P. G. Lake, Inc. v. Commissioner

P. G. Lake, Inc., Petitioner, v. Commissioner of Internal Revenue, Respondent P. G. Lake, Inc. v. Commissioner Docket No. 1630 United States Tax Court 4 T.C. 1; 1944 U.S. Tax Ct. LEXIS 62; September 15, 1944, Promulgated *62 Decision will be entered under Rule 50. Petitioner, a corporation on the calendar year accrual basis, accrued interest on an obligation owing to its president and controlling stockholder, which interest was payable January 1. The interest was not actually paid within the taxable year or within two and one-half months after the close thereof. The president filed his return on the calendar year cash receipts and disbursements basis. Held, the deduction of the amount of interest accrued but unpaid is precluded by the provisions of section 24 (c) of the Internal Revenue Code. Harry C. Weeks, Esq., for the petitioner. Loyal E. Keir, Esq., for the respondent. Arundell, Judge. ARUNDELL *1 This proceeding involves a deficiency in income tax for the year 1939 in the amount of $ 7,816.26. The sole question presented is whether section 24 (c) of the Internal Revenue Code prohibits the deduction of an amount otherwise deductible as accrued interest under section 23 (b). FINDINGS OF FACT. The petitioner, P. G. Lake, Inc., is a corporation chartered under the laws of Delaware and engaged in the business of oil production. Its principal office is at Tyler, Texas. The*63 return for the taxable year here involved was filed on the calendar year accrual basis with the collector of internal revenue for the second district of Texas. P. G. Lake, president and one of the directors of petitioner, and actively in charge, owned 60 percent of petitioner's stock. The balance was owned by his children or by trusts created by Lake for the benefit of his children. Lake kept his books and made his returns on the calendar year cash receipts and disbursements basis. In 1936 petitioner became indebted to Lake in the amount of $ 1,950,000 on account of a purchase of stock from him. This indebtedness was evidenced by 20 notes. One in the amount of $ 50,000 became *2 due and was paid in 1936. The remaining notes, each in the principal sum of $ 100,000, were payable serially on January 1 of each year thereafter for 19 consecutive years, beginning January 1, 1937. Each of the notes bore interest at the rate of 3 1/2 percent per annum, payable on January 1 of each year. Petitioner accrued the interest monthly, crediting a ledger account designated "accrued interest payable" with the amount of the accrual the first day of each month. The amounts credited to this*64 account represented only interest accrued upon the indebtedness owing Lake, and petitioner did not accrue interest in favor of any other creditor. On December 31, 1939, the accrued interest payable account showed a credit balance of $ 55,844.45. On May 17, 1940, petitioner paid Lake by check the amount of $ 156,000, representing principal in the amount of $ 100,000 and interest of $ 56,000. The interest was composed of $ 55,844.45 accrued to December 31, 1939, plus $ 155.55 accrued on January 1, 1940. No entry prior to May 17, 1940, reflecting payment of this amount of interest was made on petitioner's books. Interest in the amount of $ 165.31 on account of one day, January 1, 1939, had previously been paid on November 2, 1939. In filing its return for the year 1939 petitioner deducted from gross income interest in the amount of $ 56,009.76, consisting of $ 55,844.45 shown as a credit balance in the accrued interest payable account as of the close of the year and $ 165.31 paid on November 2, 1939. Lake and his wife filed tax returns for the year 1940 on the community property basis, together reporting the item of $ 56,000 interest. Since commencing operations petitioner had maintained*65 an open account receivable carried in Lake's name, representing loans to Lake for personal reasons. The account was settled periodically, but at irregular intervals, by Lake's payment of the amount owing. On January 1, 1940, this account showed a balance due from Lake of $ 670.36. On March 15, 1940, the balance was $ 32,226.89. By the end of April 1940 the balance amounted to $ 55,762.09, and on May 17, 1940, Lake issued his check to petitioner in the amount of $ 55,815.20, discharging the then existing balance. The accrued interest payable account and the personal account in the name of Lake were kept separately and the balances were never offset against each other. As president of petitioner Lake was authorized to draw checks on petitioner's bank account and disburse funds for any proper purpose. No countersignatures were required. On January 1, 1940, the petitioner had on deposit a cash balance of $ 346,348.16. The lowest cash balance between that date and May 17, 1940, was $ 306,548.05. Except for the indebtedness due Lake, there were no commitments against this balance. The respondent disallowed the deduction of interest in the amount of $ 56,009.76, "in accordance with*66 the provisions of section 24 (c) of *3 the Internal Revenue Code." The respondent now concedes that the amount of $ 165.31 representing interest for one day, January 1, 1939, and paid on November 2, 1939, was properly deductible. The amount of interest now in controversy is $ 55,844.45, representing interest accrued from January 2, 1939, to December 31, 1939. OPINION. The sole question here involved is whether the deduction of accrued interest otherwise allowable by section 23 (b) of the Internal Revenue Code is barred by the provisions of section 24 (c). 1 The latter section operates to prohibit the deduction of accrued interest where three specified circumstances coexist. Michael Flynn Manufacturing Co., 3 T. C. 932. Under the method of accounting employed by Lake the amount of interest sought as a deduction in this proceeding by petitioner was not reported or reportable by Lake in his 1939 return. The petitioner and Lake are "persons between whom losses would be disallowed under section 24 (b)." The petitioner, however, contends that the amount in question was "paid within the taxable year or within two and one-half months after the close*67 thereof." If this contention is sound the determination of the Commissioner must fall, for one of the essentials specified in section 24 (c) is absent; otherwise the determination must be sustained. Fincher Motors, Inc., 43 B. T. A. 673. *68 There was, as is apparent, no actual payment in cash or otherwise within two and one-half months after the close of 1939. Petitioner bases his contention upon the theory that there was a constructive payment. The statute, however, is plain in the requirement that the amount must be "paid." There is nothing in either the words of the statute or in its legislative history 2 to indicate that anything less than actual payment is sufficient. The whole purpose of the statute is to prohibit the deduction of accrued but unpaid amounts owing to one in control of a corporation. To hold that the expenses are deductible merely if accrued and within the control of the creditor is nothing less than to ignore the statute completely, because this is *4 precisely the type of situation the statute envisages. Petitioner relies upon Musselman Hub-Brake Co. v. Commissioner, 139 Fed. (2d) 65, in this connection. Although certain language in that case may be taken to lend support to the position of petitioner, the decision would seem to be based fundamentally upon the fact that notes of a cash value equal to the deduction claimed by the debtor were issued within*69 the limited period. That circumstance is not present in this case. Further, the facts of this case do not warrant the application of the doctrine of constructive payment, were such considered to be a sufficient compliance with the statute: "Constructive payment is a fiction applied only under unusual circumstances * * *." Fincher Motors, Inc., supra. In that case the president of a corporate taxpayer was entitled to a bonus for the year 1939. The amount of the bonus was ascertained after the close of the year and the board of directors determined the amount to be due and payable and ordered the payment "forthwith." Except for a minor portion, the amount was not actually paid until after the expiration of the two and one-half month period, although the corporation at all *70 times in that period had sufficient cash available to pay the bonus. The corporation contended that there was a constructive payment of the amount within the taxable year or within the two and one-half months after the close thereof, but the contention was rejected. That case is perhaps stronger on the facts than the present, inasmuch as there the amount had been ordered to be paid forthwith to the creditor. Here there is nothing more than a mere accrual of the amount due upon the books of the corporation. The amount was not ordered to be paid, nor was it credited to Lake on the books of the petitioner, nor was there any other manifestation of intention on the part of petitioner to put the amount beyond its control and within the control of Lake. It may be noted that the Circuit Court of Appeals for the Sixth Circuit in the Musselman Hub-Brake case was careful to point out that "the notes with a readily realizable value of par were more than a mere accrual of indebtedness on the books of petitioner." Petitioner, arguing from the Michael Flynn Manufacturing Co. case, contends that the amount here in question was constructively received prior to March 15, 1940, wherefore, *71 it must be held to have been likewise paid within that period. However, the fact that an amount is deemed to have been constructively received does not compel the conclusion that it was also "paid" within the meaning of the statute. Cox Motor Sales Co., 42 B. T. A. 192. Nor does the Michael Flynn Manufacturing Co. case suggest that an amount includible in gross income under subdivision (2) is to be considered "paid" under subdivision (1). In fact, the instant case is not within *5 the rule of Michael Flynn Manufacturing Co. There the attention of the Court was directed exclusively to subdivision (2) of section 24 (c), dealing with the situation where an unpaid amount is "includible in the gross income" of the creditor for the taxable year in which or with which the taxable year of the taxpayer ends. In the instant case the amount sought as a deduction was not due and payable to Lake until after the close of his taxable year which, with that of petitioner, ended December 31. Therefore, it could not have been includible in his gross income for that year. The petitioner contends alternatively that the amount of interest accrued on December*72 31, 1939, was actually paid within the two and one-half month period to the extent of advances to Lake in that period amounting to $ 32,226.89. However, it is apparent from the treatment of this account by the parties that it was not considered a payment of the accrued interest, but was an entirely separate item. No offset against the account payable to Lake was employed as the advances were made or when Lake was paid the accrued interest. On May 17 the entire amount due Lake on account of accrued interest for the year 1939 was paid by check and then he in turn paid the amount he owed to petitioner by check. This was the consistent policy in the treatment of the two accounts. Counsel for petitioner states on brief that "The whole course of dealings show that he intended that one account would off-set the other to the extent of the smaller account." We think the whole course of dealing shows clearly the exact opposite. We hold, therefore, that the determination of the Commissioner must be sustained in so far as the deduction of interest in the amount of $ 55,844.45 is concerned. Decision will be entered under Rule 50. Footnotes 1. SEC. 24. ITEMS NOT DEDUCTIBLE. * * * * (c) Unpaid Expenses and Interest. -- In computing net income no deduction shall be allowed under section 23 (a), relating to expenses incurred, or under section 23 (b), relating to interest accrued -- (1) If such expenses or interest are not paid within the taxable year or within two and one half months after the close thereof; and (2) If, by reason of the method of accounting of the person to whom the payment is to be made, the amount thereof is not, unless paid, includible in gross income of such person for the taxable year in which or with which the taxable year of the taxpayer ends; and (3) If, at the close of the taxable year of the taxpayer or at any time within two and one half months thereafter, both the taxpayer and the person to whom the payment is to be made are persons between whom losses would be disallowed under section 24 (b)↩. 2. Report of Joint Committee on Tax Evasion and Avoidance, 75th Cong., 1st sess., p. 15; Report of Committee on Ways and Means, 75th Cong., 1st sess., p. 29; Report of Finance Committee, 75th Cong., 1st sess., p. 31.↩