Nelson v. Commissioner

R. E. Nelson, et al., 1 Petitioners, v. Commissioner of Internal Revenue, Respondent Nelson v. Commissioner Docket Nos. 32013, 32014, 32015, 32016, 32017 United States Tax Court 19 T.C. 575; 1952 U.S. Tax Ct. LEXIS 7; December 30, 1952, Promulgated *7 Decisions will be entered under Rule 50. Distribution of cash by corporation to petitioners constituted payment of a taxable dividend and not repayment of a loan. D. H. Markstein, Esq., for the petitioners. Frederick T. Carney, Esq., for the respondent. Arundell, Judge. ARUNDELL *575 The respondent has determined deficiencies in income taxes and penalties for the calendar year 1946 as follows: Docket Name No. Deficiency R. E. Nelson 32013 $ 3,922.86 Lillie L. Nelson 32014 75.62 Ouida Nelson Cagle 32015 77.40 Gordon Earl Wood 32016 275.00 Gordon H. Wood, Testamentary Trust, R. E. Nelson, Trustee, u/w Gordon H. Wood 32017 478.21 Negligence Delinquency Name penalty penalty R. E. Nelson $ 196.14 Lillie L. Nelson $ 18.90 Ouida Nelson Cagle 3.87 Gordon Earl Wood 68.75 Gordon H, Wood, Testamentary Trust, R. E. Nelson, Trustee, u/w Gordon H. Wood 119.55 The deficiencies and penalties result from the respondent's controverted determination that sums received from a corporation constituted taxable dividends rather than repayment of a loan. FINDINGS OF FACT. The petitioners filed income tax returns for the taxable year*8 in question with the collector of internal revenue for the district of Alabama at Birmingham, Alabama. The petitioner in Docket No. 32016 is an individual residing in Tuscaloosa, Alabama. The petitioners in Docket Nos. 32013, 32014, 32015, and R. E. Nelson, Trustee of the petitioner in Docket No. 32017, the Gordon H. Wood Testamentary Trust, are individuals residing in Birmingham, Alabama. In the latter part of 1936, the petitioner R. E. Nelson, one Gordon H. Wood, and one W. H. Wood formed a partnership. The partnership was dissolved in April 1937 at which time it had a net worth of $ 22,360.56. In April 1937 the petitioner R. E. Nelson, Gordon H. Wood, and W. H. Wood organized the Wood Distributing Company, hereinafter referred to as the Wood Company, an Alabama corporation, to engage in the wholesale distribution of beer. The sale of beer had just been legalized in Alabama. *576 The organizers, the members of the dissolved partnership, paid in, in cash, $ 22,360.35 to the Wood Company. Of this total sum, $ 2,000 (the minimum under the Alabama law) was contributed for capital stock and each of the organizers received in turn 6 2/3 shares of the total capital stock consisting*9 of 20 shares of common with a par value of $ 100. The balance transferred to the Wood Company by the organizers, namely, $ 20,360.56, was denominated and carried on the books of account as Donated Surplus. The corporation was capitalized in this manner upon the advice of an accountant who recommended that only $ 2,000 be contributed for capital stock in order to minimize the annual franchise tax due the State of Alabama, and the balance should be carried on the books of account as Donated Surplus. The accountant also pointed out that in the event the sale of beer again became illegal in Alabama, money contributed for capital stock could not be immediately withdrawn but instead it would be necessary first to liquidate the corporation. He advised against the amount of $ 20,360.56 being carried as a loan or liability because it would jeopardize the credit rating of the corporation. The organizers followed the advice of the accountant and $ 2,000 was treated on the books as capital and the $ 20,360.56 was denominated and carried on the books of account as Donated Surplus. The $ 20,360.56 was transferred to the corporation with the oral agreement that the corporation was to return *10 it if and when it had sufficient earnings and could do so without jeopardizing its credit standing. There were no corporate minutes evidencing the agreement and no note or other evidence of indebtedness was issued to the organizers, nor was there any due date for repayment, nor was interest to be paid. The $ 20,360.56 was also carried on the corporation's balance sheets as Donated Surplus and the amount was included by the corporation as part of its equity invested capital in computing its excess profits tax. A certified public accountant who prepared the excess profits tax returns was never informed that the $ 20,360.56 was anything other than what it was designated on the books of account. The agreement further provided that the sum, or any part thereof, that was thereafter distributed was to be distributed to whomever held the stock of the corporation at the time of the distribution in an amount proportionate to their stock holdings. A purchaser of the stock was entitled to a proportionate share of the sum regardless of whether the seller took into account the value of the interest in the sum in determining the selling price. In December 1938, $ 2,400 was debited to the Donated*11 Surplus Account and $ 800 was distributed to each of the three organizers who at *577 that time were still the sole stockholders of the corporation. The balance in the Donated Surplus Account thereafter was in the amount of $ 17,960.56, which amount continued in the account until December 1946. Gordon H. Wood, one of the organizers, died in 1941 and his 6 2/3 shares of the Wood Company's stock were thereafter transferred to Roy E. Nelson, Trustee of the Gordon H. Wood Testamentary Trust. The petitioner Gordon Earl Wood was beneficiary of the trust. In 1943, the petitioner R. E. Nelson, acting in his individual capacity and not as trustee, purchased 5 2/3 shares of the Wood Company's stock held by W. H. Wood for $ 10,000. The petitioner R. E. Nelson transferred some of the shares he held in the Wood Company to his wife, the petitioner Lillie L. Nelson, and his daughter, the petitioner Ouida Nelson Cagle. In each of the years 1942, 1943, and 1944, the Wood Company paid dividends to its stockholders, which were reported by them as taxable income. The accountant, who recommended the form of capitalization of the Wood Company, advised that the sums should be distributed as dividends*12 rather than as a distribution of part of the sum carried on the books of account as Donated Surplus. At a meeting of the board of directors of the Wood Company on December 10, 1946, the following resolution was passed: That the donated surplus be repaid the stockholders, per stock records on company books as of Nov. 20, 1946, since it could be done without jeopardizing the credit standing of the company and would not hurt it financially. In December 1946, the Wood Company, then named the Hudepohl Distributing Company, 2 distributed $ 17,960.49 to the following individuals who were its stockholders at that time, and debited the Donated Surplus Account by that amount: R. E. Nelson $ 8,381.61 R. E. Nelson, Trustee Gordon H. Wood Trust 5,088.78 Lillie L. Nelson 898.02 Ouida Nelson Cagle 898.02 F. R. Gossman [not a petitioner] 2,694.06 $ 17,960.49 *13 The earned surplus and undivided profits of the Wood Company at the time of the distribution of the $ 17,960.49 was in an amount substantially in excess thereof and totaled on December 31, 1946, $ 31,653.36. *578 On December 31, 1938, and December 31, 1939, there were deficits of $ 12,366.53 and $ 9,390.93 in the earned surplus and undivided profits account of the Wood Company. At the end of each of those years, the remaining capital accounts consisted of capital stock in the amount of $ 2,000 and Donated Surplus in the amount of $ 17,960.56. Throughout the period of its existence, the Wood Company needed a substantial amount of cash and credit to finance its operations. It purchased 5 to 20 carloads of beer per month at a cost of $ 1,600 and up per carload. In some instances the purchases had to be paid for upon receipt and in other instances they were purchased upon open account with two weeks to 30 days in which to make payment. The Wood Company would in turn sell only for cash as it was required to do under Alabama law. It would usually dispose of its purchases within a week or 10 days before the amount owing to the brewers for credit purchases became due. The sum of*14 $ 20,360.56 transferred to the Wood Company by its organizers in 1937 and carried on the books of account as Donated Surplus constituted at that time and throughout the years 1937 through 1946 an investment in the corporation, that is, a contribution to the capital account of the corporation, and was not a loan. The distribution of $ 17,960.49 by the Wood Company to its stockholders in 1946 constituted a taxable dividend and not the repayment of a loan. The petitioners were advised by their accountant, who had recommended the form of capitalization of the Wood Company, that the distribution constituted repayment of a loan and did not constitute taxable income. He had prepared the Wood Company's income tax returns for several years and was conversant with tax matters. Also, he was fully apprised of the facts relating to the distribution. The petitioners, relying in good faith on his advice, did not report any of the distribution they received. The failure of the petitioners, in Docket Nos. 32014, 32016, and 32017, to make and file returns for the calendar year 1946 was due to reasonable cause and not due to willful neglect. The deficiency in Docket Nos. 32013 and 32015 was not *15 due to negligence or intentional disregard of rules and regulations. OPINION. The question before us is whether the sum of $ 17,960.49, distributed by the Wood Company to its stockholders in 1946, constituted a dividend or repayment of a loan. In support of their contention that the distribution constituted repayment of a loan, the petitioners allege that this sum, plus approximately $ 2,400 which *579 is not in issue, was loaned to the Wood Company by its organizers in 1937 upon incorporation. The incorporation of the Wood Company in 1937 followed the dissolution of a partnership composed of its three organizers, R. E. Nelson, Gordon H. Wood, and W. H. Wood. These individuals paid into the corporation $ 22,360.56 in cash, of which some $ 2,000 was designated capital stock. The remaining $ 20,360.56 was entered on the corporate books as Donated Surplus. Each of the organizers received 6 2/3 shares of the total capital stock consisting of 20 shares of common with a par value of $ 100. The petitioners contend that the parties to the transaction intended a loan of the $ 20,360.56 to the Wood Company. However, as has been stated in numerous cases where the question was whether*16 the transfer of sums to a corporation by its stockholders constituted a loan or contribution to capital, the intention of the parties is relevant; but an allegation that the parties intended a loan is not conclusive and must yield to the facts when they disclose a contrary intent. Isidor Dobkin, 15 T. C. 31, affd., per curiam, 192 F. 2d 392; Erard A. Matthiessen, 16 T. C. 781; Sam Schnitzer, 13 T. C. 43; cf. Edward G. Janeway, 2 T. C. 197. We think this principle is particularly applicable here when in addition to the usual facts indicating that the transfer did not constitute a loan there is an admittedly double intention. Although it is contended the parties to the transaction intended a loan, it is at the same time admitted that they intended that the corporation was to return the sum only if and when it had earned and accumulated sufficient funds and could make the distribution without jeopardizing its credit standing. Furthermore, the sum was to be repaid, not to the alleged lenders, but to whomsoever were the stockholders of*17 the Wood Company at the time of the distribution, and the distribution was to be in proportion to their stockholdings. The interest in this sum followed the stock certificates and was the property of the stockholder even if the buyer and seller of the stock failed to take into account the value of this interest when fixing the sales price of the stock. As explained in our findings, the holdings of two of the original stockholders were by devise and inter vivos transfer acquired by some of the petitioners herein who continued to be stockholders in 1946 and shared in the distribution in question. It is difficult to conclude that a transfer made under these circumstances constituted a loan. Another of the factors indicating that the transfer in 1937 was a contribution to capital is the obviously inadequate capitalization that would have existed if the transfer constituted a loan. The corporation's only capital in that event would have been the $ 2,000 contributed for capital stock. The Wood Company purchased 5 to 20 *580 carloads of beer per month at a cost of $ 1,600 and up per carload. Even after taking into account the fact that some of its purchases were on credit *18 and all of its sales were for cash, we think it is clear that the corporation could not have operated with capital of only $ 2,000. We think the stockholders had every reason to believe that the $ 2,000 contributed for capital stock was only a fraction of the minimum requirement for operating. Cf. Sam Schnitzer, supra;Alfred R. Bachrach, 18 T. C. 479. As we pointed out in Edward G. Janeway, supra, when there is an obviously inadequate capitalization, a strong inference arises that a sum transferred to a corporation by its stockholders and called a loan is really risk capital. Cf. Hilbert L. Bair, 16 T. C. 90. Among other significant factors is the fact that there is no note or other evidence of the alleged indebtedness, and the alleged loan bore no interest and had no due date. See Erard A. Matthiessen, supra. Moreover, the sum in question was referred to not as a loan or form of indebtedness but from the time of the incorporation of the Wood Company it was referred to as Donated Surplus and was carried as such on the corporation's*19 books of account and balance sheets. In addition, it was included as part of the corporation's equity invested capital in the corporation's excess profits tax returns. Finally, there is present here an important factor stressed in several cases where it was found that the transfer of funds by a stockholder to a corporation constituted a contribution to capital. That factor is the equal proportion between the sum transferred and the stock issued. As we have explained above, each of the original stockholders in the instant case transferred one-third of the sum in question and each received one-third of the capital stock in return. See Isidor Dobkin, supra;Edward G. Janeway, supra;Hilbert L. Bair, supra. What we have set forth above is sufficient to distinguish Weaver v. Commissioner, 58 F. 2d 755, the main authority relied on by the petitioners. There the corporation was organized with a subscribed capital stock in the sum of $ 200,000 and the sum in question, which was not transferred until approximately five years later, totaled $ 100,000, or one-half of the*20 capital stock. Moreover, the sum was to be returned to the lenders, not as here to the stockholders at the time of the distribution; and, in addition, the sum was in fact returned to the lenders in the exact amount loaned. Taking together the double intention and the other factors we have discussed above, we think it is clear that the transfer in 1937 did not constitute a loan but was, instead, a contribution to capital. Therefore, the distribution of $ 17,960.49 by the Wood Company to its stockholders in 1946 did not constitute repayment of a loan. Since the petitioners have offered no other argument in opposition to the *581 respondent's determination that the distribution was out of the Wood Company's earnings and profits and therefore a taxable dividend, we must sustain the respondent. Section 115 (a) and (b), Internal Revenue Code. The next issue is whether the failure of three of the petitioners to make and file returns for the taxable year 1946 was "due to reasonable cause and not due to willful neglect"; 3 and whether any part of the deficiency in the 1946 income tax liability of the two remaining petitioners was "due to negligence, or intentional disregard of rules*21 and regulations." 4 The deficiency in the case of all of the petitioners results solely*22 from the failure to report the distribution in question as taxable income in 1946. The petitioners, acting in good faith, relied on the advice of an accountant who had advised them that the distribution constituted repayment of a loan and was not taxable income. The accountant had recommended the form of capitalization of the Wood Company and had prepared its Federal income tax returns for several years. He was conversant with tax matters and was fully apprised of the facts relating to the distribution. Under these circumstances, we think it is clear that no part of the deficiency was due to negligence or intentional disregard of rules and regulations; and, further, that the failure of three of the petitioners to file 1946 income tax returns was due to reasonable cause and not due to willful neglect. Commissioner v. Lane-Wells Co., 321 U.S. 219; Reliance Factoring Corp., 15 T. C. 604; Rhett W. Woody, 19 T. C. 350. Decisions will be entered under Rule 50. Footnotes 1. Proceedings of the following petitioners are consolidated herewith: Lillie L. Nelson, Docket No. 32014; Ouida Nelson Cagle, Docket No. 32015; Gordon Earl Wood, Docket No. 32016; Gordon H. Wood, Testamentary Trust, R. E. Nelson, Trustee, u/w Gordon H. Wood, Docket No. 32017.↩ 2. The corporate name was changed to Hudepohl Distributing Company on January 1, 1944. Wood Company will hereinafter be used to designate both the Wood Distributing Company and its successor, the Hudepohl Distributing Company.↩ 3. SEC. 291. FAILURE TO FILE RETURN. In case of any failure to make and file return required by this chapter, within the time prescribed by law or prescribed by the Commissioner in pursuance of law, unless it is shown that such failure is due to reasonable cause and not due to willful neglect, there shall be added to the tax: 5 per centum if the failure is for not more than thirty days with an additional 5 per centum for each additional thirty days or fraction thereof during which such failure continues, not exceeding 25 per centum in the aggregate.↩ 4. SEC. 293. ADDITIONS TO THE TAX IN CASE OF DEFICIENCY. (a) Negligence. -- 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 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 * * *.↩