Lester Lumber Co. v. Commissioner

Lester Lumber Company, Inc., Petitioner, et al., 1 v. Commissioner of Internal Revenue, Respondent Lester Lumber Co. v. Commissioner Docket Nos. 17788, 17482, 17483, 17484, 17485, 17486, 17487, 17488, 17489, 17490, 17491, 17492, 17493, 17494, 14480 United States Tax Court 14 T.C. 255; 1950 U.S. Tax Ct. LEXIS 272; February 23, 1950, Promulgated *272 Decision will be entered for the petitioner in Docket No. 17788. Decision will be entered for the respondent in the other dockets. 1. The stockholders of a corporation had personal accounts standing on the books of the corporation against which they could draw at any time. At the annual meeting they agreed to have the surplus credited pro rata to their accounts and 1,971 shares of previously authorized stock issued and charged to such accounts at par. One stockholder received stock for less than his pro rata share of the surplus; the others received stock in excess of their pro rata shares of surplus. Held, the distribution of the surplus was a taxable dividend. 2. One petitioner omitted to report on his return $ 10,160 of interest credited to his account on the corporation's books and capital gain derived from a transfer of land. Imposition of 5 per cent penalty for negligence is sustained. Robert Ash, Esq., John Y. Merrell, Esq., W. T. Durant, Esq., and Leslie Kimble, C. P. A., for the petitioners. Paul E. Waring, Esq., for the respondent. Arnold, Judge. ARNOLD *256 These 15 consolidated cases involve the taxability of a distribution of surplus in 1943 which the individual petitioners contend was a nontaxable stock dividend. Petitioner George T. Lester, Sr., also contests a 5 per cent negligence penalty asserted by the respondent in the amount of $ 714.10. The issue in the corporation's case concerns the computation of its equity invested capital for excess profits tax purposes, as this may be affected by the decision on the stock dividend question. Income tax deficiencies were determined by the respondent as follows: Petitioner Docket No. Deficiency Lester Lumber Company, Inc 17788 $ 3,477.27 Christine Lester 17482 1,797.30 Darwin Lester, (Deceased) 17483 2,667.01 Doris Lester 17484 1,968.78 G. T. Lester Jr. and Annie Lester 17485 3,826.57 George T. Lester, Sr 17486 14,282.00 George W. Lester 17487 2,409.05 Lottie Lester 17488 5,015.34 Tilden Lester 17489 2,667.01 George D. Oakley and Julia Oakley 17490 2,872.81 Robert H. Oakley and Lula P. Oakley 17491 361.81 J. A. Richardson and Ida Z. Richardson 17492 1,081.56 Henry J. Turner and Ruth Turner 17493 1,104.29 Leslie E. Wells and Mable Lester Wells 17494 1,979.01 Robert E. Bell and Myrtle Bell 14480 2,142.35 *274 FINDINGS OF FACT. Petitioner Lester Lumber Co. is a corporation organized under the laws of the State of Virginia in 1917. It is a wholesale dealer in or manufacturer of lumber, roofing, cement, lime, and plaster. Its principal office is at Martinsville, Virginia. Its books are kept and its tax returns prepared on the accrual basis. It filed income and excess profits tax returns for the calendar years 1942 and 1943 with the collector of internal revenue at Richmond, Virginia. Its stock is closely held by members of the Lester family and others who are, or were, its key employees. Prior to December 20, 1943, the authorized capital stock was 5,000 shares of common stock of the par value of $ 100 per share, and 3,029 shares were issued and outstanding and were held by 15 persons. *257 Petitioners George T. Lester, Sr., Lottie Lester, George T. Lester, Jr., and Annie Lester, George W. Lester, Christine Lester, Doris Lester, Tildon Lester, George D. Oakley and Julia Oakley, Robert H. Oakley and Lula P. Oakley, J. A. Richardson and Ida Z. Richardson, Henry J. Turner and Ruth Turner, and Leslie E. Wells and Mable Lester Wells, are individuals residing at Martinsville, Virginia. *275 Darwin Lester, now deceased, was a resident of Martinsville, Virginia. These petitioners filed income tax returns for the calendar year 1943 with the collector of internal revenue at Richmond, Virginia. Petitioners Robert E. Bell and Myrtle Bell are residents of Kingstree, South Carolina. The record does not disclose where their return for the calendar year 1943 was filed. Each stockholder of Lester Lumber Co. had an open account on the corporation's books. To this account were credited salaries, dividends, and interest on the balance in the account, and withdrawals for personal use were charged to it. As a general practice the stockholder could withdraw the amount standing to his credit at any time. It was the practice of the corporation to credit interest at the current rate upon the credit balances of the stockholders' accounts. This rate in December, 1943, was 6 per cent per annum. On July 29, 1943, there was filed with the State Corporation Commission a statement made by Lester Lumber Co. as to the issuance of stock on which it is stated that the corporation proposes to issue 1,971 shares of common stock, $ 100 par value per share, in one issue to be paid for in money. *276 The statement was sworn to by G. T. Lester, Jr., president, on July 22, 1943. On December 20, 1943, the corporation had a surplus of $ 94,268.54, and on or about that date the annual meeting of the stockholders was held. The minutes of this meeting state: Pursuant to notice the stockholders of Lester Lumber Co. Inc., held their 28th annual meeting at their office, Franklin St., Martinsville, Va. Mr. Geo. T. Lester Sr. Chairman of board, called the meeting to order. General business conditions, war and past war was discussed [sic]. All stock was bought by stockholders, increasing capital stock of company to $ 500,000.00 all common stock. This was handled by J. M. Clingenspeel with the State Corporation Commission and approved by all stockholders. The stock was all sold for cash to give the corporation more working capital. 4% dividend was ordered paid on all shares of outstanding stock. Also ordered that G. T. Lester, Jr., be continued as financial agent of the Lester Lumber Co. Inc., and empowered to borrow funds, receive and discharge the obligations of the company. Motion by Geo. T. Lester, Sr., seconded by R. H. Oakley that directors be elected as a whole for next year. *277 Elected unanimously. Due to the death of H. L. Byrd the following changes was [sic] made in the officers of the corporation as G. T. Lester, Jr., Treas., H. J. Turner, Vice Pres., Lawson L. Lester, Sec., and B. Marvin Byrd, asst. sec. All officers and stockholders were present * * *. *258 The minutes do not cover all the action taken at the meeting. In addition to the action reported in the minutes the stockholders agreed to distribute the surplus to the stockholders' accounts. Pursuant to this arrangement, George T. Lester, Jr., who had charge of the corporation's books, made a debit entry on the cash book reading: "Surplus exchange to stockholders for new stock, $ 94,268.54," and credited the account of each stockholder with his share. Each account was also credited with salary due the stockholder, interest on the credit balance, a 4 per cent dividend on the stock held, and in some instances a gift from George T. Lester, Sr. At the same time each account was debited for an amount of new stock issued to the stockholder. New stock amounting to 1,971 shares was issued to the stockholders. Thirty shares were issued to Victor Lester in exchange for his note for $ 3,000. Victor*278 Lester was not previously a stockholder. The remaining shares were charged at par to the accounts of the stockholders. The amounts of surplus credited and of stock charged to each were as follows: Distribution Total value Shares prior to per books, new stock issued 12/20/43 12/20/43 Christine Lester [195] $ 6,068.79 $ 12,500 Darwin Lester [240] 7,469.28 20,000 Doris Lester [195] 6,068.79 12,500 Geo. T. Lester, Sr [275] 6,317.77 2,700 Lottie Lester [375] 11,670.75 32,500 Geo. T. Lester, Jr [340] 10,581.48 16,000 George W. Lester [168] 7,469.28 20,000 Lawson Lester [35] 1,089.27 1,500 Tilden Lester [240] 7,469.28 20,000 Myrtle Lester Bell [195] 6,068.79 12,500 Mable Lester Wells [195] 6,068.79 12,500 G. D. Oakley [285] 8,869.77 17,500 R. H. Oakley [51] 1,587.22 2,900 J. A. Richardson [100] 3,112.20 5,000 H. J. Turner [140] 4,357.08 6,000 Victor Lester 3,000 Total 3,029 94,268.54 197,100 In the distribution as recorded on the books a part of the surplus allocable to George T. Lester, Sr., was, at his direction, allotted to George W. Lester in order that the latter might acquire a larger number of new shares. The Lester Lumber Co. *279 had sufficient credit on December 20, 1943, to borrow cash in excess of $ 100,000. George T. Lester, Sr., acquired 300 shares of timberland in 1903 at a cost of $ 3,000. In 1943, desiring to make a gift to his wife and children, he deeded this land to the corporation, and in consideration thereof the corporation was to issue 300 shares of stock to his wife and children. Pursuant to this arrangement, $ 10,000 was credited to the account of Lottie Lester, his wife, and $ 20,000 was divided among *259 the accounts of his children for use in effecting purchase of the stock allotted to them. During and prior to the transfer of the land George T. Lester, Sr., realized $ 695.66 from the sale of timber cut from this land. He realized capital gain from this transaction. There was credited to the account of George T. Lester, Sr., and, with his knowledge, the amount of $ 10,160 for interest on the balance of his open account with the corporation. George T. Lester, Sr., failed to report on his income tax for 1943 any amount for this credit of interest or on account of gain resulting from this sale of land. A part of the deficiency in Docket No. 17486 was due to negligence or intentional*280 disregard of rules and regulations, but without intent to defraud. OPINION. Immediately prior to December 20, 1943, the Lester Lumber Co. had authorized common capital stock of 5,000 shares, par value $ 100 each, of which 3,029 were outstanding and 1,971 were unissued, and it had a surplus of at least $ 94,268.54. The stock was held by 15 individuals, each of whom had an open account on the corporation's books. As of December 20, 1943, there was credited to each stockholder's account a 4 per cent dividend on his stock, interest on his credit balance at 6 per cent, and a share of the surplus, and, in some cases, an amount representing a gift from George T. Lester, Sr. Each account was charged with the par value of a part of the previously unissued stock then issued and allotted to these stockholders. Except for 30 shares issued to Victor Lester for his note, the entire 1,971 shares were issued and charged to the several accounts at par value. The individual petitioners contend that, to the extent of the surplus, this was a nontaxable stock dividend, the balance of the stock issued being purchased for cash. Respondent contends that the crediting of the surplus to the stockholders*281 was equivalent to a cash dividend and the 1,971 shares were all sold for cash. Respondent relies upon the wording of the minutes of the meeting of the stockholders of December 20, 1943, to the effect that "all stock was bought by stockholders, increasing capital stock of Company to $ 500,000, all common stock. * * * The stock was all sold for cash to give the corporation more working capital." Respondent also points out that the surplus was credited to the stockholders' open accounts and the stock was charged to such accounts without distinction as to what portion of the credit balance applied to the stock represented interest, wages, gifts, dividends, or surplus, and that there was no declaration of a stock dividend. Respondent argues that from the moment the surplus was credited to the stockholders it became their property; that each stockholder understood the corporation's capital stock was to be increased and each stockholder's account was *260 to be charged with the par value; and that by leaving his share of the surplus in the account he had the benefit of offsetting against the stock the amount of the dividend constructively paid to, and received by, him. The individual*282 petitioners introduced testimony to the effect that the stockholders agreed to have the corporation issue at par the remaining authorized stock, 1,971 shares, for the pro rata share of each stockholder in the surplus and other amounts to their credit on the books. The purpose, it was said, was to put the corporation in a better credit position by tying up the surplus in capital so it could not be withdrawn and by reducing the credit balances of the stockholders on which the corporation had been paying interest at 6 per cent. The witnesses said that, although generally the stockholders could draw upon their accounts at any time, the credits for surplus were not subject to withdrawal, as they were intended to be applied against the charges for new stock, and that none of the stockholders received, or could receive, cash for his share of the surplus. George T. Lester, Jr., testified also that he personally made the entries in the ledger accounts of the stockholders, posting the various credits and the debit for issued stock at the same time, and the stockholders at no time had the opportunity to draw upon their accounts for the credits entered as their shares of the surplus. Petitioners*283 introduced as an exhibit a list of the stockholders, showing as to each the number of shares held prior to December 20, 1943, the distribution of surplus credited to his account on the books, and the face value of the new shares charged to his account, as shown in our findings of fact. The debit for new stock exceeded the credit for surplus in all cases except one. In that case George T. Lester Sr., received a credit for $ 6,317.77 of the surplus and was charged with $ 2,700 as the par value of the new stock issued to him. Why he did not receive stock to the full extent of his credit for surplus is not explained. We have pointed out the necessity of a declaration as requisite to a finding of a nontaxable stock dividend. J. Weingarten, Inc., 44 B. T. A. 798; Humphreys Manufacturing Co., 45 B. T. A. 114. Here we have no declaration, unless the understanding of the stockholders related by the witnesses will serve the purpose. There was no resolution of the board of directors on this subject, and under the Virginia Code (1919), sec. 3840, the directors have the sole power to declare dividends unless otherwise provided *284 by the certificate of incorporation. The exact terms of the arrangement are left to conjecture, and upon the critical point, whether the stockholders, or any of them, could elect to receive cash, the petitioners' own exhibit contradicts the oral testimony. Compare the two distributions involved *261 in Southeastern Finance Co., 4 T. C. 1069, pp. 1090-1091. We have held in several cases that an agreement among stockholders to distribute surplus and use it to purchase stock is a private arrangement, is not imputed to or binding upon the corporation, and does not amount to a declaration of a nontaxable stock dividend, Eugene E. Paul, 2 B. T. A. 150; W. J. Hunt, 5 B. T. A. 356; Harry Makransky, 35 B. T. A. 395; F. Brody & Sons Co., 11 T. C. 298. There being no record of a resolution of the board of directors authorizing a stock dividend, we are unable to make a finding that such a dividend was declared. However, even if the individual petitioners' oral testimony is accepted as satisfying the requirement that a stock dividend was*285 declared, the evidence does not justify the conclusion that the issuance of stock for the surplus was a nontaxable distribution. The individual petitioners' case depends upon the premise that the credits made for surplus to the accounts of the stockholders were not subject to withdrawal, but were required to be applied to the stock issued to capitalize this surplus. It is clear that the crediting of the surplus to the individual accounts would be a taxable dividend if there had been no concurrent issue of stock. Likewise, if all the stockholders had an election to take their shares in cash or in stock, the distribution would be taxable. While the individual petitioners contend they had no such election, the facts contradict this. George T. Lester, Sr., was entitled to a pro rata credit of $ 8,558.55 of the surplus. The amount credited to his account was $ 6,317.77, the difference representing a gift by him to his son, George W. Lester, to enable the latter to acquire more stock. Only $ 2,700 was charged to George, Sr.'s, account for new stock, and $ 3,617.77 remained to his credit and no more stock was available to absorb it. This balance was at his disposal and could be drawn*286 in cash. The proportionate interest of each stockholder in voting power and net worth was thereby changed. Harry Makransky, supra.This stockholder exercised dominion and control over his pro rata share of the surplus, giving part of it to a son, using part to acquire stock, and retaining part as an open credit available for his use. If one stockholder had the right to dispose of his share of the surplus as he saw fit, all the stockholders had this right, as a corporation can not discriminate between stockholders as to their rights in a distribution of profits. Fletcher on Corporations, § 5352. The corporation could not authorize a cash dividend to one stockholder and a stock dividend to others. See Harry Makransky, supra.This is consistent with the minutes of the stockholders' meeting, which state the stock was all sold for cash. Lack of cash, suggested by the witnesses as a reason for denying the existence of such a choice on the part of the stockholders, is not a sufficient ground, for it is clear the corporation's credit was sufficient to enable it to borrow to the extent *262 of the surplus. See Eugene E. Paul, supra.*287 The evidence does not establish that the stockholders had no choice in the matter. Furthermore, even if the other stockholders had no choice, the fact that George T. Lester, Sr., had an election to receive stock or other property for his share of the surplus or a part thereof, requires a conclusion, pursuant to section 115 (f) (2) of the code, 2 that the distribution of surplus constitutes a taxable dividend in the hands of all the stockholders. *288 We conclude that the distribution of the surplus was a taxable dividend to the stockholders. In the case of Lester Lumber Co., Docket No. 17788, respondent issued a notice of deficiency as a protective measure in case the surplus distribution was held to be a nontaxable stock dividend. In that notice the respondent determined that the excess profits credit for the company for the year 1943, based on invested capital, should be adjusted to eliminate $ 142,757.05 representing cash constructively received for stock issued December 20, 1943, and to restore to accumulated earnings and profits the distribution to its stockholders of $ 94,268.54. In view of our decision as to the dividend, decision will be entered for the petitioner in Docket No. 17788. In the case of George T. Lester, Sr., Docket No. 17486, respondent contends that the petitioner is liable for a 5 per cent penalty under the provisions of section 293 (a), Internal Revenue Code, for negligence in failing to report interest of $ 10,160 credited to his account on the company's books and capital gain of $ 13,847.83 realized from the sale of land to the company. Petitioner was aware that the interest was credited to his account. *289 His explanation as to that item is that his return was prepared by an attorney, as he considered the income tax law too complicated to undertake its preparation himself. As to the sale of land, he testified that, wishing to make a gift to members of his family, he deeded the land to the company in exchange for stock to be issued to members of his family, and considered that he did not realize gain from the transaction. Section 293 (a) provides that: * * * If any part of any deficiency is due to negligence, or intentional disregard of rules and regulations but without intent to defraud, 5 per centum of *263 the total amount of the deficiency (in addition to such deficiency) shall be assessed, collected, and paid in the same manner as if it were a deficiency * * *. While petitioner had his return prepared by an attorney, he did not explain whether he informed the attorney of the interest item or the sale of the land. Petitioner was aware of the crediting of interest and the omission from his return of $ 10,160 on this account was negligence. Since some part of the deficiency was due to negligence, the assertion of the penalty must be approved, and it is not necessary to decide*290 whether the failure to report capital gain was negligent. Decision will be entered for the petitioner in Docket No. 17788. Decision will be entered for the respondent in the other dockets. Footnotes 1. Proceedings of the following petitioners are consolidated herewith: Christine Lester; Darwin Lester, (Deceased); Doris Lester; G. T. Lester, Jr., and Annie Lester; George T. Lester, Sr.; George W. Lester; Lottie Lester; Tilden Lester; George D. Oakley and Julia Oakley; Robert H. Oakley and Lula P. Oakley; J. A. Richardson and Ida Z. Richardson; Henry J. Turner and Ruth Turner; Leslie E. Wells and Mable Lester Wells; and Robert E. Bell and Myrtle Bell.↩ 2. (f) Stock Dividends. -- (1) General rule. -- A distribution made by a corporation to its shareholders in its stock or in rights to acquire its stock shall not be treated as a dividend to the extent that it does not constitute income to the shareholder within the meaning of the Sixteenth Amendment to the Constitution. (2) Election of shareholders as to medium of payment. -- Whenever a distribution by a corporation is, at the election of any of the shareholders * * *, payable either (A) in its stock * * *, of a class which if distributed without election would be exempt from tax under paragraph (1), or (B) in money or any other property * * *, then the distribution shall constitute a taxable dividend in the hands of all shareholders, regardless of the medium in which paid.↩