Eastern R. & L. Co. v. Commissioner

Eastern Railway and Lumber Company, Petitioner, v. Commissioner of Internal Revenue, Respondent Eastern R. & L. Co. v. Commissioner Docket No. 13950 United States Tax Court 12 T.C. 869; 1949 U.S. Tax Ct. LEXIS 190; May 26, 1949, Promulgated *190 Decision will be entered for the respondent. Petitioner was incorporated in 1903, for the principal purpose of engaging in the logging and lumber business. After 1939 petitioner became inactive and rented its mill and equipment and sold its timber property to its principal stockholder. Held, on the facts, that the petitioner was availed of in the taxable year 1943 for the purpose of preventing the imposition of the surtax upon its shareholders through the medium of permitting its earnings or profits to accumulate instead of being distributed to its shareholders, and it is liable for the surtax imposed by section 102 of the Internal Revenue Code. *191 Thomas N. Fowler, Esq., and C. L. Stone, C. P. A., for the petitioner. T. M. Mather, Esq., for the respondent. Black, Judge. BLACK *869 The respondent determined a deficiency in petitioner's income tax for the year 1943 in the amount of $ 26,827.98 and in declared value excess profits tax in the amount of $ 418.53. These deficiencies are due to several adjustments made by the Commissioner in the net income reported by petitioner on its return. In a statement attached to the deficiency notice the respondent, among other things, advised the petitioner as follows: It is held that you have permitted earnings or profits to accumulate in excess of a reasonable amount needed for the business and thereby were availed of for the purpose of preventing the imposition of the surtax on shareholders. Therefore, in accordance with Section 102 of the Internal Revenue Code, the surtax as provided in that section has been applied in determining your income tax liability. Petitioner, by an appropriate assignment of error, contests the above holding of the respondent. The other adjustments made by the Commissioner in his deficiency notice are not contested. *870 FINDINGS*192 OF FACT. Some of the facts were stipulated, and the facts as stipulated are so found. The petitioner was incorporated in 1903 under the laws of the State of Washington, with an authorized capital stock of 2,000 shares of the par value of $ 100 each, and it was engaged principally in the logging and lumber business in that state. S. A. Agnew is its vice president and majority stockholder. Agnew was employed by petitioner in 1903 in various capacities, and particularly in the outside operations of petitioner's business. He became a stockholder with the acquisition of 30 shares in 1912, and by 1930 he held 834 shares. By December 31, 1943, he had acquired 99 1/2 per cent of the petitioner's stock, having acquired at various times over 1,990 shares of petitioner's stock. The stock ownership has remained unchanged from December 31, 1943, to the present time, except that 5 additional shares formerly owned by H. H. Henry were acquired by Agnew in January 1946. On April 1, 1927, petitioner incurred an indebtedness of $ 350,000 in the form of a bond issue, with the Lumberman's Trust Co. of Portland, Oregon, as trustee, and on April 1, 1932, petitioner was in default on the unpaid portion*193 of that bond issue. On March 10, 1933, petitioner executed a supplemental trust agreement under the above named bond issue which provided that petitioner should pay no dividends on its capital stock while any of the bonds were outstanding. These bonds were paid off in September 1940. Prior to 1939 the petitioner operated two mills, the "Eastern" mill with a daily capacity of about 140,000 feet, and the "Western" mill, with a daily capacity of about 100,000 feet. In 1939 a fire destroyed petitioner's Eastern mill and petitioner was paid the amount of $ 416,500 in insurance, the proceeds of which in September 1940 were used to pay off its bond issue and other indebtedness. After the fire the assets of petitioner consisted principally of the Western mill, 92,628,000 feet of timber, and railroad and equipment. After 1939 the petitioner did not resume operations, and it remained inactive. The principal reason for petitioner not resuming operations after 1939 was labor difficulties. In 1940 Agnew entered into an agreement with petitioner whereby he agreed to take over and operate as an individual the contracts that the petitioner had on certain lumber tracts and agreed to pay petitioner*194 the amounts it had invested in these contracts. At a meeting of petitioner's stockholders on or about February 22, 1941, some of the stockholders sought to dissolve the corporation and to liquidate its assets. Agnew opposed such action. On or about March 1941 Agnew rented petitioner's Western mill under an agreement to pay $ 1,000 per month. In 1942 the rent was increased to $ 3,000 per month, and in 1943 it was reduced to $ 2,000 *871 per month. Under this lease agreement Agnew was required to put the mill and equipment in operating condition and to maintain it. On or about February 28, 1942, Agnew purchased all of the timber of petitioner for the sum of $ 225,000. Agnew became delinquent in some of the payments due and arranged to pay for the timber as it was cut at OPA ceiling prices. At the close of 1939 petitioner had timber holdings of 92,628,000 feet, of which 68,900,000 feet were cut by and sold to Agnew between 1941 and 1945. These sales, together with the sale of 6,910,000 feet to others, left petitioner with only 17,709,000 feet on hand at the close of the year 1944. As Agnew cut timber which belonged to petitioner, he became indebted to it in the amount of*195 $ 108,005.62 by December 31, 1943, and, instead of paying petitioner, he purchased other timber in his own name. Agnew intended to sell to petitioner at a fair market value enough timber to pay his indebtedness to it. The indebtedness of Agnew to petitioner was as follows: Note Open Timber account account account Total Dec. 31, 1939 * $ 5,139.65 None * $ 5,139.65 [1940] * $ 10,145.08 None None * 10,145.08 [1941] 12,500,00 * 1,587.83 None 10,912.17 [1942] 12,500.00 8,801.41 None 21,301.41 [1943] 102,709.63 5,231.04 $ 64.96 108,005.63 [1944] 143,050.00 24,580.73 138,675.76 306,306.49 Beginning in 1941, Agnew paid out sums for the purchase of petitioner's stock and for the purchase of timber as follows: Purchase of Purchase of stock timber [1941] $ 31,550 $ 5,856.66 [1942] 13,200 15,750.00 [1943] 10,550 361,719.28 [1944] 52,949.28 Total 55,300 436,275.22 Of the above total of $ 436,275.22 paid for the purchase of timber properties, the amount of $ 68,412.78 was paid for timber properties located in Oregon. Agnew planned to have petitioner move to Oregon to *196 reenter the logging and lumber business when the timber which he owned in the State of Washington was cut off. Agnew also acquired timber properties in California, and at the time of the hearing of this proceeding he had acquired approximately 36,000 acres of timber land in California and Oregon, which cost approximately $ 500,000. The value of the depreciable assets of the petitioner, less depreciation reserve at the end of 1943, was $ 53,847.20. Thereafter no additions were made to this account. *872 Petitioner paid no dividends at any time after the year 1920. Petitioner's balance sheets as of December 31, 1940, 1941, 1942, 1943, and 1944 were as follows: Dec. 31, 1940 Dec. 31, 1941 Dec. 31, 1942 ASSETS Cash $ 16,618.72 $ 4,989.52 $ 126,747.85 Timber deposits 2,855.04 2,055.04 24.00 Accounts receivable 26,890.59 57,768.63 17,448.36 Notes receivable 209.63 12,709.63 12,709.63 Inventories 6,780.56 4,692.56 2,224.50 Scrap 9,000.00 Timber 129,624.00 146,657.50 79,685.19 Boeing timber contract 18,907.57 Land 68,777.02 65,884.32 64,234.32 Plant and buildings 778,556.53 756,992.39 756,992.39 City Standby Service 14,500.00 Union right of way and railroad construction 9,873.52 Cash value of officers insurance 66,690.00 Investments in other corporations 2,225.00 Treasury stock 900.00 900.00 900.00 City of Centralia 14,500.00 14,500.00 Union right of way 9,873.52 6,500.70 Stocks 2,225.00 2,223.00 Investments Total assets 1,152,408.18 1,079,248.11 1,084,189.94 LIABILITIES Pay roll 845.68 6.05 Accounts payable 28,186.90 9,260.20 20,830.58 Officers' accounts 20,013.15 Accounts of uncertain liability 16,469.49 Notes payable 216,111.67 151,490.00 45,254.50 Reserve for depreciation 661,462.96 691,774.76 700,328.15 Reserve for bad debts 3,630.93 2,337.61 2,279.02 Other liabilities 9,557.42 Total liabilities 946,720.78 864,426.04 768,692.25 Capital stock 200,000.00 200,000.00 200,000.00 Surplus 5,687.40 115,497.69 Surplus and timber depreciation 14,822.07 Total net worth 205,687.40 214,822.07 315,497.69 Total liabilities and net worth 1,152,408.18 1,079,248.11 1,084,189.94 *197 Dec. 31, 1943 Dec. 31, 1944 ASSETS Cash $ 206,411.77 $ 64,507.04 Timber deposits 24.00 Accounts receivable Notes receivable * 125,893.12 * 323,625.00 Inventories 2,224.50 510.50 Scrap Timber 8,900.54 Boeing timber contract Land 64,234.32 62,968.82 Plant and buildings 763,493.09 144,978.40 City Standby Service Union right of way and railroad construction Cash value of officers insurance Investments in other corporations Treasury stock City of Centralia Union right of way 6,500.70 Stocks Investments 3,098.00 3,098.00 Total assets 1,165,378.80 615,089.00 LIABILITIES Payroll Accounts payable 24,375.14 26,453.52 Officers' accounts Accounts of uncertain liability Notes payable 57,754.50 57,754.50 Reserve for depreciation 709,645.89 105,004.98 Reserve for bad debts 1,418.08 1,064.43 Other liabilites Total liabilities 793,193.61 190,277.43 Capital stock 200,000.00 200,000.00 Surplus 172,185.19 224,811.57 Surplus and timber depreciation Total net worth 372,185.19 424,811.57 Total liabilities and net worth 1,165,378.80 615,089.00 If for the year 1943 the net taxable income of the *198 community consisting of S. A. Agnew and his wife, Kathryn Agnew, had been increased by a dividend from Eastern Railway & Lumber Co. in the amount of $ 64,280.78, which was petitioner's net adjusted income after the deduction of income tax and declared value excess profits tax of $ 22,178.20 for that year, the increased income tax of the husband and the wife would have been $ 24,601.76 each, the combined total being $ 49,203.52. The earnings and profits of the petitioner were permitted to accumulate beyond the reasonable needs of its business in 1943. The petitioner was availed of in 1943 for the purpose of preventing the imposition of the surtax upon its shareholders through the medium of permitting the earnings or profits to accumulate instead of being divided or distributed. *873 OPINION. The issue in this proceeding is whether petitioner is subject to tax under section 102 of the Internal Revenue Code1 for the calendar year 1943. *199 Respondent did not determine and he does not contend that petitioner was "formed" for the purpose of avoiding surtax upon shareholders. He did determine and he does contend that petitioner was "availed of" for that purpose. The respondent determined and contends that during the taxable year in question petitioner permitted its earnings or profits "to accumulate beyond the reasonable needs of the business," as that phrase is used in section 102(c). Under section 102 (c), if petitioner's earnings or profits were permitted "to accumulate beyond the reasonable needs of the business," such fact is determinative of the purpose to avoid the imposition of the surtax upon the shareholders, unless the petitioner, by a clear preponderance of the evidence, proves to the contrary. See Whitney Chain & Manufacturing Co., 3 T. C. 1109; affd., 149 Fed. (2d) 936. The determination of whether petitioner, during the taxable year in question, permitted its earnings or profits "to accumulate beyond the reasonable needs of the business" or whether petitioner was "availed of" for the prohibited purpose is a question of fact to be determined from*200 all of the evidence. Helvering v. National Grocery Co., 304 U.S. 282; Helvering v. Chicago Stockyards Co., 318 U.S. 693; Stanton Corporation, 44 B. T. A. 56; affd., 138 Fed. (2d) 512; Cecil B. deMille, 31 B. T. A. 1161; affd., 90 Fed. (2d) 12; certiorari denied, 302 U.S. 713. We think the evidence here supports respondent's determination. Upon the evidence herein we have found as an ultimate fact that during the taxable year in question petitioner permitted its earnings or profits "to accumulate beyond the reasonable needs of the business" and that it was "availed of" for the purpose of avoiding surtax upon its shareholders. Several circumstances tend to confirm the correctness of the respondent's determination. Petitioner at the beginning *874 of the taxable year 1943 had cash on hand in the amount of $ 126,747.85 and at the end of the taxable year it had cash on hand in the amount of $ 206,411.77. At the beginning of the taxable year 1943 petitioner had quick *201 assets of $ 156,929.84 and current liabilities of $ 66,085.08, or a net working capital of $ 90,844.76. At the end of the taxable year 1943 petitioner had quick assets of $ 334,008.81 and current liabilities of $ 82,129.64, or a net working capital of $ 251,879.17. At the beginning of the taxable year 1943 petitioner had a surplus of $ 115,497.69 and at the end of the year it had a surplus of $ 172,185.19, or an increase of $ 56,687.50. During the taxable year 1943 petitioner paid no dividends. It should be borne in mind that petitioner was not an operating company. The facts show that the petitioner had been inactive since 1939. In August 1940 Agnew, who was one of the petitioner's principal stockholders, entered into an agreement with petitioner whereby he agreed to take over and operate as an individual the contracts that petitioner had on certain timber properties. In 1941 he rented petitioner's mill and equipment and in February 1942 he purchased all of its timber property. Under the arrangement for lease of the mill, Agnew was required to put it in operating condition and to maintain it. By the end of 1943, therefore, petitioner had no activity except holding the property*202 and collecting the income therefrom. It would appear, therefore, that there was no need for petitioner to accumulate any part of the earnings in 1943 for the purpose of financing the business. Certainly a net working capital of $ 251,879.17 and a surplus of $ 172,185.19 at the close of the year 1943 were beyond anything needed to carry on its limited business activities. It also appears that petitioner's earnings were being used by Agnew for his personal operations. The facts show that Agnew purchased petitioner's timber under an arrangement whereby he paid for same as it was logged at the OPA ceiling prices. As he cut the timber he became indebted to petitioner and, instead of paying over the amounts due, he used the funds to purchase additional timber for his own account. He thus used earnings and profits due the petitioner in the development of his own lumber business as he might have used them if distributed to him as dividends, since at the end of 1943 he was practically the sole stockholder. Petitioner claims that its accumulations of earnings and profits were needed, as it planned to reenter the logging and lumber business in Oregon. It maintains that $ 1,500,000 would*203 have been required for that purpose. Agnew testified that the timber properties which he purchased in Oregon were purchased for the future needs of the petitioner and that petitioner planned to move its mill machinery and equipment to Oregon when the timber properties which he owned in *875 Washington were cut, which he estimated would be in about two years from the date of the hearing in this proceeding. Notwithstanding this claim, it is our opinion that no showing has been made of any immediate or reasonably immediate need for accumulating petitioner's earnings and profits in 1943. Cf. McCutchin Drilling Co. v. Commissioner, 143 Fed. (2d) 480; Wilson Bros. & Co. v. Commissioner, 124 Fed. (2d) 606. In the latter case the court said, in affirming our decision: * * * Petitioner contends that the evidence fails to support these findings. It says that the accumulation of gains and profits was needed for future expansion, that it was its intention always to reengage in business on a scale comparable with that previously carried on by the partnership; and that about $ 1,500,000 would be required for this purpose. *204 However, on the showing made, the Board was not obliged to conclude that there was any immediate need for conserving profits. And it is plain that the corporation was used by the brothers largely as a family pocketbook. While Agnew testified that the timber properties which were purchased in Oregon were acquired for the account of petitioner, nevertheless, they were purchased in his name, rather than in that of petitioner, and the record fails to disclose any obligation on his part to convey these properties to petitioner, and he was thus free to change his mind and cut this timber for his own account. Upon all the evidence herein, we think that petitioner permitted its earnings or profits to accumulate beyond the reasonable needs of its business and that it was availed of for the purpose condemned in the statute. We hold, therefore, that petitioner is subject to tax under section 102 of the code. See McCutchin Drilling Co. v. Commissioner, supra;Wilson Bros. & Co. v. Commissioner, supra;Helvering v. National Grocery Co., supra; Whitney Chain & Manufacturing Co. v. Commissioner,*205 supra. Decision will be entered for the respondent. Footnotes *. These are amounts owed by petitioner to Agnew.↩ *. Includes accounts receivable.↩ 1. SEC. 102. SURTAX ON CORPORATIONS IMPROPERLY ACCUMULATING SURPLUS. (a) Imposition of Tax. -- There shall be levied, collected, and paid for each taxable year (in addition to other taxes imposed by this chapter) upon the net income of every corporation (other than a personal holding company as defined in section 501 or a foreign personal holding company as defined in Supplement P) 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 earnings or profits to accumulate instead of being divided or distributed, a surtax equal to the sum of the following: * * * (b) Prima Facie Evidence. -- The fact that any corporation is a mere holding or investment company shall be prima facie evidence of a purpose to avoid surtax upon shareholders. (c) Evidence Determinative of Purpose. -- The fact that the earnings or profits of a corporation are permitted to accumulate beyond the reasonable needs of the business shall be determinative of the purpose to avoid surtax upon shareholders unless the corporation by the clear preponderance of the evidence shall prove to the contrary.↩