Palm Beach Trust Co. v. Commissioner

Palm Beach Trust Company, Petitioner, v. Commissioner of Internal Revenue, Respondent Palm Beach Trust Co. v. Commissioner Docket No. 9569 United States Tax Court 9 T.C. 1060; 1947 U.S. Tax Ct. LEXIS 28; November 28, 1947, Promulgated *28 Decision will be entered under Rule 50. 1. Petitioner, a private trust company, held not a "bank," within the definition of Internal Revenue Code, section 104, and not relieved of status as a personal holding company. 2. Interest on municipal obligations held exempt from Federal income tax, notwithstanding collection through sale. 3. Penalty for failure to file personal holding company return held proper on failure of petitioner to carry burden of proving reasonable cause and lack of willful neglect. B. H. Bartholow, Esq., for the petitioner. Thomas R. Charshee, Esq., for the respondent. Opper, Judge. Johnson, Arundell, JJ., dissenting. OPPER *1061 This proceeding was brought for a redetermination of a deficiency of $ 9,912.96 in personal holding company surtax for 1941, and a penalty of $ 2,478.24. The litigated issues are whether petitioner is exempt from the status of "personal holding company" by reason of qualifying as a "bank" as that term is defined in Internal Revenue Code, section 104; whether a sale in 1941, of Miami 2 per cent certificates resulted in income received from the sale of a stock or security; and whether petitioner is liable for the 25 per cent penalty for its failure to file a personal holding company tax return for 1941. FINDINGS OF*30 FACT. All of the evidentiary facts are stipulated and are hereby found accordingly. Petitioner filed its corporation income and declared value excess profits tax return for 1941 with the collector of internal revenue for the district of Florida. Petitioner did not file a personal holding company return for the calendar year 1941. Petitioner's books of account have always been kept on the cash receipts and disbursements basis. Petitioner was incorporated on May 25, 1929, as a trust company under the laws of the State of Florida, with all the rights, powers, and privileges granted and conferred by the trust laws of that state regulating the organization, powers, and management of trust companies, except those powers relating to title insurance and receiving money on deposit subject to check. Petitioner's capital stock consisted of 1,000 shares of the par value of $ 100 per share, for which the subscribers paid $ 150 per share. The capital stock of petitioner was owned during 1941, as follows: Stockholder Shares owned John S. Phipps, president of petitioner [175] Henry C. Phipps, vice president of petitioner [200] Howard Phipps, vice president of petitioner [200] David T. Layman, Jr., secretary and treasurer of petitioner [15] R. C. Alley [10] Henry B. Martin trust [50] Townsend B. Martin trust [50] Esmond B. Martin trust [50] Alastair B. Martin trust [50] Amy Guest [200] Total 1,000 *31 *1062 A certificate of authority to commence the business of a trust company was granted to petitioner by the Comptroller of the State of Florida under date of September 22, 1930. The certificate states: It being expressly understood that this certificate of authority does not extend to a general banking business, neither does it include the acceptance of trust business from individuals, partnerships and corporations other than those who may be stockholders of the company. This certificate of authority was replaced by an amended certificate of authority under date of March 2, 1937, which provided that "the Palm Beach Trust Company of Palm Beach in the County of Palm Beach and the State of Florida, is authorized to commence the business of a trust company (without title insurance powers) under the name above given with a capital stock of one hundred thousand dollars. It being expressly understood that this amended Certificate of Authority does not extend to a general banking business, as provided for in Paragraph 17, of Section 6126, Compiled General Laws of Florida." During 1941 petitioner was subjected to supervision and examination by the authority of the State of Florida*32 having supervision over banking institutions. In reply to an inquiry from the state auditor, petitioner on January 4, 1941, advised that as of December 31, 1940, it had deposited $ 50,000 face amount of Palm Beach County bonds and $ 50,000 cash with the state treasurer; and that the deposit represented 25 per cent of its paid-in capital. The office of the Comptroller of the State of Florida made examinations of petitioner as of the close of business June 30, 1941, and December 13, 1941. Formal reports thereon were filed. During the years 1937 to 1944, inclusive, petitioner declared itself trustee and acted as trustee of various mortgages on Florida real estate for the benefit of various holders of trust certificates. The declarations of trust were evidenced by written trust agreements and trust certificates executed by petitioner. Petitioner maintained a journal and a ledger in which it recorded the transactions relating to the mortgages of which it had declared itself trustee. Petitioner regularly prepared and transmitted to the mortgagors bills for interest and principal as the same became due with respect to the mortgages. The unpaid principal with respect to the mortgages*33 as of January 1, 1941, amounted to approximately $ 300,000. During 1941 petitioner made approximately 50 collections aggregating approximately $ 90,000 on account of principal and interest with respect to the mortgages, and remitted these collections promptly to the beneficiaries named in the trust instruments, but rendered no bill and received no income for these services. Its officers received no *1063 salary in 1941 and petitioner did not receive any deposits from the general public. The beneficiaries of the trusts which petitioner administered during 1941 were for the most part children and grandchildren of two of petitioner's principal stockholders. Approximately 13 per cent of the mortgages which petitioner held in trust was held for Henry C. Phipps, Amy Guest, and Molly Phipps (wife of Michael G. Phipps, who is the son of John S. Phipps), and the remaining mortgages which the petitioner held in trust were held for the Bessemer Trust Co., which trust company was trustee for the following named individuals: John E. Phipps (grandson of John S. Phipps) Margaret Douglas (daughter of John S. Phipps) Michael G. Phipps (son of John S. Phipps) Hubert B. Phipps (son of John*34 S. Phipps) Molly Phipps (wife of Michael G. Phipps, who is the son of John S. Phipps) Sonia Phipps Farrell (daughter of Henry C. Phipps) Dita Gordon Douglas (granddaughter of John S. Phipps) Audrey Phipps Holden (daughter of Henry C. Phipps) Barbara Phipps Janney (daughter of Henry C. Phipps) John S. Phipps, Henry C. Phipps, and Howard Phipps were the principal organizers of petitioner. They were the owners of more than 50 per cent of the stock. They were the controlling members of the board of directors and were the president and vice presidents, respectively, of petitioner. Petitioner in 1941 had made no disposition of its income since its organization and had paid no dividends. The income of petitioner in the year 1941 was derived from the following sources: Interest on loans, notes, mortgages, bonds, bank deposits, etc $ 2,058.75 Gains on sales of securities, including gain on sale of Miami 2 per cent certificates (hereinafter mentioned) 12,534.70 Dividends 618.75 Total 15,212.20 Petitioner was a "personal holding company" in 1941 and not a "bank." Petitioner's failure to file a personal holding company tax return for 1941 was not due to reasonable cause, *35 but was due to willful neglect. Petitioner, in its corporation income and excess profits tax return for 1941, reported a net long term capital gain of $ 5,359.25 on the sale of Miami 2 per cent certificates of indebtedness, as follows: Sale price reported $ 10,276.50 Cost basis when acquired 4,917.25 Net long-term capital gain reported 5,359.25 In 1929 petitioner purchased $ 100,000 principal amount of Miami 6 per cent improvement bonds maturing July 1, 1934, to July 1, 1950 *1064 (hereinafter referred to as improvement bonds), half being purchased on October 11, 1929, and half on December 9, 1929. The city of Miami defaulted in making certain principal and income payments due on bonds issued by it (including the improvement bonds), and in 1934 adopted a plan for refunding its bonds. As of October 1, 1934, and in accordance with such refunding plan, the petitioner surrendered to the city of Miami the $ 100,000 principal amount of improvement bonds and received in lieu thereof a like principal amount of Miami 6 per cent refunding bonds maturing January 1, 1964 (hereinafter referred to as refunding bonds). Coupons for semiannual interest payable on January 1, *36 1935, and on all subsequent interest payment dates were attached to the refunding bonds. Under the refunding plan the city of Miami reserved the right to issue Miami 2 per cent certificates of indebtedness maturing January 1, 1947 (hereinafter referred to as certificates of indebtedness), with respect to all unpaid interest accrued on the outstanding improvement bonds up to the date of their surrender for refunding bonds and with respect to that part of the interest in excess of 3 per cent per annum accruing on the refunding bonds for the period from July 1, 1934, to January 1, 1936. The interest coupons attached to each $ 1,000 refunding bond received by petitioner, evidencing interest payable on January 1, 1935, July 1, 1935, and January 1, 1936, were in pairs designated as A coupons and B coupons, each being for $ 15 (i. e., semiannual interest on $ 1,000 at the rate of 3 per cent per annum). The city of Miami reserved the right to extend to January 1, 1947, the time for payment of the interest evidenced by the B coupons by issuing therefor its certificates of indebtedness maturing January 1, 1947. To evidence the past due interest on the improvement bonds for the 15-month period*37 from July 1, 1933, to October 1, 1934, petitioner received in 1934 certificates of indebtedness maturing January 1, 1947, in the face amount of $ 7,500 (i. e., a $ 75 certificate of indebtedness for each $ 1,000 improvement bond, evidencing interest thereon at 6 per cent per annum for 1 1/4 years). Of each such $ 75 certificate, $ 15 evidenced interest for the period from July 1 to October 1, 1934. The A coupons and B coupons for $ 15 each, payable January 1, 1935, which were attached to the refunding bonds also evidenced the interest for the period from July 1 to October 1, 1934 (as well as for the period from October 1, 1934, to January 1, 1935). To prevent a $ 15 duplication of the interest evidenced by the certificates of indebtedness and by the A and B coupons payable January 1, 1935, $ 5.50 of the interest evidenced by such A coupons was canceled by endorsement on the A coupons, and $ 9.50 of the interest evidenced by such B coupons was canceled by endorsement on the B coupons, leaving $ 5.50 as the amount of each B coupon payable *1065 January 1, 1935, which the city of Miami could either pay in cash or with respect to which it could issue certificates of indebtedness. *38 The city of Miami elected, in lieu of making payment in cash, to issue certificates of indebtedness to evidence the uncanceled semiannual interest covered by the B coupons payable January 1, 1935. Accordingly, petitioner received certificates of indebtedness maturing January 1, 1947, in the face amount of $ 550 (i. e., $ 5.50 per $ 1,000 bond). The city of Miami also elected, in lieu of making payment in cash, to issue certificates of indebtedness to evidence the semiannual interest covered by the B coupons attached to the refunding bonds which was payable July 1, 1935. Accordingly, petitioner received certificates of indebtedness maturing January 1, 1947, in the face amount of $ 1,500 (i. e., $ 15 per $ 1,000 bond). The city of Miami also elected, in lieu of making payment in cash, to issue certificates of indebtedness to evidence the interest covered by the B coupons attached to the refunding bonds which was payable January 1, 1936. Accordingly, petitioner received certificates of indebtedness maturing January 1, 1947, in the face amount of $ 1,500 (i. e., $ 15 per $ 1,000 bond). Petitioner received the 2 per cent interest on the certificates of indebtedness as the interest *39 accrued thereon. During 1941 petitioner sold all of the certificates of indebtedness it received under the refunding plan for $ 10,276.50. The face value of the certificates of indebtedness was $ 11,050, and the value thereof when received by petitioner was $ 4,917.25. No gain or loss was reported by the petitioner in its 1934 Federal income tax return on account of the exchange of the 6 per cent improvement bonds for the 6 per cent refunding bonds and the receipt of the 2 per cent certificates of indebtedness. OPINION. Whether petitioner is a personal holding company under section 501, Internal Revenue Code, depends entirely upon its ability to qualify as "a bank," within the excepting language of section 501 (b), the type of income actually received and the distribution of stock ownership being concededly otherwise encompassed by the defining provisions. For the definition of "a bank" we are referred to section 104, which is as follows: (a) Definition. -- As used in this section the term "bank" means a bank or trust company incorporated and doing business under the laws of the United States (including laws relating to the District of Columbia), of any State, or of any Territory, *40 a substantial part of the business of which consists of receiving deposits and making loans and discounts, or of exercising fiduciary powers similar to those permitted to national banks under section 11 (k) of the Federal Reserve Act, 38 Stat. 262 (U. S. C., Title 12, § 248k), as amended, and which is subject by law to supervision and examination by State, Territorial or Federal authority having supervision over banking institutions. *1066 Since petitioner is incorporated as a trust company under Florida law and is subject by law to supervision by the banking authorities of that state, but does not receive deposits nor make loans or discounts, the parties join issue in substance on whether "a substantial part" of petitioner's "business" consists of "exercising fiduciary powers similar to those permitted to national banks." 1 *41 Petitioner's operations in the fiduciary field consisted of acting as trustee under certificates of beneficial interest covering mortgages held by it for the benefit of its stockholders and their children and grandchildren, and of collecting and transmitting payments of principal and interest thereunder. During the tax year there were 15 such mortgages totaling $ 300,000, on which about 50 collections aggregating some $ 90,000 were made. It is stipulated that petitioner rendered no bill and received no income for these services. Even if it was contemplated that petitioner was eventually to be paid for these activities, a conclusion which the record by no means demonstrates, 2 its conduct of the mortgage operations, restricted and informal as they evidently were, can scarcely be considered a part of its business, certainly not a "substantial" part. The pursuit of an activity for profit is indispensably associated with the concept of "business." Flint v. Stone Tracy Co., 220 U.S. 107. As was said in Chaloner v. Helvering (App. D. C.), 69 Fed. (2d) 571, "it is essential that livelihood or profit be at least one*42 of the purposes for which the employment is pursued." It is impossible to envisage a true business, conducted with the public at arm's length, being successfully operated along these lines, at least to any substantial extent, where for a period of four years, although to some undisclosed degree theoretically collectible, fees were neither billed nor withheld. Only the stipulated fact that petitioner paid no salaries can account for the continuation of these practices, but that factor does nothing to substantiate the similarity to a true business. *1067 That it was not the purpose in excepting "banks" to exclude such restricted and intimate family ventures seems apparent not only from this consideration of the legislative language, but also from the purpose *43 to be served. The reason why Congress enacted the cognate exception of "banks" from the operation of the undistributed surplus tax (section 104 (b)) "is succintly stated in the Report of the Committee on Ways and Means, H. R. No. 2475, 74th Cong.: '* * * This seems to be a wise public policy, since the surplus of banks must be built up for the protection of the depositors * * *'. * * * The imposition of an additional tax on the undistributed earnings of a banking institution would have been equivalent to flying in the face of the settled policy of banking authorities requiring the establishment of reserves, out of the bulk of earnings, for the safety and protection of the depositing public." Staunton Industrial Loan Corporation v. Commissioner (C. C. A., 4th Cir.), 120 Fed. (2d) 930. No such public purpose is present on these facts, and the conclusion seems to be required that petitioner, not being a bank within the meaning of the defining section, was during the period in issue a personal holding company. This determination necessitates disposition of the remaining questions. The first is whether petitioner's sale of city of Miami certificates*44 of indebtedness received in lieu of interest in connection with a refunding of that city's obligations represented the realization of tax-exempt interest on such obligations or taxable capital gain to the extent of the difference between their fair market value when acquired and the sale price. That petitioner collected the proceeds of these securities by sale rather than awaiting their maturity must be treated as entirely fortuitous. Collection from the purchaser upon a transfer of tax-exempt interest does not deprive the receipt of its original character. I. T. 1337, I-1 C. B. 29. See H. Gates Lloyd, 4 T. C. 829, 838; affd. (C. C. A., 3d Cir.), 154 Fed. (2d) 643; certiorari denied, 329 U.S. 717. Yet we think respondent would never have sought to tax the proceeds of these certificates had they been held to maturity and surrendered for payment by the municipality. So much was, indeed, conceded by respondent's counsel at the hearing: "Well, if the petitioner had held these two percent certificates until maturity and were paid the interest by the corporation that would have been tax-exempt interest*45 * * *." It is stipulated that all of the certificates in controversy were issued either "To evidence the past due interest on" the municipality's original securities or "to evidence the uncancelled semi-annual interest" on the new refunding bonds issued in exchange. All of this interest, if received in cash, would have been tax exempt. That it was *1068 actually collected through subsequent disposition of an obligation intended merely to represent it seems to us ineffectual to alter the fundamental nature of the income. To this extent the deficiency is disapproved. On the penalty issue no evidence whatever was introduced. We know that petitioner failed to file a personal holding company return, but there is no testimony and no record to tell us why this statutory requirement was omitted. Petitioner's sole contention on the subject is that it obviously was of the opinion that it was not a personal holding company because it answered "no" to that question on the income tax return; and that the arguable nature of its liability as a personal holding company made this opinion reasonable. This is said to be the "reasonable cause" for failing to file a return which the penalty*46 section describes, and to demonstrate that there was no "willful neglect." Were we to accept this reasoning and eliminate the penalty, it would mean that whenever a taxpayer stated on its income tax return that it was not a personal holding company, and its liability as a personal holding company was not entirely clear, no penalty would attach, regardless of what steps the taxpayer had taken to investigate the question and of the actual state of mind of the taxpayer or its responsible officers, and irrespective of whether the information called for was otherwise available to respondent, and, indeed, of the taxpayer's motives or good faith in withholding it. We know of no case which can be said to have gone to any such lengths. The present petitioner does not seem to us to have sustained its burden of showing, as the statute requires, that the failure to file the personal holding company return was due to reasonable cause and not to willful neglect. We think the penalty was properly imposed. Decision will be entered under Rule 50. JOHNSON; ARUNDELL Johnson, J., dissenting: Provisions of the Internal Revenue Code imposing a surtax on undistributed income of personal holding*47 companies are penal in character, and for this reason should be strictly construed, Knight Newspapers v. Commissioner (C. C. A., 6th Cir.), 143 Fed. (2d) 1007; Pembroke Realty & Securities Corporation v. Commissioner (C. C. A., 2d Cir.), 122 Fed. (2d) 252. Under Florida law petitioner was organized and operated as a bank and falls literally within the definition of a bank contained in section 104 (a), Internal Revenue Code. By section 501 (b) the term "personal holding company" does not include "(2) A bank as defined in section 104." In the majority's opinion, nonetheless, petitioner is classed as a personal holding company because it failed to collect fees for its services and because *1069 the Congress' expressed purpose in excepting banks from personal holding company classification would not apparently be furthered by excepting petitioner. These reasons, in my opinion, impute to the quoted sections limitations which Congress did not enact and which a court may not judicially add. Believing that petitioner was not a personal holding company, I dissent a fortiori from the majority's approval of the *48 imposition of a penalty for failure to file a personal holding company tax return. Petitioner's obligation to do so was at best doubtful; apparently it had not filed any in prior years and the Commissioner had not required it to do so, and, while state law is not determinative of classification under the Federal revenue acts, petitioner's status as a supervised Florida bank lent plausible color to an honest belief that it fell within the specific exception of section 501 (b) (2). Failure to file under such circumstances was due in my opinion to "reasonable cause," not to "willful neglect." I do not agree that elimination of the penalty here would require elimination of the penalty in all cases where classification "was not entirely clear," as stated by the majority. This Court can decide whether doubts were reasonable on the facts established in each case presented. Arundell, J., dissenting: I would not under the facts as they appear in this case impose a penalty. Footnotes 1. Federal Reserve Act, 12 U. S. C., § 248 (k): "(k) Permitting national banks to act as trustees, etc. To grant by special permit to national banks applying therefor, when not in contravention of State or local law, the right to act as trustee, executor, administrator, registrar of stocks and bonds, guardian of estates, assignee, receiver, committee of estates of lunatics, or in any other fiduciary capacity in which State banks, trust companies, or other corporations which come into competition with national banks are permitted to act under the laws of the State in which the national bank is located. * * * * "In passing upon applications for permission to exercise the powers enumerated in this subsection, the Federal Reserve Board may take into consideration the amount of capital and surplus of the applying bank, whether or not such capital and surplus is sufficient under the circumstances of the case, the needs of the community to be served, and any other facts and circumstances that seem to it proper, and may grant or refuse the application accordingly: * * *"↩ 2. In an undisclosed portion of the "Trust Agreements," it was provided that "The reasonable fees and expenses of the trustee shall be paid" and that "the amount thereof may be withheld * * * from any moneys * * * collected." This was apparently never done.↩