McCoy-Garten Realty Co. v. Commissioner

MCCOY-GARTEN REALTY CO., PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT. McCoy-Garten Realty Co. v. Commissioner Docket No. 13675. United States Board of Tax Appeals 14 B.T.A. 853; 1928 BTA LEXIS 2896; December 20, 1928, Promulgated *2896 1. On the facts in the case, a certain instrument issued by the petitioner and denominated a certificate of preferred stock, held to be stock and not a certificate of indebtedness. 2. Held, that quarterly payments made in accordance with the terms of such stock, were dividends and do not constitute allowable deductions in computing net income. 3. Held, that the discount on the sale of said preferred stock can not be amortized over the life of the issue. Albert H. Winter, C.P.A., for the petitioner. James A. O'Callaghan, Esq., for the respondent. SIEFKIN *853 This is a proceeding for the redetermination of a deficiency in income and profits taxes of $1,401.59 for the period May 14, 1920, to December 31, 1920, and the year 1921. The deficiency results from the respondent's disallowance of deductions of $5,600 and $11,200 taken for the respective years by the petitioner in its returns as representing interest paid on its so-called cumulative preferred stock, and from the disallowance of deductions of $800 and $1,440 taken by the petitioner for the respective years as representing aliquot portions of the discount incurred*2897 upon the sale of the so-called preferred stock, allocated over the period within which said stock was redeemed. FINDINGS OF FACT. The petitioner is an Indiana corporation with its principal office at Indianapolis. It was organized in May, 1920. In the spring of 1920 Henry J. McCoy and Walter C. Garten conceived the idea of constructing a building on certain lots that they owned in Indianapolis, and which were known as 221-225 West South Street. They conferred with J. F. Wild & Co. concerning the financing of the construction of the building. J. F. Wild & Co. consented to furnish a part of the funds necessary for the construction of the building, on certain conditions which are set out in the following instrument: THIS AGREEMENT, made and entered into this 14th day of May, 1920, by and between Henry J. McCoy and Walter C. Garten, parties of the first part, and J. F. Wild & Co., party of the second part, WITNESSETH: WHEREAS, the parties of the first part are the owners of Lots six (6) and Seven (7) in Terry & Robinson's Subdivision of Out Lot Thirteen (13) in the City of Indianapolis, Marion County, Indiana, being the premises known as 221-225 West South Street, and upon*2898 which they desire to erect a six story reinforced concrete building for rental purposes, the cost of which building will *854 be in excess of $200,000, and they desire the assistance of the second party in financing the cost of such building, which assistance the second party is willing to furnish on certain terms and conditions: NOW, THEREFORE, THIS AGREEMENT WITNESSETH: 1. The first parties shall cause to be organized under the laws of the State of Indiana, a company known as McCoy-Garten Realty Company, with a capital stock of $240,000, of which, $160,000 shall be preferred stock and $80,000 shall be common stock. Such preferred stock shall bear dividends at the rate of seven per cent per annum, payable quarterly from June 1st, 1920, and shall be redeemed $25,000 annually for five years, beginning December 1st, 1921, and the remaining $35,000 December 1st, 1926, with the option to retire any of such stock at any dividend paying date at 102 per cent of par, plus accumulated dividends. Such preferred stock shall be substantially in the form of Exhibit A. hereto attached. 2. The first parties shall convey said real estate to the said Realty Company and shall submit*2899 abstract of title showing good title in said Realty Company free of all encumbrances other than taxes, not delinquent. The first parties shall also furnish all funds necessary to fully complete said building and pay the carrying charges of the company until the completion thereof, and in consideration of such real estate and of the furnishing of such additional funds necessary to complete said building, shall receive as fully paid and nonassessable, and of the common stock of the company, except the three shares subscribed for by the incorporators. 3. The first parties shall individually, in a form to be approved by the second party, guarantee the payment of all dividends upon said preferred stock and the retirement of the principal thereof at the times provided therefor. 4. So long as any of the preferred stock of said Realty Company is outstanding, it shall: (a) Not convey or encumber said real estate without the consent of all its preferred stockholders. (b) Not increase the amount of its preferred stock. (c) Pay no salaries to its officers and pay no dividends upon its common stock until all preferred stock dividends and the principal of the preferred stock due*2900 for retirement within the next twelve months have first been provided for. (d) Carry insurance against loss by fire to the amount of not less than 80% of the insurable value of the improvements upon said real estate, and also a reasonable amount of tornado and general liability insurance; all to be placed through the second party. (e) Employ the second party as Registrar of its preferred stock and pay it for such services 25 cents for each certificate registered, after the original issue; and also as fiscal agent in the making of disbursements on account of dividends and payments of principal to its preferred stockholders, and pay it for such services a fee of one-fourth of one per cent on the amount disbursed. (f) To maintain its sole banking account in the City of Indianapolis with the second party, on condition that second party shall allow interest at the rate of 3% on daily balances. 5. The first parties agree, so long as any of said preferred stock is outstanding, that they will: (a) Maintain upon the Board of Directors of said Realty Company, a representative of the second party. (b) Execute and maintain an irrevocable proxy to a representative of the second*2901 party, authorizing such representative to vote a majority of the common stock of said Realty Company in event that and so long as said Realty Company*855 may be in default in the performance of its obligations to its preferred stockholders as set out in the preferred stock certificates. (c) Maintain the sole banking account of McCoy & Garten, a partnership, in the City of Indianapolis, with the second party upon condition that the second party shall allow interest at the rate of three per cent per annum on daily balances. 6. Promptly on its incorporation, said Realty Company will accept all of the provisions of this agreement so far as they relate to it. 7. The first parties, or said Realty Company, shall pay all expenses in connection with the issuance of said preferred stock, and reasonable charges of attorneys for the second party in connection with this agreement and the carrying out of the provisions hereof. * * * 9. Subject to the compliance by the first parties, and by said Realty Company with all the terms and conditions of this agreement, the second party agrees to purchase all of said preferred stock at 95% of the par value thereof and to place the*2902 same to the credit of said Realty Company upon the first day of June, 1920; provided said stock certificates are ready for delivery and are delivered to it at or before such date. The proceeds of the purchase of such stock shall be placed on special deposit to the credit of said Realty Company to be checked out only on the signature of some officer thereof, with the counter-signature of a representative of the second party, and to be checked out for the sole purpose of paying architect's estimates in connection with the construction of such building, and provided that in the payment of any such estimates the first parties shall pay on account of each estimate such proportionate part thereof as the cost of said building over and above the proceeds of the sale of the preferred stock bears to the total cost thereof; this to the end that the funds contributed by them on account of the purchase of the common stock may be paid in and used from time to time as the proceeds of the preferred stock are paid and upon the completion of said building, the entire cost thereof shall have been paid from the proceeds of the sale of the preferred stock and the proceeds of the sale of the common stock*2903 and the company be freed of all indebtedness whatsoever. Exhibit A referred to in the foregoing instrument, and which was the form of the so-called preferred stock certificate, was as follows: MCCOY-GARTEN REALTY COMPANY, INDIANAPOLIS, INDIANA. COMMON STOCK $80,000. PREFERRED STOCK $160,000. This certifies that is the holder of , fully paid and nonassessable shares of the par value of $100 each of the McCoy-Garten Realty Company, Transferable only on the books of the company in person or by attorney on the surrender of this certificate. The holder hereof shall be entitled to receive a quarterly dividend of 1 3/4 percent upon the face value hereof, payable on the first day of March, June, September and December (the first dividend being payable September 1st, 1920), before any dividend shall be paid or set aside for the benefit of the holders of the common stock, and such dividend shall be cumulative. In the event of the liquidation of the company the holder hereof shall be entitled to receive the par value of the shares represented hereby, plus all arrearages of dividends, before anything whatever shall be paid on account of the common stock and shall not participate*2904 further in the liquidation. *856 The company will redeem the shares of stock represented by this certificate at the par value thereof, plus all arrearages of dividends, on the first day of December, 192 , and it may at its option, redeem the same at any dividend date before the date fixed for the redemption thereof at 102 per cent of par, plus all arrearages of dividends, upon giving thirty days prior written notice to the registered holder hereof. Any stock so redeemed shall be selected by the Registrar from the stock having the latest fixed dates of redemption. The Company agrees that it will not convey or encumber its property known as Lots Six (6) and Seven (7) in Terry & Robinson's Subdivision of Out Lot Thirteen (13) in the City of Indianapolis, without the written consent of the holders of all of its preferred stock, and that so long as any of its preferred stock remains outstanding it will carry insurance against loss by fire upon the improvements upon said property in an amount to at least 80 per cent of the insurable value thereof. If the Company shall fail to keep and observe all of the provisions hereof, or if it incur indebtedness in excess of $2,000, *2905 other than for taxes not delinquent, after the completion of the new improvements about to be erected by it, and if any default shall continue one month after notice thereof, then at the option of the holder hereof, the shares of stock represented hereby shall be immediately redeemable, and if said shares of stock be not thereupon redeemed, the holder shall be entitled to require the liquidation of the company and the application of its assets to the payment of its creditors and stockholders in the order provided by law, and in accordance with the provisions hereof. This certificate shall not be valid until registered by J. F. Wild & Co. as Registrar. The petitioner corporation was organized on May 14, 1920, and on that date adopted all the provisions of the agreement between McCoy and Garten and J. F. Wild & Co. so far as they related to it. On the same day McCoy and Garten executed the following instrument: In consideration of the purchase by J. F. Wild & Co. of all the preferred stock of the McCoy-Garten Realty Company, in which company the undersigned are the owners of all the common stock, and as an inducement to J. F. Wild & Co. to purchase said preferred stock, the*2906 undersigned do hereby, jointly and severally, guarantee the payments of the dividends on such preferred stock at the several times provided therefor, and the retirement of the principal of such preferred stock at the times provided for the retirement thereof on the face of such certificates. Upon demand of any and all holders of such preferred stock, the undersigned will pay the dividends on said preferred stock, which said company shall not have paid at the times provided therefor, and on demand of any and all holders of said preferred stock whose certificates of stock have not been redeemed at the dates provided therefor, the undersigned jointly and severally agree to take over and purchase said certificates at the par value thereof, plus all arrearages of dividends. The obligation hereby created shall not be exhausted by any recoveries had hereunder, but shall continue operative and binding for the benefit of each and every preferred stockholder so long as any of said preferred stock is outstanding. Some time in May, 1920, what was designated as preferred stock was issued in the amount of $160,000 and was bought by J. F. Wild & Co. at $95 per share according to the terms*2907 of the agreement. The *857 petitioner was thereupon given credit by J. F. Wild & Co. for $152,000. Of the 800 shares of common stock one was issued to the representative of Wild, and 399 1/2 shares were issued to each McCoy and Garten, who had transferred their lots to the corporation and who completed the payments for their stock as the construction of the building progressed. The building was completed early in 1921 and some tenants moved in in February of that year. During 1920 the petitioner's only income was from the interest on the balance of its deposit with J. F. Wild & Co., and amounted to only $2,447.43. McCoy and Garten individually advanced $5,600 to the petitioner during 1920 to make the quarterly payments on the so-called preferred stock. During 1921 the petitioner's earnings were insufficient to make the quarterly payments amounting to $11,200 on its so-called preferred stock and to retire the $25,000 par value of such stock that had to be retired in that year. McCoy died September 28, 1921, and thereafter on December 1, 1921, McCoy's estate and Garten advanced $8,098.63 to the petitioner to enable it to retire the $25,000 par value of such preferred*2908 stock and to make payment of the quarterly dividend due on that date. McCoy's estate and Garten each advanced for such purposes $7,433.19 in 1922, $4,000 in 1923, and $750 during 1924, prior to December of that year, when all of the so-called preferred stock was retired and the petitioner dissolved. While the net earnings of the building amounted to about $25,000 per year when the building was completely occupied, there were never sufficient funds to meet the quarterly payments on the so-called preferred stock and also retire the amount of such stock that was to be retired each year. When the terms for retiring the stock and the dividend rate were being agreed upon, it was known that the earnings of the building would not be sufficient to meet the payments required under the agreement and consequently McCoy and Garten were expecting to advance money to the petitioner to enable it to meet the required payments. All payments of so-called dividends and the retirement of stock were promptly made on the dates agreed upon. McCoy and Garten always considered as interest the amount paid by the petitioner as dividends on its preferred stock. In its income-tax returns for the period*2909 May 14, 1920, to December 31, 1920, and for the year 1921, the petitioner deducted as interest paid the amounts of $5,600 and $11,200, respectively, representing the quarterly payments on its so-called preferred stock. In its return for these years, it also took deductions of $800 and $1,440, respectively, as representing the proportional parts of the discount of $8,000 at which the so-called preferred stock was sold applicable to the respective years. In an audit of the returns, the respondent disallowed the foregoing deductions. *858 OPINION. SIEFKIN: The first question for consideration is whether the amounts paid to holders of the preferred stock were, in fact, dividends or were interest on borrowed money. This requires a consideration of all of the circumstances surrounding the transaction. What the parties called the instruments is persuasive but not conclusive. See ; ; *2910 . The petitioner, in support of its contention that the payments made constituted interest and in support of its position that it should be allowed certain deductions for amortization of bonded account, calls attention to the fact that by the terms of the contract of May 14, 1920, between McCoy and Garten as individuals, on the one hand, and the financial agents, on the other, the so-called dividends were paid irrespective of earnings. It is also pointed out that the corporation agreed not to encumber its property or incur indebtedness over $2,000; that the stock provides specific dividends on specific dates, and also provides specific dates for retirement of the principal; that the corporation pledged its assets toward the payment of the preferred stock and that McCoy and Garten further personally guaranteed payment. It is also said that the common stockholders knew that the earnings of the company would not be sufficient to meet the dividends and retirement of the preferred stock before the company was organized. On the other hand, the respondent points to the certificates of preferred stock themselves and to the contract*2911 of May 14, 1920, as evidencing the intent of the parties to issue stock rather than make a loan. In our opinion there is nothing in the written instruments evidencing the acts of the parties inconsistent with the holding that preferred stock was issued and that the holders of such preferred stock had claims against the assets of the corporation which were subordinate to those of creditors. The provision of the contract prohibiting encumbrances of the property above $2,000 is more easily interpreted as protection to preferred stockholders than, as suggested by the petitioner, as showing that the preferred stockholders were, in fact, creditors. As we view the transaction, the individuals, McCoy and Garten, wanted to raise the money for a building. They did not care how it was raised, but left it to the financial agents. The plan, as adopted, raised the money by the issuance of preferred stock calling for dividends on and retirement of such stock, performance being guaranteed by McCoy and Garten as individuals. The provisions of the contract, in our opinion, are not inconsistent *859 with the holding that the relation of the parties was what they said it was in their written*2912 instruments. We believe the situation is materially different from that considered in , in which the Circuit Court of Appeals for the Seventh Circuit held that the relationship of debtor and creditor existed under so-called preferred stock certificates. In that case it was evident that the taxpayer was compelled to execute a document incorrectly describing the relationship of the parties in order to avoid the Illinois usury law. That fact is not present in this proceeding. What we have said as to the nature of the obligation of the petitioner to the holders of the preferred stock compels a holding that the respondent correctly refused to permit the discount on the sale of the preferred stock to be amortized. This would be so even if the stock had a definite life which it has not because of the option given to retire the stock before December 1, 1926. See ; ; *2913 . Judgment will be entered for the respondent. TRAMMELL TRAMMELL, dissenting: The principal question for consideration is whether the amounts which were paid by the petitioner as so-called dividends were in fact dividends on stock or interest paid for the use of borrowed money. Whether these amounts were dividends or interest depends primarily on whether the transaction, which was carried out pursuant to the provisions of the various contracts set forth in the findings of fact, constituted a loan or an investment in preferred stock. While the formal transaction was between the banking firm of Wild & Co. and the petitioner corporation, a correct solution of the question can be reached only from an examination of all the surrounding facts and circumstances established by the record. In our consideration of the problem we are not confined solely to the provisions of the so-called certificate of preferred stock, nor of the contracts pursuant to which the "preferred stock" was issued. The rule that parol evidence can not be received to contradict or vary a written contract does not apply as against either party in*2914 an action between a party to the contract and a third person. ; . In , the Circuit Court of Appeals, Seventh Circuit, had before it the same issue which is presented here, and in its consideration of the question whether the transaction there involved *860 constituted a loan, only casual reference was made to the provisions of the first preferred stock certificates. The court's conclusion was rested on the evidence "aside from the form of the instrument which the parties adopted to embody their contracts". In determining questions of tax liability we have heretofore consistently adhered to the rule that, as against the Government, a taxpayer may be permitted to show, if it be a fact, that what purports to be a certificate of preferred stock is in reality an evidence of indebtedness, or that amounts paid as dividends were in fact interest. *2915 ; . Does the evidence here fairly establish that the transaction between Wild & Co. and the petitioner was a loan, notwithstanding that it was in the form of preferred stock? In my opinion it does. The facts show that in the spring of 1920, Henry J. McCoy and Walter C. Garten conceived the idea of constructing a building on certain lots which they owned in the City of Indianapolis. Not having sufficient money for the purpose, they consulted their banker with reference to the matter of financing the construction of the building. In other words, they applied for a loan. The banker consented to furnish the necessary funds on certain terms and conditions, which were thereafter embodied in the contract set out in our findings of fact, above. One of the conditions imposed by the banker was that McCoy and Garten should organize an Indiana corporation to which the lots mentioned should be conveyed, and which corporation should issue "preferred stock" in the amount of $160,000, "bearing dividends" at the rate of 7 per cent per annum. When all of the conditions precedent, as*2916 specified in the contract, had been complied with, the bank agreed to purchase the so-called preferred stock at 95 per cent of par. Under the terms of the contract, the corporation was bound to redeem $25,000 par value of this so-called preferred stock annually over a period of 5 years beginning December 1, 1921, and the balance of $35,000 on the corresponding date of the sixth year. The corporation was also bound under the contract not to incur indebtedness in excess of $2,000, while any of the so-called preferred stock was outstanding, thus in effect pledging the assets of the corporation as security for payment of the so-called "dividends" and redemption of the so-called preferred stock. In addition, the banker required McCoy and Garten personally to guarantee payment of the so-called "dividends" and to agree to purchase at par any amount of the so-called preferred stock not redeemed by the corporation in accordance with the contract. The so-called preferred stock certificates also provided that if the terms thereof were not complied with the stockholder would have the right to require the immediate liquidation of the corporation and the application of its assets to the payment*2917 *861 of creditors and stockholders in accordance with the provisions of the certificates. McCoy and Garten did not desire nor originally contemplate the organization of a corporation to construct and operate the proposed building. This was solely a condition imposed by the banker. The record further indicates plainly that the whole scheme, composed of the terms and conditions imposed in the contract, was conceived by the banker for the purpose of better securing the repayment of the money furnished by the bank, together with the so-called dividends and the other items, which amounted in effect only to interest or compensation for the use of the money. Certainly, there is nothing in the record to indicate that the bank purchased or at any time regarded itself as the owner of any interest in the assets and affairs of the corporation beyond the securing of compliance with the contract under which it furnished the money. A significant circumstance in support of these conclusions is the fact that in 1924, when the remainder of the so-called preferred stock outstanding was redeemed, the corporation was thereupon promptly dissolved. Also, in each year it was necessary for*2918 McCoy and Garten to pay out of their own funds, under the terms of their agreement, a substantial portion of the so-called "dividends" or amounts required to redeem the so-called preferred stock. Both in the contract and in the alleged certificate of preferred stock, reference was made to the payment of "dividends." Yet it was known, at the time of the negotiations which lead to the execution of the contract, that the corporation would not have sufficient earnings in 1920, or at any time prior to completion of the building, out of which the required "dividends" could be paid, and that it could not reasonably be expected that the corporation would ever have sufficient earnings to enable it to pay the "dividends" and redeem the so-called preferred stock as required by the contract. On this point, Garten testified: * * * When we fixed the retirement of this stock and the amount of interest we had to pay, we knew that the earnings of the building would not pay it and we expected to pay it out of our individual funds. Q. You were expecting to have to advance money to the company to pay it? A. Yes. Q. So that in no year, during the existence of this company, were the earnings*2919 sufficient to meet the interest and retirement of the stock as had been agreed? A. No, sir. * * * It appears that McCoy and Garten always considered the matter as a loan, and that the so-called "dividends" were consistently treated as interest payments. I am unable to find anything in the record which convinces me that Wild & Co. invested its money in the building enterprise, or assumed any risk in connection therewith. On the contrary, the evidence *862 indicates that the bank took every precaution to secure the repayment of the money furnished by it, together with compensation for the use of that money. In , the court in the course of its opinion, said: All the witnesses who testified before the Board of Tax Appeals described the transaction as a loan and stated that the parties made use of the so-called first preferred stock as a mere expedient to circumvent the force and effect of the usury laws. There are two primary questions the answers to which are decisive of this appeal: First, does the evidence show the transaction between Austin and the Jones Syndicate to be a loan? Second, should the*2920 taxpayer be permitted to assert that Austin was a creditor rather than a certificate holder in the syndicate? The first question must be answered in the affirmative. Aside from the form of the instrument which the parties adopted to embody their contract, there is no evidence to contradict the asserted relationship of debtor and creditor. * * * Should the court, as against the government, permit the borrower to disclose what it has in writing disputed in order that it might avoid its tax? This is the second question. * * * But the better reasoning sustains the view that a borrower whose necessities lead him to the door of the usurer may always show - by evidence aliunde the contract - the real character of the transaction. The very necessities of the borrower who pays a usurious rate of interest make it necessary for courts to admit his oral testimony to dispute his written word. * * * for an additional reason such evidence is admissible against third parties. * * * We therefore conclude that a taxpayer who borrows money at a usurious rate of interest and who, to conceal the usury, is compelled to execute a document which does not correctly disclose the relationship*2921 of the parties, may, as against the government, disclose the true relationship of debtor and creditor. Sums by it paid as interest, regardless of the name by which it is called, may be deducted by the taxpayer from its income. In the instant case, we are not advised why the bank required McCoy and Garten to enter into the particular contract in question, and imposed the terms and conditions specified as a prerequisite to furnishing the money. Whether it was to avoid the possible effect of a usury statute, or for some reason other than better to secure the repayment of the money, with compensation for its use, the record does not affirmatively show. It does, however, affirmatively appear that the "interest" and other charges, including the discount exceeded the legal rate of interest in Indiana, and it may well be that this was one reason which induced the bank to require the transaction to take this form. However, upon consideration of all the evidence, it is my opinion that the transaction with Wild & Co. constituted a loan, and that the amounts paid as so-called dividends were in fact interest, which may be deducted by the petitioner from its income.