author: Arnold:

text:
    Buffalo Eagle Mines, Inc., Petitioner v. Commissioner of Internal Revenue, Respondent.
    Docket No. 70190.
    Promulgated May 13, 1938.

      E. L. Hogsett, Esq., for the petitioner.

      P. M. OlarJe, Esq., and 8. B. Pierson, Esq., for the respondent.
   OPINION.

Arnold:

Part of the $46,616.82 payment made by petitioner was made pursuant to the terms of the Altizer lease, and part thereof was pursuant to the agreement between petitioner and its assignor, Lem-kuhl. Each of these instruments obligated the petitioner to pay 10 cents a ton upon coal produced. The lease expressly characterizes the payments of 10 cents a ton therein provided for as royalties or rents, and there is no dispute between the parties as to the tax significance of the payments to the original lessors. The petitioner has deducted them as “Rent on Business Property — Royalty”, and the respondent has allowed the deduction.

The Lemkuhl agreement makes no attempt to characterize the payments therein provided for. The agreement, after reciting that Lem-kuhl has “sold, transferred and conveyed” the properties to peti-' tioner, contains an outright promise to pay 10 cents per gross ton on the production of the company. The petitioner has treated the payments made thereunder as being in the same category as the payments made under the Altizer lease. Compare C. H. Mead Coal Co., 31 B. T. A. 190, where advance royalties were held to constitute income of the lessor.

The respondent contends that the payments made to Lemkuhl were expenditures for the acquisition of capital assets, or represented a distribution of the profits of the corporation. Whether the disputed payments are deductible depends upon the nature of the obligation created. An analysis of the agreement in the light of all the surrounding facts and circumstances should indicate the nature of the obligation, from which we can determine whether the aggregate payment was an ordinary and necessary business expense, a capital expenditure, or a plan devised to distribute profits of the corporation in the guise of royalty payments.

At the hearing the parties stipulated that “the amount of $23,-308.41 of royalties”, which is here in question, was included in the adjusted net income, as stipulated, of $29,259.74. We do not understand that the parties have stipulated that $23,308.41 is, as a matter of fact, a payment of “royalty.” Furthermore, the opening statements of counsel and the statements in their briefs, which referred to the total amount paid under the Lemkuhl agreement as royalty, does not preclude us from a determination of the legal significance of the transaction between Lemkuhl and the petitioner.

When Lemkuhl purchased the Colliery assets at the tax sale he acquired all of the right, title, and interest that the Colliery Co. had in the lease and in the improvements and equipment used in mining the coal. If Lemkuhl had elected to operate the properties, individually, he would have had the same legal and economic interests with respect to the remaining coal in place as the original lessee. That is to say, Lemkuhl acquired by his purchase the unexpired term of the original lease, which gave the owner of the lease the exclusive possession of and the right to mine and remove the remaining coal in place upon payment of certain rentals or royalties. We think it beyond question that Lemkuhl’s purchase gave him property rights which would have been subject to depletion if he had individually operated the property. Palmer v. Bender, 287 U. S. 551; Thomas v. Perkins, 301 U. S. 655; Bankers Pocahontas Coal Co. v. Burnet, 287 U. S. 308; Holly Development Co. v. Commissioner (C. C. A., 9th Cir.), 93 Fed. (2d) 146; Commissioner v. Jamison Coal & Coke Co. (C. C. A., 3d Cir.), 67 Fed. (2d) 342; Strother v. Commissioner (C. C. A., 4th Cir.), 55 Fed. (2d) 626; affd., Strother v. Burnet, 287 U. S. 314. Cf. Helvering v. Elbe Oil Land Development Co., 302 U. S. 677, affirming 34 B. T. A. 333.

Lemkuhl, however, did not elect to operate the coal properties in any capacity. He caused the petitioner to be created, offered the properties acquired to it, and upon acceptance of his offer transferred the property rights so acquired to petitioner, subject to a continuing charge of 10 cents per gross ton on each ton of coal mined. Lemkuhl thereby retained an interest in each and every ton of coal in the ground, for which he was to receive 10 cents for each ton mined. If there was no production, there was no obligation to pay Lemkuhl. The obligation to pay and the amount due were equally contingent upon the exercise of the right to exploit and remove the coal. This was no less true of the payments to be made under the original lease, except for minimum royalties, and if the one is admittedly royalties, and deductible from gross income, we think the other falls in the same category.

The respondent relies upon the reasoning in our decision in Comar Oil Co., 24 B. T. A. 688; affd., Comar Oil Co. v. Burnet, 64 Fed. (2d) 965; certiorari denied, 290 U. S. 652. In that case certain oil and gas leases were transferred to the Comar Oil Co. in consideration of stated sums of money, which sums were payable partly in cash and partly out of oil and gas as produced from the leased property. The deferred payments out of oil produced were claimed to be rentals or royalties for the use of the property. The Board held that the deferred payments out of oil and gas were not royalties, but were capital transactions. In the course of our opinion we said (p. 691) :

* * * The terms of the various assignments of leases effected absolute conveyances to the petitioner of the entire interests owned by the respective assignors, none of whom made any reservation of royalties. A royalty, as to minerals, is a rent reserved. Here, the grantor sold and the petitioner bought mineral rights for definite, fixed considerations which were to be met, in part, by deferred payments out of minerals if, as, and when produced from the leased lands. Such payments in our opinion do not constitute rentals or royalties for the use of the property.

We cited in support of our decision Mrs. J. C. Pugh, Sr., Executrix, 17 B. T. A. 429; affd., Pugh v. Commissioner, 49 Fed. (2d) 76; certiorari denied, 284 U. S. 642; L. T. Waller, 16 B. T. A. 574; affd., Waller v. Commissioner, 40 Fed. (2d) 892; Lena Brown, 24 B. T. A. 30; S. L. Herold, 17 B. T. A. 933; affd., Herold v. Commissioner, 42 Fed. (2d) 942.

The Eighth Circuit, in affirming the Board’s conclusion, spoke of the deferred payments as “overriding royalties”, concluded that the overriding royalties were correctly included in the gross income of the Comar Oil Co., and denied the deduction of the amount thereof because “it is clear that title to the property [the leases] was taken by the petitioner.”

Subsequent to the denial of certiorari in the Comar Oil Co. case, supra, the Supreme Court granted certiorari in Thomas v. Perkins, 300 U. S. 653, because of an apparent conflict in the decision of the Fifth Circuit in Perkins v. Thomas, 86 Fed. (2d) 954, with the decision of the Eighth Circuit in Comar Oil Co. v. Burnet, supra. The decision of the Supreme Court in Thomas v. Perkins, 301 U. S. 655, reveals an assignment of oil and gas leases in consideration of cash paid, $10, and the further sum of $395,000, to be paid out of the oil produced and saved from the lands, and to be one-fourth of all the oil produced and saved until the full sum was paid. The assignment recites that in consideration of the foregoing sum we “do hereby bargain, sell, transfer, assign, and convey all our rights, title, and interest in and to said leases and rights thereunder.” The fixed sum was payable only out of oil produced and was not a personal obligation of tlie assignee. The purchaser of the oil was to make payments directly to the assignors until the $395,000 was fully paid. The question which the Supreme Court was asked to determine was whether the assignee’s gross income should include moneys paid to the assignors by purchasers of the oil produced. The Supreme Court held that payments to the assignors should not be included in the assignee’s income because the proceeds received by the assignors “necessarily covered and were derived from oil not transferred by the assignment.” As the case of Comar Oil Co., supra, and cases cited in support of the principle there announced is inconsistent with the pronouncements of the Supreme Court in Thomas v. Perkins, supra, they can no longer be considered as controlling.

In Palmer v. Bender, supra, which was reviewed at length in the Perkins case, the Supreme Court, in commenting with approval on Lynch v. Alworth-Stephens Co., 267 U. S. 364, stated:

* * * regardless of the technical ownership of the ore before severance, the taxpayer, by his lease, had acquired legal control of a valuable economic interest in the ore capable of realization as gross income by the exercise of his mining rights under the lease. * * *

The Court further said:

Similarly, the lessor’s right to a depletion allowance does not depend upon his retention of ownership or any other particular form of legal interest in the mineral content of the land. It is enough if, by virtue of the leasing transaction, he has retained a right to share in the oil produced. If so he has an economic interest in the oil, in place, which is depleted by production. Thus we have recently held that the lessor is entitled to a depletion allowance on bonus and royalties, although by the local law ownership of the minerals, in place, passed from the lessor upon execution of the lease. * * *
In the present ease the two partnerships acquired by the leases to them, complete legal control of the oil in place. Even though legal ownership of it, in a technical sense, remained in their lessor, they, as lessees, nevertheless acquired an economic interest in it which represented their capital investment and was subject to depletion under the statute. * * * When the two lessees transferred their operating rights to the two oil companies, whether they became technical sublessors or not, they retained, by their stipulations for royalties an economic interest in the oil in place identical with that of a lessor. Burnet v. Harmel, supra, [287 U. S. 103, 11 A. F. T. R. 1085]; Bankers Pocahontas Coal Co. v. Burnet, supra, [287 U. S. 308]. Thus throughout their changing relationships with respect to the properties, the oil in the ground was a reservoir of capital investment of the several parties, all of whom, the original lessors, the two partnerships, and their transferees, were entitled to share in the oil produced. Production and sale of the oil would result in its depletion and also in a return of capital investment to the parties according to their respective interests. * * *

In Helvering v. Twin Bell Oil Syndicate, 293 U. S. 312, the syndicate, as the assignee of the lessee named in an oil and gas lease, extracted substantial quantities of oil. By the terms of the lease and the assignment the syndicate was obligated to pay royalties in cash or in kind totaling one-fourth of the oil extracted. The taxpayer wanted to compute its depletion allowance upon the gross proceeds of all the oil produced. The Commissioner computed the deduction upon the taxpayer’s portion of the oil produced. The Supreme Court upheld the Commissioner’s computation, denying the syndicate’s contention that its gross income was the gross production of the wells. The Court specifically stated that the taxpayer’s gross income from the property was gross income from production less the amounts which the taxpayer was obliged to pay as royalties.

This proceeding differs from the last cited Supreme Court cases in that here we have the assignee claiming the right to deduct royalties paid pursuant to contract, but not in any fixed aggregate sum. The royalties are due so long as coal is produced from the lands leased. If the question at issue was the inclusion of the royalties paid in the petitioner’s gross income, Thomas v. Perkins, supra, would be directly in point. The petitioner having included in its gross income the gross receipts from production, now seeks to deduct the payments as l'oyalty in order to correctly reflect its income. The Fourth Circuit in Burnet v. Hutchinson Coal Co., 64 Fed. (2d) 275; certiorari denied, 290 U. S. 652, permitted such a deduction, and certainly if the question here for decision was the depletion to which petitioner was entitled, Palmer v. Bender, supra, would prevent the computation of a depletion allowance based in part on the gross income of the lessor and petitioner’s assignor.

Whether the deduction be characterized as a part of the cost of production, an ordinary and necessary business expense, or as royalties or rentals for the use of the property, we are of the opinion that the $23,308.41 should be deducted from petitioner’s gross income. The obligation to pay is based upon a contractual liability which is a charge upon the operation of petitioner’s business and the production of coal. If the amount be not deductible as rental or royalty, it is certainly, deductible as an ordinary and necessary business expense for petitioner’s continued operation was dependent upon the payments being made quarterly while the mine was being operated, and without the expenditure petitioner could not operate. Monroe Sand & Gravel Co., 36 B. T. A. 747, 751; Louis C. Rollo, 20 B. T. A. 799, 806; sec. 23 (a), Bevenue Act of 1928.

In reaching our decision herein we have treated Lemkuhl as though lie were the real party in interest. We have not, however, lost sight of the fact that Lemkuhl at all times pertinent to the issue presented was acting for the former stockholders of the Colliery Co., and that by subsequent conveyances the former stockholders became ■ petitioner’s stockholders and owners of the contractual rights in the aforementioned Lemkuhl agreement. We do not believe that this fact is controlling, since the bona -fides of the transaction is not questioned. Its chief importance lies in the possibilities afforded under like circumstances to distribute profits as royalties.

Eespondent’s principal argument is directed to the possibilities afforded by this transaction. He asserts that the relationship of the parties and their formal acts indicate an intention to distribute profits in the form of extraordinary royalties. He relies upon the Board’s decision in George La Monte & Son, 13 B. T. A. 365, and a decision of the Third Circuit in Traylor Engineering & Manufacturing Co. v. Lederer, 271 Fed. 399. The La Monte decision was reversed in La Monte & Son v. Commissioner (C. C. A., 2d Cir.), 32 Fed. (2d) 220, and the Traylor Engineering case is distinguishable in that the contract there was to pay a portion of the profits after they were created, which is entirely different from an obligation to pay a fixed charge on production regardless of earnings or profits necessary for the payment of dividends. Our decisions in TV. IV. Thornburgh Manufacturing Co., 17 B. T. A. 29, and L. Schepp Co., 25 B. T. A. 419, involved situations where taxpayers were attempting to distribute profits under the guise of royalty payments. The facts in those cases are so divergent from the facts herein that we deem it unnecessary to make a detailed comparison.

The deficiency should be recomputed in accordance with the stipulation of the parties and with our decision herein.

Reviewed by the Board.

Decision will be entered under Rule 60.


source: Caselaw Access Project

author: Sternhagen : Hill,

license: Public Domain

text:
    R. L. Blaffer & Company, Petitioner, v. Commissioner of Internal Revenue, Respondent.
    Docket Nos. 81007, 87762.
    Promulgated May 17, 1938.

      Walter E. Barton, Esq., and J. L. Bloch, C. P. A., for the petitioner.

      D'eWitt M. Evans, Esq., for the respondent.
   OPINION.

Sternhagen :

The principal question is whether, in the fiscal years ended September 30,1932,1933, and 1934, the petitioner was “formed or availed of for the purpose of preventing the imposition of the surtax upon its stockholders through the medium of permitting its gains and profits to accumulate instead of being divided or distributed” and thus subject to the 50 percent tax provided in section 104, Revenue Act of 1932. The Commissioner determined that it was, and the taxpayer in contesting the determination has undertaken to prove that it was not.

In its brief, petitioner says (p. 26):

It may be admitted that the petitioner is a holding or investment company and that the prima facie presumption raised by section 104 (b) applies. This admission is supported by Blaffer’s testimony that he had petitioner do nothing but invest in and sell stocks, that it was a trading company, and that the only way he expected it to make money was through trading. Consideration of the issue must therefore start with the postulate that the corporation was formed or availed of for the condemned purpose, and must continue with the inquiry whether the evidence proves affirmatively that it was not. Drastic as the tax may be, the statute clearly expresses the legislative intent to apply it to a mere holding or investment corporation unless the corporation succeeds in establishing its purpose to be wholly other than that of preventing surtax upon its shareholders — not only that there was another purpose, but that there was a complete absence of the disapproved purpose. Obviously a holding or investment corporation may be formed or availed of for several purposes, but it can not escape this tax unless it proves that it had no purpose to enable the escape of surtax. It is to this complete lack of the condemned purpose that its evidence must be directed, and if it does not fairly prove an absence of such purpose it must fail, regardless of what other purposes it may prove. This is, in our opinion, the effect of subdivision (b), and the evidence must be examined in its entirety to determine whether it disproves the statutory presumption and the Commissioner’s determination.

The organization and existence of the corporation and the transfer to it by the Blaffers of dividend paying stocks had the effect of relieving them of the surtaxes which would have been attributable to such dividends had they continued to come to the Blaffers as owners of the stocks. The statute, however, does not operate merely because of such actual effect; it operates if such effect was the purpose. Cecil B. deMille, 31 B. T. A. 1161, 1174; affd., 90 Fed. (2d) 12; certiorari denied, 302 U. S. 713; C. H. Spitzner & Son, Inc., 37 B. T. A. 511. In the absence of the condemned purpose, the effect alone is no foundation for the tax. This is not to say that the effect is of no significance, for it may, and perhaps often does, indicate the probability of a purpose to induce it. In ordinary life it is not unreasonable to infer that the effect of a voluntary act is among the purposes of the actor. So long as the inference be not arbitrary and evidence to the contrary be entertained and fairly weighed, it may be regarded as reasonable. And in determining the purpose, the actor’s categorical statement may be of less weight than the facts and circumstances which affect it. To be skeptical of the weight to be accorded an interested witness’ statement in view of other evidence is not the same as wholly to reject the statement as if it were dishonest.

The petitioner was wholly owned by Blaffer and his wife. It was organized when they were actively trading in the stock market and after they had accumulated a fortune of over thirteen million dollars, represented by securities of many corporations in many states. It is said that the reasons for its formation grew out of the survey made by Barton and Block in 1927. It was to facilitate the administration of Blaffer’s estate at death, because the transfer of various securities was a cumbersome process. Yet only a small portion of the securities was transferred to the corporation, and those retained were still various and spread over six states. Such a purpose is not inconsistent with a further purpose to effect a saving in surtaxes. Barton and Block advised that such a corporation must make distributions to avoid this very tax. Thus Blaffer was fully advised of the use to which such a corporation could be put, and he frankly admits that he knew that a failure of the corporation to distribute would invite the tax.

But he says that in the tax years he could not properly permit the corporation to distribute because it was insolvent. This is the principal point upon which petitioner’s argument is based. The insolvency is predicated not on petitioner’s books, for they showed a steadily increasing earned surplus; they showed gross receipts each year in excess of outlay and a resulting annual net, and an annually expanding net worth. The insolvency is predicated on the comparison each year after the market collapse of the market value of its assets, consisting wholly of' securities, and the amount of its liabilities, consisting wholly of its brokerage accounts guaranteed by himself. This argument of insolvency would circumvent the clear intendment of the statute. The Board has already held that when considering a holding or investment company the diminution in market value of its securities may not be offset against income derived through gains and profits, interest, and dividends, so as to establish that the corporation was not availed of to save the shareholders from surtax. Rands, Inc., 34 B. T. A. 1094 (on review C. C. A., 6th Cir.); Nipoch Corporation, 36 B. T. A. 662 (on review C. C. A., 2d Cir.). As to a business corporation actually engaged in commercial operations, the effect of market values upon its surplus has been recognized as more substantial and the argument more engaging, C. H. Spitzner & Son, Inc., supra. In the present case the point has little force when the alleged insolvency is analyzed with regard for its substance. Blaffer and his wife were the sole shareholders. The brokers were the sole creditors (except for $7,000 owed to Blaffer in 1932 and 1933), and these creditors held the securities and Blaffer’s personal guaranty. No one else was to the slightest extent interested in the affairs of the corporation. Insolvency was a mathematical abstraction, for the creditors were fully secured by Blaffer’s individual guaranty and Blaffer had ample assets to assure it. Even article 1347 of the Texas Civil Statutes,'which petitioner cites, would go no farther than to make the directors jointly and severally liable for the corporation’s debts, to the extent of the dividend ; and such liability Blaffer had already assumed by his guaranty. To say, under these circumstances, that the large trading profits, dividends, and interest are not indicative of the purpose which underlies the tax is to give mere words and doctrine a force greater than the truth which lies behind them. Ordinarily, for purposes of im come tax, the rise and fall in value of retained assets is not a factor for consideration, and if the market value of petitioner’s securities had risen, the rise would not have had significance either in measuring its income or discovering the applicability of section 104. In Blaffer’s own hands the dividends, interest, and gains from trading would have been taxable, irrespective of the fall in the market value of securities he did not sell, and hence the purpose to enable him to escape surtax is not disproved by evidence of market value of securities held by his corporate instrument. Rands, Inc., supra; Nipoch Corporation, supra; A. D. Saenger, Inc., 33 B. T. A. 135; and R. & L. Inc., 33 B. T. A. 857, are illustrations of the extent to which the argument would operate to frustrate the statutory intent. It may not be forgotten that by section 104 (d) it was open to the shareholders to treat their distributive shares of the corporation’s income as constructively received by them and within their taxable income even though it was deemed wiser for any reason that there should be no actual distribution.

The petitioner argues that since the Blaffers transferred to it only a comparatively small portion of their securities, it may not be believed that their purpose or that of the corporation was to save surtax, for the retention of the larger portion is inconsistent with such a purpose. There is no explanation to be found in the evidence for the retention. It does not, however, overcome the prima facie purpose attaching to the corporation within the sphere and to the extent of its operations. The statute operates upon the corporation and the tax is measured by its income. The fact that the creators and shareholders limited its operations and withheld a majority of their assets still leaves the inquiry open as to the application of the statute to the corporation such as it was.

Neither the desire of Blaffer to provide an occupation for his minor son then in college nor to facilitate the administration of his estate after death is inconsistent with a purpose to escape surtaxes, Rands, Inc., supra.

It is said that the condemned purpose is disproved by the evidence that the Blaffers not only transferred stocks yielding taxable dividends, but also rid themselves of liabilities carrying deductible interest, the relinquished deductions being greater than the gross income of the dividends. For example, it appears that for the fiscal year 1930, the interest paid by the corporation was $109,856.59, while the dividends received amounted to $64,332.32, having the effect, it is said, of depriving the shareholders of a substantial factor of tax reduction. This comparison is regarded as a demonstration that there was no purpose to effect a saving of surtaxes. Again the argument falls short of the mark. The failure of the corporation to distribute to its shareholders is not considered solely with regard for the income which it may derive through corporate dividends, but with regard for its gains and profits from all sources. The corporation had trading profits of $100,227.85, which was $51,241.76 greater than its trading losses, and each year the profits exceeded the losses. This performance was the very expectation of Blaffer when he formed the corporation and transferred both the securities and the interest bearing liabilities. He said that he expected it to make money through trading. The purpose to renounce an advantageous interest deduction thus loses force, especially since in each year the net result to the corporation was a taxable net income the distribution of which would have imposed surtax upon its shareholders.

The arguments of petitioner to overcome the prima facie effect of the Commissioner’s determination have been considered separately and found inadequate. But it should not be thought that the decision is based alone on a piecemeal examination of the logical effect of each circumstance disclosed by the evidence. Dealing with a holding or investment corporation, the inquiry is a broad one of substance ; that is, whether all the evidence taken together leads reasonably to the conclusion that the corporation was not within the description of the statute. Congress has said that holding and investment corporations are vulnerable. The considerations applicable to them are not like those applicable to a manufacturing or merchandising corporation. Arguments which might be moving as to the latter, because of the nature and exigencies of its business, will have no substance when made by a holding or investment company of a single individual.

The 50 percent tax was properly applied.

In determining the deficiency, the Commissioner excluded from petitioner’s gross income gains from sales to Blaffer of $19,687.81 in 193S and $16,075 in 1934, which petitioner had included in its returns.' This exclusion by the Commissioner was because he thought it consistent with a contemporaneous disallowance by him of deductions taken by Blaffer for losses in sales by him to the corporation. In separate proceedings the Board has held such losses deductible since recognition of the transactions may not be denied. There is no dispute about the facts. The amounts should be restored to petitioner’s income.

Reviewed by the Board.

Judgment will be entered under Rule 50.

Hill,

dissenting: The majority opinion is predicated upon the findings of fact that “petitioner was a mere holding or investment company”, and that “it was formed or availed of for the purpose of preventing the imposition of the surtax upon its shareholders through the medium of permitting its gains and profits to accumulate instead of being divided or distributed.” It is said that petitioner has the burden of proving a complete lack of the condemned purpose, and if it does not do so it must fail, regardless of what other purposes it may prove. The evidence submitted is, in my opinion, amply sufficient to meet the test thus laid down.

That petitioner was not “a mere holding or investment company” is clearly established by the record. A “mere” holding or investment company is obviously one whose sole function is to hold property or make investments. Petitioner may not fairly be placed in such category.- It was also a business or trading corporation, actively engaged during the taxable years in carrying on business operations for profit. During the year 1932 petitioner derived net profit from trading in securities in the amount of $55,280.99. Its total net profit for the year was $35,020.85. Thus, except for the profit realized from its business operations it would have had no income for that year subject to tax under section 104, but would have had a substantial loss representing interest paid and other expenses. For the year 1933 petitioner’s total net profits amounted to $23,740.71, which included $21,853.55 net gain from trading operations. For the year 1934 petitioner derived total net profits of $49,796.98, including net gain from trading in the amount of $31,059.40. So far as taxable income is concerned, these facts, it seems to me, indicate that during the years before us petitioner’s function as a holding or investment company was negligible and only incidental to its business operations, rather than exclusive. The admission of its counsel that petitioner is a holding or investment company, and that the prima facie presumption raised by section 104 (b) applies, to which reference is made in the majority opinion, appears to be a legal conclusion without support in the record. However, if it may be said that such presumption ever attached, it is sufficiently rebutted by the evidence.

The next question arising for consideration is whether petitioner was formed, or availed of in the taxable years, for the purpose of enabling its shareholders to escape surtax through the medium of permitting its gains and profits to accumulate instead of being divided or distributed. As suggested by respondent in his brief, it may well be that one of the primary purposes of organizing the petitioner corporation was to permit its shareholders to realize large losses deductible from their individual incomes through sales by them to it of securities which had depreciated greatly in value below their original cost bases. But such a purpose, if it existed, is not within the ambit of section 104, and we are not here concerned with that phase of the case.

The record contains no evidence which fairly indicates, in my opinion, that petitioner was either formed or availed of for the prohibited purpose, but on the other hand discloses affirmative and uncontradicted proof to the contrary. Blaffer testified in effect that he was advised by both his attorney and accountant that it would be necessary for the corporation to declare dividends whenever earnings were available, or subject itself to the penalty tax of section 104, and that in forming the corporation he had no purpose whatever of attempting to escape surtax through accumulation of the company’s gains and profits. He further testified at length as to the motives which actuated him in organizing the corporation.. A purpose to escape surtax through accumulation of gains and profits was wholly absent. The purposes as stated by Blaffer were both reasonable and sufficient to explain and justify his actions. We may not, therefore, disregard his testimony merely because he is an interested party; particularly so, when such testimony is supported by all the surrounding facts and circumstances. C. H. Spitzner & Son, Inc., 37 B. T. A. 511.

However, if it were true that petitioner was originally formed for the purpose stated in the statute, or as the majority opinion holds, the evidence is insufficient to overcome the prima facie presumption of the statute and respondent’s determination, still petitioner would not be subject to the penalty tax of section 104, because it had no accumulation of gains and profits in the taxable years which could lawfully be divided or distributed. For the same reason it can not be said that it was “availed of” for the prohibited purpose.

This brings us to tlie principal and most important question presented in this case, namely, whether a corporation whose capital has been lost or substantially impaired through depreciation in value of its capital assets to the extent of rendering it insolvent can accumulate gains and profits distributable as dividends prior to restoration of such impairment, and, if not, whether an insolvent corporation in such circumstances is nevertheless subject to the tax imposed by section 104.

At the close of the fiscal year 1932 petitioner owned assets of the fair market value of $801,841.38, and its total liabilities, other than capital, amounted to $1,761,598.73. Its current liabilities then exceeded the fair market value of its assets in the amount of $959,-757.35. It operated largely on money borrowed from brokers, and in 1932 of its total indebtedness it owed brokers the sum of $1,687,-563.48. On the same basis, petitioner’s current liabilities exceeded its assets in 1933 and 1934 by the amounts of $491,640.94 and $123,618.35, respectively. All the stocks and bonds owned by petitioner, which constituted its principal assets, were hypothecated with brokers as collateral security for loans, in addition to which petitioner’s accounts with the brokers were personally guaranteed by its stockholders.

Clearly* j>etitioner was insolvent throughout all the taxable years. It was insolvent in 1932, 1933, and 1934 to the extent of $959,757.35, $491,640.94, and $123,618.35, respectively, on the basis of current liabilities alone, in addition to capital stock liability. The impairment of its capital stock for each of those years was far in excess of the respective amounts above set forth. The value of its assets in each of the taxable years was insufficient to pay even the indebtedness owing to the brokers, and obviously it could not have continued to operate except by reason of the guaranteeing of its accounts by its stockholders. In these circumstances petitioner could not lawfully have declared and paid a dividend out of current earnings.

A corporation can not declare and pay a dividend when it is insolvent or when the payment thereof would render it insolvent. Maugham v. State, 11 Ga. App. 440; 75 S. E. 508; Fricks v. Angemeier, 53 Ind. App. 140; 101 N. E. 329; Montgomery v. Whitehead, 40 Colo. 320; 90 Pac. 509. A corporation must maintain its capital stock at its original value before any dividends may be lawfully paid. Crawford v. Roney, 130 Ga. 515; 61 So. 117; Coleman v. Booth, 268 Mo. 64; 186 S. W. 1021; Whittaker v. Amwell National Bank, 52 N. J. Eq. 400; 29 Atl. 203; Equitable Life Assurance Society v. Union Pacific Railroad Co., 212 N. Y. 360; 106 N. E. 92; Hutchinson v. Curtiss, 92 N. Y. S. 70; Cornell v. Seddinger, 237 Pa. 389; 85 Atl. 446.

With the exception of dividends in liquidation, a corporation can declare and pay dividends only out of net profits, or when such payment does not impair its capital stock. Mobile & Ohio Railroad Co. v. Tennessee, 153 U. S. 486; Main v. Mills, 6 Bliss. 98; Roberts v. Roberts-Wicks Co., 184 N. Y. 257; 77 N. E. 13; Berryman v. Bankers Life Insurance Co., 102 N. Y. S. 695.

Whether a corporation is solvent and has surplus or net profits out of which a dividend may be paid must be determined on the basis of the then actual cash or fair market value of its assets. Whittaker v. Amwell National Bank, supra; American Steel & Wire Co. v. Eddy, 138 Mich. 403; 101 N. W. 578; Siegman v. Electric Vehicle Co., 140 Fed. 117; Mobile & Ohio Railroad Co. v. Tennessee, supra; Gannon v. Wiscassett Mills Co., 195 N. C. 119; 141 S. E. 344. In the case last cited, the court said:

Manifestly, for tlie purpose of determining the amount to be declared and paid as a dividend, it is necessary that the true value of the assets, in cash, and not the mere book value, should be ascertained, for no dividend can be lawfully declared and paid except from the surplus or net profits of the business. * * * The terms “net profits” or “surplus profits” have been defined as what remains after deducting from the present value of the assets of a corporation the amount of all the liabilities including the capital stock. [Italics supplied.]

In Mobile & Ohio Railroad Co. v. Tennessee, supra, the Supreme Court defined “surplus” or “net profits” of a corporation as the difference between the total present value of its assets, after deducting losses and liabilities, and the amount of its capital stock. See also Crawford v. Roney, supra; Coleman v. Booth, supra; Hyams v. Old Dominion Copper Min. etc. Co., 82 N. J. Eq. 507; 89 Atl. 37; affd., 83 N. J. Eq. 705; 92 Atl. 588; Roberts v. Roberts-Wicks Co., supra; Northern Bank etc. Co. v. Day, 83 Wash. 296; 145 Pac. 182.

In Mangham v. State, supra, the Court of Appeals of Georgia held that the difference between the present value of all the corporate assets and the amount of all losses, expenses, other charges, and liabilities, including the capital stock, constitutes net earnings for the purpose of dividends, and in its opinion further stated:

* * * it is not possible for an insolvent corporation to lawfully declare and distribute a dividend, for the very simple reason that it can not have any surplus or net earnings as long as it is unable to pay its indebtedness. 5 Thompson on Corporations, § 5311. As dividends can only be declared and paid out of profits, it is clear that they can not be declared unless there are profits; and even if there are profits, still they can not be declared and paid where the corporation is clearly insolvent. 5 Thompson on Corporations, § 5383. See also Cabaniss v. State, 8 Ga. App. 129, 68 S. E. 849, where it is held by this court that no declaration of a dividend is lawful in a condition of insolvency or impairment of capital stock; for any profits that may be made must first be applied to the payment of the debts of the corporation and to the restoration of the capital stock.

In C. H. Spitzner & Son, Inc., supra, this Board held that, in determining whether accumulations of gains and profits are beyond the reasonable needs of a business, it is erroneous to compute a surplus based on cost of assets which are useful to the business only to the extent of their lower market value.

If petitioner in the instant case had distributed its gains and profits in the taxable years, such distribution would not only have been unlawful and in violation of generally recognized principles of corporation law, above referred to, but would have been in direct violation of Texas law. See art. 1847, vol. 3, Vernon’s Annotated Texas Statutes (Civil). In the circumstances shown, the gains and profits of the taxable years were certainly not beyond the reasonable needs of petitioner’s business, and I think it can not fairly be said under the facts that petitioner was “availed of” for the purpose of preventing the imposition of tax upon its shareholders through the medium prescribed by the statute.

I think it is too plain for argument that petitioner had no accumulation of “gains and profits” in the taxable years which could be lawfully divided or distributed. Coincidental with receipt, its net profits became capital, and such process must continue until impairment of its paid-in capital has been restored. Although a distribution (except in liquidation) could not lawfully be made, is an insolvent corporation in such situation nevertheless subject to the penalty tax of section 104?

The majority opinion points out “that by section 104 (d) it was open to the shareholders to treat their distributive shares of the corporation’s income as constructively received by them and within their taxable income even though it was deemed wiser for any reason that there should be no actual distribution.” This view, it seems to me, places an unreasonable and strained construction upon the statute. The provision referred to has no legitimate application here. Whenever a corporation has gains and profits which may be lawfully distributed as dividends, and the stockholders prefer for any reason that no actual distribution should be made, they may under the statute include their distributive shares in their own taxable income and thus avoid the making of a distribution and also the penalty tax of section 104. But here the corporation had no gains and profits which could be lawfully distributed. Did the Congress by the cited statute intend nevertheless to compel an unlawful distribution not of gains and profits but of capital equal to the amount of current earnings, or in the absence of a distribution to impose a penalty tax of 50 percent ? To justify the imputation of such a legislative intent, we must, in my opinion, find plainer and more mandatory language than is contained in any of the subdivisions of section 104.

Reference is made in the opinion of the majority to the cases of R. & L., Inc., 33 B. T. A. 857; affd., R. & L. Inc. v. Commissioner, 84 Fed. (2d) 721; A. D. Saenger, Inc., 33 B. T. A. 135; affd., Saenger, Inc. v. Commissioner, 84 Fed. (2d) 23; Rands, Inc., 34 B. T. A. 1094; and Nipoch Corporation, 36 B. T. A. 662, as supporting the conclusion reached therein. In neither Saenger, Inc., nor R. & L., Inc., was there an impairment of capital, nor in either was it shown that if it had distributed its current gains and profits there would have been an invasion of capital. Nor was it shown in either of those cases that the accumulation of the gains and profits was necessary to meet the reasonable needs of the business. Those cases are, therefore, clearly distinguishable on the facts from the case here, where the petitioner corporation required the use of large amounts of capital to carry on its business operations.

Rands, Inc., and Nipoch Corporation, supra, can not be distinguished on principle from the instant proceeding to the extent that they hold in effect that where a corporation’s paid-in capital has been diminished in excess of its current earnings through depreciation in value of its capital assets, such corporation may nevertheless be said to have been availed of for the purpose of preventing the imposition of surtax upon its shareholders through accumulation of its gains and profits, if not distributed as dividends. Such holding, I think, is erroneous, and, therefore, should not be followed in the instant case.

For the reasons above indicated, the decision in this case should be for the petitioner.

Smith agrees with this dissent.

       SEC. 104. ACCUMULATION OS' SURPLUS TO EVADE SURTAXES.
      *******
      (b) The fact that any corporation is a mere holding or investment company, or that the gains or profits are permitted to accumulate beyond the reasonable needs of the business, shall be prima facie evidence of a purpose to escape the surtax.

       If the directors of any corporation shall knowingly declare and pay any dividend when the corporation is insolvent, or any dividend the payment of which would render it insolvent, they shall be jointly and severally liable for all the debts of the corporation then existing, and for all debts of the corporation which thereafter, during the time such directors respectively remain in office, shall be contracted. The amount for which they shall be so liable shall not exceed the amount of such dividend. If any director is absent at the time of declaring the dividend, or shall object thereto at the time such dividend is declared, and shall file his objections in writing with the secretary or other officer of the corporation having charge of the books, he shall be exempt from said liability.

       Law of Federal Income Tax, Paul and Mertens, vol. 1, § 5.10, p. 112; cf. § 26.54, vol. 3, p. 290.


author: Black:

text:
    Ralph C. Holmes, Petitioner, v. Commissioner of Internal Revenue, Respondent.
    Docket No. 85096.
    Promulgated May 17, 1938.

      Robert J. Heberle, Esq., for the petitioner.

      G. R. Marshall, Esq., for the respondent.
   OPINION.

Black:

The question in this proceeding is whether the expenditures totaling $30,577.01 were ordinary and necessary business expenses as petitioner contends, or personal expenses as respondent contends. The former are deductible; the latter are not. The pertinent sections of the Revenue Act of 1932 are as follows:

SEC. 23. DEDUCTIONS PROM GROSS INCOME.
In computing net income there shall be allowed as deductions:
(a) Expenses. — All the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business * * *.
SEC. 24. ITEMS NOT DEDUCTIBLE.
(a) General Rule. — In computing net income no deduction shall in any case be allowed in respect of—
(1) Personal, living, or family expenses * * *.

Congress has provided three prerequisites, each one of which must be met before any item of expense is deductible from gross income under section 23 (a) of the Revenue Act of 1932. The item in question must be an “ordinary and necessary expense”; it must be “paid or incurred during the taxable year”; and it must be so paid or incurred “in carrying on any trade or business” of the taxpayer. If any one of these prerequisites is absent, the item in question is not deductible.

The respondent concedes that the expenditures totaling $30,577.01 meet the second prerequisite of the statute. He contends, however, that the first and third prerequisites are absent.

We shall consider first whether petitioner paid the expenses in question “in carrying on any trade or business * * Petitioner paid the expenses from his personal funds while he was a stockholder and director of the Texas Corporation, but after he was no longer an executive officer of the corporation. Petitioner contends however that the expenditures were so closely related to his services as an executive officer of the corporation as to make them deductible from the salary which he received from it, even though they were incurred and paid after his resignation. Petitioner emphasizes the fact that he continued to be a stockholder and director in the corporation throughout the remainder of the year.

During the time that petitioner was the president and chief executive officer of the Texas Corporation, including part of the taxable year involved here, was he engaged in any trade or business? Respondent contends that he was not. We think he was. During the several years that petitioner served as president. and chief executive officer of the Texas Corporation his salary ranged from $50,000 to $100,000 per annum. We think these earnings were from a business carried on by petitioner, to wit, the business of being chief executive of an oil corporation. This view is supported by our decision in Peoples-Pittsburgh Trust Co. et al., Executors, 21 B. T. A. 588. In that case, Herbert Du Puy, during 1917 and 1918, was chairman of the board of directors of the Crucible Steel Co. of America and during those years he devoted his time and attention almost exclusively to the affairs of the corporation. On these facts we held that the business of Herbert Du Puy during 1917 and 1918 was that ,of being the executive head of the Crucible Steel Co. of America and its subsidiaries and that his expenses incurred in defending an action growing out of acts done while he was acting as chief executive of the steel company were deductible as ordinary and necessary business expenses. Our decision in that case was affirmed in Commissioner v. Peoples-Pittsburgh Trust Co., 60 Fed. (2d) 187. The court, in affirming the Board, said:

* * * The taxpayer’s business consisted in the performance of the duties devolving upon him as the executive head of the Crucible Steel Company and its subsidiaries. Though he was acting for the steel company and was doing only that which he was required to do, as its official, in the preparation and signing of the tax returns, he was, nevertheless, conducting his own business. When, therefore, he was faced with criminal charges, and was compelled to pay out large sums of money for attorney’s fees and other expenses of the trial, he paid what was necessarily incurred by reason of carrying on his own business, viz., that of acting as chief executive officer of the steel company.

Mrs. A. B. Hurt et al., Executors, 30 B. T. A. 653, was a similar case, in which we followed Peoples-Pittsburgh Trust Co., supra.

The effect of respondent’s contention on this point is that the Peoples-Pittsburgh Trust Co. case is no longer authority because of the Supreme Court’s decision in Burnet v. Clark, 287 U. S. 410, and Dalton v. Bowers, 287 U. S. 404. It is plain that the Board has not agreed with this contention because Mrs. A. B. Hurt et al., Executors, supra, was decided by the Board subsequent to the Supreme Court’s decisions in the Dalton v. Bowers and Burnet v. Clark cases. In fact, in the Hurt case we cited the two above named Supreme Court cases in support of our decision on the second point therein, which was that a loss sustained by the decedent in 1921 by reason of the worthlessness of shares of stock in a corporation of which he was the majority stockholder and director did not constitute a “net loss” under the statute, and could not be carried forward and used as a deduction from gross income in computing the taxpayer’s net income for the following year. The language of the Supreme Court in Burnet v. Clark, upon which respondent evidently relies in support of his contention, is as follows:

The respondent was employed as an officer of the corporation; the business which he conducted for it was not his own. There were other stockholders. And in no sense can the corporation be regarded as his alter ego, or agent. He treated it as a separate entity for taxation; made his own personal return; and claimed losses through dealings with it. Pie was not regularly engaged in indorsing notes, or buying and selling corporate securities. The unfortunate indorsements wore no part of his ordinary business, but occasional transactions intended to preserve the value of his investment in capital shares.

Following the reasoning of the Supreme Court quoted above, we agree entirely that the business of the Texas Corporation in the instant case was not the business of petitioner; that the corporation was in no sense his alter ego; and that business expenses or losses of the corporation would in no sense be the business expenses or losses of the petitioner. Nevertheless to so hold we do not think means that we have to hold that petitioner himself was not, at least up until the time of his resignation in May 1933, engaged in carrying on a trade or business, to wit, that of being chief executive officer of an oil corporation, for which he received large amounts of compensation. We do not believe that the Supreme Court’s decision in Burnet v. Clark and Dalton v. Bowers should be read as going so far as the Commissioner contends. Petitioner had been with the Texas Corporation for many years and had worked his way up to the position of its chief executive officer. So far as the record shows his duties and responsibilities in that position occupied his time, attention, and labor, and the purpose thereof was a livelihood or profit. Cf. Flint v. Stone Tracy Co., 220 U. S. 107. And to say that petitioner during these years that he was acting as the chief executive officer of the Texas Corporation had “no trade or business” within the meaning of the applicable statute because the Supreme Court has said in the Dalton and Clark cases that the business of a corporation is not the business of its chief executive officer, is extending the meaning of the Supreme Court decisions too far. It may well be that deductible “ordinary and necessary expenses in carrying on a trade or business” would be few and far between for a taxpayer engaged in carrying on a business as executive officer of a corporation. The most of such deductions that we can think of would be those allowable only to the corporation. However, there are some which would be allowable as deductions to the individual, if he pays them out of his own personal funds, such for example as those involved and allowed in the Peoples-Pittsburgh Trust Co. case and the Hurt case. So, as we view it, petitioner, while an executive officer of the Texas Corporation, was engaged in “carrying on a trade or business” as that term is used in section 23 (a) of the Kevenue Act of 1932. Having thus decided, we have still another inquiry which must be answered. Were the expenditures totaling $30,577.01, expended representing amounts paid by petitioner for postage, printing, clerk hire, office expense, et cetera, in acquainting stockholders of the Texas Corporation with the facts which brought about petitioner’s severance from the corporation as its chief executive officer and seeking to arouse them to what petitioner conceived to be appropriate action, ordinary and necessary expenses incurred and paid in carrying on petitioner’s trade or business as an executive officer of the corporation? We think this question must be answered in the negative.

Petitioner was not engaged in carrying on the business of executive officer of the corporation after he resigned. As pointed out by the court in Hutchings v. Burnet, 58 Fed. (2d) 514, the phrase “carrying on a trade or business” as used in the revenue statutes bears a more restricted meaning than the general definition of what constitutes business transactions. These expenditures made after May 1933 by petitioner were not for acts which were integrally a part of and proximately resulting from his business as an executive of the corporation.

There was no action for accounting brought against petitioner, either by the corporation or its stockholders. Cf. Kornhauser v. United States, 276 U. S. 145. The petitioner was not being sued by the corporation or anyone and he was not required to defend himself against any action or indictment. As a matter of fact, no complaint was ever brought or filed officially against him by the corporation or any of its stockholders. Cf. Mrs. A. B. Hurt et al., Executors, supra; Peoples-Pittsburgh Trust Co. et al., Executors, supra; Citron-Byer Co., 21 B. T. A. 308.

Petitioner’s statement in bis income tax return tbat “this expense was incurred in an effort to reestablish himself in his former position as such executive by presenting all of the facts to the stockholders” is not borne out by the evidence. Petitioner’s own literature which he mailed out to the stockholders made it plain that the issue was not whether petitioner should be reinstated.

Therefore, for reasons stated above, we hold that the expenditures in question were not incurred and paid in carrying on petitioner’s business, engaged in for part of the year 1933, of being an executive officer of the Texas Corporation.

But, says the petitioner, even though it be held that the expenses in question were not incurred and paid while carrying on his business as an executive officer of the Texas Corporation, nevertheless the expenses were incurred while he was a director and stockholder of the corporation and are therefore deductible as ordinary and necessary business expenses on that ground. The fact that one is a mere stockholder in a corporation does not constitute the “carrying on of a trade or business” within the meaning of the statute. Cf. Dalton v. Bowers, supra; Burnet v. Clark, supra. What effect on the situation does the fact have that petitioner was a director of the corporation? We have no information as to what salary or compensation petitioner received for his services as director of the corporation, but, for present purposes, we shall assume that he did receive some compensation for such services. Assuming, without deciding, that-to be a director in a corporation where compensation is received for one’s services constitutes carrying on a trade or business so as to make expenses which are properly attributable thereto deductible, such for example as traveling expenses of an out of town director, not reimbursed to him, we do not think such expenses as we have here in the instant case would be “ordinary and necessary expenses” of carrying on such trade or business.

The expenses, under the circumstances narrated in our findings, would be extraordinary we think for a director to pay out of his own personal funds. Cf. Welch v. Helvering, 290 U. S. 111. Therefore, assuming, without deciding, that to be a director in a corporation where compensation or fees are paid for such services is itself “carrying on a trade or business”, we hold that the expenditures in question were extraordinary in their character for a director to pay and are not shown to be ordinary and necessary' expenses incurred and paid in carrying on such business of being a director, if it be a business.

Reviewed by the Board.

Decision will be entered, for respondent.


author: Hill:

text:
    William Lea Taylor, Petitioner, v. Commissioner of Internal Revenue, Respondent.
    Docket No. 89461.
    Promulgated May 17, 1938.

      Homer K. Jones, O. P. A., fox the petitioner.

      Harry R. Horrow, Esq., for the respondent.
   OPINION.

Hill:

This proceeding is for the redetermination of a deficiency in income tax for the calendar year 1934 in the sum, of $1,102.74.

Petitioner assigned error as follows:

(a) The respondent erred in including in petitioner’s income for the year 1934, the amount of $9,244.00 representing dividends from the William Lea Taylor Trust.
(b) The respondent erred in holding that the income of the William Lea Taylor Trust for the year 1934 is taxable to the petitioner.

All of the facts were stipulated, and included as a part of the stipulation was a written declaration of trust by petitioner, creating the William Lea Taylor trust, executed April 28, 1932, by petitioner, as grantor, and by him and the Bank of Commerce & Trust Co., a Tennessee corporation, as trustees.

We adopt the stipulated facts as our findings of fact and will refer to and quote only such of them as may appear necessary to our decision of the questions involved.

The questions presented are:

1. Is the income realized by the William Lea Taylor trust taxable to the petitioner, as grantor, under the provisions of sections 166 and 167 of the Revenue Act of 1934?
2. Did the petitioner retain such control over and benefit from the William Lea Taylor trust that he is taxable with respect to the income realized by the trust?

Petitioner is an individual, whose office address is 81 Monroe Avenue, Memphis, Tennessee. He duly filed his income tax return for the year 1934 with the collector of internal revenue at Nashville, Tennessee.

In determining the deficiency involved in this proceeding, the Commissioner of Internal Eevenue included, in the taxable income of the petitioner, dividends received during the year 1934 by the William Lea Taylor trust in the amount of $9,244. Also, the Commissioner allowed as deductions from the gross income of petitioner the following amounts: $360 representing loss on the sale during 1934 of 200 shares of Union Compress and Warehouse preferred stock held by the trust, $458.25 representing taxes paid by the trust during that year, and $405.45 representing compensation paid to the trustees of the trust during the year 1934.

The petitioner contends that none of said income or deductions may be included or allowed in computing his taxable income for the year 1934.

The corpus of the trust during the taxable year consisted of insurance policies in the face amount of $240,000, taken out on the life of E. L. Taylor, father of petitioner, and certain shares of stock, owned by the petitioner, which were transferred by him to the trust at the time of its creation. The income of the trust during the taxable year consisted solely of dividends received on such shares. E. L. Taylor irrevocably assigned all his right, title, and interest in and to the insurance policies to the trust in 1932. By virtue of the provisions of the insurance policies the trustees of the trust have the power to surrender them and obtain their cash surrender value. The trustees of the trust, since its creation and throughout the taxable year in question, were the petitioner and the National Bank of Commerce & Trust Co. of Memphis, Tennessee, formerly the Bank of Commerce & Trust Co.

At-the time the trust was created, the petitioner was 22 years old, his father, E. L. Taylor, was 60, arid Sarah L. Taylor, his mother, was 58 years of age. Sarah L. Taylor died on April 9, 1936, during the lifetime of E. L. Taylor.

During the year 1934 all the income of the trust, consisting of $9,244 in dividends, was applied toward the payment of premiums on the insurance policies.

The trust instrument consists of article first and article second. Under article first it is provided:

2. The Trustees are hereby authorized, empowered and directed to receive the income from the trust property and to apply so much thereof as is necessary', less their compensation and the expenses of administering this trust, to pay the premiums on the life insurance policies assigned to them hereunder. If the net income shall at any time be insufficient for this purpose, the Trustees shall, unless William L. Taylor elects to advance the money- to make up the deficiency, make up such deficiency out of the principal of the trust fund, and for that purpose they are hereby given authority to pledge or sell so much of the principal as is necessary in their discretion. If the principal of the trust fund shall become so diminished that it is insufficient to pay the premiums on the policies subject to this trust, and if William L. Taylor does not elect to put up additional securities or advance additional funds for that purpose, the Trustees shall be relieved of all liability for paying the said premiums.
3. All income not expended for life insurance premiums hereunder and all dividends, proceeds of policies maturing during the lifetime of the insured, disability benefits, cash value and other amounts payable under any insurance contract hereunder received by the Trustees during the lifetime of R. L. Taylor and not needed to pay said premiums, shall be allowed to accumulate in the hands of the Trustees and become a part of the corpus of the trust estate.
4. The Trustees shall have precisely the same powers as though they were the absolute and unconditional owners of the property, and without in anywise limiting this generalization, they may:
(a) Buy any property, real, personal or mixed, on any terms or conditions whatsoever.
(b) Sell any property, real, personal or mixed, that now is or shall become a part of the within trust estate on any terms or conditions whatsoever and with or without security for such lending.
(e)Lend any money or property, real, personal or mixed that now is or shall become a part of the within trust estate on any terms or conditions whatsoever and with or without security for such lending.
(d) Exchange any property, real, personal or mixed, that now is or shall become a part of the within trust estate on any terms or conditions whatsoever. In the exercise of all of the powers conferred in Subdivision (a), (b), (e) and (d) above, the Bank of Commerce & Trust Company shall he governed by the advice of William L. Taylor, whose discretionary powers shall be controlling, and the Bank of Commerce & Trust Company, when acting .under the advice of said William L. Taylor shall be relieved of all liability in regard thereto.
(e) Surrender any policies of insurance hereunder for their cash value.
(f) Borrow money under any terms or conditions whatsoever with or without pledging, mortgaging or encumbering any or all of the property, real, personal or mixed, that now is or shall become a part of the within trust estate.
(g) Lease any or all of the property, real, personal or mixed that now is or shall become a part of the within trust estate, under any terms of rental or for any duration of time whatsoever.
(h) May give away, in their discretion, any part of the trust estate when such donation shall be approved by the adult beneficiaries.
(i) If, at any time, there be a default in the payment of the interest or principal, or both, of any note, bond, account or other obligation or security held by said Trustees, or if the Trustees be a party plaintiff or defendant to a suit of any kind or nature, at law or equity, or before any legally constituted tribunal, the said Trustees shall exercise their bona fide judgment as to the proper legal proceedings necessary to enforce such claim or suit, or whether legal proceedings shall be taken- at all, or whether an accord, compromise, renewal or any other method shall be taken in order to settle such claim or claims or suit; and when the Trustees shall exercise their bona fide judgment in the particular procedure adopted, such action shall not be open to review ■ by any legal authority, court or body.
(j) Hold in unchanged form any securities forming a part of the trust estate.
(k) Purchase additional insurance on the life of R. L. Taylor, if they deem it advisable to do so.
(l) The Trustees may sell or exercise any subscription warrants and may sell or retain any stock dividends, and all stock or proceeds of sale so acquired shall be held by the Trustees as principal and dealt with accordingly; but if, in the Judgment of the Trustees, any stock dividend is declared in lieu of an ordinary cash dividend, the Trustees shall have full power and authority to treat either the dividend or the proceeds of sale thereof as income. Investments may stand in the name of any firm acting as agent for the Trustees.
* * * * * * *
9. After the death of R. L. Taylor, the Trustees shall collect the proceeds of life insurance policies hereunder and shall add the same to the principal of the trust fund. The Trustees, however, shall not be bound to institute any legal proceedings for the collection of the proceeds of any insurance policy hereunder unless the expenses for such legal action shall be first advanced to the Trustees. * * *
***#:!<**

Under article second it is provided:

11. After the death of R. L. Taylor, the Trustees shall collect the proceeds of all life insurance policies, and shall pay over the net income from the trust estate to William L. Taylor and his mother, Sarah L. Taylor, in equal shares, such payments to continue during the lifetime of Sarah L. Taylor.
During the continuation of the trust herein declared, the Trustees, in their sole discretion, are authorized and empowered to encroach on the corpus of the trust estate in the event of the serious illness or other misfortune of either or both of said beneficiaries.
At the death of Sarah L. Taylor, the entire net income from the trust estate shall be paid to William L. Taylor. At any time after two years following the death of Sarah L. Taylor, William L. Taylor shall have the right and authority of electing to receive the entire trust estate, both principal and income, and upon the said William L. Taylor exercising such right, the Trustees shall deliver to him the entire trust estate, both principal and income, and the trust shall cease and determine.
*******

The trust instrument provides that if petitioner predeceases his mother, leaving no wife, child, or children, the trust estate shall become the property of certain named persons at her death.

Other provisions of the trust instrument directs the disposition of the trust property in the event petitioner shall predecease his mother, leaving a wife and/or child or children. Such further provisions are not important in the determination of the question presented for decision.

The Commissioner, in his explanatory statement accompanying the notice of deficiency, stated: “There has been included in your income, dividends reported by the William Lea Taylor Trust. This office is of the opinion that the income of the trust is taxable to you, the grantor, since under the provisions of the trust department, you did not permanently and unconditionally divest yourself of the corpus of the trust.”

Respondent based his determination of deficiency on sections 166 and 167 of the Revenue Act of 1934 and articles 166-1 (b) and 167-1 (b) of Regulations 86. We deem it necessary, however, to consider only the applicability of section 167 (a) (1) , supra, to the provisions of the trust instrument. We believe that the trust involved falls within the provisions of that section and that the issue presented must be resolved against the petitioner.

The operation of the trust was divided into two periods. The first period, under article first of the trust instrument, was conterminous with the life of R. L. Taylor. The second period, under article second of the trust instrument, was from and after R. L. Taylor’s death. During the first period the income of the trust was not distributable, but was to be used to pay premiums on the policies of insurance on the life of R. L. Taylor, and the excess, if any, together with any proceeds received by the trustees under any insurance contract during the life of R. L. Taylor, was to be added to the corpus of the trust. If such income should be insufficient to pay the premiums, the trustees were authorized to pay the deficit out of the corpus of the trust, unless petitioner elected to advance the money to make up such deficiency. During the second period the proceeds of any existing insurance policies on the life of R. L. Taylor were to be collected and added to the corpus of the trust, and the net income from the trust was to be distributed in equal shares to the petitioner and his mother, Sarah L. Taylor, so long as both should live. If petitioner should survive his mother he was to receive the entire net income of the trust from and after the death of his mother, and he had the right at any time after two years following her death to terminate the trust and thereupon receive both the principal and income of the trust. If Sarah L. Taylor should survive petitioner, she was to receive the entire income of the trust during her life, provided petitioner left surviving no child, children, or wife; otherwise, she was to continue to receive one-half of the income during her life.

Under paragraph 2 of the trust instrument the trustees were directed to apply the income of the trust first to the payment of their compensation and the expenses of administering the trust. They were directed to use the remainder of tbe income, called the net income, or so much thereof as should be necessary, in payment of premiums on the policies of insurance held, by the trust on the life of R. L. Taylor. Paragraph 3 of the trust instrument is as follows:

All income not expended for life insurance premiums hereunder and all dividends, proceeds of policies maturing during the lifetime of the insured, disability benefits, cash value and other amounts payable under any insurance contract hereunder received by the Trustees during the lifetime of R. L. Taylor and not needed to pay said premiums, shall be allowed to accumulate in the hands of the Trustees and become a part of the corpus of the trust estate.

Paragraph 4 provides that the trustees shall have “precisely the same powers as though they were the absolute and unconditional owners of the property” of the trust, and paragraph 4 (e) authorized them to “surrender any policies of insurance hereunder for their cash value.”

The trustees had the power, through surrendering any or all of the insurance policies for their cash value, to reduce the amount of premiums to be paid out of the income of the trust or to eliminate entirely such premiums. But whether the net income be used in the payment of such insurance premiums, or merely added to the corpus of the trust, or otherwise withheld from distribution, it would be an accumulation of the income. Any disposition thereof other than its distribution to beneficiaries of the trust is an accumulation of the income. The payment of insurance premiums out of the income is but an investment in trust property. The application of the income to such payment is to add it to the corpus of the trust and hence to accumulate it.

It follows that during the first period of operation of the trust, namely, during the lifetime of R. L. Taylor, all of the net income of the trust was to be accumulated and added to the corpus of the trust. The question, then, is, Was the accumulated income in the discretion of the grantor (petitioner) to be distributed to the grantor in the future ?

If the corpus of the trust, including the accumulated income, may in the future, in the discretion of the grantor, be distributed to him, the trust falls within the provisions of section 167 (a) (1), supra. Fanny M. Dravo et al., Executors, 34 B. T. A. 190; Arthur J. Morris, 33 B. T. A. 241. Cf. Kaplan v. Commissioner, 66 Fed. (2d) 401, construing section 219 (h) of the Revenue Act of 1924; Greenough v. Commissioner, 74 Fed. (2d) 25; Higgins v. White, 93 Fed. (2d) 359.

In paragraph 9 of the trust instrument it is provided that “after the death of R. L. Taylor, the trustees shall collect the proceeds of life insurance policies hereunder and shall add the same to the principal of the trust fund.”

In paragraph 11 of the trust instrument it is provided that after the death of E. L. Taylor the net income from the trust estate shall be paid in equal shares to petitioner and his mother, Sarah L. Taylor, during the latter’s lifetime, and at her death the entire net income shall be paid to petitioner. It is further provided in paragraph 11 as follows: “At any time after two years following the death of Sarah L. Taylor, William L. Taylor [petitioner] shall have the right and authority of electing to receive the entire trust estate, both principal and income, and, upon the said William L. Taylor exercising such right, the trustee shall deliver to him the entire trust estate, both principal and income, and the trust shall cease and determine.”

The trust instrument, therefore, definitely provides for the accumulation of all of the net income of the trust- during the lifetime of E. L. Taylor and also definitely provides that in the discretion of the grantor such accumulated income may be distributed in the future to him. Thus, the trust is brought squarely within the provisions of section 161 (a) (1), supra.

Decision will be entered for the respondent.

       SEC. 167. INCOME EOK BENEFIT OF GRANTOR.
      (a) Where any part of the income of a trust—
      (1) is, or in the discretion of the grantor or of any person not having a substantial adverse interest in the disposition of such part of the income may be, held or accumulated for future distribution to the grantor; * * *
      *******
      then such part of the income of the trust shall be included in computing the net income of the grantor.


author: TueneR :

text:
    Harvey S. Strassburger, Petitioner, v. Commissioner of Internal Revenue, Respondent.
    Docket No. 82562.
    Promulgated May 17, 1938.

      Albert L. Cuff, Esq., for the petitioner.

      Chester A. Cwinn, Esq., and Charles E. Lowery, Esq., for the respondent. ■
   OPINION.

TueneR :

The parties agree that the trust organized on September 1,1928, and designated herein as the “Manager’s Association of Blaw-Knox Company” was an “Employees’ Trust” as contemplated by section 165 of the Revenue Act of 1928. Under that provision of the statute the association was not taxable as a trust, but the amount contributed to the fund by the employer and all earnings of the fund were to be taxable to the distributee in the year in which distributed or made available to him. Petitioner invested $10,000 in the trust on June 15, 1980, and upon the termination thereof on September 26, 1931, received as his proportionate share of the trust assets the sum of $191.98 in cash and 307 shares of the capital stock of the Blaw-Knox Co., which on that date had a fair market value of $3,223.50.

In June 1933, more than two years after petitioner’s investment in the trust but less than two years after his actual receipt of the 307 shares of capital stock of Blaw-Knox Co. from the trust, petitioner sold 300 shares of the stock for $4,663.50. Petitioner claims that he sustained a capital loss amounting to $4;920.90 within the meaning of section 101 of the Revenue Act of 1932 upon the sale of the said 300 shares. The respondent concedes the amount and year of the loss as contended for by petitioner, but claims that the loss was an ordinary loss, subject, for deduction purposes, to the limitations prescribed by section 23 (r) (1) of the act. According to both parties the basis for the 307 shares of the Blaw-Knox Co. stock in the hands of the petitioner was $10,000, the amount of petitioner’s investment in the trust, less $191.98, the amount of cash received by him upon the termination of the trust, their only point of difference being as to the date on which the stock was acquired.

We have previously held, in Oscar L. Olstad, 32 B. T. A. 670 (petition for review dismissed by the Circuit Court of Appeals for the Second Circuit without written opinion), in the case of another employee of the Blaw-Knox Co. and an investor in the above trust, that the employee realized no taxable gain upon the termination of the trust and the distribution of its assets in 1981 where the cash plus the fair market value of the stock received by such employee was less than the amount of his original investment. In the stipulation and on brief, the respondent has accepted the ruling in that case as sound. We have not had before us in any prior case the question as to whether or not an employee, on such facts as those stated, sustained a deductible loss in the year in which the trust was terminated and, so far as we have been able to determine, that question has not been decided by any of the courts. If the petitioner sustained a loss in respect of his investment in the trust in the year of the trust’s termination, obviously the correct basis for determining gain or loss upon the subsequent sale of the stock received is not the basis used by the parties herein, but is the basis so used adjusted to take the loss previously sustained into account, and, under such circumstances, it is apparent that the petitioner did not have a loss upon the sale of the stock in the taxable year 1933. Inasmuch, however, as both parties have presented the instant case under the theory that the loss on the sale of the stock was sustained in 1933, and not in the year in which the trust was terminated, and, further, in view of the fact that the respondent must be sustained in his determination of the deficiency herein if petitioner did not sustain a capital loss, a finding that the shares of stock, when sold, were not capital assets will completely dispose of this case and thereby make it unnecessary to consider and determine whether or not the theory of the parties, as to the year in which the loss was sustained is erroneous or correct.

Petitioner admits that he did not acquire a legal interest in the trust assets at the time of his investment in the trust, but contends that he acquired an “equitable interest in trust assets to an extent that would entitle him to compute his holdings as from the date investment was made.” Eespondent argues that petitioner did not “acquire” the shares of stock until they were actually distributed to him by the trust and that they were therefore not “held” by him prior to that date.

We conclude that the date of the distribution by the trust is the date from which the period of holding should be computed. No other conclusion appears reasonable after examining the terms and conditions of the trust agreement. Paragraph 5 (a) of the agreement states that “the Trustee now holds” 12,133 shares of the capital stock of Blaw-Knox Co., and subparagraph (b) provides that “shares now held by the trustee, as well as any securities that may hereafter be purchased for the association shall be issued in his name as Trustee” of the association. The trustee had the right at any time, in his sole discretion, to exchange or sell and liquidate any investment of the association, including shares of stock of the Blaw-Knox Co. or any other corporate investment. Upon the final termination of the association each member was to receive his proportionate part of the assets of the association which were to be distributed by the trustee “in the discretion of the trustee in either securities or cash, or both.” If any member left the employment of the company prior to the termination of the association, for any reason other than death, incapacity, or illness, he forfeited his right to any profits accrued on the assets of the association and was “entitled to receive only the amount of cash actually paid into the association by him without profit and without interest.” In case of death, incapacity, or illness which would render the member unable to hold a remunerative position with the company, his interest in the association ceased and was to be determined as of the effective date of his death, incapacity, or illness and he or his estate was to be paid “in cash” the value of his interest on that date. The right was reserved “to change or amend all or any part of this agreement upon the joint affirmative vote of the Trustee, a majority of the advisory board and a majority of the members.”

We think the above provisions of the trust agreement conclusively show that the petitioner did not “acquire” nor become the “owner” of any shares of Blaw-Knox Co. at the time of his investment in the association. Title did not pass until the stock was distributed to petitioner by the trustee and the period of holding begins at the time he acquired title. Arthur E. Otto, 37 B. T. A. 479. Prior to termination of the trust it was not known that he would ever acquire shares of stock in Blaw-Knox Co. Prior to that time he had only the right to certain cash payments in the event of his withdrawal and a right to a proportionate share of the assets of the trust in the event of its termination, in which case the distribution might have been “in either securities or cash, or both.” Cf. Du Bois Young, 34 B. T. A. 648.

It is of some significance that section 165, supra, provides that the amount contributed to such fund by the employer and all earnings of such fund “shah be taxed to the distributee in the year in which distributed or made available to him.” Thus, for the purpose of taxation, the statute does not recognize ownership in the members of such a trust until the shares of stock or other assets are actually delivered to them. See Schaefer v. Bowers, 50 Fed. (2d) 689.

With respect to the meaning of the term “held” as used in the statute, the Supreme Court said in McFeely v. Commissioner, 296 U. S. 104, that “In common understanding to hold property is to own it. In order to hold or own one must acquire. The date of acquisition is then, that from which to compute the duration of ownership or length of holding.” We are of the opinion that petitioner did not acquire the shares of stock of Blaw-Knox Co. until they were distributed to him by the trustee on September 26, 1931, and since the duration of his ownership must be computed from that date, he had not “held” the shares of stock for more than two years when they were sold in June 1933. We therefore hold that the stock in question was not a capital asset and the petitioner did not sustain a capital loss upon the sale thereof.

Decision will be entered for the respondent.

       SEC. 165. EMPLOYEES’ TRUSTS.
      A trust created by an employer as a part of a stock bonus, pension, or profit-sharing plan for the exclusive benefit of some or all of his employees, to which contributions are made by such employer, or employees, or both, for the purpose of distributing to such employees the earnings and principal of the fund accumulated by the trust in accordance with such plan, shall not be taxable under section 161, but the amount contributed to such fund by the employer and all earnings of such fund shall be taxed to the distributee in the year in which distributed or made available to him. Such distributees shall for the purpose of the normal tax be allowed as credits against net income such part of the amounts so distributed or made available as represents the items of dividends and interest specified in section 25 (a) and (b).

       SEC. 101. CAPITAL NET GAINS AND LOSSES.
      * * * ♦ * * *
      (b) Tax in Case of Capital Net Loss. — In the case of any taxpayer, other than a corporation, who for any taxable year sustains a capital net loss (as hereinafter defined in this section), there shall be levied, collected, and paid, in lieu of all other taxes imposed by this title, a tax determined as follows: a partial tax shall first be computed upon the basis of the ordinary net income at the rate and in the manner as if this section had not been enacted, and the total tax shall be this amount minus 12% per centum of the capital net loss; but in no case shall the tax of a taxpayer who has sustained a capital net loss be less than the tax computed without regard to the provisions of this section.
      (c) Definitions. — Eor the purposes of this title—
      *******

        ca) “Capital loss” means deductible loss resulting from the sale or exchange of capital assets.
      *******
      (8) “Capital assets” means property held by the taxpayer for more than two years (whether or not connected with his trade or business), but does not include stock in trade of the taxpayer or other property of a kind which would properly be included in the inventory of the taxpayer if on hand at the close of the taxable year, or property held by the taxpayer primarily for sale in the course of his trade or business. For the purposes of this definition — * * *.

       SEC. 23. DEDUCTIONS PROM GROSS INCOME.
      In computing net income there shall be allowed as deductions:
      *******
      (e) Losses by Individuals. — Subject to the limitations provided in subsection (r) of this section, in the case of an individual, losses sustained during the taxable year and not compensated for by insurance or otherwise—
      *******
      (2) If incurred in any transaction entered into for profit, though not connected with the trade or business: * * *
      *******
      (r) Limitation on Stock Losses.—
      (1) Losses from sales or exchanges of stocks and bonds (as defined in subsection (t) of this section) which are not capital assets (as defined in section 101) shall be allowed only to the extent of the gains from such sales or exchanges (including gains which may be derived by a taxpayer from the retirement of his own obligations).