitioner’s position and answer is in sum that the prime purpose of the whole plan was the elimination of the liability of the corporation for the accumulated unpaid dividends on the preferred stock, and that, such primly intent having been accomplished when the stockholders received four-tenths of a share of the new stock and $5.50 in cash instead of their former right to unpaid accumulated dividends, and the former stock having been set up of a value of $100 per share, anid that amount of earnings transferred to capital, it is as though they received $45.50 in consideration of the surrender of the right to receive the accumulated dividends in that amount, with the same effect as if they had in fact received such amount in cash and had then purchased the four-tenths of the shares of the stock therewith.

It is true that the primary purpose of the recapitalization was to eliminate the liability for unpaid dividends upon the preferred stock, in order to apply the funds on hand to business purposes. The initial letter to the stockholders proposing the change says:

The need for a plan of readjustment of the present capitalization arises principally as a result of the substantial amount of unpaid accumulated dividends on the outstanding Convertible Preferred Stock which, as appears from the balance sheet dated December 31, 1936, previously sent to stockholders, should not be paid in cash at this time. Furthermore, it is also desirable that the Corporation retain its present working capital to finance the purchase of additional machinery and equipment required to handle the substantial increase in the volume of business which is taking place.

In the same instrument we find the following language:

The important feature of the plan is the offer of exchange set forth in Section III of the plan, whereby, in the event that the plan is declared effective by the Board of Directors upon the terms and conditions stated in the plan, the holders of the shares of Convertible Preferred Stock now outstanding will be offered, in exchange therefor, shares of the new Cumulative Prior Preferred Stock, 5% Convertible Series, and $5.50 in cash, on the basis stated in the plan and summarized above.
By accepting the offer and making the exchange, holders of the existing Cumulative Preferred Stock will thereby release their claim to all dividends accrued and in arrears on the outstanding Cumulative Preferred Stock.

Nevertheless, after much consideration of all the facts, the primary intent of the plan, and the statutes, we do not think the result desired by the petitioner can be said to follow. In the first place, it can not accurately be said that the four-tenths share of new preferred stock was issued in consideration of the surrender of the right to the accumulated dividends. The record made by the parties at the time shows that the consideration for the stock and cash received was not divided, but was both the surrender of the old stock and the surrender of the right to accumulated dividends. Thus the initial letter to the stockholders of April 27, 1937, to which reference is made above, provides “a plan of recapitalization * * * whereby the present Convertible Preferred Stock * * * may be exchanged for a new Cumulative Prior Preferred Stock * * * and an adjustment of the unpaid dividends on the present Convertible Preferred Stock may be effected.” Later the same instrument recites:

Briefly stated, the offer provides for an exchange on the basis of 1.4 shares of the new Cumulative Prior Preferred Stock, 5% Convertible Series, plus $5.50 in cash, for 1 share of present Convertible Preferred Stock (as reclassified into Class A Preferred Stock) and a release of all claim to accumulated unpaid dividends on the present Convertible Preferred Stock on the conditions stated in the plan.

Under this language it appears that there was an exchange of 1.4 shares of new stock and $5.50 in cash for one share of old stock “and a release of all claim to accumulated unpaid dividends” (italics supplied) on the old stock, and that four-tenths share of stock was not exchanged merely “for the release of all claim to accumulated unpaid dividends” on the old stock. The printed “Plan of Recapitalization” under the heading “Offer of Exchange” provides that the holders of old stock “will be offered in exchange therefor 1.4 shares of the Cumulative Prior Preferred Stock, 5% Convertible Series, and $5.50 in cash, on the terms and conditions hereinafter set forth”; and that:

By making the exchange, holders of the existing Oumulative Preferred Stock will thereby release, relinquish and discharge their claim to all dividends accrued and in arrears on the outstanding Cumulative Preferred Stock.

From this language it appears that by makmg the exchange of stock for stock the holders of the old stock “will thereby release, relinquish and discharge their claim to all dividends accrued and in arrears” [italics supplied] on the old stock. Another letter to the stockholders of June 7, 1937, says that “By accepting the offer and making the exchange, holders of the Convertible Preferred Stock will thereby release, relinquish and discharge their claim to all dividends accrued and in arrears on such Preferred Stock.” A resolution of petitioner’s board of directors on July 15, 1937, declaring the “Plan of Recapitalization” effective as approved by the stockholders on May 26, 1937. and referring to the new stock, says: “* * * such stock to be issued in exchange for, and in consideration of the delivery to the Corporation for cancellation of, shares of the [old stock] * * * on the basis of 1.4 shares of such new Cumulative Prior Preferred Stock, 5% Convertible Series, and $5.50 in cash, for each share of” the old stock. The same resolution recites “that in the opinion of this Board of Directors the present value of the full consideration, i. e., shares without par value [of the new stock] * * * together with the release and discharge of all claims to accrued unpaid dividends [on the old stock] * * * amounting to $45.50 per share * * * to be received by this Corporation for the issuance of its shares of new Cumulative Prior Preferred Stock * * * is not less than $140 per share for each share of such Convertible Preferred Stock and the said release so to be received as the consideration for the issuance of the shares of new Preferred Stock.” In the face of this language, we think it can not with reason be considered that there was, separate from the exchange of stock for stock, such an exchange of four-tenths share of stock for the right to unpaid accumulated dividends as to constitute payment of dividends to the extent of $45.50. Either the consideration for the 1.4 shares of new stock and $5.50 was one share of old stock and the release of the right to accumulate dividends, or the stock was exchanged for stock, thus complying with the text of section 112 (b) (2), (3) and (c) (1) and “thereby” there was effected the discharge of the right to dividends — which in effect is the same thing. One consideration appears for both the release of the old stock and the release of the right to accumulated dividends.

From all this we conclude that a consideration for the exchange is not separable between old stock and the right to dividends accumulated thereon. Recently, in South Atlantic Steamship Line, 42 B. T. A. 705, we had before us a situation very analogous to that herein present, and held:

In the course of readjustment of the capital structure of a corporation petitioner exchanged preferred stock upon which dividends were in arrears for new stock, bonds, and cash. Held, that receipt of the new stock was neither a dividend nor essentially equivalent to a dividend under section 115 (a) and 115 (g) of the Revenue Act of 1936; held, further, that the stock, debenture bonds, and cash were received by petitioner in the course of a reorganization and gain is recognized under section 112 (c) (1) only to the extent of the cash received.

The petitioner urges that the question there was merely one of recognition or nonrecognition of gain or loss under the sections of the statute above noted in the quotation, while here we have a different-question, that is, whether there is a right to dividends paid credit under section 27. But petitioner’s right to a dividends paid credit depends fully upon whether the distribution is taxable under section 27 (h). If it were true that the distribution is a “dividend” it must still be taxable under section 27 (h), and in the South Atlantic Steamship Line case, supra, we held that it is not. Therefore it seems inescapable that the South Atlantic Steamship Line case is controlling here, for there, as here, there was exchange of preferred stock upon which dividends were in arrears for new stock and cash (and bonds not here involved). The respondent there took the position which petitioner takes herein, that is, “that the noncumulative preferred stock was received by petitioner in exchange for arrears in dividends on the old stock and is taxable as a corporate dividend.” The respondent also urged that the petitioner there realized recognizable gain “on the receipt of new preferred stock, debenture bonds, and cash.” The petitioner contended that the gain was recognized only to the extent of the cash received. We held that the readjustment of capital structure was recapitalization within the statutory definition of section 112 (g) (1) (D) and that the exchange of securities was made pursuant to that plan and under sections 112 (b) (3) and 112 (c) (1). Further, upon respondent’s contention “that the right to undeclared accumulated dividends is separate and apart from the preferred shares” and therefore essentially equivalent to a dividend, we cited Commissioner v. Food Industries, Inc., 101 Fed. (2d) 748, where the holders of preferred stock upon which dividends were accrued but unpaid “received common stock of a new corporation in exchange for the preferred stock and also received sinking fund debentures of the new corporation for the arrearages in dividends” and where the court held that the receipt of common stock and sinking fund debentures was not taxable. Commenting on the Food Industries case, we said: “The right to arrears and dividends was not considered apart from the stock upon which the arrearages arose.” We called attention to the fact that the same reorganization with respect to other shareholders was considered “by the Circuit Courts of Appeals for the First, Second, Fourth, and Ninth Circuits with the same result. Commissioner v. Whitaker, 101 Fed. (2d) 640; Helvering v. Schoellkopf, 100 Fed. (2d) 415; Helvering v. Leary, 93 Fed. (2d) 826; Commissioner v. Kolb, 100 Fed. (2d) 920.”

From the above it appears that there was more reason in Commissioner v. Food Industries, Inc., supra, to separate the arrearages in dividends from the stock than there is here, because there they were exchanged not for the stock, but for “sinking fund debentures of the new corporation” while here they were exchanged for a consideration common to them and to the old stock.

Being unable to distinguish the present proceeding in principle from the authorities above cited, we conclude and hold that there was a nontaxable exchange within the purview of sections 112 (b) (2), (3) and (c) (1) and 112 (g) (1) (D) of the Revenue Act of 1936, and that therefore under the provisions of section 27 (h) of the same act no dividends paid credit is allowable to the petitioner, and that the respondent did not err in denying the credit claimed.

2. Our conclusion on the first issue is decisive of the second, wherein petitioner claims deduction as ordinary and necessary expenses of $15,000 paid for attorneys’ fees in connection with the transaction hereinabove discussed. The parties agree that the amount was reasonable for the services rendered in the matter. Since we have above held the transaction to be a reorganization by recapitalization under section 112 (g) (1) (D) of the Revenue Act of 1936, it follows that the amounts paid therefor are capital expenditures. Holeproof Hosiery Co., 11 B. T. A. 547; Odorono Co., 26 B. T. A. 1355. We hold that the respondent did not err in denying the deduction.

Decision will he entered under Rule 50.

       (h) Nontaxable Distributions.- — If any part of a distribution (including slock dividends and stock rights) is not a taxable dividend in the hands of such of the shareholders as are subject to taxation under this title for the period in which the distribution is made, no dividends paid credit shall be allowed with respect to such part.

       SEC. 112. RECOGNITION OF GAIN OR LOSS.

      (b) Exchanges Solely in Kind.—
      *******
      (2) Stock: por stock op same corporation. — No gain or loss shall be recognized If common stock in a corporation is exchanged solely for common stock in the same corporation, or if preferred stock in a corporation is exchanged solely for preferred stock in the Bame corporation.
      (3) STOCK POR STOCK on reorganization. — No gain or loss shall be recognized if stock or securities in a corporation a party to a reorganization are, in pursuance of the plan of reorganization, exchanged solely for stock or securities In such corporation or In another corporation a party to the reorganization.

        (c) Gain From Exchanges Not Solely in Kind.—
      (I) If an exchange would be within the provisions of subsection (b) (1), (2), (3), or (5) of this section if it were not for the fact that the property received in exchange consists not only of property permitted by such paragraph to be received without the recognition of gain, but also of other property or money, then the gain, if any, to the recipient shall be recognized, but in an amount not in excess of the sum of such money and the fair market value of such other property.

      (g) Definition of Reorganization. — As used in this section and section 113—
      (1) The term “reorganization” means * * * (D) a recapitalization * * *.

       SEC. 115. DISTRIBUTIONS BY CORPORATIONS.
      *******
      (h) Effect on Earnings and Profits of Distributions of Stock. — The distribution (whether before January 1, 1936, or on or after such date) to a distributee by or on behalf of a corporation of its stock or securities or stock or securities in another corporation shall not be considered a distribution of earnings or profits of any corporation—
      (1) if no gain to such distributee from the receipt of such stock or securities was recognized by law, or
      (2) if the distribution was not subject to tax in the hands of such distributee because it did not constitute income to him within the meaning of the Sixteenth Amendment to the Constitution or because exempt to him under section 115 (f) of the Revenue Act of 1934 or a corresponding provision of a prior Revenue Act.
      As used in this subsection the term “stock or securities” includes rights to acquire stock or securities.


author: Yan Fossan :

text:
    Estate of John Sage, Deceased, Alfred D. Sage, Robert J. Rendall, and the Fifth Avenue Bank of New York, Executors, Petitioners, v. Commissioner of Internal Revenue, Respondent.
    Docket No. 97720.
    Promulgated November 26, 1940.

      T. Girard Wharton, Esq., and Thomas A. S. Beattie, Esq., for the petitioners.

      Harold F. Noneman, Esq., for the respondent.
   OPINION.

Yan Fossan :

The single question before us is whether, in determining decedent’s taxable estate, petitioners must deduct from a charitable residuary bequest the amount paid by the charitable legatee to decedent’s widow in compromise of a contest of decedent’s will.

Petitioners contend that the estate tax is imposed upon the transfer of property at death and that the amount of the deduction should be determined as of that date. They assert that Mrs. Sage received nothing by inheritance except that given her specifically by her husband’s will. They urge that any additional amount receivable by her was by virtue of the compromise. Respondent’s contention is that the widow received the compromise payment as a bequest, devise, or inheritance and that the residuum must be reduced to the extent of the sum paid her. He relies on the decision of the Supreme Court in Lyeth v. Hoey, 305 U. S. 188.

The deduction under consideration is claimed under section 303 (a) (3) of the Revenue Act of 1926, as amended by section 406 of the Revenue Act of 1934.

In Lyeth v. Hoey, supra, an heir of a decedent opposed probate of the decedent’s will. The will contest was settled by compromise and the heir received a payment which the collector of internal revenue contended was income taxable to the heir. In holding that the compromise payment was exempt from income tax as a “bequest, devise, or inheritance”, the Supreme Court said:

There is no question that petitioner obtained that portion, upon the value of which he is sought to be taxed, because of his standing as an heir and of his claim in that capacity. It does not seem to be questioned that if the contest had been fought to a finish and petitioner had succeeded, the property which he would have received would have been exempt under the federal act. Nor is it questioned that if in any appropriate proceeding, instituted by him as heir, he had recovered judgment for a part of the estate, that part would have been acquired by inheritance within the meaning of the act. We think that the distinction sought to be made between acquisition through such a judgment and acquisition by a compromise agreement in lieu of such a judgment is too formal to be sound, as it disregards the substance of the statutory exemption. It does so, because it disregards the heirship which underlay the compromise, the status which commanded that agreement and was recognized by it. While the will was admitted to probate, the decree also required the distribution of the estate in accordance with the compromise and, so far as the latter provided for distribution to the heirs, it overrode the will. So far as the will became effective under the agreement it was because of the heirs’ consent and release and in consideration of the distribution they received by reason of their being heirs.

The position of Mrs. Sage in the present proceeding closely parallels that of the heir in Lyeth v. Hoey, supra. The amount payable to her by virtue of the compromise was hers by inheritance a.nd not by purchase. Chase National Bank of the City of New York et al., Executors, 40 B. T. A. 44; see Charlotte Keller, 41 B. T. A. 478. Petitioners’ contention, that the compromise here differed from that in the Lyeth case in that it was not incorporated in the decree of the probate court, is not persuasive. The fact of receipt by Mrs. Sage because of her standing as widow and legatee and not the absence of official court sanction is the material factor bringing this proceeding within the doctrine of Lyeth v. Hoey, supra.

Petitioners’ principal argument with respect to the inapplicability of the Lyeth decision is that there the Court was considering an income tax question, while we are confronted with an estate tax problem. They argue that, although Mrs. Sage may have received the payment because she was widow and legatee of decedent, she did not receive it from the estate pursuant to decedent’s will or as an heir. They bottom this contention on Robbins v. Commissioner, 111 Fed. (2d) 828. In that case the Circuit Court of Appeals for the First Circuit held that an indefinite bequest to a charitable institution was not deductible from decedent’s gross estate although, as the result of a contest of the will, the charity received a sum equal to the largest amount payable under the indefinite bequest. The court distinguished Lyeth v. Hoey, supra, on the ground that the Supreme Court was there considering an income tax question. We do not believe, however, that the application of the principles laid down in Lyeth v. Hoey, supra, must necessarily be limited solely to income tax questions. In Chase National Bank of the City of New York et al., Executors, supra, we held that a widow received a payment in compromise of a will contest as an inheritance. The amount payable to Mrs. Sage by the Lord Provost was receivable by her because of her standing as legatee and widow of decedent and was payable to her as such.

Petitioners further assert that the gross estate should be determined as of the date of the testator’s death without regard to events occurring after that time. That is the general rule. Ithaca Trust Co. v. United States, 279 U. S. 151; Mississippi Valley Trust Co. et al., Executors, 28 B. T. A. 387; affd., 72 Fed. (2d) 197. Here, however, the Lord Provost was not an heir, but the residuary legatee. His status was not secure until probate of the will. Piad the litigation been carried to a judgment and 25 percent allowed by the court and paid in due course, it is clear that the deductible residuary bequest would have been reduced in that amount. We are of the opinion that the agreement entered into in advance to pay Mrs. Sage 25 percent of the amount received likewise effectually limited the size of the residuum. We would ignore the substance of the matter should we decide that the residuary estate was undiminished by the amount payable to the widow. Parenthetically, it will be readily observed that a contrary conclusion would be fraught with incalculable possibilities for the evasion of estate tax.

We hold that respondent committed no error in excluding from the amount deductible as a charitable bequest the sum payable to decedent’s widow under the compromise of the will contest. See Heim v. Nee, United States District Court, Western District of Missouri, May 28, 1937.

Decision will be entered for the respondent.


author: Smith:

text:
    Estate of John A. McCandless, Deceased, Bishop Trust Company, Limited, Executor, Petitioner, v. Commissioner of Internal Revenue, Respondent.
    Docket No. 97943.
    Promulgated November 27, 1940.

      Urban E. Wild, Esq., Milton Cades, Esq., and E. B. Caxm&ron, 0. P. A., for the petitioner.

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

Smith:

This is a proceeding for the redetermination of a deficiency of $15,408.33 in income tax of the estate of John A. McCandless, deceased, during the period of administration or settlement for the fiscal year ended January 31, 1936. Only a portion of the deficiency is in controversy.

The petitioner alleges that the respondent erred in disallowing the deduction from gross income of (1) $2,925 professional fees and $1,859.35 traveling expenses which were paid by the estate during the taxable year as ordinary and necessary expenses incurred in carrying on its business, and (2) $20,504.58 representing income received by the estate during the taxable year “that was properly paid during such year to Bishop Trust Company, Limited, Trustee and sole residuary legatee under the Will and of the Estate of John A. McCandless, deceased.”

The petitioner, Bishop Trust Co., Ltd., of Honolulu, Territory of Hawaii, was during the taxable year 1936 the duly appointed and acting executor under the will and of the estate of John A. Mc-Candless, who died a resident of Honolulu on January 30, 1930.

The decedent left a large estate. He named the Bishop Trust Co., Ltd., an Hawaiian corporation, as his executor, and also as the testamentary trustee of his residuary estate, and it duly qualified as such. The decedent provided in his will that the executor should pay to his widow $1,000 per month for support and maintenance during the administration of his estate, the first of such payments to be made one month from the date of his death and succeeding payments in a like amount on the same day of each succeeding month until such time as his residuary estate should be turned over to the testamentary trustee. He also directed that the executor should pay to each of his four grandchildren for support, maintenance, and education during the administration of the estate $250 per month, the first payment to be made one month from the date of his death and succeeding payments on the same day of each succeeding month until such time as his residuary estate should be turned over to the testamentary trustee. His will further provided:

Eighth. X give, devise and bequeath all of the rest, residue and remainder of my estate, real, personal or mixed, wheresoever situated and of every kind or nature, and any property over which I shall possess any power of appointment, to Bishop Trust Company, Limited, an Hawaiian corporation, in trust for the uses and purposes and with the powers as hereinafter stated, * * *

The trustee was directed to “pay and deliver from the accumulations and net income of my said trust estate” $1,000 per month to his widow, beginning one month from the date of the last monthly payment made to the widow by the executor and continuing until such time as his eldest grandchild should attain the age of 21 years, after which the widow was to receive one-tenth of the annual net income of the trust. The trustee was also directed to “pay and deliver from the accumulations and net income of my said trust estate” $250 per month to each grandchild. After a grandchild attained the age of 21 years he or she was to receive one-tenth of the annual net income of the trust estate. Surplus income of the trust estate was to be accumulated and invested. When the youngest grandchild attained the age of 30 years the trust was to determine and one-fifth of the trust estate was to be paid over to the widow, if living, and one-fifth to each grandchild per stirpes.

On January 12, 1936, the executor filed a petition in the Circuit Court of the First Judicial Circuit, Territory of Hawaii, sitting in probate, requesting an approval of its first and final account of the administration of the estate and that “an order be made to deliver over such property as remains to the persons thereto entitled, and that petitioner be relieved from all further responsibilities as executor under the 'will and of the estate of John A. McCandless.”

On January 21,1936, the court, sitting in probate, entered an order reading in part as follows:

It Is Further Ordered, Adjudged and Decreed that Bishop Trust Company, Limited, shall forthwith upon the signing of this Order, convey, transfer and deliver to Bishop Trust Company, Limited, as Trustee under the Will and of the Estate of John A. McCandless, Deceased, the assets remaining in its hands as Executor aforesaid; and that upon the filing herein of due and proper vouchers showing the receipt by Bishop Trust Company, Limited, as Trustee under the Will and of the Estate of John A. McCandless, Deceased, of the assets remaining in the hands of Bishop Trust Company, Limited, as such Executor, Bishop Trust Company, Limited, be discharged from its trust as Executor of the Will of John A. McCandless, Deceased, in all particulars, except that Bishop Trust Company, Limited, shall remain as such Executor for such time as may be necessary to secure a substitution of itself, as Trustee as aforesaid, as Party-Petitioner in the two appeals before the United States Board of Tax Appeals against the Commissioner of Internal Kevenue now pending, so that said appeals may be properly presented and settled; and when such substitution has been effectuated, then and upon the filing herein of a verified statement by such Executor showing the same, Bishop Trust Company, Limited shall be discharged as such Executor in such particulars without any further order being entered by the Court.

Pursuant to such order the petitioner as executor, on January 22, 1936, transferred and delivered to itself as trustee the residue of the decedent’s estate and was discharged as executor of the estate, subject to the performance of specific acts, which have since been performed.

The petitioner kept its accounts and made its income tax returns, on both Form 1040 and 1041, on the cash receipts and disbursements basis and on the basis of a fiscal year beginning February 1 and ending January 31. The returns were filed with the collector at Honolulu.

The gross receipts of the estate for the taxable year ended January 31, 1936, consisted of $73,111.25 from the sales of shares of stock and $80,359.29 dividends received from domestic corporations. The respondent determined that the gross income of the estate for income tax purposes consisted solely of dividends from domestic corporations in the amount of $80,359.29, from which he permitted the deduction therefrom of a capital net loss of $2,000, sustained on the sales of shares of stock, and other items of expense aggregating $4,825.10, and arrived1 at a net income of $73,534.19.

Included in the residuary estate of the decedent which the petitioner as executor transferred to itself as trustee on January 22, 1936, pursuant to the order of the court made January 21, 1936, was $20,504.58 cash which had been received by the executor as income during the taxable year ended January 31, 1936. This amount was claimed as a deduction in the return which the petitioner, as executor, filed on behalf of the estate for the fiscal year ended January 31, 1936.

In the determination of the deficiency herein the respondent disallowed the deduction of the said amount of $20,504.58 on the ground that it did not constitute an allowable deduction under the provisions of section 162 (c) of the Kevenue Act of 1934.

The Bishop Trust Co., Ltd., as testamentary trustee, in the return filed on behalf of the trust for the taxable year begun February 1, 1935, and ended January 31, 1936, included in the gross income of the trust estate $19,639.12 of the said amount of $20,504.58 and duly paid income tax thereon.

The petitioner paid to Cameron and Johnstone, certified public accountants, during the taxable year ended January 31, 1936, $2,925 professional fees and $1,859.35 traveling expenses. These payments covered the cost of a trip to California for the investigation for Federal income tax purposes of claims for additional income taxes made upon the petitioner for the fiscal years ended January 31, 1932, January 31, 1933, and January 31, 1934; for conferences in Washington with respect to claims for additional taxes; for filing-protests and claims for refund; and for the preparation of the income tax return of the estate for the fiscal year ended January 31, 1935.

Our first question is whether the amount of $20,504.58 representing the accumulated income of the decedent’s estate during the period of administration, which the executor in final settlement of the estate paid over to itself as residuary trustee, is deductible from the gross income of the estate.

Section 162 (c) of the Revenue Act of 1934 provides that:

(c) In the case of income received by estates of deceased persons during the period of administration or settlement of the estate, and in the case of income which, in the discretion of the fiduciary, may be either distributed to the beneficiary or accumulated, there shall be allowed as an additional deduction in computing the net income of the estate or trust the amount of the income of the estate or trust for its taxable year, which is properly paid or credited during such year to any legatee, heir, or beneficiary, but the amount so allowed as a deduction shall be included in computing the net income of the legatee, heir, or beneficiary.

This issue is controlled by the Board’s decision in Estate of Ida A. White, 41 B. T. A. 525, where we held on facts not distinguishable from those in the instant case that the income of an estate in process of administration which was paid over to the residuary trustees and reported as income by the trustees in their fiduciary return for that year was deductible by the estate as income paid to a “legatee” within the meaning of section 162 (c) above. In that case we distinguished Weigel v. Commissioner (C. C. A., 7th Cir.), 96 Fed. (2d) 387, on the ground that the income there in dispute was a gain from the sale of corpus of the estate and not from income. In its opinion the Board said:

The respondent cites Weigel v. Commissioner, 96 Fed. (2d) 387, affirming 34 B. T. A. 237. The facts in that ease are readily distinguishable from those in the case at bar. There the question involved was the gain realized from the sale of corpus. By the terms of the will all estate income became part of the corpus of the trust estate. That situation does not exist here. We find that the income in question preserved its identity from its receipt by the petitioners to its payment to the legatee. It was paid as income. ⅜ *• *

Here, as in the White case, the amount in dispute was income of the estate, rather than an accretion to corpus, and it was paid over to the residuary trustee as income.

See also Lynchburg Trust & Savings Bank v. Commissioner, 68 Fed. (2d) 356; certiorari denied, 292 U. S. 640; George G. Allen et al., Trustees, 40 B. T. A. 351; and Angier B. Duke, 38 B. T. A. 1264.

We hold upon authority of the Estate of Ida A. White, supra, that the amount of $20,504.58 is deductible from the gross income of the estate.

The remaining issue is whether the amounts of $2,925 and $1,859.35, representing, respectively, accountant’s fees and expenses paid by the executor in connection with the settlement of income tax claims of the Government against the estate for years prior to the taxable year before us are legal deductions from gross income.

Section 162 of the Kevenue Acts of 1934 and 1936 provides that the income of an estate in process of administration or settlement shall be computed in the same manner as the income of an individual, with certain exceptions not material to the present issue. Section 23 of the same taxing acts provides for the deduction from the gross income of an individual of “All the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business.” (Subdivision (a)).

The immediate question before us then is whether the petitioner was engaged “in carrying on any trade or business” within the meaning of the statute during the fiscal year ended January 31, 1936. It can not be doubted that in some cases an estate in process of administration or settlement is carrying on a trade or business within the meaning of the statute. See Pyne v. United States, 35 Fed. Supp. 81. In that case the court held that upon the evidence the estate was engaged in carrying on a trade or business within the meaning of the statute. The evidence showed that the executor was under the necessity of employing several persons to assist in the administration of the estate.

The record in this proceeding does not, in our opinion, show the carrying on of a trade or business by the petitioner during the taxable year. During such year it sold certain shares of stock belonging to the estate at a loss. Its gross income consisted entirely from the receipt of dividends upon shares of stock of domestic corporations. It paid a firm of accountants fees and traveling expenses in connection with the adjustment of the income taxes of the estate for prior years. If John A. McCandless had been living during the taxable year before us and had received the dividends upon his shares of stock, and made the payments here in question, we do not think it could be held that he was carrying on a trade or business within the meaning of the statute and he would not have been ’entitled to deduct such payments. See Deputy v. duPont, 308 U. S. 488.

The facts before us are substantially the same as those which obtained in Estate of C. R. Hubbard, 41 B. T. A. 628. In that case we held that the estate was not engaged in carrying on a trade or business within the meaning of the taxing statute. The action of the respondent in disallowing the deduction from the gross income of the payments here in question is approved.

Decision will be entered under Rule 50.


author: KeRN :

text:
    Highland Farms Corporation, Petitioner, v. Commissioner of Internal Revenue, Respondent.
    Docket No. 95690.
    Promugated November 27, 1940.

      John W. Martin, Esq., and G. Kibby Munson, Esq., for the petitioner.

      James H. Yeatman, Esq., for the respondent.
   OPINION.

KeRN :

1. The Commissioner added to _ income $87,844.63 “gain from cancellation and redemption of mortgage bonds”, computed by deducting from the $200,000 face value of the bonds issued by petitioner the aggregate of (1) $6,000 discount on issuance, (2) $51,-900 representing bonds retired at par by Fidelity with money supplied by petitioner, less $1,557 discount applicable to such retired bonds, (3) $3,907.56 representing funds collected by Fidelity on notes and contracts pledged by petitioner under the mortgage and used to redeem the bonds, and (4) $51,904.81 of the damage award used to redeem the bonds.

The evidence discloses that, although the court decree of November 23, 1933, adjudged the obligation evidenced by the bonds usurious, the court recognized petitioner’s obligation to pay the full $200,000 face value of the bonds to the extent of applying as credits against the obligation the amounts which are deducted from the face value of the bonds in the deficiency notice and, in addition thereto, $20,-410.83 as a return of interest paid more than two years prior to the bringing of the suit, $25,806.80 as double the amount of interest paid within two years before the suit was brought, and $40,000 as the value of Highland Farms stock which Fidelity received when the loan was made.

The Commissioner’s determination is difficult to explain in that he properly credits the $51,904.81 portion of the damage award as a payment against the $200,000 face value of the bonds, but omits the amounts credited for interest and for the Highland Farms stock, although all of the items were applied in satisfaction of the bonds by the same decree. Since the total of amounts paid and applied by the court in satisfaction of Fidelity’s claim under the bonds equals their face value of $200,000 (apart from a mathematical error of $70 in the decree’s computation), we can perceive no justification for the determination that gain resulted from the cancellation and retirement of the bonds. For purposes of decision we confine ourselves to the issues presented and argued by the parties.

Petitioner meets the issue of whether gain was derived from cancellation and redemption of its bonds by contending that it realized no taxable gain because there was a shrinkage in the value of its assets from $623,000 to less than $25,000 and the transaction as a whole was a loss. In this it relies on Bowers v. Kerbaugh-Empire Co., 271 U. S. 170. In that case the taxpayer’s subsidiary lost in its business money which the taxpayer had borrowed and was bound to repay in a foreign currency. The taxpayer repaid the loan in the foreign currency, which had depreciated between the time of the loan and repayment, and no taxable gain was held to result, since the transaction as a whole was a loss. That case, however, has been considerably limited in scope by Burnet v. Sanford & Brooks Co., 282 U. S. 359, wherein the recovery in 1920 by a judgment of compensation for work done at a loss in earlier years was held to constitute taxable income for 1920, although the whole transaction resulted in a loss. Cf. United States v. Kirby Lumber Co., 284 U. S. 1.

But petitioner, as distinguished from the taxpayer in the Sanford & Brooks Co. case, was insolvent during the taxable year and it has been held that an insolvent taxpayer which discharges its obligations by payment of less than the amount owed realizes no taxable gain where it is still insolvent after the transaction. Sickles Co. v. United States, 31 Fed. Supp. 654; Dallas Transfer & Terminal Warehouse Co. v. Commissioner, 70 Fed. (2d) 95; Transylvania R. Co. v. Commissioner, 99 Fed. (2d) 69; Madison Railways Co., 36 B. T. A. 1106; Springfield Industrial Building Co., 38 B. T. A. 1445; Burnet v. Campbell Co., 50 Fed. (2d) 487; Commissioner v. Simmons Gin Co., 43 Fed. (2d) 327. Cf. E. B. Higley & Co., 25 B. T. A. 127; Towers & Sullivan Manufacturing Co., 25 B. T. A. 922; Porte F. Quinn, 31 B. T. A. 142; Lakeland Grocery Co., 36 B. T. A. 289.

The facts show that in 1935 petitioner’s assets, aside from the $46,180 check received under the state court decree, were worth less than $25,000. Petitioner paid $36,000 of the $46,180 to its attorneys in 1935 and used the balance to defray expenses of the suit. Petitioner still owed its attorneys $35,000 under its contract with them and, since its assets did not equal its liabilities, it was insolvent. From the cancellation of its bonds, therefore, it appears that petitioner derived no taxable gain.

A further question arises, however, from the fact that petitioner on its income tax returns for earlier years has been allowed deductions aggregating $33,314.23 for interest paid to Fidelity. In numerous cases it has been held that a taxpayer must include in taxable income amounts recovered in the taxable year where deductions in respect of such amounts have been taken in prior years. Houbigant, Inc., 31 B. T. A. 954; affirmed per curiam, 80 Fed. (2d) 1012; certiorari denied, 298 U. S. 669; Nash v. Commissioner, 88 Fed. (2d) 477; Union Trust Co. of Indianapolis v. Commissioner, 111 Fed. (2d) 60; Chicago, Rock Island & Pacific Ry Co. v. Commissioner, 47 Fed. (2d) 990; Victoria Paper Mills Co., 32 B. T. A. 666; affd., 83 Fed. (2d) 1022; Helvering v. Jane Holding Corporation, 109 Fed. (2d) 933; Commissioner v. Liberty Bank & Trust Co., 59 Fed. (2d) 320; Chevy Chase Land Co., 34 B. T. A. 150; Dixie Margarine Co., 38 B. T. A. 471; on appeal, C. C. A., 6th Cir.; Elsie A. Eckstein, 41 B. T. A. 746; Walter M. Marston, 41 B. T. A. 847; Jamaica Water Supply Co., 42 B. T. A. 359.

Despite the fact that petitioner has been allowed deductions in earlier years for the interest paid to Fidelity, the income to petitioner, if any, was received solely in the form of a cancellation of indebtedness, and this fact adequately distinguishes the instant proceeding from the cases above cited. The arguments which have prompted holdings that the taxpayer realizes no taxable gain from the cancellation of indebtedness where he is insolvent after the transaction is over are equally applicable here, even though the cancellation resulted from the application to the indebtedness of interest payments made in prior years. Petitioner, being insolvent, was unable to realize income from the cancellation of its bonds however accomplished, sinee when the transaction was all over it still did not have sufficient assets to meet its liabilities and there were not “made available” any “assets previously offset by the obligation of bonds now extinct.” See United States v. Kirby Lumber Co., 284 U. S. 1, 3. The addition to income of $87,844.63 “gain from cancellation and redemption of mortgage bonds” was error.

2. The Commissioner also added to income $98,188.09 “income from collection of damage awards”, computed by adding $42,050.95 damages received in cash, $4,232.33 interest on the award, and $57,949:05 damages applied against the retirement of bonds and trustee’s expense, and deducting from the total of $104,232.33 trustee’s expense of $1,044.24 for taxes and $5,000 trustee’s fee.

The petitioner’s cross-action in the state court for actual damages alleged that there was a plan to injure petitioner and to wreck the enterprise. The facts disclose no separate claim for loss of profits, although such a loss is mentioned in the complaint and the damages awarded by the court do not appear, in view of the facts presented in the case and the verdict of the jury on the special issues submitted to it, to have been intended as a restoration of lost profits but rather of lost capital caused by the course of injurious conduct pursued by the president of Fidelity against petitioner. United States v. Safety Car Heating & Lighting Co., 297 U. S. 88, and other cases cited by respondent involving recovery of lost profits are, therefore, distinguishable.

The situation in the instant case is akin to that found in Farmers' & Merchants' Bank of Catlettsburg v. Commissioner, 59 Fed. (2d) 912, wherein an amount received by a bank in settlement of -an action for injury inflicted on its business by a Federal Keserve bank which had employed agents to cash checks at the taxpayer bank in such manner as to attract unfavorable public comment and interfere with the taxpayer’s business was held not to constitute taxable gain. The Circuit Court in that case observed:

The fund involved must be considered in the light of the claim from which it was realized and which is reflected in the petition filed in its action against the Reserve Bank. We find nothing therein to indicate, with the certainty required in the statement of a cause of action, that petitioner sought reparation for profits which petitioner’s [Reserve Bank] misconduct prevented it from earning in 1925. * * *
We think that the gravamen of petitioner’s action against the Reserve Bank was the injury inflicted to its banking business generally, and that the true measure of damages was compensation to be determined by ascertaining how much less valuable its business was by reason of the wrongful acts of the Reserve Bank. * * *

The facts show that the value of the property pledged by petitioner to secure the bonds at the time of issuance was $623,000 and that petitioner’s total assets in 1935 were less than $25,000, a loss of almost $600,000. Deducting therefrom the $138,000 loss due to the storm of April 13, 1929, which destroyed petitioner’s strawberry crop, the $100,000 damages received under the state court’s decree restored only one-sixth of petitioner’s loss of capital between 1929 and 1935. Lost profits could have been at most but an incidental ground for the award. We must conclude that the damages in the instant case wore a compensatory payment constituting return of capital investment. Farmers’ & Merchants’ Bank of Catlettsburg v. Commissioner, supra; Hyatt Roller Bearing Co. v. United States, 43 Fed. (2d) 1008; Bankers Pocahontas Coal Co. v. United States, 55 Fed. (2d) 626; affd., 287 U. S. 308; Henri Chouteau, 22 B. T. A. 850; Edward H. Clark, 40 B. T. A. 333; John H. Schofield, 19 B. T. A. 234; Edward E. Marshall, 10 B. T. A. 1140. Cf. C. A. Hawkins, 6 B. T. A. 1023; Mrs. Lyde McDonald, 9 B. T. A. 1340. The respond ent was in error, therefore, in including the $90,000 actual damages in petitioner’s taxable income.

The punitive damages of $10,000 present a different problem. They were awarded neither for loss of capital nor for loss of profits, but as a penalty. In Central R. Co. of New Jersey v. Commissioner, 79 Fed. (2d) 697, an amount received by a taxpayer in settlement of a suit against a fiduciary for an accounting of profits earned by a corporation organized and controlled by the fiduciary for business operations adverse to the taxpayer’s interest was held to be a penalty imposed by law upon a faithless fiduciary and not taxable income. A penalty imposed by law does not meet the test of taxable income set forth in Eisner v. Macomber, 252 U. S. 189, as “ ‘the gain derived from capital, from labor, or from both combined,’ provided it be understood to include profit gained through a sale or conversion of capital assets.” The respondent erred in adding the $10,000 punitive damages to petitioner’s taxable income.

3. A claim for an additional deduction of $35,485.06 for attorneys’ fees was first presented in the petition. Respondent contends that in 1935 the balance due petitioner’s attorneys had not become fixed or determined and that petitioner’s president took the position that the attorneys were not entitled to receive anything more than the $36,000 they had already been paid.

Petitioner was on an accrual basis of accounting in 1935 and its liability under the contract of April 21, 1933, with its attorneys was fixed and definite in 1935. The $71,000 fee claimed by the attorneys liad been earned in 1935, when the judgment of the trial court became final. In that year all the events had occurred which fixed the fee and determined the liability of petitioner to pay it. The fact that payment did not take place until 1938, when the attorneys brought suit for $40,000 and a settlement was reached, does not alter the fact that the fee which had been contingent upon the outcome of the litigation constituted an accrued expense in 1935 and was deductible in that year. United States v. Anderson, 269 U. S. 422; American National Co. v. United States, 274 U. S. 99; Bonnie Bros., Inc., 15 B. T. A. 1231. On this issue also the respondent’s determination was in error.

Because of an additional deduction granted for legal fees,

Decision will be entered under Rule 50.